Part I-Examining the Financial and Ethical Issues Surrounding Subprime Loans by Slemo Warigon

Introduction

This paper discusses the financial and ethical issues surrounding subprime mortgage loans by evaluating the concepts of ethics, ethical dilemmas, social responsibility, and organizational consequences of ethical violations. The paper is organized in three parts, namely:

  • Part I provides definitions of key terms used in this paper, discusses ethics in business setting, and summarizes the concept of subprime mortgage loans including the risks they pose to both the lenders and borrowers.
  • Part II examines the role of leadership decision-making in the subprime mortgage crisis.
  • Part III evaluates the subprime mortgage loans with the notion of social responsibility by comparing and contrasting the attendant consequences for these actions, and discusses the measures that have been taken since the subprime mortgage crisis to avert recurrence of a similar crisis.

These three parts are posted at the newly created Ethics and Leadership blog to enable readers to review, interpret, and share feedback on ethical issues surrounding subprime loans.

Part I – Definitions, Ethics in Business, and Subprime Loans

Definitions and Ethical Issues

Before discussing the financial and ethical issues related to subprime loans in detail, it is useful to define key words and phrases used in this paper. Stakeholders are generally those who either affect or are affected by a firm, and more specifically those who are vital to the success of the firm (Ludescher et al., 2012). Ethics is related to morality, and variously viewed as strict adherence to a code of moral values (Stephens et al., 2012); practices that systematize moral principles and judgments in decision processes (Sroka & Lorinczy, 2015; Seto-Pamies & Papaoikonomou, 2016); a system of moral principles that delineate right and wrong behaviors (Seto-Pamies & Papaoikonomou, 2016); and, a system of norms, rules, and principles intended to regulate the conduct of an individual or group of individuals based on the foundation of free choice (Gilbert, 2011). Ethical behavior involves individual or corporate actions that avoid taking advantage of others even if such actions result in lower profits (Watkins, 2011). Ethical leadership is the perceived ethicality or propriety of a leader’s behavior and decisions in the workplace (Watkins, 2011), and usually involves communicating, promoting, and modeling ethical behavior (Christensen et al., 2014).  Corruption consists of different types of wrongful acts such as wrongful use of influence to either cause an unfair advantage or obtain a benefit for the perpetrator (ACFE, 2017). Corruption continues to permeate businesses and organizations throughout the world in spite of the increased legislation and enforcement actions (ACFE, 2017). A leader’s weak moral standards and sense of moral obligation to others tend to lead to executive corruption (Christensen et al., 2014).

Definitions of business ethics abound in management literature, and such definitions usually involve the systematic evaluation of moral beliefs, norms, values, and principles prevalent in business and the related actions of leaders, managers, employees, organizations, and institutions (Sroka & Lorinczy, 2015). According to Peter Drucker, there is no such thing as business ethics because we are either ethical or unethical regardless of the situation (Beebe, 2012; Drucker, 1981). Drucker also believed that: integrity is necessary for effective leadership, and that the best test of a leader’s integrity and character is the way the leader treats other people (Beebe, 2012); leaders in every organization are responsible for the performance of their organizations that requires them to be focused and limited and for the community as a whole (Hesselbein, 2010); and, ignoring externalities or social challenges threatens excellence, ethics, and engagement in firms, while addressing such environmental factors through corporate focus on common good can help transform challenges into strategic opportunities for the firms (Hesselbein, 2010). All these beliefs align well with the concept social responsibility of the business that this paper subsequently discusses.

Predatory lending uses aggressive sales tactics to impose abusive, harmful, and unfair loan terms borrowers (Agarwal et al., 2014). A moral maze occurs in an organization when its bureaucracy creates a diffusion of responsibility that holds no one accountable for anything (Ludescher et al., 2012). Careless lending involves lenders acting unethically by approving loans for borrowers with the increased likelihood of default and foreclosure (Gilbert, 2011). Unethical corporate behavior refers to corporate actions or decisions that focus on maximizing profit for shareholders without considering the moral principles and social standards (Eweje & Wu, 2010).  Legitimacy is a widely-held perception of desirable and proper corporate behavior that is congruent with the system of social norms and values, and the firm’s legitimacy is routinely challenged when stakeholders believe its actions or decisions deviate from socially acceptable or institutional rules (Schrempf-Stirling et al., 2016).

An ethical incident involves corporate actions that are widely viewed as detrimental to the affected community and stakeholders, thereby causing negative consequences such as bad press, and financial and legal penalties (Eweje & Wu, 2010). Empirical research shows that fragmented organizational approaches or limited support systems for addressing ethical incidents or conflicts tend to cause disparities between organizational values and business practices (Westling, 2017).  A profession describes system of internally consistent activities designed to produce products or services to meet customer needs in order to generate income for the employers and employees (Dubiel-Zielinska, 2016). Public trust indicates that members of society legitimately expect people performing professional functions to act in a manner congruent with legal, ethical, social, and professional requirements (Dubiel-Zielinska, 2016). Representatives in professions of public trust usually face ethical dilemmas, which are unclear problems that have risky consequences (Thiel et al., 2012) involving situations where performing their duties require making difficult decisions to choose between two equally important choices, reasons, or values with the possibility of satisfying and disappointing some stakeholders (Dubiel-Zielinska, 2016). Individuals and organizations respond differently to ethical dilemmas or issues (Eweje & Wu, 2010).

