On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. The bill was primarily meant to address the factors that led to the financial crisis of 2008. While an Act that contains 533 regulations will certainly be subject to criticism, there are some who argue that any financial reform is completely unnecessary and simply creates more regulatory burdens for corporations. Yet, the abuses related to mortgage backed securities that ultimately led to the real estate bubble demonstrate why at least some financial reform is required.
The need for the regulation of banks and financial service companies stems from the fact that they have one primary objective: to make money. If this is a corporation’s principal aim, then the interests of others may be adversely impacted in order to maximize profit. The mortgage backed securities fiasco provides a good example of this. At the height of the real estate boom, banks were motivated to make as many mortgage loans as possible in order to increase revenue without assuming risk. This was because banks were able to package a group of mortgages and sell them almost immediately to other companies for a tidy profit. Demand for these mortgage pools were high, so banks had an incentive to grant as many mortgages as possible and even loan mortgage funds to people that could not realistically afford to purchase a home. Mortgage payment default was not a concern to the banks since the companies that bought the mortgages from them would suffer the losses from default.
However, the companies that purchased mortgages from banks also transferred this risk to others by quickly re-packaging and selling the mortgages. These companies then divided the cash flows from the mortgage pools (i.e., the principal and interest payments that the home owners would pay) and sold them to investors. The result was essentially an investment “hot potato”. The investors holding the mortgage backed securities after the real estate bubble burst got burned.
Investors were interested in these mortgage backed securities because they wanted to receive substantially higher interest rates than low risk securities such as CDs and government bonds. However, many investors did not understand that these often complex investments were very risky since banks were loaning money to people who could not afford escalating mortgage payments. Ratings agencies compounded the problem by giving these securities investment grade ratings even though they should have realized that the chance of mortgage default, and therefore investment risk, was high.
The banks were in a “no lose” situation since they were able to sell these high risk mortgages almost immediately for a profit. They had no legal obligation to the ultimate investors. However, stakeholder theory suggests that the banks did have an ethical obligation to these investors and those to whom they provided mortgages.
Historically, business ethics theory took a much narrower view of corporate obligations to third parties. Dr. Milton Friedman held a typical opinion when he stated that companies only have an obligation to make a profit within the framework of the legal system and nothing more. Yet, if the laws are not sufficient to protect parties such as investors and home owners in the mortgage backed securities situation, the end result for the entire economy can be catastrophic, as we have seen in the past few years.
A Friedman proponent may argue that the fault for the real estate bubble lies not with the corporation, but with the investors and the home owners. Perhaps the investors failed to investigate investment risk because they were so fixated on obtaining higher yield. A prudent investor would know that with higher yield comes higher risk. As well, one could argue that it is not the bank’s responsibility to ensure that people can afford the homes that they purchased. People should learn to live within their financial means.
While Friedman supported the corporation’s maximization of profit, it was subject to the absence of deception or fraud. In the case of these bank mortgages, the banks’ hands were often not clean. They lured potential home owners with teaser rates that resulted in lower payments early in the mortgage term. However, it was clear that many banks were not as clear about the eventual large increase in payments that would occur after a number of years passed. Instead, they avoided detailed discussions of these ballooning payments and simply asked people to sign complex mortgage documents that were incomprehensible to a layperson.
Stakeholder theory goes even further. While Friedman’s view emphasizes a corporation’s duty to its shareholders, stakeholder theory asserts that a company should consider the effect of its decisions and actions on all impacted parties. This is not merely an altruistic corporate act. Paying attention to stakeholders should benefit the corporation in the long run. A bank that provides a customer with a mortgage that he or she cannot afford is liable to hold the bank in disdain when foreclosure occurs and it is revealed that the bank made the loan to generate revenue with no regard to the customer. Repeat business is unlikely.
While stakeholder theory seems rational, not all corporations will abide by its implications. As a result, financial regulation is necessary in order to compel businesses to avoid acting in ways that will be detrimental to the entire economy. With respect to mortgages, this reform in included in Title XIV of the new Act, which, among other things, requires financial institutions to verify a mortgage applicant’s ability to pay. Without imposing some potential liability on banks for the mortgage loans they grant, the catastrophic consequences that we have seen in the past several years from the real estate bubble bursting could reoccur.
