Homeowners got their first big chance to judge the fledgling regulator charged with policing abusive lending after the introduction of a broad set of mortgage rules recently.
The regulator, the Consumer Financial Protection Bureau (CFPB), gets mostly high marks for the policies, which are intended to prevent the practices that fuelled the subprime debacle and the foreclosure crisis. But the agency made a few concessions to banks that consumers advocates say could leave borrowers vulnerable.
"While the bureau's new rules promote" affordable loans and better products, "they still leave the door open for abuses," said Alys Cohen, a lawyer at the National Consumer Law Center.
The new rules, broadly outlined in the Dodd-Frank regulatory overhaul, will have enormous influence on the mortgage market. They are intended to ensure consumers don't receive home loans with deceptive terms or onerous debt burdens. In short, banks have to make affordable mortgages, and if they don't, they face a greater legal liability. Under the new rules, it will be much harder for banks to give out mortgages without properly checking income, or with interest payments that suddenly jump to much higher levels.
"These rules now require lenders to determine that borrowers have enough income to repay loans," said Michael D. Calhoun, president of the Centre for Responsible Lending. "This common-sense requirement would have prevented much of the damage of the mortgage and financial crisis."
Reduction in lending
Even so, lenders managed to put their stamp on the regulation, winning some important features. As part of a fervent lobbying effort, banks warned repeatedly that strict regulations could crimp lending at a time when the housing market was just starting to get back on its feet. Regulators seemed to give some credence to that concern. Citing the "fragile state" of the housing market, the bureau said it would allow new mortgages to meet more flexible standards for affordability during a phase-in period of up to seven years.
"It appears the rules are written so that they would not disturb the housing recovery," said Kathy Kelbaugh, a senior analyst at Moody's Investors Service who focuses on mortgages. This concession will have implications for a new product called the qualified mortgage. Such loans, which are expected to be the most common, will have to meet the affordability standards that apply to all mortgages.
They will also be subject to a significant additional condition: Borrowers' combined debt payments cannot exceed 43 per cent of income. But the phase-in period will effectively allow banks to make qualified loans with higher debt burdens for up to seven years if the loans conform to standards set by government mortgage entities like Fannie Mae or the Federal Housing Administration. Such entities have reasonably high standards, but it is a loophole that banks could exploit.
The bureau's biggest headache was deciding how to devise a required legal shield for banks. Such protection would largely insulate banks from lawsuits when certain loans go into foreclosure. It seems odd that the banks got this advantage, given the abuses during the housing bust.
And such shields don't exist in other important industries; automakers have to comply with clear standards and don't get automatic legal relief for doing so. But Congress provided the shield to encourage banks to write qualified mortgages. Lawmakers felt banks might cut back on lending if they feared the new standards increased their chances of getting sued.
Still, the bureau had some freedom. And in the end, the agency chose to apply two types of shields. Banks get more protection on prime qualified mortgages — those with lower rates made to borrowers with better credit. The shield on these loans is called a safe harbour. This substantially limits a borrower's ability to claim in court that a loan was not affordable and therefore ran afoul of the rules.
The banks get less protection on subprime qualified mortgages — those with higher interest rates that will most likely go to borrowers with weaker credit. On these loans, the weaker shield gives borrowers more leeway to contest whether a loan was affordable.
Consumer advocates think that all qualified mortgages, not just the subprime variety, should have had the weaker shield. Some analysts think the banks may have been overstating the need for a legal shield to lend. "Despite the claim that banks can't make loans without a safe harbour, they have done so for decades," Cohen said. Officials at the federal agency stress that borrowers can still challenge loans made under the safe harbour shield. For instance, a borrower can sue the bank if it can be shown that a loan didn't meet the basic debt-to-income requirements, and therefore wasn't considered qualified.
The rules also allow borrowers to introduce oral evidence to make their cases. A borrower could tell the court about a conversation with a loan officer that suggested a loan was unaffordable from the outset and should not have been made. For instance, a borrower might have told the bank that a big bonus might not re-occur, but the bank assumed the payment would be annual. But consumer advocates say that the safe harbour provision, in practice, will make it difficult for borrowers to pursue an exhaustive legal inquiry.
So the safe harbour is seen as a big win for the banks. "I think the safe harbour is pretty safe," said Elizabeth L. McKeen, a partner at the law firm, O'Melveny & Myers.
Consumer advocates also contend that the bureau overemphasised the debt-to-income ratio. Equally important for some homeowners, they say, is how much money they have after making debt payments. The bureau calls this residual income. A lower-income family might have a debt-to-income ratio of 43 percent or below. Yet the household may not have enough money to meet other living expenses like utilities and grocery bills.
The bureau recognises that residual income is important for some borrowers. For the subprime qualified mortgages, the bureau explicitly allows the borrower to cite insufficient residual income when legally contesting the mortgage. But this residual income feature doesn't exist for the prime qualified mortgages, which will probably make up most of the market.
The bureau could have demanded lenders take residual income into account for prime qualified mortgages to lessen the chances they find loopholes in the rules. But such decisions reflect the difficulty the bureau will face in policing the industry. Push too hard, and lenders might cut back on lending. Give too much, and lenders might take advantage of consumers.
"There's this constant struggle between protection and access to credit," said Leonard N. Chanin, a partner at Morrison & Foerster. (Peter Eavis / The New York Times News Service)