Industry Prevails in Illinois Courts
Home Ownership and Equity Protection Act Amendments May Chill Sub-Prime Lending in Effort to Reduce Predatory LoansThomas NotoPredatory Lending, Legislation, Regulation, HOEPA In Dec. 2000, faced with increasing pressure to address predatory lending concerns through revisions to Regulation Z, the Federal Reserve Board (Board) proposed revisions to Regulation Z that would increase the number of loans covered by Home Ownership and Equity Protection Act requirements and add certain prohibitions in connection with such loans. A summary of the proposed provisions was provided in Kirkpatrick & Lockharts Alert entitled The Federal Reserve Board Proposes Amendments to Regulation Z to Curb Alleged Predatory Lending Practice, dated Jan. 11, 2001. The Board recently finalized the proposed revisions. Compliance will be mandatory on Oct. 1. The board adopted the regulation as proposed except for two notable exceptions. First, the proposed regulation would have lowered the annual percentage rate threshold for both first and subordinate lien loans from 10 percentage points to eight percentage points above the yield on Treasury securities having comparable maturities. The final rule adopts this change only with respect to first lien loans. Second, the Board did not adopt an anti-flipping proposal that would have prohibited lenders from refinancing low cost loans within five years of origination of such loans. After consideration of the comments received, the Board staff determined that the compliance burden far outweighed any perceived benefit. Below is a brief summary of notable amendments adopted in the final regulation: ++Expansion of coverageLowers the APR trigger from 10 percentage points above the yield on Treasury securities having comparable periods of maturity for first lien loans and includes the amount of credit insurance premiums in the points and fees trigger. ++Expanded Prohibitions on HOEPA LoansAdds the following requirements for HOEPA loans: i. A prohibition, within the first 12 months of originating a HOEPA loan, on a creditor from refinancing the loan or any other HOEPA loan held by the consumer into another HOEPA loan. This provision applies equally to assignees who hold or service the loan; ii. A limitation on the inclusion of payable on demand or call provisions in HOEPA loans; and iii. A prohibition on improperly characterizing loans as open end lines of credit in order to evade the reach of HOEPA. ++Enhancement of DisclosuresChanges the required disclosures to alert borrowers, in advance of loan closing, of the total amount borrowed, which is essentially the note amount, and include disclosure, if applicable, of any credit insurance premiums paid prior to closing. ++Ability to RepayProvides that failure to routinely document and certify borrowers ability to repay their loans will create the presumption that the lender is engaging in a pattern and practice of making HOEPA loans based on homeowners equity in violation of HOEPAs provisions. I. Background In 1995, in response to evidence of allegedly abusive lending practices involving mortgage loans, Congress enacted HOEPA. HOEPA is principally implemented by Section 32 of Regulation Z1 and covers loans that are secured by a consumers principal dwelling where either (i) the annual percentage rate at consummation will exceed, by more than 10 percentage points, the yield on Treasury securities having comparable periods of maturity; or (ii) the total points and fees payable by the consumer at or before closing will exceed the greater of eight percent of the total loan amount or $465.2 Purchase money loans, reverse mortgages and open end lines of credit are not covered by HOEPA. Congress granted the Board authority to amend the APR trigger and the charges included in the points and fees trigger. With respect to the APR trigger, the Board may increase or decrease the threshold to an amount that is not less than eight percentage points nor more than 12 percentage points above the yield on Treasury securities having comparable maturities. The Board may take such action provide the amendment is consistent with the consumer protection provisions found in the Riegle Community Development and Regulatory Improvement Act of 1994 and is warranted by the need for credit. With respect to the points and fees trigger, the Board has no authority to adjust the statutorily prescribed thresholds; however, the Board may include within the calculation of points and fees such other charges as the Board determines to be appropriate.3 The final regulation reflects the Boards efforts to take advantage of the authority granted under HOEPA to extend the reach of the law to include a greater number of loans. The Board believes that such exercise of its powers is necessary to further Noels purposes of maintaining and strengthening consumer home ownership and equity protection. II. Revisions A. Expansion of Coverage 1. APR Trigger As noted above, the Truth in Lending Act (TILA) permits the Board to adjust the APR trigger by two percentage points in either direction. The Board may effect such a change no more often than once every two years. The final rule lowers the APR threshold by two percentage points to eight percentage points above the yield on Treasury securities having comparable periods of maturity for first-lien loans. The Board adopted this provision, rather than lowering the threshold for all mortgage loans, essentially for two reason. First, the Board believes that perceived predatory lending abuses occur more often in connection with first-lien loans. Note that this conclusion is based, in a large part, on anecdotal evidence as the board does not have statistical data to such effect. Second, the Board believes that the current threshold already incorporates a significant proportion of subordinate-lien loans, as such loans tend to have higher interest rates, and that a change to the threshold for subordinate-lien loans is not warranted at this time. 2. Points and Fees Trigger In addition to the APR