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Did Investment Banks Deliberately Sell Faulty Loans?

By Lauren | June 11, 2008

By now we’re all well aware that the subprime mortgage mess has done major damage to the economy, both in the U.S. and around the world.  Until recently, however, I thought that the subprime lenders had just gotten a little too greedy, approving iffy loans on an individual basis without fully considering the long-term implications of dumping all of those loans on the market at once.

So imagine my horror when NPR reported recently that the subprime mortgage debacle may be the product not of innocent over-exuberance, but of outright fraud.  According to NPR, outside auditors claim that some of the biggest investment banks on Wall Street were deliberately making ultra-risky loans to homeowners who were never likely to repay them, overlooking bad credit ratings, inflated salary claims, and other clear evidence that those homeowners were buying a lot more house than they could afford.

The banks then bundled the bad loans in with good ones, reselling the loans at appallingly profitable rates of return.  Short term, the money poured in like water; it was only when the high-risk borrowers started defaulting left and right that the full impact of the banks’ shoddy lending practices began to be felt.

NPR likened the process to mixing bad apples into a barrel of good ones, then selling the barrels to unwitting customers.  We all know what one bad apple can do in a barrel – imagine what happens when dozens of bad apples are mixed in.  If it turns out that affluent Wall Street investment bankers lined their pockets by deliberately foisting off bad loans on innocent purchasers, it will make for a very ugly harvest indeed.

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Topics: Business Ethics, corporate responsibility | 1 Comment »

One Response to “Did Investment Banks Deliberately Sell Faulty Loans?”


  1. Andrew Says:
    June 12th, 2008 at 10:09 pm

    Lauren,

    Indeed, what you describe has been common practice within the finance industry for several years.

    Left unchecked, this practice has resulted in loans being made to families with little or no concern as to whether or not the individual or concerned would be able to manage with the repayments.

    As you say, the practice involved banks making highly risky loans, packaging them together with less risky loans and then on-selling the entire package to investors (usually hedge funds or investment banks).

    Under this strategy, the bank which originated the mortgage was not exposed in the event of default – investors were. Accordingly, the bank cared little about the borrowers ability to meet the commitments of the loan.

    The investors did not care either since they believed that losses on loans which went sour would be offset by the other loans within the package.

    The upshot was that banks made loans to borrowers despite knowing that the borrowers would not be able to meet the commitments of the loan.

    This was further compounded by ‘adjustable rate mortgages’ which involved borrowers making low interest payments during the early years of the loan, only to have the loan ‘reset’ to a higher interest rate at a later date.

    Who is to blame for this mess? Several parties.

    First of all, borrowers are responsible for the debt they take on, and must bear some responsibility for their own losses. Before taking out any loan, the borrower should ensure that they can comfortably meet the commitments of that loan.

    But lenders share some of the blame as well, particularly given that many low income borrowers may not be financially literate. It is the responsibility of lenders to ensure that borrowers fully understand both the terms and conditions of the loan and the risks involved in taking out the loan. Not to do so is negligence.

    Also, the lender has an ethical duty not to offer loans which they know that the borrower cannot realistically afford.

    You may be interested to note that the crisis was not without warning. Several years ago, Business Week ran a cover feature describing the danger of lending practices in America, particularly in relation to adjustable rate mortgages.

    The warnings were there, they were ignored by the industry.

    Cheers

    Andrew

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