During 2002, consumer groups continued their push for legislation at the state and local levels against the making of “bad loans.” In this context the term “bad loans” does mean not loans that go into default, as lenders more commonly use that term. Rather, it means loans which the consumer groups believe should not have been made, either because they cost the consumer too much (even given a borrower’s unsatisfactory credit history), are made under underwriting standards that are too lenient, are made too soon after the loans which they refinance, or because they include one or more terms that the consumer groups consider “abusive.” Such loans are often labeled by their critics as “predatory,” although that term has yet to be defined in a legally meaningful way. The issues have generated a heated political battle with important potential consequences relating to credit availability and economic conditions.

Rather than attempt to summarize all of the related legislative efforts,1 this article will focus on developments during 2002 in some key states and cities: California; Georgia; New York; Cleveland, Ohio; and New York City; and will then outline some related judicial developments.

Selected State Legislative Developments

Of the new laws enacted at the state level in the last year or so, those in California, Georgia and New York are considered the most problematic for lenders, since they significantly exceed the coverage of other state laws and include prohibitions and limitations on loan terms that go well beyond the federal Home Ownership and Equity Protection Act (HOEPA).2

California

Late in 2001, California enacted Assembly Bill No. 489 (the California statute), which became effective July 1, 2002.3 The California statute imposes several requirements on “covered loans,” and inflicts civil penalties on those who violate its provisions.

Coverage

The California statute defines "covered loans" as “consumer loans” not in excess of $250,000 that are secured by real property and which have an Annual Percentage Rate (APR) more than eight percentage points above the yield on U.S. Treasury securities of comparable maturities (the T-Bill Rate) or in connection with which the borrowers paid "points and fees" in excess of six percent of the loan amount.

“Consumer loans” are loans secured by the borrower’s principal (one-to-four family) dwelling, other than reverse mortgage loans, open-end line of credit loans, loans secured by rental property or second homes and bridge loans of less than one year. “Points and fees” include all items included as “finance charges” under the federal Truth in Lending Act4 and Federal Reserve Board (FRB) Regulation Z,5 all compensation and fees paid to a mortgage broker (which may include yield spread premiums), and any items that are excluded from the finance charge under Regulation Z section 226.4(c)(7) for which the lender receives direct compensation.

Prohibitions

With respect to covered loans, the California statute prohibits: lending without regard to the borrower’s ability to repay (with such ability presumed if the borrower's debt-to-income ratio does not exceed 55 percent); prepayment fees (except under limited circumstances during the first 36 months); balloon loans of five years or less; negative amortization (except, subject to certain conditions and disclosures, on first lien loans); steering borrowers to loans of lower grade than they could qualify for; financing specified types of credit insurance; financing more than $1,000, or six percent of the principal amount of the loan not including points and fees, whichever is greater; recommending or encouraging default on an existing loan when refinancing it with a covered loan; paying loan proceeds directly to a home improvement contractors via a one-party check, and not providing a prescribed cautionary notice to the borrower before closing.

Remedies and Penalties

Violators of the California statute (who cannot or do not avail themselves of the law’s limited corrective mechanism for “bona fide errors”) are subject to administrative penalties of up to $2,500, or, in the case of a knowing and willful violation, judicially-imposed penalties of up to $25,000, plus costs of prosecution, including attorney’s fees and investigation expenses, suspension or revocation of their license, and an order of restitution or disgorgement. Consumers can also recover, in a civil action, actual damages (or the greater of actual damages or $15,000 for a “willful and knowing” violation) plus attorneys fee and costs of suit; and punitive damages if otherwise warranted under California law. Provisions of a covered loan that violate the California statute are unenforceable.

Georgia

Apparently not wanting to take a back seat to California in terms of being tough on “predatory lenders,” the State of Georgia, on April 23, 2002, enacted the toughest anti-predatory lending initiative to date, the Georgia Fair Lending Act, H.B. 1361 (the Georgia statute).6 The Georgia statute became effective on October 1, 2002.

Coverage

The Georgia statute prohibits certain practices in conjunction with the making of “high-cost home loans,” which are defined as “home loans” meeting either the APR or the points and fees threshold described below. A “home loan” is essentially a purchase-money, refinance or open-end loan not in excess of the Fannie Mae single-family conforming loan limit (Fannie Mae Limit) that is secured by a one-to-four family dwelling or a manufactured home which the borrower occupies as his/her principal dwelling. Reverse mortgages, bridge loans, and business-purpose loans are excluded.

