I would like to thank you, Mr. Chairman, and the Committee for giving me the chance to speak on this critically important issue. This is one of the most important challenges among the issues within this Committee's jurisdiction, and I welcome the opportunity to participate in the public discussion.
Homeownership is "the American dream," and America is rightfully proud of its record in the number of Americans who have achieved that.(1) The mortgage market we normally think of, and are proud of, is "productive credit" - a wealth-building credit that millions of Americans have used to make an investment in their lives and their childrens' futures: the market that has helped those 66% of Americans buy their homes; keep those homes in good repair; help finance the kids' education, and for some, helped them start a small business. But make no mistake: what we are talking about today is a threat to that dream and a very different mortgage market. Today, we are talking about asset-depletion. This is "destructive debt," with devastating consequences to both the individual homeowners and to their communities. We are talking about people who are being convinced to "spend" the homes they already own or are buying, often for little or nothing in return.(2) Tens of thousands of Americans, elderly Americans and African-Americans disproportionately among them, are seeing what for many is their only source of accumulated wealth- the equity in their homes - siphoned off. Too often, the home itself is lost.(3) Then what? How do they -- particularly the elderly -- start over?
Please keep this in mind when you hear the caution that legislative action will "dry up credit." Drying up productive credit would be of grave concern; drying up destructive debt is sound economic and public policy. (4)
In the previous panel, some of those affected by this conduct shared their experiences with you. Earlier this week, some Iowans shared their experiences with me. Their stories were typical, but the suffering caused by these practices is keenly felt by each of these individuals. One consumer who has paid nearly $18,000 for four years would have had her original $9000 mortgage paid off by now, had she not been delivered into one of these loans by an unscrupulous contractor. The lender who worked with the contractor to make the home improvement loan refinanced that mortgage with the $27,000 home improvement cost. But the contractor's payment was little more than a very large broker's fee, for he did incomplete and shoddy work, and then disappeared. The lender's promises to make it right were all words for four years, while they took her money. In the other cases, the homeowners I visited with were not looking for loans, but they have credit cards from an issuer who also has a home equity lending business. They were barraged by cross-marketing telemarketers, and convinced that it would be a sound move to refinance. Indeed a sound move - for the lender who charged $6900 in fees on $57,000 of proceeds. (The fees, of course, were financed.) These families are the faces behind these lenders' sales training motto: "These loans are sold, not bought."(5) These families are the faces behind the sordid fact that predatory lending happens because people trusted; and because these lenders and the middlemen who deliver the borrowers to them do not deserve their trust. These lives have been turned upside down by a business philosophy run amuck: a philosophy of total extraction when there's equity at hand.
I know that my counterparts in North Carolina heard similar stories, which is why former Attorney General, now Governor Easley and Attorney General Cooper as well, have been so instrumental in North Carolina's pioneering reform legislation. This problem is about these people -- in Iowa, West Virginia, Pennsylvania, North Carolina -- and all over this country; this is not about abstract market theories. And it is a problem that Congress has a pivotal role in curbing.
In some of our states, we are finding other types of predatory practices that are preying on the vulnerable by appealing to - and subverting - their dreams of buying a home. Some cities are seeing a resurgence of property flipping. In some areas of my state, we are seeing abusive practices in the sale of homes on contracts. In fact, it appears that such contracts may be taking their place along with brokers and home improvement contractors as another "feeder" system into the high-cost mortgage market.(6)
My office has made predatory lending a priority -- both in the home equity mortgage lending context and in the contract sales abuses. In addition to investigations, we are considering adopting administrative regulations to address some of the areas within the scope of our jurisdiction, and are working with a broad-based coalition on education and financial literacy programs. But today I am here to talk to this Committee solely about the home equity mortgage lending problem, because that is where Congressional action is key. HOEPA has been a benefit, but improvements are needed. Federal preemption is hindering states' ability to address these problems on their own. The measures which have been introduced or passed at the state and municipal levels dramatically demonstrate the growing awareness of the serious impact on both individuals and communities of predatory lending, and the desire for meaningful reform.(7)
A. The context: the larger subprime marketplace
Predatory lending is, at its core, a mindset that differs significantly from that operating in the marketplace in which most of us in this room participate. It is a marketplace in which the operative principle is: "take as much as you think you can get away with, however you can, from whomever you think is a likely mark." This is not Adam Smith's marketplace.
Today's prime market is highly competitive. Interest rates are low, and points and fees are relatively so. Competition is facilitated by widespread advertisement of rates and points. Newspapers weekly carry a list of terms available in the region and nationwide, and lenders advertise their rates. The effectiveness of this price competition is demonstrated by the fact that the range of prime rates is very narrow, and has been for years. But in the subprime mortgage market, there is little price competition: there are virtually no advertisements or other publicity about the prices of loans, and it is difficult for anyone seeking price information to get it. Marketing in the subprime market, when terms are mentioned at all, tends to focus on "low-monthly payments." This marketing is, at best, misleading, given the products being sold, and is often simply an outright lie.
I do not mean to imply that all subprime lending is predatory lending, nor does my use of statistics about the subprime generally so imply. However, most of the abuses do occur within the subprime market. We must understand the operations and characteristics of that marketplace in order to recognize how and why the abuses within it occur, and to try to address those problems.
The demographics of the subprime marketplace are significant. Thirty-five percent (35%) of borrowers taking out subprime loans are over 55 years old, while only 21% of prime borrowers are in that age group.(11) (This despite the fact that many of the elderly are likely to have owned their homes outright before getting into this market.) The share of African-Americans in the subprime market is double their share in the prime market.(12)
My co-panelist, Martin Eakes and his colleagues have estimated that the cost of abuses in these four areas cause homeowners to lose $ 9.1 billion of their equity annually, an average of $4600 per family per year.(13) When I look at that figure in the context of who is most likely to be hurt by those abuses, my concern mounts.(14) Others will be talking to this Committee about the fact that predatory lending is at the intersection of civil rights and consumer protection, so I will only say that, for what may be the first time, our civil rights and consumer protection divisions in attorneys general offices around the country are beginning to work together on this common problem.
