Graphic from the Board of Governors website in 2005.
Published February 6, 2024
Congress passed the Home Ownership and Equity Protection Act (HOEPA) in 1994 to curb unfair, deceptive, or abusive practices in residential mortgage refinancing and home improvement loans. The Act required additional disclosures, prohibited certain risky loan terms, and established rule-writing power for the Federal Reserve. As a result of the surge of mortgage defaults starting around 2006 and the subsequent financial crisis, the Federal Reserve's use of its powers under HOEPA came under intense scrutiny. After the crisis, the newly created Consumer Financial Protection Bureau absorbed the Fed's HOEPA powers, along with other consumer protection powers from across the federal government.
In the early 1990s, a number of consumer complaints arose involving high-cost loans and inadequate disclosures about risky loan terms. For example, some of these reports featured elderly homeowners who had substantial equity in their homes but needed a loan to pay for a major repair such as a roof replacement (US Senate 1993a). Often, these loans were based on the value of the collateral and without verification that repayment schedules were suited for limited or fixed incomes. Borrowers reported very high interest rates and being unaware of many aspects of the loan: what the monthly payments were, that the monthly payments could rise, or even that the loan was secured by their property. When borrowers refinanced to avoid default, they lost equity because of additional fees, a problem known as equity stripping through loan flipping. Economic factors in the background of these loans included the elimination of usury ceilings over the previous decade, allowing high interest rates, and the growth of homeowners' equity amid rising house prices.
Complaints about predatory loans were particularly common in low-income and minority communities in a pattern that was called "reverse redlining"—predatory lending in areas with low access to credit. Senator Donald Riegle noted that "as banks have tended to withdraw from low-income communities, a parade of shady lenders has moved in to fill the void peddling high-rate, high-fee mortgages to cash-poor homeowners" (US Senate 1993b, p. 1). Indeed, many complaints featured non-bank mortgage lenders, though some were affiliated with banks. For example, one company that was the subject of many complaints was Fleet Finance, an affiliate of Fleet Bank, which reached settlements with the states of Massachusetts and Georgia in the early 1990s over claims of predatory or discriminatory lending. 1
The Truth in Lending Act (TILA) of 1968 had been intended to address inadequate disclosures. It requires a 3-day rescission period in which a borrower can back out of a transaction. HOEPA went beyond TILA in a few ways. HOEPA required lenders to provide borrowers with an additional 3-day waiting period after receiving the disclosures, for a total of 6 days during which a loan applicant can review the disclosures or back out of the transaction. Required disclosures included information about the monthly payment and how high the monthly payment could rise; it also included a statement that "you could lose your home and any money you have put into it, if you do not meet your obligations under the loan" (Section 129(a)(1)(B)). For the mortgages it covered, HOEPA also prohibited certain risky loan features or underwriting practices. It prohibited underwriting that did not account for the borrower's ability to repay the loan, prohibited risky features including balloon payments or negative amortization, and limited prepayment penalties.
HOEPA's requirements applied only to certain mortgages. The Act was targeted at a class of the highest-cost mortgages—defined as having an annual percentage rate (APR) 10 percentage points above a comparable maturity Treasury rate or having points and fees exceeding 8 percent of the loan or $400. HOEPA's provisions also applied only to refinanced loans or home improvement loans, not to loans used to purchase homes. The focus on refinanced or home improvement loans was consistent with the nature of the consumer protection concerns that motivated the Act, concerns that existing homeowners were losing the equity they had accumulated.
For the Federal Reserve, HOEPA assigned important rule-writing powers. The Act allowed the Fed to issue rules that adjusted the definition of a high-cost loans. It also directed the Fed to write additional rules to prohibit loans the Fed viewed as unfair, deceptive, designed to evade HOEPA, associated with abusive lending practices, or not in the interest of the borrower.
