Subprime lenders under fire: does the NAACP have a viable case?

THE CHARGES ARE SERIOUS AND THE legal complaint doesn't mince words. In July, the NAACP filed a lawsuit charging a dozen lenders with "institutionalized systematic racism." This comes as the subprime mortgage crisis heats up--with 2 million foreclosure filings expected this year--which has led several major lenders and two billion-dollar hedge funds to file for bankruptcy protection. Daily developments related to the subprime meltdown increased volatility in the stock market, leading to a string of triple-digit swings in the Dow Jones industrial average.

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"It's important to us as an organization," says Angela Ciccolo, interim general counsel for the NAACP in Baltimore, "because when our community pays higher rates of interest for a home, that's money that can't be spent on college education, business development, or other costs of living." The NAACP's primary assertion is that in 2004, African American homeowners who received a subprime mortgage from the defendants were more than 30% likely to be issued a higher-rate loan than white borrowers. The lenders named in the suit include Accredited Home Lenders Inc., Ameriquest Mortgage Co., BNC Mortgage Inc., Citigroup Inc., Encore Credit, First Franklin Financial Corp., Fremont Investment & Loan, HSBC Finance Corp., Long Beach Mortgage Co., Option One Mortgage Corp., Washington Mutual Inc., and WMC Mortgage Corp.

The rise in the number of subprime foreclosures stems, at least in part, from the fact that most of these loans are adjustable rate mortgages and many borrowers are just now facing their first interest rate reset. Such loans often offer low teaser rates up front. "The rate could be 6% or 7% on the front end," says Keith Corbett, executive vice president of the Center for Responsible Lending in Durham, North Carolina. "Then in two or three years, that rate could go as high at 12%. And in most cases, it did."

To document widespread lending disparities, the NAACP cites several studies, among them, the recent findings of two nonprofits: the Center for Responsible Lending and the National Community Reinvestment Coalition. Both organizations found that African American borrowers were more likely to receive higher-cost loans, even when income and credit risk were accounted for. Perhaps most notably, the Center for Responsible Lending found that 52% of the loans made to African American borrowers in 2005 were higher-cost subprime loans, compared to 19% for white borrowers.

The complaint was filed as a class action and the NAACP is in the process of identifying individual plaintiffs to represent the class. Ultimately, the courts will decide if the suit can properly be brought as a class action--the individual's claims must be typical of the group as a whole and there must be some common defenses for the defendants. Some legal experts feel that this may be a challenge for the NAACP. "Frankly, it will be very hard for a court to frame injunctive relief under the very broad mandate that they are seeking," says John Coffee, a professor at Columbia Law School in New York City. "This is likely to become a battle of statistical experts."

Among the defendants, Citigroup has been dismissed from the lawsuit without prejudice. "Citi wants to show us what they have done, and we're going to give them an opportunity to do that," says Ciccolo, noting that Citigroup could be brought back into the suit if the NAACP believes further actions are necessary.

Most of the defendants declined to comment on the pending litigation or reasserted their commitment to fair lending. However, William Halldin, a spokesman for First Franklin Financial Corp., a subsidiary of Merrill Lynch Bank & Trust Co., says that it has a proven history of providing credit to minorities and was likely to seek a dismissal. "The complaint contains no factual allegations regarding First Franklin's actual practices," he says.

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Another defendant, Fremont Investment & Loan, had previously received a cease and desist order from The Federal Deposit Insurance Corp., which asserted that the bank was operating without effective risk-management procedures. Without admitting or denying the allegation, Fremont consented to the order. Fremont has since stopped offering residential mortgages and plans to exit that business.

To fully understand the subprime mess, it's important to look at how this situation came about. The growth of subprime lending was fueled by deregulation of the banking industry. One of the key drivers came in 1980 when Congress passed the Depository Institutions Deregulation and Monetary Control Act that, under certain circumstances, removed state interest rate caps for home mortgages. Part of the rationale was that allowing lenders to charge higher interest rates would provide them with more appropriate compensation for lending to higher-risk borrowers.

In the early 1990s, Congress enacted the Home Owners Equity Protection Act, which restricts the terms of certain high-cost loans--for instance limiting when a borrower can be charged a penalty for repaying a loan early. But it is widely accepted that this law is grossly inadequate. Such penalty charges are intended to compensate the bank for the loss of interest income. And because subprime borrowers have every incentive to refinance at a better rate, many of their mortgages carry such penalties. The prevalence of such terms is part of why some say there aren't enough consumer protections. While some states have enacted stronger protections on such penalties, for example, Congress has not yet acted to strengthen the act's rules on the same topic.

John Taylor, president and CEO of the Washington, D.C.-based National Community Reinvestment Coalition, blames the slack enforcement of existing laws. For instance, it's illegal to use race as a factor in lending decisions but enforcement depends on loan examiners making referrals to the Justice Department when they spot a discriminatory practice. "Two of the four [federal enforcement] agencies, the Office of the Comptroller of the Currency and the Office of Thrift Supervision, made zero referrals in 2006," says Taylor. "This is a year that was rich with high-cost, exotic, nontraditional mortgages that have gotten a lot of people into trouble, disproportionately African American."

The NAACP's lawsuit is just one of many public actions being taken in response to the rising foreclosure rate, and expectations are that more lawsuits will follow. In the interim, Congress is debating mortgage lending reforms, as are various state legislatures.

In Ohio, which, according to the National Delinquency Survey from the Mortgage Bankers Association, had the highest number of foreclosures in 2005 and 2006, Attorney General Marc Dann is pursuing a range of criminal investigations and civil remedies. "We have literally thousands of Ohioans who have been defrauded by people who were offering mortgages that were too good to be true," says Dann. But he doesn't believe that the mortgage lenders are the only culpable parties. "A lot of people profited handsomely from this--the investment bankers, the bond rating agencies, the loan servicing agencies--and at some point I think there ought to be some accountability."

But experts stress that despite all the negative press it's important to remember that subprime loans play an important role. Individuals who have tarnished credit should still be afforded the opportunity to own a home and access the wealth building advantages that it provides. As Taylor of the NCRC summarizes: "It's in all of our interests--whether it's African American, Latino, Asian, or white--that we have more homeowners who have more of a stake in the community."

Additional reporting by Cliff Hocker

EDITED BY NICOLE MARIE RICHARDSON: [e-mail] 

HIGHER COST LOANS AND
SUBPRIME FORECLOSURE
IMPACT BY RACE/ETHNICITY

              % of Total        2005            %
               Loans to       Projected     Borrowers
             Racial/Ethnic   Foreclosure   Affected by
                Groups          Rate       Foreclosure

African           52%                          10%
American

Latino            40%         x 19.4% =        8%

White             19%                          4%
Non-Latino

SOURCE: CENTER FOR RESPONSIBLE LENDING