The Strange Case of the Shrinking Mini-Correspondent: A Primer on Forensics

WHITE PAPER

 Jonathan Foxx

President & Managing Director

There is nothing more deceptive than an obvious fact.

The Bascombe Valley Mystery

Sir Arthur Conan Doyle

The predictable sometimes is predicted and sometimes it is not. Our biases tend to lead the way in determining a course of action based on perceived predictability. We find ways to convince ourselves that the obvious is not obvious and the necessary is really not essential. It is said that facts are stubborn things, but they are more like heat-seeking missiles if they bear ill-tidings. So, in finding the means toward a “workaround” or any method of circumventing or overcoming a problem, real or imagined, our hearty species indulges in an endless variety of obfuscations, bafflements, blinding bewilderments, miasmic confusion, discombobulating fogs of frenzy, perplexities of interests and foolish entanglements. All for the sake of avoiding ineluctable facts!

A characteristic feature of a predictable event is that it often becomes inevitable. When that happens, no manner of pleadings or remonstrations will undo the already done! It is not as if we did not know that the predictable could become the inevitable. Our biases simply refused to admit that our present plans will oneday meet their future denouement. And so it is that the strange case of the shrinking mini-correspondent took its course, gradually and inexorably, through the annals of mortgage banking to its current resting place on July 11, 2014, with the bloviatingly long title “Policy Guidance on Supervisory and Enforcement Considerations Relevant to Mortgage Brokers Transitioning to Mini-Correspondent Lenders.” Published by the Consumer Financial Protection Bureau (“CFPB” or “Bureau”), the issuance is on its way to all supervised institutions as a Policy Guidance (“Guidance”) relating to the Bureau’s exercise of its authority to supervise and enforce compliance with RESPA and Regulation X and TILA and Regulation Z in certain transactions involving “mini-correspondent lenders”.[i]

The billowing wave of the mini-correspondent began as a trickle, intensified as lenders established “mini-correspondent channels,” and gushed into a modest torrent, its demand rising in prominence on January 10, 2014. For it was on this date that the proximate cause for the new mini-correspondent channel was given its impetus, due to the Final Rule pertaining to the Ability-to-Repay guidelines and the requirements of the Qualified Mortgage rule (“Rule”). Many brokers usually seek to charge fees between 2% and 3% per loan transaction; however, under the foregoing requirements, any excess above 3% in total points and fees virtually guarantees that such loans, originated by brokers, will not be eligible for treatment as a Qualified Mortgage (QM). A consequence of the Final Rule and specifically the 3% cap was to create an incentive for many brokers to morph into a new kind of loan originator, termed the “Mini-Correspondent.”

In September 2013, in anticipation of the Rule’s compliance effective date coming just months away, my colleague, Michael Barone,[ii] and I published a White Paper and article in which we discussed the challenges facing the mini-correspondent channel. The White Paper was entitled “The Mini-Correspondent Channel: Pros and Cons.”[iii] In the article’s penultimate section, titled "Mini-Correspondents and the CFPB," the following observation was made:

“Before concluding please consider these final points.

Has anyone given consideration as to what the CFPB might take as a position when a tremendous amount of mortgage brokers transform themselves into mini-correspondents with the primary purpose of avoiding QM’s 3% points and fees cap? We surely have, and so have many others. The CFPB has not commented on this issue, but you bet they will at some point down the road. 

It is possible that the CFPB will take no issue with mortgage brokers becoming mini-correspondents! After all, this has been done for years, and when done correctly, it has been a valuable intermediary step for a brokerage firm that wishes to transition from broker to lender. 

But would it shock anyone if the CFPB took issue with the mini-correspondent channel and tried to eliminate it to the extent it is used to avoid the 3% points and fees cap? This would not be difficult. The CFPB could modify the exception to loan originators of the entity that makes the credit decision or take any number of other actions to prevent the mini-correspondent channel from growing solely for the benefit of avoiding the 3% cap. For now, we have to wait and see what their position on mini-correspondents will be.”[iv]

We were not soothsayers or prophets. The facts, such as they were, the experience working with applicable mortgage acts and practices, and the regulatory compliance concerns of our clients, gave us a unique purview.

Are we now finding that the mini-correspondent wave is running its course, shrinking in momentum, and undulating to its demise? Let us explore the requirements and implications of the Guidance.[v] Perhaps we will find a way to solve the mystery at the heart of the mini-correspondent surge and derive some insight about its potential fate.

Eliminate all other factors, and the one which remains must be the truth.

The Sign of Four

Sir Arthur Conan Doyle

Due to the Bureau becoming aware of the transitioning of mortgage brokers from their traditional roles to mini-correspondent lender roles, the CFPB has become concerned that some mortgage brokers may be shifting to the mini-correspondent model in the belief that, by identifying themselves as “mini-correspondent lenders,” they automatically alter the application of important consumer protections that apply to transactions involving mortgage brokers. The specific protections that the Bureau cites include provisions in RESPA and its implementing Regulation X,[vi] and TILA and its implementing Regulation Z.[vii] RESPA and TILA were amended by Title XIV of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).[viii] On the compliance effective date of January 10, 2014, the Final Rule (issued in January 2013) required that Regulations X and Z apply certain requirements and prohibitions to compensation paid to a mortgage broker. 

