“Subprime Mortgage Crisis!” “Predatory Loans!” These are headlines that have dominated financial news for months. Unfortunately, although the terms are used loosely and frequently, the stories have done little to educate the public—people whose homes may be lost in a foreclosure action—about what the terms mean. More importantly, there are few explanations being given for the current problems. This article will attempt to define the terms and explain the causes for these now-common problems.
The Basics
While there is no legal definition of a “predatory loan,” the concept can be explained. Put most simply, a loan should be considered predatory if the lender or broker convinces a borrower to buy a mortgage loan that lender/broker suspects or actually knows the borrower cannot afford.
The term subprime refers to a credit score. It does not reflect the borrower’s ability to pay or the borrower’s actual financial situation. Originally, the term was used by the mortgage industry and especially by the government agencies like Federal National Mortgage Association referred to as “Fannie Mae” and Federal Home Mortgage Corporation referred to as “Freddie Mac.” Any borrower with a credit score below a certain number was considered subprime; (i.e. not the best risk.)
The scores rendering a consumer “subprime” range between 640 and 680. What is overlooked is that the scores are determined solely by one of three credit reporting agencies using the Fair Isaac Credit Organization system, hence the term “FICO Score.” Obviously, credit reporting agencies don’t actually know the details of a particular consumer’s income, living arrangements, expenses, job opportunities/changes and the like. Essentially, “credit worthiness” is determined by a consumer’s payment history, the amount of credit outstanding, amount of available credit and other objective factors.
The reality of the current “crisis” is that too many consumers were granted loans where an honest evaluation would have led them to realize that they could not afford the payments if they ever increased. As we have seen in recent months, many mortgages that were once affordable have adjusted upwards to a level that consumers can no longer support. A large part of the problem stemmed from the proliferation of new and imaginative mortgage products, like the “one month adjustable rate, level payment loan” or the “you pick your payment” loan or the use of commercial loan products for residential 30 year mortgages.
Many consumers did not understand the consequences of having an adjustable rate mortgage as a result of simple deception, i.e. the lender failing to explain to the borrower that the monthly mortgage payment will, in all likelihood, increase substantially during the term of the loan. Sometimes, this failure to disclose was compounded by the “predatory” nature of the lender. It has been reported that some lenders encouraged or participated in outright fraud, such as by “suggesting” that the borrower state a fictitious income in order for the loan to be approved or by altering the borrower’s application to reflect an income higher than originally stated by the buyer. Other reports cite appraisers, who at the urging of lenders upon whom they may be dependant for business, placed a value on the property much higher than the actual market in order to have the loan approved.
Numbing Numbers
The following example illuminates how consumers can quickly run into trouble. Assume a consumer obtains a “2/28 Loan.” As the name implies, the loan has a fixed rate for two years, and an adjustable rate for 28 years. Generally, this type of loan adjusts every six months after the first two years. Each adjustment can be up to 1 percent. Assume further that a borrower begins with a low rate of 6 percent. If she borrows $100,000, the monthly payment for principal and interest would be $599.55. At the end of the second year the payment increases by $134.21 bringing the monthly payment to $733.76. After another 6 months, the interest rate increases by another 1 percent. Now, the monthly payment is $804.62. Four and one-half years after the loan’s inception, the interest has risen to 12 percent and the monthly payment to $1,028.61. This is an increase of 72 percent! Still affordable? Probably not.
In the example above, a loan is considered predatory when the lender does not fully inform the consumer of the terms of the loan. If the borrower had been supplied with all of the figures, knew and understood the risks, read all of the disclosures and still wanted to consummate the loan and the lender/broker believed that the borrower could afford the payments, the loan would not be considered predatory—foolish maybe, but not predatory.
Questions to Consider
Here are some things to consider when a borrower’s loan has become too expensive to manage. The answers will not, by themselves, prove that a loan is “predatory,” but will give a borrower an indication that there may be a problem or at least an issue to be examined.
