Mr. Chairman, it is a pleasure and an honor to address you today on the important topic of predatory lending.

Predatory lending is a real problem. It is, however, a problem that needs to be addressed thoughtfully and deliberately, with a hard head as well as a soft heart. There is no doubt that people have been hurt by the predatory practices of some creditors, but we must make sure that the cure is not worse than the disease. Unfortunately, many of the proposed or enacted municipal, state, and federal statutory responses to predatory lending would have adverse consequences that are worse than the problems they seek to redress. Many of these initiatives would reduce the supply of credit to low-income homeowners, raise their cost of credit, and restrict the menu of beneficial choices available to borrowers.

Fortunately, there is a growing consensus in favor of a balanced approach to the problem. That consensus is reflected in the viewpoints expressed by a wide variety of individuals and organizations, including Robert Litan of the Brookings Institution, Fed Governor Edward Gramlich, most of the recommendations of last year’s HUD-Treasury Report, the voluntary standards set by the American Financial Services Association (AFSA), the recent predatory lending statute passed by the state of Pennsylvania, and the recommendations and practices of many subprime mortgage lenders (including, most notably, Household). In my comments, I will describe and defend that balanced approach, and offer some specific recommendations for Congress and for financial regulators.

To summarize my recommendations at the outset, I believe that an appropriate response to predatory practices should occur in two stages: First, there should be an immediate regulatory response to strengthen enforcement of existing laws, enhance disclosure rules and provide counseling services, amend existing regulation, and limit or ban some practices. I believe that these initiatives, described in detail below, will address all of the serious problems associated with predatory lending.

In other areas--especially the regulation of prepayment penalties and balloon payments--any regulatory change should await a better understanding of the extent of remaining predatory problems that result from these features, and the best ways to address them through appropriate regulations. The Fed is currently pursuing the first systematic scientific evaluation of these areas, as part of its clear intent to expand its role as the primary regulator of subprime lending, given its authority under HOEPA. The Fed has the regulatory authority and the expertise necessary to find the right balance between preventing abuse and permitting beneficial contractual flexibility.

Congress, and other legislative bodies, should not rush to judgment ahead of the facts and before the Fed has had a chance to address these more complex problems, and in so doing, end up throwing away the proverbial baby of subprime lending along with the bath water of predatory practices.

I think the main role Congress should play at this time is to rein in actions by states and municipalities that seek to avoid established federal preemption by effectively setting mortgage usury ceilings under the guise of consumer protection rules. Immediate Congressional action to dismantle these new undesirable barriers to individuals’ access to mortgage credit would ensure that consumers throughout the country retain their basic contractual rights to borrow in the subprime market.

My detailed comments divide into four parts: (1) a background discussion of subprime lending, (2) an attempt to define predatory practices, (3) a point-by-point evaluation of proposed or enacted remedies for predatory practices, and (4) a concluding section.

1. Subprime Lending, the Democratization of Finance, and Financial Innovation

The problems that fall under the rubric of predatory lending are only possible today because of the beneficial “democratization” of consumer credit markets, and mortgage markets in particular, that has occurred over the past decade. Predatory practices are part and parcel of the increasing complexity of mortgage contracts in the high-risk (subprime) mortgage area. That greater contractual complexity has two parts: (1) the increased reliance on risk pricing using Fair Isaac Co. (FICO) scores rather than the rationing of credit via yes or no lending decisions, and (2) the use of points, insurance, and prepayment penalties to limit the risks lenders and borrowers bear and the costs borrowers pay.

These practices make economic sense and can bring great benefits to consumers. Most importantly, these market innovations allow mortgage lenders to gauge, price, and control risk better than before, and thus allow them to tolerate greater gradations of risk among borrowers.

According to last year’s HUD-Treasury report, subprime mortgage originations have skyrocketed since the early 1990s, increasing by tenfold since 1993. The dollar volume of subprime mortgages was less than 5% of all mortgage originations in 1994, but by 1998 had risen to 12.5%. As Fed Governor Edward Gramlich (2000) has noted, between 1993 and 1998, mortgages extended to Hispanic-Americans and African-Americans increased the most, by 78 and 95 percent, respectively, largely due to the growth in subprime mortgage lending.

Subprime loans are extended primarily by non-depository institutions. The new market in consumer credit, and subprime credit in particular, is highly competitive and involves a wide range of intermediaries. Research by economists at the Federal Reserve Board indicates that the reliance on non-depository intermediaries reflects a greater tolerance for lending risk by intermediaries that do not have to subject their loan portfolios to examination by government supervisors (Carey et al. 1998).

