Preserving the American Dream: Legislative Recommendations to Protect Future Borrowers in California

[courtesy of California Progress Report]

Last of a Three Part Series

Testimony of Paul Leonard
California Office Director
Center for Responsible Lending

Before the California Senate Banking Committee
August 21, 2007

California appears to be following the federal regulators in establishing new lending standards for subprime loans. Other states have shown much greater leadership in both establishing tougher lending standards and in strengthening procedures to rein in deceptive practices of brokers and lenders. Much stronger legislative action is needed to ensure that subprime borrowers get access to responsible credit that provides sustainable homeownership opportunities.

1. Ban Prepayment Penalties on Subprime Loans

Prepayment penalties are minimally addressed in the subprime statement, requiring only a grace period of 60 days before payment reset, during which a borrower must be able to refinance without paying a prepayment penalty.

Subprime prepayment penalties provide no economic benefit to borrowers. Some lenders have claimed that homeowners receive a lower interest rate in exchange for prepayment penalties, but subprime lenders’ rate sheets tell a different story. Subprime rate sheets show that when borrowers get loans with prepayment penalties, mortgage brokers are allowed an extra commission known as a “yield spread premium.” Prepayment penalties can cost borrowers thousands of dollars if they pay their loan early, and yield spread premiums increase the costs of the loan as well.

In fact, prepayment penalties serve to trap borrowers in high cost loans, or cause the borrower to lose significant home equity in order to escape them. They also limit the ability of responsible lenders to help borrowers refinance out of a loan at risk of ending in foreclosure.

Today prepayment penalties are imposed on about 70 percent of all subprime loans, (See, e.g. David W. Berson, Challenges and Emerging Risks in the Home Mortgage Business: Characteristics of Loans Backing Private Label Subprime ABS, Presentation at the National Housing Forum, Office of Thrift Supervision (December 11, 2006). According to MBA data, there was a 69.2% penetration rate for prepayment penalties on subprime ARMs originated in 2006. Doug Duncan, Sources and Implications of the Subprime Meltdown, Manufactured Housing Institute, (July 13, 2007) A recent CRL review of 2007 securitizations showed a penetration rate for prepayment penalties averaging over 70%.) compared to about 2% of prime loans. (See Berson, supra note 68. A recent MBA analysis shows that 97.6% of prime ARMs originated in 2006 had no prepayment penalty, and 99% of 2006 prime FRM had no penalty. Doug Duncan, Sources and Implications of the Subprime Meltdown, Manufactured Housing Institute, July 13, 2007)