In recent years, abuses in home mortgage lending—commonly referred to as “predatory lending”—have increasingly garnered the attention and concern of policymakers, consumer advocates, and participants in the mortgage lending industry. Once relatively rare, government enforcement actions and private party lawsuits against institutions accused of abusive home mortgage lending have increased dramatically in the last 10 years. In 2002 alone, there were dozens of settlements resulting from accusations of abusive lending. In the largest of these, a major national mortgage lender agreed to pay up to $484 million to tens of thousands of affected consumers. Predatory lending is an umbrella term that is generally used to describe cases in which a broker or originating lender takes unfair advantage of a borrower, often through deception, fraud, or manipulation, to make a loan that contains terms that are disadvantageous to the borrower. While there is no universally accepted definition, predatory lending is associated with the following loan characteristics and lending practices: Excessive fees. Abusive loans may include fees that greatly exceed the amounts justified by the costs of the services provided and the credit and interest rate risks involved. Lenders may add these fees to the loan amounts rather than requiring payment up front, so the borrowers may not know the exact amount of the fees they are paying. Excessive interest rates. Mortgage interest rates can legitimately vary based on the characteristics of borrowers (such as creditworthiness) and of the loans themselves. However, in some cases, lenders may charge interest rates that far exceed what would be justified by any risk- based pricing calculation, or lenders may “steer” a borrower with an excellent credit record to a higher-rate loan intended for borrowers with poor credit histories. Single-premium credit insurance. Credit insurance is a loan product that repays the lender should the borrower die or become disabled. In the case of single- premium credit insurance, the full premium is paid all at once—by being added to the amount financed in the loan—rather than on a monthly basis. Because adding the full premium to the amount of the loan unnecessarily raises the amount of interest borrowers pay, single-premium credit insurance is generally considered inherently abusive. Lending without regard to ability to repay. Loans may be made without regard to a borrower’s ability to repay the loan. In these cases, the loan is approved based on the value of the asset (the home) that is used as collateral. In particularly egregious cases, monthly loan payments have equaled or exceeded the borrower’s total monthly income. Such lending can quickly lead to foreclosure of the property. Loan flipping. Mortgage originators may refinance borrowers’ loans repeatedly in a short period of time without any economic gain for the borrower. With each successive refinancing, these originators charge high fees that “strip” borrowers’ equity in their homes. Fraud and deception. Predatory lenders may perpetrate outright fraud through actions such as inflating property appraisals and doctoring loan applications and settlement documents. Lenders may also deceive borrowers by using “bait and switch” tactics that mislead borrowers about the terms of their loan. Unscrupulous lenders may fail to disclose items as required by law or in other ways may take advantage of borrowers’ lack of financial sophistication. Prepayment penalties. Penalties for prepaying a loan are not necessarily abusive, but predatory lenders may use them to trap borrowers in high-cost loans. Balloon payments. Loans with balloon payments are structured so that monthly payments are lower but one large payment (the balloon payment) is due when the loan matures. Predatory loans may contain a balloon payment that the borrower is unlikely to be able to afford, resulting in foreclosure or refinancing with additional high costs and fees. Sometimes, lenders market a low monthly payment without adequate disclosure of the balloon payment. Predatory lending is difficult to define partly because certain loan attributes may or may not be abusive, depending on the overall context of the loan and the borrower. For example, although prepayment penalties can be abusive in the context of some loans, in the context of other loans they can benefit borrowers by reducing the overall cost of loans by reducing the lender’s prepayment risk. According to federal and industry officials, most predatory mortgage lending involves home equity loans or loan refinancings rather than loans for home purchases. Homeowners may be lured into entering refinance loans through aggressive solicitations by mortgage brokers or lenders that promise “savings” from debt consolidation or the ability to “cash out” a portion of a borrower’s home equity. Predatory lending schemes may also involve home improvement contractors that work in conjunction with a lender. The contractor may offer to arrange financing for necessary repairs or improvements, and then perform shoddy work or fail to complete the job, while leaving the borrower holding a high-cost loan. Abuses in loan servicing have also increasingly become a concern. Abusive mortgage lenders or servicing agents may charge improper late fees, require unjustified homeowner’s insurance, or not properly credit payments. In November 2003, the Federal Trade Commission (FTC) and the Department of Housing and Urban Development (HUD) reached a settlement with a large national mortgage servicer, Fairbanks Capital, after the company was accused of unfair, deceptive, and illegal practices in the servicing of mortgage loans. The settlement will provide $40 million to reimburse consumers. Originating lenders or brokers that engage in abusive practices can make high profits through the excessive points and fees that they charge, particularly when borrowers make their payments regularly. Even when a loan enters foreclosure, the originator of a predatory loan may still make a profit due to the high up-front fees it has already collected. Moreover, a lender that sells a loan in the secondary market shortly after origination no longer necessarily faces financial risk from foreclosure. Similarly, a mortgage broker that collects fees up front is not affected by foreclosure of the loan. According to HUD and community groups, predatory lending not only harms individual borrowers but also can weaken communities and neighborhoods by causing widespread foreclosures, which reduce property values. Predatory lending also serves to harm the reputation of honest and legitimate lenders, casting them in the same suspicious light as those making unfair loans and thus increasing their reluctance to extend credit to the traditionally underserved communities that are often targeted by abusive lenders. The market for mortgage loans has evolved considerably over the past 20 years. Among the changes has been the emergence of a market for subprime mortgage loans. Most mortgage lending takes place in what is known as the prime market, which encompasses traditional lenders and borrowers with credit histories that put them at low risk of default. In contrast, the subprime market serves borrowers who have poor or no credit histories or limited incomes, and thus cannot meet the credit standards for obtaining loans in the prime market. It is widely accepted that the overwhelming majority of predatory lending occurs in the subprime market, which has grown dramatically in recent years. Subprime mortgage originations grew from $34 billion in 1994 to more than $213 billion in 2002 and in 2002 represented 8.6 percent of all mortgage originations, according to data reported by the trade publication Inside B&C Lending. Several factors account for the growth of the subprime market, including changes in tax law that increased the tax advantages of home equity loans, rapidly increasing home prices that have provided many consumers with substantial home equity, entry into the subprime market by companies that had previously made only prime loans, and the expansion of credit scoring and automated underwriting, which has made it easier for lenders to price the risks associated with making loans to credit-impaired borrowers. Originating lenders charge higher interest rates and fees for subprime loans than they do for prime loans to compensate for increased risks and for higher servicing and origination costs. In many cases, increased risks and costs justify the additional cost of the loan to the borrower, but in some cases they may not. Because subprime loans involve a greater variety and complexity of risks, they are not the uniformly priced commodities that prime loans generally are. This lack of uniformity makes comparing the costs of subprime loans difficult, which can increase borrowers’ vulnerability to abuse. However, subprime lending is not inherently abusive, and certainly all subprime loans are not predatory. Although some advocacy groups claim that subprime lending involves abusive practices in a majority of cases, most analysts believe that only a relatively small portion of subprime loans contain features that may be considered abusive. In addition, according to officials at HUD and the Department of the Treasury, the emergence of a subprime mortgage market has enabled a whole class of credit-impaired borrowers to buy homes or access the equity in their homes. At the same time, however, federal officials and consumer advocates have expressed concerns that the overall growth in subprime lending and home equity lending in general has been accompanied by a corresponding increase in predatory lending. For example, lenders and brokers may use aggressive sales and marketing tactics to convince consumers who need cash to enter into a home equity loan with highly disadvantageous terms. Originators of subprime loans are most often mortgage and consumer finance companies, but can also be banks, thrifts, and other institutions. Some originators focus primarily on making subprime loans, while others offer a variety of prime and subprime loans. According to HUD, 178 lenders concentrated primarily on subprime mortgage lending in 2001. Fifty-nine percent of these lenders were independent mortgage companies (mortgage bankers and finance companies), 20 percent were nonbank subsidiaries of financial or bank holding companies, and the remainder were other types of financial institutions. Only 10 percent were federally regulated banks and thrifts. About half of all mortgage loans are made through mortgage brokers that serve as intermediaries between the borrower and the originating lender. According to government and industry officials, while the great majority of mortgage brokers are honest, some play a significant role in perpetrating predatory lending. A broker can be paid for his services from up-front fees directly charged to the borrower and/or through fees paid indirectly by the borrower through the lender in what is referred to as a “yield spread premium.” Some consumer advocates argue that compensating brokers this way gives brokers an incentive to push loans with higher interest rates and fees. Brokers respond that yield spread premiums in fact allow them to reduce the direct up-front fees they charge consumers. Currently no comprehensive and reliable data are available on the extent of predatory lending nationwide, for several reasons. First, the lack of a standard definition of what constitutes predatory lending makes it inherently difficult to measure. Second, any comprehensive data collection on predatory lending would require access to a representative sample of loans and to information that can only be extracted manually from the physical loan files. Given that such records are not only widely dispersed but also generally proprietary, to date comprehensive data have not been collected. Nevertheless, policymakers, advocates, and some lending industry representatives have expressed concerns in recent years that predatory lending is a significant problem. Although the extent of predatory lending cannot be easily quantified, several indicators suggest that it may be prevalent. Primary among these indicators are legal settlements, foreclosure patterns, and anecdotal evidence. In the past 5 years, there have been a number of major settlements resulting from government enforcement actions and private party lawsuits accusing lenders of abusive lending practices affecting large numbers of borrowers. Among the largest of these settlements have been the following: In October 2002, the lender Household International agreed to pay up to $484 million to homeowners across the nation to settle allegations by states that it used unfair and deceptive lending practices to make mortgage loans with excessive interest and charges. In September 2002, Citigroup agreed to pay up to $240 million to resolve charges by FTC and private parties that Associates First Capital Corporation and Associates Corporation of North America (The Associates) engaged in systematic and widespread deceptive and abusive lending practices. According to FTC staff, under the settlement close to 1 million borrowers will receive compensation for loans that misrepresented insurance products and that contained other abusive terms. In response to allegations of deceptive marketing and abusive lending, First Alliance Mortgage Company entered into a settlement in March 2002 with FTC, six states, and private parties to compensate nearly 18,000 borrowers more than $60 million dollars. Further, between January 1998 and September 1999, the foreclosure rate for subprime loans was more than 10 times the foreclosure rate for prime loans. While it would be expected that loans made to less creditworthy borrowers would result in some increased rate of foreclosure, the magnitude of this difference has led many analysts to suggest that it is at least partly the result of abusive lending, particularly of loans made without regard to the borrower’s ability to repay. Moreover, the rate of foreclosures of subprime mortgage loans has increased substantially since 1990, far exceeding the rate of increase for subprime originations. A study conducted for HUD noted that while the increased rate in subprime foreclosures could be the result of abusive lending, it could also be the result of other factors, such as an increase in subprime loans that are made to the least creditworthy borrowers. In the early 1990s, anecdotal evidence began to emerge suggesting that predatory lending was on the rise. Legal services agencies throughout the country reported an increase in clients who were facing foreclosure as a result of mortgage loans that included abusive terms and conditions. These agencies noted that for the first time they were seeing large numbers of consumers, particularly elderly and minority borrowers, who were facing the loss of homes they had lived in for many years because of a high-cost refinancing. Similar observations were also reported extensively at forums on predatory lending sponsored by HUD and the Department of the Treasury in five cities during 2000, at hearings held in four cities during 2000 by the Board of Governors of the Federal Reserve System (the Board), and at congressional hearings on the issue in 1998, 2001, 2002, and 2003. Federal officials and consumer advocates maintain that predatory lenders often target certain populations, including the elderly and some low- income and minority communities. Some advocates say that in many cases, predatory lenders target communities that are underserved by legitimate institutions, such as banks and thrifts, leaving borrowers with limited credit options. According to government officials and legal aid organizations, predatory lending appears to be more prevalent in urban areas than in rural areas, possibly because of the concentration of certain target groups in urban areas and because the aggressive marketing tactics of many predatory lenders may be more efficient in denser neighborhoods. The federal government began addressing predatory home mortgage lending as a significant policy issue in the early 1990s. In 1994, the Congress passed the Home Ownership and Equity Protection Act (HOEPA), an amendment to the Truth in Lending Act that set certain restrictions on “high-cost” loans in order to protect consumers. In 1998, as part of an overall review of the statutory requirements for mortgage loans, HUD and the Board released a report recommending that additional actions be taken to protect consumers from abusive lending practices. HUD and the Department of the Treasury formed a task force in 2000 that produced the report Curbing Predatory Home Mortgage Lending, which made several dozen recommendations for addressing predatory lending.14, As discussed in chapters 2 and 3, a variety of federal, state, and local laws have been used to take civil and criminal enforcement actions against institutions and individuals accused of abusive lending practices. Various federal agencies have responsibilities for enforcing laws related to predatory lending. In addition, some state or local enforcement authorities—including attorneys general, banking regulators, and district attorneys—have used state and local laws related to consumer protection and banking to address predatory lending practices. In addition, many private attorneys and advocacy groups have pursued private legal actions, including class actions, on behalf of borrowers who claim to have been victimized by abusive lending. Our objectives were to describe (1) federal laws related to predatory lending and federal agencies’ efforts to enforce them; (2) the actions taken by the states in addressing predatory lending; (3) the secondary market’s role in facilitating or inhibiting predatory lending; (4) how consumer education, mortgage counseling, and loan disclosures may deter predatory lending; and (5) the relationship between predatory lending activities and elderly consumers. The scope of this work was limited to home mortgage lending and did not include other forms of consumer loans. HUD-Treasury Task Force on Predatory Lending, Curbing Predatory Home Mortgage Lending: A Joint Report, June 2000. Department of Justice (DOJ), the Department of the Treasury, the Federal Deposit Insurance Corporation (FDIC), FTC, the Board, the National Credit Union Administration (NCUA), the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS). We asked each agency to provide us with the enforcement actions they have taken that—in their assessment—were related to predatory home mortgage lending. We compiled and reviewed data on these enforcement actions and other steps these agencies have taken to address abusive lending practices. We also reviewed and analyzed federal laws that have been used to combat these practices. To identify actions taken by states and localities, we reviewed and analyzed a publicly available database maintained by the law firm of Butera & Andrews that tracks state and municipal antipredatory lending legislation. We reviewed information related to this database and conducted interviews with the person who maintains it. In order to identify gaps in the completeness or accuracy of data, we compared data elements from this database and from three similar databases maintained by Lotstein Buckman, the National Conference of State Legislatures, and the Mortgage Bankers Association of America. We determined that the data were sufficiently reliable for use in this report. We also interviewed officials representing a wide range of state and local government agencies, lending institutions, and advocacy groups in a number of states and municipalities. In order to illustrate approaches taken in certain states with regard to predatory lending, we collected and analyzed additional information from two states, North Carolina and Ohio. We chose these states to illustrate the differing characteristics of two states’ approaches to addressing predatory lending—particularly with regard to legislation restricting high-cost loans and tightening regulation of mortgage lenders and brokers. We also conducted meetings with the Conference of State Bank Supervisors and the National Association of Attorneys General that included representatives from several states. Additionally, we conducted interviews with OCC, OTS, and NCUA to understand their policies and processes on federal preemption of state antipredatory lending laws. To describe the secondary market’s role, we interviewed officials and reviewed documents from the Bond Market Association, the Securities Industry Association, Fannie Mae, Freddie Mac, a due diligence contractor, and two credit rating agencies. We also spoke with officials representing federal and state agencies, and with representatives of the lending industry and consumer groups. In addition, we reviewed and analyzed several local and state laws containing assignee liability provisions. To describe the role of consumer education, mortgage counseling, and disclosures in deterring predatory lending, we interviewed officials from entities that engage in