Home Ownership and Equity Protection Act (HOEPA)
Public Hearing

June 14, 2007

Board of Governors of the Federal Reserve System
Martin Building, Terrace Level
20th and C Streets, N.W., Washington, D.C.

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banks and those other entities. 1 76
MR. EAKES:  But between you and the FTC,  2 76
you've had the authority to cover both banks and non- 3 76
banks.  Congress still in 1994, because the problem  4 76
was so severe then, and it's only a fraction then of  5 76
what it is now, that they put this authority and  6 76
mandate to the Fed, of saying "We need you to have  7 76
something extraordinary, because homes are an  8 76
extraordinary piece of the American economy, an  9 76
extraordinary piece of families' well-being and  10 76
wealth." 11 76
So I think, you know, I'm sorry I sound  12 76
shrill and impatient, but I've been making this  13 76
testimony in the House and the Senate for almost ten  14 76
years now.  So please, find the will -- 15 76
MR. CHANIN:  Let's assume, that as Susan's  16 76
guessed, that lenders underwrite a mortgage based on  17 76
not only principal and interest but taxes and  18 76
insurance; that is, in terms of underwriting. 19 76
So the question is then if you mandate  20 76
escrow, would you create any ability of the consumer,  21 76
for example, to opt-out, to deal with, for example,  22 76
Pablo's suggestion of a consumer -- what if a consumer  23 76
simply does not have the two months of taxes and  24 76
insurance to bring to the table?  Is that consumer  25 76
simply out of luck if the consumer doesn't have the  1 77
ability to escrow those funds, and cannot get the  2 77
loan?  Is that an outcome that is satisfactory to you? 3 77
MR. EAKES:  The opting out won't work.   4 77
Someone will have a form that lets you opt out, and  5 77
everyone will sign it for that lender, and they'll  6 77
start to dominate the market.   7 77
If a borrower is lacking only two months of  8 77
escrow, compared to the closing costs of getting into  9 77
a loan, which is often eight to ten percent of the  10 77
loan amount in total, that two months of escrow is not  11 77
going to be the marginal difference.  Maybe the  12 77
lender, and I think the person from Chase may have  13 77
been suggesting, is maybe you can build that into the  14 77
loan. 15 77
I mean you can have some of the loan amount  16 77
cover closing costs and cover escrow.  But ultimately,  17 77
if that's what's going to keep you out of a home, you  18 77
need to wait six more months before you become a  19 77
homeowner. 20 77
GOVERNOR KROSZNER:  I just want to go back  21 77
to Pablo on that, because that was an interesting  22 77
suggestion that you had made, that Martin has picked  23 77
up on.  Is there a way to integrate this -- these  24 77
other costs and fees in, to make sure that the person  25 77
will be able to afford the full cost they'll be  1 78
facing? 2 78
MR. SANCHEZ:  Well, that's what we're  3 78
talking about and working on right now, because we  4 78
really feel that that is a barrier.  It's not just the  5 78
two months.  It's the two months on top of the other  6 78
costs, right, that really people struggle with. 7 78
I think beyond that, we have to realize  8 78
that, I think everybody probably in this room knows  9 78
someone that's had a life event or a hiccup in their  10 78
life, that wasn't someone that was illiterate or  11 78
really down and out economically, right?  It was there  12 78
in the subprime space because something happened, and  13 78
they have the ability to do these things. 14 78
So we've got to make sure that we're  15 78
understanding all of the consumers in this space.  But  16 78
I think it's prudent for us to make sure that we offer  17 78
it, number one, across the board.  I think what we're  18 78
talking about here is there are folks that don't offer  19 78
it all, and mark it solely payment, and they have a  20 78
competitive advantage, right, because they do that. 21 78
But if we mandate the fact that we have to  22 78
