Testimony of Andrew G. Celli, Jr., Chief of the Civil Rights Bureau,
Office of New York State Attorney General Eliot Spitzer,
Before the United States House of Representatives
Committee on Banking and Financial Services
(May 24, 2000)
Mr. Chairman, members of the Committee:
My name is Andrew G. Celli, Jr. and I am Chief of the Civil Rights Bureau in the Office of the Attorney General of the State of New York, Eliot Spitzer. Thank you for this opportunity to testify about illegal, discriminatory and financially destructive practices within the sub-prime lending industry in New York State.
As you may know, the New York Attorney General has been investigating the sub-prime industry -- at both the lender and the broker levels -- for more than a year. In September 1999, our office entered into a detailed federal court consent decree with a major sub-prime lender, Delta Funding Corporation, which is based on Long Island but does business in many states. Along with the New York State Banking Department, and with the assistance of a nationally known accounting firm, we continue to monitor Delta's compliance with our consent decree.
The experience of investigating, litigating against, negotiating with, regulating and monitoring major sub-prime lenders has given our office deep insight into the nature of predatory lending in New York, and the principles and practices that work best to combat such abuses. Today, I will touch on some of those issues in my testimony, focussing on some of the major problems and macro-solutions that we are implementing in the Delta consent decree.
(1) Sub-prime Lending v. Predatory Lending
I begin by distinguishing sub-prime lending from predatory lending. Sub-prime lending simply refers to mortgage lending that exists to serve consumers who do not qualify -- by dint of their credit records, income, or otherwise -- for traditional "A" credit. Sub-prime lenders generally charge higher interest rates than "A" banks to compensate for the greater risk associated with higher-risk borrowers. Most frequently, sub-prime lending takes the form of refinance mortgages, rather than purchase money mortgages. None of this is illegal of course, and none of it is necessarily bad; indeed, good sub-prime loans can be an important mechanism for bringing credit to under served communities and borrowers.
Not all credit is good credit, however -- even in areas where credit is scarce. Indeed, in this market, credit that is inappropriate to the borrower, or extended on unfair terms, is what predatory lending is all about. Predatory lending practices occur when sub-prime lenders and the mortgage brokers with whom they deal exploit the vulnerability of higher-risk borrowers -- as well as the unavailability of other forms of credit -- to take unconscionable profits. Predatory lending is lending that is based virtually exclusively on the value of the asset being collateralized, not the income of the borrower or her ability to repay. It is characterized by far higher interest rates than are warranted, prepayment penalties, balloon payments, excessive broker fees, and, too often, a lack of full disclosure. In New York, predatory lending has one further, deeply insidious feature: it is often targeted at minority communities and, within minority communities, vulnerable populations such as the elderly.
(2) The OAG's Sub-prime Lending Investigation: Major Issues and Model Solutions
In March 1999, the Office of the Attorney General commenced an investigation into the sub-prime lending industry in New York. We served investigatory subpoenas on a number of sub-prime lenders and brokers, received and reviewed thousands of documents, and conducted scores of interviews with individual borrowers and others. As I mentioned earlier, the investigation of Delta Funding led to a lawsuit, a consent decree, and now continuing oversight and monitoring of that company's business practices. Other aspects of our investigation remain open, and so I cannot discuss them. One broad conclusion is clear, however: predatory practices exist widely within the sub-prime industry, at both the lender and the broker levels. In New York -- particularly in communities for which sub-prime lending is an important source of credit -- predatory practices are a major problem.
Though our investigation has revealed a range of predatory practices in New York, today, I would like to discuss the three practices that, in my view, are at the core of the problem within the sub-prime industry: first, the extension of credit without regard to borrowers' ability to repay -- to individuals who lack the income or other resources necessary to service the loans and sustain themselves; second, the practice of pressuring borrowers to refinance loans simply to churn additional fees -- even when the refinancing puts the borrower in a worse financial position than had no loan been extended at all; and third, the charging of excessive broker fees.
The Delta consent decree seeks to address these issues through a variety of techniques. Although the Delta decree is, of course, tailored to the specific issues raised by that company's practices, so common are such practices that we believe that the decree's principles should be considered as a model for the sub-prime lending industry as a whole.
(A) Lending Without Regard to Ability to Repay
I turn first to the problem of extending credit without regard to ability to repay -- a practice sometimes referred to as asset-based lending. In New York's sub-prime market, we have seen this practice with some regularity. Homeowners -- often those with little or no financial experience or sophistication and, in New York, too often members of racial or ethnic minority groups -- are pressured into taking out sub-prime mortgage loans which they clearly have no ability to repay. For example, some homeowners are pressured to take out loans with monthly payments so high that they are left with less than $100 per month to meet all of their other expenses. Needless to say, in these circumstances, default and foreclosure become all but certain. Our investigation clearly showed that borrowers who lack sufficient residual income are at grave risk for default or financial privation because they simply cannot make their loan payments and also pay basic expenses.
