Subprime loans: Social responsibility and the consequences

In this final part 3 of 3, I will discuss the social responsibility or lack thereof of subprime mortgages lenders. In previous part 1 of 3 of the blog I summarized the subprime mortgage mess and in part 2 of 3 blog I discussed the role that leadership decision making played in the subprime mortgage fiasco.

When mortgage lenders agreed to give mortgages to borrowers who could not pay back they failed to act in a social responsible manner. Gilbert (2011) argues that setting a policy that could lead to defaults and probably cause harm to both the borrower and lenders; even though the mortgage broker and the bank were compensated when the loan was funded and then sold to a securitizer is socially irresponsible. Individuals employed by a company have certain moral responsibilities borne from holding those positions and some of the decisions they have to make have ethical dimensions, ignoring this aspect is in fact a moral failing on their part (Gilbert, 2011).

According to Watkins (2011), individuals and organizations that believe in Laissez-faire polices may pursue monetary values without moderation. Furthermore, for individuals without ethical reflection there is no compromise, but a single minded pursuit of profit. Individuals and organizations will more likely engage in behavior that disregards the broader consequences, the more rewarding the opportunity is. According to Watkins (2011), this is exactly what happened with the subprime mortgage mess.

Subprime lenders did not care about for social consequences just profit. Gilbert (2011) cites an employee of one of subprime lenders as saying that the finance companies targeted blue collar workers, individuals with no college education, older folks on fixed income, foreigners who did not speak English and individuals with significant value in their homes. A borrower had her mortgaged refinanced or flipped seven time in a two year period, increasing her home equity loan by over $52000, while she receiving less than a $100 in cash. Gilbert (2001) cites a June 2008 Newsweek article that wrote how a mortgage broker in Cleveland, brokered 71 mortgages in one area during the period 2003 to 2006. All these mortgages were foreclosed in the next two years, leaving behind a blighted neighborhood, riddled by crime and lost home values.

It would not suffice here if Goldman Sachs’ (a leader in Wall Street investment banking) role in the subprime lending goes unmentioned. According to Watkins (2011), Goldman Sachs securitized the subprime mortgages and sold them to unwary investors with the willful knowledge that the investments were designed to lose value, as claimed by the Securities and Exchange Commission. Watkins (2011) refers to Goldman Sachs behavior of engaging in ethically controversial behavior as the Goldman Rule. Goldman Sachs convinced American International Group (AIG) to sell them credit default swaps, which earned Goldman a $14 billion dollar profit leaving the U.S. taxpayers with the bill.

                     What’s to stop this from happening again?

       The U.S. government bailout the financial institutions that were distressed by the financial crises when President George Bush signed the Emergency Economic stabilization Act of 2008 (Bayazitova & Shivdasani, 2012) which established the Troubled Asset Relief Program (TARP).The  Capital Purchase Program (CPP) announced later allowed U.S. financial institution to apply for preferred stock investment from the U.S. treasury. The American Recovery and Reinvestment Act of 2009, was signed by President Barack Obama and it included a number of spending measures and tax cuts to help spur economic recovery (Bayazitova & Shivdasani, 2012). Further, the U.S. congress passed House Rule (H.R.) 1586 that imposed a punitive 90% excise tax on employee bonus pay for financial institutions that received TARP funds.

According to Watkins (2011), the Basel III accord was signed in December of 2010 in Switzerland, as a measure to avoid future financial crises. The proposed regulation raises capital requirements for banks. The regulation seeks to control the ability of banks to leverage capital, the logic here being that larger capital requirements would provide greater insurance against future losses. Critics are doubtful whether the requirements are sufficient to avoid future crises. One of the criticisms for Basel III is that banks have until 2019 to comply and it does not address the issue of the too big to fail banks. Furthermore, Basel III does not constrain bank activities nor does it address their social responsibility. Finally institutional structures existing before the financial crises are left intact according to Damian and David (as cited by Watkins, 2011).Basel III was revised in January 2013 to improve the provision regarding the size, make up, and accessibility of liquidity buffers ( Kowalik, 2013).The new revision allowed financial institutions to use the liquidity buffer if needed among other changes.

References

Bayazitova, D., & Shivdasani, A. (2012). Assessing TARP. Review of Financial Studies, 25(2), 377-407.

Gilbert, J. (2011). Moral duties in business and their societal impacts: The case of the subprime lending mess. Business & Society Review (00453609), 116(1), 87-107. doi:10.1111/j.1467-8594.2011.00378.x

Kowalik, M. (2013). Basel Liquidity Regulation: Was It Improved with the 2013 Revisions? Economic Review (01612387), 65-87.

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

Watkins, J. P. (2011). Banking ethics and the Goldman rule. Journal of Economic Issues (M.E. Sharpe Inc.), 45(2), 363-372. doi:10.2753/JEI0021-3624450213

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

Poor Leadership decisions led us to the subprime loan financial crisis

In this part 2 of 3, I  critique the leadership decision making role in the subprime loan financial mess.In part 1 of 3 blog, I gave a summary of the subprime fiasco and the risks it posed to both lenders and borrowers.In part 3 of 3 blog, I will also evaluate subprime loans with the idea of social responsibility and then compare and contrast the evolving consequences for these actions. Finally I will highlight the measures that were taken after and other measures taken so as to avoid similar crises in the future.

According to Alfred Sloan, it is individuals that make decisions not organizations (Gilbert, 2011).Organizations only provide a framework, on which decisions can be made in an orderly manner. Therefore people are to blame for the subprime mortgage mess not organizations. But who specifically is culpable? According to Gilbert (2011), borrowers, mortgage brokers, lenders, securitizers, rating agencies and investors that bought unfamiliar fiduciary instruments are the possible culprits.