trigger, mortgage loans are covered by HOEPA if the points and fees payable by the consumer at or before loan closing exceed the greater of eight percent of the total loan amount or $465 (adjusted amount for 2001). Points and fees include all finance charges (aside from interest) broker fees, and certain closing costs in some instances. The Board has authority to expand the components of the points and fees determination and proposed to include within the calculation the costs associated with premiums for optional credit insurance (such as credit life, accident, health or loss-of-income insurance) and similar products paid by the consumer at or before closing. Commenters on this proposal were sharply divided. Those who supported the proposal viewed it as a good compromise to an outright ban on optional credit insurance where the borrower pays the premium prior to closing. Those who opposed the proposal, however, raised a variety of concerns. Some questioned the Boards authority to include the cost of credit insurance in the calculation of points and fees. Others warned that the proposal would effectively cause all loans that include the cost of credit insurance to trigger HOEPA coverage. These opponents noted that such a result will have the undesirable effect of causing lenders to cease offering certain types of credit insurance even where such insurance is beneficial to cash-poor consumers. Ultimately, the Board decided to include in the calculation of points and fees the cost of credit insurance that is paid in cash prior to loan closing or financed into the loan (whether the amount represents the entire premium or an initial payment) for purposes of determining HOEPA coverage. Even if the effect of the amendment is to cause all loans that contain such premiums to fall within HOEPAs reach, the Board believes that the amendment is necessary and consistent with the purposes of HOEPA. HOEPA was specifically designed to assist borrowers in high-cost mortgage transactions to understand the cost of the transaction. Anecdotal evidence suggested to the Board the unscrupulous lenders may pack the costs of credit insurance into the loan in an effort to increase the cost of the loan while avoiding the disclosure requirements under HOEPA. The Board believes that the amendment will have the advantageous effect of improving consumer awareness of the costs associated with credit insurance where the borrower pays the premium in cash prior to closing or the lender finances the cost into the loan. B. Prohibition of Specific Acts or Practices 1. Limitations on Refinancing HOEPA Loans Within 12-Month Period In the proposed regulation, the Board identified loan flipping as one of the more egregious practices in which predatory lenders engage. Flipping is generally viewed as the practice of frequently refinancing home-secured loans to generate additional fee income even though the refinancings may not be in the borrowers interest. To address this concern, the proposed regulation included language that would restrict the ability of lenders and borrowers to refinance HOEPA loans early in the loan transaction. The Board adopted this proposal with some modifications and clarifications. According to the final rule, within the first 12 months of originating a HOEPA loan, a creditor is prohibited from refinancing the loan or any other HOPEA loan held by the consumer into another HOEPA loan unless the refinancing is in the borrowers interest. Note that the prohibition in the final rule continues to apply to creditors who originated the loan irrespective of whether such creditors continue to hold the loan. Also, the final rule provides that assignees are under the same restriction as the original creditor while holding or even servicing a covered loan. Further, the prohibition in the final rule extends to a creditors affiliates in the event that the creditor engages in a pattern or practice of arranging loans with its affiliates in an effort to evade the prohibition. The Board believes that such a provision with respect to assignees is necessary since, in some instances, the assignee is the true creditor funding the loan.1 The prohibition is designed to prevent lenders from evading the restriction through an immediate assignment of the loan.4 As proposed, the determination of whether a benefit to the borrower existed required a lender to undertake a review of the totality of the circumstances. Although the Board acknowledges that the totality of the circumstances test raises the specter of an extremely subjective undertaking on the part of the lender, the final rule adopts the test as proposed. Notwithstanding this, in an effort to provide some guidance to lenders, the final rule sets forth a safe harbor. In the event that a loan is needed for a bona fide personal financial emergency, then the loan presumptively provides a benefit to the borrower. Note that this standard is the current standard for waiver of the three-day rescission period that is already incorporated into Regulation Z. One example of a bona fide personal financial emergency is the imminent sale of a borrowers home at foreclosure. As a practical matter, however, creditors are normally quite cautious in invoking this exception to rescission, and a similar posture might be expected here. 2. Limitations on Refinancings of Certain Low-Rate Loans The Boards proposed regulation included an extremely problematic revision that would have prohibitedduring the first five years of the loanthe refinancing of a zero interest or low-cost loan into a higher rate loan unless the refinancing was in the interest of the borrower. As proposed, the provision would have covered all low-cost loans, not just those refinanced into HOEPA loans. For purposes of the proposed amendment, a low-cost loan was defined as a fixed rate loan that carries a rate that is two percentage points or more below the yield on Treasury securities with comparable maturity, or an ARM loan where the current rate is at least two percentage points below the index or formula used by the