New study estimates the effect of predatory-lending law

Abstract

We measure the effect of a 2006 antipredatory pilot program in Chicago on mortgage default rates to test whether predatory lending was a key element in fueling the subprime crisis. Under the program, risky borrowers or risky mortgage contracts or both triggered review sessions by housing counselors who shared their findings with the state regulator. The pilot program cut market activity in half, largely through the exit of lenders specializing in risky loans and through a decline in the share of subprime borrowers. Our results suggest that predatory lending practices contributed to high mortgage default rates among subprime borrowers, raising them by about a third.

Introduction

Predatory lending has been the focus of intense academic and policy debate surrounding the recent housing crisis (2007–2010). Predatory lending—commonly defined as imposing unfair and abusive loan terms on borrowers, often through aggressive sales tactics, or loans that contain terms and conditions that ultimately harm borrowers (US Government Accountability Office, 2004, Federal Deposit Insurance Corporation (FDIC), 2006)—has also captured much media attention and appears to be a major concern for borrowers.¹ While all agree that mortgages with abusive terms are costly to borrowers and to taxpayers, the extent of the phenomenon is hard to quantify and is politically charged (e.g., Agarwal and Evanoff, 2013, Engel and McCoy, 2007). Several journalistic accounts and industry reports take the position that predatory lending had a central role in creating and feeding the housing bubble, particularly through subprime loan originations (e.g., the Financial Crisis Inquiry Commission, 2011, Hudson, 2010, Center for Responsible Lending, 2009). To our knowledge, no systematic evidence to date measures the effect of predatory lending on mortgage performance. Our paper attempts to fill this gap.

In academic literature, predatory lending is modeled as cases in which lenders possess private information about borrowers׳ future ability to repay loans and encourage mortgages with terms that borrowers cannot afford (Bond, Musto, and Yilmaz, 2009). This model clearly portrays the empirical challenge in measuring predatory lending: Because observing lenders׳ informational advantage over borrowers is difficult, measuring the size of the phenomenon and assessing its role in precipitating the subprime mortgage crisis is hard.

In this paper, we attempt to overcome this challenge by analyzing the effects of a pilot antipredatory legislative program (HB 4050) implemented in Chicago near the peak of the real-estate boom. The pilot program required “low-credit-quality” applicants and applicants for “risky” mortgages to submit their loan offers from state-licensed lenders for third-party review by financial counselors certified by the US Department of Housing and Urban Development (HUD). The fact that the pilot applied only in certain areas during a specific time period, only to certain borrower and mortgage contract combinations, and only to a specific set of lenders allows us to parse out its effect on the availability of mortgage credit with predatory characteristics and to evaluate ex post mortgage performance. The study draws on detailed loan-level data from public and proprietary sources, as well as data provided by one of the largest counseling agencies involved in the pilot.

Our empirical strategy is based on classic difference-in-differences analysis that contrasts changes in mortgage market composition and loan performance in the treated sample with those in a control sample. Unlike bacteria in a petri dish, lenders and borrowers could respond to the mandated treatment either by leaving the pilot area or by adapting to the new rules. Hence, we pay particular attention to endogenous selection of lenders and borrowers out of treatment. If predatory lending resulted in significantly higher default rates and, thus, precipitated the crisis, we should observe a significant reduction in default rates in the targeted market as predatory lending declined.

We find that following passage of the pilot program, the number of active lenders declined disproportionately in the target geographic area. The decline was particularly pronounced among state-licensed lenders that specialized in the origination of subprime loans, many of which included contract features deemed objectionable by the legislation. Nearly half of the state-licensed lenders exited the pilot zip codes, more than double the exit rate in the control areas. The remaining lenders made fewer risky loans and originated credit to borrowers with higher credit quality. Specifically, we show that the volumes of loan applications and originations by state-licensed lenders in the pilot area declined by 51% and 61%, respectively. The average FICO score of borrowers who were able to obtain credit during the pilot period was 8 points higher (15% of 1 standard deviation).

The resulting mortgages issued in the pilot area were less likely to feature risky characteristics (as defined by legislators) that would subject them to counselor review. For instance, there were fewer loans with negative amortization or prepayment penalties, as well as fewer low documentation and low down-payment loans. This set of findings suggests, therefore, that the legislation had a deep impact on market activity and likely drove much of the predatory lending activity from the market.

Although the pilot dramatically affected market activity, it had a relatively moderate effect on borrower default rates. When we restrict our analysis to the subset of market participants directly targeted by the pilot—subprime borrowers and state-licensed lenders—we find improvements in 18-month default rates of 6 to 7 percentage points, relative to the unconditional default rate of 27%. Moreover, all of the statistically measurable improvement in loan performance came from changes in the composition of lenders, many of whom were driven out by the legislation. These estimates suggest that while predatory lending contributed to high default rates, it might not have been as instrumental in precipitating the financial crisis as popularly believed.

