This article examines the growth of sub-prime lending over the last two decades. The difference between sub-prime loans and traditional prime loans is explained. The benefits of sub-prime loans for borrowers are reviewed along with the problems that sub-prime loans present for borrowers and for the overall economy. Abuses in the sub-prime loan industry, often referred to as predatory lending practices, are explained and efforts to remedy and prevent these abuses are examined. The nature of predatory lending and its impact on individuals, the economy, and society are explained. Major settlements with abusing lending companies over predatory practices are also reviewed.
Keywords Predatory Lending Practices; Prime Loans; Sub-prime Lending; Sub-prime Loans
Finance: Sub-prime LendingOverview
Sub-prime lending is a relatively new and rapidly growing segment of the financial market that provides credit to borrowers who, for one of numerous reasons, would generally not be extended credit. Borrowers, for example, who fail credit history requirements in the standard (prime) mortgage market have greater access to credit in the sub-prime market. One of the major benefits of sub-prime lending is growth in the number of homeowners. Sub-prime lending is also high-cost borrowing for those seeking and accepting such credit. Sub-prime lending cost has two major aspects: Credit history and down payment requirements. This is in contrast to the prime market, where the borrower's cost is primarily driven by the down payment providing they have an adequate credit history (Chomsisengphet & Pennington-Cross, 2006).
Sub-prime lending is often viewed as having both promises and peril for the economy as well as the individual borrower. The plus side is that sub-prime lending provides an opportunity for homeownership to those who would be otherwise excluded from the market because of discrimination or the inability to qualify for a mortgage in the past. Because poor credit history is often associated with more delinquent payments and defaulted loans, the interest rates for sub-prime loans are generally considerably higher than for prime loans (Chomsisengphet & Pennington-Cross, 2006).
Two legislative reforms allowed lenders to deliver risk-adjusted pricing that made loans available to higher-risk mortgage borrowers. The Depository Institutions Deregulatory and Monetary Control Act in 1980 eliminated rate caps and made sub-prime lending more feasible for lenders. In addition, the Tax Reform Act of 1986 eliminated interest deductions on consumer and auto loans while still allowing interest deductions on mortgage debt. According to the Department of Housing and Urban Development (HUD), the number of sub-prime lenders tripled, growing from 70 to 210 between 1994 and 1997. Sub-prime, together with alternative A mortgages, virtually replaced agency (Fannie Mae and Freddie Mac) loans.
However, in the late 1990s, financial troubles hit many sub-prime lenders who were plagued by aggressive accounting policies with respect to property valuations. This forced restatements of financials, which for many essentially wiped out their net worth. As a result of the restatements, several sub-prime lenders filed for bankruptcy and went out of business (White, 2006).
The tradition in the mortgage market was to set minimum lending standards that take into consideration a borrower's income, payment history, and down payment with some input from the local underwriter about their knowledge of the borrower. This is a non-price credit rationing approach. The sub-prime lending market is based on several different pricing tiers and loan types, which to a large extent has helped to move the mortgage market closer to price rationing, or risk-based pricing. Overall, the ultimate success of the sub-prime market will determine to what extent the entire mortgage market incorporates risk-based prices for each borrower (Chomsisengphet & Pennington-Cross, 2006).
Sub-prime lending helps to bring people into the borrowing market who probably would not have other opportunities to obtain credit. But there have definitely been abuses, especially with lending practices for people living in minority neighborhoods where 50% or more of residents are minorities. These borrowers have 35% greater odds of being saddled with prepayment penalties on sub-prime mortgages than borrowers who live in predominantly white neighborhoods (Mink, 2005) (Karger, 2007). These trends exist despite that offering loans at preferable interest rates on the basis of gender or race is illegal in the United States (Tucker, 2007).
Because of a lack of alternatives, sub-prime borrowers were attracted to alternative mortgages that provide for equity growth, which in turn has a positive impact on their credit profile. When interest rates started to rise and housing price appreciation simultaneously slowed, many sub-prime borrowers could not refinance to gain more favorable terms. Many also were unable to maintain their mortgage payments when their loans were adjusted to the higher interest rate. They also could not sell their homes because of a slow down in home sales. In the past, delinquency and default rates were closely linked to local economic conditions. Both delinquency and default rates are rising today even in some locations that have low unemployment and strong economies (“Housing Boom & Bust,” 2007).
Trends indicate that the default rate for sub-prime loans is about six times higher than for prime loans. Problems can be compounded because sub-prime borrowers encounter more difficulty in obtaining cheaper loans when interest rates fall. Thus, borrows are locked into high rate loans. This obstacle often results in “reduced access to financial markets, foreclosure, and loss of any equity and wealth achieved through mortgage payments and house price appreciation” (Chomsisengphet & Pennington-Cross, 2006).Applications Regulating the Sub-prime Marketplace
Over the last two decades, sub-prime lending programs offered by banks and other lenders have provided financial opportunities for borrowers who had impaired credit or no credit history. Sub-prime lending has supported home mortgages, automobiles, consumer credit, and credit cards. Many community banks have often offered sub-prime loans as part of an outreach program to help meet the requirements of the Community Reinvestment Act. As a result, many families were able to become homeowners because of the accessibility of credit through these programs. Such loans usually served a useful purpose and were distinguishable from sub-prime loans made on predatory terms(Bahin, 2007).Abuses
Some lending institutions or companies have been identified as having practices that are considered abusive to the borrowers who most often obtain sub-prime loans. Furthermore, the disclosure of expanded data required to be in compliance with the Home Mortgage Disclosure Act (which exposes pricing data for loans) has led “some groups to conclude that a number of lenders have violated fair lending laws.” In addition, there have been “several high-profile cases filed alleging that lenders have violated the Fair Housing Laws and the Equal Credit Opportunity Act” (Bahin, 2007).Legal Actions
Observers have expected that various types of actions will occur over the next few years including:
- Congress will continue to pass legislation that prohibits existing and emerging predatory practices and otherwise regulates the activities in the mortgage industry.
- States will continue to enact laws that impose additional requirements for lenders.
- Federal banking agencies will focus more attention on compliance with laws and regulations on the part of lending organizations.
- More class action suits will be filed on the behalf of borrowers who believe that they have been discriminated against or misled by lenders (Bahin, 2007).
The economic importance of the sub-prime market cannot be understated for the economy as a whole and for the individuals obtaining sub-prime loans. The effects of sub-prime lending are pervasive. The class actions suits that have already been filed (and others are probably still pending) involve a long list of sub-prime lenders and their aggressive lending practices (Koppel, 2007). Well over 20 sub-prime lenders have been closed down or sought buyers over the last few years. These include New Century Financial and General Electric (Stewart, 2007).
Many lenders have been accused of issuing sub-prime mortgages that prey upon the poor or uninformed consumer. The lenders have offered high-risk clients an opportunity at homeownership but with interest rates well above the going rate and above what many borrowers could actually pay (Ordower, 2007). Sub-prime loans that have gone bad have often devastated lenders and set back borrowers financially (Roney, 2007).
In 2006, Ameriquest Mortgage Company decided to settle a complex and multi-state investigation concerning allegedly deceptive consumer lending practices. The settlement was massive and included $295 million to repay borrowers who took out loans between January 1, 1999 and December 31, 2005. In addition, the company agreed to pay $30 million to cover the...
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