The Latest On Redlining & Predatory Lending

Predatory lending has been front and center for several years - and it is staying there. In fact, predatory lending is becoming a gravitational force for several lending practices of concern, including discrimination, unfair or deceptive trade practices, and more specific predatory actions such as equity stripping or loan flipping. Now, reverse redlining is also part of the line-up.These practices, and others, have been the focus of enforcement actions by the regulatory agencies and by the U.S. Department of Justice. Whether titled as fair lending cases or as unfair or deceptive trade practices, the DOJ is actively pursuing enforcement actions.

In addition to enforcement actions, there are several regulatory developments on the predatory lending front. There are the changes to Regulations C and Z that the Federal Reserve Board has issued. The OCC has issued two advisory letters on the topic - AL 2003-2 and AL-2003-3 - to strengthen the regulatory case against predatory lending practices.

In Advisory Letter 2003-2 the OCC provides guidelines for guarding against predatory and abusive lending practices. In advisory Letter 2003-3, the OCC describes the responsibility and liability of an institution when purchasing loans from other originators or originating loans through brokers or dealers.

The focus of both Advisory Letters is on dwelling-secured loans. When a predatory loan is secured by the borrower's primary dwelling, the borrower has the most to lose. However, the guidelines are appropriate for any other form of lending as well.

Defining Predatory Lending
While there are plenty of allegations and accusations, there is still no clear, agreed-upon definition of predatory lending. Each agency has tried to bring some clarity to the definition of predatory lending without including or excluding too much. What the regulators do agree on is that whether or not a loan is predatory has as much to do with the fact situation as the terms of the loan.

There is general agreement that one important element of predatory lending is making the loan without regard to the borrower's ability to service and repay the loan under the terms of the credit contract. Instead, the worst predatory lenders rely on the value of the property rather than the borrower's ability to repay the loan. In this situation, the lender is counting on the ability to foreclose on the property rather than collect payments on the loan. Such a loan is made with the intent and expectation that the borrowers will lose their property.

The OCC identifies several characteristics that are common to predatory loans. One such characteristic that has not yet been given much attention is aggressive marketing tactics. OCC describes a fundamental characteristic of predatory lending as "aggressive marketing of credit to prospective borrowers who simply cannot afford the credit on the terms being offered." Unaffordability, or the consumer's inability to repay the credit, has generally been agreed upon as a core element of predatory lending. The aggressive marketing of such products is now also part of the equation.

OCC's bulletins describe several practices that are of concern under the umbrella of predatory lending. Loan flipping - frequent renewals or rewrites of the loan that result in excessive and unnecessary origination costs for the borrower - has been much discussed. Packing - the practice of hiding fees and charging excessive fees - goes hand in hand with loan flipping as a means of maximizing the profit to the lender.

Other practices, including balloon payments and negative amortization, make it difficult or impossible for the borrower to repay the loan when it matures. This effectively leaves the consumer trapped by the lender who is able to coerce the consumer into renewing the loan with additional predatory terms and costs.

One practice that has received less attention is refinancing a special rate loan at market or above market rates. When consumers acquire equity in their home, purchased through a program such as Habitat for Humanity or with special local or state government interest subsidy programs, they are often targeted by predatory lenders who tempt them with the notion of taking out equity as cash. In the process, the consumer loses the favorable and affordable loan terms and frequently ends up being unable to afford the new credit.

This type of predatory lending, particularly when it is directed at neighborhoods where special forms of equity financing and interest subsidies have been put into play to turn around the quality of the neighborhood, is the genesis of the term reverse redlining.Consumer advocates have put forward the notion of requiring lenders to determine the consumer's existing loan terms and to ensure that any new loan is not less affordable. This idea was also raised in the discussion of ways to enhance HMDA reporting. While it did not turn in to a regulatory requirement, responsible lenders should give attention to the loan terms that would be replaced.

Preventing Predatory Lending
FNMA and FHLMC have taken steps to limit the risk of predatory loans in their portfolios. These companies have put purchase guidelines into place that are designed to identify loans that could be predatory. These include:

Loans that lack documentation of the borrower's ability to repay;
Loans with points and fees in excess of 5% of the loan amount;
Loans with an amount financed that includes a single premium credit insurance policy;
Loans with unacceptable prepayment penalties; and
Lenders that do not report credit payments.

