Subprime Lending Preamble: What are Subprime
Loans?
Subprime
Loans are a type of loan that are offered at a rate above prime, to individuals
who do not qualify for prime rate loans, i.e. higher interest rates for riskier
borrowers (Gilbert, 2011), and the reasoning behind subprime lending is simple.
Historically speaking, homebuyers needed to meet certain criteria in order to
qualify for mortgages; these criteria included good credit ratings, income
stability, among other selection factors. These mortgages were considered
“Prime” due to their low risk, i.e., small chance of payments to be late or default
(Mallach, 2008). However, due to the reduction of interest rate of Treasury
Bills to 1%, there was a surplus of cheap credit in the market, which allowed
banks and lenders to create mortgages very efficiently. Eventually, the demand
for homes declined as the majority of qualified buyers had already accomplished
their goals, leaving investors wanting more revenue, which triggered the
creation of “subprime loans” which were granted to people that did not meet the
criteria for a prime loan. Because these
loans carry a higher risk, the interest rate is also higher, and in some cases
adjustable, which partially lead to the increase in defaulted payments of 2007
to 53% (Gilbert, 2011).
This video shows in simple terms what triggered
the creation of Subprime loans and how the impact cascades down to the homeowners
and taxpayers:
The role of leadership
decision-making in the subprime loan financial crisis.
Thiel, et.al
(2012), recognizes the difference between organizations and their leaders and
explains that organizations are not the decision makers, that is to say, its
function is to create a framework in which decision making can be fashioned,
but the leaders themselves are the ones responsible for these decisions.
Gilbert (2011)
recognizes the difference between ethics and law and argues that in cases where
a person is not legally bound to do something, they might still have an ethical
reason to refrain from such action; professional are aware that not everyone
who wishes to borrow money has the means to pay it back, however, during the
crisis, this did not preclude them from writing up these mortgages.
Because of
deregulation, there were instances in which the legality allowed lenders and
other institutions to proceed, under the legal limits, in seeking profit
regardless of the consequences this might bring to others; as pointed out in
the video, once the debt is sold, it becomes someone else’s problem. This is
know as the Goldman Rule:
“I work for
nothing but my own profit — which I make by selling a product they need to men
who are willing and able to buy it. I do not produce it for their benefit at
the expense of mine, and they do not buy it for my benefit at the expense of
theirs; I do not sacrifice my interest to them nor do they sacrifice theirs to
me; we deal as equals by mutual consent to mutual advantage” (Watkins, 2011).
Social Responsibility (or lack thereof)
and the resulting consequences:
The social
Responsibility aspect has to be analyzed from different perspectives in order
to have a clear image of what were the factors that caused the snowball effect
of the subprime loan crisis. Generally speaking, when decisions are made, the
assumption of the public is that it is within the range of social
responsibility, specially if the decision makers are part of a government
entity, however, I have never seen, in my limited research, social
responsibility models that account for degrees of separation between the
decision makers and the public, for example: The federal reserve reduced the
interest rate to 1% which meant lenders could borrow debt for little money,
thus, allowing them to generate loans and mortgages to more people, which in
turn created subprime loans. In this example, the decision could have been made
with the best intentions, thinking that it would allow more people to achieve
their dreams of owning a property, and at the time it might have seemed
unnecessary to try to consider all the possible consequences of this decision
within the context of the American Economy. I often hear that “it is impossible
to predict the future” and that nobody could have seen it coming, I disagree;
Lewis (2010) shows the case of three people who predicted the bubble in the
dawn of the crisis and acted accordingly to protect their interests. This is an
example of forward thinking, which can be applied to create decision-making
models that would consider all possible scenarios and their likelihood, and if
there is a case in which the likelihood of a “good decision”, such as reducing
interest rates, that could impact the taxpayers and borrowers the way it did
during the mortgage crisis, then this decision could be deemed as “not socially
responsible” from the beginning, with numbers and science to back it up.
From the
perspective of Wall Street, the social responsibility aspects are almost
non-existent. It is the Goldman rule at play and a constant game of “hot
potato” with these loans and mortgages that blinds the decision makers from any
social responsibility. It is saddening that the consequences are mostly felt by
the millions who lost their homes, yet
those who played the hot potato game received bailouts from the government
(Watkins, 2011).
Although
lending institutions seem to have tightened their criteria for loan
qualification leaving mortgage availability to the most qualified individuals,
the majority of the outcomes are most apparent from the perspective of the
borrowers. People are far more cautious about indulging in the privileges of
leveraging debt and it seems that many of the new homebuyers I speak to these
days actually take the time to read the documents before they sign.
Sadly, apart from this, not much has really changed with respect
to the banks and corporations once deemed “too big to fail”. The role that
ethics and social responsibility plays in a corporation is not as clearly
defined in Wallstreet as it may be in other sectors and the Goldman rule
mentality is unlikely to change own its own unless forced by governmental
influence, which not only means tighter regulation to prevent another crisis
from happening, but also, learning to separate law from ethics, and holding the
decision makers accountable for their actions.
References
Gilbert,
J. (2011). Moral Duties in Business and Their Societal Impacts: The Case of the
Subprime Lending Mess. Business & Society Review (00453609), 116(1),
87-107. doi:10.1111/j.1467-8594.2011.00378.x
Lewis,
M. (2010). The big short: Inside the doomsday machine. New York: W.W.
Norton.
Mallach,
A., & Vey, J. (2008). Tackling the Mortgage Crisis: 10 Action Steps for
State Government. Retrieved July 25, 2016, from
http://www.brookings.edu/research/papers/2008/05/29-mortgage-crisis-vey
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
Watkins, J. P. (2011).
Banking Ethics and the Goldman Rule. Journal Of Economic Issues (M.E. Sharpe
Inc.), 45(2), 363-372. doi:10.2753/JEI0021-3624450213
