How Do Predatory Lending Laws Impact Bank Performance?

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INTRODUCTION

The past decade has witnessed a significant expansion of credit for many in the United States. This is particularly true for minority borrowers, those with limited or poor credit histories and those with low-incomes. Banks and other financial institutions have increasingly offered credit to this segment of the market and have frequently benefited from higher earnings on these loans. As evidence of the growth in this market, consider that in 1995, loan originations in the sub-prime market were $65 billion and by 2003 originations increased to $332 billion (Chomsisengphat and Pennington-Cross, 2006). However, as the subprime market expanded, so did concerns regarding who was receiving these high-priced loans. Awareness became particularly acute in the fall of 2007 and the expansion of the financial crisis. Each year, Housing and Urban Development (HUD) compiles a list of subprime lenders and has used this information to make the case that much of the subprime lending in the United States has been in low-income and minority neighborhoods. Others, for example, Immergluck (1999) and Marsico (2001) also find evidence that subprime lending growth is greater in low-income and minority areas. There is also concern regarding the outcome of these lending relationships; specifically, the increasing number of foreclosures and loan delinquencies. Taken together, the concern over subprime lenders targeting a certain segment of the population and the undesirable outcome of many of these loans, these developments prompted consumer advocacy groups and regulatory bodies to take a look at this growing market.

The initial regulatory response was federal regulation followed shortly by state regulation, in many states. In general, these laws restrict high cost loans, their fees and rates. The state level regulation varies tremendously from one state to another. Perhaps one reason for the variation is that there is no consensus on a definition of predatory lending. Engel and McCoy (2001) provide a set of loan criteria that define predatory lending to include at least one of the following: loans that provide no benefit to the borrower; loans with misleading nondisclosures; loans with fraud or deception; loans that require the borrower to forego redress; or loans that earn 'supranormal' profits. Pennington-Cross and Ho (2008) defined predatory lending to be whenever the borrower is unable to understand the terms and obligations of the loan. Morgan (2007) argues that any welfare-reducing form of credit can be labeled predatory lending. Similarly, the U.S. Government Accountability Office (GAO) defines a predatory loan to be one which contains terms that will ultimately harm the borrower (2004). Stressing the asymmetric information problem between the borrower and lender, Morgan (2007) defines a predatory loan to be one which the borrower would certainly decline if she shared the same information as the lender. Clearly there is no universal definition. However, it is accepted that predatory lending occurs within the subprime market. Not all subprime loans are predatory but most predatory loans are considered subprime.

Generally speaking, the predatory credit market is a subset of the subprime market. Because of a lack of data, it is not known how large this market actually is. There have been some micro estimates of the size of predatory lending. For example, Goldstein (2006) estimates that over 22 percent of all property loans in Philadelphia are predatory. Stock (2001) investigated whether predatory lending was instrumental in mortgage foreclosures in Montgomery County, Ohio. His sample of 1,198 mortgages indicated that 255 of these were predatory; this suggests that approximately 21 percent of the mortgages were predatory in this region. This limited research suggests that predatory lending is significant but certainly more evidence is required to draw conclusions about systemic practices.

With the first financial crisis of the twenty-first century, most Americans became aware of the subprime market and perhaps even of predatory lending. …