Subprime Credit and the Wealth Effect

["Christian Gregory" <christian11@xxxxxxxxxxxxxx>]

[A follow-up to the thread on mortgage refinancing and the wealth effect. As
we might expect, subprime borrowers don't have access to equity the way
others might. In addition, and consistent with Doug's recent letter to FT,
subprime credit has grown by leaps and bounds over the last half decade (b/w
1994 and 1999, 400%, according to the article). ]

Subprime Borrowers Are Haunted
By Mortgage Prepayment Penalties
By JOHN HECHINGER
Staff Reporter of THE WALL STREET JOURNAL


All over the U.S., homebuyers are reaping a bonanza in one of the biggest
mortgage-refinancing booms ever. Taking advantage of lower interest rates,
they are slashing their monthly mortgage payments or extracting tens of
thousands of dollars in equity for new cars, vacations or their children's
education.

But many low-income consumers are missing the party: "subprime" borrowers
with blemished credit, a spotty employment record or a lot of debt.
Increasingly, these homebuyers are finding that if they want to pay off
their loan early to get a better deal, they are socked with thousands of
dollars in fees.

These prepayment penalties, all but gone from the mortgages taken by average
homebuyers, are alive and well among those who don't qualify for
conventional financing. About 80% of mortgages in the subprime market
carried prepayment penalties in mid-2000, up from 50% in 1997, according to
a Standard & Poor's survey.

The penalties often assess borrowers 5% of the loan amount outstanding if
they pay the mortgage off within its first three to five years for any
reason, whether to refinance, consolidate debts or sell the home. Lenders
say they need such a provision because of the high costs they incur in
making subprime loans.

Growing Criticism

But some consumer advocates and politicians contend that borrowers aren't
being adequately informed of the prepayment penalties, which critics
characterize as a "predatory" lending practice aimed at low-income people
who may not fully understand loan terms. "Prepayment penalties rip money out
of people's pockets," says Lisa Donner, a coordinator with the Association
of Community Organizations for Reform Now, or Acorn, a nonprofit and
activist group that often targets housing issues. "Owning a home goes from
being a source of wealth into a constant drain."

See chart of the top 10 subprime mortgage lenders.

Lisa and Mark Cabral of Mount Vernon, Wash., say they didn't know they were
getting locked in. Four months ago, the Cabrals took out two new home loans
from Household International Inc.: a $102,000 loan at a 13.99% interest rate
and a $10,000 line of credit at 21.9%. They weren't planning to stay in
their manufactured home for much longer. In fact, one reason they borrowed
was to fix it up so they could sell it and move to a bigger place.

Can't Afford to Move

The work is finished, but the Cabrals say they can't afford to move, having
recently realized that the bigger loan carries a penalty of about $7,000 if
it is paid off within five years. "We didn't know a lot about these kinds of
things," says Mrs. Cabral, 36, a medical administrator who earns $24,000 a
year.

Mrs. Cabral and her husband, a construction-company superintendent, have
sued Household. Their suit, in state court in Skagit County, Wash., claims
Household didn't adequately disclose the prepayment penalty and some other
terms of the loan, and alleges fraud and deceptive trade practices. "They
took advantage of us, and now we can't sell our home," Mrs. Cabral says.

Household denies the allegations. "We don't believe we've done anything
wrong," says a spokesman, Craig Streem, who adds that the company levies
prepayment penalties on most of its loans and always discloses them.

Higher Expenses

Household incurs higher expenses than conventional lenders, Mr. Streem says,
partly because it does more creditworthiness research and partly because it
has to shell out more for collections on past-due loans. Subprime lenders
don't collect their origination fees upfront but wrap them into the loan
amount. So if a borrower refinances after just a few months, Mr. Streem
says, "you eat your own costs." Hence the prepayment penalties.

About 35 states have laws that ban or restrict prepayment penalties, many
enacted to protect consumers during the high-interest 1970s. It was these
laws, together with lending competition, that prompted lenders to drop the
penalties in most conventional mortgages.

