05/23/2011 04:29 pm ET Updated Jul 23, 2011

When Cities Sue: Local Governments Take a Bank to Court

From the time of early English common law, the era of the colonial and early American courts and straight through to the present, state and local governments have used litigation to rein in harmful and abusive practices. Over the years, such government-led lawsuits have sought to punish a range of conduct, from driving horses unsafely on the roads to polluting streams and wells. Long before there were zoning or building codes, municipalities brought nuisance actions against harmful practices, like operating a slaughterhouse in a residential neighborhood or releasing too much smoke or dust from a factory.

Today, cities are using the courts, sometimes successfully, sometimes not, to fight the proliferation of illegal handguns, climate change and even predatory lending. In recent weeks, and using fair lending laws, communities trying to fight back against what is alleged to have been discriminatory subprime lending during the height of the mortgage frenzy of the last decade have won significant victories in the courts, perhaps paving the way for more cities to follow suit.

In these two cases -- the first filed by the mayor and City Council of Baltimore, Maryland, and the second filed jointly by the City of Memphis and the surrounding Shelby County, Tennessee -- these local governments have charged Wells Fargo bank with engaging in predatory bank practices that fall along racial lines. The plaintiffs accuse the bank of offering loans to borrowers of color on terms that were less beneficial than those offered white borrowers.

This practice is known as "reverse redlining": the targeting of communities of color for loans on unfair terms. This is often juxtaposed against the practice of "redlining": when banks neglect to serve communities of color. And the two practices often follow each other. A community is redlined, and traditional banks fail to serve it. Then that same community is reverse redlined, with predatory lenders flourishing in that same market, facing few legitimate competitors.

Subprime lending during the mortgage frenzy of the last decade had a particularly racial overtone. A national study (PDF), conducted by the Federal Reserve, of lending in 2006 shows that African-American borrowers were nearly three times as likely in that year to be saddled with subprime loans as their white counterparts. When controlling for many borrower characteristics, including income, the figure changes, but not by much: African-American borrowers were still twice as likely as whites to take out a subprime loan.

And this phenomenon hit middle-income African Americans particularly hard. A study, by the New York Times, of lending in the New York City region showed that middle-income African-Americans were roughly five times as likely to take out a subprime loan as were whites of similar, or even lower, incomes.

Furthermore, a recent study conducted by this author showed a connection between African-American median incomes and foreclosure rates. The higher a state's median income for African-Americans within the state, along with several other factors including the size of the African-American population in that state, generally tended to correspond to higher foreclosure rates in that state. These findings suggest that predatory lending was more prevalent in states where the African-American middle class was stronger and larger, erasing decades of wealth gains made in these communities, particularly those made in the late 1990s.

The Baltimore and Memphis lawsuits take aim at reverse redlining practices carried out in communities of color. The plaintiffs in each case plotted out the course of Wells Fargo's lending in their communities to allege that the bank engaged in reverse redlining by lending on unfair terms in communities of color. Allegations by the plaintiffs also suggest that Wells Fargo was more likely to foreclose on mortgages found in predominantly African-American communities as compared to primarily white communities.

Moreover, the plaintiffs have produced affidavits from former Wells employees that allege that bank staffers referred to subprime loans as "ghetto loans" and borrowers of color as "mud people."

In the Baltimore lawsuit, the judge handling the case has put the plaintiffs through their paces, having dismissed the complaint several times. But each time he has offered them a chance to refile their papers to sharpen their allegations and draw a closer connection between the bank's lending, the wave of foreclosures that has hit the city and the costs the city claims to have experienced as a result of these practices. The plaintiffs allege that these foreclosures have dragged down property values in the city, forced the government to spend thousands of dollars on fire and police services and lowered the tax base.

The bank counters that it is blameless for the general economic decline of the city, and the plaintiffs cannot draw a direct relationship between Wells Fargo's practices and the particular damages the city claims it has suffered.

The court has now said that the plaintiffs' allegations identify specific properties where Wells made subprime loans to particular borrowers of color who would have qualified for prime loans. It is alleged that these subprime terms led first to default, then foreclosure. The Baltimore plaintiffs seek compensation from the bank for the drain on municipal coffers resulting from these practices. Weeks ago, the bank's most recent motion to dismiss was denied, and the case permitted to proceed.

In the case filed by the City of Memphis and Shelby County, the plaintiffs make similar arguments, tying bank practices to increased municipal and county expenditures. The judge there also recently denied the bank's efforts to dismiss that lawsuit.

The plaintiffs in these cases have now passed a critical hurdle in their attempt to hold at least one bank accountable for what the litigants allege were predatory practices that have cost local governments across the country dearly, saddling them with the job of cleaning up after the subprime debacle.

These cases now move to the discovery phase of the litigation, where the plaintiffs will have a chance to demand internal bank documents and emails and conduct interviews with bank officials. This process may yield information about such practices, not just in these communities but also nationwide, and may give rise to claims by other jurisdictions. Local governments and state attorneys general should watch these cases closely to assess the viability of bringing similar actions in their own backyards.