Fed passes reforms to combat subprime mortgage crisis

The measures promise to protect borrowers from prepayment penalties and misleading loans.

The federal regulatory process to fix some of the worst mortgage abuses is now moving ahead with greater speed.

The Federal Reserve, the nation's central bank, voted to take a wide range of actions that might prevent future malpractice, but will likely do little to help borrowers facing foreclosure. The Fed's main thrust appears aimed at banks who made loans to subprime borrowers, those with less than stellar credit ratings, and those who took out loans without proof of income or other documentation.

"This is a huge step," says Kurt Eggert, a law professor at Chapman University School of Law in Orange, Calif. and a past member of the Federal Reserve's Consumer Advisory Council. "If these steps had been taken five years ago we may not have had the meltdown, or at least it would have said there is a sheriff in town trying to force some reasonable basic rules of good lending."

The Fed's actions, announced on Tuesday, included:

•Giving protection to subprime borrowers from prepayment penalties if they payoff their loans early.

•Requiring lenders to ascertain that borrowers are aware of the need to set aside money for taxes and insurance in their monthly payments.

•Clamping down on so-called no documentation loans, which have been made to the self-employed or other people without a conventional income.

•Setting new standards to determine a borrower's ability to repay a loan.

The Fed's board of governors passed these proposals unanimously on Tuesday. The next phase for these new regulations will be opening them to public comment.

"These sound like reasonable proposals to me," says Lyle Gramley, a former Fed governor, now at Stanford Policy Research in Washington. "Subprime loans are made to those people least able to understand the terms and conditions and they need protection so this is an important step forward."

Few of the measures would have an immediate impact – the Fed has indicated it would start to implement them next year.

However, the new regulations are also taking place after the financial markets have already made changes. Banks have become particularly wary about making mortgage loans to anyone but the best borrowers because of enormous losses. Many of the mortgage brokers who made the most egregious loans are now out of business.

"The market has instilled discipline," says Richard DeKaser, chief economist at National City, a bank holding company in Cleveland.

"Much of this is insuring we don't repeat the problems going forward," he says.

Foreclosures are now at record levels and some 20 percent of subprime loans are now delinquent. And, the numbers may still rise since many of the borrowers took out loans with low "teaser rates" that will readjust upward over the next two years.

However, Mr. DeKaser says some will make the argument that the Fed's new rules may act to stifle innovation. "If I want to lend you money, who should say what the terms are to limit the extension of credit," says DeKaser. "By codifying restrictions there will be more safety in mortgage lending, but potentially limited innovation."

Some members of Congress have been jawboning the Fed to become more active. And, there is legislation pending in both the House and Senate that would make it easier for subprime borrowers to repay loans without penalty.

After the Fed's actions on Tuesday, however, some of its chief Democratic critics were unhappy with the actions, saying they were not strong enough.

"This is a clear signal that Congress must act immediately to pass legislation," said Sen. Charles Schumer of New York, chairman of the Senate Banking subcommittee on housing, in a statement.

One of the spillover effects of the mortgage crisis has been a developing credit crunch as banks have become reluctant to lend each other money. Yesterday, in a separate action designed to remedy the situation, the European Central Bank announced it has lent out $500 billion to member banks. After the announcement, international interest rates, known as the London Interbank Offer Rate (LIBOR), fell. Since many short-term loans use LIBOR as a benchmark, this rate reduction will help individuals who carry balances on credit cards, those borrowing money for car loans, and some business loans.

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