[Federal Register: July 30, 2008 (Volume 73, Number 147)]
[Rules and Regulations]
[Page 44521-44614]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr30jy08-24]
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Part III
Federal Reserve System
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12 CFR Part 226
Truth in Lending; Final Rule
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FEDERAL RESERVE SYSTEM
12 CFR Part 226
[Regulation Z; Docket No. R-1305]
Truth in Lending
AGENCY: Board of Governors of the Federal Reserve System.
ACTION: Final rule; official staff commentary.
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SUMMARY: The Board is publishing final rules amending Regulation Z,
which implements the Truth in Lending Act and Home Ownership and Equity
Protection Act. The goals of the amendments are to protect consumers in
the mortgage market from unfair, abusive, or deceptive lending and
servicing practices while preserving responsible lending and
sustainable homeownership; ensure that advertisements for mortgage
loans provide accurate and balanced information and do not contain
misleading or deceptive representations; and provide consumers
transaction-specific disclosures early enough to use while shopping for
a mortgage. The final rule applies four protections to a newly-defined
category of higher-priced mortgage loans secured by a consumer's
principal dwelling, including a prohibition on lending based on the
collateral without regard to consumers' ability to repay their
obligations from income, or from other sources besides the collateral.
The revisions apply two new protections to mortgage loans secured by a
consumer's principal dwelling regardless of loan price, including a
prohibition on abusive servicing practices. The Board is also
finalizing rules requiring that advertisements provide accurate and
balanced information, in a clear and conspicuous manner, about rates,
monthly payments, and other loan features. The advertising rules ban
several deceptive or misleading advertising practices, including
representations that a rate or payment is ``fixed'' when it can change.
Finally, the revisions require creditors to provide consumers with
transaction-specific mortgage loan disclosures within three business
days after application and before they pay any fee except a reasonable
fee for reviewing credit history.
DATES: This final rule is effective on October 1, 2009, except for
Sec. 226.35(b)(3)) which is effective on April 1, 2010. See part XIII,
below, regarding mandatory compliance with Sec. 226.35(b)(3) on
mortgages secured by manufactured housing.
FOR FURTHER INFORMATION CONTACT: Kathleen C. Ryan or Dan S. Sokolov,
Counsels; Paul Mondor, Senior Attorney; Jamie Z. Goodson, Brent Lattin,
Jelena McWilliams, Dana E. Miller, or Nikita M. Pastor, Attorneys;
Division of Consumer and Community Affairs, Board of Governors of the
Federal Reserve System, Washington, DC 20551, at (202) 452-2412 or
(202) 452-3667. For users of Telecommunications Device for the Deaf
(TDD) only, contact (202) 263-4869.
SUPPLEMENTARY INFORMATION:
I. Summary of Final Rules
A. Rules To Prevent Unfairness, Deception, and Abuse
B. Revisions To Improve Mortgage Advertising
C. Requirement To Give Consumers Disclosures Early
II. Consumer Protection Concerns in the Subprime Market
A. Recent Problems in the Mortgage Market
B. Market Imperfections That Can Facilitate Abusive and
Unaffordable Loans
III. The Board's HOEPA Hearings
A. Home Ownership and Equity Protection Act (HOEPA)
B. Summary of 2006 Hearings
C. Summary of June 2007 Hearing
D. Congressional Hearings
IV. Interagency Supervisory Guidance
V. Legal Authority
A. The Board's Authority Under TILA Section 129(l)(2)
B. The Board's Authority Under TILA Section 105(a)
VI. The Board's Proposal
A. Proposals To Prevent Unfairness, Deception, and Abuse
B. Proposals To Improve Mortgage Advertising
C. Proposal To Give Consumers Disclosures Early
VII. Overview of Comments Received
VIII. Definition of ``Higher-Priced Mortgage Loan''--Sec. 226.35(a)
A. Overview
B. Public Comment on the Proposal
C. General Approach
D. Index for Higher-Priced Mortgage Loans
E. Threshold for Higher-Priced Mortgage Loans
F. The Timing of Setting the Threshold
G. Proposal To Conform Regulation C (HMDA)
H. Types of Loans Covered Under Sec. 226.35
IX. Final Rules for Higher-Priced Mortgage Loans and HOEPA Loans
A. Overview
B. Disregard of Consumer's Ability To Repay--Sec. Sec.
226.34(a)(4) and 226.35(b)(1)
C. Prepayment Penalties--Sec. 226.32(d)(6) and (7); Sec.
226.35(b)(2)
D. Escrows for Taxes and Insurance--Sec. 226.35(b)(3)
E. Evasion Through Spurious Open-End Credit--Sec. 226.35(b)(4)
X. Final Rules for Mortgage Loans--Sec. 226.36
A. Creditor Payments to Mortgage Brokers--Sec. 226.36(a)
B. Coercion of Appraisers--Sec. 226.36(b)
C. Servicing Abuses--Sec. 226.36(c)
D. Coverage--Sec. 226.36(d)
XI. Advertising
A. Advertising Rules for Open-End Home-Equity Plans--Sec.
226.16
B. Advertising Rules for Closed-End Credit)--Sec. 226.24
XII. Mortgage Loan Disclosures
A. Early Mortgage Loan Disclosures--Sec. 226.19
B. Plans To Improve Disclosure
XIII. Mandatory Compliance Dates
XIV. Paperwork Reduction Act
XV. Regulatory Flexibility Analysis
I. Summary of Final Rules
On January 9, 2008, the Board published proposed rules that would
amend Regulation Z, which implements the Truth in Lending Act (TILA)
and the Home Ownership and Equity Protection Act (HOEPA). 73 FR 1672.
The Board is publishing final amendments to Regulation Z to establish
new regulatory protections for consumers in the residential mortgage
market. The goals of the amendments are to protect consumers in the
mortgage market from unfair, abusive, or deceptive lending and
servicing practices while preserving responsible lending and
sustainable homeownership; ensure that advertisements for mortgage
loans provide accurate and balanced information and do not contain
misleading or deceptive representations; and provide consumers
transaction-specific disclosures early enough to use while shopping for
mortgage loans.
A. Rules To Prevent Unfairness, Deception, and Abuse
The Board is publishing seven new restrictions or requirements for
mortgage lending and servicing intended to protect consumers against
unfairness, deception, and abuse while preserving responsible lending
and sustainable homeownership. The restrictions are adopted under TILA
Section 129(l)(2), which authorizes the Board to prohibit unfair or
deceptive practices in connection with mortgage loans, as well as to
prohibit abusive practices or practices not in the interest of the
borrower in connection with refinancings. 15 U.S.C. 1639(l)(2). Some of
the restrictions apply only to higher-priced mortgage loans, while
others apply to all mortgage loans secured by a consumer's principal
dwelling.
Protections Covering Higher-Priced Mortgage Loans
The Board is finalizing four protections for consumers receiving
higher-priced mortgage loans. These loans are defined as consumer-
purpose, closed-end loans secured by a consumer's principal dwelling
and
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having an annual percentage rate (APR) that exceeds the average prime
offer rates for a comparable transaction published by the Board by at
least 1.5 percentage points for first-lien loans, or 3.5 percentage
points for subordinate-lien loans. For higher-priced mortgage loans,
the final rules:
[cir] Prohibit creditors from extending credit without regard to a
consumer's ability to repay from sources other than the collateral
itself;
[cir] Require creditors to verify income and assets they rely upon
to determine repayment ability;
[cir] Prohibit prepayment penalties except under certain
conditions; and
[cir] Require creditors to establish escrow accounts for taxes and
insurance, but permit creditors to allow borrowers to cancel escrows 12
months after loan consummation.
In addition, the final rules prohibit creditors from structuring
closed-end mortgage loans as open-end lines of credit for the purpose
of evading these rules, which do not apply to open-end lines of credit.
Protections Covering Closed-End Loans Secured by Consumer's Principal
Dwelling
In addition, in connection with all consumer-purpose, closed-end
loans secured by a consumer's principal dwelling, the Board's rules:
[cir] Prohibit any creditor or mortgage broker from coercing,
influencing, or otherwise encouraging an appraiser to provide a
misstated appraisal in connection with a mortgage loan; and
[cir] Prohibit mortgage servicers from ``pyramiding'' late fees,
failing to credit payments as of the date of receipt, or failing to
provide loan payoff statements upon request within a reasonable time.
The Board is withdrawing its proposal to require servicers to deliver a
fee schedule to consumers upon request; and its proposal to prohibit
creditors from paying a mortgage broker more than the consumer had
agreed in advance that the broker would receive. The reasons for the
withdrawal of these two proposals are discussed in parts X.A and X.C
below.
Prospective Application of Final Rule
The final rule is effective on October 1, 2009, or later for the
requirement to establish an escrow account for taxes and insurance for
higher-priced mortgage loans. Compliance with the rules is not required
before the effective dates. Accordingly, nothing in this rule should be
construed or interpreted to be a determination that acts or practices
restricted or prohibited under this rule are, or are not, unfair or
deceptive before the effective date of this rule.
Unfair acts or practices can be addressed through case-by-case
enforcement actions against specific institutions, through regulations
applying to all institutions, or both. A regulation is prospective and
applies to the market as a whole, drawing bright lines that distinguish
broad categories of conduct. By contrast, an enforcement action
concerns a specific institution's conduct and is based on all of the
facts and circumstances surrounding that conduct.\1\
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\1\ See Board and FDIC, CA 04-2, Unfair Acts or Practices by
State-Chartered Banks (March 11, 2004), available at http://
www.federalreserve.gov/boarddocs/press/bcreg/2004/20040311/
attachment.pdf.
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Because broad regulations, such as the rules adopted here, can
require large numbers of institutions to make major adjustments to
their practices, there could be more harm to consumers than benefit if
the rules were effective immediately. If institutions were not provided
a reasonable time to make changes to their operations and systems to
comply with this rule, they would either incur excessively large
expenses, which would be passed on to consumers, or cease engaging in
the regulated activity altogether, to the detriment of consumers. And
because the Board finds an act or practice unfair only when the harm
outweighs the benefits to consumers or to competition, the
implementation period preceding the effective date set forth in the
final rule is integral to the Board's decision to restrict or prohibit
certain acts or practices.
For these reasons, acts or practices occurring before the effective
dates of these rules will be judged on the totality of the
circumstances under other applicable laws or regulations. Similarly,
acts or practices occurring after the rule's effective dates that are
not governed by these rules will continue to be judged on the totality
of the circumstances under other applicable laws or regulations.
B. Revisions To Improve Mortgage Advertising
Another goal of the final rules is to ensure that mortgage loan
advertisements provide accurate and balanced information and do not
contain misleading or deceptive representations. Thus the Board's rules
require that advertisements for both open-end and closed-end mortgage
loans provide accurate and balanced information, in a clear and
conspicuous manner, about rates, monthly payments, and other loan
features. These rules are adopted under the Board's authorities to:
adopt regulations to ensure consumers are informed about and can shop
for credit; require that information, including the information
required for advertisements for closed-end credit, be disclosed in a
clear and conspicuous manner; and regulate advertisements of open-end
home-equity plans secured by the consumer's principal dwelling. See
TILA Section 105(a), 15 U.S.C. 1604(a); TILA Section 122, 15 U.S.C.
1632; TILA Section 144, 15 U.S.C. 1664; TILA Section 147, 15 U.S.C.
1665b.
The Board is also adopting, under TILA Section 129(l)(2), 15 U.S.C.
1639(l)(2), rules to prohibit the following seven deceptive or
misleading practices in advertisements for closed-end mortgage loans:
[cir] Advertisements that state ``fixed'' rates or payments for
loans whose rates or payments can vary without adequately disclosing
that the interest rate or payment amounts are ``fixed'' only for a
limited period of time, rather than for the full term of the loan;
[cir] Advertisements that compare an actual or hypothetical rate or
payment obligation to the rates or payments that would apply if the
consumer obtains the advertised product unless the advertisement states
the rates or payments that will apply over the full term of the loan;
[cir] Advertisements that characterize the products offered as
``government loan programs,'' ``government-supported loans,'' or
otherwise endorsed or sponsored by a federal or state government entity
even though the advertised products are not government-supported or -
sponsored loans;
[cir] Advertisements, such as solicitation letters, that display
the name of the consumer's current mortgage lender, unless the
advertisement also prominently discloses that the advertisement is from
a mortgage lender not affiliated with the consumer's current lender;
[cir] Advertisements that make claims of debt elimination if the
product advertised would merely replace one debt obligation with
another;
[cir] Advertisements that create a false impression that the
mortgage broker or lender is a ``counselor'' for the consumer; and
[cir] Foreign-language advertisements in which certain information,
such as a low introductory ``teaser'' rate, is provided in a foreign
language, while required disclosures are provided only in English.
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C. Requirement To Give Consumers Disclosures Early
A third goal of these rules is to provide consumers transaction-
specific disclosures early enough to use while shopping for a mortgage
loan. The final rule requires creditors to provide transaction-specific
mortgage loan disclosures such as the APR and payment schedule for all
home-secured, closed-end loans no later than three business days after
application, and before the consumer pays any fee except a reasonable
fee for the review of the consumer's credit history.
The Board recognizes that these disclosures need to be updated to
reflect the increased complexity of mortgage products. In early 2008,
the Board began testing current TILA mortgage disclosures and potential
revisions to these disclosures through one-on-one interviews with
consumers. The Board expects that this testing will identify potential
improvements for the Board to propose for public comment in a separate
rulemaking.
II. Consumer Protection Concerns in the Subprime Market
A. Recent Problems in the Mortgage Market
Subprime mortgage loans are made to borrowers who are perceived to
have high credit risk. These loans' share of total consumer
originations, according to one estimate, reached about nine percent in
2001 and doubled to 20 percent by 2005, where it stayed in 2006.\2\ The
resulting increase in the supply of mortgage credit likely contributed
to the rise in the homeownership rate from 64 percent in 1994 to a high
of 69 percent in 2005--though about 68 percent now--and expanded
consumers' access to the equity in their homes.
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\2\ Inside Mortgage Finance Publications, Inc., The 2007
Mortgage Market Statistical Annual vol. I (IMF 2007 Mortgage
Market), at 4.
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Recently, however, some of these benefits have eroded. In the last
two years, delinquencies and foreclosure starts among subprime
mortgages have increased dramatically and reached exceptionally high
levels as house price growth has slowed or prices have declined in some
areas. The proportion of all subprime mortgages past-due ninety days or
more (``serious delinquency'') was about 18 percent in May 2008, more
than triple the mid-2005 level.\3\ Adjustable-rate subprime mortgages
have performed the worst, reaching a serious delinquency rate of 27
percent in May 2008, five times the mid-2005 level. These mortgages
have seen unusually high levels of early payment default, or default
after only one or two payments or even no payment at all.
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\3\ Delinquency rates calculated from data from First American
LoanPerformance.
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The serious delinquency rate has also risen for loans in alt-A
(near prime) securitized pools. According to one source, originations
of these loans were 13 percent of consumer mortgage originations in
2006.\4\ Alt-A loans are made to borrowers who typically have higher
credit scores than subprime borrowers, but the loans pose more risk
than prime loans because they involve small down payments or reduced
income documentation, or the terms of the loan are nontraditional and
may increase risk. The rate of serious delinquency for these loans has
risen to over 8 percent (as of April 2008) from less than 2 percent
only a year earlier. In contrast, 1.5 percent of loans in the prime-
mortgage sector were seriously delinquent as of April 2008.
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\4\ IMF 2007 Mortgage Market at 4.
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The consequences of default are severe for homeowners, who face the
possibility of foreclosure, the loss of accumulated home equity, higher
rates for other credit transactions, and reduced access to credit. When
foreclosures are clustered, they can injure entire communities by
reducing property values in surrounding areas. Higher delinquencies are
in fact showing through to foreclosures. Lenders initiated over 550,000
foreclosures in the first quarter of 2008, about half of them on
subprime mortgages. This was significantly higher than the quarterly
average of 325,000 in the first half of the year, and nearly twice the
quarterly average of 225,000 for the past six years.\5\
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\5\ Estimates are based on data from Mortgage Bankers'
Association's National Delinquency Survey (2007) (MBA Nat'l
Delinquency Survey).
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Rising delinquencies have been caused largely by a combination of a
decline in house price appreciation--and in some areas slower economic
growth--and a loosening of underwriting standards, particularly in the
subprime sector. The loosening of underwriting standards is discussed
in more detail in part II.B. The next section discusses underlying
market imperfections that facilitated this loosening and made it
difficult for consumers to avoid injury.
B. Market Imperfections That Can Facilitate Abusive and Unaffordable
Loans
The recent sharp increase in serious delinquencies has highlighted
the roles that structural elements of the subprime mortgage market may
play in increasing the likelihood of injury to consumers who find
themselves in that market. Limitations on price and product
transparency in the subprime market--often compounded by misleading or
inaccurate advertising--may make it harder for consumers to protect
themselves from abusive or unaffordable loans, even with the best
disclosures. The injuries consumers in the subprime market may suffer
as a result are magnified when originators' incentives to carefully
assess consumers' repayment ability grow weaker, as can happen when
originators sell their loans to be securitized.\6\ The fragmentation of
the originator market can further exacerbate the problem by making it
more difficult for investors to monitor originators and for regulators
to protect consumers.
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\6\ Benjamin J. Keys, Tanmoy K. Mukherjee, Amit Seru and Vikram
Vig, Did Securitization Lead to Lax Screening? Evidence from Suprime
Loans at 22, available at: http://ssrn.com/abstract=1093137.
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Limited Transparency and Limits of Disclosure
Limited transparency in the subprime market increases the risk that
borrowers in that market will receive unaffordable or abusive loans.
The transparency of the subprime market to consumers is limited in
several respects. First, price information for the subprime market is
not widely and readily available to consumers. A consumer reading a
newspaper, telephoning brokers or lenders, or searching the Internet
can easily obtain current prime interest rate quotes for free. In
contrast, subprime rates, which can vary significantly based on the
individual borrower's risk profile, are not broadly advertised and are
usually obtainable only after application and paying a fee. Subprime
rate quotes may not even be reliable if the originator engages in a
``bait and switch'' strategy. Price opacity is exacerbated because the
subprime consumer often does not know her own credit score. Even if she
knows her score, the prevailing interest rate for someone with that
score and other credit risk characteristics is not generally publicly
available.
Second, products in the subprime market tend to be complex, both
relative to the prime market and in absolute terms, as well as less
standardized than in the prime market.\7\ As discussed
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earlier, subprime originations have much more often been ARMs than
fixed rate mortgages. ARMs require consumers to make judgments about
the future direction of interest rates and translate expected rate
changes into changes in their payment amounts. Subprime loans are also
far more likely to have prepayment penalties. Because the annual
percentage rate (APR) does not reflect the price of the penalty, the
consumer must both calculate the size of the penalty from a formula and
assess the likelihood of moving or refinancing during the penalty
period. In these and other ways, subprime products tend to be complex
for consumers.
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\7\ U.S. Dep't of Housing & Urban Development and U.S. Dep't of
Treasury, Recommendations to Curb Predatory Home Mortgage Lending 17
(2000) (``While predatory lending can occur in the prime market,
such practices are for the most part effectively deterred by
competition among lenders, greater homogeneity in loan terms and the
prime borrowers' greater familiarity with complex financial
transactions.''); Howard Lax, Michael Manti, Paul Raca and Peter
Zorn, Subprime Lending: An Investigation of Economic Efficiency, 15
Housing Policy Debate 533, 570 (2004) (Subprime Lending
Investigation) (stating that the subprime market lacks the ``overall
standardization of products, underwriting, and delivery systems''
that is found in the prime market).
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Third, the roles and incentives of originators are not transparent.
One source estimates that 60 percent or more of mortgages originated in
the last several years were originated through a mortgage broker, often
an independent entity, who takes loan applications from consumers and
shops them to depository institutions or other lenders.\8\ Anecdotal
evidence indicates that consumers in both the prime and subprime
markets often believe, in error, that a mortgage broker is obligated to
find the consumer the best and most suitable loan terms available.
Consumers who rely on brokers often are unaware, however, that a
broker's interests may diverge from, and conflict with, their own
interests. In particular, consumers are often unaware that a creditor
pays a broker more to originate a loan with a rate higher than the rate
the consumer qualifies for based on the creditor's underwriting
criteria.
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\8\ Data reported by Wholesale Access Mortgage Research and
Consulting, Inc., available at http://www.wholesaleaccess.com/.
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Limited shopping. In this environment of limited transparency,
consumers--particularly those in the subprime market--may reasonably
decide not to shop further among originators or among loan options once
an originator has told them they will receive a loan, because further
shopping can be very costly. Shopping may require additional
applications and application fees, and may delay the consumer's receipt
of funds. This delay creates a potentially significant cost for the
many subprime borrowers seeking to refinance their obligations to lower
their debt payments at least temporarily, to extract equity in the form
of cash, or both.\9\ In recent years, nearly 90 percent of subprime
ARMs used for refinancings were ``cash out.'' \10\
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\9\ See Anthony Pennington-Cross & Souphala Chomsisengphet,
Subprime Refinancing: Equity Extraction and Mortgage Termination, 35
Real Estate Economics 2, 233 (2007) (reporting that 49% of subprime
refinance loans involve equity extraction, compared with 26% of
prime refinance loans); Marsha J. Courchane, Brian J. Surette, and
Peter M. Zorn, Subprime Borrowers: Mortgage Transitions and Outcomes
(Subprime Outcomes), 29 J. of Real Estate Economics 4, 368-371
(2004) (discussing survey evidence that borrowers with subprime
loans are more likely to have experienced major adverse life events
(marital disruption; major medical problem; major spell of
unemployment; major decrease of income) and often use refinancing
for debt consolidation or home equity extraction); Subprime Lending
Investigation, at 551-552 (citing survey evidence that borrowers
with subprime loans have increased incidence of major medical
expenses, major unemployment spells, and major drops in income).
\10\ A ``cash out'' transaction is one in which the borrower
refinances an existing mortgage, and the new mortgage amount is
greater than the existing mortgage amount, to allow the borrower to
extract from the home. Figure calculated from First American
LoanPerformance data.
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While shopping costs are likely clear, the benefits may not be
obvious or may appear minimal. Without easy access to subprime product
prices, a consumer may have only a limited idea after working with one
originator whether further shopping is likely to produce a better deal.
Moreover, consumers in the subprime market have reported in studies
that they were turned down by several lenders before being
approved.\11\ Once approved, these consumers may see little advantage
to continuing to shop for better terms if they expect to be turned down
by other originators. Further, if a consumer uses a broker believing
that the broker is shopping for the consumer for the best deal, the
consumer may believe a better deal is not obtainable. An unscrupulous
originator may also seek to discourage a consumer from shopping by
intentionally understating the cost of an offered loan. For all of
these reasons, borrowers in the subprime market may not shop beyond the
first approval and may be willing to accept unfavorable terms.\12\
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\11\ James M. Lacko and Janis K. Pappalardo, Federal Trade
Commission, Improving Consumer Mortgage Disclosures: An Empirical
Assessment of Current and Prototype Disclosure Forms at 24-26
(2007), available at: http://www.ftc.gov/os/2007/06/
P025505MortgageDisclosureReport.pdf (Improving Mortgage Disclosures)
(reporting evidence based on qualitative consumer interviews);
Subprime Lending Investigation at 550 (finding based on survey data
that ``[p]robably the most significant hurdle overcome by subprime
borrowers * * * is just getting approved for a loan for the first
time. This impact might well make subprime borrowers more willing to
accept less favorable terms as they become uncertain about the
possibility of qualifying for a loan at all.'').
\12\ Subprime Outcomes at 371-372 (reporting survey evidence
that relative to prime borrowers, subprime borrowers are less
knowledgeable about the mortgage process, search less for the best
rates, and feel they have less choice about mortgage terms and
conditions); Subprime Mortgage Investigation at 554 (``Our focus
groups suggested that prime and subprime borrowers use quite
different search criteria in looking for a loan. Subprime borrowers
search primarily for loan approval and low monthly payments, while
prime borrowers focus on getting the lowest available interest rate.
These distinctions are quantitatively confirmed by our survey.'').
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Limited focus. Consumers considering obtaining a typically complex
subprime mortgage loan may simplify their decision by focusing on a few
attributes of the product or service that seem most important.\13\ A
consumer may focus on loan attributes that have the most obvious and
immediate consequence such as loan amount, down payment, initial
monthly payment, initial interest rate, and up-front fees (though up-
front fees may be more obscure when added to the loan amount, and
``discount points'' in particular may be difficult for consumers to
understand). These consumers, therefore, may not focus on terms that
may seem less immediately important to them such as future increases in
payment amounts or interest rates, prepayment penalties, and negative
amortization. They are also not likely to focus on underwriting
practices such as income verification, and on features such as escrows
for future tax and insurance obligations.\14\ Consumers who do not
fully understand such terms and features, however, are less able to
appreciate their risks, which can be significant. For example, the
payment may increase sharply and a prepayment penalty may hinder the
consumer from
[[Page 44526]]
refinancing to avoid the payment increase. Thus, consumers may
unwittingly accept loans that they will have difficulty repaying.
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\13\ Jinkook Lee and Jeanne M. Hogarth, Consumer Information
Search for Home Mortgages: Who, What, How Much, and What Else?,
Financial Services Review 291 (2000) (Consumer Information Search)
(``In all, there are dozens of features and costs disclosed per
loan, far in excess of the combination of terms, lenders, and
information sources consumers report using when shopping.'').
\14\ Consumer Information Search at 285 (reporting survey
evidence that most consumers compared interest rate or APR, loan
type (fixed-rate or ARM), and mandatory up-front fees, but only a
quarter considered the costs of optional products such as credit
insurance and back-end costs such as late fees). There is evidence
that borrowers are not aware of, or do not understand, terms of this
nature even after they have obtained a loan. See Improving Mortgage
Disclosures at 27-30 (discussing anecdotal evidence based on
consumer interviews that borrowers were not aware of, did not
understand, or misunderstood an important cost or feature of their
loans that had substantial impact on the overall cost, the future
payments, or the ability to refinance with other lenders); Brian
Bucks and Karen Pence, Do Homeowners Know Their House Values and
Mortgage Terms? 18-22 (Board Fin. and Econ. Discussion Series
Working Paper No. 2006-3, 2006) (discussing statistical evidence
that borrowers with ARMs underestimate annual as well as life-time
caps on the interest rate; the rate of underestimation increases for
lower-income and less-educated borrowers), available at http://
www.federalreserve.gov/pubs/feds/2006/200603/200603pap.pdf.
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Limits of disclosure. Disclosures describing the multiplicity of
features of a complex loan could help some consumers in the subprime
market, but may not be sufficient to protect them against unfair loan
terms or lending practices. Obtaining widespread consumer understanding
of the many potentially significant features of a typical subprime
product is a major challenge.\15\ If consumers do not have a certain
minimum level understanding of the market and products, disclosures for
complex and infrequent transactions may not effectively provide that
minimum understanding. Moreover, even if all of a loan's features are
disclosed clearly to consumers, they may continue to focus on a few
features that appear most significant. Alternatively, disclosing all
features may ``overload'' consumers and make it more difficult for them
to discern which features are most important.
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\15\ Improving Mortgage Disclosures at 74-76 (finding that
borrowers in the subprime market may have more difficulty
understanding their loan terms because their loans are more complex
than loans in the prime market).
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Moreover, consumers may rely more on their originators to explain
the disclosures when the transaction is complex; some originators may
have incentives to misrepresent the disclosures so as to obscure the
transaction's risks to the consumer; and such misrepresentations may be
particularly effective if the originator is face-to-face with the
consumer.\16\ Therefore, while the Board anticipates proposing changes
to Regulation Z to improve mortgage loan disclosures, it is unlikely
that better disclosures, alone, will address adequately the risk of
abusive or unaffordable loans in the subprime market.
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\16\ U.S. Gen. Accounting Office, GAO 04-280, Consumer
Protection: Federal and State Agencies Face Challenges in Combating
Predatory Lending 97-98 (2004) (stating that the inherent complexity
of mortgage loans, some borrowers' lack of financial sophistication,
education, or infirmities, and misleading statements and actions by
lenders and brokers limit the effectiveness of even clear and
transparent disclosures).
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Misaligned Incentives and Obstacles to Monitoring
Not only are consumers in the subprime market often unable to
protect themselves from abusive or unaffordable loans, originators may
at certain times be more likely to extend unaffordable loans. The
recent sharp rise in serious delinquencies on subprime mortgages has
made clear that originators were not adequately assessing repayment
ability, particularly where mortgages were sold to the secondary market
and the originator retained little of the risk. The growth of the
secondary market gave lenders--and, thus, mortgage borrowers--greater
access to capital markets, lowered transaction costs, and allowed risk
to be shared more widely. This ``originate-to-distribute'' model,
however, has also contributed to the loosening of underwriting
standards, particularly during periods of rapid house price
appreciation, which may mask problems by keeping default and
delinquency rates low until price appreciation slows or reverses.\17\
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\17\ Atif Mian and Amir Sufi, The Consequences of Mortgage
Credit Expansion: Evidence from the 2007 Mortgage Default Crisis
(May 2008), available at: http://ssrn.com/abstract=1072304.
---------------------------------------------------------------------------
This potential tendency has several related causes. First, when an
originator sells a mortgage and its servicing rights, depending on the
terms of the sale, most or all of the risks typically are passed on to
the loan purchaser. Thus, originators that sell loans may have less of
an incentive to undertake careful underwriting than if they kept the
loans. Second, warranties by sellers to purchasers and other
``repurchase'' contractual provisions have little meaningful benefit if
originators have limited assets. Third, fees for some loan originators
have been tied to loan volume, making loan sales--sometimes
accomplished through aggressive ``push marketing''--a higher priority
than loan quality for some originators. Fourth, investors may not
exercise adequate due diligence on mortgages in the pools in which they
are invested, and may instead rely heavily on credit-ratings firms to
determine the quality of the investment.\18\
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\18\ Benjamin J. Keys, Tanmoy K. Mukherjee, Amit Seru and Vikram
Vig, Did Securitization Lead to Lax Screening? Evidence from Suprime
Loans at 22, available at: http://ssrn.com/abstract=1093137.
---------------------------------------------------------------------------
Fragmentation in the originator market can further exacerbate the
problem. Data reported under the Home Mortgage Disclosure Act (HMDA)
show that independent mortgage companies--those not related to
depository institutions or their subsidiaries or affiliates--in 2005
and 2006 made nearly one-half of first-lien mortgage loans reportable
as being higher-priced but only one-fourth of loans that were not
reportable as higher-priced. Nor was lending by independent mortgage
companies particularly concentrated: In each of 2005 and 2006 around
150 independent mortgage companies made 500 or more first-lien mortgage
loans on owner-occupied dwellings that were reportable as higher-
priced. In addition, as noted earlier, one source suggests that 60
percent or more of mortgages originated in the last several years were
originated through mortgage brokers.\19\ This same source estimates the
number of brokerage companies at over 50,000 in recent years.
---------------------------------------------------------------------------
\19\ Data reported by Wholesale Access Mortgage Research and
Consulting, Inc., available at http://www.wholesaleaccess.com.
---------------------------------------------------------------------------
Thus, a securitized pool of mortgages may have been sourced by tens
of lenders and thousands of brokers. Investors have limited ability to
directly monitor these originators' activities. Further, government
oversight of such a fragmented market faces significant challenges
because originators operate in different states and under different
regulatory and supervisory regimes and different practices in sharing
information among regulators. These circumstances may inhibit the
ability of regulators to protect consumers from abusive and
unaffordable loans.
A Role for New HOEPA Rules
As explained above, consumers in the subprime market face serious
constraints on their ability to protect themselves from abusive or
unaffordable loans, even with the best disclosures; originators
themselves may at times lack sufficient market incentives to ensure
loans they originate are affordable; and regulators face limits on
their ability to oversee a fragmented subprime origination market.
These circumstances warrant imposing a new national legal standard on
subprime lenders to help ensure that consumers receive mortgage loans
they can afford to repay, and help prevent the equity-stripping abuses
that unaffordable loans facilitate. Adopting this standard under
authority of HOEPA ensures that it is applied uniformly to all
originators and provides consumers an opportunity to redress wrongs
through civil actions to the extent authorized by TILA. As explained in
the next part, substantial information supplied to the Board through
several public hearings confirms the need for new HOEPA rules.
III. The Board's HOEPA Hearings
A. Home Ownership and Equity Protection Act (HOEPA)
The Board has recently held extensive public hearings on consumer
protection issues in the mortgage market, including the subprime
sector. These hearings were held pursuant to the Home Ownership and
Equity Protection Act (HOEPA), which directs the Board to hold public
hearings periodically on the home equity lending market and the
adequacy of existing law for protecting
[[Page 44527]]
the interests of consumers, particularly low income consumers. HOEPA
imposes substantive restrictions, and special pre-closing disclosures,
on particularly high-cost refinancings and home equity loans (``HOEPA
loans'').\20\ These restrictions include limitations on prepayment
penalties and ``balloon payment'' loans, and prohibitions of negative
amortization and of engaging in a pattern or practice of lending based
on the collateral without regard to repayment ability.
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\20\ HOEPA loans are closed-end, non-purchase money mortgages
secured by a consumer's principal dwelling (other than a reverse
mortgage) where either: (a) The APR at consummation will exceed the
yield on Treasury securities of comparable maturity by more than 8
percentage points for first-lien loans, or 10 percentage points for
subordinate-lien loans; or (b) the total points and fees payable by
the consumer at or before closing exceed the greater of 8 percent of
the total loan amount, or $547 for 2007 (adjusted annually).
---------------------------------------------------------------------------
When it enacted HOEPA, Congress granted the Board authority,
codified in TILA Section 129(l), to create exemptions to HOEPA's
restrictions and to expand its protections. 15 U.S.C. 1639(l). Under
TILA Section 129(l)(1), the Board may create exemptions to HOEPA's
restrictions as needed to keep responsible credit available; and under
TILA Section 129(l)(2), the Board may adopt new or expanded
restrictions as needed to protect consumers from unfairness, deception,
or evasion of HOEPA. In HOEPA Section 158, Congress directed the Board
to monitor changes in the home equity market through regular public
hearings.
Hearings the Board held in 2000 led the Board to expand HOEPA's
protections in December 2001.\21\ Those rules, which took effect in
2002, lowered HOEPA's rate trigger, expanded its fee trigger to include
single-premium credit insurance, added an anti-``flipping''
restriction, and improved the special pre-closing disclosure.
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\21\ Truth in Lending, 66 FR 65604, 65608, Dec. 20, 2001.
---------------------------------------------------------------------------
B. Summary of 2006 Hearings
In the summer of 2006, the Board held four hearings in four cities
on three broad topics: (1) The impact of the 2002 HOEPA rule changes on
predatory lending practices, as well as the effects on consumers of
state and local predatory lending laws; (2) nontraditional mortgage
products and reverse mortgages; and (3) informed consumer choice in the
subprime market. Hearing panelists included mortgage lenders and
brokers, credit ratings agencies, real estate agents, consumer
advocates, community development groups, housing counselors,
academicians, researchers, and state and federal government officials.
In addition, consumers, housing counselors, brokers, and other
individuals made brief statements at the hearings during an ``open
mike'' period. In all, 67 individuals testified on panels and 54
comment letters were submitted to the Board.
Consumer advocates and some state officials stated that HOEPA is
generally effective in preventing abusive terms in loans subject to the
HOEPA price triggers. They noted, however, that very few loans are made
with rates or fees at or above the HOEPA triggers, and some advocated
that Congress lower them. Consumer advocates and state officials also
urged regulators and Congress to curb abusive practices in the
origination of loans that do not meet HOEPA's price triggers.
Consumer advocates identified several particular areas of concern.
They urged the Board to prohibit or restrict certain loan features or
terms, such as prepayment penalties, and underwriting practices such as
``stated income'' or ``low documentation'' (``low doc'') loans for
which the borrower's income is not documented or verified. They also
expressed concern about aggressive marketing practices such as steering
borrowers to higher-cost loans by emphasizing initial low monthly
payments based on an introductory rate without adequately explaining
that the consumer will owe considerably higher monthly payments after
the introductory rate expires.
Some consumer advocates stated that brokers and lenders should be
held to a duty of care such as a duty of good faith and fair dealing or
a duty to make only loans suitable for the borrower. These advocates
also urged the Board to ban ``yield spread premiums,'' payments that
brokers receive from the lender at closing for delivering a loan with
an interest rate that is higher than the lender's ``buy rate,'' because
they provide brokers an incentive to increase consumers' interest
rates. They argued that such steps would align reality with consumers'
perceptions that brokers serve their best interests. Consumer advocates
also expressed concerns that brokers, lenders, and others may coerce
appraisers to misrepresent the value of a dwelling; and that servicers
may charge consumers unwarranted fees and in some cases make it
difficult for consumers who are in default to avoid foreclosure.
Industry panelists and commenters, on the other hand, expressed
concern that state predatory lending laws may reduce the availability
of credit for some subprime borrowers. Most industry commenters opposed
prohibiting stated income loans, prepayment penalties, or other loan
terms, asserting that this approach would harm borrowers more than help
them. They urged the Board and other regulators to focus instead on
enforcing existing laws to remove ``bad actors'' from the market. Some
lenders indicated, however, that restrictions on certain features or
practices might be appropriate if the restrictions were clear and
narrow. Industry commenters also stated that subjective suitability
standards would create uncertainties for brokers and lenders and
subject them to excessive litigation risk.
C. Summary of June 2007 Hearing
In light of the information received at the 2006 hearings and the
rise in defaults that began soon after, the Board held an additional
hearing in June 2007 to explore how it could use its authority under
HOEPA to prevent abusive lending practices in the subprime market while
still preserving responsible subprime lending. The Board focused the
hearing on four specific areas: Lenders' determination of borrowers'
repayment ability; ``stated income'' and ``low doc'' lending; the lack
of escrows in the subprime market relative to the prime market; and the
high frequency of prepayment penalties in the subprime market.
At the hearing, the Board heard from 16 panelists representing
consumers, mortgage lenders, mortgage brokers, and state government
officials, as well as from academicians. The Board also received almost
100 written comments after the hearing from an equally diverse group.
Industry representatives acknowledged concerns with recent lending
practices but urged the Board to address most of these concerns through
supervisory guidance rather than regulations under HOEPA. They
maintained that supervisory guidance, unlike regulation, is flexible
enough to preserve access to responsible credit. They also suggested
that supervisory guidance issued recently regarding nontraditional
mortgages and subprime lending, as well as market self-correction, have
reduced the need for new regulations. Industry representatives support
improving mortgage disclosures to help consumers avoid abusive loans.
They urged that any substantive rules adopted by the Board be clearly
drawn to limit uncertainty and narrowly drawn to avoid unduly
restricting credit.
In contrast, consumer advocates, state and local officials, and
Members of Congress urged the Board to adopt regulations under HOEPA.
They acknowledged a proper place for
[[Page 44528]]
guidance but contended that recent problems indicate the need for
requirements enforceable by borrowers through civil actions, which
HOEPA enables and guidance does not. They also expressed concern that
less responsible, less closely supervised lenders are not subject to
the guidance and that there is limited enforcement of existing laws for
these entities. Consumer advocates and others welcomed improved
disclosures but insisted they would not prevent abusive lending. More
detailed accounts of the testimony and letters are provided below in
the context of specific issues the Board is addressing in these final
rules.
D. Congressional Hearings
Congress has also held a number of hearings in the past year about
consumer protection concerns in the mortgage market.\22\ In these
hearings, Congress has heard testimony from individual consumers,
representatives of consumer and community groups, representatives of
financial and mortgage industry groups and federal and state officials.
These hearings have focused on rising subprime foreclosure rates and
the extent to which lending practices have contributed to them.
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\22\ E.g., Foreclosure Problems and Solutions: Federal, State,
and Local Efforts to Address the Foreclosure Crisis in Ohio: Hearing
before the Subcomm. on Housing and Comm. Oppty. of the H. Comm. on
Fin. Servs., 110th Cong. (2008); Targeting Federal Aid to
Neighborhoods Distressed by the Subprime Mortgage Crisis: Hearing
before the Subcomm. on Housing and Comm. Oppty. of the H. Comm. on
Fin. Servs., 110th Cong. (2008); Improving Consumer Protections in
Subprime Lending: Hearing before the Subcomm. on Int. Comm., Trade,
and Tourism of the S. Comm. on Comm., Sci., and Trans., 110th Cong.
(2008); H.R. 5679, The Foreclosure Prevention and Sound Mortgage
Servicing Act of 2008: Hearing before the Subcomm. on Housing and
Comm. Oppty. of the H. Comm. on Fin. Servs., 110th Cong. (2008);
Restoring the American Dream: Solutions to Predatory Lending and the
Foreclosure Crisis: S. Comm. on Banking, Hsg., and Urban Affairs,
110th Cong. (2008); Consumer Protection in Financial Services:
Subprime Lending and Other Financial Activities: Hearing before the
Subcomm. on Fin. Svcs. and Gen. Gov't of the H. Approp. Comm., 110th
Cong. (2008); Progress in Administration and Other Efforts to
Coordinate and Enhance Mortgage Foreclosure Prevention: Hearing
before the H. Comm. on Fin. Servs., 110th Cong. (2007); Legislative
Proposals on Reforming Mortgage Practices: Hearing before the H.
Comm. on Fin. Servs., 110th Cong. (2007); Legislative and Regulatory
Options for Minimizing and Mitigating Mortgage Foreclosures: Hearing
before the H. Comm. on Fin. Servs., 110th Cong. (2007); Ending
Mortgage Abuse: Safeguarding Homebuyers: Hearing before the S.
Subcomm. on Hous., Transp., and Cmty. Dev. of the S. Comm. on
Banking, Hous., and Urban Affairs, 110th Cong. (2007); Improving
Federal Consumer Protection in Financial Services: Hearing before
the H. Comm. on Fin. Servs., 110th Cong. (2007).
---------------------------------------------------------------------------
Consumer and community group representatives testified that certain
lending terms or practices, such as hybrid adjustable-rate mortgages,
prepayment penalties, low or no documentation loans, lack of escrows
for taxes and insurance, and failure to consider the consumer's ability
to repay have contributed to foreclosures. In addition, these witnesses
testified that consumers often believe that mortgage brokers represent
their interests and shop on their behalf for the best loan terms. As a
result, they argue that consumers do not shop independently to ensure
that they are getting the best terms for which they qualify. They also
testified that, because originators sell most loans into the secondary
market and do not share the risk of default, brokers and lenders have
less incentive to ensure consumers can afford their loans.
