Deck 8: Subprime Lending Fiasco: Ethics Issues

Question 1

How much, and in which ways, did unbridled self-interest contribute to the subprime lending crisis?

Answer 1

Unbridled self-interest played a significant role in the subprime lending meltdown. Some instances are:
• Homeowners failure to understand that they could not afford to own a home, - particularly when the interest rates rose.
• Sales agents were only concerned with making commissions on sales, and not looking out for the best interest of their clients.
• Banks were interested in generating transaction fees associated with making the loans and higher interest revenue without looking at the credit-worthiness of the borrowers and the risks associated with defaults.
• I nvestors who bought the high yield mortgage-backed securities were ignoring their fiscal responsibilities by not conducting due diligence on the risks associated with these securities.

Question 2

What was the most important reason for the Lehman Brothers failure?

Answer 2

13694-8.EC-1LBQ AID: 6327 | 27/02/2015
LB one of the world's most reputed investment banks, filed for bankruptcy in the year 2008, due to its alleged involvement in manipulation of the repo rate.
The most important reasons for its failure are as mentioned below:
• The poor economic climate caused by the subprime lending crisis led to degeneration of confidence, and therefore, a devaluation of financial instruments in which LB had invested.
• A Highly leveraged position prior to the onset of subprime lending crisis. In addition, masking of the extent to which LB was leveraged, prevented the investors to asses LB's liquidity ; became the most important reasons for its failure.
• BS, a rival investor, faltered and nearly collapsed, thus, bringing limelight on LB, and making it more vulnerable.
• A mismatch between longer-term assets and the shorter-term liabilities used to finance them, thus, making LB vulnerable to the cost of credit needed to finance the assets.

Question 3

Referring to the outrage over the apparent abuse of AIG, Farzad and Dwyer ask the question: If the firm could just write a multibillion-dollar check to erase the outrage-deserved or not-over the AIG payout and be done with the public agony, wouldn't it just do it?30 What would your answer be? Provide your reasoning for and against.

Answer 3

The company's decision to write a million dollar check to erase the outrage was correct because if the company would have involved in the conflict it would effects its market position. In addition, it would also affect the business of the company adversely.
On the contrary, the company just do what was asked. It would have reduced the cost burden of the company but may not have helped it to understand the market trends and thereby affect its operations.

Question 4

What should the following have done upon learning of Matthew Lee's whistleblower's letter-LB's management, board of directors, and the external auditors, E Y?

Question 5

How could increased regulation improve the exercise of unbridled self-interest in decision making?

Question 6

Because the Toronto-Dominion Bank was neither a manufacturer nor a distributor of ABCP products, did the bank have a moral responsibility to assist in the restructuring of the commercial paper market?

Question 7

In your opinion, how large should a Repo 105 transaction be to be considered material, and why?

Question 8

Arthur Andersen tried to keep its Enron audit problems quiet, whereas E Y spoke out in its own defense. Was it a good idea for E Y to send a letter, such as the one reproduced previously, to their clients? Why and why not?

Question 9

How could ethical considerations improve unbridled self-interest in ethical decision making?

Question 10

The argument is that market-to-market accounting caused AIG to record huge unrealized losses. These losses led to a downgrade in the quality of AIG stock. The downgrade and frozen credit markets led to eventual bailout. So, do you agree that the accounting rules contributed to AIG's demise?

Question 11

Is it appropriate for Goldman Sachs to "bet against their clients" through their investment activities?

Question 12

Based on the letter, should E Y be in the clear of any wrongdoing related to the Repo 105 and 108 transactions and reporting? Provide your reasons for and against.

Question 13

Identify and explain five examples where executives or directors faced moral hazards and did not deal with them ethically.

