Financial Ethics 101: Predatory Lending
By Yuqing Li
Predatory lending describes lending practices that involve the imposition of unfair, deceptive, and abusive loan terms on borrowers, entirely to the benefit of lenders.[1] This form of credit targets vulnerable populations. Consequently, borrowers likely suffer from devastating personal losses, including bankruptcy, asset foreclosure, and poverty.
History
Loan sharking, where lenders impose high-interest on loans, was a large cottage industry by the 1890s. Merchants, businessmen, and even clergymen became high-interest-rate lenders. The first scheme of loan sharks targeted at many urban laborers was salary buying. Beginning in the 1890s, finance companies prepaid workers short on cash with their weekly pay in advance.[2] The interest rate was commonly more than 20 percent a day. During the Depression, salary buying was renamed “payday lending” with the rate becoming standard at around 240 percent per year.[3] Payday lending continues today. Amounts borrowed normally ranging from $50 to $1000.[4] Major payday lending firms include Ace Cash Express, Advance America, Advance Financial and Check ’n Go.[5]
According to the Federal Deposit Insurance Corporation (FDIC), predatory lending involves at least one of the following characteristics:
a) Making unaffordable loans based on the assets of the borrower rather than on the borrower’s ability to repay the debt.
b) Inducing a borrower to refinance a loan so the lender can charge high fees when the loan is refinanced.
c) Engaging in fraud or deception to conceal the terms and conditions of the loan obligation, targeting unsophisticated consumers.[6]
In a 2002 Texas Law Review article, authors Engel and McCoy give a more exhaustive list of the predatory lending syndrome that involves one or more of the following characteristics:[7]
- Loan structure results in seriously disproportionate net harm to borrowers.
Predatory lenders aim to make as much profit as possible by various means, but the practices are often accompanied by serious net harm to borrowers, often in catastrophic amounts. The harm outweighs the benefits of the loans to borrowers and society in general. Some tactics of predatory lending include asset-based lending, where the mortgage is made to someone who cannot afford monthly payments. Borrowers with such loans will lose their homes to foreclosure, as their loans are doomed to default. Another practice involves ‘loan flipping’, in which lenders persuade homeowners to refinance their mortgages at short intervals. Lenders offer cash-short borrowers temporary relief with the option of refinancing. Nevertheless, the borrowers end up owing higher principal and interest to the lenders.
- Harmful rent-seeking
Predatory lending commonly entails exorbitant interest rates and fees to compensate for the added risk of lending to borrowers with poor credit history. The high cost of predatory loans is a form of harmful rent-seeking. ‘Economic rent’ means payments received that exceed the actual costs of the resources. Rent-seeking in economics and public policy refers to the acquisition of economic rent that involves no reciprocal contribution.[8] Predatory lending entails harmful rent-seeking because the lenders charge rates and fees that exceed the rates and fees they would obtain in a competitive market. The economic rents in the case of predatory lending may be the added fees and closing costs, including market reports and document preparation that exceed market rates. Lenders may also bill borrowers fees for duplicate charges and services which borrowers never need.
- Loans involving fraud or deceptive practices
Predatory loans entail two types of fraud. The first type of fraud consists of deceptions aimed at borrowers. Lenders and mortgage brokers may dupe borrowers with fraudulent disclosures or misrepresent the loan information. The second type of fraud involves deception on capital resources such as secondary-market purchasers of loans. Unscrupulous brokers may find various means to falsify information on the original loan to sell it in the secondary market. For instance, the lender may falsify the borrowers’ financial background, or give an overrated appraisal of the borrowers’ ability to pay. Due to the deceptive means, the secondary-market purchasers may not be aware of the fraud and become the secondary victims.
- Lack of transparency in loans not actionable as fraud
Loopholes in regulations hinder effective information disclosure, particularly on the full disclosure of the actual loan costs.
- Loans that require borrowers to waive meaningful legal redress.
Many predatory loans contain non-negotiable, mandatory arbitration clauses that prevent borrowers from judicial redress. Some clauses may prohibit borrowers from joining plaintiff class actions against lenders or shift lenders’ attorney fees to borrowers.
Statutes and Regulations
In the U.S., there are a few laws restricting predatory lending practices. Federal disclosure statutes such as the Truth in Lending Act (TILA) implemented in 1969 and the Real Estate Settlement Procedures Act (RESPA) effective in 1975 regard deceptive practices as illegal.