offer it, that we as prudent lenders understand when  23 78
it is appropriate for someone to have the ability to  24 78
opt in and opt out, I think that's reasonable. 25 78
GOVERNOR KROSZNER:  I just wanted to say  1 79
when you said -- what you mean by "it."  So what do  2 79
you mean by "it" and exactly what do you mean by  3 79
opting out of it?  Then we'll go back to -- 4 79
MR. SANCHEZ:  Well, offering the escrow;  5 79
mandating it for a certain portion of customers,  6 79
especially that first time home buyer.  I think it's  7 79
very important, because they generally don't  8 79
understand how all of this stuff works. 9 79
GOVERNOR KROSZNER:  So for a first time home  10 79
buyer, you would suggest a mandate, not an opt -- with  11 79
no opt-out? 12 79
MR. SANCHEZ:  That's correct. 13 79
GOVERNOR KROSZNER:  But for others who may  14 79
have had experience with owning homes before, you  15 79
would allow for the opt-out? 16 79
MR. SANCHEZ:  I would allow for the opt-out,  17 79
yes. 18 79
MS. BOWDLER:  So I was going to comment on - 19 79
- oh yes.  Okay, I remember.  I just wanted to echo  20 79
comments I agree, and the opt-in, the opt-out,  21 79
everybody -- I mean the stack of papers and the  22 79
signing and it's here, one more thing.   23 79
People -- I mean that's why we think that  24 79
disclosures aren't an effective way to regulate the  25 79
market, because they are not an effective way to  1 80
communicate actual risks or decisions to consumers at  2 80
the closing table, which is the time when people are  3 80
least likely to say "Whoa, whoa, whoa, stop the  4 80
train." 5 80
I mean they've already got their boxes  6 80
packed and everything.  So I don't think that's a good  7 80
idea.  In terms of talking about the financial savvy  8 80
of consumers and their ability to determine their cash  9 80
flow, because that's really what you're talking about.  10 80
 If you're going -- if somebody's going to decide that  11 80
they don't want to escrow taxes and insurance, it's  12 80
because they want to cash flow their money somehow. 13 80
Well wait.  If we look at the prime market,  14 80
where you have arguably more savvy consumers with  15 80
higher credit scores, escrow's virtually universal.   16 80
So when dealing with, again I would point to high LTVs  17 80
and cash-strapped borrowers, this is where it's even  18 80
more important, because if they can't make it up  19 80
front, are we really -- can we reasonably assume that  20 80
in six months they will have come up with the $3,000? 21 80
MS. COHEN:  I have a couple of things I'd  22 80
like to add.  On this question about what do you do  23 80
with the person with the hiccup, who finds themselves  24 80
in the subprime market?   25 80
I mean what we're really talking about here,  1 81
and this is going to come up in a variety of other  2 81
topics is the rhetoric of freedom.  To what extent is  3 81
an upper middle class person's freedom needing to be  4 81
unrestrained at the expense of someone who can't  5 81
otherwise protect themselves? 6 81
So what we're talking about here is  7 81
requiring some limited number of people who may not  8 81
need it to follow a rule, so that huge numbers of  9 81
people aren't gutted.  So to me, that's weighing one  10 81
against the other, and it's very clear what the answer  11 81
is.  Obviously, from the way I answered the question. 12 81
(Laughter.) 13 81
MS. COHEN:  But I think that that's what  14 81
it's about.  It's not about just helping those few  15 81
people  remain unrestrained.  It's about what is the  16 81
cost of not restraining those people. 17 81
I want to get back to Sandy's question about  18 81
the FTC unfairness standard and how it applies to  19 81
these various questions.   20 81
I agree with Martin, that providing a  21 81
monthly payment that doesn't include taxes and  22 81
insurance is deceptive.  But it's also unfair, because  23 81
the unfair standard at the FTC is about whether or not  24 81
it's reasonably avoidable by the consumer. 25 81
It's not reasonably avoidable on the part of  1 82
