1. The Regulation of Subprime Lending Todd J. Zywicki Professor of Law George Mason University School of Law Research Fellow, James Buchanan Center Program on Politics, Philosophy, and Economics

2. Overview Understanding the Subprime Market Understanding the Subprime Market Benefits of Subprime Lending Benefits of Subprime Lending Risks of Subprime Lending Risks of Subprime Lending Regulating the Subprime Market Regulating the Subprime Market

3. Growth of Subprime Market 1994-2005: 1994-2005: $35 billion => $600 billion $35 billion => $600 billion 5% of all mortgage originations => 20% 5% of all mortgage originations => 20% Still, as of 2005: Still, as of 2005: 33% of homes owned free and clear 33% of homes owned free and clear 57% traditional fixed-rate mortgages 57% traditional fixed-rate mortgages 10% ARMs 10% ARMs Very Young Market: Recent Turmoil on Wall Street Very Young Market: Recent Turmoil on Wall Street

4. What is “Subprime”? “Weak credit repayment history or credit characteristics that indicate reduced repayment capacity, such as high debt-to-income ratios” “Weak credit repayment history or credit characteristics that indicate reduced repayment capacity, such as high debt-to-income ratios” Low or No Doc: Have credit characteristics of prime but can’t provide full documentation of income and assets (such as self-employed) Low or No Doc: Have credit characteristics of prime but can’t provide full documentation of income and assets (such as self-employed)

5. What is “Predatory Lending”? Asset-Based Lending: Making unaffordable loans based on the assets of the borrower (collateral) rather than on the borrower’s ability to repay Asset-Based Lending: Making unaffordable loans based on the assets of the borrower (collateral) rather than on the borrower’s ability to repay Loan Flipping: Inducing repeated refinancing in order to charge high points and fees each time the loan is refinanced Loan Flipping: Inducing repeated refinancing in order to charge high points and fees each time the loan is refinanced Fraud and deception: Inflating property appraisals, doctoring loan docs, “bait and switch” terms, failure to disclose Fraud and deception: Inflating property appraisals, doctoring loan docs, “bait and switch” terms, failure to disclose Excessive Fees: Often not disclosed thoroughly Excessive Fees: Often not disclosed thoroughly Excessive Interest Rates Relative to Risk: “Steering” borrowers to higher-rate loans Excessive Interest Rates Relative to Risk: “Steering” borrowers to higher-rate loans “Unfairly” Burdensome Prepayment Penalties “Unfairly” Burdensome Prepayment Penalties Balloon payments: Often combine low monthly payment with inadequate disclosure of balloon Balloon payments: Often combine low monthly payment with inadequate disclosure of balloon Challenge: Separating Risk-Based Pricing from Predation Challenge: Separating Risk-Based Pricing from Predation

6. Peculiarities of Subprime Market Higher Costs Higher Costs Underwriting Underwriting Servicing Servicing Prepayment Risk: Three times more common Prepayment Risk: Three times more common Prepayment in Prime: changes in interest rates Prepayment in Prime: changes in interest rates Prepayment in Subprime: Improvement in FICO Prepayment in Subprime: Improvement in FICO Subprime twice as likely to prepay if no penalty Subprime twice as likely to prepay if no penalty Documentation and Income Documentation and Income Historically Specialized Lenders Historically Specialized Lenders Use of Brokers Use of Brokers Questionable Characters: Lenders and Borrowers Questionable Characters: Lenders and Borrowers

7. Types of Subprime AA: No 60 day late credit cards, 1 thirty day late mortgage or, No 60 day late AA: No 60 day late credit cards, 1 thirty day late mortgage or, No 60 day late A-minus: missed one mortgage payment or two credit card payments in last two years A-minus: missed one mortgage payment or two credit card payments in last two years Alt-A: similar credit histories by less documentation of income or assets or unusual collateral characteristics Alt-A: similar credit histories by less documentation of income or assets or unusual collateral characteristics B: 4 30 day late mortgage (or 2 30 and 1 60), 0 60 day late in past 12 months, 1 60 day late in past 24 months, no foreclosure proceedings in last 24 months B: 4 30 day late mortgage (or 2 30 and 1 60), 0 60 day late in past 12 months, 1 60 day late in past 24 months, no foreclosure proceedings in last 24 months C: 6x30, 1x60, 1x90 or 6x30, 2x 60, and 0x90 C: 6x30, 1x60, 1x90 or 6x30, 2x 60, and 0x90 D: Exceeds C, Recent Bankruptcy D: Exceeds C, Recent Bankruptcy 70% of subprime are A-minus or Alt-A 70% of subprime are A-minus or Alt-A

