Predatory Lending Laws Trickle Down From Congress To City Hall

Generally the term predatory lending refers to consumer loans with high rates of interest or high fees, or the use of to using underwriting guidelines that allow consumers to obtain loans they have little likelihood or ability to repay. Sometimes the term is used to describe unscrupulous lending practices that are not apparent from the loan documents themselves. For example, the trade group America's Community Bankers, which represents small savings associations and banks, believes that abusive practices including falsifying documents, hiding or obscuring disclosures and orally contradicting disclosures, are what characterize predatory lending.⁴ Others, including the Mortgage Bankers Association of America (MBA), also focus on specific practices as being predatory, including loan flipping.⁵ The State of Washington, in its July 3, 2000 comment to the Treasury Department on alternative lending practices, states that predatory lending is basically a problem of deceptive sales practices. North Carolina's Attorney General has defined predatory lending practices as selling the borrower on a loan with the highest interest rates and fees possible,⁶ and in an advisory to consumers on its website, lists as the first example of predatory practices, excessive mortgage broker compensation.⁷ The suggestion has also been made that lending practices can become predatory when they target particular populations, such as the inexperienced or those lacking information.⁸

If government and the lending industry cannot define predatory lending precisely, neither can the public. The MBA has published a survey showing that only one in 10 Americans has heard the term predatory lending and fewer than one in 10 Americans understands the term sub-prime lending. Many think sub-prime loans are below-market rate loans available to consumers with good credit. Perhaps this is not surprising considering the low overall level of Americans' knowledge of economics and finance; in a survey conducted for the National Council on Economic Education by Lou Harris and Associates, less than half of the adults polled understood concepts such as scarcity of resources, money and inflation, one-third understood that marketplace competition lowers prices; and only 38% of students and half of adults know that stock markets bring together buyers and sellers of securities.⁹

The charge of predatory lending is generally leveled against lenders whose customers are so-called sub-prime borrowers, i.e., the poor or those with impaired credit. Stories in the media about predatory lending are frequently illustrated with examples of abusive practices involved in loans to minority or elderly borrowers. The consequences of predatory lending, according to consumer advocates, are high foreclosure rates, abandoned properties, and community breakdown. Industry groups believe that risk-based loan pricing makes credit available to a wider group of people; they wonder aloud whether restrictions on permissible loan terms will result in a credit crunch for those who need it most, and shut the door to homeownership for many American families.¹⁰

Government agencies and industry groups are not in agreement about how to deal with predatory lending. HUD Secretary Andrew Cuomo claims that specific legislation is needed because a lack of existing laws results in an unregulated industry.¹¹ The statement that consumer lending is unregulated will come as a surprise to most lenders and brokers, however, who battle daily with state and federal laws and regulations addressing loan rates, required disclosures, recission rights, foreclosure procedures and more. The MBA would prefer to see existing laws enforced rather than enactment of new laws. The National Association of Mortgage Brokers (NAMB) also favors stepped up enforcement of present laws and industry self-regulation.

The federal government has been active at every level in predatory lending policymaking. Virtually every agency with responsibility for financial institution supervision has commented on how to prevent predatory lending. Several bills have been introduced in Congress on this topic.

On June 20, 2000, the Treasury Department and HUD released a report of their joint National Predatory Lending Task Force,¹² which recommends several approaches to curb predatory lending. The report recommends that creditors be required to encourage high-cost loan applicants to seek home mortgage counseling and that creditors be required to disclose credit scores to all borrowers on request. The task force also believes mortgage brokers should document the appropriateness of every loan made to a high-cost loan applicant and lenders should be responsible for the broker's misconduct if the lender knew about it. Certain loan terms and conditions should be disallowed on high-cost loans (such as the financing of points and fees), and the triggers for high-cost home loans under the Home Ownership and Equity Protection Act (HOEPA) should be lowered. The task force recommends prohibiting mandatory arbitration clauses in loan documents and prohibiting the sale of single-premium insurance products on mortgage loans.

The Federal Reserve Board announced a series of hearings in four cities during the summer and fall of 2000, to permit the public to participate in the predatory lending debate. The Office of Thrift Supervision issued a notice of advance rulemaking in April 2000, in which it asked for comments on whether the Alternative Mortgage Transaction Parity Act¹³ encourages inappropriate lending policies.

