The proverbial American dream of owning a home has become an all-too-real nightmare for a growing number of families. Take the case of Florence McKnight, an 84-year-old Rochester widow who, while heavily sedated in a hospital bed, signed a $50,000 loan secured by her home for only $10,000 in new windows and other home repairs. The terms of the loan called for $72,000 in payments over 15 years, after which she would still owe a $40,000 one-time payment. Her home is now in foreclosure.
Unfortunately, this is not an isolated incident. Predatory lending has emerged as the most salient public policy issue in financial services today. If progress has been made to increase access to capital for racial minorities, low-income families and economically distressed communities, that progress has always come with great struggle. And it appears there are few, if any, permanent victories. The emergence of predatory lending practices demonstrates that the struggle against redlining has not been won, but has simply taken some new turns.
After decades of redlining practices that starved many urban communities for credit and denied loans to racial minorities, today a growing number of financial institutions are flooding these same markets with exploitative loan products that drain residents of their wealth. Such “reverse redlining” may be as problematic for minority families and older urban neighborhoods as has been the withdrawal of conventional financial services. Instead of contributing to homeownership and community development, predatory lending practices strip the equity homeowners have struggled to build and deplete the wealth of those communities for the enrichment of distant financial services firms.
There are no precise quantitative estimates of the extent of predatory lending. But the growth of subprime lending (higher cost loans to borrowers with blemishes on their credit records) in recent years, coupled with growing law enforcement activity in this area, clearly indicates a surge in a range of exploitative practices. Not all subprime loans are predatory, but virtually all predatory loans are subprime. Some subprime loans certainly benefit high-risk borrowers who would not qualify for conventional, prime loans. Predatory loans, however, charge higher rates and fees than warranted by the risk, trapping homeowners in unaffordable debt and often costing them their homes and life savings. Examples of predatory practices include:
- Balloon payments that require borrowers to pay off the entire balance of a loan by making a substantial payment after a period of time during which they have been making regular monthly payments;
- Required single premium credit life insurance, where the borrower must pay the entire annual premium at the beginning of the policy period rather than in monthly or quarterly payments. (With this cost folded into the loan, the total costs, including interest payments, are higher throughout the life of the loan);
- Homeowners insurance where the lender requires the borrower to pay for a policy selected by the lender;
- High pre-payment penalties that trap borrowers in the loans;
- Fees for services that may or may not actually be provided;
- Loans based on the value of the property with no regard for the borrower’s ability to make payments;
- Loan flipping, whereby lenders use deceptive and high-pressure tactics resulting in the frequent refinancing of loans with additional fees added each time;
- Negatively amortized loans and loans for more than the value of the home, which result in the borrower owing more money at the end of the loan period than when they started making payments.
Here are some numbers to illustrate the extent of the problem: The Joint Center for Housing Studies at Harvard University reported that mortgage companies specializing in subprime loans increased their share of home purchase mortgage loans from 1 to 13 percent between 1993 and 2000. Economists at the Office of Federal Housing Enterprise Oversight found that subprime loans are concentrated in neighborhoods with high unemployment rates and declining housing values. Almost 20 percent of refinance loans to borrowers earning less than 60 percent of area median income in 2002 were made by subprime lenders, compared to just over 7 percent for borrowers earning 120 percent of median income or higher, according to research by the Association of Community Organizations for Reform Now (ACORN). The Center for Community Change reported that African Americans are three times as likely as whites to finance their homes with subprime loans; this is true even between upper-income blacks and whites. The Joint Center for Housing Studies has also revealed that race continues to be a factor in the distribution of subprime loans after other individual and neighborhood factors are taken into consideration.
One cost of the sudden increase in subprime lending has been an increase in foreclosure rates. According to the Joint Center for Housing Studies, borrowers with subprime loans are eight times more likely to default than those with prime conventional loans. Yet, it has been estimated that between 30 and 50 percent of those receiving subprime loans would, in fact, qualify for prime loans.
