Yves here. Black gives an excellent discussion of why the Trump Administration plans to gut payday lender restrictions are so destructive, as well as on the general importance of requiring that lenders be able to document that they had good reason to think the borrower would be able to repay the loan.
However, I have one quibble with his piece, which is his discussion of pre-crisis adjustable rate mortgages with rate resets. We discussed those at nauseating length before and during the crisis, studying huge analyses by CoreLogic (and objecting to their rosy conclusions) and the works of the sainted Tanta, among many other important sources back in the day.
The purpose of rate resetting ARMs was not to get borrowers in over their heads, at least not for a while. The entire premise of the rate resetting ARM was to get the borrower to refi before or shortly after the rate reset. I don’t know where Black got the idea that there were prepayment penalties on theses loans. Most subprime loans were securitized, so the originators/packagers were indifferent to performance. However, being able to sell new loans and collect all those fees again in a short period of time was an extremely attractive proposition. The tacit assumption was that housing prices would continue to rise, or at least not fall, and that even if the new mortgage terms would not be as good as the former “teaser” rate, they’d still be better than if the borrower sat pat and took the hit of seeing their mortgage go from 2% to 7% (a not uncommon jump).
In addition, the subprime lenders would often succeed in persuading borrowers to refi their loans with a higher loan balance, which they could do in as little as eighteen months back in the bubble years because home prices were rising rapidly in many markets. More than 50% of the subprime mortgages in 2005 to 2007 were “cash out refis,” meaning the borrower was paying off an old mortgage with a new one with an even bigger balance. That meant he was effectively pulling equity out of his house.
As we also discussed in those hoary old days, Countrywide, which before its sale to Bank of America had the best call center and servicing platform of any mortgage lender (not that they used those capabilities to good ends) would call their subprime borrowers who’d taken teaser rates six months into the mortgage and tell them that a reset was imminent to get them to refinance sooner.
By Bill Black, the author of The Best Way to Rob a Bank is to Own One, an associate professor of economics and law at the University of Missouri-Kansas City, and co-founder of Bank Whistleblowers United. Jointly published with New Economic Perspectives
Kate Berry, the American Banker reporter that covers consumer financial protection, has written another important article about the continuing horror story of Trump’s increasingly successful efforts to pervert the Consumer Financial Protection Bureau (CFPB) into an agency dedicated to harming consumers and protecting our Nation’s most predatory lenders. Unfortunately, her January 14, 2019 article is behind a paywall.
The Predatory ‘Sweet Spot’
The context is one of the CFPB’s most important and useful anti-predatory lending rules by payday lenders. Payday lenders often charge working class Americans interest rates well above 100 percent. (In Missouri, a hotbed of predation, they can charge more than 500 percent.) The ‘sweet spot’ for payday lenders is borrowers who will be unable to repay promptly the initial loan (with an obscene, but vastly lower initial interest rate). This sets off a cycle of additional borrowing and extending of payday loans that places the borrower into a debt spiral that frequently results in bankruptcy. Payday lenders, who exist to predate on customers, make their extraordinary profits largely from borrowers who cannot repay the initial payday loan when it comes due, but have some income and will continue to reborrow and attempt to repay for months. Predatory payday lenders optimize by finding this ‘sweet spot’ of those who have enough income and a compelling intent to repay – but not enough income to pay off the entire series of loans.
Kate Berry’s article reports that Kathy Kraninger, Trump’s new CFPB head (with no experience in consumer financial protection), intends to junk the CFPB rule provisions requiring that payday lenders underwrite their loans by documenting the borrower’s ability to repay the loan when due. She also intends to act to protect the predators’ ‘sweet spot.’ Berry reports that Kraninger also intends to optimize the predators’ ‘sweet spot.’
The latest proposal also is expected to rescind limits that the rule placed on repeat reborrowings by a single consumer; the CFPB’s data shows that payday lenders rely on reborrowings as a major source of revenue.
The two points, capacity and reborrowing, are predatory kissing-cousins. Predatory lenders’ targets reborrow because they lack the capacity to repay the initial loan when it comes due.
