Unethical Practice in Mortgage Lending

Unethical Practice in Mortgage Lending

The current financial crisis has been attributed by experts due to a whole range of issues such as sub-prime lending, excess leverage, lack of control by the SEC and other Government financial bodies and over-debt. However, the root cause of the issue is the unethical behavior of many executives who work in the financial services sector and their resultant negligence. The top executives of many financial firms began to have a short-term approach towards lending and they put their personal needs before the needs of the financial industry, economy and the American people at large. This is why we are faced with a dire financial situation that seems to only have a fading light at the end of the tunnel.

Unethical Practice -- Ways and Means

Numerous unethical practices are followed by American banks and the regulatory agencies have failed in their job to penalize and avoid these practices. Some of the practices that have the most impact are discussed below.

Sub-prime mortgage

The problem started when the banking industry began to receive numerous applications for mortgages and among these, only a small percentage were credit worthy. To make use of this increasing demand, the banks decided to relax the rules and began lending to people with lower credit ratings by increasing the rate of interest. They by-passed the established underwriting standards and this led to the accumulation of mortgages that were considered to be risky. This form of lending to people with poor credit is also known as sub-prime lending and this was effectively used by banks during the housing bubble of 2007 to generate more money by way of interest. This move was taken by the top executives after being aware of the implications that came with it. This is a classic example of unethical practice because the banks were not only exploiting the American dream of people who had less-worthy credit, but they were putting the entire industry on the line with this move.

A good case in point is the Washington Mutual Bank (WaMu). This bank was America's largest thrift bank and overall, it ranked sixth largest in the country. It had branches in 15 states and more than 40,000 people were employed here. Since 2004, it started accumulating risky mortgages from people who had less than perfect credit scores and by 2006, many of its mortgages were behind or were facing delinquencies. Further more, the bank started making losses in 2007 and eventually, it had to be shut down in 2008 (United States Senate Permanent Sub-Committee on Investigations, 2011). Due to this unethical practice of sub-prime lending, 43,000 people in this bank lost their job and millions lost their homes.

The worst part of this form of lending was that the financial institutions raised the hopes of fulfilling the American dream for millions of people when they did not have the capacity to do it. So, when this form of lending collapsed and people lost their homes, it had a psychological impact on the families and especially kids. In other words, the greed of banks raised and crashed the dreams of millions of Americans.

Predatory Lending

Predatory lending is a form of lending in which a financial institution entices potential home owners with lower advertised rates and they are charged the higher adjustable rate mortgages (ARM) at the time of the signing of the contract. Unfortunately, the person signing the contract is unaware of this increased rate. As a result, the amount of interest paid by the home owner is way less than the amount charged and this led to interest accumulations and more interest on these unpaid interest. One company was that engaged in this practice was Countrywide Financial. This company enticed users into making only interest payments at a lower rate than the contract and as a result, their debt accumulated and the bank was charging interest on the unpaid amounts as well.

When people understood what was going on, they were enraged and this led to many lawsuits. To appease the anger of home owners, Countrywide agreed to pay $600 million to settle shareholder lawsuits (The Canadian Press, 2010). This is the biggest payout since the mortgage meltdown began and this reflects the unethical practices that are followed by financial institutions and their consequences.

Fraudulent loan terms

Some banks have involved in fraudulent lending practices such as having hidden costs for lending that were never fully disclosed to the home owner at the time of signing the contract. It also started with the stated income lending in which the potential home owner can state his or her income for the application process and no effort was made by the financial institution to verify this information. They were charged a flat high rate and this is one of the reasons for the collapse of the mortgage market. One such company was Ameriquest. "Regulators have charged that Ameriquest has been too aggressive by not fully disclosing loan terms, slipping in hidden loan fees and approving some loans by distorting a person's income or value of their home in order to make the loan, and by pressuring over-extended home owners to refinance loans they could not maintain" (Sanders, 2006, p.20). It was also involved in other forms of unethical practices that led to its acquisition by Citi Group.

Complex debt instruments

In order to make more money, numerous financial institutions began creating more complex instruments. The sub-prime mortgages were packaged and sold as Mortgage Backed Securities (MBS) to other banks or investors. Another similar product was the Collateral Debt Obligations (CDO) that were also sold to other investors. This necessitated a complex form of insurance to back these products and so, credit swaps were created. The financial industry embarked on the path of creating more complex instruments without the knowledge of the home owner or the public at large. They were too complex for the understanding of a common man and this helped them to circumvent many legislation that was not equipped to handle such complexity.

Shadow Banking System

"The shadow banking system consists of financial institutions that act like banks but aren't subject to the same regulations. It includes investment banks -- traditionally, the giant firms on Wall Street -- along with hedge funds; other private equity funds; structured investment vehicles (often called SIVs) and other "special-purpose entities" (Enron used these); pension funds; and money-market funds that are regulated, but not as banks. Add in a handful of "credit" conglomerates such as GMAC and GE Capital, which do almost everything imaginable with money but don't take deposits. These players engage in a dizzying variety of transactions, including "repurchase agreements" whereby one party effectively lends cash to another for a very short period of time, often overnight" (Maggs, 2009).

This shadow banking system is another endemic problem in our financial system and through this system, the banks are performing a wide variety of unethical practices to fraud the customers in every way possible.

These were some of the ways in which the bank used the legislation, customers, the U.S. financial system and the economy to make huge profits that was enjoyed by the top executives by way of exorbitant bonuses. This had a big impact on the society -- in fact, bigger than what the executives ever imagined.