Ethical Issues of Subprime Loans

Resulting from high unemployment, inflation, and interest rates in the mid 1980’s leading to the third recession since 1973, consumer loan markets were closed as few consumers were able to pay the interest charged on mortgage loans. Loans were converted from fixed rate loans to adjustable rate lending products during the 1980’s to mitigate the risk of rising interest rates. This shifted the risk to the borrower instead of the lender (Hellwig, 2009). The Federal Reserve’s policy to lower interest rates, coupled with decreases in household income, increases in social security, disability and other assistance programs (Anderson, 2014) led to creative lending practices by banks and other lending institutions. Subprime loans, one of the new forms of consumer lending, enticed consumers with little or no credit and customers with low income.

Subprime Loans

The American dream is epitomized by the ability to own a home and accumulate wealth. Subprime loans are those which require very low or no down payment. Down payments could be made by securing a second loan which would eliminate the mortgage insurance requirement by the FHA (Federal Housing Administration) to allow the lower investment. Due to the recessions of the 1990’s, the housing market was stagnant and subprime lending increased by 410% between 1995 and 2003. These provided consumers with low income and poor credit the ability to achieve their dream. The Tax Reform Act (TRA) of 1986 led to the popularity of the subprime lending mortgage because it disallowed income tax deductions for consumer loans not secured by real property. Consumers seeking to pay down the interest charges on non-deductible loans and credit cards, turned to low interest mortgages to cash-out the equity in their homes (Chomsisengphet & Pennington-Cross, 2006).

After 1995, the mortgage backed loans became attractive to investors as housing prices increased and rates were lowered. Consumers were easily able to take the equity on their homes at very low costs. As the prime market for mortgages dropped due to high rates and regulations, bankers, brokers and mortgage companies sought lending vehicles through the sub-prime markets to maintain their volume of lending. The loans were usually originated through non-depository financing companies (Chomsisengphet & Pennington-Cross, 2006).

In essence subprime mortgage lending and its failure can be summarized into five parts. First, consumers with low or no verifiable income and poor credit scores were qualified and given loans for mortgages they could not afford. Second, the initial rate on the loans were low in order to qualify the borrower. Third, the loans were packaged into pools and sold to investors. Fourth, the investors were unable to truly gauge the risks involved in the pools as the loans included in the pools were labeled by risk into different groups. Lastly, the debt pools were held by banks and transferred to special purpose entities and maintained off the institutions financial statements (Muller-Kahle & Lewellyn, 2011).

Risks of Subprime Lending

The risks associated with the subprime lending market were widespread and could be attributed to failures by all involved in the lending practices, as well as the consumers who applied for and did not fully understand.

Risks to Lenders

The lending policies and lax credit standards, subpar underwriting policies and procedures, and the regulatory structure of the banking industry during the subprime mortgage boom led to high delinquency and foreclosures, which were the major risks to lenders and investors in the subprime mortgage market (Nguyen & Pontell, 2010). Losses resulting from the crisis have led to the closure, takeover, or re-funding of some large financial institutions in the US and abroad (Hellwig, 2009).

Risks to Investors

In order to further lessen risks, mortgage backed securities (MBS) were often pooled by the originating lender and sold to investors. These products were often guaranteed by Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) which guaranteed payments to investors. As both FHLMC and FNMA began as government agencies, although privatized, investors believed that the US government continued to back the guarantees each offered.

Risks to Homeowners

The risk to homeowners caused by the subprime mortgage market was the loss of the American Dream and their investment in their primary homestead. High interest rates, loss of credit and foreclosure on their home coupled with decreasing value of their home made refinancing impossible for homeowners. The Truth in Lending Act (TILA) of 1968 initially was intended to provide information on loans to consumers. However, during the sub-prime mortgage booms, lenders used the information to conceal the affordability of the loans being given (Sovern, 2010).

