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November 8, 1999
"What is 'predatory
lending'"?
Predatory lendinghas been much in the news lately, and legislation has been introduced in a
number of states to regulate it away. Most of this proposed legislation is
ill-advised -- a knee-jerk response to horror stories. They would prevent the
horrors imposed on a few by removing options and narrowing choices to the many.
This is a bad deal.
Equity Grabs
In my view, there are four types of
predatory lending. The first, which I will call "equity grabs ", is
lending that is intended by the lender to lead to default by the borrower so the
lender can grab the borrower's equity.
In The
Cash-Out Refinance Scam I gave an example of equity grabbing associated with
what lenders call "cash-out refinancing" -- refinancing for an amount
larger than the balance on the old mortgage. In the example, a borrower with
significant equity in his home refinanced a zero interest-rate loan into one
carrying a high interest rate plus heavy fees, with the fees included in the new
loan. The lender talked the borrower into this by putting cash in the borrower's
pocket. But the borrower was saddled with a larger repayment obligation that he
couldn't meet, resulting in default. This constituted legal thievery of the
borrower's equity.
Home improvement scams work in a similar
manner. Gullible home owners are sweet-talked into contracting for repairs for
which they are overcharged, and then the cost of the repairs plus high loan fees
are rolled into a mortgage that they cannot afford. Default follows and the
borrower loses the home.
Equity grabs are extremely difficult to
regulate away because they represent an abusive application of legitimate
activities. Most borrowers who do a cash-out refinance retain their equity, and
this is true as well for most of those who take out home improvement loans.
Lenders who provide subsidized loans can prevent equity grabs through cash-out
refinancing by incorporating restrictive provisions in the first mortgage.
Beyond that, about the only remedy that doesn't hurt more people than it helps
is provision of counseling directed at potential victims. But people can't be
compelled to seek counsel, or to listen when they receive it.
Equity Inflation
A secondary type of predatory lending I
call "equity inflation", and like equity grabs the lender aims to
profit from the borrower's default. Where equity grabs require a gullible
borrower, equity inflation requires a gullible mortgage insurer -- the Federal
Housing Administration (FHA). The lender scams the FHA into insuring a mortgage
for far more than the house is worth.
Typically this is done through
"property flipping" -- successive sham transactions at progressively
higher prices. After flipping, the price of a house worth, e.g., $40,000 is sold
to an indigent hired for the purpose for $80,000, with an FHA-insured mortgage
of $77,000. After a few payments, the borrower defaults and the lender collects
$77,000 from FHA.
The immediate victim of this type of
predatory lending is FHA. But all FHA borrowers are indirectly affected because
the insurance premiums on FHA loans must be large enough to cover losses from
all sources including scams. In contrast to equity grabs, equity inflation
constitutes fraud under existing laws, and the remedy is constant vigilance and
rigorous enforcement by FHA.
Some observers view "125%
loans" -- loans for an amount equal to 125% of the value of the property --
as inherently predatory. But these are not equity grabs, because the borrower
does not have any equity to grab. Neither do they involve equity inflation,
since these loans are not insured and the lender does not want an inflated
appraisal. Lenders who make loans in excess of the value of the property lose
money if the borrower defaults, and if the property is overvalued, they lose
even more.
But 125% loans could fall within either
of two other types of predatory lending discussed below.
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Contract
Knavery
Recently I received a letter from
a borrower who said that at the time he took out his loan, the loan
officer had told him that the prepayment penalty in his contract lapsed
after 2 years. But 5 years later when he wanted to refinance he discovered
that the penalty was still in force. By that time the loan officer was
working for another lender and no one else in the lender's office knew
anything about it. This borrower was a victim of contract knavery.
Contract knavery involves sneaking
provisions into the loan contract that disadvantage the borrower --
provisions that are not standard in the market and for which the lender
has provided no quid pro quo. Contract knavery involves a predatory
mortgage broker or lender, and an uninformed or gullible borrower.
A typical knee-jerk reaction to
contract knavery is to prohibit by law or regulation the various onerous
provisions that lenders sometimes sneak into contracts. Lenders can be
prevented from sneaking prepayment penalties into contracts, for example,
simply by making prepayment penalties illegal. And a number of states have
done this. But this type of prohibition curtails the options available to
the great majority of borrowers. Those most affected are the low-income
and cash-short borrowers
who,
to qualify for a
loan,
may need the very option the regulation
denies them.
In states that allow prepayment
penalties, borrowers who shop can get a 1/4% reduction in the rate if they
accept a prepayment penalty. There are many borrowers struggling to
qualify who would willingly exchange the right to refinance without
penalty in the future for a rate reduction now. To
protect the few who don't read their contract s,
states that
prohibit
prepayment penalties take away this option for all borrowers.
Price Gouging
Price-gouging involves charging
interest rates and/or fees that are excessive relative to what the same
borrower would have paid had they shopped the market. A large number of the
columns I write are designed to help potential borrowers avoid price
gouging. Informed borrowers who shop, even if it is only to check prices on
the internet, are very unlikely to be gouged.
Still, there are many uninformed
borrowers who don�t shop, and Government ought to protect them if there
were ways to do it that didn�t seriously harm other borrowers.
Unfortunately, the regulatory reaction to price-gouging is to set maximum
prices, which prevents borrowers from being gouged only by depriving other
borrowers of access to credit altogether. The tradeoff between protection
and harm becomes increasingly unfavorable as the market widens to provide
market access to more and more consumers.
If all borrowers had to meet the
same "A" standard and therefore deserved the same price, in theory
an omniscient regulator could set that price as the maximum, preventing
price-gouging without harming anyone. In that kind of world, of course,
consumers who didn't rate an A could borrow only from friends, relatives,
home sellers and loan sharks.
Today, a wide range of borrowers
have access to credit -- many more than in prior decades because lenders
have learned to adjust prices for individual differences in risk and cost.
But this increase in access to credit has also resulted in a widening of
prices to reflect these individual differences. And this has made it
extremely difficult to identify price-gouging. It�s out there all right,
but trying to regulate it away by setting maximum rates inevitably curbs
access to credit by weaker borrowers.
Consider the range of quoted
interest rates I cited in an earlier column for borrowers with credit
records ranging from A through D. A-rated borrowers in California on the day
I shopped were being quoted rates for zero point loans ranging from 7.875%
to 8.50% while D-rated borrowers were being offered rates ranging from
10.25% to 15%. An A borrower who was charged 9% on that day was gouged while
a D borrower who was charged 10% got a "deal".
The wider range of rates for
D-credit borrowers reflects both a wider spread of risks within this
category and probably more predatory lending. A maximum rate of 10.25%,
which is the best a regulator could come up with, would prevent gouging of
D-credit borrowers. But it would not prevent gouging of A, B or C- credit
borrowers, and it would force the weakest borrowers within the D category
out of the market.
The upshot is that as offensive as
price-gouging is, price controls are not a good remedy.
Copyright Jack Guttentag
2003
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