The rate threshold is the same as under HOEPA. The points and fees threshold is five percent of the total loan amount (for loans above $20,000 in amount) excluding up to two “bona fide discount points.” “Points and fees” include all items currently included as “points and fees” under HOEPA (as interpreted and recently revised in Regulation Z7), plus: (i) any indirect broker compensation (also known as yield special premiums); (ii) the maximum loan prepayment fee; and (iii) any prepayment fee paid on a loan being refinanced by a high-cost home loan made by the same creditor or an affiliate.

“Bona fide discount points” are points knowingly paid by the borrower to buy down the interest rate on a home loan or a high cost home-loan and which in fact result in a bona fide reduction of the interest rate (Start Rate) so long as the Start Rate is no greater than one percent above the required net yield for a 90-day standard Fannie Mae/Freddie Mac commitment (Fannie Mae/Freddie Mac Rate).

Prohibitions

The Georgia statute prohibits, in connection with any high-cost home loan: prepayment fees (except, subject to specified limits, within 24 months); balloon payments; negative amortization; higher default interest rates; requiring more than two advance payments at closing; lending without prior counseling for the borrower; lending without regard for the borrower’s repayment ability; paying home improvement contractors out of the loan proceeds by means of a one-party check or without an affidavit of completeness; modification or deferral fees; “call” provisions; and filing for foreclosure without giving the borrowers a prescribed advance written notice. The Georgia statute also limits the use of mandatory arbitration clauses and gives borrowers a right to “cure” a default at any time up to transfer of title as a result of a judicial foreclosure.

As to any home loan (this is not limited to high cost home loans), the Georgia statute additionally prohibits: the financing of certain credit insurance premiums; recommending or encouraging default on an existing loan; charging late fees above five percent of the payment in default or sooner than ten days after the due date; and charging a fee for information concerning a borrower’s payoff balance.

Lastly, the Georgia statute prohibits the “flipping” within five years of a home loan with a “covered home loan” unless the new loan provides a “reasonable, tangible net benefit to the borrower considering all of the circumstances.” A “covered home loan” is a home loan: (i) the APR on which (a) for a first lien, is more than four percent over the prime bank rate as published in FRB statistical release H.15 (Prime), or two percent over the Fannie Mae/Freddie Mac Rate, whichever is greater; or (b) for a junior lien, is more than five and one-half percent over Prime or three percent over the Fannie Mae/Freddie Mae Rate, whichever is greater; or (ii) the total points and fees charged, excluding up to two bona fide discount points, exceeds three percent of the total loan amount. 

This provision appears particularly problematic for home loan lenders both because of the relatively low threshold for covered home loans and because it requires the lender to assess the terms of both the new and refinanced loans, the cost of the new loan, and the borrower’s circumstances, and then decide whether the refinanced loan will have a “tangible net benefit” to the borrower considering all of those circumstances. When these loans go bad, courts will likely be called upon to reexamine the lender’s determination in this regard, but with the obvious benefit of hindsight.

Remedies and Penalties

Violations of the Georgia statute entitle the borrower to actual damages, statutory damages (equal to twice the interest paid and forfeiture of interest due), punitive damages, attorneys fees and court costs, and injunctive relief. Borrowers are also given a right of rescission exercisable at any time up to five years after the loan closing. A “good faith error” defense is available under prescribed, limited circumstances for unintentional violations, although not to cure an error of legal judgment. Assignees of high-cost home loans (which must be identified as such on the first page of the Note and Mortgage/Deed of Trust), and assignees of home loans made, arranged or assigned by manufactured home sellers or home improvement contractors, are subject to “all affirmative claims and any defenses” that the borrower could assert against, respectively, the original creditor and/or broker, or the seller/contractor. Also, brokers are liable under the Georgia statute for brokering home loans that violate the Georgia statute.

New York

Apparently seeking to ensure that high-risk lenders do not love New York, the Big Apple was one of the first states to tackle the problem of “bad” loans, with its adoption in October, 2000 of Part 41 of the Banking Board’s General Regulations.8 Since then, efforts have been made to enact even tougher legislative solutions, with the senior citizens’ lobby in New York being particularly active in this regard.

