Banks Improper Foreclosure and Mortgage Practices in the Banking Industry

Efficient Market Hypothesis

Real Estate Bubble

Sub-Prime Mortgages

Overview on the Value of Banks

Arguments against Financial Intermediaries

Ethical Violations

This research paper aims to shed light into what led to the global financial collapse that, for the most part, began in the U.S. housing market and the ethical implications that followed. Many researchers agree that the primary drivers that led to the real estate crisis was 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. This offered the big five banks an entire new range of operating opportunities. All of these financial tools were justified by the efficient market hypothesis and as a consequence provide evidence for the lack of a truly efficient market. As a result of the financial failures, many banks were either bought, went bankrupt, or had to be bailed out by the federal government because of the overwhelming losses in this industry. The consolidations led to the big five banks becoming more powerful than ever in history.

Another trend that emerged is that banks were so overwhelmed by the sheer numbers of foreclosures that they were facing, many of them resorted to taking short cuts in the foreclosure process or were prone to making grave errors and evicting customers that were not qualified to be in foreclosure. This paper will begin with the efficient market hypothesis and work towards the manner in which the groundwork was set for banks to begin using 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. Furthermore, it will conclude with recommendations of how regulations could potentially prevent another financial catastrophe from occurring in the future.

Efficient Market Hypothesis

The efficiency of capital market allocation is a subject that has been widely promoted in business and in economics. An efficient capital market is defined as one in which prices "fully reflect" all of the available in formation available to the public and are priced accordingly (Fama). If the market price, of a house for instance, reflects all of the available information including such items as risks and potential returns, then in theory all financial investments should be equal and speculation would not have any benefits. This model also assumes that collecting all of the public information essentially has no cost to investors. Yet these activities definitely have some costs associated with them and therefore the strong version of the efficient market hypothesis surely false (Fama). Furthermore, the formation of various asset "bubbles" in markets also suggests that the efficient market hypothesis is undoubtedly untrue (Deng).

There are many real world cases that also provide evidence against the efficiency of capital markets. One study looked at growth vs. value and large capital firms vs. small capital firms in international markets over a ten-year period (Bauman, Conover and Miller). Value stocks are thought of as stocks in which their market price is relatively low in relationship to their earnings per share or dividends per share. Growth stocks are identified by their high growth rates, high earnings per share, as well as market price appreciation. The study found that value stocks generally outperform growth stocks on a total return basis when controlling for other variables such as risk. The study also found a business's size may affect profitability where value stocks outperformed growth stocks in each size category except for the smallest category that was included in the study. The efficient market hypothesis is relevant because it served as the justification for much of the deregulation that allowed the financial industry unprecedented power to operate freely (Ball).

Real Estate Bubble

The global financial crisis, which reached its greatest heights world-wide between the years 2007 and 2009, is problematic to understand and impossible to explain through the efficient market hypothesis, since bubbles represent one of the best pieces of evidence against the credibility of the efficient market theory. The roots of the crisis can be, with hindsight, be attributed to several causes. One of the most fundamental causes can be attributed to the dismantling of the Glass-Steagall Act (Chen and Kaboub). This historic deregulation of the banking industry during the president Clinton era when regulations were lifted that completely changed the way banks do business.

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The "housing bubble" in terms of valuation had grown to a level in which the actual asset prices were much lower than the prices people were willing to pay for housing. The demand for housing was fueled by the availability of low cost loans and new speculative real estate investment tools. These tools created a market place in which buyers could purchase a mortgage with no initial investment on their behalf even if they represented a risky investment.
Creative loan instruments fueled new loan originations for buyers that were previously unable to qualify for traditional markets. This in turn, drove the value of homes way up due to the fact there was a substantial increase in demand (Demyank and Hemert). Competition for the ownership of housing was at an all-time peak in the real estate market and consumers were willing to bid against each other at higher prices. The value of property reached levels that were previously unimaginable; especially in larger markets. However, these markets did not consider systemic risk; risk that would occur if a global insurance fund like AIG went bankrupt. Therefore these bubbles were likely caused by something other than what could be considered an efficient market.

Sub-Prime Mortgages

With the relaxed regulations, a new form of loan was created. The new financial tools were referred to as sub-prime mortgages. A sub-prime mortgage involved lending to an individual whose ability to repay the debt was somewhat questionable and therefore was devised as sub-prime. Since the ability to repay among these consumers was questionable in many cases, this represented a risky category of borrowers. These asset backed securities were consequentially bundled into derivative packages and sold to investors. Banks thought they could manage the risks because only a small portion of borrowers in this category were thought to default in any given period. However it also created a conflict of interest since mortgage loan agents had no interest in what the actual repayment ability of many clients because their bank wasn't going to keep the loan and thus defaults would have represented someone else's problem.

When the financial downturn started to show its trajectory, subprime borrows, who could barely repay their loans before the crisis emerged, greatly escalated the severity of the crisis. These borrowers, who were unable to meet their payment arrangements, created a wave of foreclosures that reached levels that were unknown since the time of the great depression. The "American Dream" of homeownership had backfired and was causing banks to acquire massive loads of debt. The insurance agency, AIG, sold an insurance-like product to guarantee this derivative packages however when the bubble pooped they were overwhelmed as well. AIG eventually had to be bailed out by the federal government because it could not meet its obligations.

Since financial markets have been becoming increasingly interrelated through globalization, once the effects of the sub-prime market began to stress the system, the implications spread throughout the global economy almost instantaneously. The value of real estate prices in the United States fell swiftly thus causing many people who were in the sub-prime category to owe more on their mortgage than it was worth on the market. Thus the circumstances created a situation in which it was actually beneficial for them to walk away from the property as opposed to staying and paying a mortgage that they couldn't afford. Plus since most of the borrowers in this category didn't have any of their own money invested, it was easy for many people to just walk away from their houses.

Overview on the Value of Banks

Banks play a central role in allowing for an economy to grow. The existence of banks allows for liquidity in the local market and provides essential services that make small businesses able to compete with larger organizations. Banks can also pool risk and transform into a more diversified law of averages which can be covered by the banks interest charges. If a bank makes a thousand loans for asset backed securities then historically the default rate has been fairly low. Obviously, this doesn't apply to the subprime phenomenon of the derivative packages. However, smaller local banks can gauge their markets and there borrows fairly well and they can also determine the amount of risk and price interest accordingly.

Banks also provide many basic services that have come to be taken for granted of in a modern society. For example, by use of a bank check or through a debit card you can make a…