Three Blog Posts on Subprime Loans and Ethics
The Price of Risk: Introduction to Subprime Loans. Imagine you’re in a casino, and you have a choice between two different poker games: one that is lower risk (say it has more amateur players) and has a modest pot, while the other is higher risk (more professional players), but carries a much bigger pot. Which would you choose? As we’ll see, this metaphor of gambling and the higher cost of higher risks is actually a good way to describe a financial instrument that is widely blamed for touching off the recent recession: the subprime mortgage loan.
A subprime loan is a loan that is offered with a higher rate of interest than the market value, which is called the ‘prime’ (Ferrell, Fraedrich, & Ferrell, 2013, p. 386). Although the loan is at a higher rate of interest than the prime, it is called a ‘subprime’ loan because it is less favorable to the borrower (p. 386). This raises an obvious question: why would anyone want to take out such a loan? The answer is very simple: borrowers with poor credit, who would otherwise not qualify for a loan. And with the adjustable rate mortgage (ARM) a borrower can start repaying the loan at low rates, often for as much as three-five years, before they have to start making larger payments (p. 386).
Although someone could take out a subprime loan for essentially any reason, mortgages are the reason that has gained the most attention, and for good reason: in the year 2008, there were over 6 million people with subprime mortgage loans, totaling over $600 billion in worth (Ferrell et al., 2013, p. 386). The concept got going in the 1970s in Orange County, California, during a housing boom: the market for housing was growing very well, and subprime lending helped many people to become homeowners (pp. 386-387). And with the market growing, people could sell their homes for more than what they had paid. So what was the problem? As we’ll see next time, the subprime market had some pretty serious shortcomings, and these would ultimately set the stage for a great deal of financial trouble for many people.
The Used Car Salesmen of Lending. There’s a saying, ‘let the buyer beware’. While there’s certainly something to be said for this, there’s also a reason that the ‘used car salesman’ has become a stereotype for dishonest selling. So if I’m ‘selling’ you a loan and I know lots of things about it that you don’t, how much am I obliged to tell you? This is the central ethical issue with subprime lending, much of which has been dubbed ‘predatory lending’: subprime loans are very complex, and are often structured to include things like very high fees, which are often hidden through the use of language that is very difficult for most people who are not legal experts to understand (Gilbert, 2011, p. 100; Jennings, 2009, pp. 457-458).
As if that wasn’t enough, another issue that has come up with subprime loans is the way that lenders have sold them. The industry, the banks and financial institutions like Goldman-Sachs that offered these services, often told people that these subprime loans were the answer to other debts: in other words, if someone took out a subprime mortgage loan, then they would be able to pay off debts they owed on credit cards and automobiles, etc. (Watkins, 2011, p. 367). The reason the ploy worked was that the agents sold people on the low ‘teaser’ rates of the first three-five years of the ARM: in other words, borrowers thought they would be able to pay off all of their other loans, and then pay off their subprime loan at very low rates (p. 467).
But lenders weren’t simply sitting on these loans. Instead, they were securitizing them, pooling them and turning them into something that could be bought and sold (Wagoner, 2008, p. 6). What the lenders were selling, specifically, were collateralized debt obligations (CDOs): basically, they were selling their investors the right to collect on the debts that they, the lenders, were owed by the borrowers (p. 6). The idea was that the investors would make money from the mortgage payments that the borrowers were making (p. 6). What this meant was that the lenders had successfully transferred all of their risk to someone else—the investors (p. 6).
‘All the King’s Horses and All the King’s Men’. By now you may have spotted the basic structural weakness of the subprime market: it was a market in very expensive loans to people who wouldn’t have otherwise qualified for them. Since lending is a market, it is dependent on lenders paying what they owe, plus interest. This is the only way for the lenders to make money—unless, of course, they’ve found a way to pass that risk to somebody else.
Disaster finally struck beginning in late 2007, from a rather predictable source: too many borrowers couldn’t keep up with their payments, and started defaulting on their loans (Ferrell et al., 2013, p. 386). The result was a bout of foreclosures, and enormous losses for investment firms like Morgan Stanley, Merrill Lynch, and Citigroup (p. 387). But who was really responsible? After all, it wasn’t just the lenders who were involved: there were also the people who borrowed beyond their means, and even the investors, who purchased investments without doing due diligence by looking into how good those investments really were (Gilbert, 2011, pp. 92-95). Surely the different individuals involved are responsible for their own respective choices, whether to borrow money or lend it, or buy investments (pp. 94-100).
All of this is true, but the fact remains that it was the lenders who drove the entire process: they were playing both ends, the borrowers and the investors, against the middle, and raking in very large profits (Gilbert, 2011, p. 100). Since these were their financial instruments, do they not bear the greatest share of responsibility? One borrower told the U.S. Senate Committee on Banking, Housing and Urban Affairs that “over two years, her home equity loan increased from $11,921 to over $64,000” (p. 100). The amount of cash she received from all of this was less than $100.00, and she was hit with $52,000 in fees (p. 100). Given the degree to which the lenders sought to manipulate the market, by gulling both borrowers and investors, it is they who must be held most to account for the ruin of the economy.
Ferrell, O. C., Fraedrich, J., & Ferrell, L. (2013). Business ethics: Ethical decision making and cases (9th ed.). Mason, OH: South-Western.
Gilbert, J. (2011). Moral duties in business and their societal impacts: The case of the subprime lending mess. Business and Society Review, 116(1), pp. 87-107. Retrieved from http://search.ebscohost.com/
Jennings, M. M. (2009). Business ethics: Case studies and selected readings (6th ed.). Mason, OH: South-Western Cengage Learning.
Wagoner, J. (2008). Could better accounting have prevented the current liquidity crisis? Journal of Financial Service Professionals, 62(1), pp. 6-8. Retrieved from http://search.ebscohost.com/
Watkins, J. P. (2011). Banking ethics and the Goldman rule. Journal of Economic Issues, 45(2), pp. 363-372. DOI 10.2753/JEI0021-3624450213