An outline of applicable provisions, as they concern mortgage brokers and compensation, consist of the following four factors:

1.     Disclosure of mortgage broker compensation. 

Regulation X requires that the lender’s compensation to the mortgage broker be disclosed on the Good-Faith Estimate and HUD-1 Settlement Statement.[ix] However, payments received by the lender from an investor as compensation for a bona fide transfer of the loan in the secondary market need not be disclosed.[x]

2.     Inclusion of mortgage broker compensation in “points and fees.” 

Under Regulation Z, compensation paid to a mortgage broker by a consumer or creditor is included in points and fees for purposes of the points-and-fees cap for “qualified mortgages” and for the points-and-fees test for determining whether a mortgage is a “high-cost mortgage” under the Home Ownership and Equity Protection Act (HOEPA).[xi]   But, the interest paid to a creditor is excluded in points and fees. Excluded also are any points and fees compensation a creditor receives from a third party that purchases the loan.[xii]

3.     Restrictions on mortgage broker compensation.

TILA and Regulation Z[xiii] prohibit certain compensation arrangements between creditors and loan originators, including mortgage brokers.[xiv]

Webinar: New Year, New Rules

Brokers Compliance Group is the Exclusive Compliance Provider of the National Association of Mortgage Brokers (NAMB) and an affiliate of Lenders Compliance Group.

In cooperation with NAMB, we will be providing a quarterly webinar series in 2014.

Each webinar will be devoted to an intense review of important regulatory compliance matters.

• If you are a client of the Lenders Compliance Group of companies, you are entitled to register for FREE.
• Each attendee must individually register.
• NAMB members receive special pricing.
• Non-members of NAMB and non-clients of ours may also register for a small fee.

Our first webinar in the series will be presented on January 30, 2014, at 2PM-EST. Because space is filling up quickly, due to announcements by NAMB and media organizations, we suggest you register as soon as possible.

We are pleased to offer this webinar to our valued clients and colleagues!

Regards,
Jonathan Foxx
President & Managing Director

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WEBINAR OVERVIEW

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DESCRIPTION

New Year, New Rules - Understanding and Implementing

Thursday, January 30, 2014 at 2PM-EST

Webinar Topics:

• How do the Ability-to-Repay (ATR) requirements affect my business?
  

• Qualified Mortgage (QM) and the inconsistent impact on lenders, brokers, and mortgage loan originators
  

• Obstacles and opportunities in Loan Officer Compensation amendments
  

• Lending in the new HOEPA requirements
  

• Appraisals: Latest rules affecting ECOA and Higher-Priced Mortgage Loans
  

In this 90-minute session, we'll discuss the regulatory compliance requirements that you need to implement right away.

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Fair Lending Compliance, Ability-to-Repay and Qualified Mortgages

On October 22, 2013, the Consumer Financial Protection Bureau (Bureau), Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (Board), Federal Deposit Insurance Corporation (FDIC), and the National Credit Union Administration (NCUA) (collectively, the Agencies) issued a statement in response to inquiries from creditors about whether they would be liable under the disparate impact doctrine of the Equal Credit Opportunity Act (ECOA) [15 U.S.C. 1691 et seq., and its implementing regulation, Regulation B, 12 C.F.R. Part 1002] by originating only Qualified Mortgages as defined under the Bureau's recent Ability-to-Repay and Qualified Mortgage Standards Rule (ATR Rule). The ATR Rule implements provisions of the Truth in Lending Act (TILA).[1]

The Agencies' general approach and expectations regarding fair lending, including the disparate impact doctrine, are summarized in prior issuances.[2]

The Agencies state that they are issuing this statement to describe some general principles that will guide supervisory and enforcement activities with respect to entities within their jurisdiction as the Ability-to-Repay Rule takes effect in January 2014. Per the Agencies, the requirements of the Ability-to-Repay Rule and ECOA are compatible. ECOA and Regulation B promote creditors acting on the basis of their legitimate business needs.[3]

Therefore, the Agencies do not anticipate that a creditor's decision to offer only Qualified Mortgages would, absent other factors, elevate a supervised institution's fair lending risk.

The Bureau's Ability-to-Repay Rule implements provisions of the Dodd-Frank Act that require creditors to make a reasonable, good faith determination that a consumer has the ability to repay a mortgage loan before extending the consumer credit.[4] TILA and the Ability-to-Repay Rule create a presumption of compliance with the ability-to-repay requirements for certain "Qualified Mortgages," which are subject to certain restrictions as to risky features, limitations on upfront points and fees, and specialized underwriting requirements.

Consistent with the statutory framework, there are several ways to satisfy the Ability-to-Repay Rule, including, according to the Agencies, making responsibly underwritten loans that are not Qualified Mortgages.

The Bureau does not believe that it is possible to define by rule every instance in which a mortgage is affordable for the borrower. Nonetheless, the Agencies are recognizing that some creditors might be inclined to originate all or predominantly Qualified Mortgages, particularly when the Ability-to-Repay Rule first takes effect. The Rule includes transition mechanisms that encourage preservation of access to credit during this transition period.

