Issue: October, 2005
Author: Dee Pridgen
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Predatory Lending: The Hidden Scourge of the Housing Boom
An elderly widow is contacted at her home by a home improvement salesman who tells her she needs to replace the siding on her house because it is dirty and not up to code. She signs a contract for $17,000 on the assurance of the salesman that he can obtain financing for her. He presents her with what she believed was an application for a home improvement loan, which she signs although she does not receive any copies. Some weeks later, she is picked up and driven to a mortgage lender’s office to sign closing papers for a $49,000 mortgage loan, with payments of $459 per month, even though her total monthly income consists of $713 in social security benefits. The salesman says the extra money is for other home improvements and to buy her a car. These extras never appear and the siding job is substandard. The lender soon institutes foreclosure proceedings when the widow (predictably) cannot keep up with the payments. She later learns that her loan application had falsely stated that she earned $1500 per month as a quilt maker.
This scenario illustrates a typical case of predatory lending. These types of lending transactions represent a dark cellar of the residential mortgage industry. “Predatory” lending is typically focused on borrowers in the “subprime” sector, who do not qualify for conventional loans. This type of lending is also characterized by high rates and fees, due in part to the higher risk to the lender. What separates a legitimate high rate/high risk loan from a predatory loan is the presence of one or more of the following practices:
• Targeting of and aggressive marketing toward the elderly, racial minorities, and low income consumers.
• “Packing” the transactions with excessive fees, such as single premium credit insurance, prepayment penalties, and yield spread premiums (broker commissions paid by the lender and added to the consumer’s APR).
• “Flipping” or repeated refinancings over short periods of time, such that with each refinance, the loan originator collects additional fees and penalties, thus eating away at the borrower’s remaining equity.
• “Equity stripping” or lending without regard to the borrower’s ability to repay. Where a vulnerable consumer may be “equity rich but cash poor,” a predatory lender may be willing to set up a loan with a view toward foreclosure.
• Fraud and misrepresentations, where homeowners are led to believe their payments will be low, that they don’t qualify for a more favorable loan, or are sold overpriced and low quality goods or services.
Predatory lending appears to have sharply increased in the last 10-15 years. Subprime loans, of which predatory lending is a part, increased from $35 billion in 1994 to $160 billion in 1999, accounting for 12.5% of all residential mortgages. By 2003, subprime lending was at $330 billion and going strong. Furthermore, as of 1999, 82% of subprime first lien mortgages were being used not to purchase homes, but for home improvements or consolidation of credit card debt.
This increase can be attributed to several factors. First, as a result of rising home prices, more consumers had equity in their homes to use as collateral. Second, the federal government preempted usury ceilings on most home mortgage loans in the early 1980’s, making higher loan rates possible. Third, the tax law was amended to eliminate the deduction for interest on consumer credit, while retaining it for interest on loans secured by a home. Fourth, the industry began to “securitize” mortgage loans, by pooling them together and then offering them for sale to investors. This practice provided a flow of capital for mortgage lenders outside of the heavily regulated depository institutions that had traditionally been the main source of home mortgage loans.
The victims of predatory loans have a variety of legal remedies. On the federal side, these include: the Truth in Lending Act (TILA), the Real Estate Settlement Procedures Act (RESPA), the Home Ownership and Equity Protection Act (HOEPA), which is a 1994 addition to TILA, the Equal Credit Opportunity Act (ECOA), the Fair Housing Act, and the Federal Trade Commission Act. There are also various state laws and doctrines that can apply, including: state unfair and deceptive trade practices acts, common law fraud and unconscionability, and special state anti-predatory lending statutes.
The Truth in Lending Act requires the disclosure of credit costs in all consumer credit transactions, and also provides a three-day right of rescission for loans secured by the consumer’s principal dwelling. Predatory lending victims often allege that they were not given proper notice of the costs of credit or of their right to rescind, which can extend the right to rescind for up to three years. RESPA also requires disclosures of settlement costs and prohibits “kickbacks” to mortgage brokers.
HOEPA was passed by Congress in 1994 specifically to deal with high-cost mortgages. It uses a “triggered” approach, meaning that residential non-purchase mortgage loans with an APR of 8 percent or higher above the rate for U.S. Treasury securities, or with points and fees of more than 8% of the total loan amount, are subject to special disclosures and prohibitions. The HOEPA disclosures must be given at least three days prior to closing (a “cooling off” approach), in contrast to TILA disclosures which can be given any time up to the very last moment of “consummation.” In addition to the disclosures, if a particular loan meets the HOEPA criteria, certain particularly oppressive terms and practices are prohibited, such as prepayment penalties, default interest rates, balloon payments, negative amortization, prepayment of more than two payments, refinancing within one year, and asset-based lending. HOEPA also subjects assignees to greater liability for violations than the normal TILA standards, a very important provision due to the fact that most predatory loans are sold to other entities which would otherwise be shielded from legal responsibility for the wrongdoings of the original mortgage broker or creditor.
