The Federal Reserve signed off Monday on a long-anticipated plan to end the abusive lending practices that victimized many borrowers in the now-collapsed subprime market.
The rules, however, will only cover new loans, not existing ones, so they will have little effect on the rising tide of mortgage delinquencies and foreclosures across the country. The rules don't go into effect until Oct. 1, 2009.
Among they key changes, the rules bar lenders from making loans without proof of a borrower's income, and require lenders to ensure risky borrowers have reserved money to pay for taxes and insurance. The plan prevents lenders from making a loan without considering a borrower's ability to repay a home loan from sources other than the home's value.
Lenders will also be restricted from penalizing subprime borrowers — those with tarnished credit — who repay their loans early. Such prepayment penalties are banned if the payment can change during the initial four years of the mortgage. In other cases, a penalty can't be imposed in the first two years of the mortgage.
Some consumer groups have complained that the Fed should just eliminate prepayment penalties altogether, arguing that they leave borrowers trapped in loans they don't want.
"We know there was a lot of fraud that went into the current mortgage crisis and we know there were a lot of misinformed borrowers, and this goes a long way to addressing both of those issues," said Mark Flannery, professor of finance at the University of Florida. "This puts an affirmative burden on the lender to prevent them from granting a loan to someone who can't repay it."
While mortgage brokers and consumer groups remain generally positive about the changes, some consumer advocates blasted the Fed for not acting years ago.
"If either Congress or the Fed had created strong origination rules years ago, things would not be as bad as they are now," said Alys Cohen, staff attorney at the National Consumer Law Center. "Regulators have known about these issue for at least a decade."
Advocates did get the Fed to change its original draft so that borrowers who get a loan they cannot repay can file a lawsuit without having to prove the lender engaged in a similar "pattern or practice" of lending to others without regard to their repayment ability.
A lender, however, can find a "safe harbor" against customer lawsuits by proving it followed certain steps in verifying if the borrower could indeed repay the loan.
"Consumers don't have to prove the whole `pattern and practice,' but lenders can say, `Hey, if we follow these straightforward rules, it makes it harder for consumers to sue us for granting a loan they can't repay,'" said Kurt Eggert, a former member of the Federal Reserve Board's Consumer Advisory Council.
The plan also establishes stricter advertising standards and requires certain mortgage disclosures to be given to consumers earlier in the transaction. Ads must include additional information about rates, monthly payments, and other loan features.
"After the worst mortgage marketplace since the Great Depression, the next wave of older Americans on fixed incomes who need to tap the equity in their homes can have real confidence that they will be protected from false advertising and high pressure marketing tactics," AARP Senior Vice President David Sloane said.
In another significant change from the original draft, the Fed reversed its decision to change the way mortgage brokers disclose the commission lenders pay them.
Critics argued these payments give mortgage brokers an incentive to charge higher fees with no benefit to the consumer, while supporters said it's a legitimate way for borrowers to spread out mortgage broker fees over the life of a loan.
Austin King, financial justice director for the Association of Community Organizations for Reform Now, said: "A way to restore confidence in the housing market is to eliminate these broker kickbacks."
For Cohen, Monday's announcement was a mixed bag for consumers because it did not address the prime mortgage market, which is far larger than the subprime market.
"Prime borrowers are still out in the cold," said Cohen. "That's a major omission."