Regulating Consumer Credit Alternatives To Disclosure

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Regulating Consumer Credit Alternatives To Disclosure Powered By Docstoc
					   The Regulation of
   Subprime Lending
            Todd J. Zywicki
               Professor of Law
    George Mason University School of Law
   Research Fellow, James Buchanan Center
Program on Politics, Philosophy, and Economics
                Overview

   Understanding the Subprime Market
   Benefits of Subprime Lending
   Risks of Subprime Lending
   Regulating the Subprime Market
Growth of Subprime Market
   1994-2005:
       $35 billion => $600 billion
       5% of all mortgage originations => 20%
   Still, as of 2005:
       33% of homes owned free and clear
       57% traditional fixed-rate mortgages
       10% ARMs
   Very Young Market: Recent Turmoil on
    Wall Street
What is “Subprime”?
   “Weak credit repayment history or
    credit characteristics that indicate
    reduced repayment capacity, such as
    high debt-to-income ratios”
   Low or No Doc: Have credit
    characteristics of prime but can’t
    provide full documentation of income
    and assets (such as self-employed)
What is “Predatory Lending”?
   Asset-Based Lending: Making unaffordable loans based
    on the assets of the borrower (collateral) rather than on
    the borrower’s ability to repay
   Loan Flipping: Inducing repeated refinancing in order to
    charge high points and fees each time the loan is
    refinanced
   Fraud and deception: Inflating property appraisals,
    doctoring loan docs, “bait and switch” terms, failure to
    disclose
   Excessive Fees: Often not disclosed thoroughly
   Excessive Interest Rates Relative to Risk: “Steering”
    borrowers to higher-rate loans
   “Unfairly” Burdensome Prepayment Penalties
   Balloon payments: Often combine low monthly payment
    with inadequate disclosure of balloon
   Challenge: Separating Risk-Based Pricing from Predation
Peculiarities of Subprime Market
   Higher Costs
       Underwriting
       Servicing
   Prepayment Risk: Three times more common
       Prepayment in Prime: changes in interest rates
       Prepayment in Subprime: Improvement in FICO
       Subprime twice as likely to prepay if no penalty
   Documentation and Income
   Historically Specialized Lenders
   Use of Brokers
   Questionable Characters: Lenders and Borrowers
Types of Subprime
   AA: No 60 day late credit cards, 1 thirty day late
    mortgage or, No 60 day late
   A-minus: missed one mortgage payment or two credit
    card payments in last two years
   Alt-A: similar credit histories by less documentation of
    income or assets or unusual collateral characteristics
   B: 4 30 day late mortgage (or 2 30 and 1 60), 0 60 day
    late in past 12 months, 1 60 day late in past 24 months,
    no foreclosure proceedings in last 24 months
   C: 6x30, 1x60, 1x90 or 6x30, 2x 60, and 0x90
   D: Exceeds C, Recent Bankruptcy
   70% of subprime are A-minus or Alt-A
Basic Terms: Option One
   Grade (Option One Grade Names Differ)
   FICO Score
   Region
   LTV (Sliding Scale, Min & Max Depending
    on FICO Score)
   Full Doc or Lite Doc
   Based on 2 year Fixed, 2 year prepay
    limitation, Single Family Home
Adjustments
   Fixed or Longer Fixed Period (3 year, 5 year
    ARM)
   40 or 50 year Amortization
   Interest Only
   No Documentation
   Disposable Income
   Cash Reserves
   First Time Home Buyer
   10% Downpayment
   State Prepay Legal Prohibitions
   Type of Property (Condo, Second Home)
    Benefits of Subprime Growth

   Increased Home Ownership
   Wealth Accumulation
   Wealth Equality
   Access to Alternative Credit
        60
             61
                  62
                       63
                            64
                                 65
                                      66
                                           67
                                                68
                                                     69
                                                          70
19
   65
19
   67
19
   69
19
   71
19
   73
19
   75
19
   77
19
   79
19
   81
19
   83
19
   85
19
   87
                                                                                           Home Ownership




19
   89
19
   91
19
   93
19
                                                               Home Ownership Percentage




   95
19
   97
19
   99
20
   01
20
   03
20
   05
Change in Homeownership
                                      Home Ownership by Race

 75

 70

 65
                                                                                      White
 60
                                                                                      Black
                                                                                      Hispanic
 55
                                                                                      Asian
 50