Ironically, some of the steps taken to increase access to credit for traditionally underserved communities have inadvertently created incentives for predatory lending. The Community Reinvestment Act of 1977, which banned redlining by federally chartered banks and savings institutions, provided incentives for lenders to serve minority and low-income areas. So did the Fair Housing Act of 1968, which prohibited racial discrimination in home financing. FHA insurance and securitization of loans (lenders sell loans to the secondary mortgage market, which packages them into securities to sell to investors) reduce the risk to lenders and increase the capital available for mortgage lending. In addition, the federal government established affordable housing goals for the two major secondary mortgage market actors, Fannie Mae and Freddie Mac. Fifty percent of the mortgages they buy must be for low- and moderate-income households.
All these actions have increased access to capital, but sometimes by predatory lenders. Wall Street has become a major player by securitizing subprime loans. The involvement of investment banks in subprime lending grew from $18.5 billion in 1997 to $56 billion in 2000.
With passage of the Financial Services Modernization Act of 1999, the consolidation of financial services providers received the blessing of the federal government. Between 1970 and 1997 the number of banks in the U.S. dropped from just under 20,000 to 9,100, primarily as a result of mergers among healthy institutions. The 1999 Act removed many post Depression-era laws that had provided for greater separation of the worlds of banking, insurance and securities. Subsequent to this “reform,” it became far easier for financial service providers to enter each of these lines of business. One result is that commercial banks and savings institutions, which used to make the vast majority of mortgage loans, now make about a third of them. Mortgage banking affiliates of depository institutions, independent mortgage banks, insurance companies and other institutions that are not regulated by the federal government, including predatory lenders, have become a far bigger part of this market.
A critical implication of deregulation is the declining influence of the Community Reinvestment Act. In conjunction with the Fair Housing Act and other fair lending initiatives, the CRA is credited with generating more than $1 trillion in new investment for low- and moderate-income neighborhoods and for increasing the share of loans going to economically distressed and minority markets. Concentration and consolidation among financial institutions that had taken place for years – trends that were exacerbated by the 1999 Act – reduced the impact of CRA by making it easier for many financial institutions that are not covered by the 1977 law to enter the mortgage market. The share of mortgage loans subject to intensive review under the CRA dropped from 36.1 percent to 29.5 percent between 1993 and 2000. And the share of loans going to low-income and minority markets declined in 2001 after steadily increasing throughout the 1990s.
But these are not the last words in this debate. In many ways, community-based organizations, fair housing groups and elected officials are responding to these developments and the predatory practices that have proliferated.
Reactions to Predatory Lending
Public officials, prodded by aggressive community organizing, have proposed many regulatory and legislative changes. As of the beginning of 2004, at least 25 states and 11 localities, along with the District of Columbia, had passed laws addressing predatory lending. These proposals call for limits on fees, prepayment penalties and balloon payments; restrictions on practices that lead to loan flipping; and prohibitions against loans that do not take into consideration borrowers’ ability to repay. They provide for additional disclosures to consumers of the risks of high cost loans and of their right to credit counseling and other consumer protections.
In 2000, the Office of the Comptroller of the Currency reached a $300 million settlement with Providian National Bank in California to compensate consumers hurt by its unfair and deceptive lending practices. Later that year, Household International reached a $484 million agreement with a group of state attorneys general in which it agreed to many changes in its consumer loan practices. Household agreed to cap its fees and points, to provide more disclosure of loan terms and to provide for an independent monitor to assure compliance with the agreement. Household also negotiated a $72 million agreement with ACORN for interest rate reductions, waivers of unpaid late charges, loan principal reductions and other initiatives to help families avoid foreclosure.
