Randall S Kroszner: Protecting homeowners and sustaining home
ownership
Speech by Mr Randall S Kroszner, Member of the Board of Governors of the US Federal
Reserve System, at the American Securitization Forum 2008 Conference, Las Vegas,
Nevada, 4 February 2008.
* * *
The mortgage market has long been a source of strength in the U.S. economy, but it is facing
significant challenges, especially in the subprime segment that serves consumers who have
shorter or weaker credit records. As of November, the most recent month for which data are
available, about 20 percent of subprime adjustable-rate mortgages (ARMs) were ninety or
more days delinquent, twice the level one year earlier.1 More than 171,000 foreclosures were
started on these mortgages in the third quarter, up 36 percent from the previous quarter.2
The significance of the problems with subprime loan performance is evident in the unusually
high rate of defaults within a few months of loan origination, known as early payment
defaults. In November, nearly 7 percent of subprime ARMs originated in the previous six
months were already ninety or more days delinquent, twice the rate of the year before and
nearly four times the rate two years earlier.3
These problems have many causes, but the role of abusive lending practices is of particular
concern. Such practices have led many people into homeownership that they cannot sustain,
hurting their families as well as their neighbors and communities. Practices that have hurt
consumers have also undermined the confidence of investors and contributed to a virtual
shutdown of the subprime market. As a result, it is difficult for many borrowers, especially
those with shorter or weaker credit records, to obtain home loans.
These events have highlighted the shared interest of mortgage borrowers, their communities,
lenders, and investors in protecting borrowers from abusive practices and preserving their
choices. Abusive loans that strip their equity or cause them to lose their homes must not be
tolerated. Protecting borrowers with responsible underwriting standards also protects the
integrity and proper functioning of the mortgage market by increasing investor confidence. In
other words, effective consumer protection can reduce uncertainty about the underwriting
standards of, and hence, the value of, loans in mortgage-backed securities, thereby helping
to revive and strengthen mortgage securities markets. In this way, effective consumer
protection produces a complementary benefit for consumers by making more capital
available to meet their needs. Similarly, systematic efforts to keep borrowers who may have
trouble meeting their loan obligations in their homes on a sustainable basis, by providing
more certainty to the market, can have the complementary benefit of ensuring the flow of
capital for potential borrowers.
With these principles in mind, I will discuss current initiatives to mitigate foreclosures. Then I
will spend most of my time discussing the Board's recent initiative in proposing new
regulations to prevent abuse, unfairness, and deception in residential mortgage lending.
Preventing unnecessary foreclosures
About one-and-a-half million adjustable-rate subprime mortgages are scheduled to have their
interest rates reset this year--significantly more than in 2007--and another one-half million in
2009. While many borrowers facing reset will be able to make the higher payment, many will
not. As rates reset, it is important that we take steps to protect homeowners, communities,
the mortgage market, and the economy from the adverse consequences of unnecessary
defaults and foreclosures.
Given the high cost of foreclosures to lenders and investors and the disruption and distress
that foreclosure can cause to consumers, their families, and their communities, it is in
everyone's interest to avoid foreclosures whenever other viable options exist. With large
numbers of borrowers facing potential repayment problems, it is in the interest of borrowers
and investors alike for the industry to develop prudent loan modification programs and other
assistance to help borrowers on a systematic and sustainable basis.
The American Securitization Forum (ASF) and the Hope Now Alliance have recognized this
interest and have taken leading roles in streamlining the process for refinancing and
modifying subprime adjustable-rate mortgages. I have been an active proponent of such
streamlined systematic approaches to reduce transactions costs and to help mitigate
foreclosure risk, and I strongly encourage market participants to adopt and to implement
these fast-track modification proposals as quickly as possible. The efforts by ASF and Hope
Now have helped accelerate loan modifications in the last quarter, according to recently
released data. I applaud these efforts but more must be done as the number of households
facing resets increases. Challenges remain, for example, with respect to ongoing constraints
on servicing capacity to expedite work outs. Servicers must undertake the investment to
overcome the capacity challenges and provide transparent and timely measures of the
results.
A systematic and prudent effort to avoid unnecessary foreclosures has many benefits. Many
borrowers with subprime ARMs, for example, have been able to strengthen their credit
records by making timely payments so far. It would be very unfortunate if some of these
borrowers faced foreclosure when their payments increased merely because servicers
lacked the capacity to reach them in time with a sustainable alternative. The solid credit
history would be lost and, consequently, financing options would be reduced. Loan-by-loan
modifications can help some, but they require substantial time and effort. Where appropriate,
an efficient, systematic approach lets servicers reach more of these borrowers and prevent
more foreclosures.