Question 14

In December 2002, Stan O'Neal became CEO of Merrill Lynch Co Inc, the world's largest brokerage house. Known as "Mother Merrill" to insiders, the firm had a nurturing environment that accepted lower profit margins so that veteran employees could remain with the firm. O'Neal changed that culture. He laid off one-third of the workforce-24,000 employees-and fired nineteen senior executives while eliminating senior management perks. He put in a new young management team, expanded the firm's overseas activities, and made Merrill a more aggressive, risk friendly organization. In 2006, for example, the firm made $7 billion in trading securities, compared with $2.2 billion in 2002. Under O'Neal's leadership Merrill became the most profitable investment bank in America, making more money per broker than any of its competitors. O'Neal was rewarded well-in 2007 he became one of Wall Street's bestpaid executives, earning $48 million in salary and bonuses.
He pushed the company into new lines of business, including investing in collateralized debt obligations (CDOs). Merrill led the industry in its exposure to CDOs. Over an eighteen-month period, to the summer of 2007, its investment in these subprime mortgage-backed CDO pools rose from $1 billion to more than $40 billion. Then the subprime mortgage bubble burst.
The term "subprime" does not refer to the interest rate changed on the mortgage but, rather, to the risk associated with the borrower. Subprime mortgages are given to high-risk customers who are charged an interest rate that is greater than prime. These mortgages are typically given to people who would not normally qualify for a mortgage from a conventional lender such as a bank. From the lender's point of view, as long as house prices increase, the risk of a loss on the mortgage is low. As such, the mortgages became low-risk, high-yield investments. The lenders of these sub-prime mortgages would then package these mortgages as bundles of asset-backed synthetic securities, such as CDOs, which were sold to third parties, including individuals, corporations, pension funds, banks, insurance companies, and brokerage houses.
The subprime mortgage bubble bust when house prices in the United States began to fall. People could no longer refinance their homes nor pay off their mortgages by selling their homes. By late 2006, one in eight subprime mortgages was in default. Throughout 2007, nearly 1.5 million American homeowners lost their homes. As the housing market imploded, mortgage payment defaults increased and the value of subprime mortgages fell as did the value of the subprime mortgage-backed CDOs. By the summer of 2007, subprime-related losses were being reported by all the major financial institutions.
In the third quarter of 2007, Merrill announced a loss of $2.3 billion, compared with a profit of $3.05 billion for the third quarter in 2006. It also announced a $7.9 billion provision for losses on mort gagerelated investments, larger than the warning of a possible $5 billion write-down that it had made a month earlier. Within a week of reporting the largest quarterly loss in the company's ninety-three-year history, O'Neal resigned as Chairman and Chief Executive Officer of Merrill Lynch. Although he did not receive any severance, O'Neal did receive $161 million in stock and retirement benefits.
Subprime mortgages targeted lower income Americans, new immigrants, and people who had a poor credit history. The customers were told that because house prices had been rising, the borrower would be able to refinance the loan at a later date with the increased equity in the house. Was this an ethically correct sales pitch? Were the lenders taking advantage of financially naïve customers?

Question 15

Was LB's interpretation of SFAS 140-Repo 105 transactions could be treated as sales-correct? Provide your reasons.

Question 16

If an auditor explains a problem to the chair of an audit committee, is there any further obligation on the part of the auditor to ensure that the full board has been notified, and why?

Question 17

How much should the exiting CEOs of Fannie Mae and Freddie Mac have received when they were replaced in September 2008?

Question 18

Commission salespeople are paid their commission after they write successful insurance policies or consummate the sale of financial products. Should their commissions be recovered if the company subsequently suffers a loss as a result of the business written by the sales staff? Should there be an upper limit placed on commissions, so that no one employee receives $280 million in commissions over an eight-year period? How could such an upper limit be selected if a company wished to establish one?

Question 19

One of Goldman's main arguments in their defense is that their intentions were good-they did what they did in response to client requests, thus facilitating markets and making the world a better place.
a. Is the "good intention" argument sufficient to claimactions following from it are ethical? Why and why not? Remember the saying: "The road to hell is paved with good intentions."
b. Is there something in addition to good intentions that Goldman Sachs would have been wise to consider in its decision making?

