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Remarks by Governor Edward M. Gramlich
At Cleveland State University, Cleveland, Ohio
March 23, 2001
Governor Gramlich presented identical remarks at the Neighborhood Reinvestment
Corporation luncheon, Raleigh, North Carolina, March 26, 2001
Tackling Predatory Lending: Regulation and Education
I am pleased to participate in today's conference on predatory lending. This seems to have
become a major problem around the country, as in Ohio. Conferences such as this provide a
valuable opportunity to learn more about this very complex topic. One of the welcome
developments in recent years is the expansion of the home mortgage market to a broader
socioeconomic range of borrowers. Studies of urban metropolitan data submitted under the
Home Mortgage Disclosure Act (HMDA) have shown that lower-income and minority
consumers, who have traditionally had difficulty in getting mortgage credit, have been
taking out loans at record levels in recent years. Specifically, conventional home-purchase
mortgage lending to low-income borrowers nearly doubled between 1993 and 1999,
whereas that to upper-income borrowers rose 56 percent. Also over the same period,
conventional mortgage lending increased by about 120 percent to African-American and
Hispanic borrowers, compared with an increase of 48 percent to white borrowers.
Much of this increased lending can be attributed to the development of the subprime
mortgage market. Again using HMDA data, the number of subprime home equity loans has
grown from 66,000 in 1993 to 856,000 in 1999, a thirteen-fold increase. Over this same
period, the number of subprime loans to purchase homes increased sixteen-fold, from
16,000 to 263,000. This rapid growth has given credit access to consumers who have
difficulty in meeting the underwriting criteria of prime lenders because of blemished credit
histories or other aspects of their profiles. This expansion of credit gives people from all
walks of life a shot at the twin American dreams of owning a home and building wealth.
But along with these positive developments have come disquieting reports of abusive
lending practices, targeted particularly at female, elderly, and minority borrowers. These
practices, many of which can result in consumers' losing much of their equity in their home,
or even the home itself, are commonly referred to as "predatory lending." Predatory lending
can damage these same hardworking but low-income people and the communities in which
they live. Its growth is a noticeable blight in this otherwise attractive mortgage-lending
picture.
The term "predatory lending," much like the terms "safety and soundness" and "unfair and
deceptive practices," is far-reaching and covers a potentially broad range of behavior. As
such, it does not lend itself to a concise or a comprehensive definition. But typically
predatory lending involves at least one, and perhaps all three, of the following elements:
z
z
z
making unaffordable loans based on the assets of the borrower rather than on the
borrower's ability to repay an obligation ("asset-based lending")
inducing a borrower to refinance a loan repeatedly in order to charge high points and
fees each time the loan is refinanced ("loan flipping")
engaging in fraud or deception to conceal the true nature of the loan obligation from
an unsuspecting or unsophisticated borrower.
Some of these practices are clearly illegal and can be combated with legal enforcement
measures. But some are more subtle, involving the misuse of practices that most of the time
can improve credit market efficiency. For example, the freedom for loan rates to rise above
former usury law ceilings is generally desirable in that it matches relatively risky borrowers
with appropriate lenders. But sometimes the payments implicit in very high interest rates
can spell financial ruin for borrowers. 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. But sometimes balloon payments can ruin borrowers who do not have a rising
income stream or who are unduly influenced by an immediate need for money. Most of the
time, the ability to refinance mortgages permits borrowers to take advantage of lower
mortgage rates, but sometimes easy refinancing invites loan flipping, resulting in high loan
fees and unnecessary credit costs. Often credit life insurance is desirable, but sometimes the
insurance is unnecessary, and at times borrowers pay hefty up-front premiums as their loans
are flipped. Generally advertising enhances information, but sometimes it is deceptive. Most
of the time, disclosure of mortgage terms is desirable, but sometimes disclosures are
misleading, with key points hidden in the fine print.
Predatory lending entails either fraud or the misuse of these and other complex mortgage
provisions that are generally desirable and advantageous to a borrower, but only when the
borrower fully understands them.
