America's Community Bankers
Banking and Financial Services Committee
United States House of Representatives
May 24, 2000
Chairman and CEO
Peoples Bank, SB
Americas Community Bankers
Mr. Chairman and Members of the Committee, I am David Bochnowski, Chairman, President and CEO of Peoples Bank in Munster, Indiana. Our headquarters are in northwest Indiana, near the industrial cities of Gary and East Chicago.
I am here today representing America's Community Bankers as ACBs first vice-chairman. ACB represents the nations community banks of all charter types and sizes. ACB members pursue progressive, entrepreneurial and service-oriented strategies in providing financial services to benefit their customers and communities. Our members are both state and federally chartered and regulated by each of the federal regulators.
We appreciate this opportunity to testify. Our association and its members participate in many important programs and partnerships that help average Americans become and remain homeowners. This is just the opposite aim of the predatory lenders that are the subject of todays hearing.
Community banks are responsible participants in the process of expanding our local economies through the extension of consumer credit. We deplore the actions of unscrupulous lenders who prey upon uninformed borrowers in an effort to make a fast buck.
ACBs members have demonstrated their concern in many ways. Our board of directors has adopted a "Housing Opportunities Statement of Principles" under which our members "are committed to ensuring that all applicants receive the same degree of assistance and support in seeking credit regardless of race, gender, religion or national origin." (full statement attached) To help carry out this commitment, ACB is a founding member of the National Partnership in Homeownership, which helped increase the nations homeownership rate to a record 67 percent. ACB is also a founding member of the American Homeowner Counseling and Education Institute that supports national standards for homeownership counseling. In addition, ACB actively participates in Social Compact, a voluntary organization that promotes and honors non-profit/corporate alliances that help low-income communities. Last year Social Compact honored ACB member Roslyn (N.Y.) Savings Bank and Neighborhood Housing Services of Bedford-Stuyvesant for creating a nationally acclaimed home maintenance program that has helped to revitalize a low-income Brooklyn neighborhood.
My own institution is committed to helping underserved communities. One of our most recent efforts was opening a new, state-of-the-art office in East Chicago, where our bank was founded. We bought a full half block and now serve an increasingly diverse community. In fact, we offer services in two languages, English and Spanish. This continues a bi-lingual tradition for Peoples Bank in East Chicago we long offered service in English and Polish.
Peoples is now discussing opening another office in the industrial city of Gary, Indiana. Like East Chicago, it suffers from the shift to a less labor-intensive domestic steel industry. But, we know it takes community banks being involved in their community to help stimulate new economic activity and stabilize the mortgage market. This is what we hope to do in Gary.
This commitment of ACB and all of our members to homeownership is not only good for our communities, it is, frankly, good for our business. Predatory lending that causes homeowners to lose their homes and ruin their credit ratings undermines our communities and damages potential customers. ACB pledges to work with Congress and other policy makers to eliminate predatory lending in the most effective and speedy way and to provide all credit-worthy borrowers with access to sound loans. However, we should not underestimate the difficulty of the task. Unlike federally insured depository institutions that are subject to regular and rigorous examinations, predatory lenders are often effectively beyond the reach of federal laws. As an example of this dichotomy, Ellen Seidman, Director of the Office of Thrift Supervision, said on April 4, 2000 that the biggest abusers do not come from the ranks OTS-regulated institutions. We take seriously her repeated admonition against predatory lending: "OTS-regulated institutions shouldnt even think about getting into this part of the business."
Subprime vs. Predatory Lending
As many have emphasized during this debate, policy makers must be careful to distinguish between subprime lending and predatory lending. Many mistakenly use these terms interchangeably. Subprime lending allows individuals with some credit blemishes to qualify for loans, though at somewhat higher rates or under stricter terms than are available to the best borrowers. The rise of subprime lending has given many previously underserved borrowers a chance at homeownership previously unavailable; before the expansion of subprime lending, a potential homebuyer either qualified for a prime loan or was denied credit. Subprime loans now offer a middle ground and have helped raise home ownership levels to a record high. For many, subprime loans have made the American dream of living in a home of your own come true.
