By George W. Mantor
RISMEDIA, December 1, 2009—Back in the day, predatory lending was pretty much confined to grifters combing poorer neighborhoods looking for elderly or ignorant homeowners with substantial equity. Oh, they’re still out there.
But, the securitization of mortgages brought a level of sophistication to predatory lending that has allowed it to go on virtually undetected. If you got a loan in the last few years, it was probably packaged with a pool of other mortgages and sold off to an investor seeking a long term revenue stream. But, it doesn’t stop there.
What if a borrower pays his loan off early, killing the revenue stream? Not an unlikely occurrence, particularly given the refinancing activity that took place while prices were rising.
In one way or another, that risk and others, such as default rates, were factored into the business model and can actually contribute to profitability.
In the retail industry, one of the risks is “shrinkage” or theft. In preparing a budget for a retail business, there is an anticipation of a certain percentage of loss due to theft. The projected profit margins must be sufficient to absorb the losses. Other risks are insured against.
It is important to keep in mind that mortgage securitization makes up only a small percentage of the much larger business of securitizing debt. If you occasionally drive by a stalled strip mall or an abandoned subdivision, the money probably came from investors buying securitized debt.
Auto loans, student loans, business loans, credit cards, and just about any kind of debt you can think of have been sold as investments.
All of which illustrates two important points: there was a very high demand for these investments, and meeting the demand is very, very lucrative.
The entire compensation scheme, from street level mortgage reps all the way up through the highest levels of Wall Street, rewards volume, not quality. It’s a very simple premise; reward the behavior you want and you’ll get more of it.
That is simple enough and easy to understand, but as counterintuitive as this may seem, in the world of high finance, there is more money to be made in bad lending than there is in good.
Business model based on failure, not success.
When I was growing up, a Horatio Alger story was a metaphor for someone who overcomes obstacles to achieve great success. Horatio Alger, Jr. (1834-99) was a prolific writer of dime novel stories for boys. With uncommon courage and moral fortitude, Alger’s youths struggle against adversity to achieve great wealth and acclaim. They demonstrate the values of hard work and perseverance.
But, that’s fiction and the world has changed. Success is hard, failure is easy. Success comes at a price. For those unwilling to pay the price, there is always failure. If you are good at creating failure, you can bet on it.
For example, if I flood the market with phony shares of Bear Stearns, I can destroy its share value. If I buy a Credit Default Swap to pay me in the event of its failure, as in the case of one mystery investor who in March of 2008 did bet on Bear Stearns collapse, I would get $270 million. See how rewarding failure can be?
What does all that have to do with predatory lending? In part, it helps explain the eagerness to lend money to anyone. That is what they get paid for; matching people with money. Money was looking for you.
Wall Street touted mortgage backed securities as investment grade, and money poured in from all over the world. More money, in fact, than there were good investments. Beneath the surface, the economy has been essentially stagnant and this might normally be fatal for Wall Street.
But, with some ENRON-esque accounting tricks allowing liabilities to be reclassified as assets, leverage, tranching, and rating agencies willing to label debt “triple “A” investment grade”, there was something to trade. And, without debt to sell, a lot of high paying jobs would go away.
And, bad loans are more profitable than good ones. Armed with FICO scores and sophisticated research into a borrower’s behavior, they were able to track down exactly the borrowers they wanted. By definition, that is predatory, but they call it marketing.
Types of Predatory Lending
Perhaps the easiest and most common type of predatory lending is moving a highly qualified borrower into a more expensive loan. Most people are intimidated and confused by the mortgage process and have no real way of verifying what they are being told.
Who really knows what those credit scores mean when it comes to loan terms?
Promise one thing, deliver another
“Our underwriting standards have changed.” Who can argue with that? Not even the street level mortgage reps as it turns out, who are always the ones who have to go back to the borrower and try to explain why they have to pay another half-point and a quarter percent higher interest rate.
The 2/28 loan
Designed to implode.
According to bankrate.com, “A 2/28 subprime ARM has a low initial rate that lasts two years. After that, the loan resets; this means that the rate is adjusted upward or downward. At the first jump, the rate can conceivably climb 2 to 6 percentage points, causing monthly payments to skyrocket. (In practice, the first rate jump is usually on the smaller end of that scale, but it can keep rising every six or 12 months after that.)”
Why risk default when you can make it a certainty by developing a loan with a really high failure rate? And, you can hedge the bet further by knowing approximately when the loan will default.
The closing table surprise.
This could be virtually anything that will increase the profitability of the loan or the likelihood of a default. This isn’t much of a gamble on their part as most people do not sit at the closing table and read the actual loan documents.
Simply by doing any of these activities, they are able to increase the fees and the interest rate and maximize the profitability of the loan origination process. But, it doesn’t end there. The lenders also made side bets (Credit Default Swaps) that a substantial number of these loans would fail based on the credit profiles of the borrower or the type of loan.
Research is now revealing that a large number of securitized loans have both Truth in Lending or RESPA violations.
There are many other types of predatory lending, and if you have been a victim or suspect you may have been a victim of predatory lending, you’ll need an experienced attorney.
George W. Mantor is known as “The Real Estate Professor” for his wealth building formula, Lx2+(U²)xTFP=$? and consumer education efforts. During a career that has spanned more than three decades, he has amassed experience in new home and resale residential real estate, resort marketing, and commercial and investment property. He is currently the founder and president of The Associates Financial Group, a real estate consulting firm.
Mantor can be reached at GWMantor@aol.com.
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