Banks Failed at Social Responsibility

The old adages of the business community of win-win deals and a quality product for a reasonable price were not part of the subprime loan deal. In order to understand how and why things were able to go so far out of control, it is beneficial to review some of the key points from the original lender and buyer.

Traditionally, an individual would find a home they wished to purchase, and seek out a lender directly or through a mortgage broker. Once a loan product was selected, the consumer became a homeowner and the lender would receive a promissory note with an established interest. The interest was the money the organization made for transacting the loan. Most loans are for thirty years.  This was fair and equitable. The lender stood to make quite a bit of money over a long period.

Banks can only give so much money because of laws that require a ratio of capital on-deposit and money loaned out. Therefore, a small bank or a branch of a large bank only has a certain amount of money, yet they want to serve their entire community and members. Therefore, after so many loans the small banks would sell of the loan in a package to bigger banks.  Some banks only deal with these kinds of large transactions (in the billions at a time). The small bank would keep the loan for a year or two and make a little revenue from the interest while also aging the loan to establish a payment history. The large banks would rate the small banks with a default factor and penalize or deny future business from these originating lenders.  This helped ensure the buyer could afford the loan, that the lender would make a quality loan decision, and the large bank was buying a quality package.  The homeowner still owns the house. The lender receives funds at a premium for operation and be able to provide additional loans the community. The large bank has a nice revenue stream from the interest and holds a large percentage of secured debt.

So What Happened?

Three things happened that caused the collapse.

• The introduction of the adjustable rate mortgage (ARM). This allowed homeowner to buy more house than they could typically afford. This was an initiative to compensate for wages not increasing at the same rate homes were appreciating, most ARM’s turn to a higher rate in the third or fifth year.
• Wall Street was able to detect money, and moved in with leveraging deals and mutual funds. Eventually, the large banks want to sell some of their holdings as their ratios adjusted and in order to keep buying more new packages. Mutual funds are more a long-term investment for their shareholders. They would buy these packages from the large banks and pass the interest in as revenue among the shareholders. Homes were appreciating at a phenomenal rate and were profitable for the mutual funds. If a home went into default, they could sell it for more money than the homeowner owes, then pass those proceeds back into the fund.
• Mutual funds wanted more, large banks wanted more, and smaller banks lowered lending standards to meet the demand.

Essentially, the mutual funds were handed a ticking time bomb because when the ARM’s started to kick in, people were unable to refinance their home because of debt to income ratios and were unable to pay the higher rates. As more default came in to the mutual funds, they stopped buying from the large banks, the large banks in turn stopped buy from the small banks and the small banks stopped loaning. The small banks were stuck with the lousy loans they wrote, and the large banks were stuck with all the packages they had bought. If a picture paints a thousand words, I suggest tornado. None of the players could say anything because it would cause mass hysteria and they were trying to sell off their packages to try to recover.

When evaluating the subprime loan scandal through the mediating lens of social responsibility, it becomes quite clear that the investment bankers, originating lenders, nor Wall Street had good intentions for the consumer.  Social responsibility (SR) is honoring the duties owed to employees, stakeholders, and society in the pursuit of long-term wealth creation (Caldwell, Hayes, Karri, and Bernal, 2007).

The banks and lenders failed at their social responsibility because (a) they did not have society or the consumer’s best interests at heart when constructing their loan products and exit strategies.  (b) Their actions were not for the creation of long-term wealth. Their actions were for short term, fast flip quarterly profits. (c) They failed at their legal obligation to create wealth for their shareholders.

Organizations have an obligation to self-regulate and perform at a higher standard than the law requires. If they do not the government will intervene through legislation and regulation. Most businesses agree that government intervention is not desirable. Murphy introduced the business community to the power-responsibility equilibrium. Murphy describes the equilibrium as when either power or responsibility is out of balance in the business community, forces (usually government regulation), will be forced to bring them into balance (1980).  This is significant because according to Murphy if the businesses and the stakeholders do not accept responsibility for society, then the government will intervene.

The government did indeed respond with the signing of Dodd-Frank Wall Street Reform and Consumer Protection Act on July 21, 2010. Some highlights from the bill were the consolidation of some of the main regulatory agencies and the elimination of other agencies. The installation of a new oversight committee to increased transparency while enhancing the existing regulation of the financial markets. New consumer protection reforms, investor protection, and an overhaul of FDIC insurance protection (personal conversation, June 1 2013).

Caldwell, C., Hayes, L. A., Karri, R., & Bernal, P. (2007) Ethical Stewardship – Implication for Leadership and Trust. Journal of Business Ethics, 78, 153-164. doi: 10.1007/s10551-006-9320-1

Murphy, P. E. (2009). The relevance of responsibility to ethical business decisions. Journal of Business Ethics, 90, 245-252. doi: http://dx.doi.org/10.1007/s10551-010-0378-4

What role did leadership decision-making play in the subprime loan financial crisis?

