Predatory Lending and Mortgages: FAQs

In August 2016, the Connecticut Appellate Court released its opinion in Bank of America, N.A. v. Aubut, which recognized the predatory lending defense in Connecticut for the first time.

What is predatory lending?

For mortgage loans, predatory lending is when a lender makes a loan but doesn’t care about repayment. Under Aubut, a mortgage loan is predatory if the lender knew, or should have known, that it was destined to fail. In other words, if the lender had information showing that the risk of nonpayment was too big, the loan was predatory.

Whether the risk was too big depends on the borrower’s income, expenses, credit scores, and bankruptcies at the time of the loan. If the borrower’s income was too little to make the mortgage payments, the risk was plainly too big to take.

The risk was also too big if the income was enough for the mortgage payment but not for the borrower’s other expenses. If the borrower doesn’t have the money to pay everything, the borrower isn’t go to pay something. The “something” could be the mortgage.

Bad credit scores and bankruptcies increase the risk in a close case. They suggest that the borrower is prone to biting off more than he can chew. So even if the income and expenses suggest the mortgage is affordable, these facts may still make the loan predatory.

Why would a lender make a predatory loan?

A lender who plans to sell the loan has incentives to make a predatory loan. The incentives are the upfront costs that the originating lender charges at the closing. These include things like points, loan application fees and underwriting fees.

The originating lender gets to keep these upfront charges when it sells the loan. That’s how they make money – through the upfront fees, not from the interest you pay on the loan. Since the originator isn’t concerned about interest, it’s not concerned about repayment. That’s the buyer’s worry.

Why would the buyer buy a predatory loan? Because the buyer passes off the risk of nonpayment to investors through a mortgage securitization. With a securitization, the buyer deposits the mortgages into a pool. It then sells investors the right to receive a fraction of the payments on the mortgages in the pool. So it’s really the investors who assume the risk of nonpayment.

Why would the investors assume that risk? Opinions differ. But the root of the answer is that they didn’t know how risky the mortgages in the pools were. Some relied on others – rating agencies – to assess the risk for them, and the rating agencies didn’t do a good job. Others got caught up in the securitization frenzy and probably didn’t pay much attention to risk.

It was the securitization of predatory mortgages that led to the 2008 financial collapse. And that led to the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Does the Dodd-Frank Act prohibit predatory mortgage loans?

The Dodd-Frank Act and associated regulations prohibit predatory lending by requiring mortgage lenders to make an ability-to-pay determination. The Federal Register has an excellent explanation of how the Act and regulations accomplish this. In short, the lender must consider eight underwriting factors and use reliable third-party records to confirm the borrower’s information. If the lender fails to make an ability-to-pay determination or makes it improperly, it may be liable for damages.

Is predatory lending a defense to foreclosure?

Yes. A victim of a predatory mortgage can raise predatory lending as a defense to foreclosure under Dodd-Frank and Connecticut state law. But the effect of the defense is different under the two bodies of law.

Under Dodd-Frank, the defense reduces the amount owed on the debt by the damages the borrower would have been entitled to recover if it had sued (as discussed in the next FAQ). This probably won’t be enough to stop the foreclosure.

In Connecticut, the defense might prevent foreclosure. The Appellate Court has said that the borrower can raise the defense. But it did not say what happens if the borrower proves the defense. Since foreclosure in Connecticut is about equity – what’s fair – it seems there’s a good argument that it’s fair to bar the lender from foreclosing a mortgage that it knew or should have known the borrower couldn’t repay.

And, in Connecticut, it does not matter if it’s not the originator foreclosing. The defense is available against anyone who bought the predatory loan. This is because anyone who buys a loan buys it subject to any defenses that the borrower would have had against the originator. So, if the loan was predatory when originated, the defense is available against the party foreclosing, regardless of how many times the loan changed hands in between.

Can a predatory lending victim sue for damages?

Maybe. For loans made after the Dodd-Frank Act, the borrower can sue for damages. Under the Act, the offensive claim is available only against the originator. And in most cases the borrower must bring the claim within 3 years of taking the loan.

For loans made before Dodd-Frank, no Connecticut court has yet recognized an offensive claim of predatory lending. But “predatory lending” is really catch-all term for other claims challenging whether a lender should have made a particular loan. And Connecticut courts have recognized those other claims, at least in other contexts. So, while this could be problematic, it might not be insurmountable.

What does this mean for you?

If you’re facing a foreclosure lawsuit on a predatory loan in Connecticut, you might have a defense that could relieve you of any repayment obligation. If you’re not facing foreclosure but have been the victim of a predatory loan, you might have a claim for damages against your loan originator.