Rebuilding trust and embedding the ethic of care in the subprime mortgage environment

Mortgage lenders have an ethical obligation to exercise an ethic of care with respect to subprime mortgage lending practices. This obligation involves duties to both consumers as well as shareholders, as lenders need to exercise due diligence to understand and evaluate clients’ reasonable ability to afford and repay subprime mortgage loans. Thus, mortgage lenders have fiduciary responsibilities to borrowers, organizations, investors, shareholders, and other stakeholders; thus trust is essential to how the subprime mortgage lending system functions.

Two critical fiduciary responsibilities lenders have towards borrowers are as follows: 1) Know your client; 2) Suitability. According to Sternberg (2013), lenders need to understand how the loan will be repaid, basic income and asset information, and evidence about a client’s creditworthiness. Also, lenders need to consider whether the mortgage loan is suitable given the client’s profile (Cushman, 2015). These responsibilities affect properly analyzing default risk, which then impacts placing clients in suitable loans given their profiles. Failing to profile or consider client suitability potentially increases default risk, as the client’s willingness, ability and intent to repay are unknown.

Subprime mortgage lending potentially overlapped with predatory lending practices during the housing bubble. A portion of subprime loans were disbursed even though borrowers’ willingness, as well as ability and intent, to repay the mortgage were uncertain (Sternberg, 2013).

[Untitled advertisement]. Retrieved April 25, 2015 from http://www.federalreserve.gov/newsevents/files/bernanke-lecture-three-20120327.pdf

Furthermore, fiduciary duties to the organization, investors, and stakeholders involves not only honest dealing, but also the proper loan structure to provide sufficient collateral to maximize prompt repayment in the event of a default (Gilbert, 2011). Thus, mortgage lenders should minimize default risk and promote accurate disclosure and transparency. According to Walter (2014), failure to minimize default risk not only results in potential losses for the organization, investors, and other stakeholders, but exposes the organization to fines, which further penalizes shareholders.

After the subprime lending crisis, several measures have been taken to mitigate subprime mortgage loan risks and encourage a more ethical lending environment. Measures addressed controls and accountability at the institutional, as well as organizational and institutional levels (Nielsen & Massa, 2013). These measures refocused the subprime mortgage system towards long-term sustainability, rather than excessive lending behavior generating short-term profitability.

Organizations took actions to improve their ethical organizational climate through training, development, improved controls, and accountability. Koller, Patterson, and Scalf (2014) stated that lending firms implemented new ethics training. Also, lending organizations made changes to their organizational culture to encourage personal responsibility and accountability in the lending process (Walter, 2014). These organizations also increased controls related to mortgage fraud and corporate compliance (Koller et al., 2014). Furthermore, appropriate barriers to internal and external communication were established to control conflicts and potential fraud (Walter, 2014).

Although slower, some institutional level changes have strengthened the subprime mortgage lending environment. Watkins (2011) explained that capital requirements from Basel 3 reduces lending institution’s leverage capital, potentially limiting excessive lending practices. Also, there is increased awareness and recognition of moral hazards within the subprime mortgage lending system, which then impacts individual lending analysis (Walter, 2014).

References

Board of Governors of the Federal Reserve System. (2012, Mar 27). The Federal Reserve and the Financial Crisis [Lecture 3: The Federal Reserve’s response to the financial crisis]. Retrieved from http://www.federalreserve.gov/newsevents/files/bernanke-lecture-three-20120327.pdf

Cushman, T. (2015). The moral economy of the great recession. Society, 52(1), 9-18. doi:10.1007/s12115-014-9852-4

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

Koller, C. A. Patterson, L. A. & Scalf, E. B. (2014). When moral reasoning and ethics training fail: Reducing white collar crime through the control of opportunities for deviance. Notre Dame Journal of Law, Ethics & Public Policy, 28(2), 549-578.

Nielsen, R., & Massa, F. (2013). Reintegrating ethics and institutional theories. Journal of Business Ethics, 115(1), 135-147. doi:10.1007/s10551-012-1384-5

Sternberg, E. (2013). Ethical misconduct and the global financial crisis. Economic Affairs, 33(1), 18-33. doi:10.1111/ecaf.12010

Walter, I. (2014). Reputational risk in banking and finance: An issue of individual responsibility? Journal of Risk Management in Financial Institutions, 7(3), 299-305.