Home Ownership Equity Protection Act (HOEPA)
The Congress has passed a number of consumer protection statutes in this area. One
important law is the Home Ownership and Equity Protection Act (HOEPA) of 1994, an
amendment to the earlier Truth in Lending Act. Among other things, HOEPA requires that
the Federal Reserve Board periodically conduct public hearings to gather information about
trends within the home equity market. This summer the Board held a second round of
HOEPA hearings in Charlotte, Boston, Chicago, and San Francisco. Earlier hearings had
been held in 1997 and had led to a joint report to the Congress from the Board and HUD.
The basic approach of HOEPA is to shine a bright spotlight on high-cost mortgage loans.
For these high-cost loans, certain practices--balloon payments in the first five years,
prepayment penalties, and a pattern and practice of asset-based lending--are banned. In
addition, for HOEPA-covered loans, creditors must provide a short disclosure to borrowers
three days before the loan is closed; loans under HOEPA are also subject to the normal
three-day rescission period that pertains to other home equity loans. This gives many
HOEPA borrowers twice as long to change their minds about possibly unwise mortgage
contracts. HOEPA is not a usury law--high-cost loans can still be made--but borrowers'
protections are significantly greater for HOEPA loans than for other subprime mortgage
loans.
Last December 13 the Board solicited comments on proposed revisions to our Regulation Z,
the regulation implementing HOEPA. The goal of the changes was to curb some abuses we
were made aware of during our hearings and through other sources. At the same time, we
tried to make our amendments narrow and selective so as not to impede the general growth
of the legitimate subprime mortgage market. The important changes involved broadening
the scope of mortgage loans subject to HOEPA coverage and prohibiting specific acts and
practices.
With respect to loans subject to HOEPA, the law lays out a two-part test for coverage. The
first involves interest rates. If the annual percentage rate (APR) on a mortgage loan exceeds
the Treasury rate on a bond of comparable maturity by more than 10 percentage points, the
loan is subject to HOEPA protections. The Board has the legal authority to lower this
threshold to 8 percentage points, and the proposal recommends doing that. Data on this
segment of the mortgage market are sparse, but a special survey by the Office of Thrift
Supervision (OTS) estimates that the portion of subprime mortgage loans falling within the
HOEPA's APR trigger is currently about 1 percent, with this segment of the market rising to
about 5 percent under the proposal. From this standpoint, the effect of this change on the
general growth in subprime mortgage lending should be modest.
But these percentages are based on rates alone, and many subprime lenders feel that the
coverage percentages are higher when the second HOEPA test enters in. Under this second
test, loans with non-interest fees of more than 8 percent of the loan amount, or $465, are
covered by HOEPA. Although the Board cannot change these amounts, it can alter the items
included in this points and fees test.
The proposal recommends adding premiums on single-premium credit insurance to the
points and fees test. Premiums for this insurance are generally financed in the loan amount,
the insurance is often unnecessary, and premiums may be difficult to recover if the loan is
cancelled. When loans are flipped, financed single-premiums for credit insurance can be a
way to strip equity from a homeowner. We do not know how many additional mortgage
loans this change would bring under HOEPA, but it is likely to greatly constrict the selling
of single-premium credit insurance. Under the proposal, the provisions regarding other ways
of selling credit insurance would not change, and these alternative ways of selling credit
insurance would thereby be encouraged.
These changes would extend the coverage of HOEPA and its consumer protection
provisions. Presumably, the number of subprime foreclosures would be lessened. But
because HOEPA loans are already more costly to make and they carry a stigma in the
secondary market, these changes may also constrict lending in the very high cost segment of
the subprime market. Many consumer advocates have said that they are aware of this
possible tradeoff and accept it. Now that the proposed revisions to the regulation are out for
public comment, we will be able to examine the responses in more detail.