Financial services and mortgage industry representatives testified
that consumers need better disclosures of their loan terms, but that
substantive restrictions on subprime loan terms would risk reducing
access to credit for some borrowers. In addition, these witnesses
testified that applying a fiduciary duty to the subprime market, such
as requiring that a loan be in the borrower's best interest, would
introduce subjective standards that would significantly increase
compliance and litigation risk. According to these witnesses, some
lenders would be less willing to offer loans in the subprime market,
making it harder for some consumers to get loans.
IV. Interagency Supervisory Guidance
In December 2005, the Board and the other federal banking agencies
responded to concerns about the rapid growth of nontraditional
mortgages in the previous two years by proposing supervisory guidance.
Nontraditional mortgages are mortgages that allow the borrower to defer
repayment of principal and sometimes interest. The guidance advised
institutions of the need to reduce ``risk layering'' practices with
respect to these products, such as failing to document income or
lending nearly the full appraised value of the home. The proposal, and
the final guidance issued in September 2006, specifically advised
lenders that layering risks in nontraditional mortgage loans to
subprime borrowers may significantly increase risks to borrowers as
well as institutions.\23\
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\23\ Interagency Guidance on Nontraditional Mortgage Product
Risks, 71 FR 58609, Oct. 4, 2006 (Nontraditional Mortgage Guidance).
---------------------------------------------------------------------------
The Board and the other federal banking agencies addressed concerns
about the subprime market more broadly in March 2007 with a proposal
addressing the heightened risks to consumers and institutions of ARMs
with two or three-year ``teaser'' rates followed by substantial
increases in the rate and payment. The guidance, finalized in June
2007, sets out the standards institutions should follow to ensure
borrowers in the subprime market obtain loans they can afford to
repay.\24\ Among other steps, the guidance advises lenders to (1) use
the fully-indexed rate and fully-amortizing payment when qualifying
borrowers for loans with adjustable rates and potentially non-
amortizing payments; (2) limit stated income and reduced documentation
loans to cases where mitigating factors clearly minimize the need for
full documentation of income; (3) provide that prepayment penalty
clauses expire a reasonable period before reset, typically at least 60
days.
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\24\ Statement on Subprime Mortgage Lending, 72 FR 37569, Jul.
10, 2007 (Subprime Statement).
---------------------------------------------------------------------------
The Conference of State Bank Supervisors (CSBS) and American
Association of Residential Mortgage Regulators (AARMR) issued parallel
statements for state supervisors to use with state-supervised entities,
and many states have adopted the statements.
The guidance issued by the federal banking agencies has helped to
promote safety and soundness and protect consumers in the subprime
market. Guidance, however, is not necessarily implemented uniformly by
all originators. Originators who are not subject to routine examination
and supervision may not adhere to guidance as closely as originators
who are. Guidance also does not provide individual consumers who have
suffered harm because of abusive lending practices an opportunity for
redress. The new and expanded consumer protections that the Board is
adopting apply uniformly to all creditors and are enforceable by
federal and state supervisory and enforcement agencies and in many
cases by borrowers.
V. Legal Authority
A. The Board's Authority Under TILA Section 129(l)(2)
The substantive limitations in new Sec. Sec. 226.35 and 226.36 and
corresponding revisions to Sec. Sec. 226.32 and 226.34, as well as
restrictions on misleading and deceptive advertisements, are based on
the Board's authority under TILA Section 129(l)(2), 15 U.S.C.
1639(l)(2). That provision gives the Board authority to prohibit acts
or practices in connection with:
[[Page 44529]]
Mortgage loans that the Board finds to be unfair,
deceptive, or designed to evade the provisions of HOEPA; and
Refinancing of mortgage loans that the Board finds to be
associated with abusive lending practices or that are otherwise not in
the interest of the borrower.
The authority granted to the Board under TILA Section 129(l)(2), 15
U.S.C. 1639(l)(2), is broad. It reaches mortgage loans with rates and
fees that do not meet HOEPA's rate or fee trigger in TILA Section
103(aa), 15 U.S.C. 1602(aa), as well as types of mortgage loans not
covered under that section, such as home purchase loans. Section
129(l)(2) also authorizes the Board to strengthen the protections in
Section 129 (c)-(i) for the loans to which Section 103(aa) applies
these protections (HOEPA loans). In TILA Section 129 (c)-(i), Congress
set minimum standards for HOEPA loans. The Board is authorized to
strengthen those standards for HOEPA loans when the Board finds
practices unfair, deceptive, or abusive. The Board is also authorized
by Section 129(l)(2) to apply those strengthened standards to loans
that are not HOEPA loans. Moreover, while HOEPA's statutory
restrictions apply only to creditors and only to loan terms or lending
practices, Section 129(l)(2) is not limited to acts or practices by
creditors, nor is it limited to loan terms or lending practices. See 15
U.S.C. 1639(l)(2). It authorizes protections against unfair or
deceptive practices when such practices are ``in connection with
mortgage loans,'' and it authorizes protections against abusive
practices ``in connection with refinancing of mortgage loans.'' Thus,
the Board's authority is not limited to regulating specific contractual
terms of mortgage loan agreements; it extends to regulating loan-
related practices generally, within the standards set forth in the
statute.
HOEPA does not set forth a standard for what is unfair or
deceptive, but the Conference Report for HOEPA indicates that, in
determining whether a practice in connection with mortgage loans is
unfair or deceptive, the Board should look to the standards employed
for interpreting state unfair and deceptive trade practices statutes
and the Federal Trade Commission Act (FTC Act), Section 5(a), 15 U.S.C.
45(a).\25\
---------------------------------------------------------------------------
\25\ H.R. Rep. 103-652, at 162 (1994) (Conf. Rep.).
---------------------------------------------------------------------------
Congress has codified standards developed by the Federal Trade
Commission (FTC) for determining whether acts or practices are unfair
under Section 5(a), 15 U.S.C. 45(a).\26\ Under the FTC Act, an act or
practice is unfair when it causes or is likely to cause substantial
injury to consumers which is not reasonably avoidable by consumers
themselves and not outweighed by countervailing benefits to consumers
or to competition. In addition, in determining whether an act or
practice is unfair, the FTC is permitted to consider established public
policies, but public policy considerations may not serve as the primary
basis for an unfairness determination.\27\
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\26\ See 15 U.S.C. 45(n); Letter from FTC to the Hon. Wendell H.
Ford and the Hon. John C. Danforth (Dec. 17, 1980).
\27\ 15 U.S.C. 45(n).
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The FTC has interpreted these standards to mean that consumer
injury is the central focus of any inquiry regarding unfairness.\28\
Consumer injury may be substantial if it imposes a small harm on a
large number of consumers, or if it raises a significant risk of
concrete harm.\29\ The FTC looks to whether an act or practice is
injurious in its net effects.\30\ The agency has also observed that an
unfair act or practice will almost always reflect a market failure or
market imperfection that prevents the forces of supply and demand from
maximizing benefits and minimizing costs.\31\ In evaluating unfairness,
the FTC looks to whether consumers' free market decisions are
unjustifiably hindered.\32\
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\28\ Statement of Basis and Purpose and Regulatory Analysis,
Credit Practices Rule, 42 FR 7740, 7743, March 1, 1984 (Credit
Practices Rule).
\29\ Letter from Commissioners of the FTC to the Hon. Wendell H.
Ford, Chairman, and the Hon. John C. Danforth, Ranking Minority
Member, Consumer Subcomm. of the H. Comm. on Commerce, Science, and
Transp., n.12 (Dec. 17, 1980).
\30\ Credit Practices Rule, 42 FR at 7744.
\31\ Id.
\32\ Id.
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The FTC has also adopted standards for determining whether an act
or practice is deceptive (though these standards, unlike unfairness
standards, have not been incorporated into the FTC Act).\33\ First,
there must be a representation, omission or practice that is likely to
mislead the consumer. Second, the act or practice is examined from the
perspective of a consumer acting reasonably in the circumstances.
Third, the representation, omission, or practice must be material. That
is, it must be likely to affect the consumer's conduct or decision with
regard to a product or service.\34\
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\33\ Letter from James C. Miller III, Chairman, FTC to the Hon.
John D. Dingell, Chairman, H. Comm. on Energy and Commerce (Oct. 14,
1983) (Dingell Letter).
\34\ Dingell Letter at 1-2.
---------------------------------------------------------------------------
Many states also have adopted statutes prohibiting unfair or
deceptive acts or practices, and these statutes employ a variety of
standards, many of them different from the standards currently applied
to the FTC Act. A number of states follow an unfairness standard
formerly used by the FTC. Under this standard, an act or practice is
unfair where it offends public policy; or is immoral, unethical,
oppressive, or unscrupulous; and causes substantial injury to
consumers.\35\
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\35\ See, e.g., Kenai Chrysler Ctr., Inc. v. Denison, 167 P.3d
1240, 1255 (Alaska 2007) (quoting FTC v. Sperry & Hutchinson Co.,
405 U.S. 233, 244-45 n.5 (1972)); State v. Moran, 151 N.H. 450, 452,
861 A.2d 763, 755-56 (N.H. 2004) (concurrently applying the FTC's
former test and a test under which an act or practice is unfair or
deceptive if ``the objectionable conduct * * * attain[s] a level of
rascality that would raise an eyebrow of someone inured to the rough
and tumble of the world of commerce.'') (citation omitted); Robinson
v. Toyota Motor Credit Corp., 201 Ill. 2d 403, 417-418, 775 N.E.2d
951, 961-62 (2002) (quoting 405 U.S. at 244-45 n.5).
---------------------------------------------------------------------------
In adopting final rules under TILA Section 129(l)(2)(A), 15 U.S.C.
1639(l)(2)(A), the Board has considered the standards currently applied
to the FTC Act's prohibition against unfair or deceptive acts or
practices, as well as the standards applied to similar state statutes.
B. The Board's Authority Under TILA Section 105(a)
Other aspects of these rules are based on the Board's general
authority under TILA Section 105(a) to prescribe regulations necessary
or proper to carry out TILA's purposes 15 U.S.C. 1604(a). This section
is the basis for the requirement to provide early disclosures for
residential mortgage transactions as well as many of the revisions to
improve advertising disclosures. These rules are intended to carry out
TILA's purposes of informing consumers about their credit terms and
helping them shop for credit. See TILA Section 102, 15 U.S.C. 1603.
VI. The Board's Proposal
On January 9, 2008, the Board published a notice of proposed
rulemaking in the Federal Register (73 FR 1672) proposing to amend
Regulation Z.
A. Proposals To Prevent Unfairness, Deception, and Abuse
The Board proposed new restrictions and requirements for mortgage
lending and servicing intended to protect consumers against unfairness,
deception, and abuse while preserving responsible lending and
sustainable homeownership. Some of the proposed restrictions would
apply only to higher-priced mortgage loans, while others
[[Page 44530]]
would apply to all mortgage loans secured by a consumer's principal
dwelling.
Protections Covering Higher-Priced Mortgage Loans
The Board proposed certain protections for consumers receiving
higher-priced mortgage loans. Higher-priced mortgage loans would have
been loans with an annual percentage rate (APR) that exceeds the
comparable Treasury security by three or more percentage points for
first-lien loans, or five or more percentage points for subordinate-
lien loans. For such loans, the Board proposed to:
[cir] Prohibit creditors from engaging in a pattern or practice of
extending credit without regard to borrowers' ability to repay from
sources other than the collateral itself;
[cir] Require creditors to verify income and assets they rely upon
in making loans;
[cir] Prohibit prepayment penalties unless certain conditions are
met; and
[cir] Require creditors to establish escrow accounts for taxes and
insurance, but permit creditors to allow borrowers to opt out of
escrows 12 months after loan consummation.
In addition, the proposal would have prohibited creditors from
structuring closed-end mortgage loans as open-end lines of credit for
the purpose of evading these rules, which do not apply to lines of
credit.
Proposed Protections Covering Closed-End Loans Secured by Consumer's
Principal Dwelling
In addition, in connection with all consumer-purpose, closed-end
loans secured by a consumer's principal dwelling, the Board proposed
to:
[cir] Prohibit creditors from paying a mortgage broker more than
the consumer had agreed in advance that the broker would receive;
[cir] Prohibit any creditor or mortgage broker from coercing,
influencing, or otherwise encouraging an appraiser to provide a
misstated appraisal in connection with a mortgage loan; and
[cir] Prohibit mortgage servicers from ``pyramiding'' late fees,
failing to credit payments as of the date of receipt, failing to
provide loan payoff statements upon request within a reasonable time,
or failing to deliver a fee schedule to a consumer upon request.
B. Proposals To Improve Mortgage Advertising
Another goal of the Board's proposal was to ensure that mortgage
loan advertisements provide accurate and balanced information and do
not contain misleading or deceptive representations. The Board proposed
to require that advertisements for both open-end and closed-end
mortgage loans provide accurate and balanced information, in a clear
and conspicuous manner, about rates, monthly payments, and other loan
features. The proposal was issued under the Board's authorities to:
Adopt regulations to ensure consumers are informed about and can shop
for credit; require that information, including the information
required for advertisements for closed-end credit, be disclosed in a
clear and conspicuous manner; and regulate advertisements of open-end
home-equity plans secured by the consumer's principal dwelling. See
TILA Section 105(a), 15 U.S.C. 1604(a); Section 122, 15 U.S.C. 1632;
Section 144, 15 U.S.C. 1664; Section 147, 15 U.S.C. 1665b.
The Board also proposed, under TILA Section 129(l)(2), 15 U.S.C.
1639(l)(2), to prohibit the following seven deceptive or misleading
practices in advertisements for closed-end mortgage loans:
[cir] Advertising ``fixed'' rates or payments for loans whose rates
or payments can vary without adequately disclosing that the interest
rate or payment amounts are ``fixed'' only for a limited period of
time, rather than for the full term of the loan;
[cir] Comparing an actual or hypothetical consumer's rate or
payment obligations and the rates or payments that would apply if the
consumer obtains the advertised product unless the advertisement states
the rates or payments that will apply over the full term of the loan;
[cir] Advertisements that characterize the products offered as
``government loan programs,'' ``government-supported loans,'' or
otherwise endorsed or sponsored by a federal or state government entity
even though the advertised products are not government-supported or -
sponsored loans;
[cir] Advertisements, such as solicitation letters, that display
the name of the consumer's current mortgage lender, unless the
advertisement also prominently discloses that the advertisement is from
a mortgage lender not affiliated with the consumer's current lender;
[cir] Advertising claims of debt elimination if the product
advertised would merely replace one debt obligation with another;
[cir] Advertisements that create a false impression that the
mortgage broker or lender has a fiduciary relationship with the
consumer; and
[cir] Foreign-language advertisements in which certain information,
such as a low introductory ``teaser'' rate, is provided in a foreign
language, while required disclosures are provided only in English.
C. Proposal To Give Consumers Disclosures Early
A third goal of the proposal was to provide consumers transaction-
specific disclosures early enough to use while shopping for a mortgage
loan. The Board proposed to require creditors to provide transaction-
specific mortgage loan disclosures such as the APR and payment schedule
for all home-secured, closed-end loans no later than three business
days after application, and before the consumer pays any fee except a
reasonable fee for the originator's review of the consumer's credit
history.
VII. Overview of Comments Received
The Board received approximately 4700 comments on the proposal. The
comments came from community banks, independent mortgage companies,
large bank holding companies, secondary market participants, credit
unions, state and national trade associations for financial
institutions in the mortgage business, mortgage brokers and mortgage
broker trade associations, realtors and realtor trade associations,
individual consumers, local and national community groups, federal and
state regulators and elected officials, appraisers, academics, and
other interested parties.
Commenters generally supported the Board's effort to protect
consumers from unfair practices, particularly in the subprime market,
while preserving responsible lending and sustainable homeownership.
However, industry commenters generally opposed the breadth of the
proposal; favoring narrower and more flexible rules. They also
expressed concerns about the costs of certain proposals, such as the
requirement to establish escrows for all first-lien higher-priced
mortgage loans. Consumer advocates, federal and state regulators
(including the Federal Deposit Insurance Corporation (FDIC)), and
elected officials (including members of Congress and some state
attorneys general) supported the proposal as addressing some of the
abuses in the subprime market, but argued that additional consumer
protections are needed.
Many commenters supported the approach of using loan price to
identify ``higher-priced'' loans. Financial institution commenters and
their trade associations were concerned, however, that the proposed
price thresholds were too low, and could capture many prime loans. They
contended that broad
[[Page 44531]]
coverage would reduce credit availability because creditors would
refrain from making covered loans or would pass on compliance costs.
Many industry commenters urged the Board to use a different index to
define higher-priced mortgage loans than the proposed index of Treasury
security yields, because the spread between Treasury yields and
mortgage rates can change. Consumer advocate commenters generally, but
not uniformly, favored applying the Board's proposed protections to all
loans secured by a principal dwelling regardless of loan price. In the
alternative, they favored the proposed price thresholds but urged the
Board also to apply the protections to nontraditional mortgage loans.
Industry commenters generally, but not uniformly, supported or did
not oppose a rule prohibiting lenders from engaging in a pattern or
practice of unaffordable lending. They urged the Board, however, to
provide a clear and specific ``safe harbor'' and remove the
presumptions of violations in order to avoid unduly constraining
credit. In contrast, consumer advocate commenters and others urged the
Board to revise the ability to repay rule so that it applies on a loan-
by-loan basis and not only to a pattern or practice of disregarding
borrowers' ability to repay. These commenters argued that a requirement
to prove a ``pattern or practice'' would prevent consumers from
bringing claims and would weaken the rule's power to deter abuse.
Consumer advocate commenters and some federal and state regulators
and elected officials also maintained that a complete ban on prepayment
penalties is necessary to protect consumers. In particular, many of
these commenters argued that prepayment penalties' harms to subprime
consumers outweigh the benefits of any reductions in interest rate
consumers receive, and that the Board's proposed restrictions on
prepayment penalties would not adequately address the harms. However,
most banks and their trade associations stated that the interest rate
benefit afforded to consumers with loans having prepayment penalty
provisions lowers credit costs and increases credit availability.
Many community banks and mortgage brokers as well as several
industry trade associations opposed the proposed escrow requirement,
contending that escrow infrastructures would be costly and that
creditors would either refrain from making higher-priced loans or would
pass costs on to consumers. Consumers also expressed concern that they
would lose interest on their escrowed funds and that servicers would
fail to properly pay tax and insurance obligations. Several industry
trade associations, several large creditors and some mortgage brokers,
consumer and community development groups, and state and federal
officials, however, supported the proposed escrow requirement as
protecting consumers from expensive force-placed insurance or default,
and possibly foreclosure.
For their part, mortgage brokers and their trade associations
principally addressed the yield spread premium proposal, which they
strongly opposed. They, as well as FTC staff, argued that prohibiting
creditors from paying brokers more than the consumer agreed to in
writing would put brokers at a competitive disadvantage relative to
retail lenders. They also argued that consumers would be confused and
misled by a broker compensation disclosure. Consumer advocates, several
members of Congress, several state attorneys general, and the FDIC
contended that the proposal would do little to protect consumers and
urged the Board to ban yield spread premiums outright.
Most commenters generally supported the Board's proposed
advertising rules, although some commenters requested clarifications
and modifications. Commenters were divided about the proposal to
require early mortgage loan disclosures. Many creditors and their trade
associations opposed the proposal because of perceived operational cost
and compliance difficulties, and concerns about the scope of the fee
restriction and its application to third party originators. Consumer
groups, state regulators and enforcement generally supported the
proposed rule, however, because it would make more information
available to consumers when they are shopping for loans. Some of the
commenters requested that the Board require lenders to redisclose
before loan consummation to enhance the accuracy of information.
Industry commenters urged the Board to adopt all of the proposed
restrictions in Sec. Sec. 226.35 and 226.36 under its TILA Section
105(a) authority rather than its Section 129(l)(2) authority. They
argued that using Section 129(l)(2) authority would impose
disproportionately heavy penalties on lenders for violations and
unnecessary costs on consumers. Consumer advocates, on the other hand,
supported using Section 129(l)(2) authority and urged the Board use it
more broadly to adopt the other proposed rules concerning early
disclosures and advertising.
Public comments with respect to these and other provisions of the
rule are described and discussed in more detail below.
VIII. Definition of ``Higher-Priced Mortgage Loan''--Sec. 226.35(a)
A. Overview
The Board proposed to extend certain consumer protections to a
subset of consumer residential mortgage loans referred to as ``higher-
priced mortgage loans.'' This part VIII discusses the definition of
``higher-priced mortgage loan'' the Board is adopting. A discussion of
the specific protections that apply to these loans follows in part IX.
The Board is also finalizing the proposal to apply certain other
restrictions to closed-end consumer mortgage loans secured by the
consumer's principal dwelling without regard to loan price. These
restrictions are discussed separately in part X.
Under the proposal, higher-priced mortgage loans would be defined
as consumer credit transactions secured by the consumer's principal
dwelling for which the APR on the loan exceeds the yield on comparable
Treasury securities by at least three percentage points for first-lien
loans, or five percentage points for subordinate-lien loans. The
proposed definition would include home purchase loans, refinancings,
and home equity loans. The definition would exclude home equity lines
of credit (``HELOCs''). There would also be exclusions for reverse
mortgages, construction-only loans, and bridge loans.
The Board is adopting a definition of ``higher-priced mortgage
loan'' that is substantially similar to that proposed but different in
the particulars. The changes to the final rule are being made in
response to commenters' concerns. The final definition, like the
proposed definition, sets a threshold above a measure of market rates
to distinguish higher-priced mortgage loans from the rest of the
mortgage market. But the measure the Board is adopting is different,
and therefore so is the threshold. Instead of yields on Treasury
securities, the definition uses average offer rates for the lowest-risk
prime mortgages, termed ``average prime offer rates.'' For the
foreseeable future, the Board will obtain or, as applicable, derive
average prime offer rates from the Freddie Mac Primary Mortgage Market
Survey[reg]. The threshold is set at 1.5 percentage points above the
average prime offer rate on a comparable transaction for first-lien
loans, and 3.5 percentage points for subordinate-lien loans. The
exclusions from ``higher-priced mortgage loans'' for HELOCs and
[[Page 44532]]
certain other types of transactions are adopted as proposed.
The definition of ``higher-priced mortgage loans'' appears in Sec.
226.35(a). Such loans are subject to the restrictions and requirements
in Sec. 226.35(b) concerning repayment ability, income verification,
prepayment penalties, escrows, and evasion, except that only first-lien
higher-priced mortgage loans are subject to the escrow requirement.
B. Public Comment on the Proposal
Most industry commenters, a national consumer advocacy and research
organization, and others supported the approach of using loan price to
identify loans subject to stricter regulations. A large number and wide
variety of these commenters, however, urged the Board to use a prime
mortgage market rate instead of, or in addition to, Treasury yields to
avoid arbitrary changes in coverage due to changes in the premium for
mortgages over Treasuries or in the relationship between short-term and
long-term Treasury yields. The precise recommendations are discussed in
more detail in subpart D below. Industry commenters were particularly
concerned that the threshold over the chosen index be set high enough
to exclude the prime market. They maintained that the proposed
thresholds of 300 and 500 basis points over Treasury yields would cover
a significant part of the prime market and reduce credit availability.
Consumer and civil rights group commenters generally, but not
uniformly, opposed limiting protections to higher-priced mortgage loans
and recommended applying these protections to all loans secured by a
principal dwelling. They recommended in the alternative that the
thresholds be adopted at the levels proposed, or even lower, and that
nontraditional mortgage loans, which permit non-amortizing payments or
negatively amortizing payments, be covered regardless of loan price.
They believe the Nontraditional Mortgage Guidance is not adequate to
protect consumers.
The proposed exclusion of HELOCs drew criticism from several
consumer and civil rights groups but strong support from industry
commenters. The other proposed exclusions drew limited comment. Some
industry commenters proposed additional exclusions for loans with
federal guaranties such as FHA, VA, and Rural Housing Service. A few
commenters also proposed excluding ``jumbo'' loans, that is, loans in
an amount that exceeds the threshold of eligibility for purchase by
Fannie Mae or Freddie Mac. Other proposed exclusions are discussed
below.
C. General Approach
Cover Subprime, Exclude Prime
The Board stated in connection with the proposal a general
principle that new regulations should be applied as broadly as needed
to protect consumers from actual or potential injury, but not so
broadly that the costs, including the always-present risk of unintended
consequences, would clearly outweigh the benefits. Consistent with this
principle, the Board believes, as it stated in connection with the
proposal, that the stricter regulations of Sec. 226.35 should cover
the subprime market and generally exclude the prime market.
The Board believes that the practices that Sec. 226.35 would
prohibit--lending without regard to ability to pay from verified income
and non-collateral assets, failure to establish an escrow for taxes and
insurance, and prepayment penalties outside of prescribed limits--are
so clearly injurious on balance to consumers within the subprime market
that they should be categorically barred in that market. The reasons
for this conclusion are detailed below in part IX with respect to each
practice. Moreover, the Board has concluded that, to be effective,
these prohibitions must cover the entire subprime market and not just
subprime products with particular terms or features. Market
imperfections discussed in part II--the subprime market's lack of
transparency and potentially inadequate incentives for creditors to
make only loans that consumers can repay--affect consumers throughout
the subprime market. To be sure, risk within the subprime market has
varied by loan type. For example, delinquencies on fixed-rate subprime
mortgages have been lower in recent years than on adjustable-rate
subprime mortgages. It is not likely to be practical or effective,
however, to target certain types of loans in the subprime market for
coverage while excluding others. Such a rule would be unduly complex,
likely fail to adapt quickly enough to ever-changing products, and
encourage creditors to steer borrowers to uncovered products.
In the prime market, however, the Board believes that a case-by-
case approach to determining whether the Sec. 226.35 practices are
unfair or deceptive is more appropriate. By nature, loans in the prime
market have a lower credit risk. Moreover, the prime market is more
transparent and competitive, characteristics that make it less likely a
creditor can sustain an unfair, abusive, or deceptive practice. In
addition, borrowers in the prime market are less likely to be under the
degree of financial stress that tends to weaken the ability of many
borrowers in the subprime market to protect themselves against unfair,
abusive, or deceptive practices. The final rule applies protections
against coercion of appraisers and unfair servicing practices to the
prime market because, with respect to these particular practices, the
prime market, too, suffers a lack of transparency and these practices
do not appear to be limited to the subprime market.
With these limited exceptions, at present the Board believes that
any undue risks to consumers in the prime market from particular loan
terms or lending practices are better addressed through means other
than new regulations under HOEPA. Supervisory guidance from the federal
agencies influences a large majority of the prime market which, unlike
the subprime market, has been dominated by federally supervised
institutions.\36\ Such guidance affords regulators and institutions
alike more flexibility than a regulation, with potentially fewer
unintended consequences. In addition, the standards the Government
Sponsored Enterprises set for the loans they will purchase continue to
have significant influence within the prime market, and these entities
are accountable for those standards to regulators and Congress.\37\
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\36\ According to HMDA data from 2005 and 2006, more than three-
quarters of prime, conventional first-lien mortgage loans on owner-
occupied properties were made by depository institutions or their
affiliates. For this purpose, a loan for which price information was
not reported is treated as a prime loan.
\37\ According to HMDA data from 2005 and 2006, nearly 30
percent of prime, conventional first-lien mortgage loans on owner-
occupied properties were purchased by Fannie Mae or Freddie Mac.
This figure understates the GSEs' influence on the prime market
because it excludes the many loans that were underwritten using the
GSEs' standards but were not sold to the GSEs.
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Use the APR
The Board also continues to believe--and few, if any, commenters
disagreed--that the best way to identify the subprime market is by loan
price rather than by borrower characteristics. Identifying a class of
protected borrowers would present operational difficulties and other
problems. For example, it is common to distinguish borrowers by credit
score, with lower-scoring borrowers generally considered to be at
higher risk of injury in the mortgage market. Defining the protected
field as lower-scoring consumers would fail to protect higher-scoring
consumers ``steered'' to loans meant for lower-scoring consumers.
Moreover, the market uses different commercial scores, and choosing a
particular score
[[Page 44533]]
as the benchmark for a regulation could give unfair advantage to the
company that provides that score.
The most appropriate measure of loan price for this regulation is
the APR; few, if any, commenters disagreed with this point either. The
APR corresponds closely to credit risk, that is, the risk of default as
well as the closely related risks of serious delinquency and
foreclosure. Loans with higher APRs generally have higher credit risks,
whatever the source of the risk might be--weaker borrower credit
histories, higher borrower debt-to-income ratios, higher loan-to-value
ratios, less complete income or asset documentation, less traditional
loan terms or payment schedules, or combinations of these or other risk
factors. Because disclosing an APR has long been required by TILA, the
figure is also very familiar and readily available to creditors and
consumers. Therefore, the Board believes it appropriate to use a loan's
APR to identify loans having a high enough credit risk to warrant the
protections of Sec. 226.35.
Two loans with identical risk characteristics will likely have
different APRs if they were originated when market rates were
different. It is important to normalize the APR by an index that moves
with mortgage market rates so that loans with the same risk
characteristics will be treated the same regardless of when the loans
were originated. The Board proposed to use as this index the yields on
comparable Treasury securities, which HOEPA uses currently to identify
HOEPA-covered loans, see TILA Section 103(aa), 15 U.S.C. 1602(aa), and
Sec. 226.32(a), and Regulation C uses to identify mortgage loans
reportable under HMDA as being higher-priced, see 12 CFR 203.4(a)(12).
For reasons discussed in more detail below, the final rule uses instead
an index that more closely tracks movements in mortgage rates than do
Treasury yields.
Uncertainty
As the Board stated in connection with the proposal, there are
three major reasons why it is inherently uncertain which APR threshold
would achieve the twin objectives of covering the subprime market and
generally excluding the prime market. First, there is not a uniform
definition of the prime or subprime market, or of a prime or subprime
loan. Moreover, the markets are separated by a somewhat loosely defined
segment known as the alt-A market, the precise boundaries of which are
not clear.
Second, available data sets provide only a rough measure of the
empirical relationship between APR and credit risk. A proprietary
dataset such as the loan-level data on subprime securitized mortgages
published by First American LoanPerformance may contain detailed
information on loan characteristics, including the contract rate, but
lack the APR or sufficient data to derive the APR. Other data must be
consulted to estimate APRs based on contract rates. HMDA data contain
the APR for mortgage loans reportable as being higher-priced (as
adjusted by comparable Treasury securities), but they have little
information about credit risk.
Third, data sets can of course show only the existing or past
distribution of loans across market segments, which may change in ways
that are difficult to predict. In particular, the distribution could
change in response to the Board's imposition of the restrictions in
Sec. 226.35, but the likely direction of the change is not clear.
``Over compliance'' could effectively lower the threshold. While a
loan's APR can be estimated early in the application process, it is
typically not known to a certainty until after the underwriting has
been completed and the interest rate has been locked. Creditors might
build in a ``cushion'' against this uncertainty by voluntarily setting
their internal thresholds lower than the threshold in the regulation.
Creditors would have a competing incentive to avoid the
restrictions, however, by restructuring the prices of potential loans
that would have APRs just above the threshold to cause the loans' APRs
to come under the threshold. Different combinations of contract rates
and points that are economically identical for an originator produce
different APRs. With the adoption of Sec. 226.35, an originator may
have an incentive to achieve a rate-point combination that would bring
a loan's APR below the threshold (if the borrower had the resources or
equity to pay the points). Moreover, some fees, such as late fees and
prepayment penalties, are not included in the APR. Creditors could
increase the number or amounts of such fees to maintain a loan's
effective price while lowering its APR below the threshold. It is not
clear whether the net effect of these competing forces of over-
compliance and circumvention would be to capture more, or fewer, loans.
For all of the above reasons, there is inherent uncertainty as to
what APR threshold would perfectly achieve the objectives of covering
the subprime market and generally excluding the prime market. In the
face of this uncertainty, deciding on an APR threshold calls for
judgment. As the Board stated with the proposal, the Board believes it
is appropriate to err on the side of covering somewhat more than the
subprime market.
The Alt-A Market
If the selected thresholds cover more than the subprime market,
then they likely extend into what has been known as the alt-A market.
The alt-A market is generally understood to be for borrowers who
typically have higher credit scores than subprime borrowers but still
pose more risk than prime borrowers because they make small down
payments or do not document their incomes, or for other reasons. The
definition of this market is not precise, however.
The Board judges that the benefits of extending Sec. 226.35's
restrictions into some part of the alt-A market to ensure coverage of
the entire subprime market outweigh the costs. This market segment also
saw undue relaxation of underwriting standards, one reason that its
share of residential mortgage originations grew sixfold from 2003 to
2006 (from two percent of originations to 13 percent). \38\ See part
VIII.C for further discussion of the relaxation of underwriting
standards in the alt-A market.
---------------------------------------------------------------------------
\38\ IMF 2007 Mortgage Market at 4.
---------------------------------------------------------------------------
To the extent Sec. 226.35 covers the higher-priced end of the alt-
A market, where risks in that segment are highest, the regulation will
likely benefit consumers more than it would cost them. Prohibiting
lending without regard to repayment ability in this market slice would
likely reduce the risk to consumers from ``payment shock'' on
nontraditional loans. Applying the income verification requirement of
Sec. Sec. 226.32(a)(4)(ii) and 226.35(b)(1) to the riskier part of the
alt-A market could ameliorate injuries to consumers from lending based
on inflated incomes without necessarily depriving consumers of access
to credit.
D. Index for Higher-Priced Mortgage Loans
Under the proposal, higher-priced mortgage loans would be defined
as consumer credit transactions secured by the consumer's principal
dwelling for which the APR on the loan exceeds the yield on comparable
Treasury securities by at least three percentage points for first-lien
loans, or five percentage points for subordinate-lien loans. The
proposed definition would include home purchase loans, refinancings of
home purchase loans, and home equity
[[Page 44534]]
loans. The definition would exclude home equity lines of credit
(``HELOCs''), reverse mortgages, construction-only loans, and bridge
loans.
The Board is adopting a definition of ``higher-priced mortgage
loan'' that is substantially similar to that proposed but different in
the particulars. The final definition, like the proposed definition,
sets a threshold above a measure of market rates to distinguish higher-
priced mortgage loans from the rest of the mortgage market. But the
measure the Board is adopting is different, and therefore so is the
threshold. Instead of yields on Treasury securities, the final
definition uses average offer rates for the lowest-risk prime
mortgages, termed ``average prime offer rates.'' For the foreseeable
future, the Board will obtain or, as applicable, derive average prime
offer rates for a wide variety of types of transactions from the
Primary Mortgage Market Survey[reg] (PMMS) conducted by Freddie Mac,
and publish these rates on at least a weekly basis. The Board will
conduct its own survey if it becomes appropriate or necessary to do so.
The threshold is set at 1.5 percentage points above the average prime
offer rate on a comparable transaction for first-lien loans, and 3.5
percentage points for subordinate-lien loans. The exclusions from
``higher-priced mortgage loans'' for HELOCs and certain other types of
transactions are adopted as proposed.
Public Comment
A large number and wide variety of industry commenters, as well as
a consumer research and advocacy group, urged the Board to use a prime
mortgage market rate instead of, or in addition to, Treasury yields.
First, they argued the tendency of prime mortgage rates at certain
times to deviate significantly from Treasury yields--such as during the
``flight to quality'' seen in recent months--would lead to unwarranted
coverage of the prime market and arbitrary swings in coverage. Many of
these commenters also pointed out that changes in the Treasury yield
curve (the relationship of short-term to long-term Treasury yields) can
increase or decrease coverage even though neither borrower risk
profiles nor creditor practices or products have changed. The Board's
proposal to address this second problem by matching Treasuries to
mortgages on the basis of the loan's expected life span drew limited,
but mostly negative, comment. Although one large lender specifically
agreed with the proposed matching rules, a few others stated the rules
were too complicated.
The precise recommendations for a measure of mortgage market rates
varied. Several commenters specifically recommended using the PMMS.
They recommended that a threshold be added to the PMMS figure because
it is, by design, at the low end of the range of rates that can be
found in the prime market. Recommendations for thresholds for first-
lien loans ranged from 150 to 300 basis points over the PMMS. Some
commenters recommended approaches that would rely on both Treasuries
and the PMMS. A few recommended the approach of a recent North Carolina
law, which covers a first-lien loan only if its APR exceeds two
thresholds: 300 basis points over the comparable Treasury yield and 175
basis points over the PMMS rate for the 30-year fixed-rate loan. A few
recommended a different way to integrate Treasuries and the PMMS. Under
this approach, the threshold would be set at the comparable Treasury
yield (determined as proposed) plus 200 basis points (400 for
subordinate-lien loans), plus the spread between the PMMS 30-year FRM
rate and the seven-year Treasury.
Some commenters offered alternatives to the PMMS. A consumer
research and advocacy group and Freddie Mac suggested that the Board
could use the higher of the Freddie Mac Required Net Yield (the yield
Freddie Mac expects from purchasing a conforming mortgage) and the
equivalent Fannie Mae yield. Fannie Mae offered a similar, but not
identical, recommendation to use the higher of the current coupon yield
for Fannie Mae Mortgage Backed Securities and Freddie Mac participation
certifications (PC). These yields reflect the price at which a
government-sponsored entity (GSE) security can be sold in the market.
At least one commenter suggested that the Board could conduct its own
survey of mortgage market rates.
Discussion
Based on these comments and the analysis below, the final rule does
not use Treasury yields as the index for higher-priced mortgage loans.
Instead, the rule uses average offer rates on the lowest-risk prime
mortgage loans, termed ``average prime offer rates.'' For the
foreseeable future, the Board will obtain or, as applicable, derive
these rates for a wide variety of types of transactions from the PMMS
and publish them on a weekly basis.
Drawbacks of using Treasury security yields. There are significant
advantages to using Treasury yields to set the APR thresholds.
Treasuries are traded in a highly liquid market; Treasury yield data
are published for many different maturities and can easily be
calculated for other maturities; and the integrity of published yields
is not subject to question. For these reasons, Treasuries are also
commonly used in federal statutes, such as HOEPA, for benchmarking
purposes.
As recent events have highlighted, however, using Treasury yields
to set the APR threshold in a law regulating mortgage loans has two
major disadvantages. The most significant disadvantage is that the
spread between Treasuries and mortgage rates, even prime mortgage
rates, changes in the short term and in the long term. Moreover, the
comparable Treasury security for a given mortgage loan is quite
difficult to determine accurately.
The Treasury-mortgage spread can change for at least three
different reasons. First, credit risk may change on mortgages, even for
the highest-quality borrowers. For example, credit risk increases when
house prices fall. Second, competition for prime borrowers can
increase, tightening spreads, or decrease, allowing lenders to charge
wider spreads. Third, movements in financial markets can affect
Treasury yields but have no effect on lenders' cost of funds or,
therefore, on mortgage rates. For example, Treasury yields fall
disproportionately more than mortgage rates during a ``flight to
quality.''
Recent events illustrate how much the Treasury-mortgage spread can
swing. The spread averaged about 170 basis points in 2007, but
increased to an average of about 220 basis points in the first half of
2008. In addition, the spread was highly volatile in this period,
shifting as much as 25 basis points in a week. The spread may decrease,
but predictions of long-term spreads are highly uncertain.
Changes in the Treasury-mortgage spread can undermine key
objectives of the regulation. These changes mean that loans with
identical credit risk are covered in some periods but not in others,
contrary to the objective of consistent and predictable coverage over
time. Moreover, lenders' uncertainty as to when such changes will occur
can cause them to set an internal threshold below the regulatory
threshold. This may reduce credit availability directly (if a lender's
policy is not to make higher-priced mortgage loans) or indirectly, by
increasing regulatory burden. The recent volatility might lead lenders
to set relatively conservative cushions.
Adverse consequences of volatility in the spread between mortgages
rates and Treasuries could be reduced simply by setting the regulatory
threshold at a high enough level to ensure it excludes all
[[Page 44535]]
prime loans. But a threshold high enough to accomplish this objective
would likely fail to meet another, equally important objective of
covering essentially all of the subprime market. Instead, the Board is
adopting a rate that closely follows mortgage market rates, which
should mute the effects on coverage of changes in the spread between
mortgage rates and Treasury yields.
The second major disadvantage of using Treasury yields to set the
threshold is that the comparable Treasury security for a given mortgage
loan is quite difficult to determine accurately. Regulation C
determines the comparable Treasury security on the basis of contractual
maturity: A loan is matched to a Treasury with the same contract term.
For example, the regulation matches a 30-year mortgage loan to a 30-
year Treasury security. This method does not, however, account for the
fact that very few loans reach their full maturity, and it causes
significant distortions when the yield curve changes shape.\39\ These
distortions can bias coverage, sometimes in unpredictable ways, and
consequently might influence the preferences of lenders to offer
certain loan products in certain environments. For example, a steep
yield curve will create two regulatory forces pushing the subprime
market toward ARMs: A lender could avoid coverage on the margins by
selling ARMs rather than fixed-rate mortgages, and the consumer would
receive an APR that understates the interest rate risk from an ARM
relative to that from a fixed-rate mortgage. (Regulation Z requires the
APR be calculated as if the index does not change; a steep yield curve
indicates that the index will likely rise.) Artificial regulatory
incentives to increase ARMs production in the subprime market could
undermine consumer protection.
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\39\ Robert B. Avery, Kenneth P. Brevoort, and Glenn B. Canner,
Higher-Priced Home Lending and the 2005 HMDA Data, 92 Fed. Res.
Bulletin A123-66 (Sept. 8, 2006).
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The Board proposed to reduce distortions in coverage resulting from
changes in the yield curve by matching loans to Treasury securities on
the basis of the loan's expected life span rather than its legal term
to maturity. For example, the Board proposed to match a 30-year fixed-
rate mortgage loan to a 10-year Treasury security on the supposition
that the mortgage loan will prepay (or default) in ten years or less. A
limitation of this approach is that loan life spans change as rates of
house price appreciation, mortgage rates, and macroeconomic factors
such as unemployment rates change. Loan life spans also change as
specific loan features that influence default or prepayment rates
change, such as prepayment penalties. The challenge of adjusting the
regulation's matching rules on a timely basis would be substantial, and
too-frequent adjustments would complicate creditors' compliance.
Indeed, many commenters judged the proposed matching rules to be too
complicated. This matching problem can be reduced, if not necessarily
eliminated, by using mortgage market rates instead of Treasury security
yields to set the threshold.
