The Fed's proposal for changes in the "Truth in Lending" laws includes many excellent rules to address problems with the relationships among brokers, customers and lenders, and to clean up mortgage advertising.

But the first three rule proposals should cover all mortgage loans -- not just subprime. For disclosure and underwriting rules, it is time to end the distinction between prime and subprime.

Yes, borrowers with poor credit will still pay higher rates than those with good credit. All mortgage borrowers, however, should have their incomes verified and their ability to repay the loans carefully considered.

This way, we can prevent another mortgage-industry disaster.

Normally when bank regulators make proposals for changes in regulations and invite comments, the large industry players all put in their two cents. This time, no major players -- none of the big banks -- have commented.

That suggests these rule changes have no teeth. The meat of the proposed rule changes only cover subprime mortgages, which nobody is making right now!

In its proposal, the Fed included new rules only for "higher priced," or subprime, mortgage loans. The Fed defined "higher-priced" first mortgages as those with annual percentage rates (APRs) at least three points higher than comparable Treasury notes. Higher-priced second mortgages were defined as having APRs five points higher than comparable Treasury notes.

Here's a summary of the rules designed to protect only subprime mortgage borrowers:

  • Creditors would be required to consider a borrower's ability to repay a loan. Sounds like a good idea. During the housing boom, some of the dumber lenders would approve a first mortgage loan for 100% of the value of the home. Some dumber lenders would approve a second mortgage taking the combined loan-to-value (LTV) to 120%. The value of the home, of course, was based on a highly questionable appraisal.
  • Creditors would be required to verify the income and assets they rely on in making a loan. Another good idea. Any reason this should be done only for subprime loans? Stated income and "no doc" or "liar" loans became very popular during the housing run-up. Some mortgage brokers would steer borrowers into these loans, even though the borrowers were prepared to document their income and assets. Of course this benefitted the broker, who would earn a higher commission for a subprime loan.
  • Prepayment penalties would be permitted only if certain conditions were met, including that no penalty would apply for at least 60 days before any possible payment increase. Why allow prepayment penalties on any home loans? Some of the borrowers (victims) with loans that featured prepayment penalties never really understood them. Prepayment penalties should simply be banned for all residential mortgages.
  • Creditors would have to establish escrow accounts for taxes and insurance. No argument here. If we are going to continue the stupid practice of having different rules for subprime and prime loans, then subprime borrowers should certainly be required to have their insurance and property taxes escrowed. The full payment, including insurance and fully assessed property taxes, needs to be carefully considered by the lender and borrower during the loan approval process. These items could easily make the loan unaffordable. For more on how to avoid ruining your life, please see Six Ways to Avoid a Mortgage Mess .

No More Word Games

All of this shows that it is time to stop the nonsense of calling the mortgage mess a "subprime mortgage crisis." Most of the bad mortgages are prime mortgages. Most people who got suckered with bad deals never considered whether their loans were subprime or not. Lenders who make mortgages without following the first three rules listed above for all loans are just plain stupid. Why make a loan with a high chance of default?

By setting forth such a detailed proposal and waxing poetic about how they are protecting consumers, the Fed has done borrowers and investors a disservice. It has, in effect, stipulated which of the awful lending practices listed above will be allowed for prime borrowers.

On the Brighter Side

The Fed's proposal included the following rules, to protect all borrowers, not just subprime:

  • Lenders would be prohibited from compensating mortgage brokers by making payments known as "yield spread premiums," unless the broker previously entered into a written agreement with the consumer disclosing the broker's total compensation and other facts. A yield spread premium is a fee paid by a lender to a broker, who originates a loan with a higher rate than the lender would have agreed to for the same loan.

    The proposal is OK, but would a well-informed consumer agree to a higher rate, merely to help a broker receive a higher commission? It would be much simpler to ban the yield spread premiums. Does it make sense for brokers to be encouraged, through yield spread premiums, not to obtain the best deals for their customers?
  • Creditors and mortgage brokers would be prohibited from coercing a real estate appraiser to misstate a home's value. This is already illegal on the state level, but maybe having federal regulations to ban these practices could help scare some parasites into compliance.
  • Companies that service mortgages loans would be prohibited from engaging in certain practices. Prohibited practices would include not posting loan payments as of the date received, and applying a late principal and interest payment to a late fee first, making it appear that later payments are also late, thus causing more late fees. If a mortgage payment is received late, the payment should be posted so the loan becomes current and the late fee should be charged separately.

Seven sleazy advertising practices would be banned:

1. Advertising a "fixed rate," when the rate is fixed for only a limited time.

2. Comparing a consumer's current rate or loan payment to the advertised loan, unless the advertised loan's rate or payment will apply for the entire loan term.

3. Advertising loans as "government-supported," unless the loans are actual FHA or VA loans.

4. Prominently displaying the name of the consumer's current lender, unless the advertisement clearly states that the offer is from a different lender. Have you ever seen one of these? The sleazy refinancers fool you into opening the envelope, because it looks like the offer letter is from your current lender!

5. Advertising claims of debt elimination if the product would merely replace one debt with another.

6. Falsely creating the impression that the mortgage broker or lender has a fiduciary relationship with the customer. By this time, we should all understand the nature of these sometimes predatory relationships.

7. Foreign language advertisements that provide teaser rates in the foreign language, but only provide the required disclosures in English. Lovely.
Philip W. van Doorn joined Ratings in February 2007. He is the senior analyst responsible for assigning financial strength ratings to banks and savings and loan institutions. He also comments on industry and regulatory trends. Mr. van Doorn has fifteen years experience, having served as a loan operations officer at Riverside National Bank in Fort Pierce, Florida, and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a Bachelor of Science in business administration from Long Island University.

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