Banking Ethics, Foreclosure Fraud, and the 2008 Financial Crisis

Introduction

This research paper aims to shed light on what led to the global financial collapse that, for the most part, began in the U.S. housing market, and on the ethical implications that followed. Many researchers agree that the primary drivers of the real estate crisis were the lifting of the Glass-Steagall Act, the fostering of sub-prime lending, and the creation of derivatives and credit default swaps, which were used as complex financial instruments. These developments offered the largest banks an entirely new range of operating opportunities. All of these financial tools were justified by the efficient market hypothesis, and as a consequence they provide evidence for the absence of a truly efficient market.

As a result of the financial failures, many banks were either acquired by competitors, went bankrupt, or had to be bailed out by the federal government because of overwhelming losses in the industry. The consolidations that followed made the largest banks more powerful than at any previous point in history.

Another trend that emerged was that banks were so overwhelmed by the sheer number of foreclosures they faced that many resorted to taking shortcuts in the foreclosure process, or were prone to making grave errors and evicting customers who did not qualify for foreclosure. This paper begins with the efficient market hypothesis and works toward an examination of how the groundwork was set for banks to engage in improper foreclosure and other mortgage practices in the wake of the financial crisis of 2008. Many of these actions were clearly unethical and led to numerous cases of negative publicity. The paper concludes with recommendations for how regulations could potentially prevent another financial catastrophe from occurring in the future.

The efficiency of capital market allocation is a subject that has been widely promoted in both business and economics. An efficient capital market is defined as one in which prices "fully reflect" all available public information and are priced accordingly (Fama). If the market price of a house, for instance, reflects all available information — including risks and potential returns — then in theory all financial investments should be equal and speculation would yield no benefit. This model also assumes that gathering all public information has essentially no cost to investors. Yet these activities clearly carry some costs, and therefore the strong version of the efficient market hypothesis is almost certainly false (Fama). Furthermore, the formation of various asset "bubbles" in markets also suggests that the efficient market hypothesis is undoubtedly untrue (Deng).

Efficient Market Hypothesis

There are many real-world cases that provide evidence against the efficiency of capital markets. One study examined growth versus value stocks, and large-cap versus small-cap firms in international markets over a ten-year period (Bauman, Conover, and Miller). Value stocks are those in which the market price is relatively low in relation to earnings per share or dividends per share. Growth stocks are identified by high growth rates, high earnings per share, and market price appreciation. The study found that value stocks generally outperform growth stocks on a total-return basis when controlling for variables such as risk. It also found that a firm's size may affect profitability: value stocks outperformed growth stocks in each size category except the smallest one included in the study. The efficient market hypothesis is relevant to the financial crisis because it served as the principal justification for the deregulation that allowed the financial industry unprecedented freedom to operate (Ball).

The global financial crisis, which reached its greatest heights worldwide between 2007 and 2009, is difficult to understand and impossible to explain through the efficient market hypothesis, since asset bubbles represent some of the strongest evidence against the theory's credibility. With hindsight, the roots of the crisis can be attributed to several causes. One of the most fundamental was the dismantling of the Glass-Steagall Act (Chen and Kaboub). This historic deregulation of the banking industry, which occurred during the Clinton era, fundamentally changed the way banks conduct business.

One principal cause of the resulting recession, according to many experts, is that the U.S. real estate market was artificially overvalued through unsubstantiated appraisals (Morris). The "housing bubble" in terms of valuation had grown to a level at which the actual asset prices were far lower than what buyers were willing to pay. Demand for housing was fueled by the availability of low-cost loans and new speculative real estate investment instruments. These tools created a marketplace in which buyers could purchase a home with no initial investment of their own, even if they represented a risky credit profile.

Creative loan instruments fueled new loan originations for buyers who had previously been unable to qualify for traditional financing. This in turn drove up home values substantially, as demand increased sharply (Demyank and Hemert). Competition for homeownership was at an all-time peak and consumers were willing to bid against one another at ever-higher prices. Property values reached previously unimaginable levels, especially in larger markets. However, these markets failed to account for systemic risk — the kind of risk that would materialize if a global insurance fund like AIG were to collapse. These bubbles were therefore likely driven by something other than a genuinely efficient market.

The Real Estate Bubble

With relaxed regulations, a new form of loan was created. These new financial instruments were referred to as sub-prime mortgages. A sub-prime mortgage involved lending to an individual whose ability to repay the debt was questionable and was therefore classified as sub-prime. Because the repayment capacity of these borrowers was uncertain, they represented a risky category of credit. The resulting asset-backed securities were bundled into derivative packages and sold to investors. Banks believed they could manage the risks because only a small proportion of borrowers in this category were expected to default in any given period. However, this arrangement also created a conflict of interest: mortgage loan officers had little incentive to evaluate a client's actual repayment ability because the originating bank would not retain the loan — and thus defaults would become someone else's problem.

When the financial downturn began to reveal its trajectory, sub-prime borrowers — who had barely been managing their payments before the crisis — greatly escalated its severity. These borrowers, unable to meet their payment obligations, triggered a wave of foreclosures on a scale not seen since the Great Depression. The "American Dream" of homeownership had backfired, and banks were acquiring massive amounts of bad debt. AIG had sold an insurance-like product to guarantee these derivative packages, but when the bubble burst, AIG was overwhelmed as well. It ultimately had to be bailed out by the federal government because it could not meet its obligations.

Because financial markets had grown increasingly interrelated through globalization, once the effects of the sub-prime market began to stress the system, the implications spread through the global economy almost instantaneously. U.S. real estate prices fell sharply, causing many sub-prime borrowers to owe more on their mortgages than their homes were worth. This created a situation in which walking away from the property was, rationally, more advantageous than continuing to pay an unaffordable mortgage. Moreover, since most borrowers in this category had invested none of their own money, many found it easy to simply abandon their homes.

Banks play a central role in enabling an economy to grow. Their existence provides liquidity in local markets and delivers essential services that allow small businesses to compete with larger organizations. Banks can also pool risk and benefit from the law of averages, covering potential losses through interest charges. If a bank makes a thousand loans for asset-backed securities, the historical default rate has generally been low. This logic, of course, does not apply to the sub-prime derivative phenomenon. However, smaller local banks can assess their markets and their borrowers more accurately, allowing them to gauge risk and price interest rates accordingly.

Conclusion

Morris, A. "Robert Shiller: 'Efficient Markets and the Recession.'" 17 February 2011. Guru Focus. Web. 20 March 2012.

Occupy Wall Street. "Now Is the Time to Demand Glass-Steagall." 20 November 2011. Occupy Wall Street. Web. 19 March 2012.