Federal regulators on Thursday unveiled a set of recommendations for strengthening regulations governing mortgage lending, including improved disclosures and the adoption by all states of a nationwide licensing standard for mortgage brokers.

In announcing the recommendations Thursday, Treasury Secretary Henry Paulson said that "regulation needs to catch up with innovation and help restore investor confidence but not go so far as to create new problems, make our markets less efficient or cut off credit to those who need it."

The recommendations were outlined in a 21-page report issued by The President’s Working Group on Financial Markets, whose members include the Department of the Treasury, the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission.

The group’s recommendations for reforming the mortgage origination process include:

  • Adoption by states of "strong nationwide licensing standards" for mortgage brokers, and of federal regulators’ guidance for nontraditional and subprime mortgage lending.

  • Strengthened state and federal oversight of companies that originate and fund mortgages or have other contact with customers in the mortgage origination process.

  • Stronger consumer protection rules from the Federal Reserve, along with improved disclosures making loan terms over the life of the mortgage more transparent and easier to compare with alternative products.

The report concluded that the current turmoil in financial markets was a result in a breakdown in underwriting standards for subprime mortgages, and a "significant erosion" of market discipline by those involved in bundling those loans into securities for sale to Wall Street investors.

Originators, underwriters, credit rating agencies and global investors were all to blame, in part because they failed to provide or obtain adequate risk disclosures.

Credit rating agencies produced flawed assessments of the risks involved in investing in mortgage-backed securities (MBS) and other "structured credit" products, especially collateralized debt obligations (CDOs) that contained MBS and other asset-backed securities.

The lack of due diligence by loan securitizers, credit rating agencies and mortgage investors mean loan originators had "weak incentives to maintain strong underwriting standards," the working group concluded.

At the same time, limited government oversight of mortgage companies not affiliated with regulated banks "contributed to a rise in unsound underwriting practices in the subprime sector, including, in some cases, fraudulent and abusive practices."

Those companies made about half of higher-priced mortgages in 2006, the working group found.

State-licensed mortgage brokers who take loan applications and shop them to regulated banks and other lenders also had week incentives to maintain underwriting standards, the group’s report found.

"Weak government oversight of these entities also contributed to the rise in unsound underwriting practices," the report said.

The President’s Working Group recommended that state regulators implement strong nationwide licensing standards for mortgage brokers. The group noted that the Conference of State Ban Supervisors (CSBS) and the American Association of Residential Mortgage Regulators (AARMR) have already created a nationwide licensing system and database for mortgage professionals, which seven states signed on to when the system was launched.

The Federal Reserve has begun a review of the Truth in Lending Act (TILA) rules for mortgage loans, and plans to propose new mortgage disclosures based on the results of consumer testing, the report said.

The Fed has already proposed changes to the TILA rules to address concerns about incomplete or misleading mortgage loan advertisements and solicitations and to require lenders to provide mortgage disclosures more quickly, which will be enacted after a 90-day comment period expires.

The Fed used its authority under the Home Ownership and Equity Protection Act (HOEPA) to propose new rules in December that are intended to address abuses related to prepayment penalties, failure to escrow for taxes and insurance, stated-income and low-documentation lending, and failure to give adequate consideration to borrowers’ ability to repay. These rules should be enacted once appropriate account has been taken of feedback received over the 90-day comment period, the report said.


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