Subprime lenders have found a way to retain the penalties even in the
restrictive states. The device is an obscure federal law called the
Alternative Mortgage Transaction Parity Act. Passed in 1982 to help lenders
avoid the hassle of varying state restrictions, the law allowed them to
subject "alternative" home financing -- such as adjustable-rate mortgages --
to oversight by the federal Office of Thrift Supervision. The OTS doesn't
restrict prepayment penalties.

In 1999, Virginia noticed growing numbers of loans showing up with
prepayment penalties larger than the state cap, which is 2% of the loan
amount. The state's banking regulator warned lenders they would be cited for
violations. But a trade group sued in federal court, arguing that subprime
loans were alternative mortgages under the 1982 law and thus could be
covered by the OTS, not the state. The group's suit has prevailed at both
the district and appellate level. Virginia is seeking Supreme Court review.

At the OTS, Director Ellen Siedman has voiced concern about lenders using
the federal exemption to dodge states' restrictions on lending practices.
But she says states can still go after many practices by using
consumer-protection laws.

Subprime home loans carry interest rates three to six percentage points
higher than conventional mortgages. Household generally charges 9% to 13%,
at a time when conventional 30-year mortgages are running about 7%.
Household also charges fees of about five "points," or 5% of the loan
amount. Conventional loans may entail no points or several. They average
about one.

Offsetting the Risks

Household and other subprime lenders say they need these terms to offset the
risks they take. At the end of last year, 2.73% of subprime mortgages were
delinquent by 90 days or more -- about 10 times the level for conventional
loans -- according to market researcher Mortgage Information Corp.

The fairness issue has taken on greater importance because of explosive
growth in subprime lending. The volume of subprime mortgages grew fourfold
from 1994 to 1999, according to the trade publication Inside Mortgage
Finance, before falling about 12% last year as some lenders faced financial
problems after making bad loans. About 13% of mortgages originated last year
were subprime.

The Senate Banking Committee held a hearing last week on subprime practices,
including early-payoff penalties. The Treasury Department and the Department
of Housing and Urban Development have urged restrictions, such as barring
prepayment penalties when the borrower is selling the home. And a House bill
introduced by Rep. John J. LaFalce, Democrat of New York, would cap
prepayment penalties at 3% of loan amounts and limit them to the first two
years of a mortgage.

A few savvy borrowers turn prepayment penalties to their advantage. If they
know they will be living in their homes for several years, they can choose
to be subject to a penalty in exchange for a lower interest rate. The
better-off customers in the "prime" market occasionally agree to them. But
regulators and advocates say many uneducated borrowers don't understand the
tradeoffs. And they say the penalties often are disclosed only in the fine
print of loan documents.

Nonprofit groups often work with banks to funnel loans to low-income
neighborhoods. Boston-based Neighborhood Assistance Corp. of America often
tries to refinance borrowers out of high-interest loans. Prepayment
penalties can block this strategy, says NACA's chief, Bruce Marks, though he
adds that he sometimes can get a lender to drop the penalty after
threatening a lawsuit or a protest.

'I Knew It Was a Bad Deal'

Jacquelyn Ali heard from a friend about a NACA program, funded by Bank of
America Corp., that would allow her to refinance her 10.99% subprime loan
with a lower-rate mortgage. But Ms. Ali, who lives in suburban Atlanta, had
to wait until a $3,000 prepayment penalty expired this year to take the deal
because she couldn't afford the penalty. The original $73,000 loan was made
in 1998 and was held by the CitiFinancial unit of Citigroup, one of the
biggest subprime lenders.

"I knew it was a bad deal," says Ms. Ali, a divorced mother of two who works
as an office manager at Morehouse School of Medicine. "But I knew I had to
wait to get out." Her monthly bill has dropped roughly by half with the new
6.1% mortgage.

Leah Johnson, a Citigroup spokeswoman, says the company has "heard the
concerns voiced, and we're responding." Citigroup this year started offering
subprime borrowers a choice of opting out of a prepayment penalty at the
outset, in exchange for a higher interest rate. It also has agreed to limit
prepayment penalties to three years. A week ago, Household said it, too,
would limit the duration to three years.

