WASHINGTON - E.J. Face Jr. was amazed and bewildered when he heard that the Office of Thrift Supervision may use prepayment penalties to screen for predatory lenders.

Mr. Face, Virginia's commissioner of financial institutions has been trying for more than a year to enforce a state law limiting the fees charged to borrowers when a loan is paid off early. But he kept running into the same wall: the OTS.

He is not alone. Neil Milner, president and chief executive officer of the Conference of State Bank Supervisors, said 20 other states including Connecticut, Maryland, Ohio, and New York are having the same problem.

Through its implementation of the federal Alternative Mortgage Transaction Parity Act, the OTS puts no caps on mortgage loan prepayment penalties. Virginia law, by contrast, restricts the charges to 1% to 2% of a mortgage.

The problem is that federal law preempts state law, creating a loophole for predatory lenders.

"Our hands are tied," Mr. Face said. "We can't enforce our own laws."

But on Tuesday, OTS Director Ellen Seidman admitted that her agency's rules may have been "inadvertently" encouraging predatory lending practices. In an advanced notice of proposed rulemaking, the agency suggests ways to close the loophole - by limiting prepayment penalties, balloon payments, refinancings, rollovers, and fees. The agency is taking comments on its plan for 90 days.

The proposal was welcome news to state banking commissioners.

"The OTS is recognizing after 18 years it's appropriate to review the Parity Act," Mr. Milner said. "This is an issue we're very concerned about."

The commissioner said he hopes the OTS proposal will aid his fight against predatory lending practices, which has been hampered by an injunction prohibiting enforcement of Virginia law.

Last June 1 the National Home Equity Mortgage Association sued to block use of the stricter Virginia law after Mr. Face said state examiners would continue to refund prepayment penalties collected in excess of the state's limits. The trade group won an injunction against the state banking commission last fall, and the state appealed. Oral arguments on the appeal are scheduled to start June 5 in the U.S. Court of Appeals for the Fourth District.

The OTS proposal will not influence the appeal, according to Maury Shevin, the home equity association's general counsel. "But if the OTS changes the regulation in the future, that could obviously affect the status of the case," he said.

Mr. Shevin defended prepayment penalties, saying they make the mortgage market more stable. "They keep interest rates down and help discourage loan flipping," he said. "In my opinion, lenders would have to charge more for a loan without prepayment penalties."

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