Subprime lending is risky. The reason that so many low-income and minority borrowers rely on the subprime market is that, on average, these are riskier groups of borrowers. It is worth bearing in mind that default risk varies tremendously in the mortgage market. According to Frank Raiter of Standard & Poor’s, the probability of default (over the lifetime of the mortgage, which is typically three to five years) for the highest risk class of subprime mortgage borrowers is roughly 23%, which is more than one thousand times the default risk of the lowest risk class of prime mortgage borrowers. There is variation in default risk within the highest risk class, as well, so that some subprime mortgages have even higher risk of default.

When default risk is this great, in order for lenders to participate in the market, they must be compensated with unusually high interest rates. Consider an extreme case. For example, even if a lender were risk-neutral (indifferent to the variance of payoffs from a bundle of loans) a lender bearing a 20% risk of default (on average, in each year of the mortgage), and expecting to lose 50% on a foreclosed loan (net of foreclosure costs) should charge at least the relevant Treasury rate (given the maturity of the loan) plus 10%. On second-trust mortgages, loan losses may be as high as 100%. In that case, the risk-neutral default premium would be 20%. Added to these risk-neutral premia would be a risk premium to compensate for the high variance of returns on risky loans (to the extent that default risk is non-diversifiable), as well as premia to pay for the costs of gathering information about borrowers, and the costs of maintaining lending facilities and staff. These premia would be charged either in the form of higher interest rates or the present value equivalent of points paid in advance.

Default risk, however, is not the only risk that lenders bear. Indeed, prepayment risk is of a similar order of magnitude in the mortgage market. To understand prepayment risk, consider a 15-year amortized subprime mortgage loan of $50,000 with a 10% interest rate over the Treasury rate, zero points and no prepayment penalty. If the Treasury rate falls, say by 1%, assume that the borrower will choose to refinance the mortgage without penalty, and assume that this decline in the Treasury rate actually happens one year after the mortgage is originated.

If the interest rate on the mortgage was set with the expectation that the loan would last for 15 years, and if the cost of originating and servicing the loan was spread over that length of time, then the prepayment of the loan will result in a loss to the lender. An additional loss to the lender results from the reduction in the value of its net worth as the result of losing the revenue from the mortgage when it is prepaid (if the lender’s cost of funds does not decline by the same degree as its return on assets after the prepayment).

In the competitive mortgage market, lenders will have to protect against this loss in one of several ways: First, lenders could charge a prepayment fee to discourage prepayment, and thus limit the losses that prepayment would entail. Second, the lender could “frontload” the cost of the mortgage by charging points and reducing the interest rate on the loan. This is a commitment device that reduces the incentive of the borrower to refinance when interest rates fall, since the cost of a new mortgage (points and interest) would have to compete against a lower annual interest cost from the original loan. A third possibility would be avoiding prepayment penalties and points and simply charging a higher interest rate on the mortgage to compensate for prepayment risk.

In a competitive mortgage market, the present value of the cost to the borrower of these three alternatives is equivalent. If all three alternatives were available, each borrower would decide which of these three alternatives was most desirable, based on the borrower’s risk preferences.

The first two alternatives amount to the decision to lock in a lower cost of funds rather than begin with a higher cost of funds and hope that the cost will decline as the result of prepayment. In essence, the first two choices amount to buying an insurance policy compared to the third, where the borrower instead prefers to retain the option to prepay (effectively “betting” that interest rates will fall).

If regulation were to limit prepayment penalties, by this logic, those wishing to lock in low mortgage costs would choose a mortgage that front loads costs through points as an alternative to choosing a mortgage with a prepayment penalty.

Loan maturity is another important choice for the borrower. The borrower who wishes to bet on declining interest rates can avoid much of the cost of the third alternative mentioned above (that is, paying the prepayment risk premium) by keeping the mortgage maturity short-term (for example, by agreeing to a balloon payment of principal in, say, three years). Doing so can substantially reduce the annual cost of the mortgage.

In the subprime market, where borrowers’ creditworthiness is also highly subject to change, prepayment risk results from improvements in borrower riskiness as well as changes in U.S. Treasury interest rates. The choice of either points, prepayment penalties, or neither amounts to choosing, as before, whether to lock in a lower overall cost of mortgage finance rather than betting on the possibility of an improvement. Similarly, retaining a prepayment option, or choosing a balloon mortgage, allows the individual to “bet” on an improvement in his creditworthiness.