A rate from the prime mortgage market. To address the principal
drawbacks of Treasury security yields, the Board is adopting a final
rule that relies instead on a rate that more closely tracks rates in
the prime mortgage market. Section 226.35(a)(2) defines an ``average
prime offer rate'' as an annual percentage rate derived from average
interest rates, points, and other pricing terms offered by a
representative sample of creditors for mortgage transactions that have
low-risk pricing characteristics. Comparing a transaction's annual
percentage rate to this average offered annual percentage rate, rather
than to an average offered contract interest rate, should make the
rule's coverage more accurate and consistent. A transaction is a
higher-priced mortgage loan if its APR exceeds the average prime offer
rate for a comparable transaction by 1.5 percentage points, or 3.5
percentage points in the case of a subordinate-lien transaction. (The
basis for selecting these thresholds is explained further in part
VIII.E) The creditor uses the most recently available average prime
offer rate as of the date the creditor sets the transaction's interest
rate for the final time before consummation.
To facilitate compliance, the final rule and commentary provide
that the Board will derive average prime offer rates from survey data
according to a methodology it will make publicly available, and publish
these rates in a table on the Internet on at least a weekly basis. This
table will indicate how to identify a comparable transaction.
As noted above, the survey the Board intends to use for the
foreseeable future is the PMMS, which contains weekly average rates and
points offered by a representative sample of creditors to prime
borrowers seeking a first-lien, conventional, conforming mortgage and
who would have at least 20 percent equity. The PMMS contains pricing
data for four types of transactions: ``1-year ARM,'' ``5/1-year ARM,''
``30-year fixed,'' and ``15-year fixed.'' For the two types of ARMs,
PMMS pricing data are based on ARMs that adjust according to the yield
on one-year Treasury securities; the pricing data include the margin
and the initial rate (if it differs from the sum of the index and
margin). These data are updated every week and are published on Freddie
Mac's Web site.\40\
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\40\ See http://www.freddiemac.com/dlink/html/PMMS/display/
PMMSOutputYr.jsp.
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The Freddie Mac PMMS is the most viable option for obtaining
average prime offer rates. This is the only publicly available data
source that has rates for more than one kind of fixed-rate mortgage
(the 15-year and the 30-year) and more than one kind of variable-rate
mortgage (the 1-year ARM and the 5/1 ARM). Having rates on at least two
fixed-rate products and at least two variable-rate products supplies a
firmer basis for estimating rates for other fixed-rate and variable-
rate products (such as a 20-year fixed or a 3/1 ARM).
Other publicly available surveys the Board considered are less
suitable for the purposes of this rule. Only one ARM rate is collected
by the Mortgage Bankers Association's Weekly Mortgage Applications
Survey and the Federal Housing Finance Board's Monthly Survey of
Interest Rates and Terms on Conventional Single-Family Non-Farm
Mortgage Loans. Moreover, the FHFB Survey has a substantial lag because
it is monthly and reports rates on closed loans. The Board also
evaluated two non-survey options involving Fannie Mae and Freddie Mac.
One is the Required Net Yield, the prices these institutions will pay
to purchase loans directly. The other is the yield on mortgage-backed
securities issued by Fannie Mae and Freddie Mac. With either option,
data for ARM yields would be difficult to obtain.
These other data sources, however, provide useful benchmarks to
evaluate the accuracy of the PMMS. The PMMS has closely tracked these
other indices, according to a Board staff analysis. The Board will
continue to use them periodically to help it determine whether the PMMS
remains an appropriate data source for Regulation Z. If the PMMS ceases
to be available, or if circumstances arise that render it unsuitable
for this rule, the Board will consider other alternatives including
conducting its own survey.
The Board will use the pricing terms from the PMMS, such as
interest rate and points, to calculate an annual percentage rate
(consistent with Regulation Z, Sec. 226.22) for each of the four types
of transactions that the
[[Page 44536]]
PMMS reports. These annual percentage rates are the average prime offer
rates for transactions of that type. The Board will derive annual
percentage rates for other types of transactions from the loan pricing
terms available in the survey. The method of derivation the Board
expects to use is being published for comment in connection with the
simultaneously proposed revisions to Regulation C. When finalized, the
method will be published on the Internet along with the table of annual
percentage rates.
E. Threshold for Higher-Priced Mortgage Loans
The Board proposed a threshold of three percentage points above the
comparable Treasury security for first-lien loans, or five percentage
points for subordinate-lien loans. Since the final rule uses a
different index, it must also use a different threshold. The Board is
adopting a threshold for first-lien loans of 1.5 percentage points
above the average prime offer rate for a comparable transaction, and
3.5 percentage points for second-lien loans.
Public Comment
Industry commenters consistently contended that, should the Board
use Treasury yields as proposed, thresholds of 300 and 500 basis points
would be too low to meet the Board's stated objective of excluding the
prime market.\41\ These commenters recommended thresholds of 400 basis
points (600 for subordinate-lien loans) or higher, but a few trade
associations recommended 500 (700) or 600 (800). These commenters
contended that covering any part of the prime market would harm
consumers because the secondary market would not purchase loans with
rates over the threshold. They also stated that many originators would
seek to avoid originating such loans because of a stigma these
commenters expect will attach to such loans, the increased compliance
cost associated with the proposed regulations, and the substantial
monetary recovery TILA Section 130 would provide plaintiffs for
violations of the regulations.
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\41\ One trade association reported that some of its members
found the proposal would have covered up to one-third of prime loans
originated between November 2007 and January 2008. This and other
commenters said the effect was particularly pronounced with ARMs.
Several members of this association were reported to have found that
more than one-half of prime 7/1, 5/1, and 3/1 ARMs originated
between November 2007 and January 2008 would have been covered. A
different association of mortgage lenders indicated that some of its
members had found that almost 20 percent of prime and alt-A loans
would be covered under the proposal, though the time frame its
members used was not specified. A major lender reported that the
proposal would have captured 8-10 percent of its portfolio in 2006
and 2007, about twice the portion of its portfolio that it was
required to report as higher-priced under HMDA. The lender
represents that it did not make subprime loans in this period and
asserts that its figures are predictive of the impact the proposal
would have on the prime market overall. Another large lender that
stated it does not make subprime loans believes that about 10
percent of its current originations would fall above the proposed
thresholds. One lender, however, expressed satisfaction with the
proposed 300 basis points for first-lien loans and said an internal
analysis of historical data found it would not have captured
significant numbers of its prime loans. But this lender's analysis
found that significant numbers of prime subordinate-lien loans would
have been captured, leading the lender to recommend raising the
threshold for subordinate-lien loans to 600 basis points.
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A trade association for the manufactured housing industry submitted
that the proposed thresholds would cover a substantial majority of
personal property loans used to purchase manufactured homes. This
commenter contended that the reasons these loans are priced higher than
loans secured by real estate (such as the smaller loan amounts and the
lack of real property securing the loan) do not support a rule that
would cover personal property loans disproportionately.
Consumer and civil rights group commenters generally, but not
uniformly, opposed limiting protections to higher-rate loans and
recommended applying these protections to all loans secured by a
principal dwelling. They recommended in the alternative that the
thresholds be adopted at the levels proposed or even lower. They argued
it was critical to cover all of the subprime market and much if not all
of the alt-A market.
Discussion
As discussed above, the Board has concluded that the stricter
regulations of Sec. 226.35 should cover the subprime market and
generally exclude the prime market; and in the face of uncertainty it
is appropriate to err on the side of covering somewhat more than the
subprime market. Based on available data, it appeared that the
thresholds the Board proposed would capture all of the subprime market
and a portion of the alt-A market.\42\ Based also on available data,
the Board believes that the thresholds it is adopting would cover all,
or virtually all, of the subprime market and a portion of the alt-A
market. The Board considered loan-level origination data for the period
2004 to 2007 for subprime and alt-A securitized pools. The proprietary
source of these data is FirstAmerican Loan Performance.\43\ The Board
also ascertained from a proprietary database of mostly prime loans
(McDash Analytics) that coverage of the prime market during the first
three quarters of 2007 at these thresholds would have been very
limited. The Board recognizes that the recent mortgage market
disruption began at the end of this period, but it is the latest period
for which data were available.
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\42\ The Board noted in the proposal that the percentage of the
first-lien mortgage market Regulation C has captured as higher-
priced using a threshold of three percentage points has been greater
than the percentage of the total market originations that one
industry source has estimated to be subprime (25 percent vs. 20
percent in 2005; 28 percent vs. 20 percent in 2006). For industry
estimates see IMF 2007 Mortgage Market at 4. Regulation C's coverage
of higher-priced loans is not thought, however, to have reached the
prime market in those years. Rather, in both 2005 and 2006 it
reached into the alt-A market, which the same source estimated to be
12 percent in 2005 and 13 percent in 2006. In 2004, Regulation C
captured a significantly smaller part of the market than an industry
estimate of the subprime market (11 percent vs. 19 percent), but
that year's HMDA data were somewhat anomalous because of a steep
yield curve.
\43\ Annual percentage rates were estimated from the contract
rates in these data using formulas derived from a separate
proprietary database of subprime loans that collects contract rates,
points, and annual percentage rates. This separate database, which
contains data on the loan originations of eight subprime mortgage
lenders, is maintained by the Financial Services Research Program at
George Washington University.
---------------------------------------------------------------------------
The Board is adopting a threshold for subordinate-lien loans of 3.5
percentage points. This is consistent with the Board's proposal to set
the threshold over Treasury yields for these loans two percentage
points above the threshold for first-lien loans. With rare exceptions,
commenters explicitly endorsed, or at least did not raise any objection
to, this approach. The Board recognizes that it would be preferable to
set a threshold for second-lien loans above a measure of market rates
for second-lien loans, but it does not appear that a suitable measure
of this kind exists. Although data are very limited, the Board believes
it is appropriate to apply the same difference of two percentage points
to the thresholds above average prime offer rates.
As discussed earlier, the Board recognizes that there are
limitations to making judgments about the future scope of the rule
based on past data. For example, when the final rule takes effect, the
risk premiums for alt-A loans compared to the conforming loans in the
PMMS may be higher than the risk premiums for the period 2004-2007. In
that case, coverage of alt-A loans would be higher than an estimate for
that period would indicate.
Another important example is prime ``jumbo'' loans, or loans
extended to borrowers with low-risk mortgage
[[Page 44537]]
pricing characteristics, but in amounts that exceed the threshold for
loans eligible for purchase by Freddie Mac or Fannie Mae. The PMMS
collects pricing data only on loans eligible for purchase by one of
these entities (``conforming loans''). Prime jumbo loans have always
had somewhat higher rates than prime conforming loans, but the spread
has widened significantly and become much more volatile since August
2007. If this spread remains wider and more volatile when the final
rule takes effect, the rule will cover a significant share of
transactions that would be prime jumbo loans. While covering prime
jumbo loans is not the Board's objective, the Board does not believe
that it should set the threshold at a higher level to avoid what may be
only temporary coverage of these loans relative to the long time
horizon for this rule.
A third example is a request from a trade association for the
manufactured housing industry, including lenders specializing in this
industry, that the thresholds be set higher for loans secured by
dwellings deemed to be personal property. This association pointed to
the higher risk creditors bear on these loans compared to loans secured
by real property, which makes their rates systematically higher for
reasons apart from the risks they pose to consumers. It also maintained
that such loans have not been associated with the abusive practices of
the subprime market.\44\
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\44\ The specific concern of the commenter is with the
requirement to escrow, not, apparently, with the other requirements
for higher-priced loans. As discussed in part IX.D, the Board is
providing creditors two years to comply with the escrow requirement
for manufactured home loans.
---------------------------------------------------------------------------
Credit risk and liquidity risk can vary by many factors, including
geography, property type, and type of loan. This may suggest to some
that different thresholds should be applied to different classes of
transactions. This approach would make the regulation inordinately
complicated and subject it to frequent revision, which would not be in
the interest of creditors, investors, or consumers. Although the
simpler approach the Board is adopting--just two thresholds, one for
first-lien loans and another for subordinate-lien loans--has its
disadvantages, the Board believes they are outweighed by its benefits
of simplicity and stability.
F. The Timing of Setting the Threshold
The Board proposed to set the threshold for a dwelling-secured
mortgage loan as of the application date. Specifically, a creditor
would use the Treasury yield as of the 15th of the month preceding the
month in which the application is received. The Board noted that
inconsistency with Regulation C, which sets the threshold as of the
15th of the month before the rate is locked, could increase regulatory
burden. The Board suggested, however, that setting the threshold as of
the application date might introduce more certainty, earlier in the
application process, to the determination as to whether a potential
transaction would be a higher-priced mortgage loan when consummated.
Very few commenters addressed the precise issue. A couple of them
specifically advocated using the rate lock date to select the Treasury
yield, as in Regulation C, rather than the application date. Subsequent
outreach by the Board indicated that there are different views as to
which date to use. Some parties prefer the rate lock date because it is
more accurate and therefore would minimize coverage of loans that are
not intended to be covered and maximize coverage of loans that are
intended to be covered. Other parties prefer the application date
because they believe it increases the creditor's ability to predict,
when underwriting the loan, that the loan is, or is not, covered by
Sec. 226.35.
As noted above, the final rule requires the creditor to use the
rate lock date, the date the rate is set for the final time before
consummation, rather than the application date. Using the application
date might increase the predictability of coverage at the time of
underwriting. Using the rate lock date would increase the accuracy of
coverage at least somewhat. On balance, the Board believes it is more
important to maximize coverage accuracy.
G. Proposal To Conform Regulation C (HMDA)
Regulation C, which implements HMDA, requires creditors to report
price data on higher-priced mortgage loans. A creditor reports the
difference between a loan's annual percentage rate and the yield on
Treasury securities having comparable periods of maturity, if that
difference is at least three percentage points for first-lien loans or
at least five percentage points for subordinate-lien loans. 12 CFR
203.4(a)(12). Many commenters suggested that the Board establish a
uniform definition of ``higher-priced mortgage loan'' for purposes of
Regulation C and Regulation Z. Having a single definition would reduce
regulatory burden and make the HMDA data a more useful tool to evaluate
effects of Regulation Z. Moreover, the Board adopted Regulation C's
requirement to report certain mortgage loans as being higher-priced
with an objective of covering the subprime market and exclude the prime
market, and the definition of ``higher-priced mortgage loan'' adopted
in this rule better achieves this objective than the definition in
Regulation C for the reasons discussed in part VIII.D. Accordingly, in
a separate notice published simultaneously with this final rule the
Board is proposing to amend Regulation C to apply the same index and
threshold adopted in Sec. 226.35(a).
H. Types of Loans Covered Under Sec. 226.35
The Board proposed to apply the protections of Sec. 226.35 to
first-lien, as well as subordinate-lien, closed-end mortgage loans
secured by the consumer's principal dwelling. This would include home
purchase loans, refinancings, and home equity loans. The proposed
definition would not cover loans that do not have primarily a consumer
purpose, such as loans for real estate investment. The proposed
definition also would not cover HELOCs, reverse mortgages,
construction-only loans, or bridge loans. In these respects, the rule
is adopted as proposed.
Coverage of Home Purchase Loans, Refinancings, and Home Equity Loans
The statutory protections for HOEPA loans are generally limited to
closed-end refinancings and home equity loans. See TILA Section
103(aa), 15 U.S.C. 1602(aa). The final rule applies the protections of
Sec. 226.35 to loans of these types, which have historically presented
the greatest risk to consumers. These loans are often made to consumers
who have home equity and, therefore, have an existing asset at risk.
These loans also can be marketed aggressively by originators to
homeowners who may not benefit from them and who, if responding to the
marketing and not shopping independently, may have limited information
about their options.
The Board proposed to use its authority under TILA Section
129(l)(2), 15 U.S.C. 1639(l)(2), to apply the protections of Sec.
226.35 to home purchase loans as well. Commenters did not object, and
the Board is adopting the proposal. Covering only refinancings of home
purchase loans would fail to protect consumers adequately. From 2003
through the first half of 2007, 42 percent of the higher-risk ARMs that
came to dominate the subprime market in recent years were extended to
[[Page 44538]]
consumers to purchase a home.\45\ Delinquencies on subprime ARMs used
for home purchase have risen more sharply than they have for
refinancings. Moreover, comments and testimony at the Board's hearings
indicate that the problems with abusive lending practices are not
confined to refinancings and home equity loans.
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\45\ Figure calculated from First American LoanPerformance data.
---------------------------------------------------------------------------
Furthermore, consumers who are seeking home purchase loans can face
unique constraints on their ability to make decisions. First-time
homebuyers are likely unfamiliar with the mortgage market. Homebuyers
generally are primarily focused on acquiring a new home, arranging to
move into it, and making other life plans related to the move, such as
placing their children in new schools. These matters can occupy much of
the time and attention consumers might otherwise devote to shopping for
a loan and deciding what loan to accept. Moreover, even if the consumer
comes to understand later in the application process that an offered
loan may not be appropriate, the consumer may not be able to reject the
loan without risk of abrogating the sales agreement and losing a
substantial deposit, as well as disrupting moving plans.
Limitation to Loans Secured by Principal Dwelling; Exclusion of Loans
for Investment
As proposed, Sec. 226.35 protections are limited to loans secured
by the consumer's principal dwelling. The Board's primary concern is to
ensure that consumers not lose the homes they principally occupy
because of unfair, abusive, or deceptive lending practices. The
inevitable costs of new regulation, including potential unintended
consequences, can most clearly be justified when people's principal
homes are at stake.
A loan to a consumer to purchase or improve a second home would not
be covered by these protections unless the loan was secured by the
consumer's principal dwelling. Loans primarily for a real estate
investment purpose also are not covered. This exclusion is consistent
with TILA's focus on consumer-purpose transactions and its exclusion in
Section 104 of credit primarily for business, commercial, or
agricultural purposes. See 15 U.S.C. 1603(1). Real estate investors are
expected to be more sophisticated than ordinary consumers about the
real estate financing process and to have more experience with it,
especially if they invest in several properties. Accordingly, the need
to protect investors is not clear, and in any event is likely not
sufficient to justify the potential unintended consequences of imposing
restrictions, with civil liability if they are violated, on the
financing of real estate investment transactions.
The Board shares concerns that individuals who invest in
residential real estate and do not pay their mortgage obligations put
tenants at risk of eviction in the event of foreclosure. Regulating the
rights of landlords and tenants, however, is traditionally a matter for
state and local law. The Board believes that state and local law could
better address this particular concern than a Board regulation.
Coverage of Nontraditional Mortgages
Under the final rule, nontraditional mortgage loans, which permit
non-amortizing payments or negatively amortizing payments, are covered
by Sec. 226.35 if their APRs exceed the threshold. Several consumer
and civil rights groups, and others, contended that Sec. 226.35 should
cover nontraditional mortgage loans regardless of loan price because of
their potential for significant payment shock and other risks that led
the federal banking agencies to issue the Nontraditional Mortgage
Guidance. The Board does not believe that the enhanced protections of
Sec. 226.35 should be applied on the basis of product type, with the
limited exception of the narrow exemptions for HELOCs and other loan
types the Board is adopting. A rule based on product type would need to
be reexamined frequently as new products were developed, which could
undermine the market by making the rule less predictable. Moreover, it
is not clear what criteria the Board would use to decide which products
were sufficiently risky to warrant categorical coverage. The Board
believes that other tools such as supervisory guidance provide the
requisite flexibility to address particular product types when that
becomes necessary.
HELOC Exemption
The Board proposed to exempt HELOCs largely for two reasons. First,
the Board noted that most originators of HELOCs hold them in portfolio
rather than sell them, which aligns these originators' interests in
loan performance more closely with their borrowers' interests. Second,
unlike originations of higher-priced closed-end mortgage loans, HELOC
originations are concentrated in the banking and thrift industries,
where the federal banking agencies can use supervisory authorities to
protect borrowers. For example, when inadequate underwriting of HELOCs
unduly increased risks to originators and consumers several years ago,
the agencies responded with guidance.\46\ The Board also pointed to
TILA and Regulation Z's special protections for borrowers with HELOCs
such as restrictions on changing plan terms.
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\46\ Interagency Credit Risk Guidance for Home Equity Lending,
SR 05-11 (May 16, 2005), available at http://www.federalreserve.gov/
boarddocs/srletters/2005/sr0511a1.pdf.; Addendum to Credit Risk
Guidance for Home Equity Lending, SR 06-15 (Sept. 29, 2006),
available at http://www.federalreserve.gov/BoardDocs/SRLetters/2006/
SR0615a3.pdf.
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Several national trade associations and a few large lenders voiced
strong support for excluding HELOCs, generally for the reasons the
Board cited. Several consumer and civil rights groups disagreed,
contending that enough HELOCs are securitized to raise doubts that the
originator's interests are sufficiently aligned with the borrower's
interests. They maintained that Regulation Z disclosures and
limitations for HELOCs are not adequate to protect consumers, and
pointed to specific cases in which unaffordable HELOCs had been
extended. Other commenters, such as an association of state regulators,
agreed that HELOCs should be covered. Commenters offered very few
concrete suggestions, however, for how to determine which HELOCs would
be covered, such as an index and threshold.
The Board is adopting the proposal for the reasons stated. The
Board recognizes, however, that HELOCs present a risk of circumvention.
Creditors may seek to evade limitations on closed-end transactions by
structuring such transactions as open-end transactions. In Sec.
226.35(b)(5), discussed below in part IX.E, the Board prohibits
structuring a closed-end loan as an open-end transaction for the
purpose of evading the new rules in Sec. 226.35.
Other Exemptions Adopted
The other proposed exclusions drew limited comment. A couple of
commenters expressed support for excluding reverse mortgages while a
couple of commenters opposed it. A few large lenders voiced support for
excluding construction-only loans. A few commenters voiced support for
the exclusion of temporary bridge loans of 12 months or less, and none
of the commenters seemed to oppose it. The Board is adopting the
proposed exclusions for reverse mortgages, construction-only loans, and
temporary or bridge loans of 12 months or less.
[[Page 44539]]
Reverse mortgages. The Board is keenly aware of consumer protection
concerns raised by the expanding market for reverse mortgages, which
are complex and are sometimes marketed with other complex financial
products. Unique aspects of reverse mortgages--for example, the
borrower's repayment ability is based on the value of the collateral
rather than on income--suggest that they should be addressed separately
from this final rule. The Board is reviewing this segment of the
mortgage market in connection with its comprehensive review of
Regulation Z to determine what measures may be required to ensure
consumers are protected.
Construction-only loans. Section 226.35 excludes a construction-
only loan, defined as a loan solely for the purpose of financing the
initial construction of a dwelling, consistent with the definition of a
``residential mortgage transaction'' in Sec. 226.2(a)(24). A
construction-only loan does not include the permanent financing that
replaces a construction loan. Construction-only loans do not appear to
present the same risk of consumer abuse as other loans the proposal
would cover. The permanent financing, or a new home-secured loan
following construction, would be covered by proposed Sec. 226.35
depending on its APR. Applying Sec. 226.35 to construction-only loans,
which generally have higher interest rates than the permanent
financing, could hinder some borrowers' access to construction
financing without meaningfully enhancing consumer protection
Bridge loans. HOEPA now covers certain bridge loans with rates or
fees high enough to make them HOEPA loans. TILA Section 129(l)(1)
provides the Board authority to exempt classes of mortgage transactions
from HOEPA if the Board finds that the exemption is in the interest of
the borrowing public and will apply only to products that maintain and
strengthen homeownership and equity protection. 15 U.S.C. 1639(l)(2).
The Board believes a narrow exemption for bridge loans from the
restrictions of Sec. 226.35, as they apply to HOEPA loans, would be in
borrowers' interest and support homeownership.
The final rule, like the proposed rule, gives as an example of a
``temporary or bridge loan'' a loan to purchase a new dwelling where
the consumer plans to sell a current dwelling within 12 months. This is
not the only potential bona fide example of a temporary or bridge loan.
The Board does expect, however, that the temporary or bridge loan
exemption will be applied narrowly and not to evade or circumvent the
regulation. For example, a 12-month loan with a substantial balloon
payment would not qualify for the exemption where it was clearly
intended to lead a borrower to refinance repeatedly into a chain of 12-
month loans.
Exemptions Not Adopted
Industry commenters proposed additional exclusions that the Board
is not adopting.
Government-guaranteed loans. Some commenters proposed excluding
loans with federal guaranties such as FHA, VA, and Rural Housing
Service. They suggested that the federal regulations that govern these
loans are sufficient to protect consumers, and that new regulations
under HOEPA were not only unnecessary but could cause confusion. At
least one commenter also suggested excluding loans with state or local
agency guaranties.
The Board does not believe that exempting government-guaranteed
loans from Sec. 226.35 is appropriate. It is not clear what criteria
the Board would use to decide precisely which government programs would
be exempted; commenters did not offer concrete suggestions. Moreover,
such exemptions could attract to agency programs less scrupulous
originators seeking to avoid HOEPA's civil liability, with serious
unintended consequences for consumers as well as for the agencies and
taxpayers.
Jumbo loans. A few commenters proposed excluding non-conforming or
``jumbo'' loans, that is, loans that exceed the threshold amount for
eligibility for purchase by Fannie Mae or Freddie Mac. They cited a
lack of evidence of widespread problems with jumbo loan performance,
and a belief that borrowers who can afford jumbo loans are more
sophisticated consumers and therefore better able to protect
themselves.
The Board does not believe excluding jumbo loans would be
appropriate. The request is based on certain assumptions about the
characteristics of the borrowers who take out jumbo loans. In fact,
jumbo loans are offered in the subprime and alt-A markets and not just
in the prime market. A categorical exemption of jumbo loans could
therefore seriously undermine protections for consumers, especially in
areas with above-average home prices.
Portfolio loans. A commenter proposed excluding loans held in
portfolio on the basis that a lender will take more care with these
loans. Among other concerns with such an exemption is that it often
cannot be determined as of consummation whether a loan will be held in
portfolio or sold immediately--or, if held, for how long before being
sold. Therefore, such an exception to the rule does not appear
practicable and could present significant opportunities for evasion.
IX. Final Rules for Higher-Priced Mortgage Loans and HOEPA Loans
A. Overview
This part discusses the new consumer protections the Board is
applying to ``higher-priced mortgage loans'' and HOEPA loans. Creditors
are prohibited from extending credit without regard to borrowers'
ability to repay from sources other than the collateral itself. The
final rule differs from the proposed rule in that it removes the
proposed ``pattern or practice'' phrase and adds a presumption of
compliance when certain underwriting procedures are followed. Creditors
are also required to verify income and assets they rely upon to
determine repayment ability, and to establish escrow accounts for
property taxes and insurance. In addition, a higher-priced mortgage
loan may not have a prepayment penalty except under certain conditions.
These conditions are substantially narrower than those proposed.
The Board finds that the prohibitions in the final rule are
necessary to prevent practices that the Board finds to be unfair,
deceptive, associated with abusive lending practices, or otherwise not
in the interest of the borrower. See TILA Section 129(l)(2), 15 U.S.C.
1639(l)(2), and the discussion of this statute in part V above.
The Board is also adopting the proposed rule prohibiting a creditor
from structuring a closed-end mortgage loan as an open-end line of
credit for the purpose of evading the restrictions on higher-priced
mortgage loans, which do not apply to open-end lines of credit. This
rule is based on the authority of the Board under TILA Section
129(l)(2) to prohibit practices that would evade Board regulations
adopted under authority of that statute. 15 U.S.C. 1639(l)(2).
B. Disregard of Consumer's Ability To Repay--Sec. Sec. 226.34(a)(4)
and 226.35(b)(1)
TILA Section 129(h), 15 U.S.C. 1639(h), and Regulation Z Sec.
226.34(a)(4) prohibit a pattern or practice of extending credit subject
to Sec. 226.32 (HOEPA loans) based on consumers' collateral without
regard to their repayment ability. The regulation creates a presumption
of a violation where a creditor has a pattern or practice of failing to
verify and document repayment ability. The Board
[[Page 44540]]
proposed to revise the prohibition on disregarding repayment ability
and extend it, through proposed Sec. 226.35(b)(1), to higher-priced
mortgage loans as defined in Sec. 226.35(a). The proposed revisions
included adding several rebuttable presumptions of violations for a
pattern or practice of failing to follow certain underwriting
procedures, and a safe harbor.
The final rule removes ``pattern or practice'' and therefore
prohibits any HOEPA loan or higher-priced mortgage loan from being
extended based on the collateral without regard to repayment ability.
Verifying repayment ability has been made a requirement rather than a
presumptive requirement. The proposal provided that a failure to follow
any one of several specified underwriting procedures would create a
presumption of a violation. In the final rule, those procedures, with
modifications, have instead been incorporated into a presumption of
compliance which replaces the proposed safe harbor.
Public Comment
Mortgage lenders and their trade associations that commented
generally, but not uniformly, support or at least do not oppose a rule
requiring creditors to consider repayment ability. They maintain,
however, that the rule as drafted would unduly constrain credit
availability because of the combination of potentially significant
damages under TILA Section 130, 15 U.S.C. 1640, and a perceived lack of
a clear and flexible safe harbor. These commenters stated that two
elements of the rule that the Board had intended to help preserve
credit availability--the ``pattern or practice'' element and a safe
harbor for a creditor having a reasonable expectation of repayment
ability for at least seven years--would not have the intended effect.
Many of these commenters suggested that the rule would unduly constrain
credit unless the Board removed the presumptions of violations and
provided a clearer and more specific safe harbor. Some of these
commenters also requested additional safe harbors, such as for use of
an automated underwriting system (AUS) of Fannie Mae or Freddie Mac.
Consumer, civil rights, and community development groups, as well
as some state and local government officials, several members of
Congress, a federal regulator, and others argued that ``pattern or
practice'' seriously weakened the rule and urged its removal. They
maintain that ``pattern or practice'' would effectively prevent an
individual borrower from bringing a claim or counter-claim based on his
or her loan, and reduce the rule's deterrence of irresponsible lending.
These commenters generally support the proposed presumptions of
violations but many of them urged the Board to adopt quantitative
standards for the proposed presumptions for failing to consider debt-
to-income ratios (DTI) and residual income levels. As discussed above,
these commenters also would apply the rule to nontraditional mortgages
regardless of price, and a few would apply the rule to the entire
mortgage market including the prime market.
The comments are discussed in more detail throughout this section
as applicable.
Discussion
The Board finds that disregarding a consumer's repayment ability
when extending a higher-priced mortgage loan or HOEPA loan, or failing
to verify the consumer's income, assets, and obligations used to
determine repayment ability, are unfair practices. This section
discusses the evidence from recent events of a disregard for repayment
ability and reliance on unverified incomes in the subprime market; the
substantial injuries that disregarding repayment ability and failing to
verify income causes consumers; the reasons consumers cannot reasonably
avoid these injuries; and the Board's basis for concluding that the
injuries are not outweighed by countervailing benefits to consumers or
competition when repayment ability is disregarded or income is not
verified.
Evidence of a recent widespread disregard of repayment ability.
Approximately three-quarters of securitized originations in subprime
pools from 2003 to 2007 were 2-28 or 3-27 ARMs with a built-in
potential for significant payment shock at the start of the third or
fourth year, respectively.\47\ Originations of these types of mortgages
during 2005 and 2006 and through early 2007 have contributed
significantly to a substantial increase in serious delinquencies and
foreclosures. The proportion of all subprime mortgages past-due ninety
days or more (``serious delinquency'') was about 13 percent in October
2007, more than double the mid-2005 level.\48\ Adjustable-rate subprime
mortgages reached a serious delinquency rate of almost 28 percent in
May 2008, quintuple the mid-2005 level. The serious delinquency rate
has also risen for loans in alt-A (near prime) securitized pools to
almost 8 percent (as of April 2008) from less than 2 percent only a
year ago. In contrast, 1.5 percent of loans in the prime-mortgage
sector were seriously delinquent as of April 2008.
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\47\ In a typical case of a 2-28 discounted ARM, a $200,000 loan
with a discounted rate of 7 percent for two years (compared to a
fully-indexed rate of 11.5 percent) and a 10 percent maximum rate in
the third year would start at a payment of $1,531 and jump to a
payment of $1,939 in the third year, even if the index value did not
increase. The rate would reach the fully-indexed rate in the fourth
year (if the index value still did not change), and the payment
would increase to $2,152. The example assumes an initial index of
5.5 percent and a margin of 6 percent; assumes annual payment
adjustments after the initial discount period; a 3 percent cap on
the interest rate increase at the end of year 2; and a 2 percent
annual payment adjustment cap on interest rate increases thereafter,
with a lifetime payment adjustment cap of 6 percent (or a maximum
rate of 13 percent).
\48\ Delinquency rates calculated from data from First American
LoanPerformance on mortgages in subprime securitized pools. Figures
include loans on non-owner-occupied properties.
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Higher delinquencies have shown through to foreclosures.
Foreclosures were initiated on some 1.5 million U.S. homes during 2007,
up 53 percent from 2006, and the rate of foreclosure starts looks to be
higher yet for 2008. Lenders initiated over 550,000 foreclosures in the
first quarter of 2008, about 274,000 of them on subprime mortgages.
This was significantly higher than the quarterly average of 440,000
foreclosures in the second half of 2007 and 325,000 in the first half,
and twice the quarterly average of 225,000 for the past six years.\49\
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\49\ Estimates are based on data from MBA Nat'l Delinquency
Survey.
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Payment increases on 2-28 and 3-27 ARMs have not been a major cause
of the increase in delinquencies and foreclosures because most
delinquencies occurred before the payments were adjusted. Rather, a
major contributor to these delinquencies was lenders' extension of
credit on the basis of income stated on applications without
verification.\50\ Originators had strong incentives to make these
``stated income'' loans, and consumers had incentives to accept them.
Because the loans could be originated more quickly, originators, who
were paid based on volume, could increase their earnings by originating
more of them. The share of ``low doc'' and ``no doc'' loan originations
in the securitized subprime market rose from 20 percent in 2000, to 30
percent in 2004, to 40 percent in 2006.\51\ The prevalence of stated
income lending left wide room for the loan officer, mortgage broker, or
consumer to overstate the consumer's income so the consumer could
qualify for a larger loan
[[Page 44541]]
and the loan officer or broker could receive a larger commission. There
is substantial anecdotal evidence that borrower incomes were commonly
inflated.\52\
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\50\ See U.S. Gov't Accountability Office, GAO-08-78R,
Information on Recent Default and Foreclosure Trends for Home
Mortgages and Associated Economic and Market Developments 5 (2007);
Fannie Mae, Weekly Economic Commentary (Mar. 26, 2007).
\51\ Figures calculated from First American LoanPerformance
data.
\52\ See Mortgage Asset Research Inst., Inc., Eighth Periodic
Mortgage Fraud Case Report to the Mortgage Bankers Association
(2006) (reporting that 90 of 100 stated income loans sampled used
inflated income when compared to tax return data); Fitch Ratings,
Drivers of 2006 Subprime Vintage Performance (November 13, 2007)
(Fitch 2006 Subprime Performance) (reporting that stated income
loans with high combined loan to value ratios appear to have become
vehicles for fraud).
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Lenders relying on overstated incomes to make loans could not
accurately assess consumers' repayment ability.\53\ Evidence of this
failure is found in the somewhat steeper increase in the rate of
default for low/no doc loans originated when underwriting standards
were declining in 2005 and 2006 relative to full documentation
loans.\54\ Due in large part to creditors' reliance on inaccurate
``stated incomes,'' lenders often failed to determine reliably that the
consumer would be able to afford even the initial discounted payments.
Almost 13 percent of the 2-28 ARMs originated in 2005 appear to have
become seriously delinquent before their first reset.\55\ While some of
these borrowers may have been able to make their payments--but stopped
because their home values declined and they lost what little equity
they had--others were not able to afford even their initial payments.
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\53\ Consumers may also have been led to pay more for their
loans than they otherwise would. There is generally a premium for a
stated income loan. An originator may not have sufficient incentive
to disclose the premium on its own initiative because collecting and
reviewing documents could slow down the origination process, reduce
the number of loans an originator produces in a period, and,
therefore, reduce the originator's compensation for the period.
Consumers who are unaware of this premium are effectively deprived
of an opportunity to shop for a potentially lower-rate loan
requiring full documentation.
\54\ Determined from First American LoanPerformance data. See
also Fitch 2006 Subprime Performance (stating that lack of income
verification, as opposed to lack of employment or down payment
verification, caused 2006 low documentation loans delinquencies to
be higher than earlier vintages' low documentation loans).
\55\ Figure calculated from First American LoanPerformance data.
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Although payment shock on 2-28 and 3-27 ARMs did not contribute
significantly to the substantial increase in delinquencies, there is
reason to believe that creditors did not underwrite to a rate and
payment that would take into account the risk to consumers of a payment
shock. Creditors also may not have factored in the consumer's
obligation for the expected property taxes and insurance, or the
increasingly common ``piggyback'' second-lien loan or line of credit a
consumer would use to finance part or all of the down payment.
By frequently basing lending decisions on overstated incomes and
understated obligations, creditors were in effect often extending
credit based on the value of the collateral, that is, the consumer's
house. Moreover, by coupling these practices with a practice of
extending credit to borrowers with very limited equity, creditors were
often extending credit based on an expectation that the house's value
would appreciate rapidly.\56\ Creditors may have felt that rapid house
price appreciation justified loosening their lending standards, but in
some locations house price appreciation was fed by loosened standards,
which permitted consumers to take out larger loans and bid up house
prices. Loosened lending standards therefore made it more likely that
the inevitable readjustment of house prices in these locations would be
severe.
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\56\ Often the lender extended credit knowing that the borrower
would have no equity after taking into account a simultaneous
second-lien (``piggyback'') loan. According to Fitch 2006 Subprime
Performance, first-lien loans in subprime securitized pools with
simultaneous second liens rose from 1.1 percent in 2000 to 6.4
percent in 2003 to 30 percent in 2006. Moreover, in some cases the
appraisal the lender relied on overstated borrower equity because
the lender or broker pressured the appraiser to inflate the house
value. The prohibition against coercing appraisers is discussed
below in part X.B.
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House price appreciation began to slow in 2006 and house price
levels actually began to decline in many places in 2007. Borrowers who
could not afford their mortgage obligations because their repayment
ability had not been assessed properly found it more difficult to lower
their payments by refinancing. They lacked sufficient equity to meet
newly tightened lending standards, or they had negative equity, that
is, they owed more than their house was worth. For the same reasons,
many consumers also could not extinguish their mortgage obligations by
selling their homes. Declining house prices led to sharp increases in
serious delinquency rates in both the subprime and alt-A market
segments, as discussed above.\57\
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\57\ Estimates are based on data from MBA Nat'l Delinquency
Survey.
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Although the focus of Sec. 226.35 is the subprime market, it may
cover part of the alt-A market. Disregard for repayment ability was
often found in the alt-A market as well. Alt-A loans are made to
borrowers who typically have higher credit scores than subprime
borrowers, but the loans pose more risk than prime loans because they
involve small down payments or reduced income documentation, or the
terms of the loan are nontraditional. According to one estimate, loans
with nontraditional terms that permitted borrowers to defer principal
(``interest-only'') or both principal and some interest (``option
ARM'') in exchange for higher payments later--reached 78 percent of
alt-A originations in 2006.\58\ The combination of a variable rate with
a deferral of principal and interest held the potential for substantial
payment shock within five years. Yet rising delinquency rates to almost
8 percent in 2008, from less than 1 percent in 2006, could suggest that
lenders too often assessed repayment ability at a low interest rate and
payment that did not adequately account for near-certain payment
increases. In addition, these loans typically were made based on
reduced income documentation. For example, the share of interest-only
mortgages with low or no documentation in alt-A securitized pools
increased from around 64 percent in 2003 to nearly 80 percent in
2006.\59\ It is generally accepted that the reduced documentation of
income led to a high degree of income inflation in the alt-A market
just as it did in the subprime market.
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\58\ David Liu and Shumin Li, Alt-A Credit--The Other Shoe
Drops?, The MarketPulse (First American LoanPerformance, Inc., San
Francisco, Cal.) Dec. 2006.
\59\ Figures calculated from First American LoanPerformance
data.
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Substantial injury. A borrower who cannot afford to make the loan
payments as well as payments for property taxes and homeowners
insurance because the lender did not adequately assess the borrower's
repayment ability suffers substantial injury. Missing mortgage payments
is costly: Large late fees are charged and the borrower's credit record
is impaired, reducing her credit options. If refinancing to a loan with
a lower payment is an option (for example, if the borrower can obtain a
loan with a longer maturity), refinancing can slow the rate at which
the consumer is able to pay down principal and build equity. The
borrower may have to tap home equity to cover the refinancing's closing
costs or may have to accept a higher interest rate in exchange for the
lender paying the closing costs. If refinancing is not an option, then
the borrower and household must make sacrifices to keep the home such
as reducing other expenditures or taking additional jobs. If keeping
the home is not tenable, the borrower must sell it or endure
foreclosure, the costs of which (for example, property maintenance
costs, attorneys fees, and other fees passed on to the consumer) will
erode any equity
[[Page 44542]]
the consumer had. The foreclosure will mar the consumer's credit record
and make it very difficult for the consumer to become a homeowner again
any time soon. Many borrowers end up owing the lender more than the
house is worth, especially if their homes are sold into a declining
market as is happening today in many parts of the country. Foreclosures
also may force consumers to move, which is costly and disruptive. In
addition to the financial costs of unsustainable lending practices,
borrowers and households can suffer serious emotional hardship.
If foreclosures due to irresponsible lending rise rapidly or reach
high levels in a particular geographic area, then the injuries can
extend beyond the individual borrower and household to the larger
community. A foreclosure cluster in a neighborhood can reduce homeowner
equity throughout the neighborhood by bringing down prices, eroding the
asset that for many households is their largest.\60\ A significant rise
in foreclosures can create a cycle where foreclosures bring down
property values, reducing the ability and incentive of homeowners,
particularly those under stress for other reasons, to retain their
homes. Foreclosure clusters also can lower municipal tax revenues,
reducing a locality's ability to maintain services and make capital
investments. At the same time, revenues may be diverted to mitigating
hazards that clusters of vacant homes can create.\61\
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\60\ E.g., Zhenguo Lin, et al. Spillover Effects of Foreclosures
on Neighborhood Property Values, Journal of Real Estate Finance and
Economics Online (Nov. 2007), available at http://
www.springerlink.com/content/rk4q0p4475vr3473/fulltext.pdf.
\61\ E.g., William C. Apgar and Mark Duda. Collateral Damage:
The Municipal Impact of Today's Mortgage Foreclosure Boom
(Minneapolis: Homeownership Preservation Foundation 2005).
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Lending without regard to repayment ability also has other
consequences. It facilitates an abusive strategy of ``flipping''
borrowers in a succession of refinancings designed ostensibly to lower
borrowers' burdensome payments that actually convert borrowers' equity
into fees for originators without providing borrowers a benefit.
Moreover, relaxed standards, such as those that pervaded the subprime
market recently, may increase the incidence of abusive lending
practices by attracting less scrupulous originators into the market
while at the same time bringing more vulnerable borrowers into the
market. The rapid influx of new originators that can accompany a
relaxation of lending standards makes it more difficult for regulators
and investors alike to distinguish responsible from irresponsible
actors. See supra part II.
