With the tough times of 2007 over and done, the big question in real estate is whether 2008 will be any better.
Mortgage reform legislation has passed in both the House and the Senate, the President has recommended an interest-rate freeze for certain loans and HUD has introduced the FHASecure program. These efforts, however, have had little practical impact because final legislation from Capitol Hill has been neither completed nor signed, the President’s proposals are voluntary and as of mid-December the FHASecure program had only funded several hundred loans.
But another approach is also underway, an effort by the Federal Reserve to change the way mortgages are designed, marketed and underwritten. Because the Fed has regulatory powers, any changes it enacts can immediately impact the mortgage marketplace.
Playing By The Rules
When it was passed in 1994, the Home Ownership and Equity Protection Act (HOEPA) created a number of standards for “high-cost” loans. For instance, special disclosures were required, most balloon payments and prepayment penalties were banned, and punitive default interest rates were prohibited.
The protections found in HOEPA could offer significant consumer protection except for one problem. As the Federal Trade Commission explains, HOEPA rules “do not cover loans to buy or build your home, reverse mortgages or home equity lines of credit.”
The Fed now acknowledges that “HOEPA-covered loans are a very small portion of the subprime market” and — of course — a minuscule part of the overall mortgage marketplace. However, as limited as HOEPA has been to date, the Act contains a provision which allows for its expansion. Under HOEPA’s Section 129(I), the Federal Reserve has special authority to deal with “unfair and deceptive acts or practices.” Unlike other HOEPA provisions, this section allows the Fed to make rules which apply to all loans and all lenders.
The problem? According to Michael Calhoun, President of the Center for Responsible Lending, the Fed has never used the authority found in the 1994 legislation. Until now.
In early December the Federal Reserve proposed changes under Section 129(I) to address soaring foreclosure rates.
One major change under the Fed proposals is that it would substantially increase the number of loans covered under HOEPA. This would be done by extending the guidelines which now apply to “high cost” loans to a far-broader mortgage category which the Fed describes as “higher-priced mortgage loans,” essentially most subprime mortgages.
A “higher-priced” loan would be defined as any first lien where the interest rate is at least three percentage points above the rate for Treasury securities, or any second lien five percentage points above the Treasury rate. This is a far more rigorous standard than the current tests for “high cost” loans under HOEPA: first liens which are eight percentage points above Treasury levels, second liens that are at least ten percentage points over the Treasury standard; or, fees and points which total at least 8 percent of the loan amount.
While the number of loans defined as “higher priced” would be far larger than financing now seen as “high cost” under HOEPA, the Fed still excludes many mortgages. For instance, the new standards “would not include mortgages for vacation properties, open-end home-equity plans, reverse mortgages, or construction-only loans.” Investment property loans also would not be covered, as is now the case.
Although the new standards would exclude many borrowers, for the first time mortgages to purchase or build a home would fall under the guidelines. Several new standards would be established for most subprime loans, financing that now would generally fall into the “higher-priced” category, including:
Ability to pay
During the past few years many lenders abandoned traditional underwriting guidelines. So-called “stated income” loan applications were permitted, applications which allowed borrowers to estimate income — estimates which typically were not checked. The inevitable result was inflated income claims and increased lender risk. The Fed now proposes that lenders who make high-priced loans must verify and document the ability of a borrower to repay a loan.
The standard does not apply to all loans. Instead, lenders would only violate the rule if they engaged in a “pattern or practice” of not documenting higher-priced loans, a standard which means borrowers would have to show more than damages with their own financing to establish that the lender violated the rule, proof which few borrowers could meet.
Verification of Income and Assets
It follows that lenders will not be able to determine what is or is not affordable unless they document borrower income claims. The proposals would prohibit lenders “from relying on amounts of income, including expected income, or assets in extending credit for a higher-priced mortgage unless the creditor verifies such amounts.”
Verification, says the proposal, may be based on “the consumer’s Internal Revenue Service Form W-2, tax returns, payroll receipts, financial institution records, or other third-party documents that provide reasonably reliable evidence of the consumer’s income and assets, such as check-cashing receipts or a written statement from the consumer’s employer.”
The new guidelines are not mandatory. According to the Fed: “the proposal would not mandate underwriting standards for creditors, but would provide flexibility to allow creditors to adjust their standards for those consumers who traditionally may have had difficulty meeting full documentation underwriting requirements.”
When a lender provides the “APR” or annual percentage rate for a loan, federal rules do not require the APR to include any prepayment penalties, potentially thousands of dollars in additional costs. As the Fed points out, “a recent FTC study suggests that, even with improved disclosure, it is questionable whether consumers can accurately factor a contingent, future cost, such as a prepayment penalty, into the price of a loan. This transparency problem is compounded with respect to prepayment penalties because, unlike interest or points, the penalty is not included in the APR.”
The solution to the problem, says the Fed, is to ban prepayment penalties under four conditions:
- If the borrower’s debt-to-income ratio exceeds 50 percent of the consumer’s gross income when the loan was originated.
- If the source of the prepayment funds is not a refinancing by the creditor or its affiliate. In other words, a prepayment penalty would be okay if the cost is included in a bigger loan from another lender.
- If the penalty term exceeds five years. However, the Fed rule would also ban any prepayment penalty 60 days before loan re-sets.
- If the penalty is “not otherwise prohibited by law.”