Question 20

Organizations who use the Enterprise Risk Management (ERM) framework43 should work through the following stages: review on the internal environment, identification of the organization's risk appetite or objectives, risk identification and measurement, risk assessment, risk response, providing risk information and communications, and risk monitoring. In which of these did LB fail? Who was to blame for the failure?

Question 21

The government bailout of the financial community included taking an equity interest in publicly traded companies such as American General Insurance (AIG). Is it right for the government to become an investor in publicly traded companies?

Question 22

How should Goldman Sachs have handled each conflict of interest?

Question 23

If, as the Examiner's Report states,41 LB continued to collect the revenue from the securities involved in the Repo 105 transactions, how could LB say that they had given up ownership?

Question 24

How should the U.S. Bankruptcy Examiner's Report be regarded-as a neutral set of findings or as a signpost intended to point creditors in the direction of potential recoveries? What are the implications of each?

Question 25

Should CEOs who made large bonuses by having their firms invest in mortgagebacked securities in the early years have to repay those bonuses in the later years when the firm records losses on those same securities?

Question 26

What is leverage and why is it so important?

Question 27

How would you have advised Goldman Sachs' executives to have handled this crisis better?

Question 28

After the Enron and WorldCom fiascos, regulators sought to avoid future misrepresentation by enacting the Sarbanes-Oxley Act (SOX) in 2002. Why didn't SOX prevent Lehman's use of Repo 105 and 108 misrepresentations? Does that mean that SOX is a failure?

Question 29

Should the CEOs who refused to have their firms invest in mortgage-backed securities in the early years because the risks were too great receive bonuses in the latter years because their firms did not incur any mortgage-backed security losses? How would you determine the size of these bonuses?

Question 30

If you were Edmund Clark, how would you explain to the board of directors that you were having the bank exit a market in which your competitors were making a lot of money?

Question 31

An emerging issue Interpretation Bul-letin 42 accompanying FAS 140, gives examples indicating Repo 102 transactions would not qualify as sales, but Repo 110 would. Why do you think this Bulletin was issued?

Question 32

Should organizations that have a risk-taking culture, such as the one developed by Stan O'Neil at Merrill Lynch, enjoy the gains and suffer the losses, without recourse to government bailouts?

Question 33

The government said that AIG was "too big to fail." It was concerned that if AIG declared bankruptcy, then individuals holding personal insurance as well as other investments would have no insurance and would be in danger as the financial and liquidity crisis deepened. But many felt that the federal government should not be investing in publicly traded companies. There is risk in the marketplace, and one such risk is that occasionally businesses go bankrupt. Should the federal government have bailed out AIG, especially when it had not rescued Lehman Brothers and had let Merrill Lynch be taken over by Bank of America?

Question 34

What would an appropriate level of bonus payments be for Goldman Sachs as a whole?

Question 35

Are the criticisms that mark-to-market accounting rules contributed to the economic crisis valid?

