The mortgage lending problem in the U.S. snowballed long ago into a full-blown crisis. Most of the damage is among homeowners with subprime mortgages — loans extended to borrowers with spotty credit records, low income or both. This is particularly noticeable among harried borrowers unable to handle adjustable-rate loans.

Although it is easy to think that this problem affects only large financial institutions and real estate speculators, it actually has significant implications for homeowners in Canada — particularly if they’re older, says the Canadian Centre for Elder Law.

The centre is a non-government organization dedicated to law reform and outreach on legal issues affecting older Canadians. It is deeply concerned with “predatory lending” — in particular, its rise on this side of the border.

The expansion of the subprime sector in the U.S. has helped steer borrowers into taking out high-cost loans that they can not afford to repay. Those loan packages also have been padded with unwanted items, such expensive life insurance policies.

Older borrowers are particularly vulnerable, the centre says, because they tend to own their homes outright and generally have to make do on fixed incomes. When they look for additional cash, they may be unfamiliar with the current credit market because they have not borrowed for some time.

Could predatory lending make inroads in Canada? Perhaps, says David K. Musto, a finance professor at the Wharton School at the University of Pennsylvania and co-author of a paper entitled Predatory Lending in a Rational World with fellow professors Philip Bond and Bilge Yilmaz. Although market forces in the U.S. and Canada are different, there’s nothing to say that the contagion couldn’t cross the border at some point.

Three market conditions are associated with predatory lending, according to data collected by Musto and his colleagues: there is little competition among lenders; property owners are sitting on lots of equity; and borrowers are not well informed about loan features and risks.

Musto and his colleagues did not attempt to look at predatory lending arising from fraud. Instead, they focused on situations in which the loan terms were clear to the borrowers, but the borrowers were negatively affected nonetheless.

Subprime mortgages come in various types, but tend to share several features. They start with a “teaser rate” that keeps initial payments small and makes it easier for applicants to qualify. Later, the interest rate is reset to a new rate, generally several percentage points more than some established floating rate, such as the yield on one-year U.S. T-bills. Typically, the reset involves a drastic increase in monthly payments, coupled with punitive pre-payment penalties during the first two or three years.

After short-term interest rates rose dramatically starting in the summer of 2004, for example, subprime loans were 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, thereby driving up foreclosures.

Predatory loan practices, Musto says, arise when a lender has extra, private information about borrowers’ prospects and uses it to their disadvantage. Lenders understand the market, whereas many borrowers, even if they understand the loan terms, often don’t have a clear idea of whether they can keep afloat if interest rates rise, housing prices fall or they or their spouse lose a job.

Critics of lenders’ behaviour in the subprime markets suggest that borrowers misjudge their true probability of default and lose their homes in foreclosures, while lenders know the true odds but recover enough in foreclosure that they lend anyhow, Musto notes.

In these cases, predatory lenders will provide money even if it enhances the borrowers’ odds of defaulting, so long as there is lots of equity in the property.

Even though there may be more defaulters on risky loans than traditional ones, this cost can be offset by the higher rates charged to all these borrowers. Moreover, unscrupulous lenders know they can always recover money by foreclosing on a defaulter’s home. IE