Consumer Compliance Outlook
New Regulation Z Rules Enhance Protections for Mortgage Borrowers
Overview and Background
In response to concerns about unfair and deceptive mortgage lending and servicing practices, the Board of Governors of the Federal Reserve System (Board) issued significant new mortgage lending rules,1 which take effect on October 1, 2009, except for the new escrow rules. Federal Reserve Chairman Ben S. Bernanke stated that these new rules are “intended to protect consumers from unfair or deceptive acts or practices in mortgage lending, while keeping credit available to qualified borrowers and supporting sustainable home ownership.”2 As a result, the rule's strongest prohibitions are aimed at curbing questionable lending practices that occurred in the subprime mortgage market; however, some provisions apply to all consumer mortgages.
The rules amend Regulation Z, the implementing regulation for the Truth in Lending Act (TILA), and are issued using the Board's rulemaking authority for the Home Ownership and Equity Protection Act of 1994 (HOEPA) to prohibit deceptive acts and practices for mortgage loans and abusive acts or practices for refinancings.3 In addition to expanding protections for subprime and other consumer mortgage loans, the rules also impose restrictions on mortgage advertising. This article will discuss the specifics of the new rules and conclude with recommendations for implementing the changes.
Distinguishing New Higher-Priced Loans From Existing HOEPA Loans
Many of the key provisions of the rule relates to higher-priced loans, a new category of mortgage loans within Regulation Z containing expanded consumer protections. This new loan category should not be confused with existing HOEPA loans, often referred to as “section 32” loans. Higher-priced loans have lower triggers than HOEPA loans and therefore encompass more loans. In addition, the rule for higher-priced loans applies to purchase money mortgages, which are excluded from HOEPA's coverage. But like HOEPA, the final rule for higher-priced loans excludes home equity lines of credit (HELOCs) and construction and reverse mortgage loans. The final rule also prohibits lenders from structuring a closed-end higher-priced loan as an open-end line of credit to evade the rule's protections. The rule for HOEPA loans remains in effect, albeit with some enhancements.
New Higher-Priced Loan Triggers
Identifying higher-priced loans will be a critical part of complying with these new rules. A higher-priced loan is defined as a “consumer credit transaction secured by a consumer's principal dwelling with an annual percentage rate (APR) that exceeds the average prime mortgage offer rate for a comparable transaction as of the date the interest rate is set by:
- 1.5 or more percentage points for loans secured by a first lien on a dwelling, or
- 3.5 or more percentage points for loans secured by a subordinate lien on a dwelling.”4
The Board will publish average prime offer rates on a weekly basis on the website of the Federal Financial Institutions Examination Council. Initially, the Board will base the rates on the Freddie Mac Primary Mortgage Market Survey (PMMS), which is published weekly.5
Existing HOEPA Loan Triggers
By adding a threshold to average prime loan rates, the definition of a higher-priced loan is intended to encompass virtually all subprime loans and some Alt-A loans. HOEPA loans, on the other hand, have a much higher rate trigger and an additional points and fees trigger for determining coverage. Specifically, HOEPA loans
- have an APR that exceeds the yield on comparable Treasury securities by more than 8 percentage points for first-lien loans or 10 percentage points for subordinate-lien loans, or
- contain total points and fees that exceed the greater of 8 percent of the loan amount or $561.6
Because of the high trigger for HOEPA loans, most consumer mortgages do not fall in this category. Higher-priced loans, on the other hand, have a much lower threshold, so many more loans will qualify.
New Consumer Protections for Higher-Priced and HOEPA Loans
The new rule adds new protections for higher-priced loans and enhances existing protections for HOEPA loans. The new protections include prohibiting lenders from making loans based on collateral without regard to repayment ability, requiring lenders to verify income and obligations, and imposing more stringent restrictions on prepayment penalties. The rule also requires lenders to establish escrow accounts for taxes and mortgage-related insurance for first-lien loans.
