[Federal Register: January 9, 2008 (Volume 73, Number 6)]
[Proposed Rules]
[Page 1671-1735]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr09ja08-22]
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Part II
Federal Reserve System
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12 CFR Part 226
Truth in Lending; Proposed Rule
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FEDERAL RESERVE SYSTEM
12 CFR Part 226
[Regulation Z; Docket No. R-1305]
Truth in Lending
AGENCY: Board of Governors of the Federal Reserve System.
ACTION: Proposed rule; request for public comment.
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SUMMARY: The Board proposes to amend Regulation Z, which implements the
Truth in Lending Act and Home Ownership and Equity Protection Act. The
goals of the amendments are to protect consumers in the mortgage market
from unfair, abusive, or deceptive lending and servicing practices
while preserving responsible lending and sustainable homeownership;
ensure that advertisements for mortgage loans provide accurate and
balanced information and do not contain misleading or deceptive
representations; and provide consumers transaction-specific disclosures
early enough to use while shopping for a mortgage. The proposed
revisions would apply four protections to a newly-defined category of
higher-priced mortgage loans secured by a consumer's principal
dwelling, including a prohibition on a pattern or practice of lending
based on the collateral without regard to consumers' ability to repay
their obligations from income, or from other sources besides the
collateral. The proposed revisions would apply three new protections to
mortgage loans secured by a consumer's principal dwelling regardless of
loan price, including a prohibition on a creditor paying a mortgage
broker more than the consumer had agreed the broker would receive. The
Board also proposes to require that advertisements provide accurate and
balanced information, in a clear and conspicuous manner, about rates,
monthly payments, and other loan features; and to ban several deceptive
or misleading advertising practices, including representations that a
rate or payment is ``fixed'' when it can change. Finally, the proposal
would require creditors to provide consumers with transaction-specific
mortgage loan disclosures before they pay any fee except a reasonable
fee for reviewing credit history.
DATES: Comments must be received on or before April 8, 2008.
ADDRESSES: You may submit comments, identified by Docket No. R-1305, by
any of the following methods:
Agency Web site: http://www.federalreserve.gov Follow the instructions for submitting comments at http://www.federalreserve.gov/.
.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
docket number in the subject line of the message.
Fax: (202) 452-3819 or (202) 452-3102.
Mail: Address to Jennifer J. Johnson, Secretary, Board of
Governors of the Federal Reserve System, 20th Street and Constitution
Avenue, NW., Washington, DC 20551.
All public comments will be made available on the Board's Web site
at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as
submitted, unless modified for technical reasons. Accordingly, comments
will not be edited to remove any identifying or contact information.
Public comments may also be viewed electronically or in paper in Room
MP-500 of the Board's Martin Building (20th and C Streets, NW.) between
9 a.m. and 5 p.m. on weekdays.
FOR FURTHER INFORMATION CONTACT: Kathleen C. Ryan, Dan S. Sokolov, or
David Stein, Counsels; Jamie Z. Goodson, Brent Lattin, Jelena
McWilliams, or Paul Mondor, Attorneys; Division of Consumer and
Community Affairs, Board of Governors of the Federal Reserve System,
Washington, DC 20551, at (202) 452-2412 or (202) 452-3667. For users of
Telecommunications Device for the Deaf (TDD) only, contact (202) 263-
4869.
SUPPLEMENTARY INFORMATION:
I. Summary of Proposal
A. Proposals To Prevent Unfairness, Deception, and Abuse
B. Proposals To Improve Mortgage Advertising
C. Proposals To Give Consumers Disclosures Early
II. Consumer Protection Concerns in the Subprime Market
A. Recent Problems in the Mortgage Market
B. The Loosening of Underwriting Standards
C. Market Imperfections That Can Facilitate Abusive and
Unaffordable Loans
III. The Board's Hoepa Hearings
A. Home Ownership and Equity Protection Act (HOEPA)
B. Summary of 2006 Hearings
C. Summary of June 2007 Hearing
D. Congressional Hearings
IV. Inter-Agency Supervisory Guidance
V. Legal Authority
A. The Board's Authority Under TILA Section 129(l)(2)
B. The Board's Authority Under TILA Section 105(a)
VI. Proposed Definition of ``Higher-Priced Mortgage Loan''
A. Overview
B. Public Comment on the Scope of New HOEPA Rules
C. General Principles Governing the Board's Determination of
Coverage
D. Types of Loans Proposed To Be Covered Under Sec. 226.35
E. Proposed APR Trigger for Sec. 226.35
F. Mechanics of the Proposed APR Trigger
VII. Proposed Rules for Higher-Priced Mortgage Loans--Sec. 226.35
A. Overview
B. Disregard of Consumers' Ability To Repay--Sec. Sec.
226.34(a)(4) and 226.35(b)(1)
C. Verification of Income and Assets Relied On--Sec.
226.35(b)(2)
D. Prepayment Penalties--Sec. 226.32(d)(6) and (7); Sec.
226.35(b)(3)
E. Requirement to Escrow--Sec. 226.35(b)(4)
F. Evasion Through Spurious Open-end Credit--Sec. 226.35(b)(5)
VIII. Proposed Rules for Mortgage Loans--Sec. 226.36
A. Creditor Payments to Mortgage Brokers--Sec. 226.36(a)
B. Coercion of Appraisers--Sec. 226.36(b)
C. Servicing Abuses--Sec. 226.36(c)
D. Coverage--Sec. 226.36(d)
IX. Other Potential Concerns
A. Other HOEPA Prohibitions
B. Steering
X. Advertising
A. Advertising Rules for Open-end Home-equity Plans--Sec.
226.16
B. Advertising Rules for Closed-end Credit--Sec. 226.24
XI. Mortgage Loan Disclosures
A. Early Mortgage Loan Disclosures--Sec. 226.19
B. Future Plans To Improve Disclosure
XII. Civil Liability and Remedies; Administrative Enforcement
XIII. Effective Date
XIV. Paperwork Reduction Act
XV. Initial Regulatory Flexibility Analysis
I. Summary of Proposal
The Board is proposing to establish new regulatory protections for
consumers in the residential mortgage market through amendments to
Regulation Z, which implements the Truth in Lending Act (TILA) and the
Home Ownership and Equity Protection Act (HOEPA). The goals of the
amendments are to protect consumers in the mortgage market from unfair,
abusive, or deceptive lending and servicing practices while preserving
responsible lending and sustainable homeownership; ensure that
advertisements for mortgage loans provide accurate and balanced
information and do not contain misleading or deceptive representations;
and provide consumers transaction-specific disclosures early enough to
use while shopping.
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A. Proposals To Prevent Unfairness, Deception, and Abuse
The Board is proposing seven new restrictions or requirements for
mortgage lending and servicing intended to protect consumers against
unfairness, deception, and abuse while preserving responsible lending
and sustainable homeownership. The restrictions would be adopted under
TILA Section 129(l)(2), which authorizes the Board to prohibit unfair
or deceptive practices in connection with mortgage loans, as well as to
prohibit abusive practices or practices not in the interest of the
borrower in connection with refinancings. 15 U.S.C. 1639(l)(2). Some of
the restrictions would apply only to higher-priced mortgage loans,
while others would apply to all mortgage loans secured by a consumer's
principal dwelling.
Protections Covering Higher-Priced Mortgage Loans
The Board is proposing four protections for consumers receiving
higher-priced mortgage loans. These loans would be defined as consumer-
purpose, closed-end loans secured by a consumer's principal dwelling
and having an annual percentage rate (APR) that exceeds the comparable
Treasury security by three or more percentage points for first-lien
loans, or five or more percentage points for subordinate-lien loans.
For higher-priced mortgage loans, the Board proposes to:
[cir] Prohibit creditors from engaging in a pattern or practice of
extending credit without regard to borrowers' ability to repay from
sources other than the collateral itself;
[cir] Require creditors to verify income and assets they rely upon
in making loans;
[cir] Prohibit prepayment penalties unless certain conditions are
met; and
[cir] Require creditors to establish escrow accounts for taxes and
insurance, but permit creditors to allow borrowers to opt out of
escrows 12 months after loan consummation.
In addition, the proposal would prohibit creditors from structuring
closed-end mortgage loans as open-end lines of credit for the purpose
of evading these rules, which do not apply to lines of credit.
Protections Covering Closed-End Loans Secured by Consumer's Principal
Dwelling
In addition, in connection with all consumer-purpose, closed-end
loans secured by a consumer's principal dwelling, the Board is
proposing to:
[cir] Prohibit creditors from paying a mortgage broker more than
the consumer had agreed in advance that the broker would receive;
[cir] Prohibit any creditor or mortgage broker from coercing,
influencing, or otherwise encouraging an appraiser to provide a
misstated appraisal in connection with a mortgage loan; and
[cir] Prohibit mortgage servicers from ``pyramiding'' late fees,
failing to credit payments as of the date of receipt, failing to
provide loan payoff statements upon request within a reasonable time,
or failing to deliver a fee schedule to a consumer upon request.
B. Proposals To Improve Mortgage Advertising
Another goal of this proposal is to ensure that mortgage loan
advertisements provide accurate and balanced information and do not
contain misleading or deceptive representations. Thus the Board is
proposing to require that advertisements for both open-end and closed-
end mortgage loans provide accurate and balanced information, in a
clear and conspicuous manner, about rates, monthly payments, and other
loan features. This proposal is made under the Board's general
authority to adopt regulations to ensure consumers are informed about
and can shop for credit. TILA Section 105(a), 15 U.S.C. 1604(a).
The Board is also proposing, under TILA Section 129(l)(2), 15
U.S.C. 1639(l)(2), to prohibit the following seven deceptive or
misleading practices in advertisements for closed-end mortgage loans:
[cir] Advertising ``fixed'' rates or payments for loans whose rates
or payments can vary without adequately disclosing that the interest
rate or payment amounts are ``fixed'' only for a limited period of
time, rather than for the full term of the loan;
[cir] Comparing an actual or hypothetical consumer's current rate
or payment obligations and the rates or payments that would apply if
the consumer obtains the advertised product unless the advertisement
states the rates or payments that will apply over the full term of the
loan;
[cir] Advertisements that characterize the products offered as
``government loan programs,'' ``government-supported loans,'' or
otherwise endorsed or sponsored by a federal or state government entity
even though the advertised products are not government-supported or -
sponsored loans;
[cir] Advertisements, such as solicitation letters, that display
the name of the consumer's current mortgage lender, unless the
advertisement also prominently discloses that the advertisement is from
a mortgage lender not affiliated with the consumer's current lender;
[cir] Advertising claims of debt elimination if the product
advertised would merely replace one debt obligation with another;
[cir] Advertisements that create a false impression that the
mortgage broker or lender has a fiduciary relationship with the
consumer; and
[cir] Foreign-language advertisements in which certain information,
such as a low introductory ``teaser'' rate, is provided in a foreign
language, while required disclosures are provided only in English.
C. Proposal To Give Consumers Disclosures Early
A third goal of this proposal is to provide consumers transaction-
specific disclosures early enough to use while shopping for a mortgage
loan. The Board proposes to require creditors to provide transaction-
specific mortgage loan disclosures such as the APR and payment schedule
for all home-secured, closed-end loans no later than three days after
application, and before the consumer pays any fee except a reasonable
fee for the originator's review of the consumer's credit history.
The Board recognizes that these disclosures need to be updated to
reflect the increased complexity of mortgage products. In early 2008,
the Board will begin testing current TILA mortgage disclosures and
potential revisions to these disclosures through one-on-one interviews
with consumers. The Board expects that this testing will identify
potential improvements for the Board to propose for public comment in a
separate rulemaking.
II. Consumer Protection Concerns in the Subprime Market
A. Recent Problems in the Mortgage Market
Subprime mortgage loans are made to borrowers who are perceived to
have high credit risk. These loans' share of total consumer
originations, according to one estimate, reached about nine percent in
2001 and doubled to 20 percent by 2005, where it stayed in 2006.\1\ The
resulting increase in the supply of mortgage credit likely contributed
to the rise in the homeownership rate from 64 percent in 1994 to a high
of 69 percent in 2006--though about 68 percent now--and expanded
consumers' access to the equity in their homes. Recently, however, some
of this benefit has
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eroded. In the last two years, delinquencies and foreclosure starts
among subprime mortgages have increased dramatically and reached
exceptionally high levels as house price growth has slowed or prices
have declined in some areas. The proportion of all subprime mortgages
past-due ninety days or more (``serious delinquency'') was about 13
percent in October 2007, more than double the mid-2005 level.\2\
Adjustable-rate subprime mortgages have performed the worst, reaching a
serious delinquency rate of nearly 19 percent in October 2007, triple
the mid-2005 level. These mortgages have seen unusually high levels of
early payment default, or default after only one or two payments or
even no payment at all.
