Teaching Finance Ethics Using the Case of the Subprime Mortgage Meltdown
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Teaching Finance Ethics Using the Case of the
Subprime Mortgage Meltdown
David S. Steingard, Saint Joseph’s University
George Webster, Saint Joseph’s University
ABSTRACT
The authors present the subprime mortgage crisis as a case for teaching
business ethics in finance, arguing that the crisis lends itself to rich,
focused moral analyses of accountability, responsibility, and reparations.
Following a description of the flow of the subprime mortgage process, the
authors offer detailed financial and ethical analyses of the specific
transactions between stakeholders at three levels, the primary market
level, the subprime loan (i.e., instrument) level, and the secondary market
level. Broader implications for teaching ethics in finance are also
discussed.
INTRODUCTION
One of the most important developments in the world of finance over the last
century has been the collapse of the subprime mortgage market. This includes the closing
of thousands of subprime lenders, the rapid rise in mortgage defaults, the severe
downturn in the housing and construction industries, the staggering losses that have been
taken by financial service firms, and the negative effect this problem has had on the
economy at large. We already have seen two hedge funds collapse, emergency Federal
Reserve-backed buyout of Bear Stearns, the collapse of IndyMac, a large California
savings bank, and Fed’s astonishing takeover of both Fannie Mae and Freddie Mac (the
two largest institutions in the secondary mortgage market). The subprime mortgage story
is replete with insights about economics and finance, as well as about business ethics and
the moral evaluation of market mechanisms.i
The subprime story, from a pedagogical point of view, is compelling on two
fronts. First, the subprime story allows finance professors to explicate the complex
interrelationships between stakeholders and financial instruments in a variety of markets.
Second, considerable negative impacts from the case allow for focused moral analyses of
accountability, responsibility, and reparations. Ethical problems and concerns throughout
this process provide finance instructors richness in teaching ethics not often found infinance. This case and the ethical conflicts contained in it are well suited for finance
courses in investment management and portfolio theory. Obviously, this material can be
introduced when discussing risk and return. It is clear that something in this market is
wrong when a portfolio manager can earn two percentage points more than a fixed
income instrument with the same rating as to risk. A tranche with an AAA rating cannot
pay 8% if a General Electric bond with the same rating pays 6%. This material also can
be introduced when applying time value of money to bonds. The same argument holds
relative to risk and return.
This paper traces these relationships: the process involved in creating the
subprime loan; bundling and selling them to banks and Wall Street firms; and the
creation, rating, and sale of collateralized debt instruments in slices (tranches) to ultimate
investors. Our desire, however, is to introduce this material at an introductory level in
order to cover all business majors and give them a foundation in ethical issues in finance.
Generally, only finance majors take upper level courses, so the only exposure to finance
and ethics for all other majors in business schools is usually at the sophomore level
introductory finance course.
OVERVIEW OF THE SUBPRIME LENDING MODEL
Figure 1 outlines the structure and flow of the subprime lending process.
Structure and Flow of the Subprime Lending Process
The market for mortgages is generally divided into three segments: one for those
with good or excellent credit (prime), one for those with somewhat less than good credit
(Alt-A), and one for those with poor or no credit (subprime). The “trail” begins with the
application for a mortgage with someone with poor credit through a mortgage broker.
These borrowers usually pay two or three percentage points higher than those who have
good credit. Later we will discuss “teaser” rates offered to subprime borrowers. These
rates are artificially low at first, but reset at regular intervals to higher rates.
The mortgage broker is an agent of the subprime lender and operates under a fee-
for-service arrangement with the lender. The fee is determined by the amount of the loan,
among other factors, and is earned when the loan is approved. This practice leads to what
is known as predatory lending, which will be discussed later in the paper. Mortgage
brokers handle roughly two-thirds of all subprime originations. There is no licensing
requirement or federal regulation that governs the conduct of the mortgage broker.
Page 2 of 20Subprime Mortgage Process
Home Buyers Mortgage Brokers Subprime Lenders ŅBigÓBanks
Sell bundled
Apply to É Agent for.. Debt toÉ Buy Subprime
Subprime borrower Fee for service ŅCountrywideÓ
Teaser loans Do not own loan Bundle & Sell Bundle & Resell
Lend toÉ Lend ToÉ
Sell
Subprime
& prime
Debt toÉ
Investors Bond Rating Firms Wall Street Firms
Rate repackaged
Seek high returns Rate CDO Quality (Tranche) debt (CDO) Repackage Š
CDOÕs
Buy CDOÕ
s Carved into ŅTranchesÓ for fee
Collaterized
Sell ŅTranchesÓto domestic and global investorsÉ
The subprime lender, the next institution in the process, offers a wide range of
mortgage products, including those designed for the subprime borrower. These include
no-doc loans (no income verification required) and adjustable-rate loans that do not reset
annually. An example of this is the popular 3/27 loan that resets (i.e., the interest rates
change) after an initial three-year period of a low fixed rate. Over $800 billion of
subprime mortgages were originated in 2006. Large money center banks, such as Citicorp
and UBS, routinely buy these subprime mortgages, providing a source of funding to
subprime lenders, such as Countrywide Mortgage. The subprime lenders then issue new
mortgages with this cash.
The money center banks, in turn, bundle this debt and sell to financial firms, such
as Merrill Lynch and Bear Stearns. Bundling the debt comprises combining many small
subprime mortgages into a single instrument backed by the underlying mortgages. The
aforementioned financial firms then package these securities into new securities called
mortgage backed securities (MBSes) and collaterized debt obligations (CDOs). Nearly
$2.4 trillion of these securities were issued in 2006. When a financial firm creates either a
CDO or an MBS it is necessary to assess the risk so the security can be priced and sold.
Bond rating companies, such as Moody’s and Standard & Poor’s, perform this function
for fees and provide to the issuing firm an estimate of the quality of the debt. The role of
Page 3 of 20these firms is the subject of another ethical dilemma, which will be discussed later. The
rating companies provide advice on how to slice the debt instrument into pieces, or
tranches, so as to maximize the rating of each tranche.
