What is predatory lending? An unfair loan? What makes a loan fair? Credit risk is not distributed evenly among borrowers, therefore, to be fair, rates should not be the same.

Is it fair to lend someone money which you know they can not repay in the hope that you can foreclose on the property? While it may not be ethical, it is a gamblers mentality to accept such terms, just as gamblers may accept the odds of winning the pot or losing their shirt.

The gambler plays with full knowledge of the risks (ignore for the moment the addiction classification). The American consumer does not accept a mortgage loan with full knowledge. Why? First and foremost, consumers do not read the fine print. Second, consumers who are "gambling" for a mortgage do not shop around. They have been told their credit is damaged, no one will lend to them. They must accept any terms for the loan. Third, consumers believe the government has regulated the industry to protect them so they do not take the necessary action to protect themselves. They will cry foul after the fact, rather than arming themselves with knowledge before the fact.

Most lenders are not predatory lenders. As in any industry, there are always some bad apples. Unfortunately, the bad apples tend to tarnish the entire industry. Ethical behavior does not make front page news.

• The Mortgage Bankers Association (MBA) has listed 12 red flags to help consumers spot predatory lenders. The red flags are:Lenders who steer consumers to high rate loans.
  
  
• Lenders who falsely infer the mortgage loan as open ended and later calculating the payment on the entire amount available and insert pre-payment penalties.
  
  
• Lenders who intentionally make loans for which the borrower can not repay, with the hopes of foreclosing the property and reselling.
  
  
• Lenders who fraudulently falsify loan documents.
  
  
• Lenders who target mentally incapacitated homeowners.
  
  
• Lenders who Fraudulently forge signatures on loan documents and riders.
  
  
• Lenders who change terms at closing.
  
  
• Lenders who require credit insurance.
  
  
• Lenders who increase the interest charges when payments are late.
  
  
• Lenders who charge excessive pre-payment penalties.
  
  
• Lenders who fail to report good payment history on the borrowers credit report.
  
  
• Lenders who fail to provide accurate loan balances and payoff information.

All of the above abuses can be addressed without additional government intervention. How? Consumers must exercise their existing rights and use their brain.

Consumers have more access to the mortgage market today than at any other point in history. Not so long ago, there may have been one local bank who provided mortgages in rural areas. However, today even in isolated areas, there are numerous sources for mortgages and information. The local newspaper carries lender's rates, points and type of mortgage. The internet is full of mortgage information and lenders. Perhaps there is too much information and consumers take the loan that knocks on the door. Consumers must shop around for the best rate and terms.

Second, a basic tenant of contract law is if you sign a document, you have read it and understood it. How many consumers sign mortgage documents they have not read? I mean read the whole thing. The fine print. It is in the fine print where the consumer will find the interest charge is increased after a late payment. The consumer should not read just the rate, points and term of the loan on the first page of the contract. The consumer must read the fine print to find out if there are pre-payment penalties. How many consumers ask questions when they do not understand what they have read? Not many. Put aside your embarrassment and ask questions. If you do not fully understand the document, take it to an attorney or legal aid to explain it until you do fully understand. Additionally, loan counseling is available from city/county housing departments, community or social groups, credit counseling service or consumer advocacy agencies.

The consumer should know what they can afford. The consumer should also look at the worst case scenario. If it is an adjustable mortgage and the rate can go up two points per year with a cap of six points, can you afford to pay 6 points after 3 years. It is a gamble in exchange for a lower rate today. Similarly, the consumer should avoid interest only non-amortizing loans. At the end the principal must be paid, perhaps in one balloon payment. If you don't know how you are going to repay the balloon payment, then you are gambling and the stake is your home. The consumer is in a better position to know then the lender. The consumer may have access to a trust fund in three years or the consumer may be planning to have a family and leaving a job. The consumer should beware of solely using the equity in their property to qualify for a loan. If you can't pay for the loan, say good-bye to the equity.

The consumer should not sign a contract with blanks. If a clause in the standard contract does not apply, then N/A should be in the space, but the space should not be left empty. The consumer should also keep all the documents provided and compare them throughout the mortgage process. If the lender inserts different terms at the closing table, walk away and file a complaint. After closing (within 30 days), the consumer should request a complete set of documents to compare to the set received at closing. This way they can check for fraudulent activity.

A contract with an incapacitated person or involving fraud is voidable and can be recinded. The consumer who avoids a contract will be placed in the same position as before the contract. If a signature is forged on a loan document, this is fraud and the consumer can also bring suit for additional damages.

One does not have to accept credit life insurance. Usually the cost of a term life policy is more cost effective means of protecting the consumers family and effectively the lender than declining balance credit life. Consumers should look at the purchase of life insurance separately from any other financial transaction (buying a car, or home or other loan). While it may seem painless to finance the cost of life insurance with the loan it is more expensive and can result in the consumer being over insured.