Risks to Taxpayers

The risk to taxpayers resulting from the bailout of the banks, insurance companies, FNMA and FRMC helped to fuel anger and resentment at the policies of the Clinton and Bush administrations which rewarded the unethical behavior of Wall Street giants (Watkins, 2011) and leaving them unscathed. In essence, the bailout by the US Government allowed these institutions to continue in operation, providing large salaries and bonuses to executives, and burdening the American taxpayer.

The Role of Leadership Decision Making

Resulting from the subprime lending and the ensuing crisis in the US financial market, the SEC has questioned leaders of many financial institutions regarding their imprudent decision making (Thiel, Bagdasarov, Harkrider, Johnson, & Mumford, 2012). The market for subprime loans tempted many institutions because the loans were easily pooled and sold to unsuspecting investors. Leaders of these organizations believed that the main objective of the corporate entity was to generate profit and build wealth for its stakeholders (Watkins, 2011).

Thiel, Bagdasarov, et.al. (2012) argue that even when ethical codes are in place within an organization there is no guarantee of ethical practices by managers and leaders within the company. The objectivity of a leader within an organization was clouded by the idea of higher income and bonuses which resulted from the higher yields on loans issued during the subprime mortgage boom (Lewellyn & Muller-Kahle, 2012). Recent studies by Anderson and Galinsky (2006) provide that a higher sense of power is directly correlated to optimistic views of potential losses and a leader’s inclination to take more risks.

The perception of CEO’s within financial institutions during the economic crisis was focused on the gains and not on the consequences related to decisions they made. They were fully confident in their abilities and the outcomes of their decisions and, therefore, a cycle of riskier behavior was created (Lewellyn & Muller-Kahle, 2012).

Social Responsibility

The continued funding of subprime mortgages led to the demise of several lenders, high foreclosure, and fraudulent

behavior on the part of mortgage bankers (Nguyen & Pontell, 2010). The government has a responsibility to equally provide for low income and minorities to attain the American dream. The establishment of FNMA and FRMC were steps taken to meet their responsibility. However, the lack of governance, regulations, and accountability during the subprime crisis led to a clear default on the government’s part in meeting their obligations.

The too big to fail banking institution was less likely to be concerned with the impact of its decisions on the communities served and society at large. However, smaller banks, which are dependent on the support of its community stakeholders, were more careful and more likely to be conscious of its need to be socially responsible. Banks have lowered fees and provided more services to lower income areas (Cornett, Erhemjamts, & Tehranian, 2016).

Measures Taken

After the homeownership crisis in the US, the government took several steps to limit foreclosures and provided assistance to homeowners in modifying their loans and stay in their homes. Lending regulations were implemented and tightened, the Dodd-Frank act was enacted to guide consumers, investors and others work together with financial institutions with minimal risks. It regulated the financial markets and assigned agencies to protect consumers against fraudulent behavior by bankers and other lenders (Schafer, Schnabel, & Weder di Mauro, 2016).

The Wall Street Reform and Consumer Protection Act of 2010 led to closer oversight of commercial banking institutions. Banks have begun to engage in more community related socially responsible activities and the adoption of new practices with social responsibility at the forefront. The banking business model has begun to shift towards avoiding negative perceptions by placing more emphasis on actions instead of slogans (Paulet, Parnaudeau, & Relano, 2015).

Conclusion

The subprime mortgage crisis resulted from a vacuum created by relaxed policies of the Clinton and Bush administrations, lack of oversight of FNMA and FRMC, lack of ethics of corporate leaders in the Wall Street financial institutions, and lack of education by consumers. In effect, the high yielding loans and the profits they generated led corporate CEO’s and their management teams to make unethical decisions based on their self-interests.

