Truth in Lending

Federal RegisterJan 9, 2008

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FEDERAL RESERVE SYSTEM

12 CFR Part 226

[Regulation Z; Docket No. R-1305]

Truth in Lending

AGENCY:

Board of Governors of the Federal Reserve System.

ACTION:

Proposed rule; request for public comment.

SUMMARY:

The Board proposes to amend Regulation Z, which implements the Truth in Lending Act and Home Ownership and Equity Protection Act. The goals of the amendments are to protect consumers in the mortgage market from unfair, abusive, or deceptive lending and servicing practices while preserving responsible lending and sustainable homeownership; ensure that advertisements for mortgage loans provide accurate and balanced information and do not contain misleading or deceptive representations; and provide consumers transaction-specific disclosures early enough to use while shopping for a mortgage. The proposed revisions would apply four protections to a newly-defined category of higher-priced mortgage loans secured by a consumer's principal dwelling, including a prohibition on a pattern or practice of lending based on the collateral without regard to consumers' ability to repay their obligations from income, or from other sources besides the collateral. The proposed revisions would apply three new protections to mortgage loans secured by a consumer's principal dwelling regardless of loan price, including a prohibition on a creditor paying a mortgage broker more than the consumer had agreed the broker would receive. The Board also proposes to require that advertisements provide accurate and balanced information, in a clear and conspicuous manner, about rates, monthly payments, and other loan features; and to ban several deceptive or misleading advertising practices, including representations that a rate or payment is “fixed” when it can change. Finally, the proposal would require creditors to provide consumers with transaction-specific mortgage loan disclosures before they pay any fee except a reasonable fee for reviewing credit history.

DATES:

Comments must be received on or before April 8, 2008.

ADDRESSES:

You may submit comments, identified by Docket No. R-1305, by any of the following methods:

•

Agency Web site: http://www.federalreserve.gov.

Follow the instructions for submitting comments at

http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.

•

Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments.

•

E-mail: regs.comments@federalreserve.gov.

Include the docket number in the subject line of the message.

•

Fax:

(202) 452-3819 or (202) 452-3102.

•

Mail:

Address to Jennifer J. Johnson, Secretary, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue, NW., Washington, DC 20551.

All public comments will be made available on the Board's Web site at

http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm

as submitted, unless modified for technical reasons. Accordingly, comments will not be edited to remove any identifying or contact information. Public comments may also be viewed electronically or in paper in Room MP-500 of the Board's Martin Building (20th and C Streets, NW.) between 9 a.m. and 5 p.m. on weekdays.

FOR FURTHER INFORMATION CONTACT:

Kathleen C. Ryan, Dan S. Sokolov, or David Stein, Counsels; Jamie Z. Goodson, Brent Lattin, Jelena McWilliams, or Paul Mondor, Attorneys; Division of Consumer and Community Affairs, Board of Governors of the Federal Reserve System, Washington, DC 20551, at (202) 452-2412 or (202) 452-3667. For users of Telecommunications Device for the Deaf (TDD) only, contact (202) 263-4869.

SUPPLEMENTARY INFORMATION:

I. Summary of Proposal

A. Proposals To Prevent Unfairness, Deception, and Abuse

B. Proposals To Improve Mortgage Advertising

C. Proposals To Give Consumers Disclosures Early

II. Consumer Protection Concerns in the Subprime Market

A. Recent Problems in the Mortgage Market

B. The Loosening of Underwriting Standards

C. Market Imperfections That Can Facilitate Abusive and Unaffordable Loans

III. The Board's Hoepa Hearings

A. Home Ownership and Equity Protection Act (HOEPA)

B. Summary of 2006 Hearings

C. Summary of June 2007 Hearing

D. Congressional Hearings

IV. Inter-Agency Supervisory Guidance

V. Legal Authority

A. The Board's Authority Under TILA Section 129(l)(2)

B. The Board's Authority Under TILA Section 105(a)

VI. Proposed Definition of “Higher-Priced Mortgage Loan”

A. Overview

B. Public Comment on the Scope of New HOEPA Rules

C. General Principles Governing the Board's Determination of Coverage

D. Types of Loans Proposed To Be Covered Under § 226.35

E. Proposed APR Trigger for § 226.35

F. Mechanics of the Proposed APR Trigger

VII. Proposed Rules for Higher-Priced Mortgage Loans—§ 226.35

A. Overview

B. Disregard of Consumers' Ability To Repay—§§ 226.34(a)(4) and 226.35(b)(1)

C. Verification of Income and Assets Relied On—§ 226.35(b)(2)

D. Prepayment Penalties—§ 226.32(d)(6) and (7); § 226.35(b)(3)

E. Requirement to Escrow—§ 226.35(b)(4)

F. Evasion Through Spurious Open-end Credit—§ 226.35(b)(5)

VIII. Proposed Rules for Mortgage Loans—§ 226.36

A. Creditor Payments to Mortgage Brokers—§ 226.36(a)

B. Coercion of Appraisers—§ 226.36(b)

C. Servicing Abuses—§ 226.36(c)

D. Coverage—§ 226.36(d)

IX. Other Potential Concerns

A. Other HOEPA Prohibitions

B. Steering

X. Advertising

A. Advertising Rules for Open-end Home-equity Plans—§ 226.16

B. Advertising Rules for Closed-end Credit—§ 226.24

XI. Mortgage Loan Disclosures

A. Early Mortgage Loan Disclosures—§ 226.19

B. Future Plans To Improve Disclosure

XII. Civil Liability and Remedies; Administrative Enforcement

XIII. Effective Date

XIV. Paperwork Reduction Act

XV. Initial Regulatory Flexibility Analysis

I. Summary of Proposal

The Board is proposing to establish new regulatory protections for consumers in the residential mortgage market through amendments to Regulation Z, which implements the Truth in Lending Act (TILA) and the Home Ownership and Equity Protection Act (HOEPA). The goals of the amendments are to protect consumers in the mortgage market from unfair, abusive, or deceptive lending and servicing practices while preserving responsible lending and sustainable homeownership; ensure that advertisements for mortgage loans provide accurate and balanced information and do not contain misleading or deceptive representations; and provide consumers transaction-specific disclosures early enough to use while shopping.

A. Proposals To Prevent Unfairness, Deception, and Abuse

The Board is proposing seven new restrictions or requirements for mortgage lending and servicing intended to protect consumers against unfairness, deception, and abuse while preserving responsible lending and sustainable homeownership. The restrictions would be adopted under TILA Section 129(l)(2), which authorizes the Board to prohibit unfair or deceptive practices in connection with mortgage loans, as well as to prohibit abusive practices or practices not in the interest of the borrower in connection with refinancings. 15 U.S.C. 1639(l)(2). Some of the restrictions would apply only to higher-priced mortgage loans, while others would apply to all mortgage loans secured by a consumer's principal dwelling.

Protections Covering Higher-Priced Mortgage Loans

The Board is proposing four protections for consumers receiving higher-priced mortgage loans. These loans would be defined as consumer-purpose, closed-end loans secured by a consumer's principal dwelling and having an annual percentage rate (APR) that exceeds the comparable Treasury security by three or more percentage points for first-lien loans, or five or more percentage points for subordinate-lien loans. For higher-priced mortgage loans, the Board proposes to:

○ Prohibit creditors from engaging in a pattern or practice of extending credit without regard to borrowers' ability to repay from sources other than the collateral itself;

○ Require creditors to verify income and assets they rely upon in making loans;

○ Prohibit prepayment penalties unless certain conditions are met; and

○ Require creditors to establish escrow accounts for taxes and insurance, but permit creditors to allow borrowers to opt out of escrows 12 months after loan consummation.

In addition, the proposal would prohibit creditors from structuring closed-end mortgage loans as open-end lines of credit for the purpose of evading these rules, which do not apply to lines of credit.

Protections Covering Closed-End Loans Secured by Consumer's Principal Dwelling

In addition, in connection with all consumer-purpose, closed-end loans secured by a consumer's principal dwelling, the Board is proposing to:

○ Prohibit creditors from paying a mortgage broker more than the consumer had agreed in advance that the broker would receive;

○ Prohibit any creditor or mortgage broker from coercing, influencing, or otherwise encouraging an appraiser to provide a misstated appraisal in connection with a mortgage loan; and

○ Prohibit mortgage servicers from “pyramiding” late fees, failing to credit payments as of the date of receipt, failing to provide loan payoff statements upon request within a reasonable time, or failing to deliver a fee schedule to a consumer upon request.

B. Proposals To Improve Mortgage Advertising

Another goal of this proposal is to ensure that mortgage loan advertisements provide accurate and balanced information and do not contain misleading or deceptive representations. Thus the Board is proposing to require that advertisements for both open-end and closed-end mortgage loans provide accurate and balanced information, in a clear and conspicuous manner, about rates, monthly payments, and other loan features. This proposal is made under the Board's general authority to adopt regulations to ensure consumers are informed about and can shop for credit. TILA Section 105(a), 15 U.S.C. 1604(a).

The Board is also proposing, under TILA Section 129(l)(2), 15 U.S.C. 1639(l)(2), to prohibit the following seven deceptive or misleading practices in advertisements for closed-end mortgage loans:

○ Advertising “fixed” rates or payments for loans whose rates or payments can vary without adequately disclosing that the interest rate or payment amounts are “fixed” only for a limited period of time, rather than for the full term of the loan;

○ Comparing an actual or hypothetical consumer's current rate or payment obligations and the rates or payments that would apply if the consumer obtains the advertised product unless the advertisement states the rates or payments that will apply over the full term of the loan;

○ Advertisements that characterize the products offered as “government loan programs,” “government-supported loans,” or otherwise endorsed or sponsored by a federal or state government entity even though the advertised products are not government-supported or -sponsored loans;

○ Advertisements, such as solicitation letters, that display the name of the consumer's current mortgage lender, unless the advertisement also prominently discloses that the advertisement is from a mortgage lender not affiliated with the consumer's current lender;

○ Advertising claims of debt elimination if the product advertised would merely replace one debt obligation with another;

○ Advertisements that create a false impression that the mortgage broker or lender has a fiduciary relationship with the consumer; and

○ Foreign-language advertisements in which certain information, such as a low introductory “teaser” rate, is provided in a foreign language, while required disclosures are provided only in English.

C. Proposal To Give Consumers Disclosures Early

A third goal of this proposal is to provide consumers transaction-specific disclosures early enough to use while shopping for a mortgage loan. The Board proposes to require creditors to provide transaction-specific mortgage loan disclosures such as the APR and payment schedule for all home-secured, closed-end loans no later than three days after application, and before the consumer pays any fee except a reasonable fee for the originator's review of the consumer's credit history.

The Board recognizes that these disclosures need to be updated to reflect the increased complexity of mortgage products. In early 2008, the Board will begin testing current TILA mortgage disclosures and potential revisions to these disclosures through one-on-one interviews with consumers. The Board expects that this testing will identify potential improvements for the Board to propose for public comment in a separate rulemaking.

II. Consumer Protection Concerns in the Subprime Market

A. Recent Problems in the Mortgage Market

Subprime mortgage loans are made to borrowers who are perceived to have high credit risk. These loans' share of total consumer originations, according to one estimate, reached about nine percent in 2001 and doubled to 20 percent by 2005, where it stayed in 2006.

The resulting increase in the supply of mortgage credit likely contributed to the rise in the homeownership rate from 64 percent in 1994 to a high of 69 percent in 2006—though about 68 percent now—and expanded consumers' access to the equity in their homes. Recently, however, some of this benefit has

eroded. In the last two years, delinquencies and foreclosure starts among subprime mortgages have increased dramatically and reached exceptionally high levels as house price growth has slowed or prices have declined in some areas. The proportion of all subprime mortgages past-due ninety days or more (“serious delinquency”) was about 13 percent in October 2007, more than double the mid-2005 level.

Adjustable-rate subprime mortgages have performed the worst, reaching a serious delinquency rate of nearly 19 percent in October 2007, triple the mid-2005 level. These mortgages have seen unusually high levels of early payment default, or default after only one or two payments or even no payment at all.

Inside Mortgage Finance Publications, Inc.,

The 2007 Mortgage Market Statistical Annual

vol. I (

IMF 2007 Mortgage Market

), at 4.

Delinquency rates calculated from data from First American LoanPerformance on mortgages in subprime securitized pools. Figures include loans on non-owner-occupied properties.

The serious delinquency rate has also risen for loans in alt-A (near prime) securitized pools. According to one source, originations of these loans were 13 percent of consumer mortgage originations in 2006.

Alt-A loans are made to borrowers who typically have higher credit scores than subprime borrowers, but the loans pose more risk than prime loans because they involve small down payments or reduced income documentation, or the terms of the loan are nontraditional and may increase risk. The rate of serious delinquency for these loans has risen to over 3 percent (as of September 2007) from 1 percent only a year ago. In contrast, 1 percent of loans in the prime-mortgage sector were seriously delinquent as of October.

IMF 2007 Mortgage Market,

at 4.

The consequences of default are severe for homeowners, who face the possibility of foreclosure, the loss of accumulated home equity, higher rates for other credit transactions, and reduced access to credit. When foreclosures are clustered, they can injure entire communities by reducing property values in surrounding areas. Higher delinquencies are in fact showing through to foreclosures. Lenders initiated 430,000 foreclosures in the third quarter of 2007, about half of them on subrpime mortgages. This was significantly higher than the quarterly average of 325,000 in the first half of the year, and nearly twice the quarterly average of 225,000 for the past six years.

Estimates are based on data from Mortgage Bankers' Association's

National Delinquency Survey

(2007).

B. The Loosening of Underwriting Standards

Rising delinquencies have been caused largely by a combination of a decline in house price appreciation—and in some areas slower economic growth—and a loosening of underwriting standards. Underwriting standards loosened in large parts of the mortgage market in recent years as lenders—particularly nondepository institutions, many of which have since ceased to exist—competed more aggressively for market share. This loosening was particularly pronounced in the subprime sector, where the frequent combination of several riskier loan attributes—high loan-to-value ratio, payment shock on adjustable-rate mortgages, no verification of borrower income, and no escrow for taxes and insurance—increased the risk of serious delinquency and foreclosure for subprime loans originated in 2005 through early 2007.

Payment shock from rate adjustments within two or three years of origination could make these loans unaffordable to many of the consumers who hold them. Approximately three-fourths of originations in securitized subprime “pools” from 2004 to 2006 were adjustable-rate mortgages (ARMs) with two-or three-year “teaser” rates followed by substantial increases in the rate and payment (so-called “2-28” and “3-27” mortgages).

The burden of these payment increases on the borrower would likely be heavier than expected if the borrower's stated income was inflated, as appears to have happened in some cases, and the inflated figure was used to determine repayment ability. In addition, affordability problems with subprime loans can be compounded by unexpected property tax and homeowners insurance obligations. In the prime market, lenders typically establish escrows for these obligations, but in the subprime market escrows have been the exception rather than the rule.

Figure calculated from First American Loan Performance data.

Delinquencies and foreclosure initiations in subprime ARMs are expected to rise further as more of these mortgages see their rates and payments reset at significantly higher levels. On average in 2008, 374,000 subprime mortgages per quarter are scheduled to undergo their first interest rate and payment reset. Relative to past years, avoiding the payment shock of an interest rate reset by refinancing the mortgage will be much more difficult. Not only have home prices flattened out or declined, thereby reducing homeowners' equity, but borrowers often had little equity to start with because of very high initial cumulative loan-to-value ratios. Moreover, prepayment penalty clauses, which are found in a substantial majority of subprime loans, place an added demand on the limited equity or other resources available to many borrowers and make it harder still for them to refinance. Borrowers who cannot refinance will have to make sacrifices to stay in their homes or could lose their homes altogether.