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\1\ Inside Mortgage Finance Publications, Inc., The 2007
Mortgage Market Statistical Annual vol. I (IMF 2007 Mortgage
Market), at 4.
\2\ Delinquency rates calculated from data from First American
LoanPerformance on mortgages in subprime securitized pools. Figures
include loans on non-owner-occupied properties.
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The serious delinquency rate has also risen for loans in alt-A
(near prime) securitized pools. According to one source, originations
of these loans were 13 percent of consumer mortgage originations in
2006.\3\ Alt-A loans are made to borrowers who typically have higher
credit scores than subprime borrowers, but the loans pose more risk
than prime loans because they involve small down payments or reduced
income documentation, or the terms of the loan are nontraditional and
may increase risk. The rate of serious delinquency for these loans has
risen to over 3 percent (as of September 2007) from 1 percent only a
year ago. In contrast, 1 percent of loans in the prime-mortgage sector
were seriously delinquent as of October.
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\3\ IMF 2007 Mortgage Market, at 4.
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The consequences of default are severe for homeowners, who face the
possibility of foreclosure, the loss of accumulated home equity, higher
rates for other credit transactions, and reduced access to credit. When
foreclosures are clustered, they can injure entire communities by
reducing property values in surrounding areas. Higher delinquencies are
in fact showing through to foreclosures. Lenders initiated 430,000
foreclosures in the third quarter of 2007, about half of them on
subrpime mortgages. This was significantly higher than the quarterly
average of 325,000 in the first half of the year, and nearly twice the
quarterly average of 225,000 for the past six years.\4\
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\4\ Estimates are based on data from Mortgage Bankers'
Association's National Delinquency Survey (2007).
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B. The Loosening of Underwriting Standards
Rising delinquencies have been caused largely by a combination of a
decline in house price appreciation--and in some areas slower economic
growth--and a loosening of underwriting standards. Underwriting
standards loosened in large parts of the mortgage market in recent
years as lenders--particularly nondepository institutions, many of
which have since ceased to exist--competed more aggressively for market
share. This loosening was particularly pronounced in the subprime
sector, where the frequent combination of several riskier loan
attributes--high loan-to-value ratio, payment shock on adjustable-rate
mortgages, no verification of borrower income, and no escrow for taxes
and insurance--increased the risk of serious delinquency and
foreclosure for subprime loans originated in 2005 through early 2007.
Payment shock from rate adjustments within two or three years of
origination could make these loans unaffordable to many of the
consumers who hold them. Approximately three-fourths of originations in
securitized subprime ``pools'' from 2004 to 2006 were adjustable-rate
mortgages (ARMs) with two-or three-year ``teaser'' rates followed by
substantial increases in the rate and payment (so-called ``2-28'' and
``3-27'' mortgages).\5\ The burden of these payment increases on the
borrower would likely be heavier than expected if the borrower's stated
income was inflated, as appears to have happened in some cases, and the
inflated figure was used to determine repayment ability. In addition,
affordability problems with subprime loans can be compounded by
unexpected property tax and homeowners insurance obligations. In the
prime market, lenders typically establish escrows for these
obligations, but in the subprime market escrows have been the exception
rather than the rule.
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\5\ Figure calculated from First American Loan Performance data.
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Delinquencies and foreclosure initiations in subprime ARMs are
expected to rise further as more of these mortgages see their rates and
payments reset at significantly higher levels. On average in 2008,
374,000 subprime mortgages per quarter are scheduled to undergo their
first interest rate and payment reset. Relative to past years, avoiding
the payment shock of an interest rate reset by refinancing the mortgage
will be much more difficult. Not only have home prices flattened out or
declined, thereby reducing homeowners' equity, but borrowers often had
little equity to start with because of very high initial cumulative
loan-to-value ratios. Moreover, prepayment penalty clauses, which are
found in a substantial majority of subprime loans, place an added
demand on the limited equity or other resources available to many
borrowers and make it harder still for them to refinance. Borrowers who
cannot refinance will have to make sacrifices to stay in their homes or
could lose their homes altogether.\6\
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\6\ These effects may be mitigated for some borrowers by a
recently-announced agreement among major loan servicers and
investors to ``freeze'' many subprime ARMs at their initial interest
rates for five years.
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Relaxed underwriting was not limited to the subprime market.
According to one estimate, interest-only mortgages (most of them with
adjustable rates) and ``option ARMs''--which permit borrowers to defer
both principal and interest for a time in exchange for higher payments
later--rose from 7 percent of total consumer mortgage originations in
2004 to 26 percent in 2006.\7\ By one estimate these mortgages reached
78 percent of alt-A originations in 2006.\8\ These types of mortgages
hold the potential for payment shock and increasingly contained
additional layers of risk such as loan amounts near the full appraised
value of the home, and partial or no documentation of income. For
example, the share of interest-only mortgages with low or no
documentation in alt-A securitized pools increased from around 60
percent in 2003 to nearly 80 percent in 2006.\9\ Most of these
mortgages have not yet reset so their full implications are not yet
apparent. The risks to consumers and to creditors were serious enough,
however, to cause the federal banking agencies to issue supervisory
guidance, which many state agencies later adopted.\10\
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\7\ IMF 2007 Mortgage Market, at 6.
\8\ David Liu & Shumin Li, Alt-A Credit--The Other Shoe Drops?,
The MarketPulse (First American LoanPerformance, Inc., San
Francisco, Cal.), Dec. 2006.
\9\ Figures calculated from First American LoanPerformance data.
\10\ Interagency Guidance on Nontraditional Mortgage Product
Risks, 71 FR 58609, Oct. 4, 2006.
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A decline in underwriting standards does not just increase the risk
that consumers will be provided loans they cannot repay. It also
increases the risk that originators will engage in an abusive strategy
of ``flipping'' borrowers in a succession of refinancings, ostensibly
to lower borrowers' burdensome payments, that strip borrowers' equity
and provide them no
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benefit. Moreover, an atmosphere of relaxed standards may increase the
incidence of abusive lending practices by attracting less scrupulous
originators into the market, while at the same time bringing more
vulnerable borrowers into the market. These abuses can lead consumers
to pay more for their loans than their risk profiles warrant.
The market has responded to the current problems with increasing
attention to loan quality. Structural factors, or market imperfections,
however, make it necessary to consider regulations to help prevent a
recurrence of these problems. New regulation can also provide the
market clear ``rules of the road'' at a time of uncertainty, so that
responsible higher-priced lending, which serves a critical need, may
continue.
C. Market Imperfections That Can Facilitate Abusive and Unaffordable
Loans
The recent sharp increase in serious delinquencies has highlighted
the roles that structural elements of the subprime mortgage market may
play in increasing the likelihood of injury to consumers who find
themselves in that market. Limitations on price and product
transparency in the subprime market--often compounded by misleading or
inaccurate advertising--may make it harder for consumers to protect
themselves from abusive or unaffordable loans, even with the best
disclosures. The injuries consumers in the subprime market may suffer
as a result are magnified when originators' incentives to carefully
assess consumers' repayment ability grow weaker, as can happen when
originators sell off their loans to be securitized. The fragmentation
of the originator market can further exacerbate the problem by making
it more difficult for investors to monitor originators and for lenders
to monitor brokers. The multiplicity of originators and their
regulators can also inhibit the ability of regulators to protect
consumers from abusive and unaffordable loans.
Limited Transparency and Limits of Disclosure
Limited transparency in the subprime market increases the risk that
borrowers in that market will receive unaffordable or abusive loans.
The transparency of the subprime market to consumers is limited in
several respects. First, price information for the subprime market is
not widely and readily available to consumers. A consumer searching in
the prime market can buy a newspaper or access the Internet and easily
find current interest rates from a wide variety of lenders without
paying a fee. In contrast, subprime rates, which can vary significantly
based on the individual borrower's risk profile, are not broadly
advertised. Advertising in the subprime market focuses on easy approval
and low payments. Moreover, a borrower shopping in the subprime market
generally cannot obtain a useful rate quote from a particular lender
without submitting an application and paying a fee. The quote may not
even be reliable, as loan originators sometimes use ``bait and switch''
strategies.
Second, products in the subprime market tend to be complex, both
relative to the prime market and in absolute terms, as well as less
standardized than in the prime market.\11\ As discussed earlier,
subprime originations have much more often had adjustable rates than
more easily understood fixed rates. Adjustable-rate mortgages require
consumers to make judgments about the future direction of interest
rates and translate expected rate changes into changes in their payment
amounts. Subprime loans are also far more likely to have prepayment
penalties. The price of the penalty is not reflected in the annual
percentage rate (APR); to calculate that price, the consumer must both
calculate the size of the penalty according to a formula such as six
months of interest, and assess the likelihood the consumer will move or
refinance during the penalty period. In these and other ways subprime
products tend to be complex for consumers.
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\11\ U.S. Dep't of Hous. & Urban Dev. & U.S. Dep't of Treasury,
Recommendations to Curb Predatory Home Mortgage Lending 17 (2000)
(``While predatory lending can occur in the prime market, such
practices are for the most part effectively deterred by competition
among lenders, greater homogeneity in loan terms and the prime
borrowers' greater familiarity with complex financial
transactions.''); Howard Lax, Michael Manti, Paul Raca & Peter Zorn,
Subprime Lending: An Investigation of Economic Efficiency (Subprime
Lending Investigation), 15 Housing Policy Debate 3, 570 (2004)
(stating that the subprime market lacks the ``overall
standardization of products, underwriting, and delivery systems''
that is found in the prime market).
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Third, the roles and incentives of originators are not transparent.
One source estimates that 60 percent or more of mortgages originated in
the last several years were originated through a mortgage broker, often
an independent entity, who takes loan applications from consumers and
shops them to depository institutions or other lenders.\12\ Anecdotal
evidence indicates that consumers in both the prime and subprime
markets often believe, in error, that a mortgage broker is obligated to
find the consumer the best and most suitable loan terms available. For
example, in a 2003 survey of older borrowers who had obtained prime or
subprime refinancings, seventy percent of respondents with broker-
originated refinance loans reported that they had relied ``a lot'' on
their brokers to find the best mortgage for them.\13\ Consumers who
rely on brokers often are unaware, however, that a broker's interests
may diverge from, and conflict with, their own interests. In
particular, consumers are often unaware that a creditor pays a broker
more to originate a loan with a rate higher than the rate the consumer
qualifies for based on the creditor's underwriting criteria.
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\12\ Data reported by Wholesale Access Mortgage Research and
Consulting, Inc., available at http://www.wholesaleaccess.com/8-17-07-prs.shtml; http://www.wholesaleaccess.com/7_28_mbkr.shtml.
s.com/7_28_mbkr.shtml.
Refinance Mortgage Loan Borrowers: Broker- and Lender-Originated
Loans, Data Digest No. 83 (AARP Public Policy Inst., Washington,
DC), Jan. 2003, at 3, available at http://www.aarp.org/research/credit-debt/mortgages/experiences_of_older_refinance_mortgage_loan_borro.html
.
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Limited shopping. In this environment of limited transparency,
consumers--particularly those in the subprime market--who have been
told by an originator that they will receive a loan from that
originator may reasonably decide not to shop further among originators
or among loan options. The costs of further shopping may be
significant, including completing another application form and paying
yet another application fee. Delaying receipt of funds is another cost
of continuing to shop, a potentially significant one for the many
borrowers in the subprime market who are seeking to refinance their
obligations to lower their debt payments at least temporarily, to
extract equity in the form of cash, or both.\14\ Nearly 90 percent of
subprime ARMs used for refinancing in recent years were ``cash out.''
\15\
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\14\ See Anthony Pennington-Cross & Souphala Chomsisengphet,
Subprime Refinancing: Equity Extraction and Mortgage Termination, 35
Real Estate Economics 2, 233 (2007) (reporting that 49% of subprime
refinance loans involve equity extraction, compared with 26% of
prime refinance loans); Marsha J. Courchane, Brian J. Surette, and
Peter M. Zorn, Subprime Borrowers: Mortgage Transitions and Outcomes
(Subprime Outcomes), 29 J. of Real Estate Economics 4, 368-371
(2004) (discussing survey evidence that borrowers with subprime
loans are more likely to have experienced major adverse life events
(marital disruption; major medical problem; major spell of
unemployment; major decrease of income) and often use refinancing
for debt consolidation or home equity extraction); Subprime Lending
Investigation, at 551-552 (citing survey evidence that borrowers
with subprime loans have increased incidence of major medical
expenses, major unemployment spells, and major drops in income).
