Earlier this week, the Federal Reserve issued new, tighter rules for mortgage lenders. The recent uncertainties surrounding GSEs Fannie Mae and Freddie Mac, and this week's conversion of IndyMac Bank underscore the need for strong federal regulation in today's turbulent environment, so some might argue.

Under the Fed's new regulations, which will take effect October 2009, lenders must carefully evaluate borrower's income and assets and assure their ability to pay before granting high-risk loans. Prepayment penalties on subprime loans are prohibited, and lenders must escrow for taxes and insurance.

Other rule changes include stricter guidelines on advertising – such as the use of the phrase “fixed interest rate” and teaser rates – as well as customer service procedures. Changes also affect the disclosure, process and timeframe for lenders to collect up-front fees.

According to Federal Reserve Chairman Ben Bernanke, the new rules are designed to curb unfair or deceptive practices in mortgage lending and support sustainable home ownership, in hopes of checking surging foreclosures and declining housing prices.

“The contraction in housing activity that began in 2006 and the associated deterioration in mortgage markets that became evident last year have led to sizable losses at financial institutions and a sharp tightening in overall credit conditions.”

Michael Calhoun, president of the Center for Responsible Lending, said the new rules represent significant steps toward cleaning up a market that has spun out of control. “However, more remains to be done, including addressing nontraditional loans and yield-spread premiums (YSPs),” he said.

A growing number of states have passed their own legislation in recent months, and according to Calhoun, their laws go much further than the Fed rules. As examples he cites New York's ban on all subprime prepayment penalties and North Carolina's ban on subprime prepayment penalties as well as YSPs. California, which continues to be the hardest hit by the current foreclosure crisis, is also considering legislation this session that would limit YSPs.

The Effect on Homeowners

Borrowers must stringently document income and assets in order to qualify for home loans, but according to Gibran Nicholas, chairman of the CMPS Institute, an organization that certifies mortgage bankers and brokers, lenders will not face legal liability for loans made to special-circumstance borrowers, such as the self-employed, those starting a new job, and individuals living in areas with a poor employment outlook. Nicholas commends the Fed for loosening such restraints and making it easier for lenders to work with borrowers in unique situations.

"The final version of the rules are not as ambiguous as the Fed's original proposal, and lenders are presumed innocent so long as they follow certain requirements that have been outlined by the Fed," Nicholas said. "This means that lenders can start creating loan programs to address the unique needs of borrowers in the marketplace. This is great news for homeowners and buyers who have been shut out of the market due to the unwillingness of lenders to take risks when lending to borrowers who have unique financial circumstances."

Nicholas says that the new rule changes also allow lenders, brokers and home owners to have open communicaton with appraisers as long as it does not involve coercion or pressure to misstate the home's value. "This is fantastic news for homeowners, buyers and the entire industry," Nicholas said. "The Fed is properly addressing the issue of appraisal fraud while not overreacting to the situation."

However, according to Alan Jablonski, a California-based consumer rights attorney and mortgage broker and founder of AJ Consumer Watch,  the new rules fail to protect homeowners and home buyers from the lending practices that led to the collapse of the housing market. "There must be comprehensive changes to the laws that would require full disclosure of the costs and terms of loans, so that homeowners and buyers can fully understand the true cost of their home loan and avoid problems in the near future," he said. Carrie Bay