Sub-prime Lending

This article examines the growth of sub-prime lending over the last two decades. The difference between sub-prime loans and traditional prime loans is explained. The benefits of sub-prime loans for borrowers are reviewed along with the problems that sub-prime loans present for borrowers and for the overall economy. Abuses in the sub-prime loan industry, often referred to as predatory lending practices, are explained and efforts to remedy and prevent these abuses are examined. The nature of predatory lending and its impact on individuals, the economy, and society are explained. Major settlements with abusing lending companies over predatory practices are also reviewed.

Keywords Predatory Lending Practices; Prime Loans; Sub-prime Lending; Sub-prime Loans

Finance > Sub-prime Lending

Overview

Sub-prime lending is a relatively new and rapidly growing segment of the financial market that provides credit to borrowers who, for one of numerous reasons, would generally not be extended credit. Borrowers, for example, who fail credit history requirements in the standard (prime) mortgage market have greater access to credit in the sub-prime market. One of the major benefits of sub-prime lending is growth in the number of homeowners. Sub-prime lending is also high-cost borrowing for those seeking and accepting such credit. Sub-prime lending cost has two major aspects: Credit history and down payment requirements. This is in contrast to the prime market, where the borrower's cost is primarily driven by the down payment providing they have an adequate credit history (Chomsisengphet & Pennington-Cross, 2006).

Sub-prime lending is often viewed as having both promises and peril for the economy as well as the individual borrower. The plus side is that sub-prime lending provides an opportunity for homeownership to those who would be otherwise excluded from the market because of discrimination or the inability to qualify for a mortgage in the past. Because poor credit history is often associated with more delinquent payments and defaulted loans, the interest rates for sub-prime loans are generally considerably higher than for prime loans (Chomsisengphet & Pennington-Cross, 2006).

Two legislative reforms allowed lenders to deliver risk-adjusted pricing that made loans available to higher-risk mortgage borrowers. The Depository Institutions Deregulatory and Monetary Control Act in 1980 eliminated rate caps and made sub-prime lending more feasible for lenders. In addition, the Tax Reform Act of 1986 eliminated interest deductions on consumer and auto loans while still allowing interest deductions on mortgage debt. According to the Department of Housing and Urban Development (HUD), the number of sub-prime lenders tripled, growing from 70 to 210 between 1994 and 1997. Sub-prime, together with alternative A mortgages, virtually replaced agency (Fannie Mae and Freddie Mac) loans.

However, in the late 1990s, financial troubles hit many sub-prime lenders who were plagued by aggressive accounting policies with respect to property valuations. This forced restatements of financials, which for many essentially wiped out their net worth. As a result of the restatements, several sub-prime lenders filed for bankruptcy and went out of business (White, 2006).

The tradition in the mortgage market was to set minimum lending standards that take into consideration a borrower's income, payment history, and down payment with some input from the local underwriter about their knowledge of the borrower. This is a non-price credit rationing approach. The sub-prime lending market is based on several different pricing tiers and loan types, which to a large extent has helped to move the mortgage market closer to price rationing, or risk-based pricing. Overall, the ultimate success of the sub-prime market will determine to what extent the entire mortgage market incorporates risk-based prices for each borrower (Chomsisengphet & Pennington-Cross, 2006).

Sub-prime lending helps to bring people into the borrowing market who probably would not have other opportunities to obtain credit. But there have definitely been abuses, especially with lending practices for people living in minority neighborhoods where 50% or more of residents are minorities. These borrowers have 35% greater odds of being saddled with prepayment penalties on sub-prime mortgages than borrowers who live in predominantly white neighborhoods (Mink, 2005) (Karger, 2007). These trends exist despite that offering loans at preferable interest rates on the basis of gender or race is illegal in the United States (Tucker, 2007).