\15\ Figure calculated from First American LoanPerformance data.
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While the cost of continuing to shop is likely obvious, the benefit
may not be
[[Page 1676]]
clear or may appear quite small. Without easy access to subprime
product prices, a consumer who has been offered a loan by one
originator may have only a limited idea whether further shopping is
likely to produce a better deal. Moreover, consumers in the subprime
market have reported in studies that they were turned down by several
lenders before being approved.\16\ Once approved, these consumers may
see little advantage to continuing to shop if they expect, based on
their experience, that many of their applications to other originators
would be turned down. Furthermore, if a consumer uses a broker and
believes that the broker is shopping for the consumer, the consumer may
believe the chance of finding a better deal than the broker is small.
An unscrupulous originator may also seek to discourage a consumer from
shopping by intentionally understating the cost of an offered loan. For
all of these reasons, borrowers in the subprime market may not shop
beyond the first approval and may be willing to accept unfavorable
terms.\17\
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\16\ James M. Lacko & Janis K. Pappalardo, Fed. Trade Comm'n,
Improving Consumer Mortgage Disclosures: An Empirical Assessment of
Current and Prototype Disclosure Forms (Improving Mortgage
Disclosures), 24-26 (2007) (reporting evidence based on qualitative
consumer interviews); Subprime Lending Investigation, at 550
(finding based on survey data that ``[p]robably the most significant
hurdle overcome by subprime borrowers * * * is just getting approved
for a loan for the first time. This impact might well make subprime
borrowers more willing to accept less favorable terms as they become
uncertain about the possibility of qualifying for a loan at all.'').
\17\ Subprime Outcomes, at 371-372 (reporting survey evidence
that relative to prime borrowers, subprime borrowers are less
knowledgeable about the mortgage process, search less for the best
rates, and feel they have less choice about mortgage terms and
conditions); Subprime Mortgage Investigation, at 554 (``Our focus
groups suggested that prime and subprime borrowers use quite
different search criteria in looking for a loan. Subprime borrowers
search primarily for loan approval and low monthly payments, while
prime borrowers focus on getting the lowest available interest rate.
These distinctions are quantitatively confirmed by our survey.'').
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Limited focus. Consumers considering obtaining a typically complex
subprime mortgage loan may simplify their decision by focusing on a few
attributes of the product or service that seem most important.\18\ A
consumer may focus on loan attributes that have the most obvious and
immediate consequence such as loan amount, down payment, initial
monthly payment, initial interest rate, and up-front fees (though up-
front fees may be more obscure when added to the loan amount, and
``discount points'' in particular may be difficult for consumers to
understand). These consumers, therefore, may not focus on terms that
may seem less immediately important to them such as future increases in
payment amounts or interest rates, prepayment penalties, and negative
amortization. They are also not likely to focus on underwriting
practices such as income verification, and on features such as escrows
for future tax and insurance obligations.\19\ Consumers who do not
fully understand such terms and features, however, are less able to
appreciate their risks, which can be significant. For example, the
payment may increase sharply and a prepayment penalty may hinder the
consumer from refinancing to avoid the payment increase. Thus,
consumers may unwittingly accept loans that they will have difficulty
repaying.
---------------------------------------------------------------------------
\18\ Jinkook Lee & Jeanne M. Hogarth, Consumer Information
Search for Home Mortgages: Who, What, How Much, and What Else?
(Consumer Information Search), Financial Services Review 291 (2000)
(``In all, there are dozens of features and costs disclosed per
loan, far in excess of the combination of terms, lenders, and
information sources consumers report using when shopping.'').
\19\ Consumer Information Search, at 285 (reporting survey
evidence that most consumers compared interest rate or APR, loan
type (fixed-rate or ARM), and mandatory up-front fees, but only a
quarter considered the costs of optional products such as credit
insurance and back-end costs such as late fees). There is evidence
that borrowers are not aware of, or do not understand, terms of this
nature even after they have obtained a loan. See Improving Mortgage
Disclosures, at 27-30 (discussing anecdotal evidence based on
consumer interviews that borrowers were not aware of, did not
understand, or misunderstood an important cost or feature of their
loans that had substantial impact on the overall cost, the future
payments, or the ability to refinance with other lenders); Brian
Bucks & Karen Pence, Do Homeowners Know Their House Values and
Mortgage Terms? 18-22 (Fed. Reserve Bd. of Governors Fin. and Econ.
Discussion Series Working Paper No. 2006-3, 2006) (discussing
statistical evidence that borrowers with ARMs underestimate annual
as well as life-time caps on the interest rate; the rate of
underestimation increases for lower-income and less-educated
borrowers), available at http://www.federalreserve.gov/pubs/feds/2006/200603/200603pap.pdf
.
---------------------------------------------------------------------------
Limits of disclosure. Disclosures describing the multiplicity of
features of a complex loan could help some consumers in the subprime
market, but disclosures may not be sufficient to protect them against
unfair loan terms or lending practices. Obtaining widespread consumer
understanding of the many potentially significant features of a typical
subprime product is a major challenge.\20\ Moreover, even if all of a
loan's features are disclosed clearly to consumers, they may continue
to focus on a few features that appear most significant. Alternatively,
disclosing all features may ``overload'' consumers and make it more
difficult for them to discern which features are most important.
---------------------------------------------------------------------------
\20\ Improving Mortgage Disclosures, at 74-76 (finding that
borrowers in the subprime market may have more difficulty
understanding their loan terms because their loans are more complex
than loans in the prime market).
---------------------------------------------------------------------------
Furthermore, a consumer cannot make effective use of disclosures
without having a certain minimum level of understanding of the market
and products. Disclosures themselves, likely cannot provide this
minimum understanding for transactions that are complex and that
consumers engage in infrequently. Moreover, consumers may rely more on
their originators to explain the disclosures when the transaction is
complex; some originators may have incentives to misrepresent the
disclosures so as to obscure the transaction's risks to the consumer;
and such misrepresentations may be particularly effective if the
originator is face-to-face with the consumer.\21\ Therefore, while the
Board anticipates proposing changes to Regulation Z to improve mortgage
loan disclosures, it appears unlikely that better disclosures, alone,
will address adequately the risk of abusive or unaffordable loans in
the subprime market.
---------------------------------------------------------------------------
\21\ U.S. Gen. Accounting Office, GAO 04-280, Consumer
Protection: Federal and State Agencies Face Challenges in Combating
Predatory Lending 97-98 (2004) (stating that the inherent complexity
of mortgage loans, some borrowers' lack of financial sophistication,
education, or infirmities, and misleading statements and actions by
lenders and brokers limit the effectiveness of even clear and
transparent disclosures).
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Misaligned Incentives and Obstacles to Monitoring
Not only are consumers in the subprime market often unable to
protect themselves from abusive or unaffordable loans, originators may
at certain times be more likely to extend unaffordable loans. The
recent sharp rise in serious delinquencies on subprime mortgages has
made clear that originators may not give adequate attention to
repayment ability if they sell the mortgages they originate and bear
little loss if the mortgages default. The growth of the secondary
market gave lenders--and, thus, mortgage borrowers--greater access to
capital markets, lowered transaction costs, and allowed risk to be
shared more widely. This ``originate-to-distribute'' model, however,
may also tend to contribute to the loosening of underwriting standards,
particularly during periods of rapid house price appreciation, which
may mask problems by keeping default and delinquency rates low until
price appreciation slows or reverses.
This potential tendency has several related causes. First, when an
originator sells a mortgage and its servicing rights, depending on the
terms of the sale, most or all of the risks typically are passed on
[[Page 1677]]
to the loan purchaser. Thus, originators who sell loans may have less
of an incentive to undertake careful underwriting than if they kept the
loans. Second, warranties by sellers to purchasers and other
``repurchase'' contractual provisions have little meaningful benefit if
originators have limited assets. Third, fees for some loan originators
have been tied to loan volume, making loan sales--sometimes
accomplished through aggressive ``push marketing''--a higher priority
than loan quality for some originators. Fourth, investors may not
exercise adequate due diligence on mortgages in the pools in which they
are invested, and may instead rely heavily on credit-ratings firms to
determine the quality of the investment.
The fragmentation of the originator market can further exacerbate
the problem. Data reported under HMDA show that independent mortgage
companies--those not related to depository institutions or their
subsidiaries or affiliates--made nearly one-half of higher-priced
first-lien mortgages in 2005 and 2006 but only one-fourth of loans that
were not higher-priced. Nor was lending by independent mortgage
companies particularly concentrated: In each of 2005 and 2006 around
150 independent mortgage companies made 500 or more higher-priced
first-lien mortgage loans on owner-occupied dwellings. In addition, one
source suggests that 60 percent or more of mortgages originated in the
last several years were originated through a mortgage broker.\22\ This
same source estimates the number of brokerage companies at over 50,000
in recent years.
---------------------------------------------------------------------------
\22\ Data reported by Wholesale Access Mortgage Research and
Consulting, Inc. Available at http://www.wholesaleaccess.com/8-17-07-prs.shtml; http://www.wholesaleaccess.com/7_28_mbkr.shtml.
.com/7_28_mbkr.shtml.
Thus, a securitized pool of mortgages may have been sourced by tens
of lenders and thousands of brokers. Investors have limited ability to
directly monitor these originators' activities. Similarly, a lender may
receive a handful of loans from each of hundreds or thousands of small
brokers every year. A lender has limited ability or incentive to
monitor every small brokerage's operations and performance.
Government oversight of such a fragmented originator market faces
significant challenges. The various lending institutions and brokers
operate in fifty different states and the District of Columbia with
different regulatory and supervisory regimes, varying resources for
supervision and enforcement, and different practices in sharing
information among regulators. State regulatory regimes come under
particular pressure when a booming market brings new lenders and
brokers into the marketplace more rapidly than regulators can increase
their oversight resources. These circumstances may inhibit the ability
of regulators to protect consumers from abusive and unaffordable loans.
A Role for New HOEPA Rules
As explained above, consumers in the subprime market face serious
constraints on their ability to protect themselves from abusive or
unaffordable loans, even with the best disclosures; originators
themselves may at times lack sufficient market incentives to ensure
loans they sell are affordable; and regulators face limits on their
ability to oversee a fragmented subprime origination market. These
circumstances appear to warrant imposing a new national legal standard
on subprime lenders to help ensure that consumers receive mortgage
loans they can afford to repay, and help prevent the equity-stripping
abuses that unaffordable loans facilitate. Adopting this standard under
authority of HOEPA would ensure that it applied uniformly to all
originators and provide consumers an opportunity to redress wrongs
through civil actions to the extent authorized by TILA. As explained in
the next part, substantial information supplied to the Board through
several public hearings confirms the need for new HOEPA rules.
III. The Board's HOEPA Hearings
A. Home Ownership and Equity Protection Act (HOEPA)
The Board has recently held extensive public hearings on consumer
protection issues in the mortgage market, including the subprime
sector. These hearings were held pursuant to the Home Ownership and
Equity Protection Act (HOEPA), which directs the Board to hold public
hearings periodically on the home equity lending market and the
adequacy of existing law for protecting the interests of consumers,
particularly low income consumers. HOEPA imposes substantive
restrictions, and special pre-closing disclosures, on particularly
high-cost refinancings and home equity loans (``HOEPA loans'').\23\
These restrictions include limitations on prepayment penalties and
``balloon payment'' loans, and prohibitions of negative amortization
and of engaging in a pattern or practice of lending based on the
collateral without regard to repayment ability.
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\23\ HOEPA loans are closed-end, non-purchase money mortgages
secured by a consumer's principal dwelling (other than a reverse
mortgage) where either: (a) The APR at consummation will exceed the
yield on Treasury securities of comparable maturity by more than 8
percentage points for first-lien loans, or 10 percentage points for
subordinate-lien loans; or (b) the total points and fees payable by
the consumer at or before closing exceed the greater of 8 percent of
the total loan amount, or $547 for 2007 (adjusted annually).
---------------------------------------------------------------------------
When it enacted HOEPA, Congress granted the Board authority,
codified in TILA Section 129(l), to create exemptions to HOEPA's
restrictions and to expand its protections. 15 U.S.C. 1639(l). Under
TILA Section 129(l)(1), the Board may create exemptions to HOEPA's
restrictions as needed to keep responsible credit available; and under
TILA Section 129(l)(2), the Board may adopt new or expanded
restrictions as needed to protect consumers from unfairness, deception,
or evasion of HOEPA. In HOEPA Section 158, Congress directed the Board
to monitor changes in the home equity market through regular public
hearings.
