Statements to the Congress.
The bill is a commendable effort to address the complex issue generically called "reverse redlining" that has received considerable public attention over the past two years. It is clear that the sponsors have attempted to narrowly target the bill to areas of abuse, without overburdening the general market. If the bill progresses further, I think it is extremely important to maintain this focus. As my comments will make clear, it is the Board's view that failure to maintain a tight focus in the drafting of this bill entails substantial risk to many legitimate forms of consumer credit.
We can all agree that the abuses this bill seeks to remedy involve some truly heartwrenching personal tragedies. Some homeowners--often elderly, with substantial equity in their homes but with little income--have been targeted by home improvement contractors, loan brokers, finance companies, and mortgage companies for aggressive promotion of credit. Sometimes the potential borrowers seek the credit to consolidate other loans that are about to mature. They also obtain this type of credit for home repairs or other emergencies.
When the "dust settles," these borrowers may find that they have paid a high number of loan origination and broker points (often financed in the borrowed amount) and have agreed to a loan with an interest rate at the highest levels in the market--sometimes with monthly payments that even exceed their monthly income and often with a balloon payment due. In some cases, it is maintained that borrowers have been defrauded because the terms of their credit have been misrepresented to them. Apparently, in a substantial number of cases, borrowers are unable to keep up the payments, and they end up losing their homes through foreclosure.
My colleagues and I, as well as officers and staff members throughout the Federal Reserve System, have been closely following these issues and have, like the members of this committee, been actively considering how such abuses might be prevented in the future. Board members have met with delegations of aggrieved homeowners and have been distressed to hear firsthand of their plight. We talked with those who currently cannot afford to repay their loans and who risk losing their homes through foreclosure. Given the particular concern about these practices in Boston, the Federal Reserve Bank of Boston has investigated these practices there by meeting with public officials and community groups to work on a practical response, working with affected borrowers, and conducting workshops on deceptive credit practices. The Bank also reviewed the activities of one large nonbank subsidiary of a bank holding company in considerable detail.
Through all of these efforts we have come to appreciate the severity of the problems that high-cost mortgages cause some borrowers. However, it has also become clear that finding a solution--that itself does not have adverse consequences--is a very difficult undertaking. The problem is multifaceted and complicated.
General Comments On The Legislative Proposal
The bill would define a high-cost mortgage as one that meets at least one of the following characteristics: (1) the annual percentage rate (APR) exceeds the yield on U.S. Treasury securities having maturities comparable to the transaction by more than 10 percentage points; (2) the consumer's percentage of total monthly debt to income exceeds 60 percent after the transaction is consummated; or (3) all points and other fees paid before closing exceed 8 percent of the loan amount. We strongly support the bill's exclusion from its coverage home purchase loans and openend home equity lines of credit.
The proposed disclosures for high-cost mortgages would be required three days before loan consummation. The special disclosures for these mortgages would be made earlier than the disclosures that are already required under the TILA (required before consummation) and would provide the borrower three days before closing to review these special disclosures and to decide whether to close the loan.
Under the bill, consumers would receive information about the effect of the security interest in the home, the APR, a statement of the consumer's remaining monthly income after having made the payments on the transaction, information about variable rate features, and a statement that submitting a loan application and receiving disclosures does not obligate the consumer to complete the transaction. The TILA already requires some of this information (or some form of it) to be given before consummation of the transaction. The bill would also amend the TILA to restrict the terms of high-cost mortgage loans--for example, by prohibiting prepayment penalties, balloon payments, and negative amortization in such loans. Enforcement of these requirements is accomplished through the federal regulatory agencies and the courts, which could issue a judgment against a creditor for actual damages, civil penalties of up to $1,000 per violation (up to $500,000 in a class action), and, under the bill, forfeiture of all interest and fees earned.
In general, we believe that these problems should be addressed in a way that benefits consumers without undue compliance burden on creditors. For instance, overly restricting credit contract terms could create the risk that the cost of credit could increase or that it could be shut off altogether to marginal borrowers, or to those borrowers who happen to need credit because of special circumstances. The bill might create a disincentive to lending to these borrowers because a technical violation of even one of the proposed disclosure requirements could subject a creditor to the serious monetary penalties mentioned above. The risk of substantial litigation is likely to deter many legitimate lenders from entering this market. This should make us all the more careful to avoid having unintended results affect legitimate borrowers.