These effects may be mitigated for some borrowers by a recently-announced agreement among major loan servicers and investors to “freeze” many subprime ARMs at their initial interest rates for five years.

Relaxed underwriting was not limited to the subprime market. According to one estimate, interest-only mortgages (most of them with adjustable rates) and “option ARMs”—which permit borrowers to defer both principal and interest for a time in exchange for higher payments later—rose from 7 percent of total consumer mortgage originations in 2004 to 26 percent in 2006.

By one estimate these mortgages reached 78 percent of alt-A originations in 2006.

These types of mortgages hold the potential for payment shock and increasingly contained additional layers of risk such as loan amounts near the full appraised value of the home, and partial or no documentation of income. For example, the share of interest-only mortgages with low or no documentation in alt-A securitized pools increased from around 60 percent in 2003 to nearly 80 percent in 2006.

Most of these mortgages have not yet reset so their full implications are not yet apparent. The risks to consumers and to creditors were serious enough, however, to cause the federal banking agencies to issue supervisory guidance, which many state agencies later adopted.

IMF 2007 Mortgage Market,

at 6.

David Liu & Shumin Li,

Alt-A Credit—The Other Shoe Drops?,

The MarketPulse (First American LoanPerformance, Inc., San Francisco, Cal.), Dec. 2006.

Figures calculated from First American LoanPerformance data.

Interagency Guidance on Nontraditional Mortgage Product Risks, 71 FR 58609, Oct. 4, 2006.

A decline in underwriting standards does not just increase the risk that consumers will be provided loans they cannot repay. It also increases the risk that originators will engage in an abusive strategy of “flipping” borrowers in a succession of refinancings, ostensibly to lower borrowers' burdensome payments, that strip borrowers' equity and provide them no

benefit. Moreover, an atmosphere of relaxed standards may increase the incidence of abusive lending practices by attracting less scrupulous originators into the market, while at the same time bringing more vulnerable borrowers into the market. These abuses can lead consumers to pay more for their loans than their risk profiles warrant.

The market has responded to the current problems with increasing attention to loan quality. Structural factors, or market imperfections, however, make it necessary to consider regulations to help prevent a recurrence of these problems. New regulation can also provide the market clear “rules of the road” at a time of uncertainty, so that responsible higher-priced lending, which serves a critical need, may continue.

C. Market Imperfections That Can Facilitate Abusive and Unaffordable Loans

The recent sharp increase in serious delinquencies has highlighted the roles that structural elements of the subprime mortgage market may play in increasing the likelihood of injury to consumers who find themselves in that market. Limitations on price and product transparency in the subprime market—often compounded by misleading or inaccurate advertising—may make it harder for consumers to protect themselves from abusive or unaffordable loans, even with the best disclosures. The injuries consumers in the subprime market may suffer as a result are magnified when originators' incentives to carefully assess consumers' repayment ability grow weaker, as can happen when originators sell off their loans to be securitized. The fragmentation of the originator market can further exacerbate the problem by making it more difficult for investors to monitor originators and for lenders to monitor brokers. The multiplicity of originators and their regulators can also inhibit the ability of regulators to protect consumers from abusive and unaffordable loans.

Limited Transparency and Limits of Disclosure

Limited transparency in the subprime market increases the risk that borrowers in that market will receive unaffordable or abusive loans. The transparency of the subprime market to consumers is limited in several respects. First, price information for the subprime market is not widely and readily available to consumers. A consumer searching in the prime market can buy a newspaper or access the Internet and easily find current interest rates from a wide variety of lenders without paying a fee. In contrast, subprime rates, which can vary significantly based on the individual borrower's risk profile, are not broadly advertised. Advertising in the subprime market focuses on easy approval and low payments. Moreover, a borrower shopping in the subprime market generally cannot obtain a useful rate quote from a particular lender without submitting an application and paying a fee. The quote may not even be reliable, as loan originators sometimes use “bait and switch” strategies.

Second, products in the subprime market tend to be complex, both relative to the prime market and in absolute terms, as well as less standardized than in the prime market.

As discussed earlier, subprime originations have much more often had adjustable rates than more easily understood fixed rates. Adjustable-rate mortgages require consumers to make judgments about the future direction of interest rates and translate expected rate changes into changes in their payment amounts. Subprime loans are also far more likely to have prepayment penalties. The price of the penalty is not reflected in the annual percentage rate (APR); to calculate that price, the consumer must both calculate the size of the penalty according to a formula such as six months of interest, and assess the likelihood the consumer will move or refinance during the penalty period. In these and other ways subprime products tend to be complex for consumers.

U.S. Dep't of Hous. & Urban Dev. & U.S. Dep't of Treasury,

Recommendations to Curb Predatory Home Mortgage Lending

17 (2000) (“While predatory lending can occur in the prime market, such practices are for the most part effectively deterred by competition among lenders, greater homogeneity in loan terms and the prime borrowers' greater familiarity with complex financial transactions.”); Howard Lax, Michael Manti, Paul Raca & Peter Zorn,

Subprime Lending: An Investigation of Economic Efficiency (Subprime Lending Investigation),

15 Housing Policy Debate 3, 570 (2004) (stating that the subprime market lacks the “overall standardization of products, underwriting, and delivery systems” that is found in the prime market).

Third, the roles and incentives of originators are not transparent. One source estimates that 60 percent or more of mortgages originated in the last several years were originated through a mortgage broker, often an independent entity, who takes loan applications from consumers and shops them to depository institutions or other lenders.

Anecdotal evidence indicates that consumers in both the prime and subprime markets often believe, in error, that a mortgage broker is obligated to find the consumer the best and most suitable loan terms available. For example, in a 2003 survey of older borrowers who had obtained prime or subprime refinancings, seventy percent of respondents with broker-originated refinance loans reported that they had relied “a lot” on their brokers to find the best mortgage for them.

Consumers who rely on brokers often are unaware, however, that a broker's interests may diverge from, and conflict with, their own interests. In particular, consumers are often unaware that a creditor pays a broker more to originate a loan with a rate higher than the rate the consumer qualifies for based on the creditor's underwriting criteria.

Data reported by Wholesale Access Mortgage Research and Consulting, Inc., available at

http://www.wholesaleaccess.com/8-17-07-prs.shtml; http://www.wholesaleaccess.com/7_28_mbkr.shtml

Kellie K. Kim-Sung & Sharon Hermanson,

Experiences of Older Refinance Mortgage Loan Borrowers: Broker- and Lender-Originated Loans,

Data Digest No. 83 (AARP Public Policy Inst., Washington, DC), Jan. 2003, at 3, available at

http://www.aarp.org/research/credit-debt/mortgages/experiences_of_older_refinance_mortgage_loan_borro.html

Limited shopping

. In this environment of limited transparency, consumers—particularly those in the subprime market—who have been told by an originator that they will receive a loan from that originator may reasonably decide not to shop further among originators or among loan options. The costs of further shopping may be significant, including completing another application form and paying yet another application fee. Delaying receipt of funds is another cost of continuing to shop, a potentially significant one for the many borrowers in the subprime market who are seeking to refinance their obligations to lower their debt payments at least temporarily, to extract equity in the form of cash, or both.

Nearly 90 percent of subprime ARMs used for refinancing in recent years were “cash out.”

See

Anthony Pennington-Cross & Souphala Chomsisengphet,

Subprime Refinancing: Equity Extraction and Mortgage Termination

, 35 Real Estate Economics 2, 233 (2007) (reporting that 49% of subprime refinance loans involve equity extraction, compared with 26% of prime refinance loans); Marsha J. Courchane, Brian J. Surette, and Peter M. Zorn,

Subprime Borrowers: Mortgage Transitions and Outcomes (Subprime Outcomes)

, 29 J. of Real Estate Economics 4, 368-371 (2004) (discussing survey evidence that borrowers with subprime loans are more likely to have experienced major adverse life events (marital disruption; major medical problem; major spell of unemployment; major decrease of income) and often use refinancing for debt consolidation or home equity extraction);

Subprime Lending Investigation

, at 551-552 (citing survey evidence that borrowers with subprime loans have increased incidence of major medical expenses, major unemployment spells, and major drops in income).

Figure calculated from First American LoanPerformance data.

While the cost of continuing to shop is likely obvious, the benefit may not be

clear or may appear quite small. Without easy access to subprime product prices, a consumer who has been offered a loan by one originator may have only a limited idea whether further shopping is likely to produce a better deal. Moreover, consumers in the subprime market have reported in studies that they were turned down by several lenders before being approved.

Once approved, these consumers may see little advantage to continuing to shop if they expect, based on their experience, that many of their applications to other originators would be turned down. Furthermore, if a consumer uses a broker and believes that the broker is shopping for the consumer, the consumer may believe the chance of finding a better deal than the broker is small. An unscrupulous originator may also seek to discourage a consumer from shopping by intentionally understating the cost of an offered loan. For all of these reasons, borrowers in the subprime market may not shop beyond the first approval and may be willing to accept unfavorable terms.

James M. Lacko & Janis K. Pappalardo, Fed. Trade Comm'n,

Improving Consumer Mortgage Disclosures: An Empirical Assessment of Current and Prototype Disclosure Forms (Improving Mortgage Disclosures)

, 24-26 (2007) (reporting evidence based on qualitative consumer interviews); Subprime Lending Investigation, at 550 (finding based on survey data that “[p]robably the most significant hurdle overcome by subprime borrowers * * * is just getting approved for a loan for the first time. This impact might well make subprime borrowers more willing to accept less favorable terms as they become uncertain about the possibility of qualifying for a loan at all.”).

Subprime Outcomes

, at 371-372 (reporting survey evidence that relative to prime borrowers, subprime borrowers are less knowledgeable about the mortgage process, search less for the best rates, and feel they have less choice about mortgage terms and conditions);

Subprime Mortgage Investigation

, at 554 (“Our focus groups suggested that prime and subprime borrowers use quite different search criteria in looking for a loan. Subprime borrowers search primarily for loan approval and low monthly payments, while prime borrowers focus on getting the lowest available interest rate. These distinctions are quantitatively confirmed by our survey.”).

Limited focus

. Consumers considering obtaining a typically complex subprime mortgage loan may simplify their decision by focusing on a few attributes of the product or service that seem most important.

A consumer may focus on loan attributes that have the most obvious and immediate consequence such as loan amount, down payment, initial monthly payment, initial interest rate, and up-front fees (though up-front fees may be more obscure when added to the loan amount, and “discount points” in particular may be difficult for consumers to understand). These consumers, therefore, may not focus on terms that may seem less immediately important to them such as future increases in payment amounts or interest rates, prepayment penalties, and negative amortization. They are also not likely to focus on underwriting practices such as income verification, and on features such as escrows for future tax and insurance obligations.

Consumers who do not fully understand such terms and features, however, are less able to appreciate their risks, which can be significant. For example, the payment may increase sharply and a prepayment penalty may hinder the consumer from refinancing to avoid the payment increase. Thus, consumers may unwittingly accept loans that they will have difficulty repaying.

Jinkook Lee & Jeanne M. Hogarth,

Consumer Information Search for Home Mortgages: Who, What, How Much, and What Else? (Consumer Information Search)

, Financial Services Review 291 (2000) (“In all, there are dozens of features and costs disclosed per loan, far in excess of the combination of terms, lenders, and information sources consumers report using when shopping.”).

Consumer Information Search

, at 285 (reporting survey evidence that most consumers compared interest rate or APR, loan type (fixed-rate or ARM), and mandatory up-front fees, but only a quarter considered the costs of optional products such as credit insurance and back-end costs such as late fees). There is evidence that borrowers are not aware of, or do not understand, terms of this nature even after they have obtained a loan.

See Improving Mortgage Disclosures

, at 27-30 (discussing anecdotal evidence based on consumer interviews that borrowers were not aware of, did not understand, or misunderstood an important cost or feature of their loans that had substantial impact on the overall cost, the future payments, or the ability to refinance with other lenders); Brian Bucks & Karen Pence,

Do Homeowners Know Their House Values and Mortgage Terms?

18-22 (Fed. Reserve Bd. of Governors Fin. and Econ. Discussion Series Working Paper No. 2006-3, 2006) (discussing statistical evidence that borrowers with ARMs underestimate annual as well as life-time caps on the interest rate; the rate of underestimation increases for lower-income and less-educated borrowers), available at

http://www.federalreserve.gov/pubs/feds/2006/200603/200603pap.pdf

Limits of disclosure

. Disclosures describing the multiplicity of features of a complex loan could help some consumers in the subprime market, but disclosures may not be sufficient to protect them against unfair loan terms or lending practices. Obtaining widespread consumer understanding of the many potentially significant features of a typical subprime product is a major challenge.

Moreover, even if all of a loan's features are disclosed clearly to consumers, they may continue to focus on a few features that appear most significant. Alternatively, disclosing all features may “overload” consumers and make it more difficult for them to discern which features are most important.

Improving Mortgage Disclosures

, at 74-76 (finding that borrowers in the subprime market may have more difficulty understanding their loan terms because their loans are more complex than loans in the prime market).

Furthermore, a consumer cannot make effective use of disclosures without having a certain minimum level of understanding of the market and products. Disclosures themselves, likely cannot provide this minimum understanding for transactions that are complex and that consumers engage in infrequently. Moreover, consumers may rely more on their originators to explain the disclosures when the transaction is complex; some originators may have incentives to misrepresent the disclosures so as to obscure the transaction's risks to the consumer; and such misrepresentations may be particularly effective if the originator is face-to-face with the consumer.

Therefore, while the Board anticipates proposing changes to Regulation Z to improve mortgage loan disclosures, it appears unlikely that better disclosures, alone, will address adequately the risk of abusive or unaffordable loans in the subprime market.

U.S. Gen. Accounting Office, GAO 04-280,

Consumer Protection: Federal and State Agencies Face Challenges in Combating Predatory Lending

97-98 (2004) (stating that the inherent complexity of mortgage loans, some borrowers' lack of financial sophistication, education, or infirmities, and misleading statements and actions by lenders and brokers limit the effectiveness of even clear and transparent disclosures).

Misaligned Incentives and Obstacles to Monitoring

Not only are consumers in the subprime market often unable to protect themselves from abusive or unaffordable loans, originators may at certain times be more likely to extend unaffordable loans. The recent sharp rise in serious delinquencies on subprime mortgages has made clear that originators may not give adequate attention to repayment ability if they sell the mortgages they originate and bear little loss if the mortgages default. The growth of the secondary market gave lenders—and, thus, mortgage borrowers—greater access to capital markets, lowered transaction costs, and allowed risk to be shared more widely. This “originate-to-distribute” model, however, may also tend to contribute to the loosening of underwriting standards, particularly during periods of rapid house price appreciation, which may mask problems by keeping default and delinquency rates low until price appreciation slows or reverses.

This potential tendency has several related causes. First, when an originator sells a mortgage and its servicing rights, depending on the terms of the sale, most or all of the risks typically are passed on

to the loan purchaser. Thus, originators who sell loans may have less of an incentive to undertake careful underwriting than if they kept the loans. Second, warranties by sellers to purchasers and other “repurchase” contractual provisions have little meaningful benefit if originators have limited assets. Third, fees for some loan originators have been tied to loan volume, making loan sales—sometimes accomplished through aggressive “push marketing”—a higher priority than loan quality for some originators. Fourth, investors may not exercise adequate due diligence on mortgages in the pools in which they are invested, and may instead rely heavily on credit-ratings firms to determine the quality of the investment.

