Business ethics and the mortgage crisis

B u s i n e s s E t h i c s a n d t h e M o r t g a g e C r i s i s

Table of Contents

Introduction.................................................................................................................3

Adjustable Rate Mortgages..........................................................................................4

Interest Only Loans......................................................................................................6

Home Equity Loans.......................................................................................................8

Demographics............................................................................................................10

Conclusion..................................................................................................................13

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Introduction

The global financial crisis has impacted the world in ways that are still being defined today. In the housing market, the crisis caused a decline in the capacity and willingness of the private financial system to support lending, which led to tightened credit on a global scale and severely slowed economic growth in the U.S. and Europe.

In September 2008, the subprime housing and mortgage crisis became real for many Americans, and it continues to impact the lives of millions around the country today. Statistics show that many more Americans now live paycheck to paycheck, hardly making their mortgage payments each month. This begs the question, “Why did this happen?” Research shows that the greed of those managing the banking industry allowed them to create and provide unrealistic loans to a wide variety of homebuyers. This downward spiral began more than two years ago, and today, as the financial crisis continues, many struggling families are still trying to pick up the pieces to provide shelter for their loved ones.

To completely answer the question of how business ethics play a role in the mortgage crisis, it’s important to focus on common practices from the turn of the century. Many home loans were taken out during a housing bubble occurring on the two U.S. coasts from 2000 to 2005. These loans were given at a subprime rate, and this has led to an overwhelming number of foreclosures on home loans and, more seriously, people having to leave their homes due to the immense, unaffordable payments.

Lenders were innovative in using tools to lend to subprime borrowers while eliminating responsibility for the risk of defaulting on the loan in the future. As adjustable mortgage interest rates reset and borrowers defaulted, these tools spread that risk around the world. This created a global crisis that is still happening and affecting people everywhere. As subprime borrowers typically have poor credit, making them more likely to default, it is critical to examine the business ethics involved in such lending.

To add some insight into what the media was saying, especially from a hindsight perspective, there was an ironic article written on March 18, 2007 by Carolyn Said, a Chronicle Staff Writer, called “Why subprime mortgage crisis may have impact on stocks, lending and spending.” The article begins with, “"No credit, no savings -- no problem!” which is indicative of the nature of mortgage and loan officers leading up to the crisis. This article basically explains that the subprime industry had begun to implode, and foreshadows that the effects were rippling beyond the home buyers who got in over their heads (Said).

One of the loan types that this analysis will focus on is the interest-only loan. These loans were intended to work to keep monthly payments lower so subprime borrowers could afford them. They came with an increased risk to lenders, but

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the starting interest rates usually reset after a small number of years. Interest-only loans became dangerous because most borrowers assumed they would sell their home before the interest rates increased. During the mortgage crisis, they weren't able to sell their homes as easily, leading to them defaulting on their mortgages and banks foreclosing on their homes.

Another loan that was critical to the mortgage crisis was adjustable rate mortgages (ARMs). Nearly 80% of mortgages given out to subprime borrowers in the U.S. were adjustable-rate mortgages. Lenders were quick to give out ARMs to borrowers, which quickly led to mortgage delinquencies.

Home equity loans will also be explained in detail. By 2008, millions of Americans had surrendered equity in their homes by borrowing against the roofs over their heads. As the bill for this borrowing became due, the housing market spiraled downward.

The final area to be examined is the various demographics that were affected by the mortgage crisis. Baby boomers were looking to downsize to smaller homes, which contributed to a surplus in real estate that younger generations weren’t investing in. Young couples who were just starting out in the early 2000s were coerced into signing up for one of the aforementioned loans without truly considering the implications for the future.

Adjustable Rate Mortgages:

With no expected decline in sight, the housing bubble that lasted from the late 1990s through 2007 was considered the next big thing. It was thought that Americans should make every attempt to enter the market. Like the tech bubble, optimism could not get any higher and huge returns were being made in almost every state.

However, unlike with consumer electronics, very few people can afford to purchase a house without a loan. Many could not even afford to make their loan payments due to the inflated real estate prices. As a result, people turned to alternative sources of funding. One such source is the adjustable rate mortgage.