These efforts recently coalesced around Assembly bill A.11856, which the Governor signed into law on October 3, 2002 (New York statute).9 The New York statute is effective as to loans applied for on or after April 1, 2003. 

Coverage

The New York statute defines a “high-cost home loan” as a “home loan” which equals or exceeds the APR threshold or the points and fees threshold described below. A “home loan” is a closed- or open-end mortgage loan (but not a reverse mortgage loan) which is: (i) made to a natural person primarily for personal, family or household purposes; (ii) in a principal amount not more than the lesser of $300,000 or the Fannie Mae Limit; and (iii) secured by the borrower’s principal (one-to-four family) dwelling.

The rate threshold is an APR (using the fully-indexed rate, not a teaser rate) of, for first lien loans, eight percent, and, for subordinate liens, nine percent, over the T-Bill Rate. The points and fees threshold is: (i) five percent of the “total loan amount” (the principal amount of the loan minus any financed points and fees) for loans of $50,000 or more; (ii) six percent of the total loan amount for FHA or VA loans of at least $50,000; or (iii) the greater of six percent or $1,500 for loans under $50,000.

“Points and fees” include: (i) all items currently included as “points and fees” under HOEPA; (ii) all indirect mortgage broker compensation; and (iii) the cost of all financed single premium “credit disability, credit unemployment, credit property insurance or any other life or health insurance” (to whatever extent they are not already included as points and fees under HOEPA).10

When calculating points and fees, up to two “bona fide discount points” may be excluded. “Bona fide discount points” are points knowingly paid by the borrower to lower the loan Start Rate and which do lower it by an amount “reasonably consistent with established industry norms and practices.” A point is presumed to be a bona fide discount point if it lowers the Start Rate by at least 25 basis points. Bona fide discount points may be excluded from “points and fees” only if the Start Rate does not exceed the T-Bill Rate by more than one percent.

Restrictions and Limitations

With respect to high cost home loans, the New York statute prohibits: Call provisions; balloon payments (15 years or sooner); negative amortization; higher default interest rates; modification and deferral fees (except under certain circumstances); “oppressive” mandatory arbitration clauses; loans made “without due regard to repayment ability” or without the borrower having received specified counseling disclosures; the financing of single premium credit insurance or debt cancellation benefits; the financing of points and fees in excess of three percent of the principal amount of the loan; and the charging of points and fees when the loan refinances a lender’s own or an affiliate’s high-cost home loan.

The New York statute also prohibits: “loan flipping,” i.e., “refinanc[ing] an existing home loan [with a high-cost home loan] when the new loan does not have a ‘tangible net benefit’ to the borrower considering all of the circumstances”; and payments to or from mortgage brokers in connection with the origination of a high cost home loan that are not reasonably related to the value of goods, facilities or services actually provided by the mortgage broker.

Remedies and Penalties 

Violators (who are unable to protect themselves under the limited right provided in the New York statute to “cure” a good faith violation) can be liable to the borrower for actual (including consequential and incidental) damages, statutory damages (all of the interest, points and fees, and closing costs charged on the loan), and reasonable attorneys’ fees. Statutory damages for violations of the flipping provision, or (in certain situations) the prohibition against lending without regard to repayment, are set at the greater of $5,000 per violation or twice the amount of points and fees and closing costs charged on the loan. Borrowers also have a right to rescind a high cost home loan at any time as a defense to collection or foreclosure. Intentional violations can render a high cost home loan void. Finally, borrowers may assert, without any time limitation, in any action by an assignee to enforce a high cost home loan in default more than 60 days or to foreclose on a high cost home loan, any claims or defenses that the borrower could assert against the original lender.

Selected Local Legislative Developments

The push to enact anti-predatory lending legislation in 2002 was not limited to statehouses. It reached down to the offices of city councils and mayors in several major cities, including Cleveland, Ohio, and New York City, New York.

Cleveland, Ohio

On March 4, 2002, the Cleveland City Council adopted an anti-predatory lending ordinance which has since become effective (Cleveland Ordinance).11 The Cleveland Ordinance generally prohibits the making or arranging of “predatory loans” and disqualifies those who make predatory or “high cost” loans and their affiliates from doing business with the City.

Key Definitions

In Cleveland, a “predatory loan” is a “threshold” or “high cost” loan that involves one or more “abusive” practices or terms, including fraudulent or deceptive acts or practices, loan flipping, balloon payments, negative amortization, points and fees in excess of four percent of the total loan amount, higher default interest rates, advance payments, modification/deferral fees, mandatory arbitration clauses, prepayment penalties, financed credit insurance premiums, lending without considering the borrower’s ability to repay or without the borrower having undergone home loan counseling, and disbursing the proceeds directly to a home improvement contractor via a single-party check.

A "high-cost loan" is a loan secured by owner-occupied residential real property in Cleveland which: (i) carries an APR that exceeds the T-Bill Rate by five percent for first mortgages or eight percent for junior mortgages; or (ii) includes total points and fees equal to or greater than four percent of the total loan amount or $800, whichever is more. A “threshold loan” is a similar type of loan but which carries an APR of between four and one-half percent and six and one-half percent, for first mortgages, or six and one-half percent to eight percent, for junior mortgages, above the T-Bill Rate. Business purpose loans are not covered.

Consequences of Being a Predatory or High Cost Lender

The Cleveland Ordinance disqualifies any high cost lender or predatory lender or any of its affiliates from being awarded a city contract. It requires each city contract to contain a certification that neither the contracting party nor any affiliate is a high cost lender or predatory lender. It also prohibits any person or business entity that receives City grants from assisting a borrower in securing a high cost or predatory loan. And it prohibits the City from depositing funds with, investing in, or purchasing securities collateralized with loans originated or purchased by, entities that are, or are affiliated with, high cost lenders or predatory lenders.

New York City

Seizing a chance to take center stage, the New York City Council, on September 25, 2002, approved an ordinance (NYC Ordinance), which would make it illegal, beginning 90 days after it becomes law, for a City agency to enter into business contracts with, grant financial assistance, including tax abatements, to, or deposit City funds in, a “predatory lender” or its affiliate.12 The Mayor vetoed the bill on October 23, 2002; however, the City Council overrode the Mayor’s veto on November 20, 2002.

Coverage 

Predatory lenders are defined in the NYC Ordinance to include, with certain exceptions, financial institutions (including banks and thrifts, credit unions, mortgage bankers and mortgage brokers, and other financial services companies) that make, purchase or invest in, within a 12-month period, more than ten “predatory loans,” or “predatory loans” comprising five percent or more of their home loan business. Predatory loans are “high-cost home loans” having any one or more of 18 identified characteristics which the City Council apparently believes are, at least potentially, predatory or abusive.

“High cost home loans” are “home loans” which equal or exceed either the rate threshold or the points and fees threshold, explained below. “Home loans” include all open- and closed-end loans (other than reverse mortgage loans): (i) the principal amount of which are not in excess of the greater of $300,000 or the Fannie Mae limit; (ii) which are made to a natural person primarily for personal, family or household purposes; and (iii) which are secured by the borrower’s principal (one-to-four family) dwelling.

Both the rate threshold and the points and fees threshold are lower than the thresholds in the New York statute. The rate threshold is an APR (using the fully-indexed rate, not a teaser rate), of six percent for first-lien loans, or eight percent for subordinate-lien loans, over the T-Bill Rate. The points and fees threshold is: (i) four percent of the total loan amount for loans of $50,000 or more; or (ii) the greater of five percent of the total loan amount or $1,500, for loans under $50,000.  

“Points and fees” include the same items as are included in the definition of “points and fees” in the New York statute (except that the NYC Ordinance appears to count credit insurance premiums as points and fees regardless whether or not they are financed), plus any prepayment fees charged in connection with the payoff of a loan being refinanced by the same lender or its affiliate. Up to four “bona fide loan discount points” (points knowingly paid by the borrower to lower the Start Rate, and which do lower it, by an amount that is “reasonably consistent with established industry norms and practices”) will not count as “points and fees” provided the Start Rate does not exceed by more than two percent the Fannie Mae/Freddie Mac Rate.