Hearings the Board held in 2000 led the Board to expand HOEPA's
protections in December 2001.\24\ Those rules, which took effect in
2002, lowered HOEPA's rate trigger, expanded its fee trigger to include
single-premium credit insurance, added an anti-``flipping''
restriction, and improved the special pre-closing disclosure.
---------------------------------------------------------------------------
\24\ Truth in Lending, 66 FR 65604, 65608, Dec. 20, 2001.
---------------------------------------------------------------------------
B. Summary of 2006 Hearings
In the summer of 2006, the Board held four hearings in four cities
on three broad topics: (1) The impact of the 2002 HOEPA rule changes on
predatory lending practices, as well as the effects on consumers of
state and local predatory lending laws; (2) nontraditional mortgage
products and reverse mortgages; and (3) informed consumer choice in the
subprime market. Hearing panelists included mortgage lenders and
brokers, credit ratings agencies, real estate agents, consumer
advocates, community development groups, housing counselors,
academicians, researchers, and state and federal government officials.
In addition, consumers, housing counselors, brokers, and other
individuals made brief statements at the hearings during an ``open
mike'' period. In all, 67 individuals testified on panels and 54
comment letters were submitted to the Board.
Consumer advocates and some state officials stated that HOEPA is
generally effective in preventing abusive terms in loans subject to the
HOEPA price triggers. They noted, however, that very
[[Page 1678]]
few loans are made with rates or fees at or above the HOEPA triggers,
and some advocated that Congress lower them. Consumer advocates and
state officials also urged regulators and Congress to curb abusive
practices in the origination of loans that do not meet HOEPA's price
triggers.
Consumer advocates identified several particular areas of concern.
They urged the Board to prohibit or restrict certain loan features or
terms, such as prepayment penalties, and underwriting practices such as
``stated income'' or ``low documentation'' (``low doc'') loans for
which the borrower's income is not documented or verified. They also
expressed concern about aggressive marketing practices such as steering
borrowers to higher-cost loans by emphasizing initial low monthly
payments based on an introductory rate without adequately explaining
that the consumer will owe considerably higher monthly payments after
the introductory rate expires.
Some consumer advocates stated that brokers and lenders should be
held to a higher duty such as a duty of good faith and fair dealing or
a duty to make only loans suitable for the borrower. These advocates
also urged the Board to ban ``yield spread premiums,'' payments that
brokers receive from the lender at closing for delivering a loan with
an interest rate that is higher than the lender's ``buy rate,'' because
they provide brokers an incentive to increase consumers' interest
rates. They argued that such steps would align reality with consumers'
perceptions that brokers serve their best interests. Consumer advocates
also expressed concerns that brokers, lenders, and others may coerce
appraisers to misrepresent the value of a dwelling; and that servicers
may charge consumers unwarranted fees and in some cases make it
difficult for consumers who are in default to avoid foreclosure.
Industry panelists and commenters, on the other hand, expressed
concern that state predatory lending laws may reduce the availability
of credit for some subprime borrowers. Most industry commenters opposed
prohibiting stated income loans, prepayment penalties, or other loan
terms, asserting that this approach would harm borrowers more than help
them. They urged the Board and other regulators to focus instead on
enforcing existing laws to remove ``bad actors'' from the market. Some
lenders indicated, however, that restrictions on certain features or
practices might be appropriate if the restrictions were clear and
narrow. Industry commenters also stated that subjective suitability
standards would create uncertainties for brokers and lenders and
subject them to excessive litigation risk.
C. Summary of June 2007 Hearing
In light of the information received at the 2006 hearings and the
rise in defaults that began soon after, the Board held an additional
hearing in June 2007 to explore how it could use its authority under
HOEPA to prevent abusive lending practices in the subprime market while
still preserving responsible subprime lending. The Board focused the
hearing on four specific areas: Lenders' determination of borrowers'
repayment ability; ``stated income'' and ``low doc'' lending; the lack
of escrows in the subprime market relative to the prime market; and the
high frequency of prepayment penalties in the subprime market.
At the hearing, the Board heard from 16 panelists representing
consumers, mortgage lenders, mortgage brokers, and state government
officials, as well as from academicians. The Board also received almost
100 written comments after the hearing from an equally diverse group.
Industry representatives acknowledged concerns with recent lending
practices but urged the Board to address most of these concerns through
supervisory guidance rather than regulations under HOEPA. They
maintained that supervisory guidance, unlike regulation, is flexible
enough to preserve access to responsible credit. They also suggested
that supervisory guidance issued recently regarding nontraditional
mortgages and subprime lending, as well as market self-correction, have
reduced the need for new regulations. Industry representatives support
improving mortgage disclosures to help consumers avoid abusive loans.
They urged that any substantive rules adopted by the Board be clearly
drawn to limit uncertainty and narrowly drawn to avoid unduly
restricting credit.
In contrast, consumer advocates, state and local officials, and
Members of Congress urged the Board to adopt regulations under HOEPA.
They acknowledged a proper place for guidance but contended that recent
problems indicate the need for requirements enforceable by borrowers
through civil actions, which HOEPA enables and guidance does not. They
also expressed concern that less responsible, less closely supervised
lenders are not subject to the guidance and that there is limited
enforcement of existing laws for these entities. Consumer advocates and
others welcomed improved disclosures but insisted they would not
prevent abusive lending. More detailed accounts of the testimony and
letters are provided below in the context of specific issues the Board
is proposing to address.
D. Congressional Hearings
Congress has also held a number of hearings in the past year about
consumer protection concerns in the mortgage market.\25\ In these
hearings, Congress has heard testimony from individual consumers,
representatives of consumer and community groups, representatives of
financial and mortgage industry groups and federal and state officials.
These hearings have focused on rising subprime foreclosure rates and
the extent to which lending practices have contributed to them.
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\25\ E.g., Progress in Administration and Other Efforts to
Coordinate and Enhance Mortgage Foreclosure Prevention: Hearing
before the H. Comm. on Fin. Servs., 110th Cong. (2007); Legislative
Proposals on Reforming Mortgage Practices: Hearing before the H.
Comm. on Fin. Servs., 110th Cong. (2007); Legislative and Regulatory
Options for Minimizing and Mitigating Mortgage Foreclosures: Hearing
before the H. Comm. on Fin. Servs., 110th Cong. (2007); Ending
Mortgage Abuse: Safeguarding Homebuyers: Hearing before the S.
Subcomm. on Hous., Transp., and Cmty. Dev. of the S. Comm. on
Banking, Hous., and Urban Affairs, 110th Cong. (2007); Improving
Federal Consumer Protection in Financial Services: Hearing before
the H. Comm. on Fin. Servs., 110th Cong. (2007); The Role of the
Secondary Market in Subprime Mortgage Lending: Hearing before the
Subcomm. on Fin. Insts. and Consumer Credit of the H. Comm. on Fin.
Servs., 110th Cong. (2007); Possible Responses to Rising Mortgage
Foreclosures: Hearing before the H. Comm. on Fin. Servs., 110th
Cong. (2007); Subprime Mortgage Market Turmoil: Examining the Role
of Securitization: Hearing before the Subcomm. on Secs., Ins., and
Inv. of the S. Comm. on Banking, Hous., and Urban Affairs, 110th
Cong. (2007); Subprime and Predatory Lending: New Regulatory
Guidance, Current Market Conditions, and Effects on Regulated
Financial Institutions: Hearing before the Subcomm. on Fin. Insts.
and Consumer Credit of the H. Comm. on Fin. Servs., 110th Cong.
(2007); Mortgage Market Turmoil: Causes and Consequences, Hearing
before the S. Comm. on Banking, Hous., and Urban Affairs, 110th
Cong. (2007); Preserving the American Dream: Predatory Lending
Practices and Home Foreclosures, Hearing before the S. Comm. on
Banking, Hous., and Urban Affairs, 110th Cong. (2007).
---------------------------------------------------------------------------
Consumer and community group representatives testified that certain
lending terms or practices, such as hybrid adjustable-rate mortgages,
prepayment penalties, low or no documentation loans, lack of escrows
for taxes and insurance, and failure to consider the consumer's ability
to repay have contributed to foreclosures. In addition, these witnesses
testified that consumers often believe that mortgage brokers represent
their interests and shop on their behalf for the best loan terms. As a
result, they argue that consumers do not shop independently to ensure
that they are getting the best terms for which they qualify. They also
[[Page 1679]]
testified that, because originators sell most loans into the secondary
market and do not share the risk of default, brokers and lenders have
less incentive to ensure consumers can afford their loans.
Financial services and mortgage industry representatives testified
that consumers need better disclosures of their loan terms, but that
substantive restrictions on subprime loan terms would risk reducing
access to credit for some borrowers. In addition, these witnesses
testified that applying a fiduciary duty to the subprime market, such
as requiring that a loan be in the borrower's best interest, would
introduce subjective standards that would significantly increase
compliance and litigation risk. According to these witnesses, some
lenders would be less willing to offer loans in the subprime market,
making it harder for some consumers to get loans.
IV. Inter-Agency Supervisory Guidance
In December 2005, the Board and the other federal banking agencies
responded to concerns about the rapid growth of nontraditional
mortgages in the previous two years by proposing supervisory guidance.
Nontraditional mortgages are mortgages that allow the borrower to defer
repayment of principal and sometimes interest. The guidance advised
institutions of the need to reduce ``risk layering'' practices with
respect to these products, such as failing to document income or
lending nearly the full appraised value of the home. The proposal, and
the final guidance issued in September 2006, specifically advised
lenders that layering risks in nontraditional mortgage loans to
subprime borrowers may significantly increase risks to borrowers as
well as institutions.\26\
---------------------------------------------------------------------------
\26\ Interagency Guidance on Nontraditional Mortgage Product
Risks, 71 FR 58609, Oct. 4, 2006.
---------------------------------------------------------------------------
The Board and the other federal banking agencies addressed concerns
about the subprime market more broadly in March 2007 with a proposal
addressing the heightened risks to consumers and institutions of ARMs
with two or three-year ``teaser'' rates followed by substantial
increases in the rate and payment. The guidance, finalized in June,
sets out the standards institutions should follow to ensure borrowers
in the subprime market obtain loans they can afford to repay.\27\ Among
other steps, the guidance advises lenders to (1) use the fully-indexed
rate and fully-amortizing payment when qualifying borrowers for loans
with adjustable rates and potentially non-amortizing payments; (2)
limit stated income and reduced documentation loans to cases where
mitigating factors clearly minimize the need for full documentation of
income; (3) provide that prepayment penalty clauses expire a reasonable
period before reset, typically at least 60 days.
---------------------------------------------------------------------------
\27\ Statement on Subprime Mortgage Lending, 72 FR 37569, Jul.
10, 2007.
---------------------------------------------------------------------------
The Conference of State Bank Supervisors (CSBS) and American
Association of Residential Mortgage Regulators (AARMR) issued parallel
statements for state supervisors to use with state-supervised entities,
and many states have adopted the statements.
The guidance issued by the federal banking agencies has helped to
promote safety and soundness and protect consumers in the subprime
market. Guidance, however, is not necessarily implemented uniformly by
all originators. Originators who are not subject to routine examination
and supervision may not adhere to guidance as closely as originators
who are. Guidance also does not provide individual consumers who have
suffered harm because of abusive lending practices an opportunity for
redress. The new and expanded consumer protections that the Board is
proposing would apply uniformly to all creditors and be enforceable by
federal and state supervisory and enforcement agencies and in many
cases by borrowers.
V. Legal Authority
A. The Board's Authority Under TILA Section 129(l)(2)
The substantive limitations in new proposed Sec. Sec. 226.35 and
226.36 and corresponding revisions proposed for existing Sec. 226.32,
as well as proposed restrictions on misleading and deceptive
advertisements, would be based on the Board's authority under TILA
Section 129(l)(2), 15 U.S.C. 1639(l)(2). That provision gives the Board
authority to prohibit acts or practices in connection with:
Mortgage loans that the Board finds to be unfair,
deceptive, or designed to evade the provisions of HOEPA; and
Refinancing of mortgage loans that the Board finds to be
associated with abusive lending practices or that are otherwise not in
the interest of the borrower.
