The Fed and Foreclosures

By The New York Times | Editorial

29 November 10

here are two sides to every delinquent loan - a lender who made a bad lending decision and a borrower who cannot repay. Yet, banks have never acted as if they bear responsibility for the mortgage mess.

They have pursued foreclosures in violation of borrowers' rights to due process, as revealed by the recent robo-signing scandal. And, despite having been bailed out for their mistakes, they have pursued their self-interest, not the public interest, when it comes to modifying bad loans. They have resisted reducing principal balances for troubled borrowers, for instance, because that could force them to take losses they would rather delay.

Now, despite mounting evidence of borrower mistreatment, the Federal Reserve has proposed a rule that would disable the most effective legal tool that borrowers have to fight foreclosures.

First, some background: The Truth in Lending Act from 1968 gives borrowers the "right of rescission," the ability to undo a home refinancing or home equity loan within three years of the closing if the lender did not make proper disclosures - generally of the loan amount, interest rate and repayment terms. The law makes allowances for mere mistakes by the lender, but otherwise requires strict compliance, as well it should: disclosure is the main - often the only - consumer protection in the mortgage market.

It will come as no surprise that disclosure violations are not uncommon in the loans of the bubble years, so rescissions have become a valuable defense against foreclosure. That's because when a loan is rescinded, the lender must give up its security interest in the home - and without a security interest, the lender cannot foreclose. The borrower must still repay the loan principal, minus payments already made. Essentially, a lender that has not complied with required disclosures can get its money back, but not interest and other fees.

In practice, one of the ways that rescissions have worked is that lenders faced with rescission have instead modified the loans, by reducing principal and setting new repayment terms.

The Fed proposal would change all that. Citing concern over banks' compliance costs, it would require a borrower to pay off the remaining principal before the lender gives up its security interest. That would be clearly impossible for troubled borrowers. So the Fed's proposal would benefit the creditor who violated the law rather than the borrower, paving the way for foreclosures that otherwise could be avoided.

The Fed failed to protect consumers before the financial crisis, and is failing again. Hundreds of consumer and civil rights organizations, state and local legal aid programs, and homeowners' lawyers have signed a letter asking that the proposal be withdrawn. The Fed should comply.