Business Ethics Test 4

Question 1

What is a subprime mortage

Answer 1

A subprime mortgage is a home purchase loan offered to borrowers with low credit ratings, generally 600 or lower. Factors that lower an individual’s credit rating include (a) continually making late bill payments, (b) delinquent payments and/or payments sent to collection agencies, and (c) defaulting on debt and/or declaring personal bankruptcy

A conventional mortgage is not available to the borrower because the lender views the borrower as having a greater-than-average risk of defaulting on the loan.

In order to compensate itself for taking on greater risk by lending to people with lower credit ratings, the lender will charge the borrower a higher interest rate on a subprime mortgage than it does on a conventional mortgage

Question 2

types of home mortages

Answer 2

1. Fixed rate mortgage
   • With a fixed rate mortgage, the interest rate on the loan remains the same for the life of the loan. It never changes
2. Adjustable rate mortgage (ARM) => subprime loan
   • With an adjustable rate mortgage, the interest rate on the loan changes during the life of the loan. Usually the rate increases

Question 3

Evolution” of sub-prime loans (up to 2007):

Answer 3

(a) 20% down payment needed, (b) low down payment loans (less than 20%), which led to (c) no-down payment loans (principle and interest only), which led to (d) interest only loans (no principle paid), which led to (e) negative amortizing interest-only loans (no interest or principle paid, added to principal)

Question 4

Adjustable Rate Mortgages. Why?

Answer 4

the loan originators know that homeowners cannot afford the interest rate to which their mortgages will adjust. These originators “bank” on the fact that the homeowner will refinance before the interest rate goes up. This usually happens in +5 years. When the loan is refinanced, the originators will make another commission.

Question 5

Mortgage Backs Securities

Answer 5

• After closing, home mortgages are often resold to a third party. Thus, the loan originator gets his/her commission and is free of risk. The risk of the loan is now assumed by the new third-party mortgage holder.
• In order to minimize risk, the third-party mortgage owner (1) splits up the mortgage, (2) combines it with numerous other mortgages (these “other” mortgages can be both high risk and low risk), (3) repackages everything into new bonds or other financial instruments (mortgage backed securities), and (4) sells these new financial instruments to investors on the financial markets.
• This scenario “worked” as long as home prices continue to rise and subprime borrowers were able to refinance their homes ………

Question 6

How is corporate (organizational) culture defined?

Answer 6

Shared pattern of beliefs, expectations, and meanings that influence and guide the thinking and behaviors of the members of that organization.

Question 7

What are core values and why are they important for successful businesses? How do core values relate to corporate culture?

Answer 7

Core values are essential and enduring tenets that help define the company and are not to be compromised for financial gain or short term expediency. Offers direction and stability during challenging times. All truly exceptional and enduring companies all place great emphasis on a set of core values.

Question 8

3. How does your text define an ethical culture? What are the different cultures that influence our character and habits? Why can culture impact the bottom line?

Answer 8

Employees are empowered and expected to act in ethically responsible ways even when the law does not require it. Social environments-education, family, religion, workplace. If a supported strong ethical culture can serve as a deterrent to stakeholder damage and improve better bottom line sustainability.

Question 9

Identify several character traits that are necessary for ethical leadership. What are they?

Answer 9

Perceived as a leader with a people orientation and engaging in visible ethical action, receptivity, listening, openness, integrity, honesty, trustworthy, having broad ethical awareness and concern for multiple stakeholders, using ethical decision processes, caring for people, courageous.

Question 10

What are the characteristics of a good (or effective) leader? What are the characteristics of an ethical leader?

Answer 10

Effective/good- anyone who does well what leaders do (guide, direct, escort others towards a destination.
Ethical- respects subordinates or empowers them to creative and successful

Question 11

In order to articulate a code of conduct (or a statement of values), a company must first determine its personal code or mission. What specific questions must corporate leaders ask when determining this personal code or mission?

Answer 11

What you stand for? What the company stands for? Why does the firm exist? What are its purposes? How will you implement these objectives? How will you share these determinations and encourage a commitment to them among you colleagues and subordinated.

Question 12

After determining its personal code or mission, what three further “steps” must be taken in order to establish an effective code of conduct?