Borrowers in the subprime market are subject to significant risk that they could lose their homes as the result of death, disability, or job loss of the household’s breadwinner(s), which might make them unable to make their mortgage payments. Some households will want to insure against this eventuality with credit insurance. Credit insurance comes in two main forms: monthly insurance (which is paid as a premium each month), or “single-premium” insurance, which is paid for the life of the mortgage in a single lump sum at the time of origination, and typically is financed as part of the mortgage.

Much has been said and written recently about single-premium insurance. Single-premium insurance, it is often alleged, is a means unscrupulous lenders employ to trick borrowers into overpaying for coverage. The reason for that claim is that, in present value terms, single-premium insurance is more expensive for borrowers than monthly premium insurance.

For example, using data provided to me by Assurant Group (a major provider of credit insurance to the mortgage market), a typical single-premium policy for a 12% APR mortgage would have a monthly payment today of approximately $22 per month for 30 years. That policy provides coverage, however, for only the first five years. Its costs are amortized, however, over the entire 30-year period. A comparable five-year average monthly cost for monthly insurance would be roughly $33, but that higher monthly payment would end after five years. Clearly, monthly insurance is much cheaper on a present value basis.

Defenders of single-premium insurance argue that it is sold because insurers are unwilling to supply monthly insurance in many cases because its price (which is regulated at the state level) is set too low to be profitable for issuers. Defenders also argue that single-premium insurance has some benefits that customers appreciate which would make them prefer it, even at current prices, even if both single-premium and monthly insurance were available. The former argument seems to have some merit, although I have not been able to assemble evidence to prove or disprove it. The latter argument I find hard to believe, although I do not have evidence to refute it.

In any case, while I am in favor of regulating single-premium insurance to prevent abuse (as discussed below in section 3), I am not in favor of prohibiting it, for two reasons. First, it may be that, as defenders argue, under current state price controls, it is the only economically feasible alternative. In that case, prohibiting it, without also changing state price limits, would reduce the supply of credit insurance available to consumers.

Second, if it were possible to deregulate the pricing of credit insurance, to allow the market to set prices for both kinds of insurance, and if reasonable objections to current practices of selling credit insurance could be addressed, then some consumers would prefer single-premium coverage over monthly coverage. The reason is that the market price (in present value) of single-premium coverage would probably be lower than that of monthly coverage. Because single-premium insurance commits the borrower to the full length of time of the mortgage (and because there is the possibility that the borrowers’ risk of unemployment, death, or disability will decline after origination), if prices were set by a competitive market, single premium insurance would be less expensive (in present value terms) because buyers of monthly insurance are also purchasing an implicit option. Borrowers who want the option to be able to cancel their insurance policy (for example, to take advantage of a decline in their risk of unemployment, or upon repaying their mortgage) would prefer monthly insurance and would pay for that valuable option in the form of a higher premium per month on monthly insurance.

So, while I recognize that under current rules, single-premium insurance is priced above monthly insurance, that does not imply that buyers of single-premium insurance have been cheated, or that it should be prohibited. If we can find a way for lenders to offer both kinds of insurance in a way that enhances consumer choice, and avoids defrauding borrowers, theory suggests that this would be desirable.

In short, economists recognize that substantial points, prepayment penalties, short mortgage maturities, and credit insurance have arisen in the subprime market, in large part, because these contractual features offer preferred means of reducing overall costs and risks to consumers. Default and prepayment risks are higher in the subprime market, and therefore, mortgages are more expensive and mortgage contracts are more complex. Clearly, there would be substantial costs borne by many borrowers from limiting the interest rates or overall charges on subprime mortgages, or from prohibiting borrowers from choosing their preferred combination of rates, points, penalties, and insurance. As Fed Governor Edward Gramlich writes:

“. . . some [predatory lending practices] are more subtle, involving misuse of practices that can improve credit market efficiency most of the time. For example, the freedom for loan rates to rise above former usury ceilings is mostly desirable, in matching relatively risky borrowers with appropriate lenders. . . . 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. . . . Most of the time the ability to refinance mortgages permits borrowers to take advantage of lower mortgage rates. . . . Often mortgage credit insurance is desirable. . . .” (Gramlich 2000, p. 2)

Any attempts to regulate the subprime market should take into account the potential costs of regulatory prohibitions. As I will argue in more detail in section 3 below, many new laws and statutory proposals are imbalanced in that they fail to take into account the costs from reducing access to complex, high-cost mortgages.

