Preserving the American Dream: Legislative Recommendations to Protect Future Borrowers in California

This disparity undermines the argument that subprime borrowers freely “choose” prepayment penalties. The unfairness of prepayment penalties is even more disturbing when you consider that they are more prevalent on subprime loans in communities of color. Borrowers in minority neighborhoods are more likely to receive prepayment penalties, (Debbie Gruenstein Bocian and Richard Zhai, Borrowers in Higher Minority Areas More Likely to Receive Prepayment Penalties on Subprime Loans, Center for Responsible Lending (January, 2005)) and minorities are at greater risk for receiving higher-priced loans than white borrowers, after controlling for legitimate risk factors. (Debbie Gruenstein Bocian, Keith S. Ernst and Wei Li, Unfair Lending: The Effect of Race and Ethnicity on the Price of Subprime Mortgages, Center for Responsible Lending (May, 2006).)

More than 35 states now regulate prepayment penalties, and at least ten states ban them outright. The recent trend is to ban prepayment penalties in the subprime market. North Carolina and Minnesota just banned prepayment penalties in subprime loans.

Like Minnesota, Maine and North Carolina, California should ban prepayment penalties for all subprime loans.

2. Establish Legislative Ability to Repay Standards

Approving loans without evaluating a borrower’s ability to repay is an unfair and deceptive practice because borrowers are deceived into thinking that they can afford the loans, and they are subjected to the ultimate of injuries – the loss of their home and hard-earned equity – when rates increase, as scheduled, after two or three years. The federal regulatory subprime statement sets out some basic guidance which while stronger than current regulatory standards provides only regulatory guidance. It is not clear that the state will have adequate capacity to enforce the guidance and individual borrowers have limited access to remedies for the shortcomings of their brokers or lenders.

Moreover the guidance fails to establish any meaningful debt-to-income standards for underwriting loans. Lenders can legally circumvent the subprime statement’s ability to pay standards by simply using more elastic (and increasingly unmanageable) debt-to-income ratios.

Stronger, enforceable statutory standards should be established.

Lenders should be required to underwrite all loans based on the fully-indexed rate and fully amortizing payments, while using a debt-to-income standard (DTI) that considers property taxes, hazard insurance, and other debts. Maine, Minnesota, Ohio and North Carolina laws would serve as good models. In addition, this DTI standard should include a rebuttable presumption that the borrower had sufficient capacity to repay the loan where the lender could establish with documentation that the DTI was 50% of gross income or less.

3. Require Appropriate Documentation of Income

Verification of income is a necessary complement to effective implementation of an ability to pay standard. While lenders purport to evaluate borrowers and underwrite loans, in reality, without adequate income verification, a lender’s approval of a loan is meaningless. Borrowers often do not understand that they are paying extra higher interest rate not to document their income, even though their W-2s are readily available, or that their income is overstated. Stated income loans also increase the interest rate borrowers pay for no reason and have been proven to overstate incomes, understate repayment ability, and therefore increase foreclosures. For example, a review of a sample of “stated-income” loans disclosed that 90 percent had inflated incomes compared to IRS documents, and “more disturbingly, almost 60 percent of the stated amounts were exaggerated by more than 50 percent.” (Mortgage Asset Research Institute, Inc., Eighth Periodic Mortgage Fraud Case Report to Mortgage Bankers Association, p. 12,(April 2006); see also 2007 Global Structured Finance Outlook: Economic and Sector-by Sector-analysis, FITCH RATINGS CREDIT POLICY (New York, N.Y), December 11, 2006, at 21, commenting that the use of subprime hybrid arms “poses a significant challenge to subprime collateral performance in 2007.”)

Fitch Ratings recently noted that “loans underwritten using less than full documentation standards comprise more than 50 percent of the subprime sector . . .” (See Structured Finance: US Subprime RMBS in Structured Finance CDOs, FITCH RATINGS CREDIT POLICY (New York, NY), August 21, 2006, at 4.) “Low doc” and “no doc” loans originally were intended for use with the limited category of borrowers who are self-employed or whose incomes are otherwise legitimately not reported on a W-2 tax form, but lenders have increasingly used these loans to obscure violations of sound underwriting practices.

California should require lenders to verify and document all sources of income using either tax or payroll records, bank account statements or any reasonable alternative or third-party verification.

4. Require Impoundments (or Escrows) for Taxes and Insurance

In stark contrast to the prime mortgage market, most subprime lenders make loans based on low monthly payments that do not impound (or escrow) for property taxes or hazard insurance. By routinely omitting escrows for taxes and insurance, subprime lenders have deceived borrowers into believing that their mortgage will be affordable. This deceptive practice is also unfair, since borrowers are often required to refinance their mortgage to raise the funds to pay the required fees, needlessly causing substantial injuries of approximately 8% of the loan amount (3% in upfront points and fees, 2% in third party fees, 3% in prepayment penalties), or $24,000 for a $300,000 loan.

California statute should require that all subprime loans must both (A) include the cost of hazard insurance and property tax escrows in their ability to repay analysis of a subprime loan the cost of hazard insurance and property tax escrows and (B) establish escrow or impoundment accounts for such taxes and insurance.

5. Establish Lender Liability for Broker Acts and Omissions When Yield Spread Premiums are Charged

Finally, to effectively address subprime abuses, it is important to take a stronger approach to addressing the unfair and deceptive tactics that brokers use to push subprime refinances on borrowers. In today’s marketplace, nearly three-quarters of subprime loans are brokered. California’s current regulatory approach is complaint-driven and ineffective either in deterring broker malfeasance or in providing remedies to borrowers.