A properly underwritten subprime mortgage benefits both the borrower and the lender. To be considered properly underwritten, a subprime loan indeed any loan must be priced appropriately. The best credit risk enjoys the lowest rate; those with poorer records must pay more, but are at least granted credit. By expanding the pool of eligible borrowers, lenders are able to add earning assets to their books. By taking their borrowers credit history into account in pricing, lenders are properly compensated for the risks they take. Done right, subprime lending is good for an institutions depositors, shareholders, and the deposit insurance fund.
It is also fair to the borrowers. They can benefit from subprime lending by gaining an opportunity to repair their credit history. ACB strongly supports the reporting of good performance on such loans to credit bureaus so that borrowers get a chance to move back into the prime category. After ACB took this stance, Fannie Mae and Freddie Mac changed their servicing instructions to implement the same policy.
In contrast, predatory lending loads the dice in favor of the lender. All lending must balance the interests of lenders and borrowers, but predatory lending does not offer fair odds. The mortgage broker, home improvement contractor, or lender gain excessive fees, while borrowers who cannot meet the terms of their loans may damage their credit ratings and even lose their homes. To avoid foreclosure borrowers must often carry ultra-high debt service until they can secure new financing. These predatory lenders certainly charge far more than prime rates for credit, but not to fairly compensate for risk. They do so to extract as much equity from the borrowers home as possible and then walk away with the proceeds. Similar problems of "equity skimming" have been reported in automobile title loans.
Expanded HOEPA Coverage
Unfortunately, the general descriptions of predatory lending cannot easily be translated into clear statutory or regulatory language. Defining "predatory lending" presents a difficulty similar to that faced by the Supreme Court in a pornography case. In that instance, Justice Potter Stewart said, "I shall not today attempt further to define [pornography], but I know it when I see it." So it is with predatory lending.
In 1994, Congress attempted to address the issue by passing the Home Ownership and Equity Protection Act. HOEPA drew a line between high-cost loans which triggered special disclosures and all other loans. This bright line has the advantage of clarity, but HOEPA does not encompass all loans that might be predatory. The definition and disclosures are restricted to real estate-secured loans, and do not even address unsecured "payday" lending or automobile title loans. This area also needs more attention.
The area that HOEPA attempts to cover is easy to avoid by shifting the coupon rate and the up-front fees by small amounts. In any event, predatory lenders may not bring the required disclosures to the borrowers attention or claim they are irrelevant. Even where HOEPA might define a loan as high-cost and borrowers get the required disclosures, the loan might be made anyway.
At the same time, some loans that are not truly "predatory" might fall into the HOEPA ambit, particularly if it is tightened. Federal Reserve Governor Edward Gramlich described the problem this way in his May 1, 2000 letter to Senate Banking Committee Chairman Phil Gramm. The Governor wrote: "HOEPAs triggers may bring subprime loans not associated with unfair or abusive lending within the actss coverage. Similarly, abusive practices may occur in transactions that fall below the HOEPA triggers." In a similar letter sent on May 5 to Chairman Gramm, Comptroller of the Currency John D. Hawke, Jr. summed up the problem this way: "I am concerned that attempting to define this term [predatory lending] risks either over- or under-inclusiveness."
Despite this very real problem, Congress has before it legislation that would bring more loans under the HOEPA umbrella and increase the restrictions on those loans. ACB is concerned that sharply lowering the HOEPA thresholds could affect a number of non-predatory subprime loans. This could impose additional burdens on legitimate subprime lenders without effectively dealing with the predatory lending problem. We are also concerned that certain rates and terms might be defined as "predatory," even though in some circumstances they would be appropriate. It could depend on the facts and circumstances of each transaction. Moreover, predatory lenders will eventually find loopholes in the law or shift to lending types that are not covered. (Some HOEPA loans are only cosmetically real-estate secured, since their loan-to-value ratios are extremely high.) Mortgage lending predators might switch to automobile title lending or unsecured consumer finance to avoid HOEPA, while traditional home lenders are subject to new restrictions that do not affect the problem lenders.
