In Reversal, Fed Approves Plan to Curb Risky Lending

The Federal Reserve, acknowledging that home mortgage lenders aggressively sold deceptive loans to borrowers who had little chance of repaying them, proposed a broad set of restrictions Tuesday on exotic mortgages and high-cost loans for people with weak credit.

The new rules would force mortgage companies to show that customers can realistically afford their mortgages. They would also require lenders to disclose the hidden sales fees often rolled into interest payments, and they would prohibit certain types of advertising.

Borrowers would be able to sue their lenders if they violated the new rules, though home buyers would be allowed to seek only a limited amount in compensation. The proposed changes, which do not apply to standard mortgages for borrowers with good credit, stopped short of banning all heavily criticized practices in subprime lending and did not go as far as many consumer groups had sought.

Under its existing rules, based on the Home Ownership Equity Protection Act of 1994, the Fed’s extra protections applied to less than 1 percent of all mortgages — those with interest rates at least eight (8) percentage points above prevailing rates on Treasury securities.

The new rules, by contrast, invoked broader legal authority to apply to any mortgage with an interest rate three percentage points or more above Treasury rates. Fed officials said that would cover all subprime loans, which accounted for about 25 percent of all mortgages last year, as well as many exotic mortgages — known in the industry as “Alt-A” loans — made to people with relatively good credit scores.

Under the new rules, such borrowers would have to document their incomes, supply tax returns, earnings statements, bank records or other evidence. Lenders would not be allowed to qualify a person based only on their ability to pay the initial teaser rate.

The proposal would essentially end the practice of allowing those with poor credit to apply for “stated income” loans, often known as “liar’s loans,” which do not require borrowers to provide evidence of their incomes and assets. And it would restrict mortgages with future monthly payments beyond those that could be justified by a borrower’s projected earnings.

The Fed proposal would still leave some room for flexibility. Lenders would have to provide “reasonably reliable evidence” of a person’s income, a definition that Fed officials said would allow small business owners and others whose income may be erratic or difficult to confirm to arrange a subprime mortgage.

The Fed also refused to prohibit the much-criticized subprime lending practice of big prepayment penalties. Prepayment penalties, which can cost thousands of dollars, often block people from switching to a cheaper mortgage for two years or longer.

Under the Fed proposal, lenders would still be allowed to demand prepayment penalties, but the penalties would have to expire at least 60 days before a loan’s introductory rate was scheduled to reset at a higher level.

The new rules would also make it more difficult for lenders to include hidden sales fees, which are usually paid to the mortgage broker. Many subprime lenders tell borrowers they will not have to pay any fees, or even any costs for services like appraisals, but include those fees in what is called a “yield-spread premium” on the interest rate.

The Fed proposal would not prohibit yield-spread premiums but would require that a lender disclose the exact amount of the fees and have the borrower agree to the fees in writing.

John Taylor, president of the National Community Reinvestment Coalition, a housing advocacy group, said simply disclosing the fees was not enough because home buyers were already inundated with a blizzard of disclosure forms to sign and can easily miss the significance of what they are approving.

Borrowers “shouldn’t need to be a lawyer or financial expert,” Mr. Taylor said, “to protect themselves from unfair and deceptive lending.”