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

Part III – Subprime Loans, Social Responsibility, and Resultant Changes

Social Responsibility and Consequences of Unethical Actions

The definitions of social responsibility abound with no clear consensus regarding the exact meaning of the term (Kolk, 2016). To some, social responsibility means socially responsible behavior in an ethical sense, and others view it as a fiduciary duty imposing higher standards of behavior on the businesses than on citizens at large (Kolk, 2016).  These definitions are synonymous with the definitions of corporate social responsibility (CSR), which asserts that the social responsibility of business is an important part of its social contract consisting of generally accepted relationships, and moral obligations or duties that relate to the corporate impact on the welfare of society (Robin & Reidenbach, 1987; Gilbert, 2011). The ethical element of CSR requires firms to take actions that are legitimate, just, fair, and not harmful (Quarshie et al., 2016). Similarly, CSR consists of activities that advance a social cause beyond regulatory compliance and that focus more on managing a business entity in such a way that it can be economically profitable, law abiding, ethical, and socially responsible (Kolk, 2016; Seto-Pamies & Papaoikonomou, 2016; Christensen et al., 2014). These definitions explain why some authors use CSR and business ethics interchangeably (Rodriguez-Fernandez, 2016; Seto-Pamies & Papaoikonomou, 2016; Sroka & Lorinczy, 2015).

CSR research increasingly focuses on the social, legal, ethical, economic, environmental, and philanthropic obligations of business (Kolk, 2016; Rodriguez-Fernandez, 2016; Quarshie et al., 2016). Specifically, in recent decades, circumstances such as the: 1) increasing number of corporate fiscal abuses and opportunistic strategies in the financial markets; 2) increase of social inequities reflected in poverty, hunger, or discrimination among countries; 3) the great power held by multinational corporations; and 4) the environmental degradation caused the affected parties (e.g., shareholders, employees, customers, citizens, local community, government, and other stakeholders) to require a greater commitment and responsibility from corporate activities (Martinez et al., 2016; Kolk, 2016). All these make the operating environment both complex and turbulent, necessitating firms to develop competitive management models for obtaining profit margins in the short-term and meeting the balanced expectations of society and the different stakeholders involved in its activities in the long term (Martinez et al., 2016).  In response, an increasing majority of corporations in global economy have adopted CSR as a key tool that helps them to proactively address these environmental pressures and social challenges (Wang, Tong, Riki, & Gerard, 2016; Martinez et al., 2016). In fact, over 800 companies from more than 150 countries are signatories to the United Nations’ Global Compact, covering issues on human rights, labor standards, the environment, and anti-corruption initiatives (Wang et al., 2016).

In short, CSR is essentially about acknowledging accountability for the impact of individual and organizational choices on the larger world.  Rather than focusing exclusively on profit margins, firms are expected to make the welfare of society a priority when making corporate decisions.  It should be noted that socially responsible behaviors differ by societies, cultures, and subcultures (Robin & Reidenbach, 1987).  This explains why a socially responsible behavior by one stakeholder group has the potential to generate a complaint by another group. Also, CSR is viewed as a political process in which the meaning of corporate action is contested through discursive interaction between firms and their stakeholders (Skilton & Purdy, 2017). Similarly, traits, values, attitudes, and motivations of leaders influence either socially responsible or irresponsible behaviors in organizations (Christensen et al., 2014). For instance, leaders motivated by instrumental view tend to take CSR actions that help maximize profits for their firms, while leaders motivated by altruistic CSR promote corporate culture and behaviors that achieve greater social good (Christensen et al., 2014).

