by J. Mijin Cha
The Predatory Lending Bubble and How the Feds Made it Worse
The trouble in the subprime lending market is sending ripples through Wall Street. One of the biggest subprime lenders, New Century, has been de-listed from the New York Stock Exchange.
As this Dispatch will detail, the current mortgage and foreclosure crisis is the result of years of irresponsible lending and federal policies that shut down efforts by state and local governments to restrain the predatory lending practices that set the country up for this crisis. Despite these roadblocks by the federal government, many states are still finding solutions to help prevent these abusive lending practices.
The Crisis in Subprime Lending
At the end of last year, late mortgage payments reached the highest level in over three years and new foreclosures reached record levels. The cause? Subprime loans, that is loans for people with bad or limited credit which carry a higher interest rate, and often unfavorable terms. A report released in December 2006 shows that as many as 2.2 million subprime borrowers face foreclosure on their home loans.
Abusive Mortgage Lending: The subprime lending market is aimed at families who have bad credit or trouble getting credit. While on the surface, it seems like these loans help families with bad credit purchase homes, deceptive marketing practices and lack of information for customers create an environment of abusive lending. The Center for Responsible Lending lists seven signs of predatory lending. Among some of the more striking:
- Excessive Fees- costs that are not directly reflected in interest rates that can reach over 5 percent of the loan amount.
- Abusive Prepayment Penalties- Up to 80 percent of subprime loans carry a prepayment penalty in order to discourage refinancing at less abusive terms-- penalties that can cost more than six months' interest.
- Kickback to Brokers- when brokers deliver a loan with an inflated interest rate, the mortgage broker gets a cash bonus.
What made the problem most acute for these subprime borrowers is that when the Federal reserveBusiness Week wrote just a week ago, "About $265 billion worth of subprime loans are scheduled to have their rates adjusted upward in 2007...Many stretched homeowners may soon be paying 11% or 12% on their mortgages, while everyone else can get 30-year fixed-rate loans at a little over 6%...In effect, monetary policy is turning into a regressive tax." hiked interest rates, most borrowers could refinance to long-term loans whose rates have barely moved in the past three years. People with poor credit, however, absorbed the brunt of the shift, since their contracts usually hiked their mortgage rates in tandem with the Federal Reserve rate hikes-- and either their contracts or their bad credit prevented them from escaping these mortgages as their monthly payments skyrocketed. As
Other Predatory Practices: Subprime mortgage lending is one example of the larger problem of predatory lending imposing unfair and abusive loan terms on vulnerable buyers. One additional disturbing form of predatory lending is payday lending -where a postdated check is exchanged for a smaller amount of cash. If the check bounces for any reason, such as a health emergency or an unforeseen layoff, the borrower gets stuck in a near-impossible debt trap as the interest rate for payday lending can be as high as 911 percent for one week, 456 percent for a two week loan and 212 percent for a one-month loan. This form of lending has been particularly detrimental for military servicepeople. 20 percent of service men and women use payday loans. Predatory payday lending costs military families over $80 million a year in abusive fees.
How the Feds Pre-Empted State Law
With millions of families facing these exploitive lending practices, the question is why the government didn't act to stop it? The answer is that the states did act-- but the federal government, backed by campaign contributions from predatory lenders, shut them down and helped create this mortgage crisis.
Back in 1994, Congress did pass the Home Ownership and Equity Protection Act to protect homeowners. The law was meant to be the floor for protection: states could go above and beyond the protections offered in the Act and since then, over 30 states have passed laws offering more protection than the federal Act.
Bush Administration Preempts State Laws: However, state and local efforts have been pre-empted by the Office of Thrift Supervision (OTS) and the Office of the Comptroller of the Currency (OCC). The OCC, in particular, has promoted a theory of "field preemption" that would preempt all state laws and insulate national banks and their operating subsidiaries from virtually all state regulation. This effectively destroys any state's ability to regulate the business activities of all banks. The OCC preempted Georgia's Fair Lending Act, which had offered protection against predatory lending, including outlawing extreme prepayment fees or penalties, unreasonable monthly payments, and increased interest rates after default. This was followed by the OCC preempting the New Jersey Home Ownership Security Act, which prohibited abusive lending practices and challenges to other state laws have followed. Adding to the attack on state authority, some in Congress proposed laws to further preempt state authority over mortgage lending. One of the chief sponsors of the preemption bill was Congressman Bob Ney, who was convicted of bribery for his role in the Abramoff scandal.