consumer financial education, including several federal and state agencies, industry trade groups, and local nonprofit organizations such as the Long Island Housing Partnership, the Greater Cincinnati Mortgage Counseling Service, and the Foreclosure Prevention Project of South Brooklyn Legal Services. We also reviewed and analyzed the materials these entities produce. Additionally, we conducted a literature review of studies that have evaluated the effectiveness of consumer education and homeownership counseling. To describe the impact on older consumers, we conducted a literature review on predatory lending and the elderly and examined studies on financial exploitation of the elderly. We also examined certain enforcement activities and private party lawsuits in which elderly consumers may have been targeted by abusive lenders. We interviewed federal and state agencies that have addressed issues of financial abuse of the elderly, including the Department of Health and Human Services’ Administration on Aging and the National Institute on Aging, as well as nonprofit groups that have addressed this issue, including AARP (formerly known as the American Association of Retired Persons). In addressing all of the objectives, we met with a wide range of organizations that represent consumers, among them the National Community Reinvestment Coalition, the Coalition for Responsible Lending, the National Consumer Law Center, the Association of Community Organizations for Reform Now, and AARP. We also met with organizations representing various aspects of the mortgage lending industry, among them the American Financial Services Association, the Consumer Mortgage Coalition, the Coalition for Fair and Affordable Lending, America’s Community Bankers, the National Association of Mortgage Brokers, the Mortgage Bankers Association of America, and the National Home Equity Mortgage Association. We provided a draft of this report to the Board, DOJ, FDIC, FTC, HUD, NCUA, OCC, OTS, and the Department of the Treasury for review and comment. The agencies provided technical comments that have been incorporated, as appropriate, as well as general comments that are discussed at the end of chapter 2. The written comments of the Board, DOJ, HUD, and NCUA are printed in appendixes II through V. We conducted our work between January 2003 and January 2004 in accordance with generally accepted government auditing standards in Atlanta, Boston, New York, San Francisco, and Washington, D.C. While HOEPA is the only federal law specifically designed to combat predatory mortgage lending, federal agencies, including federal banking regulators, have used a number of federal consumer protection and disclosure statutes to take actions against lenders that have allegedly engaged in abusive or predatory lending. These statutes have enabled agencies to file complaints on behalf of consumers over issues such as excessive interest rates and fees, deceptive lending practices, and fraud. FTC, DOJ, HUD, and federal banking regulators have taken steps to address predatory lending practices through enforcement and civil actions, guidance, and regulatory changes. In some cases, agencies have coordinated their efforts through joint enforcement actions and participation in interagency working groups or task forces. However, questions of jurisdiction regarding certain nonbank mortgage lenders may challenge efforts to combat predatory lending. While the Board has authority to examine many such nonbank mortgage lenders under certain circumstances, it lacks clear authority to enforce federal consumer protection laws against them. As shown in figure 1, Congress has passed numerous laws that can be used to protect consumers against abusive lending practices. Federal agencies have applied provisions of these laws to seek redress for consumers who have been victims of predatory lending. Among the most frequently used laws are TILA, HOEPA, the Real Estate Settlement Procedures Act (RESPA), and the FTC Act. Congress has also given certain federal agencies responsibility for writing regulations that implement these laws. For example, the Board writes Regulation Z, which implements TILA and HOEPA, and HUD writes Regulation X, which implements RESPA. Also, in some cases, DOJ has brought actions under criminal fraud statutes based on conduct that can constitute predatory lending. TILA, which became law in 1968, was designed to provide consumers with accurate information about the cost of credit. Among other things, the act requires lenders to disclose information about the terms of loans— including the amount being financed, the total finance charge, and information on the annual percentage rate—that can help borrowers understand the overall costs of their loans. TILA also provides borrowers with the right to cancel certain loans secured by a principal residence within 3 days of closing or 3 days of the time at which the final disclosure is made, whichever is later. In 1994, Congress enacted the HOEPA amendments to TILA in response to concerns about predatory lending. HOEPA covers certain types of loans made to refinance existing mortgages, as well as home equity loans, that satisfy specific criteria. HOEPA covers only a limited portion of all subprime loans, although there is no comprehensive data on precisely what that portion is. The law is designed to limit predatory practices for these so-called “high-cost” HOEPA loans in several ways. First, it places restrictions on loans that exceed certain rate or fee thresholds, which the Board can adjust within certain limits prescribed in the law. For these loans, the law restricts prepayment penalties, prohibits balloon payments for loans with terms of less than 5 years, prohibits negative amortization, and contains certain other restrictions on loan terms or payments. Second, HOEPA prohibits lenders from routinely making loans without regard to the borrower’s ability to repay. Third, the law requires lenders to include disclosures in addition to those required by TILA for consumer credit transactions to help borrowers understand the terms of the high-cost loan and the implications of failing to make required payments. Each federal banking regulator is charged with enforcing TILA and HOEPA with respect to the depository institutions it regulates, and FTC is primarily responsible for enforcing the statutes for most other financial institutions, including independent mortgage lenders and nonbank subsidiaries of holding companies. In enforcing TILA and HOEPA, FTC has required violators to compensate borrowers for statutory violations. Under certain circumstances, HOEPA provides for damages in addition to the actual damages a person sustains as a result of a creditor’s violation of the act. RESPA, passed in 1974, seeks to protect consumers from unnecessarily high charges in the settlement of residential mortgages by requiring lenders to disclose details of the costs of settling a loan and by prohibiting certain other costs. Among its provisions is a prohibition against kickbacks— payments made in exchange for referring a settlement service, such as lender payments to real estate agents for the referral of business. RESPA also prohibits unearned fees such as adding an additional charge to a third party fee when no or nominal services are performed. These practices can unjustly increase the costs of loans and the settlement process. HUD enforces RESPA, working closely with federal banking regulators and other federal agencies such as the FTC and the Department of Justice. HUD often brings joint enforcement actions with these agencies, using RESPA and the statutes enforced by the other federal agencies. In addition, the banking regulators may prohibit violations of RESPA in their own regulations. The FTC Act, enacted in 1914 and amended on numerous occasions, provides the FTC with the authority to prohibit and take action against unfair or deceptive acts or practices in or affecting commerce. FTC has used the act to address predatory lending abuses when borrowers have been misled or deceived about their loan terms. Various criminal fraud statutes prohibit certain types of fraud sometimes used in abusive lending schemes, including forgery and false statements. DOJ and HUD have used these statutes to fight fraudulent schemes that have resulted in borrowers purchasing homes worth substantially less than their mortgage amounts or borrowers being unfairly stripped of the equity in their homes. HUD officials have described some of these fraudulent activities as constituting predatory lending. The following other federal laws have been used to a lesser extent to address abusive lending: The Fair Housing Act prohibits discrimination based on race, sex, and other factors in housing-related transactions, and the Equal Credit Opportunity Act (ECOA) prohibits discrimination against borrowers in the extension of credit. Federal agencies have used both laws in cases against lenders that have allegedly targeted certain protected groups with abusive loans. The Home Mortgage Disclosure Act (HMDA) requires lenders to make publicly available certain data about mortgage loans. Federal agencies have used the data provided by HMDA to help identify possible discriminatory lending patterns, including those that involve abusive lending practices. The Community Reinvestment Act (CRA) requires that banking regulators consider a depository institution’s efforts to meet the credit needs of its community—including low- and moderate-income neighborhoods—in examinations and when it applies for permission to take certain actions such as a merger or acquisition. An institution's fair lending record is taken into account in assessing CRA performance. CRA regulations state that abusive lending practices that violate certain federal laws will adversely affect an institution’s CRA performance. Also, federal banking regulators may rely on their supervisory and enforcement authorities under the laws they administer, as well as on the Federal Deposit Insurance Act, to enforce these consumer protections laws and ensure that an institution’s conduct with respect to compliance with consumer protection laws does not affect its safety and soundness or that of an affiliated institution. Finally, FTC and the banking regulators can also use the Fair Debt Collection Practices Act and Fair Credit Reporting Act in enforcement actions related to predatory lending that involve violations of credit reporting and loan servicing provisions. Although a number of federal laws have been used to protect borrowers from abusive lending or to provide them redress, not all potentially abusive practices are illegal under federal law. Enforcement officials and consumer advocates have stated that some lenders make loans that include abusive features but are designed to remain below the thresholds that would subject them to the restrictions of HOEPA. For loans not covered under HOEPA, certain lending practices many consider to be abusive are not, depending on the circumstances, necessarily a violation of any federal law. For example, it is not necessarily illegal to charge a borrower interest rates or fees that exceed what is justified by the actual risk of the mortgage loan. Nor is it per se illegal under federal law to “steer” a borrower with good credit who qualifies for a prime loan into a higher cost subprime loan. Finally, with the exception of loans covered under HOEPA, there are no federal statutes that expressly prohibit making a loan that a borrower will likely be unable to repay. FTC, DOJ, and HUD have taken enforcement actions to address violations related to abusive lending. As of December 2003, FTC reported that the agency had taken 19 actions against mortgage lenders and brokers for predatory practices. DOJ has addressed predatory lending that is alleged to be discriminatory by enforcing fair lending laws in a limited number of cases. HUD’s efforts have generally focused on reducing losses to the Federal Housing Administration (FHA) insurance fund, including implementing a number of initiatives to monitor lenders for violations of FHA guidelines. HUD reported having taken a small number of actions to enforce RESPA and the Fair Housing Act in cases involving predatory lending. Federal banking regulators stated that their monitoring and examination activities have revealed little evidence of predatory lending practices by federally regulated depository institutions. Accordingly, most banking regulators reported that they have taken no formal enforcement actions related to predatory mortgage lending abuses by the institutions they supervise. Regulators have addressed predatory lending primarily by issuing guidance to their institutions on guarding against direct or indirect involvement in predatory lending practices and by making certain changes to HOEPA and HMDA regulations. In addition, several federal agencies have coordinated certain efforts to pursue enforcement actions related to predatory lending and have shared information on their efforts to address fair lending and predatory lending. FTC is responsible for implementing and enforcing certain federal laws among lending institutions that are not supervised by federal banking regulators. FTC reported that between 1983 and 2003, it filed 19 complaints alleging deceptive or other illegal practices by mortgage lenders and brokers, 17 of them filed since 1998. For a list of these FTC enforcement actions, see appendix I. As of December 2003, FTC had reached settlements in all but one of the cases. In most of these settlements, companies have agreed to provide monetary redress to consumers and to halt certain practices in the future. In some cases, the settlements also imposed monetary penalties that the companies have paid to the government. Among the recent enforcement actions related to predatory lending that the FTC identified are the following: The Associates. In 2002, FTC settled a complaint against Associates First Capital Corporation and Associates Corporation of North America (collectively, The Associates), as well as their successor, Citigroup. The complaint alleged that the lender violated the FTC Act and other laws by, among other things, deceiving customers into refinancing debts into home loans with high interest rates and fees and purchasing high-cost credit insurance. The settlement, along with a related settlement with private parties, provides for up to $240 million in restitution to borrowers. First Alliance. In 2002, FTC, along with several states and private plaintiffs, settled a complaint against First Alliance Mortgage Company alleging that it violated federal and state laws by misleading consumers about loan origination and other fees, interest rate increases, and monthly payment amounts on adjustable rate mortgage loans. The company agreed to compensate nearly 18,000 borrowers more than $60 million in consumer redress and to refrain from making misrepresentations about future offers of credit. Fleet Finance and Home Equity U.S.A. In 1999, Fleet Finance, Inc., and Home Equity U.S.A., Inc., settled an FTC complaint alleging violations of the FTC Act, TILA, and related regulations. These violations included failing to provide required disclosures about home equity loan costs and terms and failing to alert borrowers to their right to cancel their credit transactions. To settle, the company agreed to pay up to $1.3 million in redress and administrative costs and to refrain from violating TILA in the future. Operation Home Inequity. In 1999, FTC conducted “Operation Home Inequity,” a law enforcement and consumer education campaign that sought to curb abusive practices in the subprime mortgage lending market. FTC reached settlements with seven subprime mortgage lenders that had been accused of violating a number of consumer protections laws, including the FTC Act, TILA, and HOEPA. Six companies were required to pay $572,000 in consumer redress, and all lenders were required to adhere to future lending restrictions. FTC staff told us that the operation was intended in large part to increase consumers’ awareness of predatory lending and to provide a deterrent effect by warning lenders that FTC is able and willing to take action against them. FTC staff expressed their belief that the agency’s enforcement actions over the years have been successful in deterring other lenders from engaging in abusive practices. However, in a congressional hearing in 2000 FTC had requested statutory changes that would improve its ability to enforce HOEPA. For example, FTC recommended that Congress expand HOEPA to prohibit the financing of lump-sum credit insurance premiums in loans covered by HOEPA and to give FTC the power to impose civil penalties for HOEPA violations. DOJ’s Housing and Civil Enforcement Section is responsible for enforcing certain federal civil rights laws, including the Fair Housing Act and ECOA. DOJ identified two enforcement actions it has taken related to predatory mortgage lending practices that it alleged were discriminatory. Delta Funding. In 2000, DOJ, in cooperation with FTC and HUD, brought charges against Delta Funding Corporation, accusing the consumer finance company of violations of the Fair Housing Act, HOEPA, ECOA, RESPA, and related federal regulations. Delta allegedly approved and funded loans that carried substantially higher broker fees for African American females than for similarly situated white males. Delta was also accused of violating certain consumer protection laws by paying kickbacks and unearned fees to brokers to induce them to refer loan applicants to Delta and by systematically making HOEPA loans without regard to borrowers’ ability to repay. The settlement placed restrictions on the company’s future lending operations and victims were compensated from previously established monetary relief funds. Long Beach Mortgage. In 1996 DOJ settled a complaint alleging violations of the Fair Housing Act and ECOA against Long Beach Mortgage Company. According to the complaint, the company’s loan officers and brokers charged African American, Hispanic, female, and older borrowers higher loan rates than it charged other similarly situated borrowers. The company agreed to set up a $3 million fund to reimburse 1,200 consumers who had received Long Beach loans. Representatives from both FTC and DOJ have stated that their enforcement actions can be very resource intensive and can involve years of discovery and litigation. For example, FTC filed a complaint against Capitol City Mortgage Corporation in 1998 that is still in litigation more than 5 years later. FTC staff told us that because cases involving predatory lending can be so resource intensive, the agencies try to focus their limited resources on the cases that will have the most impact, such as those that may result in large settlements to consumers or that will have some deterrent value by gaining national exposure. Similarly, DOJ officials select certain discrimination cases, including those mentioned above, in part because of their broad impact. HUD’s enforcement and regulatory activity with regard to abusive mortgage lending comes primarily through its management of the FHA single-family mortgage insurance programs, its rule-making and enforcement authority under RESPA, and its enforcement of the Fair Housing Act. Most of HUD’s enforcement activities related to abusive lending have focused on reducing losses to the FHA insurance fund. Investigators from HUD’s Office of the Inspector General have worked with investigators from U.S. Attorneys’ Offices and the FBI in a joint law enforcement effort to target fraud in the FHA mortgage insurance program, which can result in defaults and thus in losses to the insurance fund. The fraudulent activities sometimes involve property flipping schemes, which can harm borrowers by leaving them with mortgage loans that may far exceed the value of their homes. Under certain circumstances, such activity can involve predatory lending practices. To address these crimes, investigators have presented evidence of false statements and other criminal fraud and deception. In addition, representatives from HUD told us that they have processes in place to ensure that lenders adhere to agency guidelines and make loans that satisfy FHA requirements. The Office of Lender Activities and Program Compliance approves, recertifies, and monitors FHA lenders and works with them to ensure compliance. If necessary, the office refers violating lenders to HUD’s Mortgagee Review Board, which has the authority to take administrative actions such as withdrawing approval for a lender to make FHA-insured loans. HUD officials told us that the board has taken many administrative actions to address violations that could be indicative of predatory lending, such as charging excessive and unallowable fees, inflating appraisals, and falsifying documents showing income or employment. In an effort to address abusive property flipping schemes involving homes secured by FHA-insured loans, HUD issued a final rule in May 2003 that prohibits FHA insurance on properties resold less