Requiring stronger disclosures on a wider circle of loans may be ineffective for another reason: all borrowers are inundated with information and mandatory disclosures during the mortgage process. Industry and policy makers have tried repeatedly to streamline this process, but no matter how successful they are, making the biggest purchase and taking on the biggest financial obligation in your life is going to be complicated. The paperwork and disclosures can almost overwhelm even sophisticated borrowers. Fortunately, they have easy access to reputable lenders and know enough about the process to understand whether or not they are getting a fair deal. They generally have friends and relatives who have already taken out mortgages, so they can learn the easy way.
Predatory lenders do not market to these people; they target those with less experience with credit and lower levels of financial sophistication. Tightening HOEPA and adding paperwork and stronger disclosures is not likely to help. It may even give predators more opportunities to confuse.
And, as I indicated earlier in my testimony, many predatory lenders are not subject to the same strict supervision as our members. By further tightening HOEPA and other laws, there is a risk of discouraging insured depository institutions from making responsible subprime loans, which would effectively open the door even wider to unregulated predators.
Fortunately, there are effective alternatives. ACB urges Congress to bear in mind advice that the HUD/Treasury Task Force on Predatory Lending heard in Atlanta on May 2: Increase the resources available for consumer education and credit counseling. This will substitute for the social infrastructure that the victims of predatory lenders often do not have. Responsible lenders already do this for our customers. For example, ten institutions in my market jointly sponsor regular homeownership seminars. Peoples Bank hosted the most recent session conducted in both English and Spanish in our offices and over 30 people attended. We want them understand and be able to meet the obligations of homeownership. Whether through formal counseling programs like these, or in the normal loan underwriting process, our institutions work to ensure that borrowers understand their responsibilities and will be able to fulfill them.
But, clearly, more needs to be done. We are encouraged by the actions already underway in Washington. The financial regulatory agencies are exploring what they can do under current law. (I note that HOEPA already requires the Federal Reserve to "prohibit acts or practices that the Board finds to be unfair, deceptive, or designed to evade the provisions of this section.") The Departments of Housing and Urban Development and Treasury are wrapping up a series of forums and plan recommendations soon. The secondary market companies, Fannie Mae and Freddie Mac, have announced that they will not purchase HOEPA, high-cost loans. And, of course, bills have been introduced in both the House and Senate. These indicate a genuine sense of outrage at these predatory practices and have stimulated the regulatory investigations that can bear fruit faster than Congress can pass major legislation. I have included a one-page table that summarizes what is already happening.
This official activity is accompanied by a very useful wave of publicity. ACB hopes that this publicity and other official activity has a real and immediate impact on the problem where it matters most in communities that are now targeted by predatory lenders. We envision continued efforts by mainstream lenders to offer responsible products; increased reluctance of financing sources to provide funding, directly or indirectly, to predatory lenders; tougher regulation and supervision to prevent abuses; and a more educated public that can tell the difference between a fair deal and a bad one. Unlike legislation, these actions can be tailored and adjusted to deal with diverse and changing circumstances.
We think this approach is better than legislatively reducing the HOEPA thresholds and making the required disclosures ever more strongly worded and frequent. For the reasons indicated, ACB does not believe that a stricter statute would be effective. In fact, it could be very damaging. Over-tightening the statutory definitions risks tainting some legitimate loans. Regulators are planning to deny CRA credit for HOEPA loans, a step ACB supports. The secondary market, at least as far as the government-sponsored enterprises are concerned, will not now accept HOEPA loans. These are helpful steps under the current HOEPA limits, but could be perversely damaging if the current trigger values are significantly tightened.