The authority granted to the Board under Section 129(l)(2), 15
U.S.C. 1639(l)(2), is broad both in absolute terms and relative to
HOEPA's statutory prohibitions. For example, this authority reaches
mortgage loans with rates and fees that do not meet HOEPA's rate or fee
trigger in TILA Section 103(aa), 15 U.S.C. 1602(aa), as well as types
of mortgage loans not covered under that section, such as home purchase
loans. Nor is the Board's authority limited to regulating specific
contractual terms of mortgage loan agreements; it extends to regulating
loan-related practices generally, within the standards set forth in the
statute. Moreover, while HOEPA's current restrictions apply only to
creditors and only to loan terms or lending practices, TILA Section
129(l)(2) is not limited to creditors, nor is it limited to loan terms
or lending practices. See 15 U.S.C. 1639(l)(2). It authorizes
protections against unfair or deceptive practices when such practices
are ``in connection with mortgage loans,'' and it authorizes
protections against abusive practices ``in connection with refinancing
of mortgage loans.''
HOEPA does not set forth a standard for what is unfair or
deceptive, but the Conference Report for HOEPA indicates that, in
determining whether a practice in connection with mortgage loans is
unfair or deceptive, the Board should look to the standards employed
for interpreting state unfair and deceptive trade practices acts and
the Federal Trade Commission Act, Section 5(a), 15 U.S.C. 45(a).\28\
---------------------------------------------------------------------------
\28\ H.R. Rep. 103-652, at 162 (1994) (Conf. Rep.).
---------------------------------------------------------------------------
Congress has codified standards developed by the Federal Trade
Commission for determining whether acts or practices are unfair under
Section 5(a), 15 U.S.C. 45(a).\29\ Under the Act, an act or practice is
unfair when it causes or is likely to cause substantial injury to
consumers which is not reasonably avoidable by consumers themselves and
not outweighed by countervailing benefits to consumers or to
competition. In addition, in determining whether an act or practice is
unfair, the FTC is permitted to consider established public policies,
but public policy considerations may not serve as the primary basis for
an unfairness determination.\30\
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\29\ See 15 U.S.C. 45(n); Letter from FTC to the Hon. Wendell H.
Ford and the Hon. John C. Danforth (Dec. 17, 1980).
\30\ 15 U.S.C. 45(n).
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The FTC has interpreted these standards to mean that consumer
injury is the central focus of any inquiry regarding unfairness.\31\
Consumer injury may be substantial if it imposes a small harm on a
large number of consumers, or if it raises a significant risk of
[[Page 1680]]
concrete harm.\32\ The FTC looks to whether an act or practice is
injurious in its net effects.\33\ The agency has also observed that an
unfair act or practice will almost always reflect a market failure or
market imperfection that prevents the forces of supply and demand from
maximizing benefits and minimizing costs.\34\ In evaluating unfairness,
the FTC looks to whether consumers' free market decisions are
unjustifiably hindered.\35\
---------------------------------------------------------------------------
\31\ Statement of Basis and Purpose and Regulatory Analysis,
Credit Practices Rule (Credit Practices Rule), 42 FR 7740, 7743
March 1, 1984.
\32\ Letter from Commissioners of the FTC to the Hon. Wendell H.
Ford, Chairman, and the Hon. John C. Danforth, Ranking Minority
Member, Consumer Subcomm. of the H. Comm. on Commerce, Science, and
Transp., n.12 (Dec. 17, 1980).
\33\ Credit Practices Rule, 42 FR at 7744.
\34\ Credit Practices Rule at 7744.
\35\ Credit Practices Rule at 7744.
---------------------------------------------------------------------------
The FTC has also adopted standards for determining whether an act
or practice is deceptive (though these standards, unlike unfairness
standards, have not been incorporated into the FTC Act).\36\ First,
there must be a representation, omission or practice that is likely to
mislead the consumer. Second, the act or practice is examined from the
perspective of a consumer acting reasonably in the circumstances.
Third, the representation, omission, or practice must be material. That
is, it must be likely to affect the consumer's conduct or decision with
regard to a product or service.\37\
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\36\ Letter from James C. Miller III, Chairman, FTC to the Hon.
John D. Dingell, Chairman, H. Comm. on Energy and Commerce (Dingell
Letter) (Oct. 14, 1983).
\37\ Dingell Letter at 1-2.
---------------------------------------------------------------------------
Many states also have adopted statutes prohibiting unfair or
deceptive acts or practices, and these statutes employ a variety of
standards, many of them different from the standards currently applied
to the FTC Act. A number of states follow an unfairness standard
formerly used by the FTC. Under this standard, an act or practice is
unfair where it offends public policy; or is immoral, unethical,
oppressive, or unscrupulous; and causes substantial injury to
consumers.\38\ Some states require that a finding of deception be
supported by a showing of intent to deceive, while other states only
require showing that an act or practice is capable of being interpreted
in a misleading way.\39\
---------------------------------------------------------------------------
\38\ See, e.g., Kenai Chrysler Ctr., Inc. v. Denison, 167 P.3d
1240, 1255 (2007) (quoting FTC v. Sperry & Hutchinson Co., 405 U.S.
233, 244-45 n.5 (1972)); State v. Moran, 151 N.H. 450, 452, 861 A.2d
763, 755-56 (2004) (concurrently applying the FTC's former test and
a test under which an act or practice is unfair or deceptive if
``the objectionable conduct * * * attain[s] a level of rascality
that would raise an eyebrow of someone inured to the rough and
tumble of the world of commerce.'') (citation omitted); Robinson v.
Toyota Motor Credit Corp., 201 Ill. 2d 403, 417-418, 775 N.E.2d 951,
961-62 (2002) (quoting 405 U.S. at 244-45 n.5).
\39\ Compare Robinson, 201 Ill. 2d at 417 (showing of intent to
deceive required under Illinois Consumer Fraud Act) with Kenai
Chrysler Ctr., 167 P.3d at 1255 (no showing of intent to deceive
required under Alaska Unfair Trade Practices Act).
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In proposing rules under TILA Section 129(l)(2)(A), 15 U.S.C.
1639(l)(2)(A), the Board has considered the standards currently applied
to the FTC Act's prohibition against unfair or deceptive acts or
practices, as well as the standards applied to similar state statutes.
B. The Board's Authority Under TILA Section 105(a)
Other aspects of this proposal are based on the Board's general
authority under TILA Section 105(a) to prescribe regulations necessary
or proper to carry out TILA's purposes. 15 U.S.C. 1604(a). This section
is the basis for the proposal to require early disclosures for
residential mortgage transactions as well as many of the proposals to
improve advertising disclosures. These proposals are intended to carry
out TILA's purposes of informing consumers about their credit terms and
helping them shop for credit. See TILA Section 102, 15 U.S.C. 1603.
VI. Proposed Definition of ``Higher-Priced Mortgage Loan''
A. Overview
The Board proposes to extend certain consumer protections to a
subset of consumer residential mortgage loans referred to as ``higher-
priced mortgage loans.'' A creditor would be prohibited from engaging
in a pattern or practice of making higher-priced mortgage loans based
on the collateral without regard to repayment ability. A creditor would
also be prohibited from making an individual higher-priced mortgage
loan without: Verifying the consumer income and assets the creditor
relied upon to make the loan; and establishing an escrow account for
taxes and insurance. In addition, a higher-priced mortgage loan would
not be permitted to have a prepayment penalty except under certain
conditions. Finally, a creditor would be prohibited from structuring a
closed-end mortgage loan as an open-end line of credit for the purpose
of evading the restrictions on higher-priced mortgage loans, which
would not apply to open-end lines of credit.
This part VI discusses the proposed definition of a ``higher priced
mortgage loan'' and a discussion of the specific protections that would
apply to these loans follows in part VII. The Board is proposing to
apply certain other restrictions to closed-end consumer mortgage loans
secured by the consumer's principal dwelling without regard to loan
price. These restrictions are discussed separately in part VIII.
Higher-priced mortgage loans would be defined as consumer credit
transactions secured by the consumer's principal dwelling for which the
APR on the loan exceeds the yield on comparable Treasury securities by
at least three percentage points for first-lien loans, or five
percentage points for subordinate lien loans. The proposed definition
would include home purchase loans, refinancings of loans, and home
equity loans. The definition would exclude home equity lines of credit
(``HELOCs''). In addition, there would be exclusions for reverse
mortgages, construction-only loans, and bridge loans.
The definition of ``higher-priced mortgage loans'' would appear in
proposed Sec. 226.35(a). Such loans would be subject to the
restrictions and requirements in Sec. 226.35(b) concerning repayment
ability, income verification, prepayment penalties, escrows, and
evasion, except that subordinate-lien higher-priced mortgage loans
would not be subject to the escrow requirement.
B. Public Comment on the Scope of New HOEPA Rules
The June 14, 2007 hearing notice solicited comment on the following
questions concerning coverage:
Whether terms or practices discussed in the hearing notice
should be prohibited or restricted for all mortgage loans, or only for
loans offered to subprime borrowers?
Whether terms or practices should be prohibited or
restricted for loans to first-time homebuyers, home purchase loans, or
refinancings and home equity loans?
Whether terms or practices should be prohibited or
restricted only for certain products, such as adjustable-rate mortgages
or nontraditional mortgages?
Many commenters addressed the scope of any rules the Board might
propose. Some consumer and community groups favored applying some or
all prohibitions to the entire mortgage market, though other groups
recommended that certain protections (e.g., for repayment ability) be
applied to the entire market and others (e.g., for escrows) only to
subprime and nontraditional loans. In general, financial institutions
and financial services groups maintained that new rules should not be
applied to the entire market.
Most commenters suggested that, to the extent the Board targets
subprime
[[Page 1681]]
loans, it do so based on loan characteristics rather than borrower
characteristics such as credit score. Some commenters proposed that
coverage be determined by a loan's annual percentage rate (APR) and
suggested various approaches based on lender reporting of ``higher-
priced loans'' under Regulation C, which implements the Home Mortgage
Disclosure Act (HMDA). Several industry commenters, however, pointed
out drawbacks of using an approach based on HMDA reporting and
advocated instead that the Board cover only loans with ``payment
shock.''
C. General Principles Governing the Board's Determination of Coverage
Four main principles will guide the Board's determination of
appropriate coverage. First, new regulations should be applied as
broadly as needed to protect consumers from actual or potential injury,
but not so broadly that the costs, including the always-present risk of
unintended consequences, would clearly outweigh the benefits. Evidence
that consumers have actually been injured by a particular practice in a
particular market segment is important to determining proper coverage.
Protection may also be needed in a particular segment, however, to
prevent potential future injury in that segment or to limit adverse
effects should lenders circumvent protections applied to another
segment.
Second, the most practical and effective way to protect borrowers
is to apply protections based on loan characteristics, rather than
borrower characteristics. Identifying a class of protected borrowers
would present operational difficulties and other problems. For example,
it is common to distinguish borrowers by credit score, with lower-
scoring borrowers generally considered to be at higher risk of injury
in the mortgage market. Defining the protected field as lower-scoring
consumers would fail to protect higher-scoring consumers ``steered'' to
loans meant for lower-scoring consumers. Moreover, the market uses
different commercial scores, and choosing a particular score as the
benchmark for a regulation could give unfair advantage to the company
that provides that score.
Third, the rule identifying higher-priced loans should be as simple
as reasonably possible, consistent with protecting consumers and
minimizing costs. For the sake of simplicity, the same coverage rule
should apply to all new protections except where the benefit of
tailoring coverage criteria to specific protections outweighs the
increased complexity.
Fourth, the rule should give lenders a reasonable degree of
certainty during the application process regarding whether a
transaction, when completed, will be covered by a particular
protection. For some protections, reasonable certainty may be needed
early in the application process; for other protections, it may not be
needed until later. Reasonable certainty does not mean complete
certainty. A rule that would provide lenders complete certainty about
coverage early in the application process is likely not achievable.
D. Types of Loans Proposed To Be Covered Under Sec. 226.35
The Board's proposed definition of ``higher-priced mortgage loan''
has two main aspects. The first aspect is loan type--the definition
includes certain types of loans (such as home purchase loans) and
excludes others (such as HELOCs). The second aspect is loan price--the
definition includes only loans with APRs exceeding specified
thresholds. The first aspect of the definition, loan type, is discussed
immediately below, and the second is discussed thereafter.
The Board proposes to apply the protections of Sec. 226.35 to
first-lien, as well as subordinate-lien, closed-end mortgage loans
secured by the consumer's principal dwelling, including home purchase
loans, refinancings of loans, and home equity loans. The proposed
definition would not cover loans that do not have primarily a consumer
purpose, such as loans for real estate investment. The proposed
definition also would not cover HELOCs, reverse mortgages,
construction-only loans, or bridge loans.