8. Basic Terms: Option One Grade (Option One Grade Names Differ) Grade (Option One Grade Names Differ) FICO Score FICO Score Region Region LTV (Sliding Scale, Min & Max Depending on FICO Score) LTV (Sliding Scale, Min & Max Depending on FICO Score) Full Doc or Lite Doc Full Doc or Lite Doc Based on 2 year Fixed, 2 year prepay limitation, Single Family Home Based on 2 year Fixed, 2 year prepay limitation, Single Family Home

9. Adjustments Fixed or Longer Fixed Period (3 year, 5 year ARM) Fixed or Longer Fixed Period (3 year, 5 year ARM) 40 or 50 year Amortization 40 or 50 year Amortization Interest Only Interest Only No Documentation No Documentation Disposable Income Disposable Income Cash Reserves Cash Reserves First Time Home Buyer First Time Home Buyer 10% Downpayment 10% Downpayment State Prepay Legal Prohibitions State Prepay Legal Prohibitions Type of Property (Condo, Second Home) Type of Property (Condo, Second Home)

10. Benefits of Subprime Growth Increased Home Ownership Increased Home Ownership Wealth Accumulation Wealth Accumulation Wealth Equality Wealth Equality Access to Alternative Credit Access to Alternative Credit

11. Home Ownership

12. Change in Homeownership

13. Wealth Accumulation

16. Wealth Equality by Race Differences between Owners and Renters within Races are much larger than differences between races: White Households are about 2-1/2 wealthier than other races, but homeowners about 30 times wealthier (black homeowners are 36.5 times wealthier than renters) Differences between Owners and Renters within Races are much larger than differences between races: White Households are about 2-1/2 wealthier than other races, but homeowners about 30 times wealthier (black homeowners are 36.5 times wealthier than renters)

17. Wealth Accumulation

18. Wealth Equality Housing Wealth is more broadly distributed than financial (stock) wealth. Housing Wealth is more broadly distributed than financial (stock) wealth. White families have four times as much stock wealth (median) as blacks and hispanics but only twice as much home equity wealth (median) White families have four times as much stock wealth (median) as blacks and hispanics but only twice as much home equity wealth (median)

19. Housing and Rent Risk Todd Sinai and Nicholas S. Souleles, “Owner-Occupied Housing As A Hedge Against Rent Risk,” Q. J. Econ. (2005) Todd Sinai and Nicholas S. Souleles, “Owner-Occupied Housing As A Hedge Against Rent Risk,” Q. J. Econ. (2005) Homeowners Balance Two Risks Homeowners Balance Two Risks Rent Risk (variation 2.9% per year): Rent Risk (variation 2.9% per year): Homeownership and housing prices higher where rent price volatility rises Homeownership and housing prices higher where rent price volatility rises Effect greatest when rent higher portion of income Effect greatest when rent higher portion of income Asset Price Risk: Ownership higher where time horizons longer Asset Price Risk: Ownership higher where time horizons longer

20. Homeownership and Credit

21. More Credit Options Renters have Renters have More Student Loan Debt More Student Loan Debt More Automobile Debt More Automobile Debt More Credit Card Debt More Credit Card Debt

22. Causes of Rising Ownership Federal Reserve Bank San Francisco (Nov. 3, 2006): “We find that… it is likely that much of the increase is due to innovations in the mortgage finance industry that may have helped a large number of households buy homes more easily than they could have a decade ago.” Federal Reserve Bank San Francisco (Nov. 3, 2006): “We find that… it is likely that much of the increase is due to innovations in the mortgage finance industry that may have helped a large number of households buy homes more easily than they could have a decade ago.”

23. Risks of Subprime: More Debt

24. Alan Greenspan “Some of the rise in the ratios of household debt to income may not be evidence of stress. The dramatic increase during the past decade in home purchases by previous renters has expanded both the assets (that is, owned homes) and the liabilities (mortgages) of the total household sector without significantly affecting either overall household income or net worth. “Federal Reserve staff members estimate that approximately one-tenth of current home mortgage debt outstanding, or almost 1 percentage point of the average annual growth of home mortgage debt, is attributable to renters who have become homeowners since the early 1990s. “One can scarcely argue that those previous renters are less well off since becoming homeowners; yet, all else being equal, the overall household debt as a percentage of income is 8 percentage points higher currently than it presumably would have been had the homeownership ratio been stable since 1992.”

