Fed tightens rules on subprime lending
By Holden Lewis • Bankrate.com

The Fed has tightened restrictions on high-interest mortgages to protect borrowers with lousy credit from getting ripped off.

Under the old regulations, roughly 1 percent of subprime home loans were defined as high-cost loans that were subject to special disclosure rules and greater federal scrutiny. Under revised rules adopted this month by the Federal Reserve, an estimated 5 percent of subprime mortgages and home-equity loans will be defined as high-cost.

Consumer advocates welcome the changes. Bankers, casting themselves as advocates for the little guy, complain that the revised rules will harm homeowners with faulty credit.

The Fed's rule changes increase the number of loans subject to scrutiny under the Home Ownership and Equity Protection Act, known as HOEPA (rhymes with "rope-a-dope," minus the "dope"). HOEPA is a 1994 law that was designed to discourage predatory lending.

HOEPA defines high-cost loans and gives those borrowers some extra protections. If you apply for a high-cost loan that falls under HOEPA, the lender has to give you documents that explain exactly how much you're borrowing and how much you're paying in rate and fees. The lender has to provide the documentation three days in advance of closing on the loan. After closing, you have three days to change your mind and rescind the loan.

Previously, a home loan was defined as high-cost if the interest rate was 10 or more percentage points higher than the equivalent yield on a Treasury note. For example, early this week, the yield on 30-year Treasury notes was 5.5 percent. A 30-year mortgage of 15.5 percent or more would be considered a high-cost loan under HOEPA and, therefore, would fall under its restrictions.

The Fed has changed the math. Now, a first mortgage is considered high-cost if the rate is 8 percentage points above the equivalent yield on a Treasury note. Under the new rule, a mortgage of 13.5 percent would be considered a high-cost loan if the 30-year Treasury yield were 5.5 percent.

Different criteria for home equity loans
The interest-rate trigger for home equity loans didn't change. A home equity loan isn't considered high-cost unless the interest rate is 10 points above the Treasury yield.

The Fed made other changes. A home loan with points and fees that total more than 8 percent of the loan amount is considered a high-cost loan under HOEPA. Under the new rule, fees for optional credit insurance fall under that 8 percent cap; previously, they didn't.

Take, for example, this loan: A borrower with lousy credit takes out a 30-year mortgage loan for $80,000. At the time, the yield on 30-year Treasury notes is 5.5 percent. The borrower gets the loan at 14 percent interest and pays points and fees that total $4,000. The lender persuades the borrower to get credit life insurance with a one-time premium of $8,000 that is then rolled into the loan amount.

Under the old rules, that loan would not be considered high cost. The interest rate is 8.5 percentage points above the Treasury yield, and points and fees total 5 percent, excluding the credit life insurance.

Under the new rules, that loan would be considered high-cost for two reasons: First, the interest rate is more than 8 points above the Treasury yield. Second, the credit life insurance premium counts toward points and fees now, so they total $12,000 -- well above the 8 percent threshold of $6,400.

The Fed added some other rules. It now prohibits lenders from refinancing high-cost loans within a year when the transactions aren't in the borrower's interest. It requires lenders to verify in writing that borrowers are able to repay their loans.

A burden for borrowers or banks?
Bankers say the new rules are bad for borrowers.

The Mortgage Bankers Association is concerned that the rule changes "could result in reductions of credit availability to those consumers that are most in need," says John Courson, the MBA's chairman-elect.

"MBA supports protections for vulnerable consumers, and we will continue to work with regulators to that end, but we need to advance in a way that does not end up hurting the very people we are trying to help."

On the other side of the issue, a consumer advocate calls the rule changes "a small but significant step forward." But, adds John Taylor, president of the National Community Reinvestment Coalition, "the Federal Reserve took only the first step in a long staircase of needed reforms."

Taylor would like to see tighter restrictions on loan refinancing, prepayment penalties and balloon payments.

Kenneth Thomas, a banking expert who has written extensively about subprime lending, says, "That's the sign of a good law -- when both groups are unhappy."

He believes that the Fed has steered a fair course, although he believes that the bankers make a good point when they say that the new rules could restrict lending to people with bad credit histories.

"I've always come down on the side that you have to be very careful that we don't restrict subprime lending and access to credit," he says. "All of a sudden, if somebody doesn't have the choice of going to Household Finance or Citigroup, they'll have to go lower on the food chain and deal with groups that may not be as reputable as the big ones."

In other words, Thomas says, people who need to borrow will always be able to find lenders. If the government scares big corporations away from lending to people with lousy credit, "this is very good for the Tony Sopranos of the world because there will always be people who will make that loan."

Thomas says the big banks have something to cheer about: The Fed's revised rules might pre-empt cities and states from enforcing more stringent rules. In recent years, cities including Philadelphia, Chicago and Cincinnati have adopted stringent ordinances to combat predatory lending. So have several states, including New York and North Carolina.

"It's better to do something coming out of Washington, across the board, rather than something that comes out state by state and piece by piece," Thomas says. "From that perspective, lenders welcome this. It's not going to be a different law every time they go from Oakland to Chicago to New York to North Carolina."