Mortgage reform legislation passed by Congress has much stiffer limitations. In the Senate, S. 2338 would prohibit prepayment penalties for all “high cost” loans. The House bill, H.R. 3915, would ban prepayment penalties for high-cost loans. It would limit prepayment penalties for other loans to three years, however the size of the penalty would drop each year from 3 percent in year one, to two percent in year two and one percent in year three.
The Fed would require lenders who make higher-cost loans to escrow money each month to pay property tax and insurance bills. This is an important borrower protection because individuals with weak credit and limited incomes — those most likely to get “higher cost” financing — may not have the dollars necessary to pay annual or semi-annual tax bills or insurance costs.
Lenders under the Fed proposal would be allowed to offer borrowers the “opportunity” to cancel escrow collections after one year. In effect, borrowers could reduce monthly mortgage costs by opting out of escrow programs — but later might not have the money required for taxes and insurance.
Yield Spread Premiums
Mortgage lenders can sell loans above market rates. In the best case, borrowers are willing to pay a higher interest rate in exchange for a clear benefit, such as the lender’s payment of closing costs. However, it’s also possible for borrowers to pay an above-market interest cost or more fees than a loan requires without a clear benefit. Such higher costs are often reflected in bigger fees for lenders in the form of “yield spread premiums,” in essence gaining extra — and sometimes huge — profit from selling a loan at an above-market price.
It’s proposal, says the Fed, “generally would prohibit creditors from making any payment, directly or indirectly, to a mortgage broker in connection with a closed-end consumer credit transaction secured by a consumer’s principal dwelling.”
The Fed’s prohibition would not apply when lenders disclose fees and costs in advance to the borrower. This disclosure, however, could be within a blizzard of paperwork and not clearly seen as a negotiable item. The prohibition also would not apply “if a creditor can show that its payments to brokers varies based solely on factors other than the interest rate, such as loan principal amount.”
Lenders make loans on the basis of the sale value or a home or the appraised value, whichever is less. If the appraisal is tainted then the lender is likely to make a larger — and riskier — mortgage than is justified by the property.
The Fed would ban any effort by lenders to coerce appraisers who fail to deliver desired valuations. This is a case where lenders and consumers have a shared interest in getting the numbers right so that borrowers do not overpay and lenders do not take on needless risk.
The proposal applies only to financing for prime residences. Why it should not apply to all mortgage loans is unclear.
The Fed proposal would establish four new criteria for loan servicers.
- Payments would have to be credited as of the day they are received, not when processed.
- Lenders would not be allowed to “pyramid” late fees.
- Borrowers would have to receive a schedule of all possible fees and charges associated with their loans.
- The servicer would have to provide accurate pay-off information within three days after a loan had been closed.
While lenders report late and missed payments to credit bureaus, reports which inherently reduce a borrower’s credit standing, there is no requirement to report that monthly payments have been paid in a full and timely manner.
The Fed proposes changing mortgage advertising practices to assure that borrowers fully understand the costs and terms of the loans they are considering. All rates and costs must be disclosed with equal prominence for the entire loan term. In other words, big print for teaser rates and tiny print for loan specifics would not be allowed. “Fixed” rate loans would have to be, well, fixed for the entire loan term and not just a starter period. The proposal would also ban “advertisements that falsely create the impression that the mortgage broker or lender has a fiduciary relationship with the consumer.”
The catch: While the new advertising regulations would apply to financing for all “dwellings” and not just owner-occupied homes, the marketing rules would not apply to home equity loans.
The Fed proposals are only suggestions and not final regulations. After a 90-day comment period, the Fed will then issue final rules or will seek additional comments. However, the Fed proposals have already encountered opposition.
“The staff of the Financial Services Committee and I have had a chance to review the Federal Reserve’s proposed rules regarding abusive subprime loans,” says Rep. Barney Frank (D-MA), chairman of the House Financial Services Committee. “We now have confirmation of two facts we have known for some time: one, the Federal Reserve System is not a strong advocate for consumers, and two, there is no Santa Claus. People who are surprised by the one are presumably surprised by the other.”
On the other side of the political spectrum, Kieran P. Quinn, chairman of the Mortgage Bankers Association, said his group was concerned “that some of the restrictions in the proposals may unnecessarily limit the credit options available to borrowers who should otherwise qualify for homeownership.”
“The unfortunate reality of the Fed proposals is that had they been instituted when the toxic loan era began in 2001 and 2002 we would not have the national housing crisis we have today,” says James J. Saccacio, Chairman and CEO at RealtyTrac, the leading online marketplace for foreclosure properties. “The Fed could have prevented huge numbers of foreclosures even with the modest proposals it has just announced. Instead, it bought into a hands off, let the marketplace take care of it’s philosophy that’s now costing homeowners, lenders and investors hundreds of billions of dollars and has brought the Nation to the brink of recession.”
Saccacio also said that the Fed’s 90-day comment period would result in additional foreclosures.
“In the next three months — while the Fed debates and discusses how to handle an obvious and overt financial crisis — more than 500,000 households will receive their first foreclosure notices,” said Saccacio. “That’s a terrible cost to homeowners and communities nationwide, it means more lender losses and it also means less investor confidence. Surely in a time of national disruption we can take stronger actions and certainly we can move with greater speed.”
Columnist Peter G. Miller is the author of The Common-Sense Mortgage and is syndicated in more than 100 newspapers.