Coverage of Home Purchase Loans, Refinancings, and Home Equity Loans
The statutory protections for HOEPA loans are generally limited to
closed-end refinancings and home equity loans. See TILA Section
103(aa), 15 U.S.C. 1602(aa). The Board proposes to apply the
protections of Sec. 226.35 to loans of these types, which have
historically presented the greatest risk to consumers. These loans are
often made to consumers who have home equity and, therefore, have an
existing asset at risk. These loans also can be marketed aggressively
by originators to homeowners who may not benefit from them and who, if
responding to the marketing and not shopping independently, may have
limited information about their options.
The Board proposes to use its authority under TILA Section
129(l)(2), 15 U.S.C. 1639(l)(2), to cover home purchase loans as well.
Covering only refinancings of home purchase loans would fail to protect
consumers adequately. From 2003 to 2006, 44 percent of the higher-risk
ARMs that came to dominate the subprime market in recent years were
extended to consumers to purchase a home.\40\ Delinquencies on subprime
ARMs used for home purchase have risen sharply just as they have for
refinancings. Moreover, comments and testimony at the Board's hearings
indicate that the problems with abusive lending practices are not
confined to refinancings and home equity loans.
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\40\ Figure calculated from First American LoanPerformance data.
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Furthermore, consumers who are seeking home purchase loans can face
unique constraints on their ability to make decisions. First-time
homebuyers are likely unfamiliar with the mortgage market. Homebuyers
generally are primarily focused on acquiring a new home, arranging to
move into it, and making other life plans related to the move, such as
placing their children in new schools. These matters can occupy much of
the time and attention consumers might otherwise devote to shopping for
a loan and deciding what loan to accept. Moreover, even if the consumer
comes to understand later in the application process that an offered
loan may not be appropriate, the consumer may not be able to reject the
loan without risk of abrogating the sales agreement and losing a
substantial deposit, as well as disrupting moving plans.
Coverage of Subordinate-Lien Loans
The Board is proposing to apply the proposed new protections--with
the exception of the requirement to establish escrows--to subordinate-
lien loans. (The reasons for this exception are discussed below under
part VII.D.) The Board seeks comment on whether other exceptions would
be appropriate. For example, should the Board limit coverage of all or
some of the proposed restrictions to certain kinds of subordinate-lien
loans such as ``piggy backs'' to first-lien loans, or subordinate-lien
loans that are larger than the first-lien loan?
Limitation to Loans Secured by Principal Dwelling; Exclusion of Loans
for Investment
The Board is proposing to limit the protections in proposed Sec.
226.35 to loans secured by the consumer's principal dwelling. The
Board's primary concern is to ensure that consumers not lose the homes
they principally occupy
[[Page 1682]]
because of unfair, abusive, or deceptive lending practices. The
inevitable costs of new regulation, including potential unintended
consequences, can most clearly be justified when people's principal
homes are at stake.
Limiting the proposed protections to loans secured by the principal
dwelling would have the effect of excluding many, but not all, loans to
purchase second homes. A loan to a consumer to purchase a second home,
for example, would not be covered by these protections if the loan was
secured only by the second home or by another dwelling (such as an
investment property) other than the consumer's principal dwelling. Such
a loan would, however, be covered if it was instead secured by the
consumer's principal dwelling.
Limiting the proposed protections to loans secured by the principal
dwelling--and to loans having primarily a consumer purpose--would also
have the effect of excluding loans primarily for a real estate
investment purpose. This exclusion is consistent with TILA's focus on
consumer concerns and its exclusion in Section 104 of credit primarily
for business, commercial, or agricultural purposes. See 15 U.S.C.
1603(1). Real estate investors are expected to be more sophisticated
than ordinary consumers about the real estate financing process and to
have more experience with it, especially if they invest in several
properties. Accordingly, the need to protect investors is not clear,
and in any event is likely not sufficient to justify the potential
unintended consequences of imposing restrictions, with civil liability
if they are violated, on the financing of real estate investment
transactions.
The Board shares concerns that individuals who invest in
residential real estate and do not pay their mortgage obligations put
tenants at risk of eviction in the event of foreclosure. Regulating the
rights of landlords and tenants, however, is traditionally a matter for
state and local law. The Board believes that state and local law could
better address this particular tenant protection concern than a Board
regulation.
Exclusion of HELOCs
The Board proposes to exclude HELOCs from the proposed protections.
These transactions do not appear to present as clear a need for new
regulations as closed-end transactions. Most originators of HELOCs hold
them in portfolio rather than sell them, which aligns these
originators' interests in loan performance more closely with their
borrowers' interests. In addition, TILA and Regulation Z provide
borrowers special protections for HELOCs such as restrictions on
changing plan terms. And, unlike originations of higher-priced closed-
end mortgage loans, HELOC originations are concentrated in the banking
and thrift industries, where the federal banking agencies can use
supervisory authorities to protect borrowers. For example, when
inadequate underwriting of HELOCs unduly increased risks to originators
and consumers several years ago, the agencies responded with
guidance.\41\ For these reasons, the Board is not proposing to cover
HELOCs.
---------------------------------------------------------------------------
\41\ Interagency Credit Risk Guidance for Home Equity Lending,
May 16, 2005.
Available at http://www.federalreserve.gov/boarddocs/srletters/2005/sr0511a1.pdf
.
Addendum to Credit Risk Guidance for Home Equity Lending, Sept.
29, 2006. Available at http://www.federalreserve.gov/BoardDocs/SRLetters/2006/SR0615a3.pdf
.
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The Board recognizes, however, that HELOCs may represent a risk of
circumvention. Creditors may seek to evade limitations on closed-end
transactions by structuring such transactions as open-end transactions.
In proposed Sec. 226.35(b)(5), discussed below in part VII.F., the
Board proposes to prohibit structuring a closed-end loan as an open-end
transaction for the purpose of evading the new rules in Sec. 226.35.
To the extent it may instead be appropriate to apply those rules
directly to HELOCs, the Board seeks comment on how an APR threshold for
HELOCs could be set to achieve the objectives, discussed further in
subpart E., of covering the subprime market and generally excluding the
prime market.
Exclusion of Reverse Mortgages and Construction-Only Loans
The Board proposes to exclude reverse mortgages and construction-
only loans from the new protections in Sec. 226.35(b). A reverse
mortgage is defined in current Sec. 226.33(a), and the proposal would
retain this definition. The Board heard from panelists about reverse
mortgages at its 2006 HOEPA hearings and has not identified significant
abuses in the reverse mortgage market. Moreover, reverse mortgages are
unique transactions that present unique risks that are currently
addressed by Regulation Z Sec. 226.33. At an appropriate time, the
Board will review Sec. 226.33 and consider whether new or different
protections are needed for reverse mortgages.
The Board would also exclude from Sec. 226.35's protections a
construction-only loan, defined as a loan solely for the purpose of
financing the initial construction of a dwelling, consistent with the
definition of a ``residential mortgage transaction'' in Sec.
226.2(a)(24). A construction-only loan would not include the permanent
financing that replaces a construction loan. Construction-only loans do
not appear to present the same risk of consumer abuse as other loans
the proposal would cover. The permanent financing, or a new home-
secured loan following construction, would be covered by proposed Sec.
226.35. Applying Sec. 226.35 to construction-only loans, which
generally have higher interest rates than the permanent financing,
could hinder some borrowers' access to construction financing without
meaningfully enhancing consumer protection.
Exclusion of Bridge Loans
Proposed Sec. 226.35(a)(5) would exempt from Sec. 226.35
temporary or ``bridge loans'' with a term of no more than twelve
months. The regulation would give as an example a loan that a consumer
takes to ``bridge'' between the purchase of a new dwelling and the sale
of the consumer's existing dwelling. HOEPA now covers certain bridge
loans with rates or fees high enough to make them HOEPA loans. TILA
Section 129(l)(1) provides the Board authority to exempt classes of
mortgage transactions from HOEPA if the Board finds that the exemption
is in the interest of the borrowing public and will apply only to
products that maintain and strengthen homeownership and equity
protection. 15 U.S.C. 1639(l)(2). The Board believes a narrow exemption
from HOEPA for bridge loans would be in borrowers' interest and support
homeownership. The Board seeks comment on the proposed exemption.
E. Proposed APR Trigger for Sec. 226.35
Overview
The Board proposes to use an APR trigger to define the range of
transactions that would be covered by the protections of proposed Sec.
226.35. The Board seeks to set the trigger at a level that would
capture the subprime market but generally exclude the prime market.
There is, however, inherent uncertainty as to what level would achieve
these objectives. The Board believes that it may be appropriate, in the
face of this uncertainty, to err on the side of covering somewhat more
than the subprime market. Based on this approach, the Board proposes a
threshold of three percentage points above the comparable Treasury
security for first-lien loans, or five percentage points for
subordinate-lien loans. Based on available data, it appears that this
threshold would capture at least the
[[Page 1683]]
higher-priced end of the alt-A market. The Board seeks comment, and
solicits data, on the extent to which the threshold would cover the
alt-A market, and on the benefits and costs, including any potential
unintended consequences for consumers, of applying any or all of the
protections in Sec. 226.35 to the alt-A market to the extent it would
be covered. The Board also seeks comment on whether a different
threshold, such as four percentage points for first-lien loans (and six
percentage points for subordinate-lien loans), would better satisfy the
objectives of covering the subprime market, excluding the prime market,
and avoiding unintended consequences for consumers in the alt-A market.
Reasons To Use APR
The APR corresponds closely to credit risk, that is, the risk of
default as well as the closely related risks of serious delinquency and
foreclosure. Loans with higher APRs generally have higher credit risks,
whatever the source of the risk might be--weaker borrower credit
histories, higher borrower debt-to-income ratios, higher loan-to-value
ratios, less complete income or asset documentation, less traditional
loan terms or payment schedules, or combinations of these or other risk
factors. Since disclosing an APR has long been required by TILA, the
figure is also very familiar and readily available to creditors and
consumers. Therefore, the Board believes it appropriate to use a loan's
APR to identify loans having a high enough credit risk to warrant the
protections of proposed Sec. 226.35.
The APR for two loans with identical risk characteristics can be
different at different times solely because of market changes in
mortgage rates. The Board proposes to control for such market changes
by comparing a loan's APR to the yield on the comparable Treasury
security. This would be similar, but not identical, to the approach
HOEPA uses currently to identify HOEPA-covered loans, see TILA Section
103(aa), 15 U.S.C. 1602(aa), and Sec. 226.32(a), and Regulation C uses
to identify higher-priced loans reportable under HMDA, see 12 CFR
203.4(a)(12). The Board is aware of concerns that the method that these
regulations use to match mortgage loans to Treasuries leads to some
inaccuracy in coverage and makes coverage vary with changes in the
yield curve (the relationship between short-term and long-term interest
rates). As discussed in more detail below, the Board is proposing to
address these concerns in the context of Sec. 226.35.
Coverage Objectives
The Board set forth above a general principle that new regulations
should be applied as broadly as needed to protect consumers from actual
or potential injury, but not so broadly that the costs, including the
always-present risk of unintended consequences, would clearly outweigh
the benefits. Consistent with this principle, the Board believes that
the APR threshold should satisfy two objectives. It should ensure that
subprime loans are covered. Second, it should also generally exclude
prime loans.
The subprime market should be covered because it is, by definition,
the market with the highest credit risk. There are of course variations
in risk within the subprime market. For example, delinquencies on
fixed-rate subprime mortgages have been lower in recent years than on
adjustable-rate subprime mortgages. It may not be practical or
effective, however, to target certain loans in the subprime market for
coverage while excluding others. Such a rule would be more complex and
possibly require frequent updating as products evolved. Moreover,
market imperfections discussed in part II.C.--the subprime market's
lack of transparency and potentially inadequate creditor incentives to
make only loans that consumers can repay--affect the subprime market as
a whole.
There are two principal reasons why the Board seeks to exclude the
prime market from Sec. 226.35. First, there is limited evidence that
the problems addressed in Sec. 226.35, such as lending without regard
to repayment ability, have been significant in the prime market or gone
unaddressed when they have on occasion arisen. By nature, loans in the
prime market have a lower credit risk, as seen in the relatively low
default and delinquency rates for prime loans compared to sharply
increasing rates for subprime loans since 2005. Moreover, the prime
market is more transparent and competitive, characteristics that make
it less likely a creditor can sustain an unfair, abusive, or deceptive
practice. In addition, borrowers in the prime market are less likely to
be under the degree of financial stress that tends to weaken the
ability of many borrowers in the subprime market to protect themselves
against unfair, abusive, or deceptive practices. To be sure, there have
been concerns about the prime market, and this proposal would address
some of them. For example, the proposal addresses concerns about
coercion of appraisers, untransparent creditor payments to mortgage
brokers, and abusive servicing practices.
