Fed Governor Addresses Subprime, Predatory Lending

The following is excerpted from a speech made by Federal Reserve Governor Edward M. Gramlich in Philadelphia last Dec. 6 at a conference on predatory lending.

Among the complex issues that surround predatory lending is the overgeneralization that sometimes occurs when the terms "subprime lending" and "predatory lending" are equated. It is important that the distinction between the generally beneficial subprime market and destructive predatory lending be kept clear. One of the welcome developments in recent years is the expansion of the home mortgage market to all socioeconomic classes. Studies of data submitted under the Home Mortgage Disclosure Act (HMDA) have shown that lower-income and minority consumers, who have traditionally had difficulty in getting mortgage credit, have been granted loans at record levels. Specifically, conventional home-purchase mortgage lending to low-income borrowers increased nearly 75 percent between 1993 and 1998, compared with a 52 percent rise for upper-income borrowers. Also during this time, conventional mortgages to African-Americans increased 95 percent and to Hispanics, 78 percent, compared with a 40 percent increase in all conventional borrowing.

Much of this increased lending can be attributed to the development of the subprime mortgage market. This rapid growth has given access to credit to consumers who have difficulty in meeting the underwriting criteria of "prime" lenders because of blemished credit histories or other aspects of their profile.

But along with this positive development have come increasing reports of abusive lending practices, targeted particularly at female, elderly and minority borrowers. These practices, many of which can result in consumers' losing much of their equity in their home or even the home itself, are commonly referred to as "predatory lending."

The term "predatory lending" is far-reaching and covers a potentially broad range of behavior. As such, it does not lend itself to a concise or a comprehensive definition. But typically predatory lending involves at least one, and perhaps all three, of the following elements:

• Making unaffordable loans based on the assets of the borrower rather than on the borrower's ability to repay an obligation;
• Inducing a borrower to refinance a loan repeatedly in order to charge high points and fees each time the loan is refinanced ("loan flipping"); and
• Engaging in fraud or deception to conceal the true nature of the loan obligation from an unsuspecting or unsophisticated borrower.

Some of these practices are clearly illegal and can be combated with legal enforcement measures. But some are more subtle, involving misuse of practices that can improve credit market efficiency most of the time. For example, the freedom for loan rates to rise above former usury law ceilings is mostly desirable, in matching relatively risky borrowers with appropriate lenders. But sometimes, the payments implicit in very high interest rates can spell financial ruin for borrowers. Most of the time, balloon payments make it possible for young homeowners to buy their first house and match payments with their rising income stream. But sometimes, balloon payments can ruin borrowers who do not have a rising income stream and are unduly influenced by the up-front money. Most of the time, the ability to refinance mortgages permits borrowers to take advantage of lower mortgage rates. But sometimes, easy refinancing means high loan fees and unnecessary credit costs.

Often mortgage credit insurance is desirable, but sometimes the insurance is unnecessary, and sometimes borrowers pay hefty premiums up-front and often as their loans are flipped. Generally, advertising enhances information, but sometimes it is deceptive. Most of the time, disclosure of mortgage terms is desirable, but sometimes key points are hidden in the fine print.

Apart from outright fraud, predatory lending often entails the abuse of complex mortgage provisions that are generally desirable and advantageous to a borrower, but only when they are fully understood by the borrower.

The Congress has passed a number of statutes in this area. One important statute is the Home Ownership and Equity Protection Act (HOEPA) of 1994. The basic approach of HOEPA is to shine a bright spotlight on high-cost mortgage loans. For these high-cost loans, certain practices—balloon payments in the first five years and prepayment penalties—are banned. In addition, for HOEPA-covered loans, creditors must provide a short disclosure to borrowers three days before the loan is closed, in addition to the normal three-day rescission period for other mortgage loans.

The present legislative trigger for HOEPA is the Treasury rate on comparable maturity loans plus 10 percentage points. There is also a test for points and fees. The Board (of the Federal Reserve System) has the authority to alter the HOEPA threshold trigger rate to between 8 and 12 percentage points and to alter the points and fees included in that test. A study by the Office of Thrift Supervision estimates that the share of subprime mortgage loans falling under HOEPA is about 1 percent now and would rise to about 5 percent were we to use our full authority. But these percentages are based on rates alone, and many subprime lenders feel that HOEPA coverage is much broader than this when the points-and-fee test is factored in.

The Home Mortgage Disclosure Act requires depository and certain for-profit, nondepository institutions to collect, report and disclose data about applications, originations and purchases of home mortgage and improvement loans. Data now reported include the type, purpose and amount of the loan; the race or national origin, gender and income of the loan applicant; and the location of the property.

In evaluating potential changes to the act's reporting requirements, the Board considered whether the changes would improve the quality and utility of the resulting data. The Board took into account changes in the home mortgage market, including growth in areas such as home equity lines of credit and subprime lending. The objective of the proposed changes is to enhance the public's and agencies' understanding of the home mortgage market generally and the subprime market in particular.

The three fundamental changes offered in the proposal would:

• Increase the number of nondepository lenders required to submit data;
• Clarify and expand the types of reportable transactions; and
• Specify new loan elements to be included in the data.

Other steps may need to be taken, and may be taken, to deal with predatory lending. But we should be able to agree that more information is an important prerequisite to sensible policies in this area. At this point, we have plenty of anecdotes about predatory lending but not much hard information. Increased HMDA data collection is the first step in gaining broader understanding of the business practices of subprime lenders and in helping us distinguish appropriate from inappropriate lending practices.

Beyond this, we should all recognize that the best defense against predatory lending is a thorough knowledge on the part of consumers of their credit options and resources. Educated borrowers who understand their rights under lending contracts and know how to exercise those rights can thwart predatory lenders. As the knowledge base of consumers grows, the market for credit-at-any-cost diminishes. A massive educational campaign is needed to bring about this expanded consumer knowledge.

The Federal Reserve will continue to do its part through its consumer and industry education efforts. Both the Board and our 12 Reserve Banks will continue to promote our many programs designed to improve consumer financial education and literacy.