The Federal Reserve began cleaning up the subprime mortgage mess yesterday with the release of new truth in lending rules that will require, among other things, mortgage lenders to verify a borrower's income and assets before approving a loan and be more truthful in their advertising.
"The U.S. mortgage market has seen rapid innovation in recent years. Changes, such as automated underwriting models, the evolution of the secondary markets, and specialization, have had many positive effects. Some changes in practices, however, did not have such positive effects," Randall S. Kroszner, a governor with the Federal Reserve, explained. "Abusive loans that strip borrowers' equity or cause them to lose their homes should not be tolerated. Too many homeowners and communities are suffering today because of these practices, and today the Federal Reserve Board is meeting to establish tougher rules to better protect consumers while preserving their access to credit as they make some of the most important financial decisions of their lives."
These new rules, which will apply to all lenders, not just ones regulated by the Federal Reserve, will take effect in October 2009, with the exception of a new escrow requirement for loans that would be considered subprime. The new escrow rule will be phased in during 2010.
The new regulations contain a number of practices that would seem to be common-sense procedures, but which apparently disappeared during the housing boom and accompanying growth in subprime lending. For examples, the new rules "prohibit a lender from making a loan without regard to borrowers' ability to repay the loan from income and assets other than the home's value." Lenders must also confirm an applicant's stated income and assets before approving the loan.
"When borrowers cannot afford to repay their loans, they suffer significant injury, such as loss of home equity or other assets, or foreclosure," asserted a recent Federal Reserve Board staff memo on the issue. "Entire communities may experience a decline in homeowner equity if unaffordable loans are concentrated in specific neighborhoods, leading to a decline in property values. Some borrowers may not understand that they are entering into unaffordable loans or may not be able to avoid entering into such loans. There does not appear to be any benefit to consumers from loans that are unaffordable at origination or immediately thereafter."
The Fed's new guidelines also tackle the problem of prepayment penalties, banning such financial hits to borrowers if the amount of their loan payment can change within the first four years of the mortgage. (An example of this would be an adjustable rate mortgage with a one-year "teaser" rate that changes in the loan's second year.)
The regulations address timing and paperwork issues that have resulted in expensive consequences for many borrowers. That means loan servicers will have to credit payments to a customer's account the day the money is received. They will be required to provide payoff information within a "reasonable time." (For example, in one case in Minnesota, homeowners whose loans were sold to an unscrupulous loan servicer were unable to refinance into a more affordable mortgage because of delays by the servicer.) Lenders will also be required to provide a "good faith estimate of the loan costs, including a schedule of payments" to refinancing homeowners within three days.
Builders and lenders will also want to pay careful attention to their marketing, particularly if they serve a Spanish-speaking population. The Fed's new rules specifically prohibit ads where the promotional copy is in a foreign language, but the disclosures are in English. The Fed is also banning ads that promote a "fixed" rate for loans that in fact have variable payments and adjustable rates; describe mortgage products as government-supported when they are not; and other misleading practices, such as ads that imply a lender or mortgage lender is a "counselor" for the buyer.
Finally, the Federal Reserve will now require banks and mortgage lenders to offer borrowers the option of escrowing their real estate taxes and homeowners' insurance premiums. This has not been standard practice in subprime loans, according to government documents, which has left these borrowers financially stretched and perhaps unprepared for the full cost of homeownership, including property tax payments.
"The lack of escrows in the subprime market reflects a market failure," according to the memo. "This market failure causes substantial injury to borrowers. A lack of escrows in the subprime market may make it more likely that borrowers obtain mortgages they cannot afford. Borrowers who cannot afford to save or have not been adequately informed of the need to save for taxes and insurance may not have the resources to pay tax and insurance bills when they come due. … Borrowers cannot avoid this injury if they are not offered loans with escrow and do not understand the risks and responsibilities associated with a non-escrowed loan."
Alison Rice is senior editor, online, at BUILDER magazine.