Injury not reasonably avoidable. One might assume that borrowers
could avoid unsustainable loans by comparing their current and expected
incomes to their current and expected expenses, including the scheduled
loan payments disclosed under TILA and an estimate of property taxes
and homeowners insurance. There are several reasons, however, why
consumers, especially in the subprime market, accept risky loans they
will struggle or fail to repay. In some cases, originators mislead
borrowers into entering into unaffordable loans by understating the
payment before closing and disclosing the true payment only at closing
(``bait and switch''). At the closing table, many borrowers may not
notice the disclosure of the payment amount or have time to consider it
because borrowers are typically provided with many documents to sign
then. Borrowers who consider the disclosure may nonetheless feel
constrained to close the loan, for a number of reasons. They may
already have paid substantial fees and expect that more applications
would require more fees. They may have signed agreements to purchase a
new house and sell the current house. Or they may need to escape an
overly burdensome payment on a current loan, or urgently need the cash
that the loan will provide for a household emergency.
Furthermore, many consumers in the subprime market will accept
loans knowing they may have difficulty affording the payments because
they reasonably believe a more affordable loan will not be available to
them. As explained in part II.B, limited transparency of prices,
products, and originator incentives reduces a borrower's expected
benefit from shopping further for a better option. Moreover, taking
more time to shop can be costly, especially for the borrower in a
financial pinch. Thus, borrowers often make a reasoned decision to
accept unfavorable terms.
Furthermore, borrowers' own assessment of their repayment ability
may be influenced by their belief that a lender would not provide
credit to a consumer who did not have the capacity to repay. Borrowers
could reasonably infer from a lender's approval of their applications
that the lender had appropriately determined that they would be able to
repay their loans. Borrowers operating under this impression may not
independently assess their repayment ability to the extent necessary to
protect themselves from taking on obligations they cannot repay.
Borrowers are likely unaware of market imperfections that may reduce
lenders' incentives to fully assess repayment ability. See part II.B.
And borrowers would not realize that a lender was applying loose
underwriting standards such as assessing repayment ability on the basis
of a ``teaser'' payment. In addition, originators may sometimes
encourage borrowers to be excessively optimistic about their ability to
refinance should they be unable to sustain repayment. For example, they
sometimes offer reassurances that interest rates will remain low and
house prices will increase; borrowers may be swayed by such
reassurances because they believe the sources are experts.
Stated income and stated asset loans can make it even more
difficult for a consumer to avoid an unsustainable loan. With stated
income (or stated asset) loans, the applicant may not realize that the
originator is inflating the applicant's income and assets to qualify
the applicant for the loan. Applicants do not necessarily even know
that they are being considered for stated income or stated asset loans.
They may give the originator documents verifying their income and
assets that the originator keeps out of the loan file because the
documents do not demonstrate the income and assets needed to make the
loan. Moreover, if a consumer knowingly applies for a stated income or
stated asset loan and correctly states her income or assets, the
originator can write an inflated figure into the application form. It
is typical for the originator to fill out the application for the
consumer, and the consumer may not see the written application until
closing, when the borrower often is provided with numerous documents to
review and sign and may not review the application form with care. The
consumer who detects the inflated numbers at the closing table may not
realize their importance or may face constraints that make it
particularly difficult to walk away from the table without the loan.
Some consumers may also overstate their income or assets with the
encouragement of a loan originator who makes it clear that the
consumer's actual income or assets are not high enough to qualify them
for the loans they seek. Such originators may reassure applicants that
this is a benign and common practice. In addition, applicants may
inflate their incomes and assets on their own initiative in
circumstances where the originator does not have reason to know.
For all of these reasons, borrowers cannot reasonably avoid
injuries from lenders' disregard of repayment ability.
[[Page 44543]]
Moreover, other consumers who are not parties to irresponsible
transactions but suffer from their spillover effects have no ability to
prevent these injuries.
Injury not outweighed by countervailing benefits to consumers or to
competition. There is no benefit to consumers or competition from loans
that are extended without regard to consumers' ability to make even the
initial payments. There may be some benefit to consumers from loans
that are underwritten based on the collateral and without regard to
consumers' ability to sustain their payments past some initial period.
For example, a consumer who has lost her principal source of income may
benefit from being able to risk her home and her equity in the hope
that, before she exhausts her savings, she will obtain a new job that
will generate sufficient income to support the payment obligation. The
Board believes, however, that this rare benefit is outweighed by the
substantial costs to most borrowers and communities of extending
higher-risk loans without regard to repayment ability. (Adopting
exceptions to the rule for hardship cases would create significant
potential loopholes and make the rule unduly complex. The final rule
does, however, contain an exemption for temporary or ``bridge'' loans
of 12 months or less, though this exemption is intended to be construed
narrowly.)
The Board recognizes as well that stated income (or stated asset)
lending has at least three potential benefits for consumers and
competition. It may speed credit access for consumers who need credit
on an emergency basis, save some consumers from expending significant
effort to document their income, and provide access to credit for
consumers who cannot document their incomes. The first two benefits are
limited relative to the substantial injuries caused by lenders' relying
on unverified incomes. The third benefit is also limited given that
consumers who file proper tax returns can use at least these documents,
if no others are available, to verify their incomes. Among higher-
priced mortgage loans, where risks to consumers are already elevated,
the potential benefits to consumers of stated income/stated asset
lending are outweighed by the potential injuries to consumers and
competition.
Final Rule
HOEPA and Sec. 226.34(a)(4) currently prohibit a lender from
engaging in a pattern or practice of extending HOEPA loans based on the
consumer's collateral without regard to the consumer's repayment
ability, including the consumer's current and expected income, current
obligations, and employment. Section 226.34(a)(4) currently provides
that a creditor is presumed to have violated this prohibition if it
engages in a pattern or practice of failing to verify repayment
ability.
The Board proposed to extend this prohibition to higher-priced
mortgage loans, see proposed Sec. 226.35(b)(1), and to add several
additional rebuttable presumptions of violation as well as a safe
harbor. Under the proposal a creditor would have been presumed to
violate the regulation if it engaged in a pattern or practice of
failing to consider: consumers' ability to pay the loan based on the
interest rate specified in the regulation (Sec. 226.34(a)(4)(i)(B));
consumers' ability to make fully-amortizing loan payments that include
expected property taxes and homeowners insurance (Sec.
226.34(a)(4)(i)(C)); the ratio of borrowers' total debt obligations to
income as of consummation (Sec. 226.34(a)(4)(i)(D)); and borrowers'
residual income (Sec. 226.34(a)(4)(i)(E)). The proposed safe harbor
appeared in Sec. 226.34(a)(4)(ii), which provided that a creditor does
not violate Sec. 226.34(a)(4) if the creditor has a reasonable basis
to believe that consumers will be able to make loan payments for at
least seven years, considering each of the factors identified in Sec.
226.34(a)(4)(i) and any other factors relevant to determining repayment
ability.
The final rule removes the ``pattern or practice'' qualification
and therefore prohibits a creditor from extending any HOEPA loan or
higher-priced mortgage loan based on the collateral without regard to
repayment ability. Like the proposal, the final rule provides that
repayment ability is determined according to current and reasonably
expected income, employment, assets other than the collateral, current
obligations, and mortgage-related obligations such as expected property
tax and insurance obligations. See Sec. 226.34(a)(4) and (a)(4)(i);
Sec. 226.35(b)(1). The final rule also shifts the proposed new
presumptions of violations to a presumption of compliance, with
modifications. The presumption of compliance is revised to specify a
finite set of underwriting procedures; the reference to ``any other
factors relevant to determining repayment ability'' has been removed.
See Sec. 226.34(a)(4)(iii). The presumption of violation for failing
to verify repayment ability currently in Sec. 226.34(a)(4)(i),
however, is being finalized instead as an explicit requirement to
verify repayment ability. See Sec. 226.34(a)(4)(ii). This section
discusses the basic prohibition, and ensuing sections discuss the
removal of pattern or practice, the verification requirement, and the
presumption of compliance.
As discussed above, the Board finds extending higher-priced
mortgage loans or HOEPA loans based on the collateral without regard to
the consumer's repayment ability to be an unfair practice. The final
rule prohibits this practice. The Board also took into account state
laws that declare extending loans to consumers who cannot repay an
unfair practice.\62\
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\62\ See, e.g., Ind. Code Sec. Sec. 24-4.5-6-102, 24-4.5-6-
111(l)(3); Mass. Gen. Laws ch. 93A, ch. 183 Sec. Sec. 4, 18(a);
W.V. Code Sec. 46A-7-109(3)(a).
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Section 226.34(a)(4) governs the process for extending credit; it
is not intended to dictate which types of credit or credit terms are
permissible and which are not. The rule does not prohibit potentially
riskier types of loans such as loans with balloon payments, loans with
interest-only payments, or ARMs with discounted initial rates. With
proper underwriting, such products may be appropriate for certain
borrowers in the subprime market. The regulation merely prohibits a
creditor from extending such products or any other higher-priced
mortgage loans without adequately evaluating repayment ability.
The rule is intended to ensure that creditors do not assess
repayment ability using overstated incomes or understated payment
obligations. The rule explicitly requires that the creditor verify
income and assets using reliable third party documents and, therefore,
prohibits relying merely on an income statement from the applicant. See
Sec. 226.34(a)(4)(ii). (This requirement is discussed in more detail
below.) In addition, the rule requires assessing not just the
consumer's ability to pay loan principal and interest, but also the
consumer's ability to pay property taxes, homeowners insurance, and
similar mortgage-related expenses. Mortgage-related expenses, such as
homeowner's association dues or condominium or cooperative fees, are
included because failure to pay them could result in a consumer's
default on his or her mortgage (if, for example, failure to pay
resulted in a senior lien on the unit that constituted a default under
the terms of the consumer's mortgage obligations). See Sec. Sec.
226.34(a)(4); 226.34(a)(4)(i).
As of consummation. The final rule provides, as did the proposed
rule, that the creditor is responsible for assessing repayment ability
as of consummation. Two industry trade associations expressed concern
over proposed
[[Page 44544]]
comment 34(a)(4)-2, indicating that, while a creditor would be liable
only for what it knew or should have known as of consummation, events
after consummation may be relevant to determining compliance. These
commenters contend that creditors should not be held responsible for
accurately predicting future events such as a borrower's employment
stability or house price appreciation. One asserted that the rule would
lead creditors to impose more stringent underwriting criteria in
geographic areas with economies projected to decline. These commenters
requested that the Board clarify in the commentary that post-closing
events cannot be used to second-guess a lender's underwriting decision,
and one requested that the commentary specifically state that a
foreclosure does not create a presumption of a violation.
The Board has revised the comment, renumbered as 34(a)(4)-5, to
delete the statement that events after consummation may be relevant to
determining whether a creditor has violated Sec. 226.34(a)(4), but
events after consummation do not, by themselves, establish a violation.
Post-consummation events such as a sharp increase in defaults could be
relevant to showing a ``pattern or practice'' of disregarding repayment
ability, but the final rule does not require proof of a pattern or
practice. The final comment retains the proposed statement that a
violation is not established if borrowers default because of
significant expenses or income losses that occur after consummation.
The Board believes it is clear from the regulation and comment that a
default does not create a presumption of a violation.
Income, assets, and employment. The final rule, like the proposal,
provides that sources of repayment ability include current and
reasonably expected income, employment, and assets other than the
collateral. For the sake of clarity, new comment 34(a)(4)-2 indicates
that a creditor may base its determination of repayment ability on
current or reasonably expected income, on assets other than the
collateral, or both. A creditor that purported to determine repayment
ability on the basis of information other than income or assets would
have to clearly demonstrate that this information is probative of
repayment ability.
The Board is not adopting the suggestion from several commenters to
permit creditors to consider, when determining repayment ability, other
characteristics of the borrower or the transaction such as credit score
and loan-to-value ratio. These other characteristics may be critical to
responsible mortgage underwriting, but they are not as probative as
income and assets of the consumer's ability to make the scheduled
payments on a mortgage obligation. For example, if a consumer has
income of $3,000 per month, it is very unlikely that the consumer will
be able to afford a monthly mortgage payment of $2,500 per month
regardless of the consumer's credit score or loan-to-value ratio.
Moreover, incorporating these other characteristics in the regulation
would potentially create a major loophole for originators to discount
the importance of income and assets to repayment ability. For the same
reasons, the Board also is not adopting the suggestion of some
commenters to permit a creditor to rely on any factor that the creditor
finds relevant to determine credit or delinquency risk.
The final rule, like the proposal, provides broad flexibility as to
the types of income, assets, and employment a creditor may rely on.
Specific references to seasonal and irregular employment were added to
comment 34(a)(4)-6 (numbered 34(a)(4)-3 in the proposal) in response to
requests from commenters. References to several different types of
income, such as interest and dividends, were also added. These examples
are merely illustrative, not exhaustive.
The final rule and commentary also follow the proposal in
permitting a lender to rely on expected income and employment, not just
current income and employment. Expectations for improvements in
employment or income must be reasonable and verified with third party
documents. The commentary gives examples of expected bonuses verified
with documents demonstrating past bonuses, and expected employment
verified with a commitment letter from the future employer stating a
specified salary. See comment 34(a)(4)(ii)-3. In some cases a loan may
have a likely payment increase that would not be affordable at the
borrower's income as of consummation. A creditor may be able to verify
a reasonable expectation of an increase in the borrower's income that
will make the higher payment affordable to the borrower.
Several commenters expressed concern over language in proposed
comment 34(a)(4)-3 indicating that creditors are required, not merely
allowed, to consider information about expected changes in income or
employment that would undermine repayment ability. The proposed comment
gave as an example that a creditor must consider information indicating
that an employed person will become unemployed. Some commenters
contended that it is appropriate to permit lenders to consider expected
income or employment, but inappropriate to require that they do so.
Creditors are concerned that they would be liable for accurately
assessing a borrower's employment stability, which may depend on
regional economic factors.
The final comment, renumbered as 34(a)(4)-5, is revised somewhat to
address this concern. The revised comment indicates that a creditor
might have knowledge of a likely reduction in income or employment and
provides the following example: a consumer's written application
indicates that the consumer plans to retire within twelve months or
transition from full-time to part-time employment. As the example
indicates, the Board does not intend to place unrealistic requirements
on a creditor to speculate or inquire about every possible change in a
borrower's life circumstances. The sentence ``a creditor may have
information indicating that an employed person will become unemployed''
is deleted as duplicative.
Finally, new comment 34(a)(4)-7 addresses the concern of several
commenters that the proposal appeared to require them to make inquiries
of borrowers or consider information about them that Regulation B, 12
CFR part 202, would prohibit, such as a question posed solely to a
female applicant as to whether she is likely to continue her
employment. The comment explains that Sec. 226.34(a)(4) does not
require or permit the creditor to make inquiries or verifications that
would be prohibited by Regulation B.
Obligations. The final rule, like the proposed rule, requires the
creditor to consider the consumer's current obligations as well as
mortgage-related obligations such as expected property tax and required
insurance. See Sec. 226.34(a)(4)(i). The final rule does not contain
the proposed rule's reference to ``expected obligations.'' An industry
trade association suggested the reference would stifle communications
between a lender and a consumer because the lender would seek to avoid
eliciting information about the borrower's plans for future
indebtedness, such as an intention to take out student loans to send
children to college. The Board agrees that the proposal could stifle
communications. This risk does not have a sufficient offsetting benefit
because it is by nature speculative whether a mortgage borrower will
undertake other credit obligations in the future.
A reference to simultaneous mortgage obligations (proposed comment
34(a)(4)(i)-2)) has been retained but
[[Page 44545]]
revised. See comment 34(a)(4)-3. Several commenters objected to the
proposed comment. They suggested a lender has a limited ability to
identify the existence of a simultaneous obligation with an
unaffiliated lender if the borrower does not self-report. They asked
that the requirement be restricted to simultaneous obligations with the
same lender, or that it be limited to obligations the creditor knows or
has reason to know about, or that it have a safe harbor for a lender
that has procedures to prevent consumers from obtaining a loan from
another creditor without the lender's knowledge. The comment has been
revised to indicate that the regulation makes a creditor responsible
for considering only those simultaneous obligations of which the
creditor has knowledge.
Exemptions. The Board is adopting the proposed exemptions from the
rule for bridge loans, construction-only loans, reverse mortgages, and
HELOCs. These exemptions are discussed in part VIII.H. A national bank
and two trade associations with national bank members requested an
additional exemption for national banks that are in compliance with OCC
regulation 12 CFR 34.3(b). The OCC regulation prohibits national banks
from making a mortgage loan based predominantly on the bank's
realization of the foreclosure or liquidation value of the borrower's
collateral without regard to the borrower's ability to repay the loan
according to its terms. Unlike HOEPA, however, the OCC regulation does
not authorize private actions or actions by state attorneys general
when the regulation is violated. Thus, the Board is not adopting the
requested exemption.
Pattern or Practice
Based on the comments and additional information gathered by the
Board, the Board is adopting the rule without the phrase ``pattern or
practice.'' The rule therefore prohibits an individual HOEPA loan or
higher-priced mortgage loan from being extended based on the collateral
without regard to repayment ability. TILA Section 129(l)(2), 15 U.S.C.
1638(l)(2), confers on the Board authority to revise HOEPA's
restrictions on HOEPA loans if the Board finds that such revisions are
necessary to prevent unfair or deceptive acts or practices in
connection with mortgage loans. The Board so finds for the reasons
discussed below.
Public comment. Consumer advocates and others strongly urged the
Board to remove the pattern or practice element. They argued that the
burden to prove a pattern or practice is so onerous as to make it
impracticable for an individual plaintiff to seek relief, either
affirmatively or in recoupment. They suggested a typical plaintiff does
not have the resources to obtain information about a lender's loans and
loan policies sufficient to allege a pattern or practice. Moreover,
should a plaintiff be able to allege a pattern or practice and proceed
to the discovery stage, one legal aid organization commented based on
direct experience that a creditor may produce a mountain of documents
that overwhelms the plaintiff's resources and makes it impractical to
pursue such cases. One consumer group argued that the proposed rule
would not adequately deter abuse because, by the time a pattern or
practice emerged, substantial harm would already have been done to
consumers and investors. This commenter also argued that other TILA
provisions give creditors sufficient protection against litigation
risk, such as the cap on class action damages, the right to cure
certain errors creditors discover on their own, and the defense for
bona fide errors.
Several lenders and lender trade associations expressed concern
that ``pattern or practice'' is too vague to provide the certainty
creditors seek and asked for more specific guidance and examples. Other
industry commenters contended that the phrase was likely to be
interpreted to hold lenders that originate large numbers of loans
liable for errors in assessing repayment ability in just a small
fraction of their originations. For example, one large lender pointed
out that an error rate of 0.5 percent in its 400,000 HMDA-reportable
originations in 2006 would have amounted to 2,000 loans. Several
commenters cited cases decided under other statutes holding that a mere
handful of instances were a pattern or practice. To address these
concerns, two commenters requested that the phrase be changed to
``systematic practice'' and that this new phrase be interpreted to mean
willful or reckless disregard. Industry commenters generally preferred
that ``pattern or practice,'' whatever its limitations, be retained as
a form of protection against unwarranted litigation.
Discussion. The Board believes that removing ``pattern or
practice'' is necessary to ensure a remedy for consumers who are given
unaffordable loans and to deter irresponsible lending, which injures
not just individual borrowers but also their neighbors and communities.
The Board further believes that the presumption of compliance the Board
is adopting will provide more certainty to creditors than either
``pattern or practice'' or the proposed safe harbor. The presumption
will better aid creditors with compliance planning, and it will better
help them mitigate litigation risk. In short, the Board believes that
removing ``pattern or practice'' and providing creditors a presumption
of compliance will be more effective to prevent unfair practices,
remedy them when they occur, and preserve access to credit.
Imposing the burden to prove ``pattern or practice'' on an
individual borrower would leave many borrowers without a remedy under
HOEPA for loans that were made without regard to repayment ability.
Borrowers would not have a HOEPA remedy for individual, unrelated loans
made without regard to repayment ability, of which there could be many
in the aggregate. Even if an unaffordable loan was part of a pattern or
practice, the individual borrower and his or her attorney would not
necessarily have that information.\63\ By the time information about a
particular lender's pattern or practice of unaffordable lending became
widespread, the lender could have caused great injury to many
borrowers, as well as to their neighbors and communities. In addition,
imposing a ``pattern or practice'' requirement on HOEPA loans, but not
higher-priced mortgage loans, would create an anomaly.
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\63\ Federal rules of civil procedure require that a defendant's
motion to dismiss be granted unless the plaintiff alleged sufficient
facts to make a pattern or practice ``plausible.'' Bell Atlantic v.
Twombly, 127 S. Ct. 1955 (2007). Many states follow the federal
rules.
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Moreover, a ``pattern or practice'' claim can be costly to litigate
and might not be economically feasible except as part of a class
action, which would not assure individual borrowers of adequate
remedies. Class actions can take years to reach a settlement or trial,
while the individual borrower who is facing foreclosure because of an
unaffordable loan requires a speedy resolution if the borrower is to
keep the home. Moreover, lower-income homeowners are often represented
by legal aid organizations, which are barred from bringing class
actions if they accept funds from the Legal Services Corporation.\64\
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\64\ 45 CFR 1617.3.
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To be sure, many borrowers who would be left without a HOEPA remedy
for an unaffordable loan may have remedies under state laws that lack a
``pattern or practice'' requirement. In some cases, however, state law
remedies would be inferior or unavailable. Moreover, state laws do not
assure consumers uniform protection because these laws vary
considerably and
[[Page 44546]]
generally may not cover federally chartered depository institutions
(due to federal preemption) or state chartered depository institutions
(due to specific exemptions or general ``parity laws'').
For these reasons, imposing the burden to prove ``pattern or
practice'' on an individual borrower would leave many borrowers with a
lesser remedy, or without any remedy, for loans made without regard to
repayment ability. Removing this burden would not only improve remedies
for individual borrowers, it would also increase deterrence of
irresponsible lending. Individual remedies impose a more immediate and
more certain cost on violators than either class actions or actions by
state or federal agencies, which can take years and, in the case of the
agencies, are subject to resource constraints. Increased deterrence of
irresponsible lending practices should benefit not just borrowers who
might obtain higher-priced mortgage loans but also their neighbors and
communities who would otherwise suffer the spillover effects of such
practices.
The Board acknowledges the legitimate concerns that lenders have
expressed over litigation costs. As the Board indicated with the
proposal, it proposed ``pattern or practice'' out of a concern that
creating civil liability for an originator that fails to assess
repayment ability on any individual loan could inadvertently cause an
unwarranted reduction in the availability of mortgage credit to
consumers. After further study, however, the Board believes that any
increase in litigation risk would be justified by the substantial
benefits of a rule that provided remedies to individual borrowers.
While unwarranted litigation may well increase, the Board believes that
several factors will mitigate this cost. In particular, TILA imposes a
one-year statute of limitations on affirmative claims, after which only
recoupment and set-off are available; HOEPA limits the strict assignee
liability of TILA Section 131(d), 15 U.S.C. 1641(d) to HOEPA loans;
many defaults may be caused by intervening events such as job loss
rather than faulty underwriting; and plaintiffs (or their counsel) may
bear a substantial cost to prove a claim of faulty underwriting, which
would often require substantial discovery and expert witnesses.
Creditors could further contain litigation risk by using the procedures
specified in the regulation that earn the creditor a presumption of
compliance.
The Board has also considered the possibility that the statute's
``pattern or practice'' element allows creditors an appropriate degree
of flexibility to extend occasional collateral-based HOEPA loans to
consumers who truly need them and clearly understand the risks
involved. Removing ``pattern or practice'' would eliminate this
potential consumer benefit. Based on industry comments, however, the
benefit is more theoretical than real. While industry commenters may
prefer retaining ``pattern or practice'' as a barrier to individual
suits, these commenters indicated that ``pattern or practice'' is too
vague to be useful for compliance planning. Therefore, retaining
``pattern or practice'' would not likely lead a creditor to extend
legitimate collateral-based loans except, perhaps, a trivial number
such as one per year.
The Board reached this conclusion only after exploring ways to
provide more clarity as to the meaning of ``pattern or practice.''
Existing comment 34(a)(4)-2 provides that a pattern or practice depends
on the totality of the circumstances in the particular case; can be
established without the use of a statistical process and on the basis
of an unwritten lending policy; and cannot be established with
isolated, random, or accidental acts. Although this comment has been in
effect for several years, its effectiveness is impossible to assess
because the market for HOEPA loans shrank to near insignificance soon
after the comment was adopted.\65\ On its face, however, the guidance
removes little of the uncertainty surrounding the meaning of ``pattern
or practice.'' (There is only one reported decision to interpret
``pattern or practice'' under HOEPA, Newton v. United Companies
Financial Corp., 24 F. Supp. 2d 444 (E.D. Pa. 1998), and it has limited
precedential value in light of later-adopted comment 34(a)(4)-2.) The
Board re-proposed the comment but commenters provided few concrete
suggestions for making the rule clearer and the suggestions that were
offered would have left a large degree of uncertainty.
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\65\ By 2004, HOEPA loans reported under HMDA were less than one
percent of the mortgage market. The Board does not believe the
market's contraction can be traced to the guidance on pattern or
practice.
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The Board considered other potential sources of guidance on
``pattern or practice'' from other statutes and regulations. Case law
is of inherently limited value for such a contextual inquiry. Moreover,
there are published court decisions, some cited by industry commenters,
that suggest that even a few instances could be considered to meet this
standard.\66\ The Board also consulted informal guidance interpreting
``pattern or practice'' under ECOA.\67\ The Board carefully considered
how it could adapt this guidance to Sec. 226.34(a)(4). Based on its
efforts, the Board concluded that, while additional guidance could
reduce some uncertainty, it would necessarily leave substantial
uncertainty. The Board further concluded that significantly more
certainty could be provided through the ``presumption of compliance''
the final rule provides for following enumerated underwriting
practices. See Sec. 226.34(a)(4)(iii), discussed below.
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\66\ See, e.g., United States v. Balistrieri, 981 F.2d 916, 929-
30 (7th Cir. 1992); United States v. Pelzer Realty Co., Inc., 484
F.2d 438, 445 (5th Cir. 1973).
\67\ Board Policy Statement on Enforcement of the Equal Credit
Opportunity and Fair Housing Acts, Q9.
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Verification of Repayment Ability
Section 226.34(a)(4) currently contains a provision creating a
rebuttable presumption of a violation where a lender engages in a
pattern or practice of making HOEPA loans without verifying and
documenting repayment ability. The Board proposed to retain this
presumption and extend it to higher-priced mortgage loans. The final
rule is different in two respects. First, as discussed above, the final
rule does not contain a ``pattern or practice'' element. Second, it
makes verifying repayment ability an affirmative requirement, rather
than making failure to verify a presumption of a violation.
In the final rule, the regulation applies the verification
requirement to current obligations explicitly, see Sec.
226.34(a)(4)(ii)(C); in the proposal, an explicit reference to
obligations was in a staff comment. See proposed comment
34(a)(4)(i)(A)-2, 73 FR at 1732. The requirement to verify income and
assets in final Sec. 226.34(a)(4)(ii)(A) is essentially identical to
the requirement of proposed Sec. 226.35(b)(2). Under Sec.
226.34(a)(4)(ii)(A), creditors must verify assets or income, including
expected income, relied on in approving an extension of credit using
third-party documents that provide reasonably reliable evidence of the
income or assets. The final rule, like that proposed, includes an
affirmative defense for a creditor that can show that the amounts of
the consumer's income or assets relied on were not materially greater
than the amount the creditor could have verified at consummation.
Public comment. Many, but by no means all, financial institutions,
mortgage brokers, and mortgage industry trade groups that commented
support a verification requirement. They raised concerns, however, that
the particular requirement proposed would
[[Page 44547]]
restrict or eliminate access to credit for some borrowers, especially
the self-employed, those who earn irregular commission- or cash-based
incomes, and low- and moderate-income borrowers. Consumer and community
groups and government officials generally supported the proposed
verification requirement, with some suggesting somewhat stricter
requirements. Many of these same commenters, however, contended the
proposed affirmative defense would be a major loophole and urged its
elimination. The comments are discussed in further detail below as
applicable.
Discussion. For the reasons discussed above, the Board finds that
it is unfair not to verify income, assets, and obligations used to
determine repayment ability when extending a higher-priced mortgage
loan or HOEPA loan. The Board is finalizing the rule as proposed and
incorporating it directly into Sec. 226.34(a)(4), where it replaces
the proposed presumption of a violation for a creditor that has a
pattern or practice of failing to verify repayment ability. ``Pattern
or practice'' has been removed and the presumption has been made a
requirement. The legal effect of this change is that the final rule,
unlike the proposal, would rarely, if ever, permit a creditor to make
even isolated ``no income, no asset'' loans (loans made without regard
to income and assets) in the higher-priced mortgage loan market. For
the reasons explained above, however, the Board does not believe this
legal change will reduce credit availability; nor will it affect the
availability of ``no income, no asset'' loans in the prime market.
As discussed above, relying on inflated incomes or assets to
determine repayment ability often amounts to disregarding repayment
ability, which causes consumers injuries they often cannot reasonably
avoid. By requiring verification of income and assets, the final rule
is intended to limit these injuries by reducing the risk that higher-
priced mortgage loans will be made on the basis of inflated incomes or
assets.\68\ The Board believes the rule is sufficiently flexible to
keep costs to consumers, such as any additional time needed to close a
loan or costs for obtaining documentation, at reasonable levels
relative to the expected benefits of the rule.
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\68\ By requiring verification the rule also addresses the risk
that consumers with higher-priced mortgage loans who could document
income would unknowingly pay more for a loan that did not require
documentation.
---------------------------------------------------------------------------
The rule specifically authorizes a creditor to rely on W-2 forms,
tax returns, payroll receipts, and financial institution records such
as bank statements. These kinds of documents are sufficiently reliable
sources of information about borrowers' income and assets that the
Board believes it is appropriate to provide a safe harbor for their
use. Moreover, most consumers can, or should be able to, produce one of
these kinds of documents with little difficulty. For other consumers,
the rule is quite flexible. It permits a creditor to rely on any third-
party document that provides reasonably reliable evidence of the income
or assets relied on to determine repayment ability. Examples include
check-cashing or remittance receipts or a written statement from the
consumer's employer. See comment 34(a)(4)(ii)(A)-3. These examples are
only illustrative, not limiting. The one type of document that is
excluded is a statement only from the consumer.
Many commenters suggested that the Board require creditors to
collect the ``best and most appropriate'' documentation. The Board
believes that the costs of such a requirement would outweigh the
benefits. The vagueness of the suggested standard could make creditors
reluctant to accept nontraditional forms of documentation. Nor is it
clear how creditors would verify that a form of documentation that
might be best or most appropriate was not available.
The commentary has been revised to clarify several points. See
comments 34(A)(4)(ii)(A)-3 and -4. Oral information from a third party
would not satisfy the rule, which requires documentation. Creditors
may, however, rely on a letter or an e-mail from the third party.
Creditors may also rely on third party documentation the consumer
provides directly to the creditor. Furthermore, as interpreted by the
comments, the rule excludes documents that are not specific to the
consumer. It would not be sufficient to look at average incomes for the
consumer's stated profession in the region where the consumer lives or
average salaries for employees of the consumer's employer. The
commentary has been revised, however, to indicate that creditors may
use third party information that aggregates individual-specific data
about consumers' income, such as a database service used by an employer
to centralize income verification requests, so long as the information
is reasonably current and accurate and identifies the specific
consumer's income.
The rule does not require creditors that have extended credit to a
consumer and wish to extend new credit to the same consumer to re-
collect documents that the creditor previously collected from the
consumer, if the creditor believes the documents would not have changed
since they were initially verified. See comment 34(a)(4)(ii)(A)-5. For
example, if the creditor has collected the consumer's 2006 tax return
for a May 2007 loan, and the creditor makes another loan to that
consumer in August 2007, the creditor may rely on the 2006 tax return.
Nor does the rule require a creditor to verify amounts of income or
assets the creditor is not relying on to determine repayment ability.
For example, if a creditor does not rely on a part of the consumer's
income, such as an annual bonus, in determining repayment ability, the
creditor would not need to verify the consumer's bonus. A creditor may
verify an amount of income or assets less than that stated in the loan
file if adequate to determine repayment ability. If a creditor does not
verify sufficient amounts to support a determination that the consumer
has the ability to pay the loan, however, then the creditor risks
violating the regulation.
Self-employed borrowers. The Board has sought to address
commenters' concerns about self-employed borrowers. The rule allows for
flexibility in underwriting standards so that creditors may adapt their
underwriting processes to the needs of self-employed borrowers, so long
as creditors comply with Sec. 226.34(a)(4). For example, the rule does
not dictate how many years of tax returns or other information a
creditor must review to determine a self-employed applicant's repayment
ability. Nor does the rule dictate which income figure on the tax
returns the creditor must use. The Internal Revenue Code may require or
permit deductions from gross income, such as a deduction for capital
depreciation, that a creditor reasonably would regard as not relevant
to repayment ability.
The rule is also flexible as to consumers who depend heavily on
bonuses and commissions. If an employed applicant stated that he was
likely to receive an annual bonus of a certain amount from the
employer, the creditor could verify the statement with third-party
documents showing a consumer's past annual bonuses. See comment
34(a)(4)(ii)-1. Similarly, employees who work on commission could be
asked to produce third-party documents showing past commissions.
The Board is not adopting the exemption some commenters requested
for self-employed borrowers. The exemption would give borrowers and
originators an incentive to declare a borrower employed by a third
party to
[[Page 44548]]
be self-employed to avoid having to verify the borrower's income. It is
not clear how a declaration of self-employed status could be verified
except by imposing the very burden the exemption would be meant to
avoid, such as reviewing tax returns.
The affirmative defense. The Board received a number of comments
about the proposed affirmative defense for a creditor that can show
that the amounts of the consumer's income or assets the creditor relied
on were not materially greater than what the creditor could have
documented at consummation. The Board's reference to this defense as a
``safe harbor'' appears to have caused some confusion. Many commenters
interpreted the phrase ``safe harbor'' to mean that the Board was
proposing a specific way to comply with the rule. These commenters
either criticized the safe harbor as insufficiently specific about how
to comply (in the case of industry commenters) or urged that it be
eliminated as a major loophole for avoiding verifying income and assets
(in the case of consumer group and other commenters).
The Board intended the provision merely as a defense for a lender
that did not verify income as required where the failure did not cause
injury. The provision would place the burden on the lender to prove
that its non-compliance was immaterial. A creditor that does not verify
income has no assurance that the defense will be available should the
loan be challenged in court. This creditor takes a substantial risk
that it will not be able to prove through discovery that the income was
as stated. Therefore, the Board expects that the defense will be used
only in limited circumstances. For example, a creditor might be able to
use the defense when a bona fide compliance error, such as an
occasional failure of reasonable procedures for collecting and
retaining appropriate documents, produces litigation. The defense is
not likely to be helpful to a creditor in the case of compliance
examinations because there will not be an opportunity in that context
for the creditor to determine the borrower's actual income. With this
clarification, the Board is adopting the affirmative defense as
proposed.
The defense is available only where the creditor can show that the
amounts of income and assets relied on were not materially greater than
the amounts the creditor could have verified. The definition of
``material'' is not based on a numerical threshold as some commenters
suggested. Rather, the commentary has been revised to clarify that
creditors would be required to show that, if they had relied on the
amount of verifiable income or assets, their decision to extend credit
and the terms of the credit would not have been different. See comment
34(a)(4)(ii)(B)-2.
Narrower alternatives. The Board sought comment on whether the rule
should be narrowed to prohibit only extending credit where the creditor
or mortgage broker engaged in, influenced the borrower to engage in, or
knew of income or asset inflation. The vast majority of commenters who
addressed this alternative did not support it, and the Board is not
adopting it. Placing the burden on the borrower or supervisory agency
to prove the creditor knew the income was inflated would undermine the
rule's effectiveness. In the case of borrower claims or counter-claims,
this burden would lead to costly discovery into factual questions, and
this discovery would often produce conflicting evidence (``he said, she
said'') that would require trial before a factfinder. A creditor
significantly increases the risk of income inflation when it accepts a
mere statement of income, and the creditor is in the best position to
substantially reduce this risk at limited cost by simply requiring
documentation. The Board believes this approach is the most effective
and efficient way to protect not just the individual borrower but also
the neighbors and communities that can suffer from spillover effects of
unaffordable lending.
Some industry commenters suggested adopting an affirmative defense
for creditors who can show that the consumer intentionally
misrepresented income or assets or committed fraud. The Board is not
adopting this defense. As discussed above, a rule that provided
creditors with a defense where no documentation was present could
result in litigation that was costly for both sides. A defense for
cases of consumer misrepresentation or fraud where the creditor
documented the consumer's income or assets would be unnecessary.
Creditors are allowed to rely on documents provided directly by the
consumer so long as those documents provide reasonably reliable
evidence of the consumer's income or assets. A consumer who provided
false documentation to the creditor, and who wished to bring a claim
against the creditor, would have to demonstrate that the creditor
reasonably should not have relied on the document. If the only fact
that made the document unreliable was the consumer's having provided
false information without the creditor's knowledge, it would not have
been unreasonable for the creditor to rely on that document.
Obligations. The proposal essentially required a creditor to verify
repayment ability; it provided that a pattern or practice of failing to
verify repayment ability created a presumption of a violation. A
proposed comment indicated that verifying repayment ability included
verifying obligations. See proposed comment 34(a)(4)(i)(A)-2. The final
rule explicitly includes the requirement to verify obligations in the
regulation. See Sec. 226.34(a)(4)(ii)(C). A comment to this provision
indicates that a credit report may be used to verify current
obligations. A credit report, however, might not reflect certain
obligations undertaken just before or at consummation of the
transaction and secured by the same dwelling that secures the
transaction (for example, a ``piggyback'' second-lien transaction used
to finance part of the down payment on the house where the first-lien
transaction is for home purchase). A creditor is responsible for
considering such obligations of which the creditor has knowledge. See
comment 34(a)(4)-3.
Presumption of Compliance
The Board proposed to add new, rebuttable presumptions of
violations to Sec. 226.34(a)(4) and, by incorporation, Sec.
226.35(b)(1). These presumptions would have been for engaging in a
pattern or practice of failing to consider: consumers' ability to pay
the loan based on the interest rate specified in the regulation;
consumers' ability to make fully-amortizing loan payments that include
expected property taxes and homeowners insurance; the ratio of
borrowers' total debt obligations to income as of consummation; and
borrowers' residual income. See proposed Sec. 226.34(a)(4)(i)(B)-(E).
The Board also proposed a presumption of compliance for a creditor that
has a reasonable basis to believe that consumers will be able to make
loan payments for at least seven years, considering each of the factors
identified in Sec. 226.34(a)(4)(i) and any other factors relevant to
determining repayment ability.
The final rule removes the proposed presumptions of violation for
failing to follow certain underwriting practices and incorporates these
practices, with modifications, into a presumption of compliance that is
substantially revised from that proposed. Under Sec.
226.34(a)(4)(iii), a creditor is presumed to have complied with Sec.
226.34(a)(4) if the creditor satisfies each of three requirements: (1)
Verifying repayment ability; (2) determining the consumer's repayment
ability using largest scheduled payment of principal and
[[Page 44549]]
interest in the first seven years following consummation and taking
into account property tax and insurance obligations and similar
mortgage-related expenses; and (3) assessing the consumer's repayment
ability using at least one of the following measures: a ratio of total
debt obligations to income, or the income the consumer will have after
paying debt obligations. (The procedures for verifying repayment
ability are required under paragraph 34(a)(4)(ii); the other procedures
are not required.)
Unlike the proposed presumption of compliance, the presumption of
compliance in the final rule is not conditioned on a requirement that a
creditor have a reasonable basis to believe that a consumer will be
able to make loan payments for a specified period of years. Comments
from creditors indicated this proposed requirement was not necessary
and introduced an undue degree of compliance uncertainty. The final
presumption of compliance, therefore, replaces this general requirement
with the three specific procedural requirements mentioned in the
previous paragraph.
The creditor's presumption of compliance for following these
procedures is not conclusive. The Board believes a conclusive
presumption could seriously undermine consumer protection. A creditor
could follow the procedures and still disregard repayment ability in a
particular case or potentially in many cases. Therefore, the borrower
may rebut the presumption with evidence that the creditor disregarded
repayment ability despite following these procedures. For example,
evidence of a very high debt-to-income ratio and a very limited
residual income could be sufficient to rebut the presumption, depending
on all of the facts and circumstances. If a creditor fails to follow
one of the non-mandatory procedures set forth in paragraph
34(a)(4)(iii), then the creditor's compliance is determined based on
all of the facts and circumstances without there being a presumption of
either compliance or violation. See comment 34(a)(4)(iii)-1.
Largest scheduled payment in seven years. When a loan has a fixed
rate and a fixed payment that fully amortizes the loan over its
contractual term to maturity, there is no ambiguity about the rate and
payment at which the lender should assess repayment ability: The lender
will use the fixed rate and the fixed payment. But when the rate and
payment can change, as has often been true of subprime loans, a lender
has to choose a rate and payment at which to assess repayment ability.
The Board proposed that a creditor would be presumed to have
disregarded repayment ability if it had engaged in a pattern or
practice of failing to use the fully-indexed rate (or the maximum rate
in seven years on a step-rate loan) and the fully-amortizing payment.
As discussed, the final rule does not contain this proposed
presumption of violation. Instead, it provides that a creditor will
have a presumption of compliance if, among other things, the creditor
uses the largest scheduled payment of principal and interest in the
first seven years. This payment could be higher, or lower, than the
payment determined according to the fully-indexed rate and fully-
amortizing payment. The Board believes that the final rule is clearer
and simpler than the proposal. It incorporates long-established
principles in Regulation Z for determining a payment schedule when
rates or payments can change, which should facilitate compliance. See
comment 34(a)(4)(iii)(B)-1. The final rule is also more flexible than
the proposal. Instead of requiring the creditor to use a particular
payment, it provides the creditor who uses the largest scheduled
payment in seven years a presumption of compliance. The creditor has
the flexibility to use a lower payment, and no presumption of violation
would attach; though neither would a presumption of compliance.
Instead, compliance would be determined based on all of the facts and
circumstances.
Two aspects of Sec. 226.34(a)(4) help ensure that this approach
provides consumers effective protection. First, the Board is adopting
the proposed seven-year horizon. That is, under Sec.
