With mortgage foreclosures at record levels, states are scrambling to regulate lending practices and products.
For years, passing a law against predatory mortgage lending seemed like a near-impossibility in Minnesota. After all, the state boasts the nation's highest homeownership rate and its foreclosure rate is well below the national average. What did it need with rules limiting the types of mortgages available to borrowers?
That was the conventional wisdom--until six or seven months ago.
"The whole world has changed," says Prentiss Cox, a law professor who chaired Minnesota's study commission on predatory lending and helped draft new legislation. "Somewhere around November or December, the lending industry suddenly woke up out of a coma." The awakening was a rude one, coming courtesy of sharply rising foreclosure rates brought on by lax lending standards, a drop in housing prices and a sluggish economy in some areas of the country. In Minnesota, for example, foreclosures increased 79 percent from 2005 to 2006.
A big part of the problem, there and elsewhere, seems to be the emergence of so-called "exotic mortgages," particularly in the "subprime" loan market. Many of these new loan products are adjustable-rate mortgages with a fixed, low "teaser" rate for two years or less, followed by a much higher rate for the remaining life of the loan. For example, "2-28" loans might start with an interest rate fixed at 2 percent for two years, followed by a 28-year adjustable rate that might go as high as 9 percent. Other products allow borrowers to secure loans with no documentation, or no money down, or permit "negative amortization," in which borrowers can opt to pay a small amount so that they actually owe more money on their property each month.
By February of this year, policy makers in Minnesota had introduced a package of predatory mortgage lending bills considered by many to be the strongest in the country. The bills sailed through the state legislature; one was signed by the governor less than three months after it was first introduced.
Minnesota now requires mortgage brokers and banks to consider whether borrowers can afford the loan at the rate they will be charged five years into their mortgage. Under the new law, lenders must have documentation of income to verify borrowers' ability to repay, thus ending "stated-income" loans. Such loans were sometimes derided as "liar's loans" because the statements of income often deviated from actual income.
Since North Carolina passed the first predatory-lending bill back in 1999, similar measures have spread slowly to other statehouses across the country, often accompanied by epic lobbying battles between banks and consumer groups. With the recent rise in foreclosures and collapse of subprime mortgage lenders, the opposition to legislation is less intense. But the range of issues covered by the bills has grown more complicated.
Congress and federal agencies, meanwhile, are trying to figure out their role in addressing this growing problem. The Office of the Comptroller of the Currency decreed that states cannot regulate loans made by federally chartered banks, a ruling upheld this April by the U.S. Supreme Court. However, because state-chartered banks make about 70 percent of mortgage loans for single-family homes, state laws still retain much of their effectiveness. In 2006, substantive legislation was passed in Rhode Island, Ohio and Tennessee, and bills regulating some aspect of mortgage lending or foreclosure procedures have been introduced in at least 26 states this year.
THE ABILITY TO REPAY
The groundwork for most of those bills was laid in North Carolina's 1999 bill, which went after hidden high costs in subprime loans, or loans given to borrowers who don't qualify for standard, "prime" rates because of a poor or limited credit history.
Pushed by then-Attorney General and now Governor Mike Easley and then-Senate President and now Attorney General Roy Cooper, it targeted hidden high costs in subprime loans, such as prepayment penalties, a practice called "flipping" that involved repeated refinancing with no benefit to the borrower, and "yield-spread premiums," which sometimes functioned as kickbacks to mortgage brokers.
Although North Carolina was successful in shutting down those types of predatory loans, many of the loans that are now resulting in foreclosures are entirely legal under the 1999 law. "What's happened is that the nature of what we would consider predatory lending is different," said Sharon Reuss, spokesperson for the Center for Responsible Lending. "Before, it was the characteristics of predatory lending [such as prepayment penalties] that we would keep our eyes on. What's happened in the past few years is that the actual loan product itself has become abusive and horrible to borrowers."
Taken together, subprime loans and loans called Alt-A (given to borrowers with decent credit scores but who might have trouble verifying their income) currently comprise nearly 40 percent of the national mortgage market. "They're not looking to see if you can repay the loans," said former New Mexico Senator Don Kidd, who co-sponsored predatory mortgage lending legislation in 2003. "They'll reach out and feel you, and if you're still warm, they'll lend you 75 percent of the appraisal."
