Subprime Standardization : How Rating Agencies Allow Predatory Lending to Flourish in the Secondary Mortgage Market

Predatory lending, the origination of loans with abusive terms to homeowners, is rampant in the subprime mortgage market. In the last few years, many states responded to this problem by enacting consumer protection laws. Large segments of the lending industry have opposed these laws. In large part because of these complaints, momentum is building on three fronts to standardize the operations of the subprime mortgage market. First, federal regulators are preempting the application of these laws to a broad array of lending institutions and Congress is considering legislation to preempt their application to the remaining financial institutions that are still regulated by such laws. Second, Fannie Mae and Freddie Mac, the largest purchasers of residential mortgages on the secondary market, have indicated that they will not purchase loans with certain terms that they deem to be abusive. And finally, the three major rating agencies indicated that they will not rate securities backed by pools of residential mortgages if any of those mortgages violate their rating guidelines relating to predatory lending laws. While the lending industry frequently promotes the increased standardization of the secondary mortgage market as an approach that will reduce predatory behavior without hurting legitimate lenders, this article reviews these three pushes to standardize the subprime mortgage market to determine if they will achieve that goal. It concludes that the federal preemption of these laws is premature, that the Fannie Mae and Freddie Mac purchasing guidelines will have an incrementally beneficial impact and, most importantly, that the rating agency guidelines will benefit investors in and issuers of mortgage-backed securities at the expense of homeowners.The American College of Consumer Financial Services Lawyers selected this article as the best scholarly article of 2006