Presented by: Team 1

Kannan Mani Mudhaliyar, Kush Sharma ,

Lawrence Ng, Lisha Wen, Lydia Masemola
We give respect to the Lkwungen
(Songhees) and Xwsepsum (Esquimalt)
Nations on whose traditional lands we
have this opportunity to learn and grow
Subprime
Mortgage
Crisis

A nationwide financial crisis, occurring

between 2007 and 2010

Triggered by a large decline in home

prices after the collapse of a housing
bubble

Contributed to the U.S. recession of

December 2007- June 2009
WHAT IS A SUBPRIME MORTGAGE?
 Subprime mortgages are named for the borrowers that the
mortgages are given to

 People with spotty credit histories often have to pay much higher
interest rates than normal

 When home prices fell, the people were unable to pay their
mortgage monthly payments or sell the house

 Investment banks who bought and sold these loans caused downfall

of the economy
Timeline
August 25-27,
February 21, 2003: December 22,
June 2004-June 2005: IMF
Buffett Warns of 2005: Yield Curve
2006: Fed Raised Economist Warns
Financial Weapons Inverts
Interest Rates the World's Central
of Mass Destruction Bankers

The Subprime September 25, 2006:

November 2006: Home Prices Fall for
Crisis Created the
New Home Permits the First Time in 11
2007 Banking
Fall 28 Percent Years
Crisis
Effects
 Nearly 9 million jobs lost during 2008 and 2009,
roughly 6% of the workforce

 U.S. household net worth declined by nearly

$13 trillion from its Q2 2007 pre-crisis peak

 U.S. housing prices fell nearly 30% on average

and the U.S. stock market fell approximately 50%
by early 2009

 Output and income loss from the crisis comes to

at least 40% of 2007 GDP
Stakeholders with Power
Lenders

Mortgage Rating
Brokers Stakeholders Agencies

Regulatory
Agencies
Lenders
ROLE

 After the tech stock bubble burst in 2000, investors deemed

housing sector that would give high returns (Blinder)

 The Federal Reserve plummeted the short-term interest rates

2003 and 2004, leading to historically low interest rates on
home mortgages

 Banks and other lenders provided home loans at throw away

interest rates

 Refinancing of mortgages rose from $469 billion in 2000 to $2.8

trillion in 2003 (FCI Report 2011, p. 5)
Lenders
INTERESTS

 Wanted higher returns of the excess capital in hand

 Subprime mortgages gave better profits than prime mortgage loan (30
year, 20% down, fixed rate)
 Were able to do away with the risks of defaults by securitization of
mortgages

QUESTIONABLE ACTIONS
 Marketing and promotion of subprime mortgages that were designed
to default to susceptible consumers
 Repackaging of lower rated mortgage-backed securities into new
collateralized debt securities with investment grade ratings
Lenders
ANALYSIS
 Susceptible consumers were led to believe through promotion that rising housing prices
would allow them to refinance their subprime mortgage, without disclosing the risks

 As the lenders were able to push the risks downstream, they were not concerned with the
performance of the loans

 The catastrophe caused by the actions of the lenders demonstrates that the actions taken
by the lenders can be deemed immoral under the ethical theory of Utilitarianism

 The failure to provide full disclosure to the borrowers constitutes deception which is
deemed immoral under Kant’s categorical imperative

 Therefore, the actions taken by mortgage brokers were unethical

Mortgage Brokers
ROLE

 Financial intermediaries that matched borrowers with

lenders

 Assisted in the selection of loans

 Completed the loan application process for the borrowers

 In 2005, 65% of all subprime mortgages were originated

through independent mortgage brokers mortgage
(NAMB)

 Earned an average revenue of $5,300 per funded loan

(NBER)
Mortgage Brokers
INTERESTS

 Were paid fees by lenders too for generating the mortgage, in most cases without the
knowledge of the borrowers (FCI)
 Had compensation scheme that paid higher returns the riskier the mortgage
 Had no incentive to be concerned about the loan’s performance

QUESTIONABLE ACTIONS
 Enticed buyers to sign mortgages, even if they had poor credit and could not pay back
the loan
 Guided borrowers to riskier payment plans including balloon and adjustable-rate loans
Mortgage Brokers
ANALYSIS
 The compensation scheme put the interests of the mortgage brokers in conflict with
that of the home buyers

 The brokers did not disclose to the buyers that they received higher compensation,
which was the premium paid for the enhanced risks homeowners were taking

 This goes against the traditional ethical theory of fairness that suggests equal sharing
of the information amongst the parties should have been there

 Therefore, the actions taken by mortgage brokers were unethical

Rating Agencies
ROLE

 The big three credit-rating agencies — Standard &

Poor's, Moody's Investors Service and Fitch Ratings
were involved

 As the low rated MBS were hard to sell to investors,

they were repackaged with other debt securities,
and rating agencies were used to rate the new
tranches

