The Fed's Mindless New Mortgage Regulations

Back in December, I commented on the Fed's plan for more mortgage regulations. I said then that it was scary just how clueless the Federal Reserve was as far as what the problems were and how to resolve them. Today, the Federal Reserve made official new mortgage regulations and they continue to show a stunning lack of understanding. Here is a breakdown of what the regulations are.

bar lenders from making loans without proof of a borrower's income.

-- require lenders to make sure risky borrowers set aside money to pay for taxes and insurance.

-- restrict lenders from penalizing risky borrowers who pay loans off early. Such "prepayment" penalties are banned if the payment can change during the initial four years of the mortgage. In other cases, a penalty can't be imposed in the first two years of the mortgage.

-- prohibit lenders from making a loan without considering a borrower's ability to repay a home loan from sources other than the home's value. The borrower need not have to prove that the lender engaged in a "pattern or practice" for this to be deemed a violation. That marks a change -- sought by consumer advocates -- from the Fed's initial proposal and should make it easier for borrowers to lodge a complaint.

These regulations range from useless to nebulous to downright dangerous and counterproductive.

Let's start with the first. The Federal Reserve has totally eliminated stated loans for sub prime borrowers. They are rather late to the ballgame as it turns out since there are no longer any subprime banks offering stated loans. It appears the Fed thinks that the entire market blew up as a result of these stated loans and banks just continued to underwrite the exact same way without taking into account the nightmare that was created. What's frightening is that well meaning politicians, activists, and media will cheerlead the Fed's bold steps in curbing risky behavior. None will realize that the market was a much better and swifter arbitor in removing this risky behavior. Rather than waiting a full year to outlaw these loans, the market eliminated them nearly instantaneously.

Second, the Fed has created a nebulous rule that can be read multiple ways. I assume that the Fed is mandating
escrow accounts. If so, they have just made it that much more difficult for poor borrowers to get loans. I am no fan of escrows, but they are especially punitive to those with little disposable income. What escrows do is hold an account to pay for taxes and insurance. This sounds good in theory, however escrows also need to have enough at any given moment. As such, the account collects at closing enough so that when a payment is due there is enough in the account. Furthermore, banks usually hold an extra two months in reserve. All of this money is held with 0%. As such, if a loan is closed in June, the first payment is August 1, and taxes are due September 1, then the bank will require six months worth of escrows be collected at closing. If taxes are $1800 every six months, then of course that is an extra $1800 the bank will collect on top of normal closing costs. This is a great way to insure that more loans don't close needlessly.

Of course, this rule is nebulous. The Fed never specifically says anything about escrows. Banks could simply read that borrowers have enough money stashed away so that when taxes are due there is enough there. As such, they may simply require that borrowers have a minimum amount of money in the bank before they agree to do a loan. Once again, this will create another reason for a loan to be denied.

The third rule is a combination of needless, counter productive and dangerous. Again, the market banned nearly all pre payment penalties long ago. There are very few out there. That said, the language is punitive. The longer the pre payment penalty the worse it is for a borrower. The Fed says you can't have one in the first two years but you can have one longer. As such, it would only punish those borrowers that held onto a loan long term and then refinanced. Furthermore, while pre payment penalties get a bad rap, they also serve a very important purpose. Everything else being equal, your rate is lower if you accept a pre payment penalty. Now, imagine if a borrower only qualifies with a rate of 7%, and that rate can only be achieved if they take a pre payment penalty. The Fed just made sure this hypothetical borrower doesn't qualify.

Finally, the fourth rule is so outrageous and nonsensical that it will create a stream of litigation that will literally stop the industry in its tracks. What in the world does it mean

prohibit lenders from making a loan without considering a borrower's ability to repay a home loan from sources other than the home's value. The borrower need not have to prove that the lender engaged in a "pattern or practice" for this to be deemed a violation.

Apparently, the Fed thinks that banks play with their thumbs for about a month while they decide whether to approve a loan. The month that it normall takes for a bank to underwrite is spent determing whether that borrower has a "reasonable ability to pay".

Since this is so nebulous it makes lawsuits that much easier. As such, think about what the last part of the rule will do...

That marks a change -- sought by consumer advocates -- from the Fed's initial proposal and should make it easier for borrowers to lodge a complaint.

Yes, it will since "reasonable ability to pay" is very difficult to define. What's truly scary about these rules is that the Fed is supposed to know what they are doing. It is one thing when a clueless politician does something like this. It is quite another when the Federal Reserve acts, and acts cluelessly.