Sub Prime Mortgage Loans

Before the years immediately prior to the crisis, banks provided short-term, unsecured loans that were monitored and examined by lenders. Such loan agreements were executed in an ethical manner because the transactions were clear to the public and issued with the intent to benefit both the customer and the bank. However, over time banks realized the potential to profit from the Fed’s lowered interest rates of 2003 and 2004. The low-interest rates allowed banks greater latitudes in offering easy money to prospective homeowners and current homeowners, looking to refinance at lower rates. The availability of easy money created a rise in home prices. Subsequently, refinancing existing home mortgages grew in practice from 2000 to 2003, generating an increase from $469 million to 2.8 trillion. Bankers recognized the potential to increase revenue by making considerable returns and began to steer costumers away from the standard 30-year, fixed-rate, 20% down, prime mortgage loan. Instead, they offered adjustable- rate loans, which presented very low-interest rates during the first few years of the loan and explained rate increases were possible over the length of the loan. It is unclear how many bankers acted with good intent, believing that the housing bubble could afford the lowered interest rates since the Fed had set them so low at the time (Schoen, 2017).
Good intentions aside, it did not take long to see that bankers understood that sizeable of profits could be yielded from the adjustable-rate loans. At which point, homeowners were often not adequately informed about the considerations associated with an adjustable-rate loan. Most lenders did not properly explain the range of possible mortgage rates changes during the loan period. Many lending professionals did not view it as their responsibility to educate their clients and some may have rationalized their decisions as an altruist, in providing segments of the population with an opportunity for homeownership that may not otherwise have had the ability to obtain a traditional mortgage. Obvious today, the gray area of operational behavior exhibited by trusted lending professionals was burdened with significant ethical dilemmas from the onset. Nevertheless, at the time, the banking institutions grew in their resolve to profit and became increasingly creative beyond the offerings of adjustable-rate loans. Subsequently, banks began to underwrite the standards and focused on offering arrays of alternative subprime mortgage loans.

Compounding the future peril of the economic situation, bankers realized that securitization allowed for loans to be sold to investment companies, generating a plethora of ill-conceived and unfounded mortgage-backed securities. Securitization provided banks with the means to exclude these loans from their books and neglect the reporting of any such transactions allowing the flexibility to gain back the capital and proceed in providing more of the same, furthering the problem at exponential speed. Some will argue these practices are necessary competitive measures in a capitalist market and dispute the associated ethics. However, a basic understanding of business ethics and its role in corporate social responsibility points to a clear path toward the reasoning that these practices were shrouded in unethical choices. Considering the efforts taken to shield each institution’s long term commitment to the notes they provide and the lack of transparency associated with each maneuver, it is apparent that unethical decisions were made, which ultimately led to a substantial lack of trust in banking professionals. Clear choices were made to entice investors into the further depths of the subprime loan market. Investors believed they were investing in great opportunities, and felt confident in their financial positioning because they believed in the security of the system. Now it is evident that “many of the subprime mortgages, marketed to financially unsophisticated borrowers, were simply designed to default” (Orlowski,
n.d.). Unknowingly, investors gravitated towards mortgage-backed securities because they provided higher returns than their ordinary U.S. Treasury bond option. In essence, the perfect storm was forming in an otherwise perfectly sunny day.