25. Risks of Subprime

26. Delinquency

27. ARM v. Fixed

28. Foreclosure: Caveats Foreclosure still primarily driven by local economic conditions: Foreclosure still primarily driven by local economic conditions: Foreclosures highest in Michigan, Ohio, and Indiana (Automobile Industry) Foreclosures highest in Michigan, Ohio, and Indiana (Automobile Industry) Mississippi and New Orleans (Hurricanes) Mississippi and New Orleans (Hurricanes) Dramatic growth in Subprime loans for Nonowner- occupied homes: second homes and investment speculation (HMDA Data) Dramatic growth in Subprime loans for Nonowner- occupied homes: second homes and investment speculation (HMDA Data) 1990-2005: 6.6%-17.3% 1990-2005: 6.6%-17.3% 2001-2005: 8.6%-17.3% 2001-2005: 8.6%-17.3% Economics of Foreclosure and Delinquency: Economics of Foreclosure and Delinquency: Option: Default if Property Values Fall Option: Default if Property Values Fall Duress: Default if Can’t Pay Duress: Default if Can’t Pay Option and Duress are Related Option and Duress are Related

29. Deliquency Caveats Prime Market Delinquencies Prime Market Delinquencies 30 days: 1.73% 30 days: 1.73% 60 days: 0.31% 60 days: 0.31% 90 days: 0.28% 90 days: 0.28% Subprime Market Subprime Market 30 days: 7.35% 30 days: 7.35% 60 days 2.02% 60 days 2.02% 90 days: 4.04% 90 days: 4.04% Can only be true if borrowers fall behind, miss three payments and then beginning to pay again without making up all the missed payments immediately. Can only be true if borrowers fall behind, miss three payments and then beginning to pay again without making up all the missed payments immediately. Suggests subprime borrowers are essentially using missed payments as a source of short-term, fixed-rate line of credit. Suggests subprime borrowers are essentially using missed payments as a source of short-term, fixed-rate line of credit.

30. Macroeconomic Risks Diversification: House Markets and unemployment (human capital) correlated Diversification: House Markets and unemployment (human capital) correlated May stifle labor market flexibility/mobility May stifle labor market flexibility/mobility Ripple Effects on Related Markets: Ripple Effects on Related Markets: Construction and employment Construction and employment Home Depot Home Depot May be more unsteady than Prime: May be more unsteady than Prime: Risk-preferring consumers Risk-preferring consumers Consumer Default Option Consumer Default Option

31. Regulatory Responses Need to Specify Regulatory Goals and Tradeoffs Need to Specify Regulatory Goals and Tradeoffs Substantive Regulation Substantive Regulation Disclosure Regulation Disclosure Regulation Common Law Common Law Competition Competition

32. Substantive Regulation Intended Effects Intended Effects Unintended Effects Unintended Effects Term Substitution/Repricing: Heterogeneity of Subprime Loans Term Substitution/Repricing: Heterogeneity of Subprime Loans Product Substitution Product Substitution Rationing Rationing

33. Regulation and Rationing “Predatory Lending Laws Can Cause Headaches,” Parma Sun Post (July 10, 2003): When David Sanderson recently applied to a lender for a second mortgage, he was denied for an unusual reason. Undeterred, he went to another lender and was denied again. Same thing happened at a third institution. In all three cases, he was given the same reason for the denial—the lenders thought he lived in Cleveland and claimed that the city’s anti-predatory lending law prevented them from giving him the loan he needed. *** Since Cleveland’s anti-predatory lending law caps interest charges, some lenders don’t give second mortgages or home-equity loans to Cleveland residents having potential credit risks. But Sanderson lives in Fairview Park, a small, inner-ring suburb west of Cleveland. “When we were applying for loans, the companies would key in our zip code, and Cleveland would come up, he said.*** Desperate for a solution, Sanderson contacted his suburb’s City Hall. Fairview Park Mayor Eileen Patton wrote a letter on his behalf, verifying he was a resident of the suburb. “Her inquiry into the matter must have accomplished something, because we received a call from one of the companies that initially turned us down, and offered to finance us,” Sanderson said. “Sometimes it pays to e-mail the mayor.” Patton said she and City Council have received similar requests from six other residents who encountered the same problem as Sanderson’s.