Ability to Repay and Verification of Income and Assets
The final rule prohibits a lender from extending any higher-priced or HOEPA loan without regard to the borrower's repayment ability. The rule also requires lenders to confirm repayment ability by examining current and reasonably expected income, employment, assets other than collateral, current obligations, and mortgage-related obligations, such as expected property tax and insurance obligations. The final rule provides a “presumption of compliance” safe harbor for the repayment ability requirement if the creditor can show that it:
- confirms the consumer's repayment ability by verifying income or assets through tax forms, payroll receipts, financial institution records, or other third-party documents relied on for repayment;
- analyzes the consumer's repayment ability using the largest payment of principal and interest scheduled in the first seven years following consummation and takes into account current obligations, including mortgage-related obligations; and
- evaluates the consumer's repayment ability taking at least one of the following into account: the ratio of total debt obligations to income or the income remaining after paying debt obligations.
Existing §34(a)(4) of Regulation Z prohibits lenders from engaging in a pattern or practice of extending HOEPA loans without regard to the consumer's repayment ability. A violation is presumed if a creditor engages in a pattern or practice of making HOEPA loans without verifying and documenting the consumer's repayment ability. Initially, the Board had proposed extending §34's pattern or practice requirement to the new higher-priced loans and adding several additional rebuttable presumptions of violation as well as a safe harbor. In the final rule, however, the Board eliminated the pattern or practice requirement for both higher-priced and HOEPA loans. The Board explained that removing the pattern or practice requirement will help ensure that consumers have remedies against lenders who made unaffordable loans and will help deter irresponsible lending. The Board also explained that the final rule's expanded presumptions of compliance should help provide lenders with greater guidance on complying with the rule.
Prepayment Penalty Provisions
The final rule imposes significant restrictions on the use of prepayment penalties for both higher-priced and HOEPA loans. The rule prohibits penalties if a loan's payment can change during the first four years. For all other higher-priced and HOEPA loans, a prepayment penalty:
- must be otherwise permitted by law;
- may apply only during the loan's first two years; and
- may not apply if it results from a refinancing with the creditor or the creditor's affiliate. In addition, the regulation continues to prohibit prepayment penalties for HOEPA loans if the consumer's monthly debt payments at consummation exceed 50 percent of the consumer's gross income.
The final rule requires creditors to establish an escrow account for property taxes and mortgage related insurance required by the creditor before consummation for higher-priced, first-lien loans secured by the borrower's principal dwelling. Creditors may provide the borrower with an opportunity to cancel the escrow account no earlier than 12 months from consummation; the borrower must make this request in writing.
Coverage. The scope of the escrow requirement includes higher-priced loans for manufactured housing that are secured by a borrower's principal dwelling, even if the manufactured housing is considered personal property under state law. The rule also covers higher-priced, first-lien loans on condominium and cooperative units when the property is the borrower's principal residence. The rule clarifies, however, that creditors need not establish escrow accounts for loans secured by shares in a cooperative; in such cases, the cooperative association pays the property taxes and insurance. In addition, although escrow accounts are required for property taxes on condominiums, creditors need not escrow insurance if the condominium association must maintain a master insurance policy covering all units.
Effective Dates. The final rule provides an extended effective date for the escrow account requirement because the industry will have to adjust its systems and infrastructure to provide such accounts. Specifically, creditors must establish escrow accounts for covered loan applications received on or after April 1, 2010. For covered loans secured by manufactured housing, the escrow rule covers applications received on or after October 1, 2010.
Additional Details. The escrow provisions for higher-priced loans adopt the same definition of escrow account that the Department of Housing and Urban Development (HUD) uses in Regulation X, the implementing regulation for the Real Estate Settlement Procedures Act. According to Regulation X, an escrow account is any account that a servicer establishes or controls on behalf of a borrower to pay taxes, insurance premiums (including flood insurance), or other charges.7 Escrow accounts established under the new §226.35(b)(3) of Regulation Z must comply with all escrow-related provisions in Regulation X as well as the National Flood Insurance Program's requirement to escrow flood insurance when other insurance must be escrowed.8
Reasons to Require Escrow Accounts for Higher-Priced Loans. The Board explains that the escrow requirement for higher-priced loans is necessary to help protect subprime borrowers from obtaining loans they cannot afford. Unlike the prime mortgage market, the subprime mortgage market, as noted by the Board, does not commonly provide or require escrow accounts. Given that subprime borrowers often shop for loans based on monthly payment amounts, creditors that include escrow amounts in these payment estimates have a competitive disadvantage. As a result, subprime borrowers are not provided with a genuine opportunity to escrow property taxes and insurance even though such accounts may help them better understand their overall mortgage-related costs and contribute to stronger management of their overall mortgage obligations.