226.34(a)(4)(iii)(B) the relevant payment for underwriting is the
largest payment in seven years. Industry commenters requested that the
rule incorporate a time horizon of no more than five years. As these
commenters indicated, most subprime loans, including those with fixed
rates, have paid off (or defaulted) within five years. It is possible
that prepayment speeds will slow, however, as subprime lending
practices and loan terms undergo substantial changes. Moreover, the
final rule addresses commenters' concern that the proposal seemed to
require them to project the consumer's income, employment, and other
circumstances for as long as seven years as a condition to obtaining a
presumption of compliance. Under the final rule, the creditor is
expected to underwrite based on the facts and circumstances that exist
as of consummation. Section 226.34(a)(4)(iii)(B) sets out the payment
to which the creditor should underwrite if it seeks to have a
presumption of compliance. Furthermore, nothing in the regulation
prohibits, or creates a presumption against, loan products that are
designed to serve consumers who legitimately expect to sell or
refinance sooner than seven years.
A second aspect of Sec. 226.34(a)(4) that is integral to its
balance of consumer protection and credit availability is its exclusion
of two nontraditional types of loans from the presumption of compliance
that can pose more risk to consumers in the subprime market. Under
Sec. 226.34(a)(4)(iv), no presumption of compliance is available for a
balloon-payment loan with a term shorter than seven years. If the term
is at least seven years, the creditor that underwrites the loan based
on the regular payments (not the balloon payment) may retain the
presumption of compliance. If the term is less than seven years,
compliance is determined on the basis of all of the facts and
circumstances. This approach is simpler than some of the alternatives
commenters recommended to address balloon-payment loans, and it better
balances consumer protection and credit availability than other
alternatives they suggested.\69\ Consumers are statistically very
likely to prepay (or default) within seven years and avoid the balloon
payment.
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\69\ One large lender contended that balloon loans should be
exempted from a repayment-ability rule because consumers understand
their risks. Another recommended that balloon loans be exempted from
the repayment ability rule if the term of the loan exceeds seven
years for first-lien mortgages or five years for subordinate-lien
loans. A trade association representing community banks urged that
balloon payments be permitted so long as the creditor has a
reasonable basis to believe the borrower will make the payments for
the term of the loan except the final, balloon payment. This trade
association indicated that community banks often structure the loans
they hold in portfolio as 3- or 5-year balloon loans, typically with
15-30 year amortization periods, to match the maturity of the loan
to the maturity of their deposit base. A lender and a lender trade
association recommended using on short-term balloon loans a payment
larger than the scheduled payment but smaller than the fully-
amortizing payment, such as the payment that would correspond to an
interest rate two percentage points higher than the rate specified
in the presumption of compliance.
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Loans with scheduled payments that would increase the principal
balance (negative amortization) within the first seven years are also
excluded from the presumption of compliance. This exclusion will help
ensure that the presumption is available only for loans that leave the
consumer sufficient equity after seven years to refinance. If the
payments scheduled for the first seven years would cause the balance to
increase, then compliance is determined
[[Page 44550]]
on all of the facts and circumstances without a presumption of
compliance or violation.
``Interest-only'' loans can have a presumption of compliance. With
these loans, after an initial period of interest-only payments the
payment is recast to fully amortize the loan over the remaining term to
maturity. If the period of interest-only payments is shorter than seven
years, the creditor may retain the presumption of compliance if it uses
the fully-amortizing payment that commences after the interest-only
period. If the interest-only period is seven years or longer, the
creditor may retain the presumption of compliance if it assesses
repayment ability using the interest-only payment. Examples have been
added to the commentary to facilitate compliance. See comment
34(a)(4)(iii)(B)-1. Examples of variable-rate loans and a step-rate
loan have also been added.
Debt-to-income ratio and residual income. The proposal provided
that a creditor would be presumed to have violated the regulation if it
engaged in a pattern or practice of failing to consider the ratio of
consumers' total debt obligations to consumers' income or the income
consumers will have after paying debt obligations. A major secondary
market participant proposed that considering total DTI and residual
income not be an absolute prerequisite because other measures of
income, assets, or debts may be valid methods to assess repayment
ability. A credit union trade association contended that residual
income is not a necessary underwriting factor if a lender uses DTI.
Consumer and civil rights groups, however, specifically support
including both DTI and residual income as factors, contending that
residual income is an essential component of an affordability analysis
for lower-income families.
Based on the comments and its own analysis, the Board is revising
the proposal to provide that a creditor does not have a presumption of
compliance with respect to a particular transaction unless it uses at
least one of the following: the consumer's ratio of total debt
obligations to income, or the income the consumer will have after
paying debt obligations. Thus, the final rule permits a creditor to
retain a presumption of compliance so long as it uses at least one of
these two measures.
The Board believes the flexibility permitted by the final rule will
help promote access to responsible credit without weakening consumer
protection. The rule provides creditors flexibility to determine
whether using both a DTI ratio and residual income increases a
creditor's ability to predict repayment ability. If one of these
metrics alone holds as much predictive power as the two together, as
may be true of certain underwriting models at certain times, then
conditioning access to a safe harbor on using both metrics could reduce
access to credit without an offsetting increase in consumer protection.
The Board also took into account that, at this time, residual income
appears not to be as widely used or tested as the DTI ratio.\70\ It is
appropriate to permit the market to develop more experience with
residual income before considering whether to incorporate it as an
independent requirement of a regulatory presumption of compliance.
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\70\ Michael E. Stone, What is Housing Affordability? The Case
for the Residual Income Approach, 17 Housing Policy Debate 179
(Fannie Mae 2006) (advocating use of a residual income approach but
acknowledging that it ``is neither well known, particularly in this
country, nor widely understood, let alone accepted'').
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The final rule does not contain quantitative thresholds for either
of the two metrics. The Board specifically solicited comment on whether
it should adopt such thresholds. Industry commenters did not favor
providing a presumption of compliance (or a presumption of a violation)
based on a specified debt-to-income ratio. The reasons given include:
Different investors have different guidelines for lenders to follow in
calculating DTI; underwriters following the same procedures can
calculate different DTIs on the same loan; borrowers may want or, in
some high-cost areas, may need to spend more than any specified
percentage of their income on housing and may have sufficient non-
collateral assets or residual incomes to support the loan; and loans
with high DTIs have not necessarily had high delinquency rates. Two
trade associations indicated they would accept a quantitative safe
harbor if it were sufficiently flexible. Some commenters suggested a
standard of reasonableness.
Consumer and civil rights groups, a federal banking agency, and
others requested that the Board set threshold levels for both DTI and
residual income beyond which a loan would be considered unaffordable,
subject to rebuttal by the creditor. They argued that quantitative
thresholds for these factors would improve compliance and loan
performance. These commenters suggested that the regulation should
expressly recognize that, as residual income increases, borrowers can
support higher DTI levels. They provided alternative recommendations:
mandate the DTI and residual income levels found in the guidelines for
loans guaranteed by the Department of Veterans Affairs, 38 CFR 36.4840;
develop the Board's own guidelines; or impose a threshold of 50 percent
DTI with sufficient residual income. A consumer research and advocacy
group, however, supported the Board's proposal not to set a
quantitative threshold. It specifically opposed a 50 percent threshold
as too high for sustainable lending. It further maintained that any
specific DTI threshold would not be workable because proper
underwriting depends on too many factors, and the definition of
``debt'' is too easily manipulated.
The Board is concerned that making a specific DTI ratio or residual
income level either a presumptive violation or a safe harbor could
limit credit availability without providing adequate offsetting
benefits. The same debt-to-income ratio can have very different
implications for two consumers' repayment ability if the income levels
of the consumers differ significantly. Moreover, it is not clear what
thresholds would be appropriate. Limited data are available to the
Board to support such a determination. Underwriting guidelines of the
Department of Veterans Affairs may be appropriate for the limited
segment of the mortgage market this agency is authorized to serve, but
they are not necessarily appropriate for the large segment of the
mortgage market this regulation will cover.
Safe Harbors and Exemptions Not Adopted
Commenters requested several safe harbors or exemptions that the
Board is not adopting. Many industry commenters sought a safe harbor
for any loan approved by the automated underwriting system (AUS) of
Fannie Mae or Freddie Mac; some sought a safe harbor for an AUS of any
federally-regulated institution. The Board is not adopting such a safe
harbor. Commenters did not suggest a clear and objective definition of
an AUS that would distinguish it from other types of systems used in
underwriting. It would not be appropriate to try to resolve this
concern by limiting a safe harbor to the AUS's of Fannie Mae and
Freddie Mac, as that would give them an unfair advantage in the
marketplace. Moreover, a safe harbor for an AUS that is a ``black box''
and is not specifically required to comply with the regulation could
undermine the regulation. Some industry commenters sought safe harbors
for transactions that provide the consumer a lower rate or payment on
the grounds that these transactions would generally benefit the
borrower.
[[Page 44551]]
The chief example given is a refinance (without cash out) that reduces
the consumer's current monthly payment or, in the case of an ARM, the
payment expected upon reset. The Board does not believe that a safe
harbor for such a transaction would benefit consumers. For example, it
could provide an incentive to an originator to make an unaffordable
loan to a consumer and then repeatedly refinance the loan with new
loans offering a slightly lower payment each time.
One state Attorney General submitted a comment supporting
permitting an asset-based loan where the borrower has suffered a loss
of income but reasonably anticipates improving her circumstances (e.g.,
temporary disability or illness, unemployment, or salary cut), or the
borrower seeks a short-term loan because she must sell the home due to
a permanent reduction in income (e.g., loss of job, or divorce from co-
borrower) or some other event (e.g., pending foreclosure or occurrence
of natural disaster). An association of mortgage brokers also
recommended that exceptions be made for such cases.
The Board is not adopting safe harbors or exemptions for such
``hardship'' cases. As discussed above, the Board recognizes that
consumers in such situations who fully understood the risks involved
would benefit from having the ability to address their situation by
taking a large risk with their home equity. At the same time, the Board
is concerned that exceptions for such cases could severely undermine
the rule because it would be difficult, if not impossible, to
distinguish bona fide cases from mere circumvention. For some of these
cases, such as selling a home due to divorce or job loss (or any
reason) and purchasing a new, presumably less expensive home, the
carve-out for bridge loans may apply.
C. Prepayment Penalties--Sec. 226.32(d)(6) and (7); Sec. 226.35(b)(2)
The Board proposed to apply to higher-priced mortgage loans the
prepayment penalty restrictions that TILA Section 129(c) applies to
HOEPA loans. Specifically, HOEPA-covered loans may only have a
prepayment penalty if: The penalty period does not exceed five years
from loan consummation; the penalty does not apply if there is a
refinancing by the same creditor or its affiliate; the borrower's debt-
to-income (DTI) ratio at consummation does not exceed 50 percent; and
the penalty is not prohibited under other applicable law. 15 U.S.C.
1639(c); see also 12 CFR 226.32(d)(6) and (7). In addition, the Board
proposed, for both HOEPA loans and higher-priced mortgage loans, to
require that the penalty period expire at least sixty days before the
first date, if any, on which the periodic payment amount may increase
under the terms of the loan.
Based on the comments and its own analysis, the Board is adopting
substantially revised rules for prepayment penalties. There are two
components to the final rule. First, the final rule prohibits a
prepayment penalty with a higher-priced mortgage loan or HOEPA loan if
payments can change during the four-year period following consummation.
Second, for all other higher-priced mortgage loans and HOEPA loans--
loans whose payments may not change for four years after consummation--
the final rule limits prepayment penalty periods to a maximum of two
years following consummation, rather than five years as proposed. In
addition, the final rule applies to this second category of loans two
requirements for HOEPA loans that the Board proposed to apply to
higher-priced mortgage loans: the penalty must be permitted by other
applicable law, and it must not apply in the case of a refinancing by
the same creditor or its affiliate.
The Board is not adopting the proposed rule requiring a prepayment
penalty provision to expire at least sixty days before the first date
on which a periodic payment amount may increase under the loan's terms.
The final rule makes such a rule unnecessary. Under the final rule, if
the consumer's payment may change during the first four years following
consummation, a prepayment penalty is prohibited outright. If the
payment is fixed for four years, the final rule limits a prepayment
penalty period to two years, leaving the consumer a penalty-free window
of at least two years before the payment may increase.
In addition, for the reasons discussed below, the Board is not
adopting the proposed rule prohibiting a prepayment penalty where a
consumer's verified DTI ratio, as of consummation, exceeds 50 percent.
This restriction, however, will continue to apply to HOEPA loans, as
provided by the statute.
Under Regulation Z, 12 CFR 226.23(a)(3), footnote 48, a HOEPA loan
having a prepayment penalty that does not conform to the requirements
of Sec. 226.32(d)(7) is a mortgage containing a provision prohibited
by TILA Section 129, 15 U.S.C. 1639, and therefore is subject to the
three-year right of the consumer to rescind. Final Sec. 226.35(b)(2),
which the Board is adopting under the authority of Section 129(l)(2),
15 U.S.C. 1639(l)(2), applies restrictions on prepayment penalties for
higher-priced mortgage loans that are substantially the same as the
restrictions that Sec. 226.32(d)(6) and (7) apply on prepayment
penalties for HOEPA loans. Accordingly, the Board is revising footnote
48 to clarify that a higher-priced mortgage loan (whether or not it is
a HOEPA loan) having a prepayment penalty that does not conform to the
requirements of Sec. 226.35(b)(2) also is subject to a three-year
right of rescission. (The right of rescission, however, does not extend
to home purchase loans, construction loans, or certain refinancings
with the same creditor.)
Public Comment
The Board received public input about the advantages and
disadvantages of prohibiting or restricting prepayment penalties in
testimony provided at the 2006 and 2007 hearings the Board conducted on
mortgage lending, and in comment letters associated with these
hearings. In the official notice of the 2007 hearing, the Board
expressly asked for oral and written comment about the effects of a
prohibition or restriction under HOEPA on prepayment penalties on
consumers and on the type and terms of credit offered. 72 FR 30380,
30382 (May 31, 2007). Most consumer and community groups, as well as
some state and local government officials and a trade association for
community development financial institutions, urged the Board to
prohibit prepayment penalties with subprime loans. By contrast, most
industry commenters opposed prohibiting prepayment penalties or
restricting them beyond requiring that they expire sixty days before
reset, on the grounds that a prohibition or additional restrictions
would reduce credit availability in the subprime market. Some industry
commenters, however, stated that a three-year maximum prepayment
penalty period would be appropriate.
In connection with the proposed rule, the Board asked for comment
about the benefits and costs of prepayment penalties to consumers who
have higher-priced mortgage loans, as well as about the costs and
benefits of the specific restrictions proposed. Most financial
institutions and their trade associations stated that consumers should
be able to choose a loan with a prepayment penalty in order to lower
their interest rate. Many of these commenters stated that prepayment
penalties help creditors to manage prepayment risk, which in turn
increases credit availability and lowers credit costs. Industry
commenters generally opposed the proposed rule that would prohibit
prepayment
[[Page 44552]]
penalties in cases where a consumer's DTI ratio exceeds 50 percent. The
few industry commenters that addressed the proposal to require that a
prepayment penalty not apply in the case of a refinancing by the
creditor or its affiliate opposed the provision. These commenters
supported, or did not oppose, the proposal to require prepayment
penalties to expire at least sixty days before any possible payment
increase. Several financial institutions, an industry trade
association, and a secondary-market investor recommended that the Board
set a three-year maximum penalty period instead of a five-year maximum.
By contrast, many other commenters, including most consumer
organizations, several trade associations for state banking
authorities, a few local, state, and federal government officials, a
credit union trade association, and a real estate agent trade
association, supported prohibiting prepayment penalties for higher-
priced mortgage loans and HOEPA loans. Many of these commenters stated
that the cost of prepayment penalties to subprime borrowers outweigh
the benefits of any reductions in interest rates or up-front fees they
may receive. These commenters stated that the Board's proposed rule
would not address adequately the harms that prepayment penalties cause
consumers. Several commenters recommended alternative restrictions of
prepayment penalties with higher-priced mortgage loans and HOEPA loans
if the Board did not prohibit such penalties, including limiting a
prepayment penalty period to two or three years following consummation
or prohibiting prepayment penalties with ARMs.
Public comments are discussed in greater detail throughout this
section.
Discussion
For the reasons discussed below, the Board concludes that the
fairness of prepayment penalty provisions on higher-priced mortgage
loans and HOEPA loans depends to an important extent on the structure
of the mortgage loan. It has been common in the subprime market to
structure loans to have a short expected life span. This has been
achieved by building in a significant payment increase just a few years
after consummation. With respect to subprime loans designed to have
shorter life spans, the injuries from prepayment provisions are
potentially the most serious, as well as the most difficult for a
reasonable consumer to avoid. For these loans, therefore, the Board
concludes that the injuries caused by prepayment penalty provisions
with subprime loans outweigh their benefits. With respect to subprime
loans structured to have longer expected life spans, however, the Board
concludes that the injuries from prepayment penalties are closer to
being in balance with their benefits, warranting restrictions but not,
at this time, a prohibition.
Background. Prepayment risk is the risk that a loan will be repaid
before the end of the loan term, a major risk of mortgage lending.
Along with default risk, it is the major risk of extending mortgage
loans. When mortgages prepay, cash flow from loan payments may not
offset origination expenses or discounts consumers were provided on
fees or interest rates. Moreover, prepayment when market interest rates
are declining, which is when borrowers are more likely to prepay,
forces investors to reinvest prepaid funds at a lower rate.
Furthermore, prepayment by subprime borrowers whose credit risk
declines (for example, their equity or their credit score increases)
leaves an investor holding relatively riskier loans.
Creditors seek to account for prepayment risk when they set loan
interest rates and fees, and they may also seek to address prepayment
risk with a prepayment penalty. A prepayment penalty is a fee that a
borrower pays if he repays a mortgage within a specified period after
origination. A prepayment penalty can amount to several thousand
dollars. For example, a consumer who obtains a 3-27 ARM with a thirty-
year term for a loan in the amount of $200,000 with an initial rate of
6 percent would have a principal balance of $194,936 at the end of the
second year following consummation. If the consumer pays off the loan,
a penalty of six months' interest on the remaining balance--close to
six monthly payments--will cost the consumer about $5,850.\71\ A
penalty of this magnitude reduces a borrower's likelihood of prepaying
and assures a return for the investor if the borrower does prepay.
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\71\ This is a typical contractual formula for calculating the
penalty. There are other formulas for calculating the penalty, such
as a percentage of the amount prepaid or of the outstanding loan
balance (potentially reduced by the percentage (for example, 20
percent) that a borrower, by law or contract, may prepay without
penalty). As explained further below, a consumer may pay a lower
rate in exchange for having a provision providing for a penalty of
this magnitude.
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Substantial injury. Prepayment penalty provisions have been very
common on subprime loans. Almost three-quarters of loans in a large
dataset of securitized subprime loan pools originated from 2003 through
the first half of 2007 had a prepayment penalty provision.\72\ These
provisions cause many consumers who pay the penalty, as well as many
consumers who cannot, substantial injuries. The risk of injury is
particularly high for borrowers who receive loans structured to have
short expected life spans because of a significant expected payment
increase.
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\72\ Figure calculated from First American LoanPerformance data.
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A borrower with a prepayment penalty provision who has reason to
refinance while the provision is in effect must choose between paying
the penalty or foregoing the refinance, either of which could be very
costly. Paying the penalty could exact several thousand dollars from
the consumer; financing the penalty through the refinance loan adds
interest to that cost. When the consumer's credit score has improved,
delaying the refinance until the penalty expires could mean losing or
at least postponing an opportunity to lower the consumer's interest
rate. Declining to pay the penalty also could mean foregoing or
delaying a ``cash out'' loan that would consolidate several large
unsecured debts at a lower rate or help the consumer meet a major life
expense, such as for medical care. Borrowers who have no ability to pay
or finance the penalty, however, have no choice but to forego or delay
any benefits from refinancing.
Prepayment penalty provisions also exacerbate injuries from
unaffordable or abusive loans. In the worst case, where a consumer has
been placed in a loan he cannot afford to pay, delaying a refinancing
could increase the consumer's odds of defaulting and, ultimately,
losing the house.\73\ Borrowers who were steered to loans with less
favorable terms than they qualify for based on their credit risk face
an ``exit tax'' for refinancing to improve their terms.
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\73\ For the reasons set forth in part II.B., consumers in the
subprime market have had a high risk of receiving loans they cannot
afford to pay. The Board expects that the rule prohibiting disregard
for repayment ability will reduce this risk substantially, but no
rule can eliminate it. Moreover, its success depends on vigorous
enforcement by a wide range of agencies and jurisdictions.
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Prepayment penalty provisions can cause more injury with loans
designed to have short expected life spans. With these loans, borrowers
are particularly likely to want to prepay in a short time to avoid the
expected payment increase. Moreover, in recent years, loans designed to
have short expected life spans have been among the most difficult for
borrowers to afford--even before their payment increases. Borrowers
with 2-28 and 3-27 ARMs have been much more likely to become
[[Page 44553]]
seriously delinquent than borrowers with fixed-rate subprime mortgages.
In part, the difference reflects that borrowers receiving 2-28 and 3-27
ARMs have had lower average credit scores and less equity in their
homes at origination. But the large difference also suggests that these
shorter-term loans were more likely to be marketed and underwritten in
ways that increase the risk of unaffordability. A prepayment penalty
provision exacerbates this injury, especially because borrowers with
lower credit scores are the most likely to have a need to refinance to
extract cash.
Injury not reasonably avoidable. In the prime market, the injuries
prepayment penalties cause are readily avoidable because lenders do not
typically offer borrowers mortgages with prepayment penalty provisions.
Indeed, in one large dataset of first-lien prime loans originated from
2003 to mid-2007 just six percent of loans had these provisions.\74\ In
a dataset of subprime securitized loans originated during the same
period, however, close to three-quarters had a prepayment penalty
provision.\75\ Moreover, evidence suggests that a large proportion of
subprime borrowers with prepayment penalty provisions have paid the
penalty. Approximately 55 percent of subprime 2-28 ARMs in this same
dataset originated from 2000 to 2005 prepaid while the prepayment
penalty provision was in effect.\76\ The data do not indicate how many
consumers actually paid a penalty, or how much they paid. But the data
suggest that a significant percentage of borrowers with subprime loans
have paid prepayment penalties, which, as indicated above, can amount
to several thousand dollars.
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\74\ Figure calculated from McDash Analytics data.
\75\ Figure calculated from First American LoanPerformance data.
\76\ Id.
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These figures raise a serious question as to whether a substantial
majority of subprime borrowers have knowingly and voluntarily taken the
very high risk of paying a significant penalty. While subprime
borrowers receive some rate reduction for a prepayment penalty
provision (as discussed at more length in the next subsection), they
also have major incentives to refinance. They often have had difficulty
meeting their regular obligations and experienced major life
disruptions. Many would therefore anticipate refinancing to extract
equity to consolidate their debts or pay a major expense; nearly 90
percent of subprime ARMs used for refinancings in recent years were
``cash out.'' \77\ In addition, many subprime borrowers would aspire to
refinance for a lower rate when their credit risk declines (for
example, their credit score improves, or their equity increases).
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\77\ Id. It is not possible to discern from the data whether the
cash was used only to cover the costs of refinancing or also for
other purposes. See also Subprime Refinancing at 233 (reporting that
49 percent of subprime refinance loans involve equity extraction,
compared with 26 percent of prime refinance loans); Subprime
Outcomes at 368-371 (discussing survey evidence that borrowers with
subprime loans are more likely to have experienced major adverse
life events (marital disruption; major medical problem; major spell
of unemployment; major decrease of income) and often use refinancing
for debt consolidation or home equity extraction); Subprime Lending
Investigation at 551-52 (citing survey evidence that borrowers with
subprime loans have increased incidence of major medical expenses,
major unemployment spells, and major drops in income).
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Prepayment penalties' lack of transparency also suggests that
prepayment penalty provisions are often not knowingly and voluntarily
chosen by subprime borrowers whose loans have them. In the subprime
market, information on rates and fees is not easy to obtain. See part
II.B. Information on prepayment penalties, such as how large they can
be or how many consumers actually pay them, is even harder to obtain.
The lack of transparency is exacerbated by originators' incentives--
largely hidden from consumers--to ``push'' loans with prepayment
penalty provisions and at the same time obscure or downplay these
provisions. If the consumer seeks the lowest monthly payment--as the
consumer in the subprime market often does--then the originator has a
limited incentive to quote the payment for a loan without a prepayment
penalty provision, which will tend to be at least slightly higher.
Perhaps more importantly, lenders pay originators considerably larger
commissions for loans with prepayment penalties, because the penalty
assures the lender a larger revenue stream to cover the commission. The
originator also has an incentive not to draw the consumer's attention
to the prepayment penalty provision, in case the consumer should prefer
a loan without it. Although the prepayment penalty provision must be
disclosed on the post-application TILA disclosure, the consumer may not
notice it amidst numerous other disclosures or may not appreciate its
significance. Moreover, an unscrupulous originator may not disclose the
penalty until closing, when the consumer's ability to negotiate terms
is much reduced.
Even a consumer offered a genuine choice would have difficulty
comparing the costs of subprime loans with and without a penalty, and
would likely choose to place more weight on the more certain and
tangible cost of the initial monthly payment. There is a limit to the
number of factors a consumer can reasonably be expected to consider, so
the more complex a loan the less likely the consumer is to consider the
prepayment penalty. For example, an FTC staff study found that
consumers presented with mortgage loans with more complex terms were
more likely to miss or misunderstand key terms.\78\
---------------------------------------------------------------------------
\78\ Improving Consumer Mortgage Disclosures at 74
(``[R]espondents had more difficulty recognizing and identifying
mortgage cost in the complex-loan scenario. This implies that
borrowers in the subprime market may have more difficulty
understanding their loan terms than borrowers in the prime market.
The difference in understanding, however, would be due largely to
differences in the complexities of the loans, rather than the
capabilities of the borrowers.'').
---------------------------------------------------------------------------
These concerns are magnified with subprime loans structured to have
short expected life spans, which will have variable rates (such as 2-28
and 3-27 ARMs) or other terms that can increase the payment.
Adjustable-rate mortgages are complicated for consumers even without
prepayment penalties. A Federal Reserve staff study suggests that
borrowers with ARMs underestimate the amount by which their interest
rates can change.\79\ The study also suggests that the borrowers most
likely to make this mistake have a statistically higher likelihood of
receiving subprime mortgages (for example, they have lower incomes and
less education).\80\ Adding a prepayment penalty provision to an
already-complex ARM product makes it less likely the consumer will
notice, understand, and consider this provision when making decisions.
Moreover, the shorter the period until the likely payment increase, the
more the consumer will have to focus attention on the adjustable-rate
feature of the loan and the less the consumer may be able to focus on
other features.
---------------------------------------------------------------------------
\79\ Brian Bucks and Karen Pence, Do Borrowers Understand their
Mortgage Terms?, Journal of Urban Economics (forthcoming 2008).
\80\ Id.
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Moreover, subprime mortgage loans designed to have short expected
life spans appear more likely than other types of subprime mortgages to
create incentives for abusive practices. Because these loans create a
strong incentive to refinance in a short time, they are likely to be
favored by originators who seek to ``flip'' their clients through
repeated refinancings to increase fee revenue; prepayment penalties are
frequently associated with such a strategy.\81\ Moreover, 2-28 and
[[Page 44554]]
3-27 ARMs were marketed to borrowers with low credit scores as ``credit
repair'' products, obscuring the fact that a prepayment penalty
provision would inhibit or prevent the consumer who improved his credit
score from refinancing at a lower rate. These loans were also
associated more than other loan types with irresponsible underwriting
and marketing practices that contributed to high rates of delinquency
even before the consumer's payment increased.
---------------------------------------------------------------------------
\81\ See generally U.S. Dep't of Hous. & Urban Dev. & U.S. Dep't
of Treasury, Recommendations to Curb Predatory Home Mortgage Lending
73 (2000) (``Loan flipping generally refers to repeated refinancing
of a mortgage loan within a short period of time with little or no
benefit to the borrower.''), available at http://www.huduser.org/
publications/pdf/treasrpt.pdf.
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Subprime loans designed to have short expected life spans also
attracted consumers who are more vulnerable to abusive prepayment
penalties. Borrowers with 2-28 and 3-27 ARMs had lower credit scores
than borrowers with any other type of subprime loan.\82\ These
borrowers include consumers with the least financial sophistication and
the fewest financial options. Such consumers are less likely to
scrutinize a loan for a restriction on prepayment or negotiate the
restriction with an originator, who in any event has an incentive to
downplay its significance.
---------------------------------------------------------------------------
\82\ Figures calculated from First American LoanPerformance data
about securitized subprime pools show that the median FICO score was
627 for fixed-rate loans and 612 for short-term hybrid ARMs (2-28
and 3-27 ARMS).
---------------------------------------------------------------------------
Injury not outweighed by countervailing benefits to consumers or to
competition. The Board concludes that prepayment penalties' injuries
outweigh their benefits in the case of higher-priced mortgage loans and
HOEPA loans designed with planned or potential payment increases after
just a few years. For other types of higher-priced and HOEPA loans,
however, the Board concludes that the injuries and benefits are much
closer to being in equipoise. Thus, as explained further in the next
section, the final rule prohibits penalties in the first case and
limits them to two years in the second.
Prepayment penalties can increase market liquidity by permitting
creditors and investors to price directly and efficiently for
prepayment risk. This liquidity benefit is more significant in the
subprime market than in the prime market. Prepayment in the subprime
market is motivated by a wider variety of reasons than in the prime
market, as discussed above, and therefore is subject to more
uncertainty. In principle, prepayment penalty provisions allow
creditors to charge most of the prepayment risk only to the consumers
who actually prepay, rather than charging all of the risk in the form
of higher interest rates or up-front fees for all consumers. The extent
to which creditors have actually passed on lower rates and fees to
consumers with prepayment penalty provisions in their loans is debated
and, moreover, inherently difficult to measure. With limited
exceptions, however, available studies, discussed at more length below,
have shown consistently that loans with prepayment penalties carry
lower rates or APRs than loans without prepayment penalties having
similar credit risk characteristics.\83 \
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\83\ See Chris Mayer, Tomasz Piskorski, and Alexei Tchistyi, The
Inefficiency of Refinancing: Why Prepayment Penalties Are Good for
Risky Borrowers (Apr. 28, 2008) (Why Prepayment Penalties Are Good),
http://www1.gsb.columbia.edu/mygsb/faculty/research/pubfiles/3065/
Inefficiency%20of%20Refinancing%2Epdf; Gregory Elliehausen, Michael
E. Staten, and Jevgenijs Steinbuks, The Effect of Prepayment
Penalties on the Pricing of Subprime Mortgages, 60 Journal of
Economics and Business 33 (2008) (Effect of Prepayment Penalties);
Michael LaCour-Little, Prepayment Penalties in Residential Mortgage
Contracts: A Cost-Benefit Analysis (Jan. 2007) (unpublished) (Cost-
Benefit Analysis); Richard F. DeMong and James E. Burroughs,
Prepayment Fees Lead to Lower Interest Rates, Equity (Nov./Dec.
2005), available at http://www.commerce.virginia.edu/faculty_
research/faculty_homepages/DeMong/PrepaymentsandInterestRates.pdf
(Prepayment Fees Lower Rates); but see Keith E. Ernst, Center for
Responsible Lending, Borrowers Gain No Interest Rate Benefit from
Prepayment Penalties on Subprime Mortgages (2005), http://
www.responsiblelending.org/pdfs/rr005-PPP_Interest_Rate-0105.pdf
(No Interest Rate Benefit).
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Evidence of lower rates or APRs is not sufficient to demonstrate
that penalties provide a net benefit to consumers. Some consumers may
not have chosen the lower rates or APRs voluntarily and may have
preferred ex ante, had they been properly informed, to have no
prepayment penalty provision and somewhat higher rates or fees.
Borrowers with these provisions who hold their loans past the penalty
period are likely better off because they have lower rates and do not
incur a prepayment penalty; but the benefit these borrowers receive may
be small compared to the injury suffered by the many borrowers who pay
the penalty, or who cannot pay it and are locked into an inappropriate
or unaffordable loan. It does appear, however, that prepayment penalty
provisions provide some benefit to at least some consumers in the form
of reduced rates and increased credit availability.
In the case of higher-priced mortgage loans and HOEPA loans
designed to have short expected life spans, the Board concludes that
these potential benefits do not outweigh the injuries to consumers.
Available studies generally have found reductions in interest rate or
APR associated with subprime 2-28 ARMs and 3-27 ARMs to be minimal,
ranging from 18 to a maximum of 29 basis points, with one study finding
no rate reduction on such loans originated by brokers.\84\ The one
available (but unpublished) study to compare the rate reduction to the
cost of the penalty itself found a net cost to the consumer with 2-28
and 3-27 ARMs.\85\ The minimal rate reductions strengthen doubt that
the high incidence of penalty provisions was the product of informed
consumer choice. Moreover, for the reasons discussed above, prepayment
penalties are likely to cause the most significant, and least
avoidable, injuries when coupled with loans designed to have short
expected life spans, which have proved to be the riskiest loans for
consumers. On balance, therefore, the Board believes these injuries
outweigh potential benefits.
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\84\ See Effect of Prepayment Penalties 43 (finding that the
presence of a prepayment penalty reduced risk premiums by 18 basis
points for hybrid loans and 13 basis points for variable-rate
loans); Prepayment Fees Lower Rates 5 (stating that, for first-lien
subprime loans with a thirty-year term, the presence of a prepayment
penalty reduced the APR by 29 basis points for adjustable-rate loans
and 20 basis points for interest-only loans).
\85\ Cost-Benefit Analysis 26 (``For the [2-28] ARM product, the
total interest rate savings is significantly less than the amount of
the expected prepayment penalty; for the [3-28] ARM product, the two
values are approximately equal.'').
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For higher-priced mortgage loans and HOEPA loans structured to have
longer expected life spans, however, the Board concludes that the
injuries and benefits are closer to being in balance. Studies that
analyze both fixed-rate mortgages and 2-28 and 3-27 ARMs show a more
significant reduction of rates and fees for fixed-rate mortgages for
loans with prepayment penalties, ranging from 38 basis points \86\ to
60 basis points.\87\ Moreover, longer-term ARMs and fixed-rate
mortgages have had significantly lower delinquency rates than 2-28 and
3-27 ARMs, suggesting these mortgages are more likely to be affordable
to consumers. In addition, mortgages
[[Page 44555]]
designed to have longer life spans create less opportunity for flipping
and other abuses, and the borrowers offered these loans may be less
vulnerable to abuse. These borrowers have had higher credit scores and
therefore more options, and their preference for a longer-lived loan
may imply that they have a longer-term perspective and a more realistic
assessment of their situation. In fact, a smaller proportion of
borrowers with subprime fixed-rate mortgages with penalty provisions
originated between 2000 and 2005 prepaid in the first two years (about
35 percent) than did borrowers with subprime 2-28 ARMs with penalty
provisions (about 55 percent).\88\ Therefore, in the case of shorter
prepayment penalty provisions on loans structured to have longer life
spans, the Board does not conclude at this time that the injuries from
these provisions outweigh the benefits.
---------------------------------------------------------------------------
\86\ Effect of Prepayment Penalties 43. See also Cost-Benefit
Analysis 24 (finding the total estimated interest rate savings for
fixed-rate loans to be 51 basis points for retail-originated loans
and 33 basis points for broker-originated loans).
\87\ Prepayment Fees Lower Rates 5. See also Why Prepayment
Penalties Are Good 25 & fig. 4 (finding that, depending on the
borrower's FICO score, fixed-rate loans with prepayment penalties
had interest rates that were about 50 basis points (where FICO score
680 or higher) to about 70 basis points (where FICO score less than
620) lower than mortgages without prepayment penalties); but see No
Interest Rate Benefit (finding, for subprime fixed-rate loans, that
interest rates for purchase loans with a prepayment penalty were
between 39 and 51 basis points higher than for such loans without a
penalty and that for refinance loans there was no statistically
significant difference in the interest rates paid).
\88\ Figures calculated from First American LoanPerformance
data. About 90 percent of the penalty provisions on the fixed-rate
loans applied for at least two years.
---------------------------------------------------------------------------
The Final Rule
For both higher-priced mortgage loans and HOEPA loans, the final
rule prohibits prepayment penalties if periodic payments can change
during the first four years following loan consummation. For all other
higher-priced mortgage loans and HOEPA loans, the final rule limits the
prepayment penalty period to two years after loan consummation and also
requires that a prepayment penalty not apply if the same creditor or
its affiliate makes the refinance loan. For HOEPA loans, the final rule
retains the current prohibition of prepayment penalties where the
borrower's DTI ratio at consummation exceeds 50 percent; the Board is
not adopting this prohibition for higher-priced mortgage loans. The
final rule sets forth the foregoing prepayment penalty rules in two
separate sections: For HOEPA loans, in Sec. 226.32(d)(7), and for
higher-priced mortgage loans, in Sec. 226.35(b)(3).
TILA Section 129(c)(2)(C), 15 U.S.C. 1639(c)(2)(C), limits the
maximum prepayment penalty period with HOEPA loans to five years
following consummation. The Board proposed to apply this HOEPA
provision to higher-priced mortgage loans. Commenters generally stated
that a five-year maximum prepayment period was too long. Some consumer
organizations, an association of credit unions, and a federal banking
regulatory agency recommended a two-year limit on prepayment penalty
periods. A few consumer organizations recommended a one-year maximum
length. Although a financial services trade association supported a
five-year maximum, several financial institutions and mortgage banking
trade associations and a government-sponsored enterprise stated that
three years would be an appropriate maximum period for prepayment
penalties with higher-priced mortgage loans.
As discussed above, the Board concludes that the injuries from
prepayment penalty provisions that consumers cannot reasonably avoid
outweigh these provisions' benefits with respect to higher-priced
mortgage loans and HOEPA loans structured to have short expected life
spans. Accordingly, the final rule prohibits a prepayment penalty
provision with a higher-priced mortgage loan or a HOEPA loan whose
payments may change during the first four years following
consummation.\89\ A four-year discount period is not common, but a
three-year period was common at least until recently. Using a three-
year period in the regulation, however, might simply encourage the
market to structure loans with discount periods of three years and one
day. Therefore, the Board adopts a four-year period in the final rule
as a prophylactic measure.
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\89\ This rule is stricter than HOEPA's statutory provision on
prepayment penalties for HOEPA loans. This provision permits such
penalties under certain conditions regardless of a potential payment
change within the first four years. Section 129(l)(2) authorizes the
Board, however, to prohibit acts or practices it finds to be unfair
or deceptive in connection with mortgage loans--including HOEPA
loans. Since HOEPA's restrictions on prepayment penalty provisions
were adopted, much has changed to make these provisions more
injurious to consumers and these injuries more difficult to avoid.
The following risk factors became much more common in the subprime
market: ARMs with payments that reset after just two or three years;
securitization of subprime loans under terms that reduce the
originator's incentive to ensure the consumer can afford the loan;
and mortgage brokers with hidden incentives to ``push'' penalty
provisions.
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The prohibition applies to loans with potential payment changes
within four years, including potential increases and potential
declines; the prohibition is not limited to loans where the payment can
increase but not decline. The Board is concerned that such a limitation
might encourage the market to develop unconventional repayment
schedules for HOEPA loans and higher-priced mortgage loans that are
more difficult for consumers to understand, easier for originators to
misrepresent, or both. The final rule also refers specifically to
periodic payments of principal or interest or both, to distinguish such
payments from other payments, including amounts directed to escrow
accounts. Staff commentary lists examples showing whether prepayment
penalties are permitted or prohibited in particular circumstances where
the amount of the periodic payment can change. The commentary also
provides examples of changes that are not deemed payment changes for
purposes of the rule.\90\
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\90\ As discussed above, the final rule sets forth the
prepayment penalty rules in two separate sections. For HOEPA loans,
Sec. 226.32(d)(7) lists conditions that must be met for the general
penalty prohibition in Sec. 226.32(d)(6) not to apply. For higher-
priced mortgage loans, Sec. 226.35(b)(2) prohibits a penalty
described in Sec. 226.32(d)(6) unless the conditions in Sec.
226.35(b)(i) and (ii) are met. To ensure consistent interpretation
of the separate sections, the staff commentary to Sec. 226.35(b)(2)
cross-references the payment-change examples and exclusions in staff
commentary to Sec. 226.32(d)(7). The examples in staff commentary
to Sec. 226.32(d)(7)(iv) refer to a condition that final Sec.
226.35(b)(2) does not include, however--the condition that, at
consummation, the consumer's total monthly debt payments may not
exceed 50 percent of the consumer's monthly gross income. The staff
commentary to Sec. 226.35(b)(2) clarifies this difference.
---------------------------------------------------------------------------
With respect to loans structured to have longer expected life
spans, the Board concludes that the injuries from prepayment penalty
provisions that are short relative to the expected life span are closer
to being in balance with their benefits. Accordingly, for loans for
which the payment may not change, or may change only after four or more
years, the Board is not banning prepayment penalties. Instead, it is
seeking to ensure the benefits of penalty provisions on these loans are
in line with the injuries they can cause by limiting the potential for
injury to two years from consummation.
The Board recognizes that creditors may respond by increasing
interest rates, up-front fees, or both, and that some subprime
borrowers may pay more than they otherwise would, or not be able to
obtain credit when they would prefer. The Board believes these costs
are justified by the benefits of the rule. Based on available studies,
the expected increase in costs on the types of loans for which penalty
provisions are prohibited is not large. For the remaining loan types,
reducing the allowable penalty period from the typical three years to
two years should not lead to significant cost increases for subprime
borrowers. Moreover, to the extent cost increases come in the form of
higher rates or fees, they will be reflected in the APR, where they may
be more transparent to consumers than as a prepayment penalty. Thus, it
is not clear that the efficiency of market pricing would decline.
The Board is not adopting the suggestion of some commenters that it
set a maximum penalty amount. A restriction of that kind does not
appear necessary or warranted at this time.