The most common explanation offered by lenders for the high prices in the subprime market is that these are risky borrowers, and that the higher rates are priced for the higher risk. But that is far too simplistic. Neutral researchers have found that risk does not fully explain the pricing, and that there is good reason to question the efficiency of subprime lending.(15) That core mindset I mentioned earlier leads to opportunistic pricing, not pricing that is calibrated to provide a reasonable return, given the actual risk involved.
Moreover, the essence of predatory lending is to push the loan to the very edge of the borrower's capacity to handle it, meaning these loans create their own risk. We cannot accept statistics about delinquencies and foreclosure rates in the subprime market without also considering how the predatory practices -- reckless underwriting, push marketing, and a philosophy of profit maximization - create a self-fulfilling prophecy.(16) And even with comparatively high rates of foreclosures, many lenders continue to be profitable.
B. How and why it happens?
If neither risk nor legitimate market forces explain the high prices and disadvantageous terms found so frequently in the subprime market, then what does explain it?
"Push marketing:" The notion of consumers shopping for a refinance loan or a home improvement loan, comparing prices and terms, is out of place in a sizeable portion of this market. Frequently, these are loans in search of a borrower, not the other way around, as was the case with the Iowa borrowers I spoke with this week. Consumers who buy household goods with a relatively small installment sales contract are moved up the "food chain" to a mortgage loan by the lender to whom the retailer assigned the contract; door-to-door contractors come by unsolicited with offers to arrange manageable financing for home improvements; telemarketers offer to "lower monthly payments" and direct mail solicitations make false representations about savings on consolidation loans. Another aspect of push marketing is "upselling." ("Upselling" a loan is to loan more money than the borrower needs, wants, or asked for.)
"Unfair and deceptive, even downright fraudulent sales practices:" In addition to deceptive advertisements, the sales pitches and explanations given to the borrowers mislead consumers about high prices and disadvantageous terms (or obscure them) and misrepresent benefits. Some of these tactics could confuse almost anyone, but when the consumer is unsophisticated in financial matters, as is frequently the case, the tactics can be quite fruitful.
While federal and state laws require disclosures, for a variety of reasons, these laws have not proven adequate against these tactics.
Reverse competition: Price competition is distorted when lenders compete for referrals from the middlemen, primarily brokers and contractors. When the middleman gets to take the spread from an "upcharge"(17) on the interest rate or points, it should come as no surprise to anyone that some will steer their customers to the lenders offering them the best compensation. (Reverse competition is also a factor with credit insurance because of commission incentives and other profit-sharing programs.) It should also come as no surprise that the people who lack relevant education, are inexperienced or have a real or perceived lack of alternatives, are the ones to whom this is most likely to happen.
Even without rate upcharges, the brokers, who may have an agreement with the borrower, often take a fee on a percentage-basis, so they have an incentive to steer the borrower to a lender likely to inflate the principal, by upselling, fee-padding, or both. These are self-feeding fees. A 5% fee from a borrower who needs -- and wants -- just $5000 for a roof repair is only $250. But if the broker turns that into a refinance loan, of $40,000, further padded with another $10,000 of financed points, fees, and insurance premiums, his 5% is looking a lot better - $2500.
This divided loyalty of the people in direct contact with the homeowner is particularly problematic given the complexity of any financing transaction, considerably greater in the mortgage context than in other consumer credit. As with most other transactions in our increasingly complex society, these borrowers rely on the good faith and honesty of the "specialist" to help provide full, accurate and complete information and explanations. Unfortunately, much predatory lending is a function of misplaced trust.
These characteristics help explain why the market forces of standard economic theory do not sufficiently work in this market. There are too many distorting forces. Factor in the demographics of the larger subprime marketplace in which these players operate, and we can better understand how and why it happens.
Having looked at the context in which predatory lending occurs, we come to the question of definition. I know that some have expressed concern over the absence of a bright line definition. I do not see this as a hurdle, and I believe that Attorneys General are in a position to offer reassurance on this point. There is a real question as to whether a bright line definition is necessary, or even appropriate. All fifty states and the United States have laws which employ a broad standard of conduct: a prohibition against "deceptive practices," or "unfair and deceptive practices."(18) Attorneys General have enforcement authority for these laws, and so are in a position to assure this Committee that American business can and has prospered with broad, fairness-based laws to protect the integrity of the marketplace. Indeed, a good case can be made that they have helped American business thrive, because these laws protect the honest, responsible and efficient businesses as much as they protect consumers, for unfair and deceptive practices are anti-competitive.
While statutes or regulations often elaborate on that broad language with specific lists of illustrative acts and practices, it has never been seriously advanced that illustrations can or should be an exhaustive enumeration, and that anything outside that bright line was therefore acceptable irrespective of the context. There is a simple reason for this, and it has been recognized for centuries: the human imagination is a wondrous thing, and its capacity to invent new scams, new permutations on old scams, and new ways to sell those scams is infinite. For that reason, it is not possible, nor is it probably wise, to require a bright line definition.
Several models for defining the problem have been used. One relates to general principles of unfairness and deception. The Washington state Department of Financial Institution defines it simply as "the use of deceptive or fraudulent sales practices in the origination of a loan secured by real estate."(19) The Massachusetts Attorney General's office has promulgated regulations pursuant to its authority to regulate unfair and deceptive acts and practices to address some of these practices.(20) Improving on the HOEPA model has been the basis for other responses within the states, most notably North Carolina's legislation.(21) (In enacting HOEPA, Congress recognized that it was a floor, and states could enact more protective legislation.(22))
There is considerable consensus about a constellation of practices and terms most often misused, with common threads.
