Predatory Mortgage Lending and The Subprime Market

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If you turn on the TV these days then you know the US economy is in trouble.

Over the next few quarters, as the dirty laundry is aired out, we will be learning more and more about the depth and severity of our problems.

Many of the banks and lenders, with the most blood on their hands, have already started to report record losses and write offs.

Housing bubble

The problems in the real estate market stem from the housing bubble that has been created (and over inflated) in the last five years or so. And like any bubble, eventually it goes pop, with the shrapnel dispersing far and wide. And the size of this bubble looks to be extraordinary.

Whenever there is a lot of money to made (and quickly), as there was in the mortgage lending market, then greed factors heavily into the equation. And one of the ways greed manifested itself in the housing market was through unscrupulous lending practices, also referred to as predatory mortgage lending.

A little history

From about the late 1980’s on, easy credit became a staple in the American diet.

Credit was made widely available to all US citizens in the form of credit cards, car loans, low rate mortgages, etc. As we know, Americans are consumers by nature and as they began to spend (beyond their means), maxing out their credit, missing payments - so called ’subprime’ lenders began to take notice.

Miserly Sub Prime Lenders

Subprime lenders sought out borrowers who had damaged credit but owned homes - and the way they got their foot in the door was by offering attractive home improvement rates. By allowing borrowers to consolidate their debt, it opened pandora’s box for predatory lenders to offer bigger loans.

So lenders would then offer these ‘bigger’ loans based on the equity the borrower had in the home, not caring whether or not the borrower had the ability to repay the loan. And because these loans often came with inflated interest rates and massive prepayment penalties, these homeowners were being setup for failure.

The sub prime lenders didn’t care because they were making huge profits and were protected from loss by using the home as collateral. They were squeezing the lifeblood out of consumers and if the borrower defaulted on his (or her) payment, the sub prime lenders simply foreclosed on the home.

Hapless Borrowers

And here’s the other side of the equation.

Recognizing that real estate is a sound investment, people with “not so great” credit began to consolidate their debts through subprime mortgages, where the home would serve as collateral. Because they had few conventional borrowing options, working with sub prime lenders seemed like a natural fit. It sounded like a good idea on paper, right? Wrong.

The perfect storm was a brewing!

And because these borrowers were between a rock and a hard place, they were often at the mercy of the terms set by these subprime lenders. The lenders obviously knew this - took advantage of that fact - and here’s where we come full circle, right back to the whole greed thing.

A list of facts, opinions, and ideas about predatory mortgage lending:

Predatory lending occurs when a mortgage company or broker pushes unjustifiably expensive refinance or home equity options on homeowners. For example, on competitive loans, fees below 1% of the loan amount are typical. On predatory loans, fees totaling more than 5% are not uncommon.

Subprime lenders are responsible for the vast majority of predatory lending throughout the US. Many of the subprime lenders are owned by big banks, and many of these banks and investment firms bundled these sub prime loans into securities that were bought and sold on Wall Street.

It’s part of the reason why you’re seeing big banks like Washington Mutual, Citibank, and Wall Street institutions like Merrill Lynch, etc. hemorrhaging billions of dollars right now.

Predatory lenders target homeowners who are “cash-poor” but “equity-rich.” Historically, predatory lenders have targeted redlined neighborhoods, especially the elderly, needy and unsophisticated, looking to take advantage of the borrowers’ lack of understanding.

Here’s a great list I came across while researching this post, detailing the different names of abusive lending practices used by predatorial lenders, I would suggest committing them to memory.

One of the more egregious offenses is called Steering, where borrowers that have good enough credit to apply for a conventional loan, are steered into subprime loans. From there they are charged much higher interest rates.

I found this little synopsis (from 60 Minutes) that does a good job of summing up the subprime mortgage crisis:

Banks lent hundreds of billions of dollars to homebuyers who can’t pay them back. Wall Street took the risky debt, dressed it up as fancy securities, and sold it around the world as safe investments. It sounds like a shell game or Ponzi scheme; in some ways, it was a house of cards rife with corruption, greed, and negligence.

At least one out of five subprime loans will end in foreclosure—representing the highest rate of U.S. foreclosures since the Great Depression.

The cost of the subprime problem extends far beyond families that lose their homes and neighborhoods with dropping property values. Over 100 mortgage lenders already have gone out of business and tens of thousands of workers have lost their jobs. Can you say recession?

Predatory lending tactics can actually be applied to almost anything actually.

As long as there’s someone willing to lend money and someone willing to borrow, there will always be predatory lending. It most often comes in the form of credit cards, overdraft loans, payday advances, car loans, and ofcourse, the aforementioned home loans.

Internet message boards, forums, and blogs spend a lot of time and energy discussing the evils of credit card debt and naming the more aggressive companies that prey on these desperate and poor people. We will save that conversation for another day.

In conclusion

There’s a lot of debate about who is to blame for this mess, and it’s really hard to say. I think emotions are running high right now, no matter what side of the debate you fall on.

The positive that can be taken from this whole situation is that this will probably bring about big changes and better practices in the mortgage lending business, lessening the likelihood of being victimized by predatory lenders in the future.

A final thought

When applying for a mortgage, much like anything where a lot of money is involved, you have to do a tremendous amount of homework. Do yourself a favor and get second, third and fourth opinions from those closest to you before you take action…

This article was featured in Home Finance: All you need to know about home ownership at rocket finance. Here’s the rest of the articles in the series.

This post was also featured in:

• The Here’s Your Team for The Superbowl of Personal Finance! (Carnival #138) hosted by I’ve Paid For This Twice Already... For more information please visit the Carnival of Personal Finance.

Tags: predatory mortgage lending