Predatory lending and foreclosure in the United States subprime market

Predatory Lending and the United States Subprime Market

The American mortgage banking industry, in recent years has exploded with substantial lending activity due to federal interest rates being at an historical all time low. President George W. Bush in 2001 established "a national goal of at least 5.5 million new minority homeowners before the end of the decade" www.whitehouse.gov, par. 1) and this translates into a whole new segment of potential customers for the mortgage banking community. President Bush has recognized the barriers faced by minority families and has made it a goal of the administration to eliminate these barriers. Mortgage banking organizations and traditional brick and mortar banking institutions have recognized this segment and taken advantage of not only the home loan boom for the last five years but also have created new loan products to fit this niche. These loan products include a number of loans that can be classified as subprime or nonprime. For the purpose of this paper and for sake of argument, the data of this paper will focus on origination of new home loans only. One can assume the refinance market has also taken advantage of minority families and low-income individuals as well as the boom as lasted far longer than many analysts anticipated due to borrowers engaging in multiple refinances.

This type of boom in originations has spawned tremendous economic growth with regards to employment rates, reurbanization, new home building, consumer spending and confidence and made hundreds of billions of dollars for the players involved. The housing boom kept this country afloat during the darkest moments after September 11, 2001 when other industries like travel, hospitality, entertainment, energy and telecommunications seemed uncertain. All of these facts may be true about the American mortgage industry but there is a dark side to home loan lending practices.

Much has been said regarding predatory lending practice in recent years and subprime loans mainly because of many factors having to do with the borrower's credit and work histories. The subprime industry is relatively new in the mortgage world. The research done for this paper has found a direct correlation between predatory lending practices, subprime loans and the rate of foreclosure.

One can argue that such a relationship is cyclical; what comes around goes around in the manner of economic trends such as recession and depression but this is not the case with this correlation. Literature review of multiple studies and statistical data support the fact predatory lending in the form of subprime loans can result in foreclosure. This means an incredible loss not only to the borrower but also to their community and to the mortgage lender. A direct impact upon neighborhoods and economic growth at local levels can be seen nationwide. This impact also affects the health of state and federal economies on a grand scale. With this in mind, it has been discovered through research that the correlation between predatory lending of subprime loans and foreclosure is far more prominent in minority communities and low-income neighborhoods than that of white communities and high-income neighborhoods. How has this happened? How has the industry evolved to encourage such practices without accountability? What can be done at the local, state and federal levels to ensure these practices no longer continue? What policies can insure lenders protect the interests of future homeowners especially minorities?

This paper will accomplish many objectives. First this paper will define important terms from the mortgage industry language. The paper will define the elements that make up predatory lending practices. The paragraphs below will detail the difference between prime loans, subprime and how a potential borrower would fall into either category. This paper will define the term foreclosure for context purposes and briefly discuss the aftermath of foreclosure as an aspect of economic impact.

Finally this paper will offer data from the Home Mortgage Disclosure Act, also referred to as "HMDA" and statistics to prove the correlation between predatory lending and the rate of foreclosure. This data will reflect a direct relationship and provide concrete examples of the economic impact predatory lending causes because of the likelihood it results in delinquency and sometimes foreclosure. The economic impact paragraphs will explore how such lending practices have created a dramatic divide amongst borrowers with regard to race and income. Statistics will show that people of minority backgrounds are more likely to be approved for a subprime loan. Statistics will also provide a look at how banks and mortgage organizations have profited while borrowers have directly or indirectly suffered a loss. Much of this reasoning can be attributed to lack of home-buying education in minority and low-income neighborhoods. Still some of this results from lender pressure. These paragraphs will also explore how predatory lending has as a result of the rise in the rate of foreclosure, affected communities across the country. This influence can be seen in community growth, reurbanization of these particular neighborhoods.

This leads to public response. Finally this paper will discuss what is being done at community local levels but also focus on how state and federal governments are looking to improve the home-buying process to combat the practice of predatory lending. Also it will discuss how such mortgage companies like Countrywide Home Loans are attempting to not only battle predatory lending but also make the dream of homeownership a reality to the underserved populations of this country during the life of the loan.

