Randall S Kroszner: Legislative proposals on reforming mortgage
practices
Testimony by Mr Randall S Kroszner, Member of the Board of Governors of the US Federal
Reserve System, before the Committee on Financial Services, US House of
Representatives, Washington DC, 24 October 2007.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
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Chairman Frank, Ranking Member Bachus, and members of the Committee, I appreciate the
opportunity to appear before you today, to discuss recent problems in the subprime
mortgage market, Federal Reserve actions that address these developments, and potential
legislative responses. Promoting access to credit and sustainable homeownership are
important objectives, and the Board believes that responsible subprime mortgage lending
can help advance both goals.
Background
Subprime mortgages are loans intended for borrowers who are perceived to have higher
than typical credit risk. In recent years, the subprime market has grown dramatically because
of advances in credit scoring and underwriting technology, which enables lenders to charge
different borrowers different prices on the basis of calculated creditworthiness. These loans
are recognized by the higher prices they carry, which reflect subprime lenders' decisions to
seek additional compensation for the credit risk they incur.
As the overall mortgage market has grown, many new lenders and distribution channels
have developed and most of those are outside the direct jurisdiction of the federal banking
agencies. A review of data provided by mortgage lenders pursuant to the Home Mortgage
Disclosure Act reveals that lenders that are not subject to oversight by a federal banking
agency originated just under half of the higher-priced conventional first lien mortgage loans
reported in 2006.
While the expansion of the subprime mortgage market over the past decade has increased
access to credit, the subprime mortgage market during recent years was also accompanied
by a deterioration in underwriting standards. In some cases, abusive or fraudulent lending
practices resulted in homeowners taking on mortgage obligations they could not afford, with
terms they may not have fully understood. Delinquencies and foreclosures have increased.
During the past two years, serious delinquencies among subprime adjustable-rate mortgages
(ARMs) have increased dramatically, reaching nearly 16 percent in August, roughly triple the
recent low in mid-2005. For so-called near-prime loans in alt-A securitized pools (those made
to borrowers who typically have higher credit scores than subprime borrowers but still pose
more risk than prime borrowers), the serious delinquency rate has also risen, to 3 percent
from 1 percent only a year ago. These patterns contrast sharply with those in the
primemortgage sector, in which less than 1 percent of loans are seriously delinquent.
Higher delinquencies have begun to show through to foreclosures. About 320,000
foreclosures were initiated in each of the first two quarters of this year (just more than half of
them on subprime mortgages), up from an average of about 225,000 during the past six
years. Foreclosure starts tend to be high in states with stressed economic conditions and to
rise where house prices have decelerated or fallen. Adjustable-rate subprime mortgages
originated in 2006 have performed the worst, with some of them defaulting after only one or
two payments (or even no payment at all). Relative to earlier vintages, more of these loans
carried greater risks beyond weak borrower credit histories - including very high initial
cumulative loan-to-value ratios and less documentation of borrower income.
The recent increase in delinquencies and foreclosures has created personal, financial, and
social distress for many homeowners and communities. We encourage servicers of
securitized mortgages to reach out to financially stressed homeowners. Keeping families in
their homes is a matter of great importance to the Federal Reserve. In fact, the twelve
Federal Reserve Banks are working closely around the country with community and industry
groups dedicated to reducing homeowners' risks of foreclosure. Each of the Reserve Bank
community affairs offices provides significant leadership and technical assistance in this
area.
I am also pleased to serve as the Federal Reserve's representative on the board of directors
of NeighborWorks America, which has a program to encourage borrowers facing mortgage
payment difficulties to seek help by making early contact with their lenders, servicers, or
trusted counselors. NeighborWorks' Center for Foreclosure Prevention Center recently
launched a national advertising campaign to raise awareness about its 24-hour national
hotline that connects struggling borrowers with homeownership counselors. Since the launch
of the campaign this past June, the daily call volume has almost doubled from 1,000 to
almost 2,000 calls a day.
The Board's response to problems in the subprime market
The Federal Reserve has primary rule-writing authority for many consumer protection laws.
Consumer protection laws take two complementary approaches to consumer protection: one
focuses on the provision of information, and the other involves the development and
enforcement of rules against abusive practices. The Board believes it is extremely important
to strike the right balance by seeking to protect consumers from predatory lending practices
without restricting credit from responsible lenders to borrowers with shorter or lower-rated
credit histories. To achieve that balance, we coordinate with other federal and state
agencies, and consult with consumer advocates, lenders, investors, and other interested
parties.