Courts and Preemption: The courts have largely backed this federal preemption of state authority, with federal courts striking down predatory lending laws in a number of states. After the Sixth Circuit Court of Appeals struck down state banking laws in Michigan, the Supreme Court agreed to hear the case and will be making a ruling soon on whether some parts of state regulation will survive preemption.
Yet whatever the courts decide now, the damage has been done. During the critical period of the recent housing bubble, as speculation and predatory lending ran riot, state regulators were so involved in defending their laws in court that their effectiveness was undermined and the costs are being borne by some of the most vulnerable borrowers in the market.
States Rally to Increase Protection
In examining the predatory lending crisis, the Carsey Institute at the University of New Hampshire released a report that included several simple steps government can take to protect their citizens against predatory lending:
- Reduce excessive points and fees that strip equity from borrowers
- Provide consumers with additional protection for high cost loans, such as prohibiting pre-payment penalties or prohibiting financing of fees
- Require interest rates to reflect the risk of the loan rather than upfront points and fees that strip equity from borrowers
- Protect consumers in disputes with lenders, such as prohibiting mandatory arbitration, which tends to favor lenders
- Require a net tangible benefit to the borrower in any refinance loan
The bottom-line is that we need common-sense rules that prevent consumers from ending up with loans costing far higher than they thought they were signing up for initially.
State Mortgage Laws: While state laws are under challenge, there is hope that the Supreme Court will restore more authority to state regulators. Some laws and administrative actions worth highlighting:
- The Center for Responsible Lending and ACORN each track past and present predatory lending laws from around the states. As one example, Wisconsin passed a bill that prohibits balloon payments, a payment that is more than twice as large as the average of all earlier scheduled payments, limits the amount of interest that a lender can receive on a loan, and other protections for borrowers, including a full disclosure of loan terms to borrowers. There was a clarification issued by the Wisconsin Director of Legal Affairs, but the Act was not preempted.
- Connecticut introduced a bill to regulate predatory lending. SB 1039 would cap the interest charged at 12 percent per annum for loans that are less than $15,000. The text of the bill also specifically states that the provisions of the bill are to be applied to payday loans. Unfortunately, the bill died in committee.
The Illinois House introduced HB 1478, the Predatory Lending Protection Act. The Act prohibits the imposition of prepayment penalties, flipping of loans and lend financing of credit insurance. The Act also imposes limitations on high-cost loans and prohibits lending unless the lender reasonably believes that the borrower is able to make the payments to repay the loan.
Minnesota HF 387 requires lenders to ensure that borrowers are able to make the principal and interest payments on the loans before the loan is granted and prohibits the flipping of loans.
- The recent slew of subprime lenders going bankrupt has spurred state action to protect their constituents. New Hampshire's state Banking Department ordered New Century Financial Corp. to stop accepting new loan applications on Wednesday and six weeks ago charged Mortgage Lenders Network USA, INC.. with failing to fund mortgages on which it had closed. Massachusetts Secretary of State William F. Galvin has demanded documents from two Wall Street firms over their recommendations on subprime lenders.
- States are also taking action against the related abuse of payday loans: Eleven states have interest rate limits on payday lenders and proposals are being debated in ten other states. Virginia has just capped payday loan interest rates at 72 percent, still high but a vast improvement over the 400 percent payday lenders had been charging. Going even further, New Hampshire is debating a bill that would close the doors on payday loan shops. The New Hampshire bill would prevent any person from making a loan with an interest rate higher than 30 percent.
The new Congress seems more willing to grapple with the predatory lending problem, with Congressman Barney Frank from Massachusetts saying he would introduce legislation to restrict subprime lending. But while the Federal government may be trying to help the situation now, the debacle of recent years is a lesson in why federal preemption of state laws is often a recipe for disaster. While minimum federal standards are often needed, states are usually aware more quickly of problems appearing locally that need additional regulation, such as the explosion of predatory lending. We should remember in coming years that by tying the hands of state governments, federal regulators made a bad problem far, far worse.
Carsey Institute, Subprime and Predatory Lending in Rural America
Premption of State Banking Regulations
Center for Responsible Lending, Federal Preemption Favors Predatory Lending
State PIRGs, OCC Watch
New Rules Project, Preemption of State Banking Rules
ScotusBlog, Argument Preview: Watters v. Wachovia Bank
Missouri HB 989
Illinois HB 1478
Minnesota HF 387
New Hampshire HB 620
Texas SB 858
Fair Housing and Equal Opportunity: Subprime Lending