The fragmentation of the originator market can further exacerbate the problem. Data reported under HMDA show that independent mortgage companies—those not related to depository institutions or their subsidiaries or affiliates—made nearly one-half of higher-priced first-lien mortgages in 2005 and 2006 but only one-fourth of loans that were not higher-priced. Nor was lending by independent mortgage companies particularly concentrated: In each of 2005 and 2006 around 150 independent mortgage companies made 500 or more higher-priced first-lien mortgage loans on owner-occupied dwellings. In addition, one source suggests that 60 percent or more of mortgages originated in the last several years were originated through a mortgage broker.

This same source estimates the number of brokerage companies at over 50,000 in recent years.

Data reported by Wholesale Access Mortgage Research and Consulting, Inc. Available at

http://www.wholesaleaccess.com/8-17-07-prs.shtml; http://www.wholesaleaccess.com/7_28_mbkr.shtml

Thus, a securitized pool of mortgages may have been sourced by tens of lenders and thousands of brokers. Investors have limited ability to directly monitor these originators' activities. Similarly, a lender may receive a handful of loans from each of hundreds or thousands of small brokers every year. A lender has limited ability or incentive to monitor every small brokerage's operations and performance.

Government oversight of such a fragmented originator market faces significant challenges. The various lending institutions and brokers operate in fifty different states and the District of Columbia with different regulatory and supervisory regimes, varying resources for supervision and enforcement, and different practices in sharing information among regulators. State regulatory regimes come under particular pressure when a booming market brings new lenders and brokers into the marketplace more rapidly than regulators can increase their oversight resources. These circumstances may inhibit the ability of regulators to protect consumers from abusive and unaffordable loans.

A Role for New HOEPA Rules

As explained above, consumers in the subprime market face serious constraints on their ability to protect themselves from abusive or unaffordable loans, even with the best disclosures; originators themselves may at times lack sufficient market incentives to ensure loans they sell are affordable; and regulators face limits on their ability to oversee a fragmented subprime origination market. These circumstances appear to warrant imposing a new national legal standard on subprime lenders to help ensure that consumers receive mortgage loans they can afford to repay, and help prevent the equity-stripping abuses that unaffordable loans facilitate. Adopting this standard under authority of HOEPA would ensure that it applied uniformly to all originators and provide consumers an opportunity to redress wrongs through civil actions to the extent authorized by TILA. As explained in the next part, substantial information supplied to the Board through several public hearings confirms the need for new HOEPA rules.

III. The Board's HOEPA Hearings

A. Home Ownership and Equity Protection Act (HOEPA)

The Board has recently held extensive public hearings on consumer protection issues in the mortgage market, including the subprime sector. These hearings were held pursuant to the Home Ownership and Equity Protection Act (HOEPA), which directs the Board to hold public hearings periodically on the home equity lending market and the adequacy of existing law for protecting the interests of consumers, particularly low income consumers. HOEPA imposes substantive restrictions, and special pre-closing disclosures, on particularly high-cost refinancings and home equity loans (“HOEPA loans”).

These restrictions include limitations on prepayment penalties and “balloon payment” loans, and prohibitions of negative amortization and of engaging in a pattern or practice of lending based on the collateral without regard to repayment ability.

HOEPA loans are closed-end, non-purchase money mortgages secured by a consumer's principal dwelling (other than a reverse mortgage) where either: (a)

The

APR at consummation will exceed the yield on Treasury securities of comparable maturity by more than 8 percentage points for first-lien loans, or 10 percentage points for subordinate-lien loans; or (b) the total points and fees payable by the consumer at or before closing exceed the greater of 8 percent of the total loan amount, or $547 for 2007 (adjusted annually).

When it enacted HOEPA, Congress granted the Board authority, codified in TILA Section 129(l), to create exemptions to HOEPA's restrictions and to expand its protections. 15 U.S.C. 1639(l). Under TILA Section 129(l)(1), the Board may create exemptions to HOEPA's restrictions as needed to keep responsible credit available; and under TILA Section 129(l)(2), the Board may adopt new or expanded restrictions as needed to protect consumers from unfairness, deception, or evasion of HOEPA. In HOEPA Section 158, Congress directed the Board to monitor changes in the home equity market through regular public hearings.

Hearings the Board held in 2000 led the Board to expand HOEPA's protections in December 2001.

Those rules, which took effect in 2002, lowered HOEPA's rate trigger, expanded its fee trigger to include single-premium credit insurance, added an anti-“flipping” restriction, and improved the special pre-closing disclosure.

Truth in Lending, 66 FR 65604, 65608, Dec. 20, 2001.

B. Summary of 2006 Hearings

In the summer of 2006, the Board held four hearings in four cities on three broad topics: (1) The impact of the 2002 HOEPA rule changes on predatory lending practices, as well as the effects on consumers of state and local predatory lending laws; (2) nontraditional mortgage products and reverse mortgages; and (3) informed consumer choice in the subprime market. Hearing panelists included mortgage lenders and brokers, credit ratings agencies, real estate agents, consumer advocates, community development groups, housing counselors, academicians, researchers, and state and federal government officials. In addition, consumers, housing counselors, brokers, and other individuals made brief statements at the hearings during an “open mike” period. In all, 67 individuals testified on panels and 54 comment letters were submitted to the Board.

Consumer advocates and some state officials stated that HOEPA is generally effective in preventing abusive terms in loans subject to the HOEPA price triggers. They noted, however, that very

few loans are made with rates or fees at or above the HOEPA triggers, and some advocated that Congress lower them. Consumer advocates and state officials also urged regulators and Congress to curb abusive practices in the origination of loans that do not meet HOEPA's price triggers.

Consumer advocates identified several particular areas of concern. They urged the Board to prohibit or restrict certain loan features or terms, such as prepayment penalties, and underwriting practices such as “stated income” or “low documentation” (“low doc”) loans for which the borrower's income is not documented or verified. They also expressed concern about aggressive marketing practices such as steering borrowers to higher-cost loans by emphasizing initial low monthly payments based on an introductory rate without adequately explaining that the consumer will owe considerably higher monthly payments after the introductory rate expires.

Some consumer advocates stated that brokers and lenders should be held to a higher duty such as a duty of good faith and fair dealing or a duty to make only loans suitable for the borrower. These advocates also urged the Board to ban “yield spread premiums,” payments that brokers receive from the lender at closing for delivering a loan with an interest rate that is higher than the lender's “buy rate,” because they provide brokers an incentive to increase consumers' interest rates. They argued that such steps would align reality with consumers' perceptions that brokers serve their best interests. Consumer advocates also expressed concerns that brokers, lenders, and others may coerce appraisers to misrepresent the value of a dwelling; and that servicers may charge consumers unwarranted fees and in some cases make it difficult for consumers who are in default to avoid foreclosure.

Industry panelists and commenters, on the other hand, expressed concern that state predatory lending laws may reduce the availability of credit for some subprime borrowers. Most industry commenters opposed prohibiting stated income loans, prepayment penalties, or other loan terms, asserting that this approach would harm borrowers more than help them. They urged the Board and other regulators to focus instead on enforcing existing laws to remove “bad actors” from the market. Some lenders indicated, however, that restrictions on certain features or practices might be appropriate if the restrictions were clear and narrow. Industry commenters also stated that subjective suitability standards would create uncertainties for brokers and lenders and subject them to excessive litigation risk.

C. Summary of June 2007 Hearing

In light of the information received at the 2006 hearings and the rise in defaults that began soon after, the Board held an additional hearing in June 2007 to explore how it could use its authority under HOEPA to prevent abusive lending practices in the subprime market while still preserving responsible subprime lending. The Board focused the hearing on four specific areas: Lenders' determination of borrowers' repayment ability; “stated income” and “low doc” lending; the lack of escrows in the subprime market relative to the prime market; and the high frequency of prepayment penalties in the subprime market.

At the hearing, the Board heard from 16 panelists representing consumers, mortgage lenders, mortgage brokers, and state government officials, as well as from academicians. The Board also received almost 100 written comments after the hearing from an equally diverse group.

Industry representatives acknowledged concerns with recent lending practices but urged the Board to address most of these concerns through supervisory guidance rather than regulations under HOEPA. They maintained that supervisory guidance, unlike regulation, is flexible enough to preserve access to responsible credit. They also suggested that supervisory guidance issued recently regarding nontraditional mortgages and subprime lending, as well as market self-correction, have reduced the need for new regulations. Industry representatives support improving mortgage disclosures to help consumers avoid abusive loans. They urged that any substantive rules adopted by the Board be clearly drawn to limit uncertainty and narrowly drawn to avoid unduly restricting credit.

In contrast, consumer advocates, state and local officials, and Members of Congress urged the Board to adopt regulations under HOEPA. They acknowledged a proper place for guidance but contended that recent problems indicate the need for requirements enforceable by borrowers through civil actions, which HOEPA enables and guidance does not. They also expressed concern that less responsible, less closely supervised lenders are not subject to the guidance and that there is limited enforcement of existing laws for these entities. Consumer advocates and others welcomed improved disclosures but insisted they would not prevent abusive lending. More detailed accounts of the testimony and letters are provided below in the context of specific issues the Board is proposing to address.

D. Congressional Hearings

Congress has also held a number of hearings in the past year about consumer protection concerns in the mortgage market.

In these hearings, Congress has heard testimony from individual consumers, representatives of consumer and community groups, representatives of financial and mortgage industry groups and federal and state officials. These hearings have focused on rising subprime foreclosure rates and the extent to which lending practices have contributed to them.

E.g.

Progress in Administration and Other Efforts to Coordinate and Enhance Mortgage Foreclosure Prevention: Hearing before the H. Comm. on Fin. Servs.

, 110th Cong. (2007);

Legislative Proposals on Reforming Mortgage Practices: Hearing before the H. Comm. on Fin. Servs.

, 110th Cong. (2007);

Legislative and Regulatory Options for Minimizing and Mitigating Mortgage Foreclosures: Hearing before the H. Comm. on Fin. Servs.

, 110th Cong. (2007);

Ending Mortgage Abuse: Safeguarding Homebuyers: Hearing before the S. Subcomm. on Hous., Transp., and Cmty. Dev. of the S. Comm. on Banking, Hous., and Urban Affairs

, 110th Cong. (2007);

Improving Federal Consumer Protection in Financial Services: Hearing before the H. Comm. on Fin. Servs.

, 110th Cong. (2007);

The Role of the Secondary Market in Subprime Mortgage Lending: Hearing before the Subcomm. on Fin. Insts. and Consumer Credit of the H. Comm. on Fin. Servs.

, 110th Cong. (2007);

Possible Responses to Rising Mortgage Foreclosures: Hearing before the H. Comm. on Fin. Servs.

, 110th Cong. (2007);

Subprime Mortgage Market Turmoil: Examining the Role of Securitization: Hearing before the Subcomm. on Secs., Ins., and Inv. of the S. Comm. on Banking, Hous., and Urban Affairs

, 110th Cong. (2007);

Subprime and Predatory Lending: New Regulatory Guidance, Current Market Conditions, and Effects on Regulated Financial Institutions: Hearing before the Subcomm. on Fin. Insts. and Consumer Credit of the H. Comm. on Fin. Servs.

, 110th Cong. (2007);

Mortgage Market Turmoil: Causes and Consequences, Hearing before the S. Comm. on Banking, Hous., and Urban Affairs

, 110th Cong. (2007);

Preserving the American Dream: Predatory Lending Practices and Home Foreclosures, Hearing before the S. Comm. on Banking, Hous., and Urban Affairs

, 110th Cong. (2007).

Consumer and community group representatives testified that certain lending terms or practices, such as hybrid adjustable-rate mortgages, prepayment penalties, low or no documentation loans, lack of escrows for taxes and insurance, and failure to consider the consumer's ability to repay have contributed to foreclosures. In addition, these witnesses testified that consumers often believe that mortgage brokers represent their interests and shop on their behalf for the best loan terms. As a result, they argue that consumers do not shop independently to ensure that they are getting the best terms for which they qualify. They also

testified that, because originators sell most loans into the secondary market and do not share the risk of default, brokers and lenders have less incentive to ensure consumers can afford their loans.

Financial services and mortgage industry representatives testified that consumers need better disclosures of their loan terms, but that substantive restrictions on subprime loan terms would risk reducing access to credit for some borrowers. In addition, these witnesses testified that applying a fiduciary duty to the subprime market, such as requiring that a loan be in the borrower's best interest, would introduce subjective standards that would significantly increase compliance and litigation risk. According to these witnesses, some lenders would be less willing to offer loans in the subprime market, making it harder for some consumers to get loans.

IV. Inter-Agency Supervisory Guidance

In December 2005, the Board and the other federal banking agencies responded to concerns about the rapid growth of nontraditional mortgages in the previous two years by proposing supervisory guidance. Nontraditional mortgages are mortgages that allow the borrower to defer repayment of principal and sometimes interest. The guidance advised institutions of the need to reduce “risk layering” practices with respect to these products, such as failing to document income or lending nearly the full appraised value of the home. The proposal, and the final guidance issued in September 2006, specifically advised lenders that layering risks in nontraditional mortgage loans to subprime borrowers may significantly increase risks to borrowers as well as institutions.

Interagency Guidance on Nontraditional Mortgage Product Risks, 71 FR 58609, Oct. 4, 2006.

The Board and the other federal banking agencies addressed concerns about the subprime market more broadly in March 2007 with a proposal addressing the heightened risks to consumers and institutions of ARMs with two or three-year “teaser” rates followed by substantial increases in the rate and payment. The guidance, finalized in June, sets out the standards institutions should follow to ensure borrowers in the subprime market obtain loans they can afford to repay.

Among other steps, the guidance advises lenders to (1) use the fully-indexed rate and fully-amortizing payment when qualifying borrowers for loans with adjustable rates and potentially non-amortizing payments; (2) limit stated income and reduced documentation loans to cases where mitigating factors clearly minimize the need for full documentation of income; (3) provide that prepayment penalty clauses expire a reasonable period before reset, typically at least 60 days.

Statement on Subprime Mortgage Lending, 72 FR 37569, Jul. 10, 2007.

The Conference of State Bank Supervisors (CSBS) and American Association of Residential Mortgage Regulators (AARMR) issued parallel statements for state supervisors to use with state-supervised entities, and many states have adopted the statements.

The guidance issued by the federal banking agencies has helped to promote safety and soundness and protect consumers in the subprime market. Guidance, however, is not necessarily implemented uniformly by all originators. Originators who are not subject to routine examination and supervision may not adhere to guidance as closely as originators who are. Guidance also does not provide individual consumers who have suffered harm because of abusive lending practices an opportunity for redress. The new and expanded consumer protections that the Board is proposing would apply uniformly to all creditors and be enforceable by federal and state supervisory and enforcement agencies and in many cases by borrowers.

V. Legal Authority

A. The Board's Authority Under TILA Section 129(l)(2)

The substantive limitations in new proposed §§ 226.35 and 226.36 and corresponding revisions proposed for existing § 226.32, as well as proposed restrictions on misleading and deceptive advertisements, would be based on the Board's authority under TILA Section 129(l)(2), 15 U.S.C. 1639(l)(2). That provision gives the Board authority to prohibit acts or practices in connection with:

• Mortgage loans that the Board finds to be unfair, deceptive, or designed to evade the provisions of HOEPA; and

• Refinancing of mortgage loans that the Board finds to be associated with abusive lending practices or that are otherwise not in the interest of the borrower.