States are now trying to address the riskiness of such loans through laws requiring mortgage brokers to consider a borrower's "ability to repay." In addition to Minnesota, Ohio has passed such a statute, and several other states are currently considering it.
Mortgage brokers, of course, always have had to judge customers' ability to repay to some extent--otherwise underwriters wouldn't approve a loan. But for some types of exotic mortgages, mortgage brokers had to consider only introductory rates in their calculations, which might be dramatically different from the rate several years in the future.
Minnesota's changes go beyond what many other states have done, but Cox says that the net effect will just push the mortgage market back to the way it behaved about a decade ago. "I think of these as common- sense provisions, not drastic at all," he says. "What was drastic was this ahistorical and extremely risky turn in the mortgage market."
But some mortgage brokers think differently. John M. Robbins, chairman of the Mortgage Bankers' Association, said in a press release that he has "grave concerns" about imposing a standard judging a borrower's "suitability" for a mortgage loan. "Mortgage lenders are not analogous to financial analysts in this way," he stated, "and a subjective suitability standard could threaten decades of fair-lending gains." Fair-lending laws prohibit lenders from refusing to make a loan based on the borrower's race, sex, religion and other factors.
Robbins also argues that the effect of subprime loans on rising foreclosures might be overstated. Many of the states with the highest foreclosure rates also are suffering from economic downturns, he says, such as Ohio, Illinois and Michigan.
Particularly in states with high foreclosure rates, lenders and mortgage brokers worry that the tightening of mortgage-lending standards might force some prospective buyers out of the market, making it harder for those in foreclosure to sell their homes.
"On a pure, broad, economic basis, if you take one group of borrowers out of the marketplace, you're going to reduce demand," says James Hahn, a director of the Rhode Island Mortgage Bankers' Association. "There's no question that this law reduced or eliminated one group of borrowers. Who it eliminated and what the relative impact of eliminating that group is, I have no idea how to quantify."
In Rhode Island, several subprime mortgage lenders temporarily pulled out of the market due to emergency state banking regulations put in place to enforce the state's mortgage lending law, which was enacted at the end of 2006. "There are fairly rigorous limitations on high- cost loans," says Hahn. "As a result, creditors don't want to touch them."
A CAUTIONARY TALE
While Rhode Island's mortgage lending market has continued to function overall during the implementation of the new law, critics point to Georgia as a cautionary tale of a mortgage lending bill going too far.
In 2002, Georgia enacted a predatory-lending law that included a provision allowing lawsuits against mortgage lenders, banks and institutions that acquired loans on the secondary market. Because of the potential for uncapped damages among so many different entities, all three credit-rating entities stopped rating transactions involving loans covered by the Georgia law.
Despite cases such as Georgia, which amended its law in April 2003 to allow its mortgage market to return to normalcy, studies show that predatory-lending laws do accomplish much of what they intend to do. A study by the Center for Responsible Lending found that states with strong predatory-lending laws have fewer loans with abusive terms, but that subprime interest rates and loan volume remained comparable to states without such laws. The report argues that borrowers are therefore not being widely shut out from the lending market.
In the wake of rising foreclosures, states also are investigating new laws aside from those directly targeting mortgage lending. Some states are regulating "foreclosure consultants," who charge homeowners a fee to shepherd them through the foreclosure process, and "equity purchasers," who buy foreclosed homes and lease them back to the homeowners, with an eventual option to repurchase. While both professions can be perfectly legitimate, unscrupulous practitioners can also take advantage of foreclosed homeowners. New laws, such as one passed in Colorado, require written, cancelable contracts and require that homeowners have a reasonable ability to repay a loan to repurchase their homes.
In Ohio, the state has instituted one of the most direct programs to address foreclosures head-on. The Ohio Housing Finance Agency is making $10 million available to low- to moderate-income homeowners in need of a fixed-rate, 30-year mortgage loan. The program, which is funded through bonds, is intended to move people off of subprime or exotic adjustable-rate or interest-only mortgage loans.
For the states that passed laws relatively early on, the current foreclosure situation brings some validation, but also a scramble to update laws to combat relatively new lending practices.
"It has proved out everything we said: the repossessions, the people in that business going broke," says Kidd, who calls the fight to pass the predatory-lending bill in New Mexico one of the toughest in his 12-year legislative tenure. "It doesn't make you feel any better, but everything we said then is coming true."