Furthermore, as noted above, standards for dealing with problem loans may help make more
capital available for potential borrowers. By providing more certainty to the mortgage market,
clear and consistent standards can help ensure the flow of credit to potential borrowers.
While much has been done to prevent avoidable foreclosures, more still needs to be done.
For our part, the Federal Reserve has been working with financial institutions and community
groups around the country to address the challenges posed by problem loans. For instance,
we have been providing community coalitions, counseling agencies, fellow regulators, and
others with detailed analyses identifying neighborhoods at high risk of foreclosures. In
addition, all twelve of the Federal Reserve Banks have also been working with an array of
stakeholders to address these challenges on the local and regional levels.
There are also efforts under way on the international level to develop responses to recent
financial market turmoil. I represent the Board on the Financial Stability Forum, which has
established a working group to diagnose causes of recent events and make
recommendations.
The Board's proposal
I will now focus on the Board's recent proposal for stricter regulations prohibiting abusive and
deceptive practices in the mortgage market under authority of the Home Ownership and
Equity Protection Act (HOEPA). This proposal is intended to protect consumers and to
preserve consumer choice by targeting protections to borrowers who face the most risk. The
proposed regulations are designed to protect consumers from excessive layering of risk even
as the practices that increase risk may change. We have sought to ensure that these
standards are clear for lenders to reduce unintended consequences for consumers. Though
clear, the standards are intended to be not overly prescriptive, so as to preserve access to
responsible credit while amply protecting consumers. Our proposal is also comprehensive,
covering most mortgage loans with certain protections and the entire subprime market with
certain more specific regulations. While comprehensive, the proposal would focus
protections where the risks are greatest and preserve consumers' access to responsible
credit.
Our effort to produce robust, clear, and comprehensive rules was based on a rigorous
analysis of available qualitative and quantitative data. We have put this proposal out for
public comment until April 8 and eagerly seek suggestions to be able to craft the best
possible final rule.
Comprehensive scope
Let me say more about the comprehensive scope of this proposal. It would apply stricter
regulations to higher-priced mortgage loans, which we have defined broadly. We were
particularly interested in ensuring that protections remain strong over time as loan products
and lending practices change. Our analysis of the data suggested that the troubles in the
mortgage market generally arise not from a single practice in isolation, but instead from the
complex ways that risk factors and underwriting practices can affect each other, sometimes
called "risk layering." Therefore, we have proposed using a loan's annual percentage rate, or
APR, to determine whether the loan is covered by stricter regulations.4 Because the APR is
closely correlated to risk, the proposed protections would cover loans with higher risks rather
than single out particular risk factors or underwriting practices.
With the APR thresholds we have proposed, we expect that the new protections would cover
the entire subprime mortgage market and the riskier end of the "near prime" market, the latter
also known as the "alt-A" market. Covering part of the alt-A market would anticipate possible
actions by lenders to avoid restrictions on subprime loans priced near the threshold. It would
also address real risks to consumers in the alt-A segment. This segment grew very rapidly,
and it layered risks, such as undocumented income, on top of other risks, such as
nontraditional loan structures allowing borrowers to defer paying principal and interest.
Our public hearings and our analysis identified problems not just in higher-priced loans,
however, but in the broader mortgage market. Thus, our proposal addresses unfair or
deceptive practices for the vast majority of mortgage loans secured by a consumer's primary
home. Areas targeted this broadly include broker steering, appraisal coercion, unwarranted
servicing fees, and deceptive advertising. I'll touch on broker steering toward the end of my
remarks.
Robust approach to affordability
Extending credit that borrowers can afford to repay is a fundamental pillar of responsible
lending. Across the whole range of higher-priced mortgage loans, our proposal offers three
rules that, working in combination, would help ensure that borrowers can afford their
payments. First is a requirement that a lender maintain responsible underwriting practices
that genuinely assess borrowers' ability to repay. This general requirement would be
complemented by a specific requirement to verify borrowers' income and assets. A third rule
would require lenders to escrow property taxes and homeowners insurance to help
borrowers meet these obligations.
This robust approach to affordability would help ensure that the subprime market promotes
sustainable homeownership. Just as important, it would also help protect consumers from
abuse. When the law requires that monthly payments be affordable, then consumers are less
vulnerable to abusive refinancings that strip equity. When the law imposes a responsible
underwriting standard on all lenders, then irresponsible actors who would strip borrowers'
equity are easier to keep out of the market. Clear lending standards have the further
advantages of increasing investor confidence in the mortgage market and helping to revive
the flow of credit flow to consumers with shorter or weaker credit records.
