Predatory Lending

The issue of "predatory lending" continues to entrance the news media. On May 24, the House Committee on Banking and Financial Services held hearings on predatory mortgage lending. This review depends in part upon the testimony of Margot Saunders, Managing Attorney, National Law Center; Edward Gramlich, Governor, Federal Reserve Board; George Wallace for the American Financial Services Association; David Medine, Associate Director for Financial Practices, Federal Trade Commission; and Ralph Rohner, Professor of Law, Catholic University. We focus on economic issues rather than legislative details.

Subprime lending is not predatory lending. Subprime lending generally involves mortgage loans made to consumers who have poor credit records or who are seeking mortgage loans with payments that absorb a large portion of their after-tax incomes. In fact, subprime lending is better characterized as "risk-based lending." As a result of their higher risk, rates on subprime loans exceed rates on prime loans. Some risk-based loans, and even some prime loans, are predatory. Many predatory loans are illegal under current statutes. The debate centers largely on whether or not additional terms or practices should also be made illegal.

Subprime loans have become an issue largely because of the desire of Congress to enable minorities and consumers with low incomes to own their own homes. That objective has been achieved to a remarkable extent. As Governor Gramlich of the Federal Reserve has observed: "Between 1993 and 1998, conventional home-purchase mortgage lending to low-income borrowers increased nearly 75 percent, compared with a 52 percent rise for upper-income borrowers. Conventional mortgages to African-Americans increased 95 percent over this period and to Hispanics 78 percent, compared with a 40 percent increase in all conventional mortgages. A significant portion of this expansion of low-income lending appears to be in the so-called subprime lending market."

Clearly, some abusive lending practices have accompanied the rapid expansion of risk-based lending. Some of the lenders that entered the market to specialize in high-risk mortgage loans were scoundrels. However, there are three basic questions:

1. Are current practices cited as evidence of predatory lending illegal under the current statutes?
2. What are the proposals to expand the legal definition of predatory lending and to add new prohibitions of certain mortgage terms?
3. How will the availability of high-risk mortgage credit be affected by proposed changes in the legislation?

A number of current practices are currently illegal under one or another of existing statutes. There is a considerable array of federal and state statues that are designed to protect consumers when they borrow to purchase their homes. Home mortgage loans are subject to the Home Owner Equity Protection Act, (HOEPA), Fair Lending Act, the Truth in Lending Act (TILA), Equal Credit Opportunity Act, the Real Estate Settlement Procedures Act and Section 5 of the Federal Trade Commission Act, as well as provisions of various state laws. A basic issue is whether these laws need to be better enforced or expanded—or both.

The Federal Trade Commission (FTC) has the major responsibility for enforcement. Governor Gramlich has noted that over 70 percent of the subprime lenders listed by the Department of Housing and Urban Development are regulated only by the FTC. In his testimony David Medine has cited several recent cases in which the FTC had reached settlements under Section 5 of the FTC Act. The FTC has also mounted educational efforts among other law enforcement agencies and consumers.

Nonetheless, various consumer groups seek to draft new statutes or broaden the scope of existing legislation. In her testimony, Margot Saunders presented the following case as an example of predatory lending, although she does not assert that the loan is illegal under present statutes.

In this instance, the 12 percent rate presumably reflects the above-average risk of the borrower. The "trigger" that brings HOEPA into effect is a rate that is 10 percentage points above U.S. treasury bonds of comparable maturities. Since this loan was for 30 years, the comparable yields averaged 5.58 percent in 1998 and 5.87 percent in 1999. Adding ten percentage points to these yields would set the "trigger" level at about 15.6 percent to 15.9 percent, well above the 12 percent rate in this contract.

Home mortgage transactions are covered by HOEPA if closing costs exceed 8 percent of the loan amount. The closing costs in this instance amounted to 3.6 percent of the loan amount. Points are not covered by HOEPA. The legality of the charge for credit insurance is questionable. If it were required, its cost should be have been included in the finance charge. If it were not required, the consumer should have been given a clear choice of rejecting it.

Since HOEPA requires that the prospective homeowners be given these disclosures at least three days in advance of closing, and TILA provides a three-day right of rescission, prospective homeowners have a minimum of six days in which to review the terms of their agreement.

While this particular transaction does not appear to have been illegal, except possibly for the issue of the credit insurance, it is cited as an example of predatory lending that is not covered by current statutes. Consumer advocates and some regulators suggest two methods to expand the possible protection of consumers obtaining home mortgages: (1) expand the coverage of existing statutes; and—not "or"—(2) expand the list of practices defined to be illegal.

A variety of proposals would broaden the coverage of HOEPA to more loans by

(1) lowering the annual percentage rates that trigger the application of the law to first and junior mortgage loans;

(2) including all points, fees, and credit insurance charges in the points-and-fees trigger and limiting it to 5 percent of the total amount of the loan;

(3) expanding the application to open-end credit lines secured by the home.

Rather than identify which existing statute should be amended, this is simply a "wish list" of changes that have been proposed. It is representative, but not complete.

1. Prohibit the financing of single-premium, lump-sum credit insurance and other "extras" on mortgage loans. It is not unusual for the premium on credit insurance to be included as part of the loan and revealed only at the closing.

2. Prohibit the financing of all points, fees, and insurance charges and closing costs or limit those charges to not more than 3 percent of the loan amount.

3. Prohibit prepayment penalties.

4. Prohibit application of the holder-in-due course rule to home improvement loans.

5. Prohibit mandatory arbitration clauses.

6. Prohibit or limit balloon payments.

7. Establish federal protection in foreclosure proceedings.

8. Give law enforcers the power to impose civil penalties for HOEPA violations.

No good deed goes unexploited. Bringing affordable housing to minorities and consumers with lower incomes was an admirable objective. But, many of these consumers were especially vulnerable to lending tactics that were, in many cases, illegal and often overbearing. It is not surprising that the regulatory agencies, especially the FTC that has the major burden, have found it difficult in terms of funding and staff to curb illegal practices. An expansion of their budgets and staffs would be a positive step in the direction of curbing existing illegal lending practices.

The proposals to expand the coverage of existing statutes by increasing the number of transactions and lenders subject to HOEPA and other legislation do not necessarily deal with the problem. The task of a regulator who is seeking to identify "bad actors" in a field of lenders is not made easier by expanding the field of lenders.

A more direct approach might be to define or re-define what acts are bad. Here there are some troubling problems. Balloon notes might be bad in many cases, but they do have their uses. A couple may reasonably expect to refinance their mortgage or to sell their home in six years. A balloon note might make good economic sense for them. A prohibition of prepayment penalties will probably be reflected in higher interest charges. More generally, increasing the risk or costs of the lender will ultimately be reflected in higher charges for the borrower.

Finally, we have a basic problem that cannot be addressed with legislation. We have a large body of consumers who have received little or no education in survival skills in a complex economic environment. We have a large group of consumers who have not learned how to manage their personal finances. We have a small group of unconscionable predatory lenders. The market works. These two groups find each other.

This fundamental problem cannot be resolved with more legislation or more enforcement of existing laws. The finance industry and various government agencies—especially the FTC and the Federal Reserve—have published some excellent educational materials. But we need courses in grade school and high school that deal with the selection and use of credit cards, auto loans and home mortgages. We need teachers and courses that can help young consumers to develop basic living skills. Of course, this is an immense challenge and it is much easier to pass new laws.