STATEMENT OF THE AMERICAN FINANCIAL
COMMITTEE ON BANKING AND FINANCIAL SERVICES
UNITED STATES HOUSE OF REPRESENTATIVES
May 24, 2000
The American Financial Services Association (AFSA) appreciates this opportunity to express our views on home equity consumer lending issues. AFSA is the trade association for a wide variety of non-traditional, market-funded providers of financial services to consumers and small businesses. AFSA members include major providers of secured and unsecured credit.
SUMMARY OF AFSA's POSITION
The American Financial Services Association (AFSA) looks forward to working with the Subcommittee to undertake a thorough examination of the issue of "predatory lending". AFSA is extremely concerned that the pejorative term predatory lending is frequently applied to subprime home equity lending. They are two completely different activities in nature and scope.
To the extent information is available, primarily through anecdotes, predatory lending seems confined to the so-called practice of equity skimming or stripping. If the facts surrounding the anecdotes of predatory lending are as alleged, it seems to consist primarily of a criminally fraudulent practice in which a consumer is intentionally induced into a series of transactions intended to result in the loss of the consumers principal residence. Most equity stripping examples seem to involve home improvement scams where the loan is not originated directly by a lender. AFSA is not aware of any concrete information or statistics on the number of cases of equity stripping, but we can provide information as to legitimate subprime lending practices that indicate why the two are mutually exclusive.
Subprime lending is a specialized, but important offshoot of the home equity loan market that emerged in the 1990s, permitting millions of Americans with less than perfect credit to access the equity in their homes. Subprime borrowers are not old and poor, but simply may not meet the standards for traditional bank credit that are required by the bank regulatory culture which is focused on protecting the deposit insurance funds. Without subprime lenders, millions of Americans would not have participated in the credit markets over the past 10 years. These same credit markets are a major stimulus to the U.S. economic expansion while at the same time home equity is a more affordable and flexible form of credit for both prime and subprime borrowers. Subprime home equity loans frequently enable a borrower to reduce their overall level of debt and lower their overall rate. Subprime lenders, like prime lenders, do everything they can to avoid foreclosure, which almost always results in a substantial loss to the lender. Foreclosure rates among legitimate lenders are very low.
AFSA urges the Subcommittee to consider any additional home equity regulation with caution and avoid letting a limited number of lowest common denominator practices drive additional legislation that forces subprime lenders to limit credit risk and exclude worthy borrowers . It is clear that the practice of equity stripping is already illegal and in fact criminal, and the Home Ownership and Equity Protection Act (HOEPA) has a whole regimen of stringent protections for certain home equity loans. There is no information available as to why enforcement of existing laws is inadequate and there is no better deterrent to this type of behavior than successful prosecution.
Lending Policy Goals Set by Congress and the
Development of the Subprime Market
For virtually the entire century, Congress has made credit availability a goal. In the 1930s, the Congress enacted the Home Owners Loan Act establishing the Federal Home Loan Bank System. Later Congress set up the housing GSE's, Fannie Mae and Freddie Mac. In later half of the century, Congress has pushed to make credit available to segments of the market that did not have access to credit products. To this end, the Congress enacted the Fair Housing Act, ECOA, TILA, CRA, etc.
Today, Congress should take great pride in the diversity of the marketplace. Clearly, many communities and individuals have access to a wide array of financial products that were not available 10, 20 or even 30 years ago, illustrated by the unprecedented level of homeownership across the nation. Responsible lenders have responded to Congress' call to action focused on making consumer credit available, convenient, and affordable for all Americans including those with low- and moderate-incomes.
As evidence of this change in the marketplace, Governor Gramlich of the Federal Reserve recently stated:
"Between 1993 and 1998, conventional home-purchase mortgage lending to low-income borrowers increased nearly 75 percent, compared with a 52 percent rise for upper-income borrowers. Conventional mortgages to African-Americans increased 95 percent over this period and to Hispanics 78 percent, compared with a 40 percent increase in all conventional mortgage borrowing. A significant portion of this expansion of low-income lending appears to be in the so-called subprime lending market. This market has expanded considerably, permitting many low-income and minority borrowers to realize their dream of owning a home and to have a chance for acquiring the capital gains that have so increased the wealth of upper-income households."
An Overview of the Home Equity Market
The only periodic ongoing study of the home equity market is performed by the University of Michigan Survey Research Center for the Federal Reserve Board utilizing its monthly Surveys of Consumers, which is a unique monthly canvass of consumers.
