|The Banking Law Journal
This article describes subprime lending in the mortgage industry; how it has evolved over time; issues facing the industry; and “best practice” tips to survive in the changing economic and regulatory landscape, while minimizing litigation exposure.
Homeownership is viewed by many as a part of fulfilling the “American Dream.” However, it wasn’t until the mid-1990s, with the advent of subprime lending, that the American Dream became reachable by those individuals who normally would be denied credit because of lower-than-average credit scores or low net income. The mortgage industry’s subprime sector has grown from $150 billion in 2000 to $650 billion in 2007, or about a quarter of the mortgage market (See Figure 1).
The major benefit of subprime lending is that it gives homeowners who otherwise could not afford real estate, the opportunity to create wealth. Critics of subprime lending argue that this benefit comes at a great cost, because the borrowers of subprime loans are being charged excessive interest charges that will eventually place them in default.
Most recently, the subprime mortgage-lending industry is facing a crisis with governmental scrutiny of subprime lending practices, many subprime mortgage companies filing for bankruptcy, increasing foreclosures on subprime loans, and the threat of class action lawsuits against the subprime industry.
This article discusses what “subprime lending” is; what differentiates a subprime loan from a prime loan; the evolution of subprime mortgage lending; delinquency rates for subprime loans; predatory lending abuses in the subprime lending industry; litigation risks for the subprime lending industry; the future of the subprime lending industry; and tips to survive in the uncertain economic and legislative climate.
What is Subprime Lending?
Subprime lending is a relatively new and rapidly growing segment of the mortgage market servicing borrowers who, for a variety of reasons, have lower-than-average credit scores and would otherwise be ordinarily denied credit. A typical subprime borrower has a low FICO score (a credit score created by Fair Isaac Corporation to measure consumer credit worthiness), and a lower net income than average. Subprime lenders generally charge these borrowers higher interest rates to account for the increased risk associated with these loans.
Borrower costs associated with subprime lending is driven primarily by two factors: credit history and down-payment requirements (Chomsisengphet and Pennington-Cross, 2006). Traditionally, the mortgage market set minimum lending standards based on a borrower’s income, payment history, down payment, and the local underwriter’s knowledge of the borrower (Chomsisengphet and Pennington-Cross, 2006). The subprime industry, however, has introduced many different pricing tiers and products to move the market toward risk-based pricing.
What Differentiates a Subprime Loan from a Prime Loan?
From a borrower’s perspective, the main difference between a prime and subprime loan is that the upfront and continuing costs are higher for subprime loans. Upfront costs are those costs associated with originating the mortgage such as application fees and appraisal fees. Continuing costs are those costs associated with maintaining the mortgage such as mortgage insurance payments, principal and interest payments, late fees, and property taxes.
From a lender’s perspective, the main difference between a prime and subprime loan is the cost associated with the likelihood that a borrower will default on the loan. As discussed more fully below, the Mortgage Bankers Association’s (“MBA”) quarterly National Delinquency Survey (“NDS”) reported that the delinquency rate for prime loans in the third quarter of 2006 increased to 2.44%, while the delinquency rate for subprime loans, during the same time period, increased to 12.56%.
One factor in deciding whether a loan is prime or subprime is the “loan grade.” Lenders assign each loan a certain grade that is determined by the applicant’s mortgage or rent payment history, bankruptcies, and total debt-to-income ratio. Other factors that determine if a loan is prime or subprime are the loan-to-value ratio and a borrower’s credit score.
The Evolution of Subprime Lending
In the 1990s, there was a residential real estate lending boom, with subprime lending growing at an even faster rate. In 2001, the Wall Street Journal reported a tripling in the number of outstanding subprime mortgages from 1995. According to The Department of Housing and Urban Development (“HUD”), the subprime lending industry has grown from $35 billion in 1994 to $650 billion today.
Many factors have contributed to the growth of subprime lending, such as increases in capital made possible by securitization, increase in risk-based pricing facilitated by technological advances, and the deregulation of the banking industry (Howell, 2006).
The growth of the subprime industry is largely attributable to the increase in securitization. Securitization is the pooling of loans to form securities, which are subsequently sold in the secondary market. Securitization provides lenders with excess capital, that ordinarily would not be available, to make additional loans. The federal government first created a secondary market for mortgages in the 1930s to combat the Depression-era shortage of residential loan funds (Howell, 2006). In the 1970s, Government Sponsored Entities, Fannie Mae and Freddie Mac, created and sold securities backed by federally insured home loans to further increase the aggregate available residential lending capital (Howell, 2006). In the 1980s, securitization became possible in the private sector when agencies began to rate privately issued mortgage-backed securities (Howell, 2006). From 1984 to 1988, the percentage of outstanding securitized residential loans grew from 23% to 52% of all outstanding residential loans. Through securitization of private residential loans, lenders are provided with excess capital which they can in turn lend to those who ordinarily would be denied credit, thus securitization fuels the subprime loan industry.