 45

 40
         96


                 97


                         98


                                 99


                                         00


                                                 01


                                                         02


                                                                 03


                                                                         04


                                                                                 05
      19


              19


                      19


                              19


                                      20


                                              20


                                                      20


                                                              20


                                                                      20


                                                                              20
Wealth Accumulation
            Median Wealth: Owners Versus Renters

  200,000
  180,000
  160,000
  140,000
  120,000
  100,000
   80,000
   60,000
   40,000
   20,000
       0
Wealth Accumulation
           Wealth By Age: Owners v. Renters

 300,000

 250,000
                                          Owners Median
 200,000                                  Wealth
 150,000                                  Renters Median
                                          Wealth
 100,000

  50,000

      0
           Under 35   35-64     65+
Wealth Accumulation
                              Wealth by Income

350,000

300,000

250,000
                                                                 Under $20k Income
200,000
                                                                 $20k-$50k Income
150,000
                                                                 $50k+ Income
100,000

 50,000

     0
          Owners Median Net Wealth   Renters Median Net Wealth
Wealth Equality by Race
                    Wealth By Race: Homeowners v. Renters

      250,000

      200,000

      150,000                                            White Households
                                                         Black Households
      100,000                                            Hispanic Households

       50,000

           0
                Owners Median Net   Renters Median Net
                     Wealth               Wealth


   Differences between Owners and Renters within Races are much
    larger than differences between races: White Households are about
    2-1/2 wealthier than other races, but homeowners about 30 times
    wealthier (black homeowners are 36.5 times wealthier than renters)
Wealth Accumulation
      Share of Home Equity in Household Net Wealth (Median)

 90.00%
                                                          77.30%
 80.00%
 70.00%
 60.00%                                  54.70%
 50.00%                    41.60%
 40.00%
             27.20%
 30.00%
 20.00%
 10.00%
  0.00%
          All Households   Owners    Minority Owners     Owners with
                                                       Income < $20k
Wealth Equality

   Housing Wealth is more broadly
    distributed than financial (stock) wealth.
   White families have four times as much
    stock wealth (median) as blacks and
    hispanics but only twice as much home
    equity wealth (median)
Housing and Rent Risk
   Todd Sinai and Nicholas S. Souleles,
    “Owner-Occupied Housing As A Hedge
    Against Rent Risk,” Q. J. Econ. (2005)
       Homeowners Balance Two Risks
       Rent Risk (variation 2.9% per year):
          Homeownership and housing prices higher where
           rent price volatility rises
          Effect greatest when rent higher portion of income

       Asset Price Risk: Ownership higher where
        time horizons longer
Homeownership and Credit
                             Financial Obligations Ratio

                        32
                        30
                        28
 Percentage of Income




                        26
                        24                                 Renter FOR
                        22                                 Homeowner
                        20                                 FOR
                        18
                        16
                        14
                        12
                           80

                           82

                           84

                           86

                           88

                           90

                           92

                           94

                           96

                           98

                           00

                           02

                           04

                           06
                        19

                        19

                        19

                        19

                        19

                        19

                        19

                        19

                        19

                        19

                        20

                        20

                        20

                        20
                                     Year
More Credit Options


   Renters have
       More Student Loan Debt
       More Automobile Debt
       More Credit Card Debt
Causes of Rising Ownership

   Federal Reserve Bank San Francisco (Nov.
    3, 2006): “We find that… it is likely that
    much of the increase is due to innovations
    in the mortgage finance industry that may
    have helped a large number of households
    buy homes more easily than they could
    have a decade ago.”
Risks of Subprime: More Debt
                                            Debt Service Ratio by Type of Debt: 1980-2006


                         0.14

                         0.12
 Proportion of Income




                          0.1
                                                                                              Nonrevolving DSR
                         0.08                                                                 Revolving DSR
                                                                                              Mortgage DSR
                         0.06
                                                                                              Total DSR
                         0.04

                         0.02

                            0
                             q1



                                       q4



                                                 q3



                                                           q2



                                                                     q1



                                                                               q4



                                                                                         q3
                           80



                                     83



                                               87



                                                         91



                                                                   95



                                                                             98



                                                                                       02
                        19



                                  19



                                            19



                                                      19



                                                                19



                                                                          19



                                                                                    20



                                                                Year
Alan Greenspan
“Some of the rise in the ratios of household debt to income may
   not be evidence of stress. The dramatic increase during the
   past decade in home purchases by previous renters has
   expanded both the assets (that is, owned homes) and the
   liabilities (mortgages) of the total household sector without
   significantly affecting either overall household income or net
   worth.
“Federal Reserve staff members estimate that approximately
   one-tenth of current home mortgage debt outstanding, or
   almost 1 percentage point of the average annual growth of
   home mortgage debt, is attributable to renters who have
   become homeowners since the early 1990s.
“One can scarcely argue that those previous renters are less well
   off since becoming homeowners; yet, all else being equal, the
   overall household debt as a percentage of income is 8
   percentage points higher currently than it presumably would
   have been had the homeownership ratio been stable since
   1992.”
Risks of Subprime
                                     Foreclosure and Delinquency