Experts on mortgage financing have long raised concerns about problems inherent in a market dominated by broker originations. For example, Federal Reserve Board Chairman Ben S. Bernanke recently noted that placing significant pricing discretion in the hands of financially motivated mortgage brokers in the sales of mortgage products can be a prescription for trouble, as it can lead to behavior not in compliance with fair lending laws. (Remarks by Federal Reserve Board Chairman Ben S. Bernanke at the Opportunity Finance Network’s Annual Conference, Washington, D.C. (November 1, 2006).)

Whether the lender directly originates an abusive loan or funds an abusive loan originated by a broker, the borrower suffers injury, and the lender gets the asset. Moreover, lenders, who are mortgage professionals themselves, as well as repeat users of brokers’ services, have the expertise, the leverage and the capacity to exercise oversight of the brokers with whom they do business. Consumers do not. The costs of their failure to do so should therefore be borne by lenders, not borrowers

It is appropriate, therefore, to hold the lender responsible for abusive subprime loans, regardless of whether originated by the lender directly, or through the broker. Allowing lenders to obtain the benefit of broker misconduct without associated liability distorts the market and substantially undermines the effectiveness of any regulations. It would also leave borrowers without adequate remedies. Brokers are commonly thinly capitalized and transitory, leaving no assets for the borrower to recover against. Even more problematic are the hurdles that unclear lender liability creates as borrowers seek to defend foreclosures on the basis of origination improprieties.

This is true for all broker-originated loans and, to be effective, such provision should apply across the board for subprime loans. But there is even greater reason to codify lender liability where the lender pays the broker a yield spread premium. Such payments distort competitive market forces by creating a reverse competition effect – the broker shops for his or her own best deal, not the best deal for the customer. This is particularly insidious, as yield-spread premiums generate a financial conflict of interest in a professional whose primary duty should be to his customer, with the result that consumers pay a higher price than that for which they qualify.

(Theoretically, the yield spread is paid, at the consumer’s choosing, to lower closing costs. Empirically, that trade-off has not been found. See, e.g. Testimony of Howell E. Jackson, Senate Banking Committee Hearing on “Predatory Mortgage Lending Practices: Abusive Uses of Yield Spread Premiums” (January 8, 2002), (“Homeowners who are short on cash could, theoretically, use yield spread premiums to finance settlement costs. My study, however, offers compelling evidence that yield spread premiums are not being used in this way.”); See also Patricia A. McCoy, Rethinking Disclosure in a World of Risk-Based Pricing, 44 Harvard J. on Leg. 123, note 94 and sources cited therein.)

And lenders should not be allowed to use their profitable relationships with brokers as a shield to make abusive loans – lenders cannot simply offload the responsibility to place borrowers in loans they can afford. At a minimum lenders must engage in proper due diligence of the brokers they use and the brokered loans themselves.

The establishment of lender liability for broker acts and omissions is a critical step to clamp down on unfair, deceptive and abusive practices. At a minimum, yield spread premiums should be included in the calculation of what is a high cost loan under California’s predatory lending law. This was the legislature’s original intent of the law, but was subsequently overturned, erroneously and in conflict with the Department of Real Estate’s own legal opinion.

(This would require amending definitions of “covered loan” and “points and fees” to explicitly include YSPs in the counted costs of the loan. Cal. Fin. Code §§ 4970(b)(2) & (c)(2). Under current law, one way a consumer loan is deemed a covered loan and therefore receives special protections is if the total points and fees payable by the consumer at or before closing for a mortgage or deed of trust exceed 6 percent of the total loan amount. California’s definition of points and fees includes “all compensation and fees paid to mortgage brokers in connection with the loan transaction.”

A YSP is a bonus paid by a lender to a mortgage broker when a loan is originated at an interest rate higher than the minimum interest rate the lender approved. In Wolski v. Fremont Investment & Loan, 25 Cal. Rptr. 3d 500 (Cal. Ct. App. 2005), a state appellate court held that a YSP should not be included in the definition of points and fees because the lender, not the consumer, pays a YSP, and because the consumer pays excess interest only after loan closing. The Court in Wolski did not take notice of the fact that the California Department of Real Estate has issued a legal opinion on the issue, finding that yield spread premiums were originally intended by the legislature to be included in the points and fees calculation.)

Conclusion

Today we are seeing massive disruptions in the financial markets following years of reckless lending on subprime mortgages. This issue has been prominent in the media recently, but the problems are not new. For years, housing analysts and many policymakers have known that most predatory lending occurs in the subprime market, and that subprime loans too often lead to foreclosure rather than sustainable ownership.

The foreclosure crisis has large potential implications for California. Record numbers of borrowers could lose their homes. Declining housing prices could reduce the equity, wealth and spending of homeowners throughout the state. Jobs are already down sharply in the mortgage industry which has been centered in Southern California, but could spread to the home construction sector. And recent turmoil in global credit markets linked to the subprime lending crisis make the prospect of a housing-led recession a real possibility.

While other states have taken action to stem foreclosures and to raise standards on subprime lending, California has yet to enact new provisions. I hope today’s hearing marks a turning point where California will take aggressive action to sustain affordable homeownership and restore investor faith in America’s subprime mortgage markets.