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Committee on Financial Services

United States House of Representatives

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EMBARGOED UNTIL 9:30 A.M. (EDT)
Text as prepared for Delivery
May 24, 2000

TREASURY UNDER SECRETARY GARY GENSLER
HOUSE BANKING AND FINANCIAL SERVICES COMMITTEE

 

Chairman Leach, Mr. LaFalce, and Members of the Committee, I appreciate this opportunity to be here today to discuss with you the important issue of abusive lending practices.

A year ago, President Clinton announced a plan for financial privacy and consumer protection for the 21st century. The President called for specific actions to expand disclosure, enhance protection, and provide new enforcement tools to combat abusive practices in home mortgage lending.

At Treasury, we believe that one of the most important parts of our mission is to ensure that no American is left behind in the great economic success of our nation. That is why Secretary Summers joined with HUD Secretary Cuomo in April to convene a joint HUD-Treasury Task Force on Predatory Lending. Secretaries Summers and Cuomo asked the members of the Task Force to assess and better understand the problem of predatory lending nationwide. The Task Force effort will culminate in a joint report that HUD and Treasury will send to Congress next month. That report will offer a series of recommendations that build on President Clinton?s call for reforms in this area.

The remarkable growth in access to capital that has occurred during this Administration is an important achievement. Last month, Treasury released a study showing that the Community Reinvestment Act is helping to increase competition in lending to lower-income borrowers and communities across the nation. The study found that between 1993 and 1998, banks and thrifts covered by the CRA increased their mortgage lending to lower-income borrowers and communities by twice the rate that their lending to other borrowers increased. In 1998, CRA-covered lenders made $135 billion in mortgage loans to these borrowers and communities.

At the same time that banks and thrifts were increasing their lending to lower-income borrowers and areas, the amount of subprime lending in these communities was also increasing. HUD?s analysis has shown that the number of subprime refinance loans increased ten-fold between 1993 and 1998. Several years ago, many borrowers were unable to access credit at any price. Today, due to the growth of subprime lending, more lower-income and minority families have the opportunity to buy homes, to refinance their debts, and to finance educational, medical, and other important expenses.

As we continue to work to expand the availability of credit in both the prime and subprime markets, however, we also must work to prevent abusive practices. As part of the HUD-Treasury Task Force effort, we have convened four public forums to date around the country to learn how these practices are affecting our nation’s communities.

Last week, I attended one of these public forums in my native Baltimore. I was disturbed to hear of the abusive lending practices that are occurring in my hometown?s neighborhoods. In Baltimore and in other cities the Task Force has visited, these abusive practices are often targeted at the most vulnerable among us ? elderly Americans and low-income Americans - and often are targeted at minorities. Those practices are hurting not only individuals and families, but also whole communities, and are threatening to undo the enormous progress we have made over the past several years. This makes it ever more vital that we address these issues.

All Americans deserve fair access to capital. A subprime loan is a good option when the alternative is no access to credit. It is a poor option when the borrower should be qualifying for prime credit. And a subprime loan is an unacceptable option when it comes with predatory terms or inadequate disclosure. Abusive practices should have no place in our credit markets. Our goal should be to eliminate such practices and to promote the availability of prime credit to all eligible borrowers.

The four public forums held to date by HUD and Treasury, as well as this hearing, represent important steps toward identifying and addressing these practices. My testimony today will focus on two topics:

  • First, I would like to discuss the kinds of abusive practices that we are seeing in the home mortgage market, and the broader market in which these practices are taking place.
  • Second, I would like to point out specific areas that we are reviewing as we move toward issuing our final Joint Task Force report with HUD next month.

The Subprime Market

Subprime lending commonly refers to mortgage or consumer lending to borrowers with impaired or limited credit histories or high debt relative to their income. It also includes low balance loans that are smaller than those offered by most prime lenders.

The prime mortgage market is accessed primarily by borrowers seeking loans for home purchase or to obtain better rates or terms in a refinanced loan. In the subprime mortgage market, however, as much as 70 percent of loan proceeds are used for debt consolidation and other consumer credit needs. Subprime mortgage lending is therefore both part of the mortgage market and part of the consumer credit market.

In many cases, subprime lenders offer borrowers with imperfections in their credit history a second chance at credit, providing the opportunity for individuals and households to improve their financial situation. The large increase in subprime mortgage lending over the last several years has helped to expand access to credit for borrowers who were previously left behind by the credit markets. Evidence indicates, however, that abusive practices in these markets have grown as well. Therefore, understanding the subprime market is essential to understanding what steps we can take to combat abuses while preserving access to credit in this market.