The adjustable-rate mortgage was developed in the late 1950s and early 1960s, and later passed by the Wisconsin state legislature. It was not until the early 1970s that many California lenders developed their own variable-rate mortgage. That spurred on a significant increase in adjustable-rate mortgages. About a decade later, the concept had become popular countrywide (Loantech).

The adjustable-rate mortgage was originally created for one main purpose: to protect lenders from unusual increases in interest rates. When interest rates go up, the value of fixed-rate loans decreases. With an adjustable-rate mortgage, the lender can “adjust” the rate periodically by a specific number of basis points. This relieves the lender of excessive interest-rate risk. In exchange, borrowers

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are granted a lower initial rate with the expectation that the rate will increase later in the amortization schedule, usually above the fixed rate (Loantech).

During the housing boom, the adjustable-rate mortgage was one of a couple of instruments used to meet the expanding needs of subprime borrowers. Subprime borrowers are those who are missing one or more of the requirements to be eligible for a mainstream, fixed-rate mortgage. These requirements include standards for income, credit score and equity, and the ability to make a down payment.

Adjustable-rate mortgages affected the housing crisis in two ways: they gave borrowers a reason to file for bankruptcy and they encouraged predatory lending. The former is not so much unethical as unfortunate. When the housing market dropped, interest rates were still going in the opposite direction. As interest rates continued to increase, the monthly mortgage payments of adjustable-rate mortgages also went up. What reason is there to continue to pay higher and higher mortgage payments when the house you’re paying off is worth half of what you bought it for? With precisely that becoming the norm across the country, foreclosure rates skyrocketed early in 2009.

While some adjustable-rate mortgages were fair, many ARM lenders unethically took advantage of subprime borrowers. This predatory lending began before the housing bubble, but became mainstream as the bubble grew. The exact definition of predatory lending is any action by a lender that misrepresents the terms of the mortgage to the borrower (Get Legal). These actions include, but are not limited to, steering and coercing, excessive fees, sale of unnecessary products, abnormal prepayment penalties, and multiple scams (MND). Because of these abusive actions, adjustable-rate mortgages given through predatory lending practices became much more of a burden than they otherwise would have been. Interest rates change very quickly, mortgage payments can adjust above 100% of the original payment, and the possibility of refinancing not being available becomes a reality. Many of these victims have no other choice but to file for bankruptcy. It has been shown that almost half of the subprime borrowers that were victims of predatory lending would have been able to receive prime mortgages (MND).

These lending practices have finally received attention from state and federal governments. Over the past few years, most state legislatures have passed bills with the intent of preventing predatory lending and setting limits to fees and penalties. Although each state defines predatory lending as having a rate above the treasury yield and as having fees and penalties a specific percentage above average costs, rates and percentages vary widely from state to state (Lewis).

Adjustable-rate mortgages had a major effect on the subprime mortgage crisis of 2008. Due to the continued rise in interest rates and predatory lending, millions of homeowners went into bankruptcy and millions of houses were foreclosed on.

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Strides have been made to deal with these issues, especially predatory lending practices, but there is still more to be done before trust is reestablished in the lending process. The best thing that future buyers can do to avoid bankruptcy and humiliation is to be well informed about the risks and rewards involved in their mortgage options.

Interest Only Loans:

Typically, when taking out a loan for a car, house, or any other asset, part of the principal is paid back to the lender each month, along with a portion of the principal that serves as interest. Occasionally, if a loan holder has extra money, he or she may choose to pay more of the principal back on any given month than is required in order to reduce future payments or decrease the time it takes to pay off the loan. However, it is not usually the other way around – that is, only the interest being paid each month, and not the principal. Nevertheless, this type of loan does exist and was among the greatest contributors to the subprime mortgage crisis.

These types of loans, where the borrowing party is required only to pay interest each month, are called interest-only loans. The reason for their appeal is that, as mentioned, only the interest payments must be paid each month, so the borrower initially does not have to pay back a portion of the principal. However, the tradeoff for these interest-only payments is that after a certain period of time (generally five to ten years in the United States), the principal is reintroduced into the remaining monthly payments. As a result, these monthly payments become even higher than they would have been if the borrower had been paying off the principal plus interest, as in a conventional loan, from the beginning (Interest-Only Loans: Good or Bad?).

