When conservatives go too far - subprime lending

I've been meaning to write this one for a while. The Wall Street Journal had an editorial about subprime lending on February 7, 2007. The article has been laying on my desk for over a month (along with countless other items).

The subprime lending industry has been in the papers lately (mainly on the business pages or in the Journal) because some of the lenders are failing, mainly because they overstretched, lending to people who were never going to be able to pay back the loans.

Subprime lending is different from prime lending. Prime borrowers have excellent credit histories, along with good incomes and assets relative to the amount they are planning to borrow. Often they are buying a house (much of subprime lending involves mortgages) and are financing 80% of the purchase price. All of these factors make prime borrowers a low risk.

Subprime borrowers, by contrast, usually have poor credit histories, lower incomes, little or no assets, and often have substantial debt relative to their economic status.

Prime borrowers are generally able to borrow from prime lenders, getting relatively good terms on their mortgages. When you see mortgage rates in the newspaper or on websites, these are usually the rates for prime borrowers. Note that this is not the same as the "prime rate," which applies to a different context.

Subprime lenders charge higher interest rates and fees. In theory this is to make up for the risk of default due to the subprime borrower's characteristics (history, assets, etc.). Critics of the subprime industry often refer to them as predatory lenders. I am one of those critics, though I recognize that there may be "good" subprime lenders.

The Journal editorial defends the subprime industry, stating that the lenders are not predators, but rather "gatekeeper(s) to homeownership and the economic opportunity that goes with it." I respectfully disagree.

What the Journal misses is the extent to which the subprime lending industry uses deceitful tactics to trick subprime borrowers into loans with extremely bad terms, and otherwise abuse their customers. I have a case pending involving such misconduct and it has been quite an education.

The comparison between my family and my clients is instructive on the difference between prime and subprime. We bought our house in 1999. Our mortgage then carried no points and a 7% fixed interest rate over 30 years. My clients refinanced their mortgage with a subprime lender the same year, a couple months earlier. They paid 8 points (!) and their interest rate was 11% fixed over 15 years. The 8 points means that my clients paid 8% of the value of the mortgage as a fee to the lender. I had never seen or heard of an 8-point mortgage before I met these clients. Their rate was 4 interest-rate points higher than ours despite having a shorter term. In theory the points lower your interest rate so that over the 15 years your interest savings make up for the points.

But that's not even the worst of it. Those terms were fully disclosed to my clients before the loan was closed. The lender also suckered my clients into buying something called credit life insurance. Credit life is a scam. No intelligent person would buy this form of insurance if they understood how it works and shopped around for comparable life insurance. As bad as that is, in this particular loan the predatory lender did it through a single premium -- the full premium on the insurance is paid up front at the closing of the loan and rolled into the mortgage. Where someone might pay $80 per month for 15 years, instead they now pay $15,000 in one shot.

Predatory lenders engage in a variety of other scams. They fiddle with the mortgage payments, not giving the borrower correct credit to principal for phony reasons or due to "errors." A big problem is known as flipping, where the lender goes back to the well quickly, persuading the borrower to refinance again after a few years. Where the borrower has paid points up front to get a lower interest rate, they now lose the benefit of those points (the lower rate) in just a few years.

Tricks like credit life and flipping add up to what's called equity stripping. The lenders get the borrower to keep borrowing, and use the fees and other costs to strip all the equity out of the borrower's house, leaving them with nothing by the time it's all done. At the tail end of these things, the lenders use abusive debt collection practices to intimidate and harass the borrower. And I should have mentioned the front-end "steering" practice of pushing and deceiving people who qualify as prime borrowers into subprime mortgages.

Now one way of dealing with these problems, generally from the left, is to regulate the industry, and then regulate it some more. The idea is to protect helpless borrowers from the predators. This motive led to laws like the Fair Debt Collection Practices Act, Fair Credit Reporting Act, Truth in Lending Act, Homeowners Equity Protection Act, and so on. Unfortunately (but predictably), these laws are horrendously ineffective. The lenders were closely involved with these laws as they were being written, and are expert at knowing all the loopholes. The borrowers are generally unaware of anything close to the details, and often lack sufficient education to find out how to protect themselves. The penalties for lenders are trivial and at the same time, preemption is generally in effect so abused borrowers cannot resort to state law claims.

For example, if a lender files false information about you with a credit reporting agency, there's not much you can do about it. The same goes for debt collection. I've had some disputes with a couple of companies (discussed on my other blog). The amounts are small enough that they're not going to sue me. Instead they file reports with credit reporting agencies, send threatening letters and make annoying phone calls. I mostly find this amusing but my wife does not. The other day one called about the lawsuit they had filed against us. My wife, also a lawyer, was worried about this. I was able to calm her down (you don't get sued by a phone call - they have to serve you with papers and we haven't received any, and we're lawyers anyway so why are we scared about being sued?). My mother-in-law has also been home with our kids when these calls come in and they disturbed her too. She was convinced that this was really important and we had to do something about it. Now imagine how these practices (including threatening the borrower's family members) will affect someone who does not have a law degree, or for that matter a college degree.

Most of these actions are legal within the above laws because the laws are written so badly. And where they do cross the line, the penalties for violations are typically $1000 each, maximum, so you'll never be able to hire a lawyer because there's not enough money involved.

The liberal solution, of course, is even more regulation. No thanks. Your first try made things bad enough. The conservative response is to pretend there's no problem, and say we don't need more regulation.

My answer is to get the federal government out of the way. Let the borrowers who get screwed fall back on state law claims. If they file false reports with credit reporting agencies, let the consumer sue for defamation, along with punitive damages. If they use abusive debt collection practices, let the consumer sue for intentional infliction of emotional distress (not preempted in our case because the lender crossed one line too many) and punitive damages. Yes, punitive damages. For some reason the conservatives don't like tort claims and punitive damages.

This is one of the things that gets me about so-called conservatives. Our nation has a long history with tort claims and punitive damages. If you're conservative you should want to preserve that. And conservatives love punishing "criminals," however the government of the day wants to define crime - unless of course it involves white collar crime. But the idea that a jury should get to punish a company that grossly abuses its power over an uneducated consumer for some reason strikes conservatives as the wrong approach.

The thing about punitive damages is that they actually work. When punitive damages are available, that makes companies afraid. Not afraid to engage in good business practices, but rather afraid to do bad things. It's not easy to get punitive damages. You have to do some really bad things to get hit with them. I've never seen or heard of a case yet where the "conservatives" argued the company punished did nothing wrong.

I know that in the past I've commented on tort reform and my general support of it. Mainly I don't like suing people (or companies) over the everyday mistakes we all make. But when it comes to things like predatory lending, if you take a really good look at how that industry works, they're just begging to be punished. A couple of good solid whacks and maybe they'd stop their misconduct.