by Ezuma C Ezuma-Ngwu, CEO – Streams International November 19, 2013
The subprime market offered real estate loans to many individuals who would not have been able to obtain mortgage loans in the prime mortgage market. It produced wealth for many unethical enterprising individuals who took advantage of the various instruments in the subprime market including adjustable rate mortgage (ARM) to “flip” homes successfully while home values were steadily appreciating. The subprime lending market attracted many unethical individuals who devised many ways to increase their portfolio of loans. Watkins (2011) stated “the greater the profitable opportunities, the more likely individuals and organizations will engage in behavior without regard for the broader consequences”. How this vision and lack of a comprehensive evaluation of the moral hazard and below standard ethical disposition of our community produced a geometrical growth of the Subprime loan market; how this growth contributed inevitably to the precipitous fall of the housing market and its powerful impact on our economy and indeed the world will be examined in this article. We will also examine where the blame lies and what is being done to ensure this terrible mess that cost many of the aspiring lower income earners their life savings and disrupted many other lives immeasurably.
The concept of subprime loans and the risks they pose to the lender and borrower
The subprime loans, which are loans that are offered to applicants whose credit or income fell below the criteria for prime mortgage offerings was an unethical method to generate more loans in the market (Gilbert, 2011, p. 89). These subprime loans brought out the most aggressive brokers increasingly lacking moral character in a booming industry. On the other hand, many consumers who could not obtain a prime mortgage saw this as an opportunity to actualize their dream of owning a home early (Engel, McCoy, 2002). Subprime loans are by their nature riskier than prime loans and as a result, interest rates were considerably higher. Normal fixed loans, which dominated the mortgage market through the 1990s, gave way to adjustable rate mortgages (ARM), which provided a way of replacing temporarily the higher interest on loans with lower teaser rates for a few years. This loan option provided more market for the brokers, securitizers and purchasers of the securitized loan packages. In only a few years, a new underwriting method emerged where new and existing subprime loan applicant only needed to state their income. Without a verification requirement on stated income, brokers were able to increase their loan portfolio and with the pool of available loans stagnating, predatory lending became the norm (Gilbert, 2011). Some unsuspecting homeowners were encouraged to refinance out of their fixed mortgage loans into ARMs with a view to refinance when the teaser rate period was about to elapsed.
It will be a major oversight not to discuss the role of unethical and immoral behavior played in the subprime market between the late 1990s and 2008. Gilbert, 2011 stated “The subprime market increased from $120 million in 2001 and four years later to $625 billion in 2005”. At its height in 2005, only 16% of subprime mortgages were used for home purchases, majority was used for home refinancing and second mortgages” (Gilbert, 2011, p. 89). The classic definition of predatory lending is the “positive action on the part of individuals who encouraged borrowers to enter contracts that were harmful to them” (Gilbert, 2011, p. 101).
The role of leadership decision-making in the subprime loan financial crisis.
Leadership has a responsibility to manage not only profitability but sustainability of the organization. During the boom in subprime lending, leadership had a responsibility to proactively evaluate market trends and make decisions to ensure the organization takes the right path that would avoid major death traps. The subprime crisis was a death trap for many organizations such as Bear Sterns, Lehman Brothers and Countrywide. Thiel, et al. (2012) elaborated on the leader ethical decision-making (EDM) model which combines
“for trainable compensatory strategies – emotion regulation, self-reflection, forecasting and information integration”. Utilizing these four strategies, leaders will evoke sound ethical judgment, and will be able to predict the crisis earlier on in their decision making process however, not all leaders will even subscribe to the EDM model. The Goldman rule “pursue profitable opportunities regardless the effect on others” (Watkins, 2011) does arguably eliminate two of the strategies employed in the EDM model. Taken literally, the function of a good Goldman leader under the Goldman rule will not employ the emotional regulation or self-reflection strategies as described by the model. According to Watkins, the “defining characteristic of a subprime mortgage is that it is designed to essentially force a refinancing after two or three years”. The corporate leaders during the subprime loan financial crisis appeared to focus on exploring every profitable option in the subprime market to the satisfaction of their shareholders. As a consequence, they lacked the foresight and moral aptitude earlier on, either as a result of pressure from greedy stakeholders or the single minded focus on profits and did not see the crisis in the horizon until it was too late.
Some of the individuals who participated in the subprime loans knew what would happen if they were unable to refinance after the teaser rates elapsed. The lenders convinced many to obtain the loans and they would refinance in a few years however, they subsequently defaulted on their loans as rates continue to climb. Ethical responsibility seemed to have taken a back seat to these “wants” and “needs”. Both the corporations and individual homeowners blamed each other and wanted bail outs when the market collapsed. These individuals who could not afford a loan in the prime market swarmed to the subprime market for a taste of the “good life” and “American Dream” without regard to the potential consequences of a default. During the medieval times, interest bearing loans were viewed as “a sin against God, punishable by eternal damnation” (Watkins, 2011). Watkins (2011) article indicated that the Scholastics at the time viewed charging interest as taking “advantage of the needs of others”. Social responsibility assumes that we are responsible for enhancing our impact on the society. The impact of the subprime crisis showed a lack of ethical judgment on the part of lenders and borrowers alike. Unfortunately, this lack of ethical judgment was more widespread than anyone had anticipated and consequently drove a $625 billion market into a tail spin. A society that is socially responsible would have exercised restraint and realized the impact this type of lending would have on the society upon reflection and the market would not have grown from $120 million to $625 billion in only four years.
Several measures have been put in place to recover from the subprime crisis and ensure we do not find ourselves in this situation in the future.The Housing and Economic Recovery Act, 2008 was enacted to slow down the dramatic rate of foreclosures seen throughout the country by providing insurance on foreclosed mortgages, establish a new regulator in the mortgage industry, provides loans to refinance foreclosed homes, enhance mortgage disclosures and increased the national debt ceiling. During the same period, the Federal Reserve lowered interest rates charged to banks to zero in order to encourage economic growth.
The Dodd-Frank Wall Street Reform and Consumer Protection Act provided several regulations that would “create a sound foundation to grow jobs, protect consumers, rein in Wall Street and big bonuses, end bailouts and too big to fail, and prevent another financial crisis” (US Senate, 2010). This piece of legislation, if fully implemented may ensure we do not find ourselves in the “mess” again. Although,
with no leader sworn in by Congress, this legislation will establish a consumer protection agency that will ensure consumers are protected, impose new capital and leverage requirements and provide a framework for liquidating failed financial firms including establishment of rigorous standards. The legislation will create a council to identify and address risks posed by new and existing financial firms and instruments and establish transparency and accountability for exotic instruments.
- 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
- Engel, K. C., & McCoy, P. A. (2002). A tale of three markets: the law and economics of predatory lending /. Texas Law Review, 80(6), 1255-1381.
- 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
- US Senate, (2010). Brief Summary of The Dodd-Frank Wall Street Reform and Consumer Protection Acthttp://www.banking.senate.gov/public/_files/070110_Dodd_Frank_Wall_Street_Reform_comprehensive_summary_Final.pdf