Truth in Lending

Federal RegisterJul 30, 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:

Final rule; official staff commentary.

SUMMARY:

The Board is publishing final rules amending 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 final rule applies four protections to a newly-defined category of higher-priced mortgage loans secured by a consumer's principal dwelling, including a prohibition on lending based on the collateral without regard to consumers' ability to repay their obligations from income, or from other sources besides the collateral. The revisions apply two new protections to mortgage loans secured by a consumer's principal dwelling regardless of loan price, including a prohibition on abusive servicing practices. The Board is also finalizing rules requiring that advertisements provide accurate and balanced information, in a clear and conspicuous manner, about rates, monthly payments, and other loan features. The advertising rules ban several deceptive or misleading advertising practices, including representations that a rate or payment is “fixed” when it can change. Finally, the revisions require creditors to provide consumers with transaction-specific mortgage loan disclosures within three business days after application and before they pay any fee except a reasonable fee for reviewing credit history.

DATES:

This final rule is effective on October 1, 2009, except for § 226.35(b)(3)) which is effective on April 1, 2010. See part XIII, below, regarding mandatory compliance with § 226.35(b)(3) on mortgages secured by manufactured housing.

FOR FURTHER INFORMATION CONTACT:

Kathleen C. Ryan or Dan S. Sokolov, Counsels; Paul Mondor, Senior Attorney; Jamie Z. Goodson, Brent Lattin, Jelena McWilliams, Dana E. Miller, or Nikita M. Pastor, 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 Final Rules

A. Rules To Prevent Unfairness, Deception, and Abuse

B. Revisions To Improve Mortgage Advertising

C. Requirement To Give Consumers Disclosures Early

II. Consumer Protection Concerns in the Subprime Market

A. Recent Problems in the Mortgage Market

B. 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. Interagency 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. The Board's Proposal

A. Proposals To Prevent Unfairness, Deception, and Abuse

B. Proposals To Improve Mortgage Advertising

C. Proposal To Give Consumers Disclosures Early

VII. Overview of Comments Received

VIII. Definition of “Higher-Priced Mortgage Loan”—§ 226.35(a)

A. Overview

B. Public Comment on the Proposal

C. General Approach

D. Index for Higher-Priced Mortgage Loans

E. Threshold for Higher-Priced Mortgage Loans

F. The Timing of Setting the Threshold

G. Proposal To Conform Regulation C (HMDA)

H. Types of Loans Covered Under § 226.35

IX. Final Rules for Higher-Priced Mortgage Loans and HOEPA Loans

A. Overview

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

C. Prepayment Penalties—§ 226.32(d)(6) and (7); § 226.35(b)(2)

D. Escrows for Taxes and Insurance—§ 226.35(b)(3)

E. Evasion Through Spurious Open-End Credit—§ 226.35(b)(4)

X. Final 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)

XI. Advertising

A. Advertising Rules for Open-End Home-Equity Plans—§ 226.16

B. Advertising Rules for Closed-End Credit)—§ 226.24

XII. Mortgage Loan Disclosures

A. Early Mortgage Loan Disclosures—§ 226.19

B. Plans To Improve Disclosure

XIII. Mandatory Compliance Dates

XIV. Paperwork Reduction Act

XV. Regulatory Flexibility Analysis

I. Summary of Final Rules

On January 9, 2008, the Board published proposed rules that would amend Regulation Z, which implements the Truth in Lending Act (TILA) and the Home Ownership and Equity Protection Act (HOEPA). 73 FR 1672. The Board is publishing final amendments to Regulation Z to establish new regulatory protections for consumers in the residential mortgage market. 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 mortgage loans.

A. Rules To Prevent Unfairness, Deception, and Abuse

The Board is publishing 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 are 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 apply only to higher-priced mortgage loans, while others apply to all mortgage loans secured by a consumer's principal dwelling.

Protections Covering Higher-Priced Mortgage Loans

The Board is finalizing four protections for consumers receiving higher-priced mortgage loans. These loans are defined as consumer-purpose, closed-end loans secured by a consumer's principal dwelling and

having an annual percentage rate (APR) that exceeds the average prime offer rates for a comparable transaction published by the Board by at least 1.5 percentage points for first-lien loans, or 3.5 percentage points for subordinate-lien loans. For higher-priced mortgage loans, the final rules:

○ Prohibit creditors from extending credit without regard to a consumer's ability to repay from sources other than the collateral itself;

○ Require creditors to verify income and assets they rely upon to determine repayment ability;

○ Prohibit prepayment penalties except under certain conditions; and

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

In addition, the final rules 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 open-end 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's rules:

○ 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, or failing to provide loan payoff statements upon request within a reasonable time.

The Board is withdrawing its proposal to require servicers to deliver a fee schedule to consumers upon request; and its proposal to prohibit creditors from paying a mortgage broker more than the consumer had agreed in advance that the broker would receive. The reasons for the withdrawal of these two proposals are discussed in parts X.A and X.C below.

Prospective Application of Final Rule

The final rule is effective on October 1, 2009, or later for the requirement to establish an escrow account for taxes and insurance for higher-priced mortgage loans. Compliance with the rules is not required before the effective dates. Accordingly, nothing in this rule should be construed or interpreted to be a determination that acts or practices restricted or prohibited under this rule are, or are not, unfair or deceptive before the effective date of this rule.

Unfair acts or practices can be addressed through case-by-case enforcement actions against specific institutions, through regulations applying to all institutions, or both. A regulation is prospective and applies to the market as a whole, drawing bright lines that distinguish broad categories of conduct. By contrast, an enforcement action concerns a specific institution's conduct and is based on all of the facts and circumstances surrounding that conduct.

See

Board and FDIC, CA 04-2,

Unfair Acts or Practices by State-Chartered Banks

(March 11, 2004), available at

http://www.federalreserve.gov/boarddocs/press/bcreg/2004/20040311/attachment.pdf

Because broad regulations, such as the rules adopted here, can require large numbers of institutions to make major adjustments to their practices, there could be more harm to consumers than benefit if the rules were effective immediately. If institutions were not provided a reasonable time to make changes to their operations and systems to comply with this rule, they would either incur excessively large expenses, which would be passed on to consumers, or cease engaging in the regulated activity altogether, to the detriment of consumers. And because the Board finds an act or practice unfair only when the harm outweighs the benefits to consumers or to competition, the implementation period preceding the effective date set forth in the final rule is integral to the Board's decision to restrict or prohibit certain acts or practices.

For these reasons, acts or practices occurring before the effective dates of these rules will be judged on the totality of the circumstances under other applicable laws or regulations. Similarly, acts or practices occurring after the rule's effective dates that are not governed by these rules will continue to be judged on the totality of the circumstances under other applicable laws or regulations.

B. Revisions To Improve Mortgage Advertising

Another goal of the final rules is to ensure that mortgage loan advertisements provide accurate and balanced information and do not contain misleading or deceptive representations. Thus the Board's rules 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. These rules are adopted under the Board's authorities to: adopt regulations to ensure consumers are informed about and can shop for credit; require that information, including the information required for advertisements for closed-end credit, be disclosed in a clear and conspicuous manner; and regulate advertisements of open-end home-equity plans secured by the consumer's principal dwelling.

See

TILA Section 105(a), 15 U.S.C. 1604(a); TILA Section 122, 15 U.S.C. 1632; TILA Section 144, 15 U.S.C. 1664; TILA Section 147, 15 U.S.C. 1665b.

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

○ Advertisements that state “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;

○ Advertisements that compare an actual or hypothetical rate or payment obligation to 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;

○ Advertisements that make 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 is a “counselor” for 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. Requirement To Give Consumers Disclosures Early

A third goal of these rules is to provide consumers transaction-specific disclosures early enough to use while shopping for a mortgage loan. The final rule requires 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 business days after application, and before the consumer pays any fee except a reasonable fee for the 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 began 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 2005—though about 68 percent now—and expanded consumers' access to the equity in their homes.

Inside Mortgage Finance Publications, Inc.,

The 2007 Mortgage Market Statistical Annual

vol. I (

IMF 2007 Mortgage Market

), at 4.

Recently, however, some of these benefits have 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 18 percent in May 2008, more than triple the mid-2005 level.

Adjustable-rate subprime mortgages have performed the worst, reaching a serious delinquency rate of 27 percent in May 2008, five times 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.

Delinquency rates calculated from data from First American LoanPerformance.

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 8 percent (as of April 2008) from less than 2 percent only a year earlier. In contrast, 1.5 percent of loans in the prime-mortgage sector were seriously delinquent as of April 2008.

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 over 550,000 foreclosures in the first quarter of 2008, about half of them on subprime 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) (

MBA Nat'l Delinquency Survey

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, particularly in the subprime sector. The loosening of underwriting standards is discussed in more detail in part II.B. The next section discusses underlying market imperfections that facilitated this loosening and made it difficult for consumers to avoid injury.

B. 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 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 regulators to protect consumers.

