Partners (Summer 2000)
Partners (Summer 2000)
Federal Reserve Viewpoint
By Gov. Edward M. Gramlich
Federal Reserve Board Governor, Edward Gramlich, spoke last April to the Fair Housing Council of New York, Syracuse, New York, on predatory lending. The following summary highlights the complexity of both defining predatory lending and resolving issues — without eliminating access to credit for borrowers not eligible for the prime market.
This should be a time of great satisfaction for the advocates of low-income and minority borrowers because various technological changes and innovative financial products have caused an upsurge of credit to this market segment. Much of this expansion appears to be in the subprime lending market, which has opened up the possibility for many borrowers to realize their dream of owning a home and to have a chance for acquiring the capital gains that have increased the wealth of upper-income households.
But with the good news there is also bad news, or at least sobering news. Just as the expansion of subprime lending has increased access to credit, the expansion of its unfortunate counterpart, predatory lending, has made many low-income borrowers worse off.
Subprime Vs. Predatory Lending
The distinction between subprime and predatory lending is important. Subprime lending involves borrowers who do not qualify for “prime” rates — those rates reserved for borrowers with virtually blemish-free credit histories. Premiums range from about 1 point over prime for “A-minus” loans to about 6 points over prime for “D” loans. While these premiums have been questioned, long-run market forces work to minimize spreads.
Predatory lending, however, is difficult to quantify because the practices are shady, and information is incomplete or anecdotal. Abusive practices include outright fraud, excessive fees and interest rates, hidden costs, unnecessary insurance, and deceptive uses of balloon payments.
The ultimate difference between subprime and predatory lending comes back to the competitive assumptions. If one is a market optimist and believes that both lenders and borrowers are rational and well-informed, then subprime credit markets with proper rate differentials will open up. If one is a market pessimist and believes that borrowers are not well-informed and may not be fully rational, then some lenders will have opportunities to exploit these borrowers with predatory practices.
Distinguishing positive subprime lending from negative predatory lending is obviously important, particularly for regulators trying to encourage one type of lending and discourage the other.
Who Are the Subprime and Predatory Lenders?
Subprime lending tends to be done primarily by nondepository institutions, either finance companies or mortgage companies that are not subject to routine regulatory compliance audits and connected with regulated financial institutions.
In the mortgage market, relatively few of these loans are for first-time home-buyers — mostly they are for mortgage refinancings, second mortgages, or consolidating debt. Often these loans are securitized and sold to investors such as insurance companies and pension funds.
As mentioned, one distinguishes predatory lending from subprime lending by the features of the loan and, importantly, by whether the borrower understands the terms of the loan. Thus, there is no ready way to distinguish predatory from subprime lending, to identify predatory lenders, or to measure amounts. Yet most anecdotal reports or legal cases against predatory lenders have involved subprime lenders, and it is certainly logical to expect these practices to flourish in entities where regulators are remote.
Predatory lending is made possible by inadequate information. The fundamental weakness is the desire of uneducated borrowers for cash up front, typically reflecting a need for home repairs. Couple this with a lack of understanding of complex credit terms or conditions, and a resulting bargaining imbalance will often subject borrowers to outright fraud, falsifications, and even forgery. Apart from outright fraud, however, regulators and legislators feel reluctant to outlaw potentially abusive practices if these practices have legitimacy most of the time.
What Can be Done?
The Home Ownership Equity Protection Act (HOEPA) defines a class of “high cost” home purchase loans. While most analysts consider HOEPA to have been effective, many lenders reportedly skate just below the HOEPA requirements and still engage in egregious practices. Most present attempts to deal with predatory lending try to broaden the HOEPA net by lowering the threshold cost levels and by preventing abusive practices.
Many states have also attempted legislative remedies. In July 1999, North Carolina enacted laws that prohibit prepayment penalties, loan-flipping, and single-premium credit life insurance on most home loans.
Other federal statutes address predatory lending less directly. The Truth in Lending Act requires all creditors to calculate and disclose costs in a uniform matter. Under this statute, lenders must disclose information on payment schedules, prepayment penalties, and the total cost of credit, expressed as a dollar amount and as an APR.
The Real Estate Settlement Procedures Act prohibits lenders from paying fees to brokers that are not reasonably related to the value of services performed by the broker. The Equal Credit Opportunity Act prohibits discrimination in lending on the basis of a number of “prohibited basis characteristics” such as age and race. The Federal Trade Commission Act prohibits unfair and deceptive practices.
And yet, with all this legislation, predatory lending may still occur. To address this issue, the Federal Reserve joined a nine-agency working group in the fall of 1999 to develop solutions. The agencies include five that regulate depository institutions (Federal Reserve, OCC, FDIC, OTS, and NCUA), two that regulate housing (HUD and the Office of Federal Housing Enterprise Oversight), and two that regulate or prosecute deceptive trade practices in general (DoJ and the FTC). The complete regulatory net of these agencies would cover all predatory lending. The aims of the group are to tighten enforcement of existing statutes, to identify those predatory practices that might be limited by tightened regulations or legislative changes, and to establish a coordinated attack on predatory practices.
Secondary mortgage institutions such as Fannie Mae and Freddie Mac have a role. If Fannie and Freddie were merely to buy subprime loans without added inspection, these secondary market institutions could actually subsidize predatory lending. But if Fannie and Freddie were to inspect the practices of subprime lenders from whom they purchase loans, or to limit purchases of certain types of loans, they might effectively extend the domain of subprime regulations.
A final factor is consumer education. Predatory lending would not exist, or would be relatively rare, if prospective borrowers understood the true nature of their loan contracts. The Neighborhood Reinvestment Corporation (NRC) has an active borrower education program to promote just that type of understanding, and many other public and quasi-public agencies are thinking of following suit.
Predatory lending causes obvious difficulties for borrowers, is difficult for enforcers to track down, and is difficult to regulate. So far as we can tell, predatory lenders generally operate outside the main financial regulation network. These lenders are sometimes fraudulent, but probably more often they take advantage of low-income and less-educated borrowers who need cash up front and are unlikely to fully understand the loan provisions. When and if borrowers default, they can either lose their house or be induced to signing up for still more exploitative terms.
Because predatory lenders are less regulated, and because predatory loans are often difficult to identify and define, it becomes both a regulatory and an enforcement challenge to stop predatory practices. Currently, nine agencies are meeting to design a coordinated attack on the problem, and a number of legislative options are under consideration in both the federal and state legislatures. The goal is to eliminate or limit bad practices that are the unfortunate byproduct of recent efforts to democratize credit markets.
For a full text of Gov. Gramlich’s speech, refer to www.federalreserve.gov/boarddocs/speeches/2000/
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