Second, any undue risks to consumers in the prime market from
particular loan terms or lending practices can be adequately addressed
through means other than new regulations under HOEPA. Supervisory
guidance from the federal agencies influences a large majority of the
prime market which, unlike the subprime market, has been dominated by
federally supervised institutions.\42\ Such guidance affords regulators
and institutions alike more flexibility than a regulation, with
potentially fewer unintended consequences. In addition, the Government
Sponsored Enterprises continue to play a major role in the prime
market, and they are accountable to regulators and policy makers for
the standards they set for loans they will purchase.\43\
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\42\ According to HMDA data from 2005 and 2006, more than three-
quarters of prime, conventional first-lien mortgage loans on owner-
occupied properties were made by depository institutions or their
affiliates. For this purpose, a loan for which price information was
not reported is treated as a prime loan.
\43\ According to HMDA data from 2005 and 2006, nearly 30
percent of prime, conventional first-lien mortgage loans on owner-
occupied properties were purchased by Fannie Mae or Freddie Mac.
---------------------------------------------------------------------------
For these reasons, the Board does not believe that substantive
restrictions on loan terms or lending practices are warranted in the
prime market at this time. The need for such restrictions is not clear
and their potential unintended consequences could be significant.
Inherent Uncertainty of Meeting Coverage Objectives
There are three major reasons why it is inherently uncertain which
APR threshold would achieve the twin objectives of covering the
subprime market and generally excluding the prime market. First, there
is no single, precise, and uniform definition of the prime or subprime
market, or of a prime or subprime loan. Moreover, the markets are
separated by a somewhat loosely defined segment known as the alt-A
market, the precise boundaries of which are not clear.
Second, available data sets enable only estimation, not precise
calculation, of the empirical relationship between APR and credit risk.
A proprietary dataset such as First American LoanPerformance may
contain detailed information on loan characteristics, including the
contract rate, but lack the APR or sufficient data to derive the APR.
Other data must be consulted to estimate APRs based on contract rates.
HMDA data contain the APR for higher-priced loans (as adjusted by
comparable Treasury securities), but they have little information about
credit risk.
[[Page 1684]]
Third, data sets can of course show only the existing or past
distribution of loans across market segments, which may change in ways
that are difficult to predict. In particular, the distribution could
change in response to the Board's imposition of the restrictions in
Sec. 226.35, but the likely direction of the change is not clear. A
loan's APR is typically not known to a certainty until after the
underwriting has been completed, and not until closing if the consumer
has not locked the interest rate. Creditors might build in a
``cushion'' against this uncertainty by voluntarily setting their
internal thresholds lower than the threshold in the regulation.
Creditors would have a competing incentive to avoid the
restrictions, however, by restructuring the prices of potential loans
that would have APRs just above the threshold to cause the loans' APRs
to come under the threshold. Different combinations of interest rate
and points that are economically identical for an originator produce
different APRs. If proposed Sec. 226.35 were adopted, an originator
would have an incentive to achieve a rate-point combination that would
bring a loan's APR below the threshold (if the borrower had the
resources or equity to pay the points). Moreover, some fees, such as
late fees and prepayment penalties, are not included in the APR.
Creditors could increase the number or amounts of such fees to maintain
a loan's effective price while lowering its APR below the threshold. It
is not clear whether the net effect of these competing forces of over-
compliance and circumvention would be to capture more, or fewer, loans.
For all of the above reasons, there is inherent uncertainty as to
what APR threshold would achieve the objectives of covering the
subprime market and generally excluding the prime market.
The Alt-A Market
In the face of this uncertainty, deciding on an APR threshold calls
for judgment. The Board believes it may be appropriate to err on the
side of covering somewhat more than the subprime market. In effect,
this could mean covering part of the alt-A market, a possibility that
merits special consideration.
The alt-A market is generally understood to be for borrowers who
typically have higher credit scores than subprime borrowers but still
pose more risk than prime borrowers because they make small down
payments or do not document their incomes, or for other reasons. The
definition of this market is not precise, however. Moreover, the size
and character of this market segment have changed markedly in a
relatively short period. According to one source, it was 2 percent of
residential mortgage originations in 2003 and 13 percent in 2006.\44\
At least part of this growth was due to increasing flexibility of
underwriting standards. For example, in 2006, 80 percent of loans
originated for alt-A securitized pools were underwritten without full
documentation of income, compared to about 60 percent from 2000 to
2004.\45\ At the same time, nontraditional mortgages allowing borrowers
to defer principal, or both principal and interest, also expanded,
reaching 78 percent of alt-A originations in 2006.\46\
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\44\ IMF 2007 Mortgage Market, at 4.
\45\ Figures calculated from First American LoanPerformance
data.
\46\ David Liu & Shumin Li, Alt A Credit--The Other Shoe Drops?,
The MarketPulse The MarketPulse (First American LoanPerformance,
Inc., San Francisco, Cal.), Dec. 2006.
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The Board recognizes that risks to consumers in the alt-A market
are lower than risks in the subprime market. The Board believes,
however, that it may be appropriate to cover at least part of the alt-A
market with the protections of Sec. 226.35. Because of the inherent
uncertainties in setting an APR threshold discussed above, covering
part of the alt-A market may be necessary to ensure consistent coverage
of the subprime market. Moreover, to the extent Sec. 226.35 were to
cover the higher-priced end of the alt-A market, where several risks
may be layered, the regulation may benefit consumers more than it would
cost them. For example, applying an income verification requirement to
the riskier part of the alt-A market could ameliorate injuries to
consumers from lending based on inflated incomes without necessarily
depriving consumers of access to credit, if they are able to document
their incomes as Sec. 226.35(b)(2) would require. Prohibiting lending
without regard to repayment ability in this market slice could reduce
the risk to consumers from ``payment shock'' on nontraditional loans.
At the same time, the Board recognizes the potential for unintended
consequences if Sec. 226.35 restrictions were to cover part of the
alt-A market and seeks to minimize those consequences.
The Proposed Thresholds of 3 and 5 Percentage Points
Based on the foregoing considerations, the Board is proposing to
set the APR threshold for a loan at three percentage points above the
comparable Treasury security, or five percentage points in the case of
a subordinate-lien loan. Available data indicate that this threshold
would capture the subprime market but generally exclude the prime
market. In each of the last two years, the percentage of the first-lien
mortgage market Regulation C has captured as higher-priced using a
threshold of three percentage points has been greater than the
percentage of the total market originations that one industry source
has estimated to be subprime (25 percent vs. 20 percent in 2005; 28
percent vs. 20 percent in 2006).\47\ Regulation C is not thought,
however, to have reached the prime market. Rather, in both years it
reached into the alt-A market, which the same source estimated to be 12
percent in 2005 and 13 percent in 2006. In 2004, Regulation C captured
a significantly smaller part of the market than an industry estimate of
the subprime market (11 percent vs. 19 percent), but that year's HMDA
data were somewhat anomalous.\48\
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\47\ For industry estimates see IMF 2007 Mortgage Market, at 4.
\48\ The principal cause of the reporting deficit was the
unusually steep yield curve that characterized 2004. For purposes of
proposed Sec. 226.35(a), the Board is proposing to adjust the
method that Regulation C uses to calculate the higher-priced loan
threshold to reduce, though not eliminate, the effects of yield
curve changes on Sec. 226.35's coverage. This proposal is discussed
below.
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The Board does not have data indicating how closely the proposed
threshold of five percentage points for subordinate-lien loans would
correspond to the subprime home equity market. It is the Board's
understanding, however, that this threshold, which has prevailed in
Regulation C since 2004, has been at least roughly accurate.
Requests for Comment
The Board seeks comment, and supporting data, on whether different
thresholds would better satisfy the objectives of covering the subprime
market and generally excluding the prime market. The Board seeks
comment and data both as to first-lien loans and as to subordinate-lien
loans; and both as to home purchase loans and as to refinancings. The
Board also seeks comment and supporting data on the extent to which the
proposed threshold would cover the alt-A market and, as discussed
above, on the costs and benefits of such coverage. Moreover, the Board
seeks comment on whether a different threshold than that proposed, such
as four percentage points for first-lien loans (and six percentage
points for subordinate-lien loans), would better satisfy the objectives
of covering the subprime market, excluding the prime market, and
avoiding unintended
[[Page 1685]]
consequences for consumers in the alt-A market.
The Board also seeks comment on the extent to which lenders may set
an internal threshold lower than that set forth in the regulation to
ensure compliance, and the consequences that could have for consumers.
Conversely, the Board seeks comment on the extent of the risk creditors
would circumvent the proposed restrictions by charging more fees and
lower interest rates to reduce their loans' APRs, and the consequences
that could have for consumers. Is this risk significant enough to
warrant addressing separately. For example, should the Board adopt a
separate fee trigger? What fees would such a trigger include and at
what level would it be set? Alternatively, would a general prohibition
on manipulating the APR to circumvent the protections of Sec. 226.35
be practicable?
F. Mechanics of the Proposed APR Trigger
Under Regulation C, price information on a closed-end, first-lien
loan is reported if the loan's APR exceeds by three or more percentage
points (five if the loan is secured by a subordinate lien) the yield on
Treasury securities having a comparable period of maturity. A lender
uses the yield on Treasury securities as of the 15th day of the
preceding month if the rate is set between the 1st and the 14th day of
the month, and as of the 15th of the current month if the rate is set
on or after the 15th day. Although the Board proposes to use the same
numerical thresholds, the Board proposes to use somewhat different
rules for matching mortgage loans to Treasury securities.
Matching Loans to Treasury Securities
For purposes of this rulemaking, the Board proposes to use a
different approach than Regulation C uses to match loans to Treasury
securities, with the intent of reducing effects solely from changes in
the interest rate environment. Following the model of HOEPA (TILA
Section 103(aa), 15 U.S.C. 1603(aa)), Regulation C compares the APR on
a loan to the yield on Treasury securities having a period of maturity
comparable to the maturity of the loan. 12 CFR 203.4(a)(12). For
example, the APR on a fixed-rate, 30-year loan--the most common loan
term in the market--is compared to the yield on a 30-year Treasury
security. In actuality, mortgage loans are usually paid off long before
they mature, typically in five to ten years. Rates on fixed-rate 30-
year mortgage loans, therefore, more closely track yields on Treasury
securities having maturities in the range of five to ten years rather
than yields on 30-year Treasury securities. Rates on adjustable-rate
mortgages more closely track yields on Treasury securities that mature
in one to five years, depending in part on the duration of any initial
fixed-rate period. As a result, changes in the relationship of short-
term rates to long-term rates, known as the yield curve, have affected
reporting of higher-priced mortgage loans.
For purposes of the rules proposed here, the Board's goal is to
reduce this ``yield curve effect.'' Ideally, each loan would be matched
to a Treasury security that corresponds to that loan's expected
maturity, which would be determined based on empirical data about
prepayment speeds for loans with the same features. It is not
practicable, however, to match loans to Treasuries on the basis of the
full range of features that may influence prepayment speeds. For the
sake of simplicity and predictability, the Board proposes to prescribe
rules based on three features: whether the loan is adjustable-rate or
fixed-rate; the term of the loan; and the length of any initial fixed-
rate period, if the loan is adjustable-rate.
Proposed Sec. 226.35(a) that would match closed-end loans to
Treasury securities as follows. First, variable rate transactions with
an initial fixed-rate period of more than one year would be matched to
Treasuries having a maturity closest to the length of the fixed-rate
period (unless the fixed-rate period exceeds seven years, in which case
the creditor would use the rules applied to non-variable rate loans).
For example, a 30-year ARM having an initial fixed-rate period of five
years would be matched to a 5-year Treasury security. Second, variable-
rate transactions with an initial fixed-rate period of one year or less
would be matched to Treasury security having a maturity of one year.
Third, fixed-rate loans would be matched on the basis of loan term in
the following way: A fixed-rate loan with a term of 20 years or more
would be matched to a 10-year Treasury security; a fixed-rate loan with
a term of more than 7 years but less than twenty years would be matched
to a 7-year Treasury security; and a fixed-rate loan with a term of
seven years or less would be matched to the Treasury security with a
maturity closest to the term.