a subprime consumer, to end up in a hole because of  2 82
the practice of the lender.  Over and over again, I  3 82
think, you can apply either the deception test or the  4 82
unfairness test, and you're going to end up in that  5 82
same situation. 6 82
But what it requires is looking at the  7 82
consumer and the shoes they're actually standing in,  8 82
not the shoes that the median consumer is standing in,  9 82
but the median subprime consumer is standing in. 10 82
By the way, NCLC has seen too many prime loans that  11 82
are abusive. 12 82
So I'm not saying we should only regulate  13 82
the subprime market, that a lot of these practices  14 82
that we're talking about, you ought to start focusing  15 82
on that.  So I want to just raise that issue.  To me,  16 82
unfairness or deception, you can meet either standard  17 82
and it's not that hard, unfortunately. 18 82
MR. CHANIN:  Alys, let me follow up, and  19 82
I'll have to borrow the bell.  I'll retract my other - 20 82
- no.  So as we look at this question of escrow,  21 82
presumably it's certainly less of an issue or a  22 82
problem in the prime market. 23 82
So part of the question, as we explore this,  24 82
is how you would define the types of consumers, the  25 82
types of products, etcetera, that any notion of  1 83
mandating an escrow would apply to? 2 83
Earlier, we've heard that you couldn't or  3 83
shouldn't do it by product, because the market's going  4 83
to develop.  There will be new products and so forth.  5 83
 So what is the standard that might be used in terms  6 83
of defining the scope of this? 7 83
MS. COHEN:  Are you asking me that? 8 83
MR. CHANIN:  Anyone in the -- 9 83
(Laughter; simultaneous discussion.) 10 83
MR. CHANIN:  You or anyone else. 11 83
MR. EAKES:  It needs to be bright-lined,  12 83
because under the HOEPA standard, there is liability.  13 83
 There is private action liability.  So you don't want  14 83
to have a vague standard that someone trips into.  15 83
The two most obvious that jump out as  16 83
definitions to me that are bright line is use the HMDA  17 83
rate spread, which says 300 basis points above  18 83
comparable Treasury.  I would argue a little bit about  19 83
what comparable Treasury should be in an ARM loan that  20 83
resets every six months, that perhaps comparable  21 83
Treasury should be the shortest reset period, not the  22 83
30-year Treasury. 23 83
Or, if you wanted to make sure that you  24 83
didn't have distortions, which I think we see whenever  25 83
there is a Russian meltdown in '98, where you have  1 84
Treasuries become artificially low, you may not want  2 84
to tie it to Treasuries, because then you will start  3 84
capturing loans that are maybe not subprime at all in  4 84
the market. 5 84
So the historical standard is the Freddie  6 84
Mac contract rate plus 150 basis points, is equal to  7 84
the Treasury plus 300.  But it would then have the  8 84
advantage that it would be insulated from the  9 84
distortions in Treasury over time. 10 84
I would use it based on APR, something that  11 84
says if it's a higher cost, someone has made a  12 84
decision that this a higher risk loan, which is the  13 84
justification for having a higher APR. 14 84
Have it be absolutely bright line, because   15 84
the last thing you want is people who get, you know,  16 84
who don't think they're making subprime loans, and all  17 84
of a sudden have loans that are 60 percent LTV but  18 84
trigger the subprime.  We want it to be bright line 19 84
GOVERNOR KROSZNER:  I want to hear from you  20 84
guys.  How would something like that work in practice?  21 84
 So let's take Martin's proposal.  Is something like  22 84
that workable?  Where do you see the potential  23 84
problems of that, the so-called unintended  24 84
consequences that we worry about? 25 84
MR. BREWSTER:  Well, I can speak to part of  1 85
that.  One of the things we haven't talked about is  2 85
even though it's been mentioned again and again,  3 85
generally requires escrow, this is true, there's still  4 85
the possibility of that even if you require the  5 85
