Consumer Federation of California

Consumer Coalition Letter to Federal Reserve Board on Suggested Suprime Lending Regulations

RE: Docket No. OP-1288

Dear Ms. Johnson:

We write to urge the Federal Reserve Board (FRB) to use its authority
under the Home Ownership and Equity Protection Act to prevent abuses in
the mortgage market that have led to the current crisis of lost homes,
lost equity, and destabilized neighborhoods. How
much more evidence does the FRB need to see that current loan practices
and products are unsafe and in desperate need of substantial reform? Any
changes will be too late for thousands of consumers who have lost their
homes to foreclosure, deeds in lieu, short sales, and foreclosure
rescue scams. Yet decisive and immediate action by the FRB can save
borrowers in the future.

The undersigned nonprofit groups, private firms and public agencies
write in response to the FRB’s request for comments on the Home Equity
Lending Market. Collectively, we are counseling agencies, community
development corporations, legal service providers, advocacy
organizations, housing providers, local government, private firms,
research establishments, neighborhood community development initiatives
and policy think tanks, all of whom are witnessing the devastating
impacts of abusive lending practices on families, seniors, people of
color, immigrants, low and moderate income households, and the
communities in which they live.

California registered the nation’s second highest state foreclosure
rate in June of 2007, one foreclosure filing for every 315
households-2.2 times the national average, according to Realtytrac. The
state reported 38,801 foreclosure filings during the month, the most of
any state for the sixth month in a row and more than three times the
number reported in June 2006.[1]
Another foreclosure data source, DataQuick, found that statewide, the
number of trustee deeds rose almost 800% compared to the same period a
year ago.[2]
In response to the growing crisis, over one hundred community groups in
California have called for a foreclosure moratorium in order to allow
time for counseling, loan modifications and refinances to help keep
people in their homes.[3]

California cities reported six of the nation’s top 10 metropolitan
foreclosure rates in June, and the top four spots were occupied by
California cities: Stockton, Merced, Modesto and Riverside-San
Bernardino. All of the top four cities registered foreclosure rates
that were more than five times the national average. Other California
cities in the top 10 were Vallejo-Fairfield at No. 7 and Sacramento at
No. 8.[4]

This comment letter tracks the FRB’s request for comment as published in the Federal Register:

A. Prepayment penalties.

• Should prepayment
  penalties be restricted? For example, should prepayment penalties that
  extend beyond the first adjustment period on an ARM be prohibited?

Prohibit prepays as unfair and deceptive. The FRB should prohibit prepayment penalties on subprime loans as inherently unfair and deceptive. Prepayment penalties trap borrowers into higher priced and unsuitable loan products.

Most consumers do not understand these penalties, which are
counterintuitive and harmful for subprime borrowers who hope to
graduate to prime products and for distressed homeowners who need to
escape from unsuitable loans. Borrowers are not bargaining for lower rates in accepting prepayment penalties, as industry groups assert time and time again. Consumer
choice cannot explain the large difference in the prevalence of
prepayment penalties in the subprime and prime home loan markets.
Prepayment penalties are in most subprime loans because investors want
them there. The reality is that prepayment penalties provide no benefit to consumers,[5] yet increase the likelihood of foreclosure.[6]

If the FRB won’t prohibit prepayment penalties, don’t permit prepays after rate reset. Especially onerous are loans where the rates will rise or reset before the expiration of the prepayment penalty period. Borrowers
are left with the harrowing choice of paying higher rates with their
existing loan, or refinancing to a better loan and losing valuable
equity in their home, typically thousands of dollars in California.[7]If
the FRB is unwilling to prohibit prepayment penalties, it must, as a
minimum, ban such penalties that extend beyond the loan’s initial
interest rate period and find this practice unfair and deceptive. Much
of the industry has already moved to this position and is limiting the
prepayment penalty period to that of the initial interest rate of the
loan.

