Ethical Lessons of the Financial Crisis

Eileen Flynn, Eileen P. Flynn

• Publisher: Routledge
• Year: 2012
• Print ISBN: 9780415516754
• eBook ISBN: 9781136343124
• Topic: Business
• Subtopic: Business General
• Index: Business

In the aftermath of the economic crisis of 2008 it is important to ask what ethics has to say to the many stakeholders in the U.S. economy. The crisis in the financial industry, precipitated by the bursting of a bubble in the housing sector, brought the U.S. economy to the brink of a major depression. Government officials, economists and financial executives intervened to implement measures to mitigate the damage, applying their expertise and using their best judgments to rescue the economy. The actions they took required technical competence, pragmatic judgments and controversial decisions. They worked through a crisis to try to prevent a very bad situation from becoming a catastrophe. As events played out in the autumn of 2008, there was little time to reflect on how immoral conduct contributed to the crisis and how financial recovery needs to be built on an ethical foundation. The purpose of this book is to examine the role of ethics in setting things right. In taking a close look at the events of 2008 this book makes an important contribution to business ethics.

1
WHAT WENT WRONG?

On September 15, 2008, with the collapse of Lehman Brothers, the fourth largest investment bank in the United States, and an avalanche of alarming financial news, the U.S. economy faltered, and a severe recession, perhaps a depression, loomed on the immediate horizon. The problems had been building for a few years, but it was only after Lehman’s collapse that most people became acutely aware of the perilous state of the economy. People did not know that a complicated host of systemic and structural factors came together to cause the mess that dominated headlines and brought them fear and confusion. Their questions were pointed: what caused this crisis? Who is affected? What needs to be done to set things right? We address the first question in this chapter; subsequent chapters respond to the second and third questions. While there is no question that moral failure contributed to the perfect storm, we will hold off on ethical analysis for now and concentrate on what went wrong in the marketplace.

What Caused the Economic Crisis?

The financial crisis began with the issuance of mortgage loans to people who were not able to repay them, followed by the bundling of mortgages and packaging them into securities, which were sold to investors all over the world. Insurance was written to cover losses if mortgage-backed securities defaulted and this insurance was sometimes purchased by investors to speculate that there would be a crash in the housing market. Issuance of insurance on mortgage-backed securities made the crisis complex and far-reaching.

Let us begin by considering the role mortgages played in the crisis. Problematic mortgage loans were made during the boom years of 2001 to 2005, a time when home prices were rising rapidly. By 2007, housing prices stopped rising, many borrowers lacked the ability to sell their homes or make mortgage payments, and it was apparent that there were major problems in the housing sector. The combination of few home buyers, many houses for sale, and homeowners unable to make mortgage payments deflated the housing bubble.

Mortgages. Most people do not have enough money to buy a house with cash so they borrow money to buy the house. The money to buy a house comes from a lender and a borrower uses these funds to purchase the property. At the time of purchase the borrower gives a mortgage to the lender and the mortgage entitles the lender to take possession of the property in the event that the borrower does not repay the loan. The property stands as collateral against the loan.

In the vernacular, however, people think of mortgages as loans secured by properties and given by lenders to borrowers. They consider a mortgage to be an agreement requiring that money borrowed from a lender to buy a house should be repaid by the borrower. It is in this vernacular sense that we will use the term mortgage.

For most people, a mortgage is the largest and most serious financial obligation they ever undertake.¹ How do people get a mortgage? Mortgage brokers often arrange for borrowers to obtain financing in order to buy residential real estate. Alternatively, a prospective buyer can go directly to a bank or other lender to procure a mortgage. After borrowers pay off their mortgages, they own their homes. Until the mortgage loan is repaid, the house stands as collateral; if the borrower does not make payments, the lender can take steps to evict the borrower and sell the house in order to satisfy the loan. Should this occur, the process is known as foreclosure.

In the early years of the new millennium a housing bubble developed during which housing prices rose higher and higher in an over-inflated market. The bubble was created by rising home prices along with the assumption that prices would continue to increase. Both prospective homeowners and speculators who were seeking gains on real estate investments thought that it was important to buy now because tomorrow the house would cost more. There were more buyers than sellers and scarcity contributed to the bubble. In this environment many people who already owned homes borrowed against the equity in their homes and used the borrowed money to make purchases. (These loans were called home equity loans.) Both those who financed their homes with mortgages and those who borrowed money with home equity loans assumed that, if they were ever in a situation of financial distress, their homes would have appreciated in value and they could sell their property for more than they owed and pay off the mortgage and home equity loan.

In regard to appreciation in home prices, consider statistics released by the Federal Deposit Insurance Corporation in February 2005 at the height of the market:

U.S. home prices have boomed in recent years. Average U.S. home prices rose 13 percent in the year ending September 2004, and are up almost 50 percent over five years. In December 2004, the Office of Federal Housing Enterprise Oversight (OFHEO) noted, “The growth in home prices over the past year surpasses any increase in 25 years.”²

While the figures just cited relate to the nation as a whole, in some markets the increase was even higher. Hyper-inflated markets included Washington, D.C., Boston, San Diego, Las Vegas, Phoenix and South Florida. In the so-called sand states of California, Nevada, Arizona and Florida, builders borrowed money and constructed developments in anticipation of housing demand.