With the support of the mortgage brokerage industry, Congressman Robert Ney of Ohio has introduced into the House of Representatives the Consumer Mortgage Protection Act of 2000,H.R. 4213.¹⁴ It would amend the Truth-in-Lending Act to lower the trigger limits for high cost loans under TILA from 10 points over Treasury securities to 8 points for first mortgages and 9 points for subordinate mortgages. It would also restrict prepayment penalties, restrict certain closing costs where a lender refinances its loan within one year, and prohibit the encouragement of default under existing loans. It would also preclude lenders from profiting from foreclosures.

B. State Government Responses

As examples of state action to combat predatory lending, the initiatives of four states are summarized below.¹⁵ North Carolina was first to adopt a comprehensive predatory lending law in 1999; it has served as a model for other state legislatures. Massachusetts and New York have taken a regulatory approach, attempting to govern predatory lending through administrative rules. A pattern is developing in the handful of states that have acted on predatory lending -- they are reducing slightly the threshold rate at which a loan becomes a high-cost loan (from 10% over Treasury securities in HOEPA to 8% for first mortgages and 9% for second mortgages) and prohibiting certain practices considered unfair. Washington has relied on the threat of enforcement activity to protect its citizens from predatory lenders.

1. Massachusetts

Massachusetts has a two-pronged approach to predatory lending regulation at present. In the legislature, a predatory lending bill was introduced on May 15, 2000, and at the Division of Banking hearings will be held on a proposed regulation to outlaw predatory lending and amend existing rules on unfair and deceptive practices.¹⁶

The gist of the regulation is that the threshold for interest rates and fees defining high-cost mortgages would be lowered from 10 points (in the Federal HOEPA) over Treasury securities to 8 points for first mortgages and 9 points for second mortgages. The trigger for fees in a high-cost mortgage would be lowered from 8 points to 5 points. New consumer disclosures would be required, including a prominent statement on the application advising the consumer to seek less costly financing alternatives. Prepayment penalties on high cost loans would be restricted and making an improper high-cost loan based on collateral only (and not the ability to repay) would be a prohibited act. Unreasonable rates and terms, and mandatory arbitration, and class action restricting provisions in loans would be outlawed. The regulations could be enforced by either the Division of Banks or the Attorney General.

2. North Carolina

North Carolina's legislature adopted S.B. 1149 in 1999; it contains anti-flipping provisions effective October 1, 1999 and a predatory lending portion, effective July 1, 2000. North Carolina's Attorney General has been an ardent proponent of anti-predatory lending legislation and North Carolina has (perhaps unwittingly) become a source for other legislatures considering predatory lending laws. The anti-flipping restriction prevents lenders from intentionally refinancing a home mortgage loan if the borrower does not gain a tangible net benefit. The predatory lending restrictions prohibit certain loan terms in high-cost loans (loans in which the annual percentage rate is more than 10% over the rate of Treasury securities with an equivalent term as the mortgage, or where the total fees and points are more than 5% of the loan amount, or where there is a prepayment penalty due more than 30 months after closing, or in an amount greater than 2%), including call provisions, balloon payments, negative amortization, increased interest rate following default, required advance payments, and modification or deferral fees. High cost home loans cannot be made without regard for the borrower's repayment ability and a certification that the borrower has received homeownership counseling on the appropriateness of the loan. If the borrower's debt ratio exceeds 50%, the loan may be predatory; therefore, in effect, North Carolina’s law contains underwriting guidelines.

Prohibited acts in high-cost lending in North Carolina are automatically unfair and deceptive, making the lender liable to treble damages. A loan is considered usurious if the high-cost restrictions are violated.

3. New York

New York's Banking Board adopted regulations on high-cost home loans on June 28, 2000.¹⁷ High cost home loans include those with annual percentage rates higher than 8% above Treasury securities for first mortgages, and 9% for second mortgages, or loans with total points and fees more than 5% of the loan amount. Call provisions, balloon payments, negative amortization, increased interest following default, required advance payments, and modification or deferral fees are prohibited, as are mandatory oppressive arbitration clauses.

New York borrowers are entitled to a list of homeownership counselors prior to obtaining a high cost home loan. The loan application form must include the following statement directly above the borrower's signature: The loan which may be offered to you is not necessarily the least expensive loan available to you and you are advised to shop around to determine comparative interest rates, points and other fees and charges. A third disclosure of the high-cost character of the loan must be prominently placed on the top of the mortgage instrument, stating that the mortgage is a high-cost home loan subject to Part 41 of the General Regulations of the Banking Board.