If Congress, despite these concerns, still attempts to tighten the thresholds, ACB strongly urges that it recognize that changes in the marketplace have already tightened them. Under current law, a HOEPA loan is defined, in part, as one that carries an interest rate more than 10 percentage points above "the yield on Treasury securities having comparable periods of maturity ." This benchmark is flawed in the current and reasonably foreseeable interest-rate climate. Why is this so?
As a result of the steadily falling federal deficit obviously a good thing fewer long-term Treasury securities are available. Because the market sees a relative shortage of these securities, it is willing to accept a lower rate for them. Again, that helps lower the deficit. Another obviously good thing. But, these silver linings are accompanied by a cloud: even without changing the statutory standards of HOEPA, market forces are already tightening the law. This can be shown by this chart that compares recent rates for Treasury securities and securities issued by housing oriented government-sponsored enterprises:
This chart demonstrates that the rate for long-term Treasury securities is far lower than for comparable instruments issued by GSEs. As the supply of Treasury securities falls, or even dries up, HOEPAs Treasury benchmark will become lower. Whether or not Congress decides to change the existing HOEPA triggers, you may wish to consider providing the regulators with the flexibility to adjust them so that they continue to reflect your intent.
New Restrictions on HOEPA Loans
In addition to bringing more loans under the HOEPA definition, the pending legislation would also impose new restrictions. This legislation includes the LaFalceSarbanes bill (H.R. 4250/S. 2415), Rep. Neys H.R. 4213, Rep. Schakowskys H.R. 3901 and Sen. Schumers S. 2404. Some of these raise problems, particularly if the HOEPA definition is tightened to the point that it covers loans that may not be predatory, or that may be legitimate subprime loans.
Balloon Payments (LaFalce/Sarbanes & Schumer)
Balloon payment provisions can be used by predatory lenders to force foreclosures. However, they can serve an appropriate purpose where the borrower wishes to pay the loan on a long-term schedule, but fully expects to refinance before the date the balloon payment is due. For example, a borrower may have a fixed-rate, fully amortizing loan (no balloon) coupled with a line of credit with interest-only payments until a date certain when the loan must be paid in full. A borrower who is fully informed by the lender and who understands his or her obligations can avoid foreclosure by refinancing the line of credit, seeking an extension before the final due date, or taking some other action.
Arbitration Agreements (LaFalce/Sarbanes, Schakowsky & Schumer)
Arbitration agreements have been criticized when included in some HOEPA loans or loans deemed "predatory." However, Congress should remember that it can be a simple, fast, more affordable alternative to litigation. Attorneys who represent homeowners victimized by predatory lenders often complain that they lack the time and resources to pursue claims in court. Properly structured arbitration arrangements could help them. Of course, they must be fully and properly disclosed. Fortunately, consumers retain all of their substantive legal rights in arbitration proceedings. And, the record shows that there is no inherent bias against consumers in arbitration. Litigation lotteries may not offer any better odds than predatory lending itself.
Credit Insurance (LaFalce/Sarbanes & Schumer)
Predators often load loans with unreasonable fees, adding thousands to the principal that the borrower must repay. Credit insurance which provides a benefit in the case of death, disability or unemployment is one loan feature that predators can abuse. But, when properly structured and fully disclosed, financing credit insurance can benefit consumers. By barring any type of financed credit insurance, e.g., for death or disability, Congress could effectively deny consumers an economical way to finance protection that could well help prevent foreclosures.
Again, the real issue is whether the risk is one that should be insured by a particular borrower and whether the insurance premium is actuarially appropriate. Additional disclosures without consumer understanding may not be a viable solution: victims of predatory lenders already report that they do not realize that insurance is optional or understand the impact of premiums on the APR, if indeed these disclosures are ever made.