Definitions

Part of the reason predatory lending has been able to slip through the cracks without accountability or consequence is due to lack of home-buying and homeownership education. The unfortunate fact is that many Americans do not understand the mortgage banking process that leads to an approval for a loan. The following definition of terms will aid in bettering understanding the above correlation.

Subprime Loan Characteristics

In the mortgage industry, potential borrowers fall into two categories: prime and subprime. This is determined by the grade of loan in which they can be approved. This grading system is much like what one finds in school or ABCD grades. The "A" grade, of course, being the best and the "D" grade being just above failing. The grade is based on four ability to pay factors: loan to value ratio, FICO score, mortgage payment to income ratio and mortgage payment history (Slade, 4). An "A" grade falls into the 800-640 range of the FICO score with 690 being a questionable area of rating. People who fall into the 640 ranges have a chance of being put in the subprime range of below 690. Anything below 640 is considered B, C, and even D type paper loan. These loans use non-conforming elements and different ways of substantiating credit history. There are products in the marketplace that do this in order to approve a borrower that in the past would not have been able to be a homebuyer. This can be dangerous because it allows risk factors to be treated with flexibility. In other words, lenders with poor scruples may look the other way and take advantage of poor credit and prey upon this segment of people. For instance, the average loan interest rate (as of 2002) is 11.70% (Slade 4). This rate is higher than conventional conforming loans. The distribution of loan-to-value ratios is negatively skewed. According to Barrett a. Slade, "the typical subprime borrower has limited discretionary income, a less-than-perfect credit history, cash-flow concerns, or may be a first- time homebuyer with no credit history" (2).

The rationale from the lenders point-of-view regarding B, C, and D. paper loans is that due to the borrower's previous credit history, there is higher possibility of the borrower having future credit issues that could lead to default. Geoff Smith, in his testimony before Congress in 2004 expressed, "moreover, even among borrowers who do have impaired credit, the subprime market does not appear to be functioning in a way that services the interests of borrowers" (3). This is reflected by consumer confidence in their home loan approval experience. "Only 34% of credit-impaired respondents were confident that they got the lowest cost mortgage available, compared to 68% of all homeowners surveyed by Fannie Mae. Thirty-two percent of credit-impaired homeowners, compared with ten percent of other respondents, did not care but were 'just happy' to be approved" (Smith 3). This type of intimidation leads to borrowers falling into the hands of predatory lenders. Lack of education about the home-buying process and finances in general do not help either.

Predatory Lending variety of loan terms and lending practices have been described as predatory or abusive, especially when employed in high-cost or subprime loans. Some of these practices, particularly loan terms such as prepayment penalties are used in the subprime market and this does not seem to scare the borrower away. The use of such terms and practices is highly inappropriate. For example, debt-to-income ratio above 40-45% is considered normal practice with prime loan but is entirely inappropriate for subprime loans. Fifty percent for housing costs may be okay for a family with high-income but could cause potential disaster for that of a lower income. Predatory lenders look to stretch the debt-to-income ratio to a point where, it is not considered responsible lending (Smith 3). Another example of predatory practice is attaching a balloon payment to the loan. Balloon payments are typically seen in prime paperwork used when the borrower is upwardly mobile in their profession. Meaning simply, they will be making more money in the future and able to pay a large compounded payment years from origination. A balloon payment helps maximize the amount borrowed for a higher end property.

Another practice made by these lenders is to put the borrower under distress or fear of non-approval if they sop around but also to present different facts during the home-buying process and then show up at the Closing with different paperwork than discussed prior. Smith argues, "in a study of 255 very high-cost loans in Dayton, Ohio, 75% were found to have prepayment penalties and 24% had balloon payments" (4). To further suspicion, more than twice as many borrowers of these loans were acquired through mortgage brokers and were encouraged to refinance numerous times within in the first two years of the loan. Unfortunately a lot of this behavior confuses the borrower and leaves them not only dissatisfied but also uneducated. A predatory lender will use one of these practices and others as well when approving a loan to just the loan and make a dollar. This is wrong and as a result, many people end up with loans they cannot afford or pay back. This leads to foreclosure and losses for all parties involved.

