Board of Governors of the Federal Reserve System

July 14, 2008

As Chairman Bernanke has noted, the U.S. mortgage market has seen rapid innovation in recent years.  Changes, such as automated underwriting models, the evolution of the secondary markets, and specialization, have had many positive effects.  Some changes in practices, however, did not have such positive effects.  Abusive loans that strip borrowers' equity or cause them to lose their homes should not be tolerated. Too many homeowners and communities are suffering today because of these practices, and today the Federal Reserve Board is meeting to establish tougher rules to better protect consumers while preserving their access to credit as they make some of the most important financial decisions of their lives.

Last December, the Board proposed changes using our authority under the Home Ownership and Equity Protection Act, or "HOEPA."  In formulating that proposal, the Board sought a wide-range of input and information through hearings and meetings throughout the country.  When the proposal was released, we sought further public comment on the proposal generally, and on several key provisions specifically. 

In response, we received, and read, over 4,500 comment letters sent to us from community groups, industry participants, consumer advocates, and other interested individuals. We engaged in outreach to commenters to get clarification of their concerns and weigh competing viewpoints.  We gathered available data and conducted updated analyses.  We undertook on-the-ground consumer testing, which has proven to be an invaluable tool for us in determining policy effectiveness, to gauge the practical effects of one of the proposed rules on individual consumers.  Listening carefully to the commenters, collecting and analyzing data, and undertaking consumer testing, I believe, has led to more effective and improved final rules.  

Our goal throughout this process has been to protect borrowers from practices that are unfair or deceptive and to preserve the availability of credit from responsible mortgage lenders. 

The rules we are considering today expand upon earlier interagency guidance on subprime loans.  That guidance, however, only applied to certain specific subprime products, hybrid adjustable rate mortgages such as so called 2/28s and 3/27s, and only to federally supervised institutions.  Our rules today would apply much more broadly to cover all higher-priced mortgages, including virtually all closed-end subprime loans secured by a consumer's principal dwelling .  These rules also cover a broad range of issues:

• Lenders' assessment of consumers' ability to repay loans,

• Lending with little or no documentation of income,

• Prepayment penalties,

• Escrow accounts for property taxes and insurance,

• Mortgage servicing practices,

• Coercion of appraisers,

• Misleading or deceptive advertising practices, and

• Disclosure of Truth-in-Lending notices early enough to help consumers shop for a mortgage.

In a moment, we will hear about the rules in more detail, but I'd like to offer an example of how we took such substantial input into account.  On one issue, loan affordability, we had proposed a rule that would prohibit lenders from exhibiting a "pattern or practice" of making higher-cost loans without considering borrowers' ability to make their monthly mortgage payments.  This rule responded to the recent problem of some mortgage originators approving loans that borrowers clearly could not afford, then selling off the loan--and the accompanying credit risk--to someone else.   

The new rule also requires the lender to take into account future, predictable changes in payments in determining repayment ability.  A lender complies, in part, by assessing repayment ability based on the highest scheduled payment in the first seven years of the loan.  For example, on a 5-1 ARM with a payment for the first five years based on a discounted interest rate, the lender would use the scheduled payment in the sixth and seventh years, which is based on the fully-indexed rate.

During the public comment period, we received a number of comments on the "pattern or practice" element of the proposed rule, and we conducted further outreach to both consumer advocates and industry participants.  Many advocates objected to this heavy burden of proof, calling into question the effectiveness of the intended consumer protection.  Some mortgage lenders, on the other hand, suggested that the "pattern or practice" provision did not provide a safe harbor that would ensure compliance, and that their procedures for compliance would, by necessity, be equally robust under either version of the rule.  At the end of the day, we agreed that this provision would have limited the intended effectiveness of the rule, and that removing it, along with clarifying other requirements, would not impede the availability of credit to borrowers. Accordingly, the final rule establishes a lender's responsibility to assess a borrower's ability to repay on every loan originated, effectively giving wronged consumers a private right of action without demonstrating that their case was part of a broader pattern.

This is just one example of how our process of seeking broad input, gathering data, and conducting rigorous analysis achieved better rules. Similarly, this process has led us to extensive data analysis and a tougher rule on prepayment penalties, a better benchmark for defining higher-priced loans, and a number of other changes.

I believe that these new rules will provide a robust set of protections for consumers.  At the same time, we have crafted clear rules with which market participants can reasonably comply, encouraging responsible lenders to meet the needs of traditionally underserved borrowers and communities. 

Protecting borrowers with responsible underwriting standards can also provide a broader benefit of enhancing the integrity and proper functioning of the mortgage market by increasing investor confidence.  Ensuring that ability to repay by underwriting and documenting income, for example, can help to reduce investor uncertainty about the performance of mortgage-backed securities. Effective consumer protection thus can produce a complementary benefit for consumers by helping to revive mortgage funding markets and potentially improving credit availability.

In a moment, I'd like to turn to Sandy Braunstein, Director of the Board's Division of Consumer and Community Affairs, and Kathleen Ryan, staff Counsel, who will discuss the details of the proposed amendments.  There are so many people throughout the Federal Reserve who have been extremely helpful, particularly from our Division of Research and Statistics, that I cannot possibly thank them all but would like to express deep gratitude to the dedication and hard work of not only Sandy and Kitty, but also Leonard Chanin, Jim Michaels, and Dan Sokolov from the HOEPA team.

Let me close by acknowledging, as I've said before, that these rules alone will not end all of the problems in the mortgage market.  Market participants need to act responsibly and with integrity, and consumers need to be well-informed shoppers.  I do believe, though, that these changes have made for better rules that will go far in protecting consumers from unfair practices and restoring confidence in our mortgage system.