Legislative deregulation of the banking industry has also fueled the subprime lending industry. In 1980, Congress adopted the Depository Institutions Deregulation and Monetary Control Act (“DIDMCA”). DIDMCA helped the Savings and Loan (“S&L”) industry stay competitive with nonfederally chartered banks where consumers received higher rates of return (Howell, 2006). DIDMCA also enabled the S&Ls to recoup the higher interest rates they were paying by allowing them to preempt state usury laws for loans to consumers secured by first liens on their homes (Howell, 2006).
In 1982, deregulation continued with the passage of the Alternative Mortgage Transaction Parity Act which extended federal mortgage-lending regulations to most residential loans, including the permitted use of variable interest and balloon payments (Howell, 2006).
These laws opened the door for the development of a subprime market, but subprime lending would not become a viable large-scale lending alternative until the passage of the Tax Reform Act of 1986 (“TRA”) (Chomsisengphet and Pennington-Cross, 2006). The TRA increased the demand for mortgage debt because it prohibited the deduction of interest on consumer loans, yet allowed interest deductions on mortgages for a primary residence as well as one additional home (Chomsisengphet and Pennington-Cross, 2006). Next, the Financial Institutions Reform Act of 1989 (“FIRREA”) addressed the costly S&L failures of the 1980s and created incentives for S&Ls to operate as thinly capitalized mortgage brokers relying on the secondary market for loans (Howell, 2006). Finally in 1999, Congress passed the Gramm-Leach-Bliley Act permitting financial service providers to merge with insurers (Howell, 2006). Thus, banking deregulation enabled lenders to offer more varied loan products, which were attractive to more varied consumers, and further gave incentives for more lenders to enter the market.
Delinquency Rates for Subprime Loans
According to the Center for Responsible Lending (CRL), in a report released in December 2006 studying more than 6 million subprime mortgages made from 1998 through the third quarter of 2006, one in five subprime mortgages made in the last two years is likely to go into foreclosure. At that rate, the CRL estimates that 1.1 million homeowners who took out subprime loans in the past two years would lose their homes in the next few years. These foreclosures will cost homeowners an estimated $74.6 billion, primarily in equity, according to the CRL.
Recent evidence has shown that the probability of default is at least six times higher for subprime loans as opposed to prime loans. The CRL cites several factors for the increase in subprime mortgage foreclosures – including adjustable rate mortgages with steep built-in rate and payment increases, prepayment penalties, limited income documentation, and no escrowed funds available for taxes and insurance. In addition, the CRL notes that the past housing boom has only masked the high proportion of homeowners who have struggled with subprime loans.
Geographically, in the past, subprime foreclosure rates were mainly a problem for states in the central United States, such as Ohio, Oklahoma, and Tennessee (See Figure 2). Today, according to the CRL, almost every state will experience high foreclosure rates, with those rates most acutely felt in states with previously strong appreciation, such as California, New York, Maryland, and Virginia (See Figure 3).
If the delinquency rate for subprime mortgages continues to increase, it will have a negative effect on the availability of such loans. In addition, any geographic concentration of foreclosed properties will adversely impact the value of the properties in the surrounding neighborhoods.
Predatory Lending Abuses in the Subprime Lending Industry – Push to Suitability Standard
As the subprime home-mortgage industry has grown, increasing attention has focused on predatory lending abuses. Sometimes various loan practices such as fraudulent, deceptive, discriminatory, or unfavorable lending practices are referred to as “predatory lending.”
Recent studies have shown that subprime lending is most prevalent in neighborhoods with high concentrations of minorities or weaker economic conditions (Chomsisengphet and Pennington-Cross, 2006). According to the Federal Reserve, of the loans taken out by African-Americans in 2006, 55% were subprime loans. For Hispanics, the rate was 46%, while for Caucasians and Asians the rate was 17%.
In an effort to curb predatory lending practices, in 1994 Congress enacted the Home Ownership Equity Preservation Act, 15 U.S.C. § 1639 (“HOEPA”) as an amendment to the Truth in Lending Act (“TILA”). In addition, many states have enacted their own laws targeting abusive practices on top of the federal legislation to provide alternative consumer protection.
