Ethics Review of Subprime Meltdown 2008

The subprime crisis has started hurting not only the U.S. economy but also the worldwide economy and has not made its entire appearance yet. This invisible fear tumbled the worldwide stock market in mid of August 2007 and came again in late November. It has not been figured out how big its impact and how long will it take to overcome it, though many economist and financial firms have been working on figuring out them. We would like look into this crisis from ethical viewpoint.

Since the subprime crisis is complicated and somewhat systematic crisis, it is very important to understand the subprime market related to financial systems to identify who involved in the system, what kind of roles they took, how the crisis happened, what kind of ethical issues each party had, why we could not prevent it, and how we will be able to prevent similar crisis in future. After clarify these point, we look into the crisis from ethical view point.

Good old days

Until mid 1980, the loan system was simple and straight forward. Borrowers borrowed money from financial firms such as banks and loan lenders and paid for the capital and the interest periodically until they finish repaying all borrowed money. The financial firms lent the money from their assets that gathered as deposits and savings, and took the capital risks such as default. Financial firms clearly understood total loan amount and controlled the capital risks. There were clear limitations of total loan amount, since they depended on the financial firms’ assets. To minimize the capital risks, financial firms required at least 10% to 20% of down payment to borrowers and checked their financial back ground thoroughly.

Current complicated system

In mid of 80s, it became obvious that growth of loan demand exceeded the growth of financial assets that the financial firms were able to lend. And the limitation started restricting entire economic growth. To solve this problem, the financial firms started securitizing the loan and selling it to investors. The security that is backed by assets or collateralized by cash flow from loan payments is called the Asset-backed Security (ABS).

Now financial firms found that they were able to lend money as long as investors bought the security and no longer nee to take any capital risk. Instead of the capital risks that financial firms needed to take, investors took market risks and liquidation risks. No capital asset limitation applied to the financial firms. So they started lending money to riskier customer with riskier conditions with higher premium such as 11% APR under the name of subprime loan. They no longer required down payment, and started offering the teaser period that provided introductory lower interest such as 7% for normally 2 years but up to 7 years for the promotion. Once the teaser period finished, the interest rate was reset to higher interest rate such as 11%, as the result, the monthly payment increased drastically.

While upheaval of real estate market from 2003 to 2006, not only lower income family, but also high income investor used subprime loans. Investors who wanted to earn profit from flipping real estates without any cash out from their pocket used these loans instead of down payment. As shown in the Figure-1, number of subprime loans soared dramatically.[1]

Figure-1. Subprime soar in slumping market

Subprime meltdown (Behind the scene)

Now we need to know more in details who take what kind of roles step by step:

1) Loan