Does Everyone Have the Right to Credit?

Mentioning predatory lending stirs strong feelings around the banking and financial community, but there has also been some serious thinking about the problem. During a phenomenal economic boom—the country's longest ever—this hot-button issue has been an unwelcome reminder that prosperity has not cured all ills.Bankers shake their heads in bewilderment as consumer and community organizations that first grabbed headlines in the stagflation era of the 1970s by assailing denial of credit as "redlining", now complain that the same victims are being ensnared by high-cost loans.Behind this extraordinary shift is the expansion of subprime lending over the past decade, amid an explosion of overall consumer credit.Subprime loans are typically home equity loans, or second mortgages, often originated by mortgage brokers or home improvement companies. But, the category can be expanded to include credit offered by check-cashing outlets, auto lenders, pawnbrokers, rent-to-own stores and some credit card companies.Inevitably, the booming subprime area attracted sharp operators specializing in abusive practices, including frequent loan refinancings, also known as flipping, balloon payments and lump sum credit life insurance financed from loan proceeds. Their targets are the least sophisticated among us, including senior citizens. That's life, some may say. If the bad apples are exposed and gotten rid of, things will ultimately be fine.But from a broader perspective, do all consumers have some inherent right to credit?Only if you also believe in assisted suicide, says William E. Whitesell, professor of economics at Franklin & Marshall College in Lancaster, PA. "I don't agree that people have a right to commit financial suicide, but even if they do, they certainly shouldn't be aided and abetted," says Whitesell, who once served as Pennsylvania's state secretary of banking. "Lenders who engage in predatory conduct either know or should know they are preying on people or even groups that, with very little provocation, are going to proceed to do things that are not in any way in their best interest," he says.Orthodox bankers look askance at predatory activity as well, but quickly add their own complaints."Predatory lending is wrong. It's taking advantage of people, and that certainly speaks for itself. I take a very dim view of people who do that," says Gerald H. Lipkin, chief executive officer of Valley National Bancorp. in Wayne, NJ.On the other hand, Lipkin decries moral slippage among borrowers. "A credit rating is an asset and a privilege. This is really something that our educational system ought to stress more."He defines subprime lending, which his own bank does not do, as lending "to someone who cannot handle credit, to someone who has abused credit in the past." And alongside predatory lenders, he is sharply critical of the "negative advertising by some lawyers and law firms" touting bankruptcy as simple and painless. "They make it seem honorable to walk away from your debts."And in fact, a 1997 study by Purdue University and the Credit Research Center at Georgetown University concluded that "the bankruptcy system in the United States functions as unlimited insurance for financially troubled consumers with the rest of us paying the premiums." But the same yardstick can also be applied to lenders.As consumer credit, particularly via credit cards, surged during the second half of the 1990s, the veteran Wall Street bank analyst George M. Salem warned a congressional committee that credit was too frequently being "marketed, rather than underwritten," via sophisticated direct mail and other means. He warned of potential losses for lenders and investors, and consequences for the nation's economy.Few dispute, of course, that access to credit is a basic component of life in an advanced economy. Renting a car or buying products or services via the Internet—indeed, simply establishing access to the Internet itself—requires a credit card and hence a credit rating. That raises more questions, of course. Ultimately, can the private sector properly serve marginal borrowers without assuming unreasonable risks or having to operate under regulations that make such lending an unpalatable activity from a bottom-line standpoint.Whitesell, as a former regulator, thinks so. He bases that on "a sense of optimism" and some experience with the Community Reinvestment Act, which he believes has been far more effective than generally recognized.But he cautions that considerably more than jawboning will be required from regulators.To be effective, regulators will have to monitor lending practices more closely, be ready to take aggressive enforcement action when called for and tie the performance of lenders they supervise to applications by those lenders for expansion of products and services in other areas.The former regulator doubts that a public sector alternative, such as a guarantee program for loans to moderate-income borrowers akin to that for student loans or a bigger one along the lines of the Farm Credit System, would be workable—even if they were politically feasible.Critics charge that up to half of all subprime loans involve predatory practices. They also contend that up to 50% of subprime borrowers could have qualified for prime-level credit had they gotten straightforward counseling.Above all, they contend that predatory conduct has increasingly "gone mainstream" as traditional players in the banking and financial services industry have joined in.Defenders counter that egregious practices by a handful of companies have been blown out of proportion, and they insist that they are serving the needs of consumers ignored and unwanted by others.The National Home Equity Mortgage Association, a trade group, says the customers are "Mr. and Mrs. America." It asserts that the industry's mission is "to provide consumers with less-than-perfect credit a means to use the equity in their homes to obtain loans that banks and other institutions are unwilling to provide."Typically, the group says, home equity loan rates add from two to six percentage points to prime. Meanwhile, servicing costs are generally said to average 33% higher or more for "B" or "C" rated