2. Predatory Practices

So much for the “baby”; now let me turn to the “bath water.” The use of high and multiple charges, and the many dimensions of mortgage contracts, I have argued, hold great promise for consumers, but with that greater complexity also comes greater opportunity for fraud and for mistakes by consumers who may not fully understand the contractual costs and benefits they are being offered.

That is the essential dilemma. The goal of policy makers should be to define and address predatory practices without undermining the opportunities offered by subprime lending.

According to the HUD-Treasury report, predatory practices in the subprime mortgage market fall into four categories: (1) “loan flipping” (enticing borrowers to refinance excessively, sometimes when it is not in their interest to do so, and charging high refinancing fees that strip borrower home equity), (2) excessive fees and “packing” (charging excessive amounts of fees to borrowers, allegedly because borrowers fail to understand the nature of the charges, or lack knowledge of what would constitute a fair price), (3) lending without regard to the borrower’s ability to repay (that is, lending with the intent of forcing a borrower into foreclosure in order to seize the borrower’s home), and (4) outright fraud.

It is worth pausing for a moment to note that, with the exception of fraud (which is already illegal) these problems are defined by (often subjective) judgments about the outcomes for borrowers (excessive refinancing, excessive fees, excessive risk of default), not by clearly definable actions by lenders that can be easily prohibited without causing collateral harm in the mortgage market.

For example, with regard to loan flipping, it may not be easy to define in an exhaustive way the combinations of changes to a mortgage contract that make a borrower better off. There are clear cases of purely adverse change (for example, across-the-board increases in rates and fees with no compensating changes in the contract), and there are clear cases of improvement, but there are also gray areas in which a mix of changes occurs, and where a judgment as to whether the position of the borrower has improved or deteriorated depends on an evaluation of the probabilities of future contingencies and a knowledge of borrower preferences.

Similarly, whether fees are excessive can often be very difficult to gauge, since the sizes of the fees vary with the creditworthiness of the borrower and with the intent of the contract. For example, points are often used as a commitment device to limit prepayment risk.

And what is the maximum “acceptable” level of default risk on a mortgage, which would constitute evidence that a mortgage had been unreasonably offered because of the borrower’s inability to repay?

Many alleged predatory problems revolve around questions of fair disclosure and fraud prevention. These can be addressed to a great degree by ensuring accurate and complete disclosure of facts (making sure that the borrower is aware of the true APR, and making sure that legally mandated procedures under RESPA, TILA, and HOEPA are followed by the lender). In section 3, I will discuss a variety of proposals for strengthening disclosure rules and protections against fraud.

But the critics of predatory lending argue that inadequate disclosure and outright fraud are not the only ways in which borrowers may be fooled unfairly by lenders. For some elderly people, or people who are mentally incapacitated, predatory lending may simply constitute taking advantage of those who are mentally incapable of representing themselves when signing loan contracts. And for others, lack of familiarity with financial language or concepts may make it hard for them to judge what they are agreeing to.

Of course, this problem arises in markets all the time. When consumers purchase automobiles, those who cannot calculate present values of cash flows (when comparing various financing alternatives) may be duped into paying more for a car. And when renting a car, less savvy consumers may pay more than they should for gasoline or collision insurance. In a market economy, we rely on the time-honored common law principle of caveat emptor because on balance we believe that market solutions are better than government planning, and markets cannot function if those who make choices in markets are able to reverse those choices after the fact whenever they please.

But consumer advocates rightly point out that, given the importance of the mortgage decision, a misstep by an uninformed or mentally incapacitated consumer in the mortgage market can be a life changing disaster. That concern explains why well-intentioned would-be reformers have turned their attentions to proposals to regulate mortgage products. But those proposed remedies often are excessive. Reformers advocate what amount to price controls, and prohibitions of contractual features that they deem to be onerous or unnecessary.

Some of these advocates of reform, however, seem to lack a basic understanding of the functioning of financial markets and the pricing of financial instruments. In their zeal to save borrowers from harming themselves they run the risk of causing more harm to borrowers than predatory lenders.

