The subprime lending problem, just a faint blip on the radar a year ago, has snowballed into a full-blown crisis and is the subject of many proposed remedies. Those include legislation to curtail predatory lending, which is generally thought to be one of the factors that led to the issuing of so many subprime loans to borrowers with poor credit.

But what is predatory lending? And what are the conditions that make it flourish? “Predatory lending is a term that is used a lot now, but people mean different things by it,” says David K. Musto, a finance professor at Wharton and co-author of a paper titled, “Predatory Lending in a Rational World,”with finance professors Philip Bond and Bilge Yilmaz. The paper is an analysis of the theoretical incentives for lenders to issue predatory loans.

“What we take it to mean is [a situation where] I make a loan to you that reduces your expected welfare,” Musto says. “That is an example of me being a predatory lender…. I, the lender, know something extra about how this loan is going to play out.”

Three market conditions are associated with predatory lending, Musto and his colleagues found: There is little competition among lenders, property owners are sitting on lots of equity and borrowers are poorly informed about risks. In casual conversation, predatory lending usually means a loan that is bad for the borrower. “But this begs the question: How do such loans arise in the first place, when borrowing is voluntary,” Musto and his colleagues write.

To many people, loans with extraordinarily high interest rates constitute predatory lending. Critics often cite payday loans, which charge the annual equivalent of more than 100% for loans in advance of a worker’s next paycheck. Loans putting borrowers at high risk of default also are often called predatory. This would include “negative amortization” mortgages that allow borrowers to make very low monthly payments, causing the outstanding balance to grow over time rather than get smaller.

But loans that are bad for some borrowers can be appropriate for others. The payday loan might be a sensible choice for a worker in a short-term cash crunch who will pay the debt off quickly and prefers a high interest rate for a short time over the paperwork and delay of a more conventional loan from a bank or credit union. The negative amortization mortgage might make sense for a knowledgeable, disciplined borrower whose income is irregular, such as someone who lives on commissions or relies on a year-end bonus for a big part of his pay.

Subprime mortgages come in various types but tend to share several features. They start with a “teaser rate” — a low interest rate which keeps initial payments small and makes it easier for applicants to qualify. After one, two or three years, the interest rate resets to a new rate calculated by adding a “margin” of 6 or more percentage points to some established floating rate, like the yield on one-year U.S. Treasury bills. Typically, the reset involves a drastic increase in monthly payments, in some cases a near doubling. Finally, many subprime loans carry pre-payment penalties that make it prohibitively expensive for borrowers to refinance during the first two or three years.

Subprime borrowers are typically described as people with poor credit who cannot get conventional loans — people with spotty credit histories or low incomes. But not all subprime borrowers fit the mold. Some loans — no one knows how many — were made to people who could have qualified for conventional mortgages but were steered to subprime products by brokers seeking the higher-than-normal commissions these loans often paid. Other borrowers with good credit might have been drawn to subprime loans’ low teaser rates. Some apparently used subprime loans to buy second homes or investment properties.

Therefore, it is not clear how many subprime borrowers were truly victimized by predatory lenders and how many simply had bad luck with risky loans they took on with open eyes. After short-term interest rates rose dramatically, starting in the summer of 2004, subprime loans reset with much larger payments. Meanwhile, the housing bubble burst and home prices began to fall, making it hard for subprime borrowers to refinance to better loans or sell their properties. Foreclosures have spiked.

Musto and his colleagues did not attempt to look at predatory lending arising from fraud, such as cases in which lenders or mortgage brokers deceived borrowers about the terms of their loans. Such cases could be addressed with borrower education and clearer loan documents, they note.

Instead, the researchers focused on situations where the loan terms were clear to the borrowers, but the borrowers were hurt nonetheless. “How can lending bring expected harm to rational borrowers who understand their contracts?” Musto and his colleagues ask.

