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Hard Sell – Part II: The Subprime Lending Industry: Explosion and Retreat

Hard Sell – Part II: The Subprime Lending Industry: Explosion and Retreat

The Hard Sell: Combating Home Equity Lending Fraud in California

Executive Summary
Part I of this Report
Part II of this report
Part III of this report


The Subprime Lending Industry:
Explosion and Retreat


When Consumers Union published Dirty Deeds: Abuses and Fraudulent Practices In California’s Home Equity Market in 1995, we were aware that every case study featured a problem loan issued by a subprime lender. However, at that time, subprime lenders constituted just the "fringe" of all lending possibilities. Since 1995, the subprime lending industry has experienced an explosion and subprime lending has become more mainstream than ever. Those in the industry believe this expansion is a good thing for the public because they have made credit available to more people. Regulators, legislators and consumers advocates believe that this expansion will lead to greater abuses of the typical subprime borrower. In recent testimony given to the U. S. Senate Special Committee on Aging, the Federal Trade Commission concluded, "The Commission recognizes that abuses in the home equity lending market are a serious national problem. Due to sharp growth in the subprime mortgage industry, it appears that the abuses by subprime lenders are on the rise (28)." Here, we will take a closer look at the forces which drive this industry and the subprime lending connection to loans which consumers allege are costing them their homes.


According to the American Banker "more than $100 billion of mortgage loans [are] made annually to people with tarnished credit histories (29)." The subprime lending industry flourishes where there are people without credit histories and where there are those who are turned down for conventional loans from conventional lenders. While many might view the increase in the number of personal bankruptcies as an economic tragedy, this same phenomenon creates opportunity for the subprime lending industry. It was reported that "a well-known economist who tracks automobile sales predicted at year-end that some 1.1 million households will have declared bankruptcy in 1996. ‘That’s not all bad,’ he said. ‘It means 1.1 million more subprime borrowers.’ (30) " Unfortunately, many in the industry thrive on borrowers who don’t know that they may qualify for a better deal elsewhere and sign on the dotted line for a loan that gives them less value than they deserve.

One of the most compelling characteristics about subprime loans is that the majority of these loans are legal. Although these loans typically involve exorbitant interest rates and fees, this does not necessarily make them illegal because there is no ceiling on interest rates or on points or fees that a lender can charge a borrower. With the exception of those home-secured loans subject to the federal high-cost mortgage act (HOEPA) (31), balloon-payment loans (32) are not illegal, either. Even so, subprime loans don’t always add up to a good value for consumers. Many homeowners have lost their homes because of technically legal but unfair and impossible-to-repay home equity loans.

Subprime lenders typically market their generally expensive loan products to individuals who do not qualify for credit from mainstream sources such as banks, and to those who are least likely to find out if they do qualify for better credit rates from another lender. Many individuals who borrow from subprime lenders do so because traditional credit sources are absent from their communities. In those communities, check cashers and subprime lenders have proliferated in the vacuum left when mainstream financial institutions abandoned those areas.

Subprime lending is a very brisk business. According to the Wall Street Journal (33) "last year, lenders made about $120 billion in subprime-mortgage loans." There is a lot of money to be made in charging high origination fees and interest rates to people who may be desperate for a loan either because they can’t or think they can’t get a loan elsewhere. The subprime lending business is also known for engaging in aggressive marketing efforts to convince homeowners who may otherwise have no interest in a home equity loan, to sign up for one. The bottom line with subprime lending is that those who have less (either less access to credit or fewer options) will pay more for less.

Several factors have contributed to the rapid growth of the subprime lending industry. Many subprime lenders went public and offered their stock for purchase through initial public offerings. In 1996, 12 companies went public (34). Many of these companies were considered to be good investments, promising stockholders better-than-average returns on their investments because they have been so profitable. Stock purchases provided capital to develop infrastructure that allowed for rapid expansion into the marketplace. One example is CRI Mortgage, Inc. which on January 23, 1988, reported a loan origination increase of approximately 385 percent in the second half of the year following an initial public offering in June 1997. "In 1997 it funded more than $70 million in subprime mortgages . . . . compared with about $14.6 million in 1996. (35)"

Subprime lending is a lucrative business. Industry publications frequently call subprime lending one of the fastest-growing areas in the mortgage lending business. According to a 1997 article which appeared in an industry journal, "The largest factor in the growth of the subprime market is the ever-increasing prevalence of credit card and other unsecured debt that enables many consumers to get in over their heads. " (36) To the extent that lenders pursue this market and put people into very high-cost loans that they cannot afford, subprime lending may be riskier than most conventional lending but the potential payoffs to the lender more than make up for the risk. The lender can profit handsomely from loan origination fees and hefty interest rates, and borrowers are often locked into those loans by high pre-payment penalties which make refinancing financially disadvantageous. Also, there is evidence that low-income consumers may in fact be less risky because they default less than upper-income consumers for purchase money loans, and when given the opportunity for homeownership go to great lengths to keep their homes. (37)

Borrowers with perfect credit usually earn an "A" credit rating which qualifies them for the best loans on the most favorable terms. However, as competition for "A" rated borrowers heated up, profit margins for "A" lending diminished for many conventional lenders. More "A" lenders began pursuing the subprime market to compensate for these losses. Also, realizing the potential for substantial profits, larger enterprises began entering the subprime market, each striving to increase its share of the lucrative subprime pie.

