March 5 2007
A troubled credit history is a problem for debtors when they want to buy a home. Nonetheless, there is bad credit repentance and lender redemption, and the latter can be profitable. Over the last decade there has been significant growth in the subprime mortgage market. The subprime mortgage market is defined to include those borrowers with a FICO (Fair Isaac Co.) score below 570. The median FICO score is 720, with a perfect score being 850. The subprime home mortgage market, from 1994-2004, grew from $35 billion to $401 billion. The foreclosure rates range from 20-50% on subprime loans with the likelihood of default higher on many of the loans because of loan structure that includes high interest rates as well as balloon payments (see below for more discussion). The high default and foreclosure rates carried a secondary market impact at the beginning of 2007 as subprime lenders collapsed under the weight of their foreclosure portfolios in a soft real estate market.
“We made so much money, you couldn’t believe it. And you didn’t have to do anything. You just had to show up,”[1] was the comment of Kal Elsayed, a former executive at New Century Financial, a mortgage brokerage firm based in Irvine, California. With his red Ferrari, Mr. Elsayed enjoyed the benefits of the growth in the subprime mortgage market. However, those risky debtors, whose credit histories spelled trouble, are now defaulting on their loans. Century Financial is under federal investigation for stock sales and accounting irregularities as it tries to deal with his portfolio of $39.4 billion in subprime loans. “Subprime mortgage lending was easy,” is the comment of mortgage brokers and analysts, until the market changes.
The subprime market is fraught with complexities that the average consumer may not fully understand as he or she realizes the dream of home ownership or a means for paying off credit-card debt through a home equity loan. Some subprime borrowers are able to make payments initially because they have interest only loans for a three to five-year period. After that initial phase-in, their payments escalate to include principal with the result being an inability to pay or keep current. In many subprime loans, the lender builds in very high costs for closing, appraisal and other fees with a result known as “equity stripping.” The loan amount is so high that the borrower owes more than 100% of the value of the home. The lenders often return to customers and use a practice known as “flipping.” The borrowers refinance their homes on the promise of lower payments, a lower rate, or some benefit that may actually be real. However, the costs of refinancing, known as “packing” the loan amount to increase the lender’s interest in the home, the escalating interest rate, and other factors produce only a higher loan amount with a longer payment period and greater likelihood of foreclosure.
These practices, coupled with marketing techniques for subprime lenders that target the poor and elderly, have resulted in significant state and local legislation designed to curb subprime lender activities. Known as “Homeowner Security Protection Acts” or “High Cost Home Loan Acts” or “Home Loan Protection Acts,” these state laws take various approaches to protecting consumers from predatory lending practices.[2] Some states limit charges or interest rates. Other states limit foreclosures or refinancings within certain time frames. Some, such as Cleveland’s ordinance, simply prohibited predatory practices, making such activity a criminal misdemeanor. Cleveland’s ordinance was described by a court in a successful challenge by a lender as follows:
“Predatory loan” in Cleveland is defined as any residential loan bearing interest at an annual rate that exceeds the yield on comparable Treasury securities by either four and one-half to eight percentage points for first mortgage loans or six and one-half to ten percentage points for junior mortgages. In addition, loans are considered predatory if they were made under circumstances involving the following practices or include the following terms: loan flipping, balloon payments, negative amortization, points and fees in excess of four percent of the loan amount or in excess of $800 on loans below $16,000, an increased interest rate on default, advance payments, mandatory arbitration, prepayment penalties, financing of credit insurance, lending without home counseling, lending without due regard to repayment, or certain payments to home-improvement contractors under certain circumstances.[3]
Cleveland’s ordinance, like so many of the anti-predatory statutes, ran into difficulties with judicial challenges by lenders who have argued successfully that the regulation of home loans is preempted by the extensive federal regulation of both home mortgages and consumer credit. [4]
Companies that are having difficulty because of their subprime portfolios include New Century and Fremont General, a company whose shares have dropped 32% since it announced its bad loan levels in its portfolio. Also, financial companies that bought subprime loan portfolios, including H&R Block and HSBC, are suffering from the downturn and risky loans. Some of the loans are being sold back at a 25-30% discount. HSBC said it will take two years for it to fix its sagging portfolio.
What are the rights of the debtors? Evaluate the ethics of the subprime mortgage brokers. What are the ethical issues in subprime mortgage loans? Do the lenders fill a market niche? What could or should they have done differently? Do you think the federal government will make changes in consumer credit laws?
FOR MORE INFORMATION
Ben White, Saski Scholtes, and Peter Thai Larsen, “Subprime mortgage meltdown intensifies,”
Financial Times, March 6, 2007, p. 10.
[1] Julie Creswell and Vikas Bajas, “A Mortgage Crisis Begins to Spiral, and the Casualties Mount,” New York Times, March 5, 2007, pp. C1, C4.
[2] For a summary of the state legislation on predatory lending practices, see Therese G. Franzén and Leslie M. Howell, “Predatory Lending Legislation in 2004,” 60 Business Lawyer 677 (2005).
[3] Am. Financial Serv. Assn. v. Cleveland, 824 N.E.2d 553 at 557 (Oh. App. 2004).
[4] Am. Fin. Servs. Ass'n v. City of Cleveland, No. 83676, 2004 WL 2755808, (Ohio Ct. App. 2004); City of Dayton v. State, No. 02-CV-3441 (Ohio Ct. Common Pleas Aug. 26, 2003); 813 N.E.2d 707 (Ohio Ct. App. 2004)Am. Fin. Servs. Ass'n v. City of Oakland, 23 Cal. Rptr. 3d 453, 461-62 (Cal. 2005); and Mayor of New York v. Council of New York, 780 N.Y.S.2d 266 (N.Y. Sup. Ct. 2004). Cleveland’s ordinance was held to be preempted by Ohio’s laws on predatory lending.