Predatory lending

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Predatory lending refers to unconscionable lending practices that take advantage of vulnerable borrowers, such as the elderly or unsophisticated. The term also refers to the practice of convincing borrowers to agree to unfair and abusive loan terms. Such loans could take place either through outright deception or through aggressive sales tactics, taking advantage of borrowers' lack of understanding of extremely complicated transactions.

One lending tactic that is generally considered to be "predatory" is making a secured loan, such as home or car loans, with the expectation that the borrower will not repay the loan (i.e. default), and therefore the lender acquires title to the home or car in a foreclosure sale.

The typical case is where the monthly payment exceeds 50% or even 75% the borrower's after-tax income, or the borrowers income is irregular. While the borrower may be unaware their default is statistically probable, the lender should be aware of this and not make such loans.

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History

Historically, loan fees and interest rates were regulated. In the United States, deregulation starting at Citibank's urging in South Dakota, led to the effective elimination of usury laws<ref>http://www.pbs.org/wgbh/pages/frontline/shows/credit/more/rise.html</ref> in 1980.

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Profits as indicators of Predatory Lending

Large up-front fees, kickbacks and/or uncompetitive interest rates often result in extraordinary profits to predatory lenders, especially if consumers are convinced to undergo frequent refincancings.

Making loans with low fees and competitive rates that are certain to go into default is normally not a highly profitable lending strategy because the amount of the loan may not be recovered after the sale of collateral, giving the lender a financial loss on the transaction. While the borrower remains financially liable for the loan balance, any remainder is unsecured and relatively difficult to collect. However, exceptions include large unsecured loans made in order to obtain other business from the borrower, such as merger and acquisition business, and complex loans that are serviced improperly, as discussed later in this article.

In a loan secured by a home or car, lenders are still likely to take a loss because foreclosure is an expensive process, and foreclosure sales generally yield returns well below the market value of the collateral. The transaction is still profitable to the lender however, if the proceeds of the sale exceeds the loan balance. Thus, some lenders target elderly homeowners who have considerable equity in their homes, and who might be more easily deceived or coerced into taking out a mortgage loan that they cannot afford to pay back. This is one of the most common lending tactics widely considered to be predatory.

A lender might also originate a loan to a borrower without the cash flow to make the monthly payments and then immediately sell the loan to a secondary market investor. This locks in a profit for the original lender regardless of the possibility of the borrowers default. These loans are aggregated and become mortgage-backed securities. The investor in these securities has a less-than-expected yield from them when the borrower defaults.

Sadly, in many cases where a person with large credit card debt (i.e. unsecured), no assets beyond the equity in their home, and no cash flow to cover the minimum monthly payments, a better option for them may be to work out a payment plan with the credit card companies covered by the cash flow they do have, or even to declare bankruptcy so that they do not lose their home in a foreclosure sale.

Another far more complex, very innovative (but allegedly criminal) predatory tactic involves predators creating and exploiting conflicts of interest among the various purchasers and servicers of a pool of mortgages, through frivolous foreclosures of performing loans, and legal barratry contrary to fiduciary duty that are extremely profitable for the predators.<ref name="predatorix"> http://www.predatorix.com particularly "Super Future Equities vs. ORIX", SFEvsORIX.pdf sections:

A. General Background description of Commercial Mortgage Backed Securities (“CMBS”), also known as the Collateralized Mortgage Obligation ("CMO") with figures,
(2) How the Scams Work
a. First Scam (Buy Our “B-Pieces” or We Will Sue You)
b. Second Scam (Keep our “B-Pieces” Alive)
D. Orix’s Scams at Work

</ref>.

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Abusive or unfair lending practices

There are many lending practices which have been called abusive and labeled with the term "predatory lending." There is a great deal of dispute between lenders and consumer groups as to what exactly constitutes "unfair" or "predatory" practices, but the following are sometimes cited.

  • Risk based pricing. Risk-based pricing is the practice of charging more (in the form of higher interest rates and fees) for extending credit to borrowers identified by the lender as posing a greater credit risk. The lending industry argues that risk-based pricing is a legitimate practice; since a greater percentage of loans made to less creditworthy borrowers can be expected to go into default, higher prices are necessary to obtain the same yield on the portfolio as a whole. Some consumer groups argue that risk-based pricing is an excuse for price gouging vulnerable consumers. They argue that higher prices paid by more vulnerable consumers cannot always be justified by increased credit risk.
  • single premium credit insurance (this is a purchasing of insurance which will pay off the loan in case the homebuyer dies, this is more expensive than other forms of insurance because it does not involve any medical checkups, but customers almost always are not shown their choices—because usually the lender is not licensed to sell other forms of insurance. In addition, this insurance is usually financed into the loan which causes the loan to be more expensive, but at the same time encourages people to buy the insurance because they do not have to pay up front.)
  • Any situation where the loan price is negotiable, but the buyer is not aware of this. Many lenders will negotiate the price structure of the loan with borrowers. In some situations, borrowers can even negotiate an outright reduction in the interest rate or other charges on the loan. Consumer advocates argue that borrowers—especially but not only unsophisticated borrowers—are not aware of their ability to negotiate, and might even be under the misapprehension that the lender is placing the borrower's interests above its own. Thus, many borrowers do not take advantage of their ability to negotiate.
  • The most common complaint however, is with any loan which has associated fees which do not add to the APR number. These are compared to a hypothetical situation where the same money can be borrowed without fee from a line of credit. For example, a payday loan of 20 dollars may cost 2 dollars. If the borrower only had a credit card, a cash advance on the credit card might cost 4 dollars, and the payday loan would be the cheapest option (unless what I needed to purchase could be purchased by the credit card incurring no cash advance fee). However, if the borrower had a line of credit with no fees for cash advances, then if he borrowed that 20 dollars and repaid it within the same time frame as the payday loan, the interest would only cost 0.02 cents. This causes people to suggest that the 2 dollars charged on the 20 dollars is a 1000% interest rate. However it might be impossible for the borrower to obtain a no fee line of credit. This scenario occurs in many places:
    • Payday loans
    • Credit Card late fees
    • Checking Account Overdraft Fees
    • Car Dealer Finance, where the price of the car if financed is higher than if paid for in cash
    • Tax Refund Anticipation Loans
    • Certain mortgage and equity loan fees
    • Rent to own stores

