The Threat of Subprime Loans

Before 2006 most people had never heard of subprime loans.  Even if you were aware of what they were, chances are that you had no idea how they were traded amongst lenders and investors, or the effect that that would have on the financial market.  Within just a few short months however, the term would be synonymous with the financial collapse in the United States, and the recession that followed.  Subprime loans not only represented a shaky financial instrument, but also highlighted numerous ethical considerations.

Subprime loans are defined as “A type of loan that is offered at a rate above prime to individuals who do not qualify for prime rate loans”, (Gilbert, 2011. pp89).  Essentially loans were offered at an increased interest rate (as a result of the increased risk), to individuals that normally would not have qualified.  While these loans were risky, and were in fact responsible for a disproportionate number of the defaults that occurred leading up to the financial collapse in 2007, this was only one aspect of the ethical breakdown that occurred.  Further complicating the loan market was what happened after the loans were issued.

The amount of subprime loans increased from $65 billion in 1997 to $625 billion in 2005 (Lewellyn & Muller-Kahle, 2012).  This explosion of debt was the direct result of how these loans were traded after the loans were issued.  In the past, lenders would hold a mortgage until its completion.  However, they realized that they could sell these loans to intermediaries.  These intermediaries then bundled many of these loans together and offered the related cash flows from the loans to investors.  While this did spread the risk wider, increased the access to capital markets, and lowered the costs associated with the transactions, it also provided improper motivation.  Due to the fact that the securities, once approved, were then sold to someone else, loan approvers had little interest in fully evaluating the reliability of the applicant.  This situation is further complicated by the fact that many of the loan managers were compensated based on sales targets (Gilbert, 2011).  

Leadership Decision-making and the Subprime Crisis

As discussed above, there were a number of contributing factors to the subprime loan crisis.  At the center of the crisis, the leaders of a number of organizations (namely Goldman Sachs, Countrywide, Ameriquest, and Indy Bank), were responsible for the core issue of lending to high risk individuals (Thiel, Bagdasarov, Harkrider, Johnson & Mumford, 2012).  The act of lending, whether conducted via an individual lending manager, by committee or automated through a computer system, remains the responsibility of the lending organization (Gilbert, 2011).  The leaders of an organization are responsible for not only setting the policies that govern the organization, but they also carry significant momentum with their actions and the communication that they undertake.  Thiel etal, (2012) hypothesized that leaders themselves were responsible for detecting the ethical dilemmas and avoiding harmful actions.

With the common practice of selling the loans to an intermediary in place, loan managers were far less concerned with details of the applicants.  There was very little risk with taking on loans that they knew were not appropriate.  In fact, Gilbert (2011) determined that many of the loan managers did little to nothing to validate the income of many of the loan applicants.  They were driven much more by garnering higher profits than acting in a manner that more ethically took the borrowers into account.  As Pontell, Black and Geis (2014) pointed out, it is common for senior leaders to overlook higher risk ventures for the mere possibility of increased profits.  It is this lack of an ethical guide that displayed the predatory lending that was taking place (Gilbert, 2011).  The actions that the organizational leaders of the subprime lenders showed an unethical environment with little consequence or concern for the costs associate with achieving the reward of higher profits (Lewellyn & Muller-Kahle, 2012). 

Social Responsibility and Outcomes of the Subprime Crisis

On the other end of the scale to the well-known Golden Rule, is the Goldman rule.  The Goldman rule states simply that an organization seeks profits at all expense, and regardless of the effect on others (Watkins, 2011).  While this mentality was in place in the financial industry leading up to the crisis, it was responsible for the market crash, and the loss of immeasurable amounts of capital.  In this case, it was the relentless pursuit of profit that directly lead to the crisis.  The subprime loan was essentially a cheat in the system.  It lured people (often blue collar working class families) with significant amounts of debt into new debt structures that had attractive initial rates, but often ultimately led to default (Brown, 2010).  The product preyed on the cash-strapped, and those with little alternatives.  

The predatory lending practice is a massive display of a lack of total social responsibility.  The entire system built around the subprime loan product was predicated on the need for underprivileged individuals, and being able to manipulate them into transactions that not only do not make sense for them, but did them outright harm.  In one of many examples, during a U.S. Senate Committee on Banking hearing, testimony was given that detailed how a woman, who owned her home free and clear, but as the result of seven refinancing transactions that netted her $100, at a cost of $52,000, lost her home (Gilbert, 2011). 

Following the financial crisis, and subsequent bailouts of those actually responsible for the disaster, things have begun to change.  The Basel agreements have been put into place as a means of avoiding such similar events in the future.  They still allow for lending institutions to take some risks, however it significantly increases the capital required to do so.  This is accomplished by better controlling the amount of leverage that the lenders can use against their capital.  It essentially adds a larger cushion to the practice of lending, so that future losses could be more easily absorbed.  However, it is particularly interesting to note that the new structure has not been proven to provide adequate protection, and more importantly, has done little to legislate the protection of the borrower in the first place (Watkins, 2011).  In 2008, and later in 2010, legislation has been implemented to further help avoid such an event from reoccurring.  The Mortgage Disclosure Act and the Dodd-Frank Act both were focused on improving the disclosure required in the application process, and ensuring that it is understood by all parties (Sovern, 2014).  

References

Brown, K. (2010). The economics and ethics of mixed communities: Exploring the philosophy of integration through the lens of the subprime financial crisis in the US. Business & Society Review 97, 35-50. doi: 10.1007/s10551-010-0494-1

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

Lewellyn, K., & Muller-Kahle, M. (2012). CEO power and risk taking: Evidence from the subprime lending industry. Corporate Governance: An International Review. 20. doi:10.1111/j.1467-8683.2011.00903.x

Pontell, H., Black, W., & Geis, G. (2014). Too big to fail, too powerful to jail? On the absence of criminal prosecutions after the 2008 financial meltdown. Crime, Law & Social Change, 61. doi:10.1007/s10611-013-9476-4

Reiss, D. (2006). Subprime standardization: How rating agencies allow predatory lending to flourish in the secondary mortgage market. Florida State University Law Review Summer. 996.

Sovern, J. (2014). Fixing consumer protection laws so borrowers understand their payment obligations. Journal of Consumer Affairs, 48. doi:10.1111/joca.12035

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. doi:10.1007/s10551-012-1299-1

Watkins, J. P. (2011). Banking ethics and the Goldman rule. Journal of Economic Issues, 45. doi:10.2753/JEI0021-3624450213