Because predatory lending is targeted at specific groups of vulnerable consumers, including racial minorities and women, it has been attacked as illegal credit discrimination by virtue of “reverse redlining” or providing credit to certain groups on less favorable terms than are available to other consumers, stating a cause of action under either the ECOA or the FHA or their state law equivalents.
The Federal Trade Commission has also used its authority under the HOEPA, ECOA and the FTC Act to challenge predatory lending practices of several large mortgage lenders, including Delta Funding, First Alliance, Mercantile Mortgage Company, Associates First Capital Corporation (now a subsidiary of Citigroup), and Fairbanks Capital Corporation. These cases resulted in injunctions and monetary settlements up to over $200 million.
All states, including Wyoming, have unfair and deceptive practices statutes modeled on the FTC Act. These laws can also be used to challenge the deceptive marketing practices and unfair contract terms in predatory lending cases. These state laws have both a private right of action and a provision for enforcement by the state attorney general. It is also possible for private parties who have been victimized by predatory lenders to use the common law doctrines of fraud and unconscionability, particularly as defenses against a foreclosure action by the creditor.
Despite this seemingly long list of legal weapons, predatory lending has not been stopped. Critics have charged that the HOEPA thresholds have been set too high, allowing lenders to set their APR or fees just below the “trigger” and continue making profitable but predatory loans. Also, since open-end credit is exempt from HOEPA, it is feared that abusive loans will be structure as open-end home equity plans. Other approaches have been stymied by Holder in Due Course protection for distant assignees of predatory loans, as well as mandatory arbitration clauses that take the dispute out of court and into more expensive private arbitration. In response to the perceived weakness of existing legal remedies, over 25 states, including Wyoming, and several municipalities, have passed their own state statutes or local ordinances aimed at curbing abuses in residential mortgage lending. North Carolina was the first to start this trend, using a triggered approach like HOEPA, but casting a wider net than HOEPA, and also including its own list of prohibited practices. The new Wyoming Residential Mortgage Practices Act, passed in 2005, institutes a licensing system for residential mortgage lenders and brokers and also requires a special disclosure of prepayment penalties.
While some view the outpouring of state laws as a welcome crop of legislative experiments, others point to the fact that significant variations in lender obligations can increase compliance costs for interstate lenders. Citing the value of a uniform national system for regulating the financial services sector, several federal regulatory agencies have asserted preemption authority that would nullify much of the impact of the state and local anti-predatory lending laws on federally regulated financial entities. The Office of the Comptroller of the Currency (national banks), the Office of Thrift Supervision (savings and loans), and the National Credit Union Administration (credit unions) have all promulgated regulations preempting state laws in this area. At the same time, the OCC has also announced supervisory standards to address predatory lending, including an advisory stating that banks should adopt policies and procedures to avoid lending without regard to the debtor’s ability to repay, and asserting that the FTC Act’s ban on unfair or deceptive acts or practices can be used to address predatory lending practices, such as flipping and equity stripping. As more subprime lenders become subsidiaries of federally or state-chartered banks, the impact of the state laws may be diminished.
Predatory lending is unfortunately a fact of life in all states, including Wyoming. Legitimate mortgage lenders will want to comply with relevant laws. Abusive practices that occur can be addressed by the panoply of legal approaches currently available, as described above. With the new licensing statute in place in Wyoming, however, a clearer picture of the extent of the problem here should emerge, and even stronger protections for consumers may be called for.
Mary “Dee” Pridgen is Associate Dean and Professor of Law, at the University of Wyoming’s College of Law, where she has taught since 1982. Her subjects include Consumer Protection, Contracts, Antitrust, Communications Law, Constitutional Law, and Internet Law. She received her Juris Doctorate in 1974, from New York University, and a B.A. in 1971, from Cornell University. She is a member of the Order of the Coif and Phi Beta Kappa. Pridgen has been a Fulbright Scholar/Lecturer at Tokyo University in Japan and a Visiting Professor of Law at the University of Baltimore School of Law, the University of Maryland School of Law, and the Catholic University of America, Columbus School of Law. She also served as a Staff Attorney, for the Federal Trade Commission, Bureau of Consumer Protection, Washington, D.C. from 1978-82. Pridgen's publications include two treatises aimed at practicing attorneys, Consumer Protection and the Law, and Consumer Credit and the Law, both published by West Group. She is also a coauthor of a law school casebook entitled Consumer Law: Cases and Materials (West 2d ed.). She has written articles and reports on consumer law, and has given presentations at international consumer law meetings in Helsinki, Finland and Auckland, New Zealand. Pridgen was elected to the American Law Institute in 2003.
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