Furthermore, according to the issuance, the Agencies expect that creditors, in selecting their business models and product offerings, would consider “demonstrable factors” that may include credit risk, secondary market opportunities, capital requirements, and liability risk. The Ability-to-Repay Rule does not dictate precisely how creditors should balance such factors, nor do either TILA or ECOA. Consequently, as creditors assess their business models, the Agencies are clearly stating they understand that implementation of the Ability-to-Repay Rule, other Dodd-Frank Act regulations, and other changes in economic and mortgage market conditions have real world impacts and that creditors may have a legitimate business need to fine tune their product offerings over the next few years in response.

Importantly, the Agencies seem to be recognizing that some creditors' existing business models are such that all of the loans they originate will already satisfy the requirements for Qualified Mortgages. An example given is where a creditor has decided to restrict its mortgage lending only to loans that are purchasable on the secondary market might find that - in the current market - are Qualified Mortgages under the transition provision. Thereby giving Qualified Mortgage status to most loans that are eligible for purchase, guarantee, or insurance by Fannie Mae, Freddie Mac, or certain federal agency programs.

With respect to any fair lending risk, the Agencies claim that situation here is not substantially different from what creditors have historically faced in developing product offerings or responding to regulatory or market changes. The decisions creditors will make about their product offerings in response to the Ability-to-Repay Rule are similar to the decisions that creditors have made in the past with regard to other significant regulatory changes affecting particular types of loans.

An example provided is where some creditors may have decided not to offer "higher-priced mortgage loans" after July 2008 (viz., following the adoption of various rules regulating these loans or previously decided not to offer loans subject to the Home Ownership and Equity Protection Act after regulations to implement that statute were first adopted in 1995). There were no ECOA or Regulation B challenges to those decisions.

Inevitably, creditors should continue to evaluate fair lending risk as they would for other types of product selections, including by carefully monitoring their policies and practices and implementing effective compliance management systems. As with any other compliance matter, individual cases will be evaluated on their own merits.

The OCC, the Board, the FDIC, and the NCUA believe that the same principles described above apply in supervising institutions for compliance with the Fair Housing Act (FHA), 42 U.S.C. § 3601 et seq., and its implementing regulation, 24 C.F.R. Part 100.[5]

---

[1] See http://www.consumerfinance.gov/regulations/ability-to-repay-and-qualified-mortgage-standards-under-the-truth-in-lending-act-regulation-z/. Disparate impact is one of the methods of proving lending discrimination under ECOA. See 12 C.F.R. pt. 1002 & Supp. I.
[2] For instance, in 1994, eight federal agencies published the Policy Statement on Discrimination in Lending, 59 Fed. Reg. 18,266 (Apr. 15, 1994), and last year the Bureau issued a bulletin on lending discrimination, CFPB Bulletin 2012-04 (Fair Lending) (Apr. 18, 2012). In addition, the OCC, Board, FDIC, NCUA, and Bureau each have fair lending examination procedures.
[3] Even where a facially neutral practice results in a disproportionately negative impact on a protected class, a creditor is not liable provided the practice meets a legitimate business need that cannot reasonably be achieved as well by means that are less disparate in their impact. See 12 C.F.R. §1002.6; 12 C.F.R. pt. 1002, Supp. I, § 1002.6, ¶ 6(a)-2.
[4] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 1411, 124 Stat. 1376, 2142 (2010) (codified at 15 U.S.C. § 1639c).
[5] The OCC, Board, FDIC, and the NCUA have supervisory authority as to the FHA.

GSEs: Ability-to-Repay and Qualified Mortgages

Yesterday, the Federal Housing Finance Agency (FHFA) announced that it is directing Fannie Mae ("Fannie") and Freddie Mac ("Freddie") to limit their future mortgage acquisitions to loans that meet the requirements for a qualified mortgage ("qualified mortgage" or "QM"), including those that meet the special or temporary qualified mortgage definition, and loans that are exempt from the “ability to repay” ("ATR") requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank).

In January, the Consumer Financial Protection Bureau (CFPB) issued a final rule implementing the “ability to repay” provisions of Dodd-Frank, including certain protections from liability for loans that meet the criteria of a qualified mortgage as outlined in the rule.

We have discussed the ability to repay provisions HERE, HERE, HERE, HERE, and HERE.

I would like to call your attention to a few important details.*

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IN THIS ARTICLE

Overview

Eligible for Sale to Fannie and Freddie

Additional Guidance and Notifications

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Overview

Considered historically, the Consumer Financial Protection Bureau (CFPB) issued a final rule on January 10, 2013, implementing the “ability to repay” provisions of the Dodd-Frank. That rule generally requires lenders to make a reasonable, good faith determination of a consumer’s ability to repay before originating a mortgage loan and establishes certain protections from liability for QMs.

The ATR rule takes effect for applications dated on or after January 10, 2014.

It is significant that, beginning January 10, 2014, Fannie and Freddie will no longer purchase a loan that is subject to the ATR rule if the loan:

• is not fully amortizing,

• has a term of longer than 30 years, or

• includes points and fees in excess of three percent of the total loan amount, or such other limits for low balance loans as set forth in the rule.

The FHFA announcement states that "effectively, this means Fannie and Freddie will not purchase interest-only loans, loans with 40-year terms, or those with points and fees exceeding the thresholds established by the rule."

Fannie and Freddie will continue to purchase loans that meet the underwriting and delivery eligibility requirements stated in their respective selling guides. This includes loans that are processed through their automated underwriting systems and loans with a debt-to-income ratio of greater than 43 percent. But loans with a debt-to-income ratio of more than 43 percent are not eligible for protection as QMs under the CFPB’s final rule unless they are eligible for purchase by Fannie and Freddie under the special or temporary qualified mortgage definition. 

