Eat the Loan Sharks!

Let's solve the subprime mess by going after lawbreaking lenders

In early October, Bank of America quietly entered into the largest settlement in history to make amends for predatory lending, putting up more than $8 billion to rescue borrowers with faulty loans from Countrywide Financial, a notorious subprime lender recently purchased by the bank. As politicians and regulators haggle over the best approach to modify perilous mortgages and as millions of Americans fall deeper into delinquency, the Bank of America settlement offers a clear path out of the broader problem: Chuck the illegal loans and start over again, making the lawless lenders foot the bill.

Part of the backdrop here is dismayingly familiar. Explosive growth of subprime lending created perverse incentives that led to fraudulently inflated loan terms. What's less known is that some of these loans were priced higher based on the race of the borrower, with African-Americans and Latinos paying more, in secret, behind-the-scenes deals. Some of this activity will even turn out to have been criminal. There are more than 1,500 open FBI investigations into mortgage fraud, much of it concentrated in the subprime market.

Before we end up spending billions to rescue subprime borrowers, we should figure out which loans were the products of illegal behavior, rescind them, and rewrite them on terms that are fair and legal. If there is a cost associated with this process, let lenders pick up the tab, which is precisely what Bank of America is doing. This would save taxpayer money by reducing the number of loans that the government would pay to modify. It would also help to stabilize the housing market and lay the blame for much of the subprime crisis at the feet of those most responsible: the lenders who acted like predators.

Several of the cases focus on a particularly devious practice: Without borrower knowledge, many mortgage brokers received a commission from the lender for persuading a borrower to accept a higher loan interest rate than what the bank was otherwise willing to offer. The lawsuits claim that such commissions were paid more often in loans to African-Americans and Latinos than in loans to whites, revealing, again, that lenders often charged borrowers of color more than their white counterparts.

Mortgage brokers rushed into poor communities with exotic subprime loans during the early part of this decade, because these communities were underserved by traditional banks. During the height of the market, nearly half of all subprime loans went through a broker, compared with only 28 percent of prime loans. Brokers also dominated loans made to borrowers of color:

The problem with this wasn't the mortgage brokers per se. It was that many prospective borrowers wrongly assumed that the brokers were working in the borrower's best interest. But in most states, mortgage brokers do not owe any duty to the borrower to find the best possible deal. Many brokers relied on borrowers' ignorance of the mortgage market to pursue higher commissions and other financial perks for themselves. In much of the country, there's no legal remedy for this. But a few states require that brokers avoid conflicts of interest and pursue the best deal for the borrower. These states include California, home to about one-quarter of the mortgages in the United States that are in some stage of foreclosure. The Department of Justice, the state attorney general, legal-services attorneys, volunteer lawyers, and law students should all be poring over California loan documents to smoke out the brokers who violated their legally mandated duties to their clients. If a significant number of loans in California alone could be altered, consistent with the borrowers' abilities to pay, either through litigation or its threat, the federal government wouldn't have to pay as much for a national bailout.

To date, none of the proposed homeowner-rescue plans acknowledges that a significant number of the homeowners who are in distress were the victims of predatory and illegal practices

Investors won't challenge loan restructuring when the underlying loans were made on illegal terms. You don't lend your horse to Jesse James and then sue the stagecoach he robbed to get it back. Investors will have to redirect their fire from the borrowers to the brokers and lenders who did the fancy loan footwork—and perhaps the ratings agencies that blessed it.