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

Creating a subprime loan mess: structural, organizational, and individual ethical challenges

Leadership decision-making during the subprime mortgage loan crisis was ineffective in terms of policymaking, controls, monitoring, and accountability. The breakdown in trust extended beyond greed to organizations’ ethical tone and supervision, as it impaired stakeholder relationships (Sternberg, 2013).

Leaders failed to manage properly risk to control profitability, as well as sustainability and stakeholder trust, impairing organizational culture (McCormick & Stears, 2014). This breakdown contributed to toxic subcultures institutionalized throughout lending firms, as Walter (2014) explained that a reputational crisis emerged as leaders and staff failed to question and adjust unethical policies.  As Sternberg (2013) explained, when an organization does not maximize long-term shareholder value with “ordinary decency” (trust, fairness, and respecting rights) and “distributive rewards” (appropriate compensation structures), it is unethical (p. 19).

In general, leaders failed to provide sufficient controls to monitor and manage risks associated with subprime mortgage lending. Aydin (2015) explained that controls were insufficient to predict, as well as prevent, irrational and irresponsible behaviors. Policies should have monitored and controlled lending practices to reduce potential defaults posing harm to borrowers, shareholders, and other stakeholders.

Leadership decision-making set the stage for the ethical tone of the organization as well as individual loan decisions. Gilbert (2011) stated that leaders established a pattern of potential default through their policy-making, as organizations were encouraged to offer marginally creditworthy clients various types of subprime mortgage loans. Improved ethical policy-making would have improved disclosure so as to encourage lending where borrowers can reasonably be expected to afford and repay the loans (Sternberg, 2014).



[Untitled advertisement]. Retrieved April 25, 2015 from http://www.federalreserve.gov/newsevents/files/bernanke-lecture-three-20120327.pdf
 

According to Sternberg (2014), the structure of subprime loans, which is a function of policy-making, impacted their risks. For instance, down payment requirements and income verification practices were often relaxed as a result of organizational policies, impairing suitability analysis as well as fraud prevention (Calabria, 2011). Leadership policy-making resulted in easier lending practices that affected borrower incentives to default (Utt, 2008).

Furthermore, organizational policy-making promoted excessive debt. By design, subprime loans resulted in churning, as adjustable rates led to additional refinancing in rising housing markets and default in declining housing markets (Watkins, 2011). Also, Viorica (2012) explained that subprime mortgage loans led to a pattern of increasing concentration of risk, especially as borrowers withdrew equity during rising housing markets.

Decisions by organizational leaders also affected compensation, training, external networking, and managing conflicts of interest, which contributed to short-termism. Sternberg (2013) stated that staff were compensated for the number and size of loans, rather than the long-term organizational value of the loan, which incentivized short-term behaviors. Human resource leaders failed to equip sufficiently the organizations with sufficient skills and knowledge training and development to promote effective decision-making (MacKenzie, Garavan, & Carbery, 2014). Leadership decision-making also affected structures that frame and scan financial organizations’ external environments, affecting their ability to anticipate and respond to dynamic market conditions (Thiel, et al., 2012).  Furthermore, interlocking directorates were common, which led to greater conflicts of interest (Fowler, Fronmueller, & Schifferdecker, 2014).

In addition, regulatory gaps increased the vulnerability of both the mortgage lending system and overall financial system (Cushman, 2015). For instance, Mayer, Cava, and Baird (2014) explained that regulators inadequately supervised and monitored subprime lending practices, as well as risk undertaking and capitalization of Fannie Mae and Freddie Mac. Furthermore, risk transparency was inadequate as subprime mortgage loans were securitized (Viorica, 2012).

[Subprime Mortgage Securitization]. Retrieved April 25, 2015 from http://www.federalreserve.gov/newsevents/files/bernanke-lecture-three-20120327.pdf

Finally, government regulations and actions promoted moral hazards within mortgage lending. Government sponsored entities (GSEs) not only provided loan guarantees on subprime mortgage loans, but the GSEs themselves were guaranteed by the government (Sternberg, 2013). The mortgage interest deduction, as well as low interested rates encouraged by Federal Reserve actions, contributed to distortions in the housing and lending markets (Sternberg, 2013). Also, federally-mandated housing ownership goals contributed to excessive lending practices (Calabria, 2011).  

