The Federal Reserve moved yesterday to limit mortgage industry practices that led to an explosion in foreclosures, including paying bonuses to brokers for selling loans with higher interest rates and charging penalty fees to borrowers for refinancing at lower rates.
The rules proposed by the Fed are aimed mostly at the excesses of the subprime lending boom earlier this decade. The intent is to prevent lenders from misleading future borrowers, and to prevent borrowers from making bad choices - in all, to prevent people from taking loans they cannot afford to repay.
The Fed will take public comment for 90 days before finalizing the rules.
Reaction to the plan was split. The lending industry praised the Fed for showing restraint by restricting rather than banning practices identified as problematic. That approach, lenders said, would preserve the availability of loans appropriate for marginal home buyers.
Consumer advocates and Democrats in Congress criticized the proposal as tardy and flawed. The Fed's failure to act sooner allowed lending practices to spiral out of control, they said, and the rules proposed yesterday would not curb those practices sufficiently.
"The Fed did not issue these rules for all the years that it could have, all the years that it knew this stuff was going on," said John Taylor, president of the National Community Reinvestment Coalition, a leading advocacy group. "They took forever to act and now they're putting out something that's wanting."
In Boston, Attorney General Martha Coakley yesterday finalized new rules for the mortgage industry in Massachusetts. Coakley targeted the same lending practices as the Fed, but generally opted to ban rather than limit them.
For example, brokers in Massachusetts will be prohibited from collecting larger fees by persuading a customer to accept a higher interest rate. The Fed chose to limit the practice, except when brokers get customers to sign a written disclosure of the higher fees.
The Massachusetts regulations, which go into effect Jan. 2, will be the strictest in the nation, according to the industry and consumer advocates. Coakley said she was not concerned that they might limit lending in the state.
"I think that the industry went far too far," Coakley said in an interview. "As we scale back, will there be fewer people who get mortgages? Yes. But what we're trying to get at is those mortgages that were destined to fail."
The Fed's action yesterday ended years of insistence by the central bank that increased regulation of the subprime industry was unnecessary and would likely do more harm than good. Now rising foreclosures are a drag on the economy and leading congressional Democrats had threatened to take away the Fed's power to regulate the mortgage industry if it did not act aggressively.
Fed chairman Ben Bernanke said yesterday he believed action was necessary.
"We want consumers to make decisions about home mortgage options confidently, with assurance that unscrupulous home mortgage practices will not be tolerated," he said.
The new rules operate on two levels: restrictions on the general conduct of the mortgage industry, and a set of specific restrictions on loans with high interest rates that will nudge practices in the subprime industry closer to prevailing practices in the mainstream lending industry.
Federal regulation of the mortgage industry is significantly outdated. The current rules are designed for a system where a single company makes a loan. The reality is that loans are now made by independent brokers, funded by lenders, sold to investors, and serviced by specialized companies.
The Fed acted for the first time to regulate some of those players. It will impose restrictions on the incentives brokers receive from lenders to "upsell" customers into loans with higher interest rates. And it will limit the penalties charged to borrowers by companies that collect monthly mortgage payments.
The Fed did not address the question of whether investors should be responsible when a borrower receives an unaffordable loan, a key concern of consumer advocates. They contend the current system allows those in the lending industry to act with impunity because current law limits who borrowers can sue if they feel they were preyed upon.
The most controversial regulations will apply to loans with high interest rates. Here, the Fed acted to eliminate so-called "no doc" loans, by requiring borrowers to document any income they claim on a loan application.
The new provisions will require lenders to quote monthly payments to prospective borrowers that include property taxes and homeowners insurance, something subprime lenders routinely omit to make payments sound smaller.
The provisions will also limit the ability of lenders to charge a penalty intended to discourage borrowers from refinancing to lower interest rates, but it did not eliminate such fees entirely. For example, such prepayment penalties cannot be assessed within 60 days of a scheduled increase in a borrower's interest rate.
Finally the Fed suggested that lenders should try to write loans that customers can afford. But the Fed did not match a number of states laws, including the new Massachusetts regulations, that specifically require lenders to determine that a customer can afford a loan.
The Mortgage Bankers Association, a leading trade group, applauded the Fed for its balancing act. "This is a fine line to walk, and it's obvious that the officials at the Fed put a lot of thought into this proposed rule," Kieran Quinn, the group's chairman, said in a statement.
US Representative Barney Frank, Democrat of Massachusetts, had previously threatened the Fed with the loss of its rule-making authority if it did not act to protect borrowers. Yesterday, he said he was disappointed in the proposed changes, but not surprised.
"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," Frank, who heads the House Financial Services Committee, said in a statement.
He said he was specifically concerned that the Fed in its proposed rules had identified the most problematic subprime practices - those most closely associated with foreclosure - but then failed to prohibit those practices.
US Senator Christopher Dodd, Democrat of Connecticut and chairman of the Senate Banking Committee, expressed similar concerns.
Both homed in on the Fed's decision not to require that lenders determine if a borrower can afford a loan. Such a provision is included in legislation cosponsored by Frank that has passed the House, and in legislation that Dodd is trying to shepherd through the Senate. Both men said the weakness of the Fed's proposed rules underscored the need for federal legislation.
Binyamin Appelbaum can be reached at bappelbaum@globe.com.
