Yves here. Black gives an excellent discussion of why the Trump Administration plans to gut payday lender restrictions are so destructive, as well as on the general importance of requiring that lenders be able to document that they had good reason to think the borrower would be able to repay the loan.
However, I have one quibble with his piece, which is his discussion of pre-crisis adjustable rate mortgages with rate resets. We discussed those at nauseating length before and during the crisis, studying huge analyses by CoreLogic (and objecting to their rosy conclusions) and the works of the sainted Tanta, among many other important sources back in the day.
The purpose of rate resetting ARMs was not to get borrowers in over their heads, at least not for a while. The entire premise of the rate resetting ARM was to get the borrower to refi before or shortly after the rate reset. I don’t know where Black got the idea that there were prepayment penalties on theses loans. Most subprime loans were securitized, so the originators/packagers were indifferent to performance. However, being able to sell new loans and collect all those fees again in a short period of time was an extremely attractive proposition. The tacit assumption was that housing prices would continue to rise, or at least not fall, and that even if the new mortgage terms would not be as good as the former “teaser” rate, they’d still be better than if the borrower sat pat and took the hit of seeing their mortgage go from 2% to 7% (a not uncommon jump).
In addition, the subprime lenders would often succeed in persuading borrowers to refi their loans with a higher loan balance, which they could do in as little as eighteen months back in the bubble years because home prices were rising rapidly in many markets. More than 50% of the subprime mortgages in 2005 to 2007 were “cash out refis,” meaning the borrower was paying off an old mortgage with a new one with an even bigger balance. That meant he was effectively pulling equity out of his house.
As we also discussed in those hoary old days, Countrywide, which before its sale to Bank of America had the best call center and servicing platform of any mortgage lender (not that they used those capabilities to good ends) would call their subprime borrowers who’d taken teaser rates six months into the mortgage and tell them that a reset was imminent to get them to refinance sooner.
By Bill Black, the author of The Best Way to Rob a Bank is to Own One, an associate professor of economics and law at the University of Missouri-Kansas City, and co-founder of Bank Whistleblowers United. Jointly published with New Economic Perspectives
Kate Berry, the American Banker reporter that covers consumer financial protection, has written another important article about the continuing horror story of Trump’s increasingly successful efforts to pervert the Consumer Financial Protection Bureau (CFPB) into an agency dedicated to harming consumers and protecting our Nation’s most predatory lenders. Unfortunately, her January 14, 2019 article is behind a paywall.
The Predatory ‘Sweet Spot’
The context is one of the CFPB’s most important and useful anti-predatory lending rules by payday lenders. Payday lenders often charge working class Americans interest rates well above 100 percent. (In Missouri, a hotbed of predation, they can charge more than 500 percent.) The ‘sweet spot’ for payday lenders is borrowers who will be unable to repay promptly the initial loan (with an obscene, but vastly lower initial interest rate). This sets off a cycle of additional borrowing and extending of payday loans that places the borrower into a debt spiral that frequently results in bankruptcy. Payday lenders, who exist to predate on customers, make their extraordinary profits largely from borrowers who cannot repay the initial payday loan when it comes due, but have some income and will continue to reborrow and attempt to repay for months. Predatory payday lenders optimize by finding this ‘sweet spot’ of those who have enough income and a compelling intent to repay – but not enough income to pay off the entire series of loans.
Kate Berry’s article reports that Kathy Kraninger, Trump’s new CFPB head (with no experience in consumer financial protection), intends to junk the CFPB rule provisions requiring that payday lenders underwrite their loans by documenting the borrower’s ability to repay the loan when due. She also intends to act to protect the predators’ ‘sweet spot.’ Berry reports that Kraninger also intends to optimize the predators’ ‘sweet spot.’
The latest proposal also is expected to rescind limits that the rule placed on repeat reborrowings by a single consumer; the CFPB’s data shows that payday lenders rely on reborrowings as a major source of revenue.
The two points, capacity and reborrowing, are predatory kissing-cousins. Predatory lenders’ targets reborrow because they lack the capacity to repay the initial loan when it comes due.
Predation and Fraud in the GFC Based on Not Documenting Capacity to Repay
This ‘sweet spot’ strategy is a signature of predatory lending because it optimizes the CEO’s ‘take’ from ‘control fraud’ and predation. “Exploding rate ARMs” were a common late-game strategy in the run-up to the Great Financial Crisis (GFC). An exploding rate ARM was an adjustable rate mortgage with a monthly payment so low that it did not even pay the interest currently due on the mortgage. (In jargon, it was “negatively amortizing.”) This meant that the principal amount of the mortgage debt increased every month. The mortgage contract provided that after three-to-five years (sooner had there been high inflation) the monthly mortgage payment would ‘reset’ (adjust upward) – often doubling the monthly payment. The lenders’ CEOs understood, of course, that this would cause loan defaults and foreclosures to reach tsunami levels.
The defaults were particularly high because the predatory lenders consistently ‘qualified’ the borrower as (purportedly) having sufficient income to repay the loan based on the initial monthly payment – not the 2X reset payment. Indeed, many of them purported to ‘qualify’ the borrower based on a ‘teaser’ interest rate (that last only for one month or three months). The teaser rate produced an initial monthly payment that was exceptionally low. The lenders’ CEOs gamed the ‘qualifying’ standard for the sole purpose of making it appear that borrowers who typically lacked the income to repay the ‘fully indexed’ interest rate had the ability to do so.
