Predatory Lending: A Decade of Warnings
Congress, Fed Fiddled as Subprime Crisis Spread
By Kat Aaron | May 06, 2009 | ShareThis| Print This

A little more than a decade ago, William Brennan foresaw the financial collapse of 2008.

As director of the Home Defense Program at the Atlanta Legal Aid Society, he watched as subprime lenders earned enormous profits making mortgages to people who clearly couldn’t afford them.

The loans were bad for borrowers — Brennan knew that. He also knew the loans were bad for the Wall Street investors buying up these shaky mortgages by the thousands. And he spoke up about his fears.

“I think this house of cards may tumble some day, and it will mean great losses for the investors who own stock in those companies,” he told members of the Senate Special Committee on Aging in 1998.

It turns out that Brennan didn’t know how right he was. Not only did those loans bankrupt investors, they nearly took down the entire global banking system.

Washington was warned as long as a decade ago by bank regulators, consumer advocates, and a handful of lawmakers that these high-cost loans represented a systemic risk to the economy, yet Congress, the White House, and the Federal Reserve all dithered while the subprime disaster spread. Long forgotten Congressional hearings and oversight reports, as well as interviews with former officials, reveal a troubling history of missed opportunities, thwarted regulations, and lack of oversight.

What’s more, most of the lending practices that led to the disaster are still entirely legal.
Growth of an Industry

Congress paved the way for the creation of the subprime lending industry in the 1980s with two obscure but significant banking laws, both sponsored by Fernand St. Germain, a fourteen-term Democratic representative from Rhode Island.

imageSome 2.26 million people may lose their homes to foreclosure in the next two years due to subprime lending, says a recent report by the Pew Charitable Trusts. (© iStockphoto.com/fstop123)The Depository Institutions Deregulation and Monetary Control Act of 1980 was enthusiastically endorsed by then-President Jimmy Carter. The act, passed in a time of high inflation and declining savings, made significant changes to the financial system and included a clause effectively barring states from limiting mortgage interest rates. As the subprime lending industry took off 20 years later, the act allowed lenders to charge 20, 40, even 60 percent interest on mortgages.

The other key piece of legislation was the Alternative Mortgage Transaction Parity Act, passed in 1982. The act made it possible for lenders to offer exotic mortgages, rather than the plain-vanilla 30-year, fixed-rate loan that had been offered for decades.

With the passage of the Parity Act, a slew of new mortgage products was born: adjustable-rate mortgages, mortgages with balloon payments, interest-only mortgages, and so-called option-ARM loans. In the midst of a severe recession, these new financial products were seen as innovative ways to get loans to borrowers who might not qualify for a traditional mortgage. Two decades later, in a time of free-flowing credit, the alternative mortgages became all too common.

The Parity Act also allowed federal regulators at the Office of Thrift Supervision and the Office of the Comptroller of the Currency to set guidelines for the lenders they regulate, preempting state banking laws. In the late 1990s, lenders began using the law to circumvent state bans on mortgage prepayment penalties and other consumer protections.

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In the late 1980s and early 1990s, subprime loans were a relatively small portion of the overall lending market. Subprime loans carry higher interest rates and fees, and were supposed to be for people whose bad credit scores prevented them from getting a standard — or prime — loan. Consumer advocates at the time were mostly concerned about reports of predatory practices, with borrowers getting gouged by high rates and onerous fees. Congress responded in 1994 with passage of the Home Ownership and Equity Protection Act, or HOEPA.

The act, written by former Representative Joseph P. Kennedy, a Democrat from Massachusetts, created restrictions on “high-cost” loans, which were defined as having an interest rate that was more than 10 percentage points above rates for comparable Treasury securities. If points and fees totaled more than 8 percent of the loan amount, or $400, whichever was higher, the loan was also considered high cost.

High-cost loans were still legal, but contained some restrictions. Prepayment penalties and balloon payments before five years were banned or restricted. Also prohibited was negative amortization, a loan structure in which the principal actually grows over the course of the mortgage, because the monthly payments are less than the interest owed. But the bill did not include a ban on credit insurance — an expensive and often unnecessary insurance product packed into loans, creating substantial up-front costs. Nor did it ban loan flipping, in which a borrower’s loan is refinanced over and over again, stripping equity through closing costs and fees.

At the time of HOEPA’s passage, the subprime lending industry had two main elements: small, regional lenders and finance companies. The regional lenders specialized in refinancing loans, charging interest rates between 18 and 24 percent, said Kathleen Keest, a former assistant attorney general in Iowa who is now an attorney with the Center for Responsible Lending, a fair lending advocacy organization. HOEPA sought to eliminate the abusive practices of the regional lenders without limiting the lending of the finance companies — companies like Household, Beneficial, and the Associates — viewed then as the legitimate face of subprime, Keest said.

HOEPA did largely succeed in eliminating the regional lenders. But the law didn’t stop subprime lending’s rapid growth. From 1994 to 2005, the market ballooned from $35 billion to $665 billion, according to a 2006 report from the Center for Responsible Lending, using industry data. In 1998, the CRL report said, subprime mortgages were 10 percent of all mortgages. By 2006, they made up 23 percent of the market.

The loans themselves also changed during the 2000s. Adjustable-rate mortgages, which generally begin at a low fixed introductory rate and then climb to a much higher variable rate, gained market share. And over time, the underwriting criteria changed, with lenders at times making loans based solely on the borrower’s “stated income” — what the borrower said he earned. A 2007 report from Credit Suisse found that roughly 50 percent of all subprime borrowers in 2005 and 2006 — the peak of the market — provided little or no documentation of their income.

As the subprime lending industry grew, and accounts of abusive practices mounted, advocates, borrowers, lawyers, and even some lenders clamored for a legislative or regulatory response to what was emerging as a crisis. Local legal services workers saw early on that high-cost loans were creating problems for their clients, leading to waves of foreclosures in cities like Brooklyn, Philadelphia, and Atlanta.

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