In 1994, Congress enacted the first modern anti-predatory lending statute, the Home Ownership and Equity Protection Act (HOEPA). HOEPA regulates “high-cost loans” where the annual percentage rate (APR) and fees exceed the yield on comparable Treasury securities plus 8%.[9] In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in response to the Great Financial Crisis of 2007-2008 caused by subprime loans.[10] The Dodd-Frank Act established the Consumer Financial Protection Bureau (CFPB), whose role is to prevent predatory lending practices and inform consumers of their mortgage agreements. Following the Federal Government, 29 states had state mini-HOEPA statutes in effect as of 2007.[11]
The Mortgage Reform Act was signed into Title XIV of the Dodd-Frank Act in July of 2010. This part of the act limits predatory lending in several ways. First, the Mortgage Reform Act prohibits mortgage originators from receiving any compensation for the mortgage term. Second, the act prohibits mortgage originators from steering any consumer toward certain types of mortgages. This act also requires originators to ensure the consumer has a reasonable ability to repay the loan. The mortgage is required to be a qualified mortgage: the regular periodic payments for the loan may not increase the principal balance or allow the consumer to defer repayment of principal. The mortgage may not include a scheduled payment that is more than twice as large as the average of earlier scheduled payments. The mortgage may not exceed thirty years. The total points and fees payable in connection with the loan may not exceed 3 percent of the total loan amount.[12]
Case Analysis of Subprime Loans as a Type of Predatory Lending
The subprime mortgage was a new class of residential mortgages offered to borrowers with poor credit scores at the beginning of 2000. Before 2000, only the most creditworthy borrowers could obtain residential mortgages. During the financial crisis, subprime mortgages were accompanied by securitization, the means of bundling a pool of subprime mortgages into mortgage-backed securities (MBS). The subprime mortgage is considered predatory lending for the following reasons:
1. Loan Structure that Causes Great Loss to Borrowers
Information technology made it easier to securitize subprime mortgages, leading to an explosion in subprime mortgage-backed securities. The process first started with mortgage brokers and lenders lending to subprime borrowers, usually people with low income or bad credit histories. The mortgage originators will gather a pool of home mortgages. The pool will then be sold to mortgage-backed securities issuers. MBS issuers will securitize mortgages and sell them to investors.
The chain of reaction from subprime mortgages to mortgage-backed securities produced frictions between mortgagors, mortgage originators, mortgage-backed securities issuers, and rating agencies. This problematic system led to less scrupulous lending and finally gave rise to waves of foreclosure, causing a spate of households to suffer from devastating economic loss.
Friction Between Mortgage Originators and Borrowers
The mortgage originators did not make strong efforts to evaluate whether a borrower could pay off the mortgage because the mortgage originators planned to quickly sell the loans to MBS issuers. The mortgage originators earned commission fees associated with the mortgage. The more volume they originate, the more money they make. Unsophisticated borrowers might be unaware of the financial options available to them, or not able to choose from various options to act in their best interests.[13]
Friction Between Mortgage Originators and the MBS Issuers
The friction between mortgage originators and MBS issuers is related to information asymmetry. The mortgage originators knew more about the genuine situation of the borrowers, while the MBS issuers did not have this information. The mortgage originator had the incentive to make significant misrepresentations on the loan application to make the mortgage record appear better.
Friction Between MBS Issuers and Rating Agency
Rating agencies earned large fees for credit rating scores. The agencies did not have sufficient motivation to make sure their ratings were accurate. The result was wildly inflated ratings that enabled the sale of complex financial products far riskier than investors recognized.
Investors of mortgage-backed securities did not have full information about whether their investments were from subprime mortgages with high default risk.
These problems that underlie the entire subprime loan market system led to a staggering number of foreclosures in the market, and a subsequent sharp shortfall of household wealth. The number of homes in the US with at least one foreclosure filing increased from 717,522 in 2006 to 2,330,483 in 2008, a 1.2% rise in the percentage of all housing units.[14] Household wealth decreased by $17 trillion in inflation-adjusted terms from 2007 to 2009.[15]
2. Fraud and Deceptive Practices
One example of the deceptive practices by subprime mortgage lenders is the use of borrowers’ income overstatement. According to a study published in 2014, researchers found the practice of overstating a borrower’s income to obtain a larger loan. They found incomes reported on mortgage applications rose more quickly than the income increase rate reported on tax returns in the same ZIP code areas between 2002 and 2005, indicating the fraudulent misreporting of borrower’s true income.[16] The overstatement resulted from lenders’ intention to expand credit rather than a rise in demand for loans. Mortgage originators were economically motivated to artificially manufacture ostensibly qualified borrowers.
