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Monday, June 8, 2009

The Predatory Lending Farce

Those that think that the Obama economic policy is something out of their nightmare should read this piece from the Nation and understand that things could be much worse. Economic populists think that President Obama hasn't gone nearly far enough in protecting consumers against unscrupulous creditors in all sorts of ways. True believer economic populists even think the credit card bill of rights passed by the President was nothing more than window dressing.

The much-celebrated "Credit Cardholders' Bill of Rights" is a fresh example of how the Democratic Party tries to have it both ways--avoiding the tough votes while mollifying the folks. The credit card reform measure imposes new rules on the industry and does away with many of the most outrageous gimmicks bankers use to extract more money from debtors. Banks cannot raise interest rates retroactively on old credit card balances or pile on hidden fees or fail to give advance notice for rate increases. These and other changes are worthy.

The achievement seems less courageous if you know that Congress was largely ratifying the regulatory rules already adopted by the Federal Reserve last year. Or that the legislation gives the industry another nine months to gouge their customers before the new rules go into effect. Or that Visa and MasterCard, Citigroup and JPMorgan Chase are free to raise future interest rates to the sky--without limit. That is the industry's intention, as bank lobbyists reported after the bill was passed.

These folks will soon fixated on the concept of predatory lending. You can also bet that at some point President Obama will try and take up legislation against this concept. Nothing says that you are sticking up for the little guy than going after "predatory lending". I am here to say that the concept is bunk and any and all legislation to curb it will turn out to be totally counter productive.

To crysallize the problem of countering "predatory lending" let's first look at this article from a North Carolina paper.

There is no specific definition about what exactly predatory lending entails, though most observers believe that the description applies when lenders take advantage of borrowers by charging high interest rates and consider only the value of a borrower’s assets, as opposed to what the borrower can afford to pay.

In other words, predatory lending is like porn, no one knows exactly how to define it but we know it when it's in front of us. I'm here to tell you that if you can't define it, you aren't going to be able to legislate against it.

To really understand how absurd predatory lending is, I will tell you a story about my mentor in the mortgage business. At it's height he was making several hundred thousand yearly. He wound up purchasing several pieces of property including a home, for himself, with eight bedrooms that went for nearly a million dollars. When the business turned the wrong way, he began struggling with all his debt.

He fell behind on his real estate taxes, and needed a new loan to pay them off. Because he couldn't show income, he found another mortgage broker to do the loan for him. Initially, he was promised a rate of 8.99%, but when he showed up to the closing, the rate was 10.99%. My mentor was stuck. He needed his past due taxes paid, but he knew he couldn't afford the new loan. He finally relented and took the loan.

Of course, he fell behind on this loan. When the bank went to foreclose, he counter sued under several predatory lending laws. First, there was the issue of the rate changing at the end. There were other technical issues like a closing document, the right to cancel, being missing from his closing documents. My mentor was explaining in detail exactly how the law was on his side when I got bored. I realized something and so I asked him this critical question.

Let me see if I understand you. You are suing on the concept that you are too dumb to realize that you're being ripped off. Only, the reason you know how to sue is because you're so sophisticated that you know exactly how you were ripped off and how it was illegal.

My mentor won and eventually was allowed to sell and walk away with $25,000 in cash. If a mortgage broker can sue under the concept of predatory lending, then you know the concept is bunk.

Think of predatory lending as the financial version of hate crimes. Most things under "predatory lending" are already illegal: fraud for instance, but legislators feel it is so egregious they must legislate it even more.

The problem is that the concept is vague and so legislating it becomes counter productive. Often, legislators put caps on interest rates because "excessive rates" is one common description of "predatory lending". Of course, the problem is that "excessive" is in the eye of the beholder. As such, rather than the market determining the maximum rate charged a bureaucrat does. In Illinois, we have something known as the Illinois High Cost law. This sets the maximum rate that anyone can charge and also a maximum amount of fees. I've been fortunate to only run up against Illinois High cost on a few occasions however in each case perfectly good loans were taken away even though all parties agreed to the terms because the rates wound up being just over the maximum allowed by the law. This law, like all like it, is very vague and so each bank interprets it differently so often a loan isn't discovered to be out of bounds of Illinois high cost until the end. Here is one example.