The Size of the Market
The overall size of the home equity market is estimated at approximately $420 billion(1). Subprime home equity lending is estimated to account for between 21 and 35 percent of the total market or in dollar terms, between $90 billion(2) and $150 billion.(3) The subprime market is estimated to include 25 percent of all adults.
Customer Satisfaction and Knowledge
Customer satisfaction with home equity loans is extremely high--94 and 98 percent respectively for the two main types of home equity products, closed end and open end loans. "Among the small percentage of respondents who were dissatisfied, most complaints concerned the interest rate on the loan."(4)
Basic customer knowledge about home equity loans is also extremely high. Virtually all consumers knew that there was a lien on their home and 95 percent of all home equity borrowers knew about the possibility of foreclosure if they missed a payment. Nearly all households with home equity lines of credit (99 percent) and traditional home equity loans (96 percent) said they received all the information they needed when they obtained the loan. Most (86 percent and 79 percent respectively) recalled receiving the Truth in Lending statement and nearly all borrowers (94 and 97 percent respectively) saved a copy. However, only between 12 percent (open end) and two percent (closed end) indicated that the Truth in Lending statement affected their credit decision. (5)
Consumer knowledge and satisfaction regarding home equity credit
and installment credit, by type of credit. 1997
Knew or leaned there was lien on home
|Knew or learned therewas right to cancel||94||95||...|
|Searched for information(1)||44||54||33|
|Obtained the information|
|Recalled receiving Truth in|
|Saved Truth in Lending|
|Found Truth in Lending|
|Said Truth in Lending|
|Indicated satisfaction with|
Note: Percentages are for holders of the indicated type of credit.
Data have been weighted to ensure the representativeness of the sample.
1. Searched for information about other creditors or credit terms before obtaining credit.
2. Proportion of those who "searched for information."
3. Proportion of those who "recalled receiving Truth in Lending statement."
4. Respondents who said they were "very satisfied" or "somewhat satisfied with account."
SOURCE. Surveys of Consumers. 1997.
Home equity borrowers tend to have more education and higher incomes than other borrowers, with 35 percent possessing college degrees or above and 42 percent with household incomes of at least $45,000. (6) Subprime borrowers are not poor and elderly but generally are slightly younger than all U.S. homeowners, with the bulk of subprime borrowers falling into the 35-54 age bracket and having a median age of 48 as opposed to the median age of 51 for all U.S. homeowners.(7) In terms of income, the median income for all subprime borrowers is about $34,000 compared to about $37,000 for all U.S. homeowners.(8) Almost 25 percent of all subprime borrowers have household incomes in excess of $50,000.(9)
How Customers Use Their Loans
Home equity loans frequently enable subprime borrowers to reduce their existing level of overall debt rather than adding to it. The majority of subprime home equity loans (83 percent) go towards refinancing or consolidating existing debt. Refinancing of outstanding current mortgages account for approximately 44 percent of home equity loans extended to these borrowers. In many cases, this enables borrowers to obtain a lower interest rate or lower monthly payments via extending maturity, or sometimes both. Debt consolidation accounts for approximately 39 percent of the loans, which again helps borrowers to reduce their debt levels, as it is frequently less expensive to borrow against home equity. Less than 20 percent of these loans are used for other purposes such as home improvement or education.(10)
Subprime lending is a specialized,difficult business in the throes of a significant economic shakeout characterized by significant business failures and exits from the business by significant lenders. While portrayed by opponents simply as overpriced loans that provide excessive profits, the facts are to the contrary. Since 1997, over a dozen prominent subprime mortgage lenders have failed and at least that many have suffered significant financial losses over the past two years, particularly during the liquidity crisis of 1998. Stronger financial entities acquired three or four others and at least another seven voluntarily exited the business.
Subprime lenders are subject to intense underwriting review by the rating agencies such as Moody's since they securitize many of their loans. They also undergo close scrutiny by the ratings agencies for safety and soundness since they derive much of their funding from the commercial paper markets. Since commercial paper has a short maturity, 270 days at the maximum and generally much shorter, any reduction in credit quality or increase in loan losses results in immediate liquidity problems and the lender's funding dries up.
In terms of specific underwriting criteria, the portfolios of subprime lenders are generally characterized by good average credit scores (FICO Scores) although the scores are not the sole criteria for lending by any means. Successful subprime lenders do relatively little high loan to value (LTV) lending and maintain conservative LTVs, significantly below the levels characteristic of the FHA and VA programs.(11) According to Standard & Poors, in the fourth quarter of 1999, the average LTV on asset backed securities backed by subprime loans ranged between 77.57 and 78.66 depending on the type of loan. It stands to reason that if a lender is dealing with a borrower with less than tarnished credit, it needs to compensate through a variety of underwriting and pricing devices. Lower LTVs is one means available. Successful high LTV lending is more likely to occur among customers with prime customers, where they have other attributes, such as high income or assets that compensate for the lack of equity.