34. Empirical Studies State and local anti-predatory lending laws lead to reduction in volume of high-cost loans State and local anti-predatory lending laws lead to reduction in volume of high-cost loans More restrictive/severe laws lead to larger reductions in loan originations for high-cost loans (riskiest borrowers): Range from 26% (NC) to 94% (NM) More restrictive/severe laws lead to larger reductions in loan originations for high-cost loans (riskiest borrowers): Range from 26% (NC) to 94% (NM) Less impact on non-high-cost subprime (less risk subprime borrowers) Less impact on non-high-cost subprime (less risk subprime borrowers) Reduction in originations a result of reduction in applications (rejection rate actually falls) Reduction in originations a result of reduction in applications (rejection rate actually falls) Good or Bad? Reduce “Predatory” or Subprime? Good or Bad? Reduce “Predatory” or Subprime? Doesn’t control for term substitution Doesn’t control for term substitution

35. Improving Disclosures FTC study: http://ftc.gov/os/2007/06/P025505Mortga geDisclosureexecutivesummary.pdf FTC study: http://ftc.gov/os/2007/06/P025505Mortga geDisclosureexecutivesummary.pdf http://ftc.gov/os/2007/06/P025505Mortga geDisclosureexecutivesummary.pdf http://ftc.gov/os/2007/06/P025505Mortga geDisclosureexecutivesummary.pdf 26 In-Depth Interviews with their actual documents (half prime, half subprime customers) 26 In-Depth Interviews with their actual documents (half prime, half subprime customers) 819 tests with recent mortgage customers: compared forms with current disclosures (TILA, RESPA, GFE) and prototype alternative disclosures 819 tests with recent mortgage customers: compared forms with current disclosures (TILA, RESPA, GFE) and prototype alternative disclosures

36. FTC Study Results Current mortgage cost disclosures fail to convey key mortgage costs to many customers: loans more costly than believed or contained restrictions of which they were unaware Current mortgage cost disclosures fail to convey key mortgage costs to many customers: loans more costly than believed or contained restrictions of which they were unaware 2/3 didn’t recognize prepayment penalty 2/3 didn’t recognize prepayment penalty ¾ didn’t recognize optional credit insurance included ¾ didn’t recognize optional credit insurance included 25% couldn’t identify total settlement charges 25% couldn’t identify total settlement charges 1/3 couldn’t tell when settlement charges included in loan amount 1/3 couldn’t tell when settlement charges included in loan amount 1/3 didn’t recognize large balloon payment 1/3 didn’t recognize large balloon payment 90% couldn’t identify total up-front charges 90% couldn’t identify total up-front charges More errors with more complex loans More errors with more complex loans Prototype disclosures significantly increased consumer recognition of mortgage costs Prototype disclosures significantly increased consumer recognition of mortgage costs No fundamental differences between prime and subprime borrowers in ability to understand loan terms No fundamental differences between prime and subprime borrowers in ability to understand loan terms Prime 62.0% Correct v. Subprime 59.6% Prime 62.0% Correct v. Subprime 59.6%

37. Prototype Disclosures Based on Economic Theory and FTC Enforcement Actions Based on Economic Theory and FTC Enforcement Actions Better disclosures substantially increased consumer understanding Better disclosures substantially increased consumer understanding Comprehension rose from 61% average for current disclosures vs. 80% for prototype disclosures Comprehension rose from 61% average for current disclosures vs. 80% for prototype disclosures 80% of respondents viewing prototype could answer 70% of questions correctly, versus 29% under current forms 80% of respondents viewing prototype could answer 70% of questions correctly, versus 29% under current forms Improvement largest for more complex loans Improvement largest for more complex loans Improvement of 22 percentage points complex loans and 16 simple Improvement of 22 percentage points complex loans and 16 simple Improvement of 21.6 percentage points for prime borrowers and 22.4 percentage points for subprime borrowers for complex loans Improvement of 21.6 percentage points for prime borrowers and 22.4 percentage points for subprime borrowers for complex loans 66 percentage point increase in recognition of total up-front charges 66 percentage point increase in recognition of total up-front charges 43 percentage point increase in recognition of optional credit insurance 43 percentage point increase in recognition of optional credit insurance 24 percentage point increase in recognition of prepayment penalty 24 percentage point increase in recognition of prepayment penalty Lesson: Better Disclosures are Possible Lesson: Better Disclosures are Possible

