Federal

Duke, Developments in the Landscape for Consumer Credit and Payments – Part 3

Regulatory Changes in Consumer Credit and Payments

In addition to the economic recession and recovery, the regulations governing consumer payment and credit products changed significantly in the past few years. So it is especially difficult to separate the effects of economic conditions from regulatory effects on credit and debit card usage.

In December 2008, the Federal Reserve issued rules that introduced new consumer protections and revised the disclosures that consumers receive in connection with their credit card accounts. Then, in May 2009, the Congress enacted the Credit Card Accountability Responsibility and Disclosure (Credit CARD) Act, which contained additional provisions regarding credit cards and gift cards. Collectively, these rules have comprehensively overhauled the regulatory regime that applies to credit cards.

In large part, these reforms developed in response to concerns about the growing complexity of the products offered to consumers and concerns that consumers could not accurately assess the costs associated with their credit cards. To address these concerns, the Federal Reserve used extensive consumer testing to develop new disclosures to be provided with credit card solicitations and in periodic statements. These disclosures highlight key account terms and attempt to improve consumers’ understanding of the costs associated with using their cards. The resulting disclosure requirements establish a new baseline for transparency in the credit card industry. In addition, the new rules ban certain practices that increase the cost of credit in ways that cannot easily be disclosed to consumers, such as double-cycle billing. The new rules also generally prohibit card issuers from increasing interest rates applied to existing balances and require issuers to provide adequate notice of higher rates to be applied to future balances.

It is too early to draw conclusions about the ultimate impact of these changes because many of the new requirements have been in effect only since earlier this year. For example, card issuers appear to have changed their credit card pricing and underwriting models as their ability to use penalty pricing has been reduced. And some of the reduction in new account solicitations may also be due in part to the regulatory changes. But, in light of the concurrent changes in charge-off rates, economic conditions, and regulatory requirements, it is hard to separate the relative effects of each.

One way to assess the effects of regulation alone might be to watch the relative developments in business credit cards in comparison to consumer credit cards. Credit cards issued primarily for business or commercial purposes generally are not governed by the consumer protections in the Truth in Lending Act or the amendments to that act in the 2009 Credit CARD Act. Some observers have already expressed concern that some card issuers may be marketing business and professional cards to consumers in an effort to sidestep new restrictions. At the same time, some business owners and professionals might find the higher credit line availability or other terms offered on business cards to be more attractive than using their personal cards for business expenses. The federal banking agencies have sufficient supervisory and enforcement authority to ensure that issuers market and issue business cards only to borrowers who they have legitimate reason to believe are using them for business purposes. Generally speaking, the card issuer is responsible for determining whether an account is intended to be used for business or personal purposes, and indeed, business card applications commonly request information necessary to make this determination. The detailed information requested may include, for example, the type of business, annual revenue, age of the firm, number of employees, and tax identification number. The answers to these questions help verify that the applicant owns a business, as well as gauge the creditworthiness of the business.

Aside from credit cards, the regulatory landscape is also changing for other payment products. The Federal Reserve has recently issued regulations that prohibit consumers from being automatically enrolled in overdraft programs for overdrafts created by automated teller machine withdrawals and one-time debit card transactions. In addition, new disclosures are required to help consumers understand the associated costs before they choose to opt into overdraft coverage. We have also implemented new protections under the Credit CARD Act that restrict the fees and expiration dates that apply to gift cards.4

The Dodd-Frank Wall Street Reform and Consumer Protection Act requires the Federal Reserve to develop standards for debit card interchange fees and the routing of debit card transactions. I am aware of the high level of interest in this topic, and I recognize the importance of the statute and its implementation for the future development of the payment card industry. However, we plan to issue a proposal for comment soon, so I will not comment on any specific elements at this time.

Just as credit card products have undergone change in response to the new credit card rules, new regulations affecting debit card overdrafts and interchange fees are likely to result in some changes in deposit product pricing and design. For example, depository institutions have stated that they are reconsidering their ability to offer free or low-cost checking accounts if losses due to lower revenue from overdraft or interchange fees materialize. As the pricing of checking accounts changes, financial institutions and consumers may turn to certain types of reloadable prepaid cards as checking account alternatives.