Lending in this market has grown rapidly in recent years. In 1999, originations in the subprime mortgage market totaled $160 billion, which represented approximately 12.5% of the $1.3 trillion of total originations that year. This represented a 360 percent increase over the $35 billion in subprime mortgage originations in 1994. Total outstanding subprime debt at the end of 1999 was approximately $370 billion.1

Although the categories are not standardized, the borrowers in the subprime market range from ?A-? credit risks to ?C? and ?D? credit risks. An ?A-?credit risk may be a borrower who may have good credit generally but has had some minor payment delinquencies in the past year. A ?C? or ?D? credit risk may have a marginal or poor credit history, including multiple payment delinquencies in the past year or past bankruptcies.

Subprime lending generally has the following characteristics:

  • Higher risk - Lenders experience higher loan defaults and losses by subprime borrowers than by prime borrowers.
  • Lower loan amounts ? On average, loans in the subprime mortgage market are smaller than loans in the prime markets. Estimates for average subprime loan size ranging between $58,000 and $85,000, as opposed to an average of $133,000 for all mortgages.
  • Higher costs to originate - Subprime loans generally are more costly to originate than prime loans, as they often require additional review of credit history, a higher rate of rejected or withdrawn applications, and fixed costs, such as appraisals, that represent a higher percentage of a smaller loan.
  • Faster prepayments - Subprime mortgages tend to be prepaid at a much faster rate than prime mortgages.

As a result of the above characteristics, subprime loans tend to have significantly higher fees and rates than for prime loans.

The origination of a loan in the subprime market frequently involves one or more intermediaries or third parties, including home improvement contractors, mortgage brokers, and mortgage insurance companies. Some of these do not take any credit risk on the loan, and therefore are more concerned with the fees generated up-front than with the ultimate repayment of the loan.

While the subprime mortgage market provides valuable access to capital for many borrowers, consumers who replace unsecured credit with mortgage loans risk losing their homes in the event of default. We believe that it is vital for subprime borrowers to understand that the lower rate of a subprime home equity loan comes with significant risks.

Predatory Practices

Along with the benefits that have come from the expanding availability of credit in the subprime market, there is also evidence of growing abuses. In many neighborhoods, these abusive practices threaten to erode the enormous progress that has been made over the past several years in revitalizing neighborhoods and expanding home ownership.

In the public forums we have held with HUD, we have learned about some practices that are clearly abusive in any context. In many instances, the consequences for the borrowers have been disastrous.

The practices that we are seeing fall into four main categories:

  • Loan Flipping ? Some mortgage originators are refinancing loans repeatedly in a short period of time. With each successive refinancing, these originators charge high fees that reduce borrowers? equity in their homes. While fees in the subprime market can be expected to exceed those in the prime market, borrowers in some instances are charged upwards of $5,000 for each refinancing, quickly draining the equity in their home. Lenders also structure high-cost loans with terms, such as a balloon payment, that can force a lower-income borrower to refinance a loan multiple times. In many ways, loan flipping is akin to a securities broker ?churning? a customer?s stock portfolio, with the fees reducing the value of the portfolio with each purchase and sale. With mortgage loan flipping, however, the end results of default and foreclosure can be much more devastating.
  • Excessive fees - While subprime lending carries higher costs to the lender than prime lending, in some instances we have seen fees that far exceed what would be expected or justified based on economic grounds. Many of these fees may be charged by mortgage brokers and other third parties, in addition to the lender. Borrowers often do not realize how expensive their loans are, as the fees are added into the amount financed rather than paid up-front. Single-premium credit life insurance, for example, is often added to the borrower?s loan amount, raising the price of the product and disguising its true cost to the borrower.
  • Lending without regard to the borrower?s ability to repay - One troubling practice we have seen is lending based on borrowers? equity in their homes, where the borrowers clearly do not have the capacity to repay the loans. The lender may recover the loan principal by foreclosing on the borrower?s home. This can also happen where income figures or other data are falsified by a broker and not adequately verified by the lender. In particularly egregious cases, loans have been made to elderly people living on fixed incomes where the monthly payments equaled or exceeded their monthly income. Such loans quickly go into default and the lenders foreclose.
  • Outright Fraud - In many instances, abusive practices amount to nothing less than outright fraud. We have heard many stories of fraud from borrowers who testified at the HUD-Treasury regional forums. For example, in the Baltimore forum last week I was introduced to a practice that is known there as ?asset flipping.? In these instances, an unscrupulous investor buys a dilapidated house and makes superficial repairs and conspires with an appraiser and a mortgage broker to inflate the appraised value of the property. To facilitate sale at a fraudulently inflated price, the seller and broker will sometimes doctor the loan application and settlement documents. Many of the borrowers who are victims of this scheme cannot afford to repay or refinance the mortgage based on the inflated price, and these loans may go into default and foreclosure quickly. Appraisers and others engaging in this fraudulent practice are helping to send first-time home buyers ? and whole communities ? into economic ruin. Foreclosure petitions filed for homes in the Baltimore area jumped from 1,900 in 1995 to over 5,000 in 1999.