The terms and practices are designed to maximize the revenue to the lenders and middlemen, which maximizes the amount of equity depleted from the borrowers' homes. As mentioned earlier, when done by means which do not show in the credit price tags, or may be concealed through confusion or obfuscation, all the better. That makes deceptive sales techniques easier, and reduces the chances for any real competition to work.
Among those practices:
* Upselling the basic loan (includes inappropriate refinancing and debt consolidation)
The homeowner may need (and want) only a relatively small loan, for example, $3000 for a new furnace. But those loans tend not to be made. Instead these loans are turned into the "cash-out" refinancing loan, that refinances the first mortgage or consolidation loans (usually consolidating unsecured debts along with a refinance of the existing first mortgage). In the most egregious cases, O% Habitat for Humanity loans, or low-interest, deferred payment rehabilitation loans have been refinanced into high rate loans which stretch the limits of the homeowner's income. But even refinancing a 9-10% mortgage into a 14% mortgage just to get the $3000 for that furnance is rarely justifiable.
Like other practices, this has a self-feeding effect. A 5% brokers fee; or 5 points will be much more remunerative on a $50,000 loan than on a $3000 loan. Since these fees are financed in this market, they, in turn, make the principal larger, making a 14% rate worth more dollars. For the homeowner, of course, that is all more equity lost.(23)
* Upcharging on rates and points (includes yield spread premiums and steering)
The corrosive impact of yield spread premiums generally was described above in connection with the discussion of reverse competition. (See note 17.) The problem is exacerbated in the subprime market, where the much greater range of interest rates(24) makes greater upcharges possible, and the demographics of the subprime market as a whole lends itself to the type of opportunistic pricing that Prof. Jackson posed as the likely explanation.
* Excessive fees and points/padded costs
Since the fees and charges are financed as part of the loan principal, and since some of them are percentage-based fees, this kind of loan padding creates a self-feeding cost loop (an example is described earlier in the discussion of upselling), which makes this a very efficient practice for extracting more equity out of the homes
* Financing single premium credit insurance
Appendix B is a good example of how effective single premium credit insurance is as a tool for a predatory lender to strip equity from a borrower's home. It is also a good example of how well it lends itself to manipulation and deceptive sales tactics. Appendix B shows that adding a $10,000 insurance premium (of which the lender keeps approximately 35% - 40% as commission) over the life of the loan, will cost the borrower an extra $76,000 in lost equity over the life of the loan. Even if the borrower prepays (or more likely refinances) at five years, the credit insurance adds $9,400 to the payoff. And the lender's estimated commission from the premium was double the amount of revenue the lender got from the three points charged on that loan.(25)
* Prepayment penalties
Prepayment penalties trap borrowers in the high cost loans. They are especially troublesome, since borrowers are often told that they needn't worry about the high payments, because these loans are a bridge, that can be refinanced after a couple of years of good payment history.(26)
Flipping is the repeated refinancing of the consumer's loan. It is especially useful for equity-stripping when used by lenders who frontload high fees (points, truncated credit insurance,(27) and so forth). Old fees are pyramided into the new principal, and new fees get added. My staff has seen loans in which nearly 50% of the loan principal simply reflected pyramided fees from serial refinancing.
While HOEPA did succeed in reducing the incidence of one- and two-year balloons, what we are seeing now is long-term balloon loans which seem to be offered solely to enable the lender, broker or contractor to sell the loan based on the low monthly payment. We are seeing 15, and even 20-year balloon loans. The Iowa couple whose loan is discussed in Appendix B borrowed $68,000 (including a $10,000 insurance premium). Over the next twenty years of scheduled payments, they would pay $204,584, and then they would still owe a $54,300 balloon.
Unfair and deceptive sales practices in sales of the credit:
In addition to misleading advertisements, the sales pitches and explanations given to the borrowers mislead consumers about high prices and disadvantageous terms (or obscure them) and misrepresent benefits. Again, just a few examples:
* While federal and state laws require disclosures, for a variety of reasons, these laws have not proven adequate against these tactics. Techniques such as "mixing and matching" the numbers from the note and the TIL disclosure low-ball both the loan amount (disguising high fees and points), and the interest rate, thus completely pervert the basic concept of truth in lending. (28)
* When door-to-door contractors arrange financing with these high-cost lenders (often with lenders who use the opportunity to upsell the credit into a refinancing or consolidation loan), it appears to be common to manipulate the cancellation rights so that the consumer believes he must proceed with a loan which costs too much.(29)
Some of the front-line personnel selling these loans even use the lack of transparency about credit scores to convince people that they couldn't get a lower-cost loan, either from this lender or anywhere else. As one lawyer who has worked for a decade with elderly victims put it, when the broker gets through, the homeowners feel lucky if anyone would give them a dime.(30)
Ability to pay: These lenders pay less attention to the ability of the homeowner to sustain the loan over the long haul. The old standard underwriting motto of "the 3-C's: capacity, collateral, and credit-worthiness" is shortened to "1-C" - collateral. Capacity is, at best, a secondary consideration. Credit-worthiness, as mentioned above, becomes an instrument for deceptive sales practices in individual cases.
A recent example from Iowa: A 72 and 64-year old couple were approached by a door-to-door contractor, who sold them on the need for repairs to their home, and offered to make arrangements for the loan. The work was to cost about $6500. The contractor brought in a broker, who arranged for a refinance plus the cash out for the contractor. (The broker took a 5% fee on the upsold loan ($1800) plus what appears to be a yield-spread premium amounting to another $1440. Now the payments on their mortgage, (including taxes and insurance) are $546. That is nearly 60% of their income: It leaves them $389 a month for food, car and health insurance, medical expenses, gasoline and other car expenses, utilities, and everything else. This terrific deal the broker arranged was a thirty-year mortgage. The loan amount was $36,000, and the settlement charges almost $3,900, (though not all in HOEPA trigger fees). The APR is 14.7%. (31)
The consequence of all this? "Risk" becomes a self-fulfilling prophecy. Home ownership is threatened, not encouraged.
