When Creditors are Predators

"How many people remember the sub-prime crisis of 1991-1993?" William Black asked me the other day. Black is a longtime federal regulator turned economics professor. We were talking about how the collapse of the housing market in 2006-2008 catalyzed today's Great Recession.

"It's a trick question," he continued. "The same stuff was developing, all the non-amortizing loans, all the qualifying of borrowers at the teaser rate. We killed it by regulation, and there was no crisis, period. There were maybe two or three failures of institutions, but hardly in the way of that, either. It always starts out fairly small, and if you squash it when it's nice and small, there is no systemic problem at all."

Nobody squashed our current crisis, which has been building for nearly a decade. The tale of bad incentives and free-market profit-maximizing gone wrong is, by now, familiar: Dubious loan products created an artificial demand for buying and building homes. This all created a huge bubble in the housing market; when it inevitably popped, a financial sector, swollen by deregulation, crashed down with it, starting the self-reinforcing cycle of deep recession. Businesses unable to obtain credit laid off workers, and workers, already overburdened with credit-card debt and stagnant income, defaulted on loans of all kinds, further damaging banks.

As the administration attempts to deal with the immediate effects of the crisis, the next task is figuring out how to realign the bad incentives in the financial industry through regulation. Rep. Barney Frank passed legislation in the House, now awaiting Senate consideration, to prevent predatory mortgage lending, and President Barack Obama has signed legislation limiting credit-card practices that hurt borrowers. These efforts are a start, though consumer advocates want the government to go further. But the premise of all this legislation is relatively simple: We need lenders to profit when loans succeed, not when they fail. That idea needs to be the centerpiece of the next era of consumer regulation.

Elizabeth Warren, a Harvard law professor and the chair of the Congressional Oversight Panel that monitors the bank-bailout program, has proposed a very simple way to approach the problem, analogizing financial products with consumer products (and loans are nothing if not products for consumption): A company can't sell a toaster that has a one-in-five chance of catching fire and burning down your house, but it's perfectly legal to sell someone a loan with a one-in-five chance of destroying his or her financial independence. Warren proposes a financial products safety commission to review potentially hazardous products for safety and efficacy, rather like the way the Food and Drug Administration functions, before such products are marketed to consumers.

That insight is the key to understanding the problem of predatory lending. There's no widely accepted legal definition of the term, but predatory lending generally means more than just exorbitant rates and fees; it usually includes some kind of deception or fraud on the part of the lender--misinformation about payment practices, failures to disclose important details, misrepresentation of hidden costs, risks, or conflicts of interest. But a broader definition might also be useful: Predatory lending occurs when the lender's business model is based on making profits based on fees and defaults, not on the normal performance of a loan.

Ordinary loans to low- and moderate-income Americans are often, by necessity, lower in profit for lenders. The lender doesn't get the economies of scale of a large loan, and small loans to people of modest means require more careful underwriting. But mortgage lenders found another route to make money: They could make an up-front killing charging huge fees for a badly underwritten loan with a low interest rate that would later balloon, then sell the loans packaged as securities, passing off risks to the next person up the chain. That's just the part that was legal--fraud was rampant as well.

Lynn Drysdale, a consumer attorney in Tampa, Florida, offers a deadpan list of practices she encounters when defending borrowers facing foreclosure: "Falsifying loan applications, falsifying appraisals, putting people in exotic loan products ... that make it appear that they can pay, but they really can't ... telling them they can refinance within a year but not telling them there is a really high prepayment penalty."

This system "worked" for a while. As long as housing prices rose, defaulting borrowers could simply refinance into another, often even more punishing loan to avoid foreclosure. But the increase in housing prices was artificial; in fact, it was driven in part by the mortgage industry's willingness to give loans to nearly anyone and lenders' collusion with appraisers to increase home prices. Eventually, though, the bottom fell out, and the reckoning is all around us. And the same incentives are still at play in other consumer-credit markets, such as credit cards. "It's completely ass-backwards at this point," Ira Rheingold, the executive director of the National Association of Consumer Advocates, tells me. "Credit-card companies make their money when people fail. Their best customers are people who are late, people who miss payments. Credit-card companies once actually made money by offering people credit." For Rheingold, the key question is how to regulate credit-card practices "so that the incentive for credit-card company success matches consumer success."

Bank and credit-card fees, as well as payday loans, place consumers in a tight spot--many second mortgages or risky refinancings were obtained to pay down other kinds of debt. In 2008, average credit-card debt alone was $8,565. When you consider the average household income is around $50,000, you can see where problems begin to arise. Rep. Carolyn Maloney's credit-card legislation passed by Congress in April and signed into law by President Obama will help end some abusive practices, such as late-fee traps, teaser rates, and retroactive interest-rate adjustments; it will also increase consumer notice and require borrowers to consciously opt in to high-interest accounts instead of opting out.

Lenders typically argue that further restrictions on their practices will require them to raise interest rates or simply deny credit to low-income borrowers. The first argument isn't supported by empirical studies; a healthy banking system doesn't depend on exorbitant profits in any one product line. And the second is half financial blackmail--we'll only lend if we can damage--and half a real concern: There are some borrowers who simply don't qualify for any kind of traditional loan, yet socially responsible banks have in fact demonstrated that they can earn a normal rate of return by lending to surprisingly low-income people if they tailor loans to needs and work with their customers to use credit responsibly.

However, the typical practice has been to make loans with excessive costs to unqualified and qualified borrowers alike. The point is to reap the extra fees. Fannie Mae estimates that half of sub-prime borrowers qualified for prime loans--in part because banks paid brokers incentive fees to put borrowers into high-interest mortgages.

