How do predatory lending laws impact bank performance?

Author:Hendrickson, Jill M.
 
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INTRODUCTION

The past decade has witnessed a significant expansion of credit for many in the United States. This is particularly true for minority borrowers, those with limited or poor credit histories and those with low-incomes. Banks and other financial institutions have increasingly offered credit to this segment of the market and have frequently benefited from higher earnings on these loans. As evidence of the growth in this market, consider that in 1995, loan originations in the sub-prime market were $65 billion and by 2003 originations increased to $332 billion (Chomsisengphat and Pennington-Cross, 2006). However, as the subprime market expanded, so did concerns regarding who was receiving these high-priced loans. Awareness became particularly acute in the fall of 2007 and the expansion of the financial crisis. Each year, Housing and Urban Development (HUD) compiles a list of subprime lenders and has used this information to make the case that much of the subprime lending in the United States has been in low-income and minority neighborhoods. Others, for example, Immergluck (1999) and Marsico (2001) also find evidence that subprime lending growth is greater in low-income and minority areas. There is also concern regarding the outcome of these lending relationships; specifically, the increasing number of foreclosures and loan delinquencies. Taken together, the concern over subprime lenders targeting a certain segment of the population and the undesirable outcome of many of these loans, these developments prompted consumer advocacy groups and regulatory bodies to take a look at this growing market.

The initial regulatory response was federal regulation followed shortly by state regulation, in many states. In general, these laws restrict high cost loans, their fees and rates. The state level regulation varies tremendously from one state to another. Perhaps one reason for the variation is that there is no consensus on a definition of predatory lending. Engel and McCoy (2001) provide a set of loan criteria that define predatory lending to include at least one of the following: loans that provide no benefit to the borrower; loans with misleading nondisclosures; loans with fraud or deception; loans that require the borrower to forego redress; or loans that earn 'supranormal' profits. Pennington-Cross and Ho (2008) defined predatory lending to be whenever the borrower is unable to understand the terms and obligations of the loan. Morgan (2007) argues that any welfare-reducing form of credit can be labeled predatory lending. Similarly, the U.S. Government Accountability Office (GAO) defines a predatory loan to be one which contains terms that will ultimately harm the borrower (2004). Stressing the asymmetric information problem between the borrower and lender, Morgan (2007) defines a predatory loan to be one which the borrower would certainly decline if she shared the same information as the lender. Clearly there is no universal definition. However, it is accepted that predatory lending occurs within the subprime market. Not all subprime loans are predatory but most predatory loans are considered subprime.

Generally speaking, the predatory credit market is a subset of the subprime market. Because of a lack of data, it is not known how large this market actually is. There have been some micro estimates of the size of predatory lending. For example, Goldstein (2006) estimates that over 22 percent of all property loans in Philadelphia are predatory. Stock (2001) investigated whether predatory lending was instrumental in mortgage foreclosures in Montgomery County, Ohio. His sample of 1,198 mortgages indicated that 255 of these were predatory; this suggests that approximately 21 percent of the mortgages were predatory in this region. This limited research suggests that predatory lending is significant but certainly more evidence is required to draw conclusions about systemic practices.

With the first financial crisis of the twenty-first century, most Americans became aware of the subprime market and perhaps even of predatory lending. It seems likely that one response to the financial crisis will be increased regulation. More specifically, it is likely that regulators and policy makers will turn to predatory lending laws to keep the subprime mortgage market in check. If so, it is important to understand not only how these regulations impact the loan market but also the institutions that are extending the loans. That is, the predatory lending laws are, on the one hand, designed to protect borrowers from abusive lending practices. On the other hand, however, regulators and policy makers need to be careful that their regulatory decisions do not end up costing the lender so much that they retreat from this segment of the market. This paper attempts to inform regulatory and policy discussions by empirically testing whether predatory lending policies hurt the performance of the commercial bankers who are extending mortgage credit.