Because of a lack of alternatives, sub-prime borrowers were attracted to alternative mortgages that provide for equity growth, which in turn has a positive impact on their credit profile. When interest rates started to rise and housing price appreciation simultaneously slowed, many sub-prime borrowers could not refinance to gain more favorable terms. Many also were unable to maintain their mortgage payments when their loans were adjusted to the higher interest rate. They also could not sell their homes because of a slow down in home sales. In the past, delinquency and default rates were closely linked to local economic conditions. Both delinquency and default rates are rising today even in some locations that have low unemployment and strong economies (“Housing Boom & Bust,” 2007).

Trends indicate that the default rate for sub-prime loans is about six times higher than for prime loans. Problems can be compounded because sub-prime borrowers encounter more difficulty in obtaining cheaper loans when interest rates fall. Thus, borrows are locked into high rate loans. This obstacle often results in “reduced access to financial markets, foreclosure, and loss of any equity and wealth achieved through mortgage payments and house price appreciation” (Chomsisengphet & Pennington-Cross, 2006).

Applications

Regulating the Sub-prime Marketplace

Over the last two decades, sub-prime lending programs offered by banks and other lenders have provided financial opportunities for borrowers who had impaired credit or no credit history. Sub-prime lending has supported home mortgages, automobiles, consumer credit, and credit cards. Many community banks have often offered sub-prime loans as part of an outreach program to help meet the requirements of the Community Reinvestment Act. As a result, many families were able to become homeowners because of the accessibility of credit through these programs. Such loans usually served a useful purpose and were distinguishable from sub-prime loans made on predatory terms(Bahin, 2007).

Abuses

Some lending institutions or companies have been identified as having practices that are considered abusive to the borrowers who most often obtain sub-prime loans. Furthermore, the disclosure of expanded data required to be in compliance with the Home Mortgage Disclosure Act (which exposes pricing data for loans) has led “some groups to conclude that a number of lenders have violated fair lending laws.” In addition, there have been “several high-profile cases filed alleging that lenders have violated the Fair Housing Laws and the Equal Credit Opportunity Act” (Bahin, 2007).

Observers have expected that various types of actions will occur over the next few years including:

  • Congress will continue to pass legislation that prohibits existing and emerging predatory practices and otherwise regulates the activities in the mortgage industry.
  • States will continue to enact laws that impose additional requirements for lenders.
  • Federal banking agencies will focus more attention on compliance with laws and regulations on the part of lending organizations.
  • More class action suits will be filed on the behalf of borrowers who believe that they have been discriminated against or misled by lenders (Bahin, 2007).

The economic importance of the sub-prime market cannot be understated for the economy as a whole and for the individuals obtaining sub-prime loans. The effects of sub-prime lending are pervasive. The class actions suits that have already been filed (and others are probably still pending) involve a long list of sub-prime lenders and their aggressive lending practices (Koppel, 2007). Well over 20 sub-prime lenders have been closed down or sought buyers over the last few years. These include New Century Financial and General Electric (Stewart, 2007).

Many lenders have been accused of issuing sub-prime mortgages that prey upon the poor or uninformed consumer. The lenders have offered high-risk clients an opportunity at homeownership but with interest rates well above the going rate and above what many borrowers could actually pay (Ordower, 2007). Sub-prime loans that have gone bad have often devastated lenders and set back borrowers financially (Roney, 2007).

In 2006, Ameriquest Mortgage Company decided to settle a complex and multi-state investigation concerning allegedly deceptive consumer lending practices. The settlement was massive and included $295 million to repay borrowers who took out loans between January 1, 1999 and December 31, 2005. In addition, the company agreed to pay $30 million to cover the costs of the investigations.

In 2002, Household Finance Corporation's had nearly $500 million settlement with several states over similar allegations. Citigroup's had a $215 million and another $70 million settlement with the Federal Trade Commission and the Federal Reserve Board over lending practices.

Outcomes of the Settlements

Settlements often required changes in how the lending process is managed and executed. These include several oral disclosures for first lien loans. These disclosures were above and beyond the existing Truth-in-Lending Act (TILA), Real Estate Settlement Procedures Act (RESPA), and other mandated written disclosures that are designed to disclose key loan terms. These include the repayment terms, interest rates, monthly payments, existence of a prepayment penalties, and escrowed amounts, among other points.