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Eligible for Sale to Fannie and Freddie

Just a few days ago, on May 2, 2013, the FHFA directed Fannie Mae and Freddie Mac to limit future acquisitions to loans that:

• are qualified mortgages under the ability to repay rule, including those meeting the special or temporary qualified mortgage requirements; or

• are exempt from the ability to repay requirements, such as investor transactions.

Thus, effective for mortgages with application dates on or after January 10, 2014, Fannie and Freddie will not be allowed to purchase any loans if they are subject to the ATR requirements and are either:

• loans that are not fully amortizing (e.g., no negative amortization or interest-only loans);

• loans with terms in excess of 30 years (e.g., no 40-year terms); or

• loans with points and fees in excess of 3% of the total loan amount or such other limits for low balance loans as set forth in the ability to repay final rule.

Fannie will continue to purchase loans that meet the underwriting and delivery eligibility requirements (i.e., existing debt-to-income ratios, loan-to-value ratios, and reserves) stated in the Selling Guide, including loans processed through Desktop Underwriter®.

Freddie will limit future purchases to:

• Mortgages that are “qualified mortgages” under the final rule, including those meeting the special or temporary qualified mortgage requirements, and

• Mortgages that are exempt from the ATR, such as investor transactions.

Therefore, effective for mortgages subject to the final rule with applications received on or after January 10, 2014, Freddie will not be permitted to purchase the following:

• Mortgages that are not fully amortizing (e.g., Mortgages with a potential for negative amortizations or interest-only Mortgages);

• Mortgages with terms in excess of 30 years (i.e, 40-year fixed-rate Mortgages); and,

• Mortgages with points and fees in excess of 3% of the total loan amount or such other limits for low balance Mortgages as set forth in the final rule.

CFPB’s Final Rule: Ability-to-Repay and Qualified Mortgages

Yesterday, I provided an outline of the Consumer Financial Protection Bureau's (CFPB's) Regulatory Agenda for 2013. As if on cue, the CFPB has accommodated us today with the first of its forthcoming issuances.* This pertains to the Final Rule regarding Ability-to-Repay, which leaves the Final Rule issuances this month for Loan Originator Compensation, Mortgage Servicing, and Requirements for Escrow Accounts.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) required that, for residential mortgages, creditors must make a reasonable and good faith determination based on verified and documented information that the consumer has a reasonable ability to repay the loan according to its terms. It also established a "presumption" of compliance for a certain category of mortgages, which was called “qualified mortgages” or "QMs." These provisions are similar, but not identical to, the Federal Reserve Board's (FRB's) 2008 rule and cover the entire mortgage market rather than simply higher-priced mortgages. The FRB proposed a rule to implement the new statutory requirements before authority passed to the CFPB to finalize the rule. 

I have written extensively about Ability-to-Repay and the Qualified Mortgage. 

Please feel free to review these articles.

In this article, I would like to mention the premises used as the reasons for an Ability-to-Repay rule (ATR). Then I will outline the essential features of ATR, followed by a review of the "Qualified Mortgage." Finally, I will provide a general summation in order to provide some context with respect to the Final Rule's implementation.

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IN THIS ARTICLE

Premises for Ability-to-Repay
What is Ability-to-Repay?
What is the Qualified Mortgage?
Types of Qualified Mortgages
Summation

Library

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Premises for Ability-to-Repay

The CFPB believes that when consumers apply for a mortgage they "often struggle to understand how much of a monthly payment they can afford to take on." Thus, according to the CFPB, the consumer may reasonably assume that lenders and mortgage brokers would not make loans to people who cannot afford them. But in the years leading up to the financial crisis, the CFPB asserts that lenders too often made mortgages that could not be paid back.

Therefore, the purpose of ATR is to require lenders to obtain and verify information to determine whether a consumer can afford to repay the mortgage and, per the CFPB, thereby help to restore trust in the mortgage market.

These are the premises upon which the CFPB has established the need for Ability-to-Repay:

-In the lead up to the financial crisis, certain lending practices set consumers up to fail with mortgages they could not afford.

-The deterioration in underwriting standards contributed to dramatic increases in mortgage delinquencies and rates of foreclosures.

-The Dodd-Frank Act recognizes the need to mandate that lenders ensure consumers have the ability to pay back their mortgages.

-The Ability-to-Repay rule protects consumers from risky practices that helped cause the crisis.

In its review of the above-mentioned premises, the CFPB had taken the position that lenders sold no-doc and low-doc loans where consumers were “qualifying” for loans beyond their means. Lenders also "sold risky and complicated mortgages like interest-only loans, negative-amortization loans where the principal and eventually the monthly payment increases, hybrid adjustable-rate mortgages where the rate was set artificially low for years and then adjusted upwards, and option adjustable-rate mortgages where the consumer could 'pick a payment' which might result in negative amortization and eventually higher monthly payments."

In plain English, the CFPB asserts that lenders should not be able to offer no-doc, low-doc loans, otherwise known as “Alt-A” loans, where some lenders made quick sales by not requiring specific, qualifying documentation, yet then offloaded these risky mortgages by selling them to investors.

