"Under the hood" - working on the subprime loans assignment....

(Reading at Starbucks - photo from my Instagram account: https://www.instagram.com/p/BEHEpc6CyCL/?taken-by=moorefo1picblog)

Working on drafts:

Post 3 of 3:

During the financial crisis, in April 2007, federal banking regulators encouraged banks to approach homeowners in trouble to work-out a new deal. Federal banking agencies also published a “Statement on Subprime Lending” in June 2007 on the risks of offering non-traditional mortgages to subprime borrowers. 

Not surprisingly, many of the predatory mortgage-lending practices associated with subprime mortgages were later banned. Congress passed two acts: the Emergency Economic Stabilization Act of 2008 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 to resolve problems that caused the financial crisis. Some noteworthy changes included in the Dodd-Frank Act include: (1) requirement for lenders to ensure that borrowers have the means to repay loans, (2) requirement for lenders to provide a worst-case scenario for ARMs, (3) requirement for capital to be reserved against a minimum of 5% of mortgage loans sold for securitization, which would ensure that banks and bank holding companies lose if they do not underwrite quality loans, (4) requirement for intermediaries in the secondary market (securitizers) to disclose information that would provide investors with enough knowledge of loan quality, and (5) creation of an independent Consumer Financial Protection Bureau (CFPB) to make and enforce laws for the fair, equitable, and non-discriminatory access to credit. The new CFPB would take over the handling of consumer complaints about banks and other mortgage-related businesses from 7 federal agencies and also have the authority to take action against bad lending practices without a law from Congress authorizing such action, if time is of the essence.

The acts addressed noted problems that caused the mortgage and financial crisis. These changes should prevent those problems from reoccurring. Some saw problems with the new requirements. Holstein (2013) believes that 5% minimum capital reserve requirement is too low to be an “effective disincentive.” Many noted that there are still some areas or issues that need to be addressed such as the need to discourage banks from investing in the mortgage-backed securities rated AAA internally so there would be more securities available outside of the banking system (and the full benefit of securitization attained) (Holstein, 2013).

Brauneis, M., & Stachowicz, S. (2007). Subprime Mortgage Lending: New and Evolving Risks, Regulatory Requirements. Bank Accounting & Finance, 20(6), 28-34.

Docking, D. S. (2012). The 2008 financial crises and implications of the Dodd-Frank Act. Journal Of Corporate Treasury Management, 4(4), 353-363.

Holstein, A. D. (2013). How well does Dodd-Frank address regulatory gaps and market failures that led to the housing bubble? Journal Of Business & Behavioral Sciences, 25(1), 21-35.

Taub, J. (2016). The Subprime Specter Returns. New Labor Forum (Sage Publications Inc.), 25(1), 68-77.

Post 2 of 3:

Intermediaries in the secondary mortgage market that purchase loans from lenders have requirements or specifications that communicate what they will purchase/accept. This is important because the ability to turn around and sell a mortgage loan (rather than hold it) after underwriting it or providing it to a consumer, means that lenders would have less of an incentive to provide/underwrite quality loans.

There were some ethical issues with some of the loans offered. Some loan types such as “stated income” encouraged homeowners to be dishonest about their incomes in order to qualify for a loan. The financial institution did not verify or check the income noted in the application for a “stated income” loan. And, most of these “stated income” loans were classified as Alt-A loans (another type of loan considered to be loans of fairly high quality – just below prime loans or near-prime) if the borrower had a reasonable credit score.

Further, the fact that lenders (banks, mortgage brokers and other financial institutions) made the policy decision to “offer ARMs to applicants who can barely qualify at the initial rate, and who will probably be unable to meet their obligations if the rate increases in the future does present an ethical issue.” (Gilbert, 2011, p. 97) (emphasis added). The institutions advertised risky products to lower-income segments of the population such as blue-collar workers, high school graduates, and older people, and encouraged them to use the products although the products/mortgages were likely to harm them. Later, when a lot of these individuals had problem affording mortgage payments, they complained that the institutions did not adequately explain the details. This lending practice is known as predatory lending. Lenders were driven by the profit motive and did not always act in good faith.