than 90 days after their previous sale. HUD officials say that programs they have in place to improve the monitoring of FHA lenders also serve to deter predatory lending. For example, HUD’s Credit Watch Program routinely identifies those lenders with the highest early default and insurance claim rates and temporarily suspends the FHA loan origination approval agreements of the riskiest lenders, helping to ensure that lenders are not making loans that borrowers cannot repay. Also, the Neighborhood Watch program provides information to FHA participants about lenders and appraisers whose loans have high default and FHA insurance claim rates. HUD told us that it has also taken a series of actions to better ensure the integrity of appraisals used to finance FHA insured loans. As of December 2003, HUD was in the final stages of issuing a rule that would hold lenders accountable for appraisals associated with loans they make. HUD’s Office of RESPA and Interstate Land Sales is responsible for handling complaints, conducting investigations, and taking enforcement actions related to RESPA. HUD has taken several enforcement actions related to RESPA’s prohibition of kickbacks and referral fees, three of which related directly to abusive mortgage lending, as of December 2003. Also, as discussed above, in November 2003 HUD and FTC jointly filed a case against and reached settlement with a mortgage loan servicing company charged with violations of the FTC Act, RESPA, and other laws. HUD has also recently hired additional staff to enhance its RESPA enforcement efforts. Finally, in 2002, HUD issued a proposed rule designed to change the regulatory requirements of RESPA to simplify and potentially lower the costs of the home mortgage settlement process. According to HUD, as of December 2003, the final rule had been submitted to the Office of Management and Budget and was being reviewed. HUD’s Office of Fair Housing and Equal Opportunity is responsible for enforcing the Fair Housing Act. HUD identified one action—a letter of reprimand to a financial institution—related to enforcement of this act in a case involving predatory lending. According to federal banking regulators and state enforcement authorities, federally regulated depository institutions—banks, thrifts, and credit unions—have not typically engaged in predatory lending practices. Federal banking regulators have systems in place to track customer complaints and reported that they have received few complaints related to predatory lending by the institutions they supervise. The regulators conduct routine examinations of these institutions and have the authority, in cases of suspected predatory lending, to enforce a variety of fair lending and consumer protection laws. Banking regulators noted that the examination process, which involves routine on-site reviews of lenders’ activities, serves as a powerful deterrent to predatory lending by the institutions they examine. Officials of OTS, FDIC, the Board, and NCUA said that they had taken no formal enforcement actions related to predatory mortgage lending against the institutions they regulate. Officials at OCC said they have taken one formal enforcement action related to predatory mortgage lending to address fee packing, equity stripping, and making loans without regard to a borrower’s ability to pay. In November 2003, the agency announced an enforcement action against Loan Star Capital Bank seeking to reimburse 30 or more borrowers for more than $100,000 in abusive fees and closing costs that violated the FTC Act, HOEPA, TILA, and RESPA. The bank also was required to conduct a comprehensive review of its entire mortgage portfolio and to provide restitution to any additional borrowers who may have been harmed. While most federal banking regulators stated that they have taken no formal enforcement actions, representatives from some said they had taken informal enforcement actions to address some questionable practices among their institutions. For example, OTS has examined institutions that may have charged inappropriate fees or violated HOEPA and resolved the problems by requiring corrective action as part of the examination process. In addition, most of the banking regulators have taken formal enforcement actions, including issuing cease-and-desist orders, in response to activities that violated fair lending and consumer protection laws but were not necessarily deemed to constitute “predatory lending.” Federal banking regulators have issued guidance to their institutions about both predatory lending and subprime lending in general. In February 2003, OCC issued two advisory letters related to predatory lending to the national banks and the operating subsidiaries it supervises. One letter provided specific guidelines for guarding against predatory lending practices during loan originations, and the other alerted institutions to the risk of indirectly engaging in predatory lending through brokered or purchased loans. The advisory letters described loan attributes that are often considered predatory and established standards for policies and procedures for monitoring loan transactions to avoid making, brokering, or purchasing loans with such attributes. For example, the first letter stated that banks should establish underwriting policies and procedures to determine that borrowers have the capacity to repay their loans. The advisory letter also stated OCC’s position that predatory lending will also affect a national bank’s CRA rating. The advisories have also clarified ways in which predatory practices can create legal, safety and soundness, and reputation risks for national banks. For example, they laid out ways in which the origination or purchase of predatory loans may constitute violations of TILA, RESPA, HOEPA, the FTC Act, and fair lending laws. In addition, in January 2004, OCC issued a rule adopting antipredatory lending standards that expressly prohibit national banks from making loans without regard to the borrower’s ability to repay and from engaging in unfair and deceptive practices under the FTC Act. In 1999 and 2001, the Board, FDIC, OCC, and OTS issued joint guidance to their institutions on subprime lending in general. The guidance highlighted the additional risks inherent in subprime lending and noted that institutions engaging in such lending need to be aware of the potential for predatory practices and be particularly careful to avoid violating fair lending and consumer protection laws and regulations. The NCUA issued similar guidance to insured credit unions in 1999. Federal banking regulators have also previously issued guidance about abusive lending practices, unfair or deceptive acts or practices, and other issues related to predatory lending. The Board is responsible for issuing regulations that implement HOEPA and HMDA, two laws that play a role in addressing predatory lending. In December 2001, in response to concerns that HOEPA may not be adequately protecting consumers from abusive lending practices, the Board amended Regulation Z, which implements HOEPA, to lower the interest rate “trigger” that determines whether loans are covered under HOEPA in order to bring more loans under the protection of the law, require that fees paid for credit insurance and similar debt protection products be included when determining whether loans are subject to HOEPA, prohibit creditors that make HOEPA loans from refinancing the loan within one year of origination with another HOEPA loan, unless the refinancing is in the borrower’s interest, and clarify the prohibition against engaging in a “pattern or practice” of lending without regard to borrowers’ ability to repay. In February 2002, the Board also made changes to Regulation C, which implements HMDA. The changes, which went into effect in January 2004, require lenders to provide additional data that may facilitate analyses of lending patterns that may be predatory. For example if the costs to the borrower of financing a loan exceed a certain threshold determined by the Board, the lender must report the cost of the loan; if an application or loan involves a manufactured home, the lender is required to identify that fact, in part to help identify predatory practices involving these types of homes; and if a loan is subject to HOEPA, the lender is required to identify that fact in order to give policymakers more specific information about the number and characteristics of HOEPA loans. Because HOEPA expressly grants the Board broad authority to issue rules to regulate unfair or deceptive acts and practices, some consumer advocacy organizations have argued that the Board should use its authority to do more to curb predatory lending. For example, some consumer groups have called on the Board to use its rule-making authority to prohibit the financing of single-premium credit insurance—a product that is believed by many to be inherently predatory. Under the McCarran Ferguson Act, unless a federal statute is specifically related to the business of insurance, the federal law may not be construed to invalidate, impair, or supercede any state law enacted to regulate the business of insurance. Board officials say it is not clear the extent to which rules issued by the Board under HOEPA seeking to regulate the sale of single- premium credit insurance would be consistent with that standard. The Board has previously recommended that it would be more appropriate for Congress to address this issue through changes in law. Some consumer groups also have argued that the Board should increase the loan data reporting requirements of HMDA to help detect abusive lending. The Board has added certain loan pricing and other items to the HMDA reporting requirements, effective in January 2004, but did not add other data reporting requirements, such as the credit score of the applicant. Board officials said this is based on the belief that the need for additional loan data to ensure fair lending must be weighed against the costs and burdens to the lender of gathering and reporting the additional information. Federal agencies have worked together to investigate and pursue some cases involving predatory lending. For example, FTC, DOJ, and HUD coordinated to take enforcement action against Delta Funding Corporation, with each agency investigating and bringing actions for violations of the laws under its jurisdiction. DOJ conducted its enforcement action against Long Beach Mortgage Company in coordination with OTS, which investigated the initial complaint in 1993 when the company was a thrift. Federal agencies have also coordinated with state authorities and private entities in enforcement actions. For example, in 2002, FTC joined six states, AARP, and private attorneys to settle a complaint against First Alliance Mortgage Company alleging that the company used deception and manipulation in its lending practices. Federal regulators have also coordinated their efforts to address fair lending and predatory lending through working groups. For example In the fall of 1999 the Interagency Fair Lending Task Force, which coordinates federal efforts to address discriminatory lending, established a working group to examine the laws related to predatory lending and determine how enforcement and consumer education could be strengthened. Because of differing views on how to define and combat predatory lending, the group was unable to agree on a federal interagency policy statement related to predatory lending in 2001. The Task Force then continued its efforts related to consumer education and published a brochure in 2003 to educate consumers about predatory lending practices. The five banking regulators have conducted additional coordination activities through the Federal Financial Institutions Examination Council’s Task Force on Consumer Compliance. The task force coordinates policies and procedures for ensuring compliance with fair lending laws and the Community Reinvestment Act, both of which have been identified as tools that can be used to address predatory lending. The council publishes a document that responds to frequently asked questions about community reinvestment, including how examiners should consider illegal credit practices, which may be abusive, in determining an institution’s Community Reinvestment Act rating. In 2000, HUD and the Department of the Treasury created the National Task Force on Predatory Lending, which convened forums around the country to examine the issue and released a report later in the year. The report made specific recommendations to Congress, federal agencies, and other stakeholders that were aimed at (1) improving consumer literacy and disclosure, (2) reducing harmful sales practices, (3) reducing abusive or deceptive loan terms and conditions, and (4) changing structural aspects of the lending market. Some of the recommendations made in the HUD-Treasury task force report have been implemented. For example, as recommended in the report, the Board has adopted changes to HOEPA regulations that have increased the number of loans covered and added additional restrictions. In addition, as the report recommended, FTC and some states have devoted more resources in the past few years to actively pursuing high-profile enforcement cases. As discussed in chapter 5, federal and state agencies have also worked to improve one of the areas highlighted in the report: public awareness about predatory lending issues. Other recommendations made in the report have not been implemented, however. For example, Congress has not enacted legislation to expand penalties for violations of TILA, HOEPA, and RESPA or to increase the damages available to borrowers harmed by such violations. HUD and the Department of the Treasury told us that they have not formally tracked the status of the recommendations made in the report, although HUD officials said they are informally monitoring the recommendations in the report that relate to their agency. Officials at both agencies also noted that the report and its recommendations were the product of a previous administration and may or may not reflect the views of the current administration. In addition to participating in interagency groups, agencies share information related to fair lending violations under statutory requirements and formal agreements. For example, since 1992 HUD and the banking regulators have had a memorandum of understanding stating that HUD will refer allegations of fair lending violations to banking regulators and a 1994 executive order requires that executive branch agencies notify HUD of complaints and violations of the Fair Housing Act. In addition, whenever the banking regulatory agencies or HUD have reason to believe that an institution has engaged in a “pattern or practice” of illegal discrimination, they are required to refer these cases to DOJ for possible civil action. Jurisdictional issues related to the regulation of certain nonbank mortgage lenders may challenge efforts to combat predatory lending. Many federally and state-chartered banks and thrifts, as well as their subsidiaries, are part of larger financial holding companies or bank holding companies. These holding companies may also include nonbank financial companies, such as finance and mortgage companies, that are subsidiaries of the holding companies themselves. These holding company subsidiaries are frequently referred to as affiliates of the banks and thrifts because of their common ownership by the holding company. As shown in figure 2, the federal regulators of federally and state-chartered banks and thrifts also regulate the subsidiaries of those institutions. For example, as the primary regulator for national banks, OCC also examines operating subsidiaries of those banks. On the other hand, federal regulators generally do not perform routine examinations of independent mortgage lenders and affiliated nonbank subsidiaries of financial and bank holding companies engaged in mortgage lending. Some disagreement exists between states and some federal banking regulators over states’ authority to regulate and supervise the operating subsidiaries of federally chartered depository institutions. For example, OCC issued an advisory letter in 2002 noting that federal law provides the agency with exclusive authority to supervise and examine operating subsidiaries of national banks and that the states have no authority to regulate or supervise these subsidiaries. Some representatives of state banking regulators expressed concerns to us about this because of the subsidiaries’ potential involvement in predatory lending practices. OCC has stated that the subsidiaries of the institutions it regulates do not play a large role in subprime lending and that little evidence exists to show that these subsidiaries are involved in predatory lending. But some state enforcement authorities and consumer advocates argue otherwise, citing some allegations of abuses at national bank subsidiaries. However, several state attorneys general have written that predatory lending abuses are “largely confined” to the subprime lending market and to non-depository institutions, not banks or direct bank subsidiaries. OCC officials stated that the agency has strong monitoring and enforcement systems in place and can and will respond vigorously to any abuses among institutions it supervises. For example, OCC officials pointed to an enforcement action taken in November 2003 that required restitution of more than $100,000 to be paid to 30 or more borrowers for fees and interest charged in a series of abusive loans involving small “tax-lien loans.” A second issue relates to the monitoring and supervision of certain nonbank subsidiaries of holding companies. As noted previously, many federally and state-chartered banks and thrifts, as well as their subsidiaries, are part of larger financial or bank holding companies. These holding companies may also include nonbank subsidiaries, such as finance and mortgage companies, that are affiliates but not subsidiaries of the federally regulated bank or thrift. Although these affiliates engage in financial activities that may be subject to federal consumer protection and fair lending laws, unlike depository institutions they are not subject to routine supervisory examinations for compliance with those laws. While the Board has jurisdiction over these entities for purposes of the Bank Holding Company Act, it lacks authority to ensure and enforce their compliance with federal consumer protection and fair lending laws in the same way that the federal regulators monitor their depository institutions. One reason for the concern about these entities is that nonbank subsidiaries of holding companies conduct a significant amount of subprime mortgage lending. Of the total subprime loan originations made by the top 25 subprime lenders in the first 6 months of 2003, 24 percent were originated by nonbank subsidiaries of holding companies. In addition, of the 178 lenders on HUD’s 2001 subprime lender list, 20 percent were nonbank subsidiaries of holding companies. These types of subsidiaries have also been targets of some of the most notable federal and state enforcement actions involving abusive lending. For example, The Associates and Fleet Finance, which were both nonbank subsidiaries of bank holding companies, were defendants in two of the three largest cases involving subprime lending that FTC has brought. The Associates case illustrates an important aspect of the current federal regulatory oversight structure pertinent to predatory lending. The Board has authority under the Bank Holding Company Act to condition its approval of holding company acquisitions. The Board used this authority in connection with Citigroup’s acquisition of European American Bank because of concerns about the subprime lending activities of The Associates, which Citigroup had acquired and merged into its CitiFinancial subsidiary. As a condition of approving the acquisition of European American Bank, the Board directed that an examination of certain subprime lending subsidiaries of Citigroup be carried out to determine whether Citigroup was effectively implementing policies and procedures designed to ensure compliance with fair lending laws and prevent abusive lending practices. However, the Board does not have clear authority to conduct the same type of monitoring outside of the Bank Holding Company Act approval process. Although the Board has the authority to monitor and perform routine inspections or examinations of a bank holding company, this authority apparently does not extend to routine examinations of nonbank subsidiaries of bank holding companies with regard to compliance with consumer protection laws. The Bank Holding Company Act, as amended by the Gramm-Leach-Bliley Act, authorizes the Board to examine a nonbank subsidiary for specific purposes, including “to monitor compliance with the provisions of (the Bank Holding Company Act) or any other Federal law that the Board has specific jurisdiction to enforce against such company or subsidiary.” Federal consumer protection laws do not give the Board specific