Other reformers seem to understand that their proposals will reduce the availability of subprime credit to the general population, but they don’t care. Indeed, one gets the impression that some paternalistic community groups dislike subprime lending and feel entitled to place limits on the decision making authority even of mentally competent individuals. Other critics of predatory lending may have more sinister motives related to the kickbacks they receive for contractually agreeing to stop criticizing particular subprime lenders.

Whatever the motives of these advocates, it is easy to show that many of the extreme proposals for changing the regulation of the subprime mortgage market are misguided and would harm many consumers by limiting their access to credit on the most favorable terms available. There are better ways to target the legitimate problems of abuse.

3. Evaluating Proposed Reforms

Let me now turn to an analysis of each of the proposed remedies for predatory lending, which I divide into three groups: (1) those that are sensible and that should be enacted by Fed regulation, (2) those that are possibly sensible, but which might do more harm than good, and thus require more empirical study before deciding whether and how to implement them, and (3) those that are not sensible, and which would obviously do more harm than good.  

Sensible Reforms that Should Be Implemented Immediately by the Fed

Under HOEPA, the Fed is entitled to regulate subprime mortgages that either have interest rates far in excess of Treasury rates (the Fed currently uses a 10% spread trigger, but can vary that spread between 8% and 12%) or that have total fees and points greater than either 8% or $451. HOEPA already specifies some contractual limits on these loans (for example, prepayment penalties are only permissible for the first five years of the loan, and only when the borrowers’ income is greater than 50% of the loan payment). It is my understanding that the Fed currently has broad authority to establish additional regulatory guidelines for these loans, and is currently considering a variety of measures. Following is a list of measures that I regard as desirable.

Disclosure and counseling. Disclosure requirements always add to consumers’ loan costs, but in my judgment, some additional disclosure requirements would be appropriate for the loans regulated under HOEPA. I would recommend a mandatory disclosure statement like the one proposed in section 3 (a) of Senate bill S. 2415 (April 12, 2000), which alerts borrowers to the risks of subprime mortgage borrowing. It is also desirable to make counseling available to potential borrowers on HOEPA loans, and to require lenders to disclose that such counseling is available (as proposed in the HUD-Treasury report). The HUD-Treasury report also recommends reasonable amendments to RESPA and TILA that would facilitate comparison shopping and make timely information about the costs of credit and settlement easier for consumers to understand and more reliable. I also favor the HUD-Treasury suggestions of imposing an accuracy standard on permissible deviations from the Good Faith Estimate required under RESPA, requiring lenders to disclose credit scores to borrowers (I note that these scores have since been made available by Fair Isaac Co. to borrowers via the Internet), and expanding penalties on lenders for inadequate or inaccurate disclosures. The use of “testers” to verify disclosure practices would likely prove very effective as an enforcement tool to ensure that lenders do not target some classes of individuals with inadequate disclosure. I also agree with the suggested requirement that lenders notify borrowers of their intent to foreclose far enough in advance that borrowers have the opportunity to arrange alternative financing (a feature of the new Pennsylvania statute) as a means of discouraging unnecessary foreclosure. Finally, I would recommend that, for HOEPA loans where borrowers’ monthly payments exceed 50% of their monthly income, the lender should be required to make an additional disclosure that informs the borrower of the estimated high probability (using a recognized model, like that of Fair Isaac Co.) that the borrower may lose his or her home because of inadequate ability to pay debt service.

Credit history reporting. It is alleged that some lenders withhold favorable information about customers in order to keep information about improvements in customer creditworthiness private, and thus limit competition. It is appropriate to require lenders not to selectively report information to credit bureaus.

Single premium insurance. Roughly one in four households do not have any life insurance, according to the Life and Health Insurance Foundation (1998). Clearly, credit insurance can be of enormous value to subprime borrowers, and single premium insurance may be, as its defenders claim, a desirable means for reducing the risk of losing one’s home at low cost. To prevent abuse of this product, however, there should be a mandatory requirement that lenders that offer single premium insurance must do three things. (1) Lenders, when computing the equivalent monthly payment on single-premium insurance in their disclosure statement, should be required to fully amortize the cost of the insurance over the period of coverage (typically five years) rather than over a 30-year period. That will avoid confusion on the part of borrowers about the effective cost of the insurance product. (2) Lenders should clearly disclose that credit insurance is optional and that the other terms of the mortgage are not related to whether the borrower chooses credit insurance. (3) Lenders should allow borrowers to cancel their single premium insurance and receive a full refund of the payment within a reasonable time after closing (say, within 30 days, as in the Pennsylvania statute).