Over the past few years, the subject of predatory lending in the subprime mortgage industry has received heightened scrutiny by Congress. In response to recent reports suggesting a rise in predatory lending practices, some regulators and advocacy groups have begun calling for laws to make lenders more responsible for protecting borrowers’ interests. In September 2006, federal lending regulators began requiring lenders to do more to ensure that borrowers taking out certain loans understand the risks and are able to repay the debt.
Further, in recent Congressional Hearings, some consumer advocacy organizations have suggested that a “suitability standard” be imposed on the mortgage lending industry. While a specific proposal for a suitability standard for the mortgage industry is not yet fully formed, a variety of approaches have been suggested (see Mortgage Bankers Association Policy Paper 2007-1). Most approaches would require more rigid, prescribed underwriting standards, and may seek to impose a duty of fair dealing at the inception of the loan, a subjective evaluation by the lender whether a product is best suited for that borrower, the establishment of a fiduciary obligation by the lender to the borrower, and a private right of action to redress any violations (Mortgage Bankers Association Policy Paper 2007-1). The ramifications of a suitability standard seem far reaching. As the MBA points out, some lenders and secondary market participants will understandably be reluctant to expose themselves to severe legal and reputational risks – lessening competition, rationing credit and increasing prices (Mortgage Bankers Association Policy Paper 2007-1). Further, the MBA notes that those that remain in the market may be expected to increase their prices to reflect the costs resulting from increased risks, including the risk that their collateral will not be available to satisfy the debt because of suitability concerns (Mortgage Bankers Association Policy Paper 2007-1). Ultimately, the cost of a suitability standard would be on the consumer, since many borrowers will be unnecessarily denied credit, and the compliance costs will increase the price of subprime loans. Further, if there is too much push back, the burden may fall disproportionately on African-Americans and Hispanics who may not be able to secure loans to refinance or purchase homes.
Litigation Risks for the Subprime Lending Industry
With higher default rates, comes more litigation. Often litigation is commenced in conjunction with foreclosure proceedings after there has been a default. For example, as borrowers begin to default on their subprime loans, many have sought bankruptcy protection. These borrowers have then initiated adversary proceedings against subprime lenders and servicers alleging, among other things, TILA and Real Estate Settlement Procedures Act of 1974 (“RESPA”) violations, in an attempt to rescind the subprime loan. Similar claims have arisen as counterclaims to the underlying mortgage foreclosure actions. Likewise, borrowers may also seek relief from federal or state human relations commissions, which may result in predatory lending complaints.
Furthermore, sublenders have become subject of mass litigation brought by state attorney generals. For example, in January 2006, ACC Capital Holdings Corporation and its subsidiaries, Ameriquest Mortgage Company, Town & Country Credit Corporation, and AMC Mortgage Services (collectively, “Ameriquest”), reached a settlement with 49 states (all but Virginia) and the District of Columbia, whereby Ameriquest agreed to pay $325 million to compensate customers who were allegedly harmed by Ameriquest’s business practices. The settlement ended a two-year investigation into allegations that Ameriquest deceived consumers to sell mortgages, using high-pressure sales tactics to meet employee sales quotas. The company also agreed to change some of its subprime mortgage business practices, including, but not limited to:
(1) limiting the prepayment penalty for all subprime adjustable-rate mortgages;
(2) refraining from offering refinancing solicitations to current borrowers during the first two years of their subprime refinance loan;
(3) using an independent loan closer for all subprime loan closings;
(4) documenting that each subprime refinance loan provides some benefit to the borrower; and
(5) providing the same interest rate and number of discount points to all potential borrowers sharing the same credit characteristics.
Most recently, there have been several securities class-action suits brought by shareholders filed against lenders alleging violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 by publicly issuing a series of false and misleading statements regarding these companies’ business and financial results, causing their publicly traded common stock to trade at artificially inflated prices. In particular, these securities class action complaints allege that, unknown to investors, the subprime lenders knew or recklessly disregarded:
(i) that they lacked adequate internal controls, and, as a result, that their guidelines and appraisal review process were inadequate to gauge the risk involved in their lending practices;
(ii) that they were under-reserving for loan losses as conditions in the subprime industry deteriorated;
(iii) that they failed to properly account for allowances for early-payment defaults and loan repurchase losses;
(iv) due to the deterioration of the credit performance of their portfolio, they would be forced to: (a) record impairments on mortgage securities and additional loan provisions, and (b) to repurchase a greater level of loans due to defaults; and
(v) that, as a result of the adverse conditions set forth above, they could not reasonably expect to report taxable income, thus endangering their dividends and continued status as a Real Estate Investment Trust (“REIT”) (See Tanner v. Novastar Financial, Inc. and Hammer v. New Century Financial Corp).