              16
              14
              12
 Percentage




              10                                                    Delinquency Rate
               8                                                    Foreclosure inventory rate
               6                                                    new foreclosure rate
               4
               2
               0
                   Prime loans   Subprime    FHA loans   VA loans
                                  loans
                                   Type of Mortgage
Delinquency
              Delinquency Rate ARM v. Fixed

 18

 16

 14

 12

 10                                           ARM Delinquency Rate
 8                                            Fixed Delinquency Rate

 6

 4

 2

 0
      Prime                 Subprime
ARM v. Fixed
                4Q 2006 v. 1Q 2007

 1.4

 1.2

   1

 0.8
                                     Quarterly Change ARM
                                     Delinquency
 0.6
                                     Quarterly Change Fixed
                                     Delinquency
 0.4

 0.2

   0
        Prime            Subprime
 -0.2
Foreclosure: Caveats
   Foreclosure still primarily driven by local economic
    conditions:
       Foreclosures highest in Michigan, Ohio, and Indiana (Automobile
        Industry)
       Mississippi and New Orleans (Hurricanes)
   Dramatic growth in Subprime loans for Nonowner-
    occupied homes: second homes and investment
    speculation (HMDA Data)
       1990-2005: 6.6%-17.3%
       2001-2005: 8.6%-17.3%
   Economics of Foreclosure and Delinquency:
       Option: Default if Property Values Fall
       Duress: Default if Can’t Pay
       Option and Duress are Related
Deliquency Caveats
   Prime Market Delinquencies
       30 days: 1.73%
       60 days: 0.31%
       90 days: 0.28%
   Subprime Market
       30 days: 7.35%
       60 days 2.02%
       90 days: 4.04%
   Can only be true if borrowers fall behind, miss three
    payments and then beginning to pay again without
    making up all the missed payments immediately.
   Suggests subprime borrowers are essentially using
    missed payments as a source of short-term, fixed-rate
    line of credit.
Macroeconomic Risks
   Diversification: House Markets and
    unemployment (human capital) correlated
   May stifle labor market flexibility/mobility
   Ripple Effects on Related Markets:
       Construction and employment
       Home Depot
   May be more unsteady than Prime:
       Risk-preferring consumers
       Consumer Default Option
Regulatory Responses

   Need to Specify Regulatory Goals and
    Tradeoffs
   Substantive Regulation
   Disclosure Regulation
   Common Law
   Competition
          Substantive Regulation

   Intended Effects
   Unintended Effects
       Term Substitution/Repricing: Heterogeneity of
        Subprime Loans
       Product Substitution
       Rationing
Regulation and Rationing
“Predatory Lending Laws Can Cause Headaches,”
Parma Sun Post (July 10, 2003):
When David Sanderson recently applied to a lender for a second mortgage, he was
    denied for an unusual reason. Undeterred, he went to another lender and was
    denied again. Same thing happened at a third institution. In all three cases, he was
    given the same reason for the denial—the lenders thought he lived in Cleveland and
    claimed that the city’s anti-predatory lending law prevented them from giving him the
    loan he needed. ***
Since Cleveland’s anti-predatory lending law caps interest charges, some lenders don’t
    give second mortgages or home-equity loans to Cleveland residents having potential
    credit risks.
But Sanderson lives in Fairview Park, a small, inner-ring suburb west of Cleveland.
    “When we were applying for loans, the companies would key in our zip code, and
    Cleveland would come up, he said.***
Desperate for a solution, Sanderson contacted his suburb’s City Hall. Fairview Park
    Mayor Eileen Patton wrote a letter on his behalf, verifying he was a resident of the
    suburb.
“Her inquiry into the matter must have accomplished something, because we received a
    call from one of the companies that initially turned us down, and offered to finance
    us,” Sanderson said. “Sometimes it pays to e-mail the mayor.”
Patton said she and City Council have received similar requests from six other residents
    who encountered the same problem as Sanderson’s.
Empirical Studies
   State and local anti-predatory lending laws lead
    to reduction in volume of high-cost loans
   More restrictive/severe laws lead to larger
    reductions in loan originations for high-cost
    loans (riskiest borrowers): Range from 26%
    (NC) to 94% (NM)
   Less impact on non-high-cost subprime (less risk
    subprime borrowers)
   Reduction in originations a result of reduction in
    applications (rejection rate actually falls)
   Good or Bad? Reduce “Predatory” or Subprime?
   Doesn’t control for term substitution
Improving Disclosures
   FTC study:
    http://ftc.gov/os/2007/06/P025505Mortga
    geDisclosureexecutivesummary.pdf
   26 In-Depth Interviews with their actual
    documents (half prime, half subprime
    customers)
   819 tests with recent mortgage
    customers: compared forms with current
    disclosures (TILA, RESPA, GFE) and
    prototype alternative disclosures
FTC Study Results
   Current mortgage cost disclosures fail to convey key
    mortgage costs to many customers: loans more costly than
    believed or contained restrictions of which they were unaware
       2/3 didn’t recognize prepayment penalty
       ¾ didn’t recognize optional credit insurance included
       25% couldn’t identify total settlement charges
       1/3 couldn’t tell when settlement charges included in loan
        amount
       1/3 didn’t recognize large balloon payment
       90% couldn’t identify total up-front charges
   More errors with more complex loans
   Prototype disclosures significantly increased consumer
    recognition of mortgage costs
   No fundamental differences between prime and subprime
    borrowers in ability to understand loan terms
       Prime 62.0% Correct v. Subprime 59.6%
Prototype Disclosures
   Based on Economic Theory and FTC Enforcement
    Actions
   Better disclosures substantially increased consumer
    understanding
       Comprehension rose from 61% average for current disclosures
        vs. 80% for prototype disclosures
       80% of respondents viewing prototype could answer 70% of
        questions correctly, versus 29% under current forms
       Improvement largest for more complex loans
            Improvement of 22 percentage points complex loans and 16 simple
            Improvement of 21.6 percentage points for prime borrowers and
             22.4 percentage points for subprime borrowers for complex loans
            66 percentage point increase in recognition of total up-front
             charges
            43 percentage point increase in recognition of optional credit
             insurance
            24 percentage point increase in recognition of prepayment penalty
   Lesson: Better Disclosures are Possible
              Common Law

