Subprime: new laws restrict predatory lending tactics.

Overview" Companies based in Southern California dominate the subprime lending industry, which has undergone a shakeup in the past two years due to state and local laws that ban predatory lending.

As a result, the interest rates and fees that subprime lenders can charge have been restricted.

Subprime lending refers to the extension of credit to those considered high-risk borrowers. Rates on subprime loans can be 5 percent higher--and with points and fees can add as much as 10 percent above the cost of a conventional loan. That's a far cry from the 25 percent to 35 percent once common among "predatory" lenders.

Last month, a California appeals court upheld Oakland's predatory lending ordinance, which not only regulates high-cost loans, but puts lenders and financial institutions that buy the loans at risk of prosecution. After the court upheld the law, many subprime lenders pulled out of Oakland altogether.

Los Angeles also passed a lending ordinance in 2002 that contains a similar "assignee liability" provision. It has been tied up in the courts and has not yet taken effect.

Such provisions allow borrowers to sue financial institutions that purchase the pooled loans and package them for sale as mortgage-backed securities. Players in the market include J.P. Morgan Chase & Co., Lehman Brothers Holdings Inc. and Bear Stearns & Co.

In some states, lenders have succeeded in getting such laws rewritten without liability provisions.

"We're staying in California but made the decision to stop lending in Oakland," said Steve Nadou, chief operating officer at Option One Mortgage Corp. in Irvine. The firm will also cut back its volume in New Jersey, where a similar law takes effect on Nov. 28.

The issue of liability was central to a federal district court jury's June verdict in Santa Ana that held Lehman Brothers liable for providing financial backing to an aggressive home equity lender, First Alliance Corp. of Irvine, which filed for Chapter 11 bankruptcy protection in 2000.

Lehman underwrote $400 million in mortgage-backed securities for First Alliance and provided it with a $150 million line of credit. The jury held Lehman responsible for 10 percent of the $50.9 million in damages awarded to 7,500 borrowers.

Lenders: Seven of the Top I0 subprime lenders in the United States are based in Southern California, including New Century Financial Corp., Option One. and WMC Mortgage Corp. of Woodland Hills. Other large players include Wells Fargo & Co. and Countrywide Financial Corp.'s Full Spectrum unit.

Borrowers: The $140 billion subprime industry charges higher interest rates and fees because borrowers--many of whom are minorities and the elderly--have bad credit histories and therefore are higher risks.

Rates: Subprime lenders can charge up to 8 percent above the prevailing Treasury bond rate, bringing the total interest on mortgages to just over 12 percent, based on current rates. Because interest rates are at historic lows, many subprime lenders are recording record loan volume from homebuyers who wouldn't otherwise qualify for a mortgage.

California law bans 15 loan practices, including excessive prepayment penalties and unnecessary refinancing that strips borrowers of their equity, a practice known as "flipping."

Most laws also limit the fees and points that can be financed into the loan, which typically cannot exceed 6 percent of the loan's face value. Nearly all the laws ban the financing of credit life insurance, a staple of predatory lenders.

Voices

Wayne Stamm

President

U.S. Mortgage Fund, Fullerton

"The penalties for making a mistake are not that you get a slap on the wrist, but you get a lawyer who wants to strip you of every penny or put you in jail. It's a bad risk.

"California legislation has killed the secondary mortgage market except for the most elite borrower--those with perfect scores and no dings. But if you have any kind of issues, have been out of work, or have credit bruises, you can't get a second mortgage because they can't charge higher rates.

"No one has a problem with JC Penney charging 22 percent on credit cards; or auto lenders charging 15 percent or 20 percent on an auto loan. For subprime lenders, the fines are up to $15,000, five years in jail and revocation of your license. So people are getting out of it."

Brad Morrice

Vice Chairman, President, Chief Operating

Officer

New Century Financial Corp., Irvine

"We don't want to be in and out of markets. We're going to stay anyplace we can as long as we can, but we will be out of Oakland by Nov. 1. The average interest rate we charged in the third quarter is going to be 7.5 percent. We do not want to make any loan that is characterized as a high-cost under whatever definition a state or local agency comes up with.

"Rarely do we run into problems with the rate limitations--it's more likely to be the point and fee limitations, where it's more often a problem of what's included in that calculation such as fee paid to a broker, title insurance fees or prepayment penalties."

Steve Nadon

Chief Operating Officer

Option One Mortgage Corp., Irvine

"The advocates are well-intentioned but they are trying to craft legislation without taking the time to fully understand how this business actually works. As a result, if they craft legislation that is so poorly written that it shuts off the capital markets, it will stop the whole subprime sector. The secondary market is not going to buy the loans."