Fed Tightens Lending Rules

The central bank is proposing regulations that offer greater protections for home buyers and curtail abusive lending.

WASHINGTON (CNNMoney.com) -- The Federal Reserve on Tuesday proposed a much stricter set of rules for mortgage lenders as part of the central bank's effort to avert abusive lending.

Some of the rules would apply to borrowers with what the Fed called "higher-priced mortgage loans," which it defined as first-lien mortgages that carry interest rates 3 percentage points higher than the yield on comparable Treasury securities - basically, subprime loans.

Another set of proposals Tuesday would apply to all mortgage loans. The rules are subject to public comment for 90 days, after which the Fed will review comments and consider whether to make changes to them before issuing final rules.

Subprime plan

"Our goal is to promote responsible mortgage lending, for the benefit of individual consumers and the economy," said Federal Reserve Chairman Ben Bernanke. "We want consumers to make decisions about home mortgage options confidently, with assurance that unscrupulous home mortgage practices will not be tolerated."

The Fed's proposals would:

Prohibit giving people unaffordable loans. The new rules would bar lenders from extending credit without considering the consumer's ability to repay.

One reason for the spike in foreclosures among those with subprime adjustable-rate mortgages (ARMs) was that lenders measured a borrower's ability to repay the loan based on the low introductory loan rate, but not on the higher rate that the loan would reset to. The Fed proposed that lenders base affordability on a borrower's ability to repay loan at the reset rate.

Restrict use of 'liar' loans. The Fed wants to restrict the use of so-called "liar loans" or "stated income loans."

When lenders make such a loan, they don't verify the income of the potential borrower. The end result: Home buyers end up with homes they never could afford in the first place, let alone when their rate resets.

It is now insisting on verification both on borrower's income and assets.

Prohibit or limit prepayment penalties. Homeowners who want to refinance into more affordable loans are often prevented from doing so because of punitive prepayment penalties - which can amount to the equivalent of six months of mortgage payments.

The new Fed rules require that lenders waive any prepayment penalties for 60 days prior to a loan rate resetting.

Require or encourage escrowing of taxes and insurance. Subprime lenders often did not disclose the true cost of a home. They might have excluded home insurance and property taxes, for example. Nor did they collect taxes and insurance along with the mortgage payment and hold them in escrow for the borrower until they came due.

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