The Federal Reserve proposes imposing some restrictions that currently apply only to very costly loans — including a ban on most prepayment penalties — to subprime and some Alt-A loans.
The product of a series of hearings, the proposed changes in how the Fed implements the Truth In Lending Act, or TILA, are intended to protect consumers from unfair or deceptive home mortgage lending and advertising practices.
While the proposed regulations drew a mixed reaction from lenders, Connecticut Democrat Sen. Chris Dodd issued a statement slamming them as “deeply disappointing,” and “a clear signal that legislation is necessary to help protect homeowners from abusive and predatory lending practices.”
The proposed amendments to Regulation Z, which spells out the Fed’s implementation of TILA, would require lenders making “higher-priced” mortgage loans to:
- Verify a borrower’s ability to repay a loan with an adjustable-rate mortgage after a payment reset, including property taxes, homeowners insurance and other expenses.
- Document income and assets, using a borrower’s Internal Revenue Service Form W-2, tax returns, payroll receipts, financial institution records, or other third-party documents that provide reasonably reliable evidence of the consumer’s income and assets.
- Establish escrow accounts for taxes and insurance, which borrowers could opt out of after one year.
The new regulations would also ban prepayment penalties on higher-priced loans unless the consumer’s debt-to-income ratio does not exceed 50 percent of verified monthly gross income, and the source of the prepayment funds is not a refinancing by the same lender or its affiliate.
Only higher-priced mortgage loans on a primary residence — including home-purchase loans, refinancings and home-equity loans — would be subject to those provisions in the new regulations. Mortgages on vacation properties, open-end home-equity plans, reverse mortgages, or construction-only loans would be exempt, and loans to investors are, for the most part, not covered by TILA.
Higher-priced loans would be defined as first-lien mortgages with an annual percentage rate (APR) of 3 percent or more above the yield on comparable Treasury notes, or 5 percent for second mortgages.
In addition to extending some provisions of the Home Ownership and Equity Protection Act (HOEPA) to subprime loans, the proposed regulations would also create some additional new requirements for all loans, including:
- Written agreements between borrowers and mortgage brokers collecting yield spread premiums, before the consumer applies for the loan or pays any fees.
- Prohibitions on coercing appraisers to inflate property valuations.
- New requirements for loan servicers, including crediting consumers’ loan payments to the date of receipt and providing a schedule of fees to consumers upon request.
Dodd criticized the proposed language requiring lenders to evaluate a borrower’s ability to repay a loan difficult to enforce, because regulators would have to show a “pattern and practice” of violations. The Connecticut lawmaker called the language a “significant step backwards” from existing guidance on the topic from regulators.
He said allowing borrowers to opt out of escrow accounts after one year could provide unscrupulous lenders a “tool to ‘flip’ borrowers into another, wealth-stripping refinance.”
While the proposed measures don’t go as far as some consumer groups and lawmakers had wanted, they represent a significant departure for the Fed, which has come under fire from critics who say it has failed to use its authority under the Truth in Lending Act to prohibit abusive lending practices during the boom.
Lenders have argued against stricter regulations, saying market forces have put an end to many of the most egregious practices and that new restrictions could worsen the credit crunch.
“There is much to commend and much to worry about in the proposed rules,” the American Bankers Association said in a statement on the proposed Regulation Z changes.
While the ABA welcomed “uniform, national standards” that will apply to all lenders and target abuses by unregulated or lightly regulated nonbank lenders, the group warned that “replacing important lending flexibility with rigid formulas might also limit lending to some creditworthy borrowers.”
Some consumer groups wanted the Fed to simply lower the thresholds that trigger existing HOEPA requirements. Both first-lien loans with an annual percentage rate (APR) more than 8 percent above the rate on Treasury securities of comparable maturity and second-lien loans with APRs more than 10 percent higher are covered by HOEPA.
Among the most feared provisions of HOEPA are the rights it gives borrowers to sue lenders who violate its requirements, allowing them to recover statutory and actual damages, court costs and attorneys’ fees. Borrowers also have up to three years to cancel a loan that is subject to HOEPA if they can show the requirements weren’t followed.
A bill introduced Dec. 12 by Sen. Dodd, The Homeownership Preservation and Protection Act, would lower HOEPA thresholds to a range of 6 to 10 percent for first mortgages, and 8 to 12 percent for seconds. Loans in which total points and fees exceed 5 percent would also trigger HOEPA requirements under Dodd’s bill.
Opponents have warned that lowering HOEPA thresholds to cover subprime loans could discourage investors from buying mortgage-backed securities on Wall Street, further reducing the flow of investment capital into mortgage lending and increasing the cost of borrowing for home buyers.
“Any federal law that begins with amendments to existing HOEPA likely will be freighted with HOEPA’s effects,” industry lawyer and lobbyist Donald Lampe told members of the House Financial Services Committee in May. “Hardly anyone … in the secondary market funds or purchases HOEPA loans.”
Instead of lowering the threshold for triggering HOEPA requirements, the Fed proposes to create a new class of higher-priced loans that would be subject to new regulations.
Lenders who followed the rule that they verify and document a borrower’s ability to repay a loan would be granted “safe harbor” from lawsuits if they had a reasonable basis to believe that borrower would be able to make loan payments for at least seven years.
The proposed definition of a higher-priced loan — 3 percent above comparable Treasury notes for first mortgages, or 5 percent for seconds — is already used to collect data under the Home Mortgage Disclosure Act.
The definition is intended to “capture the subprime market, but generally exclude the prime market,” staff members of the Fed’s Division of Consumer and Community Affairs said in a Dec. 12 memo summarizing the proposed changes. There is no uniform definition of prime and subprime markets, however, the memo noted, and the proposed thresholds “would capture at least the higher-priced portion of the alt-A market.”
The Fed is requesting comment on whether different thresholds, such as 4 percent for first-lien loans, “would better meet the objective of covering the subprime market and excluding the prime market,” and on ways to “limit creditor circumvention” of the thresholds.
The lending industry has argued that prepayment penalties can benefit borrowers by allowing lenders to charge lower interest rates.
But critics say many consumers aren’t very good at factoring in their potential cost into the price of a loan, which is not included in the annual percentage rate. Studies have shown most borrowers with adjustable-rate mortgage (ARM) loans seek to refinance before their interest rates reset, and prepayment penalties can decrease a borrower’s home equity and increase their loan balance when financed into a new loan.
The new tougher restrictions on prepayment penalties “should allow the vast majority of subprime borrowers to refinance their mortgages without paying a prepayment penalty before the first payment increase takes effect,” Fed staff members said in a memo to the Board of Governors.
Dodd questioned the adequacy of provisions intended to limit the use of prepayment penalties and yield-spread premiums, which he said are used to put borrowers in more expensive loans than they qualify for.
All in all, the proposal “raises serious questions as to whether the Federal Reserve is the appropriate institution to house consumer protection functions,” Dodd said in a statement. “This is a clear signal that legislation is necessary to help protect homeowners from abusive and predatory lending practices.”
The House of Representatives on Nov. 15 approved a bill, HR 3915, the Mortgage Reform and Anti-Predatory Lending Act of 2007, which would limit prepayment penalties, set minimum standards for all mortgages that lenders assess a borrower’s ability to repay, and expand HOEPA restrictions.