Answer 12

1 determine its mission

2. Articulation of a clear vision regarding the firms direction
3. identify how this cultural shift will occur

Question 13

credit default swap definition

Answer 13

a financial instrument for swapping the risk of debt default (failure to repay). It is essentially an insurance policy

1. The buyer of a credit default swap (CDS) pays a premium for insuring a security against default. The buyer receives a lump sum payment if the insured security defaults.
2. The seller of a CDS is the insurer, it insures the security against default. The seller receives monthly payments from the buyer, but if the security defaults it has to pay the buyer the full amount of the security.

Question 14

Hedge against risk

Answer 14

Suppose an investment fund purchased a mortgage-backed security (MBS) from an investment bank. The fund might be worried about losing its investment. Therefore, to insure against the risk of default, it will also purchase a credit default swap on the MBS. If the MBS does default, the investment fund will lose its investment, but will receive the full value of the credit default swap. If the MBS does not default, the investment firm will eventually recoup its investment but has paid yearly premiums for insurance

Question 15

Example of a Credit Default Swap

Answer 15

1. Z Corp. purchases $10 million in mortgage-backed securities (MBS) issued by an investment bank (IB).
2. If there is risk that the MBS will default, Z Corp. will purchase a credit default swap from a hedge fund (HF). The credit default swap is worth $10 million, the full value of the MBS.
3. Z Corp will pay interest (or a premium) on the credit default swap of 2%. This means Z Corp. will pay $200,000 per year to HF for the life of the MBS, or for as long as Z Corp. wishes to insure it.
4. If the MBS does not default, HF gains the interest/premium from Z Corp. and pays nothing out. The yearly payment of $200,000 that HF receives is pure profit.
5. If the MBS does default, HF pays Z Corp. the full $10 million value of the MBS.

Question 16

Speculation

Answer 16

Suppose ABC Capital (another investment fund) believes that the MBS owned by Z Corp. is very likely to default. ABC Capital will buy a credit default swap from HF on this same MBS. Important: you don’t need to actually own a security in order to purchase a CDS on it.

Question 17

Example of a Credit Default Swap Speculation

Answer 17

1. ABC Capital purchases a credit default swap from HF on the MBS owned by Z Corp. This new CDS is also worth $10 million, the full value of the MBS.
2. ABC Capital pays HF $200,000 per year in interest/premiums for the CDS, the same amount paid by Z Corp.
3. If the MBS does not default, HF gains the interest/premium from ABC Capital and pays nothing out. The yearly payment of $200,000 that HF receives from ABC Capital is pure profit.
    Clarification: HF is now receiving $200,000 per year from both ABC Capital and Z Corp.
4. If the MBS does default, ABC Capital receives $10 million from HF.
    Clarification: If the MBS defaults, HF must now pay $10 million to both ABC Capital and Z Corp

Question 18

What was the sarbanes oxley act? Who passed it? What is its general purpose in terms of corporate governance?

Answer 18

Congress was swift to react, and the result was the passage of the sarbanes oxley act. The legislation joined by pressure from the sec, from rating agencies, from shareholders and from the public- has demonstrated changes required In Corporate governance

Question 19

In terms of management, what is the significance of section 302 of the sarbanes oxley act?

Answer 19

Requires both the ceo and CFO to certify the fairness and accuracy of financial statements and to certify that the board has processes to catch problems. The section imposes penalties of 1 million and up to 10 years in prison for knowing violations and $5 million and 20 years for willful violations and allows for civil suits for fraud from which they cannot shield themselves by using insurance. Instead of being able to plead ignorance, a ceo must now study the company’s financial statements and as questions about items he does not understand

Question 20

What is the significance of sections 406 and 402a of the SOA

Answer 20

406 directed by the SEC to require that a company disclose whether it has a code of ethics for its senior financial officials. If it does the company must disclose the contents of the code and any waivers of or change in the code that it may make. If it does not have a code the company must explain why it does not. The SEC does not enter into the details of what such a code should contain. The point is to indicate that the companies are expected to have ethics codes by which their executives should abide and that the code cannot be waived without disclosure. Once disclosed it is then up to the shareholders and the general public to decide whether the code is such as to give them enough confidence in the company to invest in it. 402a prohibits the company from giving personal loans to either the executive officers or the directors of the company

Question 21

What does the SOA require top management to do whenever they trade their own companies stock

Answer 21

Requires insiders (including executive officers and directors of a firm) to report any trading in their company’ stock within two business days after the execution of the trade. In response to the second, the executive officers of the firm and the members of the board may not trade any company stock during any period in which the employees are not allowed to trade their stock in the company’s 401k or other retirement plans

Question 22

How does SOA try to assure investors that a corporations board of directors is able to act independently of the management ? Why does it do this?

