Fed Staff Recommends Tighter Curbs on Subprime Loans

Nothing like driving by looking in the rear view mirror...



By Craig Torres and Alison Vekshin

Dec. 18 (Bloomberg) -- Federal Reserve staff recommended that policy makers issue new restrictions on subprime mortgages, from a ban on low-documentation loans to limiting penalties for borrowers who prepay their debts.

The rule proposal, which the Board of Governors will vote on later today, follows months of public comment by Congress and consumer advocates, who urged the Fed to toughen consumer protections. Finance-industry officials warned that a crackdown would curtail lending in the midst of the housing recession.

``Mortgage-market discipline has in some cases broken down and the incentives to follow prudent lending procedures have, at times, eroded,'' Fed Chairman Ben S. Bernanke said in a statement. The proposed new rules ``were carefully crafted'' to deter ``improper lending'' without ``unduly restricting mortgage credit availability,'' he said.

The proposed changes are the product of the central bank's biggest regulatory initiative since Bernanke took office in February 2006. The Fed chief is aiming to preserve the Fed's consumer-protection role after Democratic lawmakers blamed it for lax oversight and introduced legislation to set rules for mortgage lenders.

The Fed proposed tightening restrictions on so-called pre- payment penalties, requiring the escrow of taxes and insurance, and banning loans made without verification of income or assets. Lenders would be responsible for determining whether their customers can afford a loan after the initial interest rate resets.

Message to Consumers
``We want consumers to make decisions about home mortgage options confidently, with assurance that unscrupulous home mortgage practices will not be tolerated,'' Bernanke said in his prepared comments. ``Unfair and deceptive acts and practices hurt not just borrowers and their families, but entire communities, and, indeed, the economy as a whole.''

Bernanke pledged to lawmakers in July that he'd propose new mortgage rules to ``address specific practices that are unfair or deceptive.'' The Board of Governors was considering the rules at a meeting today in Washington.

The Fed staff also went beyond its initial scope of consideration, and recommended new disclosure rules aimed at mortgage brokers. The staff recommended prohibiting lenders from paying brokers fees in excess of what the borrower agreed the broker should receive. The proposal bars coercion of appraisers, and defines seven advertising practices as misleading or deceptive.

Rebuke From Congress
Congressional leaders repeatedly rebuked the Fed this year for failing to curb the lending abuses that contributed to soaring subprime-mortgage foreclosures. At a June 13 hearing, House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, threatened to strip the central bank of its authority to write consumer-protection rules if it didn't act.

Subprime loans are usually made to people with poor or incomplete credit histories. Delinquency rates on subprime loans reached 16.3 percent in the third quarter, from 14.8 percent the previous three months.

Lending standards at banks have tightened even for their best customers, causing mortgage borrowing to slow to the weakest pace in nine years in the third quarter, according to Fed figures.

Housing Starts Decline
Housing figures today showed builders broke ground on the fewest new homes in 14 years last month as sales dropped. Housing starts fell 3.7 percent from October, to a 1.187 million annual rate, the Commerce Department said in Washington. The inventory of unsold single-family homes in October climbed to 10.5 months' supply, the highest since July 1985.

``We always lock the barn door after the horse has gone,'' said David Wyss, chief economist at Standard & Poor's, New York. Fed officials are hoping to ``restore confidence in this category'' of mortgages so lenders ``will start making these loans again,'' he said.

The Fed has cut its benchmark interest rate by 1 percentage point since September in an effort to ``forestall'' risks that the housing slump and credit-market strains will tip the economy into recession. The Bush administration this month negotiated a freeze of up to five years on some subprime mortgage rates.

Fed's Authority
The Fed has rule-writing power over all financial institutions for disclosures and preventing abuse, while it shares enforcement authority with other agencies and states.
The Fed's actions coincide with efforts in Congress to stem foreclosures and protect consumers from future mortgage-lending abuses.

The House of Representatives last month passed legislation sponsored by Frank that would require lenders to ensure borrowers are issued loans they can afford to repay. It would also strengthen oversight of mortgage brokers.

Democratic Senator Christopher Dodd of Connecticut, who chairs the Senate Banking Committee, introduced similar legislation last week.

Congress last week also gave final approval to legislation that would expand the ability of the Federal Housing Administration to insure mortgages for more subprime borrowers, sending it to President George W. Bush for his signature.