Anti-predatory lending organizations such as ACORN argue that predatory loans are usually made in poor and minority neighborhoods where better loans are not readily available, and that the loss of equity and foreclosure can devastate already fragile communities.

Organizations such as AARP and ACORN have worked to stop what they describe as predatory lending. ACORN in particular has targeted specific companies such as Household Finance and H&R Block, successfully forcing them to change their practices. These groups have also spearheaded legislation that would make forms of lending deemed to be predatory illegal.

On the other side of the issue are various subprime advocates such as NHEMA, who say that many practices commonly called "predatory," particularly the practice of risk based pricing, are not actually predatory.

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Underlying issues

There are many underlying issues in the predatory lending debate on which there are many viewpoints:

  • Risk Based Pricing: The first issue is to whether risk based pricing is fair in and of itself. Risk based pricing is the universal practice of the bond markets and the insurance industry, and is implied in the stock market and in many other industries. The basic idea is that those who are more likely to default, or are deemed more risky, should pay more interest to avoid the tragedy of the commons, to avoid unfairly punishing those who have never defaulted and never will. This might be the reverse way of looking at it though, risk based pricing can also be seen as a way for a lender to lend to a group they never have been able to previously, whereby the higher charge allows them to not lose money based on the higher than normal default rate. There is some debate as to whether this concept is fair. There is also some who, while agreeing that the rates are generally set fairly relative to the risk the lender assumes, feel that it is not good to allow borrowers with credit problems to take out such a loan.
  • Competition: Some of those who believe risk based pricing is fair, nevertheless feel that many loans which they deem predatory charge prices far above the risk, using the risk as an excuse to overcharge. Others counter that competition would reduce this possibility. These criticisms may be applied to certain products and not others.
  • Financial Education: Many observers feel that competition in the markets served by what critics describe as "predatory lenders" is not affected by price because the targeted consumers are completely uneducated about the time value of money and the concept of APR, a different measure of price than what many are used to.
  • Caveat Emptor: There is an underlying debate about whether a lender should be allowed to charge whatever it wants for a service, even if it seems to make no attempts at deceiving the consumer about the price. At issue here is the belief that lending is a commodity and that the lending community has almost a fiduciary duty to advise the borrower as to how to obtain funds more cheaply. Also at issue are certain financial products which appear to only be profitable due to anti-adverse selection, that is a lack of knowledge on the part of the customers relative to the lenders. For example, some people allege that credit insurance would not be profitable to a company if only those customers who had the right "fit" for the product actually bought it (i.e., only those customers who were not able to get the generally cheaper term life insurance).
  • Discrimination: Certain groups feel that many financial institutions continue to engage in racial discrimination. Most do not allege that the loan underwriters themselves discriminate, but rather that there is a systemic discrimination. Loan brokers or other types of lending situations where the rate is negotiable or set by the salesman himself, however, have been seen as more ripe for discrimination (and in fact, certain lenders like Honda Auto Finance have had to pay settlements for alleged discrimination of their auto dealers). The discrimination that occurs in this scenario usually thought to be in this way: the loan broker would more often claim that a racial minorities' credit score is lower than it really is, justifying a higher interest rate charged, on the hope that the customer would assume that the lender was right because of an internalized bias that a minority group has a lower economic profile. It is also possible that any broker or loan salesman with some control of the rate charged would simply attempt to charge a race that he dislikes a higher rate. This is seen as being a less likely scenario, although the potential for this occurring causes some to call for the outlawing of interest rates being set by anything but non objective measures.
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Legislation combating predatory lending

Many laws at both the Federal and state government level are aimed at preventing predatory lending. Although not specifically anti-predatory in nature, the Federal Truth in Lending Act requires certain disclosures of APR and loan terms. Also, in 1994 section 32 of the Truth in Lending Act, entitled the Home Ownership and Equity Protection Act of 1994, was created. This law is devoted to identifying certain high-cost, potentially predatory mortgage loans and reining in their terms.

Twenty-four states have passed anti-predatory lending laws. Arkansas, Georgia, Illinois, Massachusetts, North Carolina, New York, New Jersey, New Mexico and South Carolina are among those states considered to have the strongest laws. Other states with predatory lending laws include: California, Colorado, Connecticut, Florida, Kentucky, Maine, Maryland, Nevada, Ohio, Oklahoma, Pennsylvania, Texas, Utah, Wisconsin, and West Virginia. These laws usually describe one or more classes of "high-cost" or "covered" loans, which are defined by the fees charged to the borrower at origination or the APR. While lenders are not prohibited from making "high-cost" or "covered" loans, a number of additional restrictions are placed on these loans, and the penalties for noncompliance can be substantial.

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See also

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External links

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References

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