For example, recognized as one of the top lenders in the subprime lending field, the Money Store (38) has led the pack in origination of subprime loans. In an effort to duplicate the success of the Money Store, in 1995, Norwest Mortgage Inc., sought to become a dominant player in the subprime lending industry through its subprime lending division called Directors Acceptance Corp. By 1996, it sought to triple its loan volume to $500 million in three years to put itself on par with the Money Store. At that time, Norwest believed it could reach its goal "by tapping Norwest customers who were turned down for conventional loans." In fact, Norwest had rejected over 30,000 mortgage loan applications, many from potential subprime borrowers. Judith Barry, the then-newly appointed Director of Director’s Acceptance Corp., correctly remarked, "That’s a lot of potential for a subprime lender."(39) One regulator interviewed for this report pondered whether borrowing can be a two-way street when a lender has both a prime and a subprime division such as Norwest. Certainly those who don’t qualify for a conventional loan will be referred to a lender’s subprime division. But will the industry practice be to refer customers away from the subprime division when borrowers qualify for conventional loans, particularly because subprime loans lead to greater profits for the lenders? The answer to this question becomes a larger concern as more large lending institutions acquire subprime subsidiaries or develop subprime divisions.

At the peak of the subprime industry explosion, The American Banker reported in May 1997 that "Everything in the subprime lending industry is more extreme than banking: Profit margins are larger, fees are steeper, collecting is harder–and regulations are much looser." (40) Its examination of some subprime industry executives illustrates that those in charge may verge on the extreme in their attitudes about the subprime industry’s place within the broader lending industry. For example, Paul Mondor, Director of Regulatory Compliance for the Mortgage Bankers Association, commented, "It’s a high-risk, high-return market. . . . It stands to reason you’ll have flashier types who worry less about bending the rules."(41) Dan Philips, the Chief Executive of FirstPlus Financial of Dallas, a company that is known for going out on a limb, even by industry standards, compared bankers with subprime lenders. "Bankers are really accountants who make loans," Mr. Philips said. "On this side of the industry, you eat what you kill." (42)


Regulatory Red Flags: Shortly after subprime lending hit its peak, the Federal Deposit Insurance Corp. (FDIC) dealt a blow to the subprime lending industry. In May 1997, it became the first agency to warn the 6,500 state-chartered banks it oversees against the risks posed by subprime lending—including home equity loans. This action was a signal that subprime lenders were putting too many consumers in over their heads and that this could cause great instability for state-chartered banks. The American Banker reported that "FDIC Director of Supervision Nicholas J. Ketcha Jr. said subprime lending had produced ‘substantial losses that have a pronounced negative impact on the overall financial condition of some institutions." (43) In spite of subprime lending producing good returns and hefty servicing fees, Mr. Ketcha warned, "this profit potential is accompanied by significant risks. The No. 1 danger is default, he said." (44)

Default levels were substantial enough to capture the agency’s attention and to generate serious concern. It was reported that in some instances "Foreclosure rates are hitting 30% or more at some financial institutions. . . . That’s a huge number," (45) according to Mark Schmidt, an Assistant Director in the FDIC’s Supervision Division.

The FDIC warning covered many aspects of subprime lending, not just direct loans to borrowers. It extended to: purchasing subprime dealer paper or loans acquired through brokers; lending to finance companies involved in the subprime market; participating in loan syndications that provide credit to subprime companies; and buying asset-backed securities issued by subprime lenders. (46)

Increasingly, regulatory bodies have been coming out in favor of upholding and enforcing consumer protections. For example, last December, Massachusetts Bank Commissioner Thomas J. Curry, in an attempt to quash any temptation of not-so-reputable lenders to exploit the vulnerable, issued a warning to state-chartered lenders that his agency was carefully scrutinizing their lending practices. "‘The division has zero tolerance for unsafe or unsound lending practices, violations of consumer protection laws and regulations and discriminatory or unfair acts and practices,’ Curry said in a letter sent to all state-chartered mortgage lenders, mortgage brokers, credit unions and banks." (47)

In January 1998, in a show of increased enforcement efforts, the Justice Department and the Federal Trade Commission announced they were investigating "alleged abuses in the booming businesses of home-equity and subprime mortgage lending." (48)

The Civil Rights Division of the Justice Department is investigating cases where borrowers are targeted because of their race or age, and other areas of violation. Joan Magagna, Acting Housing Chief for the Justice Department’s Civil Rights Division said, "We have active investigations underway in lending discrimination, and the issues we are addressing include discrimination in underwriting, marketing and pricing of loans." (49)

Currently, the cases under investigation by the Department of Justice are in Georgia, New York, and the Midwest. Although the agency was not at liberty to discuss where it might expand its investigations, the kinds of practices raising the interest of regulators appear to be the very same kinds of practices that have created cases of home equity lending fraud and abuse in California.

Also reported in the same article, the FTC’s Consumer Protection Unit "has a formal investigation underway of mortgage lenders in several parts of the country," according to FTC Chairman Robert Pitofsky. The unit is investigating alleged consumer fraud, unfair debt-collection practices, and deceptive lending.

One named target of this investigation is Capital City Mortgage, a Washington DC-area lender accused of illegal practices that have allegedly forced borrowers out of their homes. The FTC lawsuit against Capital City Mortgage alleges violations of important consumer protection laws covering fair debt-collection practices and the Truth-in-Lending Act. The FTC seeks civil penalties and restitution. Some of the most critical allegations include elements that we commonly see in California cases, such as home equity loans set up as interest-only, and non-amortizing balloon-payment loans where the borrower still owes the entire principal amount at the end of the loan. The FTC also alleged that loans were based on the value of the homes rather than the borrower’s ability to repay the loan.

Once again, although the FTC would not divulge the identities of other companies or localities under investigation, the types of practices they are examining bear the usual hallmarks of California home equity lending fraud and abuse cases. It is our hope that the FTC is probing lenders who subject California homeowners to similar predatory lending practices. Certainly, California homeowners are not strangers to the kinds of practices that have captured the interest of federal regulators.

In addition to its investigation into the subprime lending industry, last year the FTC stepped up its enforcement efforts by conducting six workshops around the country to train state regulators and law enforcement about enforcing the provisions of the Home Ownership and Equity Protection Act (HOEPA).

