One of the major drivers behind the global financial crisis has been the fall of the subprime mortgage market, which includes the closing of thousands of subprime lenders, increases in mortgage defaults and the enormous losses by financial firms.1 During this time of economic crisis we have already witnessed two hedge funds fall, a Federal Reserve buyout of Bear Stearns, the collapse of Indy-Mac bank, and government takeover of Fannie Mae and Freddie Mac.1 One has to wonder why and how this was able to happen. There was a lot or immoral lending transactions taking place in the subprime mortgage market (according to me and my beliefs). In this essay I will analyze the ethical issues surrounding the subprime mortgage market and propose a better solution to mortgage lending.
The market for mortgage loans is separated into three types of borrowers, prime which are borrowers with excellent credit, Alt-A for borrowers with good credit and subprime for borrowers with poor credit.1 Subprime mortgage lending begins when these borrowers go to a mortgage broker and ask for a loan. Subprime borrowers usually pay two or three percentage points higher than borrowers with good credit.1 The mortgage broker is an agent of the subprime lender and works under set fee in exchange for service arranged with the lender. The fee is determined by the amount of the loan and is paid when the loan is approved. Mortgage brokers handle roughly two-thirds of all subprime originations.1 There is no licensing requirement or federal regulation that governs the conduct of the mortgage broker. The subprime mortgage crisis finally manifested itself through liquidity problems in the global banking system. The crisis began when the housing bubble burst and high default rates on subprime and other debt instruments that were made to high risk borrowers with low income or poorer credit history than prime borrowers. Loan incentives and a long term trend of rising house prices encouraged borrowers to borrow, believing that they would either be able to refinance at more favorable terms. Once house prices dropped in 2006-2007 refinancing became more difficult.1 With refinancing becoming more difficult defaults and foreclosures increased because it was impossible for borrowers to pay back the loan.
The subprime mortgage market is organized around a network of mortgage brokers. The brokers are lightly regulated by the state and there is no licensing or training required. The potential problem for the borrower is that, unlike the standard 30-year fixed rate mortgage, the standard subprime mortgage is the 2-28 mortgages. The initial rate is fixed for two years and then becomes variable for twenty eight years. There are annual and lifetime caps on these mortgage products but the rates can rise annually to the borrower. These initial rates are called "teaser rates" because they are low and for the average subprime borrower these rates are very enticing. Lenders also offered "interest-only" loans, which allow borrowers to pay only the interest only for a certain amount of time. These loans frequently resulted in negative amortization, (when payments are not equal to an amount that will reduce the loan). This method is structure around rewards for the broker for closing the deal and getting the loan approved. Ironically there are even more incentives for the broker to close a loan larger than the borrower needs, which encourages brokers to turn a blind eye just so a loan can be completed.
According to Immanuel Kant, humans behave based on their maxims, or set of policies and beliefs. Each intention, decision, or action is determined by a person's maxims. Kant proposes that in order to discern between right and wrong one must examine our maxims to insure we will not use others as a mere means but instead will treat others as ends in them selves.4 This quote introduces us to term called Predatory lending which is a pejorative term used to describe unfair, deceptive, or fraudulent practices of some lenders during the loan origination process.5 While there are no legal definitions in the United States for predatory lending, an audit report on predatory lending from the office of inspector general of the FDIC broadly defines predatory lending as imposing unfair and abusive loan terms on borrowers.5
There is a clear conflict of interest when analyzing the maxim of lenders and the maxim of subprime borrowers.
Brokers are morally obligated to faithfully represent the true financial capacity of the borrower and are obligated to communicate to consumers the terms and conditions of a mortgage in a transparent and understandable manner, it's apart of their job. But there are no incentives for the lender to let a potential deal walk away. Brokers are paid for closing the loan by any means necessary and are paid more money if the loan amount is larger. In my opinion it's equivalent to a college professor being paid more for the number of students who fail the class, it's counterintuitive to the learning process as predatory lending is counterintuitive to financial lending system. Brokers don't make money when borrowers cannot pay their mortgage or foreclosed. If consumers obtain loans they are incapable of maintaining, they will jeopardize their living arrangement and credit score. Inconsistent payments or foreclosures from consumers are detrimental to the lending structure and impacts other markets. Potential borrowers are obligated to represent their ability to pay loans back truthfully and brokers are morally obligated as well to sell loans that are within the means of the borrower to pay them off.
Business ethics in the subprime mortgage industry has more sides then just the broker side. There were a lot of players in this industry who had duties to be truthful and transparent but were not. Borrowers with poor credit, and low incomes suddenly could afford homes on a subprime mortgage. In order to receive a loan in the United States potential borrowers must have their credit score carefully evaluated. Lending loans is already a risky task; lending loans to people with poor credit and little income is even more of a risk. There have been reports of borrowers lying on their subprime loan applications. Some estimates suggest false entries on applications appeared as high as fifty percent of the time on loan applications.1 This idea introduces us a term called predatory borrowing, which are borrowers who will put anything on there application in order to qualify for a loan. There is no official definition of this term but I think this idea must be discussed when examining the ethical issues surrounding subprime mortgages.
