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Cleaning up a consumer lending mess

WHEN THE CEO of HSBC, one of the world's largest banks, and legal aid attorneys who represent poverty-stricken Americans find something to agree on, it is no small event. Recently, CEO Michael Geoghegan explained that massive losses in HSBC's home mortgage lending business were caused by the mistake of "going for volume." The nation's legal aid attorneys have a different description. They call it predatory lending. Investors forget that for every "bad" loan in their portfolio, there is a family facing foreclosure on the other end. Indeed, last month Massachusetts broke an all-time record with lenders notifying 2,207 families of impending foreclosure -- nearly double this time last year.

HSBC and other players in the risky subprime mortgage business forgot their loans must eventually be repaid. Now these companies are slashing employees, folding up branches, and going out of business. Financial analysts describe this process as a "weakening" in the market that provides home equity and refinance loans to risky borrowers. This is just a polite way of saying that lenders got too greedy.

More than 30 states have passed some form of legislation attempting to discourage a variety of harsh mortgage terms such as inflated closing costs, penalty interest rates, prepayment penalties, balloon payments, broker kickbacks, and garbage credit insurance policies. Although well-intentioned, these statutes are frequently riddled with exceptions and loopholes, and -- at least according to banking industry lawyers -- do not apply to banks with federal charters, like HSBC.

No doubt much of the bout of pain in mortgage lending is due to the slowdown in real estate sales. As home prices have stagnated, lenders can no longer refinance bad loans with closing costs paid out of home equity created through appreciation in home values. But it is not like the slowdown in the real estate market should have surprised anyone -- especially mortgage lenders.

Poor performance in subprime mortgages is also linked to structural changes in the mortgage business. To see the change, policy makers should no longer picture subprime creditors as "lending" their own money. Rather, these businesses have become loan manufacturers. They produce loans for a fee, repackage them into large trusts, and then sell income from those trusts to investors. In one way or another, the individuals on the front lines of the subprime mortgage lending are compensated by commissions earned from volume rather than loan performance.

In the worst cases, businesses that sold ill-advised loans to investors were paid long ago, and now can declare bankruptcy, leaving investors with not only losses, but thousands of potential lawsuits filed by families who are learning their loans may have been illegal from the beginning.

It is time to re think national credit policies. Leaders should learn at least three lessons from the latest shakeout in the mortgage lending business.

First, consumer protection laws not only protect borrowers, but also the economy. The laws are designed to prevent "weakening" markets by helping consumers make good decisions. However, they should be updated to reflect new market realities, close loopholes, and equally cover all types of businesses.

Second, it is time to hold middlemen responsible for transferring ill-advised loans from unsuspecting borrowers to unsuspecting investors. Investment bankers, mortgage brokers, and mortgage loan pool trustees all have the opportunity to weed out problem loans before they are sold to investors. Too often these companies aid and abet the fleecing of poor borrowers. Third, waiting will not make this problem go away. Eventually the housing market will stabilize, but the structural and legal reality that facilitated the current subprime lending mess will not change until the government acts. We need rules that compel transparency, sound underwriting, and fairness at every level of the mortgage lending business. A step in the right direction would be the creation of a national advisory group tasked with drafting comprehensive consumer credit reform. This advisory group would do well to pay attention to the legal aid lawyers.

Christopher Peterson is an associate professor of law at the University of Florida.