Why Comparison-Shopping is Impossible in Subprime

With last month’s elections and the Democrats’ upcoming control in Congress, predatory home mortgages are back in the spotlight.  Congressman Barney Frank, the incoming chair of the House Financial Services Committee, has made clear that a federal anti-predatory lending law is high on his agenda, and industry representatives and consumer activists are scurrying to draft bills.  Given the recent attention on the Hill, we decided to devote our guest entries this week to residential mortgages.  Our heartfelt thanks go to Bob Lawless and his colleagues at Credit Slips for inviting us to make a guest appearance.

Today, we focus on a persistent myth: that if subprime customers just comparison-shopped, they would not end up with predatory loans.  In our humble view, no matter how smart customers are, it is impossible – totally impossible – for them to engage in informed comparison-shopping in the subprime market.  Policymakers have a hard time grasping this fact because it is so easy to comparison-shop in the prime market.  However, price revelation works differently in the subprime market, making meaningful comparison-shopping impossible.

In the prime market, lenders reveal prices up-front and for free.  Prime customers know that identical mortgages have roughly the same price.  This puts pressure on lenders to advertise firm prices and offer concessions to consumers such as lock-in commitments and interest rate buy-downs in exchange for points.  These dynamics, plus Truth-in-Lending Act disclosures that standardize prices, make it easy to comparison-shop in the prime world.

In contrast, in the subprime world of risk-based pricing, customers must reveal their creditworthiness before lenders can determine their loan prices.  Today, lenders assess creditworthiness by requiring applicants to submit a loan application plus a large application fee.  In many cases, subprime borrowers do not learn the true price of their loans until closing, due to a lack of lock-in commitments and behind-the-scenes negotiations over broker compensation.  As a result, the subprime market is a pay-to-play market where customers must pay several hundred dollars (and often wait until closing) to learn the actual price of their loans.

These dynamics make Truth-in-Lending Act disclosures break down in the subprime market.  TILA allows subprime lenders to advertise their best rates alone, which misleads customers with weaker credit.  In addition, TILA does not require lenders to reveal binding prices until closing (except for high-cost loans).  Finally, TILA disclosures for traditional adjustable-rate mortgages, interest-only mortgages, and option ARMs are hopelessly complex.

As Pat argues in a forthcoming article in the Harvard Journal on Legislation, these problems can be fixed.  In the meantime, it is time to stop blaming consumers and admit that comparison-shopping is impossible in the subprime home loan market.

Comments

[Andrew Engel]

I do not argue with your point. But I do not see inability to comparison shop -- in advance of closing -- as the only factor at play in the inability of sub-prime borrowers to avoid predatory loans. Let's face it - most predatory loan scenarios result from a "perfect storm," a confluence of factors which makes it easy for an unscrupulous lender to work a fraud, and very difficult for the borrower to guard against one. Let's count the factors (not an exhaustive list, but a good start):

1. Unsophisticated borrowers - Illiteracy, both verbal and financial, is a far greater problem then most would want to recognize. Being able to read words is thing, being able to understand them is something else. This problem grows exponentially the further down the economic scale you travel.

2. Financial distress - Most sub-prime borrowers are desperate. This desperation increases as the lending process is strung out. By the time closing comes around, these borrowers have no practical choice. They must close on the loan presented because the lender has, through honest assessment or simple lie, convinced the borrower to forego or foreclose other options. Simple things like, "don't make you mortgage payment this month because it will goof up payoff figures at closing." Of course, payment of application fees only exasperates this problem. As you note, the borrower becomes invested in a particular lender's loan to the exclusion of other possibilities.

3. Lack of information - As you point out, neither TILA nor RESPA ensures meaningful disclosure early enough in process to permit comparison. The sub-prime market is not an open one (as you state), so comparisons are not available.

4. The vig - Let's face it, when a loan officer gets paid per closed loan (as opposed to loan performance) the door is opened for lots of bad stuff to happen. Payment of vigorish to loan officers ensures that the bottom feeders drag as many victims as possible to the lending depths.

I disagree with the conclusion that comparison shopping is impossible in the sub-prime market. It's possible, just highly unlikely.