enforcement jurisdiction over nonbank subsidiaries. For this reason, FTC is the primary federal agency monitoring nonbank subsidiaries’ compliance with consumer protection laws. FTC is the primary federal enforcer of consumer protection laws for these nonbank subsidiaries, but it is a law enforcement rather than supervisory agency. Thus, FTC’s mission and resource allocations are focused on conducting investigations in response to consumer complaints and other information rather than on routine monitoring and examination responsibilities. Moreover, as discussed elsewhere in this report, states vary widely in the extent to which they regulate practices that can constitute predatory lending. The HUD-Treasury report on predatory lending argued that the Board should take more responsibility for monitoring nonbank subsidiaries of bank holding companies, in part to ensure that consumer protection laws are adequately enforced for these institutions. Similarly, in 1999, GAO recommended that the Board monitor the lending activities of nonbank mortgage lending subsidiaries of bank holding companies and consider examining these entities if patterns in lending performance, growth, or operating relationships with other holding company entities indicated the need to do so. In its written response to GAO’s recommendation, the Board said that while it has the general legal authority to examine these entities, it has neither the clear enforcement jurisdiction nor the legal responsibility for engaging in such activities, as Congress has directly charged FTC with primary responsibility over enforcement with regard to these entities. Among federal agencies, the Board is uniquely situated to monitor the activities of the nonbank mortgage lending subsidiaries of financial and bank holding companies by virtue of its role as the regulator of holding companies and its corresponding access to data (such as internal operating procedures, loan level data, and current involvement in subprime lending) that are not readily available to the public. In addition, the Board has extensive experience monitoring and analyzing HMDA data. The recent changes in HMDA reporting requirements will increase the Board’s ability to effectively monitor nonbank mortgage lending subsidiaries of holding companies for lending abuses. In contrast to the specific limits on the Board’s examination authority, its authority to enforce the federal consumer protection laws against nonbank subsidiaries is somewhat less clear. The laws themselves specify the institutions subject to enforcement by the Board, but those institutions generally do not include nonbank subsidiaries. The Board has concluded that it must defer enforcement action at least where, as here, a statute specifically prescribes its enforcement jurisdiction to cover only certain entities and specifically grants enforcement authority for other entities to another agency. Under a number of laws, federal agencies have taken action to protect consumers from abusive lending practices. While FTC has taken a number of significant enforcement actions to battle abuses in the industry, its resources are finite and, as a law enforcement agency, it does not routinely monitor or examine lenders, including the mortgage lending subsidiaries of financial and bank holding companies. Congress provided banking regulators with the authority to ensure compliance with consumer protection laws by the institutions they regulate, in part because it recognized the efficiencies of having banking regulators monitor for compliance with these laws while examining their institutions for safety and soundness. The Board is in a position to help ensure compliance with federal consumer protection laws by certain subsidiaries of financial and bank holding companies if it were clearly authorized to do so. While concerns about predatory lending extend well beyond the activities of the nonbank subsidiaries of holding companies, these entities represent a significant portion of the subprime mortgage market. Monitoring the mortgage lending activities of the nonbank subsidiaries would help the Board determine when it would be beneficial to conduct examinations of specific nonbank subsidiaries. The Board could then refer its findings to DOJ, HUD, or FTC or take its own enforcement action if a problem exists. Granting the Board concurrent enforcement authority—with the FTC—for these nonbank subsidiaries of holding companies would not diminish FTC’s authority under federal laws used to combat predatory lending. The significant amount of subprime lending among holding company subsidiaries, combined with recent large settlements in cases involving allegations against such subsidiaries, suggests a need for additional scrutiny and monitoring of these entities. The Board is in an optimal position to play a larger role in such monitoring but does not have clear legal authority and responsibility to do so for these entities with regard to monitoring compliance of consumer protection laws. To enable greater oversight of and potentially deter predatory lending from occurring at certain nonbank lenders, Congress should consider making appropriate statutory changes to grant the Board of Governors of the Federal Reserve System the authority to routinely monitor and, as necessary, examine the nonbank mortgage lending subsidiaries of financial and bank holding companies for compliance with federal consumer protection laws applicable to predatory lending practices. Also, Congress should consider giving the Board specific authority to initiate enforcement actions under those laws against these nonbank mortgage lending subsidiaries. GAO provided a draft of this report to the Board, DOJ, FDIC, FTC, HUD, NCUA, OCC, OTS, and the Department of the Treasury for review and comment. The agencies provided technical comments that have been incorporated, as appropriate. In addition, the Board, DOJ, FDIC, FTC, HUD, and NCUA provided general comments, which are discussed below. The written comments of the Board, DOJ, HUD, and NCUA are printed in appendixes II through V. The Board commented that, while the existing structure has not been a barrier to Federal Reserve oversight, the approach recommended in our Matter for Congressional Consideration would likely be beneficial by catching some abusive practices that might not be caught otherwise. The Board also noted that the approach would pose tradeoffs, such as different supervisory schemes being applied to nonbank mortgage lenders based on whether or not they are part of a holding company. Because nonbank mortgage lenders that are part of a financial or bank holding company are already subject to being examined by the Board in some circumstances, they are already subject to a different supervisory scheme than other such lenders. For example, in its comments the Board noted that it may on occasion direct an examination of a nonbank lending subsidiary of a holding company when necessary in the context of applications that raise serious fair lending or compliance issues. Accordingly, we do not believe that clarifying jurisdiction as contemplated in the Matter would result in a significant departure from the current supervisory scheme for nonbank mortgage lenders. The Board also noted that that there could be some additional cost to the nonbank mortgage lending subsidiaries of financial or bank holding companies, as well as to the Board, if the Board were to exercise additional authority. We agree and believe that Congress should consider both the potential costs as well as the benefits of clarifying the Board’s authorities. The FTC expressed concern that our report could give the impression that we are suggesting that Congress consider giving the Board sole jurisdiction—rather than concurrent jurisdiction with FTC—over nonbank subsidiaries of holding companies. Our report did not intend to suggest that the Congress make any change that would necessarily affect FTC’s existing authority for these entities and we modified our report to clarify this point. To illustrate the difference in regulatory and enforcement approaches, our draft report contrasted the Board’s routine examination authority with the FTC’s role as a law enforcement agency. In its comments, FTC noted that it uses a number of tools to monitor nonbank mortgage lenders, of which consumer complaints is only one. The agency also commented that a key difference between the FTC and the Board is that the Board has access to routine information to aid in its oversight as part of the supervisory process. Our report did not intend to suggest that the FTC’s actions are based solely on consumer complaints, and we revised the report to avoid this impression. DOJ commented that the report will be helpful in assessing the department’s role in the federal government’s efforts to develop strategies to combat predatory lending. DOJ disagreed with our inclusion in the report of “property or loan flips,” which it characterized as a traditional fraud scheme rather than an example of predatory lending. As our report states, there is no precise definition of predatory lending. We included a discussion of efforts to combat “property flipping” because HUD officials told us that these schemes sometimes involve predatory practices that can harm borrowers. As we note in the report, while HUD categorizes property flipping as a predatory lending practice, not all federal agencies concur with this categorization. Distinct from property flipping is “loan flipping”— the rapid and repeated refinancing of a loan without benefit to the borrower. This practice is widely noted in literature and by federal, state, industry, and nonprofit officials as constituting predatory lending. FDIC noted that our Matter for Congressional Consideration focuses on nonbank subsidiaries of financial and bank holding companies even though these entities comprise, according to HUD, only about 20 percent of all subprime lenders. We acknowledge that our Matter does not address all subprime lenders or institutions that may be engaging in predatory lending, but believe it represents a step in addressing predatory lending among a significant category of mortgage lenders. NCUA said that the report provides a useful discussion of the issues and that the agency concurs with our Matter for Congressional Consideration. HUD, in its comment letter, described a variety of actions it has taken that it characterized as combating predatory lending, particularly with regard to FHA-insured loans. In part because of concerns about the growth of predatory lending and the limitations of existing state and federal laws, 25 states, the District of Columbia, and 11 localities had passed their own laws addressing predatory lending practices as of January 9, 2004. Most of the state laws restrict the terms or provisions of certain high-cost loans, while others apply to a broader range of loans. In addition, some states have taken measures to strengthen the regulation and licensing of mortgage lenders and brokers, and some have used existing state consumer protection and banking laws to take enforcement actions related to abusive lending. However, regulators of federally chartered financial institutions have issued opinions stating that federal laws may preempt some state predatory lending laws and that nationally chartered lending institutions should have to comply only with a single uniform set of national standards. Many state officials and consumer advocates have opposed federal preemption of state predatory lending laws on the grounds that it interferes with the states’ ability to protect consumers. Since 1999, many states and localities have passed laws designed to address abusive mortgage lending by restricting the terms or provisions of certain loans. In addition, states have increased the registration or licensing requirements of mortgage brokers and mortgage lenders and have undertaken enforcement activities under existing consumer protection laws and regulations to combat abusive lending. According to the database of state laws, as of January 9, 2004, 25 states and the District of Columbia had passed laws that were specifically designed to address abusive lending practices. (See fig. 3.) These laws were motivated, at least in part, by growing evidence of abusive lending and by concerns that existing laws were not sufficient to protect consumers against abusive lending practices. Based on our review of the database of state laws, the predatory lending statutes in 20 of the 25 states regulate and restrict the terms and characteristics of certain kinds of “high-cost” or “covered” mortgage loans that exceed certain interest rate or fee triggers. Some state laws, such as those in Florida, Ohio, and Pennsylvania, use triggers that are identical to those in the federal HOEPA statute but add provisions or requirements, such as restrictions on refinancing a loan under certain conditions. Other state laws, such as those of Georgia, New Jersey and North Carolina, use triggers that are lower than those in HOEPA and therefore cover more loans than the federal legislation. Some states design their triggers to vary depending on the amount of the loan. For example, in New Mexico and North Carolina, covered loans greater than $20,000 are considered high cost if the points and fees on the loan exceed 5 percent of the total loan amount (North Carolina) or equal or exceed it (New Mexico). In these states, loans for less than $20,000 are considered high cost if the points and fees exceed either 8 percent of the total or $1,000. In the remaining 5 states, the predatory lending laws apply to most mortgage loans; there is no designation of loans as high cost. For example, West Virginia’s law in effect generally prohibits lenders from charging prepayment penalties on any loans and restricts points and fees to either 5 or 6 percent, depending on whether the loan includes a yield spread premium. Michigan’s law prohibits the financing of single-premium credit insurance into loans. According to the database, common provisions in state laws are designed to address the following: Lending without regard to the ability to repay. Restrictions on the making of loans without regard to the borrower’s ability to repay the loan, sometimes referred to as asset-based lending. Prepayment penalties. Limitations on the amount of a prepayment penalty, terms under which a penalty can be assessed, or both. Balloon payments. Prohibitions on loans with balloon payments or restrictions on their timing. Negative amortization. Prohibitions on loans where regularly scheduled payments do not cover the interest due. Loan flipping. Restrictions or prohibitions on the repeated refinancing of certain loans within a short period of time if the refinancing will not benefit the borrower. Credit counseling. Requirements that borrowers either receive or are notified of the availability of loan counseling. Arbitration clauses. Restrictions on mandatory arbitration clauses, which limit a borrower’s right to seek redress in court. Some laws prohibit mandatory arbitration clauses altogether, while others require compliance with certain standards, such as those set by a nationally recognized arbitration organization. Assignee liability. Provisions that expressly hold purchasers or securitizers of loans liable for violations of the law committed by the originator, under certain conditions. (See ch. 4 for more information on assignee liability.) In addition, according to the database we reviewed, 11 cities and counties have passed laws of their own designed to address predatory lending since 2000. Some local laws are similar to state laws in that they define high- cost loans and restrict their provisions, such as in Los Angeles, California. Other localities, such as Oakland, California, have passed resolutions prohibiting lenders that engage in predatory lending practices from doing business with the locality. In general, states have regulated mortgage lenders and brokers, although to varying degrees. Some state officials told us that because of concerns that unscrupulous mortgage lenders and brokers were not adequately regulated and were responsible for lending abuses, some states have increased their regulation or licensing requirements of lenders and brokers. As part of their licensing requirements, states sometimes require that these companies establish a bond to help compensate victims of predatory lenders or brokers that go out of business, and some states also require that individuals working for or as mortgage lenders and brokers meet certain educational requirements. Some states have also reorganized their agencies’ operations to better address abuses by lenders and brokers. For example, an official with the Kansas Office of the State Banking Commissioner told us that in 1999 the Kansas legislature created the Division of Consumer and Mortgage Lending, which provides additional staff for examination and enforcement activities. Similarly, an official from the Idaho Department of Finance told us that the state created the Consumer Finance Bureau in 2000 to oversee and conduct routine examinations of mortgage brokers and mortgage lenders. State law enforcement agencies and banking regulators have also taken a number of actions in recent years to enforce existing state consumer protection and banking laws in cases involving predatory lending. For example, an official from the Washington Department of Financial Institutions reported that it has taken several enforcement actions in recent years to address predatory lending. In one such action, a California mortgage company that allegedly deceived borrowers and made prohibited charges was ordered to return more than $700,000 to 120 Washington State borrowers. According to officials of the Conference of State Bank Supervisors, states reported that in addressing predatory lending they have usually relied on general state consumer protection laws in areas such as fair lending, licensing, and unfair and deceptive practices. In some states, consumer protection statutes do not apply to financial institutions, so state banking regulators, rather than the attorneys general, typically initiate enforcement activities. Because allegations of predatory practices often involve lending activities in multiple states, states have sometimes cooperated in investigating alleged abuses and negotiating settlements. For example, in 2002 a settlement of up to $484 million with Household Finance Corporation resulted from a joint investigation begun by the attorneys general and financial regulatory agencies of 19 states and the District of Columbia. State agencies have also conducted investigations in conjunction with the federal government. States have varied in their approaches to addressing predatory lending issues. We reviewed legislative and enforcement activities related to predatory lending in two states, North Carolina and Ohio, to illustrate two different approaches. North Carolina has enacted two separate laws to address concerns about predatory lending. In 1999, the legislature passed a law that attempted to curb predatory lending by prohibiting specific lending practices and restricting the terms of high-cost loans. In 2001, North Carolina supplemented its predatory lending law by adopting legislation that required the licensing of mortgage professionals (mortgage lenders, brokers, and loan officers), defined a number of prohibited activities related to the making of residential mortgages, and enhanced the enforcement powers of the banking commissioner. According to the North Carolina Commissioner of Banks, the North Carolina laws applicable to predatory lending were the product of a consensus of banks, mortgage bankers and brokers, nonprofit organizations, and other stakeholders and were intended to address lending abuses that were not prohibited by federal statutes and regulations. Among other things, the 1999 legislation, known as the North Carolina Anti- Predatory Lending Law, imposes limitations specific to both “high-cost” loans and other “consumer home loans.” North Carolina’s predatory lending law did not restrict initial interest rates but instead focused on prohibiting specific lending practices and restricting the terms of high-cost loans. In conjunction with other North Carolina laws, the 1999 legislation contains four key features. First, it bans prepayment penalties for all home loans with a principal amount of $150,000 or less. Second, it prohibits loan flipping—refinancings of consumer home loans that do not provide a reasonable, net tangible benefit to the borrower. Third, it prohibits the financing of single-premium credit life insurance. Finally, it sets a number of restrictions on high-cost loans, including making loans without regard to borrowers’ ability to repay; financing points, fees, and any other charges payable to third parties; or setting up loans with balloon payments. Further, the law prohibits home improvement contract loans under which the proceeds go directly to the contractor, and requires that borrowers receive financial counseling prior to closing. Although