Predation and Fraud in the GFC Based on Not Documenting Capacity to Repay
This ‘sweet spot’ strategy is a signature of predatory lending because it optimizes the CEO’s ‘take’ from ‘control fraud’ and predation. “Exploding rate ARMs” were a common late-game strategy in the run-up to the Great Financial Crisis (GFC). An exploding rate ARM was an adjustable rate mortgage with a monthly payment so low that it did not even pay the interest currently due on the mortgage. (In jargon, it was “negatively amortizing.”) This meant that the principal amount of the mortgage debt increased every month. The mortgage contract provided that after three-to-five years (sooner had there been high inflation) the monthly mortgage payment would ‘reset’ (adjust upward) – often doubling the monthly payment. The lenders’ CEOs understood, of course, that this would cause loan defaults and foreclosures to reach tsunami levels.
The defaults were particularly high because the predatory lenders consistently ‘qualified’ the borrower as (purportedly) having sufficient income to repay the loan based on the initial monthly payment – not the 2X reset payment. Indeed, many of them purported to ‘qualify’ the borrower based on a ‘teaser’ interest rate (that last only for one month or three months). The teaser rate produced an initial monthly payment that was exceptionally low. The lenders’ CEOs gamed the ‘qualifying’ standard for the sole purpose of making it appear that borrowers who typically lacked the income to repay the ‘fully indexed’ interest rate had the ability to do so.
Why did the predatory CEOs make exploding rate ARMs their most common mortgage product as the housing bubble was fast approaching its peak? First, it let them loan to millions more people who could not afford to repay their loans – and disguised that fact. Extremely fast growth is the first ‘ingredient’ in the ‘recipe’ for ‘accounting control fraud.’ (See my many columns if this point is new to you).
Second, it slowed down defaults, which is critical to lengthening the ‘sweet spot’ strategy’s period of success. Paying one-half the ‘fully indexed’ monthly payment is obviously far easier, particularly for borrowers with modest incomes. As long as the loan does not default, the accounting alchemy I describe next continues.
Third, accounting is nearly always the ‘secret sauce’ in financial fraud and predation ‘recipes.’ The predatory exploding rate ARM lending CEOs’ were invariably able to suborn top tier audit partners to allow the lender to book currently as income payablethe fully indexed(i.e., 2X) interest rate the borrower was contractually committed to paying (eventually). Of course, given the immense defaults certain on exploding rate ARMs as soon as the bubble stalled, the borrowers would frequently have no ability to pay the monthly payment when the interest rate doubled. Lenders called this ‘phantom interest’ because they got to treat it for GAAP accounting purposes as current income even though they frequently would never receive the additional cash from the borrowers when they defaulted in droves when their monthly payments doubled. Phantom interest became massive – producing tens of billions of dollars in largely phony income to predatory lenders – and billions of dollars in real bonuses to bank officers.
Fourth, the predatory exploding rate ARM loans typically had a substantial ‘prepayment penalty’ (very unusual for U.S. home mortgages) that the CEOs designed to lock in victims of their predation. Americans can usually get out of mortgage agreements in which they have agreed to pay too high a rate of interest by refinancing their mortgage without any prepayment penalty. The CEOs of the predatory lenders foreclosed that option (pun intended) so that they could maintain their accounting magic.
Similarly, the CEOs of fraudulent lenders used ‘liar’s’ loans as one of their two primary loan origination fraud strategies. (The other was fraudulently inflated appraisals. The Trump administration is aggressively making finance more criminogenic by reducing appraisal requirements.) Fraudulent CEOs designed liar’s loans to make loans to people who lack the actual capacity (income) to repay the loan while providing a fig leaf of fictional capacity through false ‘stated income.’ Recall that investigators concur that it was the lenders’ officials and their agents that put the lies in liar’s loans.
Dodd-Frank and the CFPB
All of these terrible experiences occurred contemporaneously during the creation of the GFC. They all involved ignoring one of the three ‘Cs’ of loan underwriting – capacity. (The other “Cs” are collateral and credit history.). The three contemporaneous nightmares of lenders ignoring the borrower’s capacity to repay the loans drove home to Congress in their creation of the Dodd-Frank the need for federal requirements that lenders establish through underwriting the borrower’s capacity to repay the loan. Congress created the CFBP largely to address this central problem of predation and its ability to generate a Gresham’s dynamic.