Prohibition on Profits (Ney)
Some have asserted that predatory lenders realize major profits by buying their own borrowers homes at foreclosure sales. To deal with this issue, the Ney bill provides that a lender "shall not profit monetarily" from a foreclosure sale involving a HOEPA mortgage. (Sec. 3(k)) We doubt that many lenders actually profit from foreclosures; it is more likely that excessive upfront fees and other loan terms provide the bulk of the profits. One banker who commented to the Office of Thrift Supervision analyzed 1331 foreclosures on his institutions subprime loans over the most recent five years, and found that:
Cash gains were recognized on the sale of 512 of these properties and losses recognized on 819 properties. The net result from the sale of all properties foreclosed during the period was a net out-of-pocket loss of $.4.17 million, an average loss of $3,133 per property. Actual losses are much higher when the imputed holding costs are taken into consideration" (italics supplied) (Robert S. Duncan, former CEO Magnolia Federal Bank; May 1, 2000 letter to OTS)
This passage, particularly the final sentence, illustrates the difficulty of the proposed "shall not profit" test. A lender may "profit" on some loans, and suffer losses on others. And, the enforcement of such a provision would have to take into account holding and other costs associated with foreclosure and sale. In summary, the provision is probably not necessary and would be very difficult to enforce.
Tightening Non-HOEPA Restrictions
In addition to adding new restrictions on HOEPA loans, some of the legislation would impose unprecedented restrictions on non-HOEPA mortgages. Rep. Schakowskys bill (H.R. 3901) would impose new restrictions on conforming loans those eligible for purchase by Fannie Mae and Freddie Mac while S. 2405, introduced by Sen. Schumer, puts new restrictions on all residential mortgages. ACB vigorously opposes many of these provisions because they would prohibit terms that are often in the best interests of both borrowers and lenders. These are our comments on specific provisions:
Prepayment Penalties (Schakowsky & Schumer)
Unreasonable prepayment penalties can make it extremely difficult for a borrower to replace a loan. In other instances, prepayment penalties which are typically in effect only three years are appropriate. They decrease the likelihood that a borrower will pay off a loan quickly (decreasing anticipated income to investors) or compensating the investors for lost income if the borrower does decide to pay off the loan. Investors who supply much of the money for the nations home mortgages find this protection valuable.
What is the benefit to the borrower? In the current marketplace investors are willing to accept a loan with lower interest rates, provided they include the protection of a prepayment penalty. This is an especially good option for borrowers who expect to remain in their homes for a long period. It is also important to emphasize that these clauses discourage the refinance option for only a limited time and are not binding at all if the borrower seeks to sell the home, not just refinance to obtain a lower rate. In some markets such as the one I serve borrowers strongly prefer loans without prepayment penalties. As a result, we do not include them in our loans.
Negative Amortization (Schakowsky)
Some loans have payment schedules that are so low that interest is added to the principal, rather than being paid as it accrues. Like a prepayment penalty, this can be harmful if too much interest is added to the loans principal and the loan does not provide a way to reverse the process. However, like a prepayment penalty, the possibility of negative amortization is not harmful in every situation. For example, some lenders offer fixed-payment, adjustable rate loans that depending on prevailing interest rates could result in some negative amortization. The interest rate on these loans is capped, the possibility of negative amortization is fully disclosed, and the negative amortization potential is itself capped. Sometimes the negative amortization is provided to assist the borrower in a time of financial stress, e.g., such as temporary unemployment. The lender may be willing to give the borrower a debt-service "holiday." If the situation reverses itself, the borrower can catch up without losing the property. If not, the borrower can be given time to sell the home and rescue the equity in it by timing the sale rather than accepting a "fire sale" price.
Ability to Repay from Income or Other Financial Resources (Schakowsky)
One technique used by predatory lenders is to saddle an individual with a loan that he or she is clearly in no position to repay. Hence, some have proposed legislation that prohibits extending credit unless the borrower can repay from income or other financial resources. This seems like a common sense requirement, and certainly it is one of the first things for which any bank examiner would look. But again, there may be some situations where, for example, both the lender and borrower understand that the loan will be outstanding for only a short time. In that case, the proposed statutory standard is too rigid.