In addition, the Ameriquest settlement required the company to provide consumers with a single page disclosure of the key loan terms within three days of obtaining loan pricing. This disclosure applied sub-prime loans as well as any other loan the company was making. Household was also required to issue the one page summary of key loan terms.

Another key aspect of these types of settlements is a requirement to provide borrowers with a new written summary disclosure if there is a material change in the terms of a loan. The new disclosure must be mailed in a timely manner before closing or otherwise delivered or made available to the consumer at least three days before closing of all loans. Such changes include an increase in interest rates, increase in discount points, increase in repayment terms, decrease in the loan amount greater than one percent, or an addition of a prepayment penalty. Ameriquest was required to use a pricing model for loans. The model is designed to offer the same interest rate and number of discount points to all potential borrowers having the same credit risk characteristics.

Ameriquest specifically faced other numerous restrictions in how it conducted business. The company was prohibited from soliciting borrowers with existing non-prime loans for refinancing within the first 24 months of the loan term unless the company received a request for a pay-off statement or is contacted by a borrower who inquires about refinancing. Ameriquest was also required to use loan closers for the closing of all non-prime loans that are independent of the branch office where the loan is originated and is not a relative of an employee processing the loan. At the closing of a loan, independent loan closers are required to have the borrower sign a statement certifying that:

  • The borrower understands that the loan is being approved because of the dollar amount of income reported by the borrower.
  • The dollar amount of income reported on the loan application by the borrower is accurate.
  • That any false statements about the dollar amount of income of the borrower may subject the borrower to criminal penalties.

The Ameriquest settlement established a model program for dealing with the independence of the appraisal function. This was designed to ensure that the branch office had the absolute smallest role possible in the appraisal process. This was implemented by establishing a panel of qualified, approved appraisers for each state in which the company does business. To become a member of the panel, an appraiser must be in good standing with their state licensing authority. They must also have had their past audit work reviewed for quality and compliance if they had done appraisals for Ameriquest in the past (Mayk, 2007).

Issue

The Dynamics & Impacts of Predatory Lending

The marketplace for and the availability of mortgage loans have changed considerably over the past several decades. According to the General Accounting Office (GAO), the biggest change has been the emergence of a market for sub-prime mortgage loans. Most mortgage lending still takes place in the prime market, which involves traditional lenders and borrowers with credit histories that classify them at a low risk of default. However, the sub-prime market serves borrowers who usually have poor credit histories or limited incomes, and who cannot meet the criteria for loans in the prime market.

Because of a lack of regulation in the past, there have been numerous abuses. Predatory lending, which is an umbrella term that is generally used to describe circumstances in which a lender takes unfair advantage of a borrower (including practices such as deception, fraud, or manipulation) to make a loan with terms that are disadvantageous and sometimes very detrimental to a borrower (“Consumer Protection,” 2004).

Attributes of Predatory Lending

Predatory lending is difficult to define because various types of loan attributes by themselves may or may not be abusive. However, depending on the context of the loan and the ability of the borrower to repay, terms such as prepayment penalties can be abusive in the context of some loans while not in other loans if they can benefit a borrower. While there is not a universally applied definition of predatory lending, loans based on predatory practices often have the following characteristics and lending practices:

  • Excessive fees which generally exceed amounts that can be justified by the costs of the services provided or the credit and interest rate risks involved. Lenders often add these fees to the loan amounts rather than requiring payment up front, and thus the borrowers usually do not know the exact amount of the fees they are being charged.
  • Excessive interest rates that are not legitimately based on the credit characteristics of borrowers or the loans themselves. However, in many cases, predatory lenders charge interest rates that far exceed what could possibly be justified by risk-based pricing calculation. In some cases, lenders have steered borrowers that have excellent credit records to higher-rate loans and succeeded in doing so because the borrower is not informed.
  • Single-premium credit insurance, a loan feature that repays the lender should the borrower die or become disabled; often the lender adds the full premium for the policy to the total loan amount financed. This practice unnecessarily raises the amount of interest a borrower pays.
  • Lending to borrows that do not have the ability to repay often involving loans that have monthly payments that equal or exceed a borrower's total monthly income.
  • Flipping loans, a practice where lenders refinance a borrower's loan repeatedly in a short period of time without any benefit to a borrower; because of high fees, this often strips the equity the borrower has in the home being financed.
  • Fraud or deceptive practices that predatory lenders may execute such as inflating property appraisals, manipulating or providing false information on loan applications or settlement documents. Such practices can also include bait and switch tactics that mislead potential borrowers about the terms of their loan.
  • Excessive prepayment penalties for prepaying a loan that predatory lenders have used to help to trap a borrower into a high-cost loan.
  • Predatory loans can contain balloon payments that a borrower is not likely to be able to afford, often resulting in foreclosure or refinancing with additional high costs and fees (“Consumer Protection,” 2004).

Causes of Predatory Lending Practices

The General Accounting Office’s 2004 report showed that many economic and legal factors contributed to the growth of the sub-prime market and to predatory lending practices. There were “changes in tax laws that increased the tax advantages of home equity loans.” There were also “rapidly increasing home prices that provided many consumers with substantial” growth in their home equity. Many loan companies entered into the sub-prime market that had previously made only prime loans. As credit scoring and automated underwriting became more prevalent, it was easier for lenders to price the risks associated with making loans to borrowers with poor credit histories. Sub-prime mortgage loans “grew from $34 billion in 1994 to more than $213 billion in 2002 and in 2002 represented 8.6 percent of all mortgage loans” (“Consumer Protection,” 2004, p. 21).

It is rather widely accepted that the majority of predatory lending occurs in the sub-prime market, which has grown dramatically in recent years. There are several reasons why lenders may become predatory. Profit is always the key motive but many practices go far beyond the desire just to maintain the balance sheet. From a business perspective, lenders need to “charge higher interest rates and fees for sub-prime loans than they do for prime loans to compensate for increased risks and for higher servicing and origination costs. In many cases, risks and costs can justify the additional cost of the loan to the borrower, but in other cases such charges may not be justified. Because sub-prime loans involve a greater variety and complexity of risks, they are not the uniformly priced commodities that prime loans generally are. This lack of uniformity makes comparing the costs of sub-prime loans difficult,” which can increase a potential borrower's vulnerability to abuse (“Consumer Protection,” 2004, p. 21).

Although several advocacy groups take the position that sub-prime lending inherently involves abusive practices in a majority of loan situations, analysts generally contend that “only a small portion of sub-prime loans contain features that are considered abusive. In addition, according to officials at HUD and the Department of the Treasury, the emergence of a sub-prime mortgage market has enabled a whole class of credit-impaired borrowers to buy homes or access the equity in their homes. At the same time, however, federal officials and consumer advocates have expressed concerns that the overall growth in sub-prime lending and home equity lending in general has been accompanied by a corresponding increase in predatory lending. For example, lenders and brokers may use aggressive sales and marketing tactics to convince consumers who need cash to enter into a home equity loan with highly disadvantageous terms” (“Consumer Protection,” 2004, p. 21-22).

The Provision of Sub-prime Loans

Companies that offer sub-prime loans are most often mortgage and consumer finance companies, but banks, thrifts, and other institutions also offer some sub-prime loans. Some lending companies originators focus primarily on making sub-prime loans, while most offer a variety of prime and sub-prime loans. According to the GAO, HUD identified 178 lenders who concentrated mostly on sub-prime mortgage lending in 2001, and “fifty-nine percent of these lenders were independent mortgage companies (mortgage bankers and finance companies), 20 percent were non-bank subsidiaries of financial or bank holding companies, while the rest were other types of financial institutions” (“Consumer Protection,” 2004, p. 22). Only ten percent of the organizations offering sub-prime loans were federally regulated banks and thrifts. As of 2004, there is no set of comprehensive and reliable data available on the extent of predatory lending nationwide. There are several reasons for the lack of data:

  • The lack of a standard definition of what constitutes predatory lending makes it inherently difficult to measure
  • Any comprehensive data collection on predatory lending would require access to a representative sample of loans and to information that can only be extracted manually from the physical loan files.
  • Because such records are not only widely dispersed but also generally proprietary, to date, comprehensive data have not been collected (“Consumer Protection,” 2004, p. 23).