These instruments include a mix of traditional bonds subprime mortgages, and
home equity loans. One quarter of the $375 billion CDO market was comprised of
subprime mortgages in 2006. Finally, investors, namely, investment companies, pension
funds, hedge funds, and some banks purchase these debt instruments because they
promise higher yields than other corporate bonds with the same rating (e.g., AAA). Fund
managers, ideally, try to improve returns without accepting additional risk. These
investors are the last link in this chain. By the time it reaches the end of the chain, the
subprime mortgage, initially issued by a subprime lender, has been sold numerous times
and repackaged once or twice and been sold as one element in a tranche. This tranche has
been given a certain quality rating that may or may not bear any relation to the debt
within the tranche.
FINANCIAL AND ETHICAL ANALYSES OF SUBPRIME LENDING
As depicted in Figure 2, the following sections provide detailed financial and
ethical discussions at three of the four levels of analysis.ii The levels we discuss are the
market level, the subprime loan level, and the secondary market level.
Subprime Lending Levels of Analysis
Figure 2
4. Economic and Political Impacts Level
3. Secondary Market Level
2. Subprime Loan Level
1. Market Level
Page 4 of 20FINANCIAL ANALYSIS AT THE MARKET LEVEL
Ethics Newsline editor Carl Hausmaniii is credited in the financial industry with
coining the phrase “perfect storm” to describe the underlying financial and ethical issues
of the current prime mortgage market crisis.iv “Subprime lending” usually means lending
to borrowers with less-than-pristine credit or to those with low income or few assets. As
with any investment, there is a relationship between risk and return. Interest rates
associated with subprime lending for residential mortgages are higher than they would be
for borrowers with good credit. Subprime loans are riskier loans, in that they are made to
borrowers unable to qualify under traditional, more stringent criteria. Subprime
borrowers are generally defined as individuals with limited incomes having FICO credit
scores below 620 in a scale that ranges from 300-850. Subprime mortgage loans have a
much higher rate of default than prime mortgages and are priced based on the risk
assumed by the lender.v
The first element of the “perfect storm” involves potential problems from
differing rates and terms for mortgages. One potential problem for a borrower is that the
standard subprime mortgage is the 2/28 mortgage and not the standard 30-year fixed rate
mortgage. The initial rate is fixed for two years and then becomes variable for 28 years.
There are annual and lifetime caps on these mortgage products, although the rates can
rise annually. A variation of this mortgage is the 3/27, which functions in exactly the
same way, except the initial rate is fixed for three years instead of two years. The initial
rates on these mortgages are usually low, called “teaser” rates, but then adjust upwards as
market interest rates rise. Also, subprime mortgages usually have prepayment penalties
associated with them. According to data from the Federal National Mortgage Association
(Fannie Mae), about 80% of subprime mortgages contain prepayment penalties.
Another element of the “perfect storm” involves the policy of the Federal Reserve
Bank. Shortly after September 11, 2001, the Federal Reserve began to lower the interest
rates on the federal funds “overnight” rate (the interest rate at which Fed-member banks
lend to each other on an overnight basis). These loans are often made so that banks can
maintain legally required reserves. The Federal Reserve Bank lowered the fed funds rate
in an effort to help prevent the economy from slipping into a recession after the
September 11th attacks. After a series of fed funds rate cuts the overnight reached a low
rate of 1% by 2003. As a result, financial institutions around the world were awash in
cash. Coupling a large new market for loans in the subprime category, along with a glut
of money, helped lead to the current situation.
The subprime mortgage crisis manifests itself through liquidity problems caused
by foreclosures in the global banking system. Foreclosures have accelerated in the United
States since late 2006, triggering a global financial crisis. The crisis began when the
housing bubble burst and high default rates on subprime and other debt instruments were
offered to high-risk borrowers with low incomes or poorer credit histories than prime
borrowers.vi Borrowers, encouraged by loan incentives and a long-term trend of rising
house prices, believed they would be able to refinance at more favorable terms or “flip”
their houses. Once house prices dropped between 2006-2007, refinancing became more
difficult. Defaults and foreclosures increased dramatically as ARMs reset at much higher
rates. During 2007 nearly 1.3 million house properties were subject to foreclosure. This
was an increase of about 805,000 from 2006, almost a 62% increase.
Page 5 of 20We posit the subprime mortgage market crisis and all its attendant problems, such
as hedge fund failures, massive write-downs of assets, and a depressed housing market
are the collective result of three distinct sets of circumstances. These sets of
circumstances resemble three legs of a stool. The “seat” of this “stool” represents the
monetary effects that have reverberated through the world economy.
One leg of this stool represents the expansionary monetary policy of the Fed’s
policy arm, the Open Market Committee (FOMC). As the technology-led economic
boom of the 1990s faded, the FOMC began to aggressively cut interest rates. Having
already cut the overnight rate in 2003 to 1%, the FOMC waited until 2005 to begin to
raise them; by 2005 it was apparent that the economy was not headed for recession.
Former Fed Chairman Alan Greenspan’s purposes in raising rates were both to maintain
positive economic growth and to prevent deflation. Greenspan’s critics argue that the
result of keeping rates so low for such a long period of time resulted in a glut of savings
globally, fueling demand for houses. The glut in the money supply resulted in low long-
term loan rates. The housing market became overheated and unsustainable.
The other criticism of the Fed is they adopted a “hands-off” approach with regard
to consumer protection laws. This resulted in lax lending standards, which, in turn,
resulted in borrowers taking out mortgages they could not afford. None of the Fed’s
measures to tighten oversight were focused on the type of adjustable-rate “teaser” loans
whose growth in 2005-2006 contributed to this crisis.
The second leg of the stool represents the influence of the capital market itself.
Fannie Mae initially purchased government insured mortgages; in the late 1960s its
charter was changed to allow it to buy conventional mortgages. The federal government’s
National Mortgage Association, Ginnie Mae, was established to buy Federal Housing
Administration (FHA) and Veterans Administration (VA) loans. Finally, the Federal
Home Loan Mortgage Corporation (Freddie Mac) was created to bring more liquidity to
the nation’s thrift institutions by buying their mortgages. These government-sponsored
enterprises (GSEs) are charged with providing liquidity to the prime mortgage market by
buying mortgages. They finance, in the main, by issuing bonds. This secondary market
now buys about two-thirds of all new mortgages issued and collectively hold over $5
trillion of total mortgages.vii The GSEs hold some of the purchased mortgages on their
own balance sheets; however, they also have begun to securitize mortgages and sell them
into the capital market. They do this by packaging these mortgages into bundles where
risks are also pooled. These securities, called collateralized mortgage obligations, or
CMOs, are sold directly to investors. The GSEs do not play as much of a role in the
subprime mortgage market as they do in the prime mortgage market.