The Future of Consumer Credit and Payments

While the pace of the economic recovery and the effects of new consumer regulations are strongly influencing lender and consumer behavior, the evolution in the consumer credit and payments landscape in the years ahead will be equally shaped by technological innovation.

Innovative product and system design in the payment card marketplace continues to produce new electronic payment products. For example, a growing number of consumers are using prepaid cards. Preliminary estimates from the Federal Reserve Bank of Boston’s 2009 Survey of Consumer Payment Choice indicate that about one-third of consumers sampled reported having a prepaid card of some type.

Offering functionality similar to credit and debit cards, prepaid cards include a variety of products targeted to different groups of customers, from general-purpose reloadable cards that may serve as deposit account substitutes for the unbanked or the underbanked to more-limited-purpose products, such as gift cards, teen spending cards, or mass transit cards. In addition, as an alternative to checks, employers issue payroll cards to employees and numerous government entities make payments and issue benefits on cards. And of course, the idea behind prepaid cards is not limited to being in card form; their function also may show up in the form of codes, stickers, cell phones, and chips embedded in any number of other devices, with payments transferring across the debit card interchange system or automated clearinghouse systems. Depending on the card type, the issuer, the purpose of issuance, the payment collection network, and the form of access, payments made using prepaid cards or other devices may be governed by different regulations and interchange fee restrictions. Consumers cannot be expected to know these differences. It will be important for regulators to monitor, over time, the effect of differences in regulation and pricing restrictions to ensure that consumers are adequately protected regardless of their payment method preferences.

Other emerging payment methods, such as mobile payments, also show potential for broad adoption in the United States. Earlier this year, the Federal Reserve Board hosted a forum on consumer protection and education issues associated with mobile payment methods. The Reserve Banks, including the Reserve Bank of Philadelphia through the efforts of the Payment Cards Center, have also been active in soliciting information from industry participants on the roles that various players are taking on in U.S. mobile payments and the forces that are affecting the rate of adoption by card issuers, merchants, networks, telecommunication firms, consumers, and others. As of yet, mobile payments do not represent a meaningful percentage of overall consumer payments in the United States, but the Federal Reserve remains engaged in monitoring the emergence of this product to ensure that adequate consumer protections are put in place as the technology is adopted more broadly in the marketplace.

Tags: adequate notice, Business, card, card issuers, consumer protections, Credit, credit card accounts, credit card solicitations, debit, disclosure requirements, economic recession, Federal, gift, impac, interest, May, overdraft, Part, regulatory effects, regulatory regime

Thursday, December 2nd, 2010 The Federal Reserve No Comments

Duke, Developments in the Landscape for Consumer Credit and Payments – Part 2

Changes in the Use of Payment Instruments

Consumer credit pricing and availability also appear to affect consumer preferences for different payment methods. When consumers decide how to pay for their purchases, they may have a variety of payment options to choose from, including cash, checks, debit cards, credit cards, prepaid cards, and even, increasingly, their mobile phones. The Federal Reserve has tracked changes in consumers’ use of payment instruments in a number of studies over the past decade. These studies cast an interesting light on the effects that weakened economic conditions have had on the mix of payments.

The number of checks processed in the United States has been declining since the late 1990s, as consumers, businesses, and governments have shifted away from checks and toward electronic payment methods. The annual number of checks dropped from more than 40 billion in 2000 to 30 billion in 2006, and we expect the data for 2009 to show continued declines.

At the same time, the use of debit and credit cards has risen. Debit card payments, in particular, have grown remarkably: Between 2000 and 2008, the number of debit card transactions grew at an annual rate of more than 17 percent, while the value of debit card transactions grew 15 percent per year. Credit card transactions have grown at a slower pace than debit card transactions over the same period–about 2 percent per year in number and roughly 5 percent per year in value. For smaller-value payments, both types of cards, but especially debit cards, have served as substitutes for checks and, very likely, cash. Although the nature of cash makes direct measurement of aggregate cash payments difficult, we can infer a trend in usage from changes in the level of small-denomination currency that is most frequently used in cash payments. The amount of small-denomination domestic currency in circulation has been steadily declining since the 1970s, leading us to believe that cash payments have similarly declined.