Many subprime homeowners need to borrow so much that they have little equity
when they first buy their homes. Then, selling the house while a prepayment
penalty is still in force can eat up much of whatever equity they've managed
to accumulate. A refinancing, either to lower the interest rate or to draw
out some cash, can cause a new prepayment penalty to kick in after the first
one has expired.

In March, Willie Irby, his left leg stiff from a stroke, walked to the front
door of his Washington, D.C., home, collected the mail and ripped open a
long-dreaded letter from his mortgage company. "Foreclosure is imminent,"
read the notice, demanding $6,155.24 in back payments. "If you wish to save
your property, you must act now."

A Painful Decision

To satisfy the debt, Mr. Irby and his wife, both in their 70s, made the
painful decision to sell the home they had bought as newlyweds. But they
soon discovered that their mortgage was blocking their escape. It carried a
prepayment penalty of $13,791. The Irbys say they didn't have the money, and
the proceeds from selling the house wouldn't cover it after they paid the
mortgage.


The Irbys found themselves in dire straits even though the house they bought
in 1959 for $16,950 was now valued at about $350,000. Over the years, they
had loaded it up with high-cost debt, mostly to remodel it and to pay
medical expenses. The amount they owed on it also grew as lenders' fees were
wrapped into the debt. Last November, the Irbys took out a new mortgage with
Option One, a unit of H&R Block Inc., believing they could lower their
monthly payments and extract another $45,000 for medical expenses. The
mortgage climbed to $314,000.

As his debt against the house skyrocketed, Mr. Irby had an uneasy feeling.
"I thought maybe I was borrowing more than I can afford," he says. But he
believed he had no choice.

The new loan's interest rate was 10.99%. According to a complaint the Irbys
subsequently filed with HUD against the lender, monthly payments on the
mortgage they took out in November were just under $3,000, while their
monthly income is about $2,750. Option One executives, while declining to
discuss specifics of the case, say the file shows that the Irbys had enough
income to qualify for the $314,000 mortgage.

This spring, the Irbys agreed to sell the house to pay off their loan. They
moved into a cramped one-bedroom apartment and decorated it with pictures of
politicians and world leaders, mementos from Mr. Irby's work in the mailroom
of the Department of Energy. The couple gave away half their furniture as
well as their washer and dryer when they moved.

When they learned about the penalty for prepaying their mortgage, the Irbys
had to pull out of the sale. "All I wanted was enough money to sell the home
and pay the people off," says Mr. Irby, 77.

The would-be buyers, Mary and Dennis Kivlighan, joined the Irbys and the
National Community Reinvestment Coalition, a Washington nonprofit group, in
the fair-housing complaint with HUD.

Late last week, after a reporter began looking into the case, Option One
reached an agreement with the Irbys. It allowed the sale to go through, with
the lender waiving about $23,000 in fees and interest, according to Option
One. Still, the lender's chief operating officer, Steve Nadon, defends
prepayment penalties, saying that without them, interest rates for all
subprime borrowers would have to rise and some would be shut out of the
market. The Irbys' fair-housing complaint is still pending with HUD.

On a recent day, Mr. Irby, his jeans still flecked with paint from
home-improvement projects, reminisced as he toured his now-empty home,
walking past the paneling and wallpaper he had hung himself. "We were here
for 40 years," he says. "My kids grew up here. We had good times here. Now,
it's gone. Once you're behind, you can't catch up."

Write to John Hechinger at john.hechinger@xxxxxxx



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Top 10 Subprime Mortgage Lenders
Ranked by 2000 mortgage originations.

Mortgage Lender  2000 volume, in billions of dollars  Percentage of market
share
CitiFinancial  $18.8  13.4%
Household Financial Services  15.3  10.9
Washington Mutual  8.1  5.8
Bank of America Home Equity  7.8  5.6
Option One Mortgage  5.3  3.8
Countrywide Credit Industries  5.2  3.7
Conseco Finance  4.4  3.2
First Franklin  4.4  3.2
New Century Financial  4.2  3.0
Alliance Funding  3.5  2.5
Industry total  140  100