escrow. 6 85
So it's not just the -- who gets the escrow,  7 85
but also how the escrow is calculated.  Some of the  8 85
escrow rules, as far as whether you require the escrow  9 85
or not, all that's simple.  So some of the stated  10 85
restrictions are out there.  So a lender could, even  11 85
escrowing, could wind up escrowing much less,  12 85
especially for a new construction loan.   13 85
That's where we see a lot of the issues,  14 85
because taxes haven't been established yet.  Taxes are  15 85
reset then a year later, and all of the sudden your  16 85
taxes are $6,000 a year, and you've only escrowed for  17 85
a thousand. 18 85
So now you've got a shortage and it sends  19 85
you into foreclosure.  So not only is the eligibility  20 85
bright line standard important, but also I think the  21 85
standard of how to calculate the escrow, and making  22 85
sure it's sufficient for what the taxes will be. 23 85
GOVERNOR KROSZNER:  But I want to hear  24 85
about, you know, some of -- the kind of proposal that  25 85
Martin has put on the table.  What do you see as being  1 86
the challenges if it were to be a rule, to try to  2 86
fashion this with all this you just said as part of  3 86
it? 4 86
Would that help to provide sort of a level  5 86
playing field for the marketplace, or do you think it  6 86
would have the consequence of perhaps excluding  7 86
borrowers who otherwise would be able to get loans ,  8 86
but there would be unintended spillover effects. 9 86
MS. SCHWARTZ:  I think it's a workable  10 86
option to have bright lines.  I think no one wants  11 86
inadvertent problems because they thought they made a  12 86
loan that was a prime loan and fell into a high cost,  13 86
something  that's spread over a certain period,  14 86
whatever that might be. 15 86
So I think whatever you come up, that makes  16 86
sure that the majority of the market ends up  17 86
escrowing, is a net positive.  I just -- I believe you  18 86
can do more than people think you can, because I've  19 86
seen it.  The market has changed, it has reacted.   20 86
We've done it with the non-traditional. 21 86
Be thoughtful about it, because if you craft  22 86
it correctly, and maybe you're very clear about pieces  23 86
of that guidance, what should be escrowed, I think  24 86
you'll see a transformation on the escrow issue  25 86
without inadvertent spillover into a very costly  1 87
situation if the lender - 2 87
GOVERNOR KROSZNER:  Can we just pursue it a  3 87
little bit more, because I want to think about it,  4 87
especially as we think about having -- obviously, we  5 87
think about the rules versus guidance.   6 87
Where would be some of the stress points or  7 87
lack of clarity that could lead to people pulling out  8 87
of a market, say responsible lenders pulling out of a  9 87
market, because of concerns of triggering some  10 87
regulatory action? 11 87
MS. SCHWARTZ:  I mean I think you either  12 87
escrow or don't escrow, and a bright line test on that  13 87
is a very reasonable suggestion.  I mean I don't worry  14 87
about that as a lender.  I know people who will worry. 15 87
So there are issues that could be a lot more  16 87
vague, that would cause concerns for liquidity and a  17 87
lot of those other factors.  But this one is not as  18 87
complicated.  I think all loans can be underwritten to  19 87
take into account the impact of taxes and insurance.   20 87
If they can't afford the loan, it shouldn't be made to  21 87
them.   22 87
MR. EAKES:  Everything that is put into this  23 87
requirement, you have two additional prime lenders  24 87
that cannot be taken out, because they are not willing  25 87
to do what they know are unsustainable non-escrow  1 88
funds. 2 88
GOVERNOR KROSZNER:  Any other comments on  3 88
this, this issue? 4 88
MS. COHEN:  I just want to respond to  5 88
Faith's comments about preferring guidance.  It's  6 88
clear that there's been a sea change because of the  7 88
proposed and implemented guidance. 8 88
I want to go back to the comment that we  9 88