Federal Legislative Scrutiny: Most recently, predatory home equity lending practices captured the attention of the United States Senate. On March 16, 1998, Senator Charles E. Grassley (R-Iowa), Chair of the Senate Special Committee on Aging, held hearings to educate the public, especially those most vulnerable to predatory lending, on how to avoid becoming victims. One of the most chilling pieces of testimony offered at the hearing came from a former employee of a lending company who "provided . . . a detailed account of how he lured non-English speakers, racial minorities and the elderly into signing away their homes by taking on big loans that promised low monthly payments." (50) This man’s testimony reinforced the warning Consumers Union has already issued regarding home equity lending: Homeowners who are equity-rich but cash-poor need to beware of companies that offer to refinance existing loans or offer financing for home improvements. Equity-rich but cash-poor homeowners are the types of people who are often victimized by home equity lending fraud and abuse.

Intra-Industry Scrutiny: Regulators, law enforcement and consumer advocates aren’t the only ones noticing what is happening in the subprime lending industry. A New York-based mortgage lender, Michael Moskowitz "says he has a hard time finding an audience to listen to him rant about his favorite subject: cleaning up the subprime mortgage industry." (51) Mr. Moskowitz has focused his efforts on persuading two New York City tabloids, the Post and the Daily News, to be more vigilant of misleading and deceptive mortgage broker ads appearing in those publications. Although Mr. Moskowitz has a business interest in questioning mortgage lender ads, as he himself advertises his mortgage lending services, he is doing more than most industry insiders to add integrity to the customer solicitation process. Often, the first point of contact the lender has with the customer is through an advertisement. Many unsuspecting homeowners are lured into impossible-to-repay loans through misleading and deceptive advertisements designed to capture their business. In this story, Mr. Moskowitz recounted the terms of a loan he considered to be unconscionable. A West Coast "D" credit lender had charged over $14,500 in origination and processing fees — for a $74,000 loan to a New Jersey-based borrower now in foreclosure on the loan. The origination and processing fees totaled 19 points. About this loan, Moskowitz commented, "That’s not American—ripping off someone who’s blind, who’s black, whose mother’s dying, . . . I don’t think that’s free enterprise." (52)

Other factors contributing to the slowing of the "explosion" include increased competition resulting in lower (not necessarily low) profits for lenders, and a changing perception about what it means to be in debt. Over the last few decades, the American perception about large debt has shifted from "shameful" to "it’s just a way of life." "As a result of a greater acceptance of large debt, loan delinquencies and personal bankruptcies are on the rise nationwide. American consumers are carrying about $1.2 trillion in installment debt, up about 50 percent from four years ago." (53)

While there are reports that lenders are increasingly meeting the credit needs of the "B" and "C " market, thus increasing credit-borrowing opportunities, this subprime market is also providing opportunities for exploitation. This is especially prevalent in the "D" market. A typical "D" borrower is someone who has just completed Chapter 7 bankruptcy, or is currently in foreclosure, or who has an extremely blemished credit history. "D" borrowers will pay the most for credit. Lenders say that this is to compensate for the increased risk of such a loan. Lenders often say that they are in the business of giving "D" borrowers a second chance. Unfortunately, there are some lenders who charge fees and interest rates to "D" borrowers that go way beyond compensation for the perceived added risk. In many cases, "D" loans end up being loans with a small principal amount, topped with exorbitant interest rates and fees, with impossible terms that set the borrower up for failure. In the end, the lender will own the property. "The point of subprime lending is to get borrowers into a better category. . . Once they prove themselves, they can refinance at better rates," (54) said Deborah Campbell, a Vice-President with Conway Financial Services. We agree that this should be the goal of subprime lending. Unfortunately, that goal is not translating into actual practice in many instances. It is this unfortunate reality that has caught the attention of regulators throughout the country.

The subprime lenders say that they help borrowers, and consumer advocates say that some borrowers are seriously harmed by subprime lending. This is the crux of the controversy between the industry, which advocates for fewer restraints on what it often refers to as "free enterprise," and consumer advocates, who recognize the serious need for regulatory control and intervention to protect the public.

Why do the poor continue to be the targets of those lenders of last resort? Regardless of the market conditions, low-income borrowers are notoriously saddled with the stigma of being poor credit risks and will continue to pay more, even when they are creditworthy and could qualify for a competitively priced loan. (55) Those who may actually have less than stellar credit will continue to be at the mercy of those lenders who will take advantage of their desperation and charge them more than what the lender really needs to protect itself from any increased risk. It is in this arena where the underbelly of subprime lenders, the "predatory lenders," dwell. Predatory lenders will continue to target low-income borrowers with fewer options because the thin veneer of giving someone a "second chance" while setting them up for failure might be more readily apparent to borrowers with more options and borrowing experience.


As competition has increased in subprime home equity lending, in order to gain a market share, some supbrime lenders have moved into higher-risk products that few other lenders offer. One of these products is commonly known as a "no-equity loan" or a "125 percent LTV (loan to value) loan." Another novel but potentially dangerous subprime lending product is a home-secured credit card that ties all purchases on the card to a borrower’s home equity. In this section, we explore the consumer implications of both of these products.


No-equity loans first appeared on the market in 1995 and their popularity with lenders and borrowers has steadily increased since that time. Touted as "what could be the hottest mortgage product of 1997," (56) No-equity loans allow homeowners to borrow more than their home is worth — up to 125 percent of value. In December 1997, it was reported that "some [lenders] have upped the ante to 135 percent and even as high as 150 percent."(57) In 1997, Scott Peterson, Vice-President of Moody’s Investor Service, estimated that "nationwide, the volume of no-equity loans is expected to double this year over last to an estimated $8 billion. A lot of lenders are marketing this as a substitute for credit-card debt." (58) No-equity loan originations are expected to reach $20 billion in 1998. (59)

These loans are used primarily for consolidating debt. Some no-equity loans also provide for extra money for home improvements along with the consolidation funds. Lenders say that the upside of these loans is that homeowners can convert all their debt into a single mortgage payment that carries an interest rate lower than conventional credit card interest rates.

