The Federal Reserve is finalizing a far-reaching mortgage proposal that would ban certain lending practices and apply to the lightly regulated subprime mortgage specialists that proliferated during the recent housing boom.
The proposal, expected in two weeks, is emerging as the most muscular use of regulatory power at the central bank since Fed Chairman Ben Bernanke took office in early 2006.
It is expected to target certain prepayment penalties as well as loans that don't escrow taxes and insurance. The plan also targets low-documentation loans and loans that are made regardless of a borrower's ability to make payments, Fed officials have said.
"These rules would apply to subprime loans offered by any mortgage lender," Bernanke said during Congressional testimony last month.
The Fed's unique power in this area, which it has never used broadly before, could affect the outcome of broader mortgage legislation pending in Congress.
Some community groups don't want the Fed to push too hard, arguing this would deter lawmakers from passing the more sweeping reforms to penalize abusive lenders. Many bankers, by contrast, hope the pending Fed rules will deter Congress from acting.
Senate Banking Committee Chairman Christopher Dodd, D-Conn., has said he will wait to see what the Fed does before deciding whether to pursue a new law.
This issue was on the table at a breakfast meeting last month between Bernanke, other central bank officials, civil rights activist Rev. Jesse Jackson, and John Taylor, president of the National Community Reinvestment Coalition.
At the two-hour meeting, Taylor warned Bernanke that the Fed's regulatory proposal could scare off legislation. Taylor favors new legislation to impose penalties on Wall Street firms that finance certain loans.
"He recognized the comment, and he nodded, but he was pretty mum about it," Taylor said.
The Fed's rulemaking has been proceeding as mortgage and housing markets have worsened this year, with much attention focused on separate efforts by Democrats on Capitol Hill and Republicans in the Bush administration to help homeowners weather the turmoil.
Of all the pending public policy proposals aimed at market problems, the Fed's has the best chance of ultimately being implemented. It only needs the approval of four board governors —not Congress or the White House.
Taylor described Bernanke as "refreshingly knowledgeable" about the issues but said the central bank chief was careful not to tip his hand. "We couldn't get any indications of what his intentions were," Taylor said.
Banking industry officials also say they can't predict the Fed's plans.
"They've been very tightlipped, and in this environment, probably rightfully so," said James Ballentine, director of grassroots and community outreach at the American Bankers Association. "We're watching closely to see what comes out of this proposal because I think it will dictate whether legislation is going to occur in this Congress or not."
The Home Ownership and Equity Protection Act of 1994 authorized the Fed to prohibit loan practices that the central bank deemed "unfair, deceptive, or designed to evade" the law. But to date, the Fed had only moved to ban certain practices on "high cost" loans. That meant that the restrictions only applied to a very small number of mortgages — just 0.1 percent of the loans made last year were covered by the law.
But as the credit problems intensified this year, Democrats on Capitol Hill increasingly chastised the Fed for its failure to use its authority more aggressively. In July, Bernanke told Congress that the Fed would likely finally use its powers in this area and he promised a proposal by the end of the year. On Thursday, Fed Governor Randall Kroszner said the proposal would come in the next two weeks.
The major question facing the Fed is how wide it will cast a net to prohibit certain mortgage practices. Unlike other bank regulators, the Fed has authority to target loan practices at both state and federally licensed lenders. But it likely cannot prohibit practices by Wall Street investors, an approach that many consumer advocates such as Taylor said is necessary to ensure widespread reform.
"The Fed will be hard pressed to enforce this rule against important members who are part of the problem here, and that includes Wall Street," Taylor said.