said earlier about credit insurance.  When I got  10 88
started on predatory lending, that was a really big  11 88
headline.  But the truth is, people are still charged  12 88
credit insurance.  When they are, they can protect  13 88
themselves because there are rules that they can  14 88
enforce with regard to credit insurance.   15 88
But if it's guidance, not only does it not  16 88
apply to all the lenders, but a borrower who ends up  17 88
in an experience where the rule was violated in the  18 88
guidance, but there's no rule that applies to the  19 88
homeowner, you know, they're stuck. 20 88
So I would like to see market change.  I'm  21 88
happy to see market correction.  But we also have to  22 88
help the actual people who are suffering, and there's  23 88
really no way to do that without a rule. 24 88
GOVERNOR KROSZNER:  Well, I think this has  25 88
been an extremely helpful discussion on this very  1 89
important issue, and I think it's been very valuable  2 89
to have the back and forth of seeing, I think, certain  3 89
areas of agreement that have emerged with respect to  4 89
the role of escrows, even though there may be still  5 89
some differences about guidance versus rules. 6 89
One of the things we'll be talking about in  7 89
the afternoon panels is the effectiveness of guidance  8 89
adopted by the states in general, or whether a rule  9 89
would be necessary.  So I think that's a very  10 89
important issue that will be coming up again this  11 89
afternoon. 12 89
But as I promised, we'll take a break.  So  13 89
we'll have a break right now, but we will start  14 89
promptly at 10:30.  Thanks. 15 89
(Whereupon, a short recess was taken.) 16 89
GOVERNOR KROSZNER:  We'd like to get started  17 89
again.   18 89
(Pause.)   19 89
GOVERNOR KROSZNER:  Once again, I want to  20 89
thank the panelists for an excellent discussion for  21 89
the first set of issues, concerning escrows.   22 89
But now we have three other topics that I  23 89
had mentioned.  One was prepayment penalties; second,  24 89
stated income as well as no and low documentation  25 89
lending; and then appropriate consideration given for  1 90
borrowers' ability to repay. 2 90
We've got about an hour and a half left, so  3 90
I'm hoping to spend about half an hour or so on each  4 90
of those topics. 5 90
So let's get to prepayment penalty issues,  6 90
and in my opening remarks, I talked about how in  7 90
certain cases they may provide some -- there may be  8 90
legitimate reasons for use of them.  But there also  9 90
may be abusive uses of them. 10 90
So I want to turn to my left, to talk a  11 90
little bit more about that -- 12 90
MR. RHEINGOLD:  Appropriately. 13 90
(Laughter.) 14 90
GOVERNOR KROSZNER:  About those -- good.   15 90
Those people got met, to see what your thoughts are on  16 90
whether these things are something that need to be  17 90
just a broad rule against them, or whether the  18 90
guidance might be appropriate, or whether, you know,  19 90
whether there could be some opportunities for them to  20 90
be used in a way that could be helpful to the certain  21 90
classes of consumers. 22 90
MR. CHANIN:  So who wants to start? 23 90
MS. BRAUNSTEIN:  Ira, please. 24 90
MR. RHEINGOLD:  You want me to start?  Okay,  25 90
I started last time.  In our view, prepayment  1 91
penalties in the subprime marketplace are probably the  2 91
most cynical thing to be done, particularly in the  3 91
last few years when we've seen the 228s and 327s and  4 91
the adjustable rate mortgages. 5 91
Those loans are written for prepayment,  6 91
period.  They are forms.  They're created with the  7 91
full notion that people are going to prepay those  8 91
loans.  Those prepayment penalties exist merely as  9 91
extra cash capital for the lender, because they know  10 91
it's going to pay and people don't know that that cost  11 91
is there. 12 91
I see no rational reason why prepayment  13 91
penalties exist in that subprime market, in that  14 91
mortgage market space.  I think they should be  15 91
excluded, and I don't see any real benefit to the  16 91
