Friday, April 20, 2007

Predatory Lending Distinguished from Bad Lending

There is a lot of news coverage of certain practices in the mortgage industry these days, particularly the sub-prime sector. I work in the industry, although more on the IT/Operations side, and as a relative short-timer at 5 years. But I certainly know enough to critique a lot of the news coverage.

To be clear, I take a pretty dim view of some of the practices that became popular in the last few years. Regarding the "liar loans", whereby borrowers mere state their income, without providing any proof (W-2 or Income Tax filing)--well, I have been bugging my more knowledgeable colleagues for years to provide me with a coherent and internally consistent explanation of their purpose. I never received one.

Regarding the practice of negative amortization loans (PoAs, for example) and qualifying borrowers based on the teaser rate of 1.5-2.5%, rather than the fully-indexed rate of 7% or so, well, it seems very clear to me that that is crazy stuff.

So we definitely have some bad practices that probably are never really in the consumer's interest, if we adopt a paternalistic viewpoint. However, that is not what is normally meant by predatory lending. That term refers to loans which contain excessive fees. Because mortgages are complicated, having many different factors and variants, and because they have so many related fees, it can potentially be difficult for a less incisive borrower to see that they are getting ripped off. So there are various state regulations against predatory lending.

The things we are talking about are a little bit different from classic predatory lending. The borrowers were not necessarily getting a bad deal--the fees and rates may have been in line with competitive benchmarks. What they were getting was a deal that they clearly couldn't afford. The mortgage originator wasn't necessarily receiving outrageous (aka, predatory) profits on the deal. No, the point of all the features that let the originator "bend the rules" was just to be able to make the deal happen, to qualify a borrower who would not otherwise be qualified.

Maybe this all seems like a difference without a distinction, but there is an important consideration. In the case of predatory lending, a fair and just resolution may be some kind of workout where the excessive fees are reimbursed. In such cases, it is reasonably to expect that the borrower can stay in their house. In cases where borrowers were qualified based on a very low teaser rate, or because they lied about their income (possibly with the encouragement of a mortgage broker), it is quite possibly or even probably unreasonable to think they can stay in the home. What is the workout--that they get to keep a 1.5% interest rate for 30 years?!

No, sadly, in those cases the best option is a sale. A smooth, well-planned sale that nets the best possible price, as opposed to a forced liquidation via foreclosure. They can't afford the house, they need to sell it. Unfortunately, the fly in that ointment is the fact that housing markets are softening, and the price the homeowner is likely to get may very well be less than they paid a year or two ago. Of course, many of those homeowners put very little down, so their economic downside (as opposed to the personal pain of selling and relocating and perhaps losing their dream of home ownership) is also limited.

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