the North Carolina predatory lending law governs the practices of lenders and mortgage brokers, some groups questioned whether it provided for effective enforcement. Specifically, concerns were focused on the lack of state licensing and oversight of all segments of the mortgage lending profession, including mortgage brokers and bankers. Additionally, some critics asserted that the statute provided the state banking commissioner with limited and uncertain authority to enforce the predatory lending provisions. As a result, even before the predatory lending legislation passed, stakeholders worked on a measure to fill the gaps left by the state’s predatory lending law. North Carolina’s second statute, the Mortgage Lending Act, was signed into law on August 29, 2001. Prior to the act, some mortgage banking firms and all mortgage brokerages domiciled in the state had been required to register with the state’s banking regulator, but individual loan originators were not. The Mortgage Lending Act imposed licensing requirements on all mortgage bankers and brokers, including individuals who originate loans, and added continuing education and testing requirements for mortgage loan officers. The provisions of the act mean that individuals as well as firms are now subject to regulatory discipline. According to the North Carolina Commissioner of Banks, the act has been effective in reducing the number of abusive brokers and individual loan originators. The commissioner noted that a large number of applications for licenses have been denied because the applicants did not meet basic requirements or did not pass the required background check. Studies on the impact of North Carolina’s Anti-Predatory Lending Law have offered conflicting conclusions. For example, one study found an overall decline in subprime mortgages and concluded that any reductions in predatory lending had been attained at the expense of many legitimate loans. Some have pointed to this evidence as suggesting that the law has reduced legitimate credit to those who most need it. Another study found a reduction in subprime originations but attributed the decline to a reduction in loans with abusive or predatory terms. Consumer advocates and state officials have cited this study as evidence that the law has worked as intended. Our review of the five studies available on the impact of the North Carolina predatory lending law suggested that data limitations and the lack of an accepted definition of predatory lending make determining the law’s impact difficult. For example, information about borrowers’ risk profiles, the pricing and production costs of the loans, and the lenders’ and borrowers’ behaviors was not available to the study researchers. In addition, the extent to which any potential reductions in predatory loans can be attributed to the Mortgage Lending Act as opposed to the Anti- Predatory Lending Law is unclear. Additional experience with the North Carolina laws may be needed in order to properly assess them. In February 2002, the Ohio legislature enacted a law with the purpose of bringing Ohio law into conformance with HOEPA. Among other things, the legislation preempted certain local predatory lending ordinances. The law was passed in response to an ordinance enacted in the city of Dayton, which was designed to fight predatory lending by regulating mortgage loans originated in that city. Proponents of the state law argued that regulating lenders is a state rather than municipal function and that lending rules should be uniform throughout the state. Some advocates argued that the state law prevents cities from protecting their citizens from abusive lending practices. The Ohio law imposes certain restrictions on high-cost loans as defined by HOEPA. These include additional restrictions on credit life or disability insurance beyond those imposed by HOEPA. The law also prohibits the replacement or consolidation of a zero- interest rate or other low-rate loan made by a governmental or nonprofit lender with a high-cost loan within the first 10 years of the low-rate loan unless the current holder of the loan consents in writing to the refinancing. Because the purpose of this law was to bring Ohio’s law into conformance with HOEPA, the law applies only to loans that qualify as mortgage loans subject to HOEPA. Thus, like predatory lending laws in some other states, the Ohio law applies to relatively few loans. In May 2002, the Ohio legislature passed another piece of legislation, designed in part to address abusive lending—the Ohio Mortgage Broker Act—that imposed requirements on the state’s mortgage brokers and loan officers. Among other things, this law required state examination, education, and licensing of loan officers, and prohibited brokers from engaging in certain deceptive or fraudulent practices. It also required that mortgage brokers and loan officers receive continuing education and take prelicensing competency tests. In the act adopting HOEPA standards, the Ohio legislature also established a Predatory Lending Study Committee, which was charged with investigating the impact of predatory lending practices on the citizens and communities of Ohio. The study committee consisted of 15 members, including representatives from state agencies, consumer groups, and the lending industry. The act required the committee to submit a report to the governor and legislators by the end of June 2003. The committee reached consensus on two major issues. First, it recommended that all appraisers in the state be licensed and subject to criminal background checks, and second, it recommended increased enforcement of the Ohio Mortgage Broker Act. The Division of Financial Institutions, which is responsible for enforcing the Ohio Mortgage Broker Act, has hired additional staff to ensure compliance with the law. The report and recommendations have been forwarded to the governor and the committee suggested that the Ohio General Assembly consider all recommendations. Other local ordinances have been passed in Ohio to address predatory lending. One of these ordinances, passed in November 2002 by the Toledo City Council to regulate mortgage lending practices, was challenged, and its enforcement stayed, because of the state HOEPA law passed in February 2002. One provision of that ordinance prohibited making an abusive loan by “taking advantage of a borrower’s physical or mental infirmities, ignorance or inability to understand the terms of the loan.” This provision drew criticism from the mortgage industry, which said the language was vague and difficult to comply with. For example, one secondary market participant noted that it would be nearly impossible to assess borrowers’ mental capabilities for loans they did not originate in the first place. Violating the law was made a criminal offense, and convicted offenders could not receive city contracts or conduct other business with the city. Significant debate has taken place as to the advantages and disadvantages of state and local predatory lending laws. In several cases, regulators of federally supervised financial institutions have determined that federal laws preempt state predatory lending laws for the institutions they regulate. In making these determinations, two regulators—OCC and OTS—have cited federal law that provides for uniform regulation of federally chartered institutions and have noted the potential harm that state predatory lending laws can have on legitimate lending. Representatives of the lending industry and some researchers agree with the federal banking regulators, arguing that restrictive state predatory lending laws may ultimately hurt many borrowers by reducing the supply of lenders willing to make subprime loans, creating undue legal risks for legitimate lenders, and increasing the costs of underwriting mortgage loans. Moreover, industry representatives have said that most predatory lending practices are already illegal under federal and state civil and criminal laws and that these laws should simply be more stringently enforced. In contrast, many state officials and consumer advocates are opposed to federal preemption of state predatory lending laws. They maintain that federal laws related to predatory lending are insufficient, and thus preemption interferes with their ability to protect consumers in their states, particularly from any potential abuses by the subsidiaries of federally chartered institutions. Because both the federal and state governments have roles in chartering and regulating financial institutions, questions can arise as to whether a federal statute preempts particular state laws. Affected parties may seek guidance from federal agencies requesting their views on whether a particular federal statute preempts a particular state law; in these instances, the agency may issue an advisory opinion or order on the issue. Because the courts are ultimately responsible for resolving conflicts between federal and state laws, these advisory opinions and orders are subject to court challenge and review. As of November 2003, one or more federal regulators had determined that federal laws preempted the predatory mortgage lending laws of the District of Columbia and five states—Georgia, New Jersey, New Mexico, New York, and North Carolina. (See table 1.) Preemption of state law is rooted in the U.S. Constitution’s Supremacy Clause, which provides for the supremacy of federal law. Over the years, the courts have developed a substantial body of precedent that has guided the analysis of whether any particular federal law or regulation overrides or preempts state law. The courts’ analysis of whether federal law preempts state law has fundamentally centered on whether Congress intended for the federal law or regulation to override state law, either from the face of the statute itself (express preemption) or from the structure and purpose of the statute (implied preemption.) In their preemption opinions, OCC, OTS, and NCUA have cited a variety of legislation and legal precedents. Since 1996, OTS has had regulations in place that describe its preemption of state lending laws. In January 2004, OCC issued a rule amending its regulations in a similar manner, clarifying what types of state laws federal law preempts in the context of national bank lending. OCC stated that it issued the rule in response to the number and significance of the questions that have arisen with respect to the preemption of state laws and to reduce uncertainty for national banks that operate in multiple states. In its rulemaking, OCC stated that it was seeking to provide more comprehensive standards regarding the applicability of state laws to lending, deposit taking, and other authorized activities of national banks. The regulations list examples of the types of state statutes that are preempted (such as laws regulating credit terms, interest rates, and disclosure requirements) and examples of the types of state laws that would not be preempted (such as laws pertaining to zoning, debt collection, and taxation). When OCC first proposed these rules, one news article stated that it “triggered a flood of letters and strong reactions from all corners of the predatory lending debate.” States and consumer groups were critical of the proposal. In contrast, the Mortgage Bankers Association of America and some large national banking companies wrote comment letters in support of OCC’s proposed rules. Federal banking regulators point out that preemption of states’ antipredatory lending laws applies only to institutions chartered by the agency issuing the preemption order. For example, OTS’s preemption opinion served to preempt New Jersey’s predatory lending statute for federally chartered thrifts but did not affect the statute’s applicability to independent mortgage companies, national banks, and state-chartered banks and thrifts. In preempting the New Jersey Home Ownership Security Act of 2002, OTS’s Chief Counsel noted that requiring federally chartered thrifts to comply with a hodgepodge of conflicting and overlapping state lending requirements would undermine Congress’s intent that federal savings institutions operate under a single set of uniform laws and regulations that would facilitate efficiency and effectiveness. Federal banking regulators have said that they have found little to no evidence of predatory lending by the institutions they regulate, pointing out that federally supervised institutions are highly regulated and subject to comprehensive supervision. They have also noted that they have issued guidance and taken numerous other steps to ensure that their institutions do not engage in predatory lending. Further, OCC has stated that state predatory lending laws, rather than reducing predatory lending among federally supervised institutions, can actually restrict and inhibit legitimate lending activity. The lending industry has generally supported preemption. For example, the Mortgage Bankers Association of America has argued that uniformity in lending regulations is central to an efficient and effective credit market. In contrast, many state officials and consumer advocates have opposed federal preemption of state predatory lending laws, for several reasons. First, they contend that state predatory lending laws are necessary to address gaps in relevant federal consumer protection laws. For example, one state official said that the predatory lending legislation adopted by his state was more focused and effective than the provisions of the Federal Trade Commission Act. In addition, opponents of preemption claim that federal regulators may not devote the necessary resources or have the willingness to enforce federal consumer protection laws relevant to predatory lending by federally chartered institutions and their subsidiaries. In response to OCC’s and OTS’s statements that there is no evidence of predatory lending among subsidiaries of federally regulated depository institutions, opponents of preemption noted that there are several cases in which allegations of abusive lending practices involving some of these subsidiaries have been raised. By providing lenders with an additional source of liquidity, the secondary market can benefit borrowers by increasing the availability of credit and, in general, lowering interest rates. While a secondary market for prime mortgage loans has existed for decades, a relatively recent secondary market for subprime loans now offers these potential benefits to subprime borrowers as well. However, the secondary market may also serve to facilitate predatory lending, as it can provide a source of funds for unscrupulous originators that quickly sell off loans with predatory terms. Secondary market participants may use varying degrees of due diligence to avoid purchasing loans with abusive terms. In addition, some states have enacted legislation with assignee liability—potentially holding purchasers liable for violations of abusive lending laws that occurred in the loan origination. However, extending liability to secondary market purchasers may cause lenders and other secondary market participants, such as credit rating agencies, to withdraw from the market, as occurred in Georgia. Originators of mortgage loans—which can include banks, other depository institutions, and mortgage lenders that are not depository institutions— may keep the loans or sell them in the secondary market. Secondary market purchasers may then hold the loans in their own portfolio or may pool together a group of loans and issue a mortgage-backed security that is backed by a pool of such loans. The securitization of mortgage loans became common during the 1980s and, by the 1990s, had become a major source of funding in the prime mortgage market. According to the Office of Federal Housing Enterprise Oversight, by the end of 2002 more than 58 percent of outstanding U.S. single-family residential mortgage debt was financed through securitization. Two government-sponsored enterprises— Fannie Mae and Freddie Mac—represented nearly 40 percent of the amount securitized. The securitization of subprime mortgage loans did not become common until the mid-1990s. The development of a secondary market for these loans has been an important factor in the growth of subprime lending, expanding subprime lenders’ access to funds and thus increasing the availability of subprime credit. The trade journal Inside B&C Lending estimated that in 2002 approximately 63 percent of new subprime mortgages, representing $134 billion, were securitized. The originators of subprime loans are often nonbank mortgage and finance companies. As secondary market participants—such as the Wall Street investment firms that have been the major underwriters for subprime securities—have grown more willing to purchase these instruments, subprime originators have gained access to an important source of liquidity that has allowed them to make more subprime loans. As shown in figure 4, the process of securitization starts with borrowers obtaining mortgages either directly from a lender or through a broker. The lender then creates a pool—a separate legal entity that purchases the mortgages and issues securities based on them. The lender hires a credit rating agency, which has no direct financial interest in the deal, to confirm the value of the securities based on the expected return and risks of the underlying mortgages. At the same time, the lender hires an underwriter to sell the securities to investors. The value of the securities is based exclusively on the mortgages themselves and is separate from the financial condition of the original lender. Finally, a servicer is hired to collect mortgage payments from the borrowers and disburse interest and principal payments to the investors. The process described above is for securitizations performed via private conduits—that is, without the participation of government-sponsored enterprises. Freddie Mac and Fannie Mae are relatively recent entrants into the subprime market; Freddie Mac began purchasing subprime loans in 1997 and Fannie Mae in 1999. Both companies have moved slowly and have limited their purchases to the segment of the subprime market with the most creditworthy of subprime loans. At present, the companies are believed to represent a relatively small portion of the overall secondary market for subprime loans. The exact portion they represent is not clear, but a study conducted for HUD estimated that the companies purchased about 14 percent of the subprime loans originated in 2002. Both Fannie Mae and Freddie Mac have stated publicly that they plan on expanding their role in the subprime market in the future. In part, this may be a result of the affordable housing goals that HUD set for the GSEs in October 2000, which increased the goals for loans made to low- and moderate-income borrowers. HUD recommended that the GSEs consider enhancing their roles in the subprime market—which often serves low- and moderate- income borrowers—to help standardize mortgage terms in that market and potentially reduce interest rates for subprime borrowers. While the GSEs are currently believed to represent a small portion of the secondary market for subprime lending, some market observers believe their share will grow. The growth of the secondary market for subprime loans has potentially benefited some consumers. By providing subprime lenders with a new source of liquidity, these lenders face lower funding costs and reduced interest rate risk, in part because the supply of lenders willing to make loans to borrowers with impaired credit has increased. Many analysts say that, as a result, mortgage loans are now available to a whole new population of consumers and interest rates on subprime loans made by reputable lenders have fallen. In addition, increased securitization of subprime lending may lead to more uniform underwriting of subprime loans, which could further reduce origination costs and interest rates to consumers. While the development of a secondary market for subprime loans may have benefits for borrowers, it can also provide a source of funds for unscrupulous originators that quickly sell off loans with predatory terms. The secondary market can complicate efforts to eliminate predatory lending by separating ownership of a loan from its originator. This separation can undermine incentives to reduce risk in lending and create incentives that may increase the attractiveness of making loans with predatory terms. As noted earlier, some originators of subprime mortgage loans make their profits from high origination fees. The existence of a market that allows originating lenders to quickly resell subprime loans may reduce the incentive these lenders have to ensure that borrowers can repay. Further, lenders often market their products through brokers that do not bear the risks associated with default, as brokers are compensated in up- front fees for the loans they help originate. Some lenders and state officials told us that unscrupulous brokers sometimes deceive originating lenders regarding borrowers’ ability to repay. Even if deceived, lenders who