[[Page 44556]]
Sixty-day window. The Board does not believe that the proposed
requirement that a prepayment penalty period expire at least sixty days
before a potential payment increase would adequately protect consumers
with loans where the increase was expected shortly. As discussed, these
loans, such as 2-28 ARMs, will tend to attract consumers who have a
short planning horizon and intend to avoid the payment increase by
refinancing. If provided only a brief penalty-free window to refinance
before the increase (as proposed, a window in months 23 and 24 for a 2-
28 ARM), the consumer deciding whether to accept a loan with a penalty
provision--assuming the consumer was provided a genuine choice--must
predict quite precisely when he will want to refinance. If the consumer
believes he will want to refinance in month 18 and that his credit
score, home equity, and other indicators of credit quality will be high
enough then to enable him to refinance, then the consumer probably
would be better off with a loan without a penalty provision. If,
however, the consumer believes he will not be ready or able to
refinance until month 23 or 24 (the penalty-free window), he probably
would be better off accepting the penalty provision. It is not
reasonable to expect consumers in the subprime market to make such
precise predictions. Moreover, for transactions on which prepayment
penalties are permitted by the final rule, a sixty-day window would be
moot because the penalty provision may not exceed two years and the
payment on a loan with a penalty provision may not change during the
first four years following consummation.\91\
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\91\ The Board sought comment on whether it should revise Sec.
226.20(c) or draft new disclosure requirements to reconcile that
section with the proposed requirement that a prepayment penalty
provision expire at least sixty days prior to the date of the first
possible payment increase. This issue is also moot.
---------------------------------------------------------------------------
Refinance loan from same creditor. The Board is adopting with minor
revisions the proposed requirement that a prepayment penalty not apply
when a creditor refinances a higher-priced mortgage loan the creditor
or its affiliate originated. HOEPA imposes this requirement in
connection with HOEPA loans. 15 U.S.C. 1639(c)(2)(B).
Some large financial institutions and financial institution trade
associations that commented opposed the proposal. A large bank stated
that the requirement would not prevent loan flipping and that mortgage
brokers would easily circumvent the rule by directing repeat customers
to a different creditor each time. A mortgage bankers' trade
association and a large bank stated that the requirement would prevent
customers from returning to the same institution with which they have
existing relationships. Another large bank stated that the rule would
place lenders at a competitive disadvantage when trying to refinance
the loan of an existing customer.
Requiring that a prepayment penalty not apply when a creditor
refinances a loan it originated will discourage originators from
seeking to ``flip'' a higher-priced mortgage loan. To prevent evasion
by creditors who might direct borrowers to refinance with an affiliated
creditor, the same-lender refinance rule covers loans by a creditor's
affiliate. Although creditors may waive a prepayment penalty when they
refinance a loan that they originated to a consumer, consumers who
refinance with the same creditor may be charged a prepayment penalty
even if a creditor or mortgage broker has told the consumer that the
prepayment penalty would be waived in that circumstance.\92\
---------------------------------------------------------------------------
\92\ This concern is evident, for example, in a settlement
agreement that ACC Capital Holdings Corporation and several of its
subsidiaries, including Ameriquest Mortgage Company (collectively,
the Ameriquest Parties) made in 2006 with 49 states and the District
of Columbia. The Ameriquest Parties agreed not to make false,
misleading, or deceptive representations regarding prepayment
penalties and specifically agreed not to represent that they will
waive a prepayment penalty at some future date, unless that promise
is made in writing and included in the terms of a loan agreement
with a borrower. See, e.g., Iowa ex rel. Miller v. Ameriquest
Mortgage Co., No. 05771 EQCE-053090 at 18 (Iowa D. Ct. 2006) (Pls.
Pet. 5).
---------------------------------------------------------------------------
The final rule requires that a prepayment penalty not apply where a
creditor or its affiliate refinances a higher-priced mortgage loan that
the creditor originated to the consumer. The final rule is based on
TILA Section 129(c)(2)(B), 15 U.S.C. 1639(c)(2)(B), which provides that
a HOEPA loan may contain a prepayment penalty ``if the penalty applies
only to a prepayment made with amounts obtained by the consumer by
means other than a refinancing by the creditor under the mortgage, or
an affiliate of that creditor.'' The Board notes that TILA Section
129(c)(2)(B), 15 U.S.C. 1639(c)(2)(B), applies regardless of whether
the creditor still holds the loan at the time of a refinancing by the
creditor or an affiliate of the creditor. In some cases, a creditor's
assignees are the ``true creditor'' funding the loan; moreover, the
rule prevents loan transfers designed to evade the prohibition.
TILA Section 129(c)(2)(B) does not prohibit a creditor from
refinancing a loan it or its affiliate originated but rather requires
that a prepayment penalty not apply in the event of a refinancing by
the creditor or its affiliate. To make clear that the associated
regulation, Sec. 226.32(d)(7)(ii), does not prohibit a creditor from
refinancing a loan that the creditor (or an affiliate of the creditor)
originated, the Board is revising the text of that regulation somewhat.
Final Sec. 226.32(d)(7)(ii) states that a HOEPA loan may provide for a
prepayment penalty if the prepayment penalty provision will not apply
if the source of the prepayment funds is a refinancing by the creditor
or an affiliate of the creditor. This change clarifies, without
altering, the meaning of the provision and is technical, not
substantive, in nature. Final Sec. 226.35(b)(2)(ii)(B) applies to
higher-priced mortgage loans rather than to HOEPA loans but mirrors
final Sec. 226.32(d)(7)(ii) in all other respects.
Debt-to-income ratio. Under the proposed rule, a higher-priced
mortgage loan could not include a prepayment penalty provision if, at
consummation, the consumer's DTI ratio exceeds 50 percent. Proposed
comments would have given examples of funds and obligations that
creditors commonly classify as ``debt'' and ``income'' and stated that
creditors may, but need not, look to widely accepted governmental and
non-governmental underwriting standards to determine how to classify
particular funds or obligations as ``debt'' or ``income.''
Most banking and financial services trade associations and several
large banks stated that the Board should not prohibit prepayment
penalties on higher-cost loans where a consumer's DTI ratio at
consummation exceeds 50 percent. Several of these commenters stated
that the proposed rule would disadvantage a consumer living on a fixed
income but with significant assets, including many senior citizens.
Some of these commenters stated that the proposed rule would
disadvantage consumers in areas where housing prices are relatively
high. Some consumer organizations also objected to the proposed DTI-
ratio requirement, stating that the requirement would not protect low-
income borrowers with a DTI ratio equal to or less than 50 percent but
limited residual income.
The Board is not adopting a specific DTI ratio in the rule
prohibiting disregard of repayment ability. See part IX.B. For the same
reasons, the Board is not adopting the proposed prohibition of a
prepayment penalty for all higher-priced mortgage loans where a
consumer's DTI ratio at consummation exceeds 50 percent. The Board is,
however, leaving the prohibition in
[[Page 44557]]
place as it applies to HOEPA loans, as this prohibition is statutory,
TILA Section 129(c)(2)(A)(ii), and its removal does not appear
warranted at this time.
This statute provides that for purposes of determining whether at
consummation of a HOEPA loan a consumer's DTI ratio exceeds 50 percent,
the consumer's income and expenses are to be verified by a financial
statement signed by the consumer, by a credit report, and, in the case
of employment income, by payment records or by verification from the
employer of the consumer (which verification may be in the form of a
pay stub or other payment record supplied by the consumer). The Board
proposed to adopt a stronger standard that would require creditors to
verify the consumer's income and expenses in accordance with
verification rules that the Board proposed and is adopting in final
Sec. 226.34(a)(4)(ii), together with associated commentary. Although
the Board requested comment about the proposal to revise Sec.
226.32(d)(7)(iii) and associated commentary, commenters did not discuss
this proposal.
As proposed, the Board is strengthening the standards that Sec.
226.32(d)(7)(iii) establishes for verifying the consumer's income and
expenses when determining whether a prepayment penalty is prohibited
because the consumer's DTI ratio exceeds 50 percent at consummation of
a HOEPA loan. There are three bases for adopting an income verification
requirement that is stronger than the standard TILA Section
129(c)(2)(A)(ii) establishes. First, under TILA Section 129(l)(2), the
Board has a broad authority to update HOEPA's protections as needed to
prevent unfair practices. 15 U.S.C. 1639(l)(2)(A). For the reasons
discussed in part IX.B, the Board believes that relying solely on the
income statement on the application is unfair to the consumer,
regardless of whether the consumer is employed by another person, self-
employed, or unemployed. Second, the Board has a broad authority under
TILA Section 129(l)(2) to update HOEPA's protections as needed to
prevent their evasion. 15 U.S.C. 1639(l)(2)(A). A signed financial
statement declaring all or most of a consumer's income to be self-
employment income or income from sources other than employment could be
used to evade the statute. Third, establishing a single standard for
verifying a consumer's income and obligations for HOEPA loans and
higher-priced mortgage loans will facilitate compliance.
For the foregoing reasons, for HOEPA loans, final Sec.
226.32(d)(7)(iii) requires creditors to verify that the consumer's
total monthly debt payments do not exceed 50 percent of the consumer's
monthly gross income using the standards set forth in final Sec.
226.34(a)(4)(ii). The Board also is revising the commentary associated
with Sec. 226.32(d)(7)(iii) to cross-reference certain commentary
associated with Sec. 226.34(a)(4).
Disclosure. For reasons discussed above, the Board does not believe
that disclosure alone is sufficient to enable consumers to avoid injury
from a prepayment penalty. There is reason to believe, however, that
disclosures could more effectively increase transparency.\93\ The Board
will be conducting consumer testing to determine how to make
disclosures more effective. As part of this process, the Board will
consider the recommendation from some commenters that creditors who
provide loans with prepayment penalties be required to disclose the
terms of a loan without a prepayment penalty.
---------------------------------------------------------------------------
\93\ For example, an FTC study based on quantitative consumer
testing using several fixed-rate loan scenarios found that improving
a disclosure of the prepayment penalty provision increased the
percentage of participants who could tell that they would pay a
prepayment penalty if they refinanced. Improving Mortgage
Disclosures 109.
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D. Escrows for Taxes and Insurance--Sec. 226.35(b)(3)
The Board proposed in Sec. 226.35(b)(3) to require a creditor to
establish an escrow account for property taxes and homeowners insurance
on a higher-priced mortgage loan secured by a first lien on a principal
dwelling. Under the proposal, a creditor may allow a consumer to cancel
the escrow account, but no sooner than 12 months after consummation.
The Board is adopting the rule as proposed and adding limited
exemptions for loans on cooperative shares and, in certain cases,
condominium units.
The final rule requires escrows for all covered loans secured by
site-built homes for which creditors receive applications on or after
April 1, 2010, and for all covered loans secured by manufactured
housing for which creditors receive applications on or after October 1,
2010.
Public Comments
Many community banks and mortgage brokers as well as several
industry trade associations opposed the proposed escrow requirement.
Many of these commenters contended that mandating escrows is not
necessary to protect consumers. They argued that consumers are
adequately protected by the proposed requirement to consider a
consumer's ability to pay tax and insurance obligations under Sec.
226.35(b)(1), and by a disclosure of estimated taxes and insurance they
recommended the Board adopt. Commenters also contended that setting up
an escrow infrastructure would be very expensive; creditors will either
pass on these costs to consumers or decline to originate higher-priced
mortgage loans.
Individual consumers who commented also expressed concern about the
proposal. Some consumers expressed a preference for paying their taxes
and insurance themselves out of fear that servicers may fail to pay
these obligations fully and on-time. Many requested that, if escrows
are required, creditors be required to pay interest on the escrowed
funds.
Several industry trade associations, several large creditors and
some mortgage brokers, however, supported the proposed escrow
requirement. They were joined by the consumer groups, community
development groups, and state and federal officials that commented on
the issue. Many of these commenters argued that failure to escrow
leaves consumers unable to afford the full cost of homeownership and
would face expensive force-placed insurance or default, and possibly
foreclosure. Commenters supporting the proposal differed on whether and
under what circumstances creditors should be permitted to cancel
escrows.
Large creditors without escrow systems asked for 12 to 24 months to
comply if the proposal is adopted.
Discussion
As commenters confirmed, it is common for creditors to offer
escrows in the prime market, but not in the subprime market. The Board
believes that this discrepancy is not entirely the result of consumers
in the subprime market making different choices than consumers in the
prime market. Rather, subprime consumers, whether they would wish to
escrow or not, face a market where competitive forces have prevented
significant numbers of creditors from offering escrows at all. In such
a market, consumers suffer significant injury, especially, but not
only, those who are not experienced handling property taxes and
insurance on their own and are therefore least able to avoid these
injuries. The Board finds that these injuries outweigh the costs to
consumers of offering them escrows. For these reasons, the Board finds
that it is unfair for a creditor to make a higher-priced mortgage loan
without presenting
[[Page 44558]]
the consumer a genuine opportunity to escrow. In order to ensure that
the opportunity to escrow is genuine, the final rule requires that
creditors establish escrow accounts for first-lien higher-priced
mortgage loans for at least twelve months. The Board believes that
consumers, creditors, and investors will all benefit from this
requirement.
Lack of escrow opportunities in the subprime market. Relative to
the prime market, few creditors in the subprime market offer consumers
the opportunity to escrow. The Board believes that, absent a rule
requiring escrows, market forces alone are unlikely to drive
significant numbers of creditors to begin to offer escrows in the
subprime market. Consumers in the subprime market tend to shop based on
monthly payment amounts, rather than on interest rates.\94\ So
creditors who are active in the subprime market, and who can quote low
monthly payments to a prospective borrower, have a competitive
advantage over creditors that quote higher monthly payments. A creditor
who does not offer the opportunity to escrow (and thus quotes monthly
payments that do not include amounts for escrows) can quote a lower
monthly payment than a creditor who does offer an opportunity to escrow
(and thus quotes a higher monthly payment that includes amounts for
escrow). Consequently, creditors in the subprime market who offer
escrows may be at a competitive disadvantage to creditors who do not.
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\94\ Subprime Mortgage Investigation at 554 (``Our focus groups
suggested that prime and subprime borrowers use quite different
search criteria in looking for a loan. Subprime borrowers search
primarily for loan approval and low monthly payments, while prime
borrowers focus on getting the lowest available interest rate. These
distinctions are quantitatively confirmed by our survey.'').
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Creditors who offer escrows could try to overcome this competitive
disadvantage by advertising the availability and benefits of escrows to
subprime consumers. Yet offering escrows entails some significant cost
to the creditor. The creditor must either outsource servicing rights to
third party servicers and lose servicing revenue, or make a large
initial investment to establish an escrow infrastructure in-house.
According to comments from some creditors, the cost to set up an escrow
infrastructure could range between one million dollars and $16 million
for a large creditor. While escrows improve loan performance \95\ and
offer creditors assurance that the collateral securing the loan is
protected, those advantages alone have not proven sufficient incentive
to make escrowing widespread in the subprime market. Rather, if a
creditor is to recoup its costs for offering an opportunity to escrow,
the creditor must convince a significant number of subprime consumers
that they would be better served by accepting a higher monthly payment
with escrows rather than a lower monthly payment without escrows. Yet
consumers' focus on the lowest monthly payments in the subprime market,
and the lack of familiarity with escrows, could make it difficult to
convince consumers to accept the higher payment. In addition, the
creditor who offered escrows would be vulnerable to competitors'
attempts to lure away existing borrowers by quoting a lower monthly
payment without disclosing that the payment does not include amounts
for escrows. Nor could a creditor who offered escrows necessarily count
on consumers who wanted to escrow finding the creditor on their own. If
only a small minority of creditors offer escrows, consumers would, on
average, have to contact many creditors in order to find one that
offers escrows and many consumers might reasonably give up the search
before they were successful.
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\95\ An industry representative at the Board's 2007 hearing
indicated that her company's internal analysis showed that escrows
clearly improved loan performance. Home Ownership and Equity
Protection Act (HOEPA): Public Hearing, at 66 (June 14, 2007)
(statement of Faith Schwartz, Senior Vice President, Option One
Mortgage Corp.), available at http://federalreserve.gov/events/
publichearings/hoepa/2007/20070614/transcript.pdf. Also, the Credit
Union National Association and California and Nevada Credit Union
Leagues comment letters note that ``[o]verall, loans with escrow
accounts are likely to perform better than loans without these
accounts.''
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Under these conditions, creditors are unlikely to offer escrows
unless their competitors are required to offer escrows. The Board
believes that creditors' failure to establish a capacity to escrow is a
collective action problem; creditors would likely be better off if
escrows were widely available in the subprime market, but most
creditors who have not offered escrows lack the necessary incentive to
invest in the requisite systems unless their competitors do. This is
the context for the Board's finding that it is unfair for a creditor to
make a higher-priced mortgage loan without offering an escrow.
Substantial injury. A creditor's failure to offer escrows can cause
consumers substantial injury. The lack of escrows in the subprime
market increases the risk that consumers will base borrowing decisions
on unrealistically low assessments of their mortgage-related
obligations. Brokers and loan officers operating in a market where
escrows are not common generally quote monthly payments of only
principal and interest. These originators have little incentive to
disclose or emphasize additional obligations for taxes and insurance.
Therefore, many consumers will decide whether they can afford the
offered loan on the basis of misleadingly low payment quotes, making it
more likely that they will obtain mortgages they cannot afford. This
risk is particularly high for first time homebuyers, who lack
experience with the obligations of homeownership. The risk is also
elevated for homeowners who currently have prime loans and contribute
to an escrow. If their circumstances change and they refinance in the
subprime market, they may not be aware that payments quoted to them do
not include amounts for escrow. For example, current homeowners who
have substantial unsecured consumer debt, but who also have equity in
their homes, can be especially vulnerable to ``loan flipping'' because
they may find a cash-out refinance offer attractive. Yet if they
assumed, erroneously, that the monthly payment quoted to them included
amounts for escrows, they would not be able to evaluate the true cost
of the loan product being offered.
The lack of escrows in the subprime market also makes it more
likely that certain consumers will not be able to handle their mortgage
obligations including taxes and insurance. Subprime consumers, by
definition, are those who have experienced some difficulty in making
timely payments on debt obligations. For this reason, some consumers
may prefer to escrow if offered a choice, especially if they know from
personal experience that they have difficulty saving on their own,
paying their bills on-time, or both. Without an escrow, these consumers
may be at greater risk that a servicer will impose costly force-placed
homeowners insurance or the local government will seek to foreclose to
collect unpaid taxes. Consumers with unpaid property tax or insurance
bills are particularly vulnerable to predatory lending practices:
originators offering them a refinancing with ``cash out'' to cover
their tax and insurance obligations can take advantage of their urgent
circumstances. The consumers who cannot or will not borrow more (for
example, because they lack the equity) face default and a forced sale
or foreclosure.
Injury not reasonably avoidable. Consumers cannot reasonably avoid
the injuries that result from the lack of escrows. As described above,
originators in the subprime market have strong incentives to quote only
principal and interest payment amounts, and much
[[Page 44559]]
weaker incentives to inform consumers about tax and insurance
obligations since doing so could put them at a competitive
disadvantage. Consumers may either be left unaware of the magnitude of
their taxes and insurance obligations, or may not realize that amounts
for taxes and insurance are not being escrowed for them if they are
accustomed to the prime market's practice of escrowing. And, in a
market where few creditors offer escrows and advertise their
availability, consumers who would prefer to escrow may give up trying
to find a creditor who offers escrows. Given the market they face,
subprime consumers have little ability or incentive to shop for a loan
with escrows, and thus cannot reasonably avoid a loan that does not
offer escrows.
Injury not outweighed by countervailing benefit to consumers or to
competition. The Board recognizes that creditors incur costs in
initiating escrow capabilities and that creditors who do not escrow can
pass their cost savings on to consumers. Creditors that offer escrows
in-house may incur potentially substantial costs in setting up or
acquiring the necessary systems, although they may also gain some
additional servicing revenue. Creditors that outsource servicing of
escrow accounts to third parties incur some cost and forgo servicing
revenue.
In addition, there are some potential costs to consumers. Servicers
may at times collect more funds than needed or fail to pay property
taxes and insurance when due, causing consumers to incur penalties and
late fees. Congress has expressly authorized the Department of Housing
and Urban Development (HUD) to address these problems through section
10 of the Real Estate Settlement Procedures Act (RESPA), 12 U.S.C.
2609, which limits amounts that may be collected for escrow accounts;
requires servicers to provide borrowers annual statements of the escrow
balance and payments for property taxes and homeowners insurance; and
requires a mortgage servicer to provide information about anticipated
activity in the escrow accounts for the coming year when it starts to
service a loan. RESPA also provides consumers the means to resolve
complaints by filing a ``qualified written request'' with the servicer.
The Board expects that the number of qualified written requests may
increase after the final rule takes effect.
On the other hand, there is evidence, described above, that where
escrows are used they improve loan performance to the advantage of
creditors, investors, and consumers alike. This appears to be an
important reason that escrows are common in the prime market and often
required by the creditor. Loans with escrows generally perform better
than loans without because escrows make it more likely that consumers
will be able to pay their obligations. By contrast, when consumers are
faced with unpaid taxes and insurance, they may need to tap into their
home equity to pay these expenses and may become vulnerable to
predatory lending. In the worst cases, consumers may lose their homes
to foreclosure for failure to pay property taxes. For these reasons,
the Board finds that the benefits from escrows outweigh the costs
associated with requiring them.
The Final Rule
The final rule prohibits a creditor from extending a first-lien
higher-priced mortgage loan secured by a principal dwelling without
escrowing property taxes, homeowners insurance, and other insurance
obligations required by the creditor. Creditors have the option to
allow for cancellation of escrows at the consumer's request, but no
earlier than 12 months after consummation of the loan transaction. The
Board is adopting an exemption for loans secured by cooperative shares
and a partial exemption for loans secured by condominium units. The
final rule defines ``escrow account'' by reference to the definition of
``escrow account'' in RESPA. Moreover, RESPA's rules for administering
escrow accounts (including how creditors handle disclosures, initial
escrow deposits, cushions, and advances to cover shortages) apply. The
final rule also complements the National Flood Insurance Program
requirement that flood insurance premiums be escrowed if the creditor
requires escrow for other obligations such as hazard insurance.\96\
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\96\ Congress authorized NFIP through the National Flood
Insurance Act of 1968 (42 U.S.C. 4001), which provides property
owners with an opportunity to purchase flood insurance protection
made available by the federal government for buildings and their
contents. NFIP requires all federally regulated private creditors
and government-sponsored enterprises (GSEs) that purchase loans in
the secondary market to ensure that a building or manufactured home
and any applicable personal property securing a loan in a special
flood hazard area are covered by adequate flood insurance for the
term of the loan. The flood insurance requirements do not apply to
creditors or servicers that are not federally regulated and that do
not sell loans to Fannie Mae and Freddie Mac or other GSEs.
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The rule is intended to address the consumer injuries described
above caused by the lack of a genuine opportunity to escrow in the
subprime market. The rule assures a genuine opportunity to escrow by
establishing a market that provides widespread escrows through a
requirement that every creditor that originates higher-priced mortgage
loans secured by a first lien on a principal dwelling establish an
escrow with each loan. The Board proposed to limit the rule to first-
lien higher-priced mortgage loans because creditors in the prime market
have traditionally required escrow accounts on first-lien mortgage
loans as a means of protecting the lender's interest in the property
securing the loan. The final rule adopts this approach. A mandatory
escrow account on a first-lien loan ensures that funds are set aside
for payment of property taxes and insurance premiums and eliminates the
need to require an escrow on second lien loans. One commenter asked the
Board to clarify in the final rule that creditors are not obligated to
escrow payments for optional items that the consumer may choose to
purchase at its discretion, such as an optional debt-protection
insurance or earthquake insurance. A commentary provision has been
added to clarify that creditors and servicers are not required to
escrow optional insurance items chosen by the consumer and not
otherwise required by creditor. See comment to Sec. 226.35(b)(4)(i).
The Board recognizes that escrows can impose certain financial
costs on both creditors and borrowers. Creditors are likely to pass on
to consumers, either in part or entirely, the cost of setting up and
maintaining escrow systems, whether done in-house or outsourced. The
Board also recognizes that prohibiting consumers from canceling before
12 months have passed will impose costs on individual consumers who
prefer to pay property taxes and insurance premiums on their own, and
to earn interest on funds that otherwise would be escrowed.\97\ By
paying property taxes and insurance premiums directly, consumers are
better able to monitor that their payments are credited on time, thus
limiting the likelihood, and related cost, of servicing mistakes and
abuses. In addition, homebuyers do not need as much cash at closing
when they are not required to have an escrow account.
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\97\ Some states require creditors to pay interest to consumers
for escrowed funds but most states do not have such a requirement.
---------------------------------------------------------------------------
The Board believes, however, that the benefits of the rule outweigh
these costs. Moreover, the rule preserves some degree of consumer
choice by permitting a creditor to provide the consumer an option to
cancel an escrow account 12 or more months after consummation. The
Board considered alternatives that would avoid requiring a creditor to
set up an escrow system,
[[Page 44560]]
or that would require a creditor to offer an escrow, but permit
consumers to opt-out of escrows at closing. These alternatives would
not provide consumers sufficient protection from the injuries discussed
above, as explained in more detail below.
Alternatives to requiring creditors to escrow. Some creditors that
currently do not escrow oppose requiring escrows because of the
substantial cost to set up new systems and maintain them over time.
They suggested that narrower, less costly alternatives would protect
consumers adequately. Most of these suggestions involved disclosure,
such as: requiring creditors to warn consumers that they will be
responsible for property tax and insurance obligations; estimating
these obligations on the TILA disclosure based on recent assessments;
and prohibiting creditors from advertising monthly payments without
including estimated amounts for property taxes and insurance.
The Board does not believe that these disclosures would adequately
protect consumers from the injuries discussed above. Because many
consumers focus on monthly payment obligations, competition would
continue to give originators incentives to downplay tax and insurance
obligations when they discuss payment obligations with consumers. A
disclosure provided at origination of the estimated property tax and
insurance premiums does not assist those consumers who need an escrow
to ensure they save for and pay their obligations on time. Moreover,
adding a disclosure to the many disclosures consumers already receive
would not be sufficient to educate first time homebuyers and homeowners
whose previous loans contained escrows who lack any real experience
handling their own taxes and insurance. Disclosure does, however, have
an important role to play. Under the final rule, an advertisement for
closed-end credit secured by a first lien on a principal dwelling that
states a monthly payment of principal and interest must prominently
disclose that taxes and insurance premiums are not included. See Sec.
226.24(f)(3). Moreover, the Board plans to explore revising the TILA
disclosures to add an estimate of property tax and insurance premium
costs to the disclosed monthly payment.
For similar reasons, merely mandating that creditors offer escrows,
but not that they require them, would not sufficiently address the
injuries associated with the failure to escrow. Without a widespread
requirement to escrow, some creditors could still press a competitive
advantage in quoting low monthly payments that do not include amounts
for escrows by encouraging consumers to decline the offered escrow. A
rule that required creditors merely to offer escrows would impose
essentially the same costs on creditors to establish escrow systems as
would the requirement to establish escrows, but would not alter the
competitive landscape of the subprime market in a way that would make
widespread escrowing more likely.
Creditors also suggested that consumers would be adequately
protected by the final rule's requirement that creditors consider a
consumer's ability to handle tax and insurance obligations in addition
to principal and interest payments when originating loans. See Sec.
226.34(a)(4). While this requirement will help ensure that consumers
can afford their monthly payment obligations, it will not adequately
address the injuries discussed above because creditors would continue
to have incentives to downplay tax and insurance obligations when they
discussed payment obligations with consumers. Nor will the rule
requiring consideration of repayment ability sufficiently assist
consumers in saving on their own.
Another alternative would be to require escrows only for first time
homebuyers or other classes of borrowers (such as previously prime
borrowers) less likely to have experience handling tax and insurance
obligations on their own. However, limiting the escrow requirement to
borrowers who are unaccustomed to paying taxes and insurance on their
own would only delay injury, rather than prevent it. For example, if
first time homebuyers with higher-priced mortgage loans were required
to escrow, those consumers would not gain the experience of paying
property taxes and insurance on their own and might reasonably believe
that escrows are standard. When those consumers went to refinance their
loan, however, creditors could mislead them by quoting payments without
amounts for escrow and the consumers might not be able to handle the
tax and insurance obligations on their own.
In addition, requiring escrows only for first time homebuyers or
other classes of borrowers would not save a creditor the substantial
expense of setting up an escrow system unless the creditor declined to
extend higher-priced mortgage loans to such borrowers. The Board
believes most creditors would not find this option practical over the
long term. Moreover, defining the categories of covered borrowers would
present practical challenges, require regular adjustment as the market
changed, and complicate creditors' compliance.
Several commenters recommended that the requirement to escrow be
limited to higher-priced mortgage loans with a combined loan-to-value
ratio that exceeds 80 percent. They contended that borrowers with at
least 20 percent equity have the option to tap this equity to finance
tax and insurance obligations. The suggested exemption could, however,
have the unintended consequence of permitting unscrupulous originators
to ``strip'' the equity from less experienced borrowers. As described
above, homeowners with existing escrow accounts who want to refinance
their loans may assume erroneously that payment quotes include escrows
when they do not, or they may prefer the security that an escrow would
provide if offered.
Cancellation after consummation. The final rule permits, but does
not require, creditors to offer consumers an option to cancel their
escrows 12 months after consummation of the loan transaction. Based on
the operation of escrows in the prime market, the Board anticipates
that creditors will likely offer cancellation in exchange for a fee.
The Board acknowledges concerns expressed by individual consumers that
requiring them to escrow for even a relatively short time will increase
their costs. These costs include the opportunity costs of the funds in
escrow, particularly if the funds do not earn interest; a fee to cancel
after 12 months; costs associated with mistakes or abuses by escrow
agents; and the cost of saving for the deposit at consummation of two
months or more of escrow payments that RESPA permits a creditor to
require. Mindful of these costs, the Board considered requiring only
that creditors offer consumers a choice to escrow either on an ``opt
in'' or ``opt out'' basis.
As explained above, the Board concluded that a requirement merely
to offer the consumer a choice to escrow would not be effective to
prevent the injuries associated with the lack of opportunity to escrow.
A requirement to offer, not require, escrows would raise creditors'
costs but would not eliminate their incentive to quote lower payment
amounts without escrows and encourage borrowers to opt-out. Requiring
creditors to disclose information about the benefits of escrowing would
not adequately address this problem. It is likely that most consumers
would reasonably focus their attention more on disclosures about the
terms of the credit being offered, such as the monthly payment amount,
rather than on information
[[Page 44561]]
about the benefits of escrowing. An originator engaged in loan flipping
might reassure the consumer that if the consumer has any difficulty
with the tax and insurance obligations the originator will refinance
the loan.
For the foregoing reasons, the Board does not believe that
requiring creditors merely to offer escrows with higher-priced mortgage
loans, with an opt out or opt in before consummation, would provide
consumers sufficient protection. The Board has concluded that requiring
creditors to impose escrows on borrowers with higher-priced mortgage
loans, with an option to cancel only some time after consummation,
would more effectively address the problems created by subprime
creditors' failure to offer escrows. This approach imposes costs on
creditors that will be passed on, at least in part, to consumers but
the Board believes these costs are outweighed by the benefits.
Moreover, to the extent that escrows improve loan performance and lead
to fewer defaults, the benefits of escrows may reduce the costs
associated with establishing and maintaining escrow accounts.
Twelve months mandatory escrow. The final rule sets the mandatory
period for escrows at 12 months after loan origination, at which point
creditors may allow borrowers to opt out of escrow. Some community
groups commented that escrows should be mandatory for a longer period
or even the life of the loan. Several groups commented that borrowers
should not be allowed to opt out unless they have demonstrated a record
of timely payments. Several commenters noted that consumers should be
allowed to opt out at loan consummation.
The Board believes that a 12 month period appropriately balances
consumer protection with consumer choice. For the reasons already
explained, a mandatory period of some length is necessary to ensure
that originators will not urge consumers to reduce their monthly
payment by choosing not to escrow immediately at, or shortly after,
loan consummation. Twelve months appears to be a sufficiently long
period to render such efforts ineffectual, and to introduce consumers
to the benefits of escrowing, as most consumers will receive bills for
taxes and insurance in that period. Moreover, 12 months is a relatively
short period compared to the expected life of the average loan,
providing consumers an opportunity to handle their own taxes and
insurance obligations after the initial escrow requirement expires.
Although fees to cancel escrow accounts are common, a consumer who
expects to hold the loan for a long period may find it worthwhile to
pay the fee. The final rule neither permits nor prohibits creditors
from imposing escrow cancellation fees and instead defers to state law
on that issue. Similarly, the rule neither requires nor prohibits
payment of interest on escrow accounts since some, but not all, states
have chosen to address consumer concerns about losing the opportunity
to invest their funds by requiring creditors to pay interest on funds
in escrow accounts.
Exemptions for Cooperatives; Partial Exemption for Condominiums
In response to comments and the Board's own analysis, the final
rule does not require escrows for property taxes and insurance premiums
for first-lien higher-priced mortgage loans secured by shares in a
cooperative if the cooperative association pays property tax and
insurance premiums. The final rule requires escrows for property taxes
for first-lien higher-priced mortgage loans secured by condominium
units but exempts from the escrow requirement insurance premiums if the
condominium's association maintains and pays for insurance through a
master policy.
Cooperatives. The final rule exempts mortgage loans for
cooperatives from the escrow requirement if the cooperative pays
property tax and insurance premiums, and passes the costs on to
individual unit owners based on their pro rata ownership share in the
cooperative. A cooperative association typically owns the building,
land, and improvements, and each unit owner holds a cooperative share
loan based on the appraisal value of the shareholder's unit. Creditors
typically require cooperative associations to maintain insurance
coverage under a single package policy, commonly called an association
master policy, for common elements, including fixtures, service
equipment and common personal property. Creditors periodically review
an association master policy to ensure adequate coverage.
At loan origination, creditors inform consumers of their monthly
cooperative association dues, which include, among other costs, the
consumer's pro rata share for insurance and property taxes. When
property taxes and insurance premiums are included in the monthly
association dues, they are generally not escrowed with the lender. This
is because the consumer's payment of the monthly association dues acts
in a manner similar to an escrow itself. In this way, the collection of
insurance premiums and property tax amounts on a monthly basis by a
cooperative association ensures that taxes and insurance are paid when
due.
Condominiums. The final rule exempts certain higher-priced mortgage
loans secured by condominium units from the requirement to escrow for
homeowners insurance where the only insurance policy required by the
creditor is the condominium association master policy. No exemption is
provided, however, for escrows for property taxes.
Typically, individual condominium units are taxed similarly to
single-family homes. Generally, each unit owner pays the property tax
for the unit and each unit is assessed its pro rata share of property
taxes for common areas. Condominium owners who do not have escrow
accounts receive property tax bills directly from the taxing
jurisdiction. The final rule requires escrows for property taxes for
all higher-priced mortgage loans secured by condominium units,
regardless of whether creditors are required to escrow insurance
premiums for such loans.
Homeowners insurance for condominiums, on the other hand, can vary
based on the condominium association's bylaws and other governing
regulations, as well as specific creditor requirements. Generally, the
condominium association insures the building and the common area under
an association master policy. In some cases, the condominium
association does not insure individual units and a separate insurance
policy must be written for each individual unit, just as it would be
for a single-family home. In other cases, the master policy does cover
individual unit owners' fixtures and improvements other than personal
property. When the condominium association insures the entire
structure, including individual units, the condominium association pays
the insurance premium and passes the costs on to the individual unit
owner. Much like the cooperative arrangement described above, the
consumer's payment of insurance premiums through condominium
association dues acts in a manner similar to an escrow account. For
this reason, the final rule does not require creditors to escrow
insurance premiums for higher-priced mortgage loans secured by
condominium units if the only insurance that the creditor requires is
an association master policy that insures condominium units.
Manufactured Housing
The final rule requires escrows for all covered loans secured by
manufactured housing for which creditors receive applications on or
after October 1, 2010
[[Page 44562]]
to allow creditors and servicers sufficient time to establish the
capacity to escrow. Manufactured housing industry commenters requested
that manufactured housing loans be exempted from the escrow
requirement. They argued that manufactured housing loans are mostly
personal property loans taxed in many local jurisdictions like other
personal property, and that creditors and servicers do not require and
do not offer escrows on manufactured housing loans.\98\ For reasons
discussed in more detail below, the final rule does not exempt from the
escrow requirement higher-priced mortgage loans secured by a first lien
on manufactured housing used as the consumer's principal dwelling. The
final rule applies to manufactured housing whether or not state law
treats it as personal or real property.\99\
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\98\ Manufactured housing creditors are currently required by
law to escrow for property taxes in Texas. Prior to passing state
legislation requiring escrows on manufactured housing, Texas
legislators observed that many manufactured housing owners were
unaware of, and unable to pay, their property tax. See Tex. SB 521,
78th Tex. Leg., 2003, effective June 18, 2003; bill analysis
available through the Texas Senate Research Center at http://
www.legis.state.tx.us/tlodocs/78R/analysis/pdf/SB00521I.pdf.
\99\ Regulation Z currently defines a dwelling to include
manufactured housing. See Sec. 226.2(a)(19). Official staff
commentary Sec. 226.2(a)(19) states that mobile homes, boats and
trailers are dwellings if they are in fact used as residences; Sec.
226.2(b) clarifies that the definition of ``dwelling'' includes any
residential structure, whether or not it is real property under
state law; Sec. Sec. 226.15(a)(1)-5 and 226.23(a)(1)-3 make clear
that a dwelling may include structures that are considered personal
property under state laws (e.g., mobile home, trailer or houseboat)
and draws no distinction between personal property loans and real
property loans.
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A manufactured home owner typically pays personal property taxes
directly to the taxing authority and insurance premiums directly to the
insurer. Manufactured housing industry commenters argued that if a
taxing jurisdiction does not have an automated personal property tax
system, creditors and servicers would have to service escrows on
manufactured housing loans manually at prohibitively high cost,
especially taking into consideration small loan size and low amount of
property taxes for an average manufactured home.
The Board believes, nonetheless, that problems associated with
first-lien higher-priced mortgage loans secured by manufactured housing
are similar to problems associated with site-built home loans discussed
above. Large segments of manufactured housing consumers are low to
moderate income families who may not enter the market with full
information about the obligations associated with owning manufactured
housing. Instead, consumers are likely to rely on the dealer or the
manufacturer as their source for information, which can leave consumers
vulnerable. Often, consumers obtain financing through the dealer, who
ties the financing to the sale of the home. In addition, commissions
and yield spread premiums may be paid to dealers for placing consumers
in high cost loans.\100\
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\100\ Kevin Jewell, Market Failures Evident in Manufactured
Housing (Jan. 2003), http://www.consumersunion.org/consumeronline/
pastissues/housing/marketfailure.html.
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In addition, manufactured homes are usually concentrated in
developments, such as parks, where they represent a large percentage of
homes. Where property tax revenues are the main source of funding for
local government services, a failure by a significant number of
homeowners to pay property taxes could cause a reduction in local
government services and an attendant decline in property values.
The Board believes that homeowners of manufactured housing should
be afforded the same consumer protections as the owners of site-built
homes. Manufactured homes provide much needed affordable housing for
millions of Americans who, like owners of site-built homes, risk losing
their homes for failure to pay property taxes. Escrows for property
taxes and insurance premiums on first-lien, higher-priced mortgage
loans secured by manufactured homes that are consumers' principal
dwellings are necessary to prevent creditors from understating the cost
of homeownership, to inform consumers that their manufactured home is
subject to property tax, and to extend an opportunity to consumers to
escrow funds each month for payment of property tax and insurance
premiums.
State Laws
Several industry commenters asked the Board to clarify in the final
rule that the escrow requirement preempts inconsistent state escrow
laws. TILA generally preempts only inconsistent state laws. See TILA
Section 111(a)(1), 15 U.S.C. 1610, Sec. 226.28. Several consumers
expressed concern that the regulation would preempt state laws
requiring creditors to pay interest on escrow accounts under certain
conditions. The final rule does not prevent states from requiring
creditors to pay interest on escrowed amounts. See comment Sec.
226.35(b)(4)(i).
Effective Date
Several industry representatives commented that the escrow
requirement would require major system and infrastructure changes by
creditors that do not currently have escrow capabilities. They asked
for an extended compliance deadline of 12 to 24 months prior to the
effective date of the final rule to allow for necessary escrow systems
and procedures to develop. The Board recognizes that creditors and
servicers will need some time to develop in-house escrowing
capabilities or to outsource escrow servicing to third parties. For
that reason, the Board agrees that an extended compliance period is
appropriate for most covered loans secured by site-built homes.
Therefore, the final rule is effective for first-lien higher-priced
mortgage loans for which creditors receive applications on or after
April 1, 2010, except for loans secured by manufactured housing.
Recognizing that there is a limited infrastructure for escrowing on
manufactured housing loans, and that yet additional time is needed for
creditors and servicers to comply with the rule, the final rule is
effective for all covered loans secured by manufactured housing for
which creditors receive applications on or after October 1, 2010.
E. Evasion Through Spurious Open-End Credit--Sec. 226.35(b)(4)
The exclusion of HELOCs from Sec. 226.35 is discussed in subpart
A. above. As noted, the Board recognizes that the exclusion of HELOCs
could lead some creditors to attempt to evade the restrictions of Sec.
226.35 by structuring credit as open-end instead of closed-end. Section
226.34(b) addresses this risk as to HOEPA loans by prohibiting
creditors from structuring a transaction that does not meet the
definition of ``open-end credit'' as a HELOC to evade HOEPA. The Board
proposed to extend this rule to higher-priced mortgage loans and is
adopting Sec. 226.35(b)(5). Section 226.35(b)(5) prohibits a creditor
from structuring a closed-end transaction--that is, a transaction that
does not meet the definition of ``open-end credit''--as a HELOC to
evade the restrictions of Sec. 226.35. The Board is also adding
comment 35(b)(5)-1 to provide guidance on how to apply the higher-
priced mortgage loan APR trigger in Sec. 226.35(a) to a transaction
structured as open-end credit in violation of Sec. 226.35. Comment
35(b)(5)-1 is substantially similar to comment 34(b)-1 which applies to
HOEPA loans.
Public Comment
The Board received relatively few comments on the proposed anti-
evasion rule. As discussed in subpart A. above, some commenters
suggested applying Sec. 226.35 to HELOCs, which would
[[Page 44563]]
eliminate the need for an anti-evasion provision. By contrast, some
creditors who supported the exclusion of HELOCs from Sec. 226.35 noted
that the presence of the anti-evasion provision would address concerns
about HELOCs being used to evade the rules in Sec. 226.35. However, a
few creditors expressed concern that the anti-evasion proposal was too
vague. One commenter stated that loans that do not meet the definition
of open-end credit would be subject to the closed-end rules with or
without the anti-evasion provision, and this commenter stated that
therefore the anti-evasion provision was unnecessary and might cause
confusion.
The Board also requested comment on whether it should limit an
anti-evasion rule to HELOCs secured by first-liens, where the consumer
draws down all or most of the entire line of credit immediately after
the account is opened. Commenters did not express support for this
alternative, and a few explicitly opposed it.