Many subprime mortgages do not meet the standards of Fannie Mae, Ginnie Mae,
and Freddie Mac, so the GSEs do not purchase these mortgages as readily as they do
prime-mortgage loans. Many subprime loans have high loan-to-value rates (due to low
down payments by borrowers), have “piggyback loans” or otherwise do not conform to
GSE standards. In these cases, the GSEs will not purchase the loans. Due to a form of
financial engineering called securitization many mortgage lenders had sold the rights to
those payments and related credit/default risk to third-party investors via mortgage-
backed securities (MBSes) and collateralized debt obligations (CDOs). Investors holding
these securities faced significant losses as the value of the underlying mortgage assets
declined.viii
Page 6 of 20The third and final leg of our “stool” was rapid house price appreciation. As long
as houses gained in value year after year, the effects of resetting the rates paid on
adjustable rate mortgages by two to four percentage points was negligible. It was simply
a matter of selling the house every two to three years and repeating the process. Due to
factors discussed earlier like the Fed’s actions), no-documentation loans, high loan-to-
value ratios, and teaser rates, homeownership rates dramatically increased. Ownership
rates jumped from 64 to 69 percent of households from 1994-2005. The rates for blacks
jumped from 42 to 49 percent and for Hispanics from 42 to 50 percent of households.
Low and moderate income households (i.e., subprime borrowers) were at the center of
this ownership boomix. In 1994 subprime originations were $35 billion, representing 55%
of total originations; by 2005, subprime originations were $35 billion, or 20% of total
originations. Further, house prices were rising, permitting borrowers who had trouble
paying the mortgage to sell the house, pay any prepayment penalties, and walk away.
Home prices in the United States increased approximately 80%, or over 12%, per
year from 2000-2006. In certain locations, prices rose much faster than the national
average. In California, for example, house prices rose about 160% (or 20% per year) over
the same period. The housing boom benefited from lax lending standards and growth in
the non-agency secondary market.x The increase in house prices was also fueled by a big
drop in interest rates due to Fed action. Rates fell on both fixed-rate and variable-rate
mortgages from about 10% in 2000 to just over 7% in 2004; this corresponds to the
easing policy following the recession of late 2000. Finally, new mortgage products
allowed borrowers to stretch their payments to purchase homes priced higher than they
normally could afford.
Overbuilding during the boom period, increasing foreclosure rates, and
unwillingness of many homeowners to sell at reduced market prices increased the supply
of housing inventory. Volume (units) of new homes dropped by 26.7% compared to a
year earlier. By January 2008, the average house stood unsold for 9.8 months, the highest
level since 1981.xi. Further, four million homes were unsold, including 2.9 million that
were vacant.xii This excess supply exerted significant downward pressure on prices. As
prices fell, more homeowners were at risk of default. According to Standard &
Poor’s/Case-Schiller Housing Price Indices, by November 2007 average prices were off
8% from their peak in 2006.xiii.
Unfortunately, much of the mortgage lending of the past several years, as well as
investments in mortgage-backed securities and other debt instruments, was predicated on
a set of narrow assumptions. Unemployment was assumed to stay low, interest rates were
forecast to stay flat and home prices were expected to continue rising 10% annually. In
other words, the three legs of the stool were assumed to remain stable.
In fact this has not happened. First, unemployment has inched up from about
4.5% in when 2006 to 6.1% in August 2008. This has caused a shift in demand for houses
leading to the most drastic reduction in house prices in recent memory. The Standard and
Poor’s/Case-Schiller U.S. Home Price Indices has shown at least an 8% increase each
year since 2001, but recently has fallen 6% in 2007.xv They forecast another 7% decline
in 2008.xvi Moody’s forecasts an overall decline of 12.3%, nationwide, from peak 2006
2nd quarter to 2009 1st quarter.xvii Housing starts have fallen from a seasonally adjusted
annual rate of over 2.1 million in 2005 to about half that at the beginning of 2007.xviii
Page 7 of 20Other factors, in addition to the ones discussed here, have fueled this crisis. For
instance, a George Mason University professor opinedxix, “There has been plenty of talk
about ‘predatory lending’ but ‘predatory borrowing’ may have been the bigger problem.”
According to one studyxx, as much as 70% of recent early payment defaults had
fraudulent misrepresentations on their original loan applications. The study looked at
more than three million loans from 1997-2006, with a majority from 2005 and 2006.
Applications with misrepresentations were five times as likely to go into default. Many of
the frauds were simple; in some cases borrowers simply lied about their income. Other
borrowers falsified income documents by using computerized applications.xxi
Another contributor to the subprime crisis involves the construction industry.
Severe contraction in the construction industry has resulted in more layoffs; the economy
has experienced net job losses each month between February and April 2008. According
to First American Loan Performance company data, 12.5 % of subprime loans made in
2002 had foreclosed by May 2005. In 2006, 1.2 million household loans were foreclosed,
an increase of 42% from the previous year. The firm estimates another two million
foreclosures in 2007 and more than that in 2008, when 2.5 million ARMs will be reset to
higher rates.xxii
The increase in foreclosures has triggered huge losses in the financial services
industry. Since mortgages were bundled and sold to banks and other investors, the value
of those securities has fallen as well. Total write-downs by banks, brokerage firms, hedge
funds, and other institutions in the meltdown totaled almost $108 billion in 2007.xxiii
Predictions made in 2006 for 2007 and 2008 include the following: two million
foreclosures, an additional $150-200 billion in housing-related losses, $2-3 trillion loss in
household wealth due to a 10% decline in house prices, and $1 billion loss in local
property tax revenue from property devaluation.xxiv
Indeed, a perfect storm has arisen, resulting in huge losses everywhere in the
economy. Some of this has been the result of market forces; some of it has been the result
of greed on the part of many market participants. Consequently, ethical questions have
been raised in conjunction with this crisis.
