Predatory Lending Reforms Gain Steam
A funny thing happened on the road to subprime: predatory lending has become a magnet for reforms.
BY RONALD S. DEUTSCH
Dr. Seuss once wrote, "From there to here. From here to there. Funny things are
happening everywhere." Perhaps that is what is happening in the judicial system when it comes to subprime lending.
As a result of a regulatory push to increase homeownership access for lower-income groups, subprime lending has flourished. These programs provide credit to borrowers with past credit problems and who otherwise wouldn't qualify for conventional prime lending products. Refinancing is a major component of this type of lending. In fact, refinancing, which accounts for more than 80% of all subprime loans, increased ten-fold between 1993 and 1998, to more than 790,000.
Today, following years of growing subprime lending, we now have a situation in which the
courts and legislative bodies are addressing the issue of predatory lending, including such problems as alarming foreclosure rates in certain metropolitan areas and the controversial practice known as "flipping," the selling of a house for an exorbitant markup that is much higher than the actual value of the property.
This issue has become a magnet for reform, with a series of private and public-private studies and policy mandates being issued or proposed. For instance, a nation-wide anti-predatory lending campaign has been launched by a collaboration that includes the government-sponsored enterprises. The "Don't Borrow Trouble" campaign that was initiated last year in Boston, and then extended to other cities across the country, includes advertisements and consumer education public service announcements.
The U.S. Department of Housing and Urban Development (HUD) has issued new housing goal
regulations for Freddie Mac and Fannie Mae, which went into effect in January, prohibiting them from receiving credit toward their affordable housing goals for the purchase of mortgages subject to the HomeOwnership and Equity Protection Act of 1994 (HOEPA) and mortgages with predatory features.
New rules issued by Fannie Mae are designed to prevent purchasing of loans from lenders that force purchasers with good credit into higher interest rate loans, requiring borrowers to purchase life insurance, and charging excessive fees to underqualified borrowers or borrowers with poor credit.
Freddie Mac's guidelines for predatory lending include not referring borrowers to higher-cost mortgage products, nor encouraging or requiring them to select one designed for less creditworthy borrowers. Also, borrowers seeking financing through a higher-priced subprime lending channel should be directed to the seller's standard mortgage product line, if they qualify. Also, it emphasizes requirements for determining borrower capacity to repay the mortgage.
In addition to the studies, reports and mandates, criminal prosecution of appraisers, real estate firms and others have been initiated. Some convictions have already been handed out in Baltimore, one of the areas that have been hardest-hit by predatory lending practices.
Although subprime plays an integral role in the mortgage industry, and has made it possible for a large segment of the population to purchase homes who otherwise might have been shut out of the market, it is also true that it has been taking some heat for the predatory lending problems.
Growing pains
The growth of subprime has been, by most measures, phenomenal.
According to HUD, subprime lenders increased their market share in the District of Columbia
from 1.4% of all conventional loans in 1983 to 10.2% in 1998. Moreover, since many of the subprime loans are made to low-income and other borrowers whose economic circumstances and credit ratings are not the best, they are required to accept more onerous loan terms to gain access to funds. As a result, subprime loans are often labeled "predatory."
In fact, HUD and the Treasury Department issued a joint report in June 2000, "Curbing
Predatory Home Mortgage Lending," detailing legislative and regulatory recommendations, including lowering the target of HOEPA triggers, increasing damages and penalties for violations of the Truth in Lending Act (TILA) and the Real Estate Settlement Procedures Act (RESPA), and restricting the financing of points and fees under HOEPA.
"What is clear is that once the courts began to accept the term "predatory," lenders began to be successfully targeted for a variety of alleged transgressions, many of them under consumer protection theories. Other discriminatory claims have also been asserted against lenders, for not originating loans to qualified candidates or not opening offices in low-income areas.
Under this legal umbrella, with the goal of further restricting the granting of so-called
"predatory" loans, legislation has been passed - or in various proposal stages - in Congress, as well as in several state and city governments.
However, one of the crucial questions to pose is whether it is accurate - or even fair - to apply the term "predatory" in certain situations.
Specifically, have we reached the point where a lender can be successfully sued for not
granting a loan as well as granting one? The answer may be yes.
On August 1, 2000, a lender was successfully sued in the United States Court of Appeals for the District of Columbia under the theory that it originated a predatory loan to a low- income borrower.
In Williams vs. First Government Mortgage and Investors Corporation, 97-7195, the facts were that the borrower was a 61 year old retired painter and handyman, who owned his own home in the District for 29 years. In 1994, the borrower had a $42,000 mortgage from Central Money Mortgage Company and paid $587.00 per month. Because he owed $1,400 in unpaid property taxes, the D.C. government advertised his house for auction in a tax sale. Not being able to pay, the plaintiff went to several lenders, including seven banks, seeking a $1,400 loan. He was repeatedly denied credit, mostly for the reason that his income was too low.
First Government offered to help by refinancing his existing mortgage and increasing the new
loan amount by the amount necessary to pay the outstanding taxes, various other fees and a two-year life insurance policy. As a result, a new 30- year loan in the amount of $58,300.00 with a 13.9% interest rate and $686 in monthly payments was originated.
Although the monthly payment was $100 more than he had been previously paying and the life of the loan was extended, Williams accepted it, believing he had no other alternatives to avoid losing his home.