After the consumer closes the loan and has made payments for several month, they should check the credit bureaus to check if the good payment history has been reported. Any time the loan changes servicers, consumers should re-check the credit bureaus. If the mortgage servicer is not reporting the good payment history to the credit bureaus, send a letter requesting them to do so and send it certified mail return receipt requested. This will insure the next time you are shopping for financing, the good credit history will appear in your favor. This also reduces the incentive the lender may have to churn your loan internally.

The Real Estate Settlement Procedures Act (RESPA) requires lenders to provide disclosures during the process of obtaining a mortgage loan. These disclosures should be read and understood completely by the consumer. These disclosures should also be maintained in a file for quick reference and comparison during the course of the loan. Unfortunately, the paper pile can get rather large and confusing. It is an important transaction and only the consumer has the incentive to protect his own interest.

The first disclosure under RESPA is the Good Faith Estimate of Settlement Costs. This form must be received with in 3 days after you apply for a loan and lists the expected closing costs. It is only an estimate. However, upon closing if the estimates are grossly different and/or additional categories of fees have appeared; the consumer must ask questions to find out why and eliminate junk fees.

The lender must also provide a Servicing Disclosure Statement. This basically says the lender may not be accepting payments and another servicer will manage collecting payments and paying from escrow for insurance and taxes. This should also be received within 3 days after you apply for your loan.

When you are referred to an affiliate during the mortgage process, the lender must provide an Affiliated Business Arrangement Disclosure. This formally informs you that you can shop around. Always shop around! Even if you end up doing business with the referred to affiliate, it is best to know all your options.

Finally, you must be provided with a HUD-1 Settlement Statement one day prior to closing. If you are not meeting at the closing table, then your attorney or escrow agent will mail the statement after closing. Personally, I have requested the statement prior to closing when my attorney was closing for me. I had questions and I found significant errors which were corrected prior to closing. Additionally, compare this statement with the other estimate and documents you have received to make sure there are no differences.

Under RESPA, the lender may only collect two months of escrow payments at closing. Within 45 days of closing, you must be provided with an Escrow Account Statement. Each year you will also receive an analysis of the escrow payments and disbursements. It is important to check the figures. Are the taxes and insurance amounts correct? Personally, I save the escrow analysis each year and add it to my mortgage file. I have also successfully removed a escrow requirement from the loan by analyzing the statement and asking so many questions that the mortgage company did not want to deal with it any more.

The Home Ownership Equity Protection Act of 1994 (part of the Truth In Lending Act) provides for additional disclosures when the Annual Percentage Rate (APR) is 10 points or more above Treasury Securities with the same maturity and when the fees and points on the loan are the larger of $451 or 8% of the loan. However, these disclosures are not required for purchase money mortgages, construction loans, reverse mortgages or home equity revolving lines of credit.

The Federal Government already requires lenders to provide the RESPA disclosures listed above and additional disclosures under the Truth in Lending Act, so what kind of government intervention will fix the predatory lending problem? Frankly, more disclosures will typically confuse the usual victim and likely add to the information overload one faces during the mortgage process. The typical predatory lending victim is elderly or ignorant. They do not understand fully the terms of the mortgage and the consequences of late payments or missed payments or increasing interest rates. Adding more disclosures won't solve the problem.

Some critics of predatory lending suggest the government should cap interest rate and fees to stop predatory lending. If you agree with this line of thinking then how do you determine the level of the cap. The question is similar to agreeing to stop pornography. In order to stop it, one must define it. "I know it when I see it". While one person may see art the next will see pornography. If we can't all agree on a definition, then how do you legislate it.

Similarly, we can all agree that predatory lending exists. Edgar and Ellen re-financed their mortgage to reduce the monthly cost and obtain some funds to pay the escalating medical bills from Edgars cancer treatment. They were charged $5,000 in fees buried in the fine print. After Edgar died, Ellen was charged a $5,000 pre-payment penalty to pay off the mortgage with the life insurance proceeds. These charges seem excessive and it is likely with the medical concerns at the time, they were not focused on the loan terms. Neither fully understood the full terms of the loan but were dealing with a difficult life situation. So to prevent this from happening again, the government should legislate the cap and the unethical mortgage lenders could not take advantage of the situation.

On the other hand, Steve and Mary started an internet company in their basement. The growth of the company has exploded. They must move out of the basement and purchase additional equipment to continue the business. There is not enough time to tap the capital markets. They decide to refinance the mortgage and use their home equity to fund the growth. Steve and Mary have maxed out 20 credit cards to start the business. While the business is growing beyond expectations, they are unable to take a salary in order to re-invest in the company. As a result, they are forced to re-finance in the sub-prime market. They agree to pay $5,000 in fees buried in the small print and the $5,000 in pre-payment penalties. It is a gamble. They are entrepreneurs and they are taking a risk in order to see this business grow. One year later, they are millionaires and the $10,000 in fees is insignificant. What if the government had a cap and made the loan illegal? The business would have failed. No new jobs would be created. No new taxes would be collected. Obviously, because of the way it turned out, one would not consider this loan predatory. Steve and Mary understood the risk they were taking and had free will to accept or decline the terms of the loan.

