2.5 Particular Remarks on the Subprime Mortgage Crisis 17- insufficient effort (the investor may invest too little in the provision of ancillary
services to the firm); and - unwanted use of discretion (the investor may use discretion in an unreasonable
way, be too controlling, or act contrary to the interests of the firm otherwise).
Management of risk. There are various ways to mitigate such risks. In any case,
the firm should apply four general policies.
The first is diversification. The firm should diversify its funding sources. (a)
The entire funding of the firm should not be from one source or institution only,
and the funding contracts of the firm should never prevent the firm from turning to
other sources for necessary funding. The consent of existing shareholders, lenders
or other investors should not be a condition. (b) In addition, the firm should not
rely on just one form of funding. For example, Northern Rock (see above) had
sought to diversify its funding sources around the world. However, it relied largely
on short-term borrowing from the capital market. When the interbank market dried
up globally, Northern Rock faced a liquidity crisis.
The second is centralisation. There should be a central authority for raising fi-
nance and for the legal review of funding contracts. Without centralisation, the
risk of conflicting contracts and covenant default could be too high. The firm
should ensure that borrowing is prohibited without the prior permission of the cen-
tral authority and only on terms and conditions approved by the central authority.
The third is managing the specific risk inherent in each transaction. The firm
can manage its own risk exposure. For example, the firm can try to reduce the risk
of default by diluting the covenants that it must comply with.
The fourth is managing investors’ perceived risk for the purpose of reducing
the cost of funding. For example, the firm tends to use many kinds of credit en-
hancements (see Volume II). The equity technique and the mezzanine technique
are amongst the most important legal techniques used by firms in the context of
corporate finance.
2.5 Particular Remarks on the Subprime Mortgage Crisis...........................
The 2007 subprime mortgage crisis can help to highlight some risks related to
funding. The subprime mortgage crisis triggered a global financial crisis followed
by a global recession.
Subprime lending. Subprime lending (also called B-paper, near-prime, or sec-
ond chance lending) was the practice of making loans to borrowers who did not
qualify for the best market interest rates because of their poor credit history. Sub-
prime lending was risky for both lenders and borrowers.
There was plenty of demand. Low interest rates, increasing property values and
a low perception of risk made subprime mortgages and adjustable rate mortgages
popular in the US.
There was also plenty of supply. One of the reasons was that the Basel Accord
was designed to deal with the risk that big borrowers might default. It required