Academic journal article Atlantic Economic Journal

Mortgage Product Substitution and State Anti-Predatory Lending Laws: Better Loans and Better Borrowers?

Academic journal article Atlantic Economic Journal

Mortgage Product Substitution and State Anti-Predatory Lending Laws: Better Loans and Better Borrowers?

Article excerpt

Introduction and Motivation

The widely recognized collapse of housing markets was facilitated in part by changes in mortgage products and the channels through which borrowers obtained loans. An expansion of certain types of mortgage products, along with a weakening of underwriting standards, led to a proliferation of loans that were either unaffordable or put borrowers underwater if home values declined. Policy-makers have long been concerned about a rapid expansion of loan products and practices that could lead to such negative outcomes. Indeed, over the last 14 years, more than half the states and several localities in the U.S. have enacted statutes and ordinances designed to regulate residential mortgage market practices and reduce abuses.

The growth and subsequent collapse of subprime lending provide indirect evidence that existing regulation and oversight of the subprime market were not successful in protecting the financial welfare of borrowers, lenders, or investors. That noted, it remains possible that anti-predatory lending (APL) laws (1) did influence the behavior of mortgage market players and led to a systematic change in the types of borrowers who took out loans. The laws may have also led to more frequent use of exotic loan products or the traditional, plain-vanilla 30-year fixed rate fully amortizing loans. In this paper, we explore such possibilities.

The disruption for families, neighborhoods, and financial institutions that has accompanied the housing and mortgage market collapse will have wide-ranging, long-lived effects. These ramifications provide at least a preliminary argument for restricting risky lending practices and products. However, lenders and borrowers might chafe in the face of such restrictions. This could be the case if the restrictions limit mechanisms that lenders use to reduce borrowers' monthly payments and make loans more affordable--at least in the short run. For example, adjustable rate mortgages (ARMs) typically feature lower interest rates than fixed rate mortgages (FRMs) because borrowers bear some of the interest rate risk (Brueckner (1986); Sa-Aadu and Sirmans (1989); Pennington-Cross and Ho (2008)). In addition, costs among ARMs can vary considerably depending on the interest rate reset (6 months, 12 months, etc.) and maximum and minimum interest rate adjustments, among other items. Empirical evidence shows that manipulation of these types of characteristics can have large impacts on the risk premium on a loan (Pennington-Cross and Ho 2008). Changes in interest rate risk can reduce the borrowers' annual percentage rate (APR) by over 300 basis points. (2)

If regulatory restrictions, which we characterize as APL laws, limit the ability of lenders to structure loans to minimize borrower monthly payments, then lenders and borrowers alike will seek alternatives for reducing monthly payments. Central to these efforts will be an attempt to avoid regulatory thresholds. State APL laws usually only apply if the APR or points and fees are above set triggers. One way to evade the triggers is to reduce the APR on loans. Lenders can achieve this by lengthening amortization schedules and increasing access to interest only and negative amortization loan products.

In addition, if APL laws impose compliance costs, such as those associated with mandatory reporting on loans that exceed triggers, the costs are likely to be passed on to consumers. The evidence indicates that laws that are more restrictive tend to drive up the cost of borrowing through slightly higher interest rates (Pennington-Cross and Ho 2008; Li and Ernst 2007). Despite being small, this increase in costs is also likely to induce lenders to substitute loans that hit or exceed APL triggers with products that fall below the triggers.

This paper asks a plain question: in light of prior evidence that volume and pricing impacts of the APL laws are fairly moderate, did lenders and borrowers find substitutes for loans that APLs banned or limited? …

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