The Board proposal also prohibits a number of specific acts and practices. There are two
provisions to reduce loan flipping. The proposal would prohibit a creditor that holds a
HOEPA loan from refinancing the original credit with another high-cost loan within twelve
months of origination. The proposal would also prohibit creditors from refinancing with
higher-rate loans certain zero-interest loans or other very low cost loans originated through
mortgage assistance programs. Both provisions have an escape clause that permits these
refinancings if the creditor can show that the loan is in the borrower's interest, a provision
likely to come into play in foreclosures or other legal proceedings in connection with the
loan. Together these provisions should reduce the most egregious instances of loan flipping-
-where creditors either flip loans immediately on origination or refinance very low interest
loans at much higher rates.
The proposal also tries to stem the practice of making loans that are not based on the
borrower's ability to repay an obligation, so-called asset-based lending. The proposal would
require that lenders document and verify consumers' ability to repay HOEPA loans. Because
a pattern or practice of making asset-based HOEPA loans is already prohibited, legitimate
subprime lenders presumably already have procedures to show that they are not engaged in
a pattern or practice of making asset-based loans. Consequently, this provision should not
affect effect legitimate subprime lenders, though it should deter predatory lenders, who will
have difficulty proving the legitimacy of their asset-based credit decisions.
These recommendations often reflect hard tradeoffs with potentially significant effects on
creditors and consumers alike. The Board will have to undertake a difficult balancing effort
when it adopts a final rule. It will be essential that we receive thoughtful comments from all
segments of the public and from the industry to help us make an informed final decision.
Home Mortgage Disclosure Act
About the same time, last November 29, the Board also solicited comments on proposed
revisions to our Regulation C, which implements the Home Mortgage Disclosure Act
(HMDA). HMDA requires depository and certain for-profit nondepository institutions to
collect, report, and disclose data about applications for, originations of, and purchases of
home-mortgage and home-improvement loans. From these data denial rates can be inferred.
Data now reported include the type, purpose, and amount of the loan; the race or national
origin, gender, and income of the loan applicant; and the location of the property. The
purposes of these HMDA reports include helping us to determine whether financial
institutions are serving the housing needs of their communities and to enforce fair lending.
The Board's proposal incorporates suggestions received in response to an earlier Advance
Notice of Proposed Rulemaking, as well as from discussions with a wide range of interested
parties. In evaluating potential changes, the Board considered whether the changes would
improve the quality and utility of the resulting data to enhance understanding of the home
mortgage market. At the same time, the Board attempted to minimize the increase in datacollection costs and reporting burden by limiting proposed changes to those likely to have
significant benefits. As we have done in the past, we will make available software to help
reduce the reporting burden for financial institutions.
The three fundamental changes in the proposal would
z
z
z
increase the number of nondepository lenders required to submit data
clarify and expand the types of reportable transactions
specify new loan elements to be included in the data.
First, with respect to the coverage of nondepository lenders, the Board's proposal would
alter definitions to require all nondepository lenders whose annual home purchase and
refinancing activity comprises at least 10 percent of the dollar value of all their loan
originations (mortgage- and nonmortgage-related), or $50 million, to report HMDA data.
The new element is the $50 million reporting floor, which extends HMDA coverage to very
large nonbank lenders with relatively small percentages of mortgage loans in their
portfolios. Because the added coverage affects very large mortgage lenders, it seems
consistent with any reasonable test of determining whether a lender is "engaged in the
business of mortgage lending," the statute's test for coverage.
Second, the expansion of the types of transactions covered is intended to improve the
integrity of the data by establishing consistency in reporting requirements. Right now, data
on refinancings and home improvement loans are unclear, and quite likely incomplete,
because the regulation provides lenders with much flexibility in determining which loans to
report. For example, lenders may avoid reporting closed-end home improvement loans by
not classifying them as such in their records. Lenders also may choose not to report openend home equity lines of credit, even if used for home improvement. The proposal would
tighten these definitions so that the resulting data would be more complete and more
consistent from one lender to the next. This change, too, certainly seems consistent with the
spirit of HMDA.
Third, the proposal specifies that three new items be reported from a consumer loan or
application: the APR, whether the loan is subject to HOEPA, and whether the loan involves
a manufactured home. Having APR and HOEPA information will assist in the identification
of subprime loans, enabling better analysis of the high-cost subprime market. We will be
able, among other things, to ascertain with much more precision the extent of present
HOEPA coverage and the way that coverage might change were the Board to extend its
HOEPA coverage, as discussed above.
