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SECTION 4E – THE INDUSTRY PRACTICES AND LEGAL FACTORS
READING 4.19 – THE SUBPRIME SAGA: BEAR STEARNS, LEHMAN, MERRILL,
AND CDOs
Use PowerPoint Slides 174 - 177 as a backdrop for the case, have the students think about the following
ethical issues in the subprime saga:
Taking advantage of borrowers who were high risk with loan terms they could not meet or with loans
that ballooned beyond their payment ability after a few years
Undue complexity in loan structure for consumers already struggling with credit issues
Lending to full value of the property
Home equity loans that left owners with no equity
Appraisals that inflated the value of the property thus allowing more loans
Qualifying borrowers for loans with falsification of financial information and other background data
Financiers were purchasing the mortgage loans without discussing or revealing the level of risk;
mortgage-backed bonds were traditionally higher rated than leveraged debt, which is what most of
the subprime market was
Hedge funds were also based on the perceived risk, not the real risk that was hidden. No one was
really told of the true credit and collateral quality of the loans
There is no question that subprime lenders filled a market niche. The problem was there was no
self-restraint. Discuss the North Carolina provisions here to illustrate how subprime lending can be done
responsibly.
Answers & Key Discussion Items
1. Use PowerPoint Slides 178 and 179 to discuss the factors that cut across such as weak boards,
2. The returns from the companies kept growing, but were strangely stable despite what should have
3. The article deals with the fact that the kinds of high-risk behaviors that netted the pressure-induced
numbers are simply not sustainable. Indeed, with the companies discussed here, they were
self-destructive. Take the students back to Units One and Two and discuss the various philosophical
The following is an excerpt from Marianne M. Jennings, “Some Thoughts on Ethics, Governance, and
Markets: A Look at the Subprime Saga,” Corporate Finance Review 12(4):40-46 (2008):
The pattern of the regulatory cycle, so evident with other issues and industries (such as the conflicts
with the audit firms pre-Enron and the analysts pre-Spitzer), is present here. There is a booming
market with double-digit returns and little regulation. Entrepreneurial sorts move into the market and
The Latency Stage of the Cycle: An Area of High Returns and Little Regulation
The troubled credit history consumers will always be with us. Traditionally, the troubled credit history
presented a problem for mortgage lenders. It was one thing to hand over a Visa card with a limit to
troubled-history debtors. It was quite another to create the more permanent relationship of
Technically speaking, the subprime mortgage market is defined to include those borrowers with a
FICO (Fair Isaac Co.) score below 570. The median FICO score is 720, with a perfect score being
850.2 During the decade, the subprime home mortgage market grew from $35 billion to $401 billion.
However, foreclosure rates on subprime loans range from 20 to 50 percent, with the likelihood of
default higher on many of the loans exacerbated because of loan structures that include high interest
rates as well as balloon payments (see below for more discussion). In the initial stages, if the
During this period of the cycle, those in industry are aware of the evolving practices in an unregulated
area. The classic pattern of the cycle is that there is no violation of the law because the law does not
(yet) cover the specific practices gaining momentum. For example, subprime loans had complexities
Another typical subprime industry practice was that the lenders/brokers built in very high costs for
1 Celeste Hammond, “Predatory Lending __ A Definition and Update,” 34 Real Estate Law Journal 176 (2005).
2 Fair Isaac was also hit by the subprime collapses. Its evaluations and predictions on many of the mortgage loans (particularly
those with no down payment) proved to be inaccurate. The result is that Fair Isaac's stock is down 10% for 2007. Michael Maiello,
“Where Was FICO?” Forbes, Sept. 17, 2007, p. 44.