consumer.   17 91
I have yet to talk to a consumer who said   18 91
-- it's funny, because I remember when I refinanced my  19 91
house, because everyone always goes back to their  20 91
experience in refinancing their houses.   21 91
I don't remember going and saying "Hey, can  22 91
I get a prepayment penalty, because I'm not going to  23 91
prepay this thing, and I'd like a lower interest rate.  24 91
 Could I get a prepayment penalty?"  They said "No, we  25 91
don't offer that for the kind of product that you're  1 92
going to get." 2 92
MR. BREWSTER:  So you had a lot of choice,  3 92
is what you're saying. 4 92
MR. RHEINGOLD:  I think it's false.  I think  5 92
it's not true.  I don't think consumers choose  6 92
prepayment penalties because they're going to get  7 92
lower interest rates.  I think it's incentive-driven  8 92
in the subprime marketplace.  I'll let others talk  9 92
about, you know, how each structure is eliminated.   10 92
But I think they're a bad product. 11 92
MS. BRAUNSTEIN:  But Ira, I guess I just  12 92
want to clarify.  Is it only for the hybrids where you  13 92
see a problem, or is it just in general, or what do  14 92
you -- 15 92
MR. RHEINGOLD:  If you're talking about --  16 92
it's interesting.  It's an interesting question.  On  17 92
fixed rate mortgages, fixed rate subprime mortgages, I  18 92
wish I saw more of those.   19 92
We're not seeing a lot of those in the  20 92
marketplace, and maybe an argument can be made that  21 92
that's what makes prepayment penalties, makes some  22 92
sense, the fact that that actually equates to a lower  23 92
interest rate, then maybe that makes some sense.   24 92
That's not what we're saying today. 25 92
And again, one, that's not the product  1 93
they're doing, and two, if it actually serves the  2 93
lower interest rate and really benefits the consumer,  3 93
then I think that's okay.  But I think in the  4 93
marketplace we're seeing now an adjustable rate  5 93
mortgage with the full expectation of receiving  6 93
prepayment penalties. 7 93
I was looking at a chart yesterday.   8 93
Seventy-five percent of all the loans that had a reset  9 93
in 2006 had the prepayment penalty paid out.  That  10 93
doesn't count that 12 percent of those loans that are  11 93
in default right now. 12 93
Seventy-five percent of the 2006 prepays  13 93
that had a reset rate and an adjustable rate mortgage  14 93
prepayment.  Twelve percent of those loans have -- are  15 93
in foreclosure, and 12 percent are far behind.  So  16 93
everyone knows those loans are going to be -- those  17 93
prepayment penalties are going to be charged. 18 93
GOVERNOR KROSZNER:  Let me turn to my right,  19 93
and see other perspectives on -- essentially, some of  20 93
the challenges if we were to do a more broad-brush  21 93
approach, of just saying these are inappropriate.   22 93
What are some of the unintended consequences that you  23 93
see there? 24 93
MS. SCHWARTZ:  Well, it's interesting.   25 93
Prepayment penalties are in the segment of the  1 94
mortgage market, because they used to refinance every  2 94
three to six months in the mid-90's and the early  3 94
90's.  To bring investors and capital into the market,  4 94
prepayment penalties were designed to keep people and  5 94
loans for two, three -- and back then, and I'd agree  6 94
with others, to say five years was still way too long  7 94
for someone who may need to refinance the loan before  8 94
that. 9 94
The purpose of a prepayment penalty can be  10 94
to preserve an investor certainty that they'll give  11 94
-- money for a loan that stays on the books longer  12 94
than three or six months, which was the practice in  13 94
the mid-90's, and we all know it.  High rates means  14 94
business, credit life insurance.  It's a very  15 94
different market.   16 94
Today, one of three loans falls in the Alt-A  17 94
or subprime loan market.  One of three loans last year  18 94
fell outside of the fixed rate Fannie and Freddie  19 94
loans.  There are a significant amount of prepayment  20 94
