Real Estate

Fed tightens up lending rules

The central bank is proposing regulations that offer greater protections for home buyers and curtail abusive lending.

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By Jeanne Sahadi, senior writer

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WASHINGTON( -- The Federal Reserve on Tuesday proposed a much stricter set of rules for mortgage lenders as part of the central bank's effort to avert abusive lending.

Some of the rules would apply to borrowers with what the Fed called "higher-priced mortgage loans," which it defined as first-lien mortgages that carry interest rates 3 percentage points higher than the yield on comparable Treasury securities - basically, subprime loans.

Another set of proposals Tuesday would apply to all mortgage loans. The rules are subject to public comment for 90 days, after which the Fed will review comments and consider whether to make changes to them before issuing final rules.

Subprime plan

"Our goal is to promote responsible mortgage lending, for the benefit of individual consumers and the economy," said Federal Reserve Chairman Ben Bernanke. "We want consumers to make decisions about home mortgage options confidently, with assurance that unscrupulous home mortgage practices will not be tolerated."

The Fed's proposals would:

Prohibit giving people unaffordable loans. The new rules would bar lenders from extending credit without considering the consumer's ability to repay.

One reason for the spike in foreclosures among those with subprime adjustable-rate mortgages (ARMs) was that lenders measured a borrower's 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 proposed that lenders base affordability on a borrower's ability to repay loan at the reset rate.

Restrict use of 'liar' loans. The Fed wants 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.

It is now insisting on verification both on borrower's income and assets.

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

The new Fed rules require that lenders waive any prepayment penalties for 60 days prior to a loan rate resetting.

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.

Across-the-board changes

Some of the Fed's proposals would apply to all types of mortgages, not just subprime loans:

Curb or better disclose broker incentives. To encourage brokers to bring in more business, lenders can pay a broker to lock-in customers to higher rate loans 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."

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

The Fed would now prohibit indirect or direct payments from lenders to brokers unless brokers disclose to borrowers the compensation they expect to receive from all sources, including the yield spread premium.

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

In the past, appraisers have often been 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 would 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. The Fed proposed rules to address incomplete or misleading mortgage ads and to require earlier and clearer disclosures by mortgage lenders so that consumers can avoid loans that are not in their interest.

An example of a prohibited advertising practice would be the use of the word "fixed" to describe a loan in which the interest rate or payment is not fixed for the entire term of the loan.

The proposed rules also state that all applicable rates and payments must be given equal prominence with advertised introductory or "teaser" rates. Lenders could not advertise a lower interest rate than what the loan is actually accruing.

That would mean an end to claims of loans with 1 percent interest rates when the rate is actually much higher. The 1 percent usually refers merely to the minimum payment consumers are required to make. Each payment made at that level means the balance owed on the mortgage grows.

From the Fed to the Hill

Some members of Congress, which is considering legislation that would crack down on mortgage lenders, have blasted the Fed for not acting sooner to avert the 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 Rep. Brad Miller, D-N.C., who co-wrote the mortgage lending abuse bill that passed in the House in November.

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. "Maybe we wouldn't fight the same battle where we've had substantial victory," he said.

One community advocate, John Taylor, chief executive of the National Community Reinvestment Coalition, said more needs to be done. "The proposed rules are not a substitute for strong anti-predatory lending legislation," he said.

Some lawmakers panned the Fed's actions.

"[The Fed] took a significant step backwards today," said Sen. Christopher Dodd, D-Conn. "The board did not even have the courage of its convictions - the board weakened its earlier guidance on requiring an originator to fully analyze a borrower's ability to repay the mortgage at the fully indexed rate, the most fundamental measure of good lending."

In addition, Dodd said the Fed's proposed steps on prepayment penalties were inadequate, and said the Fed should have banned the the use of yield-spread premium entirely.

Rep. Barney Frank, D-Mass., said the Fed's move is "confirmation of two facts we have known for some time: one, the Federal Reserve System is not a strong advocate for consumers, and two, there is no Santa Claus. People who are surprised by the one are presumably surprised by the other."  To top of page

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