Predatory Lending and Housing Disinvestment

Abstract

This paper develops a model of predatory lending within the context of refinance mortgages. The primary objective is to determine analytically the extent to which predatory lenders may decrease home equity in the refinance mortgage market. The model characterizes an individual borrower's decision to refinance or not refinance, and with whom to refinance. There exist two types of refinance applicants - prime and subprime, and three types of lenders - prime, good (i.e. non-predatory) subprime, and predatory subprime. Applicants cannot distinguish with certainty a legitimate lender from a predatory lender; they infer a lender's type via a signal. Predatory lenders are distinguished from legitimate lenders by higher lending costs and their attempts to misrepresent themselves as good subprime lenders. The model is able to address questions concerning the most desirable structure of policies designed to lower the prevalence of predatory lenders and to improve consumer awareness of predatory practices. In particular, it shows that both types of policies can experience diminishing returns, and that effective policies to combat predatory lending will be most effective when they aim to achieve both goals. In addition, policy simulations are conducted that estimate the expected change in borrower equity effected by changes in policy parameters representing the level of intensity in predatory lending and the degree of successful predatory lender deception. Using reasonable parameter values, the simulation estimates a potential annual loss in homeowner equity resulting from predatory lending of more than $9 billion.

Keywords: discrimination, predatory lending, mortgage, wealth

JEL Classification: D82, G21, R00