The authority granted to the Board under Section 129(l)(2), 15 U.S.C. 1639(l)(2), is broad both in absolute terms and relative to HOEPA's statutory prohibitions. For example, this authority reaches mortgage loans with rates and fees that do not meet HOEPA's rate or fee trigger in TILA Section 103(aa), 15 U.S.C. 1602(aa), as well as types of mortgage loans not covered under that section, such as home purchase loans. Nor is the Board's authority limited to regulating specific contractual terms of mortgage loan agreements; it extends to regulating loan-related practices generally, within the standards set forth in the statute. Moreover, while HOEPA's current restrictions apply only to creditors and only to loan terms or lending practices, TILA Section 129(l)(2) is not limited to creditors, nor is it limited to loan terms or lending practices.

See

15 U.S.C. 1639(l)(2). It authorizes protections against unfair or deceptive practices when such practices are “in connection with mortgage loans,” and it authorizes protections against abusive practices “in connection with refinancing of mortgage loans.”

HOEPA does not set forth a standard for what is unfair or deceptive, but the Conference Report for HOEPA indicates that, in determining whether a practice in connection with mortgage loans is unfair or deceptive, the Board should look to the standards employed for interpreting state unfair and deceptive trade practices acts and the Federal Trade Commission Act, Section 5(a), 15 U.S.C. 45(a).

H.R. Rep. 103-652, at 162 (1994) (Conf. Rep.).

Congress has codified standards developed by the Federal Trade Commission for determining whether acts or practices are unfair under Section 5(a), 15 U.S.C. 45(a).

Under the Act, an act or practice is unfair when it causes or is likely to cause substantial injury to consumers which is not reasonably avoidable by consumers themselves and not outweighed by countervailing benefits to consumers or to competition. In addition, in determining whether an act or practice is unfair, the FTC is permitted to consider established public policies, but public policy considerations may not serve as the primary basis for an unfairness determination.

See

15 U.S.C. 45(n); Letter from FTC to the Hon. Wendell H. Ford and the Hon. John C. Danforth (Dec. 17, 1980).

15 U.S.C. 45(n).

The FTC has interpreted these standards to mean that consumer injury is the central focus of any inquiry regarding unfairness.

Consumer injury may be substantial if it imposes a small harm on a large number of consumers, or if it raises a significant risk of

concrete harm.

The FTC looks to whether an act or practice is injurious in its net effects.

The agency has also observed that an unfair act or practice will almost always reflect a market failure or market imperfection that prevents the forces of supply and demand from maximizing benefits and minimizing costs.

In evaluating unfairness, the FTC looks to whether consumers' free market decisions are unjustifiably hindered.

Statement of Basis and Purpose and Regulatory Analysis, Credit Practices Rule (Credit Practices Rule), 42 FR 7740, 7743 March 1, 1984.

Letter from Commissioners of the FTC to the Hon. Wendell H. Ford, Chairman, and the Hon. John C. Danforth, Ranking Minority Member, Consumer Subcomm. of the H. Comm. on Commerce, Science, and Transp., n.12 (Dec. 17, 1980).

Credit Practices Rule, 42 FR at 7744.

Credit Practices Rule at 7744.

The FTC has also adopted standards for determining whether an act or practice is deceptive (though these standards, unlike unfairness standards, have not been incorporated into the FTC Act).

First, there must be a representation, omission or practice that is likely to mislead the consumer. Second, the act or practice is examined from the perspective of a consumer acting reasonably in the circumstances. Third, the representation, omission, or practice must be material. That is, it must be likely to affect the consumer's conduct or decision with regard to a product or service.

Letter from James C. Miller III, Chairman, FTC to the Hon. John D. Dingell, Chairman, H. Comm. on Energy and Commerce (Dingell Letter) (Oct. 14, 1983).

Dingell Letter at 1-2.

Many states also have adopted statutes prohibiting unfair or deceptive acts or practices, and these statutes employ a variety of standards, many of them different from the standards currently applied to the FTC Act. A number of states follow an unfairness standard formerly used by the FTC. Under this standard, an act or practice is unfair where it offends public policy; or is immoral, unethical, oppressive, or unscrupulous; and causes substantial injury to consumers.

Some states require that a finding of deception be supported by a showing of intent to deceive, while other states only require showing that an act or practice is capable of being interpreted in a misleading way.

See, e.g., Kenai Chrysler Ctr., Inc.

Denison,

167 P.3d 1240, 1255 (2007) (quoting

FTC

Sperry & Hutchinson Co.,

405 U.S. 233, 244-45 n.5 (1972));

State

Moran,

151 N.H. 450, 452, 861 A.2d 763, 755-56 (2004) (concurrently applying the FTC's former test and a test under which an act or practice is unfair or deceptive if “the objectionable conduct * * * attain[s] a level of rascality that would raise an eyebrow of someone inured to the rough and tumble of the world of commerce.”) (citation omitted);

Robinson

Toyota Motor Credit Corp.,

201 Ill. 2d 403, 417-418, 775 N.E.2d 951, 961-62 (2002) (quoting 405 U.S. at 244-45 n.5).

Compare Robinson,

201 Ill. 2d at 417 (showing of intent to deceive required under Illinois Consumer Fraud Act)

with Kenai Chrysler Ctr.,

167 P.3d at 1255 (no showing of intent to deceive required under Alaska Unfair Trade Practices Act).

In proposing rules under TILA Section 129(l)(2)(A), 15 U.S.C. 1639(l)(2)(A), the Board has considered the standards currently applied to the FTC Act's prohibition against unfair or deceptive acts or practices, as well as the standards applied to similar state statutes.

B. The Board's Authority Under TILA Section 105(a)

Other aspects of this proposal are based on the Board's general authority under TILA Section 105(a) to prescribe regulations necessary or proper to carry out TILA's purposes. 15 U.S.C. 1604(a). This section is the basis for the proposal to require early disclosures for residential mortgage transactions as well as many of the proposals to improve advertising disclosures. These proposals are intended to carry out TILA's purposes of informing consumers about their credit terms and helping them shop for credit. See TILA Section 102, 15 U.S.C. 1603.

VI. Proposed Definition of “Higher-Priced Mortgage Loan”

A. Overview

The Board proposes to extend certain consumer protections to a subset of consumer residential mortgage loans referred to as “higher-priced mortgage loans.” A creditor would be prohibited from engaging in a pattern or practice of making higher-priced mortgage loans based on the collateral without regard to repayment ability. A creditor would also be prohibited from making an individual higher-priced mortgage loan without: Verifying the consumer income and assets the creditor relied upon to make the loan; and establishing an escrow account for taxes and insurance. In addition, a higher-priced mortgage loan would not be permitted to have a prepayment penalty except under certain conditions. Finally, a creditor would be prohibited from structuring a closed-end mortgage loan as an open-end line of credit for the purpose of evading the restrictions on higher-priced mortgage loans, which would not apply to open-end lines of credit.

This part VI discusses the proposed definition of a “higher priced mortgage loan” and a discussion of the specific protections that would apply to these loans follows in part VII. The Board is proposing to apply certain other restrictions to closed-end consumer mortgage loans secured by the consumer's principal dwelling without regard to loan price. These restrictions are discussed separately in part VIII.

Higher-priced mortgage loans would be defined as consumer credit transactions secured by the consumer's principal dwelling for which the APR on the loan exceeds the yield on comparable Treasury securities by at least three percentage points for first-lien loans, or five percentage points for subordinate lien loans. The proposed definition would include home purchase loans, refinancings of loans, and home equity loans. The definition would exclude home equity lines of credit (“HELOCs”). In addition, there would be exclusions for reverse mortgages, construction-only loans, and bridge loans.

The definition of “higher-priced mortgage loans” would appear in proposed § 226.35(a). Such loans would be subject to the restrictions and requirements in § 226.35(b) concerning repayment ability, income verification, prepayment penalties, escrows, and evasion, except that subordinate-lien higher-priced mortgage loans would not be subject to the escrow requirement.

B. Public Comment on the Scope of New HOEPA Rules

The June 14, 2007 hearing notice solicited comment on the following questions concerning coverage:

• Whether terms or practices discussed in the hearing notice should be prohibited or restricted for all mortgage loans, or only for loans offered to subprime borrowers?

• Whether terms or practices should be prohibited or restricted for loans to first-time homebuyers, home purchase loans, or refinancings and home equity loans?

• Whether terms or practices should be prohibited or restricted only for certain products, such as adjustable-rate mortgages or nontraditional mortgages?

Many commenters addressed the scope of any rules the Board might propose. Some consumer and community groups favored applying some or all prohibitions to the entire mortgage market, though other groups recommended that certain protections (e.g., for repayment ability) be applied to the entire market and others (e.g., for escrows) only to subprime and nontraditional loans. In general, financial institutions and financial services groups maintained that new rules should not be applied to the entire market.

Most commenters suggested that, to the extent the Board targets subprime

loans, it do so based on loan characteristics rather than borrower characteristics such as credit score. Some commenters proposed that coverage be determined by a loan's annual percentage rate (APR) and suggested various approaches based on lender reporting of “higher-priced loans” under Regulation C, which implements the Home Mortgage Disclosure Act (HMDA). Several industry commenters, however, pointed out drawbacks of using an approach based on HMDA reporting and advocated instead that the Board cover only loans with “payment shock.”

C. General Principles Governing the Board's Determination of Coverage

Four main principles will guide the Board's determination of appropriate coverage. First, new regulations should be applied as broadly as needed to protect consumers from actual or potential injury, but not so broadly that the costs, including the always-present risk of unintended consequences, would clearly outweigh the benefits. Evidence that consumers have actually been injured by a particular practice in a particular market segment is important to determining proper coverage. Protection may also be needed in a particular segment, however, to prevent potential future injury in that segment or to limit adverse effects should lenders circumvent protections applied to another segment.

Second, the most practical and effective way to protect borrowers is to apply protections based on loan characteristics, rather than borrower characteristics. Identifying a class of protected borrowers would present operational difficulties and other problems. For example, it is common to distinguish borrowers by credit score, with lower-scoring borrowers generally considered to be at higher risk of injury in the mortgage market. Defining the protected field as lower-scoring consumers would fail to protect higher-scoring consumers “steered” to loans meant for lower-scoring consumers. Moreover, the market uses different commercial scores, and choosing a particular score as the benchmark for a regulation could give unfair advantage to the company that provides that score.

Third, the rule identifying higher-priced loans should be as simple as reasonably possible, consistent with protecting consumers and minimizing costs. For the sake of simplicity, the same coverage rule should apply to all new protections except where the benefit of tailoring coverage criteria to specific protections outweighs the increased complexity.

Fourth, the rule should give lenders a reasonable degree of certainty during the application process regarding whether a transaction, when completed, will be covered by a particular protection. For some protections, reasonable certainty may be needed early in the application process; for other protections, it may not be needed until later. Reasonable certainty does not mean complete certainty. A rule that would provide lenders complete certainty about coverage early in the application process is likely not achievable.

D. Types of Loans Proposed To Be Covered Under § 226.35

The Board's proposed definition of “higher-priced mortgage loan” has two main aspects. The first aspect is loan type—the definition includes certain types of loans (such as home purchase loans) and excludes others (such as HELOCs). The second aspect is loan price—the definition includes only loans with APRs exceeding specified thresholds. The first aspect of the definition, loan type, is discussed immediately below, and the second is discussed thereafter.

The Board proposes to apply the protections of § 226.35 to first-lien, as well as subordinate-lien, closed-end mortgage loans secured by the consumer's principal dwelling, including home purchase loans, refinancings of loans, and home equity loans. The proposed definition would not cover loans that do not have primarily a consumer purpose, such as loans for real estate investment. The proposed definition also would not cover HELOCs, reverse mortgages, construction-only loans, or bridge loans.

Coverage of Home Purchase Loans, Refinancings, and Home Equity Loans

The statutory protections for HOEPA loans are generally limited to closed-end refinancings and home equity loans.

See

TILA Section 103(aa), 15 U.S.C. 1602(aa). The Board proposes to apply the protections of § 226.35 to loans of these types, which have historically presented the greatest risk to consumers. These loans are often made to consumers who have home equity and, therefore, have an existing asset at risk. These loans also can be marketed aggressively by originators to homeowners who may not benefit from them and who, if responding to the marketing and not shopping independently, may have limited information about their options.

The Board proposes to use its authority under TILA Section 129(l)(2), 15 U.S.C. 1639(l)(2), to cover home purchase loans as well. Covering only refinancings of home purchase loans would fail to protect consumers adequately. From 2003 to 2006, 44 percent of the higher-risk ARMs that came to dominate the subprime market in recent years were extended to consumers to purchase a home.

Delinquencies on subprime ARMs used for home purchase have risen sharply just as they have for refinancings. Moreover, comments and testimony at the Board's hearings indicate that the problems with abusive lending practices are not confined to refinancings and home equity loans.

Figure calculated from First American LoanPerformance data.

Furthermore, consumers who are seeking home purchase loans can face unique constraints on their ability to make decisions. First-time homebuyers are likely unfamiliar with the mortgage market. Homebuyers generally are primarily focused on acquiring a new home, arranging to move into it, and making other life plans related to the move, such as placing their children in new schools. These matters can occupy much of the time and attention consumers might otherwise devote to shopping for a loan and deciding what loan to accept. Moreover, even if the consumer comes to understand later in the application process that an offered loan may not be appropriate, the consumer may not be able to reject the loan without risk of abrogating the sales agreement and losing a substantial deposit, as well as disrupting moving plans.

Coverage of Subordinate-Lien Loans

The Board is proposing to apply the proposed new protections—with the exception of the requirement to establish escrows—to subordinate-lien loans. (The reasons for this exception are discussed below under part VII.D.) The Board seeks comment on whether other exceptions would be appropriate. For example, should the Board limit coverage of all or some of the proposed restrictions to certain kinds of subordinate-lien loans such as “piggy backs” to first-lien loans, or subordinate-lien loans that are larger than the first-lien loan?

Limitation to Loans Secured by Principal Dwelling; Exclusion of Loans for Investment

The Board is proposing to limit the protections in proposed § 226.35 to loans secured by the consumer's principal dwelling. The Board's primary concern is to ensure that consumers not lose the homes they principally occupy

because of unfair, abusive, or deceptive lending practices. The inevitable costs of new regulation, including potential unintended consequences, can most clearly be justified when people's principal homes are at stake.

Limiting the proposed protections to loans secured by the principal dwelling would have the effect of excluding many, but not all, loans to purchase second homes. A loan to a consumer to purchase a second home, for example, would not be covered by these protections if the loan was secured only by the second home or by another dwelling (such as an investment property) other than the consumer's principal dwelling. Such a loan would, however, be covered if it was instead secured by the consumer's principal dwelling.

Limiting the proposed protections to loans secured by the principal dwelling—and to loans having primarily a consumer purpose—would also have the effect of excluding loans primarily for a real estate investment purpose. This exclusion is consistent with TILA's focus on consumer concerns and its exclusion in Section 104 of credit primarily for business, commercial, or agricultural purposes.

See

15 U.S.C. 1603(1). Real estate investors are expected to be more sophisticated than ordinary consumers about the real estate financing process and to have more experience with it, especially if they invest in several properties. Accordingly, the need to protect investors is not clear, and in any event is likely not sufficient to justify the potential unintended consequences of imposing restrictions, with civil liability if they are violated, on the financing of real estate investment transactions.

