Hunton Andrews Kurth LLP
  August 24, 2007 - Virginia

The Law of Unintended Consequences
  by John D. Burns

It is a given that any human endeavor will have effects that we do not expect. Robert Burns identified the problem with the best-laid schemes of mice and men, and investors in the mortgage banking industry are learning that lesson now.

In recent years, many borrowers entered into adjustable-rate mortgages with low initial rates, trusting that rates would stay low or that they could refinance or sell a property before larger payments came due.

In many cases, it was a bad bet, particularly in California, Florida and other “bubble” markets where borrowers currently are faced with a lethal combination of increased rates, higher monthly payments, and plummeting home prices.

These effects are especially true in subprime mortgages, where borrowers with riskier credit profiles saw the opportunity to purchase a home and took advantage of low rates and incentives.

With faltering home values, many of these borrowers now find themselves paying more than they expected for a home that no longer is worth what they are paying for it, and a credit industry that is far less willing to lend money to marginal credit risks than it was two years ago. The unfortunate result often is foreclosure.

Foreclosures, in turn, are having their own unintended consequences. With the bankruptcy of New Century Financial Corp. — one of the country’s largest mortgage providers — the enormous scope of the problem became clear. Many institutional investors hold significant stakes in mortgage-backed securities. As more borrowers default, those securities lose value, much to the chagrin of investors who had grown accustomed to double-digit returns.

Unsurprisingly, investors now are selling — and suing — and the unintended consequences are spreading further. According to a recent New York Times article, Bear Stearns Cos. recently bailed out one of its hedge funds to the tune of $3.2 billion to protect investors from the effects of the faltering subprime market.

Another Bear Stearns hedge fund holds $6 billion in equally risky investments. Wall Street waits breathlessly for the most recent mortgage performance numbers to see if and when that other shoe might drop.

Politicians are priming the pumps for statutory and regulatory solutions to the crisis, attacking the “predatory” lending tactics that some contend led the industry to its current situation.

It’s a given that something is out of kilter, and everyone — from struggling borrowers to the deepest pockets on Wall Street — is seeking a solution. While the urge to do so is understandable, such action should not be taken without comprehension of what Robert Burns picked up on so many years ago: In trying to fix the problem with even the best-laid schemes, we could end up making it worse.

The trouble lies in the tendency to muddy the important difference between subprime and predatory lending. In short, subprime describes a market, while predatory describes behavior. Subprime lenders extend credit to borrowers who do not qualify for the loans that less-risky mortgagors can obtain. In return for assuming a higher risk of default, such lenders charge higher rates and exercise tighter loss-prevention controls.

As long as all is above-board and consistent with the law, this is a legitimate part of the economy. Subprime lending provides capital to an underserved segment of the market that otherwise might not have access to necessary funds. Predatory lending, on the other hand, is unlawful behavior, including usurious interest rates, unreasonably high prepayment penalties, loan flipping, misrepresentation of terms and other unfair conduct.

Predatory lending takes advantage of the borrower. It is decidedly not acceptable, and in the long run can worsen the borrower’s situation, leaving him deeper in debt and more vulnerable than he was when he sought the loan. In taking aim at predatory lending — and those who profit from it — we should take care not to destroy what is left of the subprime market.

As seen by the struggles on Wall Street, the market is punishing those who took the chance that previously high subprime returns would continue. In response, credit providers already are tightening the reins. Regulatory steps that further discourage investment in legal subprime lending will have more unintended consequences, potentially worsening the credit crisis for the very people we otherwise seek to help.

John D. Burns is an associate with the law firm of Hunton & Williams, Raleigh. His practice focuses on financial services litigation, creditors’ rights in bankruptcy and general commercial litigation. He can be reached at (919) 899-3055 or [email protected]