References

Aydin, N. (2015). Free market madness and human nature. Humanomics, 31(1), 88.

Board of Governors of the Federal Reserve System. (2012, Mar 27). The Federal Reserve and the Financial Crisis [Lecture 3: The Federal Reserve’s response to the financial crisis]. Retrieved from http://www.federalreserve.gov/newsevents/files/bernanke-lecture-three-20120327.pdf

Calabria, M. A. (2011). Supply: A tale of two bubbles. CATO Journal, 31(3), 551-559.

Cushman, T. (2015). The moral economy of the great recession. Society, 52(1), 9-18. doi:10.1007/s12115-014-9852-4

Fowler, K. L., Fronmueller, M., & Schifferdecker, J. O. (2014). Mapping interlocking directorates: Citigroup's eight links with the mortgage crisis. Journal of Leadership, Accountability & Ethics, 11(1), 26-33.

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

Koller, C. A. Patterson, L. A. & Scalf, E. B. (2014). When moral reasoning and ethics training fail: Reducing white collar crime through the control of opportunities for deviance. Notre Dame Journal of Law, Ethics & Public Policy, 28(2), 549-578.

MacKenzie, C., Garavan, T. N., & Carbery, R. (2014). The global financial and economic crisis: Did HRD play a role? Advances in Developing Human Resources, 16(1), 34.

Mayer, D., Cava, A., & Baird, C. (2014). Crime and punishment (or the lack thereof) for financial fraud in the subprime mortgage meltdown: Reasons and remedies for legal and ethical lapses. American Business Law Journal, 51(3), 515.

McCormick, R., & Stears, C. (2014). Banks: Conduct costs, cultural issues and steps towards professionalism. Law & Financial Markets Review, 8(2), 134-144. doi:10.5235/17521440.8.2.134

Sternberg, E. (2013). Ethical misconduct and the global financial crisis. Economic Affairs, 33(1), 18-33. doi:10.1111/ecaf.12010

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

Utt, R. (2008, Apr 22). The subprime mortgage collapse: A primer on the causes and possible solutions. The Heritage Foundation Research Reports. Retrieved from http://americandreamcoalition.org/housing/bg_2127.pdf

Viorica, S. (2012). The actual collapse and the importance of moral values (ethics); some reflections regarding the roots of the current crisis. Procedia - Social and Behavioral Sciences, 58(8), 1057-1063. doi:10.1016/j.sbspro.2012.09.1086

Walter, I. (2014). Reputational risk in banking and finance: An issue of individual responsibility? Journal of Risk Management in Financial Institutions, 7(3), 299-305.

Betraying trust in complex relationships: The subprime loan crisis

Leadership, coaching, and mentoring influence how organizations handle fiduciary responsibilities. These factors impact the ethical culture of organizations, which becomes increasingly crucial to how organizations deal with complex products and complex environments. Often, individual ethical decision-making ripples through the organization and operating environment, such as in the case of subprime mortgage lending during the housing bubble from the mid-1990s to 2007 (Walter, 2014).
 

The subprime mortgage environment prior to the collapse of the housing bubble in 2007 provided an opportunity for financial organizations to build trust within the community, as well as with stakeholders and consumers. Although subprime mortgages involved a complex product operating in an increasingly complex environment, ethical decisions made at the local level significantly impacted the macroeconomic financial environment (Sternberg, 2013).

An important starting point for discussing subprime mortgages is a definition. According to Calabria (2011), subprime mortgages are characterized by the borrower’s credit quality or the credit quality of the selected mortgage type. Regulators have traditionally used a borrower’s FICO score of 660 as the boundary between subprime and prime (Calabria, 2011). The subprime mortgage loan forms included Alt-A (intermediate risk loans), no down payment, interest-only, and negative amortization, all of which had reduced borrower creditworthiness in common (Sternberg, 2013).

Beginning in the mid-1990s, diminishing lending standards facilitated the growth of subprime loans (as well as lenders’ short-term profitability), as borrowers had fewer hurdles regarding proving creditworthiness and income (Gilbert, 2011). Looser underwriting criteria increased risk in the overall mortgage system, including risks associated with fraud and misrepresentation (Utt, 2008). Unfortunately, the cumulative effect of these decisions was that organizations traded long-term sustainability for short-term profit-seeking, impairing relationships with the community, stakeholders, shareholders, and consumers Clarke & Bassell, 2013).