The Board shares concerns that individuals who invest in residential real estate and do not pay their mortgage obligations put tenants at risk of eviction in the event of foreclosure. Regulating the rights of landlords and tenants, however, is traditionally a matter for state and local law. The Board believes that state and local law could better address this particular tenant protection concern than a Board regulation.

Exclusion of HELOCs

The Board proposes to exclude HELOCs from the proposed protections. These transactions do not appear to present as clear a need for new regulations as closed-end transactions. Most originators of HELOCs hold them in portfolio rather than sell them, which aligns these originators' interests in loan performance more closely with their borrowers' interests. In addition, TILA and Regulation Z provide borrowers special protections for HELOCs such as restrictions on changing plan terms. And, unlike originations of higher-priced closed-end mortgage loans, HELOC originations are concentrated in the banking and thrift industries, where the federal banking agencies can use supervisory authorities to protect borrowers. For example, when inadequate underwriting of HELOCs unduly increased risks to originators and consumers several years ago, the agencies responded with guidance.

For these reasons, the Board is not proposing to cover HELOCs.

Interagency Credit Risk Guidance for Home Equity Lending, May 16, 2005.

Available at

http://www.federalreserve.gov/boarddocs/srletters/2005/sr0511a1.pdf.

Addendum to Credit Risk Guidance for Home Equity Lending, Sept. 29, 2006. Available at

http://www.federalreserve.gov/BoardDocs/SRLetters/2006/SR0615a3.pdf.

The Board recognizes, however, that HELOCs may represent a risk of circumvention. Creditors may seek to evade limitations on closed-end transactions by structuring such transactions as open-end transactions. In proposed § 226.35(b)(5), discussed below in part VII.F., the Board proposes to prohibit structuring a closed-end loan as an open-end transaction for the purpose of evading the new rules in § 226.35. To the extent it may instead be appropriate to apply those rules directly to HELOCs, the Board seeks comment on how an APR threshold for HELOCs could be set to achieve the objectives, discussed further in subpart E., of covering the subprime market and generally excluding the prime market.

Exclusion of Reverse Mortgages and Construction-Only Loans

The Board proposes to exclude reverse mortgages and construction-only loans from the new protections in § 226.35(b). A reverse mortgage is defined in current § 226.33(a), and the proposal would retain this definition. The Board heard from panelists about reverse mortgages at its 2006 HOEPA hearings and has not identified significant abuses in the reverse mortgage market. Moreover, reverse mortgages are unique transactions that present unique risks that are currently addressed by Regulation Z § 226.33. At an appropriate time, the Board will review § 226.33 and consider whether new or different protections are needed for reverse mortgages.

The Board would also exclude from § 226.35's protections a construction-only loan, defined as a loan solely for the purpose of financing the initial construction of a dwelling, consistent with the definition of a “residential mortgage transaction” in § 226.2(a)(24). A construction-only loan would not include the permanent financing that replaces a construction loan. Construction-only loans do not appear to present the same risk of consumer abuse as other loans the proposal would cover. The permanent financing, or a new home-secured loan following construction, would be covered by proposed § 226.35. Applying § 226.35 to construction-only loans, which generally have higher interest rates than the permanent financing, could hinder some borrowers' access to construction financing without meaningfully enhancing consumer protection.

Exclusion of Bridge Loans

Proposed § 226.35(a)(5) would exempt from § 226.35 temporary or “bridge loans” with a term of no more than twelve months. The regulation would give as an example a loan that a consumer takes to “bridge” between the purchase of a new dwelling and the sale of the consumer's existing dwelling. HOEPA now covers certain bridge loans with rates or fees high enough to make them HOEPA loans. TILA Section 129(l)(1) provides the Board authority to exempt classes of mortgage transactions from HOEPA if the Board finds that the exemption is in the interest of the borrowing public and will apply only to products that maintain and strengthen homeownership and equity protection. 15 U.S.C. 1639(l)(2). The Board believes a narrow exemption from HOEPA for bridge loans would be in borrowers' interest and support homeownership. The Board seeks comment on the proposed exemption.

E. Proposed APR Trigger for § 226.35

Overview

The Board proposes to use an APR trigger to define the range of transactions that would be covered by the protections of proposed § 226.35. The Board seeks to set the trigger at a level that would capture the subprime market but generally exclude the prime market. There is, however, inherent uncertainty as to what level would achieve these objectives. The Board believes that it may be appropriate, in the face of this uncertainty, to err on the side of covering somewhat more than the subprime market. Based on this approach, the Board proposes a threshold of three percentage points above the comparable Treasury security for first-lien loans, or five percentage points for subordinate-lien loans. Based on available data, it appears that this threshold would capture at least the

higher-priced end of the alt-A market. The Board seeks comment, and solicits data, on the extent to which the threshold would cover the alt-A market, and on the benefits and costs, including any potential unintended consequences for consumers, of applying any or all of the protections in § 226.35 to the alt-A market to the extent it would be covered. The Board also seeks comment on whether a different threshold, such as four percentage points for first-lien loans (and six percentage points for subordinate-lien loans), would better satisfy the objectives of covering the subprime market, excluding the prime market, and avoiding unintended consequences for consumers in the alt-A market.

Reasons To Use APR

The APR corresponds closely to credit risk, that is, the risk of default as well as the closely related risks of serious delinquency and foreclosure. Loans with higher APRs generally have higher credit risks, whatever the source of the risk might be—weaker borrower credit histories, higher borrower debt-to-income ratios, higher loan-to-value ratios, less complete income or asset documentation, less traditional loan terms or payment schedules, or combinations of these or other risk factors. Since disclosing an APR has long been required by TILA, the figure is also very familiar and readily available to creditors and consumers. Therefore, the Board believes it appropriate to use a loan's APR to identify loans having a high enough credit risk to warrant the protections of proposed § 226.35.

The APR for two loans with identical risk characteristics can be different at different times solely because of market changes in mortgage rates. The Board proposes to control for such market changes by comparing a loan's APR to the yield on the comparable Treasury security. This would be similar, but not identical, to the approach HOEPA uses currently to identify HOEPA-covered loans,

see

TILA Section 103(aa), 15 U.S.C. 1602(aa), and § 226.32(a), and Regulation C uses to identify higher-priced loans reportable under HMDA,

see

12 CFR 203.4(a)(12). The Board is aware of concerns that the method that these regulations use to match mortgage loans to Treasuries leads to some inaccuracy in coverage and makes coverage vary with changes in the yield curve (the relationship between short-term and long-term interest rates). As discussed in more detail below, the Board is proposing to address these concerns in the context of § 226.35.

Coverage Objectives

The Board set forth above a general principle that new regulations should be applied as broadly as needed to protect consumers from actual or potential injury, but not so broadly that the costs, including the always-present risk of unintended consequences, would clearly outweigh the benefits. Consistent with this principle, the Board believes that the APR threshold should satisfy two objectives. It should ensure that subprime loans are covered. Second, it should also generally exclude prime loans.

The subprime market should be covered because it is, by definition, the market with the highest credit risk. There are of course variations in risk within the subprime market. For example, delinquencies on fixed-rate subprime mortgages have been lower in recent years than on adjustable-rate subprime mortgages. It may not be practical or effective, however, to target certain loans in the subprime market for coverage while excluding others. Such a rule would be more complex and possibly require frequent updating as products evolved. Moreover, market imperfections discussed in part II.C.—the subprime market's lack of transparency and potentially inadequate creditor incentives to make only loans that consumers can repay—affect the subprime market as a whole.

There are two principal reasons why the Board seeks to exclude the prime market from § 226.35. First, there is limited evidence that the problems addressed in § 226.35, such as lending without regard to repayment ability, have been significant in the prime market or gone unaddressed when they have on occasion arisen. By nature, loans in the prime market have a lower credit risk, as seen in the relatively low default and delinquency rates for prime loans compared to sharply increasing rates for subprime loans since 2005. Moreover, the prime market is more transparent and competitive, characteristics that make it less likely a creditor can sustain an unfair, abusive, or deceptive practice. In addition, borrowers in the prime market are less likely to be under the degree of financial stress that tends to weaken the ability of many borrowers in the subprime market to protect themselves against unfair, abusive, or deceptive practices. To be sure, there have been concerns about the prime market, and this proposal would address some of them. For example, the proposal addresses concerns about coercion of appraisers, untransparent creditor payments to mortgage brokers, and abusive servicing practices.

Second, any undue risks to consumers in the prime market from particular loan terms or lending practices can be adequately addressed through means other than new regulations under HOEPA. Supervisory guidance from the federal agencies influences a large majority of the prime market which, unlike the subprime market, has been dominated by federally supervised institutions.

Such guidance affords regulators and institutions alike more flexibility than a regulation, with potentially fewer unintended consequences. In addition, the Government Sponsored Enterprises continue to play a major role in the prime market, and they are accountable to regulators and policy makers for the standards they set for loans they will purchase.

According to HMDA data from 2005 and 2006, more than three-quarters of prime, conventional first-lien mortgage loans on owner-occupied properties were made by depository institutions or their affiliates. For this purpose, a loan for which price information was not reported is treated as a prime loan.

According to HMDA data from 2005 and 2006, nearly 30 percent of prime, conventional first-lien mortgage loans on owner-occupied properties were purchased by Fannie Mae or Freddie Mac.

For these reasons, the Board does not believe that substantive restrictions on loan terms or lending practices are warranted in the prime market at this time. The need for such restrictions is not clear and their potential unintended consequences could be significant.

Inherent Uncertainty of Meeting Coverage Objectives

There are three major reasons why it is inherently uncertain which APR threshold would achieve the twin objectives of covering the subprime market and generally excluding the prime market. First, there is no single, precise, and uniform definition of the prime or subprime market, or of a prime or subprime loan. Moreover, the markets are separated by a somewhat loosely defined segment known as the alt-A market, the precise boundaries of which are not clear.

Second, available data sets enable only estimation, not precise calculation, of the empirical relationship between APR and credit risk. A proprietary dataset such as First American LoanPerformance may contain detailed information on loan characteristics, including the contract rate, but lack the APR or sufficient data to derive the APR. Other data must be consulted to estimate APRs based on contract rates. HMDA data contain the APR for higher-priced loans (as adjusted by comparable Treasury securities), but they have little information about credit risk.

Third, data sets can of course show only the existing or past distribution of loans across market segments, which may change in ways that are difficult to predict. In particular, the distribution could change in response to the Board's imposition of the restrictions in § 226.35, but the likely direction of the change is not clear. A loan's APR is typically not known to a certainty until after the underwriting has been completed, and not until closing if the consumer has not locked the interest rate. Creditors might build in a “cushion” against this uncertainty by voluntarily setting their internal thresholds lower than the threshold in the regulation.

Creditors would have a competing incentive to avoid the restrictions, however, by restructuring the prices of potential loans that would have APRs just above the threshold to cause the loans' APRs to come under the threshold. Different combinations of interest rate and points that are economically identical for an originator produce different APRs. If proposed § 226.35 were adopted, an originator would have an incentive to achieve a rate-point combination that would bring a loan's APR below the threshold (if the borrower had the resources or equity to pay the points). Moreover, some fees, such as late fees and prepayment penalties, are not included in the APR. Creditors could increase the number or amounts of such fees to maintain a loan's effective price while lowering its APR below the threshold. It is not clear whether the net effect of these competing forces of over-compliance and circumvention would be to capture more, or fewer, loans.

For all of the above reasons, there is inherent uncertainty as to what APR threshold would achieve the objectives of covering the subprime market and generally excluding the prime market.

The Alt-A Market

In the face of this uncertainty, deciding on an APR threshold calls for judgment. The Board believes it may be appropriate to err on the side of covering somewhat more than the subprime market. In effect, this could mean covering part of the alt-A market, a possibility that merits special consideration.

The alt-A market is generally understood to be for borrowers who typically have higher credit scores than subprime borrowers but still pose more risk than prime borrowers because they make small down payments or do not document their incomes, or for other reasons. The definition of this market is not precise, however. Moreover, the size and character of this market segment have changed markedly in a relatively short period. According to one source, it was 2 percent of residential mortgage originations in 2003 and 13 percent in 2006.

At least part of this growth was due to increasing flexibility of underwriting standards. For example, in 2006, 80 percent of loans originated for alt-A securitized pools were underwritten without full documentation of income, compared to about 60 percent from 2000 to 2004.

At the same time, nontraditional mortgages allowing borrowers to defer principal, or both principal and interest, also expanded, reaching 78 percent of alt-A originations in 2006.

IMF 2007 Mortgage Market

, at 4.

Figures calculated from First American LoanPerformance data.

David Liu & Shumin Li,

Alt A Credit—The Other Shoe Drops?

, The MarketPulse The MarketPulse (First American LoanPerformance, Inc., San Francisco, Cal.), Dec. 2006.

The Board recognizes that risks to consumers in the alt-A market are lower than risks in the subprime market. The Board believes, however, that it may be appropriate to cover at least part of the alt-A market with the protections of § 226.35. Because of the inherent uncertainties in setting an APR threshold discussed above, covering part of the alt-A market may be necessary to ensure consistent coverage of the subprime market. Moreover, to the extent § 226.35 were to cover the higher-priced end of the alt-A market, where several risks may be layered, the regulation may benefit consumers more than it would cost them. For example, applying an income verification requirement to the riskier part of the alt-A market could ameliorate injuries to consumers from lending based on inflated incomes without necessarily depriving consumers of access to credit, if they are able to document their incomes as § 226.35(b)(2) would require. Prohibiting lending without regard to repayment ability in this market slice could reduce the risk to consumers from “payment shock” on nontraditional loans. At the same time, the Board recognizes the potential for unintended consequences if § 226.35 restrictions were to cover part of the alt-A market and seeks to minimize those consequences.

The Proposed Thresholds of 3 and 5 Percentage Points

Based on the foregoing considerations, the Board is proposing to set the APR threshold for a loan at three percentage points above the comparable Treasury security, or five percentage points in the case of a subordinate-lien loan. Available data indicate that this threshold would capture the subprime market but generally exclude the prime market. In each of the last two years, the percentage of the first-lien mortgage market Regulation C has captured as higher-priced using a threshold of three percentage points has been greater than the percentage of the total market originations that one industry source has estimated to be subprime (25 percent vs. 20 percent in 2005; 28 percent vs. 20 percent in 2006).

Regulation C is not thought, however, to have reached the prime market. Rather, in both years it reached into the alt-A market, which the same source estimated to be 12 percent in 2005 and 13 percent in 2006. In 2004, Regulation C captured a significantly smaller part of the market than an industry estimate of the subprime market (11 percent vs. 19 percent), but that year's HMDA data were somewhat anomalous.

For industry estimates see

IMF 2007 Mortgage Market

, at 4.

The principal cause of the reporting deficit was the unusually steep yield curve that characterized 2004. For purposes of proposed § 226.35(a), the Board is proposing to adjust the method that Regulation C uses to calculate the higher-priced loan threshold to reduce, though not eliminate, the effects of yield curve changes on § 226.35's coverage. This proposal is discussed below.

The Board does not have data indicating how closely the proposed threshold of five percentage points for subordinate-lien loans would correspond to the subprime home equity market. It is the Board's understanding, however, that this threshold, which has prevailed in Regulation C since 2004, has been at least roughly accurate.