3 Julie Creswell and Vikas Bajas, “A Mortgage Crisis Begins to Spiral, and the Casualties Mount,” New York Times, March 5, 2007,
pp. C1, C4.
closing, appraisal, and other fees, producing a mortgage amount so high that the debtor actually
Subprime brokers and lenders often returned to customers and used a typical industry practice known
as flipping. The borrowers refinanced their homes on the broker/lender’s promise of lower payments,
a lower rate, or some benefit that may actually be real. However, the costs of refinancing, known as
The latency stage is also characterized by attention from the academic community. For example, the
lending terms were often coupled with discussions in the academic journals of subprime marketing
The steady stream of academic literature on an issue is often dismissed in the latency stage as
extreme, particularly when, as with the subprimes, things are going along swimmingly, as it were, with
The Awareness Stage of the Cycle: The Stories Emerge
During this stage of the cycle, the individual and emotional stories related to the lender/broker
practices begin to emerge. For example, in 2003, the Federal Trade Commission's settlement with
First Alliance Mortgage in which the subprime lender paid a $60 million fine for unfair trade practices
The Activism and Regulation Stages
In this stage, the stories that carry a common thread of injustice move the public, which could include
consumer borrowers affected by subprime practices, to legislative and regulatory reforms. Once the
stories of the subprime terms and industry practices began to emerge in 2003 and 2004, pieces of
state and local legislation began to dot the country as a means of curbing subprime loans
4 Catherine M. Hamberger, “Digest of Selected Articles,” 33 Real Estate Law Journal 110 (2004) provided a summary of the various
articles from other journals on the topic. See also, Jack Harris, “Dealing From the Bottom of the Deck - Will Predators Force
Subprime Lending to Fold?”, 11 Tierra Grande 3 (2004).
5 Quercia, Stegman, and Davis, “The Impact of Predatory Loan Terms on Subprime Foreclosures: The Special Case of Prepayment
Penalties and Balloon Payments,” Center for Community Capitalism of the Kenan Institute for Private Enterprise at University of
North Carolina at Chapel Hill, January 25, 2005.
Jack Harris, “Dealing From the Bottom of the Deck - Will Predators Force Subprime Lending to Fold?”, 11 Tierra Grande 3 (2004),
take various approaches to protecting consumers from predatory lending practices.6 Some states
limited charges or interest rates. Other states limited foreclosures or refinancings within certain time
frames. Some, such as Cleveland’s ordinance, simply prohibited predatory practices, making such
activity a criminal misdemeanor. Cleveland’s ordinance was described by a court in a successful
challenge by a lender as follows:
“Predatory loan” in Cleveland is defined as any residential loan bearing interest at an annual
rate that exceeds the yield on comparable Treasury securities by either four and one-half to
eight percentage points for first mortgage loans or six and one-half to ten percentage points
for junior mortgages. In addition, loans are considered predatory if they were made under
However, this first phase of regulation did not survive the many judicial challenges. Cleveland’s
ordinance, like so many of the antipredatory statutes, ran into difficulties with judicial challenges by
lenders that have argued successfully that the regulation of home loans is preempted by the
The 2007 phase of regulations has shifted to the federal level with legislation proposed by, for
example, Senator Charles Schumer (D-NY) that would prohibit brokers from selling mortgage vehicles
that are not in the borrower’s best interests, whatever the meaning of “borrower’s best interests” is.9
Additionally, this regulation phase finds that some of the mortgage lenders may have tried to ward off
the impact of the real estate market downturn and the extensive foreclosures on their financial
statements. At least one Big Four audit firm has decertified the financials of a lender. Deloitte issued
In answering the question about North Carolina’s preemptive move, have the students think about the
following:
Thinking Through the Telltale Signs of an Evolving Cycle
So often, amidst the rubble of a dynamic segment of the market that has experienced a crash, the
20-20 hindsight analysis, such as the above cycle application, does not have much of an effect on
future business conduct. “Sure,” the response is, “it’s easy to look back and see the warning signs,
but when you live through it all, you sometimes walk through not realizing what’s evolving.” Fair
enough. However, the subprime market had many of the same characteristics that were part of the
dot-com era as well as the eerily similar savings and loan collapses of the 1990s. Those
characteristics have the basic principles of business ethics that too often fail as warnings or even just
an admonition to consider self-imposed reforms before the cycle progresses to full regulation
following financial fall-out. Those lessons include:
1. Continuing double-digit returns that defy market expectations and cycles. The companies
2. Continuing expansion in a market/field that is not regulated extensively. The ethics adage here is,
“Just because it is legal does not mean it’s ethical.” No one broke the law with the subprime
3. High personal incomes for market participants that make it difficult for them to change existing
The probability of an ethical outcome is a direct function of the amount of money involved, and
the slope of the line is negative.
