The new interest rate bill now working its way through the District City Council contains a provision that many in the lending industry fear could wipe out much mortgage lending in the city.

The provision, meant as a consumer protection, extends to the so-called secondary mortgage market all the legal protections a borrower now has against his original lender.

This means that a District borrower who believes his loan fails to meet all the city requirements would be able to argue in court that he is not obligated to pay, even though the loan is owned by a secondary "holder in due course" and not by the original lender.

The result, according to sources in the lending industry, would be a significantly increased level of risk associated with loans written in Washington, especially when compared to those from other jurisdictions where secondary holders are not held accountable for defects in the original note.

The provision "essentially eliminates the negotiability of notes," John Stadtler, testifying on behalf of the Metropolitan Washington Savings and Loan League, told a council Finance and Revenue Committee hearing this week. ". . . P urchasers of notes in the secondary market would be required to accept significant risks with respect to the enforceability of purchased instruments. These risks are unacceptable to lenders with a choice. . . ."

The provision "eliminates the market -- no lender will move into the market," Walter Mess, speaking for the Mortgage Bankers of Metropolitan Washington, told the hearing.

Other industry sources generally agreed. "A lender has got to be able to sell his loans. It's the only way he can generate new money to make more" loans, said one. "But to be able to sell, he has to be able to provide a trouble-free investment. If he can't, or the buyers think he can't, then he isn't going to be able to sell. The buyer doesn't want to find he can't collect because the original lender failed to meet some local requirement."

"The connotation here is that the holder in due course has no protection. So the money is just going to stop--from legitimate sources," said another source. "This just guarantees business for the surreptitious lender."

The bill, sponsored by Councilman John A. Wilson, is primarliy concerned with raising the interest rate ceiling in the District. As written, the bill would raise the city's general interest ceiling to 21 percent, raise the ceiling on second mortgages to 24 percent, and end most of the restrictions on so-called balloon mortgages.

Balloon mortgages are loans that require relatively small payments for a set period followed by a single, large final payment.

The bill also contains provisions requiring increased levels of disclosure by lenders, and restrictions on prepayment penalties and late charges.

Sources at the District Building said after this week's hearing that councilmembers are aware of the lending industry's fears about the bill. Because of the limited time left in this council session, these sources said, it seems unlikely that the full council will act on the bill. If, as expected, Wilson reintroduces the measure next year, it is possible the holder-in-due-course section may be rewritten.

"We are going to be doing more studying and more re-examining" of the issue, said one of these sources. The lenders "have legitimate concerns."

In the past, holder-in-due-course protections in the District were abused in retail sales by unethical merchants who sold shoddy goods to low-income people on credit. The merchant then sold the buyer's note to a third party who could use the holder-in-due-course doctrine to enforce collection even though the merchandise proved defective.

"The council plainly remembers that," said one lending industry source. "But if the bill only succeeds in wiping out the legal loan market then the same people are going to be put upon. They're going to have to turn to the shoddy lender, the shoddy builder."

Several sources among the lenders said they believed the best approach to providing adequate protections for borrowers without drying up mortgage money would be to exempt large loans from the bill--on the grounds that large loans against property are generally made through reputable lenders -- and to set a one-year time limit for the borrower to assert his defenses against secondary holders. "After that, the paper would be negotiable," said one of these sources.