Ethical and Legal issues concerning sub-prime mortgage lenders

Outline

I. Introduction II. Subprime History III. What lead to subprime lenders making unethical and illegal decisions IV. What safe guards are in place V. Conclusions VI. Works cited page

Introduction

When most people hear the phrase “subprime lending”, the first thoughts that come to mind are the mortgage meltdown; predatory lenders, high interest mortgages for borrowers who have poor credit or low incomes. All of these thoughts may be true to a certain extent, but contrary to popular belief subprime mortgage lending has helped expand homeownership for all borrowers regardless of credit or income level in the US between 1995 and 2006 (Favro, 07). The problem is that this ethical and legal lending market took an unethical and illegal turn and has been cited as one of the contributing factors that aided in many Americans defaulting on their home loans that resulted in sending this country and many others into one of the biggest recessions since the Great Depression. It has been almost six years since the subprime meltdown and this country, the housing markets, and the economy have yet to fully recovered. In this research paper I will cover the history and original purpose of subprime lending, what lured the subprime lending market to take an unethical and illegal turn, and what safeguards have been put in place to lessen the likely hood of subprime mortgage lenders making unethical and illegal decisions in the future.

Before continuing, lets look at the definitions of a few words, the first is ethical: dictionary.com defines ethical as “being in accordance with the rules or standards for right conduct or practice, especially the standards of a profession”. Some of the synonyms that are associated with ethical are: moral, upright, honest, and honorable. The next definition is legal: dictionary.com defines legal as “a person who acts in a legal manner or with legal authority. The synonyms that are associated with this word are legitimate and sanctioned.

Businesses generally have a responsibility to act and operate under fiduciary duties, or obligations. There are a few categories that these duties or responsibilities fall into, but the duties I want to highlight are loyalty, care, and information, all of which are considered to be ethical and legal. These duties essentially require that a company, business, person, etc. act truthfully, in a timely fashion and in the best interest of the business and consumer (Mallor, Barnes, Bowers & Langvardt, 2013). During the peak of subprime lending, lenders were tempted by speculation of high returns on investments through subprime lending. This lure seemed to blind lenders causing them to ignore their fiduciary duties, engaging in unethical and illegal practices such as misleading shareholders about the diversity of mortgage portfolios and not verifying the ability of the borrowers to repay mortgages. Additionally, they also took advantage of borrowers through adjustable or teaser rates that they knew borrowers could not afford. All this coupled with a housing market that eventually came crashing down was a receipt for disaster that caught many by surprise.

Before we look at what lead subprime lenders to make unethical and illegal decisions, lets look at the history of the subprime lending market and how it developed to what it is today.

Subprime History

Looking back over the last 50 years to the mid 70s traditional banks such as savings and loan institutions controlled nearly 60%-70% of the mortgage market. Today that is not the case, these traditionally institutions only account for about 10% percent of the mortgage market due in part to a new class of specialized mortgage lender that emerged in the early 80s, a lender that was free from the regulations of traditional financial institutions; the subprime mortgage lender (Couch). These were lenders (investment banks, brokerage firms, insurance companies, and other financial institutions; which will be discussed in more detail) specializing in loans to borrowers who could not qualify for traditional mortgages because of poor credit scores or low incomes. Thus subprime lending began and in 1981 (Couch) the first subprime mortgages were offered to borrowers with adjustable interest rates, though the subprime mortgages as they exist today (i.e. 2/28 loan, interest only loans, option ARM, etc.) did not become widespread until the mid 90s.

In the genesis of subprime lending this market was a small market that allowed borrowers who were considered high risk to get financing at higher interests rates with incentives for the first few years that lowered monthly payments. An example is the 5-1 adjustable rate mortgage (ARM). The first number in the set refers to the initial period of the loan, during which the interest rate would stay the same. For instance if the rate was 2% the day the borrower signed the loan papers, the rate would be fixed for the first five years of the mortgage period. The second number was the adjustment period, showing how often adjustments could be made to the rate after the initial period had ended. This rate was generally considerably higher than the initial fixed rate for instance 8%, though by this time the borrowers credit was good enough to qualify for a conventional mortgage and at that point the borrower would refinance at a lower fixed interest rate. The purpose of doing this was to help those with low income or credit scores build credibility removing them from the category of high risk.

