Foreclosures of Subprime Mortgages in Chicago - Analyzing the Role of Predatory Lending Practices (WP 2006-1)
This publication is a part of:
Collection: Economics Working Paper
A dramatic rise in subprime foreclosures over the past several years has led to calls for restrictions of, or prohibitions against, a range of lending practices loosely termed "predatory." Several cities and states have enacted legislation or regulations aimed at eliminating predatory practices, and some advocacy groups have endorsed action nationally. This working paper uses data from the Chicago metropolitan area to examine the impact of two frequently cited predatory lending practices, long prepayment penalty periods and balloon payments, on the probability of foreclosure on subprime refinance and home purchase mortgages. This paper also examines the impact of low- and no-documentation, and how combinations of low- and no-documentation, long prepayment penalty periods, and balloon payments affect foreclosure rates. Findings indicate that the impact of each of those loan features on the probability of foreclosure varies by loan category, meaning whether the loan is a refinance or a home purchase loan, and whether the loan is a fixed-rate mortgage (FRM) or an adjustable-rate mortgage (ARM). Taken individually, long prepayment penalty periods and low- or no-documentation are associated with a greater or lesser probability of foreclosure, or have no significant association, depending on the loan category. Balloon payments are associated with greater probabilities of foreclosure for refinance FRMs, even though at the end of the sample period all of the loans in the dataset have more than two years (and most have more than five years) until their balloon payments are due. This indicates that the inability to make a balloon payment is not the direct cause of these higher foreclosure rates. Interactive effects between these loan features are also found to have sizable impacts on the probabilities of foreclosure. These findings indicate that the relationship between predatory lending practices and foreclosure rates is more complicated than the arguments for restricting their use suggest. Policies that encourage subprime lenders to review and tighten loan underwriting and pricing procedures to ensure that borrowers' abilities to repay their loans are fully reflected in lending decisions and terms may be more effective than prohibitions on specific lending practices. This approach is consistent with the approach taken in the recently proposed Interagency Guidance on Nontraditional Mortgage Products, which emphasizes prudent loan terms and underwriting standards rather than restricting particular loan features.