The Subprime Mortgage Crisis - Assignment Example

? SUBPRIME LOANS Table of Contents Table of Contents 2 Question 3 Question 2 4 Question 3 6 Question 4 7 References 9 The problem ment for this study is the ethical issues concerned with subprime loans in relation with the recent subprime mortgage crisis that engulfed the USA and the whole world. Question 1 Subprime crisis is believed to have had a significant role in the occurrence of Global Financial Crisis in 2008. This type of crisis situation is a consequence of the subprime lending and not caused due to over-lending by banks. The credit status relative to the borrowers is referred to as subprime. It is not the interest rate corresponding to the loan itself. “Subprime” denotes any type of loan which does not satisfy the prime guidelines of a loan. Subprime lending is a process of making loans or lending money to the borrowers who are not qualified to be given loan at the market interest rates because of their low credit ratings (Bahin, 2007). Both the borrowers and the lenders find themselves in a riskier position as a result of subprime lending. It is so because such lending is characterized by poor credit rating, high amount of interest rates associated with it, and unfavorable financial situations. The mortgage brokers played an important role in the rise and fall of financing related to subprime mortgages. The competition corresponding to the subprime loans increased as a result of increasing demand of Mortgage Backed Securities (MBSs) sought by the investment banks. The lenders were observed to be involved in activities of introducing innovative financial products which seemed to be attractive to the borrowers, and the latter were thus becoming more and more interested to borrow money from the lenders. If we consider the job responsibilities of mortgage brokers, it can be observed that they had to perform the activities related to identifying the borrowers, receiving an application for loan from the borrowers, assessing their credit worthiness, evaluating their income-to-debt ratios, and then finally sending the borrowers to the lender who meets all the criteria. However, it is worth mentioning that all these activities and processes followed by the mortgage brokers did not correspond to the actual plan. The mortgage brokers received emoluments in the form of commissions and, therefore, it worked as an incentive for them to earn greater commissions by sending even the prime credit borrowers to the subprime lenders. Even the people who had little knowledge about MBSs were attracted to them because of the increasing demand for them in the market. There were not even any kinds of licensing requirements for a person to become a mortgage broker (Sanders, 2002). All these factors led to the emergence of mortgage brokers in the market and had an impact on lowering their reputations. The lenders were exposed to such a huge number of participants in the mortgage industry that many of the borrowers received loans who should never have been lent money because they were to face financial problems while repaying the loans received by them. Based on the above evaluation of the situation it can be concluded that besides some of the minor incidents, certain specific individuals like mortgage brokers cannot be blamed for the downfall of the overall subprime mortgage lending process. The blame should actually go to the regulatory authorities and government institutions which failed to oversee the situation beforehand, to different corporate misdeeds, motivation to earn more profits, and also, to a large extent, to the borrowers themselves. Question 2 Incentive contracts or managerial incentives in a corporate organization mainly correspond with the agency theory and the problems associated with it. Jensen and Meckling (1976) are commonly associated with the term “agency theory” as found in most of the existing literature. According to Alchian and Demstez (1972), the business activities conducted by most of the organizations are mostly governed through contracts that involve voluntary exchanges. Agency problems take place when the shareholders of a company (principals) are involved in the process of hiring managers (agents) to facilitate decision making process that corresponds with the interests of the shareholders. Since people in general are found to be self-interested, it is obvious that every business firm will have people associated with it who have conflict in their interests. This suggests that managers of a company who act as principals of the shareholders sometimes will be motivated to take some decisions that would correspond with their self interests. This leads to the reduction in the welfare of the principal. The prime essence of agency problem is in the separation of control and ownership in an organization. A manager or an entrepreneur works to raise funds for the investors so as to either make use of them for some production purpose or to cash out the holdings he has on the business firm. Managers end up in getting significant control rights and have great opportunity to fulfill their self interests through the utilization of funds invested by the investors. In certain cases it may even result in managers taking inefficient decisions leading to the losses suffered by the investors. Therefore, a solution to this problem can be the provision of an incentive contract, which results in the alignment of interests of the managers and the investors. These incentive contracts can be in the form of share ownership, dismissal threat in the event of low income, etc. However, these incentive contracts can cause problems by creating self-dealing opportunities for the managers when the contracts are negotiable not with the large investors but with the board of directors of the company who are poorly motivated (Shleifer & Vishny, 1996). In the context of sub-prime crisis, these incentive contracts related to the problems associated with the agency had a significant impact on the sub-prime lenders in terms of different types of loan products that were offered by them to the potential borrowers. For most of the companies that failed during the financial crisis in 2008, the compensation packages