originate the loans and then sell them in the secondary market ultimately may not bear the risk of a loan default. Taken together, these circumstances can undermine efforts to combat predatory lending practices. Market forces provide some incentives to deter secondary market purchasers from purchasing predatory loans because these loans create both credit and reputation risk. However, predatory loans do not in all cases create unusual financial risks or losses for secondary market purchasers. For example, in most states loan purchasers are generally not liable for damages that may have resulted from the origination of abusive loans that they purchased, mitigating much of the legal risk of buying loans that may have violated laws addressing predatory lending. Moreover, loans with predatory features may carry very high interest rates and have barriers to prepayment, which may more than compensate for the increased credit risks associated with subprime loans. However, investors’ insistence on the use of credit enhancements in the securitization process may offset or mitigate the incentives to engage in predatory lending of originators who sell loans to the secondary market. Credit enhancements, which refer to a variety of approaches used to reduce the credit risk of an obligation, are common in securitization transactions, in part because of concerns that originators may try to pass on lower-quality loans. Because the price investors will pay for securities is based on risk as well as return, sellers use the enhancements to lower the risk and thus raise the price of securities. For example, the securities may be overcollateralized by ensuring that the value of the collateral backing the securities—in the case of mortgage backed securities, the face value of the loans—exceeds the value of the securities being offered for sale. The difference provides a “cushion” or reserve against possible credit losses and permits a higher loss rate on the total mortgage pool without endangering payments to the owners of the securities. Securitizers can also include recourse provisions in their loan purchases that require sellers to take back loans in the event of borrower default. As a result of these factors, the degree to which originators of loans sold in the secondary market—including loans with abusive terms—are insulated from credit risks associated with those loans varies, and the profits from selling the loans may vary with the costs of credit enhancement. Secondary market purchasers of residential mortgage loans undertake a process of due diligence designed to minimize legal, financial, and reputation risk associated with the purchase of those loans. Due diligence can play an important role in avoiding the purchase of abusive loans, but cannot necessarily identify all potentially abusive loans. Officials of Fannie Mae and Freddie Mac—which, as noted previously, are relatively recent entrants in the subprime market—are also concerned about risks but say that their due diligence processes are also designed to avoid purchasing loans that may have been harmful to consumers. Other firms’ due diligence is not necessarily specifically intended to avoid loans that may have harmed consumers but rather to avoid purchasing loans that are not in compliance with applicable law or that present undue financial or reputation risks. Loans purchased in the secondary market are usually not purchased individually but rather as a pool of many loans. Purchasers or securitizers of residential mortgage loans try to ensure that the loans in a particular pool are creditworthy and in compliance with law. Purchasers perform a general background and financial review of the institutions from which they purchase loans. In addition, secondary market purchasers of loans nearly always conduct due diligence, or a review and appraisal of confidential legal and financial information related to the loans themselves. Before or after the sale, purchasers may review electronic data containing information on the loans, such as the loan amount, interest rate, and borrower’s credit score. Purchasers also may physically review a sample of individual loans, including items such as the loan applications and settlement forms. Some industry representatives and federal agencies say that appropriate due diligence can play an important role in deterring predatory lending. Participants in the secondary market have an interest in not purchasing loans that may be considered predatory because such loans can create unwarranted legal, financial, and reputation risk. For example, if such loans violate relevant municipal, state, or federal laws, purchasing them could, in some cases, expose the buyers to legal risks such as lawsuits, fines, and penalties. Moreover, predatory loans may be more likely to go into default, increasing financial risk without a commensurate increase in expected returns. In addition, many industry officials told us that reputation risk is a major reason why they want to avoid purchasing predatory loans. Firms involved in the securitization process do not want to be associated with predatory lending activity that could affect their relationships with other firms, community groups, and government agencies. Due diligence reviews for residential mortgage loans are designed to determine the financial characteristics of the loans and to ensure compliance with applicable federal, state, and municipal laws, including those designed to prohibit predatory lending. The reviews also can be designed to detect loans that have potentially abusive terms but are not necessarily violating any law. For example, an electronic review of loan data can flag characteristics such as interest rates that appear excessive but are nonetheless legal. A loan-level file review, in which a purchaser reviews the physical loan origination documents, offers access to more information and can highlight items such as points and fees and the borrower’s capacity to repay. While nearly all purchasers of loans use due diligence to check for legal compliance, purchasers set their own guidelines for what other loan characteristics meet their standards. While due diligence in the secondary market is important, the role that it can play in deterring predatory lending by performing due diligence is limited. For one thing, more than one-third of all new subprime loans are not securitized in the first place but are held in the portfolio of the originating lender and thus do not face securitizers’ due diligence reviews. In addition, even the most thorough due diligence will not necessarily catch all abusive loans or abusive lending practices. For example: Due diligence may not detect fraud in the underwriting or approving of a mortgage. For instance, if a mortgage broker includes false information in a loan application to ensure that a borrower meets an originator’s income requirements, the process of due diligence may not detect it. The data tapes used for loan reviews do not include point and fee information. Thus, securitizers typically cannot detect excessive or unwarranted fees prior to purchasing a loan without a loan-level review. Loan flipping (repeated refinancings) can be difficult to detect because loan files do not necessarily include information on previous refinancings. Fannie Mae and Freddie Mac have relatively strict criteria for the loans they purchase, particularly subprime loans. As noted, both companies limit their purchases to the most creditworthy subprime loans. In April 2000, Fannie Mae issued guidelines to sellers of subprime loans that set criteria designed to help the GSE avoid purchasing loans with abusive features. For example, the guidelines state that Fannie Mae’s approved lenders may not “steer” a borrower who qualifies for a standard loan to a higher cost product, may not make loans without regard to the borrower’s ability to repay, and may not in most instances charge more than 5 percent of the loan amount in points and fees. Freddie Mac issued similar guidelines to its sellers and servicers in December 2000. Further, both companies, like other secondary market purchasers, rely on a system of representations and warranties, under which sellers contractually agree to buy back loans they sell that turn out not to meet the terms of the contract. Fannie Mae and Freddie Mac officials told us that they undertake a series of measures aimed at avoiding the purchase of loans with predatory characteristics. Approved sellers and servicers undergo a background check and operational review and assessment that seeks, in part, to determine whether lenders are able to comply with their guidelines. Fannie Mae and Freddie Mac also require that special steps, such as additional due diligence measures, be taken in purchasing subprime loans. For example, Fannie Mae requires that subprime loans be originated using the company’s automated desktop underwriting system, which helps ensure that borrowers are not being steered to a more expensive loan than they qualify for. Fannie Mae officials say that the automated desktop underwriting system also facilitates traditional lenders that serve subprime borrowers. In addition, both companies said that they undertake extensive and costly due diligence that goes well beyond simple legal compliance and is aimed at avoiding loans that may potentially be considered abusive or detrimental to the borrower. Both companies use an outside contractor to conduct their loan-level due diligence reviews on subprime loans. The contractor has a standard “script” that reviews a large number of data elements related to legal compliance and creditworthiness. However, the contractor told us that Fannie Mae and Freddie Mac add elements to the script to make the review more stringent with regard to identifying potentially abusive practices. For example, Freddie Mac requires the contractor to check whether the lender has gathered evidence of a borrower’s income information directly or relied on self-verification, which can raise uncertainty about a borrower’s capacity to repay. In addition, the contractor told us that Fannie Mae and Freddie Mac are more likely than other firms to reject or require a repurchase if evidence exists that the loan may involve a predatory practice—even if the loan is otherwise legally compliant. According to industry representatives, all purchasers of mortgage loans undertake a process of due diligence, but the process can vary in its degree of stringency and comprehensiveness. For example, while most firms typically pull a sample of loans for a loan-level file review, companies may review anywhere between a few percent and 100 percent of the loans. In addition, companies vary in terms of the data elements they choose to review. Some firms review prior loans made to the borrower in an effort to detect loan flipping, while others do not. Further, some companies may be more willing than others to purchase loans that are considered questionable in terms of legal compliance, creditworthiness, or other factors. As noted earlier, loans that have harmed consumers and that may be deemed “predatory” by some observers are not necessarily against the law, nor do they necessarily increase the risk of the loan. Industry officials told us that while securities firms are concerned with the reputation risk that may come with purchasing abusive loans, the primary function of their due diligence is to ensure compliance with the law and to protect investors by ensuring that loans are creditworthy. Some states have enacted predatory lending laws that have assignee liability provisions under which purchasers of secondary market loans may be liable for violations committed by the originators or subject to a defense by the borrower against collecting the loan. Assignee liability is intended to discourage secondary market participants from purchasing loans that may have predatory features and to provide an additional source of redress for victims of abusive lenders. However, depending on the specific nature of the provision, assignee liability may also have unintended consequences, including reducing access to or increasing the cost of secondary market capital for legitimate loans. For example, assignee liability provisions of a predatory lending law in Georgia have been blamed for causing several participants in the mortgage lending industry to withdraw from the market, and the provisions were subsequently repealed. Antipredatory lending laws in several states have included some form of assignee liability. Typically, with assignee liability, little or no distinction is made between the broker or lender originating a loan that violates predatory lending provisions and the person who purchases or securitizes the loans. Under these provisions, secondary market participants that acquire loans may be liable for violations of the law committed by the original lenders or brokers whether or not the purchasers were aware of the violations at the time they bought the loans. Further, borrowers can assert the same defenses to foreclosure against both originating lenders and entities in the secondary market that hold the loans (the assignees). Depending on the specific provisions of the law, assignees may have to pay monetary damages to aggrieved borrowers. As of December 2003, at least nine states and the District of Columbia had enacted predatory lending laws that expressly included assignee liability provisions, though the nature of these provisions varies greatly, according to the database of state and local legislation we reviewed. Other states have passed predatory lending laws that do not explicitly provide for assignee liability, but debate has occurred in some of these states about whether assignee liability can be asserted anyway under existing laws or legal principles. The federal HOEPA statute includes an assignee liability provision, but, as noted in chapter 2, only a limited number of subprime loans are covered under HOEPA. Assignee liability can take a variety of forms. For example, an assignee can be held liable only in defensive claims (defense to foreclosure actions and to claims regarding monies owed on a loan) or can also be assessed for damages directly, including punitive damages. Similarly, some laws include “safe harbor provisions,” under which assignee liability may not arise if the assignee has taken certain measures to avoid obtaining a high- cost loan. For example, under New Jersey law, no assignee liability arises if the assignee demonstrates, by a preponderance of evidence, that a person exercising reasonable due diligence could not determine that the mortgage was a high-cost home loan. However, many secondary market participants told us that the value of these safe harbor provisions is limited, in part because of difficulties in demonstrating compliance with safe harbor standards. For example, some secondary market participants say that the New Jersey law does not adequately define what constitutes “reasonable” due diligence. The issue of whether to include assignee liability provisions in state and local predatory lending laws has been highly controversial, because such provisions can potentially both confer benefits and cause problems. Assignee liability has two possible primary benefits. First, holding purchasers and securitizers of loans liable for abusive lending violations provides them with an incentive not to purchase predatory loans in the first place. If secondary market participants took greater action—through policy decisions or stricter due diligence—to avoid purchasing potentially abusive loans, originators of predatory loans would likely see a steep decline in their access to secondary market capital. Second, under some forms of assignee liability, consumers who have been victimized by such lenders may have an additional source of redress. In some cases, originators of abusive loans that have been sold in the secondary market are insolvent or cannot be located, leaving victims dependent on assignees for relief from foreclosure or other redress. However, assignee liability provisions may also have the serious if unintended consequence of discouraging legitimate secondary market activity. Secondary market participants say that because they do not originate the loans they purchase, even the most stringent due diligence process cannot ensure that all loans comply with applicable law. In addition, some secondary market participants state that assignee liability provisions require them to make subjective determinations about whether the loans are in compliance with law, and this ambiguity can create legal and financial risk. These factors, industry participants say, can actually end up harming consumers by raising the costs of ensuring compliance with the law and thus increasing the cost of loans to borrowers. Further, if secondary market participants are not willing to risk having to assume liability for violations committed by originators, they may pull out of the market altogether, reducing the availability and increasing the costs of legitimate subprime credit. Finally, if states’ predatory lending laws have different terms and provisions regarding assignee responsibilities, the secondary market as a whole could become less efficient and liquid, further increasing rates on legitimate subprime mortgages. Credit rating agencies have been among the secondary market players that have expressed concern about assignee liability provisions in state predatory lending laws. When a residential mortgage-backed security is created from a pool of loans, an independent credit rating agency examines the security’s underlying loans and assigns it with a credit rating, which represents an opinion of its general creditworthiness. Credit rating agencies need to monetize (measure) the risk associated with the loans underlying a security in order to assign a credit rating. Because assignee liability can create additional legal and financial risks, the major credit rating agencies typically review new predatory lending legislation to assess whether they will be able to measure that risk adequately to rate securities backed by loans covered under the law. We talked with representatives of two major credit rating agencies, firms that issue mortgage-backed securities, and the GSEs Fannie Mae and Freddie Mac to better understand how specific assignee liability provisions might affect their ability to conduct secondary market transactions. In general, the representatives told us that the most problematic assignee liability provisions for secondary market participants are those with two characteristics: Ambiguous language. Credit rating agencies and other secondary market players seek clear and objective descriptions of the loans covered by the statutes and the specific actions or omissions that constitute a violation. For example, some participants cited concerns about an ordinance enacted in Toledo, Ohio, that prohibited taking advantage of a borrower’s “physical or mental infirmities” but did not define what constituted such infirmities. Secondary market participants noted that without objective criteria, there is no way to ensure that an originator has complied adequately with the law. Punitive Damages. Under some assignee liability provisions, the potential damages a borrower can receive are restricted to the value of the loan, while other provisions allow for punitive damages, which are not necessarily capped. Secondary market participants say that the potential for punitive damages can make it very difficult to quantify the risk associated with a security. According to officials of industry and consumer advocacy organizations, the Georgia Fair Lending Act, which became effective on October 1, 2002, was one of the strictest antipredatory lending laws in the nation. It banned single-premium credit insurance and set restrictions on late fees for all mortgage loans originated in the state and, for a special category of “covered loans,” prohibited refinancing within 5 years after consummation of an existing home loan unless the new loan provided a “tangible net benefit” to the borrower. The act also created a category of “high-cost loans” that were subject to certain restrictions, including limitations on prepayment penalties, prohibitions on balloon payments, and prohibitions on loans that were made without regard to the borrower’s ability to repay. The act also included fairly strict assignee liability. Secondary market participants that purchased high-cost loans were liable for violations of the law committed by the originator of the loans they purchased, while purchasers of covered loans were subject to borrower defenses and counterclaims based on violations of the act. The act also expressly made mortgage brokers and loan servicers liable for violations. Remedies available to borrowers included actual damages, rescission of high-cost loans, attorney fees, and punitive damages. Most of the violations were civil offenses, but knowing violations constituted criminal offenses. Shortly after the Georgia Fair Lending Act took effect, several mortgage lenders announced that they