The Concept of Sub-Prime Lending
Subprime lending began when banking leaders realized that there were substantial financial benefits to lending to an untapped market of low credit scoring customers, or consumers looking to gain the monies from the equity of their pricey homes. By definition, subprime lending is the offering of higher or variable rates to borrowers that do not qualify or even have the means to pay, when or if circumstances change (Gilbert, 2011).
During the height of the housing boom, financial organizations started to lend to individuals without the standards that were used in the past. Banks are in the business of paying and selling debt (Angel, 2016). Therefore, many banks took on the risk of subprime loans with the notion of selling them quickly to other institutions. These other financial institutions were not as heavily regulated or even had underwriters that did not closely review loan documents and consequently more loans were approved, bought and sold. However, as borrowers stopped paying their mortgages and began to go into default, abandoning their homes, the banks and other lending bodies started to feel the effects of their actions. This lead to the mortgage crisis that hit the United States in 2008-2009, and was a blow to financial institutions across the country. However, conceivable it was one that they brought on themselves and one that perhaps could have been avoided (Gilbert, 2011).
There were risks involved with subprime lending practices, to not only the lender but the borrower as well. Borrowers of subprime loans were lured in by an interest rate that would enviably be adjusted to a higher rate, and would prove to be nearly impossible to pay. Other borrowers did not have the credit knowledge, financial knowledge or wherewithal to understand the effects of a variable rate mortgage and how drastically payments could change over time. This meant that the borrower’s homes became unaffordable and many quickly lost their homes. As consumers began to leave their homes the housing prices in affected areas dropped drastically. While the subprime crisis was complex, it is quite clear that the risks outweighed the benefits of financial gain banking institutions had expected. According to Gilbert (2014), the risks were substantial and included the following:
- High number of defaulted loans
- Increased foreclosures
- Borrowers being quickly removed from their homes
- Entire neighborhoods being abandoned
- Squatters taking residence in abandoned homes
- Left behind homeowners questioning the value of their homes in abandoned areas
This was in essence the kick-off of what would be the worst recession in many years and what sealed the fate of the downfall of the global economy. At the height of this crisis there were more than a million homes in foreclosure. American banks could no longer sustain debt control and the fallout effected the entire financial market, having a ripple effect across the globe (Gilbert, 2011).
Role of Leadership
While the goal of all companies is to be profitable, it seems that the banking industry has an unhealthy obsession with profitability, at any cost (Cornett, Erhemjamts, & Tehranian, 2016). Culture plays such a pivotal part of what is viewed as ethical or unethical, and because the banking culture is so unique in that they are in the business of making money from debt, it is even more conceivable that issues may arise (Stephens, Vance, & Pettegrew, 2012). Thus, it is reasonable to consider that this entire crisis sits on the shoulders of the lending industry leaders that made poor, and perhaps even unethical decisions to gain a profit. It can be argued that the extreme pressures put on financial leaders caused them to make bad decisions regarding subprime lending. However, it is the role of the leader to use their ethical decision making tactics to overcome misguided or irresponsible situations (Thiel, Bagdasarov, Harkrider, Johnson, & Mumford, 2012). With regard to the depth of how many homes were lost and the ultimate downfall of the entire housing industry, is it safe to assume that there was a lack of social responsibility on the part of financial industry leaders?
It would be quite easy to lay all blame on the financial institution leaders that made the decisions to so thoroughly risk it all for the benefits of subprime lending. However, there were so many others that had a responsibility to protect the sanctity of the housing industry. We know that lenders were negligent, but borrowers also played a role in the crisis. Some borrowers were uninformed or uneducated about the process, however others may have lied on applications get loan approval. Furthermore, some brokers intentionally did not ask the questions needed to deny loans, as a way around the borrowers lack of credit or income. There were also the rating agencies that boosted credit ratings for consumers in the subprime segment, allowing approvals that would not have happened otherwise. All of these groups played a role in the crisis. The downfall could have been prevented if the checks and balances put in place by the industry’s policy and government’s regulations would not have been ignored (Gilbert, 2011).
According to Watkins (2011), banks follow the Goldman Rule, that stats the pursuit of profit matters more than how it effects on others. This is why ultimately, above any other party involved, banking institutions total lack of regard for the welling being of its customers makes them the greatest offenders. Furthermore, they only began to care when the negative effects of their actions caused harm to their profits and financial stability (Watkins, 2011). Subsequently, there was indeed a lack of social responsibility on the part of the banking industry.
In the aftermath of the housing and subprime lending crisis, we see many lost jobs, homes and profits. The United States’ economy took a major hit, spinning the country into a deep recession (Gilbert, 2011). With all of this in mind many measures have been put in place to prevent future situations from occurring. These measures include stringent credit and loan approval processes enforced by lenders, brokers, raters and government agencies. It is now more difficult to get a home loan and the requirements are strictly enforced and reviewed by several parties. Other measures include federal regulations limiting the amount of debt a consumer can have. The new federal rule known as the ‘ability to pay’ rule, reviews borrowers credit as well as how much current debt they have, meaning that despite an acceptable credit score they may not qualify for a home loan (Bubb, & Krishnamurthy, 2015).
All of these measures together will ensure that another subprime crisis is not experienced. However, the key is for banks to continue to have good self-regulating practices (Turner, 2012). Even without governmental regulations, the banking industry should not allow unethical methods to dominate its institutions. Finally, we see that when a lack of social responsibility is coupled with poor decision making and pure greed, things go awry (Thiel et al. 2012).
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