New Requirements for all Loans Secured by Principal Dwelling
In addition to new consumer protections for higher-priced loans, the final rule prohibits coercion of appraisers, defines inappropriate practices for loan servicers, and requires early truth in lending disclosures for most mortgages.9
Coercion of Appraisers
For loans secured by a principal dwelling, other than HELOCs, the final rule prohibits creditors, mortgage brokers, and their affiliates from directly or indirectly coercing, influencing, or otherwise encouraging an appraiser to misstate or misrepresent a dwelling's value. The rule also prohibits a creditor from originating a loan based on an appraisal the creditor knows violates this rule “unless the creditor documents that it has acted with reasonable diligence to determine that the appraisal does not materially misstate or misrepresent the value of such dwelling.” 10
To facilitate compliance, the regulation identifies several examples of actions that would violate the appraiser coercion rule. For instance, improper coercion occurs if a lender excludes an appraiser from future work because the appraiser did not value a dwelling at the lender's minimum standard. Failing to pay an appraiser for similar reasons would also violate this rule. The regulation also identifies actions that would not violate this rule. For example, requesting that an appraiser provide additional information to support a valuation and asking an appraiser to correct factual errors are acceptable appraiser-related actions.
Prohibited Loan Servicer Practices
The final rule also regulates loan servicing entities with respect to certain unfair and abusive practices. Specifically, with regard to servicing loans secured by a principal dwelling, the final rule prohibits such entities from:
- failing to credit a payment to an account as of the date received;
- pyramiding late fees; and
- failing to provide an accurate loan payoff statement within a reasonable time of receiving a request for such a statement.11
The Board adopted these prohibitions to address concerns that by failing to credit payments in a timely manner or by pyramiding late fees, loan servicers were assessing unwarranted or excessive fees and, at times, improperly providing negative credit report information on consumers. In addition, failing to provide a timely payoff statement can result in delays if a consumer is trying to refinance an existing loan or increase closing-related transaction costs.
Pyramiding late fees is the practice of assessing a late fee when a timely and complete payment has been made and the only outstanding balance is a previously unpaid late fee or delinquency charge. While this practice is currently prohibited by the Board's Regulation AA and the Federal Trade Commission's credit practice rule, adding this prohibition to TILA will allow state attorneys general to enforce this provision; thus, the rule will provide additional consumer protections.
The rules and associated commentary provide additional guidance on complying with these requirements. For example, no violation of the payment crediting rule occurs if a servicer's failure to credit a payment on the date received does not result in any charge to the consumer or any reporting of negative credit information. In addition, if the servicer has written requirements for consumers to follow in making payments and accepts a payment outside these requirements, the servicer has five days from receipt to credit the payment. The commentary makes clear, however, that any payment-related requirements must be reasonable and, as an example, notes that it is reasonable to have a 5 p.m. cutoff time for accepting payments. The commentary also states that it would be reasonable to provide a payoff statement within five days of receiving a request for such a statement.
Changes from Proposal. In its final rule, the Board has eliminated the proposed requirement for servicers to provide consumers with a schedule of fees and charges. Based on its analysis of the comments received, the Board determined that the value of such statements for consumers did not outweigh the costs that producing such statements would place on loan servicers.12
Coverage. Consistent with the Department of Housing and Urban Development's Regulation X, the new rule defines a servicer as the person responsible for servicing a mortgage loan; it includes the loan originator if that person also services the loan.
Early TILA Disclosure Requirements
Regulation Z currently requires early disclosures only for loans to acquire or construct a consumer's dwelling. The final rule expands this coverage to provide early TILA disclosures for any closed-end loan subject to the Real Estate Settlement Procedures Act and secured by a principal dwelling; the rule does not apply to home equity lines of credit.13 In addition, a new requirement prohibits a lender or any person from collecting a fee, other than a credit report fee, from a borrower until after the borrower has received the early TILA disclosures. For mailed disclosures, the lender may assume that the disclosures have been received three days after mailing and assess a fee at that time.