penalties in that non-traditional segment of the  21 94
mortgage market. 22 94
So Ira says it's all cynical, because  23 94
they're on 228 ARMs or 327s.  Well, they'd be cynical  24 94
if they were five year prepay on the 228s, or a three- 25 94
year prepay on a 228, where you would cause that  1 95
borrower to have to pay that penalty upon the reset of  2 95
the mortgage, if they chose to refinance. 3 95
But in fact, if responsibly used, prepayment  4 95
penalties, programs can match the duration of the  5 95
fixed rate portion of the ARM.  If we don't have a  6 95
choice, like you had a choice; you still didn't get  7 95
one. 8 95
MR. RHEINGOLD:  They didn't have a choice. 9 95
MS. SCHWARTZ:  They didn't have a choice.   10 95
They couldn't get one, but at least you weren't  11 95
mandated on one.  They're not the problem.  If you  12 95
don't have a choice and if you're not getting a lower  13 95
rate, absolutely that's deceptive. 14 95
MR. RHEINGOLD:  That's what were these  15 95
about. 16 95
MS. SCHWARTZ:  Well, I'm with them.  I'm  17 95
with them.  So I guess my point is I put that in  18 95
regulation, put it in regulation.  Put it in perhaps a  19 95
targeted regulation.  That's very serious around  20 95
HOEPA, Section 129, that includes the substantive  21 95
requirements about how the use of that prepayment  22 95
penalty is used.   23 95
I think if you're not seeing that across the  24 95
board, you'll see market reform on the problem in that  25 95
market. 1 96
MR. RHEINGOLD:  Well, I have one response  2 96
and I'll let others speak.  But I think it's not  3 96
sufficient to make prepayments for a batch of fixed  4 96
rate term -- 5 96
MS. SCHWARTZ:  Or a 30-day before it sets or  6 96
something, or 60 or whatever that might be. 7 96
MR. RHEINGOLD:  Or six months or a year.   8 96
(Laughter.) 9 96
MR. RHEINGOLD:  Because again, I think  10 96
people fall into the trap that in fact that prepayment  11 96
is not going to happen, if it happens prior to that.   12 96
That's when the refinance loan comes into play.  I  13 96
think it has to be significant before that -- 14 96
MS. BRAUNSTEIN:  Can you suggest what you  15 96
think an appropriate time period would be? 16 96
MR. EAKES:  Well, it should be no less than  17 96
six months.  I would make the case for lack of  18 96
prepayment penalties should be in this subsection, not  19 96
in every subsection. 20 96
The first thing is every single rate sheet  21 96
for subprime lending that I know of would show a half  22 96
percent decrease in the rate, if you accept or choose  23 96
a prepayment penalty, okay.  So there's no argument on  24 96
what on the surface the rate tradeoff looks like.   25 96
It's roughly, for prepayment it's only a half percent. 1 97
The challenge is, and this was really, I  2 97
would think, when we were negotiating the North  3 97
Carolina predatory lending bill back in 1999, we had  4 97
all of the bank attorneys, which represented four of  5 97
the ten largest banks in America were located in North  6 97
Carolina, what they told us was they said we would be  7 97
perfectly fine in North Carolina if had a prohibition  8 97
on prepayment penalties across the board, for all home  9 97
loans that were below $50,000. 10 97
What they said was we have brokers who bring  11 97
us a loan and want to be paid premium, because they  12 97
have sold the borrower a higher rate.  You don't get  13 97
paid the premium unless the rate is higher than market  14 97
rate on the loan. 15 97
What the lenders then said to us was we have  16 97
to have a prepayment penalty, not because we have to  17 97
keep it for a long time, but we know those loans will  18 97
be refinanced perhaps by the very same broker within  19 97
one month, and get another premium down the street. 20 97
So we have to have at least a prepayment  21 97
penalty equal to the amount of the premium that we  22 97
paid to the broker.  It was the first time that it  23 97
dawned on me, that really the prepayment penalty is  24 97
very subtle.  It looks like you have on the rate sheet  25 97
