Fed Rules Aim to Stem Abusive Lending
Tuesday, July 15, 2008
The Federal Reserve rolled out rules yesterday aimed at curbing abusive lending practices widely used to coax unsuspecting borrowers into loans they cannot afford.
The rules take effect Oct. 1, 2009, so they will not help borrowers currently in trouble. Even so, consumer groups and Democratic leaders who initially criticized the Fed's response to the mortgage crisis praised the effort. They said even though market pressures have eliminated many of the practices targeted by regulators, the new rules would help prevent future fiascos.
"Unless the prohibitions are memorialized in a regulation, there is nothing to prevent the industry from reverting to prior bad practices," said Jaret Seiberg, an analyst at Stanford Policy Research. "That is why these rules have long-term significance."
The toughest of the rules apply to subprime loans, typically made to people with little cash or poor credit. The mortgage crisis started when borrowers with these loans began defaulting at an alarming rate more than a year ago. Since then, subprime loans have virtually vanished. Many lenders who specialized in subprime mortgages shut down, and others tightened their standards.
But federal regulators said they expected the subprime problems to resurface once the market calms. The new rules apply to all banks, financial institutions and mortgage brokers.
Under the rules, lenders can make subprime loans only to borrowers who can be reasonably expected to repay them. In doing so, they must assess the borrower's ability to pay the highest scheduled monthly payment in the first seven years of a loan. Previously, lenders considered only the ability to repay low teaser rates that could later rise sharply, as many of them did.
Lenders must also verify a borrower's income and assets, once a common practice that fell by the wayside during the housing boom. Starting in 2010, lenders must also put payments in escrow accounts for property taxes and homeowner's insurance for all first-lien mortgage loans.
"This represents a return to common sense business practices," said Deborah Goldstein, executive vice president of the Center for Responsible Lending.
The new rules also limit the use of prepayment penalties, large fees imposed on borrowers who pay off their original loans early. These fees made it tough for many distressed borrowers to refinance into better terms, and consumer advocates pushed to eliminate them.
The Fed did not go that far. Instead, it barred prepayment penalties on subprime, adjustable-rate loans with rates that reset within the first five years of a loan. On fixed-rate loans, prepayment penalties are permitted during the first two years of the loan.
Some states, including Maryland, have banned prepayment penalties on subprime loans. The state rules would trump the federal rules for state-regulated entities.
Consumer advocates wanted a far-reaching ban. They also wanted the Fed to prohibit incentive-based pay or "yield spread premiums." These are fees that mortgage brokers are paid for placing a loan with a higher rate. The Fed will consider that issue separately.