Investopedia,
a Forbes Media Company, defines a subprime loan as a type of loan offered at a
rate above prime to individuals who do not qualify for prime rate loans. Loan qualification is based on several factors
including income, credit rating and assets.
Often, subprime borrowers are turned away from traditional lenders
because of low credit ratings or other factors that suggest they have a chance
of defaulting on the debt payment. One type, but not the only type, of subprime
loan is a home mortgage (Gilbert, 2011).
During the
housing boom, subprime mortgage originations increased from $120 billion in
2001 to $625 billion in 2005 (Gilbert, 2011). According to Gilbert, as of 2005,
only 16 percent were used for home purchases. The rest were used for either
second mortgages or home refinancing. More than two- thirds of subprime mortgage
originations in 2006 were adjustable rate mortgages (ARM). These are mortgages
with an initial rate that changes (often upward) after a specified period of
time, resulting in higher monthly payments for the borrower (Gilbert, 2011).
By the end
of 2006, subprime delinquencies more than 60 days late jumped to almost 13
percent, compared to 8 percent a year earlier (Kratz, 2007). Foreclosure
proceedings were started on about 1.5 million homes during 2007 and this was 53
percent higher than in 2006. While the number of foreclosures continued to
increase dramatically in 2008 and 2009, most economic analysis identify the
beginning of the long recession as starting with the increase in mortgage
failures in 2007 (Gilbert, 2011).
Before the
housing bust, a sprawling business arose in subprime mortgages were issued to
people who had decent credit but did not have to prove their income (Reckard,
2013). The explosion of mortgage defaults that began in late 2006 vaporized an
entire industry of subprime specialists. The Wall Street firms that had bundled
the loans into securities soon began to implode and loans for the credit-
challenged disappeared (Reckard, 2013). All of these factors have led to a
major decline in stock markets and in the world economy.
Role of leadership Decision Making in the
Subprime Loan
According to Thiel et al (2012), organizational
leaders face environmental challenges and pressures that put them under ethical
risk. Corporate and financial misconduct amidst the recent world financial
crises, such as the predatory subprime lending practices of Ameriquest, Goldman
Sachs, and Indy Mac Bank, have left few wondering whether ethics in leadership
should be of greater focus moving forward (Paletta & Enrich, 2008).
Government and public officials including the Securities and Exchange
Commission and the United States Senate have questioned organizational leaders
over their dubious and, seemingly, misguided decision- making (Pulliam et al., 2010).
There were
many levels of participants in the subprime mortgage lending process which help
create the current crises. The policies of lenders and government certainly
helped the current crises, but ultimately do not absolve borrowers of
responsibility for their debts (Lehrer, 2008). The government tax system
encouraged Americans to take out very large mortgages to receive large federal
tax benefits. Who is responsible for the current mortgage crisis? Possible
culprits include the following (Gilbert, 2011):
1.
Borrowers, who may or may not have lied to lenders
in their applications;
2.
Mortgage brokers and lenders, who may or may
not have asked the right questions or enough of the right questions or checked
on the answers to these questions to justify the loans that they made;
3.
Securitizers (institutions, including
commercial banks and investment banks) that combine individual mortgage loans
into bundles, divide the bundles into tranches, and sell the resulting
collateralized mortgage obligations to investors;
4.
Rating agencies that somehow managed to turn
subprime mortgages into prime investments by giving a much higher rating to the
collateralized mortgage obligation that the individual mortgages might achieve;
and
5.
Investors who purchased these instruments
without really knowing what they were buying.
Who is responsible for the subprime crisis?
According to Benson (2008), the mortgage salespeople and brokers received
commissions, but they are not responsible for the crises. The interest and
repayment terms of mortgages must, by law, be clearly stated. The initial
lenders who securitized the mortgages benefited but are not guilty of causing
the whole crises. The agencies that gave securitizations too high ratings were
responsible, but the investors should have been more skeptical (Benson, 2008).
Borrowers are not responsible for the crises, but are not necessarily victims
either. They were given the terms of the loans upfront and willingly signed the
documents.
