Fed Proposes Crackdown on Lenders and Lending Practices

The Federal Reserve continued its flurry of activity this month by announcing on Tuesday a proposal for restrictive rules for mortgage lenders. The restrictions are aimed at limiting unfair and deceptive home-lending practices that contributed to this year's subprime meltdown.

Generally, the rules take aim at unscrupulous lenders that target subprime borrowers and others, those borrowers being persuaded that they can afford loans that should be out of reach.

"Our goal is to promote responsible mortgage lending, for the benefit of individual consumers and the economy," the Fed's chairman, Bend Bernanke, said in a statement. "We want consumers to make decisions about home mortgage options confidently, with assurances that unscrupulous home mortgage practices will not be tolerated."

The Fed's proposals, which would mean changes to Regulation Z (Truth in Lending) under the Home Ownership and Equity Protection Act, would affect subprime lenders and borrowers:

> Prohibit giving borrowers unaffordable loans. Some lenders use introductory interest rates on subprime adjustable-rate mortgages to determine a borrower's ability to repay the loan. However, this does not take into account the inevitable resetting to a higher interest rate, the bane of many subprime borrowers' current or future reality and the reason for spiking foreclosure rates. The Fed proposed that lenders base the determination of affordability on a borrower's ability to repay the loan at the reset rate.

> Restrict use of loans without income verification. Some lenders make loans without verifying the income of potential borrowers. Homebuyers then end up with homes they can't and could never afford. These are called "liar loans" or "stated income loans," and the Fed wants to eliminate them by requiring verification of income and assets.

> Prohibit or limit prepayment penalties. Many times prepayment penalties, like those incurred when homeowners want to refinance into more affordable loans, are overly punitive, adding up to six months of mortgage payments. The Fed wants to require lenders to waive prepayment penalties for 60 days prior to loan rate resetting.

> Encourage (or require) escrow for taxes and insurance. Some lenders do not disclose the entire cost of the home, including insurance and property taxes. The Fed wants lenders to collect taxes and insurance along with the mortgage payment and hold them in escrow for the borrower until they come due.

In addition to subprime loans and lenders, the Fed also made several proposals to improve all mortgage lending:

> Make broker incentives restricted and/or transparent. Some lenders will pay brokers to lock-in borrowers to higher rate loans than they would normally qualify for. This is called the "yield spread premium." The Fed wants to outlaw these payments unless they are clearly disclosed to borrowers.

> Prohibit appraiser coercion. Appraisers have often been pressured to overvalue homes by lenders. The Fed would end this practice.

> Prohibit unfair loan-servicing practices. The Fed wants to eliminate late fees that are charged more than once ("pyramided.") They would require that servicers credit consumer accounts on the day of receipt and provide records of payments.

> Require better disclosure overall. The proposed rules here include requiring complete and clear disclosure by lenders in ads and in person. This means all applicable rates advertised along with the "teaser" rates.

The Fed is inviting comment on these restrictions for 90 days.

Fed Acts to Boost Economy and Prevent Additional Subprime Fallout

The Federal Reserve made major moves this week to thwart a recession and improve economic growth.

On Tuesday, the Fed cut the interest rate again, the third cut in the last few months. The group cut the federal funds rate, an overnight bank lending rate that affects interest on credit cards, auto loans and home equity loans. The rate now stands at 4.25 percent.

The Fed also cut the discount rate, governing the interest banks pay to borrow directly from the central bank, to 4.75 percent.

On Wednesday, the Fed acted again, announcing a plan to pump billions into the financial system to ease the burgeoning credit crunch.

The plan involves auctioning off the rights to borrow money directly from the Fed. This means banks would be able to access funds without the usual interest, based on the discount rate. From December 17 until January 28, four auctions will be held, with the first two auctions offering rights at up to $20 billion each.

Around the world, other central banks will offer similar auctions. Additionally, the Fed has established foreign exchange swaps, enabling the European Central Bank and Swiss National Bank to make loans in dollars. The goal of this step is to hopefully alleviate interest rates abroad.

Analysts and economist say the auction plan could potentially help banks hurt deeply by the subprime mortgage meltdown. According to estimates, banks across the industry have already reported about $100 billion in losses associated with subprime mortgages.

The Fed has made its interest rate cuts in efforts to stem the bleeding from the housing market turmoil, and prevent major economic fallout. With their announcement this week they acknowledged that "economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending." The Fed added that "some inflation risks remain" and the Fed "will continue to monitor inflation developments carefully."

The Fed's Impact on the Economy

The Fed meets regularly every six weeks of the year to assess the state of the economy and after their two day Federal Open Market Committee (FOMC) meeting adjourns, the markets eagerly wait for any indication of their outlook on the economy or hints on the direction of interest rates. The irony is that the Fed, which is seemingly omnipotent in the eyes of the average American, really has no direct control over long term interest rates which determine what homeowners pay for a mortgage nor do they directly impact long term economic growth. What the Fed actually does is regulate monetary policy by setting short-term interest rates and controlling the supply of money in the short run. They do so through the use and control of the following tools:

• The Discount Rate - this is the interest rate which the Fed charges to loan short-term funds from a Federal Reserve Bank directly to a member bank.

• The Fed Funds Rate - this is the rate which banks charge one another for overnight loans. This is the key short term rate which directly influences changes in the prime lending rate which is charged to consumers and businesses.

• Open Market Operations - this involves the buying and selling of government securities by the Fed whereby they can both inject (by buying) and drain (by selling) funds from the money supply.

Through the use and control of the above outlined tools, the Fed can wield a lot of influence in the areas of both consumer and business spending thereby guiding economic growth. However what the Fed cannot do is control the cyclical nature of the economy and prevent its pattern of highs and lows. When the Fed decides to cut short term interest rates the news is normally well received by the financial markets and the bond market will rally unless it is perceived as overly aggressive and may possibly lead to a higher rate of inflation. If a Fed move is seen as too conservative, or not aggressive enough, bond investors will likewise reveal their disapproval by summarily selling bonds and the yield will go up as yield and price move in opposite directions.

So if the Fed controls only short term interest rates, what influences rates in the long run? The answer is bond investors and they do so through the act of both buying and selling treasury bonds and notes. It is the bond investor's reading on the economy, influenced in part by the actions of the Fed and their resulting perception of Fed actions by bond investors which determines whether they will become either buyers or sellers of bonds. However other factors determine the behavior of the bond investor as well such as their future expectation of economic growth and the overall rate of inflation. Longer term economic growth is influenced by the government's control of fiscal policy which influences government spending as well as tax policies creating incentives for both consumers and businesses to save and invest.