The Federal Reserve Board (FRB) is uniquely positioned to restore confidence in the housing market because it is the one federal agency with the authority to set standards for all home loan originators. Unfortunately, the proposed rules issued by the FRB today represent yet another missed opportunity for the agency to rein in practices that have hurt millions of American families.
The FRB's proposed rules are riddled with loopholes. Rather than eliminating the root causes of the subprime foreclosure crisis, which in turn would encourage a truly competitive market for home loans, the FRB's proposal permits many dangerous subprime lending practices to stand. An unregulated market has led to irresponsible lending practices where lenders often don't even assess ability to repay. The resulting high rate of foreclosures due to this abusive lending may well bring this country into recession—yet the FRB has chosen to issue rules that leave out many loans or will be unenforceable.
For years, mortgage lenders have operated on an uneven playing field: Banks and other depository institutions are supposed to abide by sensible lending rules, even though regulators haven't always enforced them. Finance companies that often specialize in subprime loans don't even have basic guidelines to follow. It is hard to fathom why the government gives a competitive advantage to one set of lenders over another when both have helped produce this epidemic of unsustainable loans. Rather than correcting perverse incentives to engage in reckless lending, the FRB proposed rules are extremely weak in the three most important areas it considered:
Prepayment penalties. Prepayment penalties on subprime mortgages trap families in bad loans or penalize them for improving their credit record. Rather than banning this "exit tax" on all subprime loans, the FRB only limits penalties slightly on adjustable-rate mortgages, and otherwise allows prepayment penalties to remain effective for five full years, with no limit on their size.
Yield-spread premiums. In the subprime market, prepayment penalties and kickbacks to mortgage brokers ("yield-spread premiums," compensation to mortgage brokers for signing up borrowers for higher interest loans when they qualify for a less expensive loan) go together. The Fed's proposed rule leaves yield-spread premiums intact by simply requiring written disclosure—which unscrupulous lenders can easily bury among the myriad disclosures and paperwork already required.
Ability to repay. The current mortgage crisis is largely due to lenders making loans to families without ensuring that the borrowers can afford them. The FRB is proposing rules they have previously issued in regulatory guidance to depository lenders, but they have made this rule virtually meaningless for most subprime lenders since the rule will not be enforceable. Victims will be required to show that the lender made unaffordable loans not only to him or her, but also in a "pattern or practice" to other borrowers—a standard of proof that makes it very difficult to win a case even when violations have been flagrant. The FRB acknowledged this very point in a report to Congress in 1998, when it said: "As a practical matter, because individual consumers cannot easily obtain evidence about other loan transactions, it would be very difficult for them to prove that a creditor has engaged in a 'pattern or practice' of making loans without regard to homeowners' income and repayment ability." Further, even this weak standard does not apply to non-traditional loans such as payment option ARMs.
On two other issues, the FRB's proposal is somewhat better:
Verification of income. The rules represent a step forward by addressing the lack of documentation of income that has caused significant payment problems on subprime loans, but the FRB failed to extend this rule to non-traditional mortgages, even when a borrower could easily provide a W-2 form or other proof of their income. This loophole defies common sense.
Escrow of taxes and insurance. A common deceptive lending practice is to market loans with an artificially low monthly payment by excluding mandatory tax and insurance costs. While we applaud the FRB's proposal to require the escrow of taxes and insurance for subprime loans, we are concerned that this sensible rule would not also apply to non-traditional mortgages, such as payment option adjustable-rate mortgages, and the fact that there is a one-year opt-out will reduce its effectiveness.The Center for Responsible Lending is continuing to analyze the proposed rules and may have further comments in the near future, and we will submit formal comments to the FRB in March 2008. Meanwhile, these proposed rules highlight the importance of pending legislation in Congress to assist homeowners with subprime mortgages who are facing foreclosure today and to strengthen consumer protections that will protect homeowners with subprime loans in the future.