References

Anderson, C., & Galinsky, A. D. (2006, July). Power, optimism and risk-taking. European Journal of Social Psychology, 36(4), 511-536. http://dx.doi.org/10.1002/ejsp.324

Anderson, M. H. (2014). The problem, its demographics, and proposals for change: an Economic perspective on subprime lending. Paper presented at the Fringe Economy Lending, Chicago, IL. Abstract retrieved from https://www-lexisnexis-com.proxy1.ncu.edu/hottopics/lnacademic/Default.asp?shr=t&csi=7421&sr=TITLE(%22I%20FRINGE%20ECONOMY%20LENDING%20-%20THE%20PROBLEM%20ITS%20DEMOGRAPHICS%20PROPOSALS%20FOR%20CHANGE%20AN%20ECONOMIC%20PERSPECTIVE%20ON%20SUBPRIME%20LENDING%22)%20and%20date%20is%202014

Chomsisengphet, S., & Pennington-Cross, A. (2006, January/February). The evolution of the subprime mortgage market. Federal Reserve Bank of St. Louis Review, 88(1), 31-56. Retrieved from http://epublications.marquette.edu/cgi/viewcontent.cgi?article=1052&context=fin_fac

Cornett, M. M., Erhemjamts, O., & Tehranian, H. (2016). Greed or good deeds: An examination of the relation betwen corporate social responsibility and the financial performance of US commercial banks around the financial crisis. Journal of Banking and Finance, 70, 137-159. http://dx.doi.org/10.1016/j.jbankfin.2016.04.024

Hellwig, M. F. (2009, June). Systemic risk in the financial sector: an Analysis of the subprime-mortgage financial crisis. De Economist, 157(2), 129-207. http://dx.doi.org/10.1007/s10645-009-9110-0

Lewellyn, K. B., & Muller-Kahle, M. I. (2012, May). CEO Power and risk taking: Evidence from the subprime lending industry. Corporate Governance: An International Review, 20(3), 289-307. http://dx.doi.org/10.1111/j.1467-8683.2011.00903.x

Muller-Kahle, M. I., & Lewellyn, K. B. (2011). Did board configuration matter? The case of US subprime lenders. Corporate Governance: An International Review, 19(5), 405-417. http://dx.doi.org/10.1111/j.1467-8683.2011.00871.x

Nguyen, T. H., & Pontell, H. N. (2010). Mortgage origination fraud and the global economic crisis. Criminology and Public Policy, 9(3), 591-612. http://dx.doi.org/10.1111/j.1745-9133.2010.00653.x

Paulet, E., Parnaudeau, M., & Relano, F. (2015). Banking with ethics: Strategic moves and structural changes of the banking industry in the aftermath of the subprime mortgage crisis. Journal of Business Ethics, 131(1), 199-207. http://dx.doi.org/10.1007/s10551-014-2274-9

Schafer, A., Schnabel, I., & Weder di Mauro, B. (2016). Financial sector reform after the subprime crisis: Has anything happened? Review of Finance, 20(1), 77-125. http://dx.doi.org/10.1093/rof/rfu055

Sovern, J. (2010). Preventing future economic crises through consumer protection law or how the truth in lending act failed the subprime borrowers. Ohio State Law Journal, 71(4), 761-844. Retrieved from http://eds.a.ebscohost.com.proxy1.ncu.edu/eds/detail/detail?vid=5&sid=82ee3cee-8285-49c1-a8e6-93105ad1ad83%40sessionmgr4010&bdata=JnNpdGU9ZWRzLWxpdmU%3d#AN=502144643&db=ofs

Thiel, C. E., Bagdasarov, Z., Harkrider, L., Johnson, J. F., & Mumford, M. D. (2012, April 4). Leader ethical decision making in organizations: Strategies for sensemaking. Journal of Business Ethics, 107(1), 49-64. http://dx.doi.org/10.1007/s10551-012-1299-1

Watkins, J. P. (2011, June). Banking ethics and the Goldman rule. Journal of Economic Issues, XLV(2), 363-372. http://dx.doi.org/10.2753/JEI0021-3624450213