Subprime mortgages posed several risks for both the borrower and lender. According to Viorica (2012), subprime mortgage loans often involved initial teaser rates, which led to upward rate adjustments after the teaser rate period expired. Watkins (2011) explained that a defining characteristic of subprime mortgage loans was that they were designed to encourage refinancing after two to three years.

When housing prices are rising, borrowers may choose to sell their houses for a profit or refinance at lower interest rates. When housing prices are falling, borrowers that have unsuitable subprime mortgage loans may default on the mortgages when they are unable to meet contractual obligations potentially, leading to foreclosure. The risk to lenders is that the property, if liquidated, would not be sufficient to repay the lenders promptly in the event of borrower default (Cushman, 2015).

Source: Fannie Mae, Form 10-K, filed 2004, 2005, 2007, 2008. Retrieved from http://www.fanniemae.com/portal/about-us/investor-relations/annual-reports-proxy-statements.html
 

Furthermore, increased securitization meant that many subprime loans were not ultimately held long-term by the lenders, as they were placed into loan pools held by Fannie Mae, Freddie Mac, as well as private investors. Banks reduced their risks associated with subprime mortgage receivables through selling off these loans to investors, increasing systematic exposure to default risks (Watkins, 2011). Calabria (2011) explained that subprime mortgages were nearly thirty percent of Freddie Mac’s and Fannie Mae’s direct purchases prior to the collapse of the housing bubble, and they purchased over forty percent of newly-issued private subprime mortgage instruments.

Systemic factors contributing to a financial environment encouraging short-term profit-seeking behaviors included Fannie Mae and Freddie Mac purchasing increasingly lower credit quality mortgages during the housing bubble, private lenders and investors chasing increasingly higher returns through accepting riskier mortgages, and the Federal Reserve continuing loose monetary policy, which artificially held down interest rates for risky loans (Calabria, 2011; Utt, 2008).

Trust is an important factor in managing financial relationships, and unethical actions impairing trust often result in harming consumers, stakeholders, shareholders, and the community as a whole. The subprime mortgage crisis highlighted several ethical challenges, as individual lending decisions, lapses in ethical leadership, as well as structural and systemic issues contributed to the severity of the outcomes.

References

Calabria, M. A. (2011). Supply: A tale of two bubbles. CATO Journal, 31(3), 551-559.

Clarke, C., & Bassell, M. (2013). The financial debacle necessitates a systematic approach to achieving ethical behavior in the corporate workplace. Journal of Business Systems, Governance & Ethics, 8(1), 22-33.

Cushman, T. (2015). The moral economy of the great recession. Society, 52(1), 9-18. doi:10.1007/s12115-014-9852-4

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

Fannie Mae. (2008). Form 10-K 2008. Retrieved from http://www.fanniemae.com/portal/about-us/investor-relations/annual-reports-proxy-statements.html

Fannie Mae. (2007). Form 10-K 2007. Retrieved from http://www.fanniemae.com/portal/about-us/investor-relations/annual-reports-proxy-statements.html

Fannie Mae. (2005). Form 10-K 2005. Retrieved from http://www.fanniemae.com/portal/about-us/investor-relations/annual-reports-proxy-statements.html

Fannie Mae. (2004). Form 10-K 2004. Retrieved from http://www.fanniemae.com/portal/about-us/investor-relations/annual-reports-proxy-statements.html

Sternberg, E. (2013). Ethical misconduct and the global financial crisis. Economic Affairs, 33(1), 18-33. doi:10.1111/ecaf.12010

Utt, R. (2008, Apr 22). The subprime mortgage collapse: A primer on the causes and possible solutions. The Heritage Foundation Research Reports. Retrieved from http://americandreamcoalition.org/housing/bg_2127.pdf

Viorica, S. (2012). The actual collapse and the importance of moral values (ethics); some reflections regarding the roots of the current crisis. Procedia - Social and Behavioral Sciences, 58(8), 1057-1063. doi:10.1016/j.sbspro.2012.09.1086

Walter, I. (2014). Reputational risk in banking and finance: An issue of individual responsibility? Journal of Risk Management in Financial Institutions, 7(3), 299-305.

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