Any institution that intends to sell mortgages on the secondary market should follow these standards. In fact, any institution that wants to be a responsible lender should look to these criteria as a guide for measuring their own practices.

Best Practices
The OCC recommends several practices that should be a part of any national bank's lending compliance program. (As noted above, we recommend these practices for other financial institutions as well.) You can expect examiners to look for these practices and the documentation that accompanies them.

First, give attention to underwriting policies. Your underwriting policies should lay a clear foundation for responsible rather than predatory lending. Each lender should be held to a standard that requires evaluating and verifying enough information to determine that the borrower has the capacity to repay the loan and related costs such as taxes and insurance.

The loan file should contain documentation showing that the loan officer considered the applicant's current and expected income (in full compliance with the income rules of Regulation B), other financial resources, employment status, and financial obligations. Underwriting (and documentation) should include consideration of the debt-to-income and loan-to-value ratios.

In outlining these minimum requirements for responsible lending, the OCC bulletin notes that safety and soundness guidelines require a national bank to "establish and maintain loan documentation practices that...[i]dentify the...source of repayment, and assess the ability of the borrower to repay the indebtedness in a timely manner." 12 CFR 30, Appendix A. Documentation is not simply compliance; it is safe and sound lending.

In addition to the underwriting considerations, the OCC states that institutions should avoid practices that have been identified as predatory. These include prepayment penalties that are not limited to the early years of the loan, loans with balloon payments and/or negative amortization, single-premium credit life insurance, financing points and fees, and making loans subject to HOEPA.

Consumers should be provided with information about the terms of credit. This should be presented in a way that "is sufficient to draw the borrower's attention to" terms that may be predatory. Disclosures should enable customers to decide for themselves whether the credit product being offered meets their financial needs and capabilities.

This concern about disclosure to consumers can be read as simply warning lenders to comply with Truth in Lending and RESPA. However, the Comptroller of the Currency has publically stressed the importance of clear, understandable, and timely information given to customers. Lenders should be able to provide disclosures and help customers understand how to use the information.

Finally, the OCC recommends that lenders have a form of suitability analysis before making loans. This would include an evaluation of the relative sophistication of the borrower in the context of the credit transaction, the borrower's need for or proposed use of the loan proceeds, and the borrower's and creditor's understanding of how the credit product meets his or her needs - or doesn't.

Suitability analysis places additional responsibility on the lender to at least assess the financial sophistication of the borrower.To check the effectiveness of policies and determine what actually happens, the OCC recommends loan quality reviews on a regular basis.

Purchased Liability
Many institutions assume that if they didn't originate the loan, but merely bought it (after the predatory damage was done) they cannot be held responsible. Wrong! OCC's Advisory Letter 2003-3 lays out the responsibility of lenders that purchase loans. OCC recommends that before purchasing loans, national banks should perform due diligence on third parties, both brokers and lenders. Due diligence reviews should include background checks for reputation and business practices, general competence, and internal controls.

Agreements with third parties - especially anyone originating loans for the institution - should specify rights and responsibilities - to include compliance with regulations and best practices. Institutions should also monitor and audit the performance and quality of the loans purchased. In short, the fact that someone else originated the loan or held the face-to-face meeting with the customer does not reduce or remove liability from the purchasing institution.

Enforcement
Both Advisory Letters contain clear statements of the OCC's authority to take enforcement action under the FTC Act to stop predatory lending. Both letters also contain the OCC's statement of intent to do so. The authority that the OCC relies upon for such enforcement is applicable to all chartered financial institutions. State-chartered member and non-member banks would be subject to the same enforcement authority of their regulatory agencies.

ACTION STEPS

Audit a sample of loans and assess the quality of documentation in the loan files.
Then compare the loan decisions, especially by terms and pricing, to the concerns raised by the OCC and the measurements set by FNMA and FHLMC.
Now review your loan policy. Look for allowable practices and practices that aren't prohibited that could result in predatory lending.
Revise the loan policy as appropriate and include specific requirements for minimum documentation.
Brief lending staff on the current concerns about predatory lending and the elements in the OCC bulletins. Make sure they understand the importance of the documentation standards.
Hold training on how to explain the information in Truth in Lending and RESPA disclosures to customers.