Limits on flipping. Several new laws and proposals, including a proposed rule by the Federal Reserve Board, would limit refinancing to address the problem of loan flipping. The Fed rule would prohibit refinancing of a HOEPA loan by the lender or its affiliate within the first twelve months unless that refinancing is “in the borrower’s interest.” This is a reasonable idea so long as there is a clear and reasonable safe harbor in the rule for lenders that establishes criteria under which it will be presumed that the refinancing was in the borrower’s interest. For example, if a refinancing either (a) provides substantial new money or debt consolidation, (b) reduces monthly payments by a minimum amount, or (c) reduces the duration of the loan, then any one of those features should protect the lender from any claim that the refinancing was not in the borrower’s interest.

Limits on refinancing of subsidized government or not-for-profit loans. It has been alleged that some lenders have tricked borrowers into refinancing heavily subsidized government or not-for-profit loans at market (or above-market) rates. Lenders that refinance such loans should face very strict tests for demonstrating that the refinancing was in the interest of the borrower.

Prohibition of some contractual features. Some mortgage structures add little real value to the menu of consumers’ options, and are especially prone to abuse. In my judgment, the Federal Reserve Board has properly identified payable-on-demand clauses or call provisions as an example of such contractual features that should be prohibited.

Require lenders to offer loans with and without prepayment penalties. Rather than regulate prepayment penalties further as some have proposed, I would recommend requiring that HOEPA lenders offer mortgages both with and without prepayment penalties, so that the price of the prepayment option would be clear to consumers. Then consumers could make an informed decision whether to pay for the option to prepay.

Proposals that Require Further Study

In addition to the aforementioned reforms, many other potentially beneficial, but also potentially costly, reforms have been proposed and should be studied to determine whether they are necessary over and above the reforms listed above, and whether on balance they would do more good than harm. The list of potentially beneficial reforms that are worthy of careful scrutiny includes:

(1) A limit on balloons (for example, requiring a minimum of a certain period of time between origination and the balloon payment) is worth exploring--although many of the proposed limits on balloons do not seem reasonable; for example both the Pennsylvania statute’s 10-year limit and the HUD-Treasury report’s proposed 15-year limit, seem to me far too long; but shorter-term limits on balloons (say, a three or five year minimum duration) may be desirable.

(2) The establishment of new rules on mortgage brokers’ behavior (as proposed in the HUD-Treasury report) may be worthwhile, as a means of ensuring that mortgage brokerage is not employed to circumvent effective compliance; and

(3) It may be desirable, as the Fed has proposed, to lower the HOEPA interest rate threshold from 10% to 8%. The main drawback of lowering the trigger point for HOEPA, which has been noted by researchers at the Fed, and by Robert Litan, is the potential chilling effect that reporting requirements may have on the supply of credit in the subprime market. (I note in passing that I do not agree with the proposal to include all fees into the HOEPA fee trigger; fees that are optional, and not conditions for granting the mortgage--like credit insurance--should be excluded from the calculation.)

Proposals that Should Be Rejected

Usury laws. Under the rubric of bad ideas, I will focus on one in particular: price controls. It is a matter of elementary economics that limits on prices restrict supply. Among the ideas that should be rejected out of hand are proposals to impose government price controls--on interest rates, points, and fees--for subprime mortgages.

Because of legal limits on local authorities to impose usury ceilings (due to federal preemption) states and municipalities intent on discouraging high-cost mortgage lending have pursued an alternative “stealth” approach to usury laws. The technique is to impose unworkable risks on subprime lenders that charge rates or fees in excess of government specified levels and thereby drive high-interest rate lenders from the market.

Additionally, some price control proposals are put forward by community groups like ACORN in the form of “suggested” voluntary agreements between community groups and lenders.

Several cities and states have passed, or are currently debating, stealth usury laws for subprime lending. For example, the city of Dayton, Ohio this month passed a draconian anti-predatory lending law. This law places lenders at risk if they make high-interest loans that are “less favorable to the borrower than could otherwise have been obtained in similar transactions by like consumers within the City of Dayton,” and lenders may not charge fees and/or costs that “exceed the fees and/or costs available in similar transactions by like consumers in the City of Dayton by more than 20%.”

In my opinion, it would be imprudent for a lender to make a loan in Dayton governed by this statute. Indeed, I believe that the statute’s intent must be to eliminate high-interest loans, which is why I describe it as a stealth usury law. Immediately upon the passage of the Dayton law, Bank One announced that it was withdrawing from origination of loans that were subject to the statute. No doubt others will exit, as well.