would stop doing business in the state due to the increased risk they would incur. In addition, several secondary market participants stated their intention to cease doing business in Georgia. In January 2003, the credit rating agency Standard & Poor’s announced it would stop rating mortgage-backed securities in Georgia because of the uncertainty surrounding potential liability under the act. Standard & Poor’s decision extended to securitizations of virtually all loans in the state, not just those of covered or high-cost loans. The company said that because the act did not provide an unambiguous definition of which loans were covered (and therefore subject to assignee liability), it could not adequately assess the potential risk to securitizers. In addition, the company said that it was concerned about an antiflipping provision that did not adequately define what constituted the “net tangible benefit” to borrowers that certain refinancings had to provide. The two other major credit rating agencies, Moody’s and Fitch, also said that the law would limit their ability to rate mortgage-backed securities in Georgia. In response to these events, the Georgia legislature amended the Georgia Fair Lending Act on March 7, 2003. The amendments eliminated the category of “covered home loans” and the restrictions that had existed for that category of loans. In addition, the amendments greatly reduced the scope of assignee liability under the law, restricting such liability to “high- cost” loans, and then only when the assignee is unable to show that it has exercised reasonable due diligence to avoid purchasing them. In addition, the amendments capped the amount of damages an assignee can face and prohibited assignee liability in class-action lawsuits. Once these amendments were passed, credit rating agencies announced that they would once again rate securities backed by mortgage loans originated in Georgia, and lenders said they would continue to do business in the state. Advocates of the original Georgia law argued that the legislature overreacted to actions by some members of the lending industry, and many activists said that Standard & Poor’s and others had engaged in an orchestrated effort to roll back the Georgia Fair Lending Act. Industry representatives said that the response by lenders and others was a reasonable response to a statute that created unacceptable risks of legal liability for lenders and assignees. Policymakers and industry representatives have frequently cited the events in Georgia as a lesson in what can happen when secondary market participants are held liable for violations by the original lender. Industry representatives assert that assignee liability creates undue risks to the secondary market, or makes assessing risks difficult, and ultimately reduces borrowers’ access to credit. In the case of Georgia, however, it is unclear whether the problem was assignee liability itself or the scope and characteristics of the specific assignee liability provisions contained in the original law. Georgia’s original law created concern in large part because of perceived ambiguities in defining which loans were subject to assignee liability and because assignees’ liability was subject to unlimited punitive damages. Not all states with antipredatory lending statutes that include assignee liability provisions have had lenders and credit agencies threaten to withdraw from the market to the same extent, largely because these laws generally cap an assignee’s liability, create a safe harbor, or contain less ambiguous language. The challenge to states that choose to impose assignee liability is to craft provisions that may serve their purpose of deterring predatory lending and providing redress to affected borrowers without creating an undue adverse effect on the legitimate lending market. A number of federal, state, nonprofit, and industry-sponsored organizations offer consumer education initiatives designed to deter predatory lending by, among other things, providing information about predatory practices and working to improve consumers’ overall financial literacy. While consumer education efforts have been shown to have some success in increasing consumers’ financial literacy, the ability of these efforts to deter predatory lending practices may be limited by several factors, including the complexity of mortgage transactions and the difficulty of reaching the target audience. Similarly, unreceptive consumers and counselors’ lack of access to relevant loan documents can hamper the effectiveness of mortgage counseling efforts, while the sheer volume of mortgage originations each year makes universal counseling difficult. While efforts are under way to improve the federally required disclosures associated with mortgage loans, their potential success in deterring predatory lending is likewise hindered by the complexity of mortgage transactions and by the lack of financial sophistication among many borrowers who are the targets of predatory lenders. In response to widespread concern about low levels of financial literacy among consumers, federal agencies such as FDIC, HUD, and OTS have conducted and funded initiatives designed in part to raise consumers’ awareness of predatory lending practices. In addition, a number of states, nonprofits, and trade organizations have undertaken consumer education initiatives. Prepurchase mortgage counseling—which can include a third party review of a prospective mortgage loan—may also help borrowers avoid predatory loans, in part by alerting them to the characteristics of predatory loans. In some circumstances, such counseling is required. However, a variety of factors limit the potential of these tools to deter predatory lending practices. A number of federal agencies and industry trade groups have advocated financial education for consumers as a means of improving consumers’ financial literacy and addressing predatory lending. The Department of the Treasury, as well as consumer and industry groups, have identified the lack of financial literacy in the United States as a serious, widespread problem. Studies have shown that many Americans lack a basic knowledge and understanding of how to manage money, use debt responsibly, and make wise financial decisions. As a result, some federal agencies have conducted or funded programs and initiatives that serve to educate and inform consumers about personal financial matters. For example: FDIC sponsors MoneySmart, a financial literacy program for adults with little or no banking experience and low to moderate incomes. FDIC officials told us that the program, in effect, serves as one line of defense against predatory lending. The MoneySmart curriculum addresses such topics as bank services, credit, budgeting, saving, credit cards, loans, and homeownership. MoneySmart is offered free to banks and others interested in sponsoring financial education workshops. The Federal Reserve System’s Community Affairs Offices issue media releases and distribute consumer education publications to financial institutions, community organizations, and to consumers directly. These offices also have hosted conferences and forums on financial education and predatory lending and have conducted direct outreach to communities targeted by predatory lenders. OTS and NCUA have worked with community groups on financial literacy issues and have disseminated financial education materials, including literature on predatory lending issues, to their respective regulated institutions. HUD has developed and distributed a brochure titled Don’t Be a Victim of Loan Fraud: Protect Yourself from Predatory Lenders, which seeks to educate consumers who may be vulnerable to predatory lending, especially the elderly, minorities, and low-income homeowners. Federal banking regulators give positive consideration in Community Reinvestment Act performance reviews to institutions for providing financial education to consumers in low- and moderate-income communities. OCC issued an advisory letter in 2001 providing detailed guidance for national banks, encouraging them to participate in financial literacy initiatives and specifying a range of activities that banks can provide to enhance their customers’ financial skills, including support for educational campaigns that help borrowers avoid abusive lending situations. FTC and DOJ disseminate information designed to raise consumers’ awareness of predatory lending practices, particularly those involving fraudulent acts. Brochures and other consumer materials are distributed on the agencies’ Web sites, as well as through conferences and seminars, local consumer protection agencies, consumer credit counselors, state offices, and schools. FTC has also supported public service announcements on radio and television, including Spanish-speaking media. Some of these initiatives are general financial education programs that do not specifically address predatory home mortgage lending, some address predatory lending practices as one of a number of topics, and a few focus specifically on predatory lending. Some of these initiatives are directed to a general audience of consumers, while others are directed toward low- income or other communities that are often the targets of predatory lenders. A number of different media have been used to deliver the messages, including print and online materials, speeches and spot announcements, and materials for the hearing- and visually impaired. In some cases, consumer financial education materials have been produced in a variety of languages, including Arabic, Chinese, Korean, and Spanish. Federal agencies’ consumer education campaigns typically take place in partnership with other entities, including community and nonprofit groups and state and local agencies. Federal agencies have taken some actions to coordinate their efforts related to educating consumers about predatory lending. For example, in October 2003, the Interagency Task Force on Fair Lending, which consists of 10 federal agencies, published a brochure that alerts consumers to potential pitfalls of home equity loans, particularly high-cost loans. The brochure Putting Your Home on the Loan Line is Risky Business describes common predatory lending practices and makes recommendations to help borrowers avoid them. Some state agencies have also sponsored consumer education initiatives that address predatory lending. For example, the Connecticut Department of Banking offers an educational program in both English and Spanish that partners with neighborhood assistance groups and others to promote financial literacy and educate consumers on the state’s antipredatory lending statute. The Massachusetts Division of Banks maintains a toll-free mortgage hotline to assist homeowners about potentially unethical and unlawful lending practices. The hotline helps consumers determine whether loan terms may be predatory and directs them to other sources of information and assistance. The New York State Banking Department distributes educational materials, including a video, that describe predatory lending practices. The department has also conducted educational outreach programs to community groups on the issue. Nonprofits provide a significant portion of consumer financial education on predatory lending, sometimes with support from federal, state, or local agencies. These efforts include both general financial literacy programs with a predatory lending component and initiatives that focus specifically on predatory lending issues. For example, the National Community Reinvestment Coalition, with funding support from HUD, distributes a training module to help communities across the country educate consumers about predatory lending. Some industry trade organizations and companies also have consumer education initiatives related to predatory lending: Freddie Mac has developed the CreditSmart program in partnership with universities and colleges. CreditSmart is a curriculum on credit education that is available online and has been used in academic programs and in community workshops, seminars, and credit education campaigns. Freddie Mac also helps fund and promote the “Don’t Borrow Trouble” campaign, a comprehensive public education campaign with counseling services that is designed to help homeowners avoid falling victim to predatory lenders. The campaign uses brochures, mailings, posters, public service announcements, transit ads, and television commercials. Its media toolkit and marketing consultant services have been provided to the U.S. Conference of Mayors for use in local communities. Fannie Mae supports financial literacy programs through its Fannie Mae Foundation, which sponsors homeownership education programs that focus on improving financial skills and literacy for adult students and at- risk populations, such as new Americans and Native Americans. Fannie Mae also offers a Web-based tool that allows home-buyers to compare loan products and prices. The Jump$tart Program for Personal Financial Literacy, sponsored by a coalition of corporations, industry associations—such as the Insurance Education Foundation and the American Bankers Association Education Foundation—and several government and nonprofit agencies, includes a series of modules covering topics such as managing debt and shopping for credit that are designed to improve the personal financial literacy of young adults. The Mortgage Bankers Association of America, a trade association representing mortgage companies and brokers and the real estate finance industry, disseminates a package of information describing some common warning signs of mortgage fraud and predatory lending, a consumer’s bill of rights, and appropriate contacts for consumers who believe they have been victimized by predatory lenders. The National Association of Mortgage Brokers makes presentations to first-time homebuyers to educate them on the mortgage process and credit reports, among other topics. The American Financial Services Association’s Education Foundation develops educational materials designed to improve consumers’ use of credit and overall financial literacy. Mortgage counseling can be part of general “homeownership counseling” for new homeowners but may also be offered prior to a refinancing. It gives borrowers an opportunity to receive personalized advice from a disinterested third party about a proposed mortgage or other loan. In addition to providing general advice about the mortgage process and loan products, counselors typically review the terms of proposed loans for potentially predatory characteristics. Studies evaluating the impact of homeownership counseling have found that it helps homeowners maintain ownership of their homes and avoid delinquencies, particularly when the counseling is provided one on one. HUD supports a network of approximately 1,700 approved counseling agencies across the country. The agencies provide a wide variety of education and counseling services, including homebuyer education and prepurchase counseling. HUD makes grant funds available to some of these agencies, and a portion of these funds has been earmarked exclusively for counseling for victims of predatory lending. A number of state antipredatory lending laws, such as those in New Jersey and North Carolina, require some lenders to document that a borrower has received counseling before taking out certain types of high-cost loans. In a few cases, however, borrowers may waive their right to receive such counseling. Several states, including Colorado, New York, and Pennsylvania, require lenders to provide notice to borrowers of certain loans that mortgage counseling is available and encourage them to seek it. In testimony before Congress and elsewhere, representatives of the Mortgage Bankers Association, the Consumer Mortgage Coalition, and other industry organizations have promoted the view that educated borrowers are more likely to shop around for beneficial loan terms and avoid abusive lending practices. In searching the literature for studies on the effectiveness of consumer financial education programs, we found evidence that financial literacy programs may produce positive changes in consumers’ financial behavior. However, none of the studies measured the effectiveness of consumer information campaigns specifically on deterring predatory lending practices. The majority of federal officials and consumer advocates we contacted said that while consumer education can be very useful, it is unlikely to play a substantial role in reducing the incidence of predatory lending practices, for several reasons: First, mortgage loans are complex financial transactions, and many different factors—including the interest rate, fees, specific loan terms, and borrower’s situation—determine whether the loan is in a borrower’s best interests. Mortgage loans can involve dozens of different documents that are written in highly technical language. Even an excellent campaign of consumer education is unlikely to provide less sophisticated consumers with enough information to properly assess whether a proffered loan contains abusive terms. Second, abusive lenders and brokers may use high-pressure or “push marketing” tactics—such as direct mail, telemarketing, and door-to-door contacts—that are unfair, deceptive, or designed to confuse the consumer. Broad-based campaigns to make consumers aware of predatory lending may not be sufficient to prevent many consumers— particularly those who may be uneducated or unsophisticated in financial matters—from succumbing to aggressive sales tactics. Third, the consumers who are often the targets of predatory lenders are also some of the hardest to reach with educational information. Victims of predatory lending are often not highly educated or literate and may not read or speak English. Further, they may lack access to information conveyed through the Internet or traditional banking sources, or they may have hearing or visual impairments or mobility problems. Consumer education campaigns have encouraged borrowers to seek counseling before entering into a mortgage loan, particularly a subprime refinancing loan. However, unreceptive consumers, lack of access to loan documents, fraudulent lending practices, and the uneven quality of counseling services can affect the success of these counseling efforts. For instance, some consumers may simply not respond to counseling. Officials at HUD have noted that not all first-time homebuyers avail themselves of prepurchase counseling, and that some consumers who do attend counseling sessions ignore the advice and information given to them. Further, counselors may not have access to loan documents containing the final terms of the mortgage loan. Although lenders are required to provide a good-faith estimate of the mortgage terms, they are not required to provide consumers with the final and fixed terms and provisions of a mortgage loan until closing. Moreover, predatory lenders have been known to manipulate the terms of a mortgage loan (sometimes called “bait and switch”) so that the terms of the actual loan vary substantially from that contained in the good faith estimate. In addition, counseling may be ineffective against lenders and brokers that engage in fraudulent practices, such as falsifying applications or loan documents, that cannot be detected during a prepurchase review of mortgage loan documents. Finally, the quality of mortgage counseling can vary because of a number of factors. For example, one federal official cited an instance of a mortgage company conducting only cursory telephone counseling in order to comply with mandatory counseling requirements. Although some states have mandated counseling for certain types of loans, serious practical barriers would exist to instituting mandatory prepurchase mortgage counseling nationally. HUD officials have noted that instituting a mandatory counseling program for most regular mortgage transactions nationwide would be an enormous and difficult undertaking that might not be cost-effective. Lenders originated about 10 million mortgage loans in 2002 in the United States. The cost of providing counseling for all or many of these loans would be high, and it is unclear who would or should be responsible for paying it. In addition, there is a need for trained, qualified counselors, according to federal officials and representatives of consumer and advocacy groups, and currently no system exists for effectively training large numbers of counselors while maintaining quality control. HUD requires counseling for its reverse mortgages. These mortgages allow homeowners to access the equity in their home through a lender, who makes payments to the owner. Borrowers who receive a home equity conversion mortgage insured through FHA must attend a consumer information session given by a HUD-approved housing counselor. Mandatory counseling for reverse mortgages may be reasonable because these products are complex and subject to abuse. However, reverse mortgages are also relatively uncommon; only approximately 17,610 HUD- insured reverse mortgages were originated in fiscal year 