Future of the Subprime Lending Industry
The future of the subprime lending industry will likely see change. The number of foreclosures combined with tightening lending standards and litigation risks have forced a number of mortgage firms to shutdown, file for bankruptcy, merge into larger financial firms, and/or report disappointing earnings. The past increase in competition among subprime lenders has caused the industry to recently have relatively small profit margins. As the housing market begins to cool and the Federal Reserve begins to raise short-term interest rates, subprime lenders are seeing their profits quickly erode. To stay afloat, many subprime lenders have been forced to increase their rates, however they are finding that they are not able to attract as many borrowers with those increased rates. In addition, in reaction to Congressional and consumer advocacy organizations’ concerns over predatory lending abuses, many subprime lenders have tightened their underwriting standards, which in turn has driven up their costs and decreased profits.
Analysts on Wall Street are also concerned about the future of the subprime lending industry. Moody’s and other debt-raters have placed subprime deals on watch for a possible downgrade (The Economist, Dec. 16, 2006). In addition, funds whose bonds are backed by subprime loans have fallen sharply, due, in part, to defaults in the loans backing the securities. Of the $1.02 trillion of mortgage-backed securities issued in the first half of 2006, more than 40% were linked to subprime loans, up from 6 to 8% in 2000-2003 (The Economist, Dec. 16, 2006).
While some subprime lending companies have been bought by Wall Street’s big securities firms such as Morgan Stanley, Merrill Lynch and Bear Stearns, others have been pushed towards bankruptcy, as the big banks have started scrutinizing loans offered up for securitization and thrown back “toxic” loans to the subprime lenders (The Economist, Dec. 16, 2006).
The subprime lending industry has undergone major transformations in the past twenty years. Recent scrutiny of subprime lending practices may impose changes on the industry. However, subprime lenders can minimize their litigation and regulatory exposure by reconsidering lending guidelines.
Checklist to Survive In Murky Times
The following basic checklist is meant to guide subprime lenders through the changing economic and regulatory landscape, and to minimize litigation risk.
Checklist for Subprime Lenders
• Familiarize yourself with the growing and increasingly diverse, federal, state and local laws targeting predatory lending, and review your loan terms and lending procedures to ensure that they will not expose you to unnecessary liability, loan loss and legal risks.
• Consider further tightening minimum lending standards for prime and subprime loan products.
• Carefully review underwriting standards and secondary loan sale terms to be sure you are not exposed to having to buy loans back on later default due to underwriting standards that are not consistent with the representations and warranties you make to secondary market investors.
• If not doing so already, provide the same interest rate and number of discount points to all potential borrowers sharing the same credit characteristics.
• If not already established, establish fair-lending guidelines in writing and make them available to the public.
• Continue to train employees on fair-lending guidelines.
• Review and develop procedures for updating fair-lending guidelines.
• Identify areas of disparities in lending and remedy those disparities.
• Consider separating sales functions from underwriting functions.
• Consider changing the “chain of authority” for approval of loans.
• Use an independent loan closer for all subprime loan closings.
• Limit the time period of the prepayment penalty for adjustable-rate mortgages.
• Document that each subprime refinance loan provides some benefit to the borrower.
Howell, Benjamin, Exploiting Race and Space: Concentrated Subprime Lending as Housing Discrimination, California Law Review, January, 2006.
Mortgage Bankers Association, Suitability – Don’t Turn Back the Clock on Fair Lending and Homeownership Gains, MBA Policy Paper Series, Policy Paper 2007-1, January 29, 2007 (available at http://www.mbaa.org/files/News/InternalResource/48134_Suitability-DontTurnBacktheClockonFairLendingandHomeownershipGains.pdf)
Schloemer, Ellen , Li, Wei, Ernst, Keith and Keest, Kathleen, Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners, Center for Responsible Lending, December 2006.
Stokes, Aleis and Armstrong, Laura, Some Delinquency Measures Increase in Latest MBA National Delinquency Survey, MBA, December 13, 2006 (available at http://www.mbaa.org/NewsandMedia/PressCenter/47057.htm).
Subprime Subsidence, The Economist, December 16, 2006.
Reprinted from the May 2007 issue of The Banking Law Journal