"Tangible Net Benefit" from Refinancing (Schakowsky & Schumer)
Another frequent predatory technique involves frequent refinancings. The most egregious example we have heard was refinancing low-cost Habitat for Humanity loans and replacing them with a relatively high-rate loans. We do not know how often this has occurred, but it is completely inappropriate. The proposed statutory language to address this problem would prohibit a refinancing outright unless there is a "tangible net benefit to the borrower." This sounds sensible, but what about the situation where a borrower has paid down a loan, wishes to obtain additional cash through refinancing, but interest rates have climbed above his original rate. Does refinancing provide a "tangible net benefit?" The rule suffers from vagueness. If it were in place, lenders might be reluctant to make a loan that meets a genuine consumer demand and find out the hard way that it is deemed predatory by being cited for a violation of the Truth-in-Lending Act.
Alternative Mortgage Transaction Parity Act
In 1982, Congress passed the Alternative Mortgage Transaction Parity Act (Parity Act) as part of broader financial services legislation. According to the findings and purpose of the Parity Act, Congress recognized that "increasingly volatile and dynamic changes in interest rates have seriously impaired" lenders ability to provide fixed-term, fixed rate credit. The purpose of the Act was to permit state-chartered lenders to offer alternative mortgage instruments under a system of uniform federal rules. (Alternative mortgage instruments include variable-rate loans and loans that provide for balloon payments.)
Though interest rates are not as volatile as they were in the 1970s and 1980s, alternative mortgage instruments remain a vital part of housing finance. They allow borrowers and lenders to craft mortgage terms that are adapted to the situations of individual borrowers. As our nations population becomes ever more mobile and diverse, the need to allow lenders to offer diverse mortgage products under uniform rules is as compelling as in 1982. We urge Congress to recognize this both in the context of the Parity Act and when considering changes under other statutes, such as HOEPA, the Truth in Lending Act, or the Real Estate Settlement Procedures Act.
In its recent advance notice of proposed rulemaking (ANPR) ("Responsible Alternative Mortgage Lending" Federal Register, April 5, 2000) the Office of Thrift Supervision (OTS) asked the public to comment on its implementation of the Parity Act. The Act permits state-licensed housing lenders to follow OTS rules, rather than state law, with respect to alternative mortgage instruments. OTS specifically asked which OTS rules should apply: 1) only those rules that apply exclusively to alternative mortgages, or 2) every regulation that imposes conditions that affect a federal savings institutions ability to make alternative mortgages.
ACB believes that the second option most closely tracks Congressional intent under the Parity Act. The Acts purpose was to put state-licensed institutions on the same footing as federally chartered institutions, not to provide a less restrictive regulatory environment.
The Parity Act does not provide for federal supervision of state-licensed lenders. State regulators are still responsible. ACB recommends that OTS work closely with state officials and other interested parties to ensure that federal regulations apply in fact, as well as in theory, to state-licensed lenders. This will help avoid a Catch-22 situation where state law is preempted but federal regulations are not enforced.
Other Issues Raised by Legislation
While this hearing and the pending legislation deal primarily with the issue of predatory lending, much of it either directly or indirectly affects the mortgage lending process in general. Some have even suggested that the only way to deal with predatory lending is to tackle the issue of mortgage reform. That is, revive the effort to simplify and streamline the lending and settlement process under the Truth in Lending Act (TILA) and the Real Estate Settlement Procedures Act.
Some of these ideas have merit. For example, the Schakowsky bill (H.R. 3901) would expand the definition of creditor under TILA to include mortgage brokers. They are often borrowers principal contact with the actual lender, and should be legally responsible for providing the appropriate disclosures.
Other proposals in the Ney bill (H.R. 4213) and the Schakowsky bill give lenders opportunities to correct good faith errors in disclosures by modifying loan terms to reflect their disclosures. This could be helpful in some instances.
I would like to leave this Committee with these thoughts: