Lessons that help teach responsible borrowing or responsible lending should start at a young age. (Photo: ThinkStock)

Despite large problems like a state budget that remains in shambles due to rampant government spending, California legislators are reportedly hard at work to come up what they consider to be a responsible lending approach to payday lending. Unfortunately, they abandon the concept of a self-regulating free market economy by mistaking shackling payday lenders with being responsible. The more legislators squeeze the system in which payday advances are distributed, the more difficult it becomes for quick loan outlets to turn any sort of profit, argues the responsible lending outlet Pay1Day in a recent press release.

Responsible lending means exercising informed choice

A balanced view of America’s free market economy suggests that hyperactivity to ban payday advances does not constitute a move toward responsible lending. The reality is that the facility and expense of such quick loans from payday lenders are much more relative. The recessionary economy and its resulting credit crunch have limited the options for many consumers who need short term credit. Unemployment and underemployment don’t make this crucible any easier to bear. Bills still must be paid; life’s emergencies continue. Legislators who live comfortably on their legislator salaries have proved themselves largely unable to walk in the shoes of their financially modest constituents and understand the need for payday advances. Hence, they don’t see the ill in removing such choices from the short term credit market with overzealous regulation.

Weighing expenses vs. consequences

Pay1Day points out that the bulk of quick loan customers use the product not for impulse purchases, but to help them avoid less desirable financial alternatives. More expensive avenues such as checking overdraft, utility shut off or mortgage default can be avoided if consumers have the option to pursue other forms of short term lending that are available even when credit scores are low. While it is true that the APR on a payday loan can be expensive in a relative sense if other types of bank loans are available, credit-constrained consumers generally don’t qualify for small scale bank loans at ultra-low interest rates.

Where do the charges for payday advances come from?

Contrary to the belief of groups like the Center for Responsible Lending, payday lenders do not charge rates in the neighborhood of 391 percent APR (for a standard two-week loan) simply because they can. Taxes and other legislation create operating expenses that lenders must recoup in order to function. If legislators squeeze harder, most lenders will close their doors and jobs will be lost by the thousands. Consumers who need access to short term credit are hurt in the process.

Thus, Pay1Day suggests that California and other states can maintain price-regulating competition in the market and inform consumers about their lending choices through educational programs. Educated consumers should be allowed to make their own choices. A nanny state that spoon feeds is less than desirable. A government that places heavy restrictions without any real efforts at education is far from a responsible government.

Sources:

PR Newswire

Benzinga

America’s real OK Corral for responsible lending – the mortgage crisis:

Do mortgage brokers profit excessively from yield spread premium charges? Will borrowers ever discover credit repair?

The subprime mortgage crisis helped make a mess of America’s economy, to the point where credit repair has become a questionably attainable goal at best. The path toward more house than Joe Consumer can handle financially was paved by upside down transactions with mortgage brokers. When compared with direct lenders, working with mortgage brokers generally stretches out the time it takes in which to close a mortgage loan and introduces the consumer into murkier financial waters.

Swimming with Yield Spread Premiums

A yield spread premium (YSP), according to the Center for Responsible Lending (CRL), is “a bonus a lender pays to reward a mortgage broker for placing, or steering, a borrower into a higher-cost loan than the borrower qualifies for.” That would typically include hefty prepayment penalties that keep the consumer stuck in the loan long enough to extract higher profits. The CRL points out that resulting foreclosure cases harm not only the borrower, but society as a whole in the form of lessened property values and tax revenues.

Studying the Gross Profits of Yield Spread Premiums

That’s what Antje Berndt, Burton Hollifield and Patrik Sandas of Carnegie Mellon University and the University of Virginia set out to expose in their paper “The Role of Mortgage Brokers in the Subprime Crisis.” They play a large role in the recent American mortgage market, as they are a centerpiece of subprime loans. And by the authors’ estimate, subprime mortgage loans accounted for at least 75 percent of all mortgages originated as late as 2006.

“What were the explicit and implicit incentives for mortgage brokers to match borrowers with different types of mortgages?” ask the authors. Furthermore, “Did these incentives change during the run up to the crisis?”

How Does the Yield Spread Premium Work?

Lenders provide the mortgage broker with a set of incentives. One example the authors give is a lender paying the broker a kick-back for offering more expensive loans to consumers. Sure, it gets them in a home for a while, but it works against their financial best interests. The broker, given this incentive, is working to aid the borrower first and the consumer a distant second. Or at least that’s the theory that the authors explore. They search for evidence in the records of one of the largest subprime loan originators – New Century Financial Corporation – from 1997 through March 2007. The authors study info on borrower creditworthiness, loan purpose, appraised value of the property, property location and type, type and terms of the mortgage loan, loan service records and info on broker involvement. This leads to the profit portrait.

How Does the Loan Origination Process Work?

In five steps, here’s what New Century does:

1. Brokers attract borrowers to complete loan applications. Applications are sent to a New Century account executive (AE) or the company’s Web portal.
2. AEs forward apps to New Century managers for documentation review.
3. If documentation is in place, AEs send loans through the underwriting process, where the approval or denial decision is made, based upon the consumer’s credit and mortgage histories. The interest rate and terms are set at this time and the home is appraised.
4. If approved, the loan goes to a closing agent.
5. After loan documents are sent, documents are sent via closing agent to a funding officer, who sets the wire process in motion.

Think New Century was Approving Every Subprime Consumer?

You’d be wrong, say the authors. Of the 330,000 subprime loans funded in 2006, there were nearly that many who were either withdrawn by the consumer (buyer’s remorse) or denied outright. Either way, brokers were being compensated for a good year’s work in the subprime market, it would seem.

Speaking of compensation, loan origination and credit fees play a significant role in a broker’s payment. But then there are those YSPs. The more higher-rate loans brokers originate, the more they stand to make in profit. Think that customers were being nudged (perhaps too gentle a term?) toward YSPs? Considering that brokers don’t have to disclose the yield spread premium until after the closing statement is signed, there’s very little mess until after the consumer has already opened a vein to sign the contract in blood, so to speak. YSPs account for around 65 percent of broker revenue, according to the authors. The average dollar revenue per loan was around $7,000.

Underwriting the Risky

Based upon a borrower’s characteristics (credit quality, willingness to pay, etc), the broker presents financing options to the consumer. One or more lenders receive funding requests from the broker, and the lenders make the ultimate decision. “The loan will be originated,” write the authors, “if the lender’s surplus is positive so that the lender agrees to the funding, if the gains from trade between the borrower and the broker are positive, and the fees will be set so that the surplus is split between the borrower and broker in proportion to their bargaining power.”

Other Mortgage Loan Profits

A hybrid mortgage loan (aka a fixed-period adjustable rate mortgage) is another profit machine for brokers, pumping up their returns by about 28 percent. Mortgages with “limited documentation or stated documentation” increase broker profits by 33 percent and 18 percent, respectively. Those mortgages that have prepayment penalties (yield spread premium territory) offer 29 percent greater profits. In the case of a refinancing where cash is taken out, the authors found that broker profits nearly doubled.

Some other factors that influenced ability to reap excess profit included broker experience and strength of broker-lender relationship. Lenders likely viewed such brokers as have greater bargaining power over consumers, particularly with mortgage contracts where documentation was minimal and the consumer was gullible enough to sign on. Complex mortgages with minimal documentation for the consumer (not to mention a skilled broker) roped in their share of what amount to many foreclosures. That’s hardly an environment for consumer credit repair, it would seem.

High Profit Loans and Borrower Delinquency

You can only ask so much from borrowers with limited means. As the underwriting criteria for New Century and numerous other mortgage lenders was too slack, the result was expensive mortgages without people who could pay for them. Yield spread premiums created the profits brokers desired and the lenders were happy just to see loans originated, regardless of realistic ability to pay in many cases. Thankfully, the Obama administration has paid close attention to restructuring the mortgage loan market, but will it be enough to allow consumers to find avenues for credit repair? That remains to be seen. In the meantime, if you’re looking to take out a mortgage or refinance, here’s a mortgage calculator. Do the math before a lender or broker does it for you and has you paying their yield spread premiums.

(Photo Credit: http://www.flickr.com/photos/fibonacciblue/ / CC BY 2.0)