ETHICAL ANALYSIS AT THE MARKET LEVEL
Identifying ethical issues at the market level of analysis is challenging. Individual
culpability for making unethical decisions does not exist at this level. Most of these
dynamics occur at a societal level. For example, a widespread belief that the housing
market would continue to grow at a 10% annual rate cannot be linked to the agency of an
individual. Similarly, a shared social belief that consumer income growth would rise to
match an increasing cost of living, namely housing costs, is not any individual’s
responsibility. Economic forecasts, perhaps tainted with some “irrational exuberance”xxv,
were perhaps overly optimistic, but not morally irresponsible. It would be difficult to
attach a moral judgment to something as amorphous as the market.
However, some moral accountability can be attributed to key players who shape
the market. Critics of Alan Greenspan suggest he was at fault for keeping interest rates
low, provoking much of the subprime crisis. Unlike many stakeholders in the subprime
story, Greenspan had direct control over decisions (e.g., mandating the interest rate) with
largely knowable impacts. Whether or not he used poor judgment in making these
decisions is a moral question of gatekeeping responsibility. Others blame the government
Page 8 of 20for an overly generous laissez-faire policy about regulating subprime market dynamics.
The government, in this case, is charged with making certain decisions affecting
regulation; again, how effectively they regulated is a moral question of gatekeeping
responsibility.
The unprecedented degree to which the government has bailed out subprime
disaster companies like Bear Stearns, IndyMac, Freddie Mac, and Fannie Mae may make
the government morally complicit in producing economic conditions from which
subprime loans spawned. This shifts the liability of the financial fallout from subprime
loans from private corporations who did not profit (but expected to) to the public. Of
course, government bailouts are based on the assumption that keeping the financial
system afloat, even if it means making handouts to profit-seeking corporations, is
necessary to maintain financial stability for the public good. Essentially, helping a few
corporations during tough times is a small price to pay for a widespread collapse of the
financial system.
It is reasonable to argue that the government basically let the market overinflate
and is responsible for its burst. That they have been so munificent in bailing out failing
financial institutions as well as in helping consumers may be an indication of fulfilling
some duty to repair what they helped break. Overall, though, attributing all of the
responsibility onto the Federal Reserve Bank or the United States Government is too
simplistic. The complexity of the economic situation preceding the subprime crisis is well
beyond the scope of what any individual stakeholder could generate of their own accord.
Also, mortgage brokers would have it in their best interests to encourage
mortgage consumers to take on riskier loans, predicated on the assumption that housing
values and real income would increase. Again, assigning moral indiscretion to individual
mortgage brokers who used the best available public information to counsel clients would
be unsubstantiated. Most of the individual actors in the subprime mortgage meltdown did
not directly contribute to artificially or illegitimately creating market performance
assumptions that led to the subprime meltdown. As we analyze their behavior at the
subprime and secondary market levels, however, we will see how many of them
inappropriately exploited the economic zealousness that fueled the subprime crisis.
Hausman’s idea of a “perfect storm”xxvi applies at this level of analysis., Societal
belief in continuous prosperity reflects, paradoxically, a healthy hope in human progress,
as well as an unfounded belief in sustained growth. A fine line exists between healthy
optimism for a better future and a greed that can rationalize away the reality of negative
downturns. Is it plausible to assign moral blame to an entire society for irresponsibly
advancing a halcyon economic outlook amidst obvious signs of trouble? No. Yet, as we
will see in subsequent sections, are specific ethical incursions by individual actors acting
within these market assumptions. Analogously, nobody in particular created the rules of
the game, but some of the players interpreted or ignored the rules in ways that harmed
others.
FINANCIAL ANALYSIS AT THE SUBPRIME LOAN LEVEL
The subprime mortgage market is organized around a broad base of mortgage
brokers and “net branches.” Regulation of these brokers is enforced at the state level and
is patchwork at best; neither licensing nor formal training is required. The trick in the
Page 9 of 20business is to outsource sales to these brokers and salesmen, as New Century financial
did. New Century maintained a network of 47,000 mortgage brokers and 222 branch
offices to grow to almost $60 billion in loans in 2006. Fremont Financial Corporation, for
their part, originated over $36 billion in loans the same year.
The potential problem for the borrower is that, unlike the standard 30-year fixed
rate mortgage, the standard subprime mortgage is the 2/28 mortgage. The initial rate is
fixed for two years and then becomes variable for twenty eight years. There are annual
and lifetime caps on these mortgage products but the rates can rise annually to the
borrower.
A variation of this mortgage is the 3/27, which functions in exactly the same way
as the 2/28, except that the initial rate is fixed for three years instead of two years. The
initial rates on these mortgages are usually low, called “teaser” rates, but then adjust
upwards as market interest rates rise. A typical mortgage is reset to five percentage points
over the London Interbank Offered Rate, which is based on the demand for and supply of
Eurodollars (dollar-denominated deposits in European banks). Subprime mortgages also
usually have prepayment penalties associated with them. According to data from the
Federal National Mortgage Association (Fannie Mae) about 80% of subprime mortgages
contain prepayment penalties.
Other popular mortgages issued in this market are the “interest-only” loans, which
allow borrowers to pay interest only for a period of time, and the “pick-a-payment,” for
which borrowers pick a monthly payment they can afford. Many times these loans result
in negative amortization, where the monthly payments are not high enough to reduce the
balance of the loan. The system is based on rewards for the broker for simply closing the
loan. The broker will not own the loan nor will he or she service it. There are incentives
in such cases to sell a loan that is either larger than the borrower needs or one that the
borrower cannot afford. Often, there was outright deception and fraud on the part of the
broker just so the loan could be originated.
The subprime mortgage crisis is an ongoing economic problem that manifests
itself through liquidity problems in the global banking system due to accelerating. The
crisis began when the housing bubble burst and high default rates on subprime and other
debt instruments that were made to high risk borrowers with low income or poorer credit
history than prime borrowers.xxvii Loan incentives and a long term trend of rising house
prices encouraged borrowers to borrow, believing that they would either be able to
refinance at more favorable terms or “flip” the house. Once house prices dropped in
2006-2007 refinancing became more difficult. Defaults and foreclosures increased
dramatically as ARMs reset at much higher rates.