Benjamin J. Keys, Tanmoy K. Mukherjee, Amit Seru and Vikram Vig,

Did Securitization Lead to Lax Screening? Evidence from Suprime Loans

at 22, available at:

http://ssrn.com/abstract=1093137

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 reading a newspaper, telephoning brokers or lenders, or searching the Internet can easily obtain current prime interest rate quotes for free. In contrast, subprime rates, which can vary significantly based on the individual borrower's risk profile, are not broadly advertised and are usually obtainable only after application and paying a fee. Subprime rate quotes may not even be reliable if the originator engages in a “bait and switch” strategy. Price opacity is exacerbated because the subprime consumer often does not know her own credit score. Even if she knows her score, the prevailing interest rate for someone with that score and other credit risk characteristics is not generally publicly available.

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 been ARMs than fixed rate mortgages. ARMs 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. Because the annual percentage rate (APR) does not reflect the price of the penalty, the consumer must both calculate the size of the penalty from a formula and assess the likelihood of moving or refinancing during the penalty period. In these and other ways, subprime products tend to be complex for consumers.

U.S. Dep't of Housing & Urban Development and 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 and Peter Zorn,

Subprime Lending: An Investigation of Economic Efficiency,

15 Housing Policy Debate 533, 570 (2004) (

Subprime Lending Investigation

) (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. 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/

Limited shopping.

In this environment of limited transparency, consumers—particularly those in the subprime market—may reasonably decide not to shop further among originators or among loan options once an originator has told them they will receive a loan, because further shopping can be very costly. Shopping may require additional applications and application fees, and may delay the consumer's receipt of funds. This delay creates a potentially significant cost for the many subprime borrowers seeking to refinance their obligations to lower their debt payments at least temporarily, to extract equity in the form of cash, or both.

In recent years, nearly 90 percent of subprime ARMs used for refinancings 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).

A “cash out” transaction is one in which the borrower refinances an existing mortgage, and the new mortgage amount is greater than the existing mortgage amount, to allow the borrower to extract from the home. Figure calculated from First American LoanPerformance data.

While shopping costs are likely clear, the benefits may not be obvious or may appear minimal. Without easy access to subprime product prices, a consumer may have only a limited idea after working with one originator 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 for better terms if they expect to be turned down by other originators. Further, if a consumer uses a broker believing that the broker is shopping for the consumer for the best deal, the consumer may believe a better deal is not obtainable. 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 and Janis K. Pappalardo, Federal Trade Commission,

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

at 24-26 (2007), available at:

http://www.ftc.gov/os/2007/06/P025505MortgageDisclosureReport.pdf (Improving Mortgage Disclosures)

(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 and Jeanne M. Hogarth,

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

, Financial Services Review 291 (2000) (

Consumer Information Search

) (“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 and Karen Pence,

Do Homeowners Know Their House Values and Mortgage Terms?

18-22 (Board 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 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.

If consumers do not have a certain minimum level understanding of the market and products, disclosures for complex and infrequent transactions may not effectively provide that minimum understanding. 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).

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 is 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 were not adequately assessing repayment ability, particularly where mortgages were sold to the secondary market and the originator retained little of the risk. 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, has also contributed 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.

Atif Mian and Amir Sufi,

The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis

(May 2008), available at:

http://ssrn.com/abstract=1072304

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 that 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.

Benjamin J. Keys, Tanmoy K. Mukherjee, Amit Seru and Vikram Vig,

Did Securitization Lead to Lax Screening? Evidence from Suprime Loans

at 22, available at:

http://ssrn.com/abstract=1093137

Fragmentation in the originator market can further exacerbate the problem. Data reported under the Home Mortgage Disclosure Act (HMDA) show that independent mortgage companies—those not related to depository institutions or their subsidiaries or affiliates—in 2005 and 2006 made nearly one-half of first-lien mortgage loans reportable as being higher-priced but only one-fourth of loans that were not reportable as 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 first-lien mortgage loans on owner-occupied dwellings that were reportable as higher-priced. In addition, as noted earlier, one source suggests that 60 percent or more of mortgages originated in the last several years were originated through mortgage brokers.

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

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. Further, government oversight of such a fragmented market faces significant challenges because originators operate in different states and under different regulatory and supervisory regimes and different practices in sharing information among regulators. 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 originate are affordable; and regulators face limits on their ability to oversee a fragmented subprime origination market. These circumstances 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 ensures that it is applied uniformly to all originators and provides 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 duty of care 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 addressing in these final rules.

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., Foreclosure Problems and Solutions: Federal, State, and Local Efforts to Address the Foreclosure Crisis in Ohio: Hearing before the Subcomm. on Housing and Comm. Oppty. of the H. Comm. on Fin. Servs.,

110th Cong. (2008);

Targeting Federal Aid to Neighborhoods Distressed by the Subprime Mortgage Crisis: Hearing before the Subcomm. on Housing and Comm. Oppty. of the H. Comm. on Fin. Servs.,

110th Cong. (2008);

Improving Consumer Protections in Subprime Lending: Hearing before the Subcomm. on Int. Comm., Trade, and Tourism of the S. Comm. on Comm., Sci., and Trans.,

110th Cong. (2008);

H.R. 5679, The Foreclosure Prevention and Sound Mortgage Servicing Act of 2008: Hearing before the Subcomm. on Housing and Comm. Oppty. of the H. Comm. on Fin. Servs.,

110th Cong. (2008);

Restoring the American Dream: Solutions to Predatory Lending and the Foreclosure Crisis: S. Comm. on Banking, Hsg., and Urban Affairs,

110th Cong. (2008);

Consumer Protection in Financial Services: Subprime Lending and Other Financial Activities: Hearing before the Subcomm. on Fin. Svcs. and Gen. Gov't of the H. Approp. Comm.,

110th Cong. (2008);

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).

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. Interagency 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 (

Nontraditional Mortgage Guidance

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 2007, 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 (

Subprime Statement

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 adopting apply uniformly to all creditors and are 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 §§ 226.35 and 226.36 and corresponding revisions to §§ 226.32 and 226.34, as well as restrictions on misleading and deceptive advertisements, are 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 TILA Section 129(l)(2), 15 U.S.C. 1639(l)(2), is broad. It 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. Section 129(l)(2) also authorizes the Board to strengthen the protections in Section 129(c)-(i) for the loans to which Section 103(aa) applies these protections (HOEPA loans). In TILA Section 129(c)-(i), Congress set minimum standards for HOEPA loans. The Board is authorized to strengthen those standards for HOEPA loans when the Board finds practices unfair, deceptive, or abusive. The Board is also authorized by Section 129(l)(2) to apply those strengthened standards to loans that are not HOEPA loans. Moreover, while HOEPA's statutory restrictions apply only to creditors and only to loan terms or lending practices, Section 129(l)(2) is not limited to acts or practices by 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.” Thus, the Board's authority is not 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.

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 statutes and the Federal Trade Commission Act (FTC 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 (FTC) for determining whether acts or practices are unfair under Section 5(a), 15 U.S.C. 45(a).

Under the FTC 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, 42 FR 7740, 7743, March 1, 1984 (

Credit Practices Rule

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.

Id.

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 (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.

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

Denison,

167 P.3d 1240, 1255 (Alaska 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 (N.H. 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).

In adopting final 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 these rules 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 requirement to provide early disclosures for residential mortgage transactions as well as many of the revisions to improve advertising disclosures. These rules 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. The Board's Proposal

On January 9, 2008, the Board published a notice of proposed rulemaking in the

Federal Register

(73 FR 1672) proposing to amend Regulation Z.

A. Proposals To Prevent Unfairness, Deception, and Abuse

The Board proposed new restrictions and requirements for mortgage lending and servicing intended to protect consumers against unfairness, deception, and abuse while preserving responsible lending and sustainable homeownership. Some of the proposed 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 proposed certain protections for consumers receiving higher-priced mortgage loans. Higher-priced mortgage loans would have been loans with 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 such loans, the Board proposed 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 have prohibited 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.

Proposed 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 proposed 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 the Board's proposal was to ensure that mortgage loan advertisements provide accurate and balanced information and do not contain misleading or deceptive representations. The Board proposed 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. The proposal was issued under the Board's authorities to: Adopt regulations to ensure consumers are informed about and can shop for credit; require that information, including the information required for advertisements for closed-end credit, be disclosed in a clear and conspicuous manner; and regulate advertisements of open-end home-equity plans secured by the consumer's principal dwelling.

See

TILA Section 105(a), 15 U.S.C. 1604(a); Section 122, 15 U.S.C. 1632; Section 144, 15 U.S.C. 1664; Section 147, 15 U.S.C. 1665b.

The Board also proposed, 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 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;

○ 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

C. Proposal To Give Consumers Disclosures Early

A third goal of the proposal was to provide consumers transaction-specific disclosures early enough to use while shopping for a mortgage loan. The Board proposed 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 business 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.

VII. Overview of Comments Received

The Board received approximately 4700 comments on the proposal. The comments came from community banks, independent mortgage companies, large bank holding companies, secondary market participants, credit unions, state and national trade associations for financial institutions in the mortgage business, mortgage brokers and mortgage broker trade associations, realtors and realtor trade associations, individual consumers, local and national community groups, federal and state regulators and elected officials, appraisers, academics, and other interested parties.

Commenters generally supported the Board's effort to protect consumers from unfair practices, particularly in the subprime market, while preserving responsible lending and sustainable homeownership. However, industry commenters generally opposed the breadth of the proposal; favoring narrower and more flexible rules. They also expressed concerns about the costs of certain proposals, such as the requirement to establish escrows for all first-lien higher-priced mortgage loans. Consumer advocates, federal and state regulators (including the Federal Deposit Insurance Corporation (FDIC)), and elected officials (including members of Congress and some state attorneys general) supported the proposal as addressing some of the abuses in the subprime market, but argued that additional consumer protections are needed.