Most interestingly, the recent period of economic weakness appears to have caused some consumers to shift away from credit cards not only as a source of credit but also as a method of payment. As I said earlier, between late 2008 and early 2010, the value of credit card purchases declined 10 percent. In comparison, although the rate of growth in debit card use slowed during the recession, debit card transactions did not decline in either volume or value.

This shift from credit to debit makes sense from the perspective of the consumer. If credit is tight and consumption is contracting, consumers who are reluctant or unable to increase their debt levels can use debit cards to pay for current expenses out of current, rather than future, income. In addition, for individuals with existing credit card balances, interest must be paid on new purchases as well as on previous balances. Those individuals might seek to avoid interest charges on new purchases by using debit cards. This incentive is even stronger in the presence of higher credit card interest rates. Finally, some consumers might use debit cards to track their spending in real time when budgets are tight.

Tags: cash checks, cash payments, consumer preferences, credit card transactions, currency, debit card transactions, domestic currency, electronic payment methods, Federal, interest, Payment, payment instruments, percent, prepaid cards, rate, show, small-denomination, time, value, value payments

Thursday, December 2nd, 2010 The Federal Reserve No Comments

Tarullo, Problems in Mortgage Servicing, Investor Repurchase Requests

Investor Repurchase Requests
The cost associated with foreclosure documentation problems, including robo-signing, are not the only potential liabilities facing financial institutions in the wake of the mortgage and housing crisis. As losses in MBS have been escalating, investors in MBS and purchasers of unsecuritized whole loans are more frequently exploring, and in some cases asserting, contractual and securities law claims against the parties that originated the loans, sold the loans, underwrote securities offerings, or had other roles in the process. The essence of these claims is that mortgages in the securitization pools, or sold as unsecuritized whole loans, did not conform to representations and warranties made about their quality–specifically that the loan applications contained misrepresentations or the underwriting was not in conformance with stated standards.

The potential liability associated with contract claims in securitizations is usually called put back risk because many of the relevant agreements permit the buyer of the mortgages to put them back to the seller at par. Buyers can demand that the seller or another party that makes representations repurchase the mortgages if defects are found in the underlying loan documentation or in the underwriting that conflict with the sale agreements. Although the representations and warranties in the various agreements vary considerably, they frequently require that the defect materially and adversely affect the value of the loan before put back rights can be exercised. At the time of the put back, the mortgage loan may have become seriously delinquent or entered into default. Because underperforming mortgages are typically valued substantially less than par, the put back transfers any potential loss from the buyer back to the original seller or mortgage securitizer.

Given the poor performance of the mortgage assets, investors, including the Government Sponsored Enterprises (GSEs), have sought to pursue put back claims through various legal avenues, including requesting that mortgage servicers provide underlying mortgage files and the requisite documents. A GSE will generally buy a loan out of an MBS pool when the loan becomes 120 days delinquent. The GSE will then conduct a review of the delinquent loan file, and if it finds that the loan did not comply with its underwriting standards, it will request that the loan be repurchased by the originator/seller or that the GSE be made whole on any credit losses incurred.

During the third quarter of 2010, Fannie Mae collected $1.6 billion in unpaid principal balance (UPB) from originators, and currently has $7.7 billion UPB in outstanding repurchase requests, $2.8 billion of which has been outstanding for more than 120 days. Freddie Mac has $5.6 billion UPB in outstanding repurchase requests, $1.8 billion of which has been outstanding for more than 120 days. As of the third quarter of 2010, the four largest banks held $9.7 billion in repurchase reserves, most of which is intended for GSE put backs.

There are also pending claims by some investors alleging that underwriters and sponsors of securitizations failed to comply with the federal securities laws covering the offering documents and registration statements. These suits specifically reference descriptions of the risks to investors, the quality of assets in the securitization, the order in which investors would be paid, or other factors. Most of these lawsuits are in the early stages, and it is difficult to ascertain the probability that investors will be able to shift a substantial portion of the losses on defaulted mortgages back to the parties that sold the loans or underwrote the offerings.

While the full extent of put back exposure is for this reason hard to specify with precision, the risk has been known for some time and has been an ongoing focus of supervisory oversight at some institutions. However, in light of recent increased investor activity, the Federal Reserve has been conducting a detailed evaluation of put back risk to financial institutions. We are asking institutions that originated large numbers of mortgages or sponsored significant MBS to assess and provide for these risks as part of their overall capital planning process.