Since subprime borrowers typically had insufficient income, poor credit ratings, or other factors that would have otherwise deemed them unqualified for conventional loans, these interest-only loans were even more risky for them. Not only was it unlikely that many of these borrowers would be able to finance conventional loans, but many of them most certainly could not handle the amortized payments that they would eventually be responsible for once the interest-only payments expired and the principal was tacked back onto the remaining monthly payments. Furthermore, many of these subprime borrowers were actually relying on plans to sell their houses before their loan payments began to include the principal. However, as the housing bubble began to bust a few years ago, the value of these homes went through a rapid decline and subprime homeowners were forced to default on their loans (Amadeo, Kimberly).

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As you might imagine, there has been much controversy and debate regarding why interest-only loans were granted to subprime borrowers, given the fact that it was fairly obvious that these borrowers would be taking on a great deal of risk without much collateral or sufficient income to survive an economic downturn. According to Credit Suisse, by the middle of last decade, there were a drastically increasing number of interest-only loans issued in the United States.Furthermore, almost 50% of America's population was receiving loans on houses that lacked proper documentation on the borrowers' credentials by 2006. These statistics can be seen in the following graphs:

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Naturally, this begs the question why many banks and lending institutions granted these borrowers interest-only loans to begin with. If they knew that these individuals and families could not qualify for conventional loans, or that they did not have the proper credit ratings or incomes to manage the increased risk included in these loans, why did they go ahead and issue them? There is clearly a question of ethics when it comes to many of the loans that were made in the years prior to the subprime mortgage crisis.

As you are probably aware, many lenders today work on commission. In fact, approximately 70% of homebuyers' business today transacts through independent mortgage brokers who often obtain bonuses for directing borrowers to higher-interest loans. The more loans they approve, and the higher the expected interest rates issued on these loans, the more commissions and bonuses they see at the end of the day. While this can be a positive and motivating form of making money for a lender, it can also serve as a gateway for unethical behavior. Since these lenders make money on approving loans and pushing for higher interest rates, they may not always act in the bank's or the

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borrower's best interests when deciding whether a particular loan should be approved.

Furthermore, the rapidly increasing trend of interest-only loans likely served as a catalyst for such unethical behavior. For example, many of the borrowers who ended up defaulting on their interest-only loans would never have been approved for a conventional loan – among other factors, their incomes would have been insufficient or their credit ratings would have been too low. The interest-only loans served as something of a loophole that enabled lenders to approve these individuals for loans, since the interest rates and payments on these loans were much lower at the outset.

Additionally, many of the specific terms and conditions of these interest-only loans may not have been described clearly to borrowers. Lenders often sugarcoated the true risk of these loans, making borrowers think that there would be no way they wouldn't be able to sell their homes before their monthly payments reintroduced the principal of the loan. In fact, according to Entrepreneur.com, nearly 35% of new mortgages issued in California during 2005 were interest-only, yet many borrowers "did not understand the possible consequences" and "thought they'd live in their homes for a few years, then sell for a profit or refinance." Many would argue that it was very unlikely that lenders could not foresee the serious risks that granting such loans posed to both the borrowers and the financial institutions. As a result, it is hard to dispute that a great deal of unethical decisions were made by lenders who issued these interest-only loans prior to the crisis (Lander, Gerald).

Home Equity Loans:

First, a brief background: Home equity loans are given to borrowers who are using the equity in their house as collateral for their loan. A home equity loan actually reduces the home equity, as it creates a lien against the borrower’s house. As in most cases with a traditional mortgage, since the home equity loan is secured against the property value, most banks refer to it as a second mortgage. Since the home equity loan is a secured loan, the bank or finance company will keep the property’s title or deed until the borrower pays back the entire loan amount, interest included. In the event that the borrower defaults on the loan, the creditor may assume possession of the property and sell it in order to eliminate the debt (Pritchard, Justin).

Typically, a traditional mortgage taken out on a borrower’s home is a non-recourse loan. This means that in the event that the borrower defaults on the loan, the creditor only has the right to foreclose on the property. No legal action can be taken by the creditor in order to satisfy the debt, even if the sale of the property does not provide for full repayment of the loan (Recourse Loans and Non-recourse Loans).

