One of the lesser known economic successes of the past decade has been a significant improvement in giving low-income people access to the credit they need to buy homes. In 1998, 13 percent of all new mortgages were so-called subprime loans—made to borrowers who lack established credit histories, as many poor people do—compared with 5 percent in 1994.
Subprime loans carry higher interest than is charged to most borrowers, who are in the “prime” category, but this is because subprime borrowers are more likely than others to default. Lenders charge rates and fees consistent with the risks. If banks, in particular, did not do this, regulators worried about their safety and soundness would crack down on them.
There is a dark side to subprime lending, however: loans that have been labeled predatory. The term is applied most often to loans made to uninformed, low-income, elderly and minority borrowers who are pressured to sign new mortgages or refinance their current ones on onerous terms.
In loan “flipping,” for example, homeowners are tricked into complex refinancing even when it is disadvantageous to them. In “equity stripping,” they end up paying high fees that substantially erode their equity in their homes. In the worst cases, these practices end in borrowers’ losing their homes.
The Senate Banking Committee has been holding hearings on predatory lending and considering whether to introduce a bill to halt it. Such a bill would probably put limits on prepayment penalties, refinancing fees and credit life insurance premiums. Clearly, lenders cannot be allowed to engage in practices that amount to fraud or that prey on Americans least equipped to defend themselves. Yet what many policy makers may not realize is that federal officials already have ample legal authority to stop predatory lending. They haven’t done enough with it in the past, but that is changing, and it could change more.
The Federal Trade Commission has the authority to stop deceptive trade practices, and it is now using that power to investigate whether Citigroup tricked borrowers into paying high costs on subprime loans. The Federal Reserve Board has broad authority to regulate subprime lending practices and is in the process of adopting new rules that would help prevent flipping and equity stripping.
New laws on the pattern of some already passed at the state and local level could do great harm by discouraging lenders from making any subprime loans at all. Laws that effectively limit fees and interest in mortgage contracts are tantamount to usury ceilings, which have generally been eliminated for a good reason: They force lenders to ration credit and thus deny funds to some borrowers.
In North Carolina, the Legislature enacted a statute in 1999 that punishes flipping and imposes new regulatory burdens and risks on high-cost lending. Since then, subprime mortgage lending by finance companies in the state to borrowers with incomes below $25,000 has dropped by nearly 50 percent. For those with incomes between $25,000 and $50,000, the drop has been one-third.
There are sensible ways to reduce predatory lending. The Federal Reserve Board could require lenders to inform borrowers fully about prepayment penalties—both by telling them personally and through easily understood documents. The Fed can adopt rules to curb loan flipping, though if it does so, it should make clear to lenders what type of refinancings are permissible—those that substantially reduce the borrower’s monthly payment, for example. New government- financed counseling programs for borrowers are also a good idea. And the Fed, the F.T.C. and the Department of Housing and Urban Development should send testers, masquerading as subprime loan applicants, to make sure lenders aren’t engaging in predatory practices.
This is the sort of regulation that can stop predatory lending without taking back any of the new access to home ownership that millions of Americans have gained through subprime loans.