The second section of this paper provides a concise overview of the evolution of predatory lending laws and is followed in section three with a review of the salient literature. This is a relatively new field of literature as abusive lending practices have become more prevalent with the recent national policy emphasis to increase homeownership. The fourth section of the paper outlines the empirical specifications, data, and methods. Section five contains the empirical results and section six concludes. Briefly, the results indicate that national bank performance improved relative to state bank performance following a decision by the Office of the Comptroller to reduce the predatory lending regulatory burden on national banks.

BRIEF BACKGROUND OF FEDERAL AND STATE PREDATORY LENDING LAWS

As credit expanded to low-income and higher-risk individuals and as higher delinquencies and foreclosures became evident, community and consumer advocacy groups became more vocal about their concerns that lending abuse was taking place. The initial response to these concerns was the passage of a 1994 federal law known as the Home Ownership and Equity Protection Act (HOEPA) under Regulation Z at the Federal Reserve. The purpose of HOEPA was consumer protection from potentially abusive outcomes such as high interest rates and fees. HOEPA defined loans that were closed-ended home equity loans that met APR and finance fee triggers. A closed-ended loan is one in which the borrower received a fixed sum that must be repaid over time. Protection from HOEPA was triggered if either the loan's APR exceeded a comparable Treasury bond by 8 percentage points on the first lien or if finance charges on the loan exceeded 8 percent of the loan amount or a fixed $480 amount adjusted for inflation using the consumer price index (Ho and Pennington-Cross, 2006). Further, for HOEPA-covered loans, there were lending restrictions which included no no-document loans, no balloon loans, no pre-payment penalties greater than 5 years, among others. It was anticipated that HOEPA would reduce the predatory lending that came to light in the mid 1990s.

Nonetheless, a few years later, several government agencies (Housing and Urban Development, the Federal Reserve Board, and the U.S. Department of the Treasury) once again investigated the possibility of continued abuse in this segment of the credit market. At the end of 2000, the Federal Reserve called for more stringent restrictions on loans and an expanded definition of loans covered under HOEPA (Elliehausen and Staten, 2004). However, regulators were also aware that there was a fine line between protecting against lending abuses and also servicing the credit needs of these low-income and minority credit seekers. In the end, the changes to HOEPA recommended by the Federal Reserve were made in 2002. Hoping to strike a balance between cutting off credit to this segment of the market and protecting borrowers from abusive lending practices, this further defined HOEPA-covered loans to be those more likely to have predatory characteristics. Despite these changes in federal law, the ongoing growth in the subprime market led many to believe that the HOEPA changes were not sufficient. Indeed, a 2001 study found that HOEPA covers, at a maximum, only 5 percent of all subprime mortgages (Board of Governors, 2001).

In 1999 states responded by passing their own predatory lending laws which were more restrictive and prohibitive than the federal law. While state coverage is much broader than HOEPA, there is significant variance from state to state on the specifics of their predatory lending laws. Ho and Pennington-Cross (2006) capture the extent to which state laws extend HOEPA and also the variance between states by constructing empirical indexes for each state with predatory lending laws. More recently, Bostic et al. (2008) construct predatory lending law indexes as well. However, the Bostic work attempts to refine the work of Ho-Pennington-Cross (2006) by including four coverage measures and four restriction measures and also considers the enforcement of the state laws. In this way, the indexes more precisely indicate the legal environment in each state with respect to predatory lending laws. Like the Ho and Pennington-Cross (2006) indexes, those in Bostic et al. (2008) provide insight to the variation of the laws themselves and the enforcement of the laws.

The discussion above indicates that the regulatory environment for predatory lending began with federal regulation in 1994 and was enhanced beginning in 1999 as states began implementing even more stringent laws. Consequently, for ten years, between 1994 and 2004, there was a mix of both federal and state (in some states) predatory lending laws in the United States. During this time frame, all banks operating in a state with state predatory lending laws were required to follow these laws. This changed in 2004 when the Office of the Comptroller of the Currency...

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