As the Committee knows, the Home Ownership and Equity Protection Act of 1994 (HOEPA) forbids lenders from extending loans "without regard to the borrower's ability to repay". HOEPA's prohibition covers so-called "high cost" loans -- that is, loans on which the points and fees exceed 8% of the total. As important as this prohibition is, its power and real world relevance are diminishing. We found that the number of HOEPA-covered loans is shrinking, as lenders evade the HOEPA definition by bringing in loans just under the statutory definition of "high cost". We also found that HOEPA's standard of "without regard to ability to repay" is sufficiently vague that enforcing it in court raises real challenges.
The Delta decree deals with these issues by applying strictAresidual income@ requirements to all Delta loans, not just HOEPA loans. Residual income requirements are designed to ensure that borrowers have the financial wherewithal both to make payments on the proposed loan and to pay for life's essentials -- food, clothing, utilities and so on. Here's how it works: before a Delta loan can be approved, Delta underwriters must demonstrate that, after accounting for the expected monthly payment, the proposed borrower still has a certain absolute amount of income left over to cover other expenses. Residual income -- which is pegged to the cost of living in a relevant geographic area, and the number of persons within a household who must rely on the income -- is a fixed dollar amount, not a percentage of the borrower's income.
Although neither federal nor New York State law currently applies such restrictions explicitly to most categories of loans, residual income requirements are applied by regulation to Veterans Administration loans. Indeed, the Delta decree uses VA residual income requirements as a yardstick for what is reasonable. To be sure, residual income requirements mean that some potential borrowers will not get loans. In our experience, however, such consumers ought not get loans, because, in all likelihood, they will not be able to make their payments on a sustained basis. Moreover, the Delta decree sets out certain exceptions to the residual income requirements, all designed to ensure that people who need and would benefit from loans are not improperly denied credit.
It is important to differentiate the residual income limits that we advocate from what is known asAdebt to income ratio@ or ADTI.@ DTI is widely used in the home loan industry as a measure of a borrower=s ability to pay. DTI reflects the percentage of a borrower=s income that is devoted to paying for the loan each month. Generally, a DTI over 50% -- that is, paying more than half of one=s income to debt service -- is considered unduly risky for the borrower. The problem with DTI is that it does not properly gauge risk for people at the lowest income levels. For example, a person earning $40,000 per year with a DTI of 50% will be paying $20,000 in debt payments and will have $20,000 left over for other expenses -- a financially viable situation. However, a person whose income is only $15,000 year with the same 50% DTI will have only $7,500 left over, a far more precarious situation. For this reason, while DTI is a useful gauge of a person=s ability to repay a loan in many cases, within lower income brackets -- a key part of the sub-prime industry -- DTI is much less useful than the absolute floor of residual income.
For all of these reasons, we urge serious consideration of a residual income requirement of the type included in our settlement with Delta.
The next problem that our investigation focussed on was the phenomenon known as "flipping". "Flipping" occurs when homeowners are pressured to refinance their existing loans, and thus pay a new round of fees, even though the new loan provides virtually no material financial benefit over the old loan. When flipping occurs, the new loan leaves the borrower worse off than she had been under the previous loan -- as the new fees generated for the lender and the broker create a greater total indebtedness and higher monthly payments. For example, in one case, a borrower with a $75,000 mortgage was pressured into refinancing that mortgage with a new $90,000 loan. The additional $15,000 dollars all went to cover fees to the lender and broker; the borrower did not receive a single penny in new funds. However, as a result of the larger loan amount, the borrower=s monthly payments increased more than $200 per month. In another case, a borrower with a $90,000 mortgage was pressured into refinancing that mortgage with a new $115,000 loan. Only $7,000 of the additional $25,000 went to the borrower, but her monthly payments went up more than $300 per month. In other words, this borrower wound up paying an extra $300 per month for 30 years in return for a lump-sum payment of just $7,000 -- an effective interest rate of over 50% per annum. Not surprisingly, six months later, this borrower was in default.
