WASHINGTON — The typically cautious Federal Reserve Board appeared to follow a new playbook Tuesday by issuing an unusually expansive proposal designed to curb abuses in the mortgage market that contributed to the subprime housing crisis.
The proposal's reach extends beyond the most basic questions Fed policymakers faced, such as a ban on prepayment penalties or low- and no-documentation loans, to target the way these loans are marketed and how lenders can compensate brokers.
It would specifically ban seven advertising practices, including marketing loans as fixed-rate when the rate will reset after a limited period. It also would force lenders to disclose yield-spread premiums and defined "high-cost" loans in such a way as to cover some mortgages in the Alt-A and prime markets.
Though the plan was even broader than expected, it did little to shake up the entrenched views on all sides. Those that want the plan to do the job of legislation praised it while raising a few concerns that it had gone too far, but those that favor a congressional response on lending practices derided it as too little and too late.
But it was the opinion of Senate Banking Committee Chairman Chris Dodd that was considered most crucial by the financial services industry. The Connecticut Democrat spent much of the year pushing the Fed to issue new rules under the Home Ownership and Equity Protection Act, and signaled last month that he was prepared to wait on reform legislation if the central bank's rulemaking was tough enough.
It took Sen. Dodd less than two hours, however, to decide Tuesday that the proposal was "a significant step backward."
"The board weakened its earlier guidance on requiring an originator to fully analyze a borrower's ability to repay the mortgage at the fully indexed rate, the most fundamental measure of good lending," he said in a press release. "It raises serious questions as to whether the Federal Reserve is the appropriate institution to house consumer protection functions. This is a clear signal that legislation is necessary to help protect homeowners from abusive and predatory lending practices."
The House passed a mortgage reform bill last month, and Sen. Dodd introduced legislation last week. It is expected to be a top priority for Congress early next year.
Other lawmakers argued that the Fed's move is welcome but comes too late to avert a legislative response.
"We still need legislation to move," Rep. Carolyn Maloney, D-N.Y., said in an interview. "My regret is that they did not come out with it earlier. We could have avoided this credit crunch."
Many consumer and housing advocates seemed to take a similar view. Ellen Schloemer, a research director at the Center for Responsible Lending, said the Fed lost a chance to make more widespread changes in the struggling mortgage market.
"Our big concern is that it's really a missed opportunity to put in some really good standards that could affect the entire market," she said. "If you have 20% of the cars in the U.S. unexpectedly veering off the highway and crashing — and we have one in five loans going bad now — then you'd look at reengineering the cars, not just painting a new yellow line down the road, which is what this does."
For their part, bankers appeared no happier. Some suggested the proposal went too far. "It touches on the mortgage lending process in so many different places and in so many ways that unless they're careful they could really introduce some new rigidities into the system," said Wayne Abernathy, the executive director of regulatory affairs at the American Bankers Association.
Mortgage brokers were particularly incensed by a provision in the proposal that would cut them off from being paid yield-spread premiums by lenders on certain loans. The plan calls for a ban on such payments to brokers unless they are disclosed.
"Obviously they're trying to protect their larger banking friends," said Roy DeLoach, executive vice president of the National Association of Mortgage Brokers.
Fed officials themselves may be the only ones pleased by the outcome. In a public hearing at which officials discussed the plan, Chairman Ben Bernanke called it "very promising, very effective."
The proposal, which will be open to comment for 90 days, is slated to affect a wide swath of the troubled mortgage sector.
The Fed's actions on prepayment penalties, ability to repay a loan, income verification, and escrow payments are pegged to "higher-priced mortgages."
The Fed is defining that as loans whose annual percentage rate is at least 3 percentage points higher than the yield on similar Treasury securities. That compares to 8 percentage points for loans that currently qualify for protection under HOEPA. The new standard would encompass the vast majority of the subprime market but also capture other loans, Fed officials said.
"By looking at the 300-basis-point spread, we're capturing virtually all subprime," Fed Gov. Randall Kroszner told reporters. "We're also capturing a portion of the Alt-A market. We thought that was important to make sure we were comprehensive in what we covered."
The proposal comes after months of development and debate at the central bank. Mr. Kroszner convened a hearing in June to discuss options on prepayment penalties, income documentation, ability to repay, and including taxes and insurance in escrow. On each concern, the Fed's policy shifted against the industry.
The plan would ban prepayment penalties on mortgages within 60 days of an interest rate reset. Fed Gov. Kevin Warsh asked staff members why the central bank should not go even further and ban the penalties entirely, as many lawmakers were requesting.
"We recognize that they may have some benefits," said Kathleen Ryan, a counsel in the Fed's consumer and community affairs division. "It may increase liquidity in the secondary market and therefore lower interest rates."
The proposal also would require third-party verification of a borrower's income and force lenders to assess borrowers' repayment ability and to pay taxes and insurance into escrow for at least the first 12 months of a loan.
But the proposal was especially surprising for its willingness to tackle broader issues in the mortgage market. Beyond restricting yield-spread premiums, the new rules would bar lenders or brokers from coercing or influencing appraisals, an issue of particular importance as New York Attorney General Andrew Cuomo fights appraisal inflation.
The Fed also targeted advertising practices that many critics have charged are unfair or deceptive representations of many loan features. Banks would be banned from advertising a loan rate as "fixed" unless it also disclosed whether the rates or monthly payment would be fixed for just a brief time.
