Working Paper No. 06-2 Predatory Lending in a Rational World

Regulators express growing concern over “predatory lending,” which we take to mean lending that reduces the expected utility of borrowers. We present a rational model of consumer credit in which such lending is possible, and we identify the circumstances in which it arises with and without competition. Predatory lending is associated with imperfect competition, highly collateralized loans, and poorly informed borrowers. Under most circumstances competition among lenders eliminates predatory lending. “While Georgia’s real estate foreclosure law has remained essentially the same since the 1880s, mortgage lending has changed dramatically during the past two decades...Leagues of homeowners are tapping into their equity to pay off credit cards, buy cars and take trips...One bump in the road — a job loss, a sick child, a divorce — could introduce homeowners to the harsh realities of Georgia’s foreclosure law.” “Swift foreclosures dash American dream,” Atlanta Journal and Constitution, January 30, 2005 “Any time you’re looking at equity rather than ability to repay, you’re approaching predatory lending.” (Attorney Daniel J. Mulligan, whose law firm, Jenkins & Mulligan, San Francisco, is a member of the National Association of Consumer Advocates.) “How unscrupulous lenders prey on the vulnerable,” San Francisco Chronicle, July 15, 2001.