The journalist Michael Hudson told the story of an Ameriquest branch in Los Angeles during the subprime boom: “They used scissors, tape, Wite-Out, and a photocopier to fabricate W-2s, the tax forms that indicate how much a wage earner makes each year. It was easy: Paste the name of a low-earning borrower onto a W-2 belonging to a high-earning borrower and, like magic, a bad loan prospect suddenly looked much better.” [17]
Ethics Analysis
The moral agent responsible for predatory lending is not limited to a specific person, but the collective entity of predatory lenders, loan originators, mortgage brokers, and bank and non-bank decision-makers. The consolidated action and decisions made by these parties, bear ethical scrutiny.
According to Kant, a moral agent is obliged to act morally. This obligation is derived from the respect of the universal law, i.e. the categorical imperative. The categorical imperative takes two formulations:
1) Formula of Universal Law: “act only according to that maxim whereby you can at the same time will that it should become a universal law without contradiction.”[18] The formula offers a test of whether a maxim is universalizable. This means a maxim like “one does X” can be universalized without any contradictions in conceptions and willing.
2) Formula of Humanity: “Act in such a way that you treat humanity, whether in your own person or in the person of any other, never merely as a means to an end but always at the same time as an end.”[19] This formula requires us to treat other people’s rational agency not as a means to ends but as valuable in themselves. We should treat other people with respect and dignity.
When it comes to the practice of predatory lending, there are several maxims intertwined in the practice. 1) Lenders treat the loans with foreclosure as the primary objective; 2) Lenders or brokers regard borrowers as entities to extract profit from, not treating them as people with dignity; 3) Fraudulent practices include giving false information, a lack of transparency in the loan term disclosure, and a lack of objectivity by the rating agency.
1) Lenders Treat the Loans with Foreclosure as the Primary Objective
Predatory lenders target borrowers with poor credit history. Predatory lenders or brokers are incentivized by the commission from the loans themselves, rather than from considering whether the borrowers can repay the debt. During the 2007-08 financial crisis, subprime mortgages were securitized and sold to the secondary market. Investors on the tranches believed that if the borrowers default, they can still sell the house at an elevated price. Thus, lenders and brokers have the primary objective of foreclosure.
When applying Kant’s Formula of Universal Law, contradictions in conceptions will arise. If we universalize the maxim, “all lenders will regard loans to be aimed at foreclosure.” There will be a contradiction in the conception of a loan, since the notion of a loan is based upon the borrowers’ ability to pay back, generating mutual interest for lenders and borrowers. We can thus conclude that it is a perfect duty for lenders not to regard the foremost goal of their loans as getting foreclosed.
2) Lenders or Brokers Regard Borrowers as Entities for Extracting Profit, Not Treating Them as People with Dignity.
Hill and Zocup investigated consumer experiences with predatory lending, and found consumers encounter predatory lenders’ tactics in the following ways: predatory lenders approach consumers with superficial courtesy, persuade the uninformed borrowers to take the loans, and make rapid loans to hook them in. As time passes, predatory lenders take aggressive responses to change the loan package and threaten the borrowers for late payments by a bombardment of calls. [20]
These traits reveal the false intention of predatory lenders: simply to extract borrowers for profit without regard to them as persons with dignity. The lenders regard unsophisticated borrowers as means for their gains, not as ends in themselves.
3) The Fraudulent Practice of Giving False Information, Lack of Transparency in the Loan Terms Disclosure, and the Lack of Objectivity by the Rating Agency.
The practice of giving wrongful information or the lack of transparency in the loan term disclosure is an act of lying. Because the lenders and brokers make wrongful statements to the borrowers on the intention that consumers believe to be true. Such intention of deception is a form of lying. Lying regards people as means to ends, as the act simply utilizes other people’s rational agency for one’s selfish purposes.
References
[1] Hayes, Adam. “Predatory Lending: How to Avoid, Examples and Protections.” Investopedia,https://www.investopedia.com/terms/p/predatory_lending.asp.
[2] Geisst, Charles R. Loan Sharks: The Birth of Predatory Lending. Brookings Institution Press, 2017. p. 49.