Other prohibited practices in New York are similar to North Carolina's -- lending without due regard to repayment ability is prohibited, as is the required financing of fees or charges. Loan proceeds may not be paid directly to home improvement contractors; the check must be jointly payable to the contractor and the borrower.

Lenders making 10 or more high-cost loans a year must report to the Banking Department annually the names and addresses of the three consultants, attorneys and home improvement contractors who provide the most referrals of home loans (if applicable). It appears that New York intends to marshall the assistance of referrers of high-cost home loans in regulating predatory lending, or perhaps New York intends to use the information to monitor the referrers themselves for unlawful practices.

4. Washington

The Washington Department of Financial Institutions (DFI) believes that predatory lending is a problem of deceptive sales practices and has adopted this definition: Predatory lending is the use of deceptive or fraudulent sales practices in the origination of a loan secured by real estate.¹⁸ The DFI is investigating several alleged predatory lenders; one claim proposed to be made against predatory lenders is an action for "theft by deception," a criminal act in Washington. The DFI’s view is that existing laws should be enforced more vigorously, as most predatory practices are already illegal under its lending laws.

C. City Government Responses

Chicago is the first city in the United States to address predatory lending through a city ordinance. On August 30, 2000, the City Council agreed 47-0 to prevent banks engaged in predatory lending from accepting city deposits or acting as underwriters on municipal bond issues. (The original proposal prohibited the financing of lump-sum credit life insurance, but this element was defeated.) A financial institution cannot be a depository for the City of Chicago unless it makes the following pledge:

We pledge that we are not and will not become a predatory lender as defined in Chapter 2-32 of the Municipal Code of Chicago. We further pledge that none of our affiliates is, and none of them will become, a predatory lender as defined in Chapter 2-32 of the Municipal Code of Chicago. We understand that becoming a predatory lender or becoming an affiliate of a predatory lender may result in the loss of our designation as a municipal depository.¹⁹

The same pledge must be made with each bid submitted by a financial institution for any contract with the city.

Other practices prohibited by Chicago include engaging in deceptive acts that may result in foreclosure, lending without regard to repayment ability, and the financing of fees and points in excess of 6% of the loan amount.

Baltimore’s City Council has also introduced an ordinance that would prohibit the city from depositing its funds with, or awarding contracts to, predatory lenders.²⁰

Other cities are addressing predatory lending in different ways. In Washington, DC, a bill introduced in the City Council would inhibit foreclosure, by permitting homeowners to contest foreclosure on the ground that the loan was predatory when made.²¹ A loan made to a borrower with insufficient repayment ability could be considered predatory, or one in which the lender encouraged the borrower to default on another loan. New York City, in addition to relying on rules of the New York Banking Department (Part 41, discussed above), is also the test site for a $1.1 million program of the Department of Housing and Urban Development, which will issue grants to counseling groups that provide homeownership counseling to FHA borrowers before a loan is made. ²²

Adoption of predatory lending restrictions at the city or local level is a worst case scenario for lenders and brokers. A patchwork of non-uniform laws, regulations and city-level ordinances on permissible lending practices would make it virtually impossible for national lenders and multi-state brokers to track and comply with the law.

The MBA opposes the recommendations of the HUD/Treasury Task Force, stressing that piecemeal regulatory fixes will prove ineffective. The MBA believes that comprehensive mortgage reform is the only appropriate way to deal with predatory lending. The reform program would include a closing cost guarantee with new disclosures in place of existing Truth-in-Lending and RESPA disclosures; legislation prohibiting improper practices and establishing penalties; a new system of consumer remedies; expanded borrower counseling and consumer education; and a commitment to use best practices in mortgage origination and servicing.²³

The MBA is also working with joining the National Council on Economic Education to educate consumers about mortgages and the economics of home ownership. The MBA has provided a $132,000 grant to conduct courses related to choosing the best mortgage; the courses will be offered at libraries, schools and other sites.²⁵