ETHICAL ANALYSIS AT THE SUBPRIME LOAN LEVEL
Unlike at the market level, moral accountability will be easier to assign at the
subprime level because of specific fiduciary relationships between mortgage lenders,
consumers, and brokers. As the linchpin between consumers and lenders, mortgage
brokers are caught in a natural, two-fold conflict of interestxxix. First, they are morally
obligated to faithfully represent the true financial capacity and credit history of the
consumer to the lender. Second, they are morally obligated to communicate to consumers
the terms and conditions of a mortgage in a transparent and understandable manner. An
Page 10 of 20accurate rendition of a consumer’s ability to afford a loan is essential to the financial
well-being of the consumer and the lender. If consumers obtain loans they are incapable
of maintaining, they will jeopardize their living arrangement and credit score.
Inconsistent payments or foreclosures from consumers are detrimental to the viability of a
lending institution. Consumers are obligated to represent their ability to pay loans in an
honest manner. Although perhaps not as directly responsible as brokers, lenders are
morally obligated to sell loans that are within the means of consumers to pay off. Their
conflict of interest is usually mitigated because it is in the lenders’ best interest to have a
viable consumer; lenders do not profit when consumers inconsistently pay or are
foreclosed.
Our earlier analysis of the market assumptions undergirding the subprime
mortgage meltdown suggested that pinpointing moral culpability for a collective belief in
an overvalued market was implausible. Addressing moral failings at the transactional
level of the subprime mortgage itself, however, is considerably easier. Each of the players
in the transaction had particular duties to be truthful and transparent; both of these values
were frequently undermined. Let’s examine them in turn.
The promise of continuing economic prosperity, the lowest Fed interest rates in
its history, and the massive swell in subprime mortgages, made fulfilling the dream of
home ownership a reality for millions of Americans previously economically ostracized.
People with poorer credit, lower incomes, and minimal or no collateral suddenly had
access to subprime loans and homes they could purchase. Evaluating one’s
creditworthiness for a loan involves careful scrutiny of one’s credit history and future
income stream. Providing any loan is a risky proposition; providing it to an
inexperienced, new subprime consumer is manifold times riskier. Reports of consumers
overinflating and fabricating subprime loan applications are not incidental. Some
estimates suggest falsified information appeared as much as 50% of the time on
consumers’ loan applicationsxxx Clearly, many consumers, perhaps falsely emboldened
by the ease of capital acquisition, were not truthful on their loan applications. In good
times, consumers are more honest about their ability to be financially responsible. Yet, it
is also worth noting that consumers also have a very strong self-interest in obtaining a
loan they can manage; it is safe to assume consumers do not wittingly desire to have
monthly mortgage payment stress and possible foreclosure. Historically, many consumers
have worked diligently to represent themselves fairly so they could obtain loans within
their means. Nonetheless, falsification in applying for a subprime loan is morally wrong.
Applying the criteria of truthfulness and transparency to mortgage brokers reveals
another dimension of ethical challenge. Unlike consumers, who face consequences when
procuring an unmanageable loan, brokers are not held to account. Brokers’ commissions
are generated at the time consumers sign subprime loans; after the initiation of the loan,
the broker is out of the picture. This fundamental moral problem, called a moral
hazardxxxi in economics, absolves the broker of any financial liability for fallout from the
loan they brokered; whether the consumer successfully maintains the subprime loan or
fails miserably, there is no effect on the broker. Nevertheless, a broker is always mired in
a conflict of interest between having their consumer clients sign any loan and signing a
good loan. Although brokers have a professional responsibility to uphold the best
interests of the consumer, that it makes no difference to the broker the outcome of the
loan, the temptation to “get the deal” and not care about the consequences is endemic to
Page 11 of 20the transaction. Evidence from the subprime loan debacle suggests that many brokers
routinely turned a blind eye to consumers’ loan applications’ over inflation of income and
even encouraged consumers to falsify information. Some brokers not only ignored
falsified information, but exploited the ignorance of borrowers about the risks of
potentially harmful aspects of the loan (e.g., adjustable rates and balloon payments).
Moreover, this exploitation of consumers jeopardizes the foundation of the
relationship between brokers and lenders. Lenders rely on brokers to produce loan
applicants who are viable candidates for upholding loan agreements. Again, because of
the moral hazard associated with the role of the broker in the subprime loan transaction,
they have few compelling reasons to heavily scrutinize consumers and to produce loans
with a high probability of repayment. Certainly, the basic agent-principlexxxii relationship
between the broker, the consumer, and the lender ought to be upheld; economic
functioning depends on good-faith efforts by market participants to consider the well
being of those they are representing. Yet, the lack of real consequences for brokers
brokering bad subprime deals offers a temptation to let their self-interest prevail: Why
should brokers care about the viability of the loans they broker? Of course, their
individual reputations and the collective reputations of brokers in general have been
compromised; also, trust with consumers and lenders have been shattered in light of
myriad bad subprime loan deals.
Furthermore, the collapse of the consumer mortgage industry boom—both prime
and subprime—has left many of these brokers unemployed. Ironically, some brokers
seemingly elude the moral hazard of the transaction (i.e., the consumers and lenders in
trouble), yet the collective failure of the subprime market cycles back to them. Joint
deleterious actions by a group of stakeholders can have harsh consequences affecting a
wide variety of stakeholders, including the stakeholder group provoking the problem in
the first place.xxxiii Regardless of this temptation to eschew their basic duties, brokers who
knowingly broker subprime loans through conscious manipulation and lack of oversight
are morally at fault for their harmful actions.
While lenders are generally considered to have received the brunt end of the
subprime collapse, they also have moral responsibilities they might have not attended to
properly. How effectively did banks scrutinize loan applications stewarded by brokers
after evident data about serious problems on applications became legion? Lenders’ self-
interest in signing as many loans as possible may have attenuated protocols designed to
filter out bad loan applications, on income, credit history, and the value of the property
itself.