The term Clear to Close is an industry term indicating what all of you should infer. This is the last step before closing. This is the step that my protege got the loan to before Illinois High cost took over. The loan was sent to the closing department only to have the closing department determine at the end that the loan in its current form was ILLEGAL. In other words, the closing department determined that the loan exceeded Illinois high cost regulations. Yes, despite carrying it through the process, signing all the necessary documents, and most importantly having complete borrower approval, the rate on this loan was too high. Not too high for the borrower mind you, but rather for some bureaucrat in Springfield, Illinois.

The bank of course was not immune for criticism. The rate on this loan was the same at the end as it was in the beginning. Only an incompetent or cruel bank could possibly allow for such a determination to be made in the end rather than in the beginning. The situation is complicated by the fact that this loan is an adjustable rate mortgage meaning its rate was only fixed for the beginning of the process. As a result when the bank determines the APR, they ACTUALLY allow a software system to project future rates and let that play a determination in the APR.

There is another concept that people associate with predatory lending and the concept is "transparency". You can bet that when law makers take up predatory lending legislation they will make sure to talk about "transparency". I am all for "transparency" except in mortgages. That's because "transparency" really means that the government will create yet another document for borrowers to sign before they can close. For instance, in Illinois, lawmakers started to notice that borrowers were being taken advantage of by being put into loans that didn't benefit the borrowers. Lawmakers thought that if borrowers knew what benefit said loan had they would be in a better position to judge if they should move forward.

As such, the state of Illinois passed into law the Illinois Fairness in Lending Act. In this act, Illinois law now mandated the Net Tangible Benefits disclosure. This disclosure stated just exactly how the borrower was benefitting from the loan (lower rate, lower payment, fixed rate, cash out, etc) In reality, borrowers were forced to sign yet another document they didn't understand or care about and made the process for them even more overwhelming. The whole idea was absurd. If someone didn't know how a loan was benefitting them and still was ready to close, no document was going to help them anyway. All the Illinois legislature did was make sure that everyone had to sign yet another document.

More predatory lending legislation will only mean that closing a mortgage will now require two hundred signatures not just one hundred. It's yet another practical example of what "predatory lending" legislation will mean in practicality.


steveherbln said...

True. Another piece of manipulative confusing piece of paper will get added to the loan. However the focus on predatory lending is the steering from the broker and lender to place the homeowner in unaffordable loan such as the Option- ARM which qualifies them to only make the Negative payment. Under the HOPEA there is a law preventing this. But the who lied on what is the battle. Why is it a mechanic can lose their business after three complaints from the Automotive Bureau and a doctor can be sued for malpractice. Both occupations require a signature from the client. Can't they say the consumer lied? What is needed is a seperate business entity for some one to underwrite the loan.

Steve G. said...

No, predatory lending is NOT a farce. It is a serious problem, and its definition is NOT elusive. However, it refers to many different practices in which a loan broker takes advantage of a borrower, establishing and then breaching a fiduciary duty by selling an "unsafe" loan.

A loan is unsafe when the purposes of both sides of the transaction cannot be met by its terms. That is, a borrower is entitled to rely upon the representations of a loan broker, because the size, extent, and complexity of a loan transaction is to be disclosed in advance of the process of signing a contract.

A number of firms, including Countrywide and Washington Mutual, just to name a couple, engaged in a process of advertising a loan for one price, and swapping it for a loan at a different price, at the time of closing.

Another typical method of engaging in predatory lending, is to not disclose the cost of the loan transaction until after the loan has been funded.

Yet another, is for the lender to pay a sizeable kickback to the loan broker. Now, you say, that cannot be predatory. After all, the loan broker has a right to earn some income for his or her work. But that is not really the problem. The problem is one of bait-and-switching. A typical method involves selling the borrower a loan that includes "prepaid interest" guised as "discount points." To illustrate, imagine a borrower qualifies by the lender's standards, for a 5% loan. But the loan broker sells a 5.125% loan instead. The missing 0.125% is called a "yield spread premium" which the lender amortizes over the term of the loan, in order to pay the loan broker a kickback that is not disclosed to the borrower.

Well, you think, what's wrong with that?