New Advertising Requirements and Restrictions
The final rule contains new advertising requirements for both closed- and open-end mortgage loans. These changes are meant to improve the clarity of information included in mortgage-related advertisements as well as provide outright bans on certain misleading advertising practices.
Significant Closed-End Loan Advertising Rules
Clear and Conspicuous Standard. The Board added a specific clear and conspicuous standard that applies to all closed-end loan advertisements. This new standard complements the existing clear and conspicuous standard in Regulation Z that applies to all closed-end credit disclosures. The accompanying commentary outlines several practices needed to comply with the clear and conspicuous standard for loans secured by dwellings.
Disclosure Changes to Advertisements for Dwelling-Secured Loans. Under the new rules, advertisements for home-secured loans may include only the simple annual interest rate, or the rate at which interest will accrue, along with and not more conspicuously than the disclosed APR. In addition, if an advertisement for a dwelling-secured loan includes a simple annual interest rate, such as a teaser rate, and more than one rate may apply during the loan's term, the advertisement must include:
- each simple annual rate of interest that will apply;
- the time period for which the rate will apply; and
- the loan's APR.
If an advertisement for a dwelling-secured loan states any payment amount, the advertisement must include:
- the amount of each payment that will apply during the loan's term, including any balloon payment;
- the period of time each payment will apply; and
- the fact that the payments do not include taxes and insurance premiums if a first-lien loan.
The additional disclosures discussed above must be equally prominent and in close proximity to the advertised payment or rate that triggered the required disclosures.
Prohibited Advertising Practices. The final rule prohibits a number of advertising practices for dwelling-secured loans deemed to be unfair, deceptive, associated with abusive lending practices, or otherwise not in the borrower's interest. These prohibited practices are:
- using the term “fixed” when advertising a variable- rate loan or a transaction with a planned payment increase without including information about the time period for which the rate or payment is fixed and stating “ARM,” if applicable;
- comparing the advertised rate or payment to an actual or hypothetical rate or payment without disclosing the rates or payments that will apply during the entire loan's term, and that they do not include taxes and insurance, if applicable;
- misrepresenting that a loan is government endorsed;
- using the name of the borrower's current lender without including the actual advertiser's name and disclosing that the current lender is not associated with the advertisement;
- making a misleading claim that debt will be eliminated or waived rather than replaced;
- using the term “counselor” to refer to a for-profit mortgage broker or creditor; and
- providing an advertisement in one language while providing required disclosures in another.
Significant New Open-End Advertising Rules
The final rule also includes new advertising requirements for HELOCs that include promotional rates or promotional payments. Specifically, if a HELOC advertisement includes a promotional rate or a promotional payment amount, the advertisement must include (1) the period of time during which the promotional rate or payment will apply; and (2) information about rates and payments that will apply at the end of the promotional period. A promotional rate is essentially a temporary rate — a rate provided under a variablerate plan that is not tied to the loan's index and margin used to make later rate adjustments. A promotional payment is one under a variable-rate plan that is not tied to the loan's index and margin for calculating minimum payments. Under a nonvariable-rate plan, a promotional payment is one that is less than required under the plan's terms.
Yield Spread Premium Rule: Not Adopted
One high profile part of the Board's original proposal concerned significant restrictions on payments to mortgage brokers known as yield spread premiums (YSP). In this arrangement, a lender compensates a broker if it originates a loan at a higher rate than a borrower qualified for on the lender's rate sheet. A YSP is a fee or premium paid to the broker based on the difference between the two rates. Under the proposed rule, payment of a YSP to a mortgage broker would be permitted only if:
- the consumer agreed in advance and in writing to the YSP, and
- the broker disclosed that the consumer would ultimately bear the cost of the YSP, even if paid directly by the creditor, and that the YSP arrangement could influence the broker to provide the consumer with mortgage products or terms not necessarily in the consumer's best interest.14
The Board initiated this proposal to address concerns that YSP arrangements can be unfair and deceptive to consumers. Specifically, creditor payments to brokers based on a loan's interest rate create an incentive to brokers to place borrowers into loans with higher rates than they qualify for. In addition, consumers are often unaware of these compensation arrangements and may wrongly assume the broker is working in their best interest when finding a loan. The Board intended that the proposed rule would help reduce the broker's incentive to charge higher rates and provide the consumer with more leverage in negotiating with the broker.
