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).



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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

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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

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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

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