The Final Rule
The Board is adopting the anti-evasion provision as proposed. The
rule is not meant to add new substantive requirements for open-end
credit, but rather to ensure that creditors do not structure a loan
which does not meet the definition of open-end credit as a HELOC to
evade the requirements of Sec. 226.35. The Board recognizes that
consumers may prefer HELOCs to closed-end home equity loans because of
the added flexibility HELOCs provide them. The Board does not intend to
limit consumers' ability to choose between these two ways of
structuring home equity credit. The anti-evasion provision is intended
to reach cases where creditors have structured loans as open-end
``revolving'' credit, even if the features and terms or other
circumstances demonstrate that the creditor had no reasonable
expectation of repeat transactions under a reusable line of credit.
Although the practice violates TILA, the new rule will subject
creditors to HOEPA's stricter remedies if the credit carries an APR
that exceeds Sec. 226.35's APR trigger for higher-priced mortgage
loans.
The Board is also adding comment 35(b)(5)-1 to provide guidance on
how to apply the higher-priced mortgage loan APR trigger in Sec.
226.35(a) to a transaction structured as open-end credit in violation
of Sec. 226.35. Specifically, the comment provides guidance on how to
determine the ``amount financed'' and the ``principal loan amount''
needed to determine the loan's APR. The comment provides that the
amount of credit that would have been extended if the loan had been
documented as a closed-end loan is a factual determination to be made
in each case.
X. Final Rules for Mortgage Loans--Sec. 226.36
Section 226.35, discussed above, applies certain new protections to
higher-priced mortgage loans and HOEPA loans. In contrast, Sec. 226.36
applies other new protections to mortgage loans generally, though only
if secured by the consumer's principal dwelling. The final rule
prohibits: (1) Creditors or mortgage brokers from coercing,
influencing, or otherwise encouraging an appraiser to provide a
misstated appraisal and (2) servicers from engaging in unfair fee and
billing practices. The final rule neither adopts the proposal to
require servicers to deliver a fee schedule to consumers upon request,
nor the proposal to prohibit creditors from paying a mortgage broker
more than the consumer had agreed in advance that the broker would
receive. As with proposed Sec. 226.35, Sec. 226.36 does not apply to
HELOCs.
The Board finds that the prohibitions in the final rule are
necessary to prevent practices that the Board finds to be unfair,
deceptive, associated with abusive lending practices, or otherwise not
in the interest of the borrower. See TILA Section 129(l)(2), 15 U.S.C.
1639(l)(2), and the discussion of this statute in part V.A above. The
Board also believes that the final rules will enhance consumers'
informed use of credit. See TILA Sections 105(a), 102(a).
A. Creditor Payments to Mortgage Brokers--Sec. 226.36(a)
The Board proposed to prohibit a creditor from paying a mortgage
broker in connection with a covered transaction more than the consumer
agreed in writing, in advance, that the broker would receive. The
broker would also disclose that the consumer ultimately would bear the
cost of the entire compensation even if the creditor paid any part of
it directly; and that a creditor's payment to a broker could influence
the broker to offer the consumer loan terms or products that would not
be in the consumer's interest or the most favorable the consumer could
obtain.\101\ Proposed commentary provided model language for the
agreement and disclosures. The Board stated that it would test this
language with consumers before determining how it would proceed on the
proposal.
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\101\ Creditors could demonstrate compliance with the proposed
rule by obtaining a copy of the broker-consumer agreement and
ensuring their payment to the broker does not exceed the amount
stated in the agreement. The proposal would provide creditors two
alternative means to comply, one where the creditor complies with a
state law that provides consumers equivalent protection, and one
where a creditor can demonstrate that its payments to a mortgage
broker are not determined by reference to the transaction's interest
rate.
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The Board tested the proposal with several dozen one-on-one
interviews with a diverse group of consumers. On the basis of this
testing and other information, the Board is withdrawing the proposal.
The Board will continue to explore available options to address unfair
acts or practices associated with originator compensation arrangements
such as yield spread premiums. The Board is particularly concerned with
arrangements that cause the incentives of originators to conflict with
those of consumers, where the incentives are not transparent to
consumers who rely on the originators for advice. As the Board
comprehensively reviews Regulation Z, it will continue to consider
whether disclosure or other approaches could be effective to address
this problem.
Public Comment
The Board received over 4700 comments on the proposal. Mortgage
brokers, their federal and state trade associations, the Federal Trade
Commission, and several consumer groups argued that applying the
proposed disclosures to mortgage brokers but not to creditors'
employees who originate mortgages (``loan officers'') would reduce
competition in the market and harm consumers. They contended that
disclosing a broker's compensation would cause consumers to believe,
erroneously, that a loan arranged by a broker would cost more than a
loan originated by a loan officer. These commenters stated that many
brokers would unfairly be forced out of business, and consumers would
pay higher prices, receive poorer service, or have fewer options. The
FTC, citing its published report of consumer testing of mortgage broker
compensation disclosures, contended that focusing consumers' attention
on the amount of the broker's compensation could confuse consumers and,
under some circumstances, lead them to select a more expensive loan.
Mortgage brokers and some creditors expressed concerns that the
proposed rule would not be practicable in cases where creditors forward
applications to other creditors and where brokers decide to fund an
application using a warehouse line of credit.
Consumer advocates, members of Congress, the FDIC, and others
stated
[[Page 44564]]
that the proposal would not address the conflict of interest between
consumers and brokers that rate-based compensation of brokers (the
yield spread premium) can cause. These commenters urged that the only
effective remedy for the conflict is to ban this form of compensation.
State regulators expressed concern that the proposed disclosures would
not provide consumers sufficient information, and could give brokers a
legal ``shield'' against claims they acted contrary to consumers'
interests.
Creditors and their trade associations, on the other hand,
generally supported the proposal, although with a number of suggested
modifications. These commenters agreed with the Board that yield spread
premiums create financial incentives for brokers to steer consumers to
less beneficial products and terms. They saw a need for regulation to
remove or limit these incentives.
Commenters generally did not believe the proposed alternatives for
compliance (where a state law provides substantially equivalent
protections or where a creditor can show that the compensation amount
is not tied to the interest rate) were feasible. Creditors and mortgage
brokers stated that both alternatives were vague and would be little
used. Consumer advocates believed the alternatives would likely create
loopholes in the rule.
Comments on specific issues are discussed in more detail below as
appropriate.
Discussion
The proposal was intended to limit the potential for unfairness,
deception, and abuse in yield spread premiums while preserving the
ability of consumers to cover their payments to brokers through rate
increases. Creditor payments to brokers based on the interest rate give
brokers an incentive to provide consumers loans with higher interest
rates. Many consumers are not aware of this incentive and may rely on
the broker as a trusted advisor to help them navigate the complexities
of the mortgage application process.
The proposal sought to reduce the incentive of the broker to
increase a consumer's rate and increase the consumer's leverage to
negotiate with the broker. Under the proposal, creditor payments to
brokers would be conditioned on a broker's advance commitment to a
specified compensation amount. The proposal would require the agreement
to be entered into before an application was submitted by a consumer or
prior to the payment of any fee, whichever occurred earlier. Requiring
an agreement before a fee or application would help ensure the
compensation was set as independently as possible of loan's rate and
other terms, and that the consumer would not feel obligated to proceed
with the transaction. The Board also anticipated that the proposal
would increase transparency and improve competition in the market for
brokerage services, which could lower the price of these services,
improve the quality of those services, or both.
Reasons for withdrawal. Based on the Board's analysis of the
comments, consumer testing, and other information, the Board is
withdrawing the proposal. The Board is concerned that the proposed
agreement and disclosures would confuse consumers and undermine their
decision-making rather than improve it. The risks of consumer confusion
arise from two sources. First, an institution can act as either
creditor or broker depending on the transaction; as explained below,
this could render the proposed disclosures inaccurate and misleading in
some, possibly many, cases of both broker and creditor originations.
Second, consumers who participated in one-on-one interviews about the
proposed agreement and disclosures often concluded, erroneously, that
brokers are categorically more expensive than creditors or that brokers
would serve their best interests notwithstanding the conflict resulting
from the relationship between interest rates and brokers' compensation.
Dual roles. Mortgage brokers and creditors noted that creditors and
brokers often play one of two roles. That is, an institution that is
ordinarily a creditor and originates loans in its name may determine
that it cannot approve an application based on its own underwriting
criteria and present it to another creditor for consideration. This
practice is known as ``brokering out.'' The institution brokering out
an application would be a mortgage broker under the proposed rule; to
receive compensation from the creditor, it would have to execute the
required agreement and provide the required disclosures.
The proposal requires a broker to enter an agreement and give
disclosures before the consumer submits an application, but an
institution often may not know whether it will be a broker or a
creditor for that consumer until it receives and evaluates the
application. An institution that is ordinarily a creditor but sometimes
a broker would have to enter into the agreement and give the
disclosures for all consumers that seek to apply. In many cases,
however, the institution will originate the loan as a creditor and not
switch to being a broker. In these cases, the agreement and
disclosures, which describe the institution as a broker and state its
compensation as if it were brokering the transaction, would likely
mislead and confuse the consumer. This problem also arises, if less
frequently, when an institution that ordinarily brokers instead acts as
creditor on occasion. On those occasions, the disclosures also would
likely be misleading and confusing.
The source of the problem is the proposed requirement that the
agreement be signed and disclosures given before the consumer has
applied for a loan or paid a fee. The Board considered permitting post-
application execution and disclosure by institutions that perform dual
roles. The proposed timing, however, was intended to ensure that a
consumer would be apprised of the broker's compensation and understand
the broker's role before becoming, or feeling, committed to working
with the broker. Accordingly, the Board concluded that providing this
information later in the loan transaction would seriously undermine the
proposal's objective of empowering the consumer to shop and negotiate.
Consumer testing. Consumer testing also suggested that at least
some aspects of the proposal could confuse and mislead consumers. After
publishing the proposal, a Board contractor, Macro International, Inc.
(``Macro''), conducted in-depth one-on-one interviews with a diverse
group of several dozen consumers who recently had obtained a mortgage
loan.\102\ Macro developed and tested a form in which the broker would
agree to a specified total compensation and disclose (i) that any part
of the compensation paid by the creditor would cost the consumer a
higher interest rate, and (ii) that creditor payments to brokers based
on the rate create a conflict of interest between mortgage brokers and
consumers. Throughout the testing, revisions were made to the form in
an effort to improve comprehension. The testing revealed two
difficulties with the forms tested.
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\102\ For more details on the consumer testing, see Macro's
report, Consumer Testing of Mortgage Broker Disclosures, (July 10,
2008), available at http://www.federalreserve.gov.
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First, the form's statements that the consumer would pay the broker
through a higher rate and that the broker had a conflict of interest
confused many participants. Many participants stated, upon reading the
disclosure, that if they agreed to pay the compensation the broker was
asking, then the broker
[[Page 44565]]
would be obliged to find them the lowest interest rate and best terms
available. Many participants reached this conclusion despite the clear
statement in the form tested that brokers can increase their
compensation by increasing the interest rate.
Second, many first-round participants stated or implied after
reading the form that working through a broker would cost them more
than working directly with a lender, which is not necessarily true. A
new provision was added to the disclosure stating that lenders'
employees are paid the same types of rate-based commissions as brokers
and have the same conflict of interest. Many participants, however,
continued to voice a belief that brokered loans must cost more than
direct loans.
The results of testing indicate that consumers did not sufficiently
understand some major aspects of the proposed disclosures. On the one
hand, the disclosures could cause consumers to believe that mortgage
brokers have obligations to them that the law does not actually impose.
In consumer testing, this belief seemingly resulted from the disclosure
of the fact that the consumer would pay the broker a commission, and it
persisted notwithstanding the accompanying disclosure of the conflict
of interest resulting from the rate-commission relationship. On the
other hand, the disclosures could cause consumers to believe that
retail loans are categorically less costly than brokered loans.
Notwithstanding an explicit statement in the tested forms that
commissions based on interest rates also are paid to loan officers,
many participants voiced the belief that loan officers' commissions
would be lower than brokers' commissions. They offered different
reasons for this conclusion, including for example that the lender and
not the consumer would pay the loan officer's commission.
Despite the difficulties with the disclosures observed in consumer
testing, there were also some successes. For instance, consumers
generally appeared to understand the language describing the potential
conflict of interest, as noted above, even though it often was ignored
because of seemingly conflicting information. In addition, language
intended to convey to consumers the importance of shopping on their own
behalf in the mortgage market appeared to be successful. These more
encouraging results suggest that further development of a disclosure
approach to creditor payments to mortgage originators, through
additional consumer testing, still may have merit.
Conclusion. The Board considered whether it could resolve the
problems described above by applying the proposal to the retail
channel. The Board concluded, however, that substantial additional
testing and analysis would be required to determine whether such an
approach would be effective. Therefore, the Board is withdrawing the
proposal. The Board will continue to explore available options to
address potential unfairness associated with originator compensation
arrangements such as yield spread premiums. As the Board
comprehensively reviews Regulation Z, it will continue to consider
whether disclosures or other approaches could effectively remedy this
potential unfairness without imposing unintended consequences.
Definition of Mortgage Broker
In connection with the proposal relating to mortgage broker
compensation and the proposal prohibiting coercion of appraisers, the
Board proposed to define ``mortgage broker'' as a person, other than a
creditor's employee, who for monetary gain arranges, negotiates, or
otherwise obtains an extension of credit for a consumer. A person who
met this definition would be considered a mortgage broker even if the
credit obligation was initially payable to the person, unless the
person funded the transaction from its own resources, from deposits, or
from a bona fide warehouse line of credit. Commenters generally did not
comment on the proposed definition.
Defining ``mortgage broker'' is still necessary, notwithstanding
the Board's withdrawal of the proposed regulation of creditor payments
to mortgage brokers, as mortgage brokers are subject to the
prohibitions on coercion of appraisers, discussed below. The Board is
adopting the definition of mortgage broker with a minor change to
clarify that the term ``mortgage broker'' does not include a person who
arranges, negotiates, or otherwise obtains an extension of credit for
him or herself.
B. Coercion of Appraisers--Sec. 226.36(b)
The Board proposed to prohibit creditors and mortgage brokers and
their affiliates from coercing, influencing, or otherwise encouraging
appraisers to misstate or misrepresent the value of a consumer's
principal dwelling. The Board also proposed to prohibit a creditor from
extending credit when it knows or has reason to know, at or before loan
consummation, that an appraiser has been encouraged by the creditor, a
mortgage broker, or an affiliate of either, to misstate or misrepresent
the value of a consumer's principal dwelling, unless the creditor acts
with reasonable diligence to determine that the appraisal was accurate
or extends credit based on a separate appraisal untainted by coercion.
The Board is adopting the rule substantially as proposed. The Board has
revised some of the proposed examples of conduct that violates the rule
and conduct that does not violate the rule and has added commentary
about when a misstatement of a dwelling's value is material.
Public Comment
Consumer and community advocacy groups, appraiser trade
associations, state appraisal boards, individual appraisers, some
financial institutions and banking trade associations, and a few other
commenters expressed general support for the proposed rule to prohibit
appraiser coercion. Several of these commenters stated that the rule
would enhance enforcement against parties that are not subject to the
same oversight as depository institutions, such as independent mortgage
companies and mortgage brokers. Some of the commenters who supported
the rule also suggested including additional practices in the list of
examples of prohibited conduct. In addition, several appraiser trade
associations jointly recommended that the Board prohibit appraisal
management companies from coercing appraisers.
On the other hand, community banks, consumer banking and mortgage
banking trade associations, and some large financial institutions
opposed the proposed rule, stating that its adoption would lead to
nuisance suits by borrowers who regret the amount they paid for a house
and would make creditors liable for the actions of mortgage brokers and
appraisers. Several of these commenters stated that the Board's rule
would duplicate requirements set by existing laws and guidance,
including federal regulations, interagency guidelines, state laws, and
the Uniform Standards of Professional Appraisal Practice (USPAP).
Further, some of these commenters stated that creditors have limited
ability to detect undue influence and should be held liable only if
they extend credit knowing that a violation of Sec. 226.36(b)(1) had
occurred.
Many commenters discussed appraisal-related agreements that Fannie
Mae and Freddie Mac have entered into with the Attorney General of New
York and the Office of Federal Housing Enterprise Oversight (GSE
Appraisal Agreements), which incorporated a
[[Page 44566]]
Home Valuation Code of Conduct. These commenters urged the Board to
coordinate with the parties to the GSE Appraisal Agreements to promote
consistency in the standards that apply to the residential appraisal
process.
The comments are discussed in greater detail below.
Discussion
The Board finds that it is an unfair practice for creditors or
mortgage brokers to coerce, influence, or otherwise encourage an
appraiser to misstate the value of a consumer's principal dwelling.
Accordingly, the Board is adopting the rule substantially as proposed.
Substantial injury. Encouraging an appraiser to overstate or
understate the value of a consumer's dwelling causes consumers
substantial injury. An inflated appraisal may cause consumers to
purchase a home they otherwise would not have purchased or to pay more
for a home than they otherwise would have paid. An inflated appraisal
also may lead consumers to believe that they have more home equity than
in fact they do, and to borrow or make other financial decisions based
on this incorrect information. For example, a consumer who purchases a
home based on an inflated appraisal may overestimate his or her ability
to refinance and therefore may take on a riskier loan. A consumer also
may take out more cash with a refinance or home equity loan than he or
she would have had an appraisal not been inflated. Appraiser coercion
thus distorts, rather than enhances, competition. Though perhaps less
common than overstated appraisals, understated appraisals can cause
consumers to be denied access to credit for which they qualified.
Inflated or understated appraisals of homes concentrated in a
neighborhood may affect appraisals of neighboring homes, because
appraisers factor into a property valuation the value of comparable
properties. For the same reason, understated appraisals may affect
appraisals of neighboring properties. Therefore, inflating or deflating
appraised value can harm consumers other than those who are party to
the transaction with the misstated appraisal.
Injury not reasonably avoidable. Consumers who are party to a
consumer credit transaction cannot prevent creditors or mortgage
brokers from influencing appraisers to misstate or misrepresent a
dwelling's value. Creditors and mortgage brokers directly or indirectly
select and contract with the appraisers that value a dwelling for a
consumer credit transaction. Consumers will not necessarily be aware
that a creditor or mortgage broker is pressuring an appraiser to
misstate or misrepresent the value of the principal dwelling they offer
as collateral for a loan. Furthermore, consumers who own property near
a dwelling securing a consumer credit transaction but are not parties
to the transaction are not in a position to know that a creditor or
mortgage broker is coercing an appraiser to misstate a dwelling's
value. Consumers thus cannot reasonably avoid injuries that result from
creditors' or mortgage brokers' coercing, influencing, or encouraging
an appraiser to misstate or misrepresent the value of a consumer's
principal dwelling.
Injury not outweighed by benefits to consumers or to competition.
The Board finds that the practice of coercing, influencing, or
otherwise encouraging appraisers to misstate or misrepresent value does
not benefit consumers or competition. Acts or practices that promote
the misrepresentation of the market value of a dwelling distort the
market, and any competitive advantage a creditor or mortgage broker
obtains through influencing an appraiser to misstate a dwelling's
value, or that a creditor gains by knowingly originating loans based on
a misstated appraisal, is an unfair advantage.
For the foregoing reasons, the Board finds that it is an unfair
practice for a creditor or mortgage broker to coerce, influence, or
otherwise encourage an appraiser to misstate the value of a consumer's
principal dwelling. As discussed in part V.A above, the Board has broad
authority under TILA Section 129(l)(2) to adopt regulations that
prohibit, in connection with mortgage loans, acts or practices that the
Board finds to be unfair or deceptive. 15 U.S.C. 1639(l)(2). Therefore,
the Board may adopt regulations prohibiting unfair or deceptive
practices by mortgage brokers who are not creditors and unfair or
deceptive practices that are ancillary to the origination process, when
such practices are ``in connection with mortgage loans.'' Because
appraisals play an important role in a creditor's decision to extend
mortgage credit as well as the terms of such credit, the Board believes
that it fits well within the Board's authority under Section 129(l)(2)
to prohibit creditors and mortgage brokers from coercing, influencing,
or otherwise encouraging an appraiser to misstate the value of a
consumer's principal dwelling and creditors from extending credit based
on an appraisal when they know that prohibited conduct has occurred.
Therefore, the Board issues the final rule prohibiting such acts under
TILA Section 129(l)(2), 15 U.S.C. 1639(l)(2).
The Final Rule
The Board requested comment on the potential costs and benefits of
its proposed appraiser coercion regulation. Some securitization trade
associations and financial institutions stated that creditors obtain
appraisals for their own benefit, to determine whether to extend credit
and the terms of credit extended. The Board recognizes that, because
appraisals provide evidence of the collateral's sufficiency to avoid
losses if a borrower defaults on a loan, creditors have a disincentive
to coerce appraisers to misstate value. However, loan originators may
believe that they stand to benefit from coercing an appraiser to
misstate value, for example, if their compensation depends more on
volume of loans originated than on loan performance. Despite the
disincentives cited by some commenters, there is evidence that coercion
of appraisers is not uncommon, and may even be widespread.\103\
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\103\ For example, the October Research Corporation's 2007
National Appraisal Survey (released in Dec. 2006) found that
appraisers reported being pressured to restate, adjust, or change
reported property values by mortgage brokers (71 percent), real
estate agents (56 percent), consumers (35 percent), lenders (33
percent), and appraisal management companies (25 percent).
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A few large banks and a financial services trade association
suggested that the Board prohibit mortgage brokers from ordering
appraisals, as the GSE Appraisal Agreements do. The Board declines to
determine that any particular procedure for ordering an appraisal
necessarily promotes false reporting of value. As discussed above, the
Board finds that coercion of appraisers by creditors or by mortgage
brokers is an unfair practice. Therefore, the final rule prohibits
actions by creditors and mortgage brokers that are aimed at pressuring
appraisers to misstate the value of a consumer's principal dwelling.
In addition, some commenters stated that the Board's rule would be
redundant given the existence of USPAP. USPAP, however, establishes
uniform rules regarding preparation of appraisals and addresses the
conduct of appraisers, not the conduct of creditors or mortgage
brokers. The federal financial institution regulatory agencies have
issued to the institutions they supervise regulations and guidance that
set forth standards for the policies and procedures institutions should
implement to enable appraisers to exercise independent judgment when
[[Page 44567]]
valuing a property.\104\ For example, these regulations prohibit staff
and fee appraisers from having any direct or indirect interest,
financial or otherwise, in a subject property; fee appraisers also may
not have any such interest in the subject transaction.\105\ Unlike the
Board's rule, however, these federal regulations do not apply to all
institutions. Moreover, these federal rules are part of an overarching
framework of regulation and supervision of federally insured depository
institutions and are not necessarily appropriate for application to
independent mortgage companies and mortgage brokers.
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\104\ See, e.g., 12 CFR part 208 subpart E and app. C, and 12
CFR part 225 subpart G (Board); 12 CFR part 34, subparts C and D
(Office of the Comptroller of the Currency (OCC)); 12 CFR part 323
and 12 CFR part 365 (FDIC); 12 CFR part 564, 12 CFR 560.100, and 12
CFR 560.101 (Office of Thrift Supervision (OTS)); and 12 CFR 722.5
(National Credit Union Administration (NCUA)). Applicable federal
guidance the Board, OCC, FDIC, OTS, and NCUA have issued includes
Independent Appraisal and Evaluation Functions, dated October 28,
2003, and Interagency Appraisal and Evaluation Guidelines, dated
October 27, 1994.
\105\ 12 CFR 225.65 (Board); 12 CFR 34.45 (OCC); 12 CFR 323.5
(FDIC); 12 CFR 564.5 (OTS); and 12 CFR 722.5 (NCUA).
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Some state legislatures have prohibited coercion of appraisers or
enacted general laws against mortgage fraud that may be used to combat
appraiser coercion.\106\ Not every state, however, has passed laws
equivalent to the final rule. Prohibiting creditors and mortgage
brokers from pressuring appraisers to misstate or misrepresent the
value of a consumer's principal dwelling provides enforcement agencies
in every state with a specific legal basis for an action alleging
appraiser coercion. Though states are able to take enforcement action
against certain institutions that are believed to engage in appraisal
abuses,\107\ some state laws are preempted as to other creditors. The
final rule, adopted under HOEPA, applies equally to all creditors.
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\106\ See, e.g., Colo. Rev. Stat. Sec. 6-1-717; Iowa Code Sec.
543D.18A; Ohio Rev. Code Ann. Sec. Sec. 1322.07(G), 1345.031(B),
4763.12(E).
\107\ For example, in 2006, 49 states and the District of
Columbia (collectively, the Settling States) entered into a
settlement agreement with ACC Capital Holdings Corporation and
several of its subsidiaries, including Ameriquest Mortgage Company
(collectively, the Ameriquest Parties). The Settling States alleged
that the Ameriquest Parties had engaged in deceptive or misleading
acts that resulted in the Ameriquest Parties' obtaining inflated
appraisals of homes' value. See, e,g., Iowa ex rel Miller v.
Ameriquest Mortgage Co., No. 05771 EQCE-053090 (Iowa D. Ct. 2006)
(Pls. Pet. 5). To settle the complaints, the Ameriquest Parties
agreed to abide by policies designed to ensure appraiser
independence and accurate valuations.
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In response to the Board's request for comment about the proposed
rule's provisions, commenters addressed three main topics: (1) The
terms used to describe prohibited conduct; (2) the specific examples of
conduct that is prohibited and conduct that is not prohibited; and (3)
the proscription on extending credit where a creditor knows about
prohibited conduct.
Prohibited conduct. Some commenters recommended that the Board
replace the phrase ``coerce, influence, or otherwise encourage'' with
``coerce, bribe, or extort.'' These commenters stated that the words
``influence'' and ``encourage'' are vague and subjective, whereas the
words ``bribe'' and ``extort'' would provide bright-line standards for
compliance. Like the proposed rule, the final rule prohibits a creditor
or mortgage broker from coercing, influencing, or otherwise encouraging
an appraiser to misstate the value of a dwelling. The final rule does
not limit prohibited conduct to bribery or extortion. Creditors and
mortgage brokers may act in ways that would not constitute bribery or
extortion but that nevertheless improperly influence an appraiser's
valuation of a dwelling. These actions can visit the same harm on
consumers as do bribery or extortion, and thus they are prohibited by
the final rule. The Board believes that commenters' concerns about the
clarity of the terms used in the final rule can be addressed through
the examples of conduct that is prohibited and conduct that is not
prohibited discussed below.
Examples of conduct prohibited and conduct not prohibited. The
proposal offered several examples of conduct that would violate the
rule and conduct that would not violate the rule. The Board is adopting
the proposed examples of prohibited conduct and adding two new examples
of prohibited conduct. The Board also is adopting all but one of the
proposed examples of conduct that is not prohibited.
Some commenters requested that additional actions be listed as
examples that violate the rule, such as:
[cir] Excluding an appraiser from a list of ``approved'' appraisers
because the appraiser had valued properties at an amount that had
jeopardized or prevented the consummation of loan transactions.
[cir] Telling an appraiser a minimum acceptable appraised value.
[cir] Providing an appraiser with the price stated in a contract of
sale.
[cir] Suggesting that an appraiser consider additional properties
as comparable to the subject property, after an appraiser has submitted
an appraisal report.
Final Sec. 226.36(b)(1) prohibits conduct that coerces, influences, or
encourages an appraiser to misstate or misrepresent the value of a
consumer's principal dwelling, and the list of examples the section
provides is illustrative and not exhaustive. The Board believes that it
is not necessary or possible to list all conceivable ways in which
creditors or mortgage brokers could pressure appraisers to misstate a
principal dwelling's value. However, the Board has added two examples
to enhance the list in Sec. 226.36(b)(1). The final rule does not
limit the ability of a creditor or broker to terminate a relationship
with an appraiser for legitimate reasons.
Examples of prohibited conduct. The Board is adopting the proposed
examples of prohibited conduct and adding two examples. The first added
example is a creditor's or broker's exclusion of an appraiser from
consideration for future engagement due to the appraiser's failure to
report a value that meets or exceeds a minimum threshold. This example
is adapted from a statement in the supplementary information to the
proposed rule. 73 FR 1701. The second added example is telling an
appraiser a minimum reported value of a consumer's principal dwelling
that is needed to approve the loan. This example is consistent with the
position of the Appraisal Standards Board (ASB), which develops,
interprets and amends USPAP, that assignments should not be contingent
on the reporting of a predetermined opinion of value.\108\
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\108\ See, e.g., ASB Advisory Opinion No. 19, Unacceptable
Assignment Conditions in Real Property Appraisal Assignments.
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The Board is not adopting other examples of prohibited conduct
suggested by commenters. Some commenters urged the Board to prohibit a
creditor or mortgage broker from omitting or removing an appraiser's
name from a list of approved appraisers, where the appraiser has not
valued a property at the desired amount. The Board believes such
conduct is encompassed in the examples provided in Sec.
226.36(b)(1)(i)(B) and (C).
Some commenters also requested that the Board add, as an example of
a violation, a creditor's or mortgage broker's provision to an
appraiser of the contract of sale for the principal dwelling. The Board
is not adopting the example. USPAP Standard Rule 1-5 requires an
appraiser to analyze all agreements of sale for a subject property, and
Standard Rule 2-2 requires disclosure of information contained in such
agreements or an explanation of why such information is unobtainable or
irrelevant.
[[Page 44568]]
Examples of conduct that is not prohibited. The final rule adopts
the proposed examples of prohibited conduct with one change. The Board
is not adopting proposed Sec. 226.36(b)(1)(ii)(F), which would have
provided that the rule would not be violated when a creditor or
mortgage broker terminates a relationship with an appraiser for
violations of applicable federal or state law or breaches of ethical or
professional standards. Some commenters noted that there are other
legitimate reasons for terminating a relationship with an appraiser,
and they requested that the Board include these as examples of conduct
that is not prohibited so that the provision would not be read as
implicitly prohibiting them. The Board believes that it is not feasible
to list all of the legitimate reasons a creditor or broker might
terminate a relationship with an appraiser. Accordingly, the Board is
not adopting proposed Sec. 226.36(b)(1)(ii)(F).
Some commenters suggested that the Board delete, from the examples
of conduct that is not prohibited, asking an appraiser to consider
additional information about a consumer's principal dwelling or about
comparable properties. Although in some cases a post-report request
that an appraiser consider additional information may be a subtle form
of pressure to change a reported value, in other cases such a request
could reflect a legitimate desire to improve an appraisal report.
Furthermore, federal interagency guidance directs institutions to
return deficient reports to appraisers for correction and to replace
unreliable appraisals or evaluations prior to the final credit
decision.\109\ Therefore, the Board is not deleting, from the examples
of conduct that is not prohibited, asking an appraiser to consider
additional information about a consumer's principal dwelling or about
comparable properties. However, Sec. 226.36(b) prohibits creditors and
mortgage brokers from making such requests in order to coerce,
influence, or otherwise encourage an appraiser to misstate or
misrepresent the value of a dwelling.
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\109\ See Interagency Appraisal and Evaluation Guidelines, SR
94-55 (FIS) (Oct. 24, 1994) at 9.
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Extension of credit. As proposed, Sec. 226.36(b)(2) provided that
a creditor is prohibited from extending credit if the creditor knows or
has reason to know, at or before loan consummation, of a violation of
Sec. 226.36(b)(1) (for example, by an employee of the creditor or a
mortgage broker), unless the creditor acted with reasonable diligence
to determine that the appraisal does not materially misstate the value
of the consumer's principal dwelling. The proposed comment to Sec.
226.36(b)(2) stated that a creditor is deemed to have acted with
reasonable diligence if the creditor extends credit based on an
appraisal other than the one subject to the restriction.
The Board is adopting the text of Sec. 226.36(b)(2) and the
associated commentary substantially as proposed. Some financial
institutions and financial institution trade associations stated that
the phrase ``reason to know'' is vague and that creditors should be
held liable for violations only if they extend credit when they had
actual knowledge that a violation of Sec. 226.36(b)(1) exists. The
final rule prohibits ``a creditor who knows, at or before loan
consummation, of a violation of Sec. 226.36(b)(1) in connection with
an appraisal'' from extending credit based on that appraisal, unless
the creditor acts with reasonable diligence to determine that the
appraisal does not materially misstate or misrepresent the value of the
consumer's principal dwelling. Although final Sec. 226.36(b)(2) does
not include the phrase ``reason to know'' included in the proposed
rule, the final rule's knowledge standard is not intended to permit
willful disregard of violations of Sec. 226.36(b)(1). The Board also
is adopting new commentary regarding how to determine whether a
misstatement of value is material.
Many banks asked for guidance on how to determine whether an
appraisal ``materially'' misstates a dwelling's value. In response to
these comments, the Board is adopting a new comment to Sec.
226.36(b)(2) that provides that a misrepresentation or misstatement of
a dwelling's value is not material if it does not affect the credit
decision or the terms on which credit is extended. The Board notes that
existing appraisal regulations and guidance may direct creditors to
take certain steps in the event the creditor knows about problems with
an appraisal. For example, the Interagency Appraisal and Evaluation
Guidelines dated Oct. 28, 1994 direct institutions to return deficient
reports to appraisers and persons performing evaluations for correction
and to replace unreliable appraisals or evaluations prior to making a
final credit decision. These guidelines further state that changes to
an appraisal's estimate of value are permitted only as a result of a
review conducted by an appropriately qualified state-licensed or -
certified appraiser in accordance with Standard III of USPAP.
The final rule does not dictate specific due diligence procedures
for creditors to follow when they suspect a violation of Sec.
226.36(b)(2), however. In addition, the Board does not intend for Sec.
226.36(b)(2) to create grounds for voiding loan agreements where
violations are found. That is, if a creditor knows of a violation of
Sec. 226.36(b)(1), and nevertheless extends credit in violation of
Sec. 226(b)(2), while the creditor will have violated Sec.
226.36(b)(2), this violation does not necessarily void the consumer's
loan agreement with the creditor. Whether the loan agreement is void is
a matter determined by State or other applicable law.
C. Servicing Abuses--Sec. 226.36(c)
The Board proposed to prohibit certain practices of servicers of
closed-end consumer credit transactions secured by a consumer's
principal dwelling. Proposed Sec. 226.36(d) provided that no servicer
shall: (1) Fail to credit a consumer's periodic payment as of the date
received; (2) impose a late fee or delinquency charge where the late
fee or delinquency charge is due only to a consumer's failure to
include in a current payment a late fee or delinquency charge imposed
on earlier payments; (3) fail to provide a current schedule of
servicing fees and charges within a reasonable time of request; or (4)
fail to provide an accurate payoff statement within a reasonable time
of request. The final rule, redesignated as Sec. 226.36(c), adopts the
proposals regarding prompt crediting, fee pyramiding, and payoff
statements, and modifies and clarifies the accompanying commentary. The
Board is not adopting the fee schedule proposal, for the reasons
discussed below.
Public Comment
Consumer advocacy groups, federal and state regulators and
officials, consumers, and others strongly supported the Board's
proposal to address servicing abuses, although some urged alternative
measures to address servicer abuses, including requiring loss
mitigation. Industry commenters, on the other hand, were generally
opposed to certain aspects of the proposals, particularly the fee
schedule. Industry commenters also urged the Board to adopt any such
rules under its authority in TILA Section 105(a) to adopt regulations
to carry out the purposes of TILA, and not under Section 129(l)(2).
Commenters also requested several clarifications.
Prompt crediting. Commenters generally favored, or did not oppose,
the prompt crediting rule. In particular, consumer advocacy groups,
federal and state regulators and officials, and others supported the
rule. However, some industry commenters and others
[[Page 44569]]
requested clarification on certain implementation details. Commenters
also disagreed about whether and how to address partial payments.
Fee pyramiding. Commenters generally supported prohibiting late fee
pyramiding. Several industry commenters argued, however, that a new
rule would be unnecessary because servicers are subject to a
prohibition on pyramiding under other regulations.
Fee schedule. Most commenters opposed the fee schedule proposal.
One consumer advocate group criticized the disclosure's utility where
consumers cannot shop for and select servicers. Other consumer
advocates urged the Board to adopt alternative measures they argued
would be more effective to combat fee abuses. Industry commenters also
objected to the proposal as impracticable and unnecessarily burdensome.
Most industry commenters strongly opposed disclosure of third party
fees, particularly because third party fees can vary greatly and may be
indeterminable in advance.
Payoff statements. Consumer advocates strongly supported the
proposal to require provision of payoff statements within a reasonable
time. The proposed commentary stated that it would be reasonable under
normal market conditions to provide statements within three business
days of receipt of a consumer's request. Community banks stated that
three business days would typically be adequate. However, large
financial institutions and their trade associations urged the Board to
adopt a longer time period in the commentary. These commenters also
requested other clarifications. The comments are discussed in more
detail throughout this section, as applicable.
Discussion
As discussed in the preamble to the proposed rule, the Board shares
concerns about abusive servicing practices. Consumer advocates raised
abusive mortgage servicer practices as part of the Board's 2006 and
2007 hearings as well as in recent congressional hearings.\110\
Servicer abuses have also received increasing attention both in
academia and the press.\111\ In particular, consumer advocates have
raised concerns that some servicers may be charging consumers
unwarranted or excessive fees (such as late fees and other ``service''
fees) and may be improperly submitting negative credit reports, in the
normal course of mortgage servicing as well as in foreclosures. Some of
these abusive fees, they contend, result from servicers' failure to
promptly credit consumers' accounts, or when servicers pyramid late
fees. In addition to anecdotal evidence of significant consumer
complaints about servicing practices, abusive practices have been cited
in a variety of court cases.\112\ In 2003, the FTC announced a $40
million settlement with a large mortgage servicer and its affiliates to
address allegations of abusive behavior.\113\
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\110\ See, e.g., Comment letter of the National Consumer Law
Center to Docket No. OP-1253 (Aug. 15, 2006) at 11; Legislative
Proposals on Reforming Mortgage Practices, Hearing Before the H.
Comm. On Fin. Servs., 110th Cong. 74 (2007) (Testimony of John
Taylor, National Community Reinvestment Coalition).
\111\ See, e.g., Paula Fitzgerald Bone, Toward a General Model
of Consumer Empowerment and Welfare in Financial Markets with an
Application to Mortgage Servicers, 42 Journal of Consumer Affairs
165 (Summer 2008); Katherine M. Porter, Misbehavior and Mistake in
Bankruptcy Mortgage Claims, University of Iowa Legal Study Research
Paper No. 07-29 (Nov. 2007); Kevin McCoy, Hitting Home: Homeowners
Fight for their Mortgage Rights, USA Today (June 25, 2008),
available at http://www.usatoday.com/money/industries/banking/2008-
06-25-mortgage-services-countrywide-lawsuit_N.htm; Mara Der
Hovanesian, The ``Foreclosure Factories'' Vise, BusinessWeek.com
(Dec. 25, 2006), available at http://www.businessweek.com/magazine/
content/06_52/b4015147.htm?chan=search.
\112\ See, e.g., Workman v. GMAC Mortg. LLC (In re Workman),
2007 Bankr. LEXIS 3887 (Bankr. D. S.C. Nov. 21, 2007) (servicer held
in civil contempt for, among other things, failure to promptly
credit payments made before discharge from bankruptcy and charging
of unauthorized late and attorneys fees); Islam v. Option One
Mortgage Corp., 432 F. Supp. 2d 181 (D. Mass 2006) (servicer
allegedly continued to report borrower delinquent even after
receiving the full payoff amount for the loan); In Re Gorshstein,
285 B.R. 118 (S.D.N.Y. 2002) (servicer sanctioned for falsely
certifying that borrowers were delinquent); Rawlings v. Dovenmuehle
Mortgage Inc., 64 F. Supp. 2d 1156 (M.D. Ala. 1999) (servicer failed
for over 7 months to correct account error despite borrowers' twice
sending copies of canceled checks evidencing payments, resulting in
unwarranted late and other fees); Ronemus v. FTB Mortgage Servs.,
201 B.R. 458 (1996) (among other abuses, servicer failed to promptly
credit payments and instead paid them into a ``suspense'' account,
resulting in unwarranted late fees and unnecessary and improper
accrual of interest on the note).
\113\ Consent Order, United States v. Fairbanks Capital Corp.,
Civ. No. 03-12219-DPW (D. Mass Nov. 21, 2003, as modified Sept. 4,
2007). See also Ocwen Federal Bank FSB, Supervisory Agreement, OTS
Docket No. 04592 (Apr. 19, 2004) (settlement resolving mortgage
servicing issues).
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Consumer advocates have also raised concerns that consumers are
sometimes unaware of fees charged, or unable to understand the basis
upon which fees are charged. This may occur because servicers often do
not disclose precise fees in advance; some consumers are not provided
any other notice of fees (such as a monthly statement or other after-
the-fact notice); and when consumers are provided a statement or other
fee notice, fees may not be itemized or detailed. For example, in a
number of bankruptcy cases, servicers have improperly assessed post-
petition fees without notifying either the consumer or the court.\114\
Similarly, because payoff statements lack transparency (in that they do
not provide detailed accounting information) and because consumers are
often unaware of the exact amount owed, some servicers may assess
inaccurate or false fees on the payoff statement.\115\
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\114\ See, e.g., Jones v. Wells Fargo (In re Jones), 366 B.R.
584 (E.D. La 2007) (``In this Court's experience, few, if any,
lenders make the adjustments necessary to properly account for a
reorganized debt repayment plan. As a result, it is common to see
late charges, fees, and other expenses assessed to a debtor's loan
as a result of post-petition accounting mistakes made by
lenders.''). See also Payne v. Mortg. Elec. Reg. Sys. (In re Payne),
2008 Bankr. LEXIS 1340 (Bankr. Kan. May 6, 2008); Sanchez v.
Ameriquest (In re Sanchez), 372 B.R. 289 (S.D. Tx. 2007); Harris v.
First Union Mortg. Corp. (In re Harris), 2002 Bankr. LEXIS 771
(Bankr. D. Ala. 2002); In Re Tate, 253 B.R. 653.
\115\ See, e.g., Maxwell v. Fairbanks Capital Corp. (In re
Maxwell), 281 B.R. 101, 114 (D. Mass 2002) (servicer ``repeatedly
fabricated the amount of the Debtor's obligation to it out of thin
air'').
---------------------------------------------------------------------------
Substantial injury. Consumers subject to the servicer practices
described above suffer substantial injury. For example, one state
attorney general and several consumer advocates stated that failure to
properly credit payments is one of the most common problems consumers
have with servicers. Servicers that do not timely credit, or that
misapply, payments cause the consumer to incur late fees where none
should be assessed.\116\ Even where the first late fee is properly
assessed, servicers may apply future payments to the late fee first.