4. The rumblings of regulations and the expressions of concerns are readily dismissed because of
the outstanding financial performance. Even former Federal Reserve Chairman Alan Greenspan
has confessed to not realizing the market implications of the subprime loans.12 Mr. Greenspan
The key to market predictions may rest in studying whether those who are part of the new stellar
industries are pushing the ethical envelope. Legal though their actions may be, the ongoing pressure
As the Fortune piece noted in its introduction,
11
Floyd Norris, “Audit Qualms Undo Hopes Of a Lender,” New York Times, Sept. 7, 2007, pp,. C1 and C7.
12
Sue Kirchoff, “Greenspan Slow to See Subprime Danger,” USA Today, September 14, 2007, p. 1B.
“Two things stand out about the credit crisis cascading through Wall Street: It is both totally
shocking and utterly predictable. Shocking, because a pack of the highest-paid executive on
This case is an excellent one to help the students understand, particularly with Goldman as the
CASE 4.20 – ENRON: THE CFO, CONFLICTS, AND COOKING THE BOOKS WITH
NATURAL GAS AND ELECTRICITY
Use PowerPoint Slides 180 - 196.
Be sure to emphasize that Enron had a culture similar to Bausch & Lomb, HealthSouth, and Tyco; Krispy
Kreme did not go as far, but it was trying to deceive outsiders as to where it was financially and in terms
of growth:
a. Performance mattered
b. Goals had to be achieved
c. Incentive programs for meeting goals
d. Sycophantic atmosphere – fear of employees
e. Non-responsiveness of officers to3concerns about employees
Answers and Key Discussion Items
1. The violations of the law that Enron and its officers broke included violations of Section 10b, the
federal law on insider trading. There was a lack of candor on the part of the company with regard to
its financial position, so there is the 10(b) violation for releasing overly optimistic information about the
company. These overly optimistic financial statements are a violation of 10b. Also, many of the
officers were selling shares at a time when the earnings reporting and other financial issues were
Following the Boesky and Milken scandals, part of the 1988 federal reforms included a 28-word
addition to the federal mail and wire fraud statutes that provided, “For the purposes of this chapter,
the term, scheme or artifice to defraud includes a scheme or artifice to deprive another of the
intangible right of honest services.” 18 U.S.C. §1346. The provision did lie fallow for some time until
the Enron era of company failures due to accounting fraud by officers. Prosecutors began adding the
so-called “honest services fraud” charges to mail and wire fraud as a way of obtaining harsher
2. Yes, Enron’s financial reports did give a false impression about the condition of the company. The
failure to disclose the extent of their exposure in “off the books” companies was deceptive. Also, the
manner in which they were booking revenues for future energy contracts was also deceptive. While
It is a stretch to say that there was fairness in the financial reports. A simple test is whether those
making the disclosures and preparing the financial statements would want to have this type of
The means of accounting was technically in compliance with accounting rules – the means of
accounting pushed the envelope and came as close as they possibly could to compliance with the
rules. The lack of consolidation of the financial statements gave a false impression of the financial
While the sophisticated investor defense is often touted in these cases, the reality is that there were
more duped by Enron than able to understand how they were actually making money and reporting it.
The attitude conveyed by such a defense is that the company is under no obligation to be forthcoming
Fastow also was not forthcoming about his relationships and interests in the off-the-book entities.