In addition to analyzing the obligations of consumers, brokers, and lenders, it is
worth taking a moment to examine the basic nature of the subprime loan, in and of itself,
as an ethical financial instrument. By nature, the subprime loan is endemically dangerous;
it expands the risk level for home mortgage borrowing to riskier segments of the overall
mortgage lending market. More late payments and foreclosures are expected with such a
product. On the other hand, the ability for lower-income borrowers to obtain home
ownership through a subprime loan reflects fulfillment of a basic right and need; secure,
affordable housing is a morally justifiable pursuit. Analogously, we can liken the
subprime loan to a gun. Placed in the right hands, it can serve a social good; placed in
the wrong hands it can lead to very unfavorable outcomes. As a product, then, the
subprime loan requires a great deal of care if it is to serve the noble purpose for which is
Page 12 of 20was intended. As described throughout this paper, however, the almost unregulated
context for subprime loans, coupled with serious conflicts of interest and an empty agent-
principle relationship, may construe the subprime loan product to be morally flawed.
FINANCIAL ANALYSIS OF THE SECONDARY MARKET LEVEL
At the secondary market level a fundamental change involving the large banks,
Wall Street firms, and the bond rating companies helped fuel the crisis. Fannie Mae
initially purchased government-insured mortgages, but in the late 1960s its charter was
changed to allow it to buy conventional mortgages. The government National Mortgage
Association, known as Ginnie Mae, was established to buy Federal Housing
Administration (FHA) and Veterans Administration (VA) loans. Finally the Federal
Home Loan Mortgage Corporation (Freddie Mac) was created to bring more liquidity to
the nation’s thrift institutions by buying their mortgages. All of these institutions are
referred to as government sponsored enterprises (GSEs). They are all charged with
providing liquidity to the prime mortgage market by buying mortgages. They finance, in
the main, by issuing bonds.This secondary market now buys about two thirds of all new
mortgages issued and together holds over $5 trillion of total mortgages.xxxiv The GSEs
hold some of the purchased mortgages on their own balance sheets but also have begun to
securitize mortgages and sell them into the capital market. They do this by packaging
these mortgages into bundles where risks are also pooled. These securities (collateralized
mortgage obligations or CMOs) are sold directly to investors. The GSEs do not play as
much of a role in the subprime mortgage market as they do in the prime mortgage
market. Many subprime mortgages do not meet the standards of Fannie Mae, Ginnae
Mae, and Freddie Mac so the GSE’s do not purchase these mortgages as automatically as
they do prime mortgage loans. Many subprime loans that have high loan-to-value rates,
due to low down payments by borrowers, have “piggyback loans” (essentially borrowing
the down payment), or are otherwise “nonconforming” to GSE standards. In these cases
the GSEs will not purchase the loans. Due to a form of financial engineering called
securitization many mortgage lenders had sold the rights to those payments and related
credit/default risk to third party investors via mortgage backed securities (MBSes) and
collateralized debt obligations (CDOs). Investors holding these securities faced
significant losses as the value of the underlying mortgage assets declined.xxxv
Many large financial institutions, including banks and other Wall Street financial
firms have replaced the GSEs; however, large lenders and other financial intermediaries
buy and pool subprime loans and/or merge subprime loans with prime loans into new
securities that diversify risk. These securities are sold directly to investors who can resell
to hedge funds, pension funds, and foreign investors, including banks. These instruments
are combined with other forms of debt, such as car loans or credit card debt, and sold as
collateralized debt instruments (CDOs). All that is necessary to do this is to be able to
price these instruments according to the level of risk. Enter the bond rating agencies.
In order to package and resell subprime mortgages it is necessary to evaluate the risks
associated with buying the securities.
The three rating agencies, Standard and Poor’s, Moody’s Investor Services, and
Fitch Group, Inc., began to rate the issued debt considered to be subprime. Unrated
subprime debt could not be priced and, therefore, could not be sold. The rating agencies
Page 13 of 20enabled the CMO and CDO markets to expand by virtue of their assessment of
creditworthiness of the debt being sold. Banks and other financial institutions typically
create CMOs and CDOs by bundling 100s of bonds and other securities, such as credit
card loans and car loans. These instruments also include mortgages, some of which are
subprime.
The credit rating companies help the financial institutions divide the CDOs into
tranches. Each tranche receives a separate credit rating from AAA (highest credit rating)
to unrated equity (lowest credit rating, or junk). The higher the rating on the debt, the
lower the risk and the easier it is to sell on the market. The rating agencies advise the
financial institutions on how to maximize the size of the tranche with the highest (AAA)
credit rating. In fact, they are paid by the financial institutions to do this. Charles
Calomiris, an expert on CDO finance and a professor at Columbia University comments:
“It’s important to understand that unlike in the corporate bond market, in the
securitization market, the rating agencies run the show. This is not a passive process of
rating corporate debt. This is a financial engineering business.”
Top-rated tranches receive an AAA rating. Riskier tranches receive an investment
rating down to BBB and the riskiest tranches go unrated. Unrated tranches are referred to
as equity tranches or “toxic waste.” The returns to the tranche are at a fixed spread over
LIBOR (the London Interbank Offered Rate). Changes in interest rates do not affect their
value in the same way that a change in interest rates affects a fixed-rate bond. If the
LIBOR rate rises, then the rate on the tranche also rises.
Two major problems exist in evaluating the worth of a CDO. First, CDOs are not
regulated by anyone and, second, it is difficult to find out what is in the CDO. Most are
sold in private placement (no transparent market exists) and values of these CDOs are not
made public. The entire market relies on the rating firms to assess the quality of the CDO.
What is clear is the fact that the rating agencies make enormous profits from structured
finance ratings. Fees are two to three times the fees charged to rate a corporate bond.
Finally, in this vein, the rating agencies grossly underestimated the chance of
default in subprime mortgages. At default, cash flows from debt repayment were not
enough to make full interest payments to even the highest rated tranches. As a result, the
lower-rated tranches became worthless. Even some AAA-rated tranches were worthless;
many took on losses, indicating they should not have been given an AAA rating initially.
ETHICAL ANALYSIS AT THE SECONDARY MARKET LEVEL
As we have seen in the preceding section, subprime loan failures have grim
consequences for consumers and lenders, while brokers generally escape unscathed.