Answer: “Predation can arise when a lender has extra, private information about a borrower’s prospects” for keeping up with payments. The lender has experience with thousands of borrowers in similar circumstances; a borrower, even if he understands his loan terms, may not have a clear idea of whether he can keep afloat if interest rates rise, housing prices fall, a spouse loses a job or some other adversity strikes.

Why would a lender give a mortgage to a borrower at high risk of default? It’s a numbers game. The lender knows from experience that many borrowers will not default. Even though there are more defaulters on risky loans than traditional ones, this cost is offset by the higher interest rates charged to all these borrowers, and the lender knows it can recover money by foreclosing on the defaulters’ homes.

“Critics of banks’ behavior in subprime lending markets suggest that borrowers misjudge their true probability of default and lose their homes in foreclosure, while lenders know the true odds but … recover enough in foreclosure that they lend anyhow,” Musto and his colleagues write.

To assure they can recover enough in foreclosure, predatory lenders tend to focus on homeowners who already have a lot of equity in their properties, assuring that the property can be sold for enough in foreclosure to cover the borrower’s debt. This explains why so many predatory loans involve refinancing or home-equity loans. Predatory loans are often issued to homeowners who will use the money for home improvements, which increase the properties’ collateral and widen the lender’s safety margin, the authors write.

Competition between lenders can mitigate predatory lending because lenders must appeal to borrowers by offering ever-better loan terms.

Extracting More Cash

But competition does not work as well when borrowers have a lot of home equity and very poor prospects of keeping up with payments, Musto and his colleagues say. In these cases, borrowers can be victimized by the lenders they already have. Competing lenders are scared off by the borrower’s poor prospects. But the homeowner’s current lender, facing an immediate loss if the borrower defaults, may offer a new loan in hopes of squeezing a few more payments out of the borrower. The teaser rate on the new loan will help the borrower keep afloat longer. Although the borrower will be even worse off when the rate resets later, the lender may assume the borrower is going to default later anyway.

“You’re going to suffer the cost of foreclosure at some point,” Musto says of the lender. “The only question then is do you extract more cash from the guy or do you just [foreclose] now? The existence of competition is not of any serious help to someone who’s seriously distressed on their existing loan.”

In other situations, borrowers who have good payment prospects want loans for purposes that have value to them, such as weddings or college costs, but do nothing to enhance the property’s value in a foreclosure. In these cases, predatory lenders will provide money even if it enhances the borrower’s odds of defaulting, so long as there is lots of equity in the property. “What really fosters this kind of predation is high collateral value,” Musto says.

The work by Musto, Bond and Yilmaz provides new insight into several public-policy approaches to lending issues.

It suggests, for example, that the Community Reinvestment Act of 1977 can help curb predatory lending by fostering competition. The act pushes banks and other lenders to offer loans in markets they otherwise might avoid. It would backfire — encouraging predatory lending — in cases where it results in a single lender moving into an area that previously had no lenders, since the resulting monopoly would enable the lender to dictate onerous terms to borrowers.

The Equal Credit Opportunity Act of 1976 can also backfire in some circumstances, Musto and his colleagues write. This act prohibits loan discrimination on the basis of race, color, religion, sex, marital status, age and other criteria, making it harder for lenders to identify borrowers at high risk of default. It therefore means loans are offered to people who otherwise would be denied, and lenders compensate by pushing products with high interest rates and other terms associated with predatory loans.

According to the authors, their work suggests that some laws aimed specifically at predatory lending probably do help curtail the practice. The North Carolina Predatory Lending Law of 1999 is widely considered a model, they write. It applies to mortgages of $300,000 or less charging more than 8% above a benchmark U.S. Treasury rate, and it prohibits negative amortization, interest-rate increases after a borrower default, balloon payments and other features associated with predatory loans.

Laws like this, which target high-rate loans, can work, Musto and his colleagues write. “The main legislative response to predatory lending has been to subject high-interest consumer loans to strict scrutiny,” they conclude. “In our framework, this policy can be effective in reducing the incidence of predation.”