AFSA is currently working to develop consistent and accurate foreclosure statistics for its members that engage in subprime lending. Based on Moody's statistics for subprime lenders, data is available about charge off rates, which are not limited just to foreclosures. Charge off rates for subprime loans are 1.4% and 1.6% for all home equity loans. Charge offs are higher for high LTV loans, averaging 3.5%, not surprising since these are essentially unsecured loans. Again, a chargeoff does not mean that the lender has foreclosed; it simply means that payment is not anticipated within a reasonable time frame. Some portion of these charge offs are recovered.
The charge off percentage is the maximum universe for foreclosures, and in reality, foreclosures are a much smaller percentage. Lenders do everything that they can to avoid foreclosures as they almost invariably lose money. Foreclosed property often is poorly maintained, meaning lenders must pay substantial "fix-up" costs to get the property into saleable condition. Foreclosed property often loses some (or a great deal) of its value, so that the lender is unable to recoup full payment of the original loan amount when (and if) resale occurs. Back taxes and other unpaid bills related to the property becomes the lender's liability upon repossession of the property and frequently reduce recovery. Depending upon the state in which the property is located, lenders may also incur miscellaneous costs such as Realtors fees (to re-list the house) and may have to settle other liens on the property.
No subprime lender extends credit with the intent of subsequent foreclosure.
Subprime lending is not predatory lending. AFSA believes that predatory lending cases, while not widespread, are actually cases of illegal fraud and misrepresentation, frequently involving "home improvement loans" originated by third parties. AFSA strongly opposes predatory lending and urges the Committee to carefully consider remedies under existing law and examine whether enforcement of these laws is adequate. AFSA also urges the Committee to obtain hard factual data on the actual frequency of these alleged abuses.
Governor Gramlich of the Federal Reserve provided an excellent framework for discussion of this issue in a recent speech:
A significant component of predatory lending involves outright fraud and deception, practices that are clearly illegal. The policy response should simply be better enforcement. But the harder analytical issue involves abuses of practices that do improve credit market efficiency most of the time. Mostly the freedom for loan rates to rise above former usury ceilings is desirable, in matching relatively risky borrowers with appropriate lenders. But sometimes 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 and are unduly influenced by the up-front money. Most of the time the ability to refinance mortgages permits borrowers to take advantage of lower mortgage rates, but sometimes easy refinancing means high loan fees and unnecessary credit costs. Often mortgage credit insurance is desirable, but sometimes the insurance is unnecessary, and sometimes the borrowers pay premiums up front without the ability to cancel the insurance and get a rebate when the mortgage is paid off. Generally, advertising enhances information, but sometimes it is deceptive. Most of the time disclosure of mortgage terms is desirable, but sometimes key points are hidden in the fine print.
Those who strongly advocate increased regulation of home equity lending have identified 32 practices which they claim are "predatory". Many of these are clear violations of existing deceptive and fraudulent practices laws, whether criminal fraud statutes like the federal mail fraud statute, the Federal Trade Commission Act, state deceptive practices acts, RICO or common law fraud.(12) Many of the practices they describe, however, involve legitimate business responses to the special risks which higher risk loans present. If these practices were made illegal or significantly regulated, reduction in credit availability or increase in the costs consumers pay for credit would follow. As Governor Gramlich points out, these practices overall improve market function.
The following list reviews legitimate business practices which are singled out for attention:
1. High Annual Interest Rates: Charging higher than average interest rates does not signal illegitimate lending practices. The subprime lending market serves borrowers who have significantly higher than average risk characteristics. To cover the higher risk and consequent higher likelihood of loan loss and collection expense, lenders must charge interest rates that are higher than average so as to cover their costs and return to shareholders an average profit. Just as insurers are justified in raising their rates to individuals who present increased risk, the higher interest rates charged by lenders in the subprime market reflect increased risk of loan loss. Government controls which restrict the price which may be charged for credit or which impose heavy additional regulatory burdens on this type of credit (which, because it increases costs of providing the credit, has a similar effect) predictably causes a reduction in the availability of credit to deserving borrowers who happen to have higher than average risk. These are generally less affluent than normal borrowers, young people starting a family, and people who have experienced recent job loss or similar misfortune.
