INTRODUCTION :: Like obscenity, “predatory lending” in the home-mortgage market eludes a precise or uniform definition; the phenomenon instead frequently evokes an “I know it when I see it” understanding among consumer advocates, responsible lenders, and concerned regulators. As a result, accelerating debates about predatory lending between opposing sides-consumer groups and banking industry representatives- have focused on what sorts of lending behavior should be considered predatory and how to isolate or valuate predatory lending’s alleged impact on borrowers, particularly those in low-income communities. In addition, as government institutions and market actors have begun to respond in varying degrees to various constituencies, an important new contest has emerged regarding which locus of regulatory power- federal or state-is best suited to comprehensively reform a problem as significant, complex, and not yet fully understood as predatory lending. In the last four years, twenty-six states have enacted predatory lending legislation in varying forms; thus far, federal regulators and legislators have allowed these legislative experiments to flourish, but federal preemption of this remarkably vibrant and evolving legislative process is looming. This Article argues that the promise of such state-by-state innovation has important implications for regulatory development beyond the home loan market, revealing in a concrete, measurable way the virtues of our federal system of government.
Reports of predatory lending emerged first anecdotally, as a shadowy practice of a particularly unscrupulous set of mortgage brokers and finance companies to manipulate vulnerable low-income, elderly, and minority homeowners into accepting mortgage products that would quickly and inevitably result in devastating home foreclosures. Only around the end of the 1990s did community groups and consumer advocacy organizations begin to compile these stories and recognize persistent, core patterns among them. They then demanded legislative reform to address what they contended was an exploding problem that could not be remedied by the federal and state consumer protection laws then on the books.
Some regulators and legislators initially balked at attempts to regulate an area as broad, complex, and important as the residential mortgage market to ameliorate a problem they believed could not even be defined or an impact that could not be precisely evaluated. More recently, however, a variety of definitions, or core features, of predatory lending have emerged. Some focus on the excessive cost of credit extended to borrowers; others identify certain abusive or extortionate loan terms or practices that collectively make a loan predatory. Framing the problem through the lens of law and economics, Professors Engel and McCoy define predatory lending with reference to both unreasonable cost and abusive practices. Definitions are particularly elusive because the classification of lending behavior as predatory or fair depends invariably upon context. Any definition, therefore, must be flexible and accommodate context and not only should identify core objective criteria but also should focus on the intent of the lender as well as the impact on the victim. Likewise, any attempt to regulate this vague practice should be mindful of a potentially negative impact-what one banking industry representative has referred to as “unintended consequences”-on the residential mortgage market. Specifically, the lending industry is concerned that regulation may hurt precisely those financially vulnerable populations that the legislation is meant to help by driving up the cost of and drying up access to both legitimate and illegitimate credit.
In spite of these classification difficulties, reform has recently arrived, and it has arrived quickly. The most aggressive response, however, has not been at the national level, as some might have expected, but in a flurry of state and local legislative initiatives. In 1999, North Carolina became the first state to pass comprehensive legislation to regulate the terms and conditions of high-interest-rate mortgages. Since then, twenty-five other states and eleven localities have passed laws intended to address, in some way, the practices associated with predatory lending. The subsequent state responses have been varied, reflecting the relative perceived seriousness of the predatory lending problem in their jurisdictions, the respective demands and strengths of local community groups and banking representatives, and a host of other local conditions and variations among jurisdictions. Some states have tweaked North Carolina’s aggressive approach by regulating secondary market actors who frequently finance predatory behavior without fear of liability; others have more modestly built upon the floor set by federal residential mortgage regulations; and others have simply chosen not to regulate residential mortgages at all, perhaps because lending abuses have not been as prevalent in those states or because those states are hesitant to overregulate the sensitive residential mortgage market dynamic.
