Fed to tighten up lending rules

NEW YORK (CNNMoney.com) -- The Federal Reserve on Tuesday will propose a much stricter set of rules for mortgage lenders as part of the central bank's effort to avert abusive lending.

The proposed rules are expected to crack down on lax practices in a number of ways. Among them, the rules are likely to:

Prohibit giving people unaffordable loans. One reason for the spike in foreclosures among those with subprime adjustable-rate mortgages (ARMs) was that lenders measured borrowers' ability to repay the loan based on the low introductory loan rate, but not on the higher rate that the loan would reset to. The Fed may propose that lenders base affordability on a borrowers' ability to repay a loan at the reset rate.

Restrict use of "liar" loans. The Fed is also expected to restrict the use of so-called "liar loans" or "stated income loans." When lenders make such a loan, they don't verify the income of the potential borrower. The end result: home buyers end up with homes they never could afford in the first place, let alone when their rate resets.

Prohibit or limit prepayment penalties. Homeowners who want to refinance into a more affordable loan are often prevented from doing so because of a punitive prepayment penalty - which can amount to the equivalent of six months of mortgage payments.

If the Fed doesn't ban them outright, it may at least require that lenders waive any prepayment penalties for 60 days prior to a loan rate resetting.

Curb or better disclose broker incentives. To encourage brokers to bring in more business, lenders can pay a broker to lock-in customers at higher rates than they'd otherwise qualify for.

For example, a lender might pay brokers 1 percent of the loan amount for every half point of interest added to what's known as the "par rate" - the rate the borrower would qualify for based on their credit score and other standards. This incentive is known as the "yield spread premium."

And lenders would impose prepayment penalties on borrowers as one way to ensure the lender made back the yield spread premium they paid. (How yield-spread premiums can bite you)

Require or encourage escrowing of taxes and insurance. Subprime lenders often did not disclose the true cost of a home. They might have excluded home insurance and property taxes, for example. Nor did they collect taxes and insurance along with the mortgage payment and hold them in escrow for the borrower until they came due.

Prohibit coercion of appraisers: Lenders or mortgage brokers will not be permitted to exert undue influence on appraisers to misrepresent the values of the homes involved.

In the past, appraisers have been often pressured to overvalue homes if their selling prices are higher than what appraisers think they are worth.

Prohibit loan servicers from engaging in unfair practices: The Fed will require that a servicer credit a consumer's account with payment as of the day of receipt and provide a record of payments within a reasonable period of time after it is requested. Late fees could not be "pyramided," that is, charged more than once.

Require better disclosure overall. In a letter last week to Rep. Brad Miller (D-NC), Bernanke indicated that the Fed would propose rules to address incomplete or misleading mortgage ads and to require earlier and clearer disclosures by mortgage lenders so that "consumers avoid loans that are not in their interest."

Congress has been considering its own crackdown on mortgage lenders with two bills the cover some of the same territory that the Fed is expected to cover but also go further.

While consumer advocates and lawmakers are eager to hear what the Fed is proposing and welcome the central bank taking action, they have been critical that the Fed didn't act sooner to avert the present-day mortgage mess. The Fed was given the power to issue rules to clamp down on abusive mortgage lending in 1994 under the Home Ownership and Equity Protection Act (HOEPA).

"HOEPA authorized and directed the Fed to issue rules to address unfair mortgage practices. For 13 years, that authority sat on the shelf unused," said Miller (D-NC), who co-wrote the mortgage lending abuse bill that passed in the House in November.

Still, Miller said, "it would be a huge help if the Fed proposed rules that got at the real abuses."

Where the provisions in the Senate and House bills overlap with what the Fed calls for, Miller said, it's possible they would be removed from the bills under consideration. "The number of fronts would be reduced dramatically ... maybe we wouldn't fight the same battle where we've had substantial victory."

The rules the Fed proposes on Tuesday will not be made final until the Fed receives and considers public comments on the proposals, a process which may lead the Fed to make amendments, issue new proposed rules or finalized the proposed rules it puts out this week.