It is not an insurmountable challenge to bring this experience to bear in crafting legislation and regulation, as our experience with illustrative provisions in UDAP statutes and regulations, and in HOEPA itself, show.(32)
III. WHAT CAN BE DONE NOW?
State attorneys general have used our state Unfair and Deceptive Acts and Practices (UDAP) laws against predatory mortgage lenders, including most notably, First Alliance Mortgage Company (FAMCO).(33) FAMCO demonstrates that lenders can be in technical compliance with disclosure laws like Truth in Lending and RESPA, yet nonetheless engage in widespread deception. When regulators did routine examinations, they would see very expensive loans, but no violations of any "bright line" disclosure laws. The problem was that FAMCO employees were rigorously trained as to how to disguise their 20-point charges through a sales script full of tricky and misleading information designed to mislead consumers into thinking that the charges were much lower than they were. This sales script was dubbed "The Monster Track." Attorneys General in Minnesota, Massachusetts, Illinois, Florida, California, New York, and Arizona have taken action against the company, along with the Department of Financial Institutions in Washington state. (In the wake of all the litigation and enforcement actions, the company filed bankruptcy.)
(States which either opted-out of federal preemption of state limitations on points or re-enacted them may have effectively prevented companies like FAMCO from doing business in their state. Iowa opted-out of the federal preemption on first lien points and rates, and kept a two-point limit in place. While there is no concrete proof that this point-cap is why FAMCO did not do business in Iowa, it seems a reasonable assumption.)
But our UDAP laws, and our offices are by no means as much as is needed for this growing problem.
A. Impediments to enforcement of existing laws
Some of the predatory lending practices certainly do fall afoul of existing laws. But there are important loopholes in those laws, and there are also serious impediments to enforcement of those laws against predatory lenders.
Resource limitations: One of the most significant impediments to public enforcement of existing applicable laws is insufficient resources. While state and federal agencies have many dedicated public servants working to protect consumers and the integrity of the marketplace, in the past fifteen or so years we have seen an ever-growing shortfall in the personnel when compared to the workload. The number of credit providers, the volume of lending, and the amount of problem lending have all exploded at the same time that the resources available to examine, monitor, investigate them, and enforce the laws have declined in absolute numbers. The resulting relative disparity is even greater. The experience in my state is probably not atypical. The number of licensed nondepository providers of household credit has roughly tripled in the past fifteen years, and the volume of lending has risen accordingly. (And not all out-of-state lenders operating through mail, telephone, or the Internet are licensed.) Three entire new categories of licensees have been created during those years. Yet the staff necessary to examine these licensees and undertake any investigations and enforcement actions have decreased. This is undoubtedly true at the federal level, as well as the state level.
This disparity between need and supply in the Attorneys General offices is exacerbated by the fact that credit is only one of many areas for which we have some responsibility. For example, telecommunications deregulation and the explosion in e-commerce have resulted both in expanded areas of concern for us, and an expanded volume of complaints from our citizens.
Holes in coverage: Some state UDAP statutes do not include credit as a "good or service" to which the Act applies, or lenders may be exempted from the list of covered entities.(34) Some state statutes prohibit "deceptive" practices, but not unfair practices. In my state, we have no private right of action for our UDAP statute, magnifying the impact of the problem of inadequate resources for public enforcement. Other claims which might apply to a creditors' practices may be beyond the jurisdictional authority given to public agencies.
The silent victim: There is also a threshold problem of detection. Most of the people whose homes are being drained of their equity do not complain. Like most Americans, they are unfamiliar with applicable laws and so are unaware that the lender may have crossed the bounds; many are embarrassed, or simply feel that it is yet one more of life's unfortunate turns. Coupled with the "clean paper" on many of these loans, this silence means activity goes undetected -- at least until it's too late for many. As mentioned above, regulatory examinations of the records in the lenders' offices (even if there was sufficient person-power), often do not reveal the problems.
2. Private enforcement
Mandatory arbitration: We have always recognized that the public resources for enforcement would never be adequate to assure full compliance. Thus the concept that consumers can vindicate these rights themselves is built into many of the statutes which apply to these transactions. Under these statutes, as well as common law, these actions may be brought in our courts, where impartial judges and juries representing the community at large can assess the evidence and apply the law. Some of these statutes help assure that the right is not a phantom one, by providing for attorney's fees and costs as part of the remedy against the wrong-doer. Critically, the legal system offers an open and efficient system for addressing systemic abuses - - abuses that governmental enforcement alone could not address.
But private enforcement faces a serious threat today. Mandatory arbitration clauses which deny consumers that right to access to impartial judges and juries of their peers are increasingly prevalent. This denies all of us the open system necessary to assure that systemic problems are exposed and addressed. This is not the forum to discuss in detail the way the concept of arbitration has been subverted from its premise and promise into a mechanism used by one party to a contract - the one holding all the cards - to avoid meaningful accountability for their own misconduct. These are not, as arbitration was envisioned, simple consensual agreements to choose a different forum in which to resolve differences cheaply and quickly; these are intended to insulate the ones who insist upon them from the consequences of their improper actions. While not unique to predatory mortgage lending, this rapidly growing practice in consumer transactions is a serious threat to effective use of existing laws to address predatory lending, as well as to enforcement of any further legislative or regulatory efforts to curb it. It is within Congress' power to remove this barrier.(35)
Federal laws which, by statute or by regulatory action, preempt state laws, have played a role in the growth of predatory mortgage lending.(36) Unlike some examples of federal preemption, preemption in the credit arena did not replace multiple state standards with a single federal standard. In important areas, it replaced state standards with no real standards at all.
