RateWatch #239 - Predatory Lending
February 24, 2001
by Dick Lepre
The mortgage industry is a highly regulated business. It is bound by many federal laws designed to provide consumer protection from past misdeeds - real and imagined.
Among these are RESPA (Real Estate Settlement Procedures Act), Truth in Lending, Fair Housing, Equal Credit Opportunity Act, Home Mortgage Disclosure Act, and Home Ownership and Equity Protection Act (HOEPA). In general, these pieces of legislation are designed to give folks equal access to credit regardless of race or national origin and also to prevent people from getting screwed by costs that appear at the last minute.
For those of us in the business of originating mortgages it means that we need to make sure that the disclosures are properly filled out and mailed in a timely manner. That requires adequate computer software and review of the documents that they spit out to make sure that they are accurate. Some of these forms are so complicated that they are only marginally comprehensible.
A new concern has reached Congress and is being tossed around in what could become a dangerous manner. This boogeyman is called Predatory Lending.
What Are They Talking About?
I think that what folks mean by predatory lending is something akin to the following: A mortgage broker targets a group that is perceived as vulnerable. Favorite targets seem to be the elderly and ethnic groups that the broker can relate to. My experience is lending has taught me that people's trust in folks of the same ethnic background can work against them. It certainly contributes to an activity such as predatory lending. Whites get screwed by whites. Blacks get screwed by blacks. Latinos get screwed by Latinos. Asians get screwed by Asians. This is America - the land of opportunity.
Predatory Lending Defined
The Mortgage Bankers Association of America offers a good definition of predatory lending:
-Making unaffordable loans based on the assets of the borrower rather than on the borrower's ability to repay an obligation;
-Inducing a borrower to refinance a loan repeatedly in order to charge high points and fees each time the loan is refinanced (loan flipping); or
-Engaging in fraud or deception to conceal the true nature of the loan obligation, or ancillary products, from an unsuspecting or unsophisticated borrower.
In a December 2000 Press Release the Federal Reserve defined "predatory lending":
"The term 'predatory lending' encompasses a variety of practices. Often homeowners in certain communities particularly, the elderly and minorities are targeted with offers of high-cost, home-secured credit. The loans carry high up-front fees and may be based on the homeowners' equity in their homes, not their ability to make the scheduled payments. When homeowners have problems repaying the debt, they are often encouraged to refinance the loan. Frequently this leads to another high-fee loan that provides little or no economic benefit to the borrower."
Anecdotal evidence is that such loans involve a "low-ball" quote of fees and a last minute change in fees, rate and even loan amount.
No legitimate person in the mortgage business is going to defend ill-intended practices. The real concern that some of us have is that a well-intentioned but ill-conceived implementation of these ideals will destroy the sub-prime mortgage industry. What might happen is that lenders - driven by fear of litigation - simply exit the sub-prime market. The government, in trying to protect borrowers against abuse may prevent sub-prime borrowers from obtaining any mortgage.
Guilt By Association
The problem is this: is you are going to define predatory lending you can't do it by calling it "ill-intended" or "greedy" you need to define, mathematically, what a predatory loan is. It may be impossible to craft a definition that does not also encompass sub-prime loans.
Higher than average rates are not normally signs of predatory lending. They are the result of the borrower's poor management of his or her previous credit.
Sub-prime loans Defined
The Federal Reserve offers a definition of sub-prime loans: "For the purposes of this guidance, 'sub-prime lending' is defined as extending credit to borrowers who exhibit characteristics indicating a significantly higher risk of default than traditional bank lending customers. Risk of default may be measured by traditional credit risk measures (credit/repayment history, debt to income levels, etc.) or by alternative measures such as credit scores. Sub-prime borrowers represent a broad spectrum of debtors ranging from those who have exhibited repayment problems due to an adverse event, such as job loss or medical emergency, to those who persistently mismanage their finances and debt obligations."
Local Governments Have Tried
Local governments have addressed the issue by defining things such as "high cost" mortgages. The City of Philadelphia defined a "high cost mortgage" as a loan where, "at any time over the life of the loan, the annual percentage rate of the loan equals or exceeds by more than 5 percentage points in the case of a first lien mortgage, or equals or exceeds by more than 8 percentage points in the case of a junior mortgage, the yield on Treasury securities having comparable periods of maturity to the loan maturity as of the fifteenth day of the month immediately preceding the month in which the application for the extension of credit is received by the creditor".
Maybe I am missing something but on 15th of October 1998 the yield on the 30 year Treasury was 4.96%. That plus 5 equals 9.96%. That means that any loan applied for the next month that had an APR greater than 10% would have been "predatory". Sub-prime loans often have APR's in excess of 10%.
Mortgage lending, despite the fact that it sometimes seems confusing, is driven by risk and reward. No one is going to make a high-risk (sub-prime) loan unless the reward (interest rate) is high enough. This happens to individuals, corporations and countries.
Under HOEPA, loans that have rates, points, or fees that exceed specific thresholds or triggers are subject to additional disclosure requirements and added protections. The Federal Reserve is suggesting a lowering of "triggers" which require additional disclosures.
Two Paths to the Same Result
It is important that any legislation recognize that Mr. Smith and Mr. Jones may have gotten exactly the same loan but that one may be a sub-prime loan and the other may be a predatory loan. Crafting language to distinguish between the two, yet be effective, will be extremely difficult.
To complicate things further, the mortgage industry has recognized that self-employed borrowers need to be regarded in a different manner. It is harder to determine what their income is. Thus, the loan is made based on the assets and credit history of the borrower. It is implicit that a borrower with healthy assets and a good credit history has an ability to repay. Thus, quick qualifiers or "no doc" loans have a different measure of the borrower's ability to repay than do fully documented loans.
It is of foremost importance that legislators do not blow it and cause well-intended, reputable lenders who do sub-prime to exit the market leaving folks with sub-prime credit no way of obtaining mortgage financing.
When all is said and done it is imperative that borrowers exert sufficient intelligence to not allow themselves to get screwed. The government's ability to make up for people's bad judgment is limited.
If our Uncle Sam wants to protect folks from permanently damaging themselves financially then he should pay more attention to credit card debt. In my experience, many more people ruin themselves with high interest, high balance credit card debt than are damaged by "predatory lending".
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