Fed's New Rules On Mortgages
Draw Hostility from Critics

Concerns about the U.S. mortgage crisis and turmoil in global credit markets intensified, with U.S. policy makers seeking to clamp down on the practices that created the crisis and Europe's central bank pouring an unprecedented half-trillion dollars into an effort to soothe markets.

The Federal Reserve proposed new rules that would sharply curtail the kinds of high-risk mortgages largely responsible for the global credit crunch. But the proposal drew a lukewarm, and occasionally hostile, reaction from lawmakers and other critics, who called for more-aggressive action.

The Fed's proposal came as European officials tested a new approach to the fears of default that have reduced the availability of credit world-wide. The European Central Bank, hoping to avert a year-end meltdown in Europe's money markets, swamped the markets with €348.6 billion ($501.7 billion) in two-week loans to banks, one of the largest sums a central bank has ever lent in a single shot.

The ECB's heavy lending pushed down Europe's short-term interest rates, as intended, but wasn't applauded by everyone. "They've confused the market and created a lot of volatility," said Erik Nielsen, European economist with Goldman Sachs in London.

In Washington, the Fed's proposal was greeted with jeers from influential Democrats in Congress. And in a signal of the fast-changing nature of the political debate, former Clinton Treasury Secretary Lawrence Summers called for a $50 billion to $75 billion stimulus package, including universal tax rebates, if the nation's economy shows no sign of improvement by early next year.

Democratic lawmakers pounced on the central bank for having failed to act before the current wave of home foreclosures and for not seeking bigger changes in mortgage-industry practices. They noted the Fed's proposal comes too late to help many homeowners, and that it addresses a market for risky mortgages, or subprime home loans, that has largely dried up.

One big test of the Fed's overall response will come today when the central bank announces the results of an auction of as much as $20 billion in low-rate 28-day loans to banks. The auction was designed to encourage banks to lend to each other, greasing the engine of the nation's financial system. A successful auction would be a sign that the Fed's efforts are gaining traction.

At least until then, the harsh reaction to the Fed's proposal represents a setback for Chairman Ben Bernanke, who is trying to maintain credibility on Capitol Hill at a time when Congress is scrutinizing the central bank's monetary and banking policy decisions.

Until now, Mr. Bernanke has won plaudits for his flexible approach to regulatory matters since becoming chairman in February 2006. At the same time, lawmakers including Rep. Barney Frank, a Massachusetts Democrat and chairman of the House Financial Services Committee, have threatened the central bank with legislation that would make other regulators equal to the Fed in consumer-protection authority over banks.

The threat of more than a million foreclosures in a presidential-election year has supercharged the policy debate. Rather than forestalling more-aggressive congressional action, as some banking executives and central-bank staffers had hoped, the Fed's move may have incited it.

It could also affect Treasury Secretary Henry Paulson's effort to revamp the way the U.S. handles mortgage regulation, which is currently shared by the Fed and several other agencies. Mr. Paulson described that system Monday as a "patchwork quilt." If the Treasury makes headway -- it is expected to unveil a plan early next year -- Democrats, who have questioned the Fed's commitment to protecting consumers, may see an opening to reallocate some of its authority.

"We now have confirmation of two facts we have known for some time: One, the Federal Reserve System is not a strong advocate for consumers, and two, there is no Santa Claus," Rep. Frank said yesterday. "People who are surprised by the one are presumably surprised by the other."

Years of lax lending by banks and other institutions have led to a surge in mortgage defaults over the past year as home prices have fallen from their peaks at the top of the recent housing boom. Unless lenders greatly step up efforts to restructure loans, Moody's Economy.com forecasts that three million home loans will go into default in the 30 months ending in mid-2009, and about two-thirds of those will result in foreclosures.

The Fed's proposed rules -- which would touch almost every corner of the mortgage market -- would ban lenders from making subprime loans "in a pattern or practice" that disregards a borrower's ability to repay "from sources other than the home's value." That provision is aimed at preventing lenders from assuming that rising home prices will compensate for a buyer's stretched personal finances.

The rules also would bar lenders from making high-cost loans that rely on unverified income or assets. And lenders would have to set up "escrow" accounts to ensure that subprime borrowers' property taxes and home insurance were paid. Such accounts are common on prime loans, but subprime lenders have often skipped this precaution.

In addition, the Fed proposed rules that apply to both prime and subprime loans used to finance homes occupied by the borrower, as opposed to investment properties. Among other things, these rules would clamp down on payments to mortgage brokers that can give unscrupulous brokers a way to squeeze excessive profits out of a loan.

