Author
Recently, the media have presented many stories about predatory lending practices. In both cities and rural areas, instances of predatory lending have devastated communities and left borrowers deeply in debt. When it comes to predatory lending, many people feel that they know it when they see it, but creating a comprehensive definition of the practice that does not include benign lending practices has proved difficult.
On March 26, 2001, Federal Reserve Governor Edward M. Gramlich delivered remarks titled, "Tackling Predatory Lending: Regulation and Education" to the Neighborhood Reinvestment Corporation luncheon in Raleigh, North Carolina. In the speech, Governor Gramlich discusses the common elements of predatory loans and draws distinctions between predatory lending and subprime lending. That portion of the speech is reprinted below. (For the full text of Governor Gramlich's speech, including comments on the efforts of the Federal Reserve System and the Federal Reserve Banks to address predatory lending issues, visit www.federalreserve.gov/boarddocs/speeches/2001.)
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Federal Reserve Governor Edward M. Gramlich views consumer education as the best defense against predatory lending. |
I am pleased to participate in today's conference on predatory lending. This seems to have become a major problem around the country. One of the welcome developments in recent years is the expansion of the home mortgage market to a broader socioeconomic range of borrowers. Studies of urban metropolitan data submitted under the Home Mortgage Disclosure Act (HMDA) have shown that lower-income and minority consumers, who have traditionally had difficulty in getting mortgage credit, have been taking out loans at record levels in recent years. Specifically, conventional home-purchase mortgage lending to low-income borrowers nearly doubled between 1993 and 1999, whereas that to upper-income borrowers rose 56 percent. Also, over the same period, conventional mortgage lending increased by about 120 percent to African American and Hispanic borrowers, compared with an increase of 48 percent to white borrowers.
Much of this increased lending can be attributed to the development of the subprime mortgage market. Again using HMDA data, the number of subprime home equity loans has grown from 66,000 in 1993 to 856,000 in 1999, a thirteen-fold increase. Over this same period, the number of subprime loans to purchase homes increased sixteen fold, from 16,000 to 263,000. This rapid growth has given credit access to consumers who have difficulty in meeting the underwriting criteria of prime lenders because of blemished credit histories or other aspects of their profiles. This expansion of credit gives people from all walks of life a shot at the twin American dreams of owning a home and building wealth.
But along with these positive developments have come disquieting reports of abusive lending practices, targeted particularly at female, elderly, and minority borrowers. These practices, many of which can result in consumers losing much of their equity in their home, or even the home itself, are commonly referred to as "predatory lending." Predatory lending can damage these same hardworking but low-income people and the communities in which they live. Its growth is a noticeable blight in this otherwise attractive mortgage-lending picture.
The term "predatory lending," much like the terms "safety and soundness" and "unfair and deceptive practices," is far-reaching and covers a potentially broad range of behavior. As such, it does not lend itself to a concise or a comprehensive definition. But typically, predatory lending involves at least one, and perhaps all three, of the following elements:
- Making unaffordable loans based on the assets of the borrower rather than on the borrower's ability to repay an obligation (asset-based lending);
- Inducing a borrower to refinance a loan repeatedly in order to charge high points and fees each time the loan is refinanced (loan flipping); and
- Engaging in fraud or deception to conceal the true nature of the loan obligation from an unsuspecting or unsophisticated borrower.
Some of these practices are clearly illegal and can be combated with legal enforcement measures. But some are more subtle, involving the misuse of practices that most of the time can improve credit market efficiency. For example, the freedom for loan rates to rise above former usury law ceilings is generally desirable in that it matches relatively risky borrowers with appropriate lenders. But sometimes the payments implicit in very high interest rates can spell financial ruin for borrowers.
Most of the time, balloon payments make it possible for young homeowners to buy their first house and match payments with their rising income stream. But sometimes balloon payments can ruin borrowers who do not have a rising income stream or who are unduly influenced by an immediate need for money.
Most of the time, the ability to refinance mortgages permits borrowers to take advantage of lower mortgage rates, but sometimes easy refinancing invites loan flipping, resulting in high loan fees and unnecessary credit costs.
Often credit life insurance is desirable, but sometimes the insurance is unnecessary, and at times borrowers pay hefty up-front premiums as their loans are flipped. Generally, advertising enhances information, but sometimes it is deceptive. Most of the time, disclosure of mortgage terms is desirable, but sometimes disclosures are misleading, with key points hidden in the fine print.
Predatory lending entails either fraud or the misuse of these and other complex mortgage provisions that are generally desirable and advantageous to a borrower, but only when the borrower fully understands them. . . .
In the long run, the very best defense against predatory lending is . . . thorough knowledge on the part of consumers of their credit options and resources. Educated borrowers who understand their rights under lending contracts and who know how to exercise those rights put up the best defense against predatory lenders.