Foreclosure

Countrywide Home Loan's FBRM Training Manual describes foreclosure as "a legal procedure in which a mortgaged property is sold to pay the outstanding debt in case of default" (11). Briefly, there are two types of foreclosure processes: judicial and non-judicial. Judicial is a longer process because it goes through the court system. How a foreclosure gets this distinction has to do with the state in which the property is located. The amount of time the process takes also varies from state to state depending on this distinction. For example, many states on the East Coast such as New York, New Jersey and Pennsylvania are judicial states and the process can take anywhere from six months to a year (Countrywide FBRM 12) while states in the West like Texas and California are non-judicial states where the process can take one to three months to finalize. This type of action on the part of the lender can be very scary and intimidating for the borrower. Foreclosure not only result in the borrower losing their home but can also have long-lasting and far-reaching consequences for them financially but also for the economy at larger. Foreclosure also serves as a loss for the lender should the property not be sold at auction. The property then becomes Real Estate Owned by the lender (Countrywide FBRM 37). This puts the responsibility of maintaining and improving the property for independent sale on the shoulders of the lender. This incurs further costs for them that will not be recouped upon sale of the property because the lender can only ask a fair market value. Generally, a lot of times, the property has been abandoned by the borrower or is damaged by the borrower and those repairs must be made. Foreclosure should be avoided at all costs as it is a terrible experience.

Statistics and Data

The reason behind President Bush's call for the Homeownership Challenge is not only to break down barriers but also to change how home loans are approved in this country. He believes by revamping the process will curb predatory lending because borrowers will be educated and informed. By knocking down barriers to homeownership, one being blemished credit will change how lenders view potential customers and the President thinks will allow an underserved population to finally have a presence in this market (America's Home Ownership Challenge, par. 3-4). The current administration stands by the notion that homeownership is a fundamental American right. It is good for communities because homeowners "work to maintain the value of their investment, which translates into a greater concern for neighborhoods. When citizens become homeowners, they become stakeholders as well. By increasing the ranks of stakeholders, communities not only enjoy increased stability but also benefit from a new spirit of revitalization" (Background, par. 4). Then how does one explain the disparity of minority homeowners when compared with that of white homeowner? Clearly, the white population of the country has the means for barriers not to be an issue when it comes to home purchase. They also do not suffer the same economic burden that will be explored below. Still recent years due to the factors of new home loan products and low interest rates have stimulated the minority segment. "Homeownership has in fact increased, Hispanics and African-Americans still lag behind the homeownership rate of non-Hispanic whites by more than 25 percentage points, and Asian-Americans by more than 20 percentage points. Table 1 illustrates this fact.

Homeownership Rates:

Demographic Percentage of Homeownership

Non-Hispanic whites

African-Americans

Hispanic-Americans

Asian-American (and other races)

Aaron, 1)

This data supports there is a direct correlation between predatory lending practices, subprime loans and the rate of potential foreclosure. Geoff Smith gives a fine example of this happening in Chicago when the area experienced "tremendous growth in foreclosure starts. The total number of starts went from 7,433 in 1995 to 25,145 in 2002, an increase of 238%" (7). In contrast, home loans guaranteed by FHA and the VA and prime conventional loans did not experience such growth but numbers were as follows "foreclosures rose between 1995 and 2002 from 3,387 to 6,932 for government loans while conventionals skyrocketed from 4,046 to 18,213" (Smith 7). These numbers are troubling as well but do not compare to that of subprime foreclosure starts. Of these foreclosure starts, nine foreclosures resulted in a demographic of non-white and lower-income traits. For the Chicago area, this increase of foreclosures "threatened more than two decades of work in revitalizing and stabilizing the communities" (Smith 4).

