Mortgage firms are pressing the Federal Reserve to curb homeowners’ right to invalidate loans based on flawed documents -- a right consumer groups say is one of the few weapons borrowers have to battle unfair lending.

Consumer groups and industry lawyers say a rule under consideration by the central bank would make it harder for borrowers to exercise their right of “rescission,” which forces a lender to relinquish a lien on a mortgaged property. They said the number of rescissions has grown in recent years as a result of the foreclosure crisis and allegations that mortgage documents were fabricated or processed improperly.

Ken Markison, regulatory counsel at the Mortgage Bankers Association, said the change would save lenders money. “Greater clarity will help avoid unnecessary litigation and reduce costs,” Markison said.

Wells Fargo & Co., Bank of America Corp., and JPMorgan Chase & Co., the three largest U.S. mortgage lenders, all declined to discuss rescissions or didn’t respond to requests for comment. Susan Stawick, a Fed spokeswoman, also declined to comment.

Lenders are pressing the Federal Reserve to act on the issue now because starting in July, rescission rules will come under the purview of the new Consumer Financial Protection Bureau, industry lawyers said. Jeffrey Naimon, a lawyer with Buckley Sandler LLP, described the consumer agency in an e-mail as “a much more political” regulator than the Fed.

Fed ‘Rushing’

Since the financial crisis began, the Fed has come under criticism for having failed to meet its existing legal mandate to protect consumers from deceptive mortgages and other financial products. That track record was one reason behind Congress’s push to create an independent consumer agency.

“I cannot understand why the Fed is rushing through this voluntary gift to the banks unless the Fed is afraid that if it doesn’t curtail the rights of rescission now, it will never happen,” said Kathleen Engel, a professor at Suffolk University Law School in Boston.

The right of rescission was established by the 1968 Truth in Lending Act. Borrowers who can show a material misstatement in loan documents have three years to issue a rescission notice to the lender, who must revoke its lien on the property.

Consumer and industry lawyers said rescissions have risen because of fallout from the collapse of the housing bubble, although precise numbers are hard to come by. Kathleen Day, a spokeswoman for the Center for Responsible Lending, estimated that there are “thousands” of rescission cases pending in jurisdictions around the country; by contrast, the Federal Reserve estimated that there will be 2.25 million foreclosure filings this year.

Forced Modification

Borrowers usually exercise the right of rescission during a foreclosure or other legal proceedings, effectively forcing a loan modification. The borrower seeks a new lender, the original lender returns interest and fees, and the principal is repaid by the second lender.

“It is ultimately the biggest hammer in the toolkit for a lawyer helping someone to save their home,” said Ira Rheingold, executive director of the National Association of Consumer Advocates.

The Fed issued the proposed regulation on Sept. 24 as part of an update of truth-in-lending rules, and asked for public comment by Dec. 23. The Fed filing said the new rules are part of an ongoing review of truth-in-lending rules that has been proceeding for years, and would “reduce uncertainty and litigation costs.”

“The Board does not believe that Congress intended for the creditor to lose its status as a secured creditor if the consumer does not return the loan balance,” the Fed wrote.

Compliance Burden

The Fed filings noted that rescissions are sometimes based on technicalities, such as providing only one copy of a disclosure instead of two. The goal of the new rule is to “reduce undue compliance burden and litigation risk for creditors,” the Fed said, while improving “the clarity and usefulness of disclosures for the consumer’s right to rescind.”

Day of the Center for Responsible Lending called the proposed curbs an “industry-friendly move” that contradicts the Obama administration’s goal of minimizing foreclosures.

“It runs at cross purposes with any effort to bring people to the table,” Day said in an interview.

At a mid-October meeting of the Fed’s Consumer Advisory Council, an external advisory group, consumer groups expressed opposition to the change. At the meeting, Governor Daniel Tarullo signaled that he opposed the proposed rescission rule, according to two people present. Tarullo declined requests for comment.

Consumer Bureau

Two members of the advisory council, who asked that they not be identified because the discussions were private, said they brought the dispute to the attention of Elizabeth Warren, the special adviser to President Barack Obama charged with setting up the Consumer Financial Protection Bureau. The bureau will take over responsibility for truth-in-lending regulations when it begins operations after July 21.

A coalition of consumer and civil rights groups, including Consumers Union and the NAACP, sent a letter to the Fed on Nov. 16 asking the central bank to hold off on updating truth-in- lending regulations until the CFPB starts work.

Naimon, the lawyer with Buckley Sandler who represents lenders, said that waiting for the CFPB would “result in years of additional delay.”

Rescissions add “thousands of dollars” to the cost of a foreclosure process because a bank has to hire a local law firm to manage the litigation, he said. That legal work “can’t just be done from headquarters.”

Potent Tool

With credit markets tight, lenders have become less willing to issue new mortgages, so rescissions have become a potent tool for consumers seeking a loan modification, said Robert Cook, a Hanover, Maryland-based attorney with the firm Hudson Cook LLP. Lenders lose the security on the mortgage -- the home itself -- effectively becoming unsecured creditors.

“The conventional wisdom, which I think is correct, is that rescissions rise as the economy falls,” Cook said.

The private securitization of mortgages, rare when the lending act was passed in 1968, has imposed additional costs. Under the law, Cook said, the trustee of a pool of privately securitized mortgages can pull the rescinded mortgage out and force the issuer to buy it back.

The Fed proposal would require borrowers to tender the full loan principal before the creditor relinquishes the lien, a change that would “eviscerate the single most effective tool that homeowners have to stop foreclosures,” the consumer groups wrote in their letter.

Naimon argued that rescissions are a “lose/lose proposition” because they are “often a frivolous claim” and no money will be paid to consumers, but rather to lawyers for mortgage bankers.