creditor for making rate adjustments. Based in large part on the comments received, the Board staff recommended that the Board not adopt the proposed prohibition. As noted in our Jan. 11 Alert, if adopted, the prohibition would have been extraordinarily burdensome for creditors refinancing ARM loans. IN order to determine if the transaction qualified as a low-cost loan, a lender would have been forced to obtain a copy of the old note from the borrower, compute the fully-indexed rate, and compare it to the current rate before it could determine whether it could refinance the loan. The preamble to the final rule acknowledges that the compliance burden associated with the proposed prohibition far outweighed any potential benefits, and, thus, was not incorporated into the final rule. 3. Prohibition of Due on Demand and Call Provisions The final rule adopts the Boards proposal that payable on demand or call provisions be prohibited in HOEPA loans unless the clauses are exercised in connection with default, impairment of security of fraud by the borrower. For example, a lender may not terminate and accelerate a loan in the event a consumer erroneously sends payment to the wrong location. Unlike the prohibition on balloon payments that currently exists under HOEPA, the restriction on due demand or call provisions is not limited to the first five years of the loan. These provisions are virtually identical to those presently in effect for open-end home equity lines of credit. 4. Prevention of Evasion of HOEPAs Provisions The Board hopes to limit evasion of HOEPAs provisions by prohibiting lenders from improperly classifying transactions as open-end when there is no reasonable expectation of repeated draws. Thus, any loan documented as open-end credit, but where the terms of such loan demonstrate that it does not meet the definition for open-end credit, is subject to the rules relating to closed-end credit, including the HOEPA rules where the loan triggers the APR or points and fees threshold. In may ways, this is merely a more specific application of the spurious open-end credit analysis that has already been an issue under TILA; a loan is only open-end credit if a creditor reasonably expects repeated transactions under the plan. C. Enhancement of Disclosures The final regulation adds to the list of required early disclosures under Regulation Z the disclosure of the total amount borrowed. The total amount borrowed essentially is the amount reflected on the face of the note. A disclosure made under this provision is accurate, provided it contains an amount that varies no more than $100 from the actual amount borrowed. The Board believes that, by receiving this disclosure, borrowers will be alerted well in advance of loan closing that the actual amount of the loan may be substantially higher than the amount requested once points, fees and insurance have been financed into the loan. The final rule also requires that lenders expressly indicate whether the total amount includes any optional single premium credit insurance purchased by the borrowera requirement that the Board hopes will deter creditors from packing insurance premiums into the cost of the loan without the knowledge of the borrower. The final rule further clarifies that Section 226.32(c) requires creditors to disclose the amount of a balloon payment. Generally, Section 226.32 requires creditors to disclose the amount of a regular monthly or other periodic payment, including any balloon payment. The final rule merely moves language to such effect from the Commentary to the text of the regulation. As such, the following model disclosure language was added to Appendix H-16: At the end of your loan, you will still owe us $[balloon amount]. D. Ability to Repay Section 129(h) of TILA prohibits creditors from engaging in asset-based lending through a pattern of practice of extending HOEPA loans to consumers on the sole basis of the equity in the consumers homes rather than on the consumers ability to repay their loans. The Board adopted the amendments to the regulation as proposed, which essentially required lenders to document and verify their consideration of the borrowers ability to repay HOEPA loans. Failure to keep this necessary documentation creates a rebuttable presumption that lenders are originating loans without regard to the applicants ability to repay the loan. The final rule also adopts certain language in the Commentary that requires lenders originating ARM loans subject to HOEPA to underwrite such loans based on the fully-indexed rate (as opposed to the introductory rate or the rate at the first adjustment). Such language requires lenders to take into account the maximum possible payment increases in the shortest possible time when underwriting loans. Arguably, this requirement could significantly restrict certain borrowers ability to qualify for a loan. III. Conclusion Even though the Board rejected demands from consumer groups to dramatically revise HOEPA coverage tests, an increased proportion of mortgage loans will now fall within the scope of the law. The Boards intention certainly is to provide a benefit to consumers by increasing the number of loans that will be accompanied by HOEPAs required disclosures and increased protection. Unfortunately, the regulation also may have the unintended effect of harming the very consumers that the Board hopes will benefit by leaving them with fewer financing options. Footnotes 1. 1 12 C.F.R. § 226.32. 2. This figure, originally $400, is adjusted annually based on the Consumer Price Index and is $480 for 2002. 3. 15 U.S.C. § 1602. 4. While the Board used the phrase true creditor in discussing this change, we have been advised by the Boards staff that it did not intend to alter the rule that the creditor is the entity to which a loan is initially payable. The creditor, not an assignee, has disclosure responsibilities. This article was reprinted with the permission of Kirkpatrick & Lockhart LLP. For more information, call (202) 778-9000, fax (202) 778-9100 or visit www.kl.com.