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What Is Predatory Lending?

What Is Predatory Lending?

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.

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 contracts, 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


Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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