The mortgage financing environment changed rapidly around the time of HOEPA's passage. Many of the practices that had led to HOEPA, such as the use of balloon payments or lack of verification of a borrower's ability to repay, became much more widespread over the next decade. However, such loans largely avoided HOEPA’s prohibitions as their APRs were generally below the threshold that determined HOEPA’s coverage. In some cases, lenders charged significant costs that were not included in the APR calculation. For example, one practice that received much criticism from consumer advocates was single premium credit insurance (SPCI). SPCI required a single up-front premium to cover the life of the mortgage, rather than periodic premiums. This premium represented a significant up-front cost but was not included in the HOEPA APR calculation. Borrowers often had difficulty obtaining a refund for the unused portion of their premium if the loan was paid off early.
In an effort to widen the application of HOEPA, the Fed issued a new rule in December 2001. The rule included SPCI premiums in the APR calculation. Lenders responded by largely abandoning that form of insurance, which Fed Governor Ed Gramlich considered "a very striking success" (Gramlich 2007). Gramlich viewed the other 2001 changes as "a little bit less striking." For example, the Fed expanded the definition of a high-cost mortgage (by reducing the APR threshold from 10 percentage points to 8, the lowest allowed by statute), but the change did not result in many more loans coming under the coverage of HOEPA. At peak in 2005, there were only about 36,000 loans covered by HOEPA, or less than ½ of 1 percent of all refinance or home improvement loans originated that year (Bhutta and Ringo 2016).
In the following years after the 2001 rule, consumer groups continued to report cases of unfair, deceptive, or abusive practices to the Federal Reserve Board. Many of these reports bubbled up through the Consumer Advisory Council, established in 1976 to advise the Board of Governors on its consumer protection responsibilities. Subprime loans, once quite uncommon in the early 1990s, grew over the 1990s and, at their peak, accounted for about one-fifth of new originations in 2005 (HUD 2000; Avery, Brevoort, and Canner 2007). Many subprime loans included practices that concerned consumer advocates, such as so-called 2/28 loans with teaser introductory interest rates that increased after a couple of years. As the degree of mortgage defaults became evident, the Fed determined in July 2008 that it had enough evidence of concerning practices to issue another rule using its authority under HOEPA to prevent unfairness, deception, and abuse. This rule created a new category of "higher-priced mortgages" with the intent of capturing the entire subprime market. For such mortgages, the rule created significant requirements that lenders verify borrowers' ability to repay, including the highest possible payment during the first seven years. It also created new rules that applied to all mortgage loans, such as prohibiting lenders or mortgage brokers from coercing an appraiser to misstate a home's value. However, by that time, the subprime market had already shrunk significantly.
As the severity of the 2007-2009 financial crisis became apparent, the Fed's approach to writing HOEPA regulations came under intense scrutiny. The Financial Crisis Inquiry Commission criticized the Fed for taking a "hands-off approach to the regulation of mortgage lending" by rejecting proposals from staff, the Treasury department, and consumer groups, and waiting until 2008 to finalize a new rule under HOEPA (FCIC 2011, p. 77). Senator Christopher Dodd argued that the Fed had not fulfilled "its obligation under the law" to write rules under HOEPA.
In response to the FCIC, former Chairman Greenspan defended the Fed's record (Greenspan 2011). He and other Fed officials had harbored several concerns about issuing additional regulations. One was that new regulations would only be effective if they were adequately enforced; while HOEPA applies to all mortgage lenders, major subprime mortgage lenders at the time were non-bank mortgage companies not subject to regular examination. A second concern was that the flow of funding to subprime borrowers, who historically had difficulty obtaining mortgage loans, might be cut off or diminished. During the 1993 hearings before the enactment of HOEPA, Fed Governor Larry Lindsey had expressed concern that the bill would "create a disincentive for lending" (US Senate 1993b, p. 7). Governor Ed Gramlich summarized the balance policymakers were still trying to strike in 2000:
"We should try to preserve consumers' ability to choose loan products that meet their particular needs. For example, mortgages with a balloon payment feature often are attractive because they allow distressed borrowers or young borrowers who have low cash incomes to buy homes and match payments with their rising income stream. But sometimes balloon payments can ruin borrowers who do not have a rising stream of income and who are unduly influenced by the lower short-term cost of a balloon note" (Gramlich 2000).