The subprime mortgage loan lenders employed the instrumental CSR activities primarily to maximize corporate profits, and secondarily to offer high-risk loans to low-income borrowers. Those leaders were following the Goldman Sachs’ rule by refusing to engage in socially responsible actions that lowered their opportunities to maximize corporate profits (Watkins, 2011). Milton Friedman expressed the following views that were diametrically opposed to the CSR concept (Friedman, 1970):

  • Businessmen who believe they are defending free enterprise when they declare that their firms are not concerned with only profits, but also with promoting desirable social ends by taking seriously their responsibilities for providing employment, eliminating discrimination, and avoiding pollution are actually preaching socialism and serving as the unwitting puppets of the intellectual forces working to undermine the basis of a free society.
  • Individuals, not and corporations or business, have responsibilities. Corporations are artificial persons with possibly artificial responsibilities. Thus, the CSR remains largely unclear.
  • In a free-enterprise system, a corporate leader is an employee of the business owners. He is directly and primarily responsible to his employers. This responsibility entails conducting the business in accordance with the employers’ desires, which generally are to make as much money as possible while conforming to the basic rules of the society as reflected in law and ethical custom.
  • The corporate leader is also a person in his own right. He may personally have many other responsibilities to his conscience, family, charity, church, clubs, city, or country that he voluntarily assumes. These responsibilities may compel him to devote part of his income to causes he deems worthy, refuse to work for particular businesses, leave his current job, or join his country’s armed forces. All in all, he is acting as a principal, not an agent of the business owners; spending his own money, time, and energy, not his employers’ money. These are social responsibilities of individuals, not business.
  • Asserting that the corporate leader has a social responsibility in his capacity as businessman is akin to asking the leader to act in ways that is not in the best interest of his employees.

In summary, Friedman (1970) believed that social responsibility for business requires the corporate leader to spend someone else’s money for general social interests, such as reducing returns to stockholders, raising prices to spend customers’ money, and lowering wages to spend employees’ money. All these accept the socialist view that political mechanisms, not free market mechanisms, are the appropriate way to determine the allocation of scare resources to alternative uses (Friedman, 1970).  In a free society, the only “social responsibility” of a business is to use its resources to engage in activities designed to increase its profits in compliance with legal and regulatory requirements (Friedman, 1970).

Pursuing CSR actions help firms to achieve sustainable profits from socially responsible financial investments, obtain competitive advantage, and improve relationships with key stakeholders by promoting social good (Gilbert, 2011; Paulet et al., 2015; Kolk, 2016; Rodriguez-Fernandez, 2016; Quarshie et al., 2016). Conversely, firms not pursuing CSR activities incur significant costs from bad publicity, lost customer loyalty, and penalties for noncompliance with regulatory requirements that would adversely impact corporate profits (Rodriguez-Fernandez, 2016; Sroka & Lorinczy, 2015; Watkins, 2011). Banks involved in unethical subprime mortgage loans failed to retain thousands of their talented employees, wrote off hundreds of billions of dollars on their subprime loan assets; caused financial instruments tied to securitized subprime mortgages to significantly lose value, removed borrowers from their homes due to foreclosures, and many other problems with social and economic impacts (Gilbert, 2011; Watkins, 2011; Agarwal et al., 2014; Mayer et al., 2014; Cao& Liu, 2016).

Eventually, the U.S. federal government bailed those failed banks (Watkins, 2011) without holding their leaders and managers responsible for their unethical behaviors (Mayer at al., 2014). Senior federal government leaders sent confusing messages in the aftermath of the financial crisis and resultant government bailouts, with some stating that most of those socially irresponsible lenders did was recklessly unethical rather than illegal, but others stated that the lenders committed illegal acts (Mayer et al., 2014).

Reforms After the Subprime Mortgage Crisis

Some authors argued that not prosecuting individuals responsible for the subprime mortgage crisis was due to regulatory lapses and deregulation of banking oversight by the federal government, and that this lack of accountability will not prevent people running the banks from committing the same unethical acts that caused the crisis (Mayer et al., 2014). Others argued that the government bailouts did not change the economic or business model used by conventional banks that caused the crisis (Paulet et al., 2015; Watkins, 2011).

States like Illinois passed a legislation in 2005 to curb predatory and reckless lending practices with new enforcement mechanism, tougher penalties for noncompliance, and mandatory credit counseling for borrowers with minimum credit score of 620 (Agarwal et al., 2014). The Basel III global regulatory framework introduced new regulations to improve the accountability, transparency, risk management, corporate governance, and resiliency of the banking institutions (BIS, 2011; Watkins, 2011; Paulet et al., 2015). The Basel III framework has its shortcomings, namely banks are expected to comply with the new regulations in 2019, the pre-crisis banking structure remains unchanged, social purpose of banking activities is not clearly defined, and the problem associated with certain financial firms that are too big to fail was not resolved to prevent future financial crises (Watkins, 2011; Paulet et al., 2015). However, some banks have changed their banking practices to comply with Basel III’s new regulations, and embed socially responsible behavior in their corporate culture (Paulet et al., 2015).