Evidence of Predatory Lending

Data or no data, “policymakers, advocates, and some lending industry representatives have concluded, and expressed concerns, that predatory lending is a significant problem” (“Consumer Protection,” 2004, p. 23). Although the extent of predatory lending cannot be readily or easily quantified, there are indicators that suggest that it may be prevalent. The GAO maintains that “primary among these indicators are legal settlements, foreclosure patterns, and anecdotal evidence. In the past several years, there have been major settlements resulting from government enforcement actions and private party lawsuits that accused lenders of predatory and abusive lending practices” (“Consumer Protection,” 2004, p. 23).

Among the largest of these settlements have been the following:

  • In 2002, Household International agreed to pay up to $484 million to homeowners across the nation to settle allegations by states that it used unfair and deceptive lending practices to make mortgage loans with excessive interest and charges.
  • In 2002, Citigroup agreed to pay up to $240 million to resolve charges by FTC and private parties that Associates First Capital Corporation and Associates Corporation of North America (The Associates) systematically engaged in abusive lending practices.
  • First Alliance Mortgage Company entered into a settlement in 2002 with FTC, six states, and private parties to compensate nearly 18,000 borrowers more than $60 million dollars (“Consumer Protection,” 2004, p. 23-24).

Concerns about predatory lending in the sub-prime market were further fueled by foreclosure trends. Between January 1998 and September 1999, the foreclosure rate on sub-prime mortgages was “more than 10 times the foreclosure rate for prime loans.” Although it could be expected that loans made to less creditworthy borrowers could result in a higher rate of foreclosure, the extent of this difference raised flags for the policy makers and analysts. Some analysts suggest that it is “at least partly the result of abusive lending” and particularly of loans made “without regard to the borrower's ability to repay” (“Consumer Protection,” 2004, p. 24).

Overall, the rate of foreclosures of sub-prime mortgage loans “increased substantially since 1990, far exceeding the rate of increase” for sub-prime loans that were made to borrowers. A study conducted for HUD noted that while the increased rate in sub-prime foreclosures could be the result of abusive lending, it could also be the result of other factors, such as an increase in sub-prime loans that are made to borrowers with the least ability to repay (“Consumer Protection,” 2004; Cutts & Van Order, 2005).

Conclusion

Sub-prime lending is a fairly new and quickly growing segment of the financial market that provides credit to borrowers who, for one of numerous reasons, would generally not be extended credit. Borrowers, for example, who fail credit history requirements in the standard (prime) mortgage market have greater access to credit in the sub-prime market. One of the major benefits of sub-prime lending is the growth in the number of homeowners (Chomsisengphet & Pennington-Cross, 2006).

Sub-prime lending helps to bring people into the borrowing market who probably would not have other opportunities obtain credit. But there have defiantly been abuses, especially with lending practices for people living in minority neighborhoods where residents have 35% greater odds of being saddled with prepayment penalties on sub-prime mortgages than borrowers who live in predominantly white neighborhoods.

In the late 1990s, these lenders were plagued by aggressive accounting policies with respect to property valuations. This forced restatements of financials, which for many essentially wiped out their net worth. As a result of the restatements, several sub-prime lenders filed for bankruptcy and went out of business. Well over 20 sub-prime lenders have been closed down or have sought buyers over the last few years (White, 2006).

Because of a lack of regulation in the past and perhaps hope that the sub-prime market could improve the home sales market while providing more home ownership opportunities for lower income people, there have been numerous abuses. The GAO report describes predatory lending as “an umbrella term that is generally used to describe circumstances in which a lender takes unfair advantage of a borrower (often through deception, fraud, or manipulation) to make a loan with terms that are disadvantageous” and sometimes very detrimental to a borrower (p. 18).