Answer 22

The independent members of the board are required to hold regularly scheduled meetings without management. The intent is to provide an opportunity for them to discuss the actions of the company’s executive officers and their performance, without the executives being present. The hope is to increase the independence of the board and to give them the opportunity to be more critical and probing, to raise doubts and questions in away that they would not do with the executives present

Question 23

Under SOA what are the specific responsibilities of the audit committee of the board of directors

Answer 23

1. At least one member of the committee usually the chair must be a financial expert as defined by the SEC or it must disclose why this is not a case
2. In the past the corporation usually the ceo chose the audit firm for the company. This is now a function of the audit committee which is charged with responsibility for the appointment, compensation and oversight of the accounting firm. The intent is to help make the auditing process more independent than it has sometimes been in the past when the auditors were hired by the ceo and wished to present the company in the best light even if the light did not accurately picture the condition of e firm.
3. The audit committee has the authority to engage outside council and other advisors as it deemed necessary to carry out its duties
   4 the committee must also establish procedures for receiving and acting on employee complaints
4. Protects internal whistle blowers
5. The accounting firm reports directly to the committee and not the ceo

Question 24

What is the main responsibility of the compensation committee

Answer 24

Not to control executive compensation. It is to attempt to provide more independence on the part of the committee. This is partially attained by changing the nominating procedure for the board members. The comp committee is preferably composed entirely of independent board members. The main task of the committee is to evaluate the ceo performance against his goals and to set the appropriate compensation based on this evaluation. The final compensation is decided by the independent members of the board or the compensation committee as the company specifies in its procedures. The SEC has proposed that the board submit to the shareholders for their approval new equity compensation plans

Question 25

In order to avoid conflicts of interest what does the AICPA require interms of independence. Why does it require this?

Answer 25

Requires independence of the firm or accountant from the client. This means they cannot hold any financial interest in the company. The intent is clearly to avoid conflict of interest. If the accounting firm is to certify a company’s financial statements it should have no incentive owing to financial holdings in the company, to make the firms financial situation to look better than it is.

Question 26

Under the section “accounting rules” what is the unavoidable conflict of interest that author identifies

Answer 26

Critics claim that although the purpose of certifying the accounts of a corporation is to assure the general public that the corp. accounts are correct as reported, the system is not set up to guarantee this result. The major stumbling block is that the accounting firm certifying a companies accounts works for the company whose accounts it is auditing. Although the accounting firm is independent, it’s client the one who pays its bills is the company it is examining. It has the temptation to do nothing to cause disfavor with the company that hires it.

Question 27

What problems arise when stock options are not counted as a cost or liability to a company when they are offered?

Answer 27

Under US tax laws, options are not counted as a cost or liability when they are issued, if they are valued as of the market price on the day of issue. So if many employees are paid in options and receive a lower salary because of this, although the cash paid as salary is counted as a cost to the company, the options are not. When the options are exercised, he difference between the price of the stock when exercised and the policy price of the option is considered a cost for tax purposes, even though the company did not actually spend the money.yet options are a true liability and when exercised they dilute the value of the stock of the company and reduce dividends

Question 28

How has the IASB responded to this issue?

Answer 28

As of jan. 1 2005 requires firms to expense options. To the extent hat accounting firms have taken on the additional task of consulting firms they increase the potential for conflict of interest. If the same company both suggest a policy and then audits the results it is likely to be tempted to make the results look favorable as possible

Question 29

What does the SOA prohibit public accounting firms from doing simultaneously

Answer 29

Prohibits public accounting firms from simultaneously auditing a company and providing any nonaudit services. Accounting firms may still provide consulting services, providing they do not audit the company for which they are consulting .

Question 30

Under what two conditions does a corporation have a moral responsibility to disclose appropriate information? Specifically to whom does it have a duty to disclose this information?

Answer 30

A corporation has a moral obligation to disclose appropriate information to those with whom it enters into transaction and to those whom it’s actions affect seriously and adversely. In broad terms, those affected are A. The shareholders and potential shareholders of the corporation B. The board of directors C. The workers D. Government E. The corporations suppliers and agents, F. The consumer of the corporations product and G. The general public, wether or not they are consumers of the product.