Congress, federal agencies, state legislatures, and cities from Oakland to Chicago are poised to attack the two-headed beast of predatory lending.
Beyond the heart-wrenching stories of elderly borrowers being stuck with expensive mortgages that virtually guarantee foreclosure, the picture of predatory lending gets fuzzy, and some are finding it difficult to resist the temptation to apply the label to any loan that turns out to be unwisely obtained.
It is, indeed, much easier to recognize the effects of predatory lending after the fact than to define lending practices that will be treated as predatory. But the old adage - bad facts make bad laws - still applies, as does the constitutional principle of defining an act before proscribing it. Lawmakers and regulators are being pressured to act immediately to stop predatory lending, but it must be accomplished in a way that does not jeopardize the availability of credit to individuals who sorely need it. Nor should it be done in a way that would needlessly increase all creditors' risks and costs of doing business.
What is predatory lending? Most agree that predatory lending is perpetrated within the subprime lending market. It is not, however, the same as subprime lending, which is the extension of credit to individuals who do not qualify for loans at prime rates because of impaired or limited credit histories. Government agencies and lawmakers generally acknowledge this distinction but nevertheless place undue emphasis on restricting loan features that are commonly offered by subprime lenders.
Restrictions on refinancing activity must be tailored narrowly to avoid jeopardizing the vast majority of refinancings that are legitimate and beneficial to borrowers. Prepayment penalties can be abusive, but they give creditors certainty for which they are willing to offer reduced rates and points, a trade-off that many borrowers are willing to take. Low-documentation loans - those made in reliance primarily on the value of secured property rather than a borrower's ability to repay - can be means to seize borrowers' assets, but these loans are also commonly made as accommodations to borrowers who are unable or unwilling to prove income. Other loan features like balloon payments and reverse mortgages can provide legitimate benefits to borrowers and creditors.
Most commercial banks engage in little or no subprime lending, let alone predatory lending. According to a joint study by the department of Housing and Urban Development and the Treasury, the perpetrators are intermediaries such as home-improvement contractors and loan brokers. Still, the banking industry cannot afford to sit by while government agencies fashion remedies because the industry just might find itself encumbered with broad and ill-advised remedies or, worse, fall into that all-too-familiar role of target of convenience.
Remedies. The most direct remedy for predatory lending is to prosecute predators under existing laws against fraud and misrepresentation. Another is to promote the availability of credit counseling, because informed consumers are less likely to rely on unscrupulous operators. Reforming the existing disclosure scheme to make it more helpful to consumers would also help.
But most of the other measures now being discussed are unwieldy and counterproductive, and they center on greater scrutiny of the loan application process and on restricting loan features. This is the wrong approach. Casting a wide net in order to curtail the actions of a few is almost always bad policy, and belies an intent to abandon the goal of direct enforcement against perpetrators in favor of a feel-good policy of turning nonoffending financial institutions into technical violators.
More competition, not less. A key challenge in curbing predatory lending is to do so without also choking off credit to individuals with impaired credit. And one of the best ways to maintain the flow of credit is to introduce more competition into the subprime marketplace. Lawmakers and regulators should evaluate every proposal not just for its deterrent effect but also for its effect on the compliance and reputational risks of financial institutions that are concerned with such matters.
Proposals aimed at funders and secondary market participants for subprime loans should be approached with caution. The activities of some abusive originators and brokers may indeed be subsidized by unwitting funders and purchasers of securitized loans, but the much larger picture is the flow of capital into the subprime market, which should result in more competition and thus the stabilization of fees, rates, and terms.
In the next few months, the banking industry will have opportunities in a variety of forums to participate in the process of reining in predatory lending. There should be no doubt that the industry supports sensible measures to put an end to abusive lending practices. But banks must also help ensure that legislative and enforcement efforts are targeted at perpetrators rather than the entire class of creditors.
The industry must insist that lawmakers and regulators try to define predatory lending more carefully. The challenge is a significant one and harkens back to the one the U.S. Supreme Court faced when it grappled with the definition of obscenity, leading one exasperated justice to quip, "I know it when I see it." What we should draw from the court's experience is that it did not stop there. It proceeded to develop standards to which all laws had to adhere, so people would know with reasonable certainty if a particular form of expression was no longer protected.
We are now at the juncture where we know predatory lending when we see it, but are too eager to move to the next step of prescribing means to stop it. We should not hesitate to prosecute immediately and to the fullest extent those who violate laws and regulations. But if we seek to implement more ambitious solutions too hastily, creditors and borrowers could find themselves governed not by the rule of law, but the law of unintended consequences.
Leland Chan is general counsel for the California Bankers Association.