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House Takes on the Subprime Mortgage Industry

May 4, 2009 - by Donny Shaw

Following their action on the Credit Cardholder’s Bill of Rights Act (H.R. 627) last week, the House is continuing this week to try and fix some of the regulatory lapses that contributed to the consumer debt explosion at the center of our current economic crisis. This week, the House will take up a bill to reform and regulate the subprime mortgage lending industry — the Mortgage Reform and Anti-Predatory Lending Act.

The bill has been introduced into Congress by Rep. Brad Miller [D, NC-13] (pictured) consistently since 2005 and it is partially based on a North Carolina state law that was passed in 1999, when Miller was a state legislator there. Recently, in the wake of our economic collapse and the increasing foreclosures around the country, the bill has gained a lot of appeal. It’s become clearer that fixing certain elements of the mortgage industry is important not just for protecting consumers, but also for protecting more foundational elements of our economy. It is scheduled for a vote in the House sometime this week after Tuesday, May 5th.

Basically, the bill would establish new disclosure requirements for mortgage brokers so that borrowers are made aware of their options and the the terms of different loan possibilities. It would also take away compensation incentives for mortgage brokers and banks that encourage them to steer borrowers towards variable-interest, interest-only and other kinds of subprime loans.

First, the disclosure requirements. Under the bill, mortgage brokers would be required to “diligently work to present the consumer with a range of residential mortgage loan products for which the consumer likely qualifies and which are appropriate to the consumer’s existing circumstances.” They would also be required to disclose the comparative costs and benefits of different kinds of loans. Furthermore, brokers would be required to disclose the amount of money they would be making off the different kinds of loans they are offering and any relevant conflicts of interest there may be.

What kinds of loans would be considered appropriate under the bill? From the bill text:

‘(B) APPROPRIATE LOAN PRODUCT- For purposes of paragraph (1)(B), a residential mortgage loan shall be presumed to be appropriate for a consumer if—

‘(i) the mortgage originator determines in good faith, based on then existing information and without undergoing a full underwriting process, that the consumer has a reasonable ability to repay and, in the case of a refinancing of an existing residential mortgage loan, receives a net tangible benefit, as determined in accordance with regulations prescribed under subsections (a) and (b) of section 129B; and

‘(ii) the loan does not have predatory characteristics or effects (such as equity stripping and excessive fees and abusive terms) as determined in accordance with regulations prescribed under paragraph (4).

Any failure to meet the disclosure requirements would make brokers liable to be sued, though only for up to an amount equal to three times their compensation for the mortgage plus attorney’s fees. Brokers would also be given the option to restructure a loan to conform to the bill’s standards within 90 days of receiving a complaint from the borrower. In cases where a borrower provided false information in order to qualify for a bigger loan, the bill provides complete legal protection to brokers.

Another provision in the bill is designed to take away incentives for approving mortgages that down the road, somewhere in the secondary mortgage market, will become toxic assets. This, of course, resonates directly with the credit crunch that has wreaked havoc throughout our economy in the past year. The provision would require banks that make subprime mortgage to retain at least a five percent interest in the loan as a hedge against risky lending. Here’s that provision as written into the bill text:

‘(m) Credit Risk Retention-

‘(1) IN GENERAL- The Federal banking agencies shall prescribe regulations jointly to require any creditor that makes a residential mortgage loan that is not a qualified mortgage (as defined in section 129B©), to retain an economic interest in a material portion of the credit risk for any such loan that the creditor transfers, sells or conveys to a third party.

‘(2) STANDARDS FOR REGULATIONS- Regulations prescribed under paragraph (1) shall—

‘(A) apply only to residential mortgage loans that are not qualified mortgages (as so defined);

‘(B) prohibit creditors from directly or indirectly hedging or otherwise transferring the credit risk creditors are required to retain under the regulations with respect to any residential mortgage loan; and

‘( C) require creditors to retain at least 5 percent of the credit risk on any non-qualified mortgage that is transferred, sold or conveyed.’.

To crackdown on subprime lending on a case-by-case basis, the bill would prohibit “steering incentives.” Brokers would not be able to receive extra compensation for a loan based on its terms alone. In other words, only the principal of a loan would determine the level of compensation, no the interest rate or repayment schedule.

There are several other areas covered in the bill, like new protections for renters in buildings that are foreclosed on, the establishment of an Office of Housing Counselor, and some tweaks to home appraisal standards.

Since the bill is partially based on an existing state law, we have an opportunity, via the WSJ, to look at how effective it might be:

North Carolina’s experience illustrates how tricky it is to strike that balance. The law’s suitability requirement hasn’t spurred a rash of borrower lawsuits, as critics suggested it might. Nor has it restricted credit as much as opponents feared. “There was a hue and cry about us shutting down the market and people not doing business here,” said Joseph Smith Jr., the state banking commissioner. “It’s pretty clear it didn’t really run anybody off.”

But neither has it shielded borrowers from unsavory practices as much as proponents hoped. Some practices and loan types vanished after the law was passed, but lenders adapted and replaced them with other products, some of which create similar problems for borrowers.

After the 1999 law took effect, subprime-mortgage originations in the state rose, as they did nationally. In 2001, subprime originations rose 32% from the previous year in North Carolina, according to data provided by the banking commissioner’s office. Subprime lending flattened and then nearly doubled from 2004 to 2005 as the housing market surged. North Carolina’s home-ownership rate fell slightly following passage of the law but has leveled off to about 70%, slightly above the national average, according to U.S. Census Bureau data.

A 2004 study by researchers at the University of North Carolina at Chapel Hill found a decline in refinancing activity. “The law is doing what it was intended to do: eliminate abusive loans without restricting the supply of subprime mortgage capital for borrowers with blemished credit records,” the researchers concluded.

But lenders quickly found ways to offer loans the law didn’t anticipate. Some avoided North Carolina’s prohibitions through moves by federal regulators that pre-empted state law from covering some federally regulated lenders. Other lenders rolled out adjustable-rate mortgages that weren’t proscribed by the law. One popular form was a 30-year loan that offers an introductory “teaser” rate for two years but can reset to higher levels thereafter, up to a given maximum. By offering the low initial rate, lenders could issue loans that stayed below the threshold set in North Carolina’s law.

Miller’s bill is substantially farther reaching than the North Carolina law and it will inevitably change is moves through along the legislative process the House and the Senate. Hopefully Congress can look to the North Carolina law as a guide to what works and what doesn’t, and in the end it can be used in the process to create an effective piece of legislation.

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