On August 26th the Federal Reserve Board (the "FRB"), in an exhibition of regulatory bravado rarely displayed by federal agencies, exercised its rulemaking authority under the Truth-in-Lending Act ("TILA") and its implementing Regulation Z and published in the Federal Register proposed comprehensive changes to mortgage origination practices and disclosures for consumer purpose closed-end mortgage loans (the "Proposal"). The Proposal expands on regulatory initiatives the FRB has undertaken over the past two years, in part to respond to criticisms that it had failed to properly exercise its authority under TILA to regulate the nation's mortgage lending practices—which critics have pointed to as one of the probable causes of the subprime mortgage crisis and the global recession.
Even though the FRB stated that the Proposal was issued merely as a result of its regular and on-going review of consumer regulations for which it has jurisdiction, nevertheless the Proposal may constitute the most complete—and startling—revision of Regulation Z since its inception. Moreover, embedded in the Proposal are numerous stand-alone modifications to Regulation Z that may impact the operations of many categories of lenders other than mortgage lenders and servicers.
This Alert will focus on the FRB's proposed changes to closed-end mortgage lending, including numerous proposed modifications that, if adopted, will radically alter the mortgage origination and servicing industries in the United States. (A subsequent Alert will summarize related modifications that the FRB has proposed for open-end lines of credit secured by a borrower's home or "HELOCs.")
Summary and Overview
The proposed closed-end mortgage modifications would expand TILA coverage, including disclosure obligations, to all closed-end consumer credit transactions secured by real property or a dwelling, and for discussion purposes might be grouped into five general categories: (a) disclosures required at application; (b) disclosures required within three days of application; (c) disclosures within three days prior to loan closing; (d) payment disclosures after loan closing required to be made by loan servicers; and (e) substantive limitations on lending, including compensation for mortgage loans that may be made to brokers and employees.
In regard to application disclosures, the Proposal includes the following components:
- The creation of two new, one-page disclosures that address concerns regarding mortgage loans in general and variable rate loans in particular;
- The elimination of the so-called "CHARM" brochure because of the alleged inability of borrowers to understand the brochure's variable rate lending explanations; and
- Extensive modifications to the ARM program disclosure.
In regard to the early TILA disclosures required within three days of the receipt of an application:
- The virtual elimination of the current permitted exclusions of mortgage fees and charges from the definition of the finance charge—with an accompanying increase in the stated amount of the APR;
- A complete and wholesale revision to the closed-end TILA disclosure scheme for mortgage loans, including new charts, graphs and transactional-specific disclosure requirements;
- Inclusion in the TILA disclosure of closing amounts as specified in RESPA's Good Faith Estimate of Closing Costs; and
- The imposition of formatting and type-sizing requirements of all required disclosures—including the elimination of a significant degree of lender discretion.
In regard to a final TILA disclosure that will now be required to be delivered within no later than three days prior to loan closing—whether or not any changes were made to a loan after the early TILA disclosures were delivered—two alternatives are proposed for yet another set of required disclosures to be delivered that would delay loan closing:
- If any loan terms or conditions change, the lender would be required to provide a new final TILA disclosure; or
- If the APR previously disclosed falls outside of the stated tolerance, the lender would have to provide a new final TILA disclosure, but would be permitted to disclose other changes to the loan at loan closing.
In regard to disclosures required after loan closing, significant and complicated additional loan payment disclosures would be required to be sent to borrowers by loan servicers:
- For ARM loans, the current advance notice of payment changes would have to be delivered to a borrower 60 days prior to the date the new payment is due (as compared to the current rule that imposes a 25 day notice period); and
- For non-traditional mortgage products, detailed payment information regarding payment options, including the effect those choices would have on negative amortization.
In regard to substantive limitations on compensation for mortgage loan origination, the Proposal responds to the demands of consumer advocates that the payment of yield-spread premiums ("YSPs") be banned, as follows:
- Payments to mortgage brokers and employees based upon the rate of interest of the loan—most notably, YSPs—would be prohibited;
- All other payments made to brokers and employees calculated by the terms and conditions of a loan would be prohibited as well; and
- "Steering" by a broker of a borrower to an inappropriate loan would be prohibited.
The following discussion highlights particular issues that merit attention.
A Radically Altered Use of Regulatory Authority
The foregoing changes being proposed by the FRB create three general categories for consumer lending under Regulation Z (whereas formerly there were two): open-end consumer loans, non-mortgage closed-end lending and closed-end mortgage lending. In effect, the Proposal abandons forty years of established and effective consumer disclosures and procedures and would impose an entirely new paradigm of disclosures, timing and transactional-specific disclosure requirements for closed-end mortgage loans secured by real property or a dwelling.
Naturally, the question arises regarding how the FRB could elect to adopt such a radical course of action— particularly when by so doing the FRB has chosen to impose regulatory requirements that appear to directly contradict specific statutory TILA provisions.
The answer lies in the FRB's interpretative approach to its TILA authority, which emanates from Sections 105 (a) and 129(l)(2) of TILA. Those provisions—at least according to the FRB—provide it with the ability to act as the sole and final arbiter of disclosure regimens and to impose substantive obligations on the mortgage industry where none had existed before (and whether or not Congress had already addressed the policy issue by the adoption of specific statutory language in TILA).
While the use of this authority by the FRB ultimately may be challenged under the Chevron doctrine—which recently was criticized by the Supreme Court—a more cynical view is that the Proposal constitutes an attempt by the FRB to retain its rulemaking authority in light of the threat it faces should the Consumer Financial Protection Agency be created by Congress.