They say hindsight is 20/20. In reviewing some of the particulars of the recent financial crisis, should more faults been levied on lenders?  Often people forget that businesses do not make decision and that they are artificial lifeless entity that has no social responsibility or obligations (Friedman, 1970).  They are a vehicle for the conduction of business for the shareholders and owners. Ownership can be quite convoluted but regardless of ownership, the organization is staffed with people. People do have responsibility, accountability and culpability in the decisions that are made and the consequences they produce (Gilbert, 2011).

Leadership decision-making can be divided into two groups’ policy-making (PM) and policy-implementing (PI). Both of which are enacted by people or committees at the highest levels of the organization (Gilbert, 2011). An example of policy-making is the decision to introduce or offer a new financial product such as a reverse mortgage.  Policy-implementation the process of qualifying and delivering the product to an individual consumer.  Managers and above create and establish policies (PM), all other employees or agents interpret and are bound by the policies. Policy must be legal and to that end must be ethical and moral concerning the impact on stakeholders.

Ethical leadership as introduced by James Carlopio emphasizes ethical stewardship as an approach to leadership that builds trust among stakeholders (2002, pp. 71-74).  Caldwell, Hayes, Karri, and Bernal (2007) define ethical stewardship as honoring the duties owed to employees, stakeholders, and society in the pursuit of long-term wealth creation (p.153). It is important to remember that the employees and the brokers, loan officers must qualify people based on the criteria established by the lenders senior and executive management.

As policies were changed to lessen the standards of qualification, the lenders were able to attract and increase the amount of business. These lowered standards were at the expense of the borrower and did not create win-win situations. Normally, lessened standard would create more risk on the part of the lender, but the originators were selling and transferring the risk to the new purchaser through a model called originate-to-distribute (Gilbert, 2011). By passing the risk to the seller, the originator was incentivized to sell more loans at lower standards, because they would hold little or no risk. While this approach may have been legal, clearly it is both unethical and immoral.

 

Caldwell, C., Hayes, L. A., Karri, R., & Bernal, P. (2007) Ethical Stewardship – Implication for Leadership and Trust. Journal of Business Ethics, 78, 153-164. doi: 10.1007/s10551-006-9320-1

Carlopio, J. (2002) The Best Articles about Leadership form the Last Ten Years’. BOSS Financial Review, August edition, pp. 71-74

Friedman, M. (1970, September 13). The social responsibility of business to increase its profits. New York Times, New York, NY.  32-33, 122-124, 126. Retrieved on May 28, 2013 from http://www.colorado.edu/studentgroups/libertarians/issues/friedman-soc-resp-business.html

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

What are the risks of subprime loans?

Before evaluating risks of subprime loans, there needs to be a clear understanding of the word.  The root word prime means of the best or highest quality, first class, excellent (OED, n.d.).  When applied to business it becomes a company’s description of the best of their chosen marketing demographics.  In the financial and banking industries, it refers to the profile of their ideal consumer profile.  Therefore, subprime consumers are less credit worthy but not outside their lending policies and, so they are assigned a risk factor.  Risk is the possibility of failing to repay or honor the terms of the promissory note.

Subprime loans are loans made to people with a higher degree of risk.  Risk can be mitigated by charging a higher interest rate.  For example if a prime customer can qualify for a loan at 4.9% interest, this would be considered the best rate for the ideal customer.  The less-than ideal customer can expect to pay for the same loan product anywhere from 5.0% up to the legal maximum allowable interest rate.  The amount will vary depending on the amount of risk presented during the qualification review.

The term risk has many meanings depending upon the context in which it is used.  Above risk used to represent the probability of default.  However, when discussing the risk to either the lender or the borrower the word could be best described as meaning consequences.  Consequences are not inherently good or bad rather they are results.  The results can be good or bad depending on whether it achieved or exceed the desired effect, [good] or not [bad].  The two groups involved in a subprime loan are the lender and borrower.  Below we will look at some of the consequences of loans between the two groups.

Lenders-

• Lenders have an opportunity to make more money with subprime loans.
• Loans are secured by the property, so they have less to lose.
• Lenders have a higher risk of default and higher cost associated with collections and disposal of assets

Borrowers-

• Have the opportunity to become homeowners.
• Borrowers must pay more money for the same opportunity as other borrowers.
• Have already demonstrated a propensity for financial distress.
• May have obligated to more debt than can comfortably afford because of other debts and obligations exempt from disclosure (Gilbert, 2011).

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

Prime. (n.d.). In Oxford English Dictionary. Retrieved on May 27, 2012 from: http://www.oed.com.ezproxy.apollolibrary.com/search?searchType=dictionary&q=prime&_searchBtn=Search