Requests for Comment

The Board seeks comment, and supporting data, on whether different thresholds would better satisfy the objectives of covering the subprime market and generally excluding the prime market. The Board seeks comment and data both as to first-lien loans and as to subordinate-lien loans; and both as to home purchase loans and as to refinancings. The Board also seeks comment and supporting data on the extent to which the proposed threshold would cover the alt-A market and, as discussed above, on the costs and benefits of such coverage. Moreover, the Board seeks comment on whether a different threshold than that proposed, such as four percentage points for first-lien loans (and six percentage points for subordinate-lien loans), would better satisfy the objectives of covering the subprime market, excluding the prime market, and avoiding unintended

consequences for consumers in the alt-A market.

The Board also seeks comment on the extent to which lenders may set an internal threshold lower than that set forth in the regulation to ensure compliance, and the consequences that could have for consumers. Conversely, the Board seeks comment on the extent of the risk creditors would circumvent the proposed restrictions by charging more fees and lower interest rates to reduce their loans' APRs, and the consequences that could have for consumers. Is this risk significant enough to warrant addressing separately. For example, should the Board adopt a separate fee trigger? What fees would such a trigger include and at what level would it be set? Alternatively, would a general prohibition on manipulating the APR to circumvent the protections of § 226.35 be practicable?

F. Mechanics of the Proposed APR Trigger

Under Regulation C, price information on a closed-end, first-lien loan is reported if the loan's APR exceeds by three or more percentage points (five if the loan is secured by a subordinate lien) the yield on Treasury securities having a comparable period of maturity. A lender uses the yield on Treasury securities as of the 15th day of the preceding month if the rate is set between the 1st and the 14th day of the month, and as of the 15th of the current month if the rate is set on or after the 15th day. Although the Board proposes to use the same numerical thresholds, the Board proposes to use somewhat different rules for matching mortgage loans to Treasury securities.

Matching Loans to Treasury Securities

For purposes of this rulemaking, the Board proposes to use a different approach than Regulation C uses to match loans to Treasury securities, with the intent of reducing effects solely from changes in the interest rate environment. Following the model of HOEPA (TILA Section 103(aa), 15 U.S.C. 1603(aa)), Regulation C compares the APR on a loan to the yield on Treasury securities having a period of maturity comparable to the maturity of the loan. 12 CFR 203.4(a)(12). For example, the APR on a fixed-rate, 30-year loan—the most common loan term in the market—is compared to the yield on a 30-year Treasury security. In actuality, mortgage loans are usually paid off long before they mature, typically in five to ten years. Rates on fixed-rate 30-year mortgage loans, therefore, more closely track yields on Treasury securities having maturities in the range of five to ten years rather than yields on 30-year Treasury securities. Rates on adjustable-rate mortgages more closely track yields on Treasury securities that mature in one to five years, depending in part on the duration of any initial fixed-rate period. As a result, changes in the relationship of short-term rates to long-term rates, known as the yield curve, have affected reporting of higher-priced mortgage loans.

For purposes of the rules proposed here, the Board's goal is to reduce this “yield curve effect.” Ideally, each loan would be matched to a Treasury security that corresponds to that loan's expected maturity, which would be determined based on empirical data about prepayment speeds for loans with the same features. It is not practicable, however, to match loans to Treasuries on the basis of the full range of features that may influence prepayment speeds. For the sake of simplicity and predictability, the Board proposes to prescribe rules based on three features: whether the loan is adjustable-rate or fixed-rate; the term of the loan; and the length of any initial fixed-rate period, if the loan is adjustable-rate.

Proposed § 226.35(a) that would match closed-end loans to Treasury securities as follows. First, variable rate transactions with an initial fixed-rate period of more than one year would be matched to Treasuries having a maturity closest to the length of the fixed-rate period (unless the fixed-rate period exceeds seven years, in which case the creditor would use the rules applied to non-variable rate loans). For example, a 30-year ARM having an initial fixed-rate period of five years would be matched to a 5-year Treasury security. Second, variable-rate transactions with an initial fixed-rate period of one year or less would be matched to Treasury security having a maturity of one year. Third, fixed-rate loans would be matched on the basis of loan term in the following way: A fixed-rate loan with a term of 20 years or more would be matched to a 10-year Treasury security; a fixed-rate loan with a term of more than 7 years but less than twenty years would be matched to a 7-year Treasury security; and a fixed-rate loan with a term of seven years or less would be matched to the Treasury security with a maturity closest to the term.

Timing of the Match

The proposal also would differ from Regulation C as to timing. The Treasury security yield that would be used is the yield as of the 15th of the month preceding the month in which the application is received, rather than the 15th of the month before the rate is locked. This would introduce more certainty, earlier in the application process, to the determination as to whether a potential transaction would be a higher-priced mortgage loan when consummated. The actual APR, however, would not be known to a certainty early in the application process, leaving some uncertainty as to whether a potential loan will be a higher-priced loan if it is actually originated. The APR disclosed within three days of application could change before closing for legitimate reasons such as changes in the interest rate or in the borrower's decision as to how many points to pay, if any. It is not expected, however, that an APR would change substantially in many cases for legitimate reasons.

Using two different trigger dates in Regulation C and Regulation Z § 226.35(a)—the rate lock date in the first and the application date in the second—could increase regulatory burden. Using the rate lock date in § 226.35(a), however, could increase uncertainty, relative to using the application date, as to whether a loan would be higher-priced when consummated. The Board believes the potentially somewhat higher regulatory burden from inconsistency may be justified by the increase in certainty.

Requests for Comment

The Board seeks data with which to evaluate the proposed approach to matching mortgage loans to Treasury securities and the proposal to select the appropriate Treasury security based on the application date. The Board also solicits suggestions for alternative approaches that would better meet the objectives of relative simplicity and reasonably accurate coverage.

VII. Proposed Rules for Higher-Priced Mortgage Loans—§ 226.35

A. Overview

This part discusses the new consumer protections the Board proposes to apply to “higher-priced mortgage loans.” A creditor would be prohibited from engaging in a pattern or practice of making higher-priced mortgage loans based on the collateral without regard to repayment ability. A creditor would also be prohibited from making an individual higher-priced mortgage loan without: Verifying the income and assets the creditor relied upon to make the loan; and establishing an escrow account for taxes and insurance. In addition, a higher-priced mortgage loan

could not have a prepayment penalty except under certain conditions.

The Board believes that the practices that would be prohibited, when conducted in connection with higher-priced mortgage loans, are unfair, deceptive, associated with abusive lending practices, and otherwise not in the interest of the borrower.

See

TILA Section 129(l)(2), 15 U.S.C. 1639(l)(2), and the discussion of this statute in part V above. Making higher-priced mortgage loans without adequately considering repayment ability, verifying income or assets, or establishing an escrow account for taxes and insurance significantly increases the risk that consumers will not be able to repay their loans. When consumers cannot repay their loans and must choose between losing their homes and refinancing in an effort to stay in their homes, they are more vulnerable to such abuses as loan flipping and equity stripping. Prepayment penalties in certain circumstances can exacerbate these injuries by making it more costly to exit unaffordable loans.

The Board has considered that some of the practices that would be prohibited may benefit some consumers in some circumstances. As discussed more fully below with respect to each prohibited practice, however, the Board believes that in connection with higher-priced mortgage loans these practices are likely to cause more injury to consumers than any benefit the practices may provide them. The Board has also considered that the proposed rules may reduce the access of some consumers in some circumstances to legitimate and beneficial credit arrangements, either directly as a result of a prohibition or indirectly because creditors may incur, and pass on, increased compliance and litigation costs. The Board believes the benefits of the proposal outweigh these costs.

The Board has also considered other, potentially less burdensome, approaches such as requiring more, or better, disclosures. For reasons discussed in part II.C., the Board believes that disclosures alone may not provide consumers in the subprime market adequate protection from unfair, deceptive, and abusive lending practices. The discussion below sets forth additional reasons why disclosures and other possible alternatives to the proposed prohibitions may not give adequate protection.

In addition to proposing new protections for consumers with higher-priced mortgage loans, the Board is also proposing to prohibit a creditor from structuring a closed-end mortgage loan as an open-end line of credit for the purpose of evading the restrictions on higher-priced mortgage loans, which do not apply to open-end lines of credit. This proposal is based on the authority of the Board under TILA Section 129(l)(2) to prohibit practices that would evade Board regulations adopted under authority of that statute. 15 U.S.C. 1639(l)(2).

B. Disregard of Consumers' Ability to Repay—§§ 226.34(a)(4) and 226.35(b)(1)

TILA Section 129(h), 15 U.S.C. 1639(h), and Regulation Z § 226.34(a)(4) currently prohibit a pattern or practice of extending HOEPA loans based on consumers' collateral without regard to their repayment ability. HOEPA loans are, however, a very small portion of the subprime market. The Board is proposing to extend the prohibition against a pattern or practice of lending based on consumers' collateral without regard to their repayment ability to higher-priced mortgage loans as defined in § 226.35(a). The prohibition in § 226.34(a)(4) would be revised somewhat, and this revised prohibition would be incorporated as proposed new § 226.35(b)(1).

Public Comment on Determining Ability To Repay

In the Board's June 14, 2007 hearing notice, the Board solicited comment on the following alternatives to ensure borrowers' repayment ability:

• Should lenders be required to underwrite all loans based on the fully-indexed rate and fully amortizing payments?

• Should there be a rebuttable presumption that a loan is unaffordable if the borrower's debt-to-income (DTI) ratio exceeds 50 percent?

• Are there specific consumer disclosures that would help address concerns about unaffordable loans?

Few commenters offered specific disclosure suggestions but many commenters and hearing witnesses addressed the first two questions. Most consumer and community groups who commented support a requirement to underwrite ARMs using the fully-indexed, fully-amortizing rate. Several recommended, however, that the Board require underwriting to the maximum rate possible or, at least, to a rate higher than the fully-indexed rate. These commenters are concerned that using the fully-indexed rate would not adequately assure repayment ability because indexes can increase.

All of the financial institutions and financial services trade groups who responded to the question agree that underwriting a loan based on its fully-indexed interest rate and fully-amortizing payment is generally prudent. With few exceptions, however, most of these commenters oppose codifying such a standard in a regulation, arguing that a regulation would be too rigid, constrain lenders from relying on their own experience and judgment, and make ARMs unavailable to many subprime borrowers. Several financial institutions and trade groups asked that any fully-indexed rate requirement the Board adopts be limited to ARMs with introductory fixed-rate periods of less than five years. They maintained that most borrowers having ARMs with longer fixed-rate periods refinance before the rate adjusts.

Consumer and community groups argue that a requirement to underwrite to the fully-indexed rate would not assure that loans would be affordable unless the Board also specified a maximum debt-to-income (DTI) ratio. Most groups stated that a maximum 50 percent DTI ratio would be an appropriate threshold to identify presumptively unaffordable loans. On the other hand, the vast majority of the financial institution and industry trade group commenters oppose adoption of a maximum DTI ratio. Some stated the DTI ratio is not one of the most important predictors of loan performance. Others noted the difficulties of clearly defining “debt” and “income” for purposes of such a rule, or of clearly defining mitigating factors such as high credit scores. Some identified categories of borrowers for whom high DTIs are not inappropriate, such as high-income borrowers; borrowers with substantial assets; and borrowers refinancing or consolidating loans with even higher payment burdens.

Discussion

Recent evidence of disregard for repayment ability.

Subprime loans are expected to default at higher rates than prime loans because they generally are made to higher-risk borrowers. But the high frequency of so-called 2-28 and 3-27 ARMs in subprime originations in recent years—and the recent rapid and significant increase in serious delinquencies and foreclosures among such loans originated from 2005 to early 2007, including within several months of closing—have raised serious questions as to whether originators have paid adequate attention to repayment ability. Approximately three-quarters of securitized originations in subprime pools from 2004 to 2006 were of 2-28 or 3-27 ARMs, or ARMs with interest rates discounted for two or three years and fully-indexed afterwards. In a

typical case of a 2-28 discounted ARM, a $200,000 loan with a discounted rate of 7 percent for two years (compared to a fully-indexed rate of 11.5 percent) and a 10 percent maximum rate in the third year would start at a payment of $1,531 and jump to a payment of $1,939 in the third year, even if the index value did not increase. The rate would reach the fully-indexed rate in the fourth year (if the index value still did not change), and the payment would increase to $2,152.

This example is taken from the federal agencies' proposed subprime illustrations. Proposed Illustrations of Consumer Information for Subprime Mortgage Lending, 72 FR 45495, 45497 n.2 & 45499, Aug. 14, 2007. The example assumes an initial index of 5.5 percent and a margin of 6 percent; assumes annual payment adjustments after the initial discount period; a 3 percent cap on the interest rate increase at the end of year 2; and a 2 percent annual payment adjustment cap on interest rate increases thereafter, with a lifetime payment adjustment cap of 6 percent (or a maximum rate of 13 percent).

In recent years many subprime lenders did not consider adequately whether borrowers would be able to afford the higher payment, and appeared instead to assume that borrowers would be able to refinance notwithstanding their very limited equity. Originators extended some 2-28 ARMs from 2005 to early 2007 without having reason to believe the borrower would be able to afford the payment after reset. Originators may have assumed that these borrowers would refinance before reset, an assumption that proved unrealistic, at least under newly tightened lending standards, when house prices fell and the borrowers could not accumulate enough equity to refinance. In fact, some 2-28 ARMs originated in 2005 and 2006 appear to have been made to borrowers who could not afford even the initial payment. Over 10 percent of the 2-28 ARMs originated in 2005 appear to have become seriously delinquent before their first reset.

While some borrowers may have been able to make their payments—they stopped making payment because the values of their houses declined and they lost what little equity they had—others may not have been able to afford even their initial payments.

Figure calculated from First American LoanPerformance data.

Potential reasons for unaffordable loans.

There are several reasons why borrowers, especially in the subprime market, would accept loans they would not be able to repay. In some cases, less scrupulous originators may mislead borrowers into entering into unaffordable loans by understating the payment before closing and disclosing the true payment only at closing. At the closing table, many borrowers may not notice the disclosure of the payment or have time to consider it; or they may consider it but feel constrained to close the loan. This constraint may arise from a variety of circumstances. For example, the borrower may have signed agreements to purchase a new house and to sell the current house. Or the borrower may need to escape an overly burdensome payment on a current loan, or urgently need the cash that the loan will provide for a household emergency.

In the subprime market in particular, consumers may accept loans knowing they may have difficulty affording the payments because they do not have reason to believe a more affordable loan would be available to them. Possible sources of this behavior, including the limited transparency of prices, products, and broker incentives in the subprime market, are discussed in part II.C. Borrowers who do not expect any benefit from shopping further, which can be costly, make a reasoned decision not to shop and to accept the terms they believe are the best they can get.

Furthermore, borrowers' own assessment of their repayment ability may be influenced by their belief that a lender would not provide credit to a consumer who did not have the capacity to repay. Borrowers could reasonably infer from a lender's approval of their applications that the lender had appropriately determined that they would be able to repay their loans. Borrowers operating under this impression may not independently assess their repayment ability to the extent necessary to protect themselves from taking on obligations they cannot repay. Borrowers are likely unaware of market imperfections that may reduce lenders' incentives to fully assess repayment ability.

See

part II.C. In addition, lenders and brokers may sometimes encourage borrowers to be excessively optimistic about their ability to refinance should they be unable to sustain repayment. For example, they sometimes offer reassurances that interest rates will remain low and house prices will increase; borrowers may be swayed by such reassurances because they believe the sources are experts.

Injuries from unaffordable loans.