What's wrong, is that the broker establishes a fiduciary duty with the borrower, and then establishes a confidential relationship with the lender, while misinforming the borrower that his excess was actually a discount -- when it was actually a premium. it is dishonest.

Another tactic is "points." Points are almost always paid to the broker, as if for the purpose of reducing the rate of the loan. But rather, they are for the purpose of increasing the cost of the loan.

Finally, another method is one of adding a back-end prepayment penalty. During the housing bubble, a significant number of loans would be refinanced, as housing prices routinely increased. The prepayment penalty would not be disclosed, but nevertheless increase the cost of a loan by about $5,000 -- which the lender would promptly pay to the loan broker without disclosure to the borrower.

In one notorious case, the prepayment penalty rider was not signed by the borrower, until the female loan broker visited the borrower, a day after the other loan documents were signed, bringing with her the prepayment penalty agreement and a bottle of Vodka.

Asked whether he would have paid $4,800 for the lady or the bottle of Vodka, the borrower said "no, there are cheaper women and cheaper bottles of vodka. I had no idea what I was paying for."

Two years later, the house has ZERO equity, the broker has left town, and the borrower is facing foreclosure. He was not smart enough to realize that he was borrowing more than he could afford.

So I think there are many unambiguous examples of predatory lending. Most people, when borrowing money to purchase their personal residence, do a lousy job of checking the math. They are permitted to trust their loan brokers, who must not betray them.


mike volpe said...

Did you read my piece? It doesn't sound like it Steve.

One of the examples you gave was an example I gave. Every example you gave is an example of fraud. Fraud is already illegal. Yet, folks like you want to create another category called "predatory lending".

The reason that people sign documents at the beginning and at the end is to avoid all the situations you just described. So, exactly what new laws are asking for?

If rates change from the start to the end of the loan that's fraud. If a pre payment penalty isn't disclosed that's fraud.

Why say it's also predatory lending. Fraud is already illegal. Why would you need to add another layer of laws when it's already fraud.

The example you describe is NOT yield spread premium. YSP is the amount that the bank pays to the broker to take the loan off their hands. All loans have pre paid interest. That is a standard part of any closing. The example you describe simply doesn't exist.

You can't simply add a "pre payment" penalty. That has to be disclosed at closing and it has to be disclosed at the beginning. Finally, loans with pre pays no longer exist anyway.

Costs have to be disclosed at closing. You can't add in costs after the loan has closed. That just can't happened. If it ever did, that would also be considered fraud which is already illegal.

I don't know where you get your examples but most of aren't in reality.

Finally, your definition of predatory lending is vague and nonsensical.

" it refers to many different practices in which a loan broker takes advantage of a borrower, establishing and then breaching a fiduciary duty by selling an "unsafe" loan.

A loan is unsafe when the purposes of both sides of the transaction cannot be met by its terms. That is, a borrower is entitled to rely upon the representations of a loan broker, because the size, extent, and complexity of a loan transaction is to be disclosed in advance of the process of signing a contract."

What in the world does that mean, and how do you determine this. Borrowers already sign at the beginning and at the end. The loan process inherently creates all the mechanisms you speak of.

Did you copy and paste everything because it doesn't sound as though you know what in the world you are talking about on this topic.

Anonymous said...

the problem is not the imaginary lie and bs canard created by leftist liars to cover up their disaster so called "repdatory lending" aka lendig to people who can't afford it Fannie Mae and Freddie Mac entire mo was doing this and buying up contracts from companies "insuring"(credit defaults)losses so you had companies making loans to sell them to the state. The state assumed the responsibility of it the investor is the onyl one and the business with the bill stuck on it in this gov created CRA started, low criminal interest rate bs started by Rubin, Clinton, Greenspan and criminals like Obama who waged lawsuit terrorsm forcing bank "affirmative action" aka handing money to people who have no way in hell to pay it back. Fueled by credit expansion it ballooned. Mindless leftist consumerism and anti-producer anti real economy fascist lies by the nuts and commie sin the media creating ghosts and hobgoblins mere figments of the imagination that have never and real never exists.

Tom Henry said...

Another typical method of engaging in predatory lending, is to not disclose the cost of the loan transaction until after the loan has been funded.