2. High Closing Costs: Charging borrowers for closing costs is a well established practice in mortgage lending, and permits immediate recovery of some of the considerable cost of originating a loan and reduction of the lender's exposure to loss due to early prepayment or default. Reduced risk permits interest rates to be lowered, to the benefit of borrowers. Moreover, although closing costs for subprime loans sometimes appear high in comparison to conventional purchase money loans, this appearance is misleading. Because subprime home equity mortgages are on average considerably smaller than conventional purchase money mortgage loans, a higher proportion of the total loan amount must go to cover closing costs, magnifying the size of the closing costs. Moreover, because subprime borrowers present increased risk, it is appropriate to carefully investigate credit and background and to evaluate the borrower's financial strength, even though the cost of doing so is higher than for a potential borrower with better credit. Recovering these higher costs is completely legitimate, and trying to restrict charging for them only interferes with the most efficient method for their recovery, without significant benefit to borrowers.
3. Prepayment Penalties: Prepayment penalties protect lenders from significant loss when borrowers prepay their loans before maturity, and particularly when interest rates have fallen. The home equity market is highly competitive, and one lender is often trying to capture the home equity borrowers of another. Borrowers frequently have the opportunity to refinance with another lender for a better rate or more liberal lending policies. Without prepayment penalties, the lender who made the original loan is likely to be unable to recover the cost of originating a loan before the borrower prepays. Moreover, prepayment penalties help reduce the interest rate risk facing lenders who fund home equity loans with long and short term borrowing from the capital markets. A lender who has borrowed from the market at 8% and is charging 10% will be significantly damaged in a falling interest rate environment if its borrowers prepay, since the lender cannot find borrowers of equivalent risk who will pay 10%, but must continue to pay its lenders 8%.
4. Credit Insurance: Credit insurance permits borrowers to insure themselves against the risk of death or disability which could make it difficult or impossible to make the required loan payments. Many people benefit from this form of insurance, and they value its convenience and availability. Surveys show that people strongly favor the option of purchasing credit insurance. Restricting the availability of credit insurance is clearly not desirable.
5. Refinancing: Refinancing a loan is a legitimate practice, widely engaged in by borrowers seeking to obtain a better interest rate or an increased loan amount at favorable interest rates. Attempts to restrict refinancing frequency or limit the fees charged on a refinancing restrict borrower freedom of choice and ability to structure the borrower's own financial affairs.
6. Loan Underwriting: No legitimate lender knowingly makes loans to people who cannot afford the payments. A defaulted loan is a deadweight loss for any lender, since not only is the lender's ability to recover principle at risk, the additional costs of collecting the defaulted loan increase the lender's losses. Unfortunately, no one has yet developed a completely accurate way to identify in advance borrowers who will default. Penalizing lenders whose borrowers default based on a judge or jury's second guessing the lender's original underwriting decision would significantly discourage legitimate lenders from making credit available to borrowers with imperfect credit.
7. Balloon Payments: Balloon payments are a legitimate method of structuring loan terms, and often help borrowers secure lower monthly payments and favorable interest rates. They are common in both the subprime and prime purchase mortgage money markets. For example, the well known 5/25 or 7/23 loans provide a favorable interest rate for 5 or 7 years, require payments as though the mortgage was being paid over 30 years, and have a balloon payment at the end of the initial 5 or 7 year term.
8. Negative Amortization: Negative amortization is appropriate for some borrowers, particularly when market interest rates are high, but expected to fall in the future. It allows lenders to reduce the amount of the monthly payments for a period of time, after which it is expected either interest rates will have fallen, or the borrower's ability to pay will have increased.
9. Brokers Fees: Brokers provide borrowers with legitimate services, and it is appropriate that they be paid for their services. The Real Estate Settlement Procedures Act already forbids broker fees which are not justified by the services rendered by the broker.
10. Mandatory Arbitration Clauses: Mandatory arbitration clauses both aid the consumer and the lender. Consumers are provided an economical and rapid place in which they can obtain adjudication of disputes with the lender. Often, a lawyer is unnecessary. Lenders enjoy similar benefits, and are in addition able to avoid the enormous costs of litigating in many different courts that are geographically dispursed. At the same time, the burden and expense of literally thousands of cases per year on the judicial system is avoided.
11. Co-signers: Requiring a borrower to provide a cosigner is fully legitimate and often benefits the borrower. Sometimes a borrower with poor credit can obtain credit which would otherwise be unavailable, or reduce the interest rate for a loan by obtaining a cosigner who will agree to be liable with the borrower. Lenders are willing to offer such accomodations because the cosigner reduces the lender's risk of loss on the loan.
