Evaluation of subprime loans with the notion of social responsibility.

The housing industry has gone through a rough patch for a while. In the early 2000’s the industry experienced a boom where homeowners’ experienced a rapid increase in the value of their homes. With the boom in full swing an increase in subprime lending began. People with lower incomes and high debt as well as people with poor credit ratings were able to buy homes at variable interest rates. As the rates increased borrowers no longer could pay their mortgages with most houses foreclosed on. Adding to the industry’s woes was the decline in property values leaving many homeowners owing more than what their homes were worth creating more foreclosed upon properties. Many questioned who was at fault, the lenders or the borrowers (Gilbert, 2011). Basically the question of who was at fault did not matter as much as the fact that when the bubble burst it not only affected many families and communities but in addition, the meltdown affected other industries both nationally and internationally. The result of ethically questionable lending practices created a subprime market that eventually failed and resulted in an eventual global economic crisis. Not only did families lose their homes and credit ratings, the economic crisis affected employment. As the unemployment rate climbed the personal wealth of individuals and families declined. Communities and states experienced a decline in income tax revenue forcing those in charge to make tough decisions that further affected individuals and families.

What measures have been taken since that time to assure this will not happen again?

The federal government took over Fannie Mae and Freddie Mac, which help keep the housing market alive in 2008 by calming fears that the undercapitalized entities could default on their bonds (McCoy, 2013). The federal government established Troubled Asset Relief Program, (TARP) which enabled Treasury to move quickly in restoring confidence in the nation’s banks. TARP was later extended to insurance and auto companies (McCoy, 2013). A long-term financial cure is in question. While measures have been taken to assure this will not happen again it appears that the Wall Street debt repackaging machine is back and that giant banks have descended on Washington lobbying to fight the financial reforms that would keep this from happening again (McCoy, 2013).

Links

Fannie Mae: http://www.fanniemae.com/portal/about-us/company-overview/about-fm.html
Freddie Mac: http://www.freddiemac.com/corporate/company_profile/?intcmp=AFCP
TARP: http://www.federalreserve.gov/bankinforeg/tarpinfo.htm

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

McCoy, K. (2013, September 9). 2008 financial crisis: Could it happen again? [Web log post]. Retrieved from http://www.usatoday.com/story/money/business/2013/09/08/legacy-2008-financial-crisis-lehman/2723733/

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The Role of Leadership Decision-making in the Subprime Loan Financial Crisis

Leadership decision-making is very important and played a part in the subprime loan crisis. Decision-making is not exclusive to lenders because borrowers make decisions too. A borrower’s decision-making is personal while in comparison a lender’s decision-making is business oriented. In businesses there exists a chain of command that separates the leadership from those who orchestrate the loan process. What kind of loans that are offered is a policy making decision reserved for the leadership or senior executives (Gilbert, 2011). The subprime lending segment appears to have been lacking in effective leadership decision-making. Poor leadership decision-making created a climate where predatory and negligent lending practices thrived. According to Gilbert (2011), careless lending occurs when one or more individuals with the authority to approve loans do not show care for borrowers or for investors who will be harmed by the loan default. The leadership of lending institutions should bear responsibility for the effects of the policies that they make. For example, ethically predatory lending is dishonest. Predatory lending implies that there are persons who encourage borrowers to make loans that are harmful to them (Gilbert, 2011). Further, everyone is harmed in defaults, including the lending institution and the defaulting borrower (Gilbert, 2011). Leadership decision-makers who participate in predatory lending are hurting others and go against social responsibility. The continued reign of monetary values leaves intact the Goldman Rule, which is to pursue profitable opportunities regardless the effects on others (Watkins, 2011). The Goldman Rule refers to the behavior displayed by Goldman Sachs, the most profitable bank on Wall Street, which consisted of ethically questionable activities that generated huge profits (Watkins, 2011). Leaders who consider ethics important are challenged by the fact that the quest of financial values insinuates a tradeoff between profitable opportunities and social ethics. The greater the profitable opportunities, the more likely individuals and organizations will engage in behavior without regard for the broader consequences (Watkins, 2011). Leadership decision-makers must strive to make decisions that do not take advantage of others, therefore eliminating the possibility of lowering profits.

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

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

The concept of subprime loans

A mortgage loan is classified as either prime or subprime depending on the credit risk of the borrower. Interest rates are higher on subprime mortgages, reflecting the higher credit risk (Sengupta & Emmons, 2007). The American policy of encouraging home ownership eventually necessitated making the financing of home purchases as simple as possible. Fannie Mae began demanding that lending institutions prove that they were not refusing to finance home purchases in neighborhoods considered high risk even if the prospective borrowers were good credit risks. This resulted in lending institutions lowering lending standards. With interest rates low and the easing of lending standards people were able to borrow more money. The skyrocketing values of property increased home owners’ equity. Many homeowners refinanced and took second mortgages using this equity. Banks offered easy access to money, and people were able to obtained high risk mortgages such as option-ARMs (Pritchard, n.d.). Many with poor credit ratings or with little or no documentation qualified as subprime borrowers (Pritchard, n.d.). A sharp rise in home foreclosures in 2006 mushroomed out of control in 2007 and triggered a national financial crisis that went global within a year (Allen & Carletti, 2010). The majority of the mortgage loan defaults were subprime loans. Banks and investors began losing money with the increase of homeowners defaulting on loans. To reduce risk banks began to show reluctance to lend. Eventually bank weaknesses became bank failure (Pritchard, n.d.).

Risks to Borrowers and Lenders

Subprime borrowers typically are persons that have a poor credit history or have a high a debt to income ratio. The interest rates on subprime loans are higher and this may increase the risk of the borrower defaulting on the loan, which often results in foreclosure. A great deal of subprime borrowers found that they owed more than their homes were worth once the housing bubble caused a decrease in property values, and many let the lender foreclose on their properties. Lenders of subprime loans increase their risk because of the higher possibility of borrowers defaulting. A high default rates increases monetary losses placing the lender at risk for going out of business.

References

ALLEN, F., & CARLETTI, E. (2010). An Overview of the Crisis: Causes, Consequences, and Solutions &ast. International Review of Finance. doi:10.1111/j.1468-2443.2009.01103.x

Pritchard, J. (n.d.). What Caused the Mortgage Crisis? [Web log post]. Retrieved from http://banking.about.com/od/mortgages/a/mortgagecrisis.htm

Sengupta, R., & Emmons, W. R. (2007). What is subprime lending?