With commerce increasingly crossing borders, the industry asks that it not be subjected to "balkanized" state laws, and now, even municipal ordinances. But the industry and Congress should recognize that these efforts are born of concern for what is happening now to people and to their communities, and of frustration at inaction in Congress.
Congress did, on a bipartisan basis, enact HOEPA, which has helped, but needs to be improved. However, Congress has not done anything about the vacuum (and the uncertainty) left by preemption. Some federal regulatory agencies have made the problem even worse since then, through broad (arguably overbroad) interpretations of federal law. For example the1996 expansive reading of the Alternative Mortgage Transactions Parity Act (AMTPA) to preempt state laws on prepayment penalties has contributed to the problems we are talking about today. Over a year ago, the OTS asked whether that Act and interpretations under it had contributed to the problem, and forty-four states submitted comments saying yes. But nothing has come of that.(37) In the meantime, regulators in Virginia and Illinois have been sued by industry trade associations on grounds that AMTPA preempts their rules.(38)
IV. WHAT MORE NEEDS TO BE DONE?
It is simply not the case that existing laws are adequate. In an imperfect market, there must be ground rules. These are some suggestions.
Thirty-one states submitted comments to the Federal Reserve Board urging it to adopt the HOEPA rules as proposed, without being weakened in any respect. Our comments emphasized the importance of including single-premium credit insurance among the trigger fees. ( A copy of the comments is submitted as Appendix A.)
In addition to closing the enforcement and substantive loopholes created by mandatory arbitration and preemption, HOEPA could be improved in light of the lessons we've learned from almost six years of experience with it. Some of the suggested reforms include:
* Improve the "asset-based lending" prohibition. Since this is the key issue in predatory lending, it is vital that it be effectual and enforceable. As it stands, it is neither. The "pattern and practice" requirement should be eliminated from the provision prohibiting making unaffordable loans.(39) The concept of "suitability," borrowed from the securities field, might be incorporated.
* Prohibiting the financing of single-premium credit insurance in HOEPA loans, as HUD and the FRB have recommended.
* Remove the federal preemption hurdle to state enforcement of laws prohibiting prepayment penalties, or, at a minimum, prohibit prepayment penalties in HOEPA loans. The current HOEPA provision on prepayment penalties, as a practical matter, is so convoluted as to be virtually unenforceable.
* Improve the balloon payment provisions. While we no longer see one and two year balloons, we now see 15- and 20-year balloons, whose sole purpose is to enable the lender or broker to low-ball the cost by selling on "low monthly payments." And without prepayment penalties, there is no real reason for balloon loans: if a consumer is planning on selling in five years, they can prepay the loan in any event.
* Limit the amount of upfront fees and points which can be financed.
My colleagues and other sate and local officials are seeing more and more of the hardship and havoc that results from these practices. We are committed to trying to address them as best we can within the limits of our jurisdiction and our resources. Federal preemption is part of what is limiting our ability to respond. Congress has a signal role here, for this is a national problem.
I would like to offer my continuing assistance to this Committee, and I know that my colleagues will, as well.
Thank you for giving me this opportunity to share my views with you.
1. Homeownership reached a record level of 66% in 1998. Arthur B. Kennickell, et al., Recent Changes in U.S. Family Finances: Results from the 1998 Survey of Consumer Finances, 86 Fed. Res. Bull. 1, 15-18 (2000).
2. Part of the problem with the subprime market generally is that it is not offering what many people need. Overwhelmingly, it offers refinance and consolidation loans - irrespective of whether that is wanted, warranted, or wise. See section I-C, below.
3. See Alan White and Cathy Lesser Mansfield, Subprime Mortgage Foreclosures: Mounting Defaults Draining Home Ownership, (testimony at HUD predatory lending hearings, May 12, 2000), indicating 72,000 families were in or near foreclosure.
While the foreclosures are devastating for the families, the impact on the lenders is less clear. First, there is a distinction to be made between delinquencies/defaults and actual credit loss. Second, as we note below, some of this risk to the lender is self-made. See Section II-A , below. See also Appendix B, page 1, in which insurance padding added $76,000 to the cost of the loan, raised the monthly payment nearly $100, and all by itself, created a $54,000 balloon payable after the borrower would have paid over $204,000.
4. We should also keep in mind that this prediction has been made of most consumer protection and fair lending legislation in my memory - from the original Truth in Lending up through HOEPA. And it has never happened.
5. See Gene A. Marsh, "The Hard Sell in Consumer Credit: How the Folks in Marketing Can Put You in Court," 52 Cons. Fin. Law Qtrly Rep. 295, 298 (Summer, 1998) (quoting from a sales training manual: another instruction - "sell eligible applicants to his maximum worth or high credit.")
6. As is discussed below, many homeowners do not select the lenders they use, but are delivered to those lenders by middlemen. In the case of some of the abusive land contracts, a contract seller will sell a home to an unsophisticated borrower at a greatly inflated price on a two-five year balloon, telling the buyer that their contract payments will help establish a credit record. The hitch is that it is likely to be difficult, if not impossible, to get conventional mortgage financing when the balloon comes due because the inflated sales price would make the loan-to-value ratio too high for a conventional market. The result? Another way of steering the less sophisticated home buyer into the high-cost refinancing market.
7. See section III-B, below on how preemption has hampered the ability of states to deal with the kind of predatory lending practices we are talking about in these hearings.
8. A graph of the distribution of loans around the median rate shifted from a bell-curve distribution in 1995
to a "twin peaks" distribution around the median in 1999, indicating greater segmentation within the subprime
market, and shows the "rate creep" on the high side of the distribution. See Cathy Lesser Mansfield, The Road to
Subprime "HEL" Was Paved With Good Congressional Intentions, 51 So. Car. L. Rev. 473, p. 578, Graph 2; p.
586, Graph 6 (2000).
|% of loans in securitized
subprime pools sold on
Wall Street ...
See id., p. 577 Table 1.
