One of the most important developments in the world of finance over the last century has been the collapse of the subprime mortgage market. This includes the closing of thousands of subprime lenders, the rapid rise in mortgage defaults, the severe downturn in the housing and construction industries, the staggering losses that have been taken by financial service firms, and the negative effect this problem has had on the economy at large.

We already have seen two hedge funds collapse, emergency Federal Reserve-backed buyout of Bear Stearns, the collapse of IndyMac, a large California savings bank, and Fed’s astonishing takeover of both Fannie Mae and Freddie Mac (the two largest institutions in the secondary mortgage market). The subprime mortgage story is replete with insights about economics and finance, as well as about business ethics and the moral evaluation of market mechanisms.

The subprime story, from a pedagogical point of view, is compelling on two fronts. First, the subprime story allows finance professors to explicate the complex interrelationships between stakeholders and financial instruments in a variety of markets. Second, considerable negative impacts from the case allow for focused moral analyses of accountability, responsibility, and reparations. Ethical problems and concerns throughout this process provide finance instructors richness in teaching ethics not often found in finance. This case and the ethical conflicts contained in it are well suited for finance courses in investment management and portfolio theory.

Obviously, this material can be introduced when discussing risk and return. It is clear that something in this market is wrong when a portfolio manager can earn two percentage points more than a fixed income instrument with the same rating as to risk. A tranche with an AAA rating cannot pay 8% if a General Electric bond with the same rating pays 6%. This material also can be introduced when applying time value of money to bonds. The same argument holds relative to risk and return.

This paper traces these relationships: the process involved in creating the subprime loan; bundling and selling them to banks and Wall Street firms; and the creation, rating, and sale of collateralized debt instruments in slices (tranches) to ultimate investors. Our desire, however, is to introduce this material at an introductory level in order to cover all business majors and give them a foundation in ethical issues in finance. Generally, only finance majors take upper level courses, so the only exposure to finance and ethics or all other majors in business schools is usually at the sophomore level introductory finance course.

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