Doing so results in future payments being deemed late even if they are,
in fact, paid in full within the required time period, thus permitting
the servicer to charge additional late fees--a practice commonly
referred to as ``pyramiding'' of late fees. These practices can cause
the account to appear to be in default, and thus can give rise to
charging excessive or unwarranted fees to consumers, who may not even
be aware of the default or fees if they do not receive statements. Once
consumers are in default, these practices can make it difficult for
consumers to catch up on payments. These practices also may improperly
trigger negative credit reports, which can cause consumers to be denied
other credit or pay more for such credit, and
[[Page 44570]]
require consumers to engage in time-consuming credit report correction
efforts.
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\116\ See, e.g. Holland v. GMAC Mortg. Corp., 2006 U.S. Dist.
LEXIS 25723 (D. Kan. 2006) (servicer's misapplication of borrower's
payment to the wrong account resulted in improper late fees and
negative credit reports, despite borrower's proof of canceled
checks); In re Payne, 2008 Bankr. LEXIS at *30 (servicer's failure
to properly and timely account for payments and failure to
distinguish between pre-petition and post-petition payments caused
its accounting system and payment history to improperly show
borrowers as delinquent in their payments).
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In addition, a servicer's failure to provide accurate payoff
statements in a timely fashion can cause substantial injury to
consumers. One state attorney general commented that its office often
receives complaints about unreasonable delays in the provision of
payoff statements. Consumers may want to refinance a loan to obtain a
lower interest rate or to avoid default or foreclosure, but may be
impeded from doing so due to inaccurate or untimely payoff statements.
These consumers thus incur additional costs and may be subject to
financial problems or even foreclosure. In addition to the injuries
caused by delayed payoff statements, consumers are injured by
inaccurate payoff statements. As described above, some servicers assess
inaccurate or false fees on the payoff statement without the consumer's
knowledge. Even when the consumer requests clarification, a servicer
may provide an invalid accounting of fees or charges.\117\ Or, a
servicer may provide the payoff statement too late in the refinancing
process for the consumer to obtain clarification without risking losing
his or her new loan commitment.\118\
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\117\ See, e.g., In re Maxwell, 281 B.R. 101, 114 (D. Mass
2002).
\118\ See, e.g., In re Jones, 366 B.R. at 587-588 (consumer in
bankruptcy forced to remit improper sums demanded on payoff
statement or lose loan commitment from new lender. ``Although Debtor
questioned the amounts [servicer] alleged were due, he was unable to
obtain an accounting from [servicer] explaining its calculations or
any other substantiation for the payoff.'').
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Injury not reasonably avoidable. The injuries caused by servicer
abuses are not reasonably avoidable because market competition is not
adequate to prevent abusive practices, particularly when mortgages are
securitized and servicing rights are sold. Historically, under the
mortgage loan process, a lender would often act as both originator and
collector--that is, it would service its own loans. Although some
creditors sold servicing rights, they remained vested in the customer
service experience in part due to reputation concerns and in part
because payment streams continued to flow directly to them. However,
with rise of the ``originate to distribute'' model discussed in part
II.B above, the original creditor has become removed from future direct
involvement in a consumer's loan, and thus has less incentive and
ability to detect or deter servicing abuses or respond to consumer
complaints about servicing abuses. When loans are securitized,
servicers contract directly with investors to service the loan, and
consumers are not a party to the servicing contract.
Today, separate servicing companies play a key role: they are
chiefly responsible for account maintenance, including collecting
payments, remitting amounts due to investors, handling interest rate
adjustments on variable rate loans, and managing delinquencies and
foreclosures. Servicers also act as the primary point of contact for
consumers after origination, because in most cases the original
creditor has securitized and sold the loan shortly after origination.
In exchange for performing these services, servicers generally receive
a fixed per-loan or monthly fee, float income, and ancillary fees--
including default charges--that consumers must pay.
Investors are principally concerned with maximizing returns on the
mortgage loans and are generally indifferent to the fees the servicer
charges the consumer so long as the fees do not reduce the investor's
return (e.g., by prompting an unwarranted foreclosure). Consumers are
not able to choose their servicers. Consumers also are not able to
change servicers without refinancing, which is a time-consuming,
expensive undertaking. Moreover, if interest rates are rising,
refinancing may only be possible if the consumer accepts a loan with a
higher interest rate. After refinancing, consumers may find their loans
assigned back to the same servicer as before, or to another servicer
engaging in the same practices. As a result, servicers do not have to
compete in any direct sense for consumers. Thus, there may not be
sufficient market pressure on servicers to ensure competitive
practices.\119\
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\119\ In one survey, J.D. Power found that consumers whose loans
have been sold have customer satisfaction scores 32 points lower
than those who have remained with the loan originator. J.D. Power
and Associates Reports: USAA Ranks Highest in Customer Satisfaction
with Primary Mortgage Servicing. Press Release (July 19, 2006),
available at http://www.jdpower.com/corporate/news/releases/pdf/
2006117.pdf.
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Injury not outweighed by countervailing benefits to consumers or to
competition. The injuries described above also are not outweighed by
any countervailing benefits to consumers or competition. Commenters did
not cite, and the Board is not aware of, any benefit to consumers from
delayed crediting of payments, pyramided fees, or delayed issuance of
payoff statements.
For these reasons, the Board finds the acts and practices
prohibited under Sec. 226.36(c) for closed-end consumer credit
transactions secured by a consumer's principal dwelling to be unfair.
As described in part V.A above, TILA Section 129(l)(2) authorizes
protections against unfair practices ``in connection with mortgage
loans'' that the Board finds to be unfair or deceptive. 15 U.S.C.
1639(l)(2). Therefore, the Board may take action against unfair or
deceptive practices by non-creditors and against unfair or deceptive
practices outside of the origination process, when such practices are
``in connection with mortgage loans.'' The Board believes that unfair
or deceptive servicing practices fall squarely within the purview of
Section 129(l)(2) because servicing is an integral part of the life of
a mortgage loan and as such is ``in connection with mortgage loans.''
Accordingly, the final rule prohibits certain unfair or deceptive
servicing practices under Section 129(l)(2), 15 U.S.C. 1639(l)(2).
The Final Rule
Section 226.36(c) prohibits three servicing practices. First, the
rule prohibits a servicer from failing to credit a payment to a
consumer's account as of the date received. Second, the rule prohibits
``pyramiding'' of late fees by prohibiting a servicer from imposing a
late fee on a consumer for making a payment that constitutes the full
amount due and is timely, but for a previously assessed late fee.
Third, the rule prohibits a servicer from failing to provide, within a
reasonable time after receiving a request, an accurate statement of the
amount currently required to pay the obligation in full, often referred
to as a payoff statement. Under Sec. 226.36(c)(3), the term
``servicer'' and ``servicing'' are given the same meanings as provided
in Regulation X, 24 CFR 3500.2. As described in more detail below, the
Board is not adopting the proposed rule that would prohibit a servicer
from failing to provide to a consumer, within a reasonable time after
receiving a request, a schedule of all fees and charges it imposes in
connection with mortgage loans it services.
The Board recognizes that servicers will incur additional costs to
alter their systems to comply with some aspects of the final rule. For
example, in some instances some servicers may incur costs in investing
in systems to produce payoff statements within a shorter period of time
than their current technology affords. As a result, some servicers
will, directly or indirectly, pass those costs on to consumers. The
Board believes, however, that these costs to consumers are outweighed
by
[[Page 44571]]
the consumer benefits provided by the rules as adopted.
Prompt Crediting
The Board proposed Sec. Sec. 226.36(d)(1)(i) and 226.36(d)(2) to
prohibit a servicer from failing to credit payments as of the date
received. The proposed prompt crediting rule and accompanying
commentary are substantially similar to the existing provisions
requiring prompt crediting of payment on open-end transactions in Sec.
226.10. The final rule adopts, as Sec. Sec. 226.36(c)(1)(i) and
226.36(c)(2), the rule substantially as proposed, but with revisions to
the proposed commentary to address the questions of partial payments
and payment cut-off times. Commentary has also been added or modified
in response to commenters' concerns.
Commenters generally favored, or did not oppose, the prompt
crediting rule. In particular, consumer advocacy groups, federal and
state regulators and officials, and others supported the rule. One
state attorney general and several consumer advocacy groups stated that
failure to properly credit payments is one of the most common servicing
problems they see consumers face. However, as described in more detail
below, some industry commenters and others requested clarification on
certain implementation details. Commenters also generally disagreed on
whether and how to address partial payments.
Method and timing of payments. Section 226.36(c)(1)(i) requires a
servicer to credit a payment to the consumer's loan account as of the
date of receipt, except when a delay in crediting does not result in
any charge to the consumer or in the reporting of negative information
to a consumer reporting agency, or except as provided in Sec.
226.36(c)(2). Many industry commenters, as well as the GSEs requested
clarifications on the timing and method of crediting payments, and the
final staff commentary has been revised accordingly.
For example, final comment 36(c)(1)(i)-1 makes clear that the rule
does not require a servicer to physically enter the payment on the date
received, but requires only that it be credited as of the date
received. The proposed comment explained that a servicer does not
violate the rule if it receives a payment on or before its due date and
enters the payment on its books or in its system after the due date if
the entry does not result in the imposition of a late charge,
additional interest, or similar penalty to the consumer, or in the
reporting of negative information to a consumer reporting agency.
Because consumers are often afforded a grace period before a late fee
accrues, the Board has revised the comment to reference grace periods.
The final comment thus states that a servicer that receives a payment
on or before the due date (or within any grace period), and does not
enter the payment on its books or in its system until after the
payment's due date (or expiration of any grace period) does not violate
the rule as long as the entry does not result in the imposition of a
late charge, additional interest, or similar penalty to the consumer,
or in the reporting of negative information to a consumer reporting
agency. If a payment is received after the due date and any grace
period, Sec. 226.36(c)(1)(i) does not prohibit the assessment of late
charges or reporting negative information to a consumer reporting
agency.
Some industry commenters were concerned that the rule would affect
their monthly interest accrual accounting systems. Many closed-end
mortgage loan agreements require calculation of interest based on an
amortization schedule where payments are deemed credited as of the due
date, whether the payment was actually received prior to the scheduled
due date or within any grace period. Thus, making the scheduled payment
early does not decrease the amount of interest the consumer owes, nor
does making the scheduled payment after the due date (but within a
grace period) increase the interest the consumer owes. According to
these commenters, this so-called ``monthly interest accrual
amortization method'' provides certainty to consumers (about payments
due) and to investors (about expected yields). The final rule is not
intended to prohibit or alter use of this method, so long as the
servicer recognizes on its books or in its system that payments have
been timely made for purposes of determining late fees or triggering
negative credit reporting.
The final rule also adopts proposed comment 36(d)(2)-1,
redesignated as 36(c)(2)-1, which states that the servicer may specify
in writing reasonable requirements for making payments. One commenter
expressed concern that late fees or negative credit reports may be
triggered when a timely payment requires extensive research, and the
creditor may inadvertently violate Sec. 226.36(c)(1)(i). Such research
might be required, for example, when a check does not include the
account number for the mortgage loan and is written by someone other
than the consumer. However, in this scenario, the check would typically
constitute a payment that does not conform to the servicer's reasonable
payment requirements. If a payment is non-conforming, and the servicer
nonetheless accepts the payment, then Sec. 226.36(c)(2) provides that
the servicer must credit the account within five days of receipt. If
the servicer chooses not to accept the non-conforming payment, it would
not violate the rule by returning the check.
Comment 36(c)(2)-1 provides examples of reasonable payment
requirements. Although the list of examples is non-exclusive, at the
request of several commenters, payment coupons have been added to the
list of examples because they can assist servicers in expediting the
crediting process to consumers' benefit.
The Board sought comment on whether it should provide a safe harbor
as to what constitutes a reasonable payment requirement, for example, a
cut-off time of 5 p.m. for receipt of a mailed check. Commenters
generally supported including safe harbors; accordingly, new comment
32(c)(2)-2 provides that it would be reasonable to require a cut-off
time of 5 p.m. for receipt of a mailed check at the location specified
by the creditor for receipt of such check.
Partial payments. The Board sought comment on whether (and if so,
how) partial payments should be addressed in the prompt crediting rule.
Consumer advocate and industry commenters disagreed on whether partial
payments should be credited, if the consumer's payment covers at least
the principal and interest due but not amounts due for escrows or late
or other service fees. Consumer groups argued that servicers should be
required to credit partial payments under the rule, when the payment
would cover at least the principal and interest due. They expressed
concern that servicers routinely place such partial payments into
suspense accounts, triggering the accrual of late fees and other
default fees. On the other hand, most industry commenters urged the
Board not to require crediting of partial payments, because doing so
would contradict the structure of uniform loan documents, would violate
servicing agreements, would be contrary to monthly interest accrual
accounting methods, and would require extensive systems and accounting
changes. They also argued that crediting partial payments could cause
the consumer's loan balance to increase. After crediting the partial
payment, the servicer would add the remaining payment owed to the
principal balance; thus, the principal balance would be greater than
the amount scheduled (and the interest calculated on that larger
principal balance that would be due would be
[[Page 44572]]
greater than the scheduled interest). As a result, subsequent regularly
scheduled payments would no longer cover the actual outstanding
principal and interest due.
New comment 36(c)(1)(i)-2 makes clear that whether a partial
payment must be credited depends on the contract between the parties.
Specifically, the new comment states that payments should be credited
based on the legal obligation between the creditor and consumer. The
comment also states that the legal obligation is determined by
applicable state law or other law. Thus, if under the terms of the
legal obligations governing the loan, the required monthly payment
includes principal, interest, and escrow, then consistent with those
terms, servicers would not be required to credit payments that include
only principal and interest payments. Concerns about partial payments
may be addressed in part by the fee pyramiding rule, discussed below,
which prohibits servicers from charging late fees if a payment due is
short solely by the amount of a previously assessed late fee.
Pyramiding Late Fees
The Board proposed to adopt a parallel approach to the existing
prohibition on late fee pyramiding contained in the ``credit practices
rule,'' under section 5 of the FTC Act, 15 U.S.C. 45. See, e.g., 12 CFR
227.15 (Board's Regulation AA). Proposed Sec. 226.36(c)(1)(ii) would
have prohibited servicers from imposing any late fee or delinquency
charge on the consumer in connection with a payment, when the
consumer's payment was timely and made in full but for any previously
assessed late fees. The proposed commentary provided that the
prohibition should be construed consistently with the credit practices
rule. The final rule adopts the proposal and accompanying staff
commentary.
Commenters generally supported prohibiting fee pyramiding. Several
commenters argued, however, that a new rule would be unnecessary
because servicers are subject to a regulation prohibiting fee
pyramiding, whether they are banks (12 CFR 227.15), thrifts (12 CFR
535.4), credit unions (12 CFR 706.4) or other institutions (16 CFR
444.4). However, the Board believes that adopting a fee pyramiding
prohibition under TILA Section 129(l)(2), 15 U.S.C. 1639(l)(2), would
extend greater protections to consumers than currently provided by
regulation. While fee pyramiding is impermissible for all entities
under either the Board, OTS, or FTC rules, state officials are not
granted authority under the FTC Act to bring enforcement actions
against institutions. By bringing the fee pyramiding rule under TILA
Section 129(l)(2), state attorneys general would be able to enforce the
rule through TILA, where currently they may be limited to enforcing the
rule solely through state statutes (which statutes may not be uniform).
Accordingly, the anti-pyramiding rule adopted today would provide state
attorneys general an additional means of enforcement against servicers,
thus providing an additional consumer protection against an unfair
practice.
Schedule of Fees and Charges
Proposed 226.36(d)(1)(iii) would have required a servicer to
provide to a consumer upon request a schedule of all specific fees and
charges that may be imposed in connection with the servicing of the
consumer's account, including a dollar amount and an explanation of
each and the circumstances under which each fee may be imposed. The
proposal would have required a fee schedule that is specific both as to
the amount and type of each charge, to prevent servicers from
disguising fees by lumping them together or giving them generic names.
The proposal also would have required the disclosure of third party
fees assessed on consumers by servicers. The rule was intended to bring
transparency to the market, to enhance consumer understanding of
servicer charges, and to make it more difficult for unscrupulous
servicers to camouflage or inflate fees. The Board sought comment on
the effectiveness of this approach, and solicited suggestions on
alternative methods to achieve the same objective. Given servicers'
potential difficulty in identifying the specific amount of third party
charges prior to imposition of such charges, the Board also sought
comment on whether the benefit of increasing the transparency of third
party fees would outweigh the costs associated with a servicer's
uncertainty as to such fees.
Most commenters opposed the fee schedule proposal. One consumer
advocate group argued that the disclosure would not help because
consumers cannot shop for and select servicers. Other consumer
advocates urged the Board to adopt alternative measures they argued
would be more effective to prevent servicer abuses. Industry commenters
also objected to the proposal as impracticable and unnecessarily
burdensome. Some stated that they currently provide limited fee
schedules upon request, but that they would incur a substantial time
and cost burden to reprint schedules or add addenda when fees change.
Many industry commenters strongly opposed disclosure of third party
fees. These commenters argued that fees can vary greatly by geography
(inter- and intra-state) and over the life of the loan, and are not
within the servicer's control, particularly when the consumer is in
default. Moreover, they stated, some charges relating to foreclosure or
other legal actions cannot be determined in advance. For example,
newspaper publication costs will vary depending on the newspaper and
length of the notice required; third party service providers may charge
varying prices based on the cost of labor, materials, and scope of work
required.\120\ Industry commenters maintained that servicers would pass
on to consumers the costs of the increased burden and risk incurred. At
a minimum, they argued, the fee schedule should be limited to standard
or common fees, such as nonsufficient fund fees or duplicate statement
fees.
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\120\ See, e.g., Vikas Bajaj, Contractors Are Kept Busy
Maintaining Abandoned Homes, N.Y. Times (May 26, 2008), available at
http://www.nytimes.com/2008/05/27/business/27home.html?_
r=1&scp=1&sq=florida+foreclosure&st=nyt&oref=slogin.
---------------------------------------------------------------------------
The Board has considered the concerns raised by commenters and has
concluded that the transparency benefit of the schedule does not
sufficiently offset the burdens of producing such a schedule. Thus, the
Board is not adopting proposed Sec. 226.36(d)(1)(iii). First, the
transparency benefit is limited. It is not clear that consumers would
request fee schedules sufficiently in advance of being charged any fees
so as to provide consumers the benefit of the notice intended by the
proposed rule. In addition, any schedules provided to consumers may be
out of date by the time the consumer is assessed fees. Many third party
fees would also be impractical to specify. Even if third party fees are
simply listed as ``actual charge'' or ``market price,'' the fee
schedules may be too long--possibly dozens of pages-- and detailed to
be meaningful or useful to consumers. The Board considered limiting fee
schedules to the servicer's own standard fees. However, while such
schedules might assist consumers who are current, they would be of
limited utility to delinquent consumers, who are often subject to
substantial third party fees. For the foregoing reasons, the Board is
not adopting proposed Sec. 226.36(d)(1)(iii).
The Board solicited suggestions on alternative methods to address
servicer charges and fees. Commenters urged the Board to consider a
variety of alternatives to combat abusive servicing
[[Page 44573]]
practices, including prohibiting servicers from imposing fees unless
the fee is authorized by law, agreed to in the note, and bona fide and
reasonable; prohibiting servicers from misstating the amounts consumers
owe; and requiring servicers to provide monthly statements to consumers
to permit consumers to monitor charges. The Board continues to have
concerns about transparency and abuse of servicer fees. The Board will
continue to evaluate the issue, and may consider whether to propose
additional rules in this area in connection with its comprehensive
review of Regulation Z's closed-end mortgage disclosure rules.
Loan Payoff Statements
Proposed Sec. 226.36(d)(1)(iv) would have prohibited a servicer
from failing to provide, within a reasonable time after receiving a
request from the consumer or any person acting on behalf of the
consumer, an accurate statement of the full amount required to pay the
obligation in full as of a specified date, often referred to as a
payoff statement. The proposed commentary stated that under normal
market conditions, three business days would be a reasonable time to
provide the payoff statements; however, a longer time might be
reasonable when the market is experiencing an unusually high volume of
refinancing requests.
Consumer advocates strongly supported the proposed rule, and most
community banks stated that three business days would be adequate for
production of payoff statements. However, large financial institutions
and their trade associations urged the Board to adopt a longer time
period in the commentary than three business days. Large financial
institutions and their trade associations also requested clarification
on requests from third parties, citing privacy concerns. Further, they
urged the Board to refine the rule to provide that statements should be
accurate when issued, because events could occur after issuance that
would make the payoff statement inaccurate.
The Board is adopting the rule substantially as proposed,
renumbered as Sec. 226.36(c)(1)(iii), with clarifications and changes
to the commentary. The Board has revised the accompanying staff
commentary to provide that five business days would normally be a
reasonable time to provide the statements under most circumstances, and
to make several other clarifications in response to commenters'
concerns.
Servicers' delays in providing payoff statements can impede
consumers from refinancing existing loans or otherwise clearing title
and increase transaction costs. Promptly delivered payoff statements
also help consumers to monitor inflated payoff claims. Thus, the Board
is adopting a rule requiring servicers to provide an accurate payoff
statement within a reasonable time after receiving a request.
As noted above, the proposed commentary stated that under normal
market conditions, three business days would be a reasonable time to
provide the payoff statements. Large financial institutions and their
trade associations encouraged the Board to extend the three business
day time frame to anywhere from five business days to fifteen calendar
days to provide servicers enough time to compile the necessary payoff
information. While the Board notes that the commentary's time frame is
a safe harbor and not a requirement, the Board is extending the time
frame from three to five business days to address commenters' concerns.
Several industry commenters also requested special time periods for
homes in foreclosure or loss mitigation. Some argued that emergency
circumstances (such as imminent foreclosure) require swifter servicer
action; on the contrary, others argued that such circumstances are
inherently complicated and require additional servicer time and effort.
However, the Board believes five business days should provide
sufficient time to handle most payoff requests, including most requests
where the loan is delinquent, in bankruptcy, or the servicer has
incurred an escrow advance. As discussed below, there may be
circumstances under which a longer time period is reasonable; the
response time would simply not fall under the five business day safe
harbor.
The commentary retains the proposal that the time frame might be
longer in some instances. The example has been revised, however, from
when ``the market'' is experiencing an unusually high volume of
refinancing requests to ``the servicer.'' A particular servicer's
experience may not correspond perfectly with general market conditions.
The example is intended to recognize that more time may be reasonable
where a servicer is experiencing temporary constraints on its ability
to respond to payoff requests. The example is not intended, however, to
enable servicers to take an unreasonable amount of time to provide
payoff statements if it is due to a failure to devote adequate staffing
to handling requests. The Board believes that the revised commentary
balances servicers' operational needs with consumers' interests in
promptly obtaining a payoff statement.
Under the proposed rule, the servicer would be required to respond
to the request of a person acting on behalf of the consumer. Thus, for
example, a creditor with which a consumer is refinancing may request a
payoff statement. Others who act on the consumer's behalf, such as a
non-profit homeownership counselor, also may wish to obtain a payoff
statement for the consumer. Some industry commenters expressed concern
about the privacy implications of such a requirement, and requested
that the Board permit additional time to confirm the consumer's
permission prior to releasing account information. To address these
concerns, the Board has revised the commentary to state that the
servicer may first take reasonable measures to verify the identity of
persons purporting to act on behalf of the consumer and to obtain the
consumer's authorization to release information to any such persons
before the ``reasonable time'' frame begins to run.
Industry commenters also requested that, as in the prompt crediting
rule, servicers be permitted to specify reasonable requirements to
ensure payoff requests may be promptly processed. The Board believes
clear procedures for consumer requests for loan payoff statements will
benefit consumers, as these procedures will expedite processing of a
consumer's request. Therefore, the Board is adding new commentary
226.36(c)(1)(iii)-3 to clarify that the servicer may specify reasonable
requirements for making payoff requests, such as requiring requests to
be in writing and directed to a specific address, e-mail address or fax
number specified by the servicer, or orally to a specified telephone
number, or any other reasonable requirement or method. If the consumer
does not follow these requirements, a longer time frame for responding
to the request would be reasonable.
Finally, industry commenters requested clarification that the
statement must be accurate when issued. They maintained that events
occurring after issuance of the statement cause a statement to become
inaccurate, such as when a consumer's previous payment is returned for
insufficient funds after the servicer has issued the loan payoff
statement. The Board is adding new comment 226.36(c)(1)(iii)-4 to
explain that payoff statements must be accurate when issued. The payoff
statement amount should reflect all payments due and all fees and
charges incurred as of the date of issuance. However, the Board
recognizes that events occurring after issuance and
[[Page 44574]]
outside the servicer's control, such as a returned check and
nonsufficient funds fee, or an escrow advance, may cause the payoff
statement to become inaccurate. If the statement was accurate when it
was issued, subsequent events that change the payoff amount do not
result in a violation of the rule.
D. Coverage--Sec. 226.36(d)
The Board proposed to exclude HELOCs from Sec. 226.36(d) because
most originators of HELOCs hold them in portfolio rather than sell
them, which aligns these originators' interests in loan performance
more closely with their borrowers' interests, and HELOC originations
are concentrated in the banking and thrift industries, where the
federal banking agencies can use supervisory authorities to protect
borrowers. As described in more detail in part IX.E above, the proposed
exclusion of HELOCs drew criticism from several consumer and civil
rights groups but strong support from industry commenters. For the
reasons discussed in part VIII.H above, the Board is adopting the
exclusion as proposed, renumbered as Sec. 226.36(d).
XI. Advertising
The Board proposed to amend the advertising rules for open-end
home-equity plans under Sec. 226.16, and for closed-end credit under
Sec. 226.24, to address advertisements for home-secured loans. For
open-end home-equity plan advertisements, the two most significant
proposed changes related to the clear and conspicuous standard and the
advertisement of promotional terms. For advertisements for closed-end
credit secured by a dwelling, the three most significant proposed
changes related to strengthening the clear and conspicuous standard for
advertising disclosures, regulating the disclosure of rates and
payments in advertisements to ensure that low promotional or ``teaser''
rates or payments are not given undue emphasis, and prohibiting certain
acts or practices in advertisements as provided under Section 129(l)(2)
of TILA.
The final rule is substantially similar to the proposed rule and
adopts, with some modifications, each of the proposed changes discussed
above. The most significant changes are: Modifying when an
advertisement is required to disclose certain information about tax
implications; using the term ``promotional'' rather than
``introductory'' to describe certain open-end credit rates or payments
applicable for a period less than the term of the loan and removing the
requirement that advertisements with promotional rates or payments
state the word ``introductory;'' excluding radio and television
advertisements for home-equity plans from the requirements regarding
promotional rates or payments; allowing advertisements for closed-end
credit to state that payments do not include mortgage insurance
premiums rather than requiring advertisements to state the highest and
lowest payment amounts; and removing the prohibition on the use of the
term ``financial advisor'' by a for-profit mortgage broker or mortgage
lender.
Public Comment
Most commenters were generally supportive of the Board's proposed
advertising rules. Lenders and their trade associations made a number
of requests for clarification or modification of the rules, and a few
cautioned that requiring too much information be disclosed in
advertisements could cause creditors to avoid advertising specific
credit terms, thereby depriving consumers of useful information. By
contrast, consumer and community groups as well as state and local
government officials made some suggestions for tightening the
application of the rules. The comments are discussed in more detail
throughout this section as applicable.
A. Advertising Rules for Open-End Home-Equity Plans--Sec. 226.16
Overview
The Board is revising the open-end home-equity plan advertising
rules in Sec. 226.16. As in the proposal, the two most significant
changes relate to the clear and conspicuous standard and the
advertisement of promotional terms in home-equity plans. Each of these
proposed changes is summarized below.
First, as proposed, the Board is revising the clear and conspicuous
standard for home-equity plan advertisements, consistent with the
approach taken in the advertising rules for consumer leases under
Regulation M. See 12 CFR 213.7(b). New commentary provisions clarify
how the clear and conspicuous standard applies to advertisements of
home-equity plans with promotional rates or payments, and to Internet,
television, and oral advertisements of home-equity plans. The rule also
allows alternative disclosures for television and radio advertisements
for home-equity plans by revising the Board's earlier proposal for
open-end plans that are not home-secured to apply to home-equity plans
as well. See 12 CFR 226.16(e) and 72 FR 32948, 33064 (June 14, 2007).
Second, the Board is amending the regulation and commentary to
ensure that advertisements adequately disclose not only promotional
plan terms, but also the rates and payments that will apply over the
term of the plan. The changes are modeled after proposed amendments to
the advertising rules for open-end plans that are not home-secured. See
73 FR 28866, 28892 (May 19, 2008) and 72 FR 32948, 33064 (June 14,
2007).
The Board is also implementing provisions of the Bankruptcy Abuse
Prevention and Consumer Protection Act of 2005 which requires
disclosure of the tax implications of certain home-equity plans. See
Public Law 109-8, 119 Stat. 23. Other technical and conforming changes
are also being made.
The Board proposed to prohibit certain acts or practices connected
with advertisements for closed-end mortgage credit under TILA section
129(l)(2) and sought comment on whether it should extend any or all of
the prohibitions contained in proposed Sec. 226.24(i) to home-equity
plans, or whether there were other acts or practices associated with
advertisements for home-equity plans that should be prohibited. The
final rule does not apply the prohibitions contained in Sec. 226.24(i)
to home-equity plans for the reasons discussed below in connection with
the final rule for closed-end mortgage credit advertisements. See
discussion of Sec. 226.24(i) below.
Current Statute and Regulation
TILA Section 147, implemented by the Board in Sec. 226.16(d),
governs advertisements of open-end home-equity plans secured by the
consumer's principal dwelling. 15 U.S.C. 1665b. The statute applies to
the advertisement itself, and therefore, the statutory and regulatory
requirements apply to any person advertising an open-end credit plan,
whether or not they meet the definition of creditor. See comment
2(a)(2)-2. Under the statute, if an open-end credit advertisement sets
forth, affirmatively or negatively, any of the specific terms of the
plan, including any required periodic payment amount, then the
advertisement must also clearly and conspicuously state: (1) Any loan
fee the amount of which is determined as a percentage of the credit
limit and an estimate of the aggregate amount of other fees for opening
the account; (2) in any case in which periodic rates may be used to
compute the finance charge, the periodic rates expressed as an annual
percentage rate; (3) the highest annual percentage rate which may be
imposed under the plan; and (4) any
[[Page 44575]]
other information the Board may by regulation require.
The specific terms of an open-end plan that ``trigger'' additional
disclosures, which are commonly known as ``triggering terms,'' are the
payment terms of the plan, or finance charges and other charges
required to be disclosed under Sec. Sec. 226.6(a) and 226.6(b). If an
advertisement for a home-equity plan states a triggering term, the
regulation requires that the advertisement also state the terms
required by the statute. See 12 CFR 226.16(d)(1); see also comments
16(d)-1 and -2.
Authority
The Board is exercising the following authorities in promulgating
final rules. TILA Section 105(a) authorizes the Board to adopt
regulations to ensure meaningful disclosure of credit terms so that
consumers will be able to compare available credit terms and avoid the
uninformed use of credit. 15 U.S.C. 1604(a). TILA Section 122
authorizes the Board to require that information, including the
information required under Section 147, be disclosed in a clear and
conspicuous manner. 15 U.S.C. 1632. TILA Section 147 also requires that
information, including any other information required by regulation by
the Board, be clearly and conspicuously set forth in such form and
manner as the Board may by regulation require. 15 U.S.C. 1665b.
Discussion
Clear and conspicuous standard. The Board is adopting as proposed
new comments 16-2 to -5 to clarify how the clear and conspicuous
standard applies to advertisements for home-equity plans.
Comment 16-1 explains that advertisements for open-end credit are
subject to a clear and conspicuous standard set forth in Sec.
226.5(a)(1). The Board is not prescribing specific rules regarding the
format of advertisements. However, new comment 16-2 elaborates on the
requirement that certain disclosures about promotional rates or
payments in advertisements for home-equity plans be prominent and in
close proximity to the triggering terms in order to satisfy the clear
and conspicuous standard when promotional rates or payments are
advertised and the disclosure requirements of new Sec. 226.16(d)(6)
apply. The disclosures are deemed to meet this requirement if they
appear immediately next to or directly above or below the trigger
terms, without any intervening text or graphical displays. Terms
required to be disclosed with equal prominence to the promotional rate
or payment are deemed to meet this requirement if they appear in the
same type size as the trigger terms. A more detailed discussion of the
requirements for promotional rates or payments is found below.
The equal prominence and close proximity requirements of Sec.
226.16(d)(6) apply to all visual text advertisements except for
television advertisments. However, comment 16-2 states that electronic
advertisements that disclose promotional rates or payments in a manner
that complies with the Board's recently amended rule for electronic
advertisements under Sec. 226.16(c) are deemed to satisfy the clear
and conspicuous standard. See 72 FR 63462 (Nov. 9, 2007). Under the
rule, if an electronic advertisement provides the required disclosures
in a table or schedule, any statement of triggering terms elsewhere in
the advertisement must clearly direct the consumer to the location of
the table or schedule. For example, a triggering term in an
advertisement on an Internet Web site may be accompanied by a link that
directly takes the consumer to the additional information. See comment
16(c)(1)-2.
The Board sought comment on whether it should amend the rules for
electronic advertisements for home-equity plans to require that all
information about rates or payments that apply for the term of the plan
be stated in close proximity to promotional rates or payments in a
manner that does not require the consumer to click a link to access the
information. The majority of commenters who addressed this issue urged
the Board to adopt comment 16-2 as proposed. They noted that many
electronic advertisements on the Internet are displayed in small areas,
such as in banner advertisements or next to search engine results, and
requiring information about the rates or payments that apply for the
term of the plan to be in close proximity to the promotional rates or
payments would not be practical. These commenters also suggested that
Internet users are accustomed to clicking on links in order to find
further information. Commenters also expressed concern about the
practicality of requiring closely proximate disclosures in electronic
advertisements that may be displayed on devices with small screens,
such as on Internet-enabled cellular phones or personal digital
assistants, that might necessitate scrolling or clicking on links in
order to view additional information.
The Board is adopting comment 16-2 as proposed. The Board agrees
that requiring disclosures of information about rates or payments that
apply for the term of the plan to be in close proximity to promotional
rates or payments would not be practical for many electronic
advertisements and that the requirements of Sec. 226.16(c) adequately
ensure that consumers viewing electronic advertisements have access to
important additional information about the terms of the advertised
product.
The Board is also adopting as proposed new comments to interpret
the clear and conspicuous standards for Internet, television, and oral
advertisements of home-equity plans. New comment 16-3 explains that
disclosures in the context of visual text advertisements on the
Internet must not be obscured by techniques such as graphical displays,
shading, coloration, or other devices, and must comply with all other
requirements for clear and conspicuous disclosures under Sec.
226.16(d). New comment 16-4 likewise explains that textual disclosures
in television advertisements must not be obscured by techniques such as
graphical displays, shading, coloration, or other devices, must be
displayed in a manner that allows the consumer to read the information,
and must comply with all other requirements for clear and conspicuous
disclosures under Sec. 226.16(d). The Board believes, however, that
this rule can be applied with some flexibility to account for
variations in the size of television screens. For example, a lender
would not violate the clear and conspicuous standard if the print size
used was not legible on a handheld or portable television. New comment
16-5 explains that oral advertisements, such as by radio or television,
must provide disclosures at a speed and volume sufficient for a
consumer to hear and comprehend them. In this context, the word
``comprehend'' means that the disclosures must be intelligible to
consumers, not that advertisers must ensure that consumers understand
the meaning of the disclosures. The Board is also allowing the use of a
toll-free telephone number as an alternative to certain disclosures in
radio and television advertisements.
Section 226.16(d)(2)--Discounted and Premium Rates
If an advertisement for a variable-rate home-equity plan states an
initial annual percentage rate that is not based on the index and
margin used to make later rate adjustments, the advertisement must also
state the period of time the initial rate will be in effect, and a
reasonably current annual percentage rate that would have been in
effect using
[[Page 44576]]
the index and margin. See 12 CFR 226.16(d)(2). The Board is adopting as
proposed revisions to this section to require that the triggered
disclosures be stated with equal prominence and in close proximity to
the statement of the initial APR. The Board believes that this will
enhance consumers' understanding of the cost of credit for the home-
equity plan being advertised.
As proposed, new comment 16(d)-6 provides safe harbors for what
constitutes a ``reasonably current index and margin'' as used in Sec.
226.16(d)(2) as well as Sec. 226.16(d)(6). Under the comment, the time
period during which an index and margin are considered reasonably
current depends on the medium in which the advertisement was
distributed. For direct mail advertisements, a reasonably current index
and margin is one that was in effect within 60 days before mailing. For
printed advertisements made available to the general public and for
advertisements in electronic form, a reasonably current index and
margin is one that was in effect within 30 days before printing, or
before the advertisement was sent to a consumer's e-mail address, or
for advertisements made on an Internet Web site, when viewed by the
public.
Section 226.16(d)(3)-Balloon Payment
Existing Sec. 226.16(d)(3) requires that if an advertisement for a
home-equity plan contains a statement about any minimum periodic
payment, the advertisement must also state, if applicable, that a
balloon payment may result. As proposed, the Board is revising this
section to clarify that only statements of the amount of any minimum
periodic payment trigger the required disclosure, and to require that
the disclosure of a balloon payment be equally prominent and in close
proximity to the statement of a minimum periodic payment. Consistent
with comment 5b(d)(5)(ii)-3, the Board is clarifying that the
disclosure is triggered when an advertisement contains a statement of
any minimum periodic payment amount and a balloon payment may result if
only minimum periodic payments are made, even if a balloon payment is
uncertain or unlikely. Additionally, the Board is clarifying that a
balloon payment results if paying the minimum periodic payments would
not fully amortize the outstanding balance by a specified date or time,
and the consumer must repay the entire outstanding balance at such
time.
The final rule, as proposed, incorporates the language from
existing comment 16(d)-7 into the text of Sec. 226.16(d)(3) with
technical revisions. The comment is revised and renumbered as comment
16(d)-9. The required disclosures regarding balloon payments must be
stated with equal prominence and in close proximity to the minimum
periodic payment. The Board believes that this will enhance consumers'
ability to notice and understand the potential financial impact of
making only minimum payments.
Section 226.16(d)(4)--Tax Implications
Section 1302 of the Bankruptcy Act amends TILA Section 147(b) to
require additional disclosures for advertisements that are disseminated
in paper form to the public or through the Internet, relating to an
extension of credit secured by a consumer's principal dwelling that may
exceed the fair market value of the dwelling. Such advertisements must
include a statement that the interest on the portion of the credit
extension that is greater than the fair market value of the dwelling is
not deductible for Federal income tax purposes. 15 U.S.C. 1665b(b). The
statute also requires a statement that the consumer should consult a
tax adviser for further information on the tax deductibility of the
interest.
The Bankruptcy Act also requires that disclosures be provided at
the time of application in cases where the extension of credit may
exceed the fair market value of the dwelling. See 15 U.S.C.
1637a(a)(13). The Board intends to implement the application disclosure
portion of the Bankruptcy Act during its forthcoming review of closed-
end and HELOC disclosures under TILA. However, the Board requested
comment on the implementation of both the advertising and application
disclosures under this provision of the Bankruptcy Act for open-end
credit in its October 17, 2005, ANPR. 70 FR 60235, 60244 (Oct. 17,
2005). A majority of comments on this issue addressed only the
application disclosure requirement, but some commenters specifically
addressed the advertising disclosure requirement. One industry
commenter suggested that the advertising disclosure requirement apply
only in cases where the advertised product allows for the credit to
exceed the fair market value of the dwelling. Other industry commenters
suggested that the requirement apply only to advertisements for
products that are intended to exceed the fair market value of the
dwelling.
The Board proposed to revise Sec. 226.16(d)(4) and comment 16(d)-3
to implement TILA Section 147(b). The Board's proposal applied the new
requirements to advertisements for home-equity plans where the
advertised extension of credit may, by its terms, exceed the fair
market value of the dwelling. The Board sought comment on whether the
new requirements should instead apply to only advertisements that state
or imply that the creditor provides extensions of credit greater than
the fair market value of the dwelling. Of the few commenters who
addressed this issue, the majority were in favor of the alternative
approach because many home-equity plans may, in some circumstances,
allow for extensions of credit greater than the fair market value of
the dwelling and advertisers would likely include the disclosure in
nearly all advertisements.
The final rule differs from the proposed rule and requires that the
additional tax implication disclosures be given only when an
advertisement states that extensions of credit greater than the fair
market value of the dwelling are available. The rule does not apply to
advertisements that merely imply that extensions of credit greater than
the fair market value of the dwelling may occur. By limiting the
required disclosures to only those advertisements that state that
extensions of credit greater than the fair market value of the dwelling
are available, the Board believes the rule will provide the required
disclosures to consumers when they are most likely to be receptive to
the information while avoiding overloading consumers with information
about the tax consequences of home-equity plans when it is less likely
to be meaningful to them.
Comment 16(d)-3 is revised to conform to the final rule and to
clarify when an advertisement must give the disclosures required by
Sec. 226.16(d)-4 for all home-equity plan advertisements that refer to
tax deductibility and when an advertisement must give the new
disclosures relating to extensions of credit greater than the fair
market value of the consumer's dwelling.
Section 226.16(d)(6)--Promotional Rates and Payments
The Board proposed to add Sec. 226.16(d)(6) to address the
advertisement of promotional (termed ``introductory'' in the proposal)
rates and payments in advertisements for home-equity plans. The
proposed rule provided that if an advertisement for a home-equity plan
stated a promotional rate or payment, the advertisement must use the
term ``introductory'' or ``intro'' in immediate proximity to each
mention of the promotional rate or payment. The proposed rule also
provided that such
[[Page 44577]]
advertisements must disclose the following information in a clear and
conspicuous manner with each listing of the promotional rate or
payment: The period of time during which the promotional rate or
promotional payment will apply; in the case of a promotional rate, any
annual percentage rate that will apply under the plan; and, in the case
of a promotional payment, the amount and time periods of any payments
that will apply under the plan. In variable-rate transactions, payments
determined based on application of an index and margin to an assumed
balance would be required to be disclosed based on a reasonably current
index and margin.
The final rule excludes radio and television advertisements for
home-equity plans from the requirements of Sec. 226.16(d)(6). This
modification is consistent with the approach the Board proposed, and is
adopting, for Sec. 226.24(f) which contains similar requirements for
advertisements for closed-end credit that is home-secured. See Sec.
226.24(f)(1). As the Board noted in the supplementary information to
the proposal for advertisements for home-secured closed-end loans, the
Board does not believe it is feasