06/12/2009 05:12 am ET Updated May 25, 2011

Last Call for Mortgage Reform

As housing prices rose earlier this decade, mortgage originators, brokers, servicers, and investors created and promoted ever more deceptive products to extract further profits from current and aspiring middle-class families. Distorted incentives throughout the industry made it profitable to market loans aggressively to families who never had a prayer of paying back. Prepayment penalties imposed fees on homeowners for paying mortgage debt early; adjustable rate mortgages resulted in payment shock when low teaser rates skyrocketed to exorbitant levels; borrowers with interest-only loans found that their loan principal increased as they paid back their mortgage; and "no-doc" loans locked unsuspecting borrowers into mortgages they could not afford.

Lenders often used mortgage refinancing to strip middle-class homeowners of the equity they relied on to obtain loans to help make ends meet. Negligent underwriting and plain fraud, spurred by the promise of easy profit, allowed such abusive products to proliferate from 19 percent of the mortgage market in 2005 to 31 percent in 2007. People of color were steered into high-cost mortgages even when they qualified for better products: one study finds that 54.5 percent of all conventional loans made to African Americans in 2005 were high-cost, compared to 23.3 percent made to whites.

High-risk subprime mortgages made to less creditworthy borrowers are a primary cause of the current foreclosure crisis: 1.5 million homes have been lost through subprime foreclosure and 2 million subprime mortgage holders are currently delinquent. However, risky prime mortgages - such as payment option adjustable-rate mortgages - are now just as likely to result in default as subprime mortgages. Poor and fraudulent underwriting, not irresponsible borrowers, are the primary cause of the foreclosure crisis.

Last week, the House passed the Mortgage Reform and Anti-Predatory Lending Act of 2009, which protects mortgage borrowers from certain abusive and predatory lending practices.

In addition to creating a "federal duty of care" that obliges mortgage lenders to meet minimum standards when originating a loan, the legislation requires creditors to make a good faith determination that a borrower has a reasonable ability to repay a loan and that refinancing a mortgage would provide a net benefit to the borrower. The bill also bans compensation of mortgage brokers based on the terms of mortgage loans, a practice that leads to higher interest rates for borrowers, and requires advance notice of interest rate increases for adjustable rate mortgages.

The Mortgage Reform and Anti-Predatory Lending Act takes some steps to combat and end the abusive lending practices at the root of the financial crisis. Requiring mortgages to meet minimum standards, such as ensuring a borrower's ability to repay a loan and a ban on "steering" high-cost mortgages to minorities, will help current and aspiring middle-class families avoid mortgages that saddle them with debt they will never be able to repay.

Obliging lenders to demonstrate that refinancing will provide a tangible benefit to a homeowner will protect households from equity stripping and, importantly, promote affordability. Prohibiting certain prepayment penalties, which can increase the risk of default by as much as 20 percent, and yield-spread premiums, which encourage brokers to steer borrowers into mortgages with higher interest rates, protects potential homeowners and helps realign the interests of borrowers, brokers, originators, and investors. Finally, approximately 20 percent of new foreclosure actions involve rental properties. The Act's protections for renters will protect individuals and families who are frequently given little or no notice that the property they rent is in foreclosure.

Yet, this bill contains serious shortcomings that will likely leave intact the destructive relationship between borrowers, brokers, originators, and investors that has worked in favor of profit-maximization, rather than in favor of quality home loans that all parties want to see repaid on schedule and in full.

Indeed, much could be done to improve the legislation. Provisions that permit preemption of strong state consumer protection laws by federal statutes will harm, not help, vulnerable borrowers. Further, the Center for Responsible Lending and the National Consumer Law Center raise very serious concerns about the strength of the Mortgage Reform Act. The groups worry that remedies for violations of the Act are unworkable, that the law's restrictions on prepayment penalties and yield-spread premiums are insufficient, and that not enough is done to ensure that "legal accountability flows through the mortgage chain." Lawmakers should heed these concerns as the bill works its way through Congress. Additionally, future reform should mandate that a standard mortgage option, with a fixed interest rate and no "affordability" gimmicks, be offered to all homebuyers.

Unfortunately, the Mortgage Reform and Anti-Predatory Lending Act is probably the best - and perhaps the only - opportunity in the near future to reform the mortgage industry so that it looks out for the best interests of homeowners, rather than the interest of banks and brokers. In general, the Act levels the playing field for middle-class households and so should be supported.

Still, the concerns of the Center for Responsible Lending and other groups are well-founded: homeowners might once again be left without remedy against an abusive and outsized industry that has done much harm to the economy in recent years.