Finally, Fed officials believed it was likely that predatory lenders would be able to sidestep any attempts to comprehensively delineate unfair or abusive practices. Instead, Fed officials preferred a strategy focused on enforcement of individual cases and guidance to the institutions the Fed supervised (Alvarez 2010).
The Dodd-Frank Act amended HOEPA, broadening its coverage to include home purchase loans, among other changes. The Act also established the Consumer Financial Protection Bureau (CFPB) and transferred a large array of existing consumer protection authorities to the CFPB from federal regulators, including the Fed's rule-writing authority under HOEPA. The CFPB issued a new HOEPA rule in 2013. However, with the decline of subprime lending after the financial crisis, the volume of loans covered by HOEPA has remained extremely low (Bhutta and Ringo 2016). Additional post-crisis reforms, including qualified mortgage rules, have also significantly changed the regulatory landscape of mortgage lending.
As originally written, HOEPA targeted practices that were at the fringes of mortgage markets in the early 1990s. Some of these practices became more common in the early 2000s as the mortgage market changed rapidly. While HOEPA anticipated that flexibility might be needed by assigning the Federal Reserve powers to write additional rules, the Fed's use of those powers was shaped by a number of factors, including concerns about the efficacy of new rules and a desire to preserve the flow of credit to low-income borrowers.
Looking back, former Federal Reserve Board Chairman Ben Bernanke lamented that the "story of the Fed and HOEPA isn't uplifting." During the 2000s he had shared many of the concerns expressed by Fed officials about writing rules under HOEPA, viewing HOEPA as "far from the ideal tool." With the benefit of hindsight, though, he concluded that HOEPA was "probably the best method then available to address unsafe mortgage lending" (Bernanke pp. 100-105).
References
Alvarez, Scott. Interview, Financial Crisis Inquiry Commission, March 23, 2010. Available on FRASER.
Avery, Robert B., Kenneth P. Brevoort, and Glenn B. Canner. "The 2006 HMDA Data." Federal Reserve Bulletin, December 2007: A73-A109. Available on FRASER.
Bernanke, Ben S. The Courage to Act. W.W. Norton, 2015.
Bhutta, Neil and Daniel R. Ringo. "Residential Mortgage Lending from 2004 to 2015: Evidence from the Home Mortgage Disclosure Act Data" Federal Reserve Bulletin v. 102 no. 6, November 2016. Available on FRASER.
Financial Crisis Inquiry Commission. (FCIC 2011) The Financial Crisis Inquiry Report, January 2011. Available on FRASER.
Gramlich, Edward M. "Predatory Lending Practices," Testimony before the Committee on Banking and Financial Services, U.S. House of Representatives, May 24, 2000. Available on FRASER.
Gramlich, Edward M. Interview by Lynn S, Fox, Sandra F. Braunstein, and David Skidmore, Federal Reserve Board Oral History Project, August 8, 2007. Available on FRASER
Greenspan, Alan. Testimony to the Financial Crisis Inquiry Commission, April 7, 2010. Available on FRASER.
Mayer, Christopher J. and Karen Pence. "Subprime Mortgages: What, Where, and to Whom?" NBER Working Paper 14083, June 2008. Available online.
US Department of Housing and Urban Development. (HUD 2000) "Unequal Burden: Income & Racial Disparities in Subprime Lending in America." April 12, 2000. Available on FRASER.
US Senate, Committee on Banking, Housing, and Urban Affairs. (1993a) Problems in Community Development, Banking, Mortgage Lending Discrimination, Reverse Redlining, and Home Equity Lending. Hearings, February 3, 17, and 24, 1993. Available on FRASER.
US Senate, Committee on Banking, Housing, and Urban Affairs. (1993b) The Home Ownership and Equity Protection Act of 1993. Hearings, May 19, 1993. Available on FRASER.
Published February 6, 2024. Jonathan Rose contributed to this article. Please cite this essay as: Federal Reserve History. "Home Ownership and Equity Protection Act of 1994." February 6, 2024. See disclaimer and update policy.