The CFPB payday lender rule and the more general Dodd-Frank provisions requiring that borrowers have the real capacity (income) to repay the loans obviously helps the borrower by dramatically reducing defaults and foreclosures. Requiring capacity to repay the loan, however, is also vital to protect honest, non-predatory lenders from the ‘Gresham’s’ dynamic that fraudulent and predatory CEOs generate. When cheats and predators gain a competitive advantage over honest, ethical business rivals, market forces become perverse and drive good ethics from the markets and professions. One of the best things capable regulatory and prosecutorial bodies do is to block this Gresham’s dynamic by taking action to prevent a Gresham’s dynamic. Such a regulatory action is a win-win for consumers and honest business people. When a field of business acts to block such a regulatory win-win it is certain that control frauds and predators dominate that field of business.
The Obama-era CFPB payday lending rule was aimed at preventing a Gresham’s dynamic by requiring that payday lenders underwrite prior to lending to ensure that the borrower had the capacity (income) to repay the loan when it came due. It banned the ‘sweet spot’ through that provision and the limit on reborrowing. It was a brilliant rule that exemplifies much of what modern economics, white-collar criminology, and psychology teach. Naturally, the Trump official installed to gut the CFPB, has targeted the most essential parts of the rule – capacity and reborrowing – for elimination. Kraninger’s goal is to restore the predatory payday lenders’ ability to exploit the ‘sweet spot’ of targeting borrowers who will be unable to repay the initial loan. The predators’ goal is to identify and catch those who fall in the sweet spot in a debt trap and a spiral into (eventual) bankruptcy. She is deliberately making the financial environment for payday lenders far more pathogenic. She is also making a mockery of Republican demands for regulatory actions based on research and data. She exemplifies Bastiat’s twin observations about protecting consumers from predation. Bastiat noted that the predators would always seek to corrupt the government to aid rather than prevent the predators’ abuse of the consumer.
Treat all economic questions from the viewpoint of the consumer, for the interests of the consumer are the interests of the human race.
* * *
When plunder becomes a way of life for a group of men in a society, over the course of time they create for themselves a legal system that authorizes it and a moral code that glorifies it.
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Is there a material difference between a payday lender and the old fashioned loan shark other than in some way I have never understood, pay day lending is within the law?
Parenthetically, what ever happened to usury Laws and who lobbied for their repeal?
I could be wrong….. My memory of the event is that high inflation in the late 70s inspired Carter and Congress to (use theopportunity to) overturn and loosen the usury laws so lenders could charge interest that was higher than the rate of inflation.
But nothing was done to tie the limits (are there any limits on interest now?) to inflation or make the change something temporary.
Ha, I guess as far as credit cards go, I am wrong How a Supreme Court ruling killed off usury laws for credit card rates
Where did I get that idea then? I can’t find any reference to it but I could have sworn I remembered news stories about the issue at the time.
William Brennan delivered the verdict for a unanimous Supreme Court. The Dred Scott decision of finance law.
My memory is similar to yours except that it wasn’t so much the inflation rate that was the problem, it was the high Fed interest rates used to limit inflation under Volcker. The way I remember it explained was that the Fed rate got to a point where it was higher than the interest rates credit card companies could legally charge, which pretty much meant the death of that industry. If AMEX for example had to borrow at 18% but could only charge 12% to its customers, they’d be out of business in a hurry.
At least some of those involved with the rule changes had good intentions and the change wasn’t necessarily meant to be permanent, but once the gravy train got rolling Congress wasn’t willing to go back and limit the interest rates credit card companies could charge when the Fed rate went back down in the 80s.
My understanding of the downfall of usury laws is that it started in Montana as the first state to either abolish or
reset their usury laws to a much higher rate so as to accommodate a National credit card processor wishing to relocate. For the rest of the states it was a “race to the bottom”. Anyone else have an idea?
The Marquette Decision – Smiley vs Citibank (Walter Wriston) is somewhat relevant (most for credit cards) but opening up markets at high interest rates, finding corrupt state officials to sell their wares (Delaware and South Dakota in this case) or deregulation state shops in a race to the bottom – Gresham’s dynamic certainly paved the way for the onslaught of predatory lending mimicking drugs
1. Offer them a teaser sample
2. Get them hooked on the product
3. Exploit the disadvantage (especially to those who do not understand/expect the consequences)
4. Rinse repeat — change bankruptcy and drug laws.
Guess who uses payday loans the most?
https://www.americanbanker.com/opinion/why-are-payday-loans-so-popular-with-the-military
The likely cause for such shocking numbers of uniformed payday borrowers is related to the background of those who enlist in the All-vol military. DOD enlists mostly kids right out of High School or dropouts with a GED, often married (25% of entrants) with an infant or pregnant spouse, who need income, housing, and family medical care. Burger King pays minimum wage with no benefits whereas all those goodies come with an Army enlistment contract.
