Lady D.

Apostol
Corporate governance
The system of rules, practices and processes by
which a company is directed and controlled.
It involves balancing the interests of a
company's many stakeholders.

Moral Hazard of Stock- Based Compensation

is a situation that tempts people to act
immoral or unethical ways.
 Events in the 1990’s
Top Managements of large number
companies get the idea that financial
reporting (Accounting rules and SEC
regulations) weren’t serious matters; they
undertook to pump up their stock prices by
publishing false or deceptive financial
statements.
THE SARBANES-OXLEY ACT
Three most several key areas that
contributed to the overall problem were:

 The Public Accounting Industry – Auditors

failed to ensure compliance.
 Corporate Governance – BOD failed to
control executive fraud.
 Wall Street – Reports biased in favor of
companies.
Home ownership, Mortgages and Risk

 The loan is secured by the house itself.

 If borrowers failed to make loan payments,
(default) the lender can take the house
(foreclosure).

 Mortgage qualification requires equity,

income, and good credit.
 Banks and similar financial institutions pay interest on
deposits and lend money to borrowers at high interest
rates.

 Spread – The rate difference and is how the bank pay its
expenses and earns profit.

 Two problems
 Liquidity – most of money tied up for 15-20 years as a
mortgage was slowly paid off.
 Profitability – Income were made at fixed rates, expenses
depended on short-term rates paid on deposits.
 Securitization – Mortgage is an asset to the
bank that can be sold to an investor for a
lump sum that recovers the bank’s cash plus
a fee for the originating the loan.
 Collateralized Debt Obligations (CDO) – The
bank sells most of its loans to an investment
bank that issues securities and bundles the
mortgage into a pool, It then securitizes the
pool by selling it to investors.
 Tranches

 Tranche A (Senior) – All of money coming in is

paid to the holders of this tranche (Lower risk).
 Tranche B – Stream is used to pay off the holders
of it until Tranche A is completely paid off.
 Tranche C (Junior) – High risk that the holder of
this tranche will not be paid
 Subprime mortgage market - Demand for
high return CDO's increased as interest fell.
 But then there weren't enough qualified
borrowers applying.
SUBPRIME TECHNIQUES AND IMPLICATIONS

Common Techniques are:

 Zero-Down Loans - borrowers have no equity to lose
reducing lender safety.
 Adjustable-Rate Mortgages (ARMs) - Payments can
increase, leading to default, initially charged at lower
rates. A very low early rate is called teaser rate.
 Negative Amortization (NegAm) Loans - also called
option ARMs, the principal increases until the rates resets
increasing payments dramatically. These loans have an
enormous default rate.
 Alt- A Loans - No Documentation - Ignorant or Dishonest
people could borrow money that they had little chance of
re
 BORROWING RATIONALE

 Predatory Lending - Making Loans to people

who clearly can't afford them.
 Flipping- buying a house for a quick profit on
price appreciation.