As it was contended, these actions precipitated the collapse of the housing market in 2008 and the subsequent financial crisis.

Dodd-Frank provides the authority to the CFPB to define criteria for certain loans called “Qualified Mortgages” that are presumed to meet the Ability-to-Repay rule requirements.

The salient observation about ATR is that the CFPB is issuing this rule in order "to ensure that responsible consumers get responsible loans," as well as ensuring that "lenders can extend credit responsibly - without worrying about competition from unscrupulous lenders."

CFPB’s Regulatory Agenda - 2013

As we begin a new year and prepare ourselves for the blizzard of new and revised regulations coming our way, I think it is important for us to consider the regulatory agenda that the Consumer Financial Protection Bureau (CFPB) has set for itself.* As you've heard me say so many times, preparation is protection. So, please undertake a review of the agenda that the CFPB has promised to pursue in the coming months, especially with the view of how best to prepare for the changes that are sure to follow.

It is worth noting that the CFPB reasonably anticipates having certain regulatory matters under consideration during the period from October 1, 2012 to October 1, 2013. And the CFPB will publish updates to its agenda periodically through October 1, 2013. These matters will be under consideration by the CFPB, primarily including various rulemakings mandated by the Dodd-Frank Act, such as several mortgage-related rulemakings and rulemakings to implement the CFPB's supervisory program for nondepository covered persons by, among other things, defining "larger participants" in certain consumer financial product and service markets.

The CFPB is completing several mortgage-related rulemakings in January 2013, even as it continues to assess the need and resources available for additional rulemakings. For instance, the Dodd-Frank Act mandates rulemakings to implement amendments to the Home Mortgage Disclosure Act, and to the Equal Credit Opportunity Act to create a data reporting regime concerning small, women-owned, or minority-owned business lending. Also, the CFPB has inherited proposed rules concerning mortgage loans, home equity lines of credit, and other topics from other agencies as part of the transfer of authorities under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). All of these regulatory changes will require careful planning and clear guidance with respect to implementation.

In this article, I am going to highlight the regulatory changes that the CFPB has moved into their final stages. I offer a brief outline of the regulatory issues and the CFPB's likely resolution. Each of these regulations, now approaching the status of Final Rule, is extraordinarily significant and, in some instances, constitutes formidable challenges.

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IN THIS ARTICLE

Chart

Consumer Financial Protection Bureau -
Final Rule Stage (Selected Rules)

Final Rule Stages

Loan Originator Compensation (Regulation Z)
Mortgage Servicing (Regulation X, Regulation Z)
Requirements for Escrow Accounts (Regulation Z)
TILA Ability To Repay (Regulation Z)
TILA/RESPA Mortgage Disclosure Integration
(Regulation X, Regulation Z)

Library

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Chart: Consumer Financial Protection Bureau

Final Rule Stage (Selected Rules)

This chart provides a quick overview of certain regulatory changes that the CFPB will promulgate this year. The chart also provides the anticipated Final Rule dates.

Ability-to-Repay: The Basics and a Chart

Commentary By: Jonathan Foxx
President and Managing Director of Lenders Compliance Group

On May 11, 2011, the Federal Reserve Board (FRB) issued a proposed rule (Rule) to implement ability-to-repay requirements for closed-end residential loans.[i] The Rule implements Section 1411, Section 1412, and part of Section 1414 of the Dodd-Frank Wall Street Reform and Consumer Financial Protection Act of 2010 (Dodd-Frank).[ii] Comments on the Rule are to be received by no later than July 22, 2011.[iii] Having published the proposed Rule, the FRB retired from its involvement in this matter and handed over its rulemaking authority in the subject statute to the Consumer Financial Protection Bureau (CFPB) on July 21, 2011.[iv]

As a revision to Regulation Z (the implementing regulation of the Truth in Lending Act), the Rule requires creditors to determine a consumer’s ability to repay a mortgage before making the loan and would also establish minimum mortgage underwriting standards. The Rule applies to any consumer credit transaction secured by a dwelling, except an open-end credit plan, timeshare plan, reverse mortgage, or temporary loan or ‘‘bridge’’ loan with a term of 12 months or less. [v] It appears that the Rule applies to purchase money and refinances, but not modifications of existing mortgages. There is a prohibition on prepayment penalties unless the mortgage is a prime, fixed rate, qualified mortgage - and unless the amount of the prepayment penalty is limited.

The Rule sets forth limits on prepayment penalties, the lengthening of the time creditors must retain records evidencing compliance with the ability-to-repay and prepayment penalty provisions, a prohibition to evading the Rule by structuring a closed-end extension of credit as an open-end plan, the delineation of new terms, procedures, and their resulting implications, and, very importantly, the means by which the Rule claims to offer tools to prevent likely default and mitigate risk for creditors and others who arrange, negotiate, or obtain an extension of mortgage credit for a consumer in return for compensation or other monetary gain.

Complying with the requirements of the ability-to-repay Rule is essential, because borrowers in a foreclosure proceeding will likely claim that the creditor failed to comply with the Rule as a defense by way of recoupment or set off, without regard to the normal statute of limitations under the Truth-in-Lending Act (TILA).[vi] A violation of the Rule subjects the creditor to the TILA civil monetary penalties, plus the same enhanced civil remedies that apply to violations of TILA’s high-cost loan rules,[vii] and TILA also would authorize state attorneys general to bring actions for violations of the Rule for a period of up to three years.[viii]

A loan that is a covered transaction must qualify, among other things, as a “qualified mortgage” if the creditor wishes to include a prepayment penalty in the loan.