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What makes home equity loans so much more risky is that they tend to be a recourse loan. This means that in the event of a loan default, the creditor has the ability to take legal action against the borrower in order to receive the entire loan payment. A creditor on a recourse loan is able to garnish a borrower’s wages through a deficiency judgment until all debts are satisfied (Recourse Loans and Non-recourse Loans).

As the housing bubble built, more and more homeowners began taking equity out on their homes for cash flow. Vikas Bajaj writes in the New York Times: “It is a remarkable turnabout for the many Americans who have come to regard a home as an A.T.M. with three bedrooms and 1.5 baths. When times were good, they borrowed against their homes to pay for all sorts of things, from new cars to college educations to a home theater.” The graph below shows the increasing extraction of home equity and how it was used as the housing bubble rose (Lacono, Tim).

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Home equity loans have a history of being irresponsibly used, with borrowers taking out cash for such luxuries as upscale cars and high-end weddings. Now that the price of property has fallen, more Americans are facing the possibility of foreclosure due to their fiscally irresponsible actions. Bajaj writes on the topic: “The result is a nation that only half-owns its homes. While homeownership climbed to record heights in recent years, home equity — the value of the properties minus the mortgages against them — has fallen below 50 percent for the first time, according to the Federal Reserve” (Bajaj, Vikas).

Currently, American homeowners owe over $1.1 trillion dollars on home equity loans. Since these loans are often tied to prevailing interest rates, the current economic troubles are making it harder than ever for borrowers to pay off their debt. This is most problematic for those who suffer from being strapped with subprime loans; over a third of these individuals have taken out multiple property liens to compensate for their outrageous debt (Bajaj, Vikas).

In the event of a foreclosure, the first mortgage lender is always repaid first. A home equity loan is most often a second mortgage, or second lien, against a borrower’s house, and is therefore repaid after the first mortgage. Lenders are increasingly worried that second liens will not be repaid, and so banks and finance companies have begun to take extraordinary measures in order to be repaid (Bajaj, Vikas).

Second mortgage lenders are now blocking homeowners from refinancing their debt until all or the majority of their home equity is paid off, making it difficult for borrowers to pay their bills. Second mortgage creditors have also been attempting to oppose short sales of property in instance where they will not be paid the full debt owed on the loan (Kerr, Tom). Thus, in the event that a home goes to short sale and the creditor on a second lien is not repaid, creditors will go after the borrower through collection agencies until their debt is satisfied. These defaulted home equity loans mar an individual’s credit report into the foreseeable future, making it almost impossible for the individual to ever borrow again.

The conflict between Americans who are overburdened with debt and lenders who are looking to be repaid leaves homeowners with no way out. Homeowners are continuously looking for ways to borrow more instead of living with less. “Once the number of debt-burdened Americans reaches a critical mass, the nation will sink into a collective recession,” writes Mortgage Loan journalist Tom Kerr. “With skyrocketing gas prices, higher rates on debt such as home equity loans may be a nail in the coffin for the domestic economy” (Kerr, Tom).

Demographics:

Since the housing market began its decline and foreclosure rates skyrocketed, it has not been formally examined exactly how many loans have ended in

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foreclosure or which groups have been most affected. Now that some important loans have been discussed in detail, it is critical to highlight research on how various demographics were affected by the mortgage crisis. The available research and explanations directly link back to the ethical issues surrounding the happenings of the crisis.

According to a recent study done by the Association of Community Organizations for Reform Now (ACORN): “African-American and Latino homeowners have been particularly hard-hit. Upper-income African Americans and Latinos were more than three times as likely as upper-income whites to have a high-cost loan” (Association). Further, according to new research by the Center for Responsible Lending (CRL), “While Whites are in danger of losing their homes at a rate of 14.8 percent, Blacks and Latinos are losing their homes at rates of 21.6 percent and 21.4 percent, respectively” (Gruenstein). These facts show there are immediate, clear differences in how African Americans and Latinos were affected, so it’s critical to dig deeper into this issue.

This research shows that during the first three years of the crisis, from about January 2007 through the end of 2009, it was estimated that 2.5 million foreclosures were completed. African-American and Latino families were disproportionately affected relative to their share of mortgage originations, even though the majority of households that lost homes were non-Hispanic and white. Further, it has been estimated that about 8% of both African Americans and Latinos have lost their homes to foreclosures, compared to 4.5% of whites, and racial and ethnic disparities remain even after income differences are taken into account. This poses a true ethical question regarding why these groups were affected differently. To demonstrate a visual of these statistics, the chart below shows completed foreclosures for every 10,000 loans for African Americans, Latinos and non-Hispanic whites (Gruenstein).