2003. Federally mandated mortgage disclosures, while helpful to some borrowers, may be of limited usefulness in reducing the incidence of predatory lending practices. TILA and RESPA have requirements concerning the content, form, and timing of information that must be disclosed to borrowers. The goal of these laws is to ensure that consumers obtain timely and standardized information about the terms and cost of their loans. Federal agencies, advocacy groups, and the mortgage industry have said that mortgage disclosures are an important source of information for borrowers, providing key information on loan terms and conditions and enabling borrowers to compare mortgage loan products and costs. Representatives of the lending industry in particular have said that disclosures can play an important role in fighting predatory lending, noting that clear, understandable, and uniform disclosures allow borrowers to understand the terms of their mortgage loans and thus make more informed choices when shopping for a loan. However, industry and advocacy groups have publicly expressed dissatisfaction with the current scheme of disclosures as mandated by TILA and RESPA. A 1998 report by the Board and HUD concluded that consumers cannot easily understand current disclosures, that disclosures are often provided too late in the lending process to be meaningful, that the information in disclosures may differ significantly from the actual final loan terms, and that the protections and remedies for violations of disclosure rules are inadequate. Improving the disclosure of pertinent information has been part of efforts under way over the last few years to streamline and improve the real estate settlement process. HUD issued proposed rules in July 2002 to simplify and improve the process of obtaining home mortgages and reduce settlement costs for consumers. HUD stated that the proposed changes to its RESPA regulations would, among other things, “make the good faith estimate firmer and more usable, facilitate shopping for mortgages, make mortgage transactions more transparent, and prevent unexpected charges to consumers at settlement.” Debate over the proposed rules, which as of December 2003 were still under review, has been contentious. Industry groups claim that the proposal would help fight predatory lending by helping consumers understand loan costs up front and thus enable consumers to compare products, or comparison shop. Several advocacy organizations and an industry group say the proposed rules would still allow unscrupulous mortgage originators to hide illegal or unjustified fees. Although streamlining and improving mortgage loan disclosures could help some borrowers better understand the costs and terms of their loans, such efforts may play only a limited role in decreasing the incidence of predatory lending practices. As noted above, mortgage loans are inherently complex, and assessing their terms requires knowing and understanding many variables, including interest rates, points, fees, and prepayment penalties. Brokers and lenders that engage in abusive practices may target vulnerable individuals who are not financially sophisticated and are therefore more susceptible to being deceived or defrauded into entering into a loan that is clearly not in their interests. Even a relatively clear and transparent system of disclosures may be of limited use to borrowers who lack sophistication about financial matters, are not highly educated, or suffer physical or mental infirmities. Moreover, as with prepurchase counseling, revised disclosure requirements would not necessarily help protect consumers against lenders and brokers that engage in outright fraud or that mislead borrowers about the terms of a loan in the disclosure documents themselves. Although little data is available on the incidence of predatory lending among the elderly, government officials and consumer advocacy organizations have reported consistent observational evidence that elderly consumers have been disproportionately victimized by predatory lenders. Abusive lenders are likely to target older consumers for a number of reasons, including the fact that older homeowners are more likely to have substantial equity in their homes and may be more likely to have diminished cognitive function or physical impairments that an unscrupulous lender may try to exploit. Most educational material and legal activity related to predatory lending targets the general population rather than elderly borrowers in particular. Some federal agencies and nonprofit organizations provide consumer education materials on predatory lending that specifically target the elderly. Nearly all federal, state, and consumer advocacy officials with whom we spoke offered consistent observational and anecdotal information that elderly consumers have disproportionately been victims of predatory lending. Little hard data exist on the ages of victims of predatory lending or on the proportion of victims who are elderly. Nonetheless, several factors explain why unscrupulous lenders may target older consumers and why some elderly homeowners may be more vulnerable to abusive lenders, including higher home equity, a greater need for cash to supplement limited incomes, and a greater likelihood of physical impairments, diminished cognitive abilities, and social isolation. On average, older homeowners have more equity in their homes than younger homeowners, and abusive lenders could be expected to target consumers who have substantial home equity. By targeting these owners, unscrupulous lenders are more easily able to “strip” the equity from a borrower’s home by including unjustified and excessive fees into the cost of the home equity loan. Federal officials and consumer groups say that abusive lenders often try to convince elderly borrowers to repeatedly refinance their loans, adding more costs each time. “Flipping” loans in this way can over time literally wipe out owners’ equity in their homes. In addition, some brokers and lenders aggressively market home equity loans as a source of cash, particularly for older homeowners who have limited cash flows and can use money from a home equity loan for major home repairs or medical expenses. In the overall marketplace it is common, and can be advantageous, to tap into one’s home equity when refinancing. However, unscrupulous brokers and lenders can take advantage of an elderly person’s need for cash to steer borrowers to loans with highly unfavorable terms. Further, diseases and physical impairments associated with aging can make elderly borrowers more susceptible to abusive lending. For example, declining vision, hearing, or mobility can restrict elderly consumers’ ability to access financial information and compare credit terms. In such situations potential borrowers may be susceptible to the first lender to offer what seems to be a good deal, especially if the lender is willing to visit them at home or provide transportation to the closing. Physical impairments like poor hearing and vision can also make it difficult for older borrowers to fully understand loan documents and disclosures. Similarly, while many older persons enjoy excellent mental and cognitive capacity, others experience the diminished cognitive capacity and judgment that sometimes occurs with advanced age. Age-related dementias or mental impairments can limit the capacity of some older persons to comprehend and make informed judgments on financial issues, according to an expert in behavioral medicine at the National Institute on Aging. Furthermore, a report sponsored by the National Academy of Sciences on the mistreatment of elderly persons reported that they may be more likely to have conditions or disabilities that make them easy targets for financial abuse and they may have diminished capacity to evaluate proposed courses of action. The report noted that these impairments can make older persons more vulnerable to financial abuse and exploitation. Representatives of legal aid organizations have said that they frequently represent elderly clients in predatory lending cases involving lenders that have taken advantage of a borrower’s confusion and, in some cases, dementia. Finally, both the National Academy of Sciences report and representatives of advocacy groups we spoke with noted that elderly people—particularly those who live alone—may feel isolated and lonely, and may lack support systems of family and friends who could provide them with advice and assistance in obtaining credit. Such individuals may simply be more willing to discuss an offer for a home equity loan made by someone who telephones or knocks on their door, makes personal contact, or makes an effort to gain their confidence. These personalized marketing techniques are common among lenders and brokers that target vulnerable individuals for loans with abusive terms. Federal officials, legal aid services, and consumer groups have reported that home repair scams targeting elderly homeowners are particularly common. Elderly homeowners often live in older homes and are more likely to need someone to do repairs for them. The HUD-Treasury report noted that predatory brokers and home improvement contractors have collaborated to swindle older consumers. A contractor may come to a homeowner’s door, pressure the homeowner into accepting a home improvement contract, and arrange for financing of the work with a high- cost loan. The contractor then does shoddy work or does not finish the agreed-on repairs, leaving the borrower to pay off the expensive loan. The result of lending abuses, such as losing a home through foreclosure, can be especially severe for the elderly. The National Academy of Sciences report noted that losing financial assets accumulated over a lifetime can be devastating to an elderly person, and that replacing them is generally not viable for those who are retired or have physical or mental disabilities. The financial losses older people can suffer as a result of abusive loans can result in the loss of independence and security and a significant decline in quality of life. Moreover, older victims of financial exploitation may be more likely to become dependent on social welfare services because they lack the funds to help compensate them for their financial losses. Elderly consumers represent just one of several classes of people that predatory lenders appear to target. The HUD-Treasury task force report noted that many predatory lenders also specifically target minority communities. Consumer advocacy and legal aid organizations have reported that elderly African American women appear to be a particular target for predatory lenders. This population may be targeted by predatory lenders at least in part because of their relatively low literacy levels—the result of historical inequalities in educational opportunities—which, as discussed earlier, may increase vulnerability to abusive lending. Because elderly people appear to be more susceptible to predatory lending, government agencies and consumer advocacy organizations have focused some educational efforts and legal assistance on this population. Several booklets, pamphlets, and seminars are aimed at helping inform elderly borrowers about predatory lending. In addition, while most legal activities related to predatory lending practices are designed to assist the general population of consumers, some have focused on elderly consumers in particular. Consumer financial education efforts of government and nonprofit agencies and industry associations generally seek to serve the general consumer population rather than target specific subpopulations. However, some federal and nonprofit agencies have made efforts to increase awareness about predatory lending specifically among older consumers. For example: DOJ has published a guide entitled Financial Crimes Against the Elderly, which includes references to predatory lending. In 2000, the agency cosponsored a symposium that addressed, among other topics, financial exploitation of the elderly. OTS has produced an educational training video addressing financial abuse of the elderly. The U.S. Department of Health and Human Services’ Administration on Aging provides grants to state and nonprofit agencies for programs aimed at preventing elder abuse, including predatory or abusive lending practices against older consumers. Supported activities include senior legal aid programs, projects to improve financial literacy among older consumers, and financial educational materials directed at senior citizens. FTC publishes a number of consumer information products related to predatory lending and home equity scams that discuss abusive practices targeted at the elderly. AARP, which represents more than 35 million Americans age 50 and over, offers a borrowers’ kit containing consumer tips for avoiding predatory lenders, supports a toll-free number to call for assistance regarding lending issues, and distributes fact sheets on predatory lending. Some of these materials are provided in Spanish and in formats accessible to the hearing- and visually impaired. AARP also provides information on its Web site that is designed to educate older Americans on predatory lending issues. In addition, the organization has conducted focus groups of older Americans to gather data on their borrowing and shopping habits in order to better develop strategies for preventing older people from becoming the victims of predatory lending. The National Consumer Law Center has developed a number of consumer materials aimed in part at helping elderly consumers recover from abusive loans, including a brochure titled Helping Elderly Homeowners Victimized by Predatory Mortgage Loans. Federal consumer protection and fair lending laws that have been used to address predatory lending do not generally have provisions specific to elderly persons. For example, age is not a protected class under the Fair Housing Act, which prohibits discrimination in housing-related transactions. In addition, HMDA—which requires certain financial institutions to collect, report, and disclose data on loan applications and originations—does not require lenders to report information about the age of the applicant or borrower. However, ECOA does specifically prohibit unlawful discrimination on the basis of age in connection with any aspect of a credit transaction. In the case against Long Beach Mortgage Company noted earlier, the lender was accused of violating ECOA by charging elderly borrowers, among other protected classes, higher loan rates than it charged other similarly situated borrowers. Federal and state enforcement actions and private class-action lawsuits involving predatory lending generally seek to provide redress to large groups of consumers. Little hard data exist on the age of consumers involved in these actions, but a few cases have involved allegations of predatory lending targeting elderly borrowers. For example, FTC, six states, AARP, and private plaintiffs settled a case with First Alliance Mortgage Company in March 2002 for more than $60 million. According to AARP, an estimated 28 percent of the 8,712 borrowers represented in the class-action suit were elderly. The company was accused of using misrepresentation and unfair and deceptive practices to lure senior citizens and those with poor credit histories into entering into abusive loans. The company used a sophisticated campaign of telemarketing and direct mail solicitations, as well as a lengthy sales presentation that FTC said was designed to mislead consumers in general and elderly consumers in particular about the terms of its loans. Some nonprofit groups provide legal services focused on helping elderly victims of predatory lending: The AARP Foundation Litigation, which conducts litigation to benefit Americans 50 years and older, has been party to 7 lawsuits since 1998 involving allegations of predatory lending against more than 50,000 elderly borrowers. Six of these suits have been settled, and the other is pending. The National Consumer Law Center has a “Seniors Initiative” that seeks to improve the quality and accessibility of legal assistance with consumer issues for vulnerable older Americans. One focus of the initiative is preventing abusive lending and foreclosure. The center publishes a guide for legal advocates to help them pursue predatory lending cases, and has been involved in litigation related to cases of predatory lending against senior citizens. Some local legal aid organizations that help victims of predatory lending have traditionally served older clients. For example, the majority of clients assisted by South Brooklyn Legal Services’ Foreclosure Prevention Project are senior citizens. The limited number of education and enforcement efforts related to predatory lending that specifically target older consumers—as opposed to the general population—is not necessarily problematic. Given limited resources, the most efficient and effective way to reach various subpopulations, including the elderly, is often through general education and information campaigns that reach broad audiences. Similarly, enforcement actions and private lawsuits that seek to curb the activities of the worst predatory lenders in general are likely to aid the elderly borrowers that these lenders may be targeting.

Summary: While there is no universally accepted definition, the term "predatory lending" is used to characterize a range of practices, including deception, fraud, or manipulation, that a mortgage broker or lender may use to make a loan with terms that are disadvantageous to the borrower. No comprehensive data are available on the extent of these practices, but they appear most likely to occur among subprime mortgages--those made to borrowers with impaired credit or limited incomes. GAO was asked to examine actions taken by federal agencies and states to combat predatory lending; the roles played by the secondary market and by consumer education, mortgage counseling, and loan disclosure requirements; and the impact of predatory lending on the elderly. While only one federal law--the Home Ownership and Equity Protection Act--is specifically designed to combat predatory lending, federal agencies have taken actions, sometimes jointly, under various federal consumer protection laws. The Federal Trade Commission (FTC) has played the most prominent enforcement role, filing 19 complaints and reaching multimillion dollar settlements. The Departments of Justice and Housing and Urban Development have also entered into predatory lending-related settlements, using laws such as the Fair Housing Act and the Real Estate Settlement Procedures Act. Federal banking regulators, including the Federal Reserve Board, report little evidence of predatory lending by the institutions they supervise. However, the nonbank subsidiaries of financial and bank holding companies--financial institutions which account for a significant portion of subprime mortgages--are subject to less federal supervision. While FTC is the primary federal enforcer of consumer protection laws for these entities, it is a law enforcement agency that conducts targeted investigations. In contrast, the Board is well equipped to routinely monitor and examine these entities and, thus, potentially deter predatory lending activities, but has not done so because its authority in this regard is less clear. As of January 2004, 25 states, as well as several localities, had passed laws to address predatory lending, often by restricting the terms or provisions of certain high-cost loans; however, federal banking regulators have preempted some state laws for the institutions they supervise. Also, some states have strengthened their regulation and licensing of mortgage lenders and brokers. The secondary market--where mortgage loans and mortgage-backed securities are bought and sold--benefits borrowers by expanding credit, but may facilitate predatory lending by allowing unscrupulous lenders to quickly sell off loans with predatory terms. In part to avoid certain risks, secondary market participants perform varying degrees of "due diligence" to screen out loans with predatory terms, but may be unable to identify all such loans. GAO's review of literature and interviews with consumer and federal officials suggest that consumer education, mortgage counseling, and loan disclosure requirements are useful, but may be of limited effectiveness in reducing predatory lending. A variety of factors limit their effectiveness, including the complexity of mortgage transactions, difficulties in reaching target audiences, and counselors' inability to review loan documents. While there are no comprehensive data, federal, state, and consumer advocacy officials report that the elderly have disproportionately been victims of predatory lending. According to these officials and relevant studies, older consumers may be targeted by predatory lenders because, among other things, they are more likely to have substantial home equity and may have physical or cognitive impairments that make them more vulnerable to an unscrupulous mortgage lender or broker.