The downside, on the other hand, is quite steep. The fees charged to originate no-equity loans are generally very high, sometimes as much as 10 percent of the loan amount. Interest on no-equity loans averages 13 percent to 15 percent. (Average credit card rates today are about 17 percent. Some lenders even offer teaser rates as low as 6 percent.) (60) Extremely high profits provide ample incentive for lenders to aggressively pursue the no-equity market. For example, it was reported that while DiTech Funding Corporation of Irvine, California, one of the big players in the no-equity loan market, "can earn a 0.25 percent net profit margin on its 30-year, fixed-rate loans, the no-equity loans fetch an eye-popping 6 percent." (61)

Although a no-equity loan may reduce the amount of monthly credit card payments, does it save money? In most cases, a borrower using a no-equity loan to pay off credit-card debt will pay thousands of dollars more and take longer to repay than if he or she simply continues to make the current payments on her credit card. This is because the high interest and fees in a no-equity loan will result in an overall increase in indebtedness. For example:

Consider an average homeowner with $35,000 in credit-card bills and making the minimum monthly payments of about $700. A typical no-equity loan would cut the monthly payments to $479. But that borrower would end up paying nearly $115,000 over 20 years for the privilege of cutting monthly payments by 32 percent. If that same borrower continued making the $700 monthly payments on the old credit-card accounts, the debt would be repaid in less than seven years with total payments of $58,100. (62)

Borrowers typically seek no-equity loans because they want to lower their monthly payments. This raises two important issues. The first is how much will this cost in the long run, which is addressed by the hypothetical example above. The second issue is whether a no-equity loan is the lowest-cost alternative for achieving the goal of lower monthly payments. In some instances, consumers can avoid an expensive no-equity loan by seeking confidential credit counseling to learn about potentially less expensive credit alternatives.

Some lenders tout no-equity loans as a way to achieve long term financial security, but there are those who disagree. For example, Robert K. Heady, publisher of Bank Rate Monitor in North Palm Beach, Florida, which tracks the mortgage industry said, "This is simply another way for people to fall more deeply into debt . . . . The biggest danger is that people are tapping into the biggest single asset in their life — and then some." (63) And a Michigan economist believes that they will lead to more bankruptcies and foreclosures. Frank P. Stafford, a University of Michigan economics professor, conducted a study of home equity loans. His study showed that "homeowners who mortgaged more than 80 percent of their home’s value to help pay off personal debt ended up a few years later with more debt than net worth." (64) He continued, "Our research showed that people who borrowed these high amounts weren’t putting aside money. They weren’t creating a financial buffer. The high borrowers were converting it into spending . . . . My personal view is that 125 percent loans are quite dangerous." (65)

Borrowers are often lured into no-equity loans because they believe that the interest may be tax deductible, unlike other types of non-real estate secured credit interest. There are limits to what interest can be deducted in a no-equity loan situation. According to the Internal Revenue Service, on a second mortgage, homeowners may only deduct as much as 100 percent of their home’s value up to $100,000, but not on any portion that exceeds the fair market value of their homes. However, for those for whom the standard tax deduction is a better deal, deductibility of home equity interest is not relevant. Some borrowers may not realize that interest deductibility of the loan is irrelevant until they put pencil to paper at tax time. At that point it is too late to back out of the loan.

The tax implications don’t just end with whether interest is deductible. If a no-equity borrower loses a home to foreclosure, he or she could be surprised by a big tax bill. "That’s because the Internal Revenue Service regards as income the amount of the loan over the market value that goes unpaid or is ‘forgiven’ by the lender," according to Sharon Dodson, a San Diego certified public accountant. (66)

Another downside is that borrowers may find themselves stuck in their homes, unable to sell or move. They may be forced to wait until their homes sufficiently appreciate in value to avoid paying lenders more than the proceeds from the sale of their homes.

There is concern over the impact these loans can have on the general economy. Ron McCord, immediate past-President of the Mortgage Bankers Association of America, has "noted that ‘with the economy on the rise, there is no indication yet of higher mortgage delinquencies,’ but he said that an economic slowdown could trigger delinquencies, especially in the 125 percent home equity loans." (67) In an economic downturn, no-equity loans might prove to be an industry time bomb, particularly because higher unemployment will mean more mortgage delinquencies and foreclosures.

Although many lenders claim that they make these loans only to individuals with spotless credit, the availability of no-equity loans is widely publicized through television, newspaper and radio advertisements. Already, "Homeowners are all too familiar with the [no-equity loan] products. Junk mail offers for 125 percent home-equity loans fill kitchen trash cans around Southern California." (68) Regulators, consumer advocates, and mortgage lending industry members interviewed for this report have predicted that as more lenders enter the no-equity lending arena, the class of those eligible for no-equity loans, once limited to those with the best credit, will begin to open up in order to give lenders a competitive share of the market. This means that these extremely risky loans will begin to filter down to riskier borrowers who may already be in financial straits. They predict that marketing efforts will become even more aggressive or possibly even deceptive in order to preserve market share.


One of the most perilous products to emerge from the subprime lending industry is a credit card secured by a borrower’s home equity. First Alliance Mortgage Co. (First Alliance) of Irvine, California, is heavily marketing this product to high-risk borrowers. This credit card product was examined in a recent Wall Street Journal story about the perils of subprime borrowing. (69) The story revealed that First Alliance home secured cardholders must pay annual interest of up to 24.8 percent, pay a sign-up fee of $179.50, and a $38.50 annual fee.

Unlike any other credit card, every purchase made with this card becomes part of a loan secured by the borrower’s home equity. Therefore, if the borrower does not pay he will lose his house in foreclosure. First Alliance’s Secured Gold MasterCard creates instant home-secured debt for all cash advances and purchases tied to the card, no matter how minor. A First Alliance cardholder’s home equity hangs in the balance for purchases as insignificant as movie tickets or a toaster. If the borrower does not pay this credit card debt, First Alliance has the right to order the home sold through foreclosure in order to get repaid what it is owed.