Effects at the subprime loan transactions level have exponentially compounded effects at
the secondary market level.
If troubled subprime loans were contained between consumers, brokers, and
lenders, then the crisis would be significantly mitigated. Bad subprime loans would be
less prevalent if lenders actually kept the loans they provided to subprime applicants.
That is, lenders who maintain ownership of loans would work diligently to insure that
consumers and brokers are honest and produce loans on which the lenders can profit.
This is a natural check-and-balance structured upon lenders’ self-interests; however,
Page 14 of 20during the subprime crisis, lenders misrepresented these loans to private financial
institutions who, in turn, bundled them into MBSes and CDOs for investors.
Revisiting our analysis of the moral hazard at the subprime loan level, we see that
lenders at the secondary market level also have no incentive to insure the quality of the
subprime loans they provide to consumers. Often, these loans do not remain in the
lenders’ possession until the point when consumers have difficulty in repayment due to
personally adverse economic circumstances (e.g., job loss), adjustable rates resetting, or
simply the fact the loans were not calibrated within consumers’ means in the first place.
While the subprime loan is passed on to the private financial institutions, this
“hot potato” does not stop scalding there. Bundles of the loans into MBSes and CDOs
ultimately land in the hands of a wide variety of private investors, corporations, and
public institutions, domestically and globally. Again, the moral hazard and agent-
principle concepts apply here. Private institutions have a fiduciary responsibility to sell
their investors investments transparent in their construction and to estimate risk as
honestly as possible. The complexity and newness of these consolidated investment
vehicles make it difficult for financial institutions to accurately portray the investment.
Are they ethically responsible for selling investments that ended up performing so
miserably? Is it reasonable to expect sellers of MBSes and CDOs to warn investors of the
potential pitfalls of such a volatile product? It could be that overall societal enthusiasm
for boom times helped assuage any doubts that subprime loans might have fatal flaws;
nobody really knew how noxious these investments could be because all stakeholders
were blissfully, but dangerously, trapped in a bubble about to burst.
In spite of this rationalization, there are at least two stakeholder situations at the
secondary market level where we can assign moral culpability. First, several cases have
occurred where private financial institutions both encouraged investors (their clients) to
invest in subprime backed securities, taking a considerable loss, while simultaneously
divesting these loans from their own institutional portfolios at an enormous profit. There
is a clear conflict of interest here; knowingly directing your clients to invest in a product
that you have abandoned because it is faltering is not morally justifiable. Second, the role
of the ratings agencies in the process of the validating the worthiness of these
consolidated subprime investments is morally suspect. Ideally, rating agencies are
impartial judges of an investment’s value and risk. Arguably, rating agencies violated
their core duty to assure the public trust by not thoroughly investigating the convoluted
nature of the consolidated subprime investments. Unlike with bonds, stocks, companies,
and other more straightforward evaluations, accurately estimating the viability of
consolidated subprime investments is practically impossible. They are just too complex to
understand enough to advance a reasonable adjudication of their worth.
Adding to this complexity was a unique conflict of interest on the part of
organizations like Moody’s regarding excessive fees demanded of private financial
institutions for evaluating subprime investments. These fees, which could be three times
the normal rate for evaluating securities, definitely influenced unsubstantiated favorable
ratings for some MBSes and CDOs; self-interest prevailed over realistic valuations.
The fact that private financial institutions had knowledge of failing subprime-
based investments, and sold them to investors anyway, makes them morally responsible
for the harm done to those investors. Rationalizations offered by ratings agencies about
following a reasonable set of assumptions in evaluating subprime-based securities are
Page 15 of 20ethically unsound. Given they were dealing with a new type of security, ratings agencies
should have been extra cautious, altering conventional ratings methodologies
accordingly. For example, ratings agencies presumed the previous ten years of 10%
annual growth would continue unabated. It can be argued that this presumption
conveniently undermined a conservative and prudent forecast, especially for an untested
and inherently risky product. Likewise, disregarding the possibility that income may not
actually keep up with housing market growth is dubious. In both of these instances,
ratings agencies may have consciously focused on too narrow of historical assumptions;
they may have only marshaled that evidence that inflated the value of subprime-backed
securities. Ratings agencies have a critical gatekeeping obligation to present untainted,
truthful financial evaluations to society. Ethical justifications by ratings agencies that
their methodologies were conceived on sound assumptions are morally suspect. Ratings
agencies who eschewed their duties to provide accurate evaluations for investors are
morally responsible for a good part of the damage related to the subprime mortgage
meltdown.
Aside from the particular instances noted above, where private institutions and
ratings agencies violated their obligation to be truthful to investors, the bulk of the
tragedy surrounding the subprime mortgage meltdown is not attributable to individual
actors. As we discussed in the earlier market level analysis section, much of the frenzy
for consolidated investments based on subprime loans was legitimately motivated by
broader, promising economic conditions and forecasts. In a sense, then, the subprime
crisis is really a failing of society—functionally, by business and government at the
institutional level—to detect the inevitable economic collapse based on the faltering
subprime mortgage loan instrument. All of the stakeholders played an important part in
contributing to the crash, but no stakeholder in particular can be held entirely responsible.
PROGNOSTICATION ABOUT THE FUTURE OF THE SUBPRIME MORTGAGE
MELTDOWN
As we move into the fourth quarter of 2008 the evidence on the root causes of the
subprime crisis suggests there is more pain to come. To date, we have witnessed nine
bank failures, a forced fire sale of Bear Stearns at $10 per share, the collapse of two
hedge funds, Freddie Mac and Fannie Mae government takeovers, and trouble that
extends to the thrift industry. The financial service industry has written off over $300
billion since 2006 and no one is certain of how much more will be written off; no one is
certain how much the debt is worth. Savings and loan banks, combined wrote off $8.8
billion in the fourth quarter of 2007 and over $46 billion for the first half of 2008. The
Federal Deposit Insurance Fund has lost $8 billion (or over 15%) in one year. Over 100
banks are on the FDIC’s watch list. of banks it considers to be in some financial distress.