In the pending legislation, Congress will ban those fees, as well as require mortgage originators to ensure that borrowers can repay loans and achieve a net benefit from them; it would also make originators hold on to 5 percent of any loan they pass up the chain to ensure they have skin in the game. While all this is a step in the right direction, consumer advocates worry that overly loose standards and a lack of enforcement authority won't give the bill much teeth--Rheingold calls it a "convoluted mess, a cockamamie scheme." Instead, he argues that everyone on the chain, from the originator to a Wall Street investor, should be legally liable for the outcome of each loan--investors to borrowers, and originators to investors.

"We need to redo the securitization system so that it's not a liability-avoidance system," Rheingold says. "Any mortgage or any transfer of that mortgage, liability fully goes along the way so that risk goes along with that, so that everybody is worried about their liability and acts appropriately."

More disclosure isn't a silver bullet either, for mortgages or consumer credit. Indeed, complicated disclosure forms are more confusing than clarifying for borrowers who aren't financial experts, and often end with clauses saying lenders can change the terms at anytime; for example, the recently passed credit-card reform had to prohibit the common practice of retroactively raising credit-card interest rates on past balances. For complicated mortgage products, it's better to ensure there is legal accountability and that consumers aren't even offered products that are likely to lead to late payments, excess fees, and defaults.

One regulation worth pursuing, so simple it will make you laugh, is to end non-verification loans--those made without any proof of income. In the industry, these were termed liar-loans. "If we had said that to get a loan you have to show a pay stub--at least one pay stub--we would not be in this mess today," says Mark Seifert, the executive director of the East Side Organizing Project, a community group that works on foreclosure prevention. This, too, is part of Rep. Frank's mortgage legislation, which requires that the underwriting explicitly consider a borrower's income and existing debt to ensure that a loan could reasonably be paid back.

The last part of the regulatory agenda is simple, too: Put a cap on the fees and interest charged on loans, whether for mortgages, credit cards, or smaller lines of credit like payday loans. It's time to revisit anti-usury laws that used to limit loan interest--the Center for Responsible Lending believes that capping consumer loans at 36 percent interest is a "quick, commonsense" way to prevent borrowers from becoming trapped in debt, taking out one loan after another just to stay afloat. It's a reflection of how far we've fallen that a 36 percent interest cap is considered progress. That used to be considered usury.

As we go to press, the Treasury is preparing to present Congress with a proposal for comprehensive financial-regulation overhaul. Several options have been floated; one, to consolidate the four major regulators into one organization, has been quashed by congressional leaders, but it's possible that the Office of Thrift Supervision, a notoriously lackluster regulator, will be eliminated, and the Securities and Exchange Commission and the Commodity Futures Trading Commission may be combined. All of these changes are in the interest of ensuring a systemic approach to protecting the economy from risk. Derivatives, the financial products that helped explode the financial crisis, will come under scrutiny. The administration has also apparently embraced Warren's idea of the Financial Product Safety Commission, which would have important and welcome influence protecting consumer borrowers.

In all of these efforts, it is important that federal standards allow states the freedom to demand more from regulated institutions--reforms need to clarify that state regulators have the right to impose higher standards, as is the case with minimum-wage laws--and that the federal standard is a floor, not a ceiling. Otherwise, pro-consumer regulators and law-enforcement officers at the state level could have their hands tied. Home loan giant Countrywide Financial, for instance, switched regulators in 2007 to gain access to broader preemption authority, thus avoiding state regulators.

"The feds were aggressive in only one area, and that was preempting state regulation," William Black says. "Even though the [attorneys general] were kind of heroes in this, they were driven from the field by the preemption doctrine."

Limiting federal preemption should go hand in hand with more funding to the moribund FBI white-collar-crimes unit and the Department of Housing and Urban Development's near-disbanded mortgage-fraud investigators to ensure that regulations are actually enforced. In late May, President Obama signed legislation championed by Sen. Patrick Leahy of Vermont that expands fraud statutes to include mortgage lenders and their agents, among other technical fixes to make it easier to prosecute lenders who make false statements. The law also appropriates funding to hire hundreds of new FBI agents and Department of Justice attorneys to focus on combating mortgage fraud. Underlying the whole problem of credit for lower-income Americans is the larger challenge of asset building. Building the kind of advantages available to the wealthy can be very difficult, but the government can adopt policies, ranging from children's savings accounts to making the first-time homebuyer tax credit refundable, that encourage saving, provide access to financial education, and develop shared equity resources. These strategies would help create an environment where credit builds wealth instead of destroying it.

"We should be more worried about giving people more disposable income, livable wages, so they have enough income that they can actually buy a house," Rheingold says. "Instead, what we've seen over the last 15 or 20 years is income stagnation, but to make up for that income stagnation, we've made credit incredibly accessible."

Ultimately, finding policy solutions is only part of the challenge. Now that the crisis has laid bare the perverse incentives of the financial sector, Congress and the president should take an aggressive approach toward restructuring the way lenders do business. It will take political capital, and likely plenty of real capital from consumer-advocacy organizations trying to match the millions bankers spend lobbying to maintain the status quo. Veterans of these battles are skeptical of the idea that progress will come easily, if at all, given the success of lenders at stymieing legislation they dislike--a bill that would have allowed bankruptcy courts to modify home loans to make them viable failed due to lender lobbying. If some consolation is to be taken from the current recession, it is that a politician who opposes the bankers is making a very smart investment of political capital indeed.

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