Through the regional forums and our own research, we have seen three patterns emerge in the use of these predatory practices:

  • First, certain actors in these markets are preying on the most vulnerable in our society - the elderly, recent immigrants, minorities, and individuals with lower incomes and less education.
  • Second, borrowers in these markets often have limited access to the mainstream financial sector. Even those borrowers who would likely qualify for a prime loan are not accessing credit at a bank. There are various estimates that between 15 and 35 percent of those currently borrowing in the subprime market could qualify for a prime loan. On the one hand, banks may not be doing enough to reach out to these borrowers. We have seen evidence that older borrowers, having held a prime mortgage from a bank for many years, received a higher cost subprime loans to pay for repair work on their homes. In some inner-city areas, this may reflect the fact that banks have receded over time, and have been replaced by unregulated finance companies. On the other hand, subprime lenders may effectively be capturing borrowers in these markets. For example, it may reflect a failure on the part of subprime lenders to fully report the payment history of their borrowers.
  • Third, these practices are most often coupled with the deceptive or high-pressure sales tactics of mortgage brokers, home improvement contractors or lenders themselves. Unscrupulous actors may take advantage of a borrower?s lack of financial sophistication or vulnerable situation. They may hide disclosures from borrowers, begin work on a borrower?s home and then ?bait and switch? with new loan terms before the loan is closed, finance fees without borrowers? knowledge, or lead them to believe that they must purchase products such as credit insurance in order to close the loan.

Areas for Review

There should be no place in our credit markets for the abusive practices that we have seen in our Public Forums. We at Treasury and HUD continue to review the information we have gathered as we look for ways to reduce abusive lending practices through better enforcement of existing laws, use of existing regulatory authority, and new statutory provisions. We are examining how existing regulatory authority could be used to address some of the practices that we are seeing.

The Office of Thrift Supervision has suggested additional steps that could be taken under its existing authority, which Director Seidman will discuss further. As Comptroller Hawke will discuss, the Office of the Comptroller of the Currency has the authority to review abusive practices on a case-by-case basis. Assistant Secretary Apgar will discuss what HUD is doing with respect to Federal Housing Administration (?FHA?) mortgages and Real Estate Settlement Procedures Act (?RESPA?) enforcement. We also are encouraging the Federal Reserve Board to use its authority to restrict abusive practices, such as loan flipping, to issue further regulations using its authority under the Home Ownership Equity Protection Act (?HOEPA?), and to require the collection of additional Home Mortgage Disclosure Act (?HMDA?) and other data in this market.

We are also examining what additional legislation may be necessary. While it is too early to say what our recommendations will be when our report comes out next month, there are four general areas we are reviewing: 1) consumer financial literacy; 2) sales practices; 3) loans terms and conditions; and 4) market structure.

Consumer Financial Literacy

The success of predatory lenders points to the increasing need for improvements in consumer financial literacy. Consumer education, clearer disclosures, and better consumer counseling can help consumers avoid becoming the victims of abusive lending practices.

To this end, Treasury recently announced a consumer education initiative, the National Partners for Financial Empowerment, with participants from other government agencies, including HUD, as well as the financial services industry, and consumer and community organizations. Educational efforts will be an important factor in limiting the growth of predatory lending.

The impact of consumer education will be limited, however, without clear, understandable disclosures. Mortgage loans are inherently complex transactions, even for the most sophisticated borrowers. The availability of a broad range of products and terms has also made comparing loans increasingly difficult.

We see the need for better disclosures. The 1998 Joint Report to Congress by the Federal Reserve Board and HUD on RESPA and Truth in Lending Act (?TILA?) will form a base for those recommendations. We are continuing to examine issues raised in the 1998 report to see if other recommendations could be made that would improve disclosure.

We also are looking at the potential benefits of credit counseling for borrowers. High quality counseling services may enable borrowers to make better and more informed credit decisions. We are examining whether there are some instances where it is appropriate to require counseling, either before a loan is made, or foreclosed on.

