Predatory lending laws could thwart smaller mortgages
By Michael D. Larson • Bankrate.com

Finding lenders willing to fund small mortgages has always been a chore. Now, it could get even tougher, an unintended consequence of attempts to help borrowers.

Consumer advocates and lawmakers around the country have been on the warpath the past two years about predatory lending, the practice of providing high-cost mortgages to unsophisticated borrowers, particularly the elderly and minorities.

Compelling stories of lending abuse and a rash of foreclosures have prompted legislation designed to strongly discourage and even ban certain mortgage lender and broker practices.

But many industry players warn there's a potential payback to all this rule making: They won't be able to make money on smaller mortgages. Some have already backed away from doing them, while others are raising minimum loan thresholds or removing economic incentives that allow brokers to offer low-balance loans. As a result, borrowers buying inexpensive homes, paying for home repairs or consolidating debts could have a harder time finding the financing they need.

"I have done a lot of $30,000 purchases and all of a sudden, I'm finding myself unable to do those now," says Michael Edelstein, president of Pittsburgh mortgage broker First Funding Corp. "More and more, a lot of the lenders I deal with are realizing there's no profit, and all of a sudden they're no longer going to originate a loan under $20,000. I have one lender who for any loan under $31,000, they increase the interest rate by 2 percent and they increase the points by one.

"What you're looking at now," he adds, "fees are increasing and interest rates are ultimately going to have to increase or the programs are going to have to disappear."

Small chance gets smaller
For years, borrowers who needed small loans had a harder time finding them than borrowers looking for larger ones. Lenders and brokers generally gravitate toward larger loans because they get paid for their work on a percentage basis. Someone who charges a one-point origination fee, for instance, can make $2,000 on a $200,000 mortgage, but only $500 on a $50,000 mortgage. And all other things being equal, large loans cost the same to make as small ones.

"We have some decent homes in our area for $30,000, $40,000, $50,000. Oklahoma is still one of those areas where you can buy a decent home for that price" and small mortgages are common, says Ellie Wade, president of the Oklahoma Association of Mortgage Brokers. "As much as I'd like to help everyone I can, why would I spend time on a $20,000 loan when I can spend time on a $100,000 one? That sounds terribly tacky, but if (people) were to put themselves in the same situation, they'd do so too."

Traditionally, lenders have compensated for the lower-profit-but-same-cost-to-originate dilemma by charging more points, higher interest rates or some combination thereof on small loans. Mortgage brokers could stay in the business too by getting more of their compensation from their wholesale lenders than their small-loan borrowers, many of whom don't make much money or have subprime credit and little cash for closing costs.

The process works like this: Rather than charge, say, three points to a borrower, a broker can get that borrower to accept a higher interest rate, then deliver the higher-rate loan to the wholesale lender. Because the higher-rate loan is more valuable to the lender, the lender is willing to pay the broker what's called a yield spread premium, or back-end points. That way, the broker gets paid, the lender gets a higher-yielding loan and the borrower doesn't have to pay as much out of pocket at closing.

Some of the predatory lending rules being proposed and enacted, however, cap the fees lenders and brokers can charge. Others restrict lenders from financing too many points into a borrower's loan principal. In Illinois, for instance, rules taking effect this month will prevent state-chartered banks and some mortgage brokers from financing fees and points equal to more than 6 percent of the loan balance into a borrower's mortgage.

Many rules also restrict the use of balloon payments and prepayment penalties, require borrowers to obtain counseling before taking out loans and provide borrowers with increased foreclosure protection. Some even have what you might call a "scarlet letter" provision. In Philadelphia, regulations taking effect this summer prevent lenders who make predatory loans from receiving city contracts or business. They also mandate that the city keep a list of lenders deemed high-cost or predatory on file and make that list available to the public free of charge.

"This is great legislation that is really going to protect people in Philadelphia," says Jeff Ordower, head organizer with the Pennsylvania chapter of the Association of Community Organizations for Reform Now. The consumer advocacy group helped organize demonstrations in favor of the rules. "This is about really cleaning up a horribly corrupt industry.

"There are a lot of lenders trying to make good loans, good subprime loans, and I'm sure there are some brokers who are doing a good job. But by and large, this is an industry that operates like the Wild West," he adds. "We're looking forward to (the law) being enforced and chasing the bad guys out of town."

The baby and the bathwater
But lenders say it won't just be the "bad guys" heading for the exits. They say even laws that don't explicitly cap fees will make lending unprofitable or impractical. The cost of complying with so many different regulations and jurisdictions will cause problems, as well. And many lenders, faced with the threat of lawsuits or public shame if they make loans branded as "high cost" or "predatory," will just throw in the towel and go elsewhere.

"You have these laws going into effect that are: 1) lowering the return that they are able to obtain on these loans and 2) increasing the risk," says Ric Pace, director of the regulatory advice services practice at PricewaterhouseCoopers LLP in Washington. "You have a situation where the return is being restricted based on the limitations on interest rates and fees and the risk from a compliance standpoint is increasing. That causes them to evaluate the whole economics of lending in the area."

The 6-percent Illinois fee-cap sounds reasonable for a $130,000 loan, for instance, but 6 percent of $30,000 is only $1,800. That may not be enough to compensate for all the work involved in processing subprime or otherwise difficult loans. That's because loan officers have to work with borrowers to get credit mistakes cleared up, verify self-employment and asset records and underwrite the loans manually, rather than process them through automated underwriting systems. The problem can be worse for mortgage brokers who have to cover their fees and fees charged by their wholesale lenders. Borrowers who can't pay the fees out-of-pocket and can't finance them into their loans may not be able to get mortgages at all.

"Brokers, loan officers, even the management in banks, they're all, in essence, entrepreneurs," says Edelstein, the Pittsburgh broker. "If you're not producing, you're not collecting a paycheck. You have to go where the money is."

With overzealous fee restrictions, he adds, "a lot of these low-income people who consumer advocates purport to be helping are going to find themselves in a position where they're renting five years later."

Still hope for low-income borrowers
For now, most borrowers in need of small loans can still find brokers and lenders willing to make them. But the price tag is rising in some cases. Consumers may want to explore their options now before lenders and brokers start pulling back, especially in cities where regulations are especially tight, such as Chicago and Philadelphia. Some experts even predict that borrowers will eventually have just one place to go for small mortgages -- consumer finance companies, such as Citigroup Inc.'s CitiFinancial and Associates units or Household International Inc.'s HFC and Beneficial divisions.

But others argue that industry officials are crying wolf. They say the restrictions being debated and passed now will protect consumers from predatory lenders while still allowing them to borrow from conscientious ones.

"I would have to suggest that the cream will rise to the top," says Dan Burke, a state representative from Chicago involved in Illinois' fight against abusive loans.

"Legitimate and certainly well-intentioned lenders, I think, will find a way to continue to do business and engage in a profitable business."