The Chilling Impact
of Anti-Predatory Lending Laws

Two recent developments are reinforcing the Federal Reserve Board's concern that a patchwork quilt of state laws intended to curb predatory lending may actually put the brakes on legitimate subprime mortgage markets. Economists and lenders have argued that new state and local laws that use the mortgage loan interest rate as a trigger for additional lender restrictions and disclosures are substantially increasing the cost of making subprime mortgage loans. Apparently Bank of America agreed with that assessment when it announced in mid-August that it was selling its entire $26 billion subprime loan portfolio along with its loan origination, fulfillment and servicing operations. The bank will sell its 96 EquiCredit subprime mortgage branches to several different lenders over the next six to nine months. Bank of America chairman and CEO Kenneth D. Lewis said that the company is concerned about the increasingly chilly climate for subprime mortgage lending. "While subprime real estate lending has experienced growth in revenues, the challenges posed by that growth have proved to be significant. In addition, the cost of managing this highly regulated business continued to increase."

Evidence from North Carolina during the 9-month phase-in of its anti-predatory lending law suggests that other lenders have curtailed their lending activity in response to the more restrictive regulatory environment. Using a database assembled by PriceWaterhouseCoopers and commissioned by the American Financial Services Association (AFSA), Professors Michael E. Staten and Gregory Elliehausen at Georgetown University's McDonough School of Business found that low-income customers in North Carolina experienced a sharp decline in subprime mortgage originations between October, 1999 and July, 2000, the period during which some features of the North Carolina statute were being phased in.

In July 1999 the North Carolina General Assembly passed a law which was intended to reduce predatory lending by banning certain practices on all mortgage loans and creating a new category of high-cost mortgages subject to additional restrictions. The statute was enacted in phases. Some features became effective for loans originated on or after October 1, 1999.¹ The rest of the anti-predatory features became effective on July 1, 2000.

The anti-predatory features included an interest rate trigger mechanism for classifying closed-end mortgage loans as "high-cost" loans similar to the Federal Home Ownership and Equity Protection Act (HOEPA).² Limits on the features of high-cost loans include the following:

• Lender must confirm that a borrower received home ownership counseling prior to closing the loan
• Lender must document borrower's ability to repay
• Limits on loan features include
  • No call provision
  • No balloon payment
  • No negative amortization
  • No increased interest rate as a consequence of default
  • No modification or deferral fees
• No financing of fees or charges if the borrower refinances a loan from the same lender.

These requirements impose more restrictions on mortgage lenders than prevailed under the federal HOEPA at the time of passage, increasing the cost of making mortgage loans to higher risk segments of the North Carolina market. Economic analysis generates the prediction that lenders would respond to higher costs by reducing the supply of mortgage credit. Because the AFSA data set contains information on the Zip Code of the property securing the loan, it can be used to test for changes in the volume and characteristics of loans originated in North Carolina over time and relative to surrounding states. The AFSA data set contains all subprime mortgage loans generated by nine AFSA member companies between July 1, 1995 and June 30, 2000, more than 1.4 million loans. The window for detecting changes in lending patterns following passage of the North Carolina statute is narrow because the data set contains loans originated through the end of the second quarter, 2000 but not beyond. Consequently, many of the changes contained in the statute were known to be coming but not yet effective during the sampling period.

Nevertheless, the charts below provide some interesting evidence that suggests something was impacting the volume and type of originations in North Carolina, relative to other states, following passage of the anti-predatory statute. The first two charts display the year-over-year percentage change in originations of first mortgages for two groups of borrowers, those with incomes less than $25,000 and those with incomes between $25,000 and $50,000. For both groups, first mortgage originations fell precipitously in the fourth quarter of 1999 relative to the same quarter one year earlier, and the year-over-year decline continued through the end of the second quarter, 2000. Originations in South Carolina and Virginia do not display the dramatic decline in activity for these lower-income borrowers. However, analysis of originations for borrowers with incomes greater than $50,000 did not reveal any evidence of a turndown unique to North Carolina and not present for borrowers in the surrounding states.

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The final pair of figures repeats the sequence for borrowers with second mortgages. With the exception of a sharp downturn in originations in South Carolina for borrowers with incomes less than $25,000 (although not as sharp as in North Carolina) the patterns through the sequence are remarkably similar to those observed for first mortgages.

A review of the charts strongly suggests that, beginning in the fourth quarter of 1999, something was affecting the lower income segments of the North Carolina subprime mortgage market differently than in the neighboring states. One possibility is the regulatory change in North Carolina. Although not all of the components of the statute had been implemented during this period, some components were in place and the regulatory climate for closed-end mortgage loans had certainly been altered. Lenders may have scaled back their promotion of closed-end subprime mortgage loans in anticipation of the phased-in enactment, which would have affected origination volume in advance of July 1, 2000. Of course, it is possible that some yet-to-be-identified factor may have produced this peculiar result. However, the timing and patterns are consistent with a reduction in supply by North Carolina mortgage lenders in response to the higher costs imposed by the passage of the lending statute.

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¹These features included a ban on prepayment fees on first mortgages less than $150,000.

²The "high-cost" loan triggers are exceeded if a loan meets any of the following criteria: 1) APR would qualify the loan for HOEPA protections, 2) points and fees exceed 5 percent of the loan amount for loans greater than or equal to $20,000 or the lesser of $1,000 or 8 percent of the loan amount for loans less than $20,000, 3) loan allows for the assessment of a prepayment fee more than 30 months after closing.