However, subprime loans have also enabled “some borrowers to move beyond their credit-blemished past into homes” (Smith & Hevener, 2014, p. 323). A lot of Americans took advantage of low down-payment loans and other types of subprime loans to own a home. Banks therefore helped the community by providing loans to the underserved, meeting the requirements of the Community Reinvestment Act of 1977. This Act was seen as partially responsible for the subprime mortgage crisis.

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

Brauneis, M., & Stachowicz, S. (2007). Subprime Mortgage Lending: New and Evolving Risks, Regulatory Requirements. Bank Accounting & Finance (08943958), 20(6), 28-34.

Leonhard, C. (2011). Subprime Mortgages and the Case for Broadening the Duty of Good Faith. University Of San Francisco Law Review, 45(3), 621-654.

Ross, L. M., & Squires, G. D. (2011). The Personal Costs of Subprime Lending and the Foreclosure Crisis: A Matter of Trust, Insecurity, and Institutional Deception. Social Science Quarterly (Wiley-Blackwell), 92(1), 140-163. doi:10.1111/j.1540-6237.2011.00761.x

Smith, M., & Hevener, C. (2014). Subprime lending over time: the role of race. Journal Of Economics & Finance, 38(2), 321-344. doi:10.1007/s12197-011-9220-9

Post 1 of 3:

Subprime mortgage loans contributed significantly to the 2008 financial crisis and a long recession. The significant and growing number of mortgage failures/foreclosures in 2007, which economists believe was the beginning of the long recession, were mostly on subprime mortgages. In 2007, less than 20% of all outstanding mortgage loans in the US were subprime loans, but more than half of the foreclosure initiations were on subprime loans.

A subprime mortgage loan is a mortgage loan for persons who present more risk because they have a less than desired credit score (there is more risk that the loan would not be repaid). In the U.S., the number of subprime mortgage loans by banks, mortgage brokers, and other financial institutions increased from $35 billion in 1994 to more than $600 million in 2005. The majority of the $600 million + of subprime mortgage loans (84%) were for the refinancing of existing mortgages and for second mortgages. Many consumers used high home values to obtain additional loans (effectively borrowing against the increased value of their homes).

In 2006, more than two-thirds of the subprime mortgage loans were adjustable rate mortgages (ARMs), which means that the interest rate of the mortgages would adjust or change over time. Some were balloon mortgages and other types of mortgages. Subprime loans were risky for the borrower. ARMs had the risk that the interest rate would adjust to a rate that made the mortgage unaffordable. For balloon mortgage loans, there was the risk that when the (large) balloon came due in a future year, the borrower who could not afford the balloon payment would not qualify for a new mortgage loan for the balloon amount.

For lenders, the loans were considered risky and therefore had a higher interest rate/return for the increased risk of non-payment or default on the loans. However, lenders usually sold the loans to intermediaries in the secondary mortgage market – institutions that created mortgage-backed securities or collateralized mortgage obligations – at a profit. When the loans were sold, the risk transferred to institutions that purchased the loans.  When the institutions pooled the mortgages and sold as securities in the financial market, the risk transferred to security holders. It is believed that the increase in the secondary mortgage market or securitization of mortgages was one reason for the growth in subprime loans.

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. doi:10.1111/j.1467-8594.2011.00378.x

Pajarskas, V., & Jočienė, A. (2014). Subprime Mortgage Crisis In The United States In 2007-2008: Causes and Consequences (Part I). Ekonomika / Economics, 93(4), 85.

Ross, L. M., & Squires, G. D. (2011). The Personal Costs of Subprime Lending and the Foreclosure Crisis: A Matter of Trust, Insecurity, and Institutional Deception. Social Science Quarterly (Wiley-Blackwell), 92(1), 140-163. doi:10.1111/j.1540-6237.2011.00761.x

Blog created for the MGT7019-8 Ethics in Business course at Northcentral University.
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