The recent 131-page anti-predatory lending law passed in the District of Columbia is similarly unworkable. Lenders are subject to substantial penalties if they are deemed to have lent at an interest rate “substantially greater than the home borrower otherwise would have qualified for, at that lender or at another lender, had the lender based the annual percentage rate upon the home borrowers’ credit scores as provided by nationally recognized credit reporting agencies,” or if loan costs are “unconscionable,” or if loan discount points are “not reasonably consistent with established industry customs and practices.”

The District law is fundamentally flawed in several respects. First, it essentially requires lenders to charge no more than the rate indicated by the customer’s credit score. That is an improper use of credit scores. Credit scores are not perfect indicators of risk; they are used as one of many--and sometimes not the primary--means of judging whether and on what terms to make a loan. Second, the D.C. law places the ridiculous burden on the lender of making sure, prior to lending, that his customer could not find a better deal from his competitors. Finally, the vague wording makes the legal risks of subprime lending so great that no banker would want to engage in it.

As Donald Lampe points out, massive withdrawal from the subprime lending market occurred in response to the overly zealous initiative against predatory lending by the state of North Carolina. To quote from Lampe’s (2001) summary of the North Carolina experience:

“Virtually all residential mortgage lenders doing business in North Carolina have elected not to make ‘high-cost home loans’ that are subject to N.C.G.S 24-1.1E. Instead, lenders seek to avoid the ‘thresholds’ established by the law.” (p. 4)

Michael Staten of the Credit Research Center of Georgetown University has compiled a new database on subprime lending that permits one to track the chilling effect of the North Carolina law on subprime lending in the state. The sample coverage of the database nationwide includes 39% of all subprime mortgage loans made by HMDA-reporting institutions in 1998.

Staten’s statistical research (reproduced with permission in an appendix to this testimony) compares changes in mortgage originations in North Carolina with those in South Carolina and Virginia, before and after the passage of the North Carolina law (which was passed in July 1999 and phased in through early 2000). South Carolina and Virginia are included in these tables as controls to allow for changes over time in mortgage originations in the Upper South that were not specific to North Carolina.

As shown in the appendix, Staten finds that originations of subprime mortgage loans (especially first-lien loans) in North Carolina plummeted after passage of the 1999 law, both absolutely and relatively to its neighbors, and that the decline was almost exclusively in the supply of loans available to low- and moderate-income borrowers (those most dependent on high-cost credit). For borrowers in the low-income group (with annual incomes less than $25,000) originations were cut in half; for those in the next income class (with annual incomes between $25,000 and $49,000) originations were cut by roughly a third. The response to the North Carolina law provides clear evidence of the chilling effect of anti-predatory laws on the supply of subprime mortgage loans to low-income borrowers.

Robert Litan (2001) had anticipated this result. He wrote that:

“. . . statutory measures at the state and local level at this point run a significant risk of unintentionally cutting off the flow of funds to creditworthy borrowers. This is a very real threat and one that should be seriously considered by policy makers at all levels of government, especially in light of the multiple, successful efforts that federal law in particular has made to increase lending in recent years to minorities and low income borrowers.

“The more prudent course is for policy makers at all levels of government to wait for more data to be collected and reported by the Federal Reserve so that enforcement officials can better target practices that may be unlawful under existing statutes. In the meantime, Congress should provide the federal agencies charged with enforcing existing statutes with sufficient resources to carry out their mandates, as well as to support ongoing counseling efforts to educate vulnerable consumers about the alternatives open to them in the credit market and the dangers of signing mortgages with unduly onerous terms.” (p. 2)

The history of the last two decades teaches that usury laws are highly counterproductive. Limits on the ability of states to regulate consumer lenders headquartered outside their state were undermined by the 1978 Marquette National Bank case (see DeMuth 1986). In 1982, the federal government further expanded consumers’ access to credit by preempting state restrictions on mortgage lending by mortgage lenders headquartered within the state (the Alternative Mortgage Transaction Parity Act of 1982).

These measures were crucial contributors to the democratization of consumer finance, and particularly, mortgage finance in recent years. The Marquette case opened a flood of competition in credit card lending, which led the way to establishing a deep market in consumer credit receivables and the new techniques for credit scoring--innovations which have increased the supply and reduced the cost of consumer credit.

