Subprime Lending Blog

This is the post excerpt.

subprime lending

This blog will briefly address ethical issues regarding subprime loans. As noted in the figure above,  banks make prime loans to its favorite customers at low-interest rates.  However,  it can also make loans to subprime lenders who assume the risk and lend to subprime borrowers at high interest rates.  In this scenario, the subprime lender may be able to make a huge profit based on the difference between its costs and the money it collects from the subprime borrower.   The profit motive is supported by Milton Friedman (1970)  who wrote that “the social responsibility of business is to increase its profits”.  However, a problem arises when these risky subprime loans go into default, and if too many of these subprime loans follow suit, it can become a crisis.  Consequently, McDowell (2010) noted that the crisis became apparent in 2007 when there was a significant rise in mortgage delinquencies and foreclosures in the United States that had a significant adverse impact on financial markets and banks around the world.

This blog will initially expand on the concept of subprime loans and the risks to lenders and borrowers. The role leadership played as part of the financial crisis that ensured will be addressed. Also, the concept of social responsibility will be covered from the standpoint of subprime loans. Finally, the blog will address what measures have been taken by government and other institutions to ensure that it will never happened again.



The Role of Leadership During the Subprime Loan Crisis

The U.S. financial market towards the end of the 2010s entered a period of unprecedented instability where the estimated losses due to subprime mortgages were between $400 billion and $500 billion (Mamatzakis & Bermpei, 2015). The reasons for the subprime lending crisis can be at least partly traced to decisions made by individual mortgage brokers and lending officers. These individuals had moral or ethical responsibilities because of their positions, but the profit motive appeared to outweigh these responsibilities.

An analysis of the rights and duties approach to ethics by Gilbert (2011) showed that:

Some of these individuals failed in their moral duties and that their failure is partly to       blame for the resulting harmful consequences; and

Some mortgage lenders automated the process to the degree that approval to grant an individual loan was computerized.

However, without the human element, this process could lead to problems.  If all the criteria set by the lender were met, human review was not required, and computer approval followed.  However, some individual person or committee of individuals still set the criteria.

Morever, Mamatzakis & Bermpei (2015) found that:

The board size asserts a negative effect on performance consistent with the ‘agency            cost’ hypothesis, particularly for banks with board size higher than ten members.              However, CEO power asserts a positive effect on performance in line with the                      ‘stewardship’.  However, both groups set policy, so they are partially to blame for the          crisis.   In addition, an increase in the ownership held by the board has a negative              impact on the performance of banks below an identified ownership threshold. On              the other hand, for banks with board ownership above the threshold value this effect        proves to be positive, indicating an alignment between shareholders’ and managers’          incentives.

Furthermore, Gilbert (2011) noted that:

Policy-making decisions are usually made by managers of an organization, and the            more breadth or scope the policy has, the higher the level of manager involved in              making the decision. Policy-implementing decisions can be made by individuals at            any level, but they are often made by workers below the level of manager. Policy-              implementing decisions are more constrained by the fact that the policy has already          been determined, and the decision at hand is intended to implement specific case of         the general policy.

Consequently, because of the profit motive, leadership during the crisis was not as responsible as it should have been considering the problems it caused for the country. Also, individual mortgage brokers and lending officers were also to blame because they were acting with a profit motive.

Corporate Social Responsibility During the Crisis

Corporate social responsibility (CSR) is the moral obligation that maximizes the positive impact of the firm, while it minimizes the negative impact (Persons, 2012).  It can benefit the company, its customers, and the environment if properly executed, and in effect will impact the triple bottom line, profits, people, and the planet.  Closely related to CSR are sustainability and the Triple Bottom Line.  Persons (2012) found that relationship between these concepts are as follows:

Sustainability in general, is the ability of the organization to know, understand, and          consider all factors that impact its value and drive its ability to continue to operate            into the future.  It relies on the Triple Bottom Line concept of profits, people, and the        planet which involve not only economic and financial matters, but also                                  environmental and social views.

There were a number of options banks gave homeowners to save their properties, such as renegotiating the interest rate or terms of the loan, forgiving part of the debt, giving more time to pay arrears, or refinancing the mortgage.  In addition, having seminars or job counseling in the local community would provide potential customers with more information on which option or other data that might be best for the borrower. However, there are other options the bank could take as part of its CSR responsibilities.

Cornett, Erhemjamts, & Tehranian (2015) found that banks’ obsession with profitability was a major reason for the financial crisis, but noted the following:

Two measures of the banks’ service to society and their local communities around the       financial crisis were deposit fee revenue and presence in low income communities.           Corporate social responsibility encompasses issues associated with how banks                     provide services to customers in their local community, including charging of various       fees on deposits. Fees charged as a percent of deposits average 0.51 percent, ranging         from 0 to 3.67 percent and

CSR also encompasses the extent to which banks conduct business in low income               communities. The average percentage of deposits coming from low income                           communities is 49.19 percent.