Supervisory Responses
The revelation of documentation flaws in foreclosure processes raise two kinds of questions for supervisors: First, what actions are appropriate and sufficient to respond to problems identified at specific regulated banking organizations? Second, what does the failure of supervisory examinations to uncover these flaws counsel for future supervisory practice?

With respect to the question of actions aimed at specific institutions, the Federal Reserve and the other federal banking agencies have significant supervisory and enforcement tools that can be used to address certain types of deficiencies in the foreclosure and mortgage transfer process. For example, numerous enforcement tools are available to address safety and soundness issues such as inadequate controls and processes, weaknesses in risk-management and quality control, and certain types of compliance weaknesses in foreclosure operations. These tools include supervisory enforcement actions that require an institution to correct deficient operations in a prescribed period of time and Civil Money Penalties (CMPs) for egregious actions. The agencies may also lower examination ratings, which can result in limiting the permissible activities and affiliations of financial firms and trigger other supervisory reviews and limitations, and restrict the ability of institutions to expand. The agencies also have the authority to assess CMPs on individuals who are responsible for violations, to issue cease and desist orders on responsible individuals, or, if the statutory criteria are met, to remove them from banking. In addition, we may make referrals to law enforcement agencies, or require institutions to file Suspicious Activity Reports, as appropriate.

Although the examinations are not yet fully completed, based on what we have already learned, the Federal Reserve expects to use many or all of these tools through the course of our review of foreclosure and other mortgage matters. In particular, the Federal Reserve has already emphasized to the industry and to institutions we supervise the importance of addressing identified weaknesses in risk-management, quality control, audit, and compliance practices. The problems that are evident to date raise significant reputation and legal risk for the major mortgage servicers. These weaknesses require immediate remedial action. They will also affect the rating assigned by Federal Reserve supervisors to management of bank holding companies, even where the servicing activity was in a banking subsidiary of a holding company. In addition, the federal banking agencies expect that employees are adequately trained and have sufficient resources to appropriately review the facts and circumstances of files when preparing documents, and that legal processes are fully and properly followed. Banking organizations also must ensure quality control for third-party service providers, including legal services.

With respect to future supervisory practice more generally, two points for increased emphasis are already apparent. First, this episode has underscored the importance of our using the new authority given the Federal Reserve in the Dodd-Frank Wall Street Reform and Consumer Protection Act to send our examiners into non-bank affiliates of large bank holding companies, including those in large institutions that have become bank holding companies only in the last couple of years.

Second, our experience suggests that the utility of examining and validating internal control processes within firms may extend beyond improvements to the specific processes subject to the exam. We have found that problems in foreclosure practices do not seem as pervasive in institutions in which we had previously examined other internal control processes, found shortcomings, and insisted on corrective action. While we would not draw strong conclusions from such a limited experience, it seems possible that a firm may improve its general approach to control processes once it has been required to remedy problems in discrete areas. If this relationship is borne out, it could be a significant advance in supervisory practice, insofar as resource constraints will always limit the number of supervisory examinations.

Possible Need for Structural Solutions
Beyond remedial or punitive measures directed at specific firms and future-oriented changes in supervisory practice, structural solutions may be needed to address the range of problems associated with mortgage servicing. Similarly, the foreclosure documentation problems are another reminder of the degree to which foreclosure has been preferred to mortgage modification, notwithstanding various efforts to change this imbalance. Here again, a more structural solution may be needed

The explosive growth of securitization as a vehicle for financing mortgages was accompanied by the emergence of a sizeable mortgage servicing industry–that is, a group of firms servicing mortgages that they did not own or, in many cases, that they had not originated. While there have surely been economies associated with this industry, there have also been chronic problems. It has been increasingly apparent that the inadequacy of servicer resources to deal with mortgage modifications–an area that was a point of supervisory emphasis–was actually a reflection of a larger inability to deal with the challenges entailed in servicing mortgages in many jurisdictions and dealing with a complicated investor base. For example, foreclosure procedures are specifically the province of real property law governed by the states, and can vary not only by state, but also within states and sometimes even within counties. With or without regulatory changes, it is quite probable that servicer fees to securitization trusts will increase to reflect the costs associated with the complexities of the contemporary mortgage model.

