FTC Staff Comment Before the Federal Reserve In the Matter of Truth in Lending, Home Equity Disclosure and Substantive Rule

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BOARD ~:g~~i~JORSOF 	COMMISSION 	AUTHORIZED
THE FEDERAL RESERVE SYSTEM
In The Matter of
Truth in LendinK;Home Equity
Disclosure and Substantive Rule
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)
)
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Docket No. R-0687
Comments of the Staff of
the Bureau of Economics
of the Federal Trade Commission l
April 20, 1990
1 These comments are the views of the staff of the Bureau of Economics of
the Federal Trade Commission. 	They are not necessarily the views of the
Commission 	or 	any 	individual 	Commissioner. 	Inquiries 	regarding 	these
comments should be directed to Kenneth Kelly (202-326-3358) of the FTC's
Bureau of Economics.

BEFORE THE
BOARD OF GOVERNORS OF
THE FEDERAL RESERVE SYSTEM
In The Matter of
Truth In Lending; Home Equity
Disclosure and Substantive Rule
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)
)
)
Docket No. R-0687
Comments of the Staff of
the Bureau of Economics
of the Federal Trade Commission'
I. Introduction
The staff of the Bureau of Economics of the Federal Trade Commission
(FTC) appreciates this opportunity to comment on the proposal by the Board of
Governors of the Federal Reserve System to delete or revise a provision in
Regulation Z (Truth in Lending) that permits creditors to freeze or limit
borrowing when the maximum rate cap on an open-end variable-rate home
equity line is reached. s 	We believe that consumers' interests would best be
served by allowing creditors the freedom to contract with informed borrowers
for the right to freeze or limit borrowing when the rate cap is reached.
II. Expertise of the Staff of the Federal Trade Commission
The 	FTC 	is 	an 	independent 	regulatory 	agency' 	responsible 	for
maintaining competition and safeguarding the interests of consumers. 4 	Upon
request by federal, state, and local government bodies, the staff of the FTC
often analyzes regulatory or legislative proposals that may affect competition
or the ability of consumers to make informed choices among various goods and
services. In enforcing the Federal Trade Commission Act, the Commission has
gained considerable experience in analyzing the possible effects of various
private and governmental restraints on competition and in weighing the costs
and benefits to consumers of these restraints. 	In addition 	the Commission
shares responsibility for enforcing the Truth in Lending Act~ (Regulation Z6),
the 	Equal 	Credit Opportunity 	Act 7 (Regulation 	B 8 ), and 	the 	Fair Credit
2 These comments are the views of the staff of the Bureau of Economics of
the Federal Trade Commission. 	They are not necessarily the views of the
Commission 	or 	any 	individual 	Commissioner. 	Inquiries 	regarding 	these
comments should be directed to Kenneth Kelly (202-326-3358) of the FTC's
Bureau of Economics.
s 55 Fed. Reg. 10465, March 21, 1990.
" 15 U.S.c. § § 41-59.
5 15 U.S.c. § § 1601-1677e.
6 12 C.F.R. 226.
7 15 U.S.C. §§ J691-1991f.

Reporting Act,9 and its staff has gained substantial experience in the area of
consumer credit. We also note that in 1985, the Commission submitted comments
to 	the 	Federal 	Reserve Board on Regulation 	Z,10 and 	the 	FTC staff 	has
commented to various state bodies on proposed legislation relating to interest
rate ceilings.u
III. Analysis of the Proposed Modifications to Regulation Z
Under Regulation Z,n a creditor has the right to freeze or limit further
borrowing on an open-end variable-rate home equity line when the annual
percentage rate on 	the credit line equals the 	maximum rate capP 	Two
alternative modifications are being considered: (i) delete the provision giving
such a right to creditors; or (ii) modify the provision so that creditors who wish
to retain this right would be required to place such a limitation in 	their
contracts.
Creditors are required by Regulation Z to have a maximum rate cap
in 	variable-rate open-end credit line agreements secured 	by a consumer's
residence. 	However, they are free to offer whatever maximum cap they wish,
subject only to state usury regulations. When a creditor establishes a maximum
8(... continued)
8 12 C.F.R. 202.
