New Fed Rules on Subprime Loans and Implications for California

By Paul Leonard
California Office Director
Center for Responsible Lending

Today the Federal Reserve helped return the home lending industry to common-sense business practices by issuing new rules for mortgage lenders. We are pleased to see that the Fed has adopted some key protections for borrowers who receive subprime loans, including the following critical provisions:

• Requires that lenders evaluate a borrower's ability to repay a subprime loan, and verify income;

• Prohibits abusive prepayment penalties which trap borrowers in short-term subprime ARMs, and limits them for fixed loans;

• Requires the escrow of taxes and insurance for subprime loans.

The Federal Reserve did not, however, tackle all of the abuses that have troubled the mortgage lending market. It is unfortunate that the new rules do not cover the non-traditional (Alt-A) loans, such as payment-option ARMs, that have had a major hand in today's massive foreclosures.

Additionally, the Fed postponed addressing yield-spread premiums (YSPs)-the kickbacks that reward brokers for steering borrowers into costlier loans-which means that incentives to overcharge borrowers still exist. Although we are pleased the Fed recognized that its original disclosure-oriented broker rules were insufficient to curb abuses, we hope they will act quickly to tackle unfair yield spread premiums.

Implications for California

While many states have taken the lead in establishing new predatory lending standards, California legislators have not yet acted. New predatory lending legislation is now under discussion by California's legislative leadership, and we urge them to produce a bill that will complement and enhance the new federal rules.

State-regulated lenders originated 60 percent of California's subprime loans in 2006 [CRL calculations based on 2006 HMDA data]. California has the authority to issue tougher rules for the majority of subprime lenders that operate in the state, and, indeed, such stronger rules are necessary for the well-being and future of California's homeowners, communities and economy. Additionally, the Fed's new regulations will not take effect until October 2009; state legislation would take effect much sooner.

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