Many commenters supported the approach of using loan price to identify “higher-priced” loans. Financial institution commenters and their trade associations were concerned, however, that the proposed price thresholds were too low, and could capture many prime loans. They contended that broad

coverage would reduce credit availability because creditors would refrain from making covered loans or would pass on compliance costs. Many industry commenters urged the Board to use a different index to define higher-priced mortgage loans than the proposed index of Treasury security yields, because the spread between Treasury yields and mortgage rates can change. Consumer advocate commenters generally, but not uniformly, favored applying the Board's proposed protections to all loans secured by a principal dwelling regardless of loan price. In the alternative, they favored the proposed price thresholds but urged the Board also to apply the protections to nontraditional mortgage loans.

Industry commenters generally, but not uniformly, supported or did not oppose a rule prohibiting lenders from engaging in a pattern or practice of unaffordable lending. They urged the Board, however, to provide a clear and specific “safe harbor” and remove the presumptions of violations in order to avoid unduly constraining credit. In contrast, consumer advocate commenters and others urged the Board to revise the ability to repay rule so that it applies on a loan-by-loan basis and not only to a pattern or practice of disregarding borrowers' ability to repay. These commenters argued that a requirement to prove a “pattern or practice” would prevent consumers from bringing claims and would weaken the rule's power to deter abuse.

Consumer advocate commenters and some federal and state regulators and elected officials also maintained that a complete ban on prepayment penalties is necessary to protect consumers. In particular, many of these commenters argued that prepayment penalties' harms to subprime consumers outweigh the benefits of any reductions in interest rate consumers receive, and that the Board's proposed restrictions on prepayment penalties would not adequately address the harms. However, most banks and their trade associations stated that the interest rate benefit afforded to consumers with loans having prepayment penalty provisions lowers credit costs and increases credit availability.

Many community banks and mortgage brokers as well as several industry trade associations opposed the proposed escrow requirement, contending that escrow infrastructures would be costly and that creditors would either refrain from making higher-priced loans or would pass costs on to consumers. Consumers also expressed concern that they would lose interest on their escrowed funds and that servicers would fail to properly pay tax and insurance obligations. Several industry trade associations, several large creditors and some mortgage brokers, consumer and community development groups, and state and federal officials, however, supported the proposed escrow requirement as protecting consumers from expensive force-placed insurance or default, and possibly foreclosure.

For their part, mortgage brokers and their trade associations principally addressed the yield spread premium proposal, which they strongly opposed. They, as well as FTC staff, argued that prohibiting creditors from paying brokers more than the consumer agreed to in writing would put brokers at a competitive disadvantage relative to retail lenders. They also argued that consumers would be confused and misled by a broker compensation disclosure. Consumer advocates, several members of Congress, several state attorneys general, and the FDIC contended that the proposal would do little to protect consumers and urged the Board to ban yield spread premiums outright.

Most commenters generally supported the Board's proposed advertising rules, although some commenters requested clarifications and modifications. Commenters were divided about the proposal to require early mortgage loan disclosures. Many creditors and their trade associations opposed the proposal because of perceived operational cost and compliance difficulties, and concerns about the scope of the fee restriction and its application to third party originators. Consumer groups, state regulators and enforcement generally supported the proposed rule, however, because it would make more information available to consumers when they are shopping for loans. Some of the commenters requested that the Board require lenders to redisclose before loan consummation to enhance the accuracy of information.

Industry commenters urged the Board to adopt all of the proposed restrictions in §§ 226.35 and 226.36 under its TILA Section 105(a) authority rather than its Section 129(l)(2) authority. They argued that using Section 129(l)(2) authority would impose disproportionately heavy penalties on lenders for violations and unnecessary costs on consumers. Consumer advocates, on the other hand, supported using Section 129(l)(2) authority and urged the Board use it more broadly to adopt the other proposed rules concerning early disclosures and advertising.

Public comments with respect to these and other provisions of the rule are described and discussed in more detail below.

VIII. Definition of “Higher-Priced Mortgage Loan”—§ 226.35(a)

A. Overview

The Board proposed to extend certain consumer protections to a subset of consumer residential mortgage loans referred to as “higher-priced mortgage loans.” This part VIII discusses the definition of “higher-priced mortgage loan” the Board is adopting. A discussion of the specific protections that apply to these loans follows in part IX. The Board is also finalizing the proposal 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 X.

Under the proposal, 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, and home equity loans. The definition would exclude home equity lines of credit (“HELOCs”). There would also be exclusions for reverse mortgages, construction-only loans, and bridge loans.

The Board is adopting a definition of “higher-priced mortgage loan” that is substantially similar to that proposed but different in the particulars. The changes to the final rule are being made in response to commenters' concerns. The final definition, like the proposed definition, sets a threshold above a measure of market rates to distinguish higher-priced mortgage loans from the rest of the mortgage market. But the measure the Board is adopting is different, and therefore so is the threshold. Instead of yields on Treasury securities, the definition uses average offer rates for the lowest-risk prime mortgages, termed “average prime offer rates.” For the foreseeable future, the Board will obtain or, as applicable, derive average prime offer rates from the Freddie Mac Primary Mortgage Market Survey®. The threshold is set at 1.5 percentage points above the average prime offer rate on a comparable transaction for first-lien loans, and 3.5 percentage points for subordinate-lien loans. The exclusions from “higher-priced mortgage loans” for HELOCs and

certain other types of transactions are adopted as proposed.

The definition of “higher-priced mortgage loans” appears in § 226.35(a). Such loans are subject to the restrictions and requirements in § 226.35(b) concerning repayment ability, income verification, prepayment penalties, escrows, and evasion, except that only first-lien higher-priced mortgage loans are subject to the escrow requirement.

B. Public Comment on the Proposal

Most industry commenters, a national consumer advocacy and research organization, and others supported the approach of using loan price to identify loans subject to stricter regulations. A large number and wide variety of these commenters, however, urged the Board to use a prime mortgage market rate instead of, or in addition to, Treasury yields to avoid arbitrary changes in coverage due to changes in the premium for mortgages over Treasuries or in the relationship between short-term and long-term Treasury yields. The precise recommendations are discussed in more detail in subpart D below. Industry commenters were particularly concerned that the threshold over the chosen index be set high enough to exclude the prime market. They maintained that the proposed thresholds of 300 and 500 basis points over Treasury yields would cover a significant part of the prime market and reduce credit availability.

Consumer and civil rights group commenters generally, but not uniformly, opposed limiting protections to higher-priced mortgage loans and recommended applying these protections to all loans secured by a principal dwelling. They recommended in the alternative that the thresholds be adopted at the levels proposed, or even lower, and that nontraditional mortgage loans, which permit non-amortizing payments or negatively amortizing payments, be covered regardless of loan price. They believe the Nontraditional Mortgage Guidance is not adequate to protect consumers.

The proposed exclusion of HELOCs drew criticism from several consumer and civil rights groups but strong support from industry commenters. The other proposed exclusions drew limited comment. Some industry commenters proposed additional exclusions for loans with federal guaranties such as FHA, VA, and Rural Housing Service. A few commenters also proposed excluding “jumbo” loans, that is, loans in an amount that exceeds the threshold of eligibility for purchase by Fannie Mae or Freddie Mac. Other proposed exclusions are discussed below.

C. General Approach

Cover Subprime, Exclude Prime

The Board stated in connection with the proposal 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, as it stated in connection with the proposal, that the stricter regulations of § 226.35 should cover the subprime market and generally exclude the prime market.

The Board believes that the practices that § 226.35 would prohibit—lending without regard to ability to pay from verified income and non-collateral assets, failure to establish an escrow for taxes and insurance, and prepayment penalties outside of prescribed limits—are so clearly injurious on balance to consumers within the subprime market that they should be categorically barred in that market. The reasons for this conclusion are detailed below in part IX with respect to each practice. Moreover, the Board has concluded that, to be effective, these prohibitions must cover the entire subprime market and not just subprime products with particular terms or features. Market imperfections discussed in part II—the subprime market's lack of transparency and potentially inadequate incentives for creditors to make only loans that consumers can repay—affect consumers throughout the subprime market. To be sure, risk within the subprime market has varied by loan type. For example, delinquencies on fixed-rate subprime mortgages have been lower in recent years than on adjustable-rate subprime mortgages. It is not likely to be practical or effective, however, to target certain types of loans in the subprime market for coverage while excluding others. Such a rule would be unduly complex, likely fail to adapt quickly enough to ever-changing products, and encourage creditors to steer borrowers to uncovered products.

In the prime market, however, the Board believes that a case-by-case approach to determining whether the § 226.35 practices are unfair or deceptive is more appropriate. By nature, loans in the prime market have a lower credit risk. 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. The final rule applies protections against coercion of appraisers and unfair servicing practices to the prime market because, with respect to these particular practices, the prime market, too, suffers a lack of transparency and these practices do not appear to be limited to the subprime market.

With these limited exceptions, at present the Board believes that any undue risks to consumers in the prime market from particular loan terms or lending practices are better 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 standards the Government Sponsored Enterprises set for the loans they will purchase continue to have significant influence within the prime market, and these entities are accountable for those standards to regulators and Congress.

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. This figure understates the GSEs' influence on the prime market because it excludes the many loans that were underwritten using the GSEs' standards but were not sold to the GSEs.

Use the APR

The Board also continues to believe—and few, if any, commenters disagreed—that the best way to identify the subprime market is by loan price rather than by 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.

The most appropriate measure of loan price for this regulation is the APR; few, if any, commenters disagreed with this point either. 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. Because 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 § 226.35.

Two loans with identical risk characteristics will likely have different APRs if they were originated when market rates were different. It is important to normalize the APR by an index that moves with mortgage market rates so that loans with the same risk characteristics will be treated the same regardless of when the loans were originated. The Board proposed to use as this index the yields on comparable Treasury securities, which 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 mortgage loans reportable under HMDA as being higher-priced,

see

12 CFR 203.4(a)(12). For reasons discussed in more detail below, the final rule uses instead an index that more closely tracks movements in mortgage rates than do Treasury yields.

Uncertainty

As the Board stated in connection with the proposal, 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 not a 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 provide only a rough measure of the empirical relationship between APR and credit risk. A proprietary dataset such as the loan-level data on subprime securitized mortgages published by 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 mortgage loans reportable as being higher-priced (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. “Over compliance” could effectively lower the threshold. While a loan's APR can be estimated early in the application process, it is typically not known to a certainty until after the underwriting has been completed and the interest rate has been locked. 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 contract rates and points that are economically identical for an originator produce different APRs. With the adoption of § 226.35, an originator may 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 perfectly achieve the objectives of covering the subprime market and generally excluding the prime market. In the face of this uncertainty, deciding on an APR threshold calls for judgment. As the Board stated with the proposal, the Board believes it is appropriate to err on the side of covering somewhat more than the subprime market.

The Alt-A Market

If the selected thresholds cover more than the subprime market, then they likely extend into what has been known as the alt-A market. 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.

The Board judges that the benefits of extending § 226.35's restrictions into some part of the alt-A market to ensure coverage of the entire subprime market outweigh the costs. This market segment also saw undue relaxation of underwriting standards, one reason that its share of residential mortgage originations grew sixfold from 2003 to 2006 (from two percent of originations to 13 percent).

See

part VIII.C for further discussion of the relaxation of underwriting standards in the alt-A market.

IMF 2007 Mortgage Market

at 4.

To the extent § 226.35 covers the higher-priced end of the alt-A market, where risks in that segment are highest, the regulation will likely benefit consumers more than it would cost them. Prohibiting lending without regard to repayment ability in this market slice would likely reduce the risk to consumers from “payment shock” on nontraditional loans. Applying the income verification requirement of §§ 226.32(a)(4)(ii) and 226.35(b)(1) 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.

D. Index for Higher-Priced Mortgage Loans

loans. The definition would exclude home equity lines of credit (“HELOCs”), reverse mortgages, construction-only loans, and bridge loans.

The Board is adopting a definition of “higher-priced mortgage loan” that is substantially similar to that proposed but different in the particulars. The final definition, like the proposed definition, sets a threshold above a measure of market rates to distinguish higher-priced mortgage loans from the rest of the mortgage market. But the measure the Board is adopting is different, and therefore so is the threshold. Instead of yields on Treasury securities, the final definition uses average offer rates for the lowest-risk prime mortgages, termed “average prime offer rates.” For the foreseeable future, the Board will obtain or, as applicable, derive average prime offer rates for a wide variety of types of transactions from the Primary Mortgage Market Survey® (PMMS) conducted by Freddie Mac, and publish these rates on at least a weekly basis. The Board will conduct its own survey if it becomes appropriate or necessary to do so. The threshold is set at 1.5 percentage points above the average prime offer rate on a comparable transaction for first-lien loans, and 3.5 percentage points for subordinate-lien loans. The exclusions from “higher-priced mortgage loans” for HELOCs and certain other types of transactions are adopted as proposed.

Public Comment

A large number and wide variety of industry commenters, as well as a consumer research and advocacy group, urged the Board to use a prime mortgage market rate instead of, or in addition to, Treasury yields. First, they argued the tendency of prime mortgage rates at certain times to deviate significantly from Treasury yields—such as during the “flight to quality” seen in recent months—would lead to unwarranted coverage of the prime market and arbitrary swings in coverage. Many of these commenters also pointed out that changes in the Treasury yield curve (the relationship of short-term to long-term Treasury yields) can increase or decrease coverage even though neither borrower risk profiles nor creditor practices or products have changed. The Board's proposal to address this second problem by matching Treasuries to mortgages on the basis of the loan's expected life span drew limited, but mostly negative, comment. Although one large lender specifically agreed with the proposed matching rules, a few others stated the rules were too complicated.

The precise recommendations for a measure of mortgage market rates varied. Several commenters specifically recommended using the PMMS. They recommended that a threshold be added to the PMMS figure because it is, by design, at the low end of the range of rates that can be found in the prime market. Recommendations for thresholds for first-lien loans ranged from 150 to 300 basis points over the PMMS. Some commenters recommended approaches that would rely on both Treasuries and the PMMS. A few recommended the approach of a recent North Carolina law, which covers a first-lien loan only if its APR exceeds two thresholds: 300 basis points over the comparable Treasury yield and 175 basis points over the PMMS rate for the 30-year fixed-rate loan. A few recommended a different way to integrate Treasuries and the PMMS. Under this approach, the threshold would be set at the comparable Treasury yield (determined as proposed) plus 200 basis points (400 for subordinate-lien loans), plus the spread between the PMMS 30-year FRM rate and the seven-year Treasury.

Some commenters offered alternatives to the PMMS. A consumer research and advocacy group and Freddie Mac suggested that the Board could use the higher of the Freddie Mac Required Net Yield (the yield Freddie Mac expects from purchasing a conforming mortgage) and the equivalent Fannie Mae yield. Fannie Mae offered a similar, but not identical, recommendation to use the higher of the current coupon yield for Fannie Mae Mortgage Backed Securities and Freddie Mac participation certifications (PC). These yields reflect the price at which a government-sponsored entity (GSE) security can be sold in the market. At least one commenter suggested that the Board could conduct its own survey of mortgage market rates.

Discussion

Based on these comments and the analysis below, the final rule does not use Treasury yields as the index for higher-priced mortgage loans. Instead, the rule uses average offer rates on the lowest-risk prime mortgage loans, termed “average prime offer rates.” For the foreseeable future, the Board will obtain or, as applicable, derive these rates for a wide variety of types of transactions from the PMMS and publish them on a weekly basis.

Drawbacks of using Treasury security yields

. There are significant advantages to using Treasury yields to set the APR thresholds. Treasuries are traded in a highly liquid market; Treasury yield data are published for many different maturities and can easily be calculated for other maturities; and the integrity of published yields is not subject to question. For these reasons, Treasuries are also commonly used in federal statutes, such as HOEPA, for benchmarking purposes.

As recent events have highlighted, however, using Treasury yields to set the APR threshold in a law regulating mortgage loans has two major disadvantages. The most significant disadvantage is that the spread between Treasuries and mortgage rates, even prime mortgage rates, changes in the short term and in the long term. Moreover, the comparable Treasury security for a given mortgage loan is quite difficult to determine accurately.

The Treasury-mortgage spread can change for at least three different reasons. First, credit risk may change on mortgages, even for the highest-quality borrowers. For example, credit risk increases when house prices fall. Second, competition for prime borrowers can increase, tightening spreads, or decrease, allowing lenders to charge wider spreads. Third, movements in financial markets can affect Treasury yields but have no effect on lenders' cost of funds or, therefore, on mortgage rates. For example, Treasury yields fall disproportionately more than mortgage rates during a “flight to quality.”

Recent events illustrate how much the Treasury-mortgage spread can swing. The spread averaged about 170 basis points in 2007, but increased to an average of about 220 basis points in the first half of 2008. In addition, the spread was highly volatile in this period, shifting as much as 25 basis points in a week. The spread may decrease, but predictions of long-term spreads are highly uncertain.

Changes in the Treasury-mortgage spread can undermine key objectives of the regulation. These changes mean that loans with identical credit risk are covered in some periods but not in others, contrary to the objective of consistent and predictable coverage over time. Moreover, lenders' uncertainty as to when such changes will occur can cause them to set an internal threshold below the regulatory threshold. This may reduce credit availability directly (if a lender's policy is not to make higher-priced mortgage loans) or indirectly, by increasing regulatory burden. The recent volatility might lead lenders to set relatively conservative cushions.

Adverse consequences of volatility in the spread between mortgages rates and Treasuries could be reduced simply by setting the regulatory threshold at a high enough level to ensure it excludes all

prime loans. But a threshold high enough to accomplish this objective would likely fail to meet another, equally important objective of covering essentially all of the subprime market. Instead, the Board is adopting a rate that closely follows mortgage market rates, which should mute the effects on coverage of changes in the spread between mortgage rates and Treasury yields.

The second major disadvantage of using Treasury yields to set the threshold is that the comparable Treasury security for a given mortgage loan is quite difficult to determine accurately. Regulation C determines the comparable Treasury security on the basis of contractual maturity: A loan is matched to a Treasury with the same contract term. For example, the regulation matches a 30-year mortgage loan to a 30-year Treasury security. This method does not, however, account for the fact that very few loans reach their full maturity, and it causes significant distortions when the yield curve changes shape.

