ECN741: Urban EconomicsMortgage Markets and Predatory Lending

Predatory Lending

•Class Outline

▫The mortgage market today

▫Predatory lending

▫The default crisis

▫The new Consumer Finance Protection Bureau

Predatory Lending

“It’s A Wonderful Life”

•Mortgage markets used to be simple.

▫People opened savings accounts in S&Ls; these S&Ls loaned out their deposits to other people in the form of mortgages.

▫At any given time, all mortgages were issued at the same interest rate; but people with credit problems were turned down for a loan.

Predatory Lending

New Institutions

• How times have changed!

▫Now commercial banks can issue mortgages.

▫Most mortgages are now issued by mortgage brokers, who do not have deposits, but instead raise capital from depository lenders or investors .

▫Secondary mortgage market institutions (Fannie Mae, Freddie Mac) bring investors and borrowers together by buying mortgages and packaging them into “mortgage backed securities,” which anyone can buy.

Predatory Lending

Types of Service in a Mortgage

•A mortgage offers four types of services:

▫Mortgage origination (using “underwriting”)

▫Mortgage servicing

▫Default and prepayment risk acceptance

▫Capital provision

▫An S&L did all of these things; now they are often provided by different institutions.

Predatory Lending

The Emergence of Mortgage Brokers

•Mortgage brokers, often working as independent entities, originate a large share of loans and may provide the only contact with the borrower until closing.

•The mortgage broker plays an important role in pricing the loan, and the broker’s compensation may depend on the interest rate and fees paid by the consumer.

Predatory Lending

New Institutions

Predatory Lending

The Loss of Connection with Borrowers (and Scholars)

•Mortgages are sold and re-sold; packaged and re-packaged.

•Data systems do not trace the participants and may not even keep track of the title.

•Links to the original broker may be lost—with no way to hold the broker accountable for poor underwriting decisions.

Predatory Lending

The Secondary Mortgage Market

•Of the 20.2 million home loans originated or purchased in 2004 by lenders covered by HMDA, 14.1 million, or roughly 70 percent, were sold in 2004.

•An unknown number of these loans were (or will be) sold on the secondary market in later years.

Predatory Lending

The Role of the GSEs, Pre-Crash• Fannie Mae and Freddie Mac, originally government-

sponsored enterprises (GSEs), were private companies widely thought (correctly) to have implicit government backing.

• They mainly purchased conventional, low-risk loans for

purchase or refinancing.

• They bought 35% of the loans purchased by secondary-market institutions.

• Other purchasers included banks (8%), private securitization pools (5%), and mortgage and insurance companies (9%).

• About 11% of purchases were by firms affiliated with the original lender.

Predatory Lending

The Mortgage Market

Borrowers =Households

Lenders =Investors

Banks Individuals Thrifts Pension Funds

Intermediaries Mortgage Secondary Banker Mortgage Mortgage Market Broker Institutions =GSE’s

Regulators Financial Other Federal FTC Reserve HUD Comptroller of Justice the Currency OTS FDIC

Supplemental Service Providers

Credit Scoring Agencies Private Mortgage Insurance Companies Local Governments (Bonds)

Note: This mess is the system before the Dodd-Frank Act and the CFPB

Predatory Lending

New Products

•These changes have led to new products.

▫Many types of mortgages are now issued, some of them, called subprime, at high interest rates.

▫Many high-risk borrowers can now get a mortgage if they are willing to pay a high rate.

▫Lenders buy credit scores and automated underwriting systems to predict which potential borrowers are most likely to default.

Predatory Lending

The Pros and Cons of New Products

• These new products dramatically changed mortgage markets.

▫This products had the great advantage that they expanded the set of people who could obtain mortgages.

▫And the great disadvantage that they opened the door for a lot of mischief in the form of unwarranted fees and pricing practices and in the form of charging some people more that they should have paid.

Predatory Lending

New Practices

•With new products come new practices.

▫The complexity of today’s mortgage market puts consumers at a disadvantage.

▫Some unscrupulous lenders use misleading or fraudulent tactics to collect interest payments or fees above competitive levels, which is called predatory lending.

Predatory Lending

Types of Predatory Lending

• Questionable or illegal practices include:

▫ Making loans that exceed the borrower’s ability to pay, sometimes with “teaser rates” (2/28 or 3/27 loans);

▫ Inducing repeated refinancing accompanied by high fees (‘‘loan flipping’’);

▫ Inducing the consumer, through deception or fraud, to accept loan add-ons, such as credit insurance;

▫ ‘‘Steering’’ borrowers qualified for lower-rate loans into higher-priced loans;

▫ Overestimating the value of the collateral to overstate available equity or induce a consumer to pay an inflated price for a home.

Predatory Lending

The Extent of Predatory Lending

•Nobody knows how much predatory lending exists.

• Interest rates are much higher in minority and low-income neighborhoods, where household have little experience with homeownership.