9 15 U.S.c. §§ 1681-186lt.
10 ill letter of July 19, 1985, from the Federal Trade Commission to the
Honorable William Wiles, Secretary, Board of Governors of the Federal Reserve
System on proposed amendments to Regulation Z.
11 ~ letter of March 18, 1987, from Jim Moseley, Director. Dallas Regional
Office •. Federal 	Trade Commission, 	to The 	Honorable Garrey Carruthers,
Governor of New Mexico; letter of April 20, 1987, from Janet M. Grady,
Director, San Francisco Regional Office, Federal Trade Commission, to The
Honorable Ross Johnson, Vice Chairman of the Committee on Finance and
Insurance, California State Assembly; letter of May 15, 1987, from John M.
Peterson, Director, Chicago Regional Office, Federal Trade Commission, to The
Honorable Monroe L. Flinn, Illinois State House of Representatives; letter of
May 29, 1987, from Edward Manno Shumsky, Director, New York Regional
Office, Federal Trade Commission, 	to 	The 	Honorable 	Herman 	D. 	Farrel,
Chairman of the Committee on Banks, New York State Assembly. See letter of
September 8, 1989, from Thomas B. Carter, Director, Dallas Regional Office,
Federal 	Trade Commission, 	to 	the 	Honorable 	Robert 	H. 	Henry, 	Attorney
General of the State of Oklahoma.
12 § 226.5b(f)(3)(vi)(G). 	'-... .
13 As the proposal states "[the current regulation} does not expressly require
that the contract (as opposed to the disclosures) state that a creditor has the
right to freeze a line of credit if the rate cap is reached. 	Creditors arc
specifically required to disclose if they have retained the ability to freeze a line
when the rate cap is reached, and this disclosure duty may be met by including
it in the agreement. 	As a practical matter, the Board 	believes that most
creditors 	who 	wish 	to 	preserve 	this 	right 	include 	the 	provision 	in 	their
contracts." 55 Fed. Reg. 10465.
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rate cap on an open-end, variable-rate home equity loan, it runs the risk that its
own cost of funds may exceed this rate cap should interest rates rise.
To solve this problem, some creditors retain a right to freeze additional
borrowing when the maximum rate cap is reached, and, in return, provide
consumers with features, such as a more favorable interest rate formula (that
is, a lower premium over the relevant index), a lower maximum cap, or a higher
credit limit. 	Alternatively, those consumers whose plans may depend on being
able to borrow substantial funds in the future, for example, to pay college
tuition, may be willing to accept less desirable features (such as less favorable
interest rates) in order to preserve their ability to borrow years hence.
The first alternative modification would deny creditors the right to
restrict borrowing when the maximum rate cap is reached on ,a home equity
line of credit. This alternative could harm consumers. Creditors could be more
reluctant to offer variable-rate open-end home equity lines of credit if they
were 	not able 	to 	limit 	borrowing 	when 	market 	interest 	rates exceed 	the
maximum rate cap. If creditors continue to offer these credit lines, they will
be forced to. bear additional risk. 	To cover the costs of bearing this risk,
creditors may adjust other aspects of the loan package, such as the interest rate
formula, 	the maximum 	rate cap, introductory rates, origination 	fees, and
frequency of adjustment. u
There 	is 	empirical 	evidence 	that 	restricting 	credit 	terms 	through
regulation causes changes in other aspects of credit agreements to the detriment
of consumers. 	For example, the 	economic 	literature 	on 	consumer 	credit
indicates that interest rate ceilings may substantially harm many consumers. 1S
Creditors, like all others in the marketplace, must earn a competitive rate of
return. 	Therefore, when an imposed interest rate ceiling is lower than the
competitive market rate that would prevail in its absence, creditors will make
adjustments, for example, by increasing other charges or reducing the volume
of credit available to higher-risk borrowers. 16 Villegas found that "low-income
households in states with usury ceilings had significantly lower levels of
14 Under one interpretation of this first proposal, while creditOrs would not
have the right to unilaterally limit borrowing when the maximum rate cap is
reached, borrowers would be able to seek inclusion of such terms in their
contracts to obtain the favorable interest rates and other benefits that might
be satisfactory to creditors if they were permitted to limit borrowing at the
maximum rate cap. If transactions of this sort proposed by borrowers were not
costly, then the first alternative modification would have no effect. 	However,
if creditors cannot offer such a restriction as part of their standard contract
forms, then it may be too costly for individual borrowers to negotiate their
rights away in order to secure what they want from creditors.
