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National Mortgage Professional
Apr 17, 2007

Income inequality: Time for predatory lending laws?Yuliya Demyanykpredatory lending, fraud, income inequality, economic growth This article first appeared in the October 2006 issue of The Regional Economist: A Quarterly Review of Business and Economic Conditions and is reprinted here with The Regional Economist's permission. Income inequality - the gap between the rich and the poor - seems to indicate a higher probability of a predatory lending law being adopted. States that recently adopted predatory lending laws had higher than average levels of income inequality over the past 10 years than their non adopting counterparts. Predatory lending - an illegal activity by lenders or brokers leading to a further decrease of well being of relatively poor individuals - could generate greater inequality between individuals in the U.S. economy. Predatory lending laws - the laws aimed at reducing fraudulent lending activity - may do the most good in reducing inequality in states where inequality is larger. Between 1999 and last year, 24 states plus the District of Columbia adopted laws to combat predatory lending. The law in each state is designed to restrict origination of specific types of loans - mostly mortgages - and/or to require lenders to disclose details about those loans to state regulators. Predatory lending, even though it lacks an exact definition, is most often associated with lending to relatively poor borrowers, to those who are uneducated about the lending process and to those whose credit scores are low. Borrowers with incomes and/or credit scores below a certain threshold are usually not able to obtain credit unless they pay higher prices for their loans. Such loans are called sub-prime or high cost loans. Not all high cost loans are predatory, though. Lending is considered predatory or fraudulent when lenders or brokers: -Take advantage of borrowers by charging very high fees that are not justified by a risk factor; -Issue loans knowing they can never be repaid or would almost certainly lead to home losses and complete bankruptcy; or -Change the terms of a loan at closing, thus knowingly misleading borrowers.1 The relatively weak are both the easiest prey for predatory lenders and those most likely to suffer the greatest economic losses. If predatory lending, which tends to hurt poor people disproportionately more than those who are better off, is populated in an economy, then inequality may increase. Income inequality Income inequality in the United States is greater than in any other developed country. Moreover, it has been increasing during the past 25 years.2 Whatever the actual level of an individual's income, a person might be discouraged and unhappy if he is relatively poorer than many other people in society. Therefore, rising income inequality might be considered harmful to society not only because it represents a disparity between people, but also, as some research shows, because it can cause slower economic growth, an increase in crime, worse overall well being, poor educational outcomes and even higher death rates, the same way a higher level of poverty (absolute, not relative) would.3 Besides predatory lending, there are a number of possible factors that can be responsible for inequality in a society. Differences in education and abilities create wage differentials leading to income differences; race, gender and cultural differences can give rise to discrimination in the labor market. Also, income inequality can rise if wealth circulates only among those who have the means to invest and to increase already existing wealth. Several countrywide economic factors may affect inequality as well. For example, some research studies show that faster economic growth and greater economic development in an economy would benefit the rich and the poor equally. Because the "boats" of both would rise the same, however, the level of inequality would remain the same.4 Other studies show that countries with better developed financial intermediaries experience faster declines in both inequality and poverty.5 However, financial development that offers greater credit availability to previously left out borrowers (those with lower credit scores and incomes) can also open the door for more fraudulent lending. The number and variety of loan products available on the market these days are reaching enormously large magnitudes. A single financial institution can offer more than 600 different types of mortgage loans, which can confuse borrowers regarding what product to choose and allow unscrupulous lenders to take advantage of not just the poor but all who don't know enough to protect themselves. Such development, once again, can increase income inequality. If predatory lending leads to higher income inequality in an economy, then laws that restrict predatory activity would seem to be most needed in those states where inequality is relatively large. The analysis conducted for this article shows that predatory lending laws were indeed adopted in states where they might do the most good in reducing inequality. Income inequality in states with predatory lending laws To examine a possible link between income inequality and predatory lending in the United States, an individual level income inequality measure, a Gini index, is calculated separately for each state and year for the past 10 years. The Gini index is one of the most widely used measures of income inequality. The Gini index would be zero in an economy in which everyone has the same income; the index would be 100 percent in an economy where one person has all the income and everybody else has zero income. The average income inequality across the U.S. states was about 50 percent in the year 2000.6 It is too early to formally test for any actual real effects that predatory lending laws have on states' economies and, in particular, whether these laws are really fighting income inequality. Future studies are needed to address this issue. In addition, more studies are needed to test whether there are factors that influence both predatory lending (and the probability a predatory lending law will be adopted) and income inequality at the same time. Yuliya Demyanyk is an economist at the Federal Reserve Bank of St. Louis. She can be contacted by e mail at [email protected] Footnotes 1. See www.hud.gov for more examples of predatory lending activities. 2. The U.S. Census Bureau publishes different historical income inequality measures at www.census.gov/hhes/income/histinc/ie6.html. 3. See Kennedy et al. (1996) and Kaplan et al. (1996). 4. For a list of references, see www.economist.com/inequality. 5. See Beck et al. (2004). 6. Author's calculations based on the data from the Current Population Survey. References Adams, Richard H. Jr. "Economic Growth, Inequality, and Poverty: Findings from a New Data Set." The World Bank, Policy Research Working Paper 2972, 2003. Aghion, Philippe; Caroli, Eve; and Garcia Penalosa, Cecelia. "Inequality and Economic Growth: The Perspective of the New Growth Theories." Journal of Economic Literature, 1999, Vol. 37, No. 4., pp. 1615 60. Alesina, Alberto; and Rodrik, Dani. "Distributive Politics and Economic Growth." Quarterly Journal of Economics, 1994, Vol. 109, No. 2, pp. 465 90. Beck, Thorsten; Demirguc Kunt, Asli; and Levine, Ross. "Finance, Inequality and Poverty: Cross Country Evidence," NBER Working Paper No. 10979, Issue December 2004. Ho, Giang; and Pennington Cross, Anthony. "States Fight Predatory Lending in Different Ways," Federal Reserve Bank of St. Louis The Regional Economist, January 2006, pp. 12 13. Kaplan, George A.; Pamuk, Elsie R.; Lynch, John W.; Cohen, Richard D.; and Balfour, Jennifer L. "Inequality in Income and Mortality in the United States: Analysis of Mortality and Potential Pathways," British Medical Journal, April 1996, Vol. 312, pp. 999 1003. Kennedy, Bruce P.; Kawachi, Ichiro; and Prothrow Stith, Deborah. "Income Distribution and Mortality: Cross Sectional Ecological Study of the Robin Hood Index in the United States," British Medical Journal, April 1996, Vol.312, pp. 1004 07. The Economist, June 15, 2006.
Published
Apr 17, 2007
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