Collecting price data on subprime lending is extraordinarily difficult, as the author of this article, one of my constituents, Professor Mansfield of Drake University law school, reported to the House Committee on Banking and Financial Services a year ago. (May 24, 2000). As noted above, unlike the prime market, there is no advertising information about rates and points in the subprime market available to most consumers. Furthermore, that information is not reported for any regulatory purposes. It is not information required by the Home Mortgage Disclosure Act (HMDA). These statistics relate solely to pools of loans packaged as securities, where interest rate information is required by SEC rules for prospective investors.
9. Figures cited in U.S. Dept. of Treasury Comment on Regulation Z (HOEPA) Proposed Rulemaking, Docket No. R-1090 (January 19, 2001), at page 7.
10. Estimate courtesy of the Coalition for Responsible Lending. Recently, three major lenders, Citigroup, Household and American General, announced they will stop selling single premium credit insurance.
11. Howard Lax, Michael Manti, Paul Raca, Peter Zorn, Subprime Lending: An Investigation of Economic Efficiency, p. 9 (unpublished paper, February 25,2000).
12. Twelve percent of subprime loans are taken out by African-Americans. Subprime loans are 51% of home loans in predominately African-American neighborhoods, compared with 9% in white neighborhoods. Blacks in upper-income neighborhoods were twice as likely to be in the subprime market as borrowers in low-income white neighborhoods. HUD, Unequal Burden: Income and Racial Disparities in Subprime Lending in America.
The Zorn, et. al study also notes that lower income borrowers are also twice as likely to be in the subprime market "despite the fact that FICO scores are not strongly correlated with income." p. 9. The Woodstock Institute study also found that the market segmentation "is considerably stronger by race than by income. Daniel Immergluck and Marti Wiles, Two Steps Back: The Dual Mortgage Market, Predatory Lending, and the Undoing of Community Development, p. iii (Woodstock Institute, November 1, 1999.)
With the aid of a Community Lending Partnership Initiative grant, the Rural Housing Institute is gathering information on lending in Iowa. Preliminary data indicates a similar picture of racial disparities in Iowa, though the researchers are awaiting the results of the 2000 Census income data to see whether the correlation in Iowa is similarly more correlated to race than income.
13. The per family figure was found in Coalition for Responsible Lending Issue Paper, "Quantifying the Economic Cost of Predatory Lending." (March 9, 2001). Mr. Eakes' testimony today may reflect revised figures.
14. According to 1990 census, the median net worth for an African American family was $4,400. Comparing that to Mr. Eakes estimate of $4,600 per family loss is, to put it mildly, sobering.
15. Howard Lax, Michael Manti, Paul Raca, Peter Zorn, Subprime Lending: An Investigation of Economic
Efficiency, p. 3-4 (unpublished, February 25,2000). While risk does play a key role, "borrowers' demographic
characteristics, knowledge and financial sophistication also play a statistically and practically significant role in
determining whether they end up with subprime mortgages." Id. p. 3.
16. It is beyond the scope of my comments to discuss the relationship between risk and pricing. But it is
important that policy-makers look not just at delinquency and foreclosure rates without also looking at actual losses
17. An "upcharge" is when the loan is written at a rate higher than the underwriting rate. For example, an
evaluation of the collateral, the borrower's income and debt-to-income ratio, and credit history indicates the
borrower qualifies for a 11.5% interest rate. But the broker has discretion to write the note at 14%, and the broker
gets extra compensation from that rate spead. He may get it all, or there may be a sharing arrangement with the
lender, e.g broker gets first 1%, and they split the other 1.5%. The Eleventh Circuit has recently found that a
referral fee would violate RESPA. Culpepper v. Irwin Mtg. Corp., 253 F. 3d 1324 (2001)
16. It is beyond the scope of my comments to discuss the relationship between risk and pricing. But it is important that policy-makers look not just at delinquency and foreclosure rates without also looking at actual losses and revenues.
17. An "upcharge" is when the loan is written at a rate higher than the underwriting rate. For example, an evaluation of the collateral, the borrower's income and debt-to-income ratio, and credit history indicates the borrower qualifies for a 11.5% interest rate. But the broker has discretion to write the note at 14%, and the broker gets extra compensation from that rate spead. He may get it all, or there may be a sharing arrangement with the lender, e.g broker gets first 1%, and they split the other 1.5%. The Eleventh Circuit has recently found that a referral fee would violate RESPA. Culpepper v. Irwin Mtg. Corp., 253 F. 3d 1324 (2001)
A recent review of yield-spread premiums in the prime market found that they added an average cost of over $1100 on each transaction in which they were charged. The author found that the most likely explanation for the added cost was not added value, nor added services. Rather, it is a system which lends itself to price discrimination: extra broker compensation can be extracted from less sophisticated consumers, while it can be waived for the few who are savvy about the complex pricing practices in today's mortgage market. See Report of Howell E. Jackson, Household International Professor of Law, Harvard Law School, pp. 72 , 81 (July 9, 2001), submitted as expert witness report in Glover v. Standard Federal Bank, Civ. No. 97-2068 (D. Minn.)
18. See Section III, below, for a discussion of the adequacy of these laws to address predatory mortgage lending.
19. See, Comments from John Bley, Director of Financial Institutions, State of Washington, on Responsible Alternative Mortgage Lending to OTS (July 3, 2000). (I note that some abuses also occur in the servicing and collection of these loans, so limiting a statutory definition to the origination stage only would leave gaps.) Mr. Bley's letter notes that the HUD/Treasury definition, quoted in his letter, is similar: "Predatory lending- whether undertaken by creditors, brokers , or even home improvement contractors - involves engaging in deception or fraud, manipulating the borrower through aggressive sales tactics, or taking unfair advantage of a borrower's lack of understanding about loan terms. These practices are often combined with loan terms that , alone or in combination, are abusive or make the borrower more vulnerable to abusive practices."