These distortions can bias coverage, sometimes in unpredictable ways, and consequently might influence the preferences of lenders to offer certain loan products in certain environments. For example, a steep yield curve will create two regulatory forces pushing the subprime market toward ARMs: A lender could avoid coverage on the margins by selling ARMs rather than fixed-rate mortgages, and the consumer would receive an APR that understates the interest rate risk from an ARM relative to that from a fixed-rate mortgage. (Regulation Z requires the APR be calculated as if the index does not change; a steep yield curve indicates that the index will likely rise.) Artificial regulatory incentives to increase ARMs production in the subprime market could undermine consumer protection.

Robert B. Avery, Kenneth P. Brevoort, and Glenn B. Canner,

Higher-Priced Home Lending and the 2005 HMDA Data

, 92 Fed. Res. Bulletin A123-66 (Sept. 8, 2006).

The Board proposed to reduce distortions in coverage resulting from changes in the yield curve by matching loans to Treasury securities on the basis of the loan's expected life span rather than its legal term to maturity. For example, the Board proposed to match a 30-year fixed-rate mortgage loan to a 10-year Treasury security on the supposition that the mortgage loan will prepay (or default) in ten years or less. A limitation of this approach is that loan life spans change as rates of house price appreciation, mortgage rates, and macroeconomic factors such as unemployment rates change. Loan life spans also change as specific loan features that influence default or prepayment rates change, such as prepayment penalties. The challenge of adjusting the regulation's matching rules on a timely basis would be substantial, and too-frequent adjustments would complicate creditors' compliance. Indeed, many commenters judged the proposed matching rules to be too complicated. This matching problem can be reduced, if not necessarily eliminated, by using mortgage market rates instead of Treasury security yields to set the threshold.

A rate from the prime mortgage market.

To address the principal drawbacks of Treasury security yields, the Board is adopting a final rule that relies instead on a rate that more closely tracks rates in the prime mortgage market. Section 226.35(a)(2) defines an “average prime offer rate” as an annual percentage rate derived from average interest rates, points, and other pricing terms offered by a representative sample of creditors for mortgage transactions that have low-risk pricing characteristics. Comparing a transaction's annual percentage rate to this average offered annual percentage rate, rather than to an average offered contract interest rate, should make the rule's coverage more accurate and consistent. A transaction is a higher-priced mortgage loan if its APR exceeds the average prime offer rate for a comparable transaction by 1.5 percentage points, or 3.5 percentage points in the case of a subordinate-lien transaction. (The basis for selecting these thresholds is explained further in part VIII.E) The creditor uses the most recently available average prime offer rate as of the date the creditor sets the transaction's interest rate for the final time before consummation.

To facilitate compliance, the final rule and commentary provide that the Board will derive average prime offer rates from survey data according to a methodology it will make publicly available, and publish these rates in a table on the Internet on at least a weekly basis. This table will indicate how to identify a comparable transaction.

As noted above, the survey the Board intends to use for the foreseeable future is the PMMS, which contains weekly average rates and points offered by a representative sample of creditors to prime borrowers seeking a first-lien, conventional, conforming mortgage and who would have at least 20 percent equity. The PMMS contains pricing data for four types of transactions: “1-year ARM,” “5/1-year ARM,” “30-year fixed,” and “15-year fixed.” For the two types of ARMs, PMMS pricing data are based on ARMs that adjust according to the yield on one-year Treasury securities; the pricing data include the margin and the initial rate (if it differs from the sum of the index and margin). These data are updated every week and are published on Freddie Mac's Web site.

See http://www.freddiemac.com/dlink/html/PMMS/display/PMMSOutputYr.jsp.

The Freddie Mac PMMS is the most viable option for obtaining average prime offer rates. This is the only publicly available data source that has rates for more than one kind of fixed-rate mortgage (the 15-year and the 30-year) and more than one kind of variable-rate mortgage (the 1-year ARM and the 5/1 ARM). Having rates on at least two fixed-rate products and at least two variable-rate products supplies a firmer basis for estimating rates for other fixed-rate and variable-rate products (such as a 20-year fixed or a 3/1 ARM).

Other publicly available surveys the Board considered are less suitable for the purposes of this rule. Only one ARM rate is collected by the Mortgage Bankers Association's Weekly Mortgage Applications Survey and the Federal Housing Finance Board's Monthly Survey of Interest Rates and Terms on Conventional Single-Family Non-Farm Mortgage Loans. Moreover, the FHFB Survey has a substantial lag because it is monthly and reports rates on closed loans. The Board also evaluated two non-survey options involving Fannie Mae and Freddie Mac. One is the Required Net Yield, the prices these institutions will pay to purchase loans directly. The other is the yield on mortgage-backed securities issued by Fannie Mae and Freddie Mac. With either option, data for ARM yields would be difficult to obtain.

These other data sources, however, provide useful benchmarks to evaluate the accuracy of the PMMS. The PMMS has closely tracked these other indices, according to a Board staff analysis. The Board will continue to use them periodically to help it determine whether the PMMS remains an appropriate data source for Regulation Z. If the PMMS ceases to be available, or if circumstances arise that render it unsuitable for this rule, the Board will consider other alternatives including conducting its own survey.

The Board will use the pricing terms from the PMMS, such as interest rate and points, to calculate an annual percentage rate (consistent with Regulation Z, § 226.22) for each of the four types of transactions that the

PMMS reports. These annual percentage rates are the average prime offer rates for transactions of that type. The Board will derive annual percentage rates for other types of transactions from the loan pricing terms available in the survey. The method of derivation the Board expects to use is being published for comment in connection with the simultaneously proposed revisions to Regulation C. When finalized, the method will be published on the Internet along with the table of annual percentage rates.

E. Threshold for Higher-Priced Mortgage Loans

The Board proposed a threshold of three percentage points above the comparable Treasury security for first-lien loans, or five percentage points for subordinate-lien loans. Since the final rule uses a different index, it must also use a different threshold. The Board is adopting a threshold for first-lien loans of 1.5 percentage points above the average prime offer rate for a comparable transaction, and 3.5 percentage points for second-lien loans.

Public Comment

Industry commenters consistently contended that, should the Board use Treasury yields as proposed, thresholds of 300 and 500 basis points would be too low to meet the Board's stated objective of excluding the prime market.

These commenters recommended thresholds of 400 basis points (600 for subordinate-lien loans) or higher, but a few trade associations recommended 500 (700) or 600 (800). These commenters contended that covering any part of the prime market would harm consumers because the secondary market would not purchase loans with rates over the threshold. They also stated that many originators would seek to avoid originating such loans because of a stigma these commenters expect will attach to such loans, the increased compliance cost associated with the proposed regulations, and the substantial monetary recovery TILA Section 130 would provide plaintiffs for violations of the regulations.

One trade association reported that some of its members found the proposal would have covered up to one-third of prime loans originated between November 2007 and January 2008. This and other commenters said the effect was particularly pronounced with ARMs. Several members of this association were reported to have found that more than one-half of prime 7/1, 5/1, and 3/1 ARMs originated between November 2007 and January 2008 would have been covered. A different association of mortgage lenders indicated that some of its members had found that almost 20 percent of prime and alt-A loans would be covered under the proposal, though the time frame its members used was not specified. A major lender reported that the proposal would have captured 8-10 percent of its portfolio in 2006 and 2007, about twice the portion of its portfolio that it was required to report as higher-priced under HMDA. The lender represents that it did not make subprime loans in this period and asserts that its figures are predictive of the impact the proposal would have on the prime market overall. Another large lender that stated it does not make subprime loans believes that about 10 percent of its current originations would fall above the proposed thresholds. One lender, however, expressed satisfaction with the proposed 300 basis points for first-lien loans and said an internal analysis of historical data found it would not have captured significant numbers of its prime loans. But this lender's analysis found that significant numbers of prime subordinate-lien loans would have been captured, leading the lender to recommend raising the threshold for subordinate-lien loans to 600 basis points.

A trade association for the manufactured housing industry submitted that the proposed thresholds would cover a substantial majority of personal property loans used to purchase manufactured homes. This commenter contended that the reasons these loans are priced higher than loans secured by real estate (such as the smaller loan amounts and the lack of real property securing the loan) do not support a rule that would cover personal property loans disproportionately.

Consumer and civil rights group commenters generally, but not uniformly, opposed limiting protections to higher-rate loans and recommended applying these protections to all loans secured by a principal dwelling. They recommended in the alternative that the thresholds be adopted at the levels proposed or even lower. They argued it was critical to cover all of the subprime market and much if not all of the alt-A market.

Discussion

As discussed above, the Board has concluded that the stricter regulations of § 226.35 should cover the subprime market and generally exclude the prime market; and in the face of uncertainty it is appropriate to err on the side of covering somewhat more than the subprime market. Based on available data, it appeared that the thresholds the Board proposed would capture all of the subprime market and a portion of the alt-A market.

Based also on available data, the Board believes that the thresholds it is adopting would cover all, or virtually all, of the subprime market and a portion of the alt-A market. The Board considered loan-level origination data for the period 2004 to 2007 for subprime and alt-A securitized pools. The proprietary source of these data is FirstAmerican Loan Performance.