The collection of data on mobile or manufactured home loans will contribute to an improved
understanding of this type of lending, which employs different underwriting criteria from
those for loans secured by conventional homes. Because manufactured home loans have
much higher denial rates than other mortgage loans, such data would also enhance
understanding of denial patterns in this market.
Again, the Board tried to balance competing interests in fashioning this proposal. As with
HOEPA, it will be critical that the Board receives thoughtful public comment on the
proposal to assist it in making its final rule on this regulation.
Other steps may need to be taken, and may be taken, to deal with predatory lending. But
these proposals should represent important first steps. The HOEPA changes extend the
coverage and protections of HOEPA and limit some current practices that may end in abuse.
The HMDA changes should greatly improve our information about lending practices for
high-cost mortgages. Both proposals may limit abusive practices in the short-run and should
greatly improve our knowledge and enforcement ability in the long-run. At the same time,
the HOEPA proposal is designed to interfere minimally with the vast bulk of subprime
lending, and the HMDA proposal is designed to gather useful data while limiting reporting
burden.
Consumer Education
Going beyond these regulatory and data-collection measures, we should all recognize that in
the long-run the very best defense against predatory lending is probably in neither of these
approaches. Rather, it is in a thorough knowledge on the part of consumers of their credit
options and resources. Educated borrowers who understand their rights under lending
contracts and who know how to exercise those rights put up the best defense against
predatory lenders. As the knowledge base of consumers grows, the market for credit-at-anycost diminishes.
Unfortunately, as is often the case, the best long-run solutions can be the most difficult to
implement. A massive educational campaign is needed to bring about this expanded
consumer knowledge, particularly within the socioeconomic groups most likely affected by
predatory lending. Many efforts are under way. As one example, the Neighborhood
Reinvestment Corporation, a publicly funded entity that is known for its community training
and homebuyer counseling programs, has embarked on a huge low-income-homeowner
education project. As another, the American Bankers Association has formed a working
group to educate bankers and local communities about predatory lending.
We in the Federal Reserve System are also trying to do our part. We have undertaken many
projects designed to promote community and consumer education and financial literacy.
Board staff have been active in an interagency task force convened to identify strategies for
combating predatory lending. This group is also looking for ways to support the broad array
of organizations that offer consumer and community education to complement homeowner
education efforts. We have also been active in planning conferences on the topic, similar to
today's conference.
Further, nearly every one of the twelve Reserve Banks has published articles devoted to
predatory lending in its Community Affairs newsletters. In aggregate, these reach tens of
thousands of community development and housing organizations nationwide. The Federal
Reserve Banks of Atlanta, Philadelphia, and right here in Cleveland have sponsored
seminars to educate community leaders and lenders on the differences between legitimate
subprime lending and predatory lending. These meetings have also provided a forum for
groups assisting victims to report the most egregious practices of unscrupulous lenders and
the devastating impact of these loans on their clients. Federal Reserve Bank of Boston staff
members have worked closely with a secondary market purchaser to promote an educational
campaign through local community groups. Chicago Reserve Bank officials have facilitated
a task force of area advocacy groups, lenders, and real estate industry representatives to help
develop recommendations for combating predatory lending. The Chicago Fed has also
launched "Project Money Smart," a resource on its web site that provides a comprehensive
overview of consumer information on personal finance topics, including managing credit,
understanding mortgages, and protection against fraud. And the Dallas Fed has published
"Building Wealth," a manual designed to help individuals and families develop a plan for
building personal wealth. This Bank's web site offers an interactive tool for customizing
wealth-building strategies by setting financial goals, seeking guidance, budgeting, saving
and investing, and managing debt.
These are a few examples of ways in which the Federal Reserve is trying to improve
financial literacy in all segments of the population. The educational challenge is difficult,
but these initiatives and other collaborative education efforts can greatly improve financial
market efficiency. In the long run, they provide the best defense against predatory lending.
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