Fed Takes Aim at Deceptive Home Lending Practices

By David Cho
Washington Post Staff Writer
Wednesday, December 19, 2007

The Federal Reserve proposed new regulations yesterday to clean up a broad array of deceptive mortgage lending practices, a move that represents the central bank's most significant response to the nation's housing tumult.

The proposed rules signify a shift by the Fed toward an active regulatory role over the mortgage business and would affect a wide range of borrowers, lenders, banks and brokers. Home buyers would have to provide proof of income to ensure that they are not taking on more debt than they can handle. Mortgage ads could not promote only low "teaser" rates. Victims of predatory lending would be empowered to sue their mortgage providers.

The Fed can unilaterally impose the rules on mortgage lenders based on its authority to police lending practices, but the central bank has been wary of using this power. Lawmakers have criticized the Fed for not acting sooner.

Chairman Ben S. Bernanke said it took time to write regulations that are balanced. They "were carefully crafted with an eye toward deterring improper lending and advertising practices without unduly restricting mortgage credit availability," he said.

Consumer advocates credited the Fed for its effort to protect ordinary homeowners but said the rules would not go far enough. The Fed is not seeking to ban several practices that were widely used to coax unsuspecting borrowers into high-interest loans, the advocates said.

Congressional Democrats were more vociferous, accusing the Fed of putting the interests of the banking system before those of homeowners. They noted that the central bank is seeking to curb -- but not eliminate -- the compensation that mortgage brokers receive from lenders for selling high-interest loans to borrowers. And it seeks to restrict -- rather than ban -- the use of prepayment penalties, which discourage holders of subprime adjustable-rate mortgages from refinancing their loans before the rates jump. Congress wants to outlaw these practices altogether.

Sen. Charles E. Schumer (D-N.Y.) said the Fed's move will force Congress to pass far more stringent measures. Christopher J. Dodd (D-Conn.), chairman of the Senate Banking Committee, called the rules "a significant step backwards" because they advocate weaker lending standards than what the Fed proposed in a guidance paper a few months ago.

Added Barney Frank (D-Mass.), chairman of the House Financial Services Committee: "We now have 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."

The debate over how the Fed should tackle the mortgage mess is intensifying as the crisis continues to roil Wall Street and threatens to bring down the economy. The number of people who are losing their homes or have failed to make their monthly payments has reached record levels. Fresh data released yesterday showed that the construction of single-family homes slid to its lowest level in more than 16 years as demand for new houses wilts.

The Fed's role is seen as vital because it can act quickly and because its rules, which could be finalized after a 90-day public comment period, would apply to all lenders. Legislation by Congress would trump the Fed's authority but may take more time to enact. While a measure on mortgage reform has passed the House, a Senate bill is likely not to get a full-chamber vote until next year. The versions also have to be reconciled.

Consumer advocates said they will continue to push for stricter legislation on Capitol Hill. Jim Carr, chief operating officer of National Community Reinvestment Coalition, said the Fed was overly concerned about how the rules would affect mortgage lenders.

"I don't think the mortgage lending industry is going to fold up and close shop if you purge practices that have been proven year after year to be predatory to unsophisticated consumers," Carr said.

Michael Calhoun, president of the Center for Responsible Lending, said the Fed should have taken a page from Congress and banned lenders from giving loans to home buyers who cannot afford to pay after their adjustable rates increase. Instead, it merely proposed prohibiting them from "engaging in a pattern or practice" of selling such mortgages -- language Calhoun said is too vague and "riddled with loopholes."

Industry associations expressed more support for the Fed's effort.

"It sets some tough standards, but it appears to take a reasonable and balanced approach that we hope will be workable," said Steve O'Connor, senior vice president of government affairs for the Mortgage Bankers Association.

Fed officials added that they are gaining a better understanding of the underlying causes of the mortgage mess.

Although a lot of attention was cast on the Bush administration's plan to offer a five-year rate freeze to some holders of subprime adjustable-rate mortgages, Fed researchers found that many homeowners are defaulting not because the rates on their mortgages are increasing but because they did not realize their payments would be so high when the cost of home insurance and property taxes is tacked on to the monthly cost. Many home buyers, especially the poor and immigrants, were confused by the massive stack of documents they had to sign at closing.

As a result, Fed officials crafted rules that would require lenders to establish an escrow account for insurance and taxes for holders of subprime loans and to provide better and clearer documentation on what home buyers would pay on a monthly basis.

Fed officials also noted that mortgage default rates were highest for homeowners who had provided little or no documentation. Under the new rules, borrowers would have to provide independent proof of their income, though some flexibility is given to the self-employed.

These regulations seek to "strive to protect borrowers from practices that are unfair or deceptive," said Randall S. Kroszner, a Fed governor who oversaw the drafting of the proposed rules. He added that the agency wanted "to do so without unintentionally causing responsible lending to shrink or unduly limiting consumer choice."

On Capitol Hill, the House yesterday voted to prevent forgiven mortgage debt from being taxed as income. The Senate has already passed the bill, which can spare homeowners from taxes as high as 35 percent on canceled mortgage debt. White House press secretary Dana Perino told Bloomberg News that President Bush would sign it.

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