This memorandum represents the Division of Supervision and Consumer Protection (DSC) response to the draft report entitled, Challenges and FDIC Efforts Related to Predatory Lending (Assignment No.2005-023) (“Draft Report”) prepared by the FDIC’s Office of Inspector General (OIG) The objective of the OIG audit, started on March 2, 2005, was to determine challenges faced and efforts undertaken by the FDIC to identify, assess, and address the risks posed to institutions and consumers by predatory lending. The OIG also reviewed the efforts taken by the other federal banking regulators to address predatory lending.

     The Draft Report recognizes the significant supervisory challenges attendant to predatory lending and identifies certain characteristics that are potentially indicative of predatory lending activities. The Draft Report recommends that the FDIC 1) clarify its overall approach to predatory lending, and 2) review existing guidance to identify gaps in examiner coverage of predatory lending. DSC agrees with these recommendations and will develop an overall supervisory approach to predatory lending that will include a review of existing supervisory policies and practices. DSC will also review existing examiner guidance and, if necessary. develop additional guidance to address predatory lending. These actions will be completed by year end.

Overview

     The FDIC ensures that the 5,000 banks under its supervision engage in safe and sound lending, adhere to consumer protection laws, and invest in their communities. Predatory lending often involves both borrower deception and poor underwriting standards. The FDIC thus views predatory lending as a major consumer protection challenge and a significant safety and soundness concern. FDIC efforts to address predatory lending have been in place formally since 1999 and include: examiner guidance in both the risk management and compliance disciplines; enforcement policy; public policy advancement through speeches and testimony; and active financial education and other outreach activities.

Examination Guidqnce and Training

     Predatory lending is most often associated with abusive lending practices in the subprime mortgage market. In 2001, the banking agencies jointly issued Expanded Examination Guidance for Subprime Lending Programs. The expanded guidance which supplements previous subprime lending examination guidance issued in 1999, was developed to strengthen the examination and supervision of institutions with significant subprime lending programs. Moreover, this expanded examination guidance formed the basis of an interagency predatory lending examination strategy for risk management and compliance examinations. The FDIC took a leadership role to ensure the examination guidance distinguished between well-managed and responsible subprime lending programs and subprime lending programs that involved predatory practices. The examination guidance provides a usefu1 overview of the issue of predatory lending in the subprime mortgage market and reflects the approach of the agencies to the issue. It states, in part:

     In addition to the 2001 guidance, the FDIC has issued guidance on matters related to predatory lending, whether or not labeled as such.^{[ 1 ]} In 2004, to make certain that the industry understood our concerns, the FDIC and Federal Reserve Board jointly issued detailed guidance about how to avoid unfair or deceptive practices. And, in June 2005, the FDIC issued examination procedures intended to ensure that FDIC examiners have the tools necessary to evaluate compliance with the FTC Act.

     The FDIC has also recently worked closely with the other financial regulatory agencies to develop guidance for banks about non-traditional mortgage products. As the Draft Report recognizes, these products pose a supervisory challenge because they, “…may contain terms that are appropriate for some borrowers but predatory to others”.^{[ 2 ]} The proposed guidance addresses both safety and soundness and consumer protection concerns.

     Both compliance and risk management examiners at the FDIC have received training in the last several years on issues and activities associated with predatory lending. The training highlighted issues raised by consumer organizations, findings by several government studies, and unfair and deceptive practices found by the federal banking agencies. As a result of this training, examiners have a heightened awareness of predatory lending concerns and are prepared to address them by applying both consumer protection laws and safety and soundness standards. Additionally, in 2002, the FDIC established a Fair Lending Examination Specialist Program that assigned an expert Fair Lending Examination Specialist to each Regional and Area Office to assist compliance examiners in conducting fair lending examinations. These examinations include consideration of discriminatory lending and certain predatory lending activities, such as discriminatory pricing and steering.

Enforcement Policy

     The FDIC has vigorously enforced existing consumer protection and fair lending laws and regulations, including the Home Ownership and Equity Protection Act of 1994, the Truth in Lending Act, the Real Estate Settlement Procedures Act, the Fair Housing Act, the Equal Credit Opportunity Act, the Community Reinvestment Act, and the Federal Trade Commission Act (FTC Act). These authorities provide the FDIC with a range of tools to address predatory lending practices.

     The Draft Report states there is no universally accepted definition of predatory lending.^{[ 3 ]} In a report issued in June 2000, HUD and the Treasury Department explained that “…the predatory nature of many loans typically’ is not the result of a single term or characteristic, but a series of characteristics that in combination impose substantial hardship on the borrower”. ^{[ 4 ]} We agree with the Draft Report that identifying or recognizing predatory lending in a specific loan transaction can be a challenge because each loan transaction must be viewed in its totality, including the associated marketing practices, terms of the agreement, various parties involved in the loan transaction, and financial sophistication of the parties involved. As a result, there is no simple “checklist” to follow in identifying predatory lending.^{[ 5 ]}

     In view of this challenge, we agree with the Draft Report that Section 5 of the FTC Act is an important tool to use where otherwise lawful loan features are included in transactions in an unfair and deceptive way. These features include balloon payments, high loan to value loans, prepayment penalties, mandatory arbitration clauses, high cost ancillary products such as single- premium life insurance, and high cost fees financed into the loan. While subprime lending is a legal activity, some consumers accept subprime products because they have been misled about whether they qualify for products with prime rates and terms or about the features of the subprime loans. As the Draft Report states:

[T]he FDIC can rely on the FTC Act as authority for issuing enforcement actions against financial institutions for unfair, abusive, and deceptive acts or practices, which could include any or all of the characteristics potentially associated with predatory lending that our [OIG] research identified during this audit.^{[ 6 ]}

     Although the FDIC to date has not identified violations involving unfair or deceptive practices in mortgage lending by FDIC supervised institutions, we have taken enforcement action against institutions that violated the FTC Act in a different context involving other credit products. OIG staff reviewed compliance examination reports that documented our actions.^{[ 7 ]} The FDIC is prepared to extend enforcement of the FTC Act to mortgage lending.

Public Policy: Speeches & Testimony

     The FDIC has also made its concerns about predatory lending known in numerous speeches and testimony by FDIC officials since 2000. These include speeches before forums sponsored by the National Association of Affordable Lenders, the National Congress for Community and Economic Development, America’s Community Bankers and others, and testimony before Congress. These public statements of policy addressed the different types of predatory practices discussed in the Draft Report, in addition to others, and laid out strategies to identify and prevent predatory lending. The collected speeches and testimony provided guidance not only to the industry, but also communicated the FDIC perspective on predatory lending to examiners as well.

Financial Education

     In addition to our supervisory programs, the FDIC’s ongoing public awareness and education initiatives play an important part in combating predatory practices and complement our supervisory programs. As acknowledged in the Draft Report, the FDIC has long recognized the value of consumer education as an additional tool in combating predatory lending abuses. The FDIC’s award-winning Money Smart financial education program and the FDIC Consumer News play an important role in the FDIC’s efforts to provide helpful free information to the public, financial institutions and our examination staff.

     The FDIC’s financial education program is primarily focused on helping low- and Moderate-income adults develop money-management skills. Two versions are available for free- one for classroom use (in English, Spanish. Chinese, Korean, Vietnamese, and Russian), the other for computer-based, self-paced learning (in English and Spanish). Classes are offered through an extensive network of Money Smart “partners,” including financial institutions, non- profit organizations and government agencies. Since 2001, about 495,000 people have taken M oney Smart classes and 95,000 new banking relationships have been established.

     In addition. FDIC Community Affairs staff have hosted or participated in numerous anti- predatory lending conferences and forums that promote the use of Money Smart and other means to prevent predatory lending or correct its effects on low and moderate-income individuals and others.

Conclusion

     In summary, predatory lending harms individuals and communities and raises risk management and consumer compliance concerns for financial institutions. Predatory loans can have a negative impact on a bank’s Community Reinvestment Act evaluation. The loans may violate fair lending laws and other consumer protection laws, resulting in legal or regulatory action. Questionable loan underwriting and the risk of litigation raise additional safety and soundness concerns. For these reasons, the FDIC maintains a strong supervisory strategy developed over several years to combat predatory lending in the financial system through vigorous safety and soundness and compliance examination and enforcement, industry outreach and adult financial education programs. The development of an articulated overall supervisory approach to predatory lending, based on a review of existing supervisory polices and practices that address predatory lending, as recommended by the OIG Draft Report, will enhance the FDIC’s efforts in this area. We will complete this task by year-end.

OIG Recommendation

“Describe in policy the FDIC’s overall supervisory approach to predatory lending.”

DSC Response

     The FDIC agrees that it will be beneficial to articulate an overall supervisory approach as stated above to address any predatory lending practices that FDIC examiners may find. By year- end, USC will develop a formal policy statement describing its approach to combating predatory lending.

OIG Recommendation

“Review existing examiner, financial institution, and consumer guidance and determine whether additional guidance is needed to address predatory lending.”

DSC Response

     The Draft Report suggests that we consider the approaches of the other agencies. The supervisory approaches of the OCC and OTS to predatory lending are based, in large part, on their authority under the National Bank Act and Home Owners Loan Act to supervise institutions pursuant to federal law. The FDIC has worked closely with state supervisors to take action to address activities that violate state anti-predatory lending laws. As explained above, the FDIC has also required banks subject to its supervision to correct unfair and deceptive acts or practices under the FTC Act and disengage from unsafe or unsound lending practices.

     The Federal Reserve Board, which also works with state authorities, mentions predatory lending as a potential risk to be considered when evaluating reputation risk during examinations, FDIC examiners undertake a similar risk assessment, although the guidance does not use the phrase “predatory lending.” Under the FTC Act examination guidance issued in June 2005, FDIC compliance examiners must consider the risks for unfair or deceptive acts or practices when they develop a risk profile for an institution. To assess this risk, examiners evaluate: consumer complaints received by the bank or the FDIC; whether the bank’s product lines are high risk; the quality of the bank’s compliance management system; and the bank’s past performance.

     We will carefully review any overall supervisory strategy in use by the other agencies with an eye to enhancing the FDIC’s strategy as the OIG suggests. By year-end, DSC will complete the recommended review and determine whether any new or enhanced policy or guidance is necessary in light of the strategy statement developed in response to Recommendation 1.