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Predatory Lending: Lessons Learned
In 2002, an enforcement action involving predatory lending was brought by the Federal Trade Commission and several state attorneys general. The case against First Alliance Mortgage Company. We can learn valuable lessons from this case.
First Alliance, organized to do business in several states, marketed a mortgage product to sub-prime consumers. Loans made by First Alliance were generally first mortgages that refinanced existing mortgages on the consumer's homes.
First Alliance's target customers usually had poor or inadequate credit histories - customers who would experience difficulty in obtaining conventional financing. The target customers were generally not sufficiently sophisticated in lending terminology to identify the deception and contradictions in the First Alliance sales presentation.
Misrepresentations
Having targeted a consumer with poor credit and high equity in their home, First Alliance lenders were trained to represent their product by making statements such as "you are prequalified to receive up to $X." The loan has "no application fees," "no up-front appraisal fees," "low rates," "no out-of-pocket expenses" and "low payments."
In reality, the company did impose loan costs - lots of them. Borrowers typically paid between 10% and 25% of the amount financed.
To make matters worse, the product was a discounted variable rate loan. The terms and limitations of the discount were not explained. Instead, the discounted period was used to deceive consumers. For example, lenders used the discounted period to illustrate the "low payment" without explaining the circumstances and timing - and inevitability of payment increases. They also refrained from explaining that the loan had a floor and the rate would never fall below the initial payment even if the index did.
Mis-using Truth in Lending
One interesting aspect of the case brought by the FTC is that the agency used Truth in Lending disclosures to measure and prove unfair and deceptive practices. Truth in Lending disclosures are intended to provide consumers with information to understand the cost of the loan and to compare the costs of different loan offerings. First Alliance subverted that purpose and use Truth in Lending disclosure to deceive customers. First Alliance did this by representing disclosures, such as the "Amount Financed", to stand for something other than what it actually was.
The company's lenders explained to borrowers that the "Amount Financed" was "the total amount of money that you will borrow." This effectively concealed the fact that the borrowers were also borrowing and financing the prepaid finance charges.
The sales talk also failed to properly represent the discount and rate cap features of the loan. Consumers were told that the rate would change based on the LIBOR index; that the rate on the loan would rise and fall with the index. In reality the rate would rise based on the discount period and also on increases in the LIBOR index. Rates would fall with the index but only to the extent that the floor was reached. If the index fell below the loan's rate floor, the rate would not continue to follow the index down.
As a final violation of Truth in Lending, FTC cited the company for failing to provide consumers with the required booklet, "Consumer Handbook on Adjustable Rate Mortgages."
Consequences
The mortgage company and its principal owners are required to make restitution to all affected consumers. This may run as high as $60 million. The company (which is currently in bankruptcy) and its principals are enjoined from engaging in mortgage lending for a period of at least 10 years.
This case is likely to have a powerful ripple effect. It demonstrates the extent of predatory lending and proves the damage to consumers. This can only add fuel to the already hot fires of concern. It will also make it difficult to argue against any regulatory developments intended to restrict or prohibit predatory lending.
The responsible lending industry can respond to this case not only by being a responsible lender, but by using consumer disclosures as education tools. The more consumers know about and understand TIL disclosures, the more consumers are empowered to stop predatory lenders.
The loan officers at First Alliance actually told customers to ignore their Truth in Lending disclosures by saying it was just something required by the government. Financial institutions making responsible and fair loans to consumers should advise consumers how to use and understand the Truth in Lending disclosure. That makes regulation work for the consumer in the way it is intended.
ACTION STEPS
- Review with loan officers how they present and explain terms and conditions of loans. Evaluate this in the context of predatory lending.
- Develop scripts to explain key loan terms to consumers and train your lenders on the use of these scripts.
- Brief management on the key elements of this case. This is an ideal opportunity to drive home the regulators' concern about predatory lending.
Copyright © 2002 Compliance Action. Originally appeared in Compliance Action, Vol. 7, No. 4, 5/02
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