[Pat McCoy]

I totally agree that the other four factors you listed exacerbate predatory lending. But the fact remains that you cannot get a binding subprime quote right now before paying an application fee and going through underwriting. That makes meaningful comparison shopping impossible in subprime (unless consumers are willing to pay for multiple loan applications simply to comparison-shop, which is not a reasonable expectation). This point is important because some policymakers in Washington think the cure to predatory lending is comparison-shopping. I disagree with that policy prescription for all of the reasons you listed and also because meaningful comparison-shopping is not even possible -- at least not today -- in subprime.

[Andrew Engel]

I have not practiced in the area for a couple of years, so I cannot speak to the current practices of sub-prime lenders as to application fees. However, a few years ago application fees were not the norm in my area. Here in Ohio, predatory loans were mostly originated either through finance companies or mortage brokers. I simply did not see application fees.

I completely agree that the idea of comparison shoppping as a means of combatting these practices is absurd. But what can you do. Additional disclosure regulation will do little to help. Most of the affected borrowers are functionally, if not actually, illiterate, so more words and numbers will not clarify issues to those people. I do not think you should regulate application fees out of the market. You could require a formatted quote be provided at a set time (say a week) before closing. You could also address YSPs more directly. The HUD regulation revisions were awful. YSPs can serve a legitimate purpose, but you rarely see them used properly. You could put teeth into the GFE requirement of RESPA.

Come on, let's hear your ideas.

[Pat McCoy]

As we'll explain later this week, our main proposals for abusive lending reforms do not involve disclosure. However, certain reforms of the Truth in Lending Act (TILA) and the Real Estate Settlement Procedures Act (RESPA) would result in major improvements in the price revelation process in subprime. At a minimum, TILA and RESPA should require lenders to provide loan applicants with legally binding quotes seven days before closing. I also support binding closing cost packages under RESPA with appropriate consumer safeguards. YSPs should also be banned unless they result in a buydown of interest rates or fees. But I would reform disclosures even further. Today it is actually possible for subprime lenders or brokers to quote firm prices from rate sheets before taking a loan application by using a consumer's credit report and credit score. This idea is not new -- HUD espoused it several years ago. Ultimately, that is a goal that the law should work toward.

[Andrew Engel]

The idea of a YSP resulting in a buydown of the rate is antithetical. It can, however, result in lower cash cost. Has anyone thought about requiring a comparison of cost with a YSP and without the YSP. E.G. With a the YSP of 1.0% ($500 paid to the broker) your closing cost is $1000.00, but your rate is 9.0%. Without a YSP, your costs go up to $1500.00, but your rate is 8.5%

[Jim Hawkins]

It sounds like segmenting the market (among borrowers with varying degrees of credit-worthiness) undermined the efficacy of disclosures. I'm curious whether you think the benefits of market-segmentation outweigh the harm done to disclosures. Other fringe lending products like Rent to Own stores don't differentiate between borrowers, so comparison shopping is easier.

[Observer]

How about a one-page view of the loan info, similar to what credit card companies are required to provide.

The one-page view should include an amortization table, spelling out total interest paid for the life of the loan, the interest rate, and any fees (which should be standardized across all banks under the same 5 fee names for all banks).

This approach would both inform the consumer, and prevent shady fees, since any fee padding must go into one of the 5 fee category names, where the consumer could easily see where one fee was twice another bank's fee.

[Pat McCoy]

Unfortunately, in the subprime mortgage market as it now operates, I see few benefits to market segmentation. Many of these loans enable borrowers to buy homes, but at what price? Too many subprime loans are loaded with fees and made with scant regard for ability to repay. (Tonight's online New York Times reports, in fact, that subprime default rates are rising). Prime-eligible borrowers are steered to unnecessarily costly subprime loans. Because people can't comparison-shop in any meaningful sense, that removes competitive pressures on pricing. Excessive prices are the result.

In response to the last comment, I too favor short disclosures. We can learn a lot from the success of the Schumer box. The Schumer box already contains an estimate of aggregate interest over the life of the loan (the finance charge) and the annual percentage rate incorporates the interest rate and certain fees. For adjustable-rate mortgages (plain vanilla and exotic), I propose another short disclosure in the Harvard Journal on Legislation article.

The big problem, however, is the timing of disclosures. They need to be made before application, before people pay application fees (which I do see all the time in Connecticut). HUD has advocated this approach, which I describe in the article.

[Diane Cipa]

Disclosures are not the answer. We need to rid the industry of predators. Our industry is mired in referral webs creating conflicts of interest. In this environment predators thrive.

Please visit http://coalitionpetition.blogspot.com/ and consider joining us.