Fed in tug of war over mortgage rules

Federal Reserve on Monday is expected to tighten regulations to protect homebuyers. Consumer groups and lenders each hope arguments win out.

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NEW YORK (CNNMoney.com) -- The Federal Reserve is caught in a tug-of-war as it prepares on Monday to unveil final rules overhauling mortgage lending.

Consumer groups are arguing that the regulations, as proposed in December, contain too many loopholes, allowing reckless lending to continue. Industry executives say the proposals place too great a burden on lenders and will prompt them to further restrict credit.

It appears the Fed was swayed by the more than 2,500 comments submitted on the proposals since it has signaled it has revised them, industry insiders say. But it remains to be seen which side the Fed favored.

"The question is which way will the Fed head?" said Kurt Eggert, law professor at the Chapman University School of Law and former Fed Consumer Advisory Council member. "That's what we're all waiting to see."

Though the proposals won't help the millions of homeowners who've already fallen behind in their mortgages, the Fed is aiming to prevent another such crisis by tightening lending standards, particularly for subprime mortgages.

"Our goal is to promote responsible mortgage lending, for the benefit of individual consumers and the economy," Fed Chairman Ben Bernanke said when the standards were proposed.

Bernanke said the proposals "were carefully crafted with an eye toward deterring improper lending ... without unduly restricting mortgage credit availability."

To better protect subprime borrowers from getting into loans they couldn't handle, the Fed proposed four new requirements. The rules would:

  • Require lenders to verify income and assets.
  • Prohibit them from engaging in a "pattern or practice" of making loans borrowers can't afford
  • Limit prepayment penalties.
  • Require lenders establish escrow accounts for taxes and insurance.

Also, for all loans regardless of rate, the regulator would ban the practice of allowing banks to pay brokers for steering homeowners into higher-priced loans, unless that compensation was disclosed in advance. And it would prohibit brokers from coercing appraisers into misstating a home's value.

Consumer advocates: More is needed

With the proposals, the Fed is attempting to answer critics who charged the agency could have flexed its muscles several years ago, clamping down on unscrupulous lenders during the real estate boom.

"Had these rules been in place, many of these things wouldn't have happened," said Ken Wade, chief executive of NeighborWorks America, a national community revitalization group chartered by Congress whose board is made up of bank regulators. The late Edward Gramlich, a former Fed governor who served as chairman of NeighborWorks' board, pushed unsuccessfully to rein in the mortgage industry.

Still, Wade and other consumer advocates say the proposed rules need to be tightened further to be effective.

For instance, the Fed should outright prohibit lenders from originating loans without considering the borrower's ability to pay. It's very difficult to prove a "pattern or practice" of such behavior, said Jim Carr, chief operating officer of the National Community Reinvestment Coalition, an advocacy group.

"We really need to just have firm rules that close the door on the potential and the incentive for misbehavior," Carr said. "Considering we're in the midst of the worst housing collapse in half-a-century, one would think the rules would be stern enough to make clear these practices are not acceptable."

Advocates also want the Fed to ban all prepayment penalties, not just limit them. As proposed, the regulation would prevent lenders from imposing a penalty at least 60 days before a jump in monthly payments.

Also, they say the agency should eliminate so-called "yield-spread premiums," which some call a kickback to mortgage brokers for signing up borrowers for higher-cost loans when they could afford traditional ones. All parties in the mortgage industry should clearly disclose their fees, advocates say.

"No lender should be able to hide the additional fees they charge," Wade said. "It creates confusion for the consumer."

Industry warns credit could be restricted

Industry executives, meanwhile, say increased regulation would prompt lenders to originate fewer mortgages. The proposals would raise lenders' liability and workload.

"If the rule passes, I'm afraid the Fed will have to back off on some of it because it will hurt homeownership," said Bill Howe, vice president of the National Association of Mortgage Brokers.

Many brokers, bankers and trade associations submitted comments critiquing the Fed's proposals and warning of the consequences.

High among their concerns is that the Fed's measure for what constitutes a subprime loan - one with a mortgage rate three percentage points above the yield on a comparable Treasury note - would capture some prime loans as well, subjecting borrowers to greater scrutiny.

They are also asking for clear guidelines on how they should evaluate a borrower's ability to repay the loan. However, the final rules should allow the lenders some flexibility in assessing borrowers' capabilities, executives say.

Also, the industry doesn't want the Fed to impose too many limitations on the penalties lenders assess borrowers who pay their mortgages early. Lenders are more willing to extend credit to subprime borrowers when they know the homeowners can't quickly refinance into a lower cost loan without a big penalty.

"Prepayment fees allow borrowers access to lower rates and, for some borrowers, whose risk profiles are more challenged, their only opportunity for mortgage financing," wrote Kieran Quinn, chairman of the Mortgage Bankers Association.

For community banks, requiring escrow accounts would be an expensive hurdle.

"To require community banks to do so would cause extraordinary time and expense to purchase additional software and computer systems and to hire additional staff," wrote John Barrett, president of First National Bank of Oxford in Mississippi. "That expense would quickly find its way into the pricing of loans and the addition of fees. Conceivably, community banks would find themselves driven to avoid those loans that trigger the escrow requirement, thereby denying credit to those customers the regulations seek to protect."

Enforcement essential

However the Fed tilts, a key question left unanswered is who will make sure the rules are followed. While all lenders would be subject to the new rules, oversight is divided up among various state and federal agencies, depending on the business' charter.

"You have to make sure the rules are enforced or else they don't mean anything," Wade said. To top of page

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