Mortgage Backed Securities and Financial Reform

On July 21, 2010, President Obama signed themortgages.
Dodd-Frank Wall Street Reform and ConsumerHistorically, business ethics theory took a much
Protection Act into law. The bill was primarily meant tonarrower view of corporate obligations to third parties.
address the factors that led to the financial crisis ofDr. Milton Friedman held a typical opinion when he
2008. While an Act that contains 533 regulations willstated that companies only have an obligation to make
certainly be subject to criticism, there are some whoa profit within the framework of the legal system and
argue that any financial reform is completelynothing more. Yet, if the laws are not sufficient to
unnecessary and simply creates more regulatoryprotect parties such as investors and home owners in
burdens for corporations. Yet, the abuses related tothe mortgage backed securities situation, the end result
mortgage backed securities that ultimately led to thefor the entire economy can be catastrophic, as we
real estate bubble demonstrate why at least somehave seen in the past few years.
financial reform is required.A Friedman proponent may argue that the fault for the
The need for the regulation of banks and financialreal estate bubble lies not with the corporation, but with
service companies stems from the fact that theythe investors and the home owners. Perhaps the
have one primary objective: to make money. If this is ainvestors failed to investigate investment risk because
corporation's principal aim, then the interests of othersthey were so fixated on obtaining higher yield. A
may be adversely impacted in order to maximizeprudent investor would know that with higher yield
profit. The mortgage backed securities fiasco providescomes higher risk. As well, one could argue that it is
a good example of this. At the height of the realnot the bank's responsibility to ensure that people can
estate boom, banks were motivated to make asafford the homes that they purchased. People should
many mortgage loans as possible in order to increaselearn to live within their financial means.
revenue without assuming risk. This was becauseWhile Friedman supported the corporation's
banks were able to package a group of mortgagesmaximization of profit, it was subject to the absence
and sell them almost immediately to other companiesof deception or fraud. In the case of these bank
for a tidy profit. Demand for these mortgage poolsmortgages, the banks' hands were often not clean.
were high, so banks had an incentive to grant as manyThey lured potential home owners with teaser rates
mortgages as possible and even loan mortgage fundsthat resulted in lower payments early in the mortgage
to people that could not realistically afford to purchaseterm. However, it was clear that many banks were
a home. Mortgage payment default was not anot as clear about the eventual large increase in
concern to the banks since the companies that boughtpayments that would occur after a number of years
the mortgages from them would suffer the lossespassed. Instead, they avoided detailed discussions of
from default.these ballooning payments and simply asked people to
However, the companies that purchased mortgagessign complex mortgage documents that were
from banks also transferred this risk to others byincomprehensible to a layperson.
quickly re-packaging and selling the mortgages. TheseStakeholder theory goes even further. While
companies then divided the cash flows from theFriedman's view emphasizes a corporation's duty to its
mortgage pools (i.e., the principal and interest paymentsshareholders, stakeholder theory asserts that a
that the home owners would pay) and sold them tocompany should consider the effect of its decisions
investors. The result was essentially an investmentand actions on all impacted parties. This is not merely
"hot potato". The investors holding the mortgagean altruistic corporate act. Paying attention to
backed securities after the real estate bubble burst gotstakeholders should benefit the corporation in the long
burned.run. A bank that provides a customer with a mortgage
Investors were interested in these mortgage backedthat he or she cannot afford is liable to hold the bank in
securities because they wanted to receivedisdain when foreclosure occurs and it is revealed that
substantially higher interest rates than low riskthe bank made the loan to generate revenue with no
securities such as CDs and government bonds.regard to the customer. Repeat business is unlikely.
However, many investors did not understand thatWhile stakeholder theory seems rational, not all
these often complex investments were very riskycorporations will abide by its implications. As a result,
since banks were loaning money to people who couldfinancial regulation is necessary in order to compel
not afford escalating mortgage payments. Ratingsbusinesses to avoid acting in ways that will be
agencies compounded the problem by giving thesedetrimental to the entire economy. With respect to
securities investment grade ratings even though theymortgages, this reform in included in Title XIV of the
should have realized that the chance of mortgagenew Act, which, among other things, requires financial
default, and therefore investment risk, was high.institutions to verify a mortgage applicant's ability to
The banks were in a "no lose" situation since theypay. Without imposing some potential liability on banks
were able to sell these high risk mortgages almostfor the mortgage loans they grant, the catastrophic
immediately for a profit. They had no legal obligation toconsequences that we have seen in the past several
the ultimate investors. However, stakeholder theoryyears from the real estate bubble bursting could
suggests that the banks did have an ethical obligationreoccur.
to these investors and those to whom they provided