This report argues that the practice of offering subprime mortgages is unethical because it eliminates a company’s sense of fiduciary duty to the consumer and other financial institutions, contributing to the instability of the financial industry. I begin by describing the relevant features of the sub prime mortgage industry and two ethical concepts central to my argument, i.e. ‘stakeholders’ and ‘fairness’. I will then argue that the act of offering subprime mortgages detracts from a business’s ability to operate under a fiduciary duty of maintaining fairness to the consumer and other stakeholders, thereby making the practice unethical.
The bankruptcy of Lehman Brothers in 2008 was the precursor to the global financial crisis. In essence, subprime mortgages are loans that are generally given to those who have a low credit rating, and are therefore disqualified from receiving favorable interest rates. Hence, consumers are given “lower-than market, short-term, flexible “teaser” interests rates” to entice potential customers to take out these mortgages on their homes (p.106). Teaser rates usually last around six months and eventually interest rates return to market value or higher. The collapse of the financial industry was ignited by the subprime mortgages being “pooled together and “securitized”, or split up into financial instruments and then sold onto the market (p.106).” These actions contributed to the spread of risk across a multitude of investors, particularly as consumers defaulted in large numbers.
Two major factors contributed to the ignition of the subprime mortgage crisis. The first was ignited by the actions of aggressive loan lenders offering subprime mortgages to customers who had a low credit score or income, and therefore would be less likely to be able to afford market mortgage rates. Secondly, aggressive mortgage lending practices led to an increased demand for residential mortgages, thereby driving up house prices. Once teaser rates began to expire, mortgage defaults in the U.S. skyrocketed, and the “value of the bonds and financial instruments secured by these subprime mortgages fell (p.106).” This contributed to the free fall of the housing market, which further led to the reduced value of property used to secure these subprime mortgages and the mortgage-backed bonds secured by the mortgages on the houses. Hence, a systematic problem evolved where financial institutions “holding large positions in lower-rated financial instruments that were secured by subprime mortgages”, such as the Lehman Brothers, suffered dramatic losses in the value of their portfolios (p.106). The interrelationship between many of the financial institutions further intensified the problem, as no institution was left unscathed. Once mortgage-backed securities being used as collateral for loans began to shrink, this further increased the risks from default and led to the renegotiation of many loans.
Two concepts help to articulate the ethical issues that are relevant to this case. Edward Freeman defines a stakeholder as “any group or individual who can affect, or is affected by, the achievement of a corporation’s purpose (p.69).” The first concept relates to the notion of the stakeholders. In this case, stakeholders range from consumers, loan lenders, financial institutions, property owners, as well as shareholders. Hence, “stakeholders are the broad constituency served by business (p.69)”, and decisions made by lenders should take into account the interests of stakeholders such as the consumer and financial institutions. Companies dispensing the subprime mortgages should have thought of the widespread negative consequences that would ensue by trying to drive up profit for shareholders and considered the interests of the stakeholders involved. The second ethical concept is the notion of ‘fairness’. ‘Fairness’ is the part of justice that relates to equity (p.100)”, while also “giving each individual their due (p.100).” In this case, fairness in the financial markets means that all parties should have equal access to information relevant to the loan and financial tools. Thereby, the aggressive practice of offering subprime mortgages and securitizing them on the market demonstrates an unethical business practice due to its regard for self-interests, and the destruction of maintaining fiduciary duty to stakeholders.
The practice of offering subprime mortgages affects a variety of stakeholders, ranging from shareholders, to the consumer, and the financial institutions. Milton Friedman argues, “the notion of social responsibility in business is objectionable (p.30).” In his view, businesses would owe a fiduciary duty to shareholders, rather than society or stakeholders. In the case of consumers, lenders took on riskier investments to increase returns, allowing consumers to play a risky game by buying houses they could barely afford. Aggressive lending practices targeted individuals who didn’t necessarily understand the risks of the financial decisions they were making, giving them a false impression that costs were low, when in fact they were offered teaser rates.
The facts of the case present a dilemma where businesses are often placed in a position of taking advantage of improving profits for shareholders, and neglecting their duty to follow and practice fair lending practices. Lenders knowingly ignored their fiduciary duty to honor fair practices by taking advantage of consumers through the offer of teaser rates, without ensuring consumers would have the ability to repay the loans. Although the practice of offering subprime mortgages is not illegal, the practice is unethical because consumers and financial institutions, such as the Lehman Brothers, were misled about the true diversity of their loan portfolios; hence, many firms incurred huge losses. Consumers have the right to fair practices, and therefore institutions and lenders should compete for customers based on the quality of their services and fair prices rather than using risky business practices.
As the textbook points out, “the damage caused to the financial system and the losses to the investing public far exceed[ed] the benefits from profits generated for the individual firms and shareholders (p.107)”. Promoting strong business ethics, particularly in risky ventures, is essential in protecting the consumer, the lender, and the financial institutions. Abandoning fair business practices in pursuit of profits is therefore unethical because it puts the entire economy at risk, which outweighs the minimal benefits supplied by these ventures.
- Grace, D, Cohen, S., & Holmes, W.R.. Business Ethics: Canadian Edition (2013). Oxford University Press.