Subprime Governance: Managerial Agency Costs in Vertically Integrated Banks

Abstract: This study examines how corporate governance altered the relationship between vertical integration and performance in the mortgage banking industry during the period leading to the 2007 housing crisis. Prior research has argued that the vertical integration of mortgage origination and securitization aligned divisional incentives and thus improved loan performance. We show that, consistent with theory in both organizational economics and strategy, vertical integration only improved loan performance in those banks with strong corporate governance. Detailed analysis of governance characteristics suggests that this effect is primarily explained by external monitoring by institutional investors. We interpret these findings as suggesting that the additional control afforded by vertical integration can, in the hands of poorly monitored managers, offset gains from aligned divisional incentives. These findings support the view that the effect of vertical integration depends on the specific characteristics and capabilities of firms.