The First Alliance Secured Gold MasterCard is an expensive credit product that exposes borrowers to the risk of losing their homes to foreclosure without making the product a better value. Equity-secured debt usually contains trade-offs which the consumer must weigh. Generally, consumers will pay a lower interest rate for a loan that is based on the borrower’s home equity than for other types of loans, secured or otherwise. The consumer must gauge the increased risk of losing the home through foreclosure if the debt is not paid with the benefit of lower interest rates and tax deductible interest. Credit card interest rates tend to be one of the most expensive forms of credit, and the First Alliance Secured Gold MasterCard is no exception, even though it is tied to a home’s equity. The product costs the consumer as much or more than most other credit card products and subjects the borrower’s home to the risk of foreclosure. It also costs more than most home-secured loans.

Used thoughtfully, a well-priced credit card can give a consumer purchasing power and flexibility. However, credit cards lend themselves to more casual purchasing and indebtedness than a home equity line of credit which requires a more thoughtful process and which most homeowners use for major debt consolidation or home improvements. One look at the figures for outstanding credit card debt bears this out. This is a nation of debtors. "American consumers are carrying about $1.2 trillion in installment debt, up about 50 percent from four years ago." (70) Billions of dollars in home equity could be put on the line for everyday purchases if home-secured credit cards become the wave of the future.

Like the no-equity loan, this credit card is an example of the new products that the subprime lending industry must develop in order to retain a competitive advantage. As the marketplace for subprime home lending gets more crowded driving profits down, products such as this home secured credit card help subprime lenders differentiate themselves and create new market niches within the subprime industry. Unfortunately, this is not the type of new product that might benefit consumers.

Consumers Union became aware of First Alliance and its home-secured credit card after the company had filed an application with the Office of Thrift Supervision to purchase Standard Pacific Savings, an Irvine, California thrift institution. First Alliance had already been issuing the home-secured credit card through an affinity arrangement with Fidelity Federal Bank. It intended to continue issuing this product, but as a thrift institution, it wouldn’t need to rely on its affinity arrangement with Fidelity Federal Bank. Instead it would be able to cut out the middleman and issue the product directly to consumers.

After analyzing First Alliance’s application and accompanying materials it submitted to the Office of Thrift Supervision, Consumers Union decided to oppose the application. Our opposition to the application was based on several factors. First, First Alliance had neglected to divulge that it was the subject of five recent pending lawsuits (71) in the San Francisco Bay Area. These lawsuits allege that the company has engaged in fraud and unfair and deceptive business practices with respect to their mortgage lending. Additionally, the home-secured credit card it was expected to market through the acquisition is expensive and extremely risky, especially given the target market as identified by the company — primarily low-income, marginalized borrowers. Aggressive marketing strategies might be used to successfully capture a target market of inexperienced credit card borrowers. Taken together, we believed that these factors would result in a high incidence of foreclosures involving the company’s target homeowners who obtained a First Alliance home equity-secured credit card.

Shortly before the Office of Thrift Supervision was to decide on First Alliance’s application, the company withdrew its application — this at a time when its lending practices had begun to generate substantial scrutiny. According to First Alliance, the reason it withdrew its application was that the time had expired in which it had to consummate the deal with the seller. Although First Alliance will continue issuing this credit card through its affinity arrangement, it has yet to find a direct conduit to issue this product to consumers.


In this section, we will take a closer look at First Alliance, a subprime lending company which in January 1998 was identified as an "industry leader." (72) The company described details of its business practices in its regulatory filing with the Office of Thrift Supervision (OTS), which it submitted in connection with the proposed acquisition of Standard Pacific Savings, as mentioned earlier in this report. The information the company submitted to the OTS gives the public a glimpse into how this subprime lending company is organized and managed. This information adds great substance to the complaints we have received from consumers regarding what they describe as this lender’s unfair mortgage lending practices. Our findings are based upon materials First Alliance submitted to the OTS, upon news accounts involving the company, and upon complaints we have received from consumers. While each subprime lender is unique, there are certain characteristics endemic to this industry, such as the costliness of subprime products, the target market, and the competitive marketing approaches to capture that market. Certainly there are many variations on these themes. First Alliance is but one example of a company within an industry that is generating significant consumer and regulatory dissatisfaction and concern.


First Alliance Mortgage Co. (FAMCO) was established in 1971. FAMCO stock is publicly traded on the NASDAQ Stock Market under the symbol "FACO." At the time of its application to the Office of Thrift Supervision, FAMCO maintained a total of 24 offices distributed throughout 13 states, with one office in the United Kingdom. In December 1997, it was reported that FAMCO maintained 32 offices, including several in the United Kingdom, and that it originates more than $500 million in loans a year, according to Mark Mason, FAMCO’s then Chief Financial Officer. (73)


First Alliance is mainly in the business of selling homeowners equity-based home loans. It is also in the business of issuing a home-secured credit card, discussed earlier in this report. In describing its target market for this credit card, the company also reviewed its methodology for targeting homeowners for its home equity loans. First Alliance intends to initially market the home-secured credit card to existing or prospective First Alliance borrowers, who on closer inspection include long time homeowners with accumulated equity to tap into. A great many of these homeowners are low-income individuals without access to traditional sources of credit. Many are inexperienced with mainstream credit products such as credit cards. We are greatly concerned that these are the same characteristics shared by many homeowners who are at high risk of losing their homes to home equity lending fraud and abuse.

The company believes there is a likelihood that the consumers of their credit card product will be similar in characteristics to the users of its other mortgage products. Page 22 of the company’s Application states, "Existing statistics for current FAMCO borrowers indicate that if this trend is followed a substantial volume of low- and moderate-income individuals will obtain access to the credit card product." It expects that "many of the non-conforming borrowers who become credit card holders are expected to be new or relatively new to traditional credit products." First Alliance asserted in its papers filed with the OTS that it has identified as its primary target market "low- and moderate-income individuals" who fall below "80% of the median family income for Orange County."