16 ill. '-Jb Villegas, "The Impact of Usury Ceilings on Consumer Credit,"
56 S. Econ. J. 126 (1989); Canner & Fergus, "The Economic Effects of Proposed
Ceilings on Credit Card Interest Rates," Fed. Reserve Bull., Jan. 1987 at 	I;
Nathan, "Economic Analysis of Usury Laws," 10 J. Bank Res. 200 (1980); Ostas,
"Effects of Usury Ceilings in the Mortgage Market," 3J J. Fin. 82J (1976). ill
ahQ Barth, "The Effect of Government Regulations on Personal Loan Markets:
A Tobit Estimation of a Microeconomic Model," 37 J. Fin. J233 (1982).
16 Villegas, "An Analysis of the Impact of Interest Rate Ceilings," 37 J. Fin.
94J (1982).
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· ;
consumer credit than low-income households in states without usury ceilings.
A similar result is also found for middle-income households, but the reduction
in credit is not as large."17 	Villegas found no benefit to consumers from such
ceilings, since his results showed no significant difference between the interest
rates paid for consumer credit in states with usury ceilings compared to states
without 	them. I8 	Therefore, 	to 	the 	extent 	that 	this 	regulation 	restricts
competition among creditors by forcing all firms to offer the same terms for
lending when the maximum rate cap is reached, it could result in packages of
terms and rates for open-end variable-rate home equity credit lines that are less
preferable to both borrowers and creditors.
The second alternative modification proposed does not present these
problems because it allows creditors to offer variable-rate open-end home equity
credit lines that may be frozen or reduced when the maximum rate cap is
reached, as long as this right is disclosed in the contract. Since this alternative
leaves lenders free to compete on terms as well as rates for such lines of credit,
informed consumers are free to choose those combinations of rates and terms
that best suit their needs. I9
Consumers who are not willing to pay a premium (in terms of less
favorable terms or rates) for the right to borrow additional funds when the
maximum rate cap is reached will then not be forced to do so as, in effect, they
would be under the first alternative modification. If there are consumers who
are willing to pay a premium sufficient to make it profitable for lenders to
forego imposing a freeze or a reduced lending level after the cap has been
reached, competitive forces could be expected to make such rates available. If
lenders do not in fact offer the option, this may simply suggest that the cost to
lenders of providing the option of continued borrowing when the maximum rate
cap is reached is greater than what consumers are willing to pay (in terms of
higher maximum rate caps, interest rates, origination fees, closing costs, etc.) in
order to get this feature. 	Those consumers who anticipate a need for funds
in the future, who expect interest rates to rise, and who, therefore, would place
greater 	value 	on 	a 	credit . line 	without 	restrictions 	on 	borrowing, 	have
alternatives that may better suit their needs than a variable-rate open-end home
equity credit line. 	For example, rather than obtaining a home equity line of
credit, they might obtain a second trust loan for the full amount of their need
for funds, and invest those funds in excess of their immediate needs until such
time as they will be needed.
17 Villegas, ~ note 8, at 1-40.
18 lliliL.
19 A recent Washington Post story describes the wide variety of terms and
rates for home equity credit lines available to Washington area homeowners.
Stt H. Jane Lehman, "The Home Equity Loan Attraction: Decline in Default
Rate Has Lenders Competing for Borrowers," Washington Post, Saturday, March
24, 1990 at F 1.
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IV. Conclusion
Both economic theory and empirical evidence indicate that regulatory
restrictions on the supply of consumer credit are often not in the interests of
consumers. 	It would therefore appear preferable to modify Regulation Z to
grant lenders the right to offer contractual terms that give them the option to
freeze or limit further borrowing on open-end variable-rate home equity credit
lines when the annual percentage rate on such credit lines is at the maximum
cap rate, rather than to eliminate this option.
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