Now, we will look at how subprime lending got out of control and what lured many subprime lenders into making unethical decisions that contributed to sending this country into an economic nightmare.
What lead to lenders making unethical and illegal decisions
In looking at the ethical and legal issues concerning subprime lending as stated earlier the subprime lending market was initially a small market. In the mid 90s less than 5% of mortgages in the US were subprime mortgages, and this was due in part because traditional banking institutions offered fixed-rate, prime-market mortgages. Very few alternative mortgages were available to borrowers. By 2005 nearly 20% of mortgage loans were subprime. The rise in subprime lending was due to changes in the banking system and in federal laws. These new laws allowed investment banks, brokerage firms, insurance companies, and other financial institutions to offer mortgages. These companies competed aggressively with traditional banks and each other to offer new products to borrowers that resulted in a wide variety of mortgage products and choices for prospective borrowers, including subprime loans.
If we continue to peel the onion the terrorist attacks in 2001 shook an already struggling economy, which was just making the turn from a recession that was brought by the dotcom bubble of the late 90s. In response to the terrorist attacks in 2001 the Federal Reserve began cutting rates until the federal fund rate was about 1%. The intent was to use the low rate as a catalyst to encourage borrowing, spending, and investing to jump-start a stalled economy. It work and the economy started moving. With the low interest rates real estate started to look very attractive. The number of homes and the prices that they sold for increased at alarming rates. With the real estate market looking very lucrative asset-back securities (a financial security backed by a loan, lease or receivables against assets) become a very popular investment. Additionally, with credit rating agencies like Moody’s and Standard & Poor’s putting their “AAA” approval on these types of securities it signaled that these investments were safe (Barnes, 2007). As the real estate market continued to grow asset backed securities began to be bundled with subprime loans. Even though these loans were being placed into different risk categories, they were still receiving “AAA” ratings. Because of the good ratings subprime lenders had an opening to sell their risky debt to investors. As a result, originating subprime loans became very profitable. Financial law and regulations during this time became lax. It wasn't long before subprime mortgage lenders were overlooking the basic requirements such as proof of income; credit checks, and down payments. Also, subprime lenders were guilty of predatory lending practices (“originating loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities” (THE FINANCIAL CRISIS INQUIRY COMMISSION, 2011)). Many borrowers were lulled into a false sense of security, and took sub prime mortgages assuming they would be able to sell or refinance their homes before the adjustable interest rate period kicked in because real estate prices were rising so fast at the time. Investors too were mislead by lenders who passed the risk to them by allowing them to invest in some of the debt in exchange for a high rate of return on asset-backed securities which in the end ended up being worth absolutely nothing.

Seeing some of the contributing factors that lead to ethical and legal dilemmas with subprime lending, now we look at the safe guards that are being implemented to prevent unethical or illegal subprime mortgage practices.

What safe guards are in place

Since the subprime meltdown, there have been some dramatic changes in the requirements to qualify for prime/subprime mortgage loans. These requirements make qualifying for a mortgage loan more stringent than in the past. Before a person didn’t have to do much to qualify for a loan during the housing market bubble. There was a bill put in place in 2010 that revamped the financial mortgage market. Some of the requirements were implemented straightaway: * “Lenders are now required to retain at least 5% of the loans that are securitized * There are stricter limits on prepayment penalties, or fees when borrowers pay off the loan * Lenders have to scrutinize borrower’s financials to ensure they have the ability to repay the loan (will be required to show lots of paperwork—pay stubs, bank account statements, tax forms, etc.) * Brokers will no longer be paid based on navigating a borrower to a particular type of loan * Appraisal management companies that order appraisals will now have to be registered with the state” (Timitaos, 2010)