At the time of closing, Williams was receiving $1,072 a month in disability benefits, $100 of which went to health insurance, plus up to $3,000 a year from part-time work. The court stated that he had roughly $1,200 a month in disposable income, over half of which went to First Government to cover his monthly payments. This left little more than $500 each month to buy necessities for himself and his dependents.
The court noted that he had 11 children and 23 grandchildren, with his household having at
least seven people in it at any given time. However, the court failed to indicate that his grown children and grandchildren also contributed rental monies toward the household income.
The plaintiff, Williams, kept up with his loan payments for 12 months, but then his financial
condition worsened. According to the court, he began to run out of food by the latter part of each month, his electricity, gas and water were cut off and eventually he began missing payments.
Williams filed suit to enjoin the foreclosure and rescind the loan. He also sought damages
pursuant to statutory and common-law causes of action. Specifically, he alleged, in part, that First Government violated section 28-3904(r) of the D.C. Consumer Protection Procedures Act (CPPA) by knowingly taking advantage of his inability to protect his interests in the loan transaction or in the alternative by knowingly making him a loan that he could not repay with any reasonable probability.
After a five-day trial, the jury returned a verdict in favor of Williams on his CPPA claim in the amount of $8,400. After trebling the jury's award to $25,200, as authorized by section 28-3905(k)(1) of the CPPA, the court awarded attorney fees of $199,340. The court noted that the awarding of attorney fees did not have to be proportionate to the amount of damages awarded.
The court came to a number of conclusions, including:
- First Government should have taken into consideration that the borrower was disabled and as he became older through the 30-year loan term, he would be unable to supplement his fixed income with earnings from part-time work.
- It should also have taken into account that the plaintiff was unable to fully understand the transaction since he only had a sixth-grade education from the segregated schools of Savannah, Ga., and that he possessed poor reading skills.
It appears that the law in the District of Columbia has now transformed the relationship between a lender and borrower into that of a fiduciary and beneficiary. This situation seems to have evolved from the growth of compliance laws during the past few decades, including TILA and its accompanying Regulation Z (1968), the Fair Housing Act (1968), the Fair Credit Reporting Act (1971), RESPA (1974), the Equal Credit Opportunity Act (1974), the Home Mortgage Disclosure Act (1975), the Fair Debt Collection Practices Act (1978) and the Truth in Lending Simplification and Reform Act (part of the Depository Institutions Deregulation and Monetary Control Act of 1980).
However, good faith efforts to comply with these rules normally went unpunished.
In 1994, as a result of Rodash vs AIB Mortgage Co., the mortgage lending environment became substantially more difficult when the remedy of rescission was established as a result of the lender's failure to include a third party's $22 Federal Express expense in the finance charge calculation.
Class-action lawsuits regarding issues, such as yield spread premiums, add-on fees or force placed insurance, have caused the lending environment to become even more unfriendly.
However, lenders received relief in 1995 when TILA was amended to reduce a creditor's
liability for minor inaccuracies, and more recently, with the Financial Services Modernization Act, otherwise known as the Gramm-Leach Bliley Act of 1999. Effective November 12, 2000, it requires financial institutions to disclose their policies and practices on disclosure of non-public personal information to third parties.
The basic premise, however, has always been that a borrower was responsible for his own
actions, and that, once reasonably informed about the cost of credit, they were bound by their
decision. Under the Williams rationale, the environment has changed once again to one that is - at the least - a role of self policing.
Walking a thin line
This entire situation poses an obvious question: Is there a fine line between predatory lending and lending to individuals with less-than-perfect credit?
Perhaps the judiciary is now instructing lenders that they would rather a subprime borrower be denied credit than granting a loan that might give them a second chance in maintaining ownership of their home, but which may also extend the borrower's agony. On the other hand, a lender must be certain it does not wrongfully deny credit. The key may be in pricing and in the establishment of clear, unambiguous definitions and standards as to what constitutes an acceptable loan versus a predatory one.
To run the risk of running afoul of Ben Franklin's classic advice that "Smart men don't need advice, and fools don't take it," my advice is therefore guarded. The lending community is forced to walk a tight-rope, to act responsibly and make credit available at rates that reflect the costs and risks of lending, without engaging in abusive lending practices. This is difficult since some of the characteristics that cause a borrower to enter the subprime category are also characteristics that may make the customer vulnerable to predatory lending practices.
However, it is not a sine quo non that a subprime loan is always predatory. Predatory as
defined by Webster's Dictionary means "to ensnare."
In the context of providing a loan, it is the allegation that alender preys on a borrower's weakness that is the source of litigation. The demarcation line between acceptable subprime lending and unacceptable is indeed blurry.
Clearly, standards must be established in order for lenders to safely engage in the encouraging of lending to low-income borrowers and in the denying of such credit. Guidance must be established to preserve a legitimate subprime lending environment as a resource to residents who need it most. Without such clear guidance, subprime lenders have now been put in a defensive position, hoping the environment will change.
Ronald S. Deutsch is a principal in the Maryland law firm of Cohn, Goldberg & Deutsch, a USFN member. He can be reached at the firm's Towson office, (410) 296-2550.
This article was previously published in the March 2001 Issue of Servicing Management