   Fraud
   FTC
   Federal Reserve
Education

   Government Programs: Assessment
   Purpose of Education?
       Prevent Fraud
       Make Market Work Better
   North Carolina Experiment
Market and Contract
   How do we make market work better?
   How do we make subprime loans more
    homogeneous and more of a commodity?
Assignee Liability
   Freddie Mac and Fannie Mae will not purchase loans defined
    as high cost in some states
   Ratings services will not rate mortgage-backed securities
    transactions that contain high cost loans in some states or
    require additional credit enhancements for transactions that
    include high-cost loans
   Assignee liability would further raise risk of buying subprime
    loans
   Would likely reduce capital available for subprime market
   Empirical evidence: Negative evaluation by a credit rating
    agency associated with a large decline in originations of high-
    cost loans and smaller increase in originations of non-high-
    cost loans
   Not clear that assignees can reasonably police this at low cost
   Securitization may help to encourage subprime loans to be
    more homogeneous in terms: Assignee liability would reduce
    this
Suitability

   Would make lenders liable if they allow
    borrowers to take home mortgages that
    aren’t “suitable” or that “they can’t afford”
   Based on securities law where seek to
    protect people of limited means from
    being sold securities that are too risky for
    them
Net Benefit?
Jack Guttentag: “For there to be a net benefit, the
  borrower must have the mortgage long enough for the
  monthly cost reductions to exceed the upfront costs.
  Only the borrower has any idea of how long they want
  the mortgage…I recently reviewed a cash-out refinance
  in which the borrower paid about $12,000 in refinance
  costs and a quarter-percent rate increase in a loan of
  $150,000 to raise $4,500 in cash. Was there a net
  benefit? There is no objective way for the loan provider
  to answer the question. The price was very high, but
  maybe the borrower needed the cash to pay for life-
  saving medicine for his children.”
Suitability
   Are the following motives suitable for ARM
    or Interest Only Loan?
       Reduce cash outflow to invest the excess in
        securities.
       Reduce cash outflow to pay down a second
        mortgage.
       Pay principal when convenient.
       Buy more house.
       Reduce payment to avoid default.
Agencies Statement on Subprime
   OCC, Fed, FDIC, OTS, NCUA: June 29, 2007
   Guidance, Not Proscriptive
   Primary concern is “payment shock” not substantive
    terms: prepayment penalties, balloon payments, interest
    rate resets, lack of escrow for taxes and insurance
   Evaluate borrower’s ability to repay at fully indexed rate
    not just intro rate
   Improve Disclosures
   Limit use of reduced-documentation loans
   Encourage workouts
   Risk-layering
   Prepayment penalties should end at least 60 days prior
    to reset date
   Awareness that may limit lending versus payment shock

				
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