Timing of the Match
The proposal also would differ from Regulation C as to timing. The
Treasury security yield that would be used is the yield as of the 15th
of the month preceding the month in which the application is received,
rather than the 15th of the month before the rate is locked. This would
introduce more certainty, earlier in the application process, to the
determination as to whether a potential transaction would be a higher-
priced mortgage loan when consummated. The actual APR, however, would
not be known to a certainty early in the application process, leaving
some uncertainty as to whether a potential loan will be a higher-priced
loan if it is actually originated. The APR disclosed within three days
of application could change before closing for legitimate reasons such
as changes in the interest rate or in the borrower's decision as to how
many points to pay, if any. It is not expected, however, that an APR
would change substantially in many cases for legitimate reasons.
Using two different trigger dates in Regulation C and Regulation Z
Sec. 226.35(a)--the rate lock date in the first and the application
date in the second--could increase regulatory burden. Using the rate
lock date in Sec. 226.35(a), however, could increase uncertainty,
relative to using the application date, as to whether a loan would be
higher-priced when consummated. The Board believes the potentially
somewhat higher regulatory burden from inconsistency may be justified
by the increase in certainty.
Requests for Comment
The Board seeks data with which to evaluate the proposed approach
to matching mortgage loans to Treasury securities and the proposal to
select the appropriate Treasury security based on the application date.
The Board also solicits suggestions for alternative approaches that
would better meet the objectives of relative simplicity and reasonably
accurate coverage.
VII. Proposed Rules for Higher-Priced Mortgage Loans--Sec. 226.35
A. Overview
This part discusses the new consumer protections the Board proposes
to apply to ``higher-priced mortgage loans.'' A creditor would be
prohibited from engaging in a pattern or practice of making higher-
priced mortgage loans based on the collateral without regard to
repayment ability. A creditor would also be prohibited from making an
individual higher-priced mortgage loan without: Verifying the income
and assets the creditor relied upon to make the loan; and establishing
an escrow account for taxes and insurance. In addition, a higher-priced
mortgage loan
[[Page 1686]]
could not have a prepayment penalty except under certain conditions.
The Board believes that the practices that would be prohibited,
when conducted in connection with higher-priced mortgage loans, are
unfair, deceptive, associated with abusive lending practices, and
otherwise not in the interest of the borrower. See TILA Section
129(l)(2), 15 U.S.C. 1639(l)(2), and the discussion of this statute in
part V above. Making higher-priced mortgage loans without adequately
considering repayment ability, verifying income or assets, or
establishing an escrow account for taxes and insurance significantly
increases the risk that consumers will not be able to repay their
loans. When consumers cannot repay their loans and must choose between
losing their homes and refinancing in an effort to stay in their homes,
they are more vulnerable to such abuses as loan flipping and equity
stripping. Prepayment penalties in certain circumstances can exacerbate
these injuries by making it more costly to exit unaffordable loans.
The Board has considered that some of the practices that would be
prohibited may benefit some consumers in some circumstances. As
discussed more fully below with respect to each prohibited practice,
however, the Board believes that in connection with higher-priced
mortgage loans these practices are likely to cause more injury to
consumers than any benefit the practices may provide them. The Board
has also considered that the proposed rules may reduce the access of
some consumers in some circumstances to legitimate and beneficial
credit arrangements, either directly as a result of a prohibition or
indirectly because creditors may incur, and pass on, increased
compliance and litigation costs. The Board believes the benefits of the
proposal outweigh these costs.
The Board has also considered other, potentially less burdensome,
approaches such as requiring more, or better, disclosures. For reasons
discussed in part II.C., the Board believes that disclosures alone may
not provide consumers in the subprime market adequate protection from
unfair, deceptive, and abusive lending practices. The discussion below
sets forth additional reasons why disclosures and other possible
alternatives to the proposed prohibitions may not give adequate
protection.
In addition to proposing new protections for consumers with higher-
priced mortgage loans, the Board is also proposing to prohibit a
creditor from structuring a closed-end mortgage loan as an open-end
line of credit for the purpose of evading the restrictions on higher-
priced mortgage loans, which do not apply to open-end lines of credit.
This proposal is based on the authority of the Board under TILA Section
129(l)(2) to prohibit practices that would evade Board regulations
adopted under authority of that statute. 15 U.S.C. 1639(l)(2).
B. Disregard of Consumers' Ability to Repay--Sec. Sec. 226.34(a)(4)
and 226.35(b)(1)
TILA Section 129(h), 15 U.S.C. 1639(h), and Regulation Z Sec.
226.34(a)(4) currently prohibit a pattern or practice of extending
HOEPA loans based on consumers' collateral without regard to their
repayment ability. HOEPA loans are, however, a very small portion of
the subprime market. The Board is proposing to extend the prohibition
against a pattern or practice of lending based on consumers' collateral
without regard to their repayment ability to higher-priced mortgage
loans as defined in Sec. 226.35(a). The prohibition in Sec.
226.34(a)(4) would be revised somewhat, and this revised prohibition
would be incorporated as proposed new Sec. 226.35(b)(1).
Public Comment on Determining Ability To Repay
In the Board's June 14, 2007 hearing notice, the Board solicited
comment on the following alternatives to ensure borrowers' repayment
ability:
Should lenders be required to underwrite all loans based
on the fully-indexed rate and fully amortizing payments?
Should there be a rebuttable presumption that a loan is
unaffordable if the borrower's debt-to-income (DTI) ratio exceeds 50
percent?
Are there specific consumer disclosures that would help
address concerns about unaffordable loans?
Few commenters offered specific disclosure suggestions but many
commenters and hearing witnesses addressed the first two questions.
Most consumer and community groups who commented support a requirement
to underwrite ARMs using the fully-indexed, fully-amortizing rate.
Several recommended, however, that the Board require underwriting to
the maximum rate possible or, at least, to a rate higher than the
fully-indexed rate. These commenters are concerned that using the
fully-indexed rate would not adequately assure repayment ability
because indexes can increase.
All of the financial institutions and financial services trade
groups who responded to the question agree that underwriting a loan
based on its fully-indexed interest rate and fully-amortizing payment
is generally prudent. With few exceptions, however, most of these
commenters oppose codifying such a standard in a regulation, arguing
that a regulation would be too rigid, constrain lenders from relying on
their own experience and judgment, and make ARMs unavailable to many
subprime borrowers. Several financial institutions and trade groups
asked that any fully-indexed rate requirement the Board adopts be
limited to ARMs with introductory fixed-rate periods of less than five
years. They maintained that most borrowers having ARMs with longer
fixed-rate periods refinance before the rate adjusts.
Consumer and community groups argue that a requirement to
underwrite to the fully-indexed rate would not assure that loans would
be affordable unless the Board also specified a maximum debt-to-income
(DTI) ratio. Most groups stated that a maximum 50 percent DTI ratio
would be an appropriate threshold to identify presumptively
unaffordable loans. On the other hand, the vast majority of the
financial institution and industry trade group commenters oppose
adoption of a maximum DTI ratio. Some stated the DTI ratio is not one
of the most important predictors of loan performance. Others noted the
difficulties of clearly defining ``debt'' and ``income'' for purposes
of such a rule, or of clearly defining mitigating factors such as high
credit scores. Some identified categories of borrowers for whom high
DTIs are not inappropriate, such as high-income borrowers; borrowers
with substantial assets; and borrowers refinancing or consolidating
loans with even higher payment burdens.
Discussion
Recent evidence of disregard for repayment ability. Subprime loans
are expected to default at higher rates than prime loans because they
generally are made to higher-risk borrowers. But the high frequency of
so-called 2-28 and 3-27 ARMs in subprime originations in recent years--
and the recent rapid and significant increase in serious delinquencies
and foreclosures among such loans originated from 2005 to early 2007,
including within several months of closing--have raised serious
questions as to whether originators have paid adequate attention to
repayment ability. Approximately three-quarters of securitized
originations in subprime pools from 2004 to 2006 were of 2-28 or 3-27
ARMs, or ARMs with interest rates discounted for two or three years and
fully-indexed afterwards. In a
[[Page 1687]]
typical case of a 2-28 discounted ARM, a $200,000 loan with a
discounted rate of 7 percent for two years (compared to a fully-indexed
rate of 11.5 percent) and a 10 percent maximum rate in the third year
would start at a payment of $1,531 and jump to a payment of $1,939 in
the third year, even if the index value did not increase. The rate
would reach the fully-indexed rate in the fourth year (if the index
value still did not change), and the payment would increase to
$2,152.\49\
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\49\ This example is taken from the federal agencies' proposed
subprime illustrations. Proposed Illustrations of Consumer
Information for Subprime Mortgage Lending, 72 FR 45495, 45497 n.2 &
45499, Aug. 14, 2007. The example assumes an initial index of 5.5
percent and a margin of 6 percent; assumes annual payment
adjustments after the initial discount period; a 3 percent cap on
the interest rate increase at the end of year 2; and a 2 percent
annual payment adjustment cap on interest rate increases thereafter,
with a lifetime payment adjustment cap of 6 percent (or a maximum
rate of 13 percent).
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In recent years many subprime lenders did not consider adequately
whether borrowers would be able to afford the higher payment, and
appeared instead to assume that borrowers would be able to refinance
notwithstanding their very limited equity. Originators extended some 2-
28 ARMs from 2005 to early 2007 without having reason to believe the
borrower would be able to afford the payment after reset. Originators
may have assumed that these borrowers would refinance before reset, an
assumption that proved unrealistic, at least under newly tightened
lending standards, when house prices fell and the borrowers could not
accumulate enough equity to refinance. In fact, some 2-28 ARMs
originated in 2005 and 2006 appear to have been made to borrowers who
could not afford even the initial payment. Over 10 percent of the 2-28
ARMs originated in 2005 appear to have become seriously delinquent
before their first reset.\50\ While some borrowers may have been able
to make their payments--they stopped making payment because the values
of their houses declined and they lost what little equity they had--
others may not have been able to afford even their initial payments.
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\50\ Figure calculated from First American LoanPerformance data.
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Potential reasons for unaffordable loans. There are several reasons
why borrowers, especially in the subprime market, would accept loans
they would not be able to repay. In some cases, less scrupulous
originators may mislead borrowers into entering into unaffordable loans
by understating the payment before closing and disclosing the true
payment only at closing. At the closing table, many borrowers may not
notice the disclosure of the payment or have time to consider it; or
they may consider it but feel constrained to close the loan. This
constraint may arise from a variety of circumstances. For example, the
borrower may have signed agreements to purchase a new house and to sell
the current house. Or the borrower may need to escape an overly
burdensome payment on a current loan, or urgently need the cash that
the loan will provide for a household emergency.
In the subprime market in particular, consumers may accept loans
knowing they may have difficulty affording the payments because they do
not have reason to believe a more affordable loan would be available to
them. Possible sources of this behavior, including the limited
transparency of prices, products, and broker incentives in the subprime
market, are discussed in part II.C. Borrowers who do not expect any
benefit from shopping further, which can be costly, make a reasoned
decision not to shop and to accept the terms they believe are the best
they can get.
Furthermore, borrowers' own assessment of their repayment ability
may be influenced by their belief that a lender would not provide
credit to a consumer who did not have the capacity to repay. Borrowers
could reasonably infer from a lender's approval of their applications
that the lender had appropriately determined that they would be able to
repay their loans. Borrowers operating under this impression may not
independently assess their repayment ability to the extent necessary to
protect themselves from taking on obligations they cannot repay.
Borrowers are likely unaware of market imperfections that may reduce
lenders' incentives to fully assess repayment ability. See part II.C.
In addition, lenders and brokers may sometimes encourage borrowers to
be excessively optimistic about their ability to refinance should they
be unable to sustain repayment. For example, they sometimes offer
reassurances that interest rates will remain low and house prices will
increase; borrowers may be swayed by such reassurances because they
believe the sources are experts.
Injuries from unaffordable loans. When borrowers cannot afford to
meet their payment obligations, they and their communities suffer
significant injury. Such borrowers are forced to use up home equity or
other assets to cover the costs of refinancing. If refinancing is not
an option, then borrowers must make sacrifices to keep their homes. If
they cannot keep their homes, then they must sell before they had
planned or endure foreclosure and eviction; in either case they may owe
the lender more than the house is worth. If a neighborhood has a
concentration of unaffordable loans, then the entire neighborhood may
endure a decline in homeowner equity. Moreover, if disregard for
repayment ability contributes to a rise in delinquencies and
foreclosures, as appears to have happened recently, then the credit
tightening that may follow can injure all consumers who are potentially
in the market for a mortgage loan.
Potential benefits. There does not appear to be any benefit to
consumers from loans that are clearly unaffordable at origination or
immediately thereafter. The Board recognizes, however, that some
consumers may in some circumstances benefit from loans whose payments
would increase significantly after an initial period of reduced
payments. For example, some consumers may expect to be relocated by
their employers and therefore intend to sell their homes before