Assessment of repayment ability
Now I want to discuss the major elements of our proposed regulations for higher-priced loans
in a little more depth, starting with the requirement to assess repayment ability. The
regulations would prohibit a lender from engaging in a pattern or practice of making
higherpriced loans based on the value of the borrower's house rather than on the borrower's ability
to repay from income, or from assets other than the house. This prohibition is intentionally
broad to capture all risks to loan performance and the different ways that these risks can be
layered. Moreover, the proposal avoids prescribing quantitative underwriting requirements.
For example, the proposal would prohibit a pattern or practice of disregarding the ratio of
applicants' income to their debt, but it does not prescribe a maximum ratio because the
appropriate number depends heavily on other risk factors, which vary from loan to loan.
At the same time, the proposal does offer specifics. For example, it would create a
presumption that a lender had violated the regulations if it engaged in a pattern or practice of
failing to underwrite at the fully-indexed rate.5 This presumption is derived from the subprime
guidance the agencies issued last year.
It bears emphasis, however, that our proposed regulations would be more robust and
comprehensive than the guidance. The regulations would apply to all mortgage lenders,
including independent mortgage companies. Guidance, in contrast, does not ensure
uniformity of coverage. Moreover, the regulations would be legally enforceable by
supervisory and enforcement agencies. Just as important, the regulations, unlike the
guidance, would be legally enforceable by consumers. Borrowers who brought timely actions
could recover statutory damages for violations, above and beyond any actual damages they
suffered.
The proposed requirement to assess repayment ability is intended to protect consumers from
abusive practices while maintaining their access to responsible credit. We recognize that
satisfying both objectives at the same time is a challenge. The proposed rule's potential for
consumer actions, coupled with its careful avoidance of prescribing quantitative underwriting
thresholds, could raise compliance and litigation risk. In turn, this could raise the cost of
credit for higher-risk borrowers or limit the availability of responsible credit. That is why we
have proposed prohibiting a "pattern or practice" of disregarding repayment ability rather than
attaching a risk of legal liability to every individual loan that does not perform. This approach
is meant to preserve choices for borrowers with shorter or weaker credit records while
protecting them from lenders who have a practice of disregarding repayment ability or are
found to exhibit a pattern of unaffordable loans.
We anticipate vigorous comment on our proposed approach and have specifically solicited
suggestions for its implementation.
Income verification
When we looked closely at why so many borrowers had mortgages that they struggled to
repay so soon after taking out the loan, the prevalence of "stated-income" lending was a
clear culprit. Substantial anecdotal evidence indicates that failing to verify income invited
fraud. Moreover, when we looked at the loan-level data we saw a clear correlation between
"low-doc" or "no-doc" lending and performance problems, particularly early payment defaults.
That is why we have proposed to complement a broad requirement to assess repayment
ability with a specific requirement to verify the income or assets a lender relies on to make a
credit decision. We recognize that stated-income lending may have a proper place when not
layered on top of too many other risks. Indeed, stated income lending and "no/low-doc"
lending are defining features of the alt-A market, which has long served borrowers with good
credit scores who seek some underwriting flexibility. We would target the verification
requirement to higher-priced loans, including the higher-priced end of the alt-A market, where
the risks of stated-income lending could be layered on top of too many other risks. This
targeting is intended to maintain consumer access to responsible credit.
The proposal identifies standard documents that would be acceptable, such as W-2 forms. It
also allows, however, any third party documents that provide reasonably reliable evidence of
income. This rule is meant to preserve consumer choice by allowing the market to identify
credible nontraditional documentation of consumer income--for example, check-cashing
receipts. In that regard, the proposal responds to input we gathered through the HOEPA
hearing I chaired last June. Several panelists spoke of the fact that some consumers may
have access to only nonstandard documents and others, such as self-employed
entrepreneurs, may have some difficulty documenting their income. To help ensure that the
proposal preserves access to credit for the full range of consumers, we have sought public
comment on this issue.
Escrows for taxes and insurance
Another part of our proposal for higher-priced loans--a requirement to escrow taxes and
insurance--would also help ensure that borrowers can afford their payments. Escrowing has
become standard practice in the prime market, and the case for making it standard in the
subprime market, too, appears compelling. Consumers with shorter or weaker credit histories
may be less likely to appreciate the sizable burden that taxes and insurance can add to the
cost of homeownership, or more vulnerable to being misled by payment quotes that leave out
these amounts. Moreover, when we looked at the data, we saw in the unusually high level of
early payment defaults possible evidence that the lack of escrows hurt consumers who did
not have experience paying property tax and insurance bills.
