Lenders and servicers electing to participate in the Administration's Making Home Affordable loan modification program (the "Modification Program") should be aware of an operational and legal risk raised by the consumer staff of the Federal Reserve Board (the "FRB"). Specifically, the consumer staff has taken the position that, pursuant to the Equal Credit Opportunity Act (the "ECOA"), a denial of a residential borrower's request to have his/her loan modified—when the loan is not yet in default—requires that the lender or servicer provide an adverse action notice. Not only does this interpretative position impose processing difficulties, it creates the potential for unanticipated litigation for lenders or servicers who fail to comply.
A short history is in order. The ECOA and the FRB's implementing Regulation B at Section 202.9 requires that a lender provide an adverse action notice to a loan applicant upon the denial of an application for an extension of credit. Based on the definition of "extension of credit" found in Section 202.2(q) of Regulation B, the prevailing view by many practitioners has historically been that an adverse action notice is not required if the modification of a loan does not either replace the original obligation (i.e, a modification that does not constitute a refinance) or increase the amount of credit extended. (In instances in which a default on a loan occurs, Section 202.2(c)(2)(ii) of Regulation B specifically exempts loan modifications or workouts from being deemed adverse action—which means that the denial of a loan modification request, following a missed payment or other default, does not require providing the borrower an adverse action notice.)
Utilizing a holistic view of the intended scope of the ECOA as the justification of their legal position, the FRB staff has determined that the denial of a requested loan modification pursuant to the Modification Program by a consumer who is experiencing financial difficulties—but who is not yet in default—requires that the lender or servicer provide an adverse action notice. While we disagree with this interpretative posture by the FRB staff, the fact that the staff is taking this position creates legal and operational risks to lenders and loan servicers, several of which are as follows:
- Application Processing. From a compliance perspective, the inescapable conclusion one must take from the FRB staff's informal guidance is that lenders and servicers must treat the receipt of a request for a loan modification under the Modification Program as an application for credit under Regulation B. Among other things, this means that time frames for processing a modification request fall under the timing rules of Section 202.9(a) of Regulation B, and the adverse action notice must contain an adequate explanation for the denial pursuant to Section 202.9(b).
More importantly, from a processing viewpoint, loan servicers are frequently unfamiliar with adverse action requirements (due in no small measure to the exemption available for loans in default, discussed above). At the minimum, lenders and their servicers should ensure that they treat the receipt of a request for a loan modification as an application for credit, and provide a properly completed and timely adverse action notice in the event of a denial.
Finally, because the Modification Program includes a screening tool to determine whether a borrower falls within coverage, a determination must be made whether a lender or servicer should require that a more detailed application be submitted in order to deem an application to be complete.
- Record Retention. Similarly, because the FRB staff deems a denial of a request for a loan modification to constitute adverse action, the recordkeeping requirements of Section 202.12(b) of Regulation B arguably apply. Accordingly, lenders must retain application materials relating to a denial for 25 months.
- Legal Risk Avoidance and Policy Implications. Although the FRB staff position is "informal," it appears to have been widely circulated among federal agencies and provided to lenders and servicers who have made inquiry.
We are concerned that this legal position could cause lenders and servicers to avoid the potential liability and processing difficulties by refusing to offer loan modifications for home borrowers who have not yet defaulted. Stated another way, lenders and servicers might opt to participate in the Treasury's Modification Program only after a payment or other loan default has occurred. (Further, while the consumer staff of the FRB have indicated that their legal conclusion focuses on the Administration's Modification Program, the same logic arguably would apply to the ordinary instance in which a loan modification is requested—which is a significant expansion of the coverage of the adverse action rules of Regulation B.)
Considering both the oversight currently in place at the federal level for the Modification Program—as well as the stated policy by the Administration to facilitate loan modifications for consumers experiencing economic distress—we believe that the FRB staff's interpretative position may impede the effectiveness of an important component of the Modification Program. While we are continuing to discuss this issue with the FRB staff, we are providing this information because of the legal uncertainty that has been created. (Our view is that the FRB staff's interpretative position is such a departure from the status quo ante as to warrant public debate through a proposed amendment to the Regulation B Commentary.)
Lenders and servicers should view this issue as reflective of other formal and informal procedural matters that might be imposed as programmatic or regulatory requirements of the Modification Program. For example, we understand that certain servicers may be required to collect monitoring information; similar concerns have also arisen regarding the scope of coverage of HMDA and the FCRA.
Accordingly, we recommend that regulatory compliance requirements in regard to the Modification Program be closely monitored.