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Predatory Lending: Unfair & Unsound
The agencies have spoken on the topic of subprime lending. On the last day of January, 2001, the bank regulatory agencies issued their "Examination Guidance for Subprime Lending Programs." This includes a definition (of sorts) of predatory lending.
There are several significant aspects of this issuance. First, we finally have a definition of predatory lending. Second, the issuance officially states that subprime lending can be important for the bank to offer, meeting credit needs that cannot be met with traditional products. Third, the topic of subprime and predatory lending is dealt with in a safety and soundness context. Finally, the issuance provides some guidance on subprime lending for both compliance and safety and soundness programs.
Predatory or Subprime
First, now we have something tangible to work with in deciding what is or is not predatory. This begins with subprime. The agencies define subprime lending as loans to borrowers who typically have weakened credit histories. Weakened credit histories are characterized by such problems as payment delinquencies, charge-offs, judgments, and bankruptcies.
Another measurement for subprime loans is the borrower's reduced repayment capacity. This can be measured by credit scores, debt-to-income ratios and other criteria indicating credit weaknesses. It is in these considerations related to reduced capacity to repay that lending practices begin to enter the predatory lending zone.
The agencies have made clear that these measurements of subprime lending should only be applied at the time of origination or purchase of the loan. The test applies only when the lender is making the loan decision. A loan does not become predatory or subprime because of what may later happen to the borrower or the loan. Subsequent developments are a different can of worms.
Good Subprime Lending
Second, CRA gets support in the form of a statement in this issuance that subprime lending can be important. Loans that are "appropriately underwritten, priced, and administered" can enhance credit access for borrowers with special credit needs.
The real significance of this statement is to whom the statement is made. This issuance is not a compliance message, but is directed to the safety and soundness examiners. Because it is issued to safety and soundness examiners, it should be a useful tool in persuading loan officers to pay attention to compliance guidelines.
Safety and Soundness
Third, we now face squarely the issue of safety and soundness. There are several techniques put forward for dealing with the safety and soundness concerns. They all come down to proper underwriting and documentation. So here is fuel for your compliance mantra of documentation.
Examiners are directed to evaluate loans by certain forms of documentation including debt-to-income ratios, evaluation of cash flow and the ability to pay for family living expenses after payment of debt, and the borrowers' credit scores. These are all basic elements of loan underwriting documentation. Unfortunately for the bank and the compliance manager, loan officers have been known to speed things up by not writing this sort of information down.
Also identified as unsafe and unsound is a loan that can only be repaid from the collateral. Examiners are directed to write up such loans as unsafe and unsound.
This issuance demonstrates how important it is to document the loan decision. Examiners will be evaluating the subprime loan in the context of what was considered at the time it was made. If the loan officer fails to document his or her considerations, the examiner will have to presume the worst.
There is some additional warning from the agencies on documentation. Banks that engage in subprime lending programs must have adequate procedures to estimate and document the level of capital necessary to support the program. Again, this turns on the documentation prepared by the loan officer.
Defining Predatory
Finally, this publication actually defines predatory lending. The key element to determine whether lending is predatory is whether there is a "commensurate exchange of value" in both directions between lender and borrower. A predatory loan is one which simply takes advantage of the borrower. The lender gets the fees and interest or the goods - and sometimes both. A responsible loan officer should always be asking what the borrower gets that is of value to the borrower.
A loan, like any other contract, is an exchange of values. The regulators are using this value exchange concept to measure the motives of the lender. It should also prove to be a useful training tool. Use it to get lenders thinking about what the borrower gets from the loan.
Much has been said about predatory lending. There have been numerous ideas and examples put forward. The agencies have distilled these examples and ideas down to three principles. The three principles pretty much cover the territory of what is predatory.
The three elements are:
- Making unaffordable loans based on the assets of the borrower rather than on the borrowers ability to repay an obligation;
- Inducing a borrower to refinance a loan repeatedly in order to charge high points and fees each time the loan is refinanced; and
- Engaging in fraud or deception to conceal the true nature of the loan obligation or ancillary products, from an unsuspecting or unsophisticated borrower.
These three elements pretty much sum it up. A common element in examples of predatory lending is the fact that the loan is based what the lender can make from the transaction without regard to the borrower's benefit. Thus, loans that are based on the value of the collateral without taking into account whether the borrower can repay would be captured by this definition.
Pay close attention to the agencies' use of the word "unaffordable." A loan is unaffordable when the customer cannot repay the loan. This means that a bank's underwriting process should determine whether the applicant does in fact have the resources to repay the loan. Looking at - and documenting - a cash flow analysis and debt-to-income ratios are critical steps in underwriting.
The practice of loan flipping is addressed in the second element. A common practice among some finance companies, it results in the customer being trapped in a loan with little opportunity to enjoy the use of the principal and a lifetime to pay off finance charges.
There are plenty of good reasons to refinance a loan. The best one is that rates are now lower and the borrower can reduce the overall cost of the loan by refinancing, even if this means paying some up-front costs.
There may also be valid reasons to refinance or rewrite a loan to avoid a delinquency or a collection action. Debt consolidation loans definitely have a place in the credit world. But the predatory loan is one that puts the borrower in the position of needing such a loan. Debt consolidation should only arise when the borrower's circumstances have changed for the worse after the loan was made. A change in employment or a sudden new expense would be such a change.
Banks should avoid the kind of loan that anticipates the need to refinance it simply to make the payment. This is a loan the borrower cannot afford.
Finally, the agencies identify fraud and deception (the opposite of all those "Truth in…" laws) as a predatory practice. The document specifically identifies practices that take advantage of "unsuspecting or unsophisticated" borrowers. Indirectly, this makes consumer education programs, conducted for CRA purposes, even more important.
ACTION STEPS
- Make sure you have clear underwriting for any subprime lending. This should include clear guidelines for treatment of credit scores, slow payments, delinquencies, and worse in the applicant's credit history.
- Use this issuance to remind loan officers about the importance of documenting loan underwriting and that the debt-to-income ratio must be written down.
- Brief lenders on the difference between subprime lending and predatory lending. Make sure they understand the difference and that subprime can be important for the CRA program.
- Add the "exchange of value" concept to lender training. Get them thinking about what the customer values in the loan transaction.
- Audit your refinancing practices. Make sure they do not fall into the zone of loan flipping. A good refinancing offers a clear benefit to the borrower.
Copyright © 2001 Compliance Action. Originally appeared in Compliance Action, Vol. 6, No. 2, 2/01
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