A 'flip' look at predatory lending: will the Fed's revised Regulation Z end abusive refinancing practices?

• Author: Pyle, Michael J.

The regulation of predatory loans can be a tedious business. The whole topic redounds of such yawn-inducing terms as "single-premium credit insurance" and "negative amortization." Yet the human costs of predatory lending are no less real for all the financial jargon that masks them. Thousands of Americans, especially minorities and the elderly, have lost their homes due to sharp lending practices. The effective regulation of such abusive lending, while not a very sexy endeavor, could markedly improve the quality of life for some of the nation's most vulnerable people. This reality has led thirteen states and several major cities to undertake statutory and regulatory reform efforts in the past three years. The Federal Reserve Board (Fed), too, has attempted to rein in predatory lending through the recent promulgation of its revised standards under Regulation Z.

This Comment will attempt to analyze the potential efficacy of the Fed's effort by examining a specific portion of the revised Regulation Z, namely, its prohibition of so-called loan "flipping." (1) This rule forbids the refinancing of any "high-cost loan" (2) within one year of its initiation, unless that refinancing is "in the borrower's interest." (3) The prosecutorial discretion embedded within the new federal antiflipping provision represents a potential improvement over the previous generation of predatory lending regulations. This is because a discretionary standard better enables regulators and judges to end illegitimate mortgage refinancings, while still permitting others to go forward when warranted by individual circumstances. Such a result can improve both the justice and efficiency of the regulatory regime. Even so, like all other regulatory systems relying on prosecutorial discretion, also present is the opportunity for over- and underenforcement. In the case of the antiflipping provision, most of the worry has been that the standard will be overenforced and cause the market for legitimate subprime (4) loans to dry up. This Comment argues that this fear is overstated and that the real worry is underenforcement.

I

Predatory lending is a long-standing social problem. But its salience was never greater than in the 1990s, when the market for subprime loans exploded. (5) The upside of this boom was that more low-income and high-risk borrowers were able to gain access to the credit markets than ever before--these borrowers helped fuel the expansion in personal spending at the heart of the Clinton-era economy. The downside was a dramatic increase in home foreclosures. During the eight years from 1993 to 2000, overall foreclosures skyrocketed by sixty-eight percent; (6) in some urban areas, such as Chicago, they as much as doubled. (7) Although there is little empirical evidence indicating how many of these subprime foreclosures were due directly to predatory lending, anecdotal evidence suggests that loan predation was at least a contributing factor in a disturbingly high percentage. (8)

Such foreclosures impose huge personal and social costs on those whom they affect, even indirectly. There are, first, the immediate personal consequences for an individual involved in a foreclosure proceeding. That person loses what is almost undoubtedly her most valuable economic asset, in addition to giving up the simple security and stability of having somewhere to call home. Substantial dignitary costs are also at stake. This is especially true in a society like ours, where home ownership is emphasized as a central pillar of the American Dream. Yet individuals do not alone bear the costs of foreclosures; entire communities can feel the consequences as well. Chicago's mayor, Richard Daley, described the way that the effects of foreclosures have rippled through some neighborhoods in his city:

We are seeing a pattern in the city and in the suburbs.... It's the same story: A family has suddenly abandoned their home. In many cases, it is elderly people who have lived there for many years.... Once abandoned, these homes have been taken over by gangs and drug people, and they become breeding places for crime. (9) The costs of predatory lending, then, are distressingly large--and not only do they leave individual lives in shambles, but neighborhoods too.

Bad as this may seem, the situation is even more upsetting because it is primarily the nation's minority and elderly communities upon whom such lenders prey. Black Americans, for example, are five times more likely than whites to refinance their homes in the subprime market. This remains true even among affluent blacks, who are twice as likely to refinance their homes in the subprime market as low-income whites. (10) Elderly homeowners are also the frequent targets of subprime lenders. (11) The elderly are particularly inviting to these lenders because they often need quick cash for home repairs or retirement and already have significant equity in their homes...