12. Open End Mortgages: Although advocates of increased regulation have attacked "spurious open end mortgages" as illegitimate, in fact they are open end mortgages properly classified under the regulations the Federal Reserve Board has promulgated after lengthy consideration. No one has been able to establish a clear causative link between the classification of a loan as open end or closed end and abusive practices. However, if the relatively clear tests of open end and closed end credit were to become blurred, compliance with the Truth in Lending Act would be significantly complicated, since the required disclosures for open end and closed end credit are fundamentally different.
13. Permitting borrowers to apply loan proceeds as they wish: Those urging heavier regulation have argued that a lender acts illegitimately if the borrower uses home equity loan proceeds to pay off low interest obligations or unsecured debt. While it often seems clear with the wisdom of hindsight whether a particular decision by the consumer to pay one or another debt with loan proceeds, regulation which penalized a lender for these borrower decisions would place the lender in the role of controlling borrower use of the loan. Such interference is not in the interest of borrowers, nor consistent with consumer choice. For example, it would result in making illegal the actions of thousands of homeowners who have used homequity loans to pay off debts from their childrens' educations and medical treatment. Favorable tax deductibility of interest and much longer loan terms than the loan which was paid off provided may make payments affordable.
14. Making loans in excess of 100% Loan to Value (LTV): There is nothing illegitimate in making loans in excess of collateral value. For example, a lender may be willing to lend to a borrower 110% of real estate value at a rate which is more favorable than the average weighted interest rate that could be obtained for a smaller home equity loan combined with an unsecured loan.
15. Force Placed Insurance: Lenders must be able to ensure that the collateral is protected by insurance. If a homeowner fails to keep the property insured, the lender has no choice but "force place" the insurance to protect the value of the collateral. It is also appropriate for the borrower to pay the cost of such insurance, even though the premium is often considerably higher than what a consumer would pay to continue conventional insurance. Insurers have learned that force place insurance is often riskier than conventional coverage.
Each of these practices is an entirely legitimate business practice. It is possible that some lenders may nonetheless incorporate one or more of them into a scheme to defraud or trick the debtor. However, it is the fraud, not the practice itself, which is the appropriate target of governmental intervention. Present law provides a formidable arsenal to attack and control fraudulent conduct, and neither consumer advocates nor governmental officials lack the tools to control abusive practices when they occur. While no one seriously condones predatory lending practices, additional regulation is not only not needed, it is likely to seriously restrict the market forces which have made low cost, affordable credit widely available to the American consumer.
Adequacy of Present Regulation
At the core, the practices advocates of increased regulation focus upon are common garden variety fraudulent practices that have been with us for a long time. State and federal governments have already developed elaborate laws to prevent and penalize the kinds of fraudulent practices which have been listed. In addition to common law fraud, extremely powerful anti-fraud statutes are available to attack abusive lending practices. These include the federal mail fraud statutes, state deceptive practices acts enforced by state attorneys general and civil class action suits brought by "private attorneys general", the Federal Trade Commission prohibition on unfair and deceptive acts and practices and administrative proceedings to proscribe such practices by rule or adjudicatory proceeding, RICO, and a wide range of criminal fraud statutes. More specific statutes include the Home Owner's Equity Protection Act, both the Fair Lending and Equal Credit Opportunity Acts forbidding discriminatory practices in lending, and the Real Estate Settlement Procedures Act. The latter both requires a disclosure of closing costs, including an itemization of to whom each closing cost is paid and in what amount, and forbids the payment of unearned fees to entities not owned by the payor if the fee can be characterized as on account of a referral.
Again, AFSA opposes truly predatory lending where there is intent out the outset to deprive a consumer of their home through intentionally fraudulent means. Again, existing law covers these practices thoroughly. To the extent these abuses are increasing, more resources for enforcement should curb these practices.
Subprime lending and predator lending are clearly not the same thing. As the above discussion of the industry, its practices and customers indicates it is a specialized type of lending that meets a real need for ordinary people. It is neither easy or wildly profitable. It makes a significant contribution to an improved standard of living for many consumers and contributes heavily to U.S. economic growth. Subprime lenders have no intent or interest in taking a consumer's house. AFSA urges Congress to move carefully in this area to avoid collateral damage to legitimate lending.
1. Canner, Glenn B., Thomas A. Durkin, and Charles A. Luckett, "Recent Developments in Home Equity Lending,", Federal Reserve Bulletin, Vol. 84, No. 4 (April 1998), pp. 241-251.
3. Weicher, John C., The Home Equity Lending Industry, Indianapolis, Indiana: The Hudson Institute,1997
4. Canner et al.
6. Ibid.7. Weicher, 1997. 8. Ibid.