If the FRB won’t prohibit prepayment penalties, create a 90-day window for refinances. Beyond
merely tying the prepayment penalty period to the initial interest rate
of the loan, the FRB should allow for a 90-day period prior to the
first interest rate adjustment during which time the consumer is able
to refinance without penalty. This is consistent with
the recently released interagency Statement on Subprime Lending which
includes limits on prepayment penalties that allow for a reasonable
period of time, typically at least 60 days, for customers to refinance
prior to the expiration of the initial fixed interest rate period
without penalty.

If the FRB won’t prohibit prepayment penalties, add prepays to HOEPA calculation. In
the alternative to banning prepayment penalties, and in addition to
restricting their duration, the FRB should include prepayment penalties
in the points and fees calculation under HOEPA. This would extend HOEPA’s protections to more consumers.

• Would enhanced disclosure of prepayment penalties help address concerns about abuses?

Disclosures are not enough. In isolation, enhanced disclosures would be unlikely to address our concerns about abuses. Adding
one more disclosure to the large pile of documents given to borrowers
will not significantly enhance their understanding of their mortgages. To
the extent borrowers are misled about their loan terms, they are doubly
victimized by prepayment penalties which effectively prevent them from
refinancing out of bad loans. A common practice of loan
sellers is to tell apprehensive borrowers not to worry because they can
always refinance if there are problems, thereby guaranteeing that a few
thousand dollars in prepayment penalties will be incurred. Most borrowers do not understand this dynamic at all. However,
coupling added disclosure with home loan counseling would probably
result in borrowers better understanding their prepayment penalty
provisions and more informed decision making.

• How would a prohibition or restriction on prepayment penalties affect consumers and the type and terms of credit offered?

Regulation would serve consumers’ interests. Prohibiting,
or in the alternative, restricting, prepayment penalty provisions would
likely have little affect on the availability of credit, but will
greatly increase consumer flexibility and ability to preserve and
utilize, not lose, home equity. Prime borrowers are generally not forced to accept prepayment penalties in their loans, yet have reasonable access to credit. So,
too, in those states that have prohibited or severely restricted
prepayment penalties, there has been no drying up of credit.[8]

B.Escrow for taxes and insurance on subprime loans.

• Should escrows for taxes and insurance be required for subprime mortgage loans?

Yes.Many borrowers’ decisions about
whether or not they are able to afford a particular loan are based on
their understanding of the monthly obligations under that loan.By
failing to include the prorated monthly costs of taxes and insurance in
that calculation, borrowers overestimate their own ability to repay the
loan.Additionally, we have repeatedly seen the lack of escrows used as a tool of deceit by unscrupulous mortgage brokers.Consumers
are often exposed to "bait and switch" tactics by brokers who tell them
that taxes and insurance will be included in their monthly payments but
who ultimately arrange for a loan lacking escrows.In other instances, consumers are denied basic information and advice on the potential ramifications of forgoing an escrow.Consumers
who are already carrying a debt load that stretches their financial
resources can be pushed over the edge by the unexpected addition of
thousands of dollars in additional annual costs for property taxes and
insurance.

• If escrows were required, should consumers be permitted to "opt out" of escrows?

Opt out in limited circumstances. Consumers
should be permitted to opt out either at loan closing or during the
term of the loan only with written proof of participation in a publicly
subsidized property tax and/or insurance program.The
State of California, for example, provides a property tax postponement
program to qualifying senior citizens and to disabled citizens.[9]If
consumers could "opt out" of tax and insurance escrows without
providing proof of their participation in an alternative program, there
would be a substantial risk that they would either "opt out" of escrow
unknowingly-by initialing yet another form among dozens received at
closing, without explanation or comprehension-or would be induced to do
so by their broker or lender.

• Should lenders be required to disclose the absence of escrows to consumers and if so, at what point during a transaction?Should lenders be required to disclose an estimate of the consumer’s tax and insurance obligations? 

