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Subprime Lending
Risk v. Profit
Regulators are expressing growing concerns about the risks involved in sub-prime lending. At the same time, these regulators support risk-based pricing. What is the difference and why is sub-prime lending such a concern? And where does predatory lending fit into this?
Sub-prime lending was a leading cause of recent bank failures. Three banks that failed, BestBank, Keystone, and PTL all had concentrations of sub-prime loans. These failures have so raised the concern levels of regulators that the agencies are issuing warnings about sub-prime lending. Examiners are warning banks about the hazards of sub-prime lending and developing approaches to assess the degree of a bank's risk exposure.
At the same time, pressures of CRA and market demands are leading banks into the sub-prime market. Although regulators and banks alike object to the use of the term "CRA loan," the fact is that this is used to refer to a loan that a bank would not have made traditionally but for the impetus of CRA. The term "CRA loan" is used to describe a higher risk loan that is made to a borrower with poor qualifications by standard underwriting.
Community groups assert that many applicants that appear unqualified have the character and will to repay the loan. Bank's merely need to learn how to find them. These groups also want banks in their market making loans so that their community is less vulnerable to predatory lenders. So the challenge for banks is to enter the sub-prime market with the fairness that is expected of banks.
According to Ellen Seidman, Director, Office of Thrift Supervision, "the private sector has begun to focus on the fact that meeting financial services or other needs in traditionally underserved markets is about more than meeting a legal obligation. It is about business opportunities, community advancement, and making a difference." [from a speech to
Neighborhood Reinvestment Training Institute, 2/23/00.]
Risk-based pricing
The best tool banks have for entering the sub-prime market is risk-based pricing. In the business of sub-prime lending, there is an important difference between predatory lending and risk-based pricing. Any system of risk-based pricing is necessarily founded on a risk analysis. Both the decision to make the loan and the decision of how to price the loan are based on the lender's analysis of the risk the applicant presents.
The basis of risk analysis is a careful look at the applicant, including the applicant's credit history and ability to pay. This underwriting produces an assessment of risk in making the loan. High risk leads to higher pricing while the lower risk customer gets a better offer. At some point - chosen by each lender - the assessed risk exceeds the lender's willingness to take the risk at any price. These become denials.
Risk-based lending has a rational basis. It may not be as scientific or accurate as we would like it to be - yet. But it is based on analysis of factors that relate to credit performance. Risk-based underwriting is an important tool for lenders making loans to non-traditional customers that present more risk that the traditional "A" risk bank customer.
In risk-based pricing, the price of the loan is based on the estimated risk the borrower presents. A high risk customer has to pay more to get credit. Banks have traditionally specialized in lending to "A" customers. The pressures of CRA and market competition are taking banks into the business of lending to "B," "C," and even "D" customers. The difference between success and failure is making lending and pricing decisions based on an accurate assessment of risk.
Predatory lending
Predatory lending is quite different. While predatory lenders may target high-risk consumers, the sale and pricing of the product is not based on analysis; it is based on whatever the predator is able to get from the victim. Sub-prime lending may also involve outright fraud and deception.
The biggest threat from predatory lending practices is destruction of neighborhoods. Often the target neighborhoods for predatory lenders are the very communities that banks and neighborhood organizations have worked hard to build up. First-time home-owners who received help in preparing and filing their mortgage application may be particularly vulnerable to the intricate scripts of sub-prime marketers. They give up a fair deal for one that will cause them to lose their home.
Predatory lending could be looked at as this decade's equivalent to block-busting. These lenders create transactions. Predatory lenders substitute expensive loans for the original loan that had more favorable terms. Practices include promises of instant money and "excellent" terms. They may offer to lower the payment without explaining that this involves increasing the term of the loan.
Seidman's agenda
In her remarks to the Neighborhood Reinvestment Training Institute, Seidman laid out three steps that can make a difference.
First, there are legal strategies to pursue. The most obvious legal strategy is enforcement, taking action against illegal practices. However, Siedman warns that enforcement rarely does anything positive, but positive responses are what is needed.
Second, and more effective than enforcement, is enhancing competition. Siedman states that predatory lenders are successful because there is little or no competition. She urged the Institute to play a role in educating their consumer members and in working with banks to bring customers and banks together.
Siedman suggested that community organizations can take steps beyond traditional education, such as identifying reliable home improvement contractors and lenders, establishing systems for identifying unscrupulous lenders entering the community, and encouraging community residents to establish banking relationships.
Third, education is an essential component. The targets of predatory lending need information to recognize fair and unfair credit offers. They need to learn how to recognize scams. Siedman encouraged community organizations to work with financial organizations in developing and offering information about shopping for credit, recognizing scams and predatory offers, and learning how to use information - such as Truth in Lending disclosures - to evaluate credit offers.
ACTION STEPS
- Meet with key lenders to discuss how they analyze risk. Consider whether their methods are responsible or border on predatory.
- Check the marketing methods for loans. Pay particular attention to telemarketing scripts and training of telemarketers.
- Review the criteria used in underwriting. Look carefully at how the criteria are used. Make sure that the underwriting is sound and based on risk; not merely an exercise for predatory lending.
- In your next loan audit, evaluate how effectively the underwriting techniques and lending decisions identify risk.
- Review the defaulted loans and compare the borrower's qualifications with performing loans. Consider whether the bank took excessive risk in making those loans.
- Look for interested community organizations to work with in community education and community lending programs.
Copyright © 2000 Compliance Action. Originally appeared in Compliance Action, Vol. 5, No. 2, 3/00
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