The Ethics of Subprime Loans

What is a Subprime Loan?

The mortgage markets have many facets and moving parts, with interest rates being tied to the risk of a particular loan.  The key to differentiating between one mortgage and another mortgage is the risk level associated with the borrower that is being assumed by the lender.  Prime rate loans are mortgages that are rated low risk, provide for lower risk of the borrower defaulting on their loans as they have strict guidelines for approval (Demyanyk & Van Hemert, 2011). 

Borrowers are required to have good credit scores of 680 and higher, have ten to twenty percent cash available for down payments, bringing equity to their transaction and have great income to support their existing obligations as well as their new loan.  In the early 2000’s the mortgage market began to change (Demyanyk & Van Hemert, 2011).  As the mortgage market began to slowdown, lenders began to advertise loans that were offered to borrowers with more relaxed underwriting standards.  The subprime loans criteria was borrowers using up to an over 50% of their income for their payments, zero money down or 100% financing, and they had FICO scores of less than 600.  These borrowers exposed the lenders and investors to a great amount of risk, as they were somewhat over their heads at closing.  Click the link below for a explanation of Subprime Mortgages.

  Click here for short video on subprime loans.

Other examples of Subprime loan products included interest only loans, and the dreaded 3 or 5 year Adjustable Rate Mortgage, which payments started our low and affordable, but when the adjustment happened, the payment would increase 200 to 300% (Ghent, Hernández-Murillo, & Owyang, 2014).  The loans often front load fees and points and large prepayment penalties if borrowers tried to refinance.  The main difference in the subprime loans is they were not serviced by Fannie Mae or Freddie Mac and initially they were not governmentally regulated, which left the subprime market with  would have the  who had a higher risk of defaulting on their loans, thus creating a “subprime” market (Ghent et al., 2014). 

Lenders Role in Subprime Growth

Initially in the 1990’s, subprime loans were a small part of larger lenders and their programs were seen as a way to give back to the communities in which they had already made millions in profit.  It was to be an entry way to home ownership and real estate wealth for the first time home buyers.  However, as our economy shifted in early 2001, the growth and profitability in this market was astounding, as the subprime loans doubled from 1995 – 2000, however the market jumped a shocking 250% from 2000 to 2003 to $332 billion (Xudong & Bostic, 2009).   From 2000 to 2007, leading lenders, like Bank of America and Wells Fargo, began to cash in on revenue possibilities and created subprime extensions of their existing business models.  In fact, many of leadership within these banks had their compensation and bonus packages tied to the growth and success of this subprime market; thus explaining the leadership’s desperate desire to increase the growth within such a risky market, at any cost.  Leaders like Angelo Mozilo, CEO of Countrywide Financial and IndyMac Financial, both leaders of the subprime market in 2007, as well as several others at the time, continued to encourage their staff to drive more loans to the subprime market, even though in 2007, many of the earlier 5 year Adjustable Rate Mortgages had already began to go into default and the real estate market began its free fall.  Mozilo was the most notable culprit, receiving an outrageous salary in 2006 of nearly $470 million in salary, bonus and stock options (Agarwal, Ambrose, Chomsisengphet, & Sanders, 2012). 

Leaders like Mozilo were in this game to make money, as it was a completely unregulated market.  Driven by greed, and huge profits and personal compensation, there was no reason to change the rules and stop approving the very high risky loans.  They made the rules and the rules of the game were to make as much money as possible, without any regard to the borrowers, the community and the market as a whole.  Click picture below for subprime market information (Agarwal et al., 2012).

By late 2004 to 2007, as the subprime market surged, lenders began to become even more creative in offering subprime products to the public, with loans like the 5 year ARM, Hybrid loans, Option ARMs, etc. (Demyanyk & Van Hemert, 2011)   Although the real estate market bubble was growing, the revenue being generated from this financial market was astounding, a hand full of lenders continued to lend to the poorest of the poor, in the minority lead neighborhoods and continued relax their normal lending requirements to drive more low income borrowers to the real estate mortgage market (Demyanyk & Van Hemert, 2011).   

