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