"Unfair and deceptive acts and practices hurt not just borrowers and their families, but entire communities, and, indeed, the economy as a whole," Mr. Bernanke said before voting to issue the proposal. "They have no place in our mortgage system."

The public will have 90 days to comment before the Fed finalizes the rules.

The proposal falls short of the more sweeping changes sought by consumer groups and senior Democrats. Democratic leaders including Rep. Frank and Senate Banking Committee Chairman Christopher Dodd made clear they plan to push ahead with their legislative plans to tighten regulation of the mortgage industry.

Sen. Dodd said the Fed's moves amount to "a clear signal that legislation is necessary to help protect homeowners from abusive and predatory lending practices." For instance, Sen. Dodd has said the Fed should prohibit prepayment penalties on all subprime loans. Instead, the Fed proposed that prepayment penalties on subprime loans should expire at least 60 days before a loan resets to a higher rate.

Sen. Dodd said he plans to "re-examine" legislation he introduced last week on mortgage-lending practices because he is now considering taking more power away from the central bank. His displeasure with the Fed could also derail the hopes of Fed governor Randall Kroszner, who was renominated for a 14-year term at the Fed in May; his current term ends Jan. 31. Mr. Kroszner and two other nominees need Dodd's approval before facing a Senate confirmation vote.

"It is unfortunate that so many consumers have had to go over the cliffs of foreclosure to get attention," said Jim Carr, chief operating officer at the National Community Reinvestment Coalition, which represents local groups that promote affordable housing.

The Fed's proposal wouldn't assign any liability to Wall Street firms that market securities based on loans that turn out to be unfair or deceptive. There are bills currently being considered in Congress, however, that would do just that. A Fed official said the central bank lacks legal authority to do so.

The Fed's overall response to the housing bubble is becoming a sensitive topic now that the repercussions are clear. The late Edward Gramlich, a Fed governor from 1997 to 2005, recalled earlier this year that he proposed in or around 2000 that the Fed use its authority to send examiners into the offices of certain consumer-finance lenders to tackle the growing problem of predatory lending.

Alan Greenspan, then Fed chairman, opposed the move, Mr. Gramlich said. Mr. Greenspan has confirmed his opposition. More recently, Mr. Greenspan told National Public Radio there was little the Fed could have done short of a sudden increase in interest rates that would have popped the housing bubble and also "broken the back of the economy."

Yesterday, the Fed was clearly aware of the intense scrutiny it was under. For the first time in the central bank's history it allowed television cameras to record audio and video from the entire meeting.

The banking industry generally supported the Fed's approach. The American Financial Services Association called the proposal "measured," while the Independent Community Bankers of America said it was an "important step." The American Bankers Association, however, said that some parts of the proposal were too rigid and "could make it harder for bankers to tailor products for their customers."

Though the Fed's proposal would apply to all subprime lenders, the central bank wouldn't be alone in enforcing it. A final rule would make it much easier for state attorneys general, the Federal Trade Commission and private lawsuits to go after those who violated the new policies.

The subprime market addressed by the proposals is now a fraction of its former size. It mushroomed in the first half of this decade as lenders rushed to grab the higher profit margins available on such loans. At the peak of the housing market in 2005, lenders granted about $625 billion of subprime loans. They accounted for a fifth of all home mortgages that year, according to trade publication Inside Mortgage Finance.

Competing for this business, lenders loosened their standards, often requiring no down payments and no proof of income. For years, home-price gains masked the repercussions of these decisions because borrowers who fell behind could easily sell their homes for more than they owed or refinance with even easier terms. As home prices flattened out and began to fall last year, defaults jumped. Investors who had been eager to buy subprime loans from the lenders recoiled from the market, leaving little money available for them.

Now, lenders are making only a trickle of subprime loans. Guy Cecala, publisher of Inside Mortgage Finance, says subprime lending is running at an annual rate of about $50 billion, or around 2% of the mortgage market.

The subprime market "is never going to be the size it was," said Thomas Kelly, a spokesman for J.P. Morgan Chase & Co.'s mortgage operations. Mr. Kelly said Chase continues to offer subprime loans but borrowers need to show better credit scores and verifiable income and make a down payment, generally at least 10%. Like most lenders, Chase has stopped making subprime loans that "reset" to a much higher rate after two to three years at a lower introductory rate.

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