The Board also ascertained from a proprietary database of mostly prime loans (McDash Analytics) that coverage of the prime market during the first three quarters of 2007 at these thresholds would have been very limited. The Board recognizes that the recent mortgage market disruption began at the end of this period, but it is the latest period for which data were available.

The Board noted in the proposal that 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). For industry estimates see

IMF 2007 Mortgage Market

at 4. Regulation C's coverage of higher-priced loans is not thought, however, to have reached the prime market in those years. Rather, in both 2005 and 2006 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 because of a steep yield curve.

Annual percentage rates were estimated from the contract rates in these data using formulas derived from a separate proprietary database of subprime loans that collects contract rates, points, and annual percentage rates. This separate database, which contains data on the loan originations of eight subprime mortgage lenders, is maintained by the Financial Services Research Program at George Washington University.

The Board is adopting a threshold for subordinate-lien loans of 3.5 percentage points. This is consistent with the Board's proposal to set the threshold over Treasury yields for these loans two percentage points above the threshold for first-lien loans. With rare exceptions, commenters explicitly endorsed, or at least did not raise any objection to, this approach. The Board recognizes that it would be preferable to set a threshold for second-lien loans above a measure of market rates for second-lien loans, but it does not appear that a suitable measure of this kind exists. Although data are very limited, the Board believes it is appropriate to apply the same difference of two percentage points to the thresholds above average prime offer rates.

As discussed earlier, the Board recognizes that there are limitations to making judgments about the future scope of the rule based on past data. For example, when the final rule takes effect, the risk premiums for alt-A loans compared to the conforming loans in the PMMS may be higher than the risk premiums for the period 2004-2007. In that case, coverage of alt-A loans would be higher than an estimate for that period would indicate.

Another important example is prime “jumbo” loans, or loans extended to borrowers with low-risk mortgage

pricing characteristics, but in amounts that exceed the threshold for loans eligible for purchase by Freddie Mac or Fannie Mae. The PMMS collects pricing data only on loans eligible for purchase by one of these entities (“conforming loans”). Prime jumbo loans have always had somewhat higher rates than prime conforming loans, but the spread has widened significantly and become much more volatile since August 2007. If this spread remains wider and more volatile when the final rule takes effect, the rule will cover a significant share of transactions that would be prime jumbo loans. While covering prime jumbo loans is not the Board's objective, the Board does not believe that it should set the threshold at a higher level to avoid what may be only temporary coverage of these loans relative to the long time horizon for this rule.

A third example is a request from a trade association for the manufactured housing industry, including lenders specializing in this industry, that the thresholds be set higher for loans secured by dwellings deemed to be personal property. This association pointed to the higher risk creditors bear on these loans compared to loans secured by real property, which makes their rates systematically higher for reasons apart from the risks they pose to consumers. It also maintained that such loans have not been associated with the abusive practices of the subprime market.

The specific concern of the commenter is with the requirement to escrow, not, apparently, with the other requirements for higher-priced loans. As discussed in part IX.D, the Board is providing creditors two years to comply with the escrow requirement for manufactured home loans.

Credit risk and liquidity risk can vary by many factors, including geography, property type, and type of loan. This may suggest to some that different thresholds should be applied to different classes of transactions. This approach would make the regulation inordinately complicated and subject it to frequent revision, which would not be in the interest of creditors, investors, or consumers. Although the simpler approach the Board is adopting—just two thresholds, one for first-lien loans and another for subordinate-lien loans—has its disadvantages, the Board believes they are outweighed by its benefits of simplicity and stability.

F. The Timing of Setting the Threshold

The Board proposed to set the threshold for a dwelling-secured mortgage loan as of the application date. Specifically, a creditor would use the Treasury yield as of the 15th of the month preceding the month in which the application is received. The Board noted that inconsistency with Regulation C, which sets the threshold as of the 15th of the month before the rate is locked, could increase regulatory burden. The Board suggested, however, that setting the threshold as of the application date might 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.

Very few commenters addressed the precise issue. A couple of them specifically advocated using the rate lock date to select the Treasury yield, as in Regulation C, rather than the application date. Subsequent outreach by the Board indicated that there are different views as to which date to use. Some parties prefer the rate lock date because it is more accurate and therefore would minimize coverage of loans that are not intended to be covered and maximize coverage of loans that are intended to be covered. Other parties prefer the application date because they believe it increases the creditor's ability to predict, when underwriting the loan, that the loan is, or is not, covered by § 226.35.

As noted above, the final rule requires the creditor to use the rate lock date, the date the rate is set for the final time before consummation, rather than the application date. Using the application date might increase the predictability of coverage at the time of underwriting. Using the rate lock date would increase the accuracy of coverage at least somewhat. On balance, the Board believes it is more important to maximize coverage accuracy.

G. Proposal To Conform Regulation C (HMDA)

Regulation C, which implements HMDA, requires creditors to report price data on higher-priced mortgage loans. A creditor reports the difference between a loan's annual percentage rate and the yield on Treasury securities having comparable periods of maturity, if that difference is at least three percentage points for first-lien loans or at least five percentage points for subordinate-lien loans. 12 CFR 203.4(a)(12). Many commenters suggested that the Board establish a uniform definition of “higher-priced mortgage loan” for purposes of Regulation C and Regulation Z. Having a single definition would reduce regulatory burden and make the HMDA data a more useful tool to evaluate effects of Regulation Z. Moreover, the Board adopted Regulation C's requirement to report certain mortgage loans as being higher-priced with an objective of covering the subprime market and exclude the prime market, and the definition of “higher-priced mortgage loan” adopted in this rule better achieves this objective than the definition in Regulation C for the reasons discussed in part VIII.D. Accordingly, in a separate notice published simultaneously with this final rule the Board is proposing to amend Regulation C to apply the same index and threshold adopted in § 226.35(a).

H. Types of Loans Covered Under § 226.35

The Board proposed 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. This would include home purchase loans, refinancings, 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. In these respects, the rule is adopted as proposed.

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 final rule applies 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 proposed to use its authority under TILA Section 129(l)(2), 15 U.S.C. 1639(l)(2), to apply the protections of § 226.35 to home purchase loans as well. Commenters did not object, and the Board is adopting the proposal. Covering only refinancings of home purchase loans would fail to protect consumers adequately. From 2003 through the first half of 2007, 42 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 more sharply than 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.

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

As proposed, § 226.35 protections are limited 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.

A loan to a consumer to purchase or improve a second home would not be covered by these protections unless the loan was secured by the consumer's principal dwelling. Loans primarily for a real estate investment purpose also are not covered. This exclusion is consistent with TILA's focus on consumer-purpose transactions 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 concern than a Board regulation.

Coverage of Nontraditional Mortgages

Under the final rule, nontraditional mortgage loans, which permit non-amortizing payments or negatively amortizing payments, are covered by § 226.35 if their APRs exceed the threshold. Several consumer and civil rights groups, and others, contended that § 226.35 should cover nontraditional mortgage loans regardless of loan price because of their potential for significant payment shock and other risks that led the federal banking agencies to issue the Nontraditional Mortgage Guidance. The Board does not believe that the enhanced protections of § 226.35 should be applied on the basis of product type, with the limited exception of the narrow exemptions for HELOCs and other loan types the Board is adopting. A rule based on product type would need to be reexamined frequently as new products were developed, which could undermine the market by making the rule less predictable. Moreover, it is not clear what criteria the Board would use to decide which products were sufficiently risky to warrant categorical coverage. The Board believes that other tools such as supervisory guidance provide the requisite flexibility to address particular product types when that becomes necessary.

HELOC Exemption

The Board proposed to exempt HELOCs largely for two reasons. First, the Board noted that 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. Second, 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.

The Board also pointed to TILA and Regulation Z's special protections for borrowers with HELOCs such as restrictions on changing plan terms.

Interagency Credit Risk Guidance for Home Equity Lending, SR 05-11 (May 16, 2005), available at

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

; Addendum to Credit Risk Guidance for Home Equity Lending, SR 06-15 (Sept. 29, 2006), available at

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

Several national trade associations and a few large lenders voiced strong support for excluding HELOCs, generally for the reasons the Board cited. Several consumer and civil rights groups disagreed, contending that enough HELOCs are securitized to raise doubts that the originator's interests are sufficiently aligned with the borrower's interests. They maintained that Regulation Z disclosures and limitations for HELOCs are not adequate to protect consumers, and pointed to specific cases in which unaffordable HELOCs had been extended. Other commenters, such as an association of state regulators, agreed that HELOCs should be covered. Commenters offered very few concrete suggestions, however, for how to determine which HELOCs would be covered, such as an index and threshold.

The Board is adopting the proposal for the reasons stated. The Board recognizes, however, that HELOCs present a risk of circumvention. Creditors may seek to evade limitations on closed-end transactions by structuring such transactions as open-end transactions. In § 226.35(b)(5), discussed below in part IX.E, the Board prohibits structuring a closed-end loan as an open-end transaction for the purpose of evading the new rules in § 226.35.

