Fed acts to stamp out deceptive mortgage practices

By David Lawder and Karey Wutkowski

WASHINGTON (Reuters) - The U.S. Federal Reserve Board on Monday approved new rules to ban misleading and deceptive practices in mortgage lending, including prepayment penalties for many subprime loans.

The long-awaited Fed rules also prohibit lenders from making "higher-priced loans" unless they verify that borrowers have the ability to repay from income and assets other than the home's value.

This must be based on the highest payment in the loan's first seven years -- effectively ensuring that consumers can handle the higher payments after rates reset on adjustable-rate mortgages, the Fed said.

Fed Chairman Ben Bernanke vowed to vigorously enforce the new rules, which do not take effect until October 2009. The rules are not retroactive and will not apply to current borrowers' contracts.

"Besides offering broader protection for consumers, a uniform set of rules will level the playing field for lenders and increase competition in the mortgage market, to the ultimate benefit of borrowers," Bernanke said at a Fed board meeting.

Aggressive lending practices to lure borrowers with promises of low initial interest rates into loans they could not afford and may not have understood helped build the housing boom that turned into a slump when those risky subprime loans went sour.

Regulators have been under fire from critics who charge they have been slow to rein in lending firms.

Monday's announcement came a day after the Fed and the U.S. Treasury revealed measures to shore up confidence in top mortgage finance companies Fannie Mae (FNM.N) and Freddie Mac (FRE.N), with pledges to extend the firms more credit or buy shares.

Bernanke said the Fed's rulemaking on mortgage lending practices will continue, with the central bank focusing next on yield spread premiums.

Yield spread premiums are payments to mortgage brokers that are often tied to the level of interest rate paid. The system created incentives for brokers to steer borrowers into higher cost loans, even if they could qualify for a lower rate.

"The effort is not over," Bernanke said.

But some consumer groups were upset the Fed did not go further with its rulemaking and immediately ban yield spread premiums.

"It's simply a way for a broker to receive an unearned payment," said Jim Carr, chief operating officer of the National Community Reinvestment Coalition, an advocacy group.

"VIRTUALLY ALL" SUBPRIME LOANS COVERED

Bernanke said the rapid rise in U.S. mortgage delinquencies and foreclosures were imposing "large costs" on borrowers, their communities and the national economy. The new rules would keep credit "available to qualified borrowers and supporting sustainable homeownership," he said.