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This presents a severe ethical dilemma, as the foreclosure crisis continues to challenge the financial stability of families across the country. It will be particularly harmful to African-American and Latino families, as these groups already fall behind their white equivalents in the areas of income, overall wealth and educational completion. Even if foreclosures only demonstrated a one-time cost to the affected family, these demographic discrepancies would remain unethical and troubling. However, research shows that the costs are complex and long-term, and the losses in wealth resulting from foreclosures will disproportionately affect communities of color due to the decline in value of neighboring properties.

Continuing the examination of recent research, the latest Home Mortgage Disclosure Act (HMDA) research reveals somewhat alarming mortgage trends for people of color. The research explains, “African-American and Latino families are less likely to receive sustainable home loans; they pay more for the mortgages they do get; they are more likely to experience foreclosure; and, as a result, the gap in homeownership is rapidly growing wider between white families and families of color” (National).

The research explains some important factors to consider, all of which directly link to the ethical discussion around the mortgage crisis and how it affected various ethnic groups. The first area discussed is unsustainable loans. It is noted that African-Americans, Latinos and other groups of color were recipients of an unreasonable amount of abusive subprime mortgages, even after risk factors such as income and credit scores are taken into account.

Next, from an ethical standpoint, the fact that these groups have less access to credit should be considered. This report shows that across all categories of loans, African-American and Latino borrowers had a greater chance of being denied a loan than whites, even after considering factors such as income and the property’s location. Lastly, abusive lending has led to overall shrinking homeownership in these groups. “The homeownership gap between non-Hispanic white borrowers and borrowers of color has widened,” as explain in this research. The table below visually demonstrates this gap (National).

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It has been estimated that, “between 2009 and 2012, $194 and $177 billion, respectively, will have been drained from African-American and Latino communities in these indirect ‘spillover’ losses alone” (Gruenstein). The fact that foreclosures come along with such high costs highlights the impact of careless and ill-monitored lending. As many foreclosures are still going to happen in the near future, it is critical that policymakers take action to help stabilize the market, allow families to keep their homes, and ensure that home lending is conducted more ethically in the future.

Conclusion

As this analysis of the mortgage crisis comes to a close, it can be seen that severe ethical issues were presented and dealt with across various groups of people in the US. It is impossible to quantify the exact impact that ill advised lending had on every affected family; however, through extensive research on the topic, it is evident that the recovery is fragile. According to many economists and industry experts, there is no guarantee that the housing market will stabilize anytime soon, in fact, the possibility of a second crash still emerges as a likely possibility. This analysis has identified some of the root causes of the mortgage crisis, and the impacts will persist until and unless these root causes are eliminated.

Recent news indicates that there are many efforts across the nation to battle the causes of the crisis, which can be seen in a recent story explaining that Connecticut’s Governor M. Jodi Rell announced that $1.3 million for the state’s Mortgage Crisis Job Training Program is expected to be approved this month. This program is geared towards helping borrowers at risk of foreclosure by increasing their job skills and earning potential, and represents a second chance to help people with their credit. Further, there are programs targeting the demographic groups mentioned in this analysis as well.

As much as homeowners and families are being assisted by local programs and agencies, a larger issue remains. Although the government bailed out the nation's biggest banks, the courts still are sorting out who gets stuck with mortgage losses; it is said that banks could lose more than $100 billion. This liability facing banks stems from the $2 trillion in subprime mortgages that were underwritten and sold during the crisis. It has been nearly two years since the inception of the subprime mortgage crisis, and the nation could have another debt crisis brewing that could prove to be even more devastating.

As each day unfolds in the US and world markets, the ethical issues presented during the mortgage crisis will open doors to other areas that are sure to impact the mortgage industry, current homeowners and prospective homebuyers for years to come. Every day there are numerous stories highlighting that the mortgage crisis is ongoing, and just when the nation thought it was safe to go back in the real estate world, threatening discoveries entire the economy. As long

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as we continue to see headlines such as the following, one can only guess when the crisis will truly end.

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