Everyone wants to protect consumers--particularly those whose age or income makes them vulnerable to abusive lending practices--against losing their homes, perhaps their only substantial assets. Appealing as it is to assume that more disclosure will cause people to act prudently, the Board is not convinced that more TILA information--even if provided separately from and earlier than all other disclosures--will effectively deter consumers from entering into high-cost mortgages or ensure that they better understand the possible consequences. For example, it is likely that people facing default on pre-existing loans would agree to any (even high-cost) terms after full disclosure to fend off losing their homes. Ordinarily, given the choice of addressing a consumer protection issue with disclosure requirements or credit restrictions, we would opt for informing consumers about their credit choices, such as through TILA disclosures. We believe the credit market works best when it is unencumbered and when consumers have the information they need to compare available credit terms.
With high-cost mortgages, however, consumers are already required to receive a substantial amount of disclosures about the terms of the loan. They receive the APR, a disclosure of the security interest and the payment schedule on such loans, for example, although later than is proposed under the bill. The benefit of the special disclosures in advance of this information is less than obvious because most of these homeowners already have three days after closing to review their existing cost disclosures and to cancel the transaction under current law. (1)
Obviously despite these protections, there are problems today. Borrowers nevertheless enter into these high-cost obligations. It appears that few if any rescind these high-cost transactions after having received cost disclosures--even consumers who may have been misled about their credit terms or were subjected to high-pressure sales tactics. Thus, despite the good intentions of the sponsors and our own usual preference for disclosure rules over other restrictions, we have doubts whether simply increasing the information given will have much positive impact.
Thus, it may be that the more realistic way to address these various problems is through some of the substantive restrictions proposed in section 2 of the bill. The principal substantive restriction under the TILA now affecting these loans--the right of rescission--could be enhanced somehow for high-cost loans--for example
by lengthening the rescission period--as an alternative to adopting restrictions on credit terms. This may prove particularly efficacious in cases in which the borrower is actively solicited by a broker or lender, rather that having initiated the credit shopping. We would be happy to work with committee staff on such an alternative, although I am not confident that high-cost mortgage borrowers who may desperately need credit would be any more likely to rescind their loans with greater disclosures about rescission or a longer "cooling-off" period than they are now.
SPECIFIC COMMENTS ON THE LEGISLATIVE PROPOSAL
We have attached, for the committee's information, detailed comments on the entire bill.(2) However, I would like to make a few comments on the provisions. Our objective is to have the Congress avoid the unintended consequence of terminating legitimate credit options in the process of enacting this bill. We suggest that the definition of a high-cost mortgage be changed to be a transaction in which two or more of the conditions are satisfied. Consider each point in turn:
First, consider the criterion that high-cost loans bear interest rates at more than 10 points above the current rate on Treasury securities of equal duration. I can understand that 10 percentage points may seem to be a large spread. In the present rate environment, however, this criterion implies an interest rate threshold of 14 percent to 15 percent. Yet many individuals, and not just those with low and moderate incomes, currently finance moderate-sized home repair items by using their credit cards. The effective interest rate on these cards may well be in the 18 percent to 21 percent range. It does not seem appropriate to consider extensions of credit at 14 percent or 15 percent rates as high-cost when individuals now often assume much higher rates to accomplish the same purpose. The interest rate alone should not be considered the basis for establishing a loan as "high cost" unless a substantially higher spread is adopted.
Second, consider the 60 percent of income criterion. I have regularly opposed the use of such factors because income is often a poor guide to the ability to repay a loan. Consider first what I call the "widow situation." Let us imagine a widow who is left with her home, a little income (say, earnings on her husband's life insurance), and some real estate that could be fixed up and sold to improve her financial situation. She is consuming the capital represented by the life insurance proceeds. She realizes that it cannot continue, and indeed that is the reason why she is seeking to liquidate some of her property. But it is easy to imagine that the financing costs on the repairs she must undertake will exceed 60 percent of her income on a short-term basis. Would you put at risk her ability to borrow by defining her loan as "high cost" simply because of her temporary low income? Again, I think that using simply one of the three criterion listed as sufficient for that definition creates an overly broad scope for this bill.
A second class of individuals who would be unintended victims of this legislation would be people who are starting small businesses and using their homes as equity for fixed-term second mortgages. Because the incomes of these individuals are temporarily depressed, use of income as the sole criterion for the high-cost designation is particularly ill advised. Yet these types of mortgages may be the best source of credit available to these potential entrepreneurs.