When borrowers cannot afford to meet their payment obligations, they and their communities suffer significant injury. Such borrowers are forced to use up home equity or other assets to cover the costs of refinancing. If refinancing is not an option, then borrowers must make sacrifices to keep their homes. If they cannot keep their homes, then they must sell before they had planned or endure foreclosure and eviction; in either case they may owe the lender more than the house is worth. If a neighborhood has a concentration of unaffordable loans, then the entire neighborhood may endure a decline in homeowner equity. Moreover, if disregard for repayment ability contributes to a rise in delinquencies and foreclosures, as appears to have happened recently, then the credit tightening that may follow can injure all consumers who are potentially in the market for a mortgage loan.

Potential benefits.

There does not appear to be any benefit to consumers from loans that are clearly unaffordable at origination or immediately thereafter. The Board recognizes, however, that some consumers may in some circumstances benefit from loans whose payments would increase significantly after an initial period of reduced payments. For example, some consumers may expect to be relocated by their employers and therefore intend to sell their homes before their payment would increase significantly. Moreover, a planned increase in the payment that would not be affordable at consumers' current incomes (as of consummation) may be affordable at the incomes consumers can document that they reasonably expect to earn when the payment increases. The proposal described below is intended to provide sufficient flexibility to creditors to ensure that credit would be available under such circumstances.

Consumers may also benefit from loans with payments that could increase after an initial period of reduced payments if they have a realistic chance of refinancing, before the payment burden increases substantially, into lower-rate loans that were more affordable on a longer-term basis. This benefit is, however, quite uncertain, and it is accompanied by substantial risk. Consumers would have to both improve their credit scores sufficiently and accumulate enough equity to qualify for lower-rate loans. Concerns about the affordability after reset of 2-28 and 3-27 ARMs originated from 2005 to early 2007 illustrate the hazards of counting on both developments occurring before payments become burdensome. Marketed as “affordability products,” these loans often were made with high loan-to-value ratios on the assumption that house prices would appreciate. In areas where house price appreciation slowed or prices declined outright, the assumption proved unreliable. Moreover, the Board is not aware of evidence on the proportion of such borrowers who were actually able to raise their credit scores enough to

qualify for lower-rate loans had they accumulated sufficient equity. In short, evidence from recent events is consistent with a conclusion that a widespread practice of making subprime loans with built-in payment shock after a relatively short period on the basis of assuming consumers will accumulate sufficient equity and improve their credit scores enough to refinance before the shock sets in can cause consumers more injury than benefit.

The Proposed Prohibition

HOEPA and § 226.34 prohibit a lender from engaging in a pattern or practice of extending credit subject to § 226.32 (HOEPA loans) to a consumer based on the consumer's collateral without regard to the consumer's repayment ability, including the consumer's current and expected income, current obligations, and employment. Under the proposal, the prohibition in § 226.34(a)(4) would be revised to clarify and strengthen it. The revised § 226.34(a)(4) would be incorporated into § 226.35(b) as one of the restrictions that apply to higher-priced mortgage loans. Higher-priced mortgage loans would be defined in § 226.35(a) as explained above.

As proposed, Regulation Z would prohibit a lender from engaging in a pattern or practice of making higher-priced mortgage loans based on the value of consumers' collateral without regard to consumers' repayment ability as of consummation, including consumers' current and reasonably expected income, current and reasonably expected obligations, employment, and assets other than the collateral. Each of the elements of this proposed standard is discussed below.

Collateral-based lending.

The proposal would prohibit a pattern or practice of collateral-based lending with higher-priced mortgage loans. The Board recognizes that this proposal may reduce the availability of credit for consumers whose current and expected income and non-collateral assets are not sufficient to demonstrate repayment ability. For example, unemployed borrowers with limited assets apart from their homes may have more difficulty obtaining mortgage credit under this proposal if their combined risk factors are high enough that the APR of their potential loan would exceed the proposed threshold in § 226.35(a).

“Pattern or practice.”

The Board is not proposing to prohibit making an individual loan without regard to repayment ability, either for HOEPA loans or for higher-priced mortgage loans. Instead, the Board is proposing to retain the pattern or practice element in the prohibition, and to include that element in the proposed new prohibition for higher-priced mortgage loans. The “pattern or practice” element of the prohibition is intended to balance potential costs and benefits of the rule. Creating civil liability for an originator that fails to assess repayment ability on any individual loan could inadvertently cause an unwarranted reduction in the availability of mortgage credit to consumers. The “pattern or practice” element is intended to reduce that risk while helping prevent originators from making unaffordable loans on a scale that could cause consumers substantial injury.

Whether a creditor had engaged in the prohibited pattern or practice would depend on the totality of the circumstances in the particular case, as explained in an existing comment to § 226.34(a)(4). The comment further indicates that while a pattern or practice is not established by isolated, random, or accidental acts, it can be established without the use of a statistical process. It also notes that a creditor might act under a lending policy (whether written or unwritten) and that action alone could establish a pattern or practice of making loans in violation of the prohibition.

The Board is not proposing to adopt a quantitative standard for determining the existence of a pattern or practice. Nor does it appear feasible for the Board to give examples, as the inquiry depends on the totality of the circumstances. Comment is sought, however, on whether further guidance would be appropriate and specific suggestions are solicited.

“Current and expected income.”

The statute and regulation both prohibit a creditor from disregarding a consumer's repayment ability, including current and expected income. The Board proposes to retain the references to expected and current income, and to clarify that expectations of income must be reasonable. The Board believes consumers may benefit if a creditor is permitted to take into account reasonably expected increases in income. For example, a consumer seeking a professional degree or certificate may, depending on the job market and other relevant circumstances, reasonably anticipate an increase in income after obtaining the degree or certificate. Under the proposal, a creditor could consider such an increase. For consumers who do not have a current income and cannot demonstrate a reasonable expectation of income, creditors may consider assets other than the collateral.

Other proposed clarifications.

Several other revisions are proposed for clarity. The phrase “as of consummation” would be added to make clear that the prohibition is based on the facts and circumstances that existed as of consummation. Under proposed comment 34(a)(4)-2, events after consummation, such as an unusually high default rate, may be relevant to determining whether a creditor has violated § 226.34(a)(4), but events after consummation do not, by themselves, establish a violation. The comment would provide the following example: a violation is not established if borrowers default after consummation because of serious illness or job loss.

In addition, to clarify the basis for determining repayment ability the regulation and existing comments would be revised, and new comments would be added. First, comment 34(a)(4)-1 (renumbered as 34(a)(4)-3) would be revised to clarify the regulation's reference to employment as a factor in determining repayment ability. The comment would indicate that in some circumstances it may be appropriate or necessary to take into account expected changes in employment. For example, depending on all of the facts and circumstances, it may be reasonable to assume that students obtaining professional degrees or certificates will obtain employment upon receiving the degree or certificate.

Second, the regulation would be revised to refer not just to current obligations but also to expected obligations. This would make the reference to obligations parallel to the statute and regulation's references to current and expected income. Proposed comment 34(a)(4)(i)(A)-2 would clarify that, where two different creditors are extending loans simultaneously to the same consumer, one a first-lien loan and the other a subordinate-lien loan, each creditor would generally be expected to verify the obligation the consumer is undertaking with the other creditor. A pattern or practice of failing to do so would create a presumption of a violation.

Third, the revised regulation would make clear that creditors may rely on assets other than the collateral to determine repayment ability. An existing comment would be revised to give these examples: A savings accounts or investments that can be used by the consumer. The Board believes it is appropriate for lenders to consider non-collateral assets such as these in determining repayment ability, and for consumers to be free to substitute assets for income in meeting their obligations.

Fourth, minor revisions would be made to § 226.34(a)(4) solely for clarity. The term “consumer” in the regulation would be put in the plural, “consumers,” to reflect that the prohibition concerns a pattern or practice. The phrase “based on consumers' collateral” would be revised to read “based on the value of consumers' collateral.” No change in meaning is intended.

Proposed Presumptions

Section 226.34(a)(4) contains a provision creating a rebuttable presumption of a violation where a lender engages in a pattern or practice of failing to verify and document repayment ability. The proposed regulation would retain this presumption, which would be incorporated in proposed § 226.35(b)(1). The Board is also proposing to add new, rebuttable presumptions to § 226.34(a)(4) and, by incorporation, § 226.35(b)(1). These would be presumptions of a violation for engaging in a pattern or practice of failing to consider: consumers' ability to pay the loan based on the interest rate specified in the regulation (§ 226.34(a)(4)(i)(B)); consumers' ability to make fully-amortizing loan payments that include expected property taxes and homeowners insurance (§ 226.34(a)(4)(i)(C)); the ratio of borrowers' total debt obligations to income as of consummation (§ 226.34(a)(4)(i)(D)); and borrowers' residual income (§ 226.34(a)(4)(i)(E)).

A new comment 34(a)(4)(i)-1 would clarify that the presumption for failing to verify income as well as the proposed new presumptions would be rebuttable by the lender with evidence that the lender did not disregard repayment ability. The comment would also clarify that the presumptions are not exhaustive. That is, a creditor may violate § 226.34(a)(4) (or § 226.35(b)(1)) by patterns or practices other than those specified in paragraph 34(a)(4)(i).

Each of the proposed presumptions is discussed in turn below. Comment is sought generally on the appropriateness of the proposed presumptions, and on whether additional presumptions should be adopted.

Failure to verify

. Section 226.34(a)(4) contains a provision creating a rebuttable presumption of a violation where a lender engages in a pattern or practice of failing to verify and document repayment ability. The proposed regulation would retain this presumption, though it would be placed, along with other proposed new presumptions, in new sub-paragraph (i) of § 226.34(a)(4). It would also be revised to refer explicitly to the aspects of repayment ability identified in § 226.34(a)(4), namely, borrower's current and reasonably expected income and assets, current and reasonably expected obligations, and employment. It would also refer to the verification requirements stated in § 226.35(b)(2)(i). Under § 226.35(b)(2), a lender would be required to verify amounts the lender relies on by the consumer's Internal Revenue Service Form W-2, tax returns, payroll receipts, financial institution records, or other third-party documents that provide reasonably reliable evidence of the consumer's income and assets.

See

part VII.C. A new comment would clarify that a pattern or practice of failing to verify obligations would also trigger a presumption of a violation. It would indicate, however, that a credit report generally may be used to verify obligations.

Ability to make fully-indexed, fully-amortizing payments

. Variable rate mortgages with discounted initial rates have become common in the subprime market. In a typical example, a loan would have an index and margin at consummation of 11.5 percent but a discounted initial rate for the first two years of 7 percent. Determining repayment ability on the basis of the initial rate would not give a realistic picture of the borrower's ability to afford the loan once the rate began adjusting according to the agreed index and margin.

The Board is proposing in § 226.34(a)(4)(i)(B) that a pattern or practice of failing to consider a borrower's repayment ability at the fully-indexed rate would create a presumption of a violation of § 226.34(a)(4) (or § 226.35(b)(1)).

As discussed in part IV above, concerns about underwriting practices for products with introductory rates or payments led the Board and the other federal supervisory agencies to issue guidance advising institutions to qualify borrowers using the fully-indexed rate and fully amortizing payments.

Section 226.34(a)(4)(i)(B) would also address the case of a step-rate loan, a loan in which specific interest rate changes are agreed to in advance. For example, the parties could agree that the interest rate on the loan would be 5 percent for two years, 6 percent for two years, and 7 percent thereafter. The regulation would provide that, for such loans, a failure to consider the borrower's repayment ability at the highest interest rate possible within the first seven years of the loan's term (seven percent in the example) would create a presumption of a violation. The Board seeks comment on whether a shorter period, such as five years, would be appropriate.

The Board also seeks comment on whether this presumption should be modified to accommodate loans with balloon payments and, if so, how it should be modified.

Borrower debt-to-income ratio and residual income

. The proposed presumptions of a violation for failure to consider the debt-to-income ratio (§ 226.34(a)(4)(i)(D)) or residual income ((§ 226.34(a)(4)(i)(E)) reflect the fact that this information generally is part of a responsible determination of repayment ability. Comment 34(a)(4)(i)(D)-1 would clarify, however, that the Board is not proposing a specific debt-to-income ratio that would create a presumption of a violation; nor is the Board proposing a specific ratio that would be a safe harbor. Similarly, comment 34(a)(4)(i)(E)-1 would indicate that the regulation does not require a specific level of residual income.

The Board is concerned that making a specific debt-to-income ratio or residual income level either a presumptive violation or a safe harbor could limit credit availability without providing adequate off-setting benefits. These are but two of many factors that determine repayment ability. For example, depending on the circumstances, the repayment risk implied by a high debt-to-income ratio could be offset by other factors that reduce the risk, such as a high credit score and a substantial down payment. The Board is reluctant to adopt a quantitative standard for one or two underwriting factors when repayment ability depends on the totality of many inter-relating factors.

It is possible, however, that adopting a quantitative standard for the debt-to-income ratio or other underwriting factors would provide at least some benefit to creditors and, by extension, consumers, by providing bright lines. The Board seeks comment on whether it should adopt a presumption of a violation, or a safe harbor, at a 50 percent debt-to-income ratio, or at a lower or higher ratio. What exceptions would be necessary for borrowers with high incomes or substantial assets, or for other cases? Comment is also sought on whether the Board should in addition, or instead, adopt quantitative standards for presumptive violations, or safe harbors, based on other underwriting factors.

Property taxes and insurance

. Section 226.34(a)(4)(i)(C) would create a separate presumption of a violation of § 226.34(a)(4) (or § 226.35(b)(1)) for a pattern or practice of failing to consider the borrower's repayment ability based on a fully-amortizing payment that includes expected property taxes,

homeowners insurance, and other specified housing expenses. This is intended to address concerns that some creditors would determine a borrower's ability to repay a nontraditional loan that offered an option to defer principal or interest for several years on the basis of a payment that was non-amortizing (interest only) or negatively amortizing (less than interest). Negative amortization also can arise on variable-rate transactions with annual payment caps. The proposed presumption would encourage lenders to consider the fully-amortizing payment, as the Subprime Guidance advises lenders to do.

See

part V. The fully-amortizing payment would be based on the term of the loan. For example, the amortizing payment for a 2-28 ARM would be calculated based on a 30-year amortization schedule.

Proposed Time Horizon

The Board recognizes that it may not be reasonable, or to consumers' benefit, to hold creditors responsible for assuring repayment ability for the life of a loan. Most mortgage loans have terms of thirty years but prepay long before that. The Board seeks to ensure that consumers retain the ability to exchange lower initial payments for higher payments later, or for a balloon payment at the end of the loan. Accordingly, a safe harbor for creditors may be appropriate so long as it assures payments will be affordable for a reasonable time. Proposed § 226.34(a)(4)(ii) would provide that a creditor does not violate § 226.34(a)(4) if the creditor has a reasonable basis to believe that consumers will be able to make loan payments for at least seven years, considering each of the factors identified in § 226.34(a)(4)(i) (such as the fully-indexed rate and the fully-amortizing payment schedule) and any other factors relevant to determining repayment ability.

This proposal is not intended to preclude creditors from offering loans with substantial payment increases before seven years. If such loans fell outside of the safe harbor, they could nonetheless be justified in appropriate circumstances. For example, a consumer with a documented intent to sell the home within three years may reasonably choose a loan with a substantial payment increase in the third year. The Board seeks comment, however, on whether specifying a shorter time horizon, such as five years, would be appropriate.