In practice, distinguishing predatory lending practices from merely aggressive ones could be difficult. To make headway in separating the two, we exploit another feature of the antipredatory program. The heart of the HB4050 pilot was the imposition of a mortgage review requirement for risky borrowers and for those who chose risky loans. During the review, counselors identified loans that were suspected of having predatory characteristics, e.g., loans with above-market rates, loans appearing to be unaffordable based on borrower characteristics, and loans with indications of fraud. We analyze a sample of 121 loans for which we have detailed counselor assessment data.² We conjecture that loans that were flagged as predatory and yet were pursued by borrowers (i.e., borrowers ignored the counselors׳ advice) were more likely to default relative to nonflagged loans. We find that these predatory loans had 18-month delinquency rates that were 6.5 percentage points higher than nonflagged loans. The difference in delinquency rates was even higher for loans with fraud indicia, which had a 12.3 percentage point differential.

Our findings have important implications for policy makers. First, the pilot program was a blunt policy tool that swept up a wide swath of borrowers, lenders, and products and caused substantial market disruption. Second, despite the measureable improvements in mortgage performance in the subpopulation most affected by the pilot, default rates remained alarmingly high, suggesting that predatory lending practices could have played a relatively limited role in triggering the crisis. In fact, because some of the loans eliminated by the pilot could have been aggressive instead of predatory, we are likely to be overstating the effect of predatory lending practices. Third, evaluation of welfare gains or losses stemming from such policy programs is fraught with difficulties, many of which are exacerbated by the distortions that exist in housing markets. Our paper does not attempt to gauge the welfare consequences of the pilot, and policy makers should be aware that such consequences are difficult to measure. Finally, the HB4050 pilot demonstrates the political difficulty of implementing policies that lean against asset bubbles.³ Specifically, interest groups (real-estate professionals as well as community activists) protested against the legislation. Both groups viewed the preceding run-up in real-estate prices as an opportunity for their constituents to achieve their goals (profits or housing access), and they therefore perceived the legislation as harmful.

Our paper relates to two strands of the literature. The first explores the role of intermediaries in precipitating the financial crisis. Keys, Mukherjee, Seru, and Vig (2010) show that securitization leads to lax screening by mortgage lenders. Ben-David, 2011, Ben-David, 2012 finds that intermediaries expanded the mortgage market by enabling otherwise ineligible borrowers to misrepresent asset valuations to obtain larger loans and by pushing buyers to overpay for properties. Rajan, Seru, and Vig (forthcoming) show that soft information about borrowers is lost as the chain of intermediaries in the origination process becomes longer, leading to a decline in the quality of originated mortgages. Finally, Agarwal and Ben-David (2013) study the role of loan officer compensation leading up to the financial crisis.

The second strand of the literature studies predatory lending in personal finance. In particular, researchers have focused on the debate about whether payday lending helps or exploits borrowers. Morse (2011) shows that borrowers in areas with payday lending are more resilient to natural disasters. In contrast, Melzer (2011) uses cross-border variation and finds no evidence that payday lending alleviates hardship. Bertrand and Morse (2011) find that providing additional information about loans to payday borrowers reduces loan take-up. Agarwal, Skiba, and Tobacman (2009) show that payday borrowers preserve access to formal credit through their credit cards while paying very high interest rates on their payday loans.

Section snippets

Illinois Predatory Lending Database Pilot Program (HB4050)

The pilot program that we use in this paper as our experiment took place from September 2006 to January 2007. The purpose of the current section is to provide background about the program.

Data and selection of control groups and empirical test design

Our study relies on several complementary sources of data that cover the calendar years 2005–2007. First, we use data collected under the Home Mortgage Disclosure Act (HMDA) to assess elements of supply and demand for credit. In the absence of loan application and counseling data collected under the statutory authority of HB4050, we turn to HMDA as the next best source of information on loan application volume, rejection rates, and so forth. Using information from HUD and hand-collected data,

The effects of HB4050 on predatory lending

The legislation disrupted mortgage markets by changing the loan origination process for certain borrowers and products. This section empirically evaluates its effect on loan volumes, borrower and mortgage characteristics, and lender participation.

The effect of the antipredatory program on default rates

3 Data and selection of control groups and empirical test design, 4 The effects of HB4050 on predatory lending establish that the legislation reduced market activity in general and, in particular, improved the average credit quality of borrowers, improved the risk profile of mortgages, and affected lenders that originated risky loans. From the point of view of the legislators, these effects are in line with their objective—to reduce what was perceived to be predatory lending activity.

Given

Estimating the default rate of predatory loans

With estimates obtained in 3 Data and selection of control groups and empirical test design, 4 The effects of HB4050 on predatory lending, 5 The effect of the antipredatory program on default rates, we can calculate the default rate of predatory loans, after making some assumptions about loan distribution across markets. In this exercise, predatory loans are defined as loans that were not originated during the HB4050 pilot period, presumably because of the effect of the treatment. Our goal here

Conclusion

Whether predatory lending was an important factor in precipitating the subprime crisis is one of the key questions in the academic and policy debate about the sources of the crisis and its aftermath. The main empirical challenge in answering this question is that it is difficult to distinguish predatory loans from nonpredatory loans on an ex ante basis. In general, predatory lenders exploit borrowers by having an informational advantage over them. This informational advantage is not easily

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