Other Exemptions Adopted

The other proposed exclusions drew limited comment. A couple of commenters expressed support for excluding reverse mortgages while a couple of commenters opposed it. A few large lenders voiced support for excluding construction-only loans. A few commenters voiced support for the exclusion of temporary bridge loans of 12 months or less, and none of the commenters seemed to oppose it. The Board is adopting the proposed exclusions for reverse mortgages, construction-only loans, and temporary or bridge loans of 12 months or less.

Reverse mortgages.

The Board is keenly aware of consumer protection concerns raised by the expanding market for reverse mortgages, which are complex and are sometimes marketed with other complex financial products. Unique aspects of reverse mortgages—for example, the borrower's repayment ability is based on the value of the collateral rather than on income—suggest that they should be addressed separately from this final rule. The Board is reviewing this segment of the mortgage market in connection with its comprehensive review of Regulation Z to determine what measures may be required to ensure consumers are protected.

Construction-only loans.

Section 226.35 excludes 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 does 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 depending on its APR. 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

Bridge loans.

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 for bridge loans from the restrictions of § 226.35, as they apply to HOEPA loans, would be in borrowers' interest and support homeownership.

The final rule, like the proposed rule, gives as an example of a “temporary or bridge loan” a loan to purchase a new dwelling where the consumer plans to sell a current dwelling within 12 months. This is not the only potential

bona fide

example of a temporary or bridge loan. The Board does expect, however, that the temporary or bridge loan exemption will be applied narrowly and not to evade or circumvent the regulation. For example, a 12-month loan with a substantial balloon payment would not qualify for the exemption where it was clearly intended to lead a borrower to refinance repeatedly into a chain of 12-month loans.

Exemptions Not Adopted

Industry commenters proposed additional exclusions that the Board is not adopting.

Government-guaranteed loans

. Some commenters proposed excluding loans with federal guaranties such as FHA, VA, and Rural Housing Service. They suggested that the federal regulations that govern these loans are sufficient to protect consumers, and that new regulations under HOEPA were not only unnecessary but could cause confusion. At least one commenter also suggested excluding loans with state or local agency guaranties.

The Board does not believe that exempting government-guaranteed loans from § 226.35 is appropriate. It is not clear what criteria the Board would use to decide precisely which government programs would be exempted; commenters did not offer concrete suggestions. Moreover, such exemptions could attract to agency programs less scrupulous originators seeking to avoid HOEPA's civil liability, with serious unintended consequences for consumers as well as for the agencies and taxpayers.

Jumbo loans

. A few commenters proposed excluding non-conforming or “jumbo” loans, that is, loans that exceed the threshold amount for eligibility for purchase by Fannie Mae or Freddie Mac. They cited a lack of evidence of widespread problems with jumbo loan performance, and a belief that borrowers who can afford jumbo loans are more sophisticated consumers and therefore better able to protect themselves.

The Board does not believe excluding jumbo loans would be appropriate. The request is based on certain assumptions about the characteristics of the borrowers who take out jumbo loans. In fact, jumbo loans are offered in the subprime and alt-A markets and not just in the prime market. A categorical exemption of jumbo loans could therefore seriously undermine protections for consumers, especially in areas with above-average home prices.

Portfolio loans

. A commenter proposed excluding loans held in portfolio on the basis that a lender will take more care with these loans. Among other concerns with such an exemption is that it often cannot be determined as of consummation whether a loan will be held in portfolio or sold immediately—or, if held, for how long before being sold. Therefore, such an exception to the rule does not appear practicable and could present significant opportunities for evasion.

IX. Final Rules for Higher-Priced Mortgage Loans and HOEPA Loans

A. Overview

This part discusses the new consumer protections the Board is applying to “higher-priced mortgage loans” and HOEPA loans. Creditors are prohibited from extending credit without regard to borrowers' ability to repay from sources other than the collateral itself. The final rule differs from the proposed rule in that it removes the proposed “pattern or practice” phrase and adds a presumption of compliance when certain underwriting procedures are followed. Creditors are also required to verify income and assets they rely upon to determine repayment ability, and to establish escrow accounts for property taxes and insurance. In addition, a higher-priced mortgage loan may not have a prepayment penalty except under certain conditions. These conditions are substantially narrower than those proposed.

The Board finds that the prohibitions in the final rule are necessary to prevent practices that the Board finds to be unfair, deceptive, associated with abusive lending practices, or 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.

The Board is also adopting the proposed rule prohibiting 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 rule 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 Consumer's 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) prohibit a pattern or practice of extending credit subject to § 226.32 (HOEPA loans) based on consumers' collateral without regard to their repayment ability. The regulation creates a presumption of a violation where a creditor has a pattern or practice of failing to verify and document repayment ability. The Board

proposed to revise the prohibition on disregarding repayment ability and extend it, through proposed § 226.35(b)(1), to higher-priced mortgage loans as defined in § 226.35(a). The proposed revisions included adding several rebuttable presumptions of violations for a pattern or practice of failing to follow certain underwriting procedures, and a safe harbor.

The final rule removes “pattern or practice” and therefore prohibits any HOEPA loan or higher-priced mortgage loan from being extended based on the collateral without regard to repayment ability. Verifying repayment ability has been made a requirement rather than a presumptive requirement. The proposal provided that a failure to follow any one of several specified underwriting procedures would create a presumption of a violation. In the final rule, those procedures, with modifications, have instead been incorporated into a presumption of compliance which replaces the proposed safe harbor.

Public Comment

Mortgage lenders and their trade associations that commented generally, but not uniformly, support or at least do not oppose a rule requiring creditors to consider repayment ability. They maintain, however, that the rule as drafted would unduly constrain credit availability because of the combination of potentially significant damages under TILA Section 130, 15 U.S.C. 1640, and a perceived lack of a clear and flexible safe harbor. These commenters stated that two elements of the rule that the Board had intended to help preserve credit availability—the “pattern or practice” element and a safe harbor for a creditor having a reasonable expectation of repayment ability for at least seven years—would not have the intended effect. Many of these commenters suggested that the rule would unduly constrain credit unless the Board removed the presumptions of violations and provided a clearer and more specific safe harbor. Some of these commenters also requested additional safe harbors, such as for use of an automated underwriting system (AUS) of Fannie Mae or Freddie Mac.

Consumer, civil rights, and community development groups, as well as some state and local government officials, several members of Congress, a federal regulator, and others argued that “pattern or practice” seriously weakened the rule and urged its removal. They maintain that “pattern or practice” would effectively prevent an individual borrower from bringing a claim or counter-claim based on his or her loan, and reduce the rule's deterrence of irresponsible lending. These commenters generally support the proposed presumptions of violations but many of them urged the Board to adopt quantitative standards for the proposed presumptions for failing to consider debt-to-income ratios (DTI) and residual income levels. As discussed above, these commenters also would apply the rule to nontraditional mortgages regardless of price, and a few would apply the rule to the entire mortgage market including the prime market.

The comments are discussed in more detail throughout this section as applicable.

Discussion

The Board finds that disregarding a consumer's repayment ability when extending a higher-priced mortgage loan or HOEPA loan, or failing to verify the consumer's income, assets, and obligations used to determine repayment ability, are unfair practices. This section discusses the evidence from recent events of a disregard for repayment ability and reliance on unverified incomes in the subprime market; the substantial injuries that disregarding repayment ability and failing to verify income causes consumers; the reasons consumers cannot reasonably avoid these injuries; and the Board's basis for concluding that the injuries are not outweighed by countervailing benefits to consumers or competition when repayment ability is disregarded or income is not verified.

Evidence of a recent widespread disregard of repayment ability.

Approximately three-quarters of securitized originations in subprime pools from 2003 to 2007 were 2-28 or 3-27 ARMs with a built-in potential for significant payment shock at the start of the third or fourth year, respectively.

Originations of these types of mortgages during 2005 and 2006 and through early 2007 have contributed significantly to a substantial increase in serious delinquencies and foreclosures. 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 reached a serious delinquency rate of almost 28 percent in May 2008, quintuple the mid-2005 level. The serious delinquency rate has also risen for loans in alt-A (near prime) securitized pools to almost 8 percent (as of April 2008) from less than 2 percent only a year ago. In contrast, 1.5 percent of loans in the prime-mortgage sector were seriously delinquent as of April 2008.

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. 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).

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

Higher delinquencies have shown through to foreclosures. Foreclosures were initiated on some 1.5 million U.S. homes during 2007, up 53 percent from 2006, and the rate of foreclosure starts looks to be higher yet for 2008. Lenders initiated over 550,000 foreclosures in the first quarter of 2008, about 274,000 of them on subprime mortgages. This was significantly higher than the quarterly average of 440,000 foreclosures in the second half of 2007 and 325,000 in the first half, and twice the quarterly average of 225,000 for the past six years.

Estimates are based on data from

MBA Nat'l Delinquency Survey.

Payment increases on 2-28 and 3-27 ARMs have not been a major cause of the increase in delinquencies and foreclosures because most delinquencies occurred before the payments were adjusted. Rather, a major contributor to these delinquencies was lenders' extension of credit on the basis of income stated on applications without verification.

Originators had strong incentives to make these “stated income” loans, and consumers had incentives to accept them. Because the loans could be originated more quickly, originators, who were paid based on volume, could increase their earnings by originating more of them. 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.

The prevalence of stated income lending left wide room for the loan officer, mortgage broker, or consumer to overstate the consumer's income so the consumer could qualify for a larger loan

and the loan officer or broker could receive a larger commission. There is substantial anecdotal evidence that borrower incomes were commonly inflated.