[3] Ibid. p.235
[4] Stanley, Daniel. “Payday Lending: An Ethics Evaluation.” Seven Pillars Institute, 17 Oct. 2018,https://sevenpillarsinstitute.org/payday-lending-an-ethics-evaluation/.
[5] Romm, Tony. “Payday Lenders Aim to Evade Federal Probes as Borrowers Plead for Help.” Washington Post, 1 Nov. 2023. www.washingtonpost.com, https://www.washingtonpost.com/business/2023/10/28/payday-lending-supreme-court-lobbying/.
[6] Federal Deposit Insurance Corporation. FDIC: FIL-6-2007: FDIC’s Supervisory Policy on Predatory Lending. 2007,https://www.fdic.gov/news/financial-institution-letters/2007/fil07006a.html.
[7] Engel, Kathleen C., and Patricia A. McCoy. “A Tale of Three Markets: The Law and Economics of Predatory Lending.” Texas Law Review, vol. 80, no. 6, May 2001. DOI.org (Crossref), https://doi.org/10.2139/ssrn.286649.
[8] Majaski, Christina. “What Is Rent Seeking in Economics, and What Are Some Examples?” Investopedia,https://www.investopedia.com/terms/r/rentseeking.asp.
[9] Bostic, Raphael W., et al. “State and Local Anti-Predatory Lending Laws: The Effect of Legal Enforcement Mechanisms.” Journal of Economics and Business, vol. 60, no. 1–2, Jan. 2008, pp. 47–66. DOI.org (Crossref), https://doi.org/10.1016/j.jeconbus.2007.09.003. (1) where the annual percentage rate (APR) at consummation exceeds the yield on comparable Treasury securities plus 8% (10%) for first-lien (subordinate-lien) loans; or (2) where the total points and fees exceed the greater of 8% of the total loan amount or $400 (subject to annual indexing).
[10] Hayes, Adam. “Dodd-Frank Act: What It Does, Major Components, and Criticisms.” Investopedia,https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp.
[11] Bostic, Raphael W., et al. “State and Local Anti-Predatory Lending Laws: The Effect of Legal Enforcement Mechanisms.” Journal of Economics and Business
[12] Wonderly, Joe. “Anti-Predatory Lending: Title XIV of the Dodd-Frank Act.” Review of Banking & Financial Law, vol. 30, no. I, 2010, pp. 93–101, https://www.bu.edu/rbfl/issues/volume-30/.
[13] Ashcraft, Adam B.; Schuermann, Til (2008) : Understanding the securitization of subprime mortgage credit, Staff Report, No. 318, Federal Reserve Bank of New York, New York, NY https://www.econstor.eu/bitstream/10419/60823/1/587537833.pdf
[14] Pew Research Center. “V. Foreclosures in the U.S. in 2008.” Pew Research Center’s Hispanic Trends Project, 12 May 2009,https://www.pewresearch.org/hispanic/2009/05/12/v-foreclosures-in-the-u-s-in-2008/.
[15] William Emmons, and Bryan Noeth. Who Suffered the Most from the Crisis? | St. Louis Fed. July 2012,https://www.stlouisfed.org/publications/regional-economist/july-2012/household-financial-stability–who-suffered-the-most-from-the-crisis.
[16] Jiang, Wei, et al. “Liar’s Loan? Effects of Origination Channel and Information Falsification on Mortgage Delinquency.” The Review of Economics and Statistics, vol. 96, no. 1, Mar. 2014, pp. 1–18. Silverchair, https://doi.org/10.1162/REST_a_00387.
[17] Appelbaum, Binyamin. “How Mortgage Fraud Made the Financial Crisis Worse.” The New York Times, 12 Feb. 2015. NYTimes.com, https://www.nytimes.com/2015/02/13/upshot/how-mortgage-fraud-made-the-financial-crisis-worse.html.
[18] Kant, Immanuel. Grounding for the Metaphysics of Morals. Translated by James W. Ellington, Hackett Publishing, 1993.
[19] Ibid.
[20] Hill, Ronald Paul, and John C. Kozup. “Consumer Experiences with Predatory Lending Practices.” Journal of Consumer Affairs, vol. 41, no. 1, June 2007, pp. 29–46. DOI.org (Crossref), https://doi.org/10.1111/j.1745-6606.2006.00067.
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