Despite DOD reports, most enlistees are not the creme de la creme claimed. It is not that they are lying, but a C average at my prep school would equate to an A+ average at Roxborough High . Nobody in my prep school would enlist in the post-draft military. One must factor in the SES of the enlistee’s parents too. These are folks from economically-depressed areas who might have few financial resources and surely a number of recruits are sending money home.
Finally, factor in the op-tempo for deployable specialties and you have the 19-year-old bread-winner in Syria trying to pay bills for a wife and baby stateside in Fort Hood with no control over spouse impulse buying and no experience managing a household budget to begin with.
Thus, first-term enlistees are, as a group, extremely vulnerable to predatory lending.
Perhaps the DoD should have their own non-profit payday loan shops on or near bases.
Howard Karger’s book on payday lending is a good primer, historical context 1990’s for how the payday industry took hold and has not looked back since.
https://www.barnesandnoble.com/w/shortchanged-howard-karger/1007258205
Other good reads include:
Donald Morgan
https://www.newyorkfed.org/research/staff_reports/sr309.html
Payday Lending: A Business Model that Encourages Chronic Borrowing
Michael A. Stegman, Robert Faris
First Published February 1, 2003 Research Article
https://doi.org/10.1177/0891242402239196
Ernst, Farris & King (Center of Responsible Lending) publications —> the website has several publications, that are excellent as well.
So glad both BB and Yves are writing about this topic —
There usually were prepayment penalties on subprime and Alt-A mortgages but they had short-timers, typically 12 and 24 months. That way people were still encouraged to churn but the trust/servicer would get a bonus if there was a strong enough incentive for people to refi more than once every year or two. That is, the penalties weren’t really designed to discourage prepayments but, rather, to share the gravy anybody refi’ing a mortgage so quickly was presumed to be receiving.
Michael Olenick is correct regarding prepayment penalties on subprime and Alt-A mortgages. Ours was with New Century, it was a 2/28 loan, with the reset being from 3.9% to 11% after the 28th month. The prepayment penalty was 5 or 10% of the mortgage balance as I recall. The interest rate itself was tied to 6 month LIBOR, allegedly, although I gave up trying to verify that.
the American Banker article that Bill referenced does not seem to be under a paywall right now..
https://www.americanbanker.com/news/cfpb-to-scrap-key-underwriting-portion-of-payday-rule
maybe its a fluke…
The Consumer Financial Protection Bureau is expected to eliminate underwriting requirements in a highly anticipated revamp of its payday lending rule, according to sources familiar with the bureau’s proposal.
The CFPB in October signaled its interest in “revisiting” the ability-to-repay provisions in the 2017 small-dollar lending rule issued under former Director Richard Cordray.
But sources familiar with the agency’s thinking say the CFPB — now led by Trump appointee Kathy Kraninger — has concluded the best approach is to remove those provisions altogether. Under the current rule, which has not yet gone fully into effect, lenders must verify a borrower’s income as well as debts and other spending, to assess one’s ability to repay credit while meeting living expenses.
Kathy Kraninger
The CFPB — now led by Trump appointee Kathy Kraninger — has concluded the best approach is to remove the ability-to-repay provisions altogether from its payday lending rule.
Bloomberg News
Such a course would gut the centerpiece of a rule that consumer advocates had hailed as a preventive measure against spiraling debt for consumers who rely on short-term credit.
The agency under then-acting CFPB Director Mulvaney signaled its intent to reopen the rule as far back as January 2018. Now the acting White House chief of staff, Mulvaney sided with two payday lending trade groups that sued the CFPB in April to invalidate the regulatory restrictions.
In court documents, the CFPB argued that payday lenders would suffer “irreparable harm” from the 2017 final payday rule and that it was “in the public interest” to reopen the rulemaking.
“Lenders throughout the market will face substantial decreases in revenue once the Rule’s compliance date takes effect, which will lead many to exit the market,” agency said in a motion.
