Predatory Lending - Underlying Issues

Underlying Issues

There are many underlying issues in the predatory lending debate:

• Judicial practices: Some argue that much of the problem arises from a tendency of the courts to favor lenders, and to shift the burden of proof of compliance with the terms of the debt instrument to the debtor. According to this argument, it should not be the duty of the borrower to make sure his payments are getting to the current note-owner, but to make evidence that all payments were made to the last known agent for collection sufficient to block or reverse repossession or foreclosure, and eviction, and to cancel the debt if the current note owner cannot prove he is the "holder in due course" by producing the actual original debt instrument in court.

• Risk-based pricing: The basic idea is that borrowers who are thought of as more likely to default on their loans should pay higher interest rates and finance charges to compensate lenders for the increased risk. In essence, high returns motivate lenders to lend to a group they might not otherwise lend to -- "subprime" or risky borrowers. Advocates of this system believe that it would be unfair—or a poor business strategy—to raise interest rates globally to accommodate risky borrowers, thus penalizing low-risk borrowers who are unlikely to default. Opponents argue that the practice tends to disproportionately create capital gains for the affluent while oppressing working-class borrowers with modest financial resources. Some people consider risk-based pricing to be unfair in principle. Lenders contend that interest rates are generally set fairly considering the risk that the lender assumes, and that competition between lenders will ensure availability of appropriately-priced loans to high-risk customers. Still others feel that while the rates themselves may be justifiable with respect to the risks, it is irresponsible for lenders to encourage or allow borrowers with credit problems to take out high-priced loans. For all of its pros and cons, risk-based pricing remains a universal practice in bond markets and the insurance industry, and it is implied in the stock market and in many other open-market venues; it is only controversial in the case of consumer loans.

• Competition: Some believe that risk-based pricing is fair but feel that many loans charge prices far above the risk, using the risk as an excuse to overcharge. These criticisms are not levied on all products, but only on those specifically deemed predatory. Proponents counter that competition among lenders should prevent or reduce overcharging.

• Financial education: Many observers feel that competition in the markets served by what critics describe as "predatory lenders" is not affected by price because the targeted consumers are completely uneducated about the time value of money and the concept of Annual percentage rate, a different measure of price than what many are used to.

• Caveat emptor: There is an underlying debate about whether a lender should be allowed to charge whatever it wants for a service, even if there is no evidence that it attempted to deceive the consumer about the price. At issue here is the belief that lending is a commodity and that the lending community has an almost fiduciary duty to advise the borrower that funds can be obtained more cheaply. Also at issue are certain financial products which appear to be profitable only due to adverse selection or a lack of knowledge on the part of the customers relative to the lenders. For example, some people allege that credit insurance would not be profitable to lending companies if only those customers who had the right "fit" for the product actually bought it (i.e., only those customers who were not able to get the generally cheaper term life insurance). Regardless, the majority of U.S. courts have refused to treat the lender-borrower relationship as a fiduciary one and declined to impose a duty of care upon lenders in the making of loans. Thus, once the lender has complied with all relevant statutory disclosure obligations, it remains solely the borrower's problem to ascertain whether the loan they are getting is the right fit for them.

OCC Advisory Letter AL 2003-2 describes predatory lending as including the following:

• Loan “flipping” – frequent refinancings that result in little or no economic benefit to the borrower and are undertaken with the primary or sole objective of generating additional loan fees, prepayment penalties, and fees from the financing of credit-related products;
• Refinancings of special subsidized mortgages that result in the loss of beneficial loan terms;
• “Packing” of excessive and sometimes “hidden” fees in the amount financed;
• Using loan terms or structures – such as negative amortization – to make it more difficult or impossible for borrowers to reduce or repay their indebtedness;
• Using balloon payments to conceal the true burden of the financing and to force borrowers into costly refinancing transactions or foreclosures;
• Targeting inappropriate or excessively expensive credit products to older borrowers, to persons who are not financially sophisticated or who may be otherwise vulnerable to abusive practices, and to persons who could qualify for mainstream credit products and terms;
• Inadequate disclosure of the true costs, risks and, where necessary, appropriateness to the borrower of loan transactions;
• The offering of single premium credit life insurance; and
• The use of mandatory arbitration clauses.