Fed acts to stamp out deceptive mortgage practices

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.

The new rules mainly cover a new category of "higher-priced loans" that include virtually all subprime mortgages.

The rules will also cover some Alt-A home mortgages, which are held by borrowers who are rated above the subprime category but below the more pristine prime borrower.

They ban prepayment penalties on such loans if the monthly payment can rise during the initial four years. For other higher-priced loans, the period for pre-payment penalties cannot last for more than two years.

Such penalties have prevented some borrowers from refinancing or paying off loans early, locking them into unaffordable payments after interest rates reset.

Lenders must verify that borrowers have income and assets other than a home's value to make payments on higher-priced loans, the Fed said.

"The final rule establishes a lender's responsibility to assess a borrower's ability to repay on every loan originated, effectively giving wronged consumers a private right of action without demonstrating that their case was part of a broader pattern," Fed Governor Randall Kroszner said in a statement.

The new rules also require lenders to establish, in the case of higher-priced loans, an escrow account for property taxes and insurance payments. Many subprime loans did not include these, leaving borrowers unable to pay these added costs.

In addition the rules ban certain lending and servicing practices for other mortgages, including failing to credit payments on the day they are received, and coercing or encouraging appraisers to misrepresent the value of a home.

Certain deceptive advertising practices also are banned, including the use of the term "fixed" associated with an interest rate or monthly payment when it can change.

Kroszner said during a briefing after the meeting that the Fed will have to work closely with other banking regulators and state officials, especially because many lenders fall outside the Fed's supervisory powers.

"The real challenge we have going forward, not only with us but with all regulators, is enforcement," he said.

(Editing by Neil Stempleman)