Subprime Loan and Social Responsibility
According
to Watkins (2011), subprime mortgages offered an opportunity to tap a new
source of profits, namely, the increase in housing prices. The Goldman Rule,
pursue profitable opportunities regardless the effects of other, rests on the
assumption that increases in profitable opportunities increase the opportunity
cost of ethical behavior (Watkins, 2011). Subprime loans offered the
opportunity for financial institutions gain hefty profits. The opportunity
offered from issuing subprime loans proved too great a temptation and passing
off the risks to others provided an even greater temptation (Watkins, 2011).
Ethics is defined as a system of rules or
standards governing the conduct of a person or group. There is no generally
agreed upon body of ethical rules or interpretations as there is for law
(Gilbert, 2011). Possible rules or standards as defined by Gilbert (2011) that
would apply in business settings include the following:
1.
Treat others fairly;
2.
Observe the rights of others and the duties
they impose;
3.
Do not hurt others, directly or indirectly;
4.
Follow the law;
5.
Treat others as you wish to be treated;
6.
Treat others as you have been treated;
7.
Be merciful; and
8.
Be just.
Goldman Sachs engaged in ethically questionable
activities when the company successfully persuaded AIG to sell credit default
swaps for which it earned $14 billion (Watkins, 2011). With the courtesy of
U.S. tax payers, Goldman Sachs securitized the subprime mortgages and sold them
to unsuspected investors. In April 2010, the Securities and Exchange Commission
claimed Goldman Sachs sold investors a subprime mortgage investment that was
secretly designed to lose value (Watkins, 2011).
In the
aftermath of the subprime loans crisis, new lending rules and regulations were
put into place to address subprime mortgage lending. Mortgage defaults that began
in 2006 have vaporized an entire industry of subprime lending. Today’s
high-risk lenders differ from those during the housing boom in key ways
(Reckard, 2013). Subprime lenders care because they are holding loans on their
books rather than selling them to investors (Reckard, 2013). Subprime mortgage
lenders now care about borrowers’ collateral, down payments, income, and
ability to pay the mortgage. Today there are borrowers who can make a big down
payment, have documents that prove they have the income to pay the loan, and
have a good recent job history- but have a credit score that would make it
impossible to receive a loan (Reckard, 2013).
Benson, G. (2008). Collaborative
Fiasco. Bloomberg Business Week. Retrieved on 19
July 2013 from: http://www.businessweek.com/debateroom/archives/2008/03/subprimeborrowersnotinnocents.html
Finger, R. (2012). Meet The New
Subprime: It Will Cost Us Billions. Forbes. Retrieved on
18 July 2013, from: http://www.forbes.com/sites/richardfinger/2012/09/30/
Gilbert, J. (2011). Moral Duties
in Business and Their Societal Impacts: The Case of the Subprime
Lending Mess. Business and Society Review, 116:1
87-107.
Kratz, E. (2007). The Risk in
Subprime. CNN Money. Retrieved on 18 July 2013 from: http://money.cnn.com/2007/02/28/magazines/fortune/subprime.fortune/
Lehrer, E. (2008). Willing
Customers. Bloomberg Business Week. Retrieved on 19 July 2013 from: http://www.businessweek.com/debateroom/archives/2008/03/subprimeborrowersnotinnocents.html
Paletta, D. & Enrich, D. (2008). Crises Deepens and Big Bank Fails.
The Wall Street Journal.
Retrieved 20 July 2013
from http://online.wsj.com/article/SB121581435073947103.html
Pulliam, S., Scannell, K., Lucchetti, A., & Ng, S. (2010). Wall Street Probe Widens. The Wall
Street Journal.
Retrieved 19 July 2013 from:
Reckard, S. (2013). Lenders
venturing back into subprime market. LA Times. Retrieved on 19 July 2013 from:
Thiel, C., Harkrider, L. & Mumford, M. (2012). Leader Ethical Decision- Making in
Organizations:
Strategies for Sensemaking. Journal of Business Ethics, 107, 49-64.
Watkins, J. (2011). Banking
Ethics and the Goldman Rule. Journal of Economic Issues, Vol.
XLV, No. 2, pp.
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