Although I hope to make the substantive case that an aggressive legislative response to predatory lending is necessary, an important corollary proposition of this Article is, in a sense, procedural. I believe that the regulatory response is currently occurring at the correct locus of public policy decisionmaking in our federal system-the state legislature. Indeed, the current state and local legislative response appears to be an exemplary manifestation of what Justice Brandeis has famously identified as a chief virtue of federalism: allowing states to serve as laboratories for experimentation with public policy.
Scholars have long posited that state governments enjoy the advantages of responsiveness, flexibility, and innovativeness and that they can maximize local preferences without consequence to the rest of the nation by tailoring reforms to local conditions. Thus, state predatory lending legislation would appear to be a good empirical test of these hypotheses. Regulatory responses-or “experiments”-to predatory lending are particularly appropriate at the state or local level because: (i) the problem is both immature and difficult to define; (ii) its economic and social costs on borrowers are hard to isolate or evaluate; and (iii) the positive or negative effects of any particular regulatory strategy are thereby hard to quantify abstractly or in isolation; rather, they require empirical assessment. As a result, the recent efforts by federal regulators to preempt some aspects of state predatory lending legislation and emerging congressional attempts to more broadly preempt this legislation are at a minimum premature, and they may even be counterproductive.
My Article thus proceeds on eventually intersecting tracks. It depends almost as much on a defense of the experimentation rationale for federalism as it does on an analysis of predatory lending practices. In recent years, scholars have lamented the merely abstract defenses of federalism reflected in recent Supreme Court jurisprudence and have called for efforts to understand how federalism really works and how its purported benefits should be valued. In this Article, I attempt to offer a partial answer to those questions by demonstrating that the federalist legislative response to predatory lending is a concrete example of the value of federalism. At the point of this intersection, I urge federal regulators or legislators, as well as scholars, to observe this valuable example of federalism in action and to forebear on imposing a federal solution in the name of uniformity.
In Part II of this Article, I offer a comprehensive description of the residential subprime lending market from which predatory lending emerges, and I chart its explosive growth. I describe the interrelated forces that have driven the subprime market’s growth, including the changing consumer credit demand; the emergence of alternative, under-regulated lending institutions; and that market’s reliance on the powerful, new financial tool of mortgage securitization-a process which both provides the subprime market with enormous liquidity and insulates it from the risks associated with predatory behavior. A full understanding of the subprime market is critical because a countervailing goal of any sensible predatory lending reform is to ensure that access by consumers to legitimate subprime credit is not unnecessarily diminished in the fervor of reform.
In Part III, I demonstrate the ways in which the subprime market is not efficient. This analysis suggests, contrary to industry analysis, that carefully tailored legislative restrictions on some aspects of the market will not diminish the availability, cost, or profitability of subprime lending. I describe how these inefficiencies allowed predatory lending to emerge from the subprime sector and detail some practices and loan terms that, depending on context, can fairly be classified as abusive. In Part IV, I describe the failure of pre-existing consumer protection laws, regulatory efforts, or the market itself to respond to this new complex problem. In Part V, I describe the remarkable, perhaps unprecedented, emergence of state reforms in twenty-six jurisdictions as an interactive and innovative process and offer a rough taxonomy of the state experimentation. These state laws isolate a core set of abusive lending practices and terms, offering an encyclopedia of predatory lending and suggest that the variations among them require observation and assessment. As a result of this experimentation and early empirical studies of state efforts, I argue that emerging attempts by regulators and federal legislators to preempt state laws in the name of uniformity are premature and potentially misguided.
Finally, in Part VI, I place this process within the broader debate on the value of federalism generally and the state experimentation rationale for preserving state autonomy in particular. I deconstruct arguments supporting the virtues of state experimentation to test whether the state responses to predatory lending validates them. I conclude that states should enjoy independence, free from federal preemption, to experiment with solutions to predatory lending and certain other economic or social problems in order to advance what I believe is a preeminent value of federalism-producing good public policy.
September 2015, Vol. 67, No. 5
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