Social Responsibility in the Subprime Market

In the late 80’s and 90’s, subprime loans made up a small percentage of the mortgage market, but, as the economy began to decline and compensation and bonus packages began to shrink for several banking leaders, the focus of giving back to the community no longer remained a priority, as lenders saw the profitability of this subprime market (Gilbert, 2011).  They began to target areas that would present the best opportunities for them to maximize their compensation, not to preserve and grow struggling communities with home ownership (Richter & Craig, 2013).  In fact, research has shown that during the height of the subprime market from 2000 to 2007, there was a positive correlation between the amount of loans made in communities with minorities living below the poverty level (Richter & Craig, 2013).  The lower they reduced their underwriting standard, the higher the profitability to the markets.  Additionally, research showed that lenders would advertise seeking specific minority racial groups that would be first generation in realizing the American dream of home ownership, who would unquestionably agree to the terms of their financing.  They drew lines in these neighborhoods, and each home door to door would have been financed through a subprime loan product (Nguyen, 2011).  Today, these neighborhoods are completely vacant, filled with   blighted property and crime.

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While these families were already struggling economically, they are now faced with the additional burden of losing their homes and not being able to now secure any housing after foreclosure.  What was most revolting, those that were living at or below the poverty level, research showed also having limited to no formal education and may not have been able to understand the complexities of their loans and their requirements (Nguyen, 2011).

During this time, banks and finance company continued to act extremely socially irresponsible as once the profits continued to flow, they came into these impoverished communities pretending to  help these struggling communities realize the American Dream, when in fact their goal was to increase their profits (Gilbert, 2011).  There was no intention of these loans ever getting repaid, and as such they defrauded their investors as well as the affected communities.  Unfortunately, however, no one realized the ramifications of the actions of this rogue subprime industry, until the real estate bubble finally burst in 2008 and foreclosures reached record levels, countrywide (Xudong & Bostic, 2009).  

Corrective Measures to Subprime Industry

House Bill (HB) 3915 has played a major role in changes to the subprime market.  First, they established the National Mortgage Licensing System Registry to bring uniformity to the mortgage markets, nationally (Black, 2008).  Initially $45 million was authorized to the Federal Bureau of Investigation to investigate any instances of mortgage fraud, in general.  They instituted HUD and it Office of Housing Counseling to advertise and teach and offer technical assistance to borrowers regarding home ownership in contrast to renting.  The most important component, which also has the largest grey area is that mortgage brokers have got to exercise a duty of “care” to their clients and must make a reasonable assessment as to whether the application can repay the loan, as opposed to simply approving loans for profitability (Black, 2008).  This will be evidenced by examining the number of prime loan origination versus subprime originations.  Directing prime rate borrowers to subprime products, is also prohibited especially those that are of the same credit worthiness as a result of their race, ethnicity, age or gender.  Finally, HB3915 also lowered the front end expense like no longer allowing borrowers finance points and fees and lowering the APR to no more than 8% over the treasury interest rate (Black, 2008). 

Capping interest rates and educating subprime borrowers is a terrific start for government regulation, however, unless corporations exercise their social responsibility to care, unfortunately, there will always be a way around these new laws (Santos, 2011).

References

Agarwal, S. s. f. o., Ambrose, B. W. b. p. e., Chomsisengphet, S. s. c. o. t. g., & Sanders, A. B. a. g. e. (2012). Thy Neighbor's Mortgage: Does Living in a Subprime Neighborhood Affect One's Probability of Default? Real Estate Economics, 40(1), 1-22. doi:10.1111/j.1540-6229.2011.00311.x

Black, J. W. (2008). MORTGAGE REFORM AND ANTI-PREDATORY LENDING ACT OF 2007: A SUBOPTIMAL RESPONSE TO A SUBPRIME PROBLEM. University of Florida Journal of Law & Public Policy, 19, 497.

Demyanyk, Y., & Van Hemert, O. (2011). Understanding the Subprime Mortgage Crisis. Review of Financial Studies, 24(6), 1848-1880.

Ghent, A. C., Hernández-Murillo, R., & Owyang, M. T. (2014). Differences in subprime loan pricing across races and neighborhoods. Regional Science and Urban Economics, 48, 199-215. doi:10.1016/j.regsciurbeco.2014.07.006

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

Nguyen, T. H. (2011). Fraud and the subprime mortgage crisis. [electronic resource]: El Paso [Tex.] : LFB Scholarly Pub., 2011.

Richter, F. G. C., & Craig, B. R. (2013). Lending patterns in poor neighborhoods. Journal of Economic Behavior and Organization, 95, 197-206. doi:10.1016/j.jebo.2013.03.005

Santos, J. A. C. (2011). Bank Corporate Loan Pricing Following the Subprime Crisis. Review of Financial Studies, 24(6), 1916-1943.

Xudong, A., & Bostic, R. W. (2009). Policy incentives and the extension of mortgage credit: Increasing market discipline for subprime lending. Journal of Policy Analysis & Management, 28(3), 340-365. doi:10.1002/pam.20436