Although several advocacy groups take the position that sub-prime lending inherently involves abusive practices in a majority of loan situations, analysts generally contend that only a small portion of sub-prime loans contain features that are considered abusive. Policymakers, advocates, and some lending industry representatives have concluded that and expressed concerns that predatory lending is a significant problem. Although the extent of predatory lending cannot be readily or easily quantified, there are indicators that suggest that it may be prevalent (“Consumer Protection,” 2004).

Terms & Concepts

Non-price Credit Rationing: A traditional approach to mortgage lending which was to set minimum lending standards taking into consideration a borrower's income, payment history, and down payment with some input from the local underwriter about their knowledge of the borrower.

Predatory Lending Practices: Ways in which lenders abuse or exploit borrowers through predatory terms in loans.

Predatory Terms: Terms in a loan that are considered abusive or unfairly detrimental to the borrower.

Risk-based Pricing: Many of the loans in the sub-prime lending market are based on an analysis of the risks that each individual borrower presents with their credit history, the property they want financed, and their ability to pay, or for the lender to recover the loan amount in some manner.

Sub-prime Lending: The practice of providing credit to borrowers who, for one of numerous reasons, would generally not be extended credit; could include borrowers for example, who do not meet credit history requirements within the prime mortgage market.

Sub-prime Market: That segment of the lending market that provides or specializes in making sub-prime loans.

Bibliography

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Karger, H. (2007). The home ownership myth. Dollars & Sense, (270), 13-19. Retrieved January 5, 2008, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25293500&site=ehost-live

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Suggested Reading

Collins, B. (2007). Sub-prime defaults soar in 2006. Mortgage Servicing News, 11(3), 1-29. Retrieved January 5, 2008, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25116313&site=ehost-live

Coy, P. (2007, December 17). The sub-prime mess, now in plastic? Business Week, (4063), 032. Retrieved January 5, 2008, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=27794791&site=ehost-live

Dymi, A. (2007). Almost half of '06 mortgages to minorities were sub-prime. National Mortgage News, 32(4), 2-2. Retrieved January 5, 2008, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=27102067&site=ehost-live

England, R. (2007). A cloud over the economy. Mortgage Banking, 68(2), 38-48. Retrieved January 5, 2008, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=27494340&site=ehost-live

Filisko, G. (2007). Sub-prime lending fallout. National Real Estate Investor, 49(7), 93-96. Retrieved January 5, 2008, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25775514&site=ehost-live

Isaac, W. (2007). Worries about sub-prime lending are overblown. American Banker, 172(190), 2. Retrieved January 5, 2008, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26937657&site=ehost-live

Live now, pay later. (2007). Economist, 383(8523), 31. Retrieved January 5, 2008, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=24617743&site=ehost-live

Mcgeer, B. (2007). Small bank looks for exit after a sub-prime disaster. American Banker, 172(81), 1-4. Retrieved January 5, 2008, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=24886251&site=ehost-live

Oshinsky, J., Fleishman, B., Murray, J., & Fields, J. (2007). Insurance coverage for sub-prime lending losses, litigation, and investigations. Real Estate Finance (Aspen Publishers Inc.), 24(3), 15-17. Retrieved January 5, 2008, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=27143044&site=ehost-live

Smith, M., & Hevener, C. (2014). Subprime lending over time: The role of race. Journal of Economics & Finance, 38(2), 321–44. Retrieved November 21, 2014, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=94833915

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White, B. (2007). Sub-prime lending market: Avoiding risk in a risky business. Mortgage Banking, 67(8), 19-22. Retrieved January 5, 2008, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25151954&site=ehost-live

Essay by Michael Erbschloe

Michael Erbschloe is an information technology consultant, educator, and author. He has taught graduate level courses and developed technology-related curriculum for several universities and speaks at conferences and industry events around the world. Michael holds a Master Degree in Sociology from Kent State University. He has authored hundreds of articles and several books on technology.