20. 940 C.M.R.§ 8.00, et seq. See also United Companies Lending Corp. v. Sargeant, 20 F. Supp. 2d 192 (D. Mass. 1998)
21. N.C. Gen. Stat. §24 -1-.1E. See also 209 C.M.R. 32.32 (Massachusettes Banking Commission); Ill. Admin. Code 38, 1050.110 et seq.; N.Y. Comp Codes & Regs. Tit. 3 § 91.1 et seq. Some cities have also crafted ordinances along these lines, Philadelphia and Dayton being two examples. While legal concerns about preemption and practical concerns about "balkanization" have been raised in response to this increasingly local response much care and thought has gone into the substantive provisions , building on the actual experience under HOEPA, and may be a good source of suggestions for improvements on HOEPA itself.
22. "[P]rovisions of this subtitle preempt state law only where federal and state law are inconsistent, and then only to the extent of the inconsistency. The Conferees intend to allow states to enact more protective provisions than those in this legislation." H.R. Conf. Rep. No. 652, 103d Cong. Sess. 147, 162 (1994), 1994 U.S.C.C.A.N. 1992. That has not prevented preemption challenges, however. The Illinois DFI regulations have been challenged by the Illinois Association of Mortgage Brokers, alleging that they are preempted by the Alternative Mortgage Transaction Parity Act.
23. While most of these loans are more than amply secured by the home, well within usual loan-to-value ranges, some lenders are upselling loans into the high LTV range, which bumps the loan into a higher rate. Some do this by "loan-splitting," dividing a loan into a large loan for the first 80-90% if the home's equity, at, for example, 13-14%, and a smaller loan for the rest of the equity (or exceeding the equity) at 16 - 21%. These loans are often made by "upselling," not because the borrower sought a high LTV loan. The practice seems to involve getting inflated "made-to-order" appraisals, then upselling the loan based on the phony "appreciation." As with some of the other tactics, like stiff prepayment penalties, these loans marry the homeowner to this lender. The homeowner can't refinance with a market-rate lender.
24. See text accompanying note 8.
25. See Appendix B, p. 2 line 5. Compare columns 5 and 6. This is not a hypothetical example. It is a loan made to an Iowa couple.
26. This is another instance which demonstrates the limits of disclosures. A recent loan we saw has an "Alternative Mortgage Transactions Parity Act Prepayment Charge Disclosure," which explains that state law is preempted, and provides an example of how their formula would apply to a $100,000 loan. It is doubtful the example would score on any literacy scale below upper college-level.
27. Truncated credit insurance is insurance sold for a term less than the loan term. In the example in Attachment B, page 1, the loan premium financed in the 20-year balloon note purchased a 7-year policy. That front-loads the premium, so if the loan was refinanced at 5 years, over 90% of the premium would have been "earned", and rolled over into the new loan principal - but without any insurance coverage from that extra $9400 in the new loan.
28. This was the technique at issue in the FAMCO cases, see Section III, below.
29. The practice is a variation of "spiking." ("Spiking" means to start work or otherwise proceed during the
cooling off period, which leads the consumer to believe they can't cancel, "because work has begun.") By trying to
separate the sale of the home improvement from the financing for it, the borrowers right to cancel under either the
state door-to-door sales act or the TIL are subverted. This practice, which appears to be common, is described more
fully in National Consumer Law Center, Truth in Lending § 126.96.36.199, esp. 188.8.131.52.2 (4th Ed. 1999.)
30. Oral presentation of an AARP lawyer at a conference on predatory mortgage lending in Des Moines,
Iowa, June, 1999.
30. Oral presentation of an AARP lawyer at a conference on predatory mortgage lending in Des Moines, Iowa, June, 1999.
It is a fertile area for misrepresentations. When looking at mortgage lending in the prime market, the Boston Federal Reserve Bank found that approximately 80% of applicants had some ding on their credit record which would have, looked at in isolation, justified a denial.
The recent move by Fair Isaac to bring transparency to credit scores may help, but it will more likely be a help in the prime market than in the subprime market. Again, a knowledgeable broker or contractor-cum-broker would assure that the consumer knew that, but the reverse competition effect may impede that.
31. The homeowners tried to exercise their right to cancel. But the lender claims they never got the notice, and the contractor told them not to worry about those payments, they'd lower them.....
32. A good example is the FTC Credit Practices Rule, 16 C.F.R. 444, which prohibited certain practices common in the consumer finance industry as unfair or deceptive. At the time it was under consideration, opponents predicted it would "dry up credit to those who need it the most." It didn't. (Indeed, it was predicted that HOEPA would "dry up credit to those who need it the most." It hasn't.)
33. FAMCO's practices were the subject of a New York Times article, Diana B. Henriques, "Mortgaged Lives", NYT, A1 (March 15, 2000).
34. The theory for exempting lenders is generally that other regulators are monitoring the conduct of the entity. Yet the regulator may not have the jurisdictional authority to address unfair and deceptive acts and practices generally.
35. The European Union recognizes the problems inherent in mandatory arbitration in consumer transactions, and includes it among contract terms that are presumptively unfair. See European Union Commission Recommendation No. 98/257/EC on the Principles Applicable to the Bodies Responsible for the Out-of-Court Settlement of Consumer Disputes, and Council Directive 93/13/EC of 5 April 1993 on Unfair Terms in Consumer Contracts.
36. See, e.g. Mansfield, The Road to Subprime "HEL", note 8, above.
37. It is also possible that AMTPA has contributed to the prevalence of the "exploding ARM" by predatory lenders, as the existence of a variable rate is one of the triggers for AMTPA coverage. 12 U.S.C. §3802 Although we are focused today on mortgage lending, we are also concerned about overbroad preemption interpretations by the OCC affecting our ability to address problems in other areas, such as payday lending, and, now, perhaps even car loans.
