In the fast and loose world of subprime lending, companies vie to sell fee-packed loans to poor, elderly and credit-impaired borrowers.
To their fans, these California lenders were part of a $270-billion-a-year business that made money by doing good, helping consumers in low-income and minority neighborhoods consolidate their bills or pay for home improvements even if they had credit problems that made them less than “prime” customers.
To their critics, though, subprime lenders were part of a dark industry that targeted the desperate and naive, aggressively selling them loans with fees and interest rates so high they seemed almost designed to drive borrowers into foreclosure.
“There’s nothing wrong with subprime lending as long as the lenders comply with the law,” said Gene Marsh, a University of Alabama law professor who has testified before Congress on the issue and served as an expert witness in lawsuits against lenders. “The fact is there are some people in the country who just aren’t going to get credit anywhere else. It’s the techniques that cause people to flinch.”
In March, in a move that rocked the subprime world, First Alliance, a 29-year-old industry pioneer, filed for bankruptcy amid growing allegations that it engaged in a pattern of fraudulent lending in several states, including California.
To some observers, the surprise bankruptcy filing was an effort by First Alliance’s founder and majority shareholder, Brian Chisick, to frustrate angry borrowers who have sued the Irvine company and Chisick personally for allegedly violating consumer-protection laws.
Others saw the action as the inevitable move of a business that relied on short-term loans from investment houses like Lehman Brothers to survive but found its lines of credit evaporating after The New York Times and ABC News drew attention to the company’s controversial track record in a joint investigation.
One thing is certain: The lawsuits combined with ongoing probes of First Alliance by the U.S. Department of Justice and several state attorneys general and new criticisms from the Federal Reserve have turned the spotlight on the world of subprime lending.
It’s a world where insider jargon such as “securitization” and “flipping” can obscure a simple truth, amply demonstrated by the First Alliance fiasco: In this business, the risks go both ways.
Subprime lending is nothing new. But the niche exploded during the 1990s, thanks to the growth and popularity of securitization, a way of gathering individual loans into mutual-fund-like pools and then selling shares in the pool to investors.
Securitization isn’t new, either. That’s what Fannie Mae, the Federal National Mortgage Association, has been doing for years with conventional mortgages, purchasing the mortgages from lenders, repackaging them and selling them to investors as bonds.
Before the 1990s, however, mortgages from subprime lenders were rarely pooled and sold to Wall Street. Instead, they were sold as whole loans to individual investors who had an appetite for risk.
All that changed as the extended bull market drew more investors into the financial markets and sent fund managers scrambling for new places to invest all the new cash.
When the first couple of subprime securitizations were snapped up by portfolio managers and other yield-hungry investors, Wall Street got the message and began encouraging subprime players such as First Alliance.
At first, firms like Lehman Brothers simply handled the back-end details of bundling the thousands of individual loans into bond offerings and lining up investors to buy the bonds.
But gradually, the Wall Street firms began to get active on the front end as well, making short-term loans to subprime lenders that were then used to make more loans.
The thinking? By encouraging more subprime lending, the Wall Street firms were not only getting a better short-term return on their cash than they could get from comparable Treasury bonds, they were also ensuring a steady stream of lucrative business for their securitization teams.
By loosening its purse strings, Wall Street unleashed a torrent of subprime loans. Between 1993 and 1998, mortgage refinancing by companies like First Alliance grew 890 percent, from less than 100,000 loans to more than 800,000, according to the Woodstock Institute, a Chicago non-profit group that authored a 1999 study that criticized abuses in the industry.
During the same period, refinancings from prime lenders barely budged at about 5 million a year.
As existing subprime lenders and new players that were lured into the market by the promise of easy profits scrambled to line up customers and sell loans, some but not all adopted marketing and sales tactics that were quickly labeled “predatory” by critics.
Some of these included:
“Asset-based lending,” or making a loan based on the value of the property that secures it rather than on the ability of the borrower to repay.
“Packing,” the practice of loading loans with outrageous and unnecessary fees, often hidden.
“Flipping,” or encouraging borrowers to refinance frequently to generate new fees.
“Stripping,” or structuring payments that fail to cover the interest on a loan and which result in rising, rather than falling, balances.
“I’m telling you, they are really, really clever,” said Tom Jenkins, a San Francisco attorney who represents several Bay Area borrowers suing subprime lenders. “They’re uncommon thieves. They target unsophisticated people and elderly people, who unfortunately become more trusting with age.”
Wall Street may have provided subprime lenders with the means, but it was Congress that provided the industry with the opportunity that fueled its explosive growth. In 1977, Congress passed the Community Reinvestment Act, a law designed to force traditional banks to make loans in the lower-income and minority neighborhoods they had traditionally shunned.
The law created two situations that the subprime lenders ultimately exploited. First, as conventional banks complied with the CRA by making mortgage loans in traditionally red-lined areas, they created a new class of homeowners who had “little experience in financial matters,” according to the Woodstock Institute report.
These consumers ultimately proved easy pickings for unscrupulous subprime lenders, says Dan Immergluck, a top official at Woodstock.
BORROWERS BEWARE
Before you sign any final loan papers, you should be able to answer the following questions and find the information in your loan documents.
– Can the lender seize your property and sell it if you fall behind in your payments?
– How much money are you really borrowing?
– What items have been included in the financed amount and how much is the lender charging in origination fees?
– What is the annual percentage rate? Will the rate ever change? What is the finance charge?
– How many payments will you make over the life of the loan? What is the payment schedule?
– Does the schedule include any balloon payments? What are the penalties for late payments? What are the penalties for prepayment?
— Orange County Register