The Rule provides a presumption of compliance with the ability-to-repay requirements if the mortgage loan is a ‘‘qualified mortgage,’’ which does not contain certain risky features and limits points and fees on the loan. Furthermore, one feature of a higher-risk mortgage loan (i.e., subject to enhanced appraisal requirements under Dodd-Frank § 1471) is the loan may not be a qualified mortgage.[ix]

There are four (4) options to the determination of compliance with the Rule. The Rule refers to these origination options as “methods” and equips each method with a description of (1) limits on the loan features or term, (2) limits on points and fees, (3) underwriting requirements, and (4) payment calculations.

Option # 1: General Ability-to-Repay Standard

A creditor can meet the general ability-to-repay standard or test by:

• Considering and verifying the following eight (8) underwriting factors:

1. Income or assets relied upon in making the ability-to-repay determination;

2. Current employment status;

3. The monthly payment on the mortgage;

4. The monthly payment on any simultaneous mortgage;

5. The monthly payment for mortgage-related obligations;

6. Current debt obligations;

7. The monthly debt-to-income ratio, or residual income; and

8. Credit history.

• Underwriting the payment for an adjustable-rate mortgage based on the fully indexed rate.

Comment: This is an option that will be carefully reviewed by plaintiff’s counsel in an action to challenge a creditor’s compliance with the Rule. Consequently, enforcing compliance with the Rule will require fully vetted, tested, and continually updated, written procedures to govern every aspect of the application and underwriting process. Without clear and unambiguous policies and internal enforcement of appropriate policies and procedures, the creditor is allowing exposure to such a challenge. This option contains rigorous underwriting criteria and requires unmitigated, fact-based evaluations. Option # 1- the ability-to-repay test - is somewhat unstable (due to the invariant rigors of procedural compliance) though a relatively favorable methodology for the creditor, even if the loan flow process leaves very little room for error.

Option # 2: Qualified Mortgage (QM)

A creditor can originate a “qualified mortgage,” which provides special protection from liability. Two alternative definitions of a “qualified mortgage” are being considered by the CFPB:

Alternative # 1: Provides a legal safe harbor and defines a “qualified mortgage” as a mortgage for which:

· The loan does not contain negative amortization, interest-only payments, or a balloon payment, or a loan term exceeding 30 years;

· The total points and fees do not exceed three (3%) percent of the total loan amount;

· The income or assets relied upon in making the ability-to-repay determination are considered and verified;[x] and,

· The underwriting of the mortgage (a) is based on the maximum interest rate that may apply in the first five years, (b) uses a payment scheduled that fully amortizes the loan over the loan term, and (c) takes into account any mortgage-related obligations.

Alternative # 2: Provides a rebuttable presumption of compliance and would define a “qualified mortgage” as including the criteria listed under Alternative # 1 (above) as well as additional underwriting requirements from the general ability-to-repay standard (see Option # 1). In any event, under Alternative # 2, the creditor would also have to consider and verify:

· The consumer’s employment status;

· The monthly payment for any simultaneous mortgage;

· The consumer’s current debt obligations;

· The monthly debt-to-income ratio or residual income; and

· The consumer’s credit history.

Comment: Two alternatives are given: in Alternative # 1, to obtain a legal safe harbor, the creditor must consider and verify the borrower’s current or reasonably expected income or assets to determine the borrower’s repayment ability; and, in Alternative # 2, to obtain a rebuttable presumption of compliance, the creditor must consider and verify the borrower’s current or reasonably expected income or assets (i.e., other than the value of the dwelling in question), the borrower’s current employment status (assuming the creditor relies on employment income), the borrower’s monthly payment on any simultaneous loan, the borrower’s current debt obligations, the borrower’s monthly DTI or residual income, and the borrower’s credit history. It should be noted that the second alternative is for the most part similar to the ability-to-repay test.

Winning the Future - Losing the Past

Jonathan Foxx is the President and Managing Director of Lenders Compliance Group.

“Winning the Future!” By now, most of us have heard President Obama's new slogan for his 2012 re-election campaign. 

But for the mortgage industry and consumers, it seems like something very vital is at stake: causes of the recent financial meltdown are creeping and clawing their way back. 

Perhaps we are not so much Winning the Future as Losing the Past.

Famous Last Words

Here are the very last words of the 1616 page Senate's amendments to the House's financial reform bill, which together formed the basis of the Dodd-Frank Act (Dodd-Frank):

Amend the title so as to read: An Act to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes. (My Emphasis) 

The nomenclature "too big to fail," otherwise known by the acronym TBTF, was placed into the legislative language right then and there!

But that phrase "too big too fail" itself never actually made it into the 2319 page Dodd-Frank Act.

Did it just disappear forever or merely reappear with a make-over?

What’s In A Name

Dodd-Frank saw to it that the pesky and politically unpopular term "too big to fail" disappeared, but the concept was craftily replaced with a shiny new term, known as a "systemically important financial institution," also prestigiously having an acronym of its very own: "SIFI." (Pronounced in the same way as you would pronounce SciFi!)

