The Federal Reserve is considering using its rule-making authority to ban some mortgage lending practices as unfair and deceptive, but would prefer to issue guidelines and improve disclosures lenders provide to borrowers.
That’s according to Federal Reserve Chairman Ben Bernanke, who delivered his most extensive comments on problems in subprime lending in a speech today at a conference in Chicago.
Bernanke and other federal banking regulators have been criticized by some lawmakers for alleged inaction in the face of a sharp rise in delinquencies and foreclosures in subprime mortgage loans. Bernanke acknowledged the trend, but said he remains convinced that market forces, not regulators, should have the greatest influence over lending practices.
Bernanke said that there are some signs that market forces are already curbing the lending practices that contributed to the rise in foreclosures. Investors are scrutinizing subprime loans more carefully and lenders have tightened underwriting standards, he said.
“Markets can overshoot, but, ultimately, market forces also work to rein in excesses,” Bernanke said. “For some, the self-correcting pullback may seem too late and too severe. But I believe that, in the long run, markets are better than regulators at allocating credit.”
Bernanke said effective disclosures of loan terms “should be the first line of defense against improper lending,” followed by guidelines that outline practices lenders should follow when making loans.
Rules should be formulated with caution, Bernanke said, because lending practices that seem inappropriate in some circumstances may be appropriate in others.
“Rules are useful if they can be drawn sharply, with bright lines, and address practices that are never, or almost never, legitimate,” Bernanke said.
The Home Ownership Equity Protection Act (HOEPA) gives the Federal Reserve Board the power to prohibit unfair or deceptive mortgage lending practices. In 2001, the Fed used its authority under HOEPA to ban several practices for high-cost loans, including “loan flipping,” the practice of frequent and repeated refinancing to generate fees for lenders.
Bernanke said the Fed is considering consider whether other lending practices meet the legal definition of “unfair and deceptive” and should be prohibited under HOEPA. Any new rules would have to be drawn sharply, he said, because HOEPA violations expose lenders not only to regulatory enforcement but private lawsuits on behalf of borrowers.
“Insufficiently clear rules could create legal and regulatory uncertainty and have the unintended effect of substantially reducing legitimate subprime lending,” Bernanke said.
The Federal Reserve also writes the regulation implementing the Truth in Lending Act’s requirements that borrowers must be provided with clear disclosures of loan terms.
Bernanke said the Fed last summer began a “top-to-bottom evaluation” of mortgage-related disclosures, holding four open hearings around the country. Using consumer testing, including research on disclosures provided to credit card customers, the Fed will be working to improve disclosures associated with mortgage lending, Bernanke said.
While the rules and disclosures that the Federal Reserve is involved in drafting under HEOPA and the Truth in Lending Act apply to all lenders, guidelines issued by federal regulators apply only to federally chartered banks and thrifts, unless states move to adopt them.
Last summer, the Federal Reserve and other federal regulators issued new guidelines for nontraditional, “exotic” interest-only and pay-option loans. The guidelines require more thorough disclosures and stricter underwriting standards — including qualifying borrowers at “fully indexed” interest rates — and have since been implemented by 33 states.
Federal regulators issued guidelines for subprime loans in 1999, which were expanded in 2001. A draft proposal to update the guidelines for subprime loans by incorporating some of the new guidance on exotic loans was put forward in February.
Bernanke said guidelines are often a better approach than rules because they “can be modified as needed to apply to different situations, and thus can be a more flexible tool than rules for accomplishing regulators’ goals.”
In advocating a restrained approach by regulators, Bernanke acknowledged the increased prevalence of subprime lending and problems posed by delinquencies and foreclosures, but said the effect on the economy overall appears to be limited.
Subprime lending “began to expand in earnest” in the mid-1990s, he said, spurred by innovations that reduced the costs for lenders of assessing and pricing risks, such as credit scoring. The growth of the secondary market for mortgages — in which loans are pooled, securitized and sold to investors — has “given mortgage lenders greater access to the capital markets, lowered transaction costs, and spread risk more broadly, thereby increasing the supply of mortgage credit to all types of households.”
Those factors also laid the groundwork for an expansion of higher-risk mortgage lending, and today about 7.5 million mortgages — about 14 percent of all first-lien loans — are subprime, Bernanke said, using adjusted numbers from the Mortgage Bankers Association. Alt-A or “near-prime” loans account for another 8 percent to 10 percent of mortgages, he said.
About two thirds of subprime loans — or 9 percent of outstanding mortgages — carry adjustable interest rates, and the rate of serious delinquencies on those loans rose sharply in 2006. Recently, the rate of serious delinquencies (90 days or more overdue) on subprime ARM loans stood at 11 percent, about double the recent low seen in 2005.
In the fourth quarter of 2006, about 310,000 foreclosure proceedings were initiated, compared with an average of about 230,000 per quarter in the previous two years, Bernanke said, citing adjusted MBA figures. Subprime mortgages accounted for more than half of new foreclosures in the fourth quarter of 2006, he said.
While the seasoning of mortgages — the tendency for mortgages that are several years old to have higher delinquency rates — accounts for some of the rise, Bernanke said lower home-price appreciation, rising interest rates, and regional economic problems have also played a role.
But Bernanke laid some of the blame on mortgage originators, who “evidently loosened underwriting standards” as the demand for loans tailed off at the end of the boom.
The practice of selling mortgages to investors may have contributed to the weakening of underwriting standards, Bernanke said, because it allowed originators to distance themselves from the risk of a loan defaulting. Loan originators were offered incentives based on the number of loans closed, rather than their quality, he noted.
Intense competition in the subprime mortgage lending industry — driven in part by excess capacity in the lending industry built up during the refinancing boom earlier in the decade — may also have been a contributor to loosened underwriting standards, Bernanke said.
Bernanke acknowledged that the recent rise in delinquencies has serious consequences for borrowers, including foreclosure, the loss of home equity, and reduced access to credit. Others may suffer too, he said, as geographically concentrated foreclosures tend to reduce property values in the surrounding area.
He said federal regulators are encouraging banks and thrifts to work with borrowers who are in trouble. Workouts, in which loan terms are restructured so borrowers can stay current on their payments, are often in the interest of both parties, he said.
The legal and accounting rules associated with loans that have been securitized and sold to private investors can make the process more difficult, he noted.
Although the problems in subprime lending are having an effect on the housing market, they don’t appear to be spilling over to the economy or the financial system, Bernanke said.
Real gross domestic product has expanded a little more than 2 percent in the past year, compared with 3.75 percent in the previous three years, Bernanke said, and “the cooling of the housing market is an important source of this slowdown.
It’s likely that subprime mortgage lending boosted home sales “somewhat, and curbs on this lending are expected to be a source of some restraint on home purchases and residential investment in coming quarters,” Bernanke said.
He said to expect further increases in delinquencies and foreclosures this year and next as many ARM loans reset.
“All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system,” Bernanke said.
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