That kind of information was actually disclosed in the 10K, but not in enough detail. Also, finding that
The sophisticated investor issue is going to fall by the wayside fairly quickly. See Goldman (Case
2.11) on change in definition because of the too-easy evasion of disclosure by investment bankers
and others. The Enron employees were heavily invested in Enron stock, largely because of the
3. Is this fair? Would I want this information? Am I creating a false impression? Discuss with the
students the possible categories of violations:
a. Giving or allowing a false impression
b. Taking unfair advantage
There are substantial violations of the twelve categories of ethical dilemmas.
4. Yes, Fastow had a conflict of interest. He made money each time there was an off-the-book deal
from the off-the-book entities even though he was transferring Enron assets. The higher the price
Enron paid, the more commission he earned as an officer of the selling company. He stood to make
There should have been full disclosure and the nature of the transactions should have been approved
by an independent board or by the shareholders themselves. However, they could not disclose these
5. The credo moments are the same as those discussed in previous units. They were signing
documents that they knew contained false information. They knew that the financial reports did not
reflect accurately the true financial picture of the company. Emphasize to the students that both
Delainey and Fastow realized too late that family was more important than the money and that their
6. Yes, Ms. Watkins was an internal whistleblower. But, as Ms. Watkins herself has noted, she only blew
the whistle in enough time to help the government with its case. She did not act quickly enough to
save the investments of employees and others and to reform the accounting practices. Paula Reiker
This is a good time to encourage a credo element such as, “I will never allow money to change my
Compare & Contrast
1. Use PowerPoint Slides 194 and 195. Mr. Delainey was aware that the company had crossed into
illegality and fraud but could not bring himself to speak up or walk away. Olson, on the other hand,
was willing to endure the ridicule and the loss of employment that resulted from his challenges to
Use PowerPoint Slides 197 - 203 to provide a summary of the factors that get in the way of ethics
and the cultural factors that influence behaviors in organizations.
2. The prosecutions in this latest wave of business scandals have proven to be brilliant and successful.
The prosecutors work their way up through the company gathering information and witnesses through
plea bargains. They also only bring those charges they know that they can prove in court. They do
not focus on the financial reporting acts themselves – those are complex beasts and intent is difficult
to prove. Instead they have focused on the relatively simple crime of knowing the company had
CASE 4.21 – ARTHUR ANDERSEN: A FALLEN GIANT
Answers and Key Discussion Items
1. The case perhaps was a bad legal case in that it was difficult to prove criminal intent to destroy
evidence on the part of Arthur Andersen when it was individuals who were actually engaged in the
document destruction. The problem with the old statute was that it required specific knowledge of the
exact charges being investigated and in what area before criminal intent could be established. The
2. The students should understand that Duncan was a respected member of the community and
dedicated to his family. The students need to understand that they should not be taking away the fact
that Duncan lost his way and that’s why he allowed Enron such accounting flexibility. What they need
to take away from the case is that when there is pressure combined with money, even the best
individuals can succumb to that pressure and make the types of decisions or offer their imprimatur to
3. The relationship between Sullivan and Andersen auditors is the very essence of the changes made
Yes, the consulting arrangements with companies that were also auditors were a conflict of interest.
Under the Sarbanes-Oxley reforms passed following Enron’s collapse, such dual contracts are
The controls that were missing were that central management could change division numbers
4. Andersen slipped gradually as it competed for more consulting. Consulting overpowered the
absolutes of auditing. Duncan was conflicted because taking a firm position on the audit issues meant
Compare and Contrast
The bankruptcy trustee is trying to get companies to understand that technical compliance is no longer
the issue. The issue is whether the information is qualitatively material, not quantitatively material or
In the case of Lehman, they used the same strategy as Enron did in spinning debt off the books.
Emphasize to the students the importance of studying history in business and drawing parallels in
conduct as you make decisions about financial reporting, strategy, and other aspects of doing business.
CASE 4.22 – THE ETHICS OF WALKING AWAY
Use PowerPoint Slides 174 and 175 again.
Answers and Key Discussion Items
1. This simple case illustrates that we often make decisions because everyone else is doing it (the
The lender, the neighbors, the city, the economy of the city, all banks, economic implications. There is a
ripple effect from these decisions because affecting the value and occupancy of property changes a
community.
