Business forum: Adjustable mortgage a pig in a poke

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Only part of the story of how the Federal Reserve contributed to the economic crisis has been told. The part that has not received attention involves the Fed's failure to enable subprime borrowers to tell what their monthly payments would be. Obviously, borrowers who cannot predict their monthly payments cannot predict whether they will be able to make those payments,

The story starts more than 40 years ago, when Congress passed the Truth in Lending Act. The act requires that key loan terms be boiled down to a single comprehensible page, so borrowers can make the right loan decisions. Congress also directed the Federal Reserve to create rules to make that happen.

Fast-forward to the 1980s, when adjustable-rate loans became common. It is impossible to know at the time the borrower takes out such loans what future payments will be, because by definition with such loans, payments change from time to time.

So regulators adopted a two-pronged strategy. First, soon after the borrower applied for the loan, the lender would provide the borrower with some disclosures. Later, at the closing, the borrower would see the final loan terms. The problem for the many subprime borrowers who took out adjustable-rate loans is that the first of these disclosures was of only limited value, while the second was actually misleading.

Take the early disclosures. The Fed's model form gives borrowers a historical example of how payments shift over time. But the form notes that the rates it assumes may be different from the borrower's actual rates. That means borrowers cannot tell from the form what their payments will be.

The final loan disclosures are even worse. To see why, imagine that you took out one common form of subprime loan, in which you received a low "teaser" rate for the first two years, after which the rate would adjust every six months, typically to a higher rate.

The Fed's arcane commentary directs lenders to assume that interest rates at the time of the future adjustments will be whatever they were at the time of the loan closing. So the Truth In Lending form might show a low monthly payment for the first two years -- the teaser rate -- followed by 28 years of a somewhat higher monthly payment, which never changes again.

This is misleading because if interest rates were generally low at the time of the closing but higher at the time of the adjustments after the two years expired, the actual payments could be much higher than the form showed. And while the Truth in Lending form might show payments would be unchanged for 28 years, they could change every six months.

The Fed should not be in the consumer protection business. We need a separate Consumer Financial Protection Agency, something the House of Representatives has now voted for.

Last year Congress changed the law to require lenders to tell borrowers what their highest monthly payments may be.


Jeff Sovern is a professor of law at St. John's University School of Law in Jamaica, N.Y.


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