The 1982 Parity Act expanded the range of competition in consumer mortgage finance preempting state prohibitions on alternative mortgages originated by both depository and non-depository institutions. In particular, as I understand this law, it effectively preempts state usury laws as applied to subprime mortgages. Because mortgage lending relies on real estate as security, it can be provided more inexpensively than credit card loans or other unsecured consumer credit (Calomiris and Mason 1998). Thus the 1982 Act provided an important benefit to consumers over and above the beneficial undermining of state usury laws after the Marquette case.

But the new stealth usury laws of North Carolina, Dayton, and Washington D.C., and similar proposals elsewhere, pose a new threat. If Congress fails to restore the preemption principle in the subprime mortgage market established in 1982, then lenders will be driven out of the high-risk end of the market, and therefore, many consumers will be driven out of the mortgage market and into higher-cost, less desirable credit markets (credit cards, pawn shops, and worse).

That is not progress. Congress should do everything in its power to amend the Parity Act to clearly define stealth usury laws as usury laws, not consumer protection laws, and thus prevent any further damage to individuals’ access to credit from these pernicious state and city initiatives.

Other prohibitions. I have already argued against further regulatory or statutory limits on prepayment penalties, or prohibition of single-premium credit insurance, in favor of alternative approaches to the abuses that sometimes accompany these features.

I am also opposed to the many proposals that would prevent borrowers from agreeing to mandatory binding arbitration to resolve loan disputes. Individuals should be able to choose. If an individual wishes to commit to binding arbitration, that commitment reduces the costs to lenders of originating mortgages, and in the competitive mortgage market, that cost saving is passed on to consumers. Requiring consumers not to commit to binding arbitration is only good for America’s trial lawyers.

4. Conclusion

For the most part, predatory lending practices can be addressed by focusing efforts on better enforcing laws against fraud, improving disclosure rules, offering government-financed counseling, and placing a few well thought out limits on credit industry practices. The Fed already has the authority and the expertise to formulate those rules and is in the process of doing so, based on a new data collection effort that will permit an informed and balanced approach to regulating subprime lending.

The main role of Congress, in my view, should be to monitor the Fed’s rule making as it evolves, make sure that the Fed has the statutory authority that it needs to set appropriate regulations, and amend the 1982 Parity Act to reestablish federal preemption and thus defend consumers against the ill-conceived usury laws that are now spreading throughout the country.

Members of Congress, and especially members of this committee, also should speak out in defense of honest subprime lenders, of which there are many. The possible passage of state and city usury statutes is not the only threat to the supply of subprime loans. There is also the possibility that bad publicity, orchestrated by community groups, itself could force some lenders to exit the market.

Some community organizations have been waging a smear campaign against subprime lenders. To the extent that zealous community groups, whether out of noble or selfish intent, succeed in smearing subprime lenders as a group, the public relations consequences will have a chilling effect on the supply of subprime credit. The first casualty will be the truth. The second casualty will be access to credit for the poor.

References 

Calomiris, Charles W., and Joseph R. Mason (1998). High Loan-to-Value Mortgage Lending. Washington: AEI Press.

Carey, Mark, Mitch Post, and Steven A. Sharpe (1998). “Does Corporate Lending by Banks and Finance Companies Differ? Evidence on Specialization in Private Debt Contracting.” Journal of Finance 53 (June), 845-78.

DeMuth, Christopher C. (1986). “The Case Against Credit Car Interest Rate Regulation.” Yale Journal on Regulation 3 (Spring), 201-41.

Gramlich, Edward M. (2000). “Remarks by Governor Edward M. Gramlich at the Federal Reserve Bank of Philadelphia Community and Consumer Affairs Department Conference on Predatory Lending.” December 6.

Household International Inc. (2001). “News Release: Household International to Discontinue Sale of Single Premium Credit Insurance on All Real Estate Secured Loans.” July 11.

Lampe, Donald C. (2001). “Update on State and Local Anti-Predatory Lending Laws and Regulations : The North Carolina Experience.” American Conference Institute, Predatory Lending Seminar, San Francisco, June 27-28.

Litan, Robert E. (2001). “A Prudent Approach To Preventing ‘Predatory’ Lending.” Working Paper, The Brookings Institution, 2001.

U.S. Department of Housing and Urban Development and U.S. Department of the Treasury (2000). Curbing Predatory Home Mortgage Lending: A Joint Report. June.

Charles W. Calomiris is an Arthur F. Burns Scholar in Economics at AEI.