Sales practices

While enhanced consumer literacy is a start, it is not enough. Unscrupulous actors in this market are still engaging in deceptive and fraudulent sales practices that victimize the most vulnerable borrowers. We are looking for ways to identify these actors and to provide borrowers with the opportunity for redress.

Abusive sales practices tend to occur most frequently with mortgage creditors and brokers that are not subject to direct supervision. For these entities, enforcement of most federal consumer protection laws rests with the Federal Trade Commission (?FTC?) and with state authorities. Providing the resources requested in the President?s budget for the FTC could assist in combating predatory lending practices. We should also seek to identify and promote best practices at the state and local level.

HOEPA currently prohibits lenders from engaging in a ?pattern or practice? of asset-based lending. We are examining whether it would be appropriate to require lenders to evaluate a borrower?s ability to repay a loan in all cases. If such an approach is adopted, policies to prohibit this abusive practice should build in flexibility for underwriting.

An important area that we are looking at is the establishment of standards for mortgage originations. State authorities may wish to take a careful look at their licensing requirements for mortgage brokers, home improvement contractors, appraisers, and other market participants. Financial institutions should ensure that the brokers with which they do business are not using abusive sales practices to make loans.

Loan Terms and Conditions

Aside from abusive sales practices, there are some terms and conditions in loans that are inherently abusive. An example of such a term is single premium credit life insurance, in which the borrower must pay the cost of credit life insurance up-front. Both HUD and the Federal Reserve Board agreed in their 1998 Report that such requirements should be prohibited for at least some class of loans. Additionally, the President called for the prohibiting the sale of single-premium credit life insurance in May 1999.

In looking at statutory changes, one issue we must consider is whether the current HOEPA structure is the appropriate mechanism for addressing abusive practices. Under HOEPA, specific practices are prohibited that are considered abusive for the most vulnerable borrowers who are taking out high cost loans. Measured by the current interest rate trigger, less than one percent of subprime loans are covered by HOEPA. While we need further data on fees, this indicates that HOEPA is likely not covering the bulk of potentially abusive loans.

An example of practices that may be appropriate to restrict in this context include limits on the financing of fees and penalties for a refinanced high-cost loan. Short-term balloon payments may also be especially onerous for borrowers of high-cost loans, and further restrictions ? as proposed by HUD and the Board ? may also be appropriate in this area. One of the signal achieved in the mortgage market in the last century was the creation by FHA of the self-amortizing 30-year mortgage. This product enabled millions of Americans to own their own homes. That is why, in the context of these loans, we need to be concerned about the impact of balloon payment on homeowners. Further restrictions on balloon payments - as proposed by HUD and the Board - deserve consideration.

There may be general agreement, however, that some practices are inappropriate regardless of whether the loan falls under HOEPA. For example, requirements for the purchase of single premium credit life insurance do not appear to be appropriate for any borrower, not just for borrowers under higher cost loans.

Market Structure

Finally, we are looking at a broad range of market structure issues. One such issue is the extent to which increased competition could help to reduce some of these practices. While in some markets there may competition among subprime lenders for business, this competition can sometimes be a ?race to the bottom? by brokers and lenders who misrepresent the terms of the loans they are offering. We need to find ways to promote healthy competition in these markets.

We are looking at ways to encourage subprime and prime lenders to facilitate the graduation of subprime borrowers to the prime markets. The subprime market should provide borrowers a ladder to the prime markets, rather than acting as a ceiling that keeps borrowers from accessing prime credit.

At the same time, we are considering the role that the secondary markets play in this lending. Purchasers of subprime loans in the secondary market have economic incentives to avoid purchasing fraudulent or abusive loans, as such loans are likely to have higher rates of default and loss.

As we further examine market structure issues, we continue to examine the need for additional data on loans in the subprime markets. There is a dearth of information on rates and fees in these markets, and many lenders may not report under HMDA. This is an area we will look at carefully in our final report.

Conclusion

As we continue to seek ways to expand access to capital for low- and moderate-income individuals and areas, predatory lending practices threaten to undue a portion of the progress so many have worked to achieve. Working with HUD, we hope to develop recommendations that will strike an appropriate balance between preventing abusive practices and preserving consumer options and access to capital.

We applaud the efforts of members of Congress who have shown leadership by introducing proposals to combat abusive lending practices. We look forward to discussing the conclusions and recommendations of our report and to working with this Committee on these important issues.

Thank you.

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1.  Mortgage Market Statistical Annual for 2000, Inside Mortgage Finance Publications, Inc., vol. II, pages 1-2.



 

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