Question 36

In December 2002, Stan O'Neal became CEO of Merrill Lynch Co Inc, the world's largest brokerage house. Known as "Mother Merrill" to insiders, the firm had a nurturing environment that accepted lower profit margins so that veteran employees could remain with the firm. O'Neal changed that culture. He laid off one-third of the workforce-24,000 employees-and fired nineteen senior executives while eliminating senior management perks. He put in a new young management team, expanded the firm's overseas activities, and made Merrill a more aggressive, risk friendly organization. In 2006, for example, the firm made $7 billion in trading securities, compared with $2.2 billion in 2002. Under O'Neal's leadership Merrill became the most profitable investment bank in America, making more money per broker than any of its competitors. O'Neal was rewarded well-in 2007 he became one of Wall Street's bestpaid executives, earning $48 million in salary and bonuses.
He pushed the company into new lines of business, including investing in collateralized debt obligations (CDOs). Merrill led the industry in its exposure to CDOs. Over an eighteen-month period, to the summer of 2007, its investment in these subprime mortgage-backed CDO pools rose from $1 billion to more than $40 billion. Then the subprime mortgage bubble burst.
The term "subprime" does not refer to the interest rate changed on the mortgage but, rather, to the risk associated with the borrower. Subprime mortgages are given to high-risk customers who are charged an interest rate that is greater than prime. These mortgages are typically given to people who would not normally qualify for a mortgage from a conventional lender such as a bank. From the lender's point of view, as long as house prices increase, the risk of a loss on the mortgage is low. As such, the mortgages became low-risk, high-yield investments. The lenders of these sub-prime mortgages would then package these mortgages as bundles of asset-backed synthetic securities, such as CDOs, which were sold to third parties, including individuals, corporations, pension funds, banks, insurance companies, and brokerage houses.
The subprime mortgage bubble bust when house prices in the United States began to fall. People could no longer refinance their homes nor pay off their mortgages by selling their homes. By late 2006, one in eight subprime mortgages was in default. Throughout 2007, nearly 1.5 million American homeowners lost their homes. As the housing market imploded, mortgage payment defaults increased and the value of subprime mortgages fell as did the value of the subprime mortgage-backed CDOs. By the summer of 2007, subprime-related losses were being reported by all the major financial institutions.
In the third quarter of 2007, Merrill announced a loss of $2.3 billion, compared with a profit of $3.05 billion for the third quarter in 2006. It also announced a $7.9 billion provision for losses on mort gagerelated investments, larger than the warning of a possible $5 billion write-down that it had made a month earlier. Within a week of reporting the largest quarterly loss in the company's ninety-three-year history, O'Neal resigned as Chairman and Chief Executive Officer of Merrill Lynch. Although he did not receive any severance, O'Neal did receive $161 million in stock and retirement benefits.
O'Neal transformed Merrill Lynch from a conservative bank into an aggressive risk-taking institution. Risk-taking means that there is the potential for high rewards as well as large losses. From 2002, when O'Neal became CEO, Merrill's share rose 53 percent. Should the investors now be upset that, as a result of the subprime mortgage meltdown, Merrill's stock price fell by about 30 percent in 2007?

Question 37

Knowing that LB could not obtain a "true sale" opinion from a U.S. lawyer under U.S. law, should LB have tried to obtain the opinion from a U.K. law firm? Why and why not?

Question 38

The global economic crisis was caused by the meltdown in the U.S. housing market. Should the U.S. government bear some of the responsibility of bailing out the economies of all countries that were harmed by this crisis?

Question 39

Is it right that perks such as holidays at luxury resorts are only provided to senior executives and the sales staff but not to the other employees of the firm?

Question 40

Would bonuses paid in Goldman Sachs stock be more appropriate than those paid in cash?

Question 41

Given that the marketplace for securities is global, and that the risks involved can affect people worldwide, should there be a global regulatory regime to protect investors? If so, should it be based on the regulations of one country? Should enforcement be global or by country?

Question 42

If Goldman Sachs really is innocent of all conflicts, why has the firm's reputation suffered?

Question 43

Do the Repo 105 arrangements constitute fraud? Why and why not?

Question 44

Should members and executives in investment firms be forced to be members of a profession with entrance exams and with adherence to a professional code such as is the case for professional accountants or lawyers?

Question 45

Prepare the journal entries for a Repo 105 transaction sequence for $1 million in securities.

Question 46

What is the auditor's responsibility if a fraud is suspected or discovered? What professional standards are most important in such cases, and why?

Question 47

Does the Dodd-Frank Act go far enough, or are some important issues not addressed?

Question 48

The banks in Canada are highly regulated by the federal government. If the banks could not come to a voluntary agreement, should the federal government have forced the banks through legislation to providing $950 million financial support to help solve the ABCP liquidity crisis?

