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New Research Demonstrates Link between Poor Corporate Governance and Toxic Mortgages

NYU Stern and Washington University in St. Louis professors show that vertically integrated banks without corporate governance controls were the worst lenders in the 2008 crisis

Claudine Gartenberg_body

Our study highlights that in integrated banks, managers have more control, which places a heavier burden on corporate governance.

In a new study, Professor Claudine Gartenberg of the NYU Stern School of Business and Professor Lamar Pierce of the Olin Business School at Washington University in St. Louis find that integrated banks – firms that both originate and then securitize a mortgage – with poor corporate governance are twice as likely to issue loans that will default compared to similar firms with strong governance.
 
“Our study highlights that in integrated banks, managers have more control, which places a heavier burden on corporate governance,” says Professor Gartenberg.  “For firms with weak governance, managers had little incentive to monitor themselves and avoid overaggressive lending and outright fraud.”  According to the authors, the worst lenders during the 2008 crisis, including Washington Mutual and New Century Financial, were both integrated and poorly governed.  “We hope that our findings can help direct regulators to put greater focus on these types of integrated firms.”
 
The authors examined a detailed database of 100,000 loans.  Key findings include:
  • For non-integrated firms, there is no difference in default likelihood between firms with strong vs. weak corporate governance.
  • For integrated firms, the probability of default is roughly twice as high in firms ranked in the bottom 10% in terms of corporate governance relative to firms ranked in the top 10%.
  • Loans from the top 10% of best-governed integrated firms were 35% less likely to default versus the average loan on the market.
  • Loans from the worst 10% governed integrated firms were 26% more likely to default versus the market.
  • Poorly monitored bank executives used their control over the integrated business to issue low-quality loans that supported short-term growth. 
The article, “Subprime Governance: Agency Costs in Vertically Integrated Banks and the 2008 Mortgage Crisis,” was recently accepted for publication in the Strategic Management Journal.
 
To speak with Professor Gartenberg, please contact her directly at cgartenb@stern.nyu.edu; or contact Carolyn Ritter, critter@stern.nyu.edu, 212-998-0624, in NYU Stern’s Office of Public Affairs, or Erika Ebsworth-Goold, Eebsworth-goold@wustl.edu, 314-935-2914, at Washington University in St. Louis.


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