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
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the philosophy of integration through the lens of the subprime financial crisis
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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
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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
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Reiss, D. (2006). Subprime
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Sovern, J. (2014). Fixing consumer protection laws so borrowers
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Thiel, C., Bagdasarov, Z., Harkrider, L., Johnson, J., & Mumford,
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