Profits at FDIC-insured banks fell by 86% during the second quarter of 2008.xxxvi Over
the next year the financial services industry will continue to experience its most severe
crisis in 30 years; already almost six quarters of earnings have been wiped out.xxxvii
At the housing industry level, as of May, 2008 there were 4.5 million homes on
the market. This represents an 11-month supply.xxxviii Total real estate assets lost $435
billion in value and financial assets lost $1.3 trillion.xxxix
Page 16 of 20The loss is just as severe on a personal level. Moody’s forecasts home prices to
fall by 12.3% by first quarter of 2009 from 2006. Housing starts have been halved from
the level in 2007. In 2008, 2.5 million adjustable rate mortgages will reset to higher rates
because mortgage rates have risen to over 6.255 for 30-year fixed.xl Analysts’
predictions include for two million foreclosures in 2008-2009 and a loss in household
wealth of between $2-3 trillion due to a 10% decline in house prices. Estimates of
property tax losses are about $1 billion.xli
INSIGHTS ABOUT TEACHING ETHICS IN FINANCE
Analysis of the subprime mortgage meltdown in this paper offers many insights
for finance professors who desire to integrate more ethics into their pedagogy. In addition
to a specific analysis of the particular subprime case study, there are a number of useful,
more general conclusions about the healthy functioning of markets and the fundamental
ethical preconditions necessary for them. These can be integrated and applied in any
teaching related to markets, economics, and finance:
1. Transparency: Misinformation leads to misinformed choices and harmful
consequences. Of course, how much information to disclose, ignore, or obfuscate,
even fabricate, and to whom are weighty moral questions. At the very least,
however, stakeholders have a right to know information that could have material
impacts on the consequences of their decisions.
2. The rights of capital: Making a profit and maintaining competitive advantage is
always constrained by a basic moral duty to be trustworthy and not manipulate
others for personal gain.xliv An absence of deception is necessary to establish trust.
Free-market systems are, in essence, not totally free; they depend upon a solid
moral foundation to function properly.
3. Fiduciary responsibility and gatekeeping: All stakeholders in a market situation
have obligations to limit their self-interest by considering moral impacts of their
actions on others. Certain stakeholders, as we have seen with brokers and ratings
agencies in the subprime case, have additional duties to be accountable to specific
parties (agent-principle relationship) and society at large (gatekeeping).
4. Risk and return: All economic decisions involve calculations of risk and return.
As illuminated in the subprime case, there are degrees of moral responsibility
associated with both distributing (selling) and receiving (purchasing) risk.
Determining a standard of reasonableness is a critical skill of moral adjudication
as it relates to risk and return. Potential for a moral hazard ought to be related to
risk-and-return calculations, although frequently is not.
In addition to moral learnings explicated throughout the case, we have provided
some basic definitions of ethical concepts in the endnotes for the paper. All of these can
be employed by finance professors to enhance pedagogical discussions of ethics related
to finance. We hope finance professors will continue to evolve in their pedagogy the
financial and ethical analyses presented here.
Page 17 of 20Endnotes
i
“Moral” and “ethical” are used interchangeably throughout the paper.
ii
We do not include explication of the fourth level of analysis or the systemic
nature of the levels due to space considerations of this manuscript.
iii
http://www.globalethics.org/newsline/2007/08/27/subprime-lending-subpar-
ethics-and-the-perfect-storm/
iv
Shiller, Robert J. (2008). The Subprime Solution: How Today's Global
Financial Crisis Happened and What to Do about It.
v
http://en.wikipedia.org/wiki/Subprime.
vi
Subprime Mortgage Crisis, episode 0629007, Bill Moyers Journal, PBS,
6/29/07.
vii
Tabulated from Home Mortgage Disclosure Act (HMDA) data 2005.
viii
Ibid, Bill Moyer’s Journal.
ix
Source: U.S. Census Bureau data.
x
Data From Moody’s: economy.com.
xi
The Boston Consulting Group, “Investment banking and Capital Markets
Report,” 11/07.
xii
Census Bureau Reports on Residential Vacancies and Home Onwership,
U.S. Census Bureau, 10/26/07.
xiii
America’s Economy, 2008.
xv
Data from Standard and Poor’s, 2007.
xvi
Ibid.
xvii
Moody’s Economy.com.
xviii
Source: Commerce Department.
xix
January 13, 2008 column in the New York Times.
xx
BasePoint Analytics.
xxi
New York Times.com.
Page 18 of 20xxii
Bureau of labor Statistics, 2007.
xxiii
Data from: http://services.Inquirer.Net, article id = 101568.
xxiv
Source; David Gaffon, WSJ.com.
xxv
Shiller, Robert J. (2005). Irrational Exuberance.
xxvi
http://www.globalethics.org/newsline/2007/08/27/subprime-lending-subpar-
ethics-and-the-perfect-storm/
xxvii
Bill Moyer’s Journal, episode 06292007, PBS, 6/29/07.
xxix
A “conflict of interest” is defined as a: “…situation in which one’s ethical or
legal duties as an employee or professional conflict with one’s personal
interests. Even the appearance of a conflict of interest can undermine the
integrity or trust that must often be presupposed in business situations.”
Source: DesJardins, Joseph. (2008). An Introduction to Business Ethics
(Third Edition).
xxx
Wall Street Journal, 2007.
xxxi
A “moral hazard” is defined as: “One of two main sorts of market failures
often associated with the provision of insurance. Moral hazard means that
people with insurance may take greater risks than they would do without it
because they know they are protected, so the insurer may get more claims
than it bargained for.” While this definition specifically applies to insurance,
the analogy to the sales of financial instruments, considering risk and return,
is similar. Source: The Economist.com
.
xxxii
The “agent-principal relationship” is defined as: “A U.S. common law
concept that understands employees as agents of employers (the “principal”).
Agents are hired to perform certain tasks and have duties to always act in the
best interests of their employer. These “fiduciary duties” include loyalty,
obedience, and confidentiality. Source: DesJardins, Joseph. (2008). An
Introduction to Business Ethics (Third Edition).
xxxiii
In an ironic turn of events, some unemployed brokers have turned to
counseling financially troubled mortgage holders.
xxxiv
Tabulated from Home Mortgage Disclosure Act (HMDA) data 2005.
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