- 1. Who is the lender? Is it a local bank, a well-known mortgage company or an out-of-state direct mail solicitor? Normally, a local bank will lend on the true risk, meaning the borrower’s history with the bank, the value of the collateral (a local bank may have better information), the borrower’s employment history and, of course, the borrower’s FICO score. An out-of-state lender has less personal information on local home values, no knowledge of the local economy, no direct information about borrower’s employment status and no ability to discern if the income shown on the application is accurate. But, it does know the FICO score!
2. Is the entity who is making the loan the end lender or is it merely originating loans for sale to the secondary market, and therefore, probably for securitization? End lenders stay “on the risk” and therefore tend to be more conservative in underwriting. Further, if the loan is originated for sale and there is an underlying problem, the purchaser may attempt to invoke a Holder in Due Course or Bona Fide Purchaser defense to a borrower’s attempts to force a modification. This makes the borrower’s attorney’s job more difficult when trying to stave off a foreclosure.
3. If the loan was a refinance, did the borrower receive a full three days to consider rescission or did the borrower execute a document relinquishing her right to rescind at the closing? Without sufficient time to consider the transaction, the borrower may be coerced into a refinance or second mortgage that she later realizes is not in her best interest. That, of course, is the very reason a “cooling off period” is required. One indication that the right to rescind was relinquished is if the refinancing lender paid itself off before the rescission period was over. If so, there was no effective three day rescission period. A full transaction history will determine the answer.
4. Was the loan in the borrower’s best interest? Did the borrower get cash back, a better rate, a longer term or reduced payments? If not, many states would deem the loan the mortgage equivalent of what is known in securities brokerage terms as “churning,” essentially refinancing where the borrower has a minimal benefit, but the lender/broker/originator receives generous fees.
5. Could the borrower end up owing more than what was borrowed, despite making all of the payments on-time? Specifically, is the loan a Negative Amortization credit facility? This type of loan can appear to have a low interest rate or may be termed a “Simple Interest Mortgage” wherein the interest is calculated daily with no grace period. (A so-called conventional mortgage that has a fixed rate for thirty years incorporates at least the following terms, as they are contained in all Fannie Mae and Freddie Mac documents: 1. a 30-year term; 2. a 30 year amortization schedule, showing 360 equal payments; 3. a 15-day grace period from the due date of each payment wherein no late fee/penalty is charged; 4. a late fee, if applicable, of 3 percent of the regular P&I payment for that month; 5. no reduction or extra credit for making payments before the contractual due date each month.)
In a Simple Interest Mortgage, there is set amortization schedule and a fixed term. However, there is not one day when interest does not accrue. This product is the mortgage equivalent to the long-gone, 90-day note: pay early and you pay less interest, pay a few days late and pay a few days extra interest. The stakes for mortgages, however, are much higher. Assume a $465,000 loan at 7.5 percent with a payment of principal and interest of $3, 400 +/- each month. Further, assume that in the first few months, the interest portion of the payment is about $3,200. If the borrower pays 15 days late, the borrower pays an additional $1,600 interest for that “month” creating an “interest accrued but not paid” account with the lender. This can multiply quickly with large loans to a point where the borrower owes $25,000 more than what was borrowed after three years.
The “predatory” nature of a loan is often not obvious, in part because the circumstances of the loan’s origination are not typically scrutinized until the threat of or on the eve of a foreclosure that results in a bankruptcy. Additionally, predatory loans and lending practices are not reserved for owner-occupied residential loans or subprime loans, but come in all shapes and sizes. Recall the Lender Liability Theory of the late 1980’s, wherein commercial lenders were held liable for a borrower’s business failure if the lender should have known the business would fail because of, not in spite of, the loan. It seems that nothing changes much, just recycles.
The current “crisis” is similar to an old fashioned “run on the bank.” When confidence erodes enough, all of the depositors in a bank clamor for a cashout of their account at the same time. No bank in the land has enough liquidity to pay every depositor at once. That is, what we are experiencing today in the mortgage market and what the recent Federal Reserve moves on rates and the discount window have tried to address.
The law provides remedies for a consumer if a loan is determined to be predatory. Readers are welcome to contact the author at the e-mail address listed above for further discussion.