Consumer protection regulations
The Board believes it is important to provide consumers with pertinent and accurate
information. Clearly, information is critical to the effective functioning of markets. A core
principle of economics is that markets are more competitive, and therefore more efficient,
when accurate information is available to both consumers and suppliers. When information
on alternatives is readily available, product offerings must meet customers' demands and
offering prices must reflect those of market competitors. If consumers are well informed, they
are in a better position to make decisions that are in their best interest. As a result, a
significant component of the rule-writing process involves crafting disclosure requirements
that provide consumers with consistent and relevant information about the terms and fees of
financial products.
To be effective, disclosures must give consumers information that they can readily
understand at a time when the information is relevant. To that end, the Federal Reserve will
propose improvements to the rules governing the disclosure of mortgage loan terms and
conditions and the timing of those disclosures. We will soon begin an extensive consumer
testing process to ensure that the new disclosures we propose will be comprehensible and
useful to borrowers. To further improve consumers' access to meaningful information, we are
also developing proposed changes to the Truth in Lending Act (TILA) rules to address
concerns about incomplete or misleading mortgage loan advertisements and solicitations,
and to require lenders to provide mortgage disclosures more quickly so that consumers can
get the information they need when it is most useful to them.
The Federal Reserve is keenly aware, however, that disclosure alone may not be sufficient to
combat abusive practices. In addition to providing consumers with better information, the
Federal Reserve plans to exercise its rulemaking authority under the Home Ownership and
Equity Protection Act (HOEPA) to address unfair or deceptive mortgage lending practices.
We plan to propose rules by the end of this year that would apply to subprime loans offered
by all mortgage lenders. We share the concerns of Congress that certain lending practices
may have led to the problems we are seeing in the subprime market today. We are looking
closely at practices such as prepayment penalties, failure to offer escrow accounts for taxes
and insurance, stated-income and low-documentation lending, and the failure to give
adequate consideration to a borrower's ability to repay.
To ensure that any new rules will protect consumers without inappropriately reducing access
to credit, the Board has obtained input from a wide variety of interested parties. I chaired a
full day hearing in June that yielded valuable insight from both industry and consumer
groups. The Board also solicited written comments from the public on the practices
discussed at the hearing. The Board received nearly 100 comment letters, and staff is closely
examining the issues raised and discussing possible remedies. Other federal and state
agencies have been consulted as part of our efforts under HOEPA. We have also sought the
views of our Consumer Advisory Council, which advises the Board on matters in the area of
consumer financial services. The council's members represent the interests of consumers,
communities, and the financial services industry.
Coordinated enforcement of consumer protection laws
Enforcement of consumer protection measures is also critical to protecting consumers from
irresponsible or predatory lending. Indeed, the consumer financial services laws
implemented by the Federal Reserve contain a number of substantive protections, reflecting
carefully considered judgments by Congress that certain practices should be restricted or
prohibited. The Federal Reserve enforces these rules through oversight of the institutions it
examines for compliance with consumer protection laws and regulations.
The regulatory scheme for the mortgage industry has become extremely complex as the
breadth and depth of this market has grown over the past decade and the role of nonbank
mortgage lenders, particularly in the subprime market, has increased. As I mentioned
previously, data collected under the Home Mortgage Disclosure Act show that independent
mortgage companies made about half of higher-priced mortgages in 2006. In addition, there
has been an increased presence of mortgage brokers, often independent entities who take
loan applications and shop them to depository institutions or other lenders. These market
developments have resulted in mortgage lending extending beyond the federal banking
agencies' oversight, and this underscores the importance of collaborating with the state
banking agencies and other organizations to address concerns in the subprime mortgage
market.
To this end, we have launched a cooperative pilot project with other federal and state
agencies to conduct reviews of non-depository lenders with significant subprime mortgage
operations. The reviews will evaluate the companies' underwriting standards and
seniormanagement oversight of risk-management strategies for ensuring compliance with
consumer protection laws and regulations. Our partners in this initiative are the Office of
Thrift Supervision, the Federal Trade Commission, and state agencies represented by the
Conference of State Banking Supervisors (CSBS) and the American Association of
Residential Mortgage Regulators (AARMR). At the conclusion of the reviews, the agencies
will analyze the results and determine whether to continue the project and, if so, how to focus
future reviews.
Loss mitigation efforts
The Board also has worked with the other federal financial agencies to guide federally
supervised institutions as they deal with borrower mortgage default. In April 2007, the federal
financial institution agencies issued a Statement on Working with Mortgage Borrowers. The
statement encourages federally regulated institutions to work constructively with residential
borrowers at risk of default and to consider prudent workout arrangements that avoid
unnecessary foreclosures. In cooperation with CSBS, the federal financial agencies issued a
Statement on Loss Mitigation Strategies for Servicers of Residential Mortgages in September
2007 to address subprime and other mortgage loans that have been transferred into
securitization trusts. The statement calls on servicers of securitized mortgages to review the
governing documents for the trusts to determine the full extent of their authority to restructure
loans that are delinquent or in default or are in imminent risk of default.
To the extent possible, efforts should be made to avoid foreclosure. We encourage servicers
to reach out to financially stressed homeowners, to make every effort to keep them in their
homes. Lenders and servicers, for example, may be able to assist troubled borrowers by
modifying the loan, deferring payments, extending the loan maturities, converting an
adjustable-rate mortgage to a fixed-rate or fully-indexed loan, or capitalizing delinquent
amounts. The best outcome is a loss mitigation strategy that results in a mortgage obligation
that the borrower can meet in a sustained manner. The use of these and other
lossmitigation techniques is consistent with the interagency guidance that emphasizes the
importance of prudent underwriting practices to help ensure that borrowers can meet the
terms of their mortgage obligations and maintain homeownership.
Legislative responses
Congress is appropriately concerned about problems in the mortgage market. The Mortgage
Reform and Anti-Predatory Lending Act of 2007 takes a comprehensive approach and is
appropriately focused on the more problematic practices in the subprime mortgage market.
We share Congress's concerns with these practices. As with regulations, it is important that
new laws carefully target lending abuses without unduly restraining responsible lending.
Getting this balance right is particularly critical now, as many borrowers facing rate
adjustments may need to refinance into more affordable loans.
The Mortgage Reform and Anti-Predatory Lending Act of 2007 would provide greater
oversight and regulation of mortgage brokers, an approach that has merit. A nationwide
registration and licensing system for all mortgage loan brokers would help limit the ability of
bad actors to move to a new state after having run afoul of regulators in other states. The
CSBS and AARMR have a promising initiative to establish a national registry. It would be
appropriate for any new legislation to ensure that all individual brokers are included in the
same nationwide registry.
The Mortgage Reform and Anti-Predatory Lending Act of 2007 also addresses concerns
about loans made without consideration of a borrower's ability to repay. The Board firmly
believes that lenders should give due consideration to a borrower's ability to repay a loan,
before the loan is extended. We and the other regulators have emphasized this several times
in a variety of guidance statements on mortgage lending. This is also one of the areas we are
looking at in our revisions to the HOEPA rules. In developing laws or rules to address
repayment ability, the rules must be specific enough so that creditors can determine whether
their practices are in compliance because legal uncertainty could have the unintended effect
of reducing credit options for creditworthy subprime borrowers. At the same time, rules must
be flexible enough to allow creditors to consider the pertinent factors and individual
circumstances of particular consumers and to innovate prudently and fairly.
The Mortgage Reform and Anti-Predatory Lending Act of 2007 would require originators to
present borrowers with loans that are appropriate to the borrower's circumstances. In the
case of refinancings, the bill provides that the loan must provide a "net tangible benefit" to the
borrower. As I have discussed, the Board supports the goal of ensuring that consumers do
not receive unaffordable and abusive loans. However, it is critical to carefully craft such laws
or rules to ensure that they do not inappropriately reduce credit availability in the mortgage
market, to the detriment of consumers.
The Mortgage Reform and Anti-Predatory Lending Act of 2007 would hold securitizers and
loan purchasers ("assignees") liable for the actions of mortgage originators. The
securitization market is critical to increasing the resources available to fund home purchases
and great care should be taken to ensure that investors in the securitization market can
quickly and accurately assess and mitigate the risks, including the compliance risks, of
mortgages sold in this market. Such laws should be very clearly delineated to ensure that
they do not have a detrimental impact on the ability of lenders to securitize loans.
Specifically, assignees must be able to conduct due diligence and determine whether an
originator has complied with the law, so that they can evaluate and price for any risks.
Finally, the bill would enhance HOEPA's protections by prohibiting abusive practices, such as
prohibiting the financing of single-premium credit life insurance. HOEPA's points and fees
trigger would be lowered and additional fees added. These potential actions merit discussion,
and we welcome the opportunity to continue to work with congressional staff on these and
other provisions in new legislation.
Conclusion
The Board is engaged in several activities to assist consumers, and continues to develop
rules that will improve consumer disclosures, address unfair or deceptive practices, and help
consumers facing default and foreclosure. We look forward to working with Congress to
enhance consumer protection laws while maintaining access to credit.