The Delta decree effectively prevents "flipping" by requiring that, whenever a loan is refinanced, the borrower=s monthly payments may not increase by more than 2.5% of the new funds which the borrower obtained from the loan. An example illustrates the principle: Say, a homeowner has a $90,000 mortgage. Delta wants to extend the homeowner a refinance loan of $100,000. Of the $100,000 lent, $90,000 goes to pay off the old loan, $6,000 goes to new fees (the bulk of which generally are broker fees), and only $4,000 goes to the borrower. Because the so-called "new funds" -- that is, the actual benefit to the borrower -- are only $4,000, under the decree, the borrower's monthly payment may increase by no more than 2.5% of that amount, or $100. Because the lender cannot charge the commensurate increase in overall monthly payments that would ordinarily result from paying interest on the new extra fees, the 2.5% rule bars "pure" flipping and creates a strong economic disincentive to male loans that provide only marginal benefits to the borrower.
The Attorney General's Office urges the study and inclusion of such a prohibition in any legislative or regulatory effort to combat flipping.
(C) Excessive Broker Fees
The third practice involves excessive broker fees. Many mortgage brokers receive outrageous fees for virtually no work. Some brokers routinely charge up to 10% of the total loan value in fees. Thus, on a $90,000 loan -- which is a typical loan amount -- a broker will receive $9,000 of the borrower=s money for less than one day=s work. Because this 10% almost always comes out of the balance of the loan -- that is, the portion that is supposed to go to the borrower -- the borrower pays interest on this money, which he or she never receives. The result is to raise the effective interest rate on the actual loan monies received to usurious heights.
Other brokers inflate their fees through what is known as aAyield spread premium.@ A yield spread premium is paid by the lender to the broker whenever the broker convinces a borrower to take out a loan at an interest rate above Apar,@ that is, at a rate higher than the rate the lender would otherwise quote a comparable borrower. So, for example, if a given borrower would normally, based on his or her credit history, be entitled to a loan at 12% interest, but a broker somehow convinces the borrower to pay an interest rate of 12.4%, the lender then pays the broker a 1% fee -- what amounts to a kickback -- for convincing the borrower to pay this inflated interest rate. The borrower, who pays the higher interest rate, gets no direct benefit from this yield spread premium.
While some actors in the sub-prime industry suggest that the borrower receives an indirect benefit in reduced up-front broker fees, our investigation revealed no such consistent reduction or benefit. Rather, our investigation uncovered standing agreements between brokers and lenders, by which the lenders automatically approve borrowers for a higher-than-par interest rate -- without telling the borrower -- just so that the broker can receive his yield spread premium.
Because our settlement was with the lender -- Delta -- rather than with the brokers, the consent decree provides less detail on this issue. However, two important changes would substantially eliminate this problem.
First, given the grave abuses of yield spread premiums, we have supported state proposals to prohibit yield spread premiums entirely. In the alternative, we have supported a rule that permits lenders to pay -- and brokers to collect -- yield spread premiums only where they can show that such yield spread premiums result in lowered up-front broker fees. In other words, the lender must show that the borrower received a benefit in return for paying the higher interest rate -- namely, that the broker charged a smaller up-front fee from the proceeds of the loan. Brokers and lenders should be required to demonstrate this on an aggregate basis, showing that they do loans both without and with the yield spreads, and that the yield spread loans consistently had up-front broker fees reduced in the amount of the yield spread premium.
In addition, we advocate an outright cap on the fees which any broker can receive on a particular loan. In the regular, prime market, a broker's fee of one or two percent is standard. Notably, even when a sub-prime lender like Delta originates its own loan itself -- without a broker intermediary -- and thus completes the broker=s part of the work itself, it generally takes only a fee of only 2% for this work. Our investigation revealed no reason for allowing significantly higher fees when dealing with the sub-prime market. To be sure, sub-prime loans are somewhat more risky; but that risk is born by the lender, who makes up for it with a higher interest rate. The broker does not bear that risk and so need not be compensated for it.
Therefore, a 3% cap on broker fees seems fair, and we have supported such at the state level. Any legislation or regulatory action on this point must, however, make it clear that the capped amount includes all fees to the broker whether paid directly or indirectly. This would eliminate or severely restrict the payment of yield spread premiums and would prevent brokers from taking fees from some indirect sources, thus evading the cap.
Finally, it is worth reiterating that most of the proposals I have discussed today are more than hypothetical suggestions -- they are part of a court ordered consent decree which this office is presently monitoring. The fact that it is a settlement, and that Delta agreed to abide by these restrictions, indicates that the restrictions can be imposed without banning sub-prime loans altogether or drying up needed credit in poor and minority communities. Therefore, we urge this committee to consider these provisions for adoption in legislation covering the sub-prime industry as a whole.
Thank you for this opportunity to testify here today. If there are any questions, I would be happy to answer them.