I happened to meet an official in the Fed’s Banking Supervision and Regulation division at a cocktail party this evening and chatted him up. He helped brief Roger Cole before met with the Senate Banking Committee last month to defend the Fed’s conduct regarding subprimes, so he is up to speed on this topic.
Readers may recall that I have been sympathetic towards the Fed in this case. The Fed’s charter focuses its attention towards the soundness of the currency and the safety and stability of banks. Consumer protection has never been one of its mandates. True, Congress did pass something called the Home Ownership Equity Protection Act in 1994, which increased the obligation of banks to report on subprime lending and also gave provided greater consumer protection for high cost borrowers in the subprime category. While the record shows that the Office of the Comptroller of the Currency took a much more active role than the Fed did in restraining the subprime lending of the banks it supervised, over half the originators were state-regulated mortgage brokers or finance companies, beyond the reach of either institution.
I was taken aback at what this individual said, and while he was not speaking in an official capacity, I have no reason to think his views were unrepresentative.
His view was that the Fed was not at all at fault in the subprime matter. He said that he disagreed with Roger Cole’s statement that in hindsight, the Fed could have done better. He said the Fed had enforced the laws that were in effect at the time (query why then did the OCC read and enforce HOEPA differently?).
He also asserted that there was a tremendous amount of consumer fraud, that the FBI was pursuing a lot of cases (if so, I wonder why this hasn’t been reported, since people like the Fed and the subprime originators would have every reason to present the institutions, rather than the consumers, as victims). In the narrow sense, there clearly was a lot of fraud, since in the “no doc” loans, a very high proportion of borrowers overstated their income by large amounts. But the implication of the Fed official’s statement was that the fraud was “fraud for profit” meaning the intent was to make off with money, as opposed to “fraud for housing” in which one gets to live in a house one shouldn’t on paper have. In “fraud for housing” a sensible lender will come out whole (even in a no-doc scenario, if the buyer makes a high enough down payment and the lender gets a realistic appraisal, it will come out fine even in a foreclosure, unless the local housing market falls out of bed). So despite the Fed guy’s aggrieved tone, it’s hard to see the lenders as victims.
Equally disturbing was his confidence that the markets were working fine. He noted that several banks had taken earnings hits, and that credit issuance was being tightened. He also said that subprimes had enabled a lot of people to buy housing who otherwise couldn’t have. I mentioned predatory lenders and he dismissed the Ameriquest case, in which the nation’s biggest home lender to people with poor credit agreed to pay $325 million to settle charges of fraud and overbilling. Many observers deemed this payment to be trivial when compared to the harm done to borrowers, some of whom lost their life’s savings. Only after some pressing did he accept the point that the products were difficult even for financially literate people to understand, and better disclosure was needed.
This “blame the poor” attitude seems almost Victorian. In the modern world, the rich need to present their wealth as legitimate, as the product of talent and hard work, as opposed to having the deck stacked in their favor. As a corollary, therefore, the poor have to be poor because they deserve it. Otherwise, the whole “wealth makes right” construct fails.
And this shift in attitudes is more recent than it might seem. Consider this 2002 speech by Fed Governor Edward M. Gramlich on predatory lending (as an aside, I can’t see the Fed of today even acknowledging the existence of predatory lending, since that means they might have to do something about it…..):
In my remarks today, I would like to address an issue that has been of critical concern to housing advocates across the country–predatory lending.
Over the past decade, there have been significant efforts to promote increased access to credit for homeownership by various government agencies, the mortgage industry, and community groups. Great progress has been made, as evidenced by new highs in homeownership rates for nearly all racial and income groups. Many factors have contributed to this success. In particular, advances in technology, increased competition, deregulation, and low interest rates have served as important catalysts in improving access to credit, particularly for lower-income and minority populations and communities. The result has been an expansion of the home mortgage market to a much broader socioeconomic range of borrowers.
Studies of urban metropolitan data submitted under the Home Mortgage Disclosure Act (HMDA) have shown that lower-income and minority consumers, groups that traditionally have had difficulty in getting mortgage credit, have been taking out housing loans at record levels in recent years. Specifically, the number of conventional home-purchase mortgage loans to lower-income borrowers nearly doubled between 1993 and 2000, whereas the number of loans to upper-income borrowers rose 66 percent. Also over the same period, the number of conventional mortgage loans increased 122 percent to African-American borrowers and 147 percent to Hispanic borrowers, compared with an increase of 35 percent to white borrowers.
Much of this increased lending can be attributed to the development of the subprime mortgage market. Again using HMDA data, the number of subprime home equity loans has grown from 66,000 in 1993 to 658,000 in 2000, a tenfold increase. Over this same period, the number of subprime loans to purchase homes increased nineteenfold, from 16,000 to more than 306,000. This rapid growth has given access to consumers who were not previously served by credit markets, either because they had difficulty in meeting the underwriting criteria of prime lenders or for other reasons.
However, the rise in the use of credit by lower-income homeowners has not come without cost. It has been accompanied by increasing reports of abusive, unethical, and in some cases illegal, lending practices. These reports raise questions about the numbers just presented, and more broadly, jeopardize the twin American dreams of owning a home and building wealth. These reports tell of lenders who extend credit to borrowers unable to repay the debt (so-called asset-based lending); repeatedly refinance, or “flip,” loans for the purpose of collecting fees; incorporate credit terms and products that are of questionable value to the borrower but significantly increase the cost of credit; and in some cases resort to outright fraud. These reports also tell of victims losing hard-earned equity in their homes and sometimes even losing their homes to foreclosure. Of particular interest to you today is that lenders often target elderly homeowners, who tend to have the highest levels of equity in their homes. Other groups that have disproportionately been prey for unscrupulous creditors are women, minorities, and lower-income households. The activities, referred to collectively as predatory lending, are a scourge on the mortgage industry.
Understanding Predatory Lending
In understanding the problem, it is particularly important to distinguish predatory lending from generally beneficial subprime lending. Predatory lending refers to activities and practices just cited–asset-based lending, loan flipping, packing of unnecessary fees and insurance, fraudulent or deceptive practices. Subprime lending, on the other hand, refers to entirely appropriate and legal lending to borrowers who do not qualify for prime rates, those rates reserved for borrowers with virtually blemish-free credit histories. Premiums for extending credit to these borrowers compensate lenders for the increased risk that they incur and range several percentage points over rates charged on prime loans. Although some have argued that these premiums are excessive, market forces should eliminate inappropriate spreads over time.
Some predatory lending involves outright fraud and deception, practices that are already illegal. But some predatory lending is more subtle, involving the misuse of conventions that most of the time can improve credit market efficiency. For example, the flexibility in loan rates that allows them to rise above former usury law ceilings is generally desirable in that it permits relatively risky borrowers to be matched with appropriate lenders. But sometimes the payments implicit in very high interest rates can spell financial ruin for borrowers. As another example, the ability to refinance mortgages allows borrowers to take advantage of lower mortgage rates, but sometimes easy refinancing invites loan flipping, which generates high loan fees and unnecessary credit costs. And again, credit life insurance is often desirable, but sometimes the insurance is unnecessary, and at times borrowers pay hefty up-front premiums as their loans are flipped…..
Note Gramlich’s confidence that competition would eliminate any excess premium charged to subprime borrowers. I wonder how he would explain what transpired.