 The rating firms ignored the prior ratings given to

the lower MBS tranches, reapplied the same
rating logic to the new CDO
Rating Agencies
INTERESTS

 Were hired and paid by the securitizers to rate their securities

 Had an intrinsic reason to please its customers for continued business
 The ratings were only considered as opinion of the agency and they were not
liable for erroneous judgements

QUESTIONABLE ACTIONS
 Assisted in transfer of the risks downstream
 Looked away when lenders repackaged securities
Rating Agencies
ANALYSIS
 Had conflict of interests with the investors

 Were aware, or should have been aware, of the strategy implemented by the lenders to
minimize their own risks

 Allowed the lenders to “rating shop” by competing with each other to give the highest
rating

 The harm brought by the agencies’ actions, which should have been foreseen, exceeded
any benefits, and therefore, unethical under ethical theory of utilitarianism

 The actions also violate Kant’s “means only” principle and fails Rawls’ veil of ignorance test,
and therefore, can be deemed unethical
Regulatory Agencies
ROLE

 Federal Reserve, Securities Exchange Commission, and

Treasury Department were involved

 Allowed subprime mortgages to overshadow prime

mortgages

 Allowed the reassignment of the ratings of the securities

 Involved in bailout of financial firms after the fall

Regulatory Agencies
QUESTIONABLE ACTIONS

 Did not take adequate steps to ensure that the banks engaged in sufficient
risk management

 Decided to rescue Bear Stearns, Fannie Mae and Freddy Mac, AIG, Goldman
Sachs and Morgan Stanley, Washington Mutual, Wachovia, and Citigroup

 Decided not to rescue Lehman Brothers

Regulatory Agencies
ANALYSIS
 Despite the red flags, regulators did not clean up subprime lending practices,
requiring banks to lower their leverage ratios, and increasing the reserve requirements.

 This inaction clearly produced far more harm than good to those affected, and is
therefore, unethical under ethical theory of utilitarianism

 Moreover, Kant’s categorical imperative and Rawls’ veil of ignorance theory suggests
the regulators should have employed sufficient risk management practices
Regulatory Agencies
ANALYSIS
 Rescuing financial institutions like Bear Stearns limited the global financial collapse
and therefore, ethical under utilitarianism

 Kant’s categorical imperative and Rawls’ difference principle both suggests the
rescue was ethical

 The use of principle of moral hazard to justify letting Lehman Brothers go bankrupt
does not hold because it caused market paralysis and eventually, led to the fall of the
entire sector
 Stakeholders without Power
Businesses
 Due to the recession, cash flow from consumers got lessened and they were not
able to get loans from banks as most of the banks were running out cash

 Many business in US filed bankruptcy, nearly 20,000 business firms filed in 2006 and
in 2009 nearly 61,000 dried out

 Especially real estate business in 2009 took a hard hit were 20% of the commercial
spaces were unoccupied

 The debt of commercial loans exceeded the value of the property

 Stakeholders without Power
Consumers

 As a result of the crisis, unemployment boomed in many parts of the

country leaving most of the people in poverty (especially in sub-
urban)

 Many consumers lost their homes since they were unable to pay the
mortgage.

 Consumers could not afford to buy their daily requirement which

caused a steep decline in GDP of the nation.

 The GDP decreased by 4.7% and consumer spending which

constituted 2/3th of the GDP dropped at 3.5% annual rate
 CSR and the Crisis
 Although one of the basic need of housing of those who were
considered unworthy of credit were met by the lenders, the
companies intentionally violated underwriting standards
 Socially responsible institutions strive to obtain consumer
satisfaction and commitment (Jizi, Dixon and Stratling), and
therefore, abiding to policies and determining creditworthiness
was a must by these corporates
 It is the duty of co-operations to take responsibility for their
practices implemented and how they are used as pertaining to
the consumer, shareholder, communities and the environment in
which they operate in (Carroll)
 Therefore, it can be said that the lending companies did not
display socially responsible behaviour
Recommendations
Dodd-Frank Reform Act

 Liquidity requirement : higher cash ratio to assets held

 Capital requirement : higher reserve requirements
 Clearinghouse for swaps : the Commodity Futures Trading
Commission
(CFTC) for most swaps, and the Securities and Exchange
Commission (SEC) for securities based swaps
 Volcker rule : restricts the ways banks can invest, limiting
speculative trading and eliminating proprietary trading
 Sarbanes-Oxley Act (SOX) : establishes a mandatory bounty
program
Recommendations

Reinstatement of the Glass Steagall Act

 Separating investment banking from retail
banking
 Retail banks were prohibited from using
depositors' funds for risky investments

Culpability in the credit rating process

 Role of SEC Office of Credit Ratings
Recommendations

Too big to fail concept must go

 The questionable notion of financial institutions being so large and
interconnected that they must be backed by government

Education, transparency and training

 Educating investors the risk and reward of these new financial
tools
 Transparency in the creation of financial instruments
 Training of financial education in schools
Thank you!!

Questions?