borrowers.In another category are credit card lenders like Providian Financial Corp. and Metris Companies Inc., who serve people with impaired credit by offering cards secured by savings accounts. Providian, which has settled some lawsuits over its business practices, says it makes a strenuous effort to provide "credit education" to its borrowers. The "credit care" section of its Web site notes that "good credit is invaluable in today's world."A major sticking point is that no one has a clear idea of where prudent risk-adjusted underwriting ends and abuse begins, let alone hard figures about such loans.Indeed, while Federal Reserve Chairman Alan Greenspan has said that abusive lending practices are "of concern," neither the Fed with all its data nor other regulators last year could provide Congress with a precise definition of the problem or estimate its size.Lawyers for the U.S. Department of Justice offered up a list of practices that "may be predatory or abusive either singly or in combination," but could give no encompassing description from a legal perspective.Nevertheless, passions have been stirred. Joining the familiar activists have been such heavyweights as the Social Investment Forum and the American Association of Retired Persons, whose public policy arm has charged that "more than 25% of all Americans are targets of predatory lending companies."The New York Times and the ABC News documentary show 20/20 joined forces to offer a withering critique of abuses in high-rate, high-fee financing. The City of Chicago adopted a restrictive ordinance.Matters reached a boil last autumn after Citigroup, North America's biggest financial institution, unveiled plans to acquire Associates First Capital Inc., a Texas company often accused of abuses. Citigroup vowed to address any problems, but challengers of the deal were not mollified.Notably, opponents of predatory practices have focused on "upward culpability" and moved to pressure not just lenders but commercial or investment banks doing business with those lenders, as well as insurers and trustees in securitizations of subprime loans.Whitesell agrees, and likens some conduct in the financial and legal communities to activities during the savings and loan industry crisis of a dozen years ago. "There were those who not only could have known but should have known that their customers and clients were engaging in highly questionable conduct," he says. "Their decision was to look away."Some activist organizations, such as California-based Hermandad Mexicana Nacional, a group supporting immigrants, are even pushing for reparations. They have demanded a victim compensation fund, along with stepped up programs by Fannie Mae and Freddie Mac to convert many subprime loans to prime status.The censorious atmosphere has cast a pall over the entire subprime sector, whose growth and profitability had attracted many major institutions over the past several years.Ironically, the arguments carry such ardor because all parties agree that subprime lending—the industry itself actually prefers to call it "nonprime"—is important, even crucial, for consumers and the economy. The Shareholder Action Network frankly puts it this way: "Subprime lending is actually a necessary component of the current banking system. Without subprime lending, people with marginal credit would not have access to mortgages, second mortgages or home improvement loans."Among lenders themselves, the saying goes that "80% of Americans are two paychecks away from subprime."And Fed Governor Edward M. Gramlich has pointed out: "Subprime lending is not necessarily 'predatory' in nature. In fact, over the past several years, the rise in subprime lending has significantly expanded access to credit to tens of millions of Americans. Many previously faced a much steeper hill to home ownership or to unlocking the financial benefits of the equity in their homes."The argument over subprime lending is really a debate over giving people "a second chance," says Lipkin, the New Jersey banker.Altogether, the questions about suprime lending and the predatory practices it sometimes spawns are nearly as broad as the forces that have brought the issue to the surface.Well into the 1970s, higher-risk borrowers were mostly served by an established network of consumer finance companies operating within state usury laws and other strictures—including prohibition in some areas of second mortgages, now better known as home equity loans.Moreover, a conservative business ethic prevailed. Household Finance Corp., an industry leader, for many years advertised itself with an upbeat radio jingle that still managed to be cautionary. It began: "Never borrow money needlessly...."Then, inflation forced the dismantling of interest rate ceilings in the early 1980s and set the stage for other financial deregulation. A surge in home values created a market for equity lending, and Wall Street began taking the secondary mortgage market seriously.Finally, the decade-long economic upswing and especially the enormous bull market in stocks created for many people a sense of entitlement. Credit itself may not be seen as a right, but home ownership virtually is, Fannie Mae chairman Franklin D. Raines has pointed out. He sees this as reflecting considerable economic progress.Meanwhile, the enormous borrowing binge of the 1990s is finally showing some signs of ebbing. A binge it surely has been. Gary J. Gordon, a veteran securities analyst at PaineWebber Group, calculates that the debt burden, the percentage of consumers' income devoted to debt servicing, is now at a record 15.3%, up from 12.7% in 1993. The previous peak was 14.7%, in 1989.All forms of debt have grown faster than incomes, and the cost of debt has of course risen in the past year as interest rates have gone up, he said. During the year 2000, credit card debt grew roughly 10% and mortgage debt by 8 or 9% in 2000, while incomes grew by about 6%.Those figures suggest that subprime lending will only grow in the future, even if the pace of consumer lending overall slows. That will certainly be so if the U.S. economy finally enters a slowdown or even a recession. All of which suggests that the debate over predatory lending will hardly be resolved easily or soon.