During the housing boom the mortgage brokerage industry thrived. Mortgage brokers were kept busy securing mortgages for first-time home buyers who were eager to buy a house and for people who wanted to trade up. A broker is an intermediary between a lender and a borrower. The broker brings the two together and arranges financing for a home purchase in the form of a mortgage. The broker gets paid a salary and/or commission for performing this service. In an ideal situation, a borrower would have a dependable source of income and would be able to afford reasonable mortgage payments and a lender would have enough capital to continue to operate even if a significant number of borrowers did not repay their loans. Both lender and borrower would be well served by the broker if the broker ascertained that the borrower’s employment and credit history were acceptable and that borrowers could meet their debt obligations.

Given the tenor of the times, however, many mortgage brokers sidestepped established protocols and obtained financing for borrowers who lacked the ability to repay their loans. These types of mortgages were called subprime mortgages. The term subprime is often misunderstood by people who think that the loan itself is somehow less than reasonable or ideal. This is not the meaning of subprime. Subprime means that borrowers likely lack the ability to repay the amount they owe. Certain classes of borrowers are subprime, such as those with poor credit scores, insecure employment, or wages so low that they cannot make payments. The mortgages that they procure may or may not be reasonable loans.

During the course of the housing bubble, novel types of mortgages were introduced to borrowers and some of these were unsound. Each of these mortgages differs from a so-called prime mortgage. A prime mortgage is obtained by a borrower with a dependable source of income and a good credit score; this mortgage typically has a term of fifteen, twenty or thirty years and a fixed rate of interest. Prime mortgages are issued to borrowers with substantial down payments of approximately 20 percent. Unsound mortgages included interest-only loans in which the borrower would pay only the interest for a specified number of years and then, at the conclusion of the term, the principal would be due in full. (In a traditional mortgage, a borrower pays down the principal over the course of the loan; interest is included along with principal in each payment.) Adjustable rate mortgages (ARMs) were also issued in which the rate of interest the borrower paid was linked to changes in the market. Typically, the rate would be low at the outset and would reset to higher rates down the road, as interest rates fluctuated in the economy. There was also a product known as a balloon mortgage which typically came due in five to seven years. With a balloon mortgage, a consumer’s payments are roughly comparable to what a person would be required to pay monthly on a thirty-year mortgage but, at the end of the term of five or seven years, the entire principal amount comes due. The most novel type of mortgage that was marketed was termed pick-a-pay. With this the borrower was allowed to choose each month from among options: make a predetermined minimum payment; pay the interest only; pay the principal only; or make a traditional payment of interest and principal. However, if the payment that was picked was for an amount that was less than the required traditional payment, the difference would be added to the principal of the loan so that the total amount owed would increase.

Alt-A is another type of mortgage. Alt-A mortgages may be somewhat risky in that the borrower may be a self-employed individual whose income varies, the borrower may have a troubled credit history, or the borrower may want the mortgage for investment property; mortgages that are of an amount larger than the amount that Fannie Mae and Freddie Mac will guarantee ($417,000 in 2010) are also placed in the category Alt-A. Alt-A mortgages are not bought on the secondary mortgage market by Fannie and Freddie. The mortgages that are bought by Fannie and Freddie are referred to as agency paper. Alt-A mortgages are an alternative to agency paper; hence the name, Alt-A. (The missions of Fannie Mae and Freddie Mac will be explained below.)

Peter Wallison, an attorney and Counsel to the U.S. Treasury Department from 1981 to 1985, was a member of the Financial Crisis Inquiry Commission. Mr. Wallison answers the important questions of how much money and what percent of mortgages were subprime and Alt-A:

I’ve spent several years examining and writing about the activities of Fannie Mae and Freddie Mac and the housing policies of the U.S. government. In this work, I have found that there are approximately 25 million subprime and other non-prime loans, known as Alt-A loans, that are now on the books of banks and financial institutions in this country and abroad. These weak loans, which total over $4 trillion, constitute almost 50 percent of all mortgages in the United States. They began to default at very high rates in 2007, when housing prices leveled off.³

When subprime mortgages were issued the tendency was to ignore the downside and the assumption was that if people could not make payments they could refinance or sell their homes and settle their debts. When the housing market collapsed, however, it was impossible to sell homes at inflated prices and the option of refinancing ceased to exist. This led to high numbers of foreclosures as well as many homeowners owing more on their mortgages than they could reasonably expect to receive from the sale of their property. There were more homes for sale than buyers and prices were declining. The U.S. housing market was in crisis and its repercussions would be felt throughout the global economy. (Owing more than the property is worth is known as being underwater.)

