WASHINGTON — This may be the first time in banking history that the financial services industry is hoping a pending regulation from the Federal Reserve Board takes a hard line against potentially abusive lending practices.
A tough rule under the Home Ownership and Equity Protection Act, which is expected to be released Tuesday, could help stem momentum for even more severe mortgage reform legislation and ensure that all mortgage lenders, not just banks, operate under the same rules.
But although a wide range of industry and consumer group representatives said the Fed is likely to go further than it ever has to curb deceptive and unfair products, few thought the central bank's plan would be enough to dampen the push for reform legislation.
"Regardless of whatever the Fed does, there are going to be folks on the Hill saying we need to do more," said Bill Himpler, the executive vice president of federal affairs at the American Financial Services Association.
A worsening housing market would keep pressure on lawmakers to do something.
"You're still going to see legislative action," said Steve O'Connor, a senior vice president of government affairs at the Mortgage Bankers Association. "But it's an open question how much traction various proposals will have."
Just how far the Fed rule will go remains unclear, but most sources do not expect the agency to stick to its traditional hands-off approach. The central bank has been severely criticized for not doing enough to head off the subprime crisis; Senate Banking Committee Chairman Chris Dodd has blamed the Fed for not writing rules under HOEPA that would have banned abusive subprime products.
Most sources said this criticism has been taken to heart, at least by Fed Chairman Ben Bernanke.
"My gut tells me it will not be the same old Fed," said Brian Gardner, a political analyst for KBW Inc.'s Keefe, Bruyette & Woods Inc. "It will be a more politically astute Fed, and they will have something tougher in there than you would normally expect."
The Fed declined to comment for this article. Fed officials have so far said the proposal will target five areas: prepayment penalties, failure to offer escrow accounts for taxes and insurance, stated-income and low documentation loans, the failure of lenders to give adequate consideration to a borrower's ability to repay, and disclosures.
In a letter to Rep. Brad Miller, D-N.C., sent Friday, Mr. Bernanke said the proposal would curb many of the system's worst abuses but ensure that credit availability is not restricted. The Fed chief singled out proposed new disclosure rules, hinting that the Fed plans to study whether it should require the disclosure of yield-spread premiums — which are often used to compensate mortgage brokers.
"The board is also committed to providing more effective and comprehensive disclosures to help consumers avoid loans that are not in their interest," he said in the letter. "In this regard, we will be conducting extensive consumer testing to assist us in developing improved mortgage loan disclosures. As we test consumer disclosures, we will also consider the need for improved disclosures concerning mortgage brokers and how they are compensated."
Industry observers said they expect the Fed to place tough restrictions in the other areas it targeted, though stopping short of outright bans. In this way, the HOEPA rule would mirror the approach taken by federal regulators in subprime guidance released in June. Many also expect the rule to be limited to subprime products.
For example, industry representatives said the Fed will probably propose banning prepayment penalties for a limited period, perhaps 60 days, before interest rate resets. The Fed may also offer language on what constitutes a reasonable prepayment penalty, they said.
The central bank also is likely to try to curb the use of low-doc loans, which lenders accepted on nearly half of all subprime credits approved last year, according to data from the Office of the Comptroller of the Currency.
Rob Rowe, the regulatory counsel for Independent Community Bankers of America, said the Fed may still allow no-documentation loans if a borrower has sufficient income, shown, for example, through a large down payment. But if there is an easy way for a lender to verify income, the Fed is liable to encourage that instead, he said.
"There's going to be something to say [that], if it's easily verified, then you have to do that," he said.
Some community groups are already worried about the impact any kind of restriction on low-doc loans could have. "We want to make sure the requirements in this area are strong enough to cut out the fraud and abuse but also flexible for those with difficult-to-document income," said Janis Bowdler, a senior policy analyst at the National Council of La Raza, who fears restrictive measures could hamper immigrants' access to homeownership.
Another controversial issue in the subprime crisis has been lenders that do not escrow for taxes and insurance. Consumer groups said they expect the Fed to offer strong language requiring escrowing on all subprime loans.
Industry representatives are not so sure, however, saying the central bank may only require a clear disclosure of the escrow amount and mandate it for certain loans. Others say the Fed may require escrow but let borrowers opt out.
Industry representatives and consumer groups agree more on how the Fed is likely to describe a borrower's ability to repay. They expect this to closely follow the summer's guidance and require that lenders use the fully indexed rate, instead of a teaser rate, when underwriting subprime mortgages.
"I'd be surprised to see them do anything less than that," Ms. Bowdler said. "Whether they do more — as in a debt-to-income ratio — I'm not sure. I would like to see them come out really strong, but to be honest I think ability to repay will take a legislative fix."
Industry representatives are also debating how much impact the new rule will have, arguing that many in the industry have already stopped offering exotic subprime mortgage products.
"The very fact that the Fed is proposing regulations makes sure most of the industry won't do those things," said Paul Leonard, the vice president for government affairs at the Housing Policy Council. "It'll more level the playing field because it will affect all originators."
Not everyone agrees. Wayne Abernathy, the executive director of financial institutions policy at the American Bankers Association, said he is concerned the Fed could overreact.
"They'll probably put in place some standards above and beyond what we have, and our worry is there will be more regulatory burden than is necessary and it will reduce our flexibility to develop new and existing products for nontraditional borrowers," he said. "I don't think the Fed is going to nibble. Whatever they do is going to make a real impact."