Is the SIFI a different kind of indomitable beast than the TBTF monstrosity?

Let's take a closer look, by reading some Dodd-Frank descriptions of this SIFI creature:

• Entities that are systemically important or can significantly impact the financial system of the United States.

• The terms 'systemically important' and 'systemic importance' mean a situation where the failure of or a disruption to the functioning of a financial market utility or the conduct of a payment, clearing, or settlement activity could create, or increase, the risk of significant liquidity or credit problems spreading among financial institutions or markets and thereby threaten the stability of the financial system of the United States.

And here is one of several factors that may be taken into consideration, when deciding to protect us from the flailing SIFI:

• The effect that the failure of or a disruption to the financial market utility or payment, clearing, or settlement activity would have on critical markets, financial institutions, or the broader financial system.

Now you might argue that TBTF is a somewhat colloquial expression, a political and journalistic tool, but its successor, SIFI, is now enshrined into law along with certain actionable remediation. Conceptually, however, I see very little light between the meaning of the two terms.

So did Dodd-Frank conquer the "too big to fail" beast, wrestling the TBTF to the ground, casting it into chains, pulling off its griftopic mask, and finding underneath the "systemically important financial institution," that rapaciously attenuated SIFI?

Are We Safe From The SIFI?      

Let us presume that Dodd-Frank actually provides viable regulatory remedies for keeping this SIFI chained up. As you may know, I have written extensively about the breathtaking lack of formidable brakes in Dodd-Frank to avoid the SIFI debacle. Indeed, certain markets are still exposed to systemic failure, as that term is defined by Dodd-Frank. In some cases, certain markets are inadequately addressed by or they are not even regulated through Dodd-Frank.

In any event, let us just suppose that somehow Dodd-Frank actually has all the regulatory remedies it needs to keep the SIFI under control. What may happen in another meltdown?

Systemic Risk

One of the determinants of the effectiveness of protection from SIFIs is best described in a recent report from Standard and Poor's. It is entitled "The U. S. Government Says Support For Banks Will Be Different 'Next Time' -- But Will It?" Link Here – PDF

Although the title speaks for itself, or begs the question, the report offers the one and only factor that really counts when it comes to SIFIs running loose: government intervention inevitably will crowd out a regulatory framework and trumps everything else! So, inevitably, this is the outcome that may happen.

And I quote:

It would seem "too big to fail" has ended. But, has it really? Standard & Poor's Ratings Services believes that the primary goal of DFA is to make banks less risky and better capitalized so the need for extraordinary support is reduced. However, given the importance of confidence sensitivity in the effective functioning of banks, we believe that under certain circumstances and with selected systemically important financial institutions (SIFI), future extraordinary government support is still possible. The U.S. government has a long track record of supporting the banking system. But the government's authority to regulate and supervise hasn't always prevented bank failures or the need for selected bailouts or tailored assistance. Time and time again, the U.S. government has found ways - many times reluctantly - to contain systemic risk and limit economic fallout when large financial institutions are on the brink of failure. 

And then, referring to Dodd-Frank, comes this conclusion:

This legislation, in our view, has not addressed the demand side of risk, risk-mitigation efforts, or the fact that a two-tier regulatory system will likely continue to move risks into the loosely regulated shadow-banking system.

(My Emphasis)

Translation: S&P understands regulatory risk. The TBTF monster has shape-shifted into the SIFI monster and continues to have the hidden powers to destroy the country’s economic stability at some unspecified time in the future. The government will be expected to prop up the "too big to fail" financial institution, irrespective of the regulatory safety net.

Mortgage Industry Nemesis

Near its height, mortgage brokers alone accounted for more than 500,000 people, and originated between 68% and 70% of residential mortgage loans. Then came the wave of predatory lending accusations, attacks on the yield spread premium as a compensation source, allegations of mortgage fraud and steering, and so forth. This was accompanied by foreclosures that eclipsed the Great Depression.

By early 2010 more than 1 million homes were seized, defaults soared to more than 10% percent and foreclosures reached record numbers – in the first quarter alone! Along the way, the number of mortgage brokers shrank to 246,900 by the middle of last year, which is a drop of over 50% from its high. But this was not a shaking out of "bad" brokers over "good" brokers. Many believe that the decline had been due, in part, to more restrictive compliance standards.

And that is just a snap shot of what mortgage brokers have been going through, not to mention the regulatory burdens placed on mortgage bankers, banks, investors, and servicers - each with its own brand of significant and often costly challenges, just to survive and also comply with new regulatory compliance laws.

Wall Street operates by different standards, as it likely should - each market often marches to the beat of a different drummer. But the Credit Default Swap - the "shadow banking" favorite – has not gone away at all; in fact, the CDS market is bigger, more entrenched and far more pervasive than ever.

Other than a devastated mortgage industry and a legitimately wary consumer, and a blizzard of new regulations purportedly in response to the economic crisis, what has actually changed to fully prevent systemic failure?

Straddling Two Worlds

In my recent 2-part article, Ability-to-Repay: Regulating or Underwriting?, I discuss how this one area of legislation alone causes a substantial increase in government encroachment on underwriting, with the effect - intended or unintended - of rationing credit. My conclusions, based on a detailed analysis of this law, is:

1) There is gradual nationalizing of underwriting guidelines.