Economic Impact of Predatory Lending

The data represents after controlling issues of credit, economic conditions and neighborhood demographics, subprime loans lead to foreclosures at twenty or more times the rate of prime loans. Meaning for every 100 subprime loans made in a typical neighborhood from 1996 to 2001; there resulted an additional nine foreclosures in 2002. The reason foreclosures happen in areas of lower income are because "residents are less likely to be able to avoid foreclosure via borrowing from friends or relatives" (Smith 9). This makes a strong case for the correlation between foreclosure rates and predatory lending because subprime loans are so high in these areas. It is unfortunate because the borrowers bear a great amount of the cost of the foreclosure to a point where the neighborhood next door is affected. Not only does a foreclosure "damage credit ratings but it also hurts the owners' prospects to not only in credit markets but also in labor and insurance markets and in the market for rental housing" (Smith 5). The estimated loss for a foreclosed family is $7,200. The average cost to the city of Chicago for one foreclosure in 2002 was "city expenses of $27,000 and neighborhood expenses of $10,000" (Smith 5). It has been observed that the same predatory lenders have foreclosure rates of more than ten to fifteen percent in specific areas of Chicago (Smith, 5). These foreclosures have been mapped to specific black communities of Chicago.

In contrast, the rate of subprime loan delinquencies also impacts economies like California. Lepine argues, that while "subprime loans help boost the nation's homeownership rate, these loans have raised concerns about whether buyers are setting themselves up for financial disaster" (2). Foreclosure and delinquency is on the rise and Lepine believes it is due to the flexibility of subprime parameters of approval. He writes, " one point four percent of subprime loans in California were more than 90 days past due or in foreclosure, compared with 0.2% of prime loans" (3). This leads to a higher rate of refinance practices for this state.

Predatory lending practices have direct and in direct effects on the economy because the tools used to offer flexible approvals, set people up for failure and results in a defaulted loan. Such an event in a person's life can affect how they function and live. Many face homelessness and unemployment do to such loss. Others face divorce and losing children to protective services. In many ways, foreclosure leads to losing one's life and bliss. It has been documented at Countrywide Home Loans that nine of ten subprime loans go into foreclosure because of an unforeseen hardship such as loss of a job, birth of a child, health issues, a family passing, divorce, or car repairs (Countrywide FBRM, 15). The steps to foreclosure can be agonizing and embarrassing for many but can happen extremely quickly. It is also documented that four out of five households with a subprime loan, also live paycheck to paycheck.

Obviously, any change in financial status will lead to loss even when the borrower plays catch up. It is becomes a vicious cycle due to the fact the loan is designed to maximize criteria. Foreclosure has a negative affect on communities because people move away as a result. Businesses disappear and commerce dwindles. Other borrowers in the area start to feel that negativity and do not care for their properties as much. This is what is called economic down turn. The unfortunate is that one sees this trend all too often in minority area of low-income. Such a feeling in the community causes an increase in crime and violence for the people who remain. When left alone, these area further deteriorate until virtually very little is left.

Public Response to Economic Impact

Governments on local, state and federal levels have seen the results of predatory lending and have put policies and procedures into action to eradicate such practices in the subprime design for flexibility. HUD has created a task force that watches over lending practices and makes sure lenders are accountable for predatory actions. As a result many lenders have been fined in the millions for such actions. Meanwhile, states like Georgia, New York and California have put laws on the books that make it harder for lenders to use different predatory elements in the same originated loan.

Still the real change has come at the federal level with the legislation called Real Estate Settlement Procedures Act or "RESPA." This document makes it mandatory for mortgage companies to communicate the exact details of loan information in connection with the purchase of a property. A mortgage company like Countrywide must follow the laws of how this information is communicated to the borrower or risk being fined. Better yet, risk a class action lawsuit. This document makes it clear exactly the terms of the loan and the amount of debt involved. If the borrower should have any question, they also have the right to contest the information. This due diligence "ensures that one understands the nature of their purchase and this makes the borrower better able to avoid circumstances like foreclosure" (Empowering the Homebuyer, par. 5). What is legislation has resulted in for the home buying public is an increased awareness of such practices and a new knowledge of the process. This fits and aligns itself with Bush's overall plan to modernize the home loan process. This has resulted in an abundance of financial counseling services rather they be non-profit or commercial. These program have reached into communities that are minority and foreign in nature. This is in response to Bush's local initiatives to be taken across the nation to eliminate barriers. This initiative has created "strategic partnerships with 20 top housing marketers between homebuilders, lenders, local officials and community leaders to develop approaches that address challenges at the state and local levels" (Empowering the Homebuyer, par. 6). The availability of these programs, make homeownership a reality for many but also opens doors to understanding how loans work. Housing counselors work one-on-one with borrowers to aid them in understanding how credit works. Fannie Mae also offers pamphlet through the mail and via the World Wide Web that has an outline of how to qualify for a prime loan. This web site is also offered in multiple languages to better serve Spanish and Chinese communities.

The company mentioned throughout this paper, Countrywide was founded on the premise that homeownership should be available to all Americans from every walk of life. The co-founders, Angelo Mozilo and David Loeb recognized the lack of mortgage products in the banking field at the end of the 1960s. Because they believed mortgage banking should not discriminate, they called the start-up Countrywide to encompass the concept of the American Dream.

In December of 2001, Countrywide Home Loans was "ranked highest in overall customer satisfaction among the largest national mortgage lenders" by J.D. Powers and Associates (Simon, 2001 par. 1). This ranking was based on the inaugural Home Mortgage Study conducted by the global marketing firm. Mozilo attributes this excellence to the touch point technique, as it is understood interaction with the customer can be rare. It is important to establish excellence "from the initial phone call about applying...through maintaining a relationship over the life of the loan" (Simon, par. 4). Mozilo continues by saying "every decision made is reviewed for its impact on customers" (Simon, par. 4). It is employee excellence that is main driver behind this success but also it is Countrywide's conscious effort to maintain relationships and acquire new ones. It does this by employing two critical elements to its business practice. First, as Countrywide continues to diversify and grow, it implements new programs or whole new divisions to serve a segment of the community. Second, it applies new technologies to make the customer service experience seamless.

Countrywide, within its Loan Administration arm has numerous effective programs to enhance communication and add value with the borrower. These programs are evident in every step of the loan process. Countrywide understands a need to serve minority groups in homeownership education. As a result it created WeHouseAmerica, which works with underserved populations across the country to make them aware of homeownership being an option. This has added value to these customers' lives by aiding them in the home buying process. It has also provided credit counseling and other cutting edge products to these people. One example is a low documentation loan that establishes credit on past rental history and utility bill payments. This opens up the company to a whole new marker but also establishes the company as someone who cares and goes the extra mile. Another area that is proactive in customer relations is the Loss Mitigation department. Their main objective is to communicate with the customer while the customer may be having financial troubles. It is Countrywide's goal to work with customers and retain them rather than allow a foreclosure. It is the diligent work of these employees and their message of help to the customer that influences the relationship and establishes appreciation. This appreciation also creates possible avenues for cross selling later. Really it is the premise that a company would care enough to work with a customer through hard times that underscores this significant action. Many analysts would argue Countrywide's motivation is purely business and profit oriented but it is clear Countrywide values its customers throughout the life of the loan and this creates success. The company takes a personal stake in establishing customer relationships and this adds value to every aspect of its business.

Conclusion

The research done for this paper found a direct correlation between predatory lending practices, subprime loans and the rate of foreclosure. This paper accomplished many objectives. First this paper defined important mortgage industry language. Then this paper offered data from the HMDA and statistics to prove the correlation between predatory lending of subprime loans and the rate of foreclosure. This data reflected a direct relationship and provided concrete examples of the economic impact predatory lending causes because of the likelihood it resulted in delinquency and sometimes foreclosure. The economic impact paragraphs explored how such lending practices have created a dramatic divide amongst borrowers with regard to race and income. Finally this paper discussed what is being done at community local levels but also focused on how state and federal governments are looking to improve the home-buying process to combat the practice of predatory lending. Also it will discussed how such mortgage companies like Countrywide Home Loans are attempting to battle predatory lending. Still, HUD's analysis reported as part of the HMDA data "demonstrates the exponential growth in subprime lending and its disproportionate impact on low-income and, particularly minority homeowners and communities throughout the nation" (Subprime Lending Report 2).