Why did the predatory CEOs make exploding rate ARMs their most common mortgage product as the housing bubble was fast approaching its peak? First, it let them loan to millions more people who could not afford to repay their loans – and disguised that fact. Extremely fast growth is the first ‘ingredient’ in the ‘recipe’ for ‘accounting control fraud.’ (See my many columns if this point is new to you).
Second, it slowed down defaults, which is critical to lengthening the ‘sweet spot’ strategy’s period of success. Paying one-half the ‘fully indexed’ monthly payment is obviously far easier, particularly for borrowers with modest incomes. As long as the loan does not default, the accounting alchemy I describe next continues.
Third, accounting is nearly always the ‘secret sauce’ in financial fraud and predation ‘recipes.’ The predatory exploding rate ARM lending CEOs’ were invariably able to suborn top tier audit partners to allow the lender to book currently as income payablethe fully indexed(i.e., 2X) interest rate the borrower was contractually committed to paying (eventually). Of course, given the immense defaults certain on exploding rate ARMs as soon as the bubble stalled, the borrowers would frequently have no ability to pay the monthly payment when the interest rate doubled. Lenders called this ‘phantom interest’ because they got to treat it for GAAP accounting purposes as current income even though they frequently would never receive the additional cash from the borrowers when they defaulted in droves when their monthly payments doubled. Phantom interest became massive – producing tens of billions of dollars in largely phony income to predatory lenders – and billions of dollars in real bonuses to bank officers.
Fourth, the predatory exploding rate ARM loans typically had a substantial ‘prepayment penalty’ (very unusual for U.S. home mortgages) that the CEOs designed to lock in victims of their predation. Americans can usually get out of mortgage agreements in which they have agreed to pay too high a rate of interest by refinancing their mortgage without any prepayment penalty. The CEOs of the predatory lenders foreclosed that option (pun intended) so that they could maintain their accounting magic.
Similarly, the CEOs of fraudulent lenders used ‘liar’s’ loans as one of their two primary loan origination fraud strategies. (The other was fraudulently inflated appraisals. The Trump administration is aggressively making finance more criminogenic by reducing appraisal requirements.) Fraudulent CEOs designed liar’s loans to make loans to people who lack the actual capacity (income) to repay the loan while providing a fig leaf of fictional capacity through false ‘stated income.’ Recall that investigators concur that it was the lenders’ officials and their agents that put the lies in liar’s loans.
Dodd-Frank and the CFPB
All of these terrible experiences occurred contemporaneously during the creation of the GFC. They all involved ignoring one of the three ‘Cs’ of loan underwriting – capacity. (The other “Cs” are collateral and credit history.). The three contemporaneous nightmares of lenders ignoring the borrower’s capacity to repay the loans drove home to Congress in their creation of the Dodd-Frank the need for federal requirements that lenders establish through underwriting the borrower’s capacity to repay the loan. Congress created the CFBP largely to address this central problem of predation and its ability to generate a Gresham’s dynamic.
The CFPB payday lender rule and the more general Dodd-Frank provisions requiring that borrowers have the real capacity (income) to repay the loans obviously helps the borrower by dramatically reducing defaults and foreclosures. Requiring capacity to repay the loan, however, is also vital to protect honest, non-predatory lenders from the ‘Gresham’s’ dynamic that fraudulent and predatory CEOs generate. When cheats and predators gain a competitive advantage over honest, ethical business rivals, market forces become perverse and drive good ethics from the markets and professions. One of the best things capable regulatory and prosecutorial bodies do is to block this Gresham’s dynamic by taking action to prevent a Gresham’s dynamic. Such a regulatory action is a win-win for consumers and honest business people. When a field of business acts to block such a regulatory win-win it is certain that control frauds and predators dominate that field of business.
The Obama-era CFPB payday lending rule was aimed at preventing a Gresham’s dynamic by requiring that payday lenders underwrite prior to lending to ensure that the borrower had the capacity (income) to repay the loan when it came due. It banned the ‘sweet spot’ through that provision and the limit on reborrowing. It was a brilliant rule that exemplifies much of what modern economics, white-collar criminology, and psychology teach. Naturally, the Trump official installed to gut the CFPB, has targeted the most essential parts of the rule – capacity and reborrowing – for elimination. Kraninger’s goal is to restore the predatory payday lenders’ ability to exploit the ‘sweet spot’ of targeting borrowers who will be unable to repay the initial loan. The predators’ goal is to identify and catch those who fall in the sweet spot in a debt trap and a spiral into (eventual) bankruptcy. She is deliberately making the financial environment for payday lenders far more pathogenic. She is also making a mockery of Republican demands for regulatory actions based on research and data. She exemplifies Bastiat’s twin observations about protecting consumers from predation. Bastiat noted that the predators would always seek to corrupt the government to aid rather than prevent the predators’ abuse of the consumer.
Treat all economic questions from the viewpoint of the consumer, for the interests of the consumer are the interests of the human race.
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When plunder becomes a way of life for a group of men in a society, over the course of time they create for themselves a legal system that authorizes it and a moral code that glorifies it.