Policy making and implementation is done by the leaders in an organization (Gilbert, 2011).According to Gilbert (2011), individuals at any level in the organization can implement policy decisions which have already been decided on. However policy making is made at a managerial level and the higher the managerial level is in the company, the wider the scope of the policy.

The decision to offer adjustable rate mortgages (ARM) to unqualified individuals, who will likely default on the loan when the rate increases in the future, represents is an ethical issue (Gilbert, 2011).Individuals who actually set a policy, whose likely result is predictable are involved in an ethical scenario even if they do not recognize it, according to Gilbert (2011), however they are consequently responsible for the results. Thiel, Bagdsarov, Harkrider, Johnson & Mumford (2012) argue that organizations should take a proactive role in developing leaders’ sense making abilities so that they can comprehensively understand ethical quandaries and consequently make more ethical decisions.

According to Muller-Kahle & Lewellyn (2011), board of director tenure versus subprime lending specialization and board gender diversity versus subprime lending showed strong negative relationships. Moreover, they discovered a strong positive correlation between outside director preoccupation and subprime lender specialist. These factors of director tenure, board diversity and outside director preoccupation are core to corporate governance and consequently to the decision making process in an organization. Muller-Kahle and Lewellyn (2011) concluded that corporate governance played a major role in the decision to get involved in the subprime lending.

References

Gilbert, J. (2011). Moral duties in business and their societal impacts: The case of the subprime lending mess. Business & Society Review (00453609), 116(1), 87-107. doi:10.1111/j.1467-8594.2011.00378.x

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

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

What are Subprime loans and what risks do they pose to the lender and borrower?

In this part 1 of 3 , I will give a summary of the subprime fiasco.In part 2 of 3 will critique the leadership decision making role in the subprime loan financial mess.Finally in part 3 of 3 I will evaluate subprime loans with the idea of social responsibility and then compare and contrast the evolving consequences for these actions. Finally I will highlight the measures that were taken after and other measures taken so as to avoid similar crises in the future.

            An excellent outline of the subprime mortgage loan process is given by Kranacher (as cited by Muller-Kahle & Lewellyn, 2011). At the beginning, people with poor credit rating were able to acquire loans with practically no income verification. Then mortgage lenders utilized a lower tease rate to qualify borrowers so as to receive a commission. Loans were then re-bundled and sold into collateralized debt obligations (CDOs). Speculators were unable to measure the risk of these fiduciary instruments. CDOs were then bundled into loan groupings on the premise of risk level, named by credit rating agencies (CRA) as AAA to A for the best class, BBB to B for the middle class, and the riskiest were not appraised or secured by bond insurance. A significant number of CDOs were then moved to off the books special purpose vehicles (SPV) and held by Wall Street banks at a high interest rate. When the property holders with poor credit and appreciating payments started to foreclose, the worst of the CDOs were not protected and the remaining CDOs were deficiently secured by underfunded bond security, which caused enormous financial losses and dramatic collapse of many financial institutions and a worldwide financial emergency.

The breakdown of the subprime market caused the unraveling of the U.S. economy (Watkins, 2011). Investopedia defines a subprime loan as one that is tendered at a rate above prime to people who don't meet all requirements for prime rate loans (Gilbert, 2011) The U.S. Department of Housing and Urban Development, in expounding subprime lending, said the loans carry an inflated rate of interest than prime loans to indemnify for increased credit risk and one type of subprime loan is a home mortgage (Gilbert, 2011). According to the Watkins (2011), the Subprime lending mortgage market was a financial windfall for subprime lending specialists. The essential feature of a subprime mortgage was to compel the mortgagee to refinance every two or three years according to Gorton (as cited by Watkins, 2011), hence providing fees to the bank, while prepayment penalties additionally  protected creditors from efforts of homeowners to turn over their loans to obtain lower interest rates. Banks could also diversify risk, by securitizing the cash flows from mortgages. Consequently, by early 2005 major Wall Street banks were deeply submerged in the Subprime mortgage mix (Watkins, 2011).

During 2007, foreclosure proceeding begun on about 1.5 million homes in the United States. This was a 53% increase from 2000 and according to economic analysts the number of foreclosures accelerated dramatically in 2008 and 2009 (Gilbert, 2011). Subprime mortgages were less than 20 percent of all mortgages outstanding, but just over a moiety of these foreclosure initiations were on subprimes. According to Gilbert (2011) foreclosures spread to other classes of mortgages, later in the financial crisis, but the quandary originated and grew immensely colossal mainly with subprimes.

The subprime lending mess was characterized by individuals defaulting on loans, banks, and other mortgage lenders foreclosing on houses, borrowers being evicted from their homes, unkempt lawns blighting neighborhoods, and vacant house being taken over by unauthorized squatters, after they were abandoned by the borrowers and neglected by the lenders (Gilbert, 2011). Including having to write-off billion of dollars on their subprime assets, companies involved in the subprime mess had to lay-off tens of thousands of employees. Millions of people in the United States lost their homes. The fiscal instruments such as Collateralized Mortgage Obligations (CMOs) and Collateralized Debt Obligations (CDOs) that were dependent on securitized mortgages depreciated in value, and this decline substantially contributed to a freezing of credit markets, unemployment and a global economic recession                  ( Gilbert,2011).

References

Gilbert, J. (2011). Moral duties in business and their societal impacts: The case of the subprime lending mess. Business & Society Review (00453609), 116(1), 87-107. doi:10.1111/j.1467-8594.2011.00378.x

Watkins, J. P. (2011). Banking ethics and the Goldman rule. Journal of Economic Issues (M.E. Sharpe Inc.), 45(2), 363-372. doi:10.2753/JEI0021-3624450213

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