Many consumers, may have falsified there loan applications to get a home, falsification in applying for a subprime loan is morally and ethically wrong. One could argue that false borrower applications are a product of lenders turning a blind eye. Whether or not we know what truly happened remains to be seen, but something wrong definitely was at the root of these transactions. This idea then brings up a very interesting point. Applying this notion of honesty and transparency to brokers reveals a different side to this ethical equation. Unlike borrowers, who face penalties when acquiring a loan they cannot pay, brokers are not held responsible. The broker's profit is made when the loan is signed and complete; after this transaction, the broker is done.
The moral hazard in this situation, strips the broker of any liability for a collapse from the loan they created, it doesn't matter if the borrower maintains the subprime loan or not, once the broker gets their money why should they care? Brokers hold a professional responsibility to keep the best interests of the borrower in mind but using the recent financial recession as evidence, I think it's fair to say some brokers systematically turned a blind eye to borrower's loan applications and even encouraged consumers to falsify information. Many brokers ignored falsified applications, and exploited the ignorance of borrowers about the risks on subprime loans. I'm sure that no one could have predicted the domino effect subprime mortgages had on economy but I have a friend who worked as a broker in the subprime mortgage industry and they said at least 75% of his colleagues were providing loans just for the pay day and not for consumer interests.
Purposely misleading consumers and falsifying loan applications put the relationship between brokers and lenders in danger. Lenders need brokers to provide them with quality applications by borrowers who can pay back the loan. But then again why would the broker turn away a client if he or she is not responsible for what happens to a loan once it is paid? Ironically, the same brokers who collectively failed to approve quality loans and issued bad loans are out of jobs now. Thus far we have analyzed the roles of borrowers, brokers, and lenders, but we have not analyzed the subprime loan model by itself. By nature, the subprime loan is a financially unstable loan; there is a lot of risk involved. As we have all witnessed, this tool in the wrong hands can be a devastating, immoral instrument.
On the other hand, these loans give the ability for lower-income borrowers to obtain home ownership which is apart of the American dream. But this dream must be cared for and placed in the right hand or else this dream can turn into a nightmare. As we can see through out this paper, having a nearly unregulated context for subprime loans, combined with conflicts of interest between borrower and broker equals a morally flawed subprime loan system. Personally I do not know how to fix the subprime lending process but I do know key elements that the upgraded loan process must have in order to be more ethical and sustainable. The first key element is accountability. Most financial decisions are made by calculating the risk and return. There are levels of moral responsibility linked with both selling and buying risk. Deciding on what is a sensible standard for risk and return is important. The potential for a moral hazard should to be related to risk-and-return calculations. It should be public record for how many default mortgages are listed under a broker's license, this way consumers and lenders can easily pin point potential moral hazards. Also incentives and bonuses should be given to brokers who provide the most sustainable mortgages, instead of the other way around as a mentioned earlier brokers have no incentive to operate on moral grounds. The second key is transparency, misinformation could result in a terrible downturn of events as we have all witnessed with the financial crisis and could have easily been stopped if borrowers knew what they were getting into. Lastly, if lenders are allowed the freedom to make risky loans, then they must not be allowed to pass the costs to taxpayers if those loans go bad. This action here is just rewarding unethical behavior. Two wrongs don't make a right, if the lenders issue bad loans then they must deal with the consequences.
Endnote References
1 Office of the Comptroller of the Currency. Subprime Lending. (Online) Retrieved from http://www.fdic.gov/news/news/press/2001/pr0901a.html (Accessed May 5, 2010)
2Subprime crisis and financial meltdown. (Online) Retrieved from http://www.scribd.com/doc/8369180/DAVIS-LAZARUS-Subprime-crisis-and-financial-meltdown (Accessed May 5, 2010)
3The Finance Professional Post. The Seven Deadly Frictions of Subprime Mortgage Credit Securitization. (Online) Retrieved from http://post.nyssa.org/nyssa-news/2010/04/the-seven-deadly-frictions-of-subprime-mortgage-credit-securitization.html (Accessed May 5, 2010)
4Kantian ethics: What Immanuel Kant was talking about. (Online). Retrieved from http://www.helium.com/items/933995-kantian-ethics-what-immanuel-kant-was-talking-about (Accessed May, 5 2010)
5FDIC Office of Inspector General. Audit Report. (Online). Retrieved from http://www.fdicoig.gov/reports06/06-011.pdf (Accessed May 5, 2010)