that you're going to get a seven percent loan  or,  1 98
with prepayment penalty, 6-1/2. 2 98
But the way it works in practice is someone  3 98
brings in a loan that would have qualified for that  4 98
seven and 6-1/2 tradeoff, that is at 8-1/2 or 8,  5 98
depending on whether they have a prepayment penalty. 6 98
Without the prepayment penalty, you can't do  7 98
the racial steering that we see so often in this  8 98
industry.  So I would argue that this segment, and  9 98
particularly because if you are African-American or  10 98
Latino, in any marketplace in America for home loans,  11 98
you are 500 percent more likely to get prepayment  12 98
penalties in America today, because of the steering  13 98
between subprime and prime. 14 98
The prime marketplace where you really do  15 98
get competition, and people understand it better and  16 98
there are free riders on the market, have two to four  17 98
percent of the loans that have prepayment penalties.   18 98
You can't tell me that the borrowers who have credit  19 98
blemishes, who have less choice in the market because  20 98
they're more desperate, choose 70 percent of the time  21 98
 to have that feature. 22 98
It really is something that is what is  23 98
offered to the borrowers.  It is a mechanism of  24 98
compensation.  What we did in North Carolina is  25 98
prohibited prepayment penalties.  We restricted it not  1 99
to restrict overall lending; we allowed the interest  2 99
rate on subprime loans to float as high as they need  3 99
it to be. 4 99
We just said let's take the compensation  5 99
that was least transparent and move it back into  6 99
payments and back into penalty fees, and do away with  7 99
it.   8 99
One other point and I'll be quiet.  I was at  9 99
a panel discussion with the general counsel for New  10 99
Century, and he said to me "Why are you so worried  11 99
about the rate resets, this exploding payment after  12 99
two years, because whether you're fixed rate or   13 99
anything else, we refinance these loans.  We refinance  14 99
them all virtually before we ever get to the two-year  15 99
period. 16 99
"You shouldn't be worried about the reset,"  17 99
and I'm thinking well, that's a good argument to me  18 99
about why the reset is irrelevant.   19 99
But it's a devastating argument about what  20 99
prepayment penalties are.  If you think about it, a  21 99
prepayment penalty in every case in this marketplace  22 99
is paid out of the equity of the home.   23 99
The borrower hasn't saved up money in order  24 99
to pay the prepayment penalty.  It is a very  25 99
sophisticated way of having asset-based lending, that  1 100
part of the compensation, the back-end fee. 2 100
I would argue that under HOEPA, one of your  3 100
standards is if there is a practice that begins to  4 100
take loans out of the HOEPA category.  If you have a  5 100
premium interest rate, say you're charged an extra one  6 100
percent, which happens all the time throughout this  7 100
industry, above what you qualify for, and you put a  8 100
prepayment penalty on top of that for two years, three  9 100
years, you have in essence paid up front fees. 10 100
You're going to pay it, either in the  11 100
interest in the higher premium rate, or you're going  12 100
to pay it in the prepayment penalty at the back end.   13 100
Why does that not count in calculating the fees that  14 100
would kick you into a HOEPA loan?  It is a method of  15 100
offloading that makes no rational sense. 16 100
Most people in America outside of economics,  17 100
you know, I actually studied economics.  I know you  18 100
guys don't believe that.  What we're doing here, it is  19 100
possible clearly to have a prepayment penalty and have  20 100
it lower the rate.  That's what in economic theory it  21 100
should do. 22 100
But all of the studies that we've done, the  23 100
professor at Harvard did, showed that when you  24 100
actually look at what happens, the borrowers do not  25 100

NEAL R. GROSS
COURT REPORTERS AND TRANSCRIBERS
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