Cornett, Erhemjamts, & Tehranian (2015)  also found that:

Despite the too-big-to-fail status of these banks, the crisis appears to have served as a         wakeup call for the banks and their stakeholders to enhance their CSR records.  The           results show that this is associated with higher bank performance.   As such another         benefit of this increased CSR is that the likelihood of another crisis is lower.


Measures Taken to Ensure the Subprime Crisis Never Happens Again

The government took several steps intended to lessen the damage of the subprime loan crisis (Duca, 2011) as follows:

One set of actions was aimed at encouraging lenders to rework payments and other           terms on troubled mortgages or to refinance “underwater” mortgages (loans                       exceeding the market value of homes) rather than aggressively seeking foreclosure.           This reduces repossessions whose subsequent sale could further depress house                   prices;

Congress also passed temporary tax credits for homebuyers that increased housing           demand and eased the fall of house prices in 2009 and 2010;

To buttress the funding of mortgages, the Congress greatly increased the maximum            size of mortgages that the Federal Housing Administration (FHA).   Because FHA                  loans allow for low down payments, the agency’s share of newly issued                                  mortgages jumped from under 10 percent to over 40 percent; and

The Federal Reserve, which lowered short-term interest rates to nearly 0 percent by           early 2009, took additional steps to lower longer-term interest rates and stimulate               economic activity (Duca, 2011).

There were three major economic stimulus packages, grossing more than $1.6 trillion in value, that were instituted within one year and yet, their impact on the economy has been slow to come (Choi, 2013) as follows:

Economic stimulus act of 2008: To stimulate the economy by giving a tax refund of             $168 billion;

Emergency economic stabilization act of 2008 or Troubled Asset Relief Program                  (TARP):  To provide $700 billion financial aids to financial institutions; and

American recovery and reinvestment act of 2009: To spend $787 billion to                             rejuvenate economy and help mortgage borrowers.

The condensation of all ideas that can solve or prevent future financial crises in the U.S. is written into law under the Wall Street Reform and Consumer Protection Act of 2010 or better known as the Dodd–Frank Act.   Among its numerous titles and subtitles that contain many important regulatory solutions for the future financial crises, the following are noteworthy (Choi, 2013):

Creation of the Financial Stability Oversight Council (FSOC), the Consumer Financial         Protection Bureau (CFPB), the Federal Insurance Office within the U.S. Treasury                 Department, the Office of Credit Ratings within the Securities and Exchange                         commission (SEC), The Council of Inspectors General on Financial Oversight, and               the Office of Housing counseling within the Department of Housing and Urban                   Development; and

New or strengthened regulations on proprietary trading, executive compensation,             and corporate governance, skin-in-the-game provision, marked-to-market                             requirement, “qualified mortgage” definition and application, corporate funeral                 plan, and hedge fund operation.

The Concept of Subprime Loans and The Risks to Lenders and Borrowers

Leading up to what later would become a crisis, in the early and mid-2000s, high-risk mortgages became available from lenders who funded mortgages by repackaging them into pools that were sold to investors (Duca, 2013).  These mortgages enabled more first-time homebuyers to obtain mortgages and home ownership rose.  Because of the low interest rates at that time, some subprime lenders chose high interest, high risk mortgages to make a profit since there was always a profit motive as part of corporate social responsibility (Friedman, 1970).   However, these mortgages came at a steep price to the buyer, such as high interest rate loans, inflated property values, and balloon payment clauses, all of which could be a precursor to default.

In February 2007, the Federal Home Loan Mortgage Corporation (Freddie Mac) announced that that it would no longer buy the subprime mortgages and mortgage-related securities.  In April 2007, there was a Chapter 11 bankruptcy filing by a leading subprime mortgage lender, New Century Financial Corporation followed by the June 2007 downgrading of many second-lien subprime mortgage bonds by the Standard and Poor’s and Moody’s Investor Services (Choi, 2013).     In addition, there were other reasons for the crisis as noted by Choi (2013) as follows:

Inadequate supervision of the credit rating agencies, such as when Moody’s and Standard and Poor’s gave a wrong stamp of approval to badly packaged securities, as well as inadequate regulatory supervision by the Securities and Exchange Commission (SEC) and state governments of mortgage insurance companies;

Home appraisers who inflated home values were not properly supervised by state governments; and

    Greed-driven, no-document mortgages issued by various mortgage companies, such as     the Countrywide Financial Corporation and Wachovia were not questioned by the             Securities and Exchange Commission (SEC) and various state governments.

The most risk for a subprime loan was clearly on the lender because if there was a default, the lender would have to absorb most of the loss until such time as the property could be resold, but there was an additional loss if the mortgage balance exceeded the market value.  Consequently, if there were too many defaults, the lender would have to file for bankruptcy or be sold.  While the borrower could simply walk away, the individual’s or family’s credit rating was ruined for 7 to 10 years.  In addition, there could be tax implications for the borrower if the loan or portion thereof was forgiven.