General Request for Comment

In addition to the specific requests for comment stated above, the Board seeks comment on whether proposed §§ 226.34(a)(4) and 226.35(b)(1) would ensure that creditors adequately consider repayment ability without unduly constraining credit availability. The Board seeks data and information that could help the Board evaluate the costs and benefits of the proposal as it would affect the subprime market and any portion of the alt-A market to which the proposal may apply.

C. Verification of Income and Assets Relied on—§ 226.35(b)(2)

Proposed § 226.35(b)(2) would prohibit creditors in a transaction subject to § 226.35(a) from relying on amounts of assets or income, including expected income, in extending credit unless the creditor verifies such amounts. Creditors who fail to verify income or assets before extending credit are given a safe harbor if they can show that the amounts of the consumer's income or assets relied on were not materially greater than what the creditor could have documented at consummation.

Public Comment on Stated Income Lending

In the hearing notice, the Board solicited comment on the following questions:

• Whether stated income or low-documentation loans should be prohibited for certain loans, such as loans to subprime borrowers?

• Whether stated income or low-documentation loans should be prohibited for higher-risk loans, for example, for loans with high loan-to-value ratios?

• How a restriction on stated income or low-documentation loans would affect consumers and the type and terms of credit offered?

• Whether lenders should be required to disclose to the consumer that a stated income loan is being offered and allow the consumer the option to document income?

Consumer and community groups, individuals, and political officials, and some financial institutions and groups, favored greater restrictions on stated income loans for two reasons. First, some borrowers who could easily document their income have been harmed by receiving stated income loans that cost them more than a full documentation loan. According to commenters, these borrowers did not realize that they could have received a less costly loan by documenting their incomes. Second, other borrowers have been harmed when originators inflated their incomes—often without consumers' knowledge—to assure the originator would be able to make the loan or to enable the originator to make a larger loan, which might have higher payments that were less affordable to the consumer. To address these concerns, these commenters favored requiring creditors to obtain some documentation to support a consumer's statement of income or assets. Some suggested that documentation be required only for subprime loans, while others suggested it be required for all loans.

In contrast, most financial institution and financial services trade group commenters opposed prohibiting stated income loans. These commenters argued that financial institutions should retain flexibility to accommodate borrowers who may have difficulty fully documenting their income, or whose credit risk profile is strong enough that their income is not used as an underwriting factor. Some of these commenters did, however, support the banking agencies' use of guidance, such as the Subprime Statement, to address any risks of stated income loans. One major mortgage lender supported limiting stated income lending in subprime loans by a new regulation, if the regulation allowed for mitigating circumstances.

Discussion

Until recently, large and increasing numbers of home-secured loans in the subprime market were underwritten without fully verifying the borrower's income and assets.

The share of “low doc” and “no doc” loan originations in the securitized subprime market rose from 20 percent in 2000, to 30 percent in 2004, to 40 percent in 2006.

Low and no documentation loans are more prevalent in the Alt-A market, where originations of such loans in securitized pools rose from about 60 percent in 2000-2004 to 80 percent in 2006. Not all low doc or no doc loans are stated income loans (because in some cases originators did not rely on income or assets as the source of repayment), but many are.

See

U.S. Gov't Accountability Office, GAO-08-78R,

Information on Recent Default and Foreclosure Trends for Home Mortgages and Associated Economic and Market Developments

5 (2007); Fannie Mae, Weekly

Economic Commentary

(Mar. 26, 2007).

Figures calculated from First American Loan Performance data.

Lending based on unverified, or minimally verified, incomes or assets can be appropriate for consumers whose risk profiles justify the potential increased risk and who might otherwise have to incur a significant cost to document their incomes or assets. The practice, however, increases the risk

that credit is extended on the basis of inflated incomes and assets, which, in turn, can injure not just the particular borrowers whose incomes or assets were inflated but their neighbors, as well. The practice also presents an opportunity for originators to mislead consumers who could easily document their incomes and assets into paying a premium for a stated income or stated asset loan. These concerns are addressed in turn below.

Risk of inflated incomes and assets

. There is anecdotal evidence that the incomes used in stated income loans were often inflated.

There is also evidence in the form of a higher rate of default for low doc and no doc loans (many of which are stated income loans) than for full documentation loans, and in the increase in the rate of default for low/no doc loans originated when underwriting standards were declining.

See

Mortgage Asset Research Inst., Inc.,

Eighth Periodic Mortgage Fraud Case Report to the Mortgage Bankers Association

(2006) (reporting that 90 of 100 stated income loans sampled used inflated income when compared to tax return data); Fitch Ratings,

Drivers of 2006 Subprime Vintage Performance (Fitch 2006 Subprime Performance)

(November 13, 2007) (reporting that stated income loans with high combined loan to value ratios appear to have become vehicles for fraud).

Michelle A. Danis and Anthony Pennington-Cross,

The Delinquency of Subprime Mortgages

, Journal of Economics and Business (forthcoming 2007);

see also Fitch 2006 Subprime Performance

(stating that lack of income verification, as opposed to lack of employment or down payment verification, caused 2006 low documentation loans delinquencies to be higher than earlier vintages' low documentation loans).

Stated income lending programs give originators incentives as well as opportunities to inflate an applicant's income or assets, or to encourage applicants to do so. Compensating the originator based on loan size and origination volume, common practices, may give the originator incentives to maximize loan size and origination volume at the expense of loan quality. Inflating income or assets can increase both loan size and origination volume, because it can cause a creditor to accept an application that would otherwise have been rejected or met with an offer of a smaller loan.

The nature of the application process makes it possible that an applicant would not learn that the originator had inflated the applicant's income or assets. In many cases, applicants may not even know that they are obtaining stated income loans. They may have given the originator documents verifying their income and assets that the originator kept from the loan file so that the loan could be classified as “stated income, stated assets.” If an applicant has applied knowingly for a stated income or stated assets loan, the originator may fill out the financial statement on the standard application form based on information the applicant provides orally. The applicant may not review the form closely enough to detect errors in the stated income or assets, especially if seeing the form for the first time at the closing table. A consumer who detects errors at the closing table may not realize their importance or may face constraints that make it particularly difficult to walk away from the table without the loan.

While some originators may inflate income without consumers' knowledge, other originators may tacitly encourage applicants to knowingly state inflated incomes and assets by making it clear that their actual incomes and assets are not high enough to qualify them for the loans they seek. Such originators may reassure applicants that this is a benign and common practice. In addition, applicants may inflate their incomes and assets on their own initiative in circumstances where the originator does not have reason to know.

Injuries from inflated income and assets

. The injuries to consumers from extending credit based on inflated incomes and assets are apparent. Borrowers whose loans are underwritten based on inflated income may receive larger loans with payments larger than they can comfortably afford and, therefore, face a higher risk of default as well as a higher risk of serious delinquency leading to foreclosure or distress sale. These risks are particularly pronounced for borrowers in the subprime market because their financial situations often are more precarious. The injuries caused by income inflation are not limited either to the particular borrowers whose incomes were inflated by the originator, nor to particular borrowers who inflated their incomes on their own. The practice can injure many other consumers, too. Inflating applicant incomes raises the risk of distress sales and foreclosures, concentrations of which can depress an entire community. Moreover, a widespread practice of inflating applicant incomes in an area with rapid house price appreciation—the kind of area where the practice may be most likely to arise—may fuel this appreciation and contribute to a “bubble.”

Undisclosed premiums

. Stated income lending also potentially injures consumers by leading them to pay more for their loans than they otherwise would. There is generally a premium for a stated income loan. An originator may not have sufficient incentive to disclose the premium on its own initiative because collecting and reviewing documents could slow down the origination process, reduce the number of loans an originator produces in a period, and, therefore, reduce the originator's compensation for the period. The risk that a consumer would not be aware of the premium may be particularly acute where products are complex, as is often true in the subprime market and was, at least until recently, true in the alt-A market due to the rapid growth of interest-only loans and option ARMs. Thus, consumers who can document income with little effort may choose not to because they are unaware of the cost of a stated income loan. Such consumers are effectively deprived of an opportunity to shop for a potentially lower-rate loan requiring full documentation.

The Board recognizes that stated income lending in the subprime market may have potential benefits. It may speed credit access by several days for consumers who need credit on an emergency basis. It may save some consumers from expending significant effort to document their income, and it may provide access to credit for consumers who otherwise would not have access because they actually cannot document their income, for whatever reason. For the reasons discussed above, however, the Board believes that, within the subprime market, where risks to consumers are already elevated, the potential benefits to consumers of stated income/stated asset lending may be outweighed by the potential injury to consumers and competition. Stated-income lending is a significant part of the neighboring alt-A market, but, there too, it can raise concerns. Until the recent tightening of underwriting standards in the alt-A market, stated-income lending was increasingly layered on top of other risks, such as loan terms that permit the borrower to defer payment of interest or principal.

The Board's Proposal

To address the injuries to consumers from stated income loans in the higher-priced market, the Board proposes to require creditors to verify the income and assets

they rely on

with third-party documents that provide reasonably reliable evidence such as W-2 forms, tax returns, payroll receipts, or financial institution records. The rule is intended to be flexible and appropriately balance costs with benefits.

The benefits of the proposal would appear to be significant. The rule should make it more difficult for any party to inflate incomes or assets on higher-priced mortgage loans and, therefore,

reduce the frequency of the practice and the injuries to consumers the practice can cause. The rule also should eliminate the risk that consumers with higher-priced mortgage loans who could document income would unknowingly pay more for a loan that did not require documentation.

The proposal could have costs as well. In general, the time from application to closing could be longer if an applicant were required to produce, and the creditor required to review, third party documents verifying income. Also, consumers who did not have documents verifying their income readily at hand would face the inconvenience of obtaining such documents. Another cost could be reduced access to credit for consumers who would have difficulty documenting their income. As explained further below, the Board believes the regulation is sufficiently flexible to keep these costs to reasonable levels relative to the expected benefits of the proposed rule.

Five elements of the proposal are intended to reduce the costs to consumers and creditors that income verification may entail. First, the proposed rule requires that only the income or assets the creditor relies upon in approving the extension of credit be verified. For example, if a creditor does not rely on a part of the consumer's income, such as an annual bonus, in approving the extension of credit, the creditor would not need to verify the consumer's bonus.

Creditors would, however, still be prohibited from engaging in a pattern or practice of extending higher-priced mortgage loans to consumers based on the collateral without regard to repayment ability.

See

proposed § 226.35(b)(1). Consequently, creditors would not be able to evade the proposed income verification rule by consistently declining to consider income or assets.

Second, the proposed rule specifically authorizes a creditor to rely on W-2 forms, tax returns, payroll receipts, and financial institution records. These kinds of documents generally have proven to be reliable sources of information about borrowers' income and assets. Moreover, most consumers can, or should be able to, produce one of these kinds of documents with little difficulty. Thus, the proposed safe harbor for relying on one of these kinds of documents should protect consumers while minimizing costs.

Third, creditors may use any other third-party documents that provide reasonably reliable evidence of the borrower's income and assets. Examples of other third-party documents that provide reasonably reliable evidence of the borrower's income include check-cashing receipts or a written statement from the consumer's employer.

See

proposed comment 35(b)(2)-4. These are but examples, and a creditor may rely on third-party documents of any kind so long as they are reasonably reliable. The one kind of document that is categorically excluded is a statement only from the consumer.

Fourth, the proposal is not intended to limit creditors' ability to adjust their underwriting standards for consumers who for legitimate reasons have difficulty documenting income, such as self-employed borrowers, or employed borrowers with irregular income.

For example, the rule would not dictate that a creditor must have at least two year's tax returns to approve an extension of credit to a self-employed borrower. As another example, if a creditor relied on a statement by an employed applicant that the applicant was likely to receive an annual bonus from the employer, the creditor could verify the statement with third-party documents showing a consumer's past annual bonuses.

See

proposed comment 35(b)(4)(i)-1. The same would hold for credit extended to employees who work on commission.

For depository institutions and their affiliates, safety and soundness considerations would continue to govern underwriting, as always.

Fifth, creditors who have extended credit to a consumer and wish to extend new credit to the same consumer need not re-collect documents that the creditor previously collected from the consumer if the documents would not have changed since they were initially verified.

See

proposed comment 35(b)(2)(i)-4. For example, if the creditor has collected the consumer's 2006 tax return for a loan in May 2007, and the creditor makes another loan to that consumer in August 2007, the creditor may rely on the 2006 tax return.

Proposed safe harbor.

The proposed rule would contain a safe harbor for creditors who fail to verify income before extending credit if the amounts of income or assets relied on were not materially greater than the creditor could have verified when the extension of credit was consummated.

See

proposed § 226.35(b)(2)(ii) and comment 35(b)(2)(ii)-1. The proposed safe harbor would cover cases where the creditor's failure to verify income would not have altered the decision to extend credit to the consumer or the terms of the credit.

Requests for Comment

The Board seeks comment on whether, and in what specific circumstance, the proposed rule would reduce access to credit for certain borrowers, such as the self-employed, who may have difficulty documenting income and assets. The Board also requests comment on whether the rule could be made more flexible without undermining consumer protection. Comment on these questions is solicited both with respect to the subprime market and any part of the alt-A market that the proposed definition of “higher-priced mortgage loan” would tend to cover. Comment is also sought on the appropriateness of the proposed safe harbor, and on whether other safe harbors would be appropriate.

Potential alternatives.

The Board believes the proposed rule would provide consumers a significant new protection against lending based on income or asset inflation. It is also expected that creditors, regulators, and courts would find it relatively easy to determine compliance with the proposed rule. The Board recognizes, however, that the rule is broad in that it imposes a blanket requirement on all creditors to verify, for every higher-priced mortgage loan they originate, the income and assets they rely on, without consideration of the extent to which the risks of inflating income or assets may vary from case to case. This rule could increase costs for creditors as well as consumers. The rule is also broad in another respect: It imposes a blanket verification requirement on creditors even though consumers, themselves, may inflate their stated incomes without the creditor's knowledge. Such consumers might in some instances seek to enforce the proposed rule through civil actions.

For these reasons, the Board seeks suggestions of narrower alternatives that would impose fewer costs on creditors and consumers while providing sufficient protection to consumers who may be injured, directly or indirectly, by stated income lending. For example, should the Board, instead of adopting the proposed rule, prohibit creditors and mortgage brokers from inflating incomes, influencing consumers to inflate incomes, or extending credit while having reason to believe that a consumer inflated income or was influenced to inflate income? Would a rule attempting to distinguish cases where creditors or brokers were not complicit in applicants' inflating incomes be cost-effective and practicable? If such a rule were adopted, should it provide a safe harbor for verifying income?

Subordinate-lien loans.

The Board's proposal covers both first-lien and subordinate-lien loans, but the Board requests comment on whether the proposed rule should make an exception for all subordinate-lien loans, or for subordinate-lien loans in amounts

less than a specified dollar amount, or less than a specified percentage of the home's value. Requiring income and asset verification for subordinate-lien loans could in some cases increase costs without providing meaningful protection to consumers. For example, if a consumer has a record of making timely payments on a first-lien loan, then verifying income or assets for a small subordinate-lien loan—assuming the creditor relied on income or assets to make the credit decision—may not provide sufficient additional information about the borrower's ability to repay the debt to justify the cost of verification. Thus, the Board seeks suggestions for potential exemptions for subordinate-lien loans that would not undermine consumer protection.

D. Prepayment Penalties—§ 226.32(d)(6) and (7); § 226.35(b)(3)

Pursuant to TILA Section 129(c), a HOEPA-covered loan may not provide for a prepayment penalty unless: the borrower's debt-to-income (DTI) ratio at consummation does not exceed 50 percent (and deb

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