A number of mortgage bankers say “that lending standards are tighter today than at any time in the past two decades, and most loans being made today are conventional fixed-rate loans that are backed in some way by the federal government.” (Timitaos, 2010) I can attest to the new stringent standards that the government has implemented. I recently purchased some investment property, and to actually get approved for the loan I had to do everything but give the bank my blood and DNA samples to prove that I was financially stable to repay the loan. They begin by checking my credit score, and asked if I had 20 percent of the loan to put down, which is typical when buying investment property. What I was not prepared for was what I thought was an interrogation of myself, my financials, and background history of my family. Additionally, I had to show that I had 30K in liquid cash in addition to the 20 percent that was already required. The loan officer was frank, when I asked was all this necessary? His response was “the bank (Wells Fargo) has an obligation to protect its interest as a lender and my interest as a borrower.” He continued saying, “we do not want a repeat of what happened five years ago [subprime meltdown].”

Though I was not dealing with a subprime lender, ethically that was the right thing to do, legally that was the right thing to do. Initially, I thought this was very stringent, but after thinking in the best interest of the bank as the lender, and myself as the borrower, these requirements are justified for a number of reasons. One it shows that there is minimal risk that I would default on the loan. Second, by not defaulting on the loan, it allows the houses in the neighborhood that I brought the investment property to maintain their value. Third, by not defaulting on the loan it helps the bank and other investors who buy securities stay in business, which will ultimately lead to a continuing and thriving economy.

Conclusion

At the root of the subprime problem many subprime lenders were blinded by greed and forsook their fiduciary duties of loyalty, care, and information. The subprime lending market was small for a reason, because this market was made up of high-risk borrowers. The idea of lucrative gains by gambling on a high-risk mortgage market at first seemed to be a win-win for everyone involved. In hinds sight many people invested in borrowers who were already deemed high-risk that coupled with lax financial laws and regulations and unethical and illegal decisions ended up being a receipt for disaster. As I stated in the beginning the subprime lending market helped expand homeownership for all borrowers regardless of race and income level in the US between 1995 and 2006. The problem was that this small market was supposed to be used to help high-risk borrowers qualify for conventional loans but it grew and expanded to the point where control of this market was lost and we paid a hefty price. The upside to this whole situation is the subprime mortgage market is going through a serious overhaul to prevent something like this from happening again.

Works Cited Page

Barnes, R. (2007, Sept 04). The Fuel That Fed The Subprime Meltdown. Retrieved from http://www.investopedia.com/articles/07/subprime-overview.asp

Couch, A. (n.d.). The history of sub prime mortgages. Retrieved from http://www.ehow.com/about_6507781_history-sub-prime-mortgages.html

Favro, T. (07, April 14). Us subprime mortgage crisis hurts individuals and whole communities. Retrieved from http://www.citymayors.com/finance/us-subprime.html

Mallor, J. P., Barnes, A. J., Bowers, T., & Langvardt, A. W. (2013). Business law: The ethical, global, and e-commerce environment. New York, NY: McGraw-Hill/Irwin

THE FINANCIAL CRISIS INQUIRY COMMISSION. Financial Crisis Inquiry Commission , (2011). The financial crisis inquiry report (111-21). Retrieved from Government Printing Office, website: http://www.gpo.gov/fdsys/pkg/GPO-FCIC/content-detail.html

Thibodeaux, W. (n.d.). How business ethics relates to subprime mortgage market read more: How business ethics relates to subprime mortgage market | ehow.com http://www.ehow.com/info_7754132_business-relates-subprime-mortgage-market.html

Timitaos, N. (2010). How financial overhaul changes the mortgage market. The Wall Street Journal , Retrieved from http://blogs.wsj.com/developments/2010/07/16/how-financial-overhaul-changes-the-mortgage-market/