Question 49

If you were the audit partner in charge in the United States, what would you have required be done in regard to the Linklater "true sale" letter?

Question 50

What were the three most important ethical failures that contributed to the subprime lending fiasco?

Question 51

In December 2002, Stan O'Neal became CEO of Merrill Lynch Co Inc, the world's largest brokerage house. Known as "Mother Merrill" to insiders, the firm had a nurturing environment that accepted lower profit margins so that veteran employees could remain with the firm. O'Neal changed that culture. He laid off one-third of the workforce-24,000 employees-and fired nineteen senior executives while eliminating senior management perks. He put in a new young management team, expanded the firm's overseas activities, and made Merrill a more aggressive, risk friendly organization. In 2006, for example, the firm made $7 billion in trading securities, compared with $2.2 billion in 2002. Under O'Neal's leadership Merrill became the most profitable investment bank in America, making more money per broker than any of its competitors. O'Neal was rewarded well-in 2007 he became one of Wall Street's bestpaid executives, earning $48 million in salary and bonuses.
He pushed the company into new lines of business, including investing in collateralized debt obligations (CDOs). Merrill led the industry in its exposure to CDOs. Over an eighteen-month period, to the summer of 2007, its investment in these subprime mortgage-backed CDO pools rose from $1 billion to more than $40 billion. Then the subprime mortgage bubble burst.
The term "subprime" does not refer to the interest rate changed on the mortgage but, rather, to the risk associated with the borrower. Subprime mortgages are given to high-risk customers who are charged an interest rate that is greater than prime. These mortgages are typically given to people who would not normally qualify for a mortgage from a conventional lender such as a bank. From the lender's point of view, as long as house prices increase, the risk of a loss on the mortgage is low. As such, the mortgages became low-risk, high-yield investments. The lenders of these sub-prime mortgages would then package these mortgages as bundles of asset-backed synthetic securities, such as CDOs, which were sold to third parties, including individuals, corporations, pension funds, banks, insurance companies, and brokerage houses.
The subprime mortgage bubble bust when house prices in the United States began to fall. People could no longer refinance their homes nor pay off their mortgages by selling their homes. By late 2006, one in eight subprime mortgages was in default. Throughout 2007, nearly 1.5 million American homeowners lost their homes. As the housing market imploded, mortgage payment defaults increased and the value of subprime mortgages fell as did the value of the subprime mortgage-backed CDOs. By the summer of 2007, subprime-related losses were being reported by all the major financial institutions.
In the third quarter of 2007, Merrill announced a loss of $2.3 billion, compared with a profit of $3.05 billion for the third quarter in 2006. It also announced a $7.9 billion provision for losses on mort gagerelated investments, larger than the warning of a possible $5 billion write-down that it had made a month earlier. Within a week of reporting the largest quarterly loss in the company's ninety-three-year history, O'Neal resigned as Chairman and Chief Executive Officer of Merrill Lynch. Although he did not receive any severance, O'Neal did receive $161 million in stock and retirement benefits.
As a result of the subprime mortgage debacle, the CEOs at Merrill Lynch, Citigroup, Bear Stearns, and Morgan Stanley all resigned or were fired. Their departure packages were $161 million, $68 million, $40 million, and $18 million, respectively. Are these settlements unreasonably high, given the huge financial losses and write-downs that their companies recorded?

Question 52

Should consolidated financial statements of a U.S. parent company include (i.e., consolidate) foreign subsidiary accounts prepared on a basis not considered appropriate U.S. GAAP?

Question 53

Based on the conflicts of interest raised in the case, has Goldman Sachs, in effect, shorted itself? Explain why and why not.

Question 54

Should senior officers who have extensive firm-specific knowledge be hired back as consultants to help rectify their mistakes?

Question 55

Would the adoption of IFRS have prevented the Repo 105 misrepresentations?