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.

Efficient Market Hypothesis

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).

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 Real Estate Bubble

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.

Conclusion

No matter what the future of banking looks like, one thing is fairly certain: banks will continue to exist. Without the invention of the banking system, society would likely still be reliant on a barter system. The modern world simply is not possible without a system of exchange that banks facilitate. That said, the future of banking could — and most likely should — involve increased regulation. Despite the fact that banks are too valuable to eliminate altogether, their structure and range of operations is definitely open to debate.

During the financial crisis, the five largest banks were overwhelmed by foreclosures, placing enormous stress on departments that handled such cases. While there are many individual instances of banks processing loans and foreclosures in deeply unethical ways, the larger picture must be appreciated to fully understand the phenomenon. The current banking system is both unethical and unsustainable in its present form. Financial institutions have grown too large to effectively service their accounts.

The sheer size of these institutions pressured banks to process foreclosures as quickly as possible, and many employees overstepped their authority by taking unethical shortcuts as well as by committing errors. However, if the banks had not been under such extreme stress, the number of unethical incidents would almost certainly have been far smaller. The wave of unethical actions by the banks was largely a product of the environment that had emerged. To change that environment, it is likely that banks will need to be broken up and their powers curtailed, so that financial institutions can once again become a stable backbone of the economy rather than a destabilizing force that creates havoc.

Works Cited

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Chen, B. and F. Kaboub. The Repeal of the Glass-Steagall Act and the Subprime Mortgage Crisis. 8 February 2012. Web. 19 March 2012.

Demyank, Y. and O. Hemert. "Understanding the Subprime Mortgage Crisis." 5 December 2008. Social Science Research Network. Web. 19 March 2012.

Deng, P. "Rethinking Efficient Market Hypothesis." 7 June 2009. Economist Online. Web. 20 March 2012.

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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.