38. Illinois Assoc. of Mortgage Brokers v. Office of Banks and Real Estate, (N.D. Ill, filed July 3, 2001); National Home Equity Mortgage Association. v. Face, 239 F. 3d 633 (4th Cir. 2001), cert. Filed June 7, 2001.
39. It is not a violation to make unaffordable loans, it is only a violation to engage in a "pattern and practice of doing so," a difficult enforcement challenge. See Newton v. United Companies, 24 F. Supp. 2d 444 (E.D. Pa 1998)
40. The market distortions involved in the sale of credit insurance are too well documented to warrant our repeating them in detail in this letter. Abuses in credit insurance have been the subject of Congressional attention as far back as 1955. The "reverse competition" effect which comes into play when it is the selling creditor which selects the group policy it will sell to its borrowers has long been a criticism of this product. See, e.g. Cope v. Aetna Finance Co., 412 F.2d 635, 640 n. 14 (1st Cir. 1969); Spears v. Colonial Bank of Alabama, 514 So. 2d 814, 819 (Ala. 1987); New York Insurance Adm. Code, Reg. 27A - 11 NYCRR 185.0. Marketing abuses have also long been of concern to Attorneys General. See note 6, infra.
41. The argument sometimes made is that consumers find it more convenient to spread out the premium over the life of the loan, which is unconvincing. Very few consumers understand the financial impact of financing a 5-year insurance over 20 years at 15% interest. In one of the loans examined in the Attachment, the insurance premiums alone turned the mortgage from a fully amortizing loan to a 20-year balloon. The consumer had merely been told that the insurance would cost "$40 extra a month." That figure represented the $10,000+ cost of the premium over 240 months without financing it at 15%. In truth, the insurance alone created the balloon payment of over $54,000, and raised the monthly payments by over $90/mo during the preceding 239 months.
42. For disclosure purposes, Reg. Z, 226.4(d), provides that "voluntary" insurance premiums may be excluded from the finance charge.
43. OSC § 226. 4(d)-5; see also OSC § 226.4(b)(7) and (8), codifying the Board's historic position, see, e.g FRB Staff Letter No. 1270 (Dec. 20, 1977). See also Hager v. American General Fin., 37 F. Supp. 778 (S.D. W.Va. 1999); Slovak v. American General Fin., 1998 WL 830656 (E.D. Pa. 1998); Kaminski v. Shawmut Credit Union, 494 F. Supp. 723 (D. Mass. 1980); Matter of Tower Loan of Mississippi, FTC Dkt. # 9241 (complaint filed July 5, 1990) (consent order).
44. See Attachment A.
45. E.g. Attorneys General in Arizona, California, Iowa, Wisconsin have taken action in insurance packing cases. For a listing of some insurance packing cases, see, e.g. National Consumer Law Center, The Cost of Credit: Regulation and Legal Challenges §§ 8.5.4 and 8.7.4, text accompanying notes 642 -646
46. John Fonseca, Handling Consumer Credit Cases, Chap. 12 (3rd ed. 1986).
47. 65 Fed. Reg. 81438, 81441 (December 26, 2000).
48. See estimates collected in Cathy Lesser Mansfield, The Road to Subprime "HEL" Was Paved With Good Congressional Intentions: Usury Deregulation and the Subprime Home Equity Market, 51 So. Car. L. Rev. 473, 527 - 531 (2000), citing estimates that the number of subprime loans increased by 890% between 1993 and 1998, and that subprime lenders tripled their market share between 1995 and 1997.
49. As the Board is aware from the letter a number of us sent to the Board in 1997, our offices have long been concerned with the way that spurious open-end credit has been used to facilitate deceptive sales practices and undermine informed credit decisions, particularly in the door-to-door context. (See 62 Fed. Reg. 64769 (Dec. 7, 1997).
50. In many cases, the long-term payments simply pay off the financed fees and the interest on them.
51. Documents on sixteen of the loans were provided by a neighborhood organization following a public meeting which Governor Gramlich attended in Des Moines, Iowa in the fall of 2000. The seventeenth , from the same lender, came to our attention through a consumer complaint.
52. These documents indicate the company engages in "loan-splitting," or writing two separate loan transactions for what is really a single loan. Apparently it does so in order to make high LTV loans. One loan is written for up to 95% LTV, the second loan is written, in theory, for the remainder of the equity up to 110%, though one set of these loans appears closer to 140% - 200% LTV.
53. For this loan, we had only a HUD-1, which does not give us the APR. However, it was a loan under $25,000, and all the other loans of that size from this lender had APRs over 17%, so it is probable that it was also a HOEPA loan.
54. This is the lower of two inconsistent figures given on the TIL authorization and the HUD-1.
It is note-worthy that this is a 20-year balloon note. After $204,539 in 239 monthly payments, a $54,327 balloon is scheduled. Without this $10,000 in financed, single-premium insurance, these borrowers would save $100 a month for 20 years, and NOT have a balloon at the end of the road. In effect, 20 years of $855/mo payments would reduce the principal on this loan as written by little more than the amount of the insurance premiums alone.
55. Board of Governors / HUD Joint Report to the Congress Concerning Reform to the Truth in Lending Act and the Real Estate Settlement Procedures Act 66, note 100 (July, 1998).
56. See National Consumer Law Center, The Cost of Credit: Regulation and Legal Challenges §§ 8.5.5,
8.7.2 - 8.7.4. One of the borrowers (whose loan was split to make a high LTV loan), states she informed the loan
originator of her preexisting condition when she filled out the application. She states he asked if she was planning
on surgery or "anything drastic" in the future, and when she responded negatively, he instructed her to write "no" in
response to the question about existing conditions. On the second loan, joint credit life was written for over $7000,
though one of the spouses income on the application is clearly listed as social security disability. It appears that the
nature of the disability is such that she would have been ineligible for coverage.
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