But even though both Mulvaney and Kraninger have supported using statistical analysis to to weigh a regulation’s cost, some attorneys and consumer advocates say it is is unclear how the CFPB will explain changes to the underwriting requirements since no new research on payday loans has been released in the last year.
“Gutting the ability-to-repay requirement completely is going to be difficult for the bureau to defend,” said Casey Jennings, an attorney at Seward & Kissel and a former attorney in the CFPB’s Office of Regulations, who worked on the 2017 rule.
The 2017 final payday rule stated that it was “an unfair and abusive practice” for a lender to make a short-term balloon-payment loan “without reasonably determining that consumers have the ability to repay the loans according to their terms.”
The CFPB is expected within days or weeks to issue a proposal to reopen the rule for public comment. The overhauled regulation would replace the 1,690-page rulemaking — the result of five years of research — finalized in Cordray’s last days at the agency.
The latest proposal also is expected to rescind limits that the rule placed on repeat reborrowings by a single consumer; the CFPB’s data shows that payday lenders rely on reborrowings as a major source of revenue.
However, the CFPB is expected to leave intact payment provisions that would limit the number of times a lender can try to extract loan payments directly from consumers’ bank accounts, sources said.
Consumers groups say retracting the core ability-to-repay requirements and reborrowing limits would leave consumers vulnerable.
“Our expectation is that the CFPB will weaken the payday rule to the point that it has no practical value,” said Alex Horowitz, a senior research officer on the small-dollar lending project at the Pew Charitable Trusts.
The bureau’s statement in October said the agency planned to reconsider only the ability-to-repay mandate — and not the limit on lender’s attempted debits from a consumer’s bank account — “in significant part because the ability-to-repay provisions have much greater consequences for both consumers and industry than the payment provisions.”
In November, a federal court suspended the August 2019 compliance date for key parts of the original 2017 rule, since the bureau under then-acting Director Mick Mulvaney had said it planned to propose changes in January.
The CFPB has been overseeing the $38.5 billion payday industry since its inception in 2011. During that time, payday lenders have fought all federal efforts to regulate the industry.
The two payday lending trade groups that sued the CFPB last year to invalidate the 2017 rule claimed that the bureau under Cordray cherry-picked research to support tough restrictions on lenders.
“The rule as previously proposed was really just an attempt to penalize industry,” said Jamie Fulmer, a senior vice president at Advance America in Spartanburg, S.C., one of the largest payday lenders. “There was a tremendous amount of academic research on both sides that was put forth but the bureau only dwelled on research studies that supported their positions, and dismissed the counter arguments.”
Payday lenders have sought to frame the debate as one of access to credit, arguing that it makes sense for cash-strapped consumers to have access to short-term, small-dollar lending options, and they dispute characterizations that their business model is predatory.
“Anything that restricts consumers’ ability to access credit when they need it is bad for the consumer,” said Fulmer.
Still, a consumer using one of those options may have to pay as much as $60 to borrow $400 for a couple of weeks, and their annual interest rates range from 300% to 500%.
Consumer advocates are likely to sue the CFPB over its changes but can only do so after the rule is finalized.
Eliminating underwriting requirements for payday loans could create “ground-breaking precedent for interpreting federal agency actions,” said Jennings.
Many consumer attorneys believe the CFPB faces a tough hurdle in defending its changes against charges under the Administrative Procedure Act that a new regulation is “arbitrary and capricious.”
“The underlying research didn’t change; the only thing that changed was the director of the agency,” Jennings said. “I think it’s quite possible that a court finds that arbitrary and capricious.”
The CFPB’s 2017 final payday rule under Cordray sought to strike a balance by constraining repeat borrowings that pushed many borrowers into a cycle of debt, without eliminating two-to-four-week loans altogether.
Regulators have also opened the door for banks to get into installment lending as an alternative to payday lenders.
In May, the Office of the Comptroller of the Currency endorsed banks’ offering affordable installment loans. In September, U.S. Bank announced that it would offer installment loans with monthly payments that do not exceed 5% of a borrower’s monthly income, with prices markedly lower than a payday loan.
For data on prepayment penalties on ARMS, see this paper: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1290716
More than 50% had prepayment penalties.The goal, I believe, was to make sure that the lender got a substantial benefit from the house price increase that made the refi possible.
Can’t download from that link. Here’s a working paper version: https://research.stlouisfed.org/wp/more/2008-039/ . See Table 3.