•But subprime loans are clearly more common in places with more credit problems, as one would expect with no predatory lending.

Predatory Lending

Evidence on Predatory Lending

•For a recent discussion of predatory lending practices, see

▫http://www.responsiblelending.org/tools-resources/signs-of-predatory-lending.html

Predatory Lending

3-3.99 4-4.99 5-5.99 6-6.99 7-7.99 8 or more0%

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Share of High-Priced Conventional Home-Purchase Loans by Race/

Ethnicity, 2006

BlackHispanicAsianWhite

Percentage Points by which APR Exceeds Treasury Rate

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f L

oan

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Predatory Lending

3-3.99 4-4.99 5-5.99 6-6.99 7-7.99 8 or more0%

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Share of High-Priced Conventional Home-Purchase Loans by Percent Black

in the Tract, 2006

< 10%10-19%20-49%50-79%80-100%

Percentage Points by which APR Exceeds Treasury Rate

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Predatory Lending

3-3.99 4-4.99 5-5.99 6-6.99 7-7.99 8 or more0%

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Share of High-Priced Conventional Home-Purchase Loans by Average Tract

Income, 2006

LowModerateMiddleUpper

Percentage Points by which APR Exceeds Treasury Rate

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Predatory Lending

The Default Crisis

• Starting about 2005, the number of defaults, i.e. missed mortgage payments, started to increase.

• When payments are missed over 3 or more months, lenders foreclose, that is, they take over the house.

• Re-negotiation is rare; the lender holding the loan is unlikely to be the party who issued it.

• Millions of homeowners have lost their homes; millions more will do so!

Predatory Lending

Homeowners in Trouble

• A homeowner is “under water” if its mortgage is greater than the value of its house.

• According to recent (unprecedented!) figures:

▫ Almost 23% of homeowners with mortgages are underwater.

▫ About 38% of homeowners with 2nd mortgages are underwater.

▫ The share of underwater owners is 63% in Nevada, 50% in Arizona, 46% in Florida, 36% in Michigan, and 31% in California.

Predatory Lending

Homeowners in Trouble, Continued

• Because of the recessions, many homeowners have fallen behind on their mortgage payments and cannot, because they are “under water,” solve the problem by borrowing against their home equity.

• Cumulative missed payments constitute default on a mortgage.

• Three months of default puts a homeowner in danger of foreclosure, which is the process by which the lender takes over title to the house.

Predatory Lending

Foreclosures

• One-third of non-FHA-insured mortgages are at least 90 days behind on payments.

• There were 219,258 foreclosure filings in April 2011; roughly 3 million foreclosures have occurred since 2007.

• The rate of filings has been going down—but only because recent developments are slowing the process.

▫ Several large lenders (including GMAC Mortgage, JP Morgan, and Bank of America) have suspended foreclosure proceedings for some of 2011 due to fraud allegations, especially lack of clear titles.

▫ Both the federal government and many state governments are investigating illegal foreclosure behavior by lenders, including inaccurate calculations of what a borrower owes (e.g., by ignoring federal loan-modification programs) or charging unspecified default fees.

Predatory Lending

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Delinquency and Foreclosure by Type of Loan (HUD)

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Impact of Foreclosures

• The high volume of foreclosures has resulted in:

▫Many neighborhoods with empty houses, which brings down housing prices.

▫Some locations with many foreclosed houses placed on the market by lenders, which drives down prices still further.

▫Some locations with many houses held by lenders but kept off the market while lenders wait for market conditions to improve; this sustains prices but undermines buyer choice.

Predatory Lending

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Predatory Lending

Predatory Lending and the Default Crisis

•To some degree, the default crisis may reflect the combination of legitimate subprime loans and an economic downturn.

•But predatory lending played a major role.

•Thanks to the onerous terms imposed by predatory lenders, many borrowers have been unable to keep up with their payments.

Predatory Lending

Mortgage Brokers and the Default Crisis

•Many observers think that predatory lending by mortgage brokers plays a key role in the default crisis.

•The theory is that mortgage brokers do not bear the risk because they make their money simply by originating the loan.

•This is called moral hazard (= being insured against a risk over which one has control)

Predatory Lending

Who Issued Higher Priced Loans?

Predatory Lending

Evidence on Moral Hazard

• A recent paper by Mian and Sufi (QJE, November 2009) finds evidence of moral hazard.

• Zip codes with high loan-denial rates in 2001 and without income or employment increases thereafter experienced large decreases in denial rates from 2001 to 2005.

• These patterns were linked to a sharp increase in the share of loans sold by originators shortly after origination (called “disintermediation”).

• The result: large increases in defaults from 2005 to 2007.

Predatory Lending

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Spillover Into the Financial Crisis

• The huge increase in foreclosures spilled over into the entire economy.

• Firms that own mortgages without insurance were hurt (and many firms underestimated risk).