The foundation of the economic crisis was laid when mortgage brokers did not properly examine their client’s credit and employment information and, lacking this data, arranged for mortgages that could not be repaid. This failure was abetted by consumers who did not understand or agree with the basic tenet that money borrowed should be paid back and that income sufficient to repay a loan is required of a borrower. The unfounded assumption that housing prices would continue to rise prompted lenders and borrowers not to worry about a worst-case scenario. Precisely such a scenario occurred when large numbers of borrowers became delinquent in their payments and lenders moved to foreclose record numbers of properties.

Mortgage brokers arranged mortgages. Mortgage lenders provided funds for borrowers. Mortgage lenders, such as mortgage companies and community banks, did not hold on to individual mortgages on specific properties. Instead, they sold these mortgages to large banks, or firms such as Fannie Mae and Freddie Mac. Buyers of mortgages bundled these mortgages and then sold shares in these so-called securities to investors. Investors bought the securities, known as mortgage-backed securities (MBS) and collateralized debt obligations (CDOs), in order to receive regular payments generated from interest and principal paid by borrowers. Since mortgage brokers and lenders were transferring repayment risk to investors, as long as they were able to pass subprime loans on to investors, they did not stand to lose money if the housing sector faltered. In view of the fact that the issuance of large numbers of unconventional subprime mortgages during a housing bubble was a first, lenders might have thought that it represented a viable new reality or they might not have cared about the stability of the market because they were not at risk on the downside. As far as mortgage brokers were concerned, they earned more from arranging unconventional mortgages than from traditional mortgages and, therefore, they had no financial incentive to question the wisdom of arranging subprime mortgages for their clients.

By carrying large numbers of subprime mortgage loans on their books and also owning mortgage-backed securities, major mortgage corporations like IndyMac and Countrywide were in a precarious position when the housing market crashed. On the brink of collapse, Countrywide was acquired by Bank of America on July 1, 2008 and IndyMac was closed by the U.S. Office of Thrift Supervision on July 11, 2008. The market for mortgage-backed securities had disintegrated, neither of these financial institutions could collect from large numbers of subprime borrowers, some of their mortgage holders who were underwater on their homes walked away instead of repaying, and foreclosures were at a record high. The mortgage lending industry was in disarray and the implications of this fact were unsettling financial markets.

Before its collapse, IndyMac specialized in making Alt-A mortgages, which were too big to be sold to Fannie Mae or Freddie Mac. (As noted above, at the time Fannie and Freddie did not purchase mortgages for more than $417,000 and Indy-Mac’s Alt-A mortgages were for larger amounts than this.) In addition to problems related to mortgages, IndyMac also had approximately 10,000 depositors⁴ who had more than $1 billion on deposit. When these depositors became aware of IndyMac’s exposure to subprime mortgages, they went in large numbers to withdraw their deposits and this run on the bank contributed to its failure.

Before it imploded under the weight of subprime mortgages, Countrywide was the largest mortgage lender in the United States. As its fortunes declined, so did its stock price, from approximately $30 a share in August 2007 to less than $6 a share when it was taken over by Bank of America in July 2008. Bankrate.com explains why Countrywide’s insolvency was a major shock to the mortgage industry:

Countrywide is the nation’s biggest mortgage lender. It funded $39 billion in mortgage loans in July (2007). It’s also the largest or next-largest loan servicer. The servicer is the company you send your monthly mortgage payment to. It then distributes the money to pay the principal, interest, taxes and insurance. Americans owe about $13 trillion in mortgages, and Countrywide services about $1.4 trillion of that. So a significant percentage of mortgage-paying homeowners send a check to Countrywide every month.⁵

(Bank of America bought Countrywide to expand its operations and make money. As it turned out, however, the bad mortgages issued by Countrywide wound up costing Bank of America more than $20 billion in settlement costs in the second quarter of 2011 alone, with future costs hard to estimate. In view of this fact, the $2.5 billion that Bank of America paid to acquire Countrywide cannot seem like a good deal.⁶)

In retrospect, it is easy to understand that subprime mortgages should not have been issued and more attention should have been paid to the qualifications of borrowers who procured subprime mortgages. The false assumptions that fueled the housing bubble should have been recognized. Hindsight is 20/20 but, while the stage was being set for an implosion, the facts we now comprehend did not inform the practices of mortgage brokers, mortgage lenders, mortgage securitizers, investors or subprime borrowers. Common sense was obscured by the euphoria of the bubble psychology that had taken hold. However, the cause of the crisis entailed more than this: it involved financial deal making on an international scale that attempted to game the system and generate profits for investors who had nothing to do with procuring or issuing mortgage loans. Faulty analyses by credit rating agencies contributed to a sense of false optimism and exploitation of regulatory loopholes allowed the creation of problematic financial products to go undetected until several major U.S. financial firms teetered on the brink of bankruptcy.

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Table of contents

• Cover
• Title
• Copyright
• Contents
• Introduction
• 1. What Went Wrong?
• 2. Who Is Affected?
• 3. What Needs to be Done to Set Things Right?
• 4. Ethics and Recovery
• 5. Individual Ethics
• 6. Social Ethics
• Notes
• Further Reading
• Index