Fed to Clamp Down on Exotic and Subprime Loans

The Wall Street Journal


WASHINGTON — With no end in sight to the turbulence in the housing and financial markets, the chairman of the Federal Reserve said on Tuesday morning that it would issue new lending rules next week to restrict exotic mortgages and high-cost loans for people with weak credit.


The chairman, Ben S. Bernanke, also said that the Fed was considering extending its program of low-cost overnight loans to the nation’s largest investment banks into next year. The lending program, which is supposed to be temporary, began in March in response to liquidity problems on Wall Street during the near-collapse of Bear Stearns, which was sold to JPMorgan Chase to avert going into bankruptcy.

At a forum in Arlington, Va., on lending for low- and moderate-income households, Mr. Bernanke said Bear Stearns’s difficulties had highlighted weaknesses in the financial system that policy makers were trying to address. He said they included poorly underwritten mortgages, regulatory gaps, tight credit and insufficiently capitalized financial institutions.

“The financial turmoil is ongoing, and our efforts today are concentrated on helping the financial system return to more normal functioning,” Mr. Bernanke said, according to an advance text of his speech issued by the Fed. “It is not too soon, however, to begin to think about the steps we might take to reduce the incidence and severity of future crises.”

Mr. Bernanke repeated his support for overhauling the oversight of Fannie Mae and Freddie Mac, the two mortgage financing giants, which suffered significant stock declines on Monday. He and other senior government officials have expressed hope that the two companies can play a central role in helping to prop up the markets by providing billions of dollars of investments in mortgages.

“If these firms are strong, well-regulated, well-capitalized and focused on their mission, they will be better able to serve their function of increasing access to mortgage credit, without posing undue risks to the financial system or the taxpayer,” he said.

The decision to consider extending the Fed’s Wall Street credit program, which provides overnight loans to the 20 largest investment banks who serve as “primary dealers” and trade Treasury securities directly with the Fed, suggested that the Fed is coming to believe that the crisis that has been plaguing financial markets may spill into next year.

The lending program was originally set to last at least six months, through mid-September. It was established at the same time that officials were engineering the rescue of Bear-Stearns after Fed officials concluded that credit markets had all but frozen, raising fears of widespread defaults on Wall Street.

Under federal law, the program can continue only if the Fed continues to determine there are “unusual and exigent circumstances” in the markets. The program allows the government to hold as collateral a wide variety of investments, including hard-to-sell securities backed by mortgages.

“Although short-term funding markets remain strained, they have improved somewhat since March,” Mr. Bernanke said, reflecting both the intervention of the Fed in offering loans to Wall Street and “ongoing efforts of financial firms to repair their balance sheets and increase their liquidity.”

The Federal Reserve is expected to announce new mortgage lending rules at a meeting on Monday. It is not known whether the Fed will significantly change the proposal it made last December, which provoked more than 5,000 letters, including heavy criticism from the mortgage industry and other parts of the housing industry.

Industry lobbyists maintained that at a time of tight credit, tougher rules could make many mortgages more expensive by creating more paperwork and potentially exposing lenders to more lawsuits. They also complained that the restrictions were too broad and would restrain lenders from issuing otherwise creditworthy loans. Three of the industry’s most influential trade groups – the American Bankers Association, the Mortgage Bankers Association and the Independent Community Bankers of America – separately filed letters criticizing the proposals.

On the other hand, consumer groups complained that the proposed rules would not be strong enough. They maintained that any efforts to further weaken the proposal would render it all but useless.

Mr. Bernanke said there would be changes to the original proposal in response to the letters that were sent to the Fed. But he did not specify them.

“These new rules, which will apply to all lenders and not just banks, will address some of the problems that have surfaced in recent years in mortgage lending, especially high-cost mortgage lending,” Mr. Bernanke said. “We received many helpful comments on our proposal and we incorporated a number of them into the final rules.”

The proposals were made after the Fed came under criticism for being captive to the lending industry and had failed over many years to supervise it adequately. They would not cover existing mortgages, but would apply only to new ones.

Under the proposal issued last December, mortgage companies would be required to show that customers could realistically afford their mortgages. Lenders would have to disclose hidden fees often rolled into interest payments. And certain types of advertising considered misleading would be prohibited.

As envisioned when the proposal was issued, the Fed sought to broadly apply special consumer protection to a far broader class of borrowers than it had previously. Under its existing rules, based on the Home Ownership Equity Protection Act of 1994, the Fed’s extra protections had originally applied to less than 1 percent of all mortgages – those with interest rates at least eight percentage points above the prevailing rates on Treasury securities.

But the proposed new rules, by contrast, invoked broader legal authority to apply to any mortgage with an interest rate three percentage points or more above Treasury rates. Fed officials said that would cover all subprime loans, which accounted for about 25 percent of all mortgages last year, as well as many exotic mortgages – known in the industry as “Alt-A” loans – made to people with relatively good credit scores.

Industry lobbyists had complained that the definition was too broad and would sweep in many conventional kinds of loans, making them more expensive for borrowers.

Among those who argued that the proposals did not go far enough was Sheila C. Bair, the Republican head of the Federal Deposit Insurance Corporation and senior members of the House Financial Services Committee.

Ms. Bair proposed making it easier for borrowers to sue lenders by eliminating the proposed requirement that the borrowers would have to establish a pattern of abusive practices. She said that forcing borrowers to show a pattern of abuse “clearly favors lenders by limiting the number of individual consumer lawsuits and the ability of regulators to pursue individual violations.”

Ms. Bair also recommended that the Fed eliminate a so-called safe harbor provision in the proposal that protects lenders who fail to verify the income or assets of a borrower in some circumstances.