The impetus for change in the mortgage servicing industry is likely only to increase as the advantages of servicing rights for regulatory capital purposes become limited after the new Basel III requirements are implemented.¹ It is possible that servicing issues can be satisfactorily addressed through the actions of the various primary regulators. However, in light of the range of problems already encountered, and the prospect of further changes in the industry–including the possible migration of more servicing activity to non-banking organizations–it seems reasonable at least to consider whether a national set of standards for mortgage servicers may be warranted.

The case for concerted, coordinated action is much clearer with respect to the slow-moving pace of mortgage modifications. Regardless of the findings that emerge from the examinations underway, and remedial actions required to correct past mistakes, this episode has again drawn attention to what can only be described as a perverse set of incentives for homeowners with underwater mortgages. Homeowners who try to obtain a modification of the terms of their mortgages are all too frequently subject to delay and disappointment, while those who simply stop paying their mortgages have found that they can often stay in their homes rent free for a time before the foreclosure process moves ahead. Moreover, many homeowners believe, reportedly on the basis of communications from servicers, that the only way they can qualify for modifications is by stopping their mortgage payments and thus becoming delinquent.

Quite apart from the impact upon families who lose their homes, the dominance of foreclosures over modifications raises macroeconomic concerns. The number of foreclosures initiated on residential properties has soared from about 1 million in 2006, the year that house prices peaked, to 2.8 million last year. Over the first three quarters of this year, we have seen a further 2 million foreclosure filings, and an additional 2.3 million homes were in foreclosure at the end of September. All told, we expect about 2.5 million foreclosure filings this year and next year and about 2.4 million more in 2012. While our outlook is for filings to decline in coming years, they will remain high by historical standards. Currently, more than 4.5 million mortgage loans are 90 days or more past due or in foreclosure. These numbers compare to just 520,000 permanent loan modifications executed under the Treasury Department’s Home Affordable Modification Program (HAMP) and an additional 1.6 million proprietary loan modifications by servicers participating in the HOPE NOW Alliance program.²

The Federal Reserve believes that in most cases the best way to assist struggling borrowers is a mortgage modification allowing them to retain their home with an affordable mortgage payment. In a housing market where values have declined so much, following a period in which all actors relied upon rising house prices to sustain mortgage practices, foreclosures simply do not make sense as a preferred response. Foreclosures are costly to all parties and more broadly to our economy. Lenders and investors incur financial losses arising from the litigation expenses associated with the foreclosure process and the loss on the defaulted mortgage when the foreclosed property sells at a liquidation price that is substantially less than the loan balance. Local governments must contend with lower property tax revenue and the ramifications of neglected properties that may threaten public safety. Additionally, neighbors and neighborhoods suffer potential spillover effects from foreclosure sales because foreclosures may reduce the attractiveness of the neighborhood or may signal to potential buyers a forthcoming decline in neighborhood quality. In the end, an overhang of homes awaiting foreclosure is unhealthy for the housing market and can delay a recovery in housing markets and the broader economy.

Several possible explanations have been suggested for the prominence of foreclosures: the lack of servicer capacity to execute modifications, purported financial incentives for servicers to foreclose rather than modify, what until recently appeared to be easier execution of foreclosures relative to modifications, limits on the authority of securitization trustees, and conflicts between primary and secondary lien holders. Whatever the merits and relative weights of these various explanations, the social costs of this situation are huge. It just cannot be the case that foreclosure is preferable to modification for a significant proportion of mortgages where the deadweight costs of foreclosure, including a distressed sale discount, are so high. While some banks and other industry participants have stepped forward to increase the rate of modifications relative to foreclosures, many have not done enough. We need renewed attention in many quarters of government and the financial industry, and among investors in mortgage-backed securities, to the lagging incidence of modifications.

Tags: action, authority, Banking, compliance, contract claims, documentation problems, enforcement, Federal, financial institutions, Foreclosure, loan documentation, misrepresentations, mortgage assets, potential liability, relevant agreements, remedial, representations and warranties, securitization, securitizations, Servicing

Wednesday, December 1st, 2010 The Federal Reserve No Comments

Bernanke, Mortgage Foreclosures and the Future of Housing

Speech at the Federal Reserve System and Federal Deposit Insurance Corporation Conference on Mortgage Foreclosures and the Future of Housing, Arlington, Virginia