In response to information provided and pressure exerted by consumer groups, the Federal Trade Commission (FTC) took enforcement action against 19 lenders and brokers for predatory practices in 2002 and negotiated the largest consumer protection settlement in FTC history with Citigroup. The company agreed to pay $215 million to resolve charges against its subsidiary, The Associates, for various deceptive and abusive practices. The suit was aimed primarily at unnecessary credit insurance products The Associates packed into many of its subprime loans.
A number of nonprofits have developed programs to help victims of predatory lending to refinance loans on more equitable terms that serve the financial interests of the borrowers. Many lenders, often in partnership with community-based groups, have launched educational and counseling programs to steer consumers away from predatory loans.
But progress cannot be assumed. Three federal financial regulatory agencies (Comptroller of the Currency, National Credit Union Administration, and Office of Thrift Supervision) have issued opinions that federal laws preempt some state predatory lending laws for lenders they regulate. In communities where anti-predatory lending laws have been proposed, lobbyists for financial institutions have introduced state level bills to preempt or nullify local ordinances or to weaken consumer protections. Legislation has also been introduced in Congress to preempt state efforts to combat predatory lending. Preliminary research on the North Carolina anti-predatory lending law – the first statewide ban – suggested that such restrictions reduced the supply and increased the cost of credit to low-income borrowers. Subsequent research, however, found that the law had the intended impact; there was a reduction in predatory loans but no change in access to or cost of credit for high-risk borrowers. Debate continues over the impact of such legislative initiatives. And the fight against redlining, in its traditional or “reverse” forms, remains an ongoing struggle.
The Road Ahead
The tools that have been used to combat redlining emerged in conflict. The Fair Housing Act was the product of a long civil rights movement and probably would not have been passed until several years later if not for the assassination of Martin Luther King Jr. that year. Passage of the CRA followed years of demonstrations at bank offices, the homes of bank presidents and elsewhere. And recent fights against predatory lending reflect the maturation of several national coalitions of community advocacy and fair housing groups that include ACORN, the National Community Reinvestment Coalition, the National Training and Information Center, the National Fair Housing Alliance and others. As Frederick Douglass famously stated in 1857:
“If there is no struggle, there is no progress… Power concedes nothing without a demand. It never did, and it never will.”
Homeownership remains the American dream, though for all too many it is a dream deferred. As Florence McKnight and many others have learned, it can truly become a family’s worst nightmare. The unanswered question remains: for how long will the dream be denied?
Though opponents said North Carolina’s predatory lending law would reduce the flow of loans to low income borrowers, a 2003 study showed that the law actually works as it was intended. It cuts down on predatory loans but not legitimate ones.
The study showed that 90 percent of the decline in loans after the law was enacted in 1999 could be traced to predatory loans. Most of the decline was in loans for refinancing, which is the most popular way for lenders to prey on their victims.
The law, which was the first passed by a state government to curb predatory lending, included a ban on prepayment penalties on loans of $150,000 or less and a ban on unnecessary refinancing. It also curbed lending without regard to a homeowner’s ability to repay.
Between 1998 and 2002, subprime lending dropped 3 percent in North Carolina, while it increased 17 percent nationally. In neighboring Virginia and Georgia, subprime lending increased by still larger amounts. The researchers also found that, while subprime loans for refinancing dropped after the law was passed, similar loans for home purchases increased 72 percent. So the law did not limit the amount of credit available, but it did cut down on predatory lending.
Critics of the law might have suspected that subprime loans would become less available to borrowers with the worst credit scores. But lending to these borrowers actually increased by about 7 percent.
Reports issued by these critics in recent years relied on data from an industry trade group that opposes the law to make their claims. The authors of the 2003 study, on the other hand, used a dataset they said was the most comprehensive available on the subprime mortgage market. The data is used by federal banking regulators as well as government-sponsored entities like Fannie Mae.
“Assessing the Impact of North Carolina’s Predatory Lending Law,” by Roberto G. Quercia, Michael A. Stegman and Walter R. Davis. Housing Policy Debate, Vol. 15, Issue 3, 2004, p. 573. www.fanniemaefoundation.org.