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 LoanPerformance data.

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

(November 13, 2007)

(Fitch 2006 Subprime Performance)

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

Lenders relying on overstated incomes to make loans could not accurately assess consumers' repayment ability.

Evidence of this failure is found in the somewhat steeper increase in the rate of default for low/no doc loans originated when underwriting standards were declining in 2005 and 2006 relative to full documentation loans.

Due in large part to creditors' reliance on inaccurate “stated incomes,” lenders often failed to determine reliably that the consumer would be able to afford even the initial discounted payments. Almost 13 percent of the 2-28 ARMs originated in 2005 appear to have become seriously delinquent before their first reset.

While some of these borrowers may have been able to make their payments—but stopped because their home values declined and they lost what little equity they had—others were not able to afford even their initial payments.

Consumers may also have been led 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. Consumers who are unaware of this premium are effectively deprived of an opportunity to shop for a potentially lower-rate loan requiring full documentation.

Determined from First American LoanPerformance data.

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).

Figure calculated from First American LoanPerformance data.

Although payment shock on 2-28 and 3-27 ARMs did not contribute significantly to the substantial increase in delinquencies, there is reason to believe that creditors did not underwrite to a rate and payment that would take into account the risk to consumers of a payment shock. Creditors also may not have factored in the consumer's obligation for the expected property taxes and insurance, or the increasingly common “piggyback” second-lien loan or line of credit a consumer would use to finance part or all of the down payment.

By frequently basing lending decisions on overstated incomes and understated obligations, creditors were in effect often extending credit based on the value of the collateral, that is, the consumer's house. Moreover, by coupling these practices with a practice of extending credit to borrowers with very limited equity, creditors were often extending credit based on an expectation that the house's value would appreciate rapidly.

Creditors may have felt that rapid house price appreciation justified loosening their lending standards, but in some locations house price appreciation was fed by loosened standards, which permitted consumers to take out larger loans and bid up house prices. Loosened lending standards therefore made it more likely that the inevitable readjustment of house prices in these locations would be severe.

Often the lender extended credit knowing that the borrower would have no equity after taking into account a simultaneous second-lien (“piggyback”) loan. According to

Fitch 2006 Subprime Performance,

first-lien loans in subprime securitized pools with simultaneous second liens rose from 1.1 percent in 2000 to 6.4 percent in 2003 to 30 percent in 2006. Moreover, in some cases the appraisal the lender relied on overstated borrower equity because the lender or broker pressured the appraiser to inflate the house value. The prohibition against coercing appraisers is discussed below in part X.B.

House price appreciation began to slow in 2006 and house price levels actually began to decline in many places in 2007. Borrowers who could not afford their mortgage obligations because their repayment ability had not been assessed properly found it more difficult to lower their payments by refinancing. They lacked sufficient equity to meet newly tightened lending standards, or they had negative equity, that is, they owed more than their house was worth. For the same reasons, many consumers also could not extinguish their mortgage obligations by selling their homes. Declining house prices led to sharp increases in serious delinquency rates in both the subprime and alt-A market segments, as discussed above.

Estimates are based on data from

MBA Nat'l Delinquency Survey.

Although the focus of § 226.35 is the subprime market, it may cover part of the alt-A market. Disregard for repayment ability was often found in the alt-A market as well. 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. According to one estimate, loans with nontraditional terms that permitted borrowers to defer principal (“interest-only”) or both principal and some interest (“option ARM”) in exchange for higher payments later—reached 78 percent of alt-A originations in 2006.

The combination of a variable rate with a deferral of principal and interest held the potential for substantial payment shock within five years. Yet rising delinquency rates to almost 8 percent in 2008, from less than 1 percent in 2006, could suggest that lenders too often assessed repayment ability at a low interest rate and payment that did not adequately account for near-certain payment increases. In addition, these loans typically were made based on reduced income documentation. For example, the share of interest-only mortgages with low or no documentation in alt-A securitized pools increased from around 64 percent in 2003 to nearly 80 percent in 2006.

It is generally accepted that the reduced documentation of income led to a high degree of income inflation in the alt-A market just as it did in the subprime market.

David Liu and 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.

Substantial injury.

A borrower who cannot afford to make the loan payments as well as payments for property taxes and homeowners insurance because the lender did not adequately assess the borrower's repayment ability suffers substantial injury. Missing mortgage payments is costly: Large late fees are charged and the borrower's credit record is impaired, reducing her credit options. If refinancing to a loan with a lower payment is an option (for example, if the borrower can obtain a loan with a longer maturity), refinancing can slow the rate at which the consumer is able to pay down principal and build equity. The borrower may have to tap home equity to cover the refinancing's closing costs or may have to accept a higher interest rate in exchange for the lender paying the closing costs. If refinancing is not an option, then the borrower and household must make sacrifices to keep the home such as reducing other expenditures or taking additional jobs. If keeping the home is not tenable, the borrower must sell it or endure foreclosure, the costs of which (for example, property maintenance costs, attorneys fees, and other fees passed on to the consumer) will erode any equity

the consumer had. The foreclosure will mar the consumer's credit record and make it very difficult for the consumer to become a homeowner again any time soon. Many borrowers end up owing the lender more than the house is worth, especially if their homes are sold into a declining market as is happening today in many parts of the country. Foreclosures also may force consumers to move, which is costly and disruptive. In addition to the financial costs of unsustainable lending practices, borrowers and households can suffer serious emotional hardship.

If foreclosures due to irresponsible lending rise rapidly or reach high levels in a particular geographic area, then the injuries can extend beyond the individual borrower and household to the larger community. A foreclosure cluster in a neighborhood can reduce homeowner equity throughout the neighborhood by bringing down prices, eroding the asset that for many households is their largest.

A significant rise in foreclosures can create a cycle where foreclosures bring down property values, reducing the ability and incentive of homeowners, particularly those under stress for other reasons, to retain their homes. Foreclosure clusters also can lower municipal tax revenues, reducing a locality's ability to maintain services and make capital investments. At the same time, revenues may be diverted to mitigating hazards that clusters of vacant homes can create.

E.g.,

Zhenguo Lin, et al.

Spillover Effects of Foreclosures on Neighborhood Property Values,

Journal of Real Estate Finance and Economics Online (Nov. 2007), available at

http://www.springerlink.com/content/rk4q0p4475vr3473/fulltext.pdf.

E.g.,

William C. Apgar and Mark Duda.

Collateral Damage: The Municipal Impact of Today's Mortgage Foreclosure Boom

(Minneapolis: Homeownership Preservation Foundation 2005).

Lending without regard to repayment ability also has other consequences. It facilitates an abusive strategy of “flipping” borrowers in a succession of refinancings designed ostensibly to lower borrowers' burdensome payments that actually convert borrowers' equity into fees for originators without providing borrowers a benefit. Moreover, relaxed standards, such as those that pervaded the subprime market recently, 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. The rapid influx of new originators that can accompany a relaxation of lending standards makes it more difficult for regulators and investors alike to distinguish responsible from irresponsible actors.

See

supra part II.

Injury not reasonably avoidable.

One might assume that borrowers could avoid unsustainable loans by comparing their current and expected incomes to their current and expected expenses, including the scheduled loan payments disclosed under TILA and an estimate of property taxes and homeowners insurance. There are several reasons, however, why consumers, especially in the subprime market, accept risky loans they will struggle or fail to repay. In some cases, originators mislead borrowers into entering into unaffordable loans by understating the payment before closing and disclosing the true payment only at closing (“bait and switch”). At the closing table, many borrowers may not notice the disclosure of the payment amount or have time to consider it because borrowers are typically provided with many documents to sign then. Borrowers who consider the disclosure may nonetheless feel constrained to close the loan, for a number of reasons. They may already have paid substantial fees and expect that more applications would require more fees. They may have signed agreements to purchase a new house and sell the current house. Or they 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.

Furthermore, many consumers in the subprime market will accept loans knowing they may have difficulty affording the payments because they reasonably believe a more affordable loan will not be available to them. As explained in part II.B, limited transparency of prices, products, and originator incentives reduces a borrower's expected benefit from shopping further for a better option. Moreover, taking more time to shop can be costly, especially for the borrower in a financial pinch. Thus, borrowers often make a reasoned decision to accept unfavorable terms.

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.B. And borrowers would not realize that a lender was applying loose underwriting standards such as assessing repayment ability on the basis of a “teaser” payment. In addition, originators 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.

Stated income and stated asset loans can make it even more difficult for a consumer to avoid an unsustainable loan. With stated income (or stated asset) loans, the applicant may not realize that the originator is inflating the applicant's income and assets to qualify the applicant for the loan. Applicants do not necessarily even know that they are being considered for stated income or stated asset loans. They may give the originator documents verifying their income and assets that the originator keeps out of the loan file because the documents do not demonstrate the income and assets needed to make the loan. Moreover, if a consumer knowingly applies for a stated income or stated asset loan and correctly states her income or assets, the originator can write an inflated figure into the application form. It is typical for the originator to fill out the application for the consumer, and the consumer may not see the written application until closing, when the borrower often is provided with numerous documents to review and sign and may not review the application form with care. The consumer who detects the inflated numbers at the closing table may not realize their importance or may

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