that were offered to their executives were mostly based on performances and were delivered to them either in cash or in the form of equities. These types of stock options proved to be beneficial for the executives when there was an increase in the stock prices; however, if the stock price declines, it will have no detrimental impact on the real wealth earned by the executives (Pfeffer, 2007). Managers of the companies thus had the opportunity or incentive to be involved in risk-taking actions that have the potential for higher returns but at the cost of a high level of risks and uncertainties. These types of actions would have been instrumental in the case of the subprime lenders as well if they had been encouraged to offer high risk instruments like MBSs to the potential investors of the companies. Question 3 Sub-prime mortgages or loans were mainly constructed for the purpose of offering loan opportunity to those people who were unable to borrow money from financial institutions because of their inadequacy to meet all the criteria to receive a loan. However, subprime loans with the increased default risk for the lenders resulted in high interest rates associated with it. The main disadvantages for those borrowers were their low credit worthiness and low income levels. Individuals having financial problems face difficulties in obtaining credits, especially in cases of borrowing money for financing real estate or automobiles. These are the individuals who are mostly engaged in subprime lending activities (Bhardwaj & Sengupta, 2012). However, the greed for making quick money and the increasing demand for derivative instruments like MBSs resulted in a sudden surge in the subprime market in the USA before its downfall leading to the global financial crisis (GFC). Therefore, the primary motives of subprime loans were for the benefits of the subprime borrowers and can be made institutional through adequate regulatory steps. They require limitations at some places or points in the process of subprime lending. Those limitations can be in the form creating an upper limit for the maximum amount of interests that can be charged on any type of residence mortgage loans. Limits can also be imposed on the associated fee amounts charged by the lenders from the borrowers. Removing any kind of penalties associated with pre-payment of debts by the borrowers can also help regulate the subprime mortgaging process in an effective way. Creating a maximum limit of the incentives that can be earned by the mortgage brokers can also be helpful in strengthening the control over subprime lending process (Dam, 2010). Question 4 The subprime mortgage crisis, if analyzed from the point of view of systemic risks associated with it, has the potential of causing a collapse in the global financial system as a whole, leading to a situation of a true systemic breakdown. The regulations against systemic risks that existed during the time of subprime mortgage crisis were mainly focused on the banks and not on financial market as a whole. Various organizations were observed as having access to the financial markets without even going through the banking system. The subprime mortgage crisis was truly instrumental in triggering the global financial crisis, which resulted in a series of failure events in the financial market worldwide (Hellwig, 2009). This is attributed to the systemic breakdown of the financial market as a whole. Most of the protections or regulations concerning systemic risks were focused on the banks. However, in the case of the subprime market, different financial instruments like MBSs, which helped in securitizing the mortgages, proved to be a major source of capital for many investment banks and other business organizations. The financial markets where all these financial transactions took place were not that well regulated and thus were the sources of high-level systemic risks (Schwarcz, 2008). The subprime mortgage crisis was a result of a market failure and not of any kinds of institutional failures. The subprime crisis resulted in a systemic collapse of the financial marked as a whole and was not restricted to the subprime market. A positive correlation is observable between systemic risks and markets. As a result of this, the investors were unable to avoid the systemic risks associated with the activities that were going on in the subprime market. The impact of the crisis in the subprime market in the USA was observed to be systemic where it extended beyond the MBSs to the credit market in general and thereby led to the global financial crisis. At that, if we consider the stakeholders involved in the process of subprime lending process, the main stakeholders who were institutional in the process were subprime lenders, borrowers, mortgage brokers, and the investors of MBSs. All these stakeholders were engulfed in the crisis and were affected greatly because of the failure of the subprime market. References Alchian, A. A., & Demsetz, H. (1972). Production, information costs, and economic organization. American Economic Review, 62(December), 777–795. Bahin, C. M. (2007). More regulation of subprime lending. Community Banker, 70-71. Bhardwaj, G., & Sengupta, R. (2012). Subprime mortgage design. Journal of Banking & Finance, 36(5), 1503-1519. Dam, K. W. (2010). The subprime crisis and financial regulation: International and comparative perspectives. Chicago Journal of International Law, 10(2), 581. Hellwig, M. F. (2009). Systemic risk in the financial sector: An analysis of the subprime-mortgage financial crisis. De Economist, 157(2), 129-207. Jensen, M., & Meckling, W. (1976). Theory of the firm: Managerial behaviour, agency costs and ownership structure. The Journal of Financial Economics, 3, 305–360. Pfeffer, J. (2007). What were they thinking? Unconventional wisdom about management. Massachusetts: Harvard Business Press. Sanders, B. (2002). Mortgage broker's license questioned. New Hampshire Business Review, 24(16), 1A. Schwarcz, S. L. (2008). Markets, systemic risk, and the subprime mortgage crisis. SMU law review, 61(2), 209. Shleifer, A., & Vishny, R. W. (1997). A survey of corporate governance. The Journal of Finance, 52(2), 737-783. Read More