The Federal Reserve Board this week began soliciting public comments on a proposed rule that would give mortgage lenders two ways to show they have sufficiently vetted a consumer's "ability to repay" a mortgage.

Due to lax underwriting during the subprime and alt-A era, Congress decided lenders should be held liable for making loans homebuyers cannot afford. But lawmakers also directed regulators to establish underwriting standards for a "qualified mortgage" that is so prudent lenders would be shielded from litigation.

"A creditor can originate a qualified mortgage which provides special protection from liability," the Fed says in a summary of the Truth in Lending Act proposal. The Fed is proposing underwriting standards for two alternative qualified mortgages.

The first alternative provides a "legal safe harbor" if the lender originates standard, fully amortizing mortgages not exceeding 30 years and the points and fees do not exceed 3% of the loan amount.  The borrower's income and assets must be verified and the lender must qualify the borrower based on the maximum interest rate during the first five years of the loan.

Lenders are likely to gravitate to the first alternative.  The second provides less legal protection but requires greater due diligence. Under the second alternative, lenders must comply with requirements of the first alternative. But they also have to verify the borrower's employment and credit history while considering the borrowers' other debt obligations and debt-to-income ratios.  In return, lenders receive a "rebuttal presumption of compliance" with the qualified mortgage test.

Community Mortgage Banking Project managing director Glen Corso said the first alternative appears to provide a real safe harbor. "If this option does offer a true legal safe harbor, lenders and investors will have the legal certainty necessary to provide low cost mortgage credit without the added expense of excessive defensive measures undertaken strictly to ward off class action attorneys," Corso said.

The comment period ends July 22 when general rulemaking for the Truth in Lending Act will be transferred to the Consumer Financial Protection Bureau.   The new bureau, not the Fed, will be responsible for finalizing the ability to repay rule. 

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