While consumer advocates are asking the government to stop predatory lending, the Federal Reserve Board is moving slowly. The final hearings, held September 7, were used to gather information and balance the availability of sub-prime loans against the abuses of predatory lenders. Most people agree, the Fed is not likely to act until next year.

The Research Institute for Housing America funded by the Mortgage Bankers Association of American has published a report called "Credit Risk and Mortgage Lending: Who Uses Sub-Prime and Why?". The report includes several surprising findings which may impede further regulation of the mortgage market. Over all the market for sub-prime mortgages is distributed similarly to the overall mortgage market. This contradicts the premise that sub-prime lenders targets low income borrowers.

The report used actual credit histories and credit scores and found higher risk credit impaired consumers use the sub-prime market but that the ratio of moderate and upper income users of sub-prime was the same as the overall market. Sub-Prime consumers generally had the cash for the downpayment. The report did find that Sub-Prime users were disproportionately African-American and Asian. The report can provide fuel for both sides of the predatory lending issue.

In a free market economy (almost), there is a domino effect when any aspect is tampered with artificially. Government regulation of mortgage rates and fees will limit the availability of mortgage money.
As few as 5 years ago, mortgage money was used to put people in homes. Today, the impact of "mortgage money" goes well beyond the housing sector. Consumers have used equity to finance consumption.

The 1998 Fed survey of consumer finances found a 20% increase in consumers mortgage debt. Overall, 68% of consumers have some mortgage debt. Consumers still have over $5.3 TRILLION of untapped equity!

Consumers available equity spurs growth across the economy, not just for durable goods or purchases associated with settling into a new home. In fact, the Fed found that 43% of home equity loans were used to finance home improvements, 21% was used for debt consolidation, 8% was used to invest, 6% financed education, and 5% to purchase a vehicle.

Home Ownership is at the highest level of all time. While the rise in the stock market has fueled the expansion in the housing market, the mortgage market deserves the credit for making home ownership attainable to more Americans. Saddling mortgage lenders with more regulation is not likely to solve the problem (especially without "policing") and will only restrict the availability of mortgage money.

The negative press for Sub-Prime lending and Predatory lending is already affecting the mortgage marketplace.

Three years ago, the major banks jumped into the marketplace by setting up or purchasing sub-prime affiliates. The list includes household names: Key Corp. acquired Champion Mortgage Co. for $200 million in 1997. First Union bought The Money Store for $2.1 Billion in 1998. Citibank merged with Travelers Group in 1998. Bank of America merged with NationsBank 1998.

The concept was the one stop shop and convenience for consumers. During a period of historically low interest rates, the high yield was a strong motivator. At the same time, the securitazation (bundling the Sub-Prime mortgages together into a mortgage backed security and selling to investors) process expanded for Sub-Prime loans. Creating a secondary market for Sub-Prime mortgages provided lenders with of source of money to lend and increased the availability of Sub-Prime mortgages. The Sub-Prime market in 1994 was $35 billion and grew to $160 Billion in 1999.

The consolidation of the industry was supposed to help consumers. Banks have a lower cost of funds from depositors than mortgage bankers. Therefore, the savings from the lower cost of funds could be passed onto consumers. Banks are also subject to more government oversight then mortgage lenders. The Loan Officer of a Sub-Prime affiliate of a bank is an employee of the bank. The bank is responsible for monitoring the employees activities. On the other hand, Mortgage Brokers are middlemen. They are contractors who derive their income base on fees earned on making deals.

All that glitters is not gold. The banks found the Sub-Prime marketplace not as profitable as they had hoped. The Sub-Prime lenders appeared more profitable under the "gain on sale" accounting method used but the banks were actually losing money based on more traditional accounting methods. The Russian debt default in 1998 reduced the secondary market for Sub-Prime mortgages thus placing pressure on bank reserves. The liberal underwriting standards for Sub-Prime mortgages during the boom in Sub-Prime lending further increased banks risk.

As a result, the banks have dumped the Sub-Prime affiliates like hot potatoes. First Union said in June of 2000 it would close the Money Store. Bank of America is looking for a buyer of it's Sub-Prime affiliate. It is clear the sub-prime market is changing again. It is not clear the government needs to throw a wrench in the works to prevent predatory lending. The sub-prime market is a niche market. However, government interference in the Sub-Prime market will affect the whole economy and all of us.

Knowledge Is Power. Consumers must educate themselves. Children should learn about the economy and financial markets in schools. How many High School or even College graduates can balance a checkbook? How many understand the time value of money, interest rates and compounding? Many do not have these life skills but receive their first credit card before they graduate college. Food for thought!

The morale of the story is Caveat Emptor. Let the buyer (or borrower) beware.