• Firms that held insurance, either directly or through some complex financial transaction, were hurt.

• Because the risks were fairly concentrated in a few firms and because those firms borrowed short-term to accept long-term risk, the foreclosure crisis spiraled out of control.

Predatory Lending

Foreclosures and Disadvantaged Groups

• The impact of foreclosures has not been even; historically disadvantaged groups have been hit particularly hard.

▫ Due to past discrimination, Blacks and Hispanics have poorer credit characteristics and were more likely to have sub-prime or predatory loans—even without current discrimination.

▫ Some lenders marketed sub-prime or predatory loans in minority neighborhoods and often gave those loans to households that qualified for more favorable terms.

▫ The result: Relatively high foreclosure rates—and a huge loss of equity—for Black and Hispanic households.

Predatory Lending

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Estimated 2007-2009 Foreclosure Rate on First-Lien Owner-Occupied Mortgage Origi-

nations (2005-2008),

by Borrower Race and Ethnicity

Predatory Lending

It Was Not the Fault of Fannie and Freddie

• Fannie Mae and Freddie Mac were large, profitable private organizations that packaged loans meeting certain standards. During the crisis, they were bought (back) by the federal government.

• Some people say they caused the crisis by going too far in encouraging homeownership. This is nonsense.

• They mainly purchased conventional, low-risk loans for purchase or refinancing; they purchased very few sub-prime loans before the crisis.

• Starting in about 2004, however, they started to invest in institutions that purchased sub-prime loans, so they took huge losses when the crisis came. That’s why the federal government had to buy them back—and why they may be dismanteled.

Predatory Lending

Predatory Lending

No Other Country Had Fannie, Freddie, or CRA,but…….

Predatory Lending

It Was Not the Fault of CRA

• The Community Reinvestment Act of 1977 requires depository lenders to serve all parts of their traditional lending areas.

• Lenders who do not serve low-income or minority areas may be denied the ability to set up new offices or make other business changes.

• Lenders have altered their practices because of CRA regulations, which were strengthened in the Clinton Administration.

• Some people say CRA’s push to serve low-income areas is a key cause of the crisis. Nonsense.

• CRA only applies to depository lenders. They were not the ones issuing subprime loans. CRA does not apply to mortgage brokers or the institutions that package mortgage loans.

Predatory Lending

What Has Happened Since the Crisis?

•Changes in borrowing

•Defaults and Foreclosures

•The Consumer Finance Protection Bureau

Predatory Lending

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3-3.99 4-4.99 5-5.99 6-6.99 7-7.99 8 or more0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

Share of High-Priced Conventional Home-Purchase Loans by Race/Ethnicity, 2006 and

2010

Black. 2010Hispanic, 2010White, 2010Black, 2006Hispanic, 2006White, 2006

Percentage Points by which APR Exceeds Treasury Rate

Perc

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Loan

s

Predatory Lending

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

•The Dodd-Frank Act established the Consumer Finance Protection Bureau (CFPB).

•Many of the pieces of this act relating to the CFPB went into effect on July 21, 2011, but Congressional epublicans are trying to hold it up.

Predatory Lending

The Consumer Finance Protection Bureau

Predatory Lending

The Consumer Finance Protection Bureau

•The CFPB will

▫Make sure that consumers have the information they need to understand the terms of their agreements with financial companies

▫Make regulations and guidance as clear and streamlined as possible so providers of consumer financial products and services can follow the rules on their own.

Predatory Lending

The Consumer Finance Protection Bureau

• The CFPB will also implement and enforce new protections under the Dodd-Frank Act that will:

▫ Require mortgage lenders to determine that a borrower has the ability to repay a loan by verifying income and making sure borrowers can afford loans even after teaser rates expire and payments rise.

▫ Prohibit prepayment penalties, which can make it expensive to refinance, for high cost loans and adjustable-rate mortgages.

▫ Put an end to practices like paying bonuses to mortgage brokers and loan officers who steer borrowers into higher-cost loans than they otherwise qualify for.

Predatory Lending

HOEPA

• The Home Ownership and Equity Protection Act of 1994 (HOEPA) was designed to (pretend to) combat predatory lending.

▫But it was so restricted that it applied to less than 1% of loans!

• State-level HOEPAs

▫Many states had HOEPA-type laws. For an analysis of their impacts, see Bostic et al., “State and local anti-predatory lending laws: The effect of legal enforcement mechanisms.” J. of Econ. & Business (2008).

Predatory Lending

Predatory Lending and CFPB

•The D0dd-Frank Act

▫Expands the range of loans subject to HOEPA

▫Expands the list of prohibited practices (as discussed earlier).

•Can the CFPB can prevent predatory practices from returning once the housing and mortgage markets return to normal?

Predatory Lending

Predatory Lending and Fair Lending

•The CFPB is also now the principal enforcer of fair lending laws.

▫Which are discussed in our next class.