Conclusion

The unethical banking practices, including the predatory and reckless lending decisions, caused the subprime mortgage crisis that adversely impacted all stakeholders. These ethical incidents significantly decreased public trust in both the banking institutions and regulatory environment controlled by the government. Stakeholders or members of society legitimately expect professional lenders to act in a manner consistent with legal, ethical, social, and professional requirements in order to earn and retain public trust. Executive leaders who consistently serve as accountable and ethical role models help promote ethical behavior throughout their firms, thereby helping to prevent recurrence of a disastrous financial crisis.


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

Part II – The Leadership Decision-Making and Subprime Mortgage Crisis

Studies show that demographics such as race and ethnicity played a significant role in subprime mortgage lending decisions than risk factors (Deloughy, 2012), with adverse effects on predominantly African-American and Hispanic borrowers (Deloughy, 2012; Ghent et al., 2014; Gabriel et al., 2015). Empirical research results also show that borrower represented by Congressional representatives received more favorable subprime mortgage lending decisions in terms of larger loan amounts at discounted interest rates (Gabriel et al., 2015). Further, empirical studies show that subprime loans increased in states with lender-friendly foreclosure laws, and decreased in states with laws that are friendly to defaulting borrowers (Cao & Liu, 2016).

The subprime mortgage crisis began in 2007 (Cao & Liu, 2016; Agarwal et al., 2014;), Housing prices started a steady decline in 2008, causing 45 percent of borrowers to default their subprime mortgage loans (Gabriel et al., 2015), and FHA loan to capture 19 percent of the mortgage market share (Cao & Liu, 2016). By 2010, another 45 percent of borrower defaulted on their subprime mortgages (Gabriel et al., 2015), thereby worsening the crisis for the economies of numerous countries, including the United States (Mayer et al., 2014). The mortgage borrowers, brokers, lenders, securitizers, rating agencies, investors, governments, academia, and other stakeholders contributed to this global financial crisis (Gilbert, 2011; Seto-Pamies & Papaoikonomou, 2016; Watkins, 2011; Ludescher et al., 2012). Some researchers asserted that predatory and reckless subprime lending decisions created and fed the housing bubble that ultimately led to the financial crisis (Agarwal et al., 2014; Gilbert, 2011; Watkins, 2011).

Many stakeholders were responsible for the financial crisis. Government leaders were blamed for improper regulation that mandated lenders to offer loan to low-income individuals, and deregulation that encouraged banks to engage in predatory lending practices without regard to harmful impacts on both borrowers and financial market (Ludescher et al., 2012). Corporate leaders, managers, and employees were also blamed for not making ethical decisions that considered the welfare of borrowers, awareness of their moral obligation to society at large, and potential consequences of their unethical decisions on our interconnected economic systems (Gilbert, 2011; Thiel et al., 2012; Ludescher et al., 2012). The banking institutions were blamed for failing to provide their leaders with a holistic framework (e.g., sensemaking model) for making ethical decisions in a complex and fluid business environment (Thiel et al., 2012), and promoting corporate cultures that reward greed and profit maximization at the expense of expense of ethical and moral considerations (Gilbert, 2011; Ludescher et al., 2012). Borrowers were also blamed for knowingly accepting high-risk mortgage loans that forced them to live beyond their means (Ludescher et al., 2012).

The following sections discuss the consequences of these unethical actions, measures taken prevent reoccurrence of the financial crisis.

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.

Why I Started This Blog

I am currently pursuing my Doctor of Business Administration (DBA) degree program with specialization in Organizational Leadership at Northcentral University. I started this blog because it is required by the University’s Ethics in Business and Ethical Leadership courses. I plan to share my thoughts, ideas, concepts, and research related to organizational leadership and ethics. I welcome feedback from readers on the evolving contents of this blog.