Forms and Disclosure Changes
While the exercise of the FRB's authority over mortgage lending practices is a recent development, Regulation Z's closed-end disclosure scheme has been substantively revised only once since TILA was first adopted. That regulatory initiative—dubbed Truth-in-Lending Simplification—resulted in the creation of the socalled "federal box" and segregated disclosures that have proven to be readily adaptable as consumer lending has evolved over the decades.
Nevertheless, in just about every instance in which TILA disclosures would have to be provided, the Proposal would require that new, transaction-specific disclosures be created and provided to loan applicants for mortgage loans. Commencing with the computation of the APR and the finance charge, the Proposal dispenses with the former disclosure schemes, and in their place would impose a completely new set of closed-end disclosures, including accompanying timing rules.
The impact of these proposed changes might only be appreciated by determining whether existing loan origination systems would be capable of creating the complex system of mortgage forms and delivering them to the loan applicant. Similarly, loan servicers accustomed to preparing standard fixed rate and variable rate payment disclosures will be confronted with the need to completely modify their loan servicing systems, including the possible applicability of the proposed requirements on existing loans currently being serviced.
At the minimum, industry participants that have begun to consider the operational modifications that would be necessary to comply with the changes contained in the Proposal have expressed concerns that the proposed changes will require significant systems modification—if not complete systems replacement. Particularly in those instances in which legacy systems would need to be modified, preliminary estimates are that an extensive time period will be required to achieve a reasonable degree of compliance with the proposed modifications.
Substantive Loan Origination Requirements
In what might appear to be a strategy to force the mortgage industry to focus its criticism on compensation rather than on the broad scope of disclosure reforms, the FRB has proposed to prohibit YSPs and practically all other forms of compensation payable to third party brokers and a lender's own employees (termed "originators") when based upon the terms and conditions of a mortgage loan. Should this modification be adopted, the continued use by the mortgage industry of broker networks may be jeopardized.
The implications of the compensation limitations proposed by the FRB are daunting. First, it would appear that while a lender would still be able to pay a broker for a mortgage loan, a lender would be prohibited from paying a broker a YSP, and splitting compensation between a borrower and a lender as part of the same transaction would also be prohibited. Second, secondary market purchasers of loans would be prohibited from paying brokers for loans originated by a creditor when based upon the terms or conditions of the loan (i. e., indirect payments would be prohibited). Third, the Proposal would require that a lender maintain records of its payments to brokers for a 25-month period following loan origination.
Finally, of course, these compensation limitations may radically alter the fundamental structure by which consumer mortgage loans are originated. Rather than relying upon a network of mortgage brokers—which offloads personnel costs relating to loan solicitation functions—mortgage lenders may be forced to develop alternative solicitation systems to identify loan applications.
A Potential Section 8 RESPA Concern
In addition to the disruption that may be caused by eliminating YSPs and similar compensation approaches, the broker compensation proposal potentially exposes both lenders and brokers to RESPA Section 8 liability. Specifically, for the first time, broker compensation for loans will be capable of being monitored and disclosed in a manner that would permit plaintiffs to determine whether the amount of broker compensation being paid by a lender is uniform for identical products and services being provided by the broker.
The effect of this change is that it might be possible to allege Section 8 violations of RESPA should a broker be unable to reasonably demonstrate differences between compensation received for the value of the settlement services provided for mortgage loans that on their face appear identical. Because Section 8 liability is equally applicable to both lenders (who might pay the compensation) and brokers (who would receive the compensation), careful consideration would have to be given to ensure that a lender's payments to a loan broker would not run afoul of Section 8's limitations.
Observations and Conclusions
The scope and breath of the Proposal by the FRB for closed-end mortgage lending is so extensive that it is impossible to summarize in this Alert all of the major modifications to Regulation Z that will affect the mortgage origination and servicing industries. At the minimum it is strongly suggested that industry participants review the Proposal and commence an analysis of the impact on their mission-critical functions that would be affected.
We offer the following observations:
First, although the FRB also points out that many of its proposed disclosure changes are supported by consumer research conducted as part of its regulatory review—the veracity of that consumer research remains to be independently verified, particularly in regard to the underlying premise that the radical changes contained in the Proposal will actually result in greater consumer awareness and the ability to compare loan products. Further, it is altogether unclear whether the modifications contained in the Proposal would have in any way affected the conduct in the mortgage market that led to the subprime mortgage crisis.
Second, an objective reading of the Proposal evidences a decided hostility to variable rate lending—as evidenced by the numerous and complicated disclosures that would be required to be provided by a lender should a variable rate loan product be offered. The increased complexity of the disclosures that would be required for variable rate loans is so extreme that one must wonder whether the FRB is engaging in a form of social or economic regulatory engineering by effectively eliminating variable rate lending as a loan product on a go-forward basis.
Third, while no one has ever claimed that Regulation Z is an inviting regulatory document to read and enjoy, it is suggested that the Proposal as currently drafted may be incomprehensible for new entrants into the world of consumer compliance who attempt to understand its complexities and requirements. When one factors into consideration that the FRB has likely increased TILA liability because of the statutory authorities it has employed—such as its authority to deem certain lending practices to be unfair and deceptive—the prospects for technical violations and litigation may be substantially increased.
Finally, whether or not the Proposal is an attempt by the FRB to retain jurisdiction over TILA and Regulation Z, industry participants cannot assume that numerous elements of the Proposal will not eventually be adopted —either by the FRB or by the Consumer Financial Protection Agency. We therefore strongly urge that comments be drafted and directed to the FRB regarding elements of the Proposal that are unworkable either from an operational or economic viewpoint.