Predatory Characteristics

Features that make a high cost loan “predatory” include: No “reasonable and tangible benefit” to the borrower when it refinances the borrower’s existing home loan; no reasonable basis to believe that the borrower could repay it; no credit counseling received by the borrower prior to closing; points and fees charged in excess of four percent of the loan amount (or credit limit); balloon payments; prepayment fees (more than one year after closing); “unfair” or “oppressive” mandatory arbitration clauses; and points and fees charged when it refinances within five years a high-cost home loan made by the same lender (or an affiliate).

Filing Requirement

Financial institutions wishing to contract with or receive financial assistance from a City agency or act as a depository for City funds must file with the City a sworn statement that neither the institution nor any of its affiliates is or will become a predatory lender (Statement).

Consequences of Being a Predatory Lender

The NYC Ordinance authorizes the City comptroller to recommend that the City not invest in, and/or divest, stocks or securities of a predatory lender or predatory lender affiliate. The City comptroller can also investigate an institution that does business with the City to determine whether it is a predatory lender, and, if it is, require corrective action and request City agencies to cease doing business with it and take further appropriate action. Also, filing a false Statement can result in a fine of not less than $25,000 in addition to other penalties. 

Judicial Developments

Judicial developments concerning state and local anti-predatory lending laws have been relatively sparse so far. Decisions in cases where such laws have been challenged have for the most part been limited to the preliminary phases of litigation, such as requests for temporary restraints against enforcement and motions to dismiss. The results have been mixed.

Oakland and Cleveland Ordinances Upheld

During 2002, both the Oakland Ordinances and the Cleveland Ordinance survived judicial challenges raised by the American Financial Services Association (AFSA).

On June 21, 2002, the California Superior Court gave the City of Oakland the go-ahead to begin enforcing the Oakland Ordinances, ruling that they were not preempted by the subsequently-enacted California statute.13 The court indicated that preemption only exists if there is a conflict between the state and the local law, and a conflict only exists if the local law “duplicates, contradicts, or enters an area fully occupied by [the state law].” 14
Supported by: (i) a California legislative counsel’s opinion indicating that, if the California statute were to be enacted, “a local government ordinance to regulate high cost lending would not be preempted by state law”;15 and (ii) California Governor Davis’ statement of concern, upon signing the California statute, that it did not include “definite language that would preempt local governments from enacting their own versions of anti-predatory lending legislation,”16 the court found that the California statute and the Oakland Ordinances were not duplicative since they had different coverage triggers and in some instances prohibited different acts. 

Interestingly, the court actually expanded coverage of the Oakland Ordinances by finding that an exemption for federally-chartered banks, credit unions and savings associations contradicted state law and had to be stricken. This exemption, it said, conflicted with a separate state law requiring local regulatory guidelines to “promote continued parity between the state and federal levels in order to avoid creation of discriminatory burdens upon state institutions ¼.”17

Following the Oakland decision, an Ohio Court of Common Pleas, on July 25, 2002, denied AFSA’s motion to temporarily restrain enforcement of the Cleveland Ordinance.18 The court discounted AFSA’s witnesses’ assertions of irreparable harm to lenders resulting from enforcement of the Cleveland Ordinance to be speculative (e.g., “the banks may be exposed to civil lawsuits, may decide to leave the Cleveland market or may incur increased costs of loans”),19 while viewing the testimony of three elderly victims of predatory lenders doing business in Cleveland as adequately demonstrating that the public interest would not be served by restraining enforcement of the ordinance. These individuals testified that they were not aware of provisions in their loans requiring prepayment fees or balloon payments, that they paid exorbitant fees to refinance their home loans and that one refinanced his home loan five times in three years and, in the process, paid $2,300 in appraisal fees alone.

Georgia Statute Challenged 

On October 16, 2002, the National Minority Mortgage Bankers Association, three mortgage industry members and six prospective individual borrowers filed suit in the Fulton County, Georgia Superior Court against the Georgia Banking Department seeking a declaratory judgment that the Georgia statute is unconstitutional and preempted by federal law.20 Specifically, these plaintiffs claim: first, that the Georgia statute is so vague, indefinite and overbroad as to violate the due process clauses of the Fifth and Fourteenth Amendments of the United States Constitution and a similar clause in the Georgia Constitution; second, that specific provisions of the Georgia statute are preempted by the provisions of the federal Alternative Mortgage Transaction Parity Act of 1982 (Parity Act),21 or the Federal Arbitration Act22; and third, that the requirement in the Georgia statute for mandatory counseling violates the plaintiffs’ right of free speech under the First Amendment to the United States Constitution.