Disclosure reform is inadequate.Since
we assert that escrow should be required in all subprime loans except
those where the consumer provides proof of participation in an
alternative tax and/or insurance payment program, additional disclosure
requirements related to escrow accounts under this regulatory regime
would not be necessary.

Disclosure requirements are better than nothing, but often fail in
their primary purpose-which is to guarantee that the consumer knows of
potential risks and can therefore make an informed decision about
whether or not to accept those risks.From
our experience in counseling consumers in mortgage loan transactions,
it has become apparent that the many disclosures required in these
transactions are often misunderstood by subprime borrowers with limited
financial literacy, and obfuscated by brokers and lenders who have
either failed to explain key loan terms and disclosures to borrowers or
have actively misrepresented or concealed these terms.

• How would escrow requirements affect consumers and the type of and terms of credit offered?

Escrow serves consumers’ interest. Escrow
requirements such as the ones suggested above would have no deleterious
effect on consumers or on the type of and terms of credit offered.Tax and insurance escrows are common practice for many subprime lenders, and are the industry norm for prime lenders.A
lack of regulation in this particular area primarily benefits those
brokers who would attempt to secure loans unsuited to the borrowers’
income.

C. "Stated-income" or "low doc" loans.

• Should stated-income or low doc loans be prohibited for certain loans?

Yes, prohibit stated income or low doc for certain loans. Stated-income
applications should be prohibited in conjunction with any "exotic" loan
products, including but not limited to: Interest-only loans, Piggy-back
loans, Option ARMs, and Hybrid ARMs. It is clear to us that the
marginal utility of extending credit to consumers with widely
fluctuating and/or speculative income is outweighed by the enormous and
well-documented risks involved with literally betting the house on the
representations written in small print on the last few pages of a loan
application-often completed by mortgage brokers with a vested financial
interest in insuring that the borrower qualifies for the loan,
regardless of their actual ability to repay.

The widespread availability of "stated
income" loans in conjunction with high-risk products from subprime
lenders over the last several years is one of the driving forces behind
the recent and well-documented foreclosure spike in our communities.
Despite reported market corrections, stated-income loans are still sold
aggressively. According to the Inside Mortgage Finance MBS Database,
32.2% of the mortgages pooled in subprime MBS during the first half of
2007 were underwritten based on stated-income or similarly defined "no
ratio" documentation.[10]

The stated-income feature has allowed
brokers to inflate borrowers’ incomes in a manner designed to increase
broker fees and to make a deal work, even if the borrower’s actual
income is woefully inadequate to support a loan of the given size.Meanwhile, the artificially low initial payments conceal the true cost of the loan from the consumer.It
is not until the payments reset and begin to adjust upwards that many
consumers realize that their financial position is untenable.At that point, consumers have few options.They
cannot legitimately refinance, since to do so would require an even
larger loan than the one they should not have been qualified for in the
first place.They cannot afford to stay, and,
increasingly, in a homeowner market that has flat lined or declined
(particularly in higher-cost areas), consumers are unable even to sell
their homes, since the home is indebted for more than its value.

Make stated income loans subject to HOEPA.
We strongly recommend that, where stated-income loans are permitted,
they automatically be subject to HOEPA, independent of the fee and APR
triggers that traditionally bring loans within HOEPA’s protections.This
would help to insure that these loans, which were ostensibly designed
to be marketed to a limited and highly particularized customer base,
are no longer widely used by predatory lenders and brokers.

Stated-income loans have afforded predatory
lenders and brokers the ability to gouge consumers for massive closing
costs and fees without triggering HOEPA’s protections.Since
HOEPA’s points and fees trigger is set as a percentage, brokers and
lenders can simply inflate the total loan value to collect the same
undeserved fees at a lower overall percentage.This
loophole creates a perverse incentive for brokers and lenders to
inflate total loan amounts; it can be easily closed by extending HOEPA
protections to all stated-income loans.Wherever the FRB
ultimately comes down on stated-income loans, strong oversight of
brokers is necessary to prevent further abuses.

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