Preliminary research at the Federal Reserve suggests that many government-sanctioned mortgages implicitly involve loans to families that require that more than 60 percent of their income be used for credit purposes. In 1987, for example, roughly 10 percent to 12 percent of all FHA-insured refinancings involved borrowers with debt-to-income ratios greater than 60 percent. To avoid limiting the availability of credit under government-sponsored programs, you might consider exempting these mortgages from coverage under the legislation.
Finally, the third criterion, an 8 percent limit on points and fees, is unduly restrictive for small loans. For many reasons, including the paperwork costs imposed by law and regulation, a substantial fixed cost is involved in processing the loan. Indeed, this cost is often cited as the reason why many banks do not make small loans at all. An 8 percent limit on points and fees would make these loans even scarcer. Consider a $2,000 loan for a new roof, for example. The 8 point test translates to a $160 threshold. By any of the cost standards I am aware of, this amount is uncomfortably low.
Again, I am sure we all agree that we want to avoid the unintended consequence of making loans more difficult to get. My colleagues and I have wrestled with the conflicting tradeoffs involved. One option is to raise the thresholds proposed for each of the three criteria cited above. We believe that a better option is to look for a pattern of abusive terms by requiring that two of the three criteria be met before designating the loan as "high cost." Absent such a change, it would be difficult for us to conclude that this legislation would not risk significant impairment of loan availability in many legitimate and non-abusive instances.
Of all of the provisions in section 2 of the bill, the substantive limitations on balloon payments, negative amortization, and prepayment penalties seem particularly focused on the problems associated with high-cost mortgages. Without the bill's exclusion of home purchase loans, some common balloon mortgage products such as the so-called "7-23" loans could have been affected by the restrictions. And, without the exclusion, the negative amortization restrictions might well freeze out many potential homebuyers from the market if the rate environment of the late 1970s should return. Further, as mentioned in our attached technical comments, the definition of negative amortization may have the unintended consequence of restricting reverse annuity mortgages because the balance on these loans increases with the payouts to the elderly borrower over the loan term. Thus, I again stress that it is very important to keep the focus of the bill narrow.
We also have some concern about the provision that would amend the TILA assignee liability and expose an assignee to all the claims and defenses the consumer could assert against the creditor from failure to comply with any TILA requirement. The Federal Trade Commission's rule on unfair and deceptive practices addresses this issue to some degree already. That rule has essentially eliminated holder-in-due-course status for assignees of consumer credit sale contracts but not of direct loans. Also, the provision would create. a second, more expansive standard for assignee liability than is present in the TILA, which now specifies that assignees are liable only for TILA violations that are apparent on the face of the documents for the loan assigned. In addition, the penalties are much more severe (loss of all finance charges paid) than under existing law. This potential for increased liability could discourage the purchase, and ultimately the origination, of loans--and therefore restrict the availability of credit to marginal borrowers without alternative sources of credit.
Finally, to the extent that the Congress chooses not to defer regulatory policy to the states, the Board believes a clear and complete federal preemption should be considered to clarify coverage and reduce regulatory compliance burdens.
The committee is to be commended for attempting to resolve a complicated and important problem caused by high-cost mortgages. It is clear that the issues raised by high-cost mortgages are complex and that the appropriate federal response to the problems they raise is equally complicated. Many of these issues, relating to fraud and misrepresentation or usury, are already regulated by the states. Other issues, such as disclosure about the cost of credit and the ability to rescind a loan entered into through high-pressure tactics, are already handled to a great degree in federal law. The other issues raised, such as the terms of the credit contract, would be addressed in S.924 by imposing restrictions on the parties, ability to contract for those terms. Although we do not favor federal restrictions on credit terms, we believe that these restrictions would better address the problems created by high-cost mortgages than the additional disclosures that have been proposed.
In crafting the final form of this legislation, it is essential that the committee avoid the problem of unintended consequences. Given the reported difficulties that some sectors of the economy have in accessing credit, it would be an unfortunate outcome of well-intentioned legislation if these sectors were cut out of the credit market entirely. I would recommend to this committee that during the course of their deliberations they solicit information from creditors active in second mortgage lending to determine how the proposed legislation might affect the availability of credit. We need to be better informed of this market, but absent perfect information, it is essential to keep the focus of this legislation as narrow as possible to eliminate abusive practices while minimizing adverse consequences which the Congress clearly would not have intended. (2.)The attachment to this statement is available from Publications Services, Board of Governors of the Federal Reserve System, Washington, DC 20551.
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|Title Annotation:||Lawrence B. Lindsey statement|
|Publication:||Federal Reserve Bulletin|
|Date:||Jul 1, 1993|
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