Ethics in Business

Ethics in business plays a key role in the long-term survival and viability of various business entities in the global economy. Corporations use codes of ethics, ethical values, and moral norms to be publicly viewed as ethical organizations even though, in practices, they often engage in unethical activities (Sroka & Lorinczy, 2015). Some of the basic rules of ethics in business include the expectations to 1) be just, 2) treat others fairly and mercifully, 3) observe the rights of others, 4) avoid hurting others, 5) follow the golden rule of treating others as one wishes to be treated, and 6) comply with legal and regulatory requirements (Gilbert, 2011). Generally, ethical individuals and organizations do not break laws (Gilbert, 2011), or commit criminal deeds. However, some argued that, in the age of the Wall Street scandals, it is hard to determine who really committed criminal deeds, and how punishment should appropriately fit the crimes; they cited the example of Dennis Kozlowski, former CEO of Tyco, who transformed the company from a $1.5 billion firm to a global enterprise worth more than $100 billion, but was sentenced to prison in 2003 for 8 to 25 years for various wrongful acts (Kaplan, 2009). The author argued that the punishment meted out to Kozlowski was not at par with the little or no punishment meted out to corporate executives who practically brought down the global economy in 2008 (Kaplan, 2009).

Accounting and auditing practitioners argued that a lack of ethics and morality was the root cause of accounting and financial failures that engulfed Enron, WorldCom, AOL, Global Crossing, Tyco, Lehman Brothers, Washington Mutual, and AIG (Stephens et al., 2012). The practitioners observed that: 1) any effort to reverse such failures will not be successful if the underlying ethical and moral problems are not addressed; 2) decline in ethics was due to cultural factors linked to the failing system of both morality and accounting profession’s ethical rules; 3) the cavalier attitudes of today’s youth toward ethics and morality are not helping the accounting profession to turn the ethical corner; and 4) instead of relying on situational ethics, accounting practitioners must recognize the link between ethics and morality in order to know the right thing to do or act ethically in any situation (Stephens et al., 2012).

The Tone at the Top

In fighting white collar crimes in any organization, professionals in government watchdog and regulatory agencies are taught that the tone at the top sets the climate for either ethical or unethical behavior throughout the organization. This concept is congruent with these key observations made by the accounting practitioners (Stephens et al., 2012):

  • Every organization should have code of ethics based on moral principles that is widely promoted in the organization and public domains so that both internal and external stakeholders are fully aware of the organization’s commitment to be held accountable for the actions of its leaders and employees.
  • Corporate executives should act as ethical role models by demonstrating personally and publicly to all stakeholders that they will be personally accountable for business decisions or actions. When these leaders serve as ethical role models, they help promote ethical behavior throughout their organizations.
  • Corporate executives should also communicate clearly that they expect: 1) all their employees to consistently act morally and ethically; 2) leaders to follow up this corporate directive based on moral principles with ethical behavior that is congruent with their words; and 3) actions by leaders and employees will be continually reviewed to determine whether they are right or wrong, rather than whether corporate rules were fully complied with, or the actions were not illegal.

When the right tone is not set at the top in the workplace, and our leaders fail to consistently exemplify ethical behavior, we start to think or rationalize that we can get away with unethical behaviors as long as we do not get caught.  As the authors noted, people generally believe they would commit ethical violations to get ahead in their careers, or make more money if the risk of getting caught is negligible (Stephens et al., 2012). Further, without effective mechanism for corporate or individual accountability for either known or unknown ethical breaches, we tend to start thinking that unethical actions are culturally acceptable (Stephens et al., 2012).

The Concept of Subprime Loans and Attendant Risks to Lenders and Borrowers

Subprime loans are made by lenders to borrowers whose low credit scores and relatively high credit risk prevent them from qualifying for prime rate loans (Gilbert, 2011; Cao & Liu, 2016; Watkins, 2011), and such loans typically include home mortgages (Gilbert, 2011). The subprime mortgage loans require little or no down payments (Cao & Liu, 2016) and initially offer low interests rates that are later adjusted to higher rates to indemnify increased credit risk of such loans (Gilbert, 2011; Watkins, 2011). These loans are examples of predatory and careless lending practices discussed previously.

The subprime mortgage lending market enabled less creditworthy borrowers to buy houses, and provided a new source of corporate profits for lenders due to the prevalent unethical behavior, desperation of households, appreciation of home prices, declining interest rates, and the liberal policies of the Clinton and Bush administrations (Watkins, 2011). In fact, subprime mortgage loans increased from $120 billion in 2001 to $625 billion in 2005, with new mortgages accounting for only 16 percentage of the loans while home refinancing and second mortgages accounted for the remaining 84 percent (Gilbert, 2011). Also, the significant increase of these subprime mortgage loans from 2001 to 2006 caused the Federal Housing Administration (FHA) loans to decrease to the lowest level in history (Cao & Liu, 2016).

Borrowers faced the risks of defaulting on their mortgage loans and having their homes foreclosed as a result, devaluing their investments, and losing their livelihoods (Mayer et al., 2014; Gilbert, 2011). Lenders who originally approved the subprime mortgage loans reduced their risks by securitizing or selling such loans to investors (Watkins, 2011; Gilbert 2011; Ludescher, 2012). New Century Financial Corporation was the second largest U.S. subprime mortgage lender (Gabriel et al., 2015), and other key players in the subprime mortgage market included Ameriquest, Goldman Sachs, Bear Stearns, Morgan Stanley, and Merrill Lynch (Mayer et al., 2014; Thiel et al., 2012; Watkins, 2011; Gilbert, 2011).

Ethical issues related to leadership decisions contributing to the subprime mortgage crisis are discussed in the next section.

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