Factually, the plaintiffs allege that the industry member-plaintiffs have been or expect to be put out of business as a result of the Georgia statute, that the borrower-plaintiffs have not been able to obtain credit solely because of the Georgia statute and that at least 14 national lenders have announced that they will not purchase “high cost” or “covered loans” in Georgia.

Illinois State and Chicago Ordinance Found Preempted at Least in Part by The Parity Act

In an opinion delivered by Judge Easterbrook on October 21, 2002, the Seventh Circuit U.S. Court of Appeals determined that the Parity Act preempts provisions of the anti-predatory lending regulations adopted by the Illinois Office of Banks and Real Estate (OBRE Regulations)23 and remanded the matter to the lower court to determine exactly which provisions were preempted.24

On remand, the lower court will have to address the controversial issue of the scope of the Parity Act preemption. The Seventh Circuit pointed out in its decision that the federal Office of Thrift Supervision (OTS) previously took the position that state lenders could make alternative mortgage transactions on the same terms as OTS-regulated thrifts even if some of those terms were not specifically mentioned in OTS regulations as being applicable to state housing creditors under the Parity Act.25 However, the court also noted that the OTS, in its commentary to its most recent rule revisions, now seems to indicate that only federal regulations accompanied by an OTS declaration of preemptive force may displace state law.26

Summary 

The proliferation of state statutes and local ordinances such as those discussed above, with their ever-expanding triggers and prohibitions, vague standards, and remedies and penalties that many creditors consider onerous, is making it increasingly difficult for national and regional lenders, and local lenders in the affected jurisdictions, who lend to persons with less than perfect credit histories, to continue to make loans to their customers in those jurisdictions. Reports of lenders ceasing to make non-prime loans in some of these locations are common,27 and some studies are showing that credit to non-prime borrowers in North Carolina, where this trend began in 1999,28 has in fact become more scarce or costly as a result of the North Carolina predatory lending “experiment.”29 Continuation of these trends damage the financial prospects of such borrowers and even the entire economy, and can only enhance the prospects for enactment of a uniform (and necessarily preemptive) federal law.
 
Endnotes

1.See, e.g., Florida H.B. 2262, enacted April 22, 2002; Maryland H.B. 649, enacted May 16, 2002; Ohio H.B. 386, enacted Feb. 22, 2002. For further background, see Donald C. Lampe, Predatory Lending Initiatives, Legislation, and Litigation: Federal Regulations, State Law and Preemption, 56 CONSUMER FIN. L.Q. REP. 78 (2002).
2.Pub. L. 103-325, 109 Stat. 2160. See generally RALPH J. ROHNER AND FRED H. MILLER, TRUTH IN LENDING  6.09 (Am. Bar Assoc. 2000).
3.Cal. Fin. Code, § 4970 et seq.
4.15 U.S.C. 1601 et seq., specifically, 15 U.S.C. § 1605.
5.12 C.F.R. § 226 et seq., specifically, 12 C.F.R. § 226.4(a) and (b).
6.O.C.G.A. §7-6A et seq.
7.12 C.F.R. § 226.32, as amended effective October 1, 2002.
8.3 NYCRR Part 41 (eff. Oct. 1, 2000). See, e.g., Marc J. Lifset and Geoffrey C. Rogers, The New York Part 41 Predatory Lending Rules and Remedies, 56 CONSUMER FIN. L. Q. REP. 87 (2002).
9.N.Y. Pub. L. 2002, ch. 636.
10.HOEPA includes as “points and fees” premiums paid at or before closing only for “credit life, accident, health, or loss-of-income insurance, or debt cancellation coverage.” 12 C.F.R. § 226.32 (b)(1)(iv).
11.Cleveland Ord. No. 372-02.
12.N.Y.C. Proposed Int. No. 67-A.
13.American Financial Services Association v. City of Oakland, No. 2001-027338 (Cal. Sup. Ct., Almeida Cty., July 21, 2002).
14.Id., slip. op. at 4, quoting from Great Western Shows, Inc. v. County of Los Angel