2) The imposition of an ability-to-repay requirement as a regulatory mandate is an assertion that market forces cannot discipline lenders or incentivize lenders to act in their own self-interest.

3) There is a substantial shift in liabilities, because this mandate shifts the burden of compliance to the lenders in order to assure that their contractually bound borrowers can pay back their loans.

4) The law imposes a new kind of theory for a regulatory framework.

5) This law infantilizes lenders by making them comply with a regulator's ad hoc way of rationing the extension of credit.

6) Rationing of credit leads to the diminution of arms-length, contractual counterparties.

7) The law changes the dynamics in the inherent, due diligence tension among the parties to a residential mortgage transaction and raises serious issues about the systemic consequences soon to be engendered.

And yet, the Mortgage Bankers Association sent an extensive letter to the Federal Reserve Board (dated 7/22/11 - one day after the CFPB received its statutory authority over the subject legislation - Link Here) which corroborates my aforementioned conclusions. Nevertheless, the MBA letter also manages to support the concept of the Ability-to-Repay provisions:

• MBA has long supported establishment of an ability to repay requirement for mortgage loans. However, since the requirement will apply broadly and bring considerable liability to lenders and assignees for any violations, it is essential that the rule's QM requirements include unambiguous definitions and means of compliance. Clear "bright line" requirements will ensure the provision of sustainable mortgage credit to the widest array of qualified borrowers at affordable costs.

• If these requirements are implemented incorrectly, however, we are deeply concerned that far too many borrowers will be excluded from affordable mortgage credit and/or will be subject to unreasonably increased financing costs, in turn harming the very people Dodd-Frank was intended to protect and undermining the nation's economic recovery.

Personally, I prefer clear and “unambiguous definitions;” however, the MBA's position seems too embracing, even if it recognizes the effect such legislation could have on rationing credit.

Losing The Past

The dramatic changes that the mortgage industry has gone through are partly of its own doing and partly due to the economic downturn caused by many macro- and microeconomic issues. Some legislation that has been made into law, such as Dodd-Frank, is supposedly a means to prevent another economic meltdown.

Without a stronger real estate market, there really cannot be much of a recovery. We are experiencing a recession that is being made worse by the lack of consumer demand. This is not a recession caused simply by the lack of consumer confidence. If the consumer does not have spending money, or feels the need to sit on the sidelines, the recession will become an ever expanding morass, lasting many years. Despite what the government and political leaders authoritatively proclaim, the recession did not really end, except in the most abstruse technical sense. Nothing could be more obvious! 

Laws that promise to prevent the spawning of TBTFs, or their progeny, the SIFIs, or whatever you want to call them, but also institute the wide-ranging set of regulations that are now clogging up the mortgage industry, only economically hurt the consumer, due to higher pricing, pressure on origination efficiency, and impediments to innovation. Many mortgage market participants must pass on their costs, due to the burden of higher overhead and lower profit margins.

Sometimes, over-regulating may be just as ineffective as under-regulating - especially when, in many cases, existing regulations just need to be enforced.

I am privileged to run the first mortgage risk management firm in the country. We navigate regulations day in and day out for our valued clients. Regulations are important to the safety and soundness of a financial institution and protect the consumer. But it is better to have a few, new, smart regulations than a plethora of mediocre regulations.

There is no way to really win the future by not looking back, gaining insights, correctly identifying errors, and then carefully, incrementally, intelligently, providing regulatory remedies that help to preserve the mortgage industry.

"Winning the Future" may be a catchy phrase. But an overbearing approach to regulatory risk will not win the future, though it may assuredly lead to losing the past.

What do you think?

I would welcome your comments.
Please feel free to join the forum below.

Ability-to-Repay: Regulating or Underwriting? Part II

Jonathan Foxx is the President and Managing Director of Lenders Compliance Group.

Click below to download my article:

ABILITY-TO-REPAY:

REGULATING OR UNDERWRITING?

Part II

It has been published in the National Mortgage Professional Magazine - July 2011.

I am providing this article to you as a courtesy, for your personal use. I hope you enjoy it.

Please feel free to contact me at any time.

EXCERPT # 1

It seems to me that the imposition of an ability-to-repay requirement as a regulatory mandate is an admission that market forces cannot discipline lenders or incentivize lenders to act in their own self-interest. 

This is an obvious shift in liabilities, because this mandate shifts the burden of compliance to the lenders in order to assure that their contractually bound borrowers can pay back their loans. Parties to any contract can become adversaries! 

In other words, the relationship between the creditor and the borrower is innately affected and extensively undermined by this Rule, inasmuch as it imposes a new kind of theory for a regulatory framework and, in my estimation, infantilizes lenders by making them comply with a regulator's ad hoc way of rationing the extension of credit.

ABILITY-TO-REPAY:

REGULATING OR UNDERWRITING?

Part II

EXCERPT # 2

If the rationing of credit is meted out through this regulatory construct, it can be legitimately asserted as well that lenders are not arms-length, contractual counterparties; that is, lenders now will have a duty to assess a prospective borrower's ability to repay, irrespective of collateral value and securitization.

This change in the dynamics between and the inherent, due diligence tension among the parties to a residential mortgage transaction raise serious issues about the systemic consequences soon to be engendered.

ABILITY-TO-REPAY:

REGULATING OR UNDERWRITING?

Part II