The National Association of Mortgage Brokers (NAMB) has stated that the best solution to the predatory lending problem is a two-fold approach: increased enforcement of existing laws and industry self-regulation.²⁶ Like the MBA, the NAMB has a best practices initiative, focused on consumer disclosures. The NAMB has also proposed a universal registry of loan originators, which would be available to employers, wholesalers and secondary market agencies. Complaints against bad actors would presumably lead to the refusal of reliable companies to do business with them and hopefully, drive them out of business.²⁷

Fannie Mae and Freddie Mac have established anti-predatory lending guidelines and have stated that they will not purchase loans that are not suitable and fair. Fannie Mae's underwriting guidelines and Mortgage Consumer's Bill of Rights prohibit these practices in connection with loans it buys: (1) steering consumers to high-cost products; (2) charging excessive fees (generally more than 5%); (3) charging prepaid single premium credit life insurance; and (4) charging prepayment penalties unless the borrower was given an alternative without a penalty or the borrower gets a benefit in exchange for giving up the ability the right to prepay without penalty.²⁸

Freddie Mac is implementing a nationwide public service campaign to warn American homebuyers about predatory lending traps.²⁹ The Don't Borrow Trouble campaign uses a mix of ads, websites, and other announcements to educate borrowers about making informed credit decisions and will run in Chicago, Baltimore, New Orleans, Los Angeles, Oakland, Raleigh-Durham, Cleveland, and other cities.

Consumers have gone to court and to the media with stories of abusive lending. About five years ago, a TV news magazine show did an exposé of equity stripping loans in Atlanta, Georgia, bringing national attention to exploitative lending practices there. The lender involved set up a multi-million dollar loan program to make affordable loans available in an attempt to counter the negative publicity. In Washington, DC, a court recently awarded a disabled 61-year old nearly $200,000 in attorney's fees and more than $8,000 in damages against his lender under the District's consumer protection law. The lender refinanced the borrower's mortgage at 13.9%. The borrower's monthly income was $1,200 but his combined loan payments and health insurance payments were nearly $800. The potential for a wave of anti-lender lawsuits against lenders is enormous if predatory lending initiatives continue to spread and consumer advocates become more aggressive in pursuing remedies on behalf of borrowers.

Lenders and mortgage brokers have taken a reactive posture to the wave of legislative and regulatory initiatives on predatory lending. Their arguments against new laws are that they will not cure the perceived harm, will result in the restriction of credit to needy borrowers, and are not necessary if existing laws and regulations are enforced. In light of the increasing publicity given to predatory lending and specific tales of victimization, a more pro-active approach might be appropriate.

One possibility is industry creation of a recovery fund for the victims of predatory lending. A fund would provide a tangible remedy for genuine damage caused by abusive lending practices. In addition to monetary compensation, by creating a list of lenders and brokers whose actions cause payout from the fund, the recovery fund could help prevent reputational damage to legitimate lenders and brokers.

Similar or analogous funds could provide a blueprint. In Chicago, the Neighborhood Housing Services of Chicago, City of Chicago, and 14 Chicago area lenders have established the Neighborhood Ownership Recovery Mortgage Assistance Loan Program³⁰ to refinance predatory loans with more affordable fixed-rate loans and to provide counseling services. Florida’s mortgage broker licensing law includes a mandatory payment by registered mortgage brokers which is used to fund a recovery fund to compensate victims of brokers engaged in unlawful acts. The Securities Investor Protection Corporation (SIPC) protects customers of registered broker-dealers against losses caused by the financial failure of the broker-dealer. The SIPC is not a government agency or regulatory authority, but a nonprofit, membership corporation funded by its member broker-dealers.

The difficulty of defining predatory lending has not prevented an avalanche of proposals to eliminate it. The federal governments efforts appear unlikely to advance rapidly or soon, and will be delayed by agency deliberation about appropriate, comprehensive and meaningful rules. Non-uniform state and local efforts are already being implemented, however, and will probably flourish in the near future. Patchwork regulation will make compliance more difficult and costly for lenders, and increase the risk of inadvertent non-compliance. Seizing on opportunities created by a complex legal environment, consumer advocates and lawyers may create a tidal wave of litigation alleging predatory practices. Lenders might then retreat to conventional lending only and avoid marginal borrowers.

These results might be forestalled if the lending and brokerage communities jointly identify abusive practices, adopt an industry-wide best practices platform, and voluntarily establish a recovery fund to remedy the harms caused by predatory lending.