38. Common Law Fraud Fraud FTC FTC Federal Reserve Federal Reserve

39. Education Government Programs: Assessment Government Programs: Assessment Purpose of Education? Purpose of Education? Prevent Fraud Prevent Fraud Make Market Work Better Make Market Work Better North Carolina Experiment North Carolina Experiment

40. Market and Contract How do we make market work better? How do we make market work better? How do we make subprime loans more homogeneous and more of a commodity? How do we make subprime loans more homogeneous and more of a commodity?

41. Assignee Liability Freddie Mac and Fannie Mae will not purchase loans defined as high cost in some states Freddie Mac and Fannie Mae will not purchase loans defined as high cost in some states Ratings services will not rate mortgage-backed securities transactions that contain high cost loans in some states or require additional credit enhancements for transactions that include high-cost loans Ratings services will not rate mortgage-backed securities transactions that contain high cost loans in some states or require additional credit enhancements for transactions that include high-cost loans Assignee liability would further raise risk of buying subprime loans Assignee liability would further raise risk of buying subprime loans Would likely reduce capital available for subprime market Would likely reduce capital available for subprime market Empirical evidence: Negative evaluation by a credit rating agency associated with a large decline in originations of high- cost loans and smaller increase in originations of non-high- cost loans Empirical evidence: Negative evaluation by a credit rating agency associated with a large decline in originations of high- cost loans and smaller increase in originations of non-high- cost loans Not clear that assignees can reasonably police this at low cost Not clear that assignees can reasonably police this at low cost Securitization may help to encourage subprime loans to be more homogeneous in terms: Assignee liability would reduce this Securitization may help to encourage subprime loans to be more homogeneous in terms: Assignee liability would reduce this

42. Suitability Would make lenders liable if they allow borrowers to take home mortgages that aren’t “suitable” or that “they can’t afford” Would make lenders liable if they allow borrowers to take home mortgages that aren’t “suitable” or that “they can’t afford” Based on securities law where seek to protect people of limited means from being sold securities that are too risky for them Based on securities law where seek to protect people of limited means from being sold securities that are too risky for them

43. Net Benefit? Jack Guttentag: “For there to be a net benefit, the borrower must have the mortgage long enough for the monthly cost reductions to exceed the upfront costs. Only the borrower has any idea of how long they want the mortgage…I recently reviewed a cash-out refinance in which the borrower paid about $12,000 in refinance costs and a quarter-percent rate increase in a loan of $150,000 to raise $4,500 in cash. Was there a net benefit? There is no objective way for the loan provider to answer the question. The price was very high, but maybe the borrower needed the cash to pay for life- saving medicine for his children.”

44. Suitability Are the following motives suitable for ARM or Interest Only Loan? Are the following motives suitable for ARM or Interest Only Loan? Reduce cash outflow to invest the excess in securities. Reduce cash outflow to invest the excess in securities. Reduce cash outflow to pay down a second mortgage. Reduce cash outflow to pay down a second mortgage. Pay principal when convenient. Pay principal when convenient. Buy more house. Buy more house. Reduce payment to avoid default. Reduce payment to avoid default.

45. Agencies Statement on Subprime OCC, Fed, FDIC, OTS, NCUA: June 29, 2007 OCC, Fed, FDIC, OTS, NCUA: June 29, 2007 Guidance, Not Proscriptive Guidance, Not Proscriptive Primary concern is “payment shock” not substantive terms: prepayment penalties, balloon payments, interest rate resets, lack of escrow for taxes and insurance Primary concern is “payment shock” not substantive terms: prepayment penalties, balloon payments, interest rate resets, lack of escrow for taxes and insurance Evaluate borrower’s ability to repay at fully indexed rate not just intro rate Evaluate borrower’s ability to repay at fully indexed rate not just intro rate Improve Disclosures Improve Disclosures Limit use of reduced-documentation loans Limit use of reduced-documentation loans Encourage workouts Encourage workouts Risk-layering Risk-layering Prepayment penalties should end at least 60 days prior to reset date Prepayment penalties should end at least 60 days prior to reset date Awareness that may limit lending versus payment shock Awareness that may limit lending versus payment shock