There is little doubt that knowledgeable bankers should have had the foresight and ability to calculate and project the eventual impact of the risk filled practices that were employed and caused the GFC. Hindsight demonstrates that the profit they sought, by risking reputations, good sense and professional wisdom, provided them with incredible gains and allowed them to gain much leverage. “They borrowed heavily in the commercial paper and short-term ‘repo market” and became dangerously over-leveraged (Schoen, 2017). Soon after, they were very
dangerously over-leveraged. These deals were often very private which began to cause uncertainty within the banks amongst themselves. It became much harder for other banks to know how much a lender or other bank was leveraging through commercial paper and repurchasing markets. Further on, investment banks were far more successful than the retail and commercial banks because they “were not subject to the same capital requirements as commercial and retail banks. Rather, investment banks were permitted to rely on their internal risk models in determining capital requirements. This enabled them to achieve higher leverage” (Schoen, 2017). Investment banks
realized this and began to act upon it and continued to for a period of about four years, leading them to, “Reaching a 40:1 leverage means that the investment bank’s capital constituted a mere 2.5
% of its assets; the remaining 97.5 % is borrowed” (Schoen, 2017). This reality achieved by investment bankers resonated with a common underlying theme, echoing the voices that investment banking institutions made compromised unethical decisions because it benefited them and solely them. What they were unable to see or chose to ignore was that in the long run, their selfish choices would have consequential results that would result in bankruptcy and even their own loss of employment and financial security.
It is understandable that bankers and brokers involved in making the perilous decisions will claim that they performed in ways to benefit their customers and themselves. Although profitable short-term yields were garnished for their clients, the levels of profits generated for themselves provided adequate proof that their intentions were primarily focused on acting in a manner that positioned their own gain first and foremost. Schoen assists in proving the reasoning behind the actions taken by the brokers by stating that “By 2007, more than half of all subprime loans were being originated by mortgage brokers rather than by banks. Because brokers are paid fees by the lender for generating the mortgage (often without the borrower’s knowledge), they have no incentive to be concerned about the loan’s performance” (Schoen, 2017). The most crucial fact
stated is that these borrowers were not educated on the fact that their brokers were paid fees for these mortgages, meaning they did not care if they performed well or not. Therefore, they put their borrowers at risk and set them up to default just to profit off of them. It is clear that an unregulated financial system facilitated brokers to choose unethical paths in pursuit of higher profits, foregoing sound judgement founded in moral responsibility (Harvey, 2013).
Unfortunately, the deregulation did not end at the investment banks, brokers, and lenders. It continued within credit rating agencies that would “evaluate bonds and securities issued by firms and governments to determine the likelihood that the issuer will repay the debtor can recover losses in the event of a default” (Scalet & Kelly, 2012). In the past, rating agencies had used rated debt instruments that provided a rating on the mortgage-backed securities which made them a very reliable source. Such trusted and respected financial tools were used by “investors who want information about debt instruments but may not have the resources or ability to assess the public and nonpublic information about the firm or government issuing the debt” (Scalet & Kelly, 2012). Investors relied heavily on the information provided by these agencies because their core responsibility was to provide honest ratings to investors and they had exclusive access to the information needed to assess the securities. Unfortunately, the aftermath of the GFC made it clear that credit rating agencies knowingly issued some of their highest ratings to securities that were continually defaulting. The ethical issue behind the credit rating agencies is that before the crisis they were well trusted and were honest with consumers on the ratings of securities. Greed must have also knocked at their door because they too, set ethics aside and engaged in questionable practices that yielded terrible packages made to default as A-rated debt. The issue behind their actions is that the information they provide is not accessible to the public or potential investors. It is clearly stated and known by many that credit rating agencies were the only ones with access to the necessary information to evaluate these packages (Scalet & Kelly, 2012). Ultimately, bankers, lenders, and brokers acted irresponsibly in packaging debt options designed to default, and the public was misguided in part due to the credit rating agency industry’s malpractice. By colluding with banks in providing false ratings, credit rating agencies exacerbated the problem and increased the risk of financial hardship for many and eventually had a significant role in the global crisis that could have caused a collapse of the global economy. Ethical and honest credit ratings could have highlighted possible problems, alerting the public to the housing crisis earlier, possibly avoiding the magnitude of the crisis that followed. As such, it is reasonable why credit rating agencies “have come under intense scrutiny” (Scalet & Kelly, 2012). In response to the consequential actions taken by trusted professionals, the 2012 Dodd-Frank Wall Street Reform was passed to help prevent the deregulation that had been occurring in the financial industry.