Funding all those ARMs

Predatory Lending: The Study and a Verdict
by Lucy Griffin, BOL Guru

There is predatory lending in Jefferson County, Kentucky. The Urban Studies Institute at the University of Louisville has completed a study for the Louisville Urban League. The findings are interesting - and clear. The entire financing industry should be concerned about predatory lending. Responsible financial institutions should take active steps to prevent predatory lending and to educate consumers. This is not a study that can be dismissed with allegations of bias. The study is carefully done. The results are clear. In short, it is convincing.

The Practices
The researchers identified specific lending practices that would be considered predatory. These include the familiar practices such as loan flipping and churning, packing loans with up-front costs such as credit life insurance, offering loans with low installments but large balloon payments, and high to excessive rates.

The study also included practices that have not been so frequently identified. One problem is the use of inflated appraisals to support making a loan that the borrower cannot afford and the property cannot support. Along with this practice is the question of inflating the applicant's income to make them appear to qualify for the loan.

The study also identified loans with prepayment penalties, particularly when the penalties are imposed on loans with high interest rates. Other practices fall into unfair or deceptive categories, such as misleading or fraudulent advertisements, aggressive marketing or sales practices, using pressure or intimidation, fraudulent home repair schemes, and forcing customers to sign notes with mandatory arbitration agreements.

The Methodology
After evaluating a series of practices and considering how to determine their frequency, the researchers honed in on several practices that, particularly when used in tandem, were measurable as well as causing consumer harm. These included loans with very high interest rates, loans with prepayment penalties combined with high interest rates, balloon payment loans, and high loan-to-value ratios. The researchers examined court records for foreclosures that resulted in auctions. The 1,555 records covered a three year period from January 2000 through December 2002. The theory behind the methodology was that predatory lending is likely to result in foreclosures and that therefore foreclosures produce material for the study.

In addition, there were plenty of foreclosures. The report noted that mortgage foreclosure rates have increased dramatically in the state. In Jefferson County, the locus of the study, foreclosures increased from 438 in 1995 to 1,262 in 2002.

The researchers used court records as the information source for the study. These documents provided information about interest rates, prepayment penalties, balloon payments, the principal amount of the loan, and the auction appraisal and sale prices.

This information was used to identify four indicators that suggest predatory loans. These measurements were very high interest rates defined as rates that make the loan subject to HOEPA, prepayment penalties combined with high interest rates, balloon payments, and high loan-to-value ratios. While not including all characteristics of predatory loans, each of these loan characteristics went to the heart of the matter: the ability of the borrower to repay based on loan pricing and underwriting.

The Findings The researchers used the selected predatory loan characteristics to identify the loans for analysis. Of the 1,555 foreclosures studied, 509 foreclosures were on loans with one or more predatory characteristics. Of these loans, which constituted almost a third of the loan pool studied, almost three quarters (73%) had prepayment penalties combined with high interest rates.

The study also found that 57% of the loans with high interest rates had prepayment penalties while only 19% of loans with lower interest rates had prepayment penalties. The conclusion is inescapable: lenders use prepayment penalties to make it difficult or expensive for a borrower to refinance to reduce the interest rate. In effect, if the borrower learns that the rate is unfairly or unnecessarily high, the borrower may also find that refinancing is too expensive because of the prepayment penalty. These are loans where the lender - or predator - is going to make a profit either way.

Of the loans identified as predatory, 29% had balloon payments, 10% had very high (HOEPA) interest rates, and 5% had high loan-to-value ratios. While significant, these numbers leave the high rate-prepayment penalty loans as the primary predatory product.

There's more
The analysis showed that the loans that went into foreclosure were relatively new loans. In most of the cases, the loans were only 2 - 4 years old. And it gets worse. The data showed that in 65% of the entire sample and 61% of the sample with predatory characteristics, the foreclosure purchaser was the original lender.

Finally, the researchers looked at geography. They found that homeowners with mortgages were more likely to experience foreclosure in areas where there were high poverty levels and minority population.

Who Are the Predators?
The report also names names. And there are a lot of bank names on the list. This is in part because the researchers used the bank name to represent the entire holding company. So if The Associates had made some of the loans that landed in the foreclosure study, the loans were put into the Citibank bucket. The named banks included Bank One, USBank, Banker Trust Company of California, and Citigroup. Together, these four institutions accounted for over 25% of all predatory foreclosure loans.

The report notes that while active subprime lenders such as the Kentucky Housing Corporation accounted for a large number of foreclosures, these lenders had relatively few foreclosures involving loans with predatory characteristics.

Rebuttal
Industry members studied do have some points in rebuttal. For example, some practices defined as predatory were not further analyzed. The existence of a prepayment penalty was treated equally, even though some penalties were clearly punitive while others were less significant.

From another angle, it is not unusual or atypical for the lender to be the primary bidder at the foreclosure auction. This kind of self-bidding is not necessarily evidence of a predatory practice. In fact, if the loan was made simply to make a profit on the property, the practice of self-bidding doesn't make sense. Moreover, this observation is made without any further analysis of what ultimately happened to the property.

ACTION STEPS

Take a hard look at your lending products. Look for products that could be considered predatory.
Now look at how these products are marketed. Take steps to upgrade the marketing if any information is withheld or the ads could be considered deceptive.
Analyze your lending, denial, and collection practices by loan product and geography. Look for any patterns or discrepancies that could be considered predatory.
Compare age of loans to foreclosures and collections to identify potential problem products or practices.
Give your lenders and your board the list of practices that are considered predatory and advise them to avoid the practices.
Find out about affordable housing loan programs in your market. Compare your loan products to a city, county or state affordable housing program.