Although the Board continues to have concerns about unfair acts or practices associated with mortgage broker compensation arrangements, this particular proposal has been withdrawn. The Board found through consumer testing that some aspects of the proposal could confuse and mislead consumers; in fact, the testing showed consumers did not sufficiently understand some major aspects of the proposed disclosures. As a result, the Board withdrew the proposal but intends to explore additional ways of addressing the potentially unfair aspects of mortgage broker compensation arrangements in the future.
Compliance Management Recommendations
As with any significant regulatory changes, implementing these changes throughout an institution effectively, thoroughly, and in a timely manner is critical. Identifying how the rule affects your organization and then instituting a plan to implement them are good places to start.
Conduct a Compliance Risk Assessment
The scope of the final rule is broad. It is therefore important to identify all of the areas of operations within an institution that will be affected. Specifically, the institution must assess which bank products or business lines may be subject to the new rule. For instance, what bank departments or offices would originate higher-priced or HOEPA loans? Does the bank advertise mortgages? Do these advertisements include teaser rates or payment amounts?
Next, the institution should identify the specific regulatory requirements that apply to these products or business lines and assess whether the organization currently complies with any of the requirements. For example, an institution may already require escrow accounts for higher-priced, first-lien loans. In that case, bank management should confirm that its procedures comply with those outlined in Regulation Z and, if not, implement appropriate compliance measures for any identified compliance gaps.
Prepare and Implement a Compliance Action Plan
Once an institution has finished assessing its compliance status, it should prepare and implement a plan for updating its compliance management program to address the final rule. The plan should also include methods for monitoring whether internal compliance efforts are working effectively.
Update Policies and Procedures. An important part of complying with the final rule will be updating any affected bank policies and procedures. Changes to policies and procedures should be comprehensive. Such changes could include developing or modifying procedures for:
- properly identifying higher-priced mortgages;
- preventing the origination of higher-priced and HOEPA loans with prohibited terms;
- ensuring that lenders conduct appropriate income verifications on higher-priced and HOEPA loans;
- establishing escrow accounts for all higher-priced, first-lien loans;
- providing early TILA disclosures for all newly covered loans;
- implementing loan servicing practices that ensure timely payment credits and mailing of loan payoff statements; and
- preparing and reviewing mortgage-related advertisements.
An institution's compliance plan should also prepare for the changes to the price reporting provisions of Regulation C. A recent amendment to Regulation C requires modifications to an institution's HMDA data collection and reporting procedures.15 The amendment makes the threshold for reporting HMDA rate spreads conform to the new definition of higher-priced mortgage loans.
Brief the Board of Directors and Senior Management. Compliance staff should provide the board of directors and senior management with a general summary of Regulation Z's changes and explain how the rule will affect the institution's practices and procedures. Staff should also update the board of directors and senior management periodically on efforts within the institution to comply with the new rules.
Conduct Staff Training. Implementing effective and appropriate staff training will be a critical element of the institution's effort to comply with the final rule. Training is most effective when tailored to an individual's job responsibilities and should encompass not only a review of regulatory changes but also new internal bank policies and procedures.
Modify Internal Controls. An institution should evaluate how internal controls can be improved to ensure full compliance with Regulation Z's new requirements. Such controls could include expanded second reviews of higher-priced loans, mortgage-related advertisements, and loan servicing practices. Enhancements to an institution's mortgage processing systems could also help identify covered loans and help prevent improper practices related to such loans. Similarly, an institution may want to conduct periodic tests of its higher-priced and HOEPA loans for compliance with the final rule.
Expand Compliance Audit Coverage. After the institution's compliance plan has been fully implemented, compliance audits should be expanded to include thorough and comprehensive reviews of any new Regulation Z requirements applicable to the bank. In general, the audits should evaluate the effectiveness of the institution's compliance management response to the Regulation Z changes. For instance, has staff training been effective? Have internal controls helped maintain compliance and prevent violations? Have policies and procedures helped provide effective guidance on complying with the final rule?
Additional information about the Regulation Z amendments can be found on the Board's website . Specific issues and questions should be raised with the consumer compliance contact at your Reserve Bank or with your primary regulator.