We have proposed to address the problem with a requirement to escrow taxes and insurance
on higher-priced loans, accompanied by a limited allowance for opt-out. We wanted the
regulations to prevent irresponsible efforts to encourage borrowers to opt out. So the rule
would not permit opt-out at the closing table, but instead would require that twelve months
pass before a consumer may opt out. In this respect the proposal is intended to preserve
consumer choice while protecting consumers from unaffordable mortgage obligations.
Prepayment penalties
Having discussed the rules that would promote affordability, I want to say a word about our
proposed rule on prepayment penalties. These penalties can take a toll on consumers who
have riskier loans, and many consumers may not even be aware their loans have a penalty.
Accordingly, we have proposed a ban on prepayment penalties in circumstances of a high
degree of risk to the consumer, and we are also addressing transparency concerns.
The proposed rule would ban prepayment penalties where they are most likely to prevent a
consumer from refinancing a loan that has a particularly burdensome payment. Specifically,
a penalty would be prohibited where the borrower's debt-to-income ratio exceeds 50 percent,
and a penalty would have to expire before a loan's payment could increase. The rule would
also ban prepayment penalties where they are more likely to be part of a "loan flipping"
scheme--specifically, where a lender or its affiliate refinances the lender's own loan.
An approach tailored to the degree of risk to the consumer appears to us to be in the best
interest of consumers overall. Banning penalties altogether could cause all borrowers,
including those who do not prepay, to bear the full cost of investors' prepayment risk. That
result would raise questions of fairness, and it could reduce consumer choice.
We share concerns, however, that consumers often do not knowingly choose loans with
penalties. We are tackling those concerns head-on. Through rigorous consumer testing, we
are developing a new disclosure for prepayment penalties to improve consumer awareness
and understanding. This should empower consumers to make better informed choices and
improve competition.
Steering
I have so far discussed the elements of our proposal that would seek to ensure that
underwriting practices and loan terms on higher-priced loans do not present unwarranted
risks to consumers. There is another potential source of risk to consumers that I want to
address that is related to "steering"--the risk that when they use the services of a mortgage
broker, they do not appreciate the extent to which the broker's interests may diverge from the
consumer's interests because of "yield spread premiums."6
The growth of the market for brokerage services has no doubt increased competition in the
market for mortgage loans, to the benefit of consumers. Moreover, the yield spread premium,
a payment from a lender to a broker based on the loan's interest rate, is sometimes the best
way for a consumer to fund the cost of a broker's services. However, when a lender pays a
broker for a loan that has a higher rate, that payment can create a conflict of interest
between the broker and the consumer. This conflict is problematic if the consumer does not
know it exists or assumes, incorrectly, that the broker is obligated to put the consumer's
interests first. In such cases, the consumer cannot protect his or her own interests, and
competition for loans and for brokerage services does not work effectively.
Therefore, we have proposed to prohibit a lender, for both prime and subprime loans, from
paying a broker any more than the consumer had expressly agreed that the broker would
receive. This agreement must be executed up-front, before the consumer has submitted an
application and become invested in closing the deal. The combination of stricter regulation
and better disclosure that we are proposing should help reduce a broker's incentive to steer a
consumer to a higher rate, empower consumers to shop and negotiate among brokers, and
preserve consumers' option to use the services of a broker.
Better and earlier information for consumers
Lastly, to protect consumers and promote competition, our proposed regulation would
prohibit misleading mortgage advertising and require that consumers receive loan-specific
disclosures early in the application process, when they can use the information to shop more
effectively. We recognize, however, that we face a challenge in ensuring that disclosures for
mortgage loans remain effective. We have begun a comprehensive program of rigorous
consumer testing of potential improvements to current disclosures.
Conclusion
There are more elements of our comprehensive proposal that I do not have time today to
discuss, such as a prohibition against coercing appraisers and restrictions on unwarranted
servicing fees. We anticipate vigorous public comment on this proposal, and once we have
carefully considered all the input we receive, we will move expeditiously to a final rule. As I
noted at the outset, effective consumer protection can help to restore confidence in the
mortgage markets and help to preserve the flow of capital to consumers who wish to
purchase a home.
It is not too early to emphasize that the effectiveness of the final rule will depend critically on
effective enforcement. The Federal Reserve will do its part to ensure compliance among the
institutions it supervises. We also have been instrumental in launching a pilot project with
other federal and state agencies to conduct consumer compliance reviews of non-depository
lenders and other industry participants. I am sure we will be aided in these efforts by a new
system for registering and tracking mortgage brokers recently launched by the Conference of
State Bank Supervisors.
While we work to build effective consumer protections and enforcement regimes for future
consumers, we will also continue our efforts, and encourage the initiatives many others are
undertaking, to limit unnecessary foreclosures for consumers who are hurting now.