In its statement about how these income and experience factors affect the thrift’s Community Reinvestment Act (CRA) requirements at pages 23 and 24 of the Application, First Alliance suggests that providing the home-secured credit card to low-income homeowners is helping to serve financially underserved communities. There is no question that some communities do not have access to adequate and quality financial services. However, we do not believe that it is a community service to aggressively market an expensive, extremely risky product to those who are not experienced with credit cards and the potential pitfalls of an entirely new product that ties casual consumer purchases to a home’s equity. A good credit card can be a useful financial tool. But one that results in home foreclosure for non-payment can be a recipe for disaster.


First Alliance’s marketing efforts are very focused on those who have been redlined out of traditional credit options. By its own admission, the company does not seek out a wide segment of the potential equity-based borrowing population. Instead, its marketing methodology focuses on a distinct segment of the home-equity lending market by narrowly targeting homeowners they believe to be predisposed to using the Company’s products and services, and who otherwise satisfy its underwriting guidelines. (74)

First Alliance looks at several factors in order to determine who is "pre-disposed" to purchasing a loan from the company. The company identifies "Targeted Homeowners" by looking for indicators of redlining, factors which might make a homeowner "a more likely candidate for the Company’s products and services." These include: prior consumer finance borrowing; the amount of equity in the home; the length of time the homeowner has owned the home; credit problems; and lack of significant credit history. (75)

These are some of the factors that characterize the "equity-rich" but "cash-poor" homeowners who are the most likely targets for abusive and/or fraudulent home equity loans. Borrowers who have a history of prior consumer finance borrowing may be those who have not usually had access to credit from conventional lenders. Those who have been in their homes for a significant period of time may have accumulated substantial equity in their homes. To some lenders, even though the borrower may not have the income to support a loan, the home’s substantial equity would secure repayment for a loan that might not otherwise be made. Factors such as credit problems or a lack of significant credit history would tend to push these borrowers away from conventional credit possibilities. These are often the less sophisticated borrowers with few credit options who are easy targets for exploitation by high-cost lenders. Many times, even borrowers with adequate credit options and good credit get snared into high-cost lending because they were aggressively pursued and didn’t realize the pitfalls of the product.

As described in First Alliance’s OTS Application, the company engages in very aggressive telemarketing and mailing efforts to sign "Targeted Homeowners" on to equity-based loans. Homeowners have reported to us that they have, in some cases for years, received weekly mailings from the company and frequent unsolicited telephone calls offering loans and urging them to set up appointments for a "free appraisal." Homeowners have reported that sales representatives hound them with persistent sales efforts even after responding with a definitive "NO, thank you."

The reports we have received from homeowners are consistent with First Alliance’s own description of its mailing campaigns and telemarketing efforts. (76) In its filing with the OTS, the company admits to distributing over 1.5 million pieces of solicitation mail monthly from its mail-processing center in Orange, California. The mailing campaigns are apparently successful. The company states that "mailing campaigns result in over 4,000 inbound loan inquiry calls from Targeted Homeowners monthly." The outbound telemarketing department "uses computerized predictive dialers to continually solicit the Targeted Homeowners and the Company’s current borrowers." The company employs telemarketing representatives to sell the company’s products and obtain information about the homeowner, the subject property, and the amount of equity in the home. It also uses telemarketing representatives "to place follow-up calls to prospective borrowers who have previously set and later canceled appointments to have a Company appraiser visit . . . . failed to show up for an appointment with a loan
officer . . . or declined a loan program offered to them by the Company."

The employee and company motivation for getting Targeted Homeowners signed into loans is quite significant. First Alliance had designed a rating and compensation system for employees who deal directly with the Targeted Homeowners during the entire lending process, from initial contact to loan closing. As described by First Alliance in its OTS filing, each employee responsible for each stage of the loan process is rated and compensated based upon success in moving the Targeted Homeowner on to the next stage of the loan process. Staff performance is monitored on a weekly and monthly basis. (77) Successful loan closings generate high loan origination and other fees which results in a significant portion of First Alliance’s profit base. Forty-eight percent of the total revenue for the quarter ending March 1997 came from loan origination and other fees charged by the company. (78) The company’s compensation system and reliance on loan origination fees for a significant portion of its profits creates tremendous incentives for aggressively pursuing potential borrowers for loans that generally require higher interest rates and fees.


Once a borrower defaults, the company quickly mobilizes its aggressive collection efforts. The company claims that its no-nonsense approach is responsible for keeping company losses to a minimum. Among consumers and their advocates, First Alliance has a reputation for not working with a borrower who is having problems keeping up with payments, a scenario which is all too common among borrowers who are put in over their heads. Instead, borrowers have reported that the company will use a borrower’s default as an opportunity to refinance the borrower’s loan with a new loan, thereby generating new origination fees and costs to be borne by the borrower’s equity. Repeated refinancing, also known as "churning," quickly drains a homeowner’s equity while giving the homeowner the impression that everything is okay because monthly payments are now "affordable."


What have these business practices brought to First Alliance? First Alliance has earned a reputation as a very good investment and a "leader" in its industry because of the company’s profitability (79). However, this profitability has not been without cost. Some of First Alliance’s business practices have generated increased scrutiny for the subprime industry and significant consumer lawsuits and complaints.

For example, the San Francisco Bay Area lawsuits mentioned at p. 16 above were the subject of a page-one San Francisco Examiner article on October 27, 1997. (80) The information about the lawsuits was the second part of a three-part series on predatory home-equity lending.

First Alliance’s alleged business practices have also generated two recent stories in The Arizona Republic. (81) Both of these articles recount consumers’ reports that they were duped into unaffordable loans. One example includes an 82-year old former minister who wanted to borrow $26,000 to pay off his car and an old business debt. He reported that after examining the loan papers a few weeks after he signed, he discovered that he received a loan not for $26,000 but for $34,566. The additional amount was because First Alliance charged him a loan origination fee of nearly $7,000 (or 26 points) to borrow the $26,000. When the borrower wanted out, he said he was told that he would have to pay a pre-payment penalty of $2,500 plus the full principle amount. (82)

The Arizona Republic described these other customers in Arizona who were unhappy with First Alliance:

Michael Manguso, who has owned McFarland’s Carpet Service for 50 years, said he ‘got sick’ when he realized the [company] . . . had charged him nearly $15,000 in origination fees on a loan. An 82-year old liquor salesman says he ‘got cheated’ out of $20,000. [And] Albert Cole, 63, a truck driver, and his wife, Scholastica, got stuck with a $5,000 origination fee and an adjustable interest rate that goes up 1 percent every six months no matter what. (83)

Negative stories have emerged from the United Kingdom as well, where First Alliance Mortgage Co. maintains several offices. First Alliance’s lending practices are prominently featured in a column discussing how "Ruthless American loan sharks are swarming into Britain, creating misery for borrowers." (84) British stories contain accounts that borrowers were told that no loan application fee would be charged, yet they were charged an "arrangement fee" plus other charges. One couple said that despite claims in mailers that First Alliance could give a borrower an affordable loan, their monthly payments tripled with a First Alliance loan. They are now facing foreclosure of their home. By this account, this couple paid nearly one-third the loan amount in fees and costs. Their solicitor commented, "To charge £11,000 for a £37,000 mortgage is extortionate. The practice, by mainly US lenders, of targeting vulnerable borrowers should be investigated." (85) The borrowers are Diogo and Joanna Victor of Colindale, North London. Mr. Victor said, "I felt under a lot of pressure to sign with them. They rushed the deal through. Their representative saw me at home and gave me some literature which I had only one day to read before I had to go to their office to sign the contract." (86) The columnists reporting the Victor’s story concluded, "We’re sending our report to the Office of Fair Trading, which has the power to shut down these loan sharks." (87)

These stories suggest that while expanded business might provide more borrowing opportunities, those opportunities might not always be in the borrower’s best interest. In analyzing First Alliance’s business practices we found that they are a successful company that has gone public and has profited handsomely by making home equity loans to equity rich but cash poor borrowers. We find it very troubling that numerous First Alliance borrowers in different parts of the globe have reported similar high-pressure sales tactics, and in some cases, made allegations of trickery. Even if the loan documents reveal otherwise, some borrowers allege they were led to believe that the documents said something else. They claim that it is the "something else" that they bargained for, but that is not what they necessarily received. Regulators and legislators must more closely examine these consumer reports because they are the very practices that often induce homeowners into home equity loans that can cost them their homes.

As mentioned earlier, First Alliance is but one example of a company within an industry that has generated many consumer complaints regarding home equity lending practices. Any investigation into these types of practices should not be limited only to First Alliance Mortgage Co.


In 1995, we reported that the most common targets for home equity lending fraud and abuse are the elderly and minority homeowners, particularly African-American and Latinos. Accumulated home equity, lack of familiarity with the lending process and decreased access to traditional credit are three factors that make these groups prime targets for unscrupulous lenders. New information suggests that this target will only get broader. Minorities now comprise 30 percent of the nation’s homeowners. (88)

In November 1994, President Bill Clinton launched the National Homeownership Strategy program with the goal of adding up to eight million more families to the homeownership rolls by the end of the year 2000, particularly focusing the government’s efforts on families who once considered homeownership unattainable.

A recent study suggests that these efforts are paying off. According to "The State of the Nation’s Housing: 1997," released by the Joint Center for Housing Studies of Harvard University, minorities and immigrants are helping to boost homeownership to record levels. According to the report, Hispanic homeownership rose 16.3 percent over the past three years. Homeownership by blacks and other minority groups also showed large increases.

The increase in homeownership rates, particularly among minorities, is a very positive sign. However, given what we know about the usual targets for home equity lending fraud and abuse, once these new homeowners accumulate equity through the years, the ranks of potential targets will swell. This is particularly true if minority access to competitively priced traditional sources of credit remains elusive.

In spite of increasing homeownership rates among minorities, discrimination in obtaining mortgage loans is still a factor and a barrier to becoming a homeowner. While praising the increasing numbers of new homeowners, Housing Secretary Andrew Cuomo noted that a recent Federal Reserve Board report found that blacks, American Indians, and Hispanics were more likely than whites or Asian Americans to be turned down for conventional home loans. (89)

This difficult climate for minorities in mortgage borrowing creates tremendous opportunities for subprime lenders, some of whom will take full advantage of another’s misfortune even if it is the result of unlawful discrimination. The government, regulators, legislators and law enforcement must continue to enforce unlawful discrimination laws to remove unfair barriers to affordable mortgage borrowing. This, along with continued efforts to increase homeownership among populations traditionally left out will help the government achieve the goal of increasing homeownership, and more importantly, sustaining homeownership for those who are at great risk of losing their homes to home equity lending fraud and abuse.



(28) Equity Predators, Stripping, Flipping and Packing Their Way to Profits: Hearings Before Senate Special Committee on Aging 105th Cong. (March 16, 1998) (Statement of Jodie Bernstein, Director, Bureau of Consumer Protection, Federal Trade Commission).

(29) Karen Talley, Norwest Bids to Dominate Subprime Lending Under New Chief, American Banker, August 8, 1996.

(30) Three Trends are Reshaping Auto Finance, ABA Banking Journal, Feb. 1997, p. 34.

(31) HOEPA bars credit terms such as balloon payments and requires additional disclosures when total points and fees payable by the consumer exceed $400 or 8 percent of the total loan amount, whichever is larger. On February 6, 1998 the Board of Governors of the Federal Reserve System adjusted this amount to $435 for 1998.

(32) A balloon-payment mortgage is a loan that requires a large lump-sum payment at the end of the loan period. Traditional, regular mortgages are paid off in consistent monthly payments over 15, 20, or 30 years. Payments are applied to both interest and principal. With a balloon payment loan, the monthly payments go only to pay off the interest. This makes the payments unrealistically low relative to the obligation. After a few years, the full balance of the mortgage loan becomes due, including all or most of the principal.

(33) John R. Wilke, Justice Department and FTC Probe Lenders for Alleged Abuses, The Wall Street Journal, January 30, 1998.

(34) What will ’97 bring to sub-prime lending industry? Annual Review and Forecast, Real Estate Weekly, Jan. 22, 1997, p. D8.

(35) CFI Funded More Than $70 Million in Subprime Loans; In 1997, an Increase of %385 Over 1996; Company Says Growth Came Principally in Second Half of Year Following IPO Which Funded Development of an Infrastructure Capable of Handling Rapid Expansion, PR Newswire, Jan. 23, 1998.

(36) Raymond Rusnak, Subprime auto finance: What’s the fuss? What’s the future? A credit perspective, 79 Journal of Lending & Credit Risk Management 23 (April 1997).

(37) Mortgage Insurance Companies of America, MICA Fact Book 1994-1995, p. 13.

(38) First Union Corp. purchased the Money Store for $2.1 billion on March 4, 1998. This acquisition gave First Union Corp. "coast-to-coast presence in the consumer home-equity and small-business loan industries." First Union Agrees to Buy Money Store, Los Angeles Times, March 5, 1998, p. D1.

(39) Karen Talley, Norwest Bids to Dominate Subprime Lending Under New Chief, American Banker, August 8, 1996, p. 9.

(40) Heather Timmons, The Two Faces Of B&C Lending: Type-A Daredevils Thriving In B&C Mortgage Market, American Banker, Tuesday, May 6, 1997.

(41) Id.

(42) Id.

(43) In a First, FDIC Warns Banks About Dangers Of Subprime Lending, by Barbara A. Rehm, The American Banker, Section: Washington; Pg. 2, Tuesday, May 13, 1997.

(44) Id.

(45) Id.

(46) Id.

(47) Id.

(48) John R. Wilke, Justice, FTC, Probe Lenders, Allege Abuses, The Wall Street Journal, January 30, 1998, p. A3.

(49) Id.

(50) Cecilia Balli, Panel Hears From Victims of Equity Predators, Los Angeles Times, March 17, 1998, p. A9.

(51) Heather Timmons, Crusader Fights to Clean Up Subprime Lending, American Banker, February 10, 1998, p. A14.(52) Id.

(53) Kathleen Howley, Borrowers with credit problems have options; You don’t need a perfect history to obtain a mortgage because banks are offering up a variety of ‘sub-prime’ lending products, The Boston Globe, January 4, 1998, p. G1.

(54) Id.

(55) Ironically, it is the well-heeled (those earning more than $50,000 a year) who are responsible for 44 percent of the late credit card payments. The truly low-income (those earning less than $15,000 per year) were responsible for only 4 percent of all late credit card payments. These facts were revealed in a recent survey by the American Bankers Association. See id.

(56) Vivian Marino, Hot New Mortgage Product Requires No Home Equity, The Inter-City Express, February 7, 1997, p. 1.

(57) John Handley, Easy Money; Subprime, No-Equity Loans Are Tempting — But Are They Wise?, Chicago Tribune, December 7, 1997, p. C1.

(58) Ann Perry, No-equity mortgage can help — or hinder, The State Journal-Register (Springfield, IL), September 14, 1997, p. 56.

(59) Paul Mesner, No-equity loans are way to cope with heavy debt, The News and Observer (Raleigh, NC), September 11, 1997, p. C8.

(60) Edmund Sanders, Think before leaping into no-equity loan; Old saying applies: If it sounds too good to be true, it almost certainly is, The Fresno Bee, January 4, 1998, p. F4.

(61) Edmund Sanders, Taking a Gamble On DiTech, Orange County Register, February 8, 1998, p. K1.

(62) Sanders, supra, note 56, at p. 4.

(63) Vivian Marino, Hot New Mortgage Product Requires No Home Equity, The Inter-City Express, February 7, 1997, p. 1.

(64) Theresa Sullivan Barger, Stretching Equity; Loans For More Than A Home’s Worth Can Consolidate Debt But Have Dangers, The Hartford Courant, November 8, 1997, p. D1.

(65) Id.

(66) Ann Perry, No-equity mortgage can help—or hinder, The State Journal-Register (Springfield, IL), September 14, 1997, p. 56.

(67) John Handley, Special from the Chicago Tribune, Easy Loans May Not Be Wise, The Record (Bergen County, NJ), February 1, 1998, p. B04.

(68) Edmund Sanders, Taking a Gamble On DiTech, Orange County Register, February 8, 1998, p. K1.

(69) Karen Hube, In the Wild West of Subprime Lending, Borrowers Have to Dodge Many Bullets, The Wall Street Journal, March 18, 1998, p. C14.

(70) Kathleen Howley, Borrowers with credit problems have options; You don’t need a perfect history to obtain a mortgage because banks are offering up a variety of ‘sub-prime’ lending products, The Boston Globe, January 4, 1998, p. G1.

(71) All cases were filed in the Superior Court of the State of California. Four of the cases were filed in Santa Clara County: Mary Ryan v. First Alliance Mortgage Company, et al., No. CV759815; Lucretia Wilder v. First Alliance Mortgage Company, et al., No. CV760638; Velda L. Durney v. First Alliance Mortgage Company, et al., No. CV765935; Edward S. Pagter, and Joanne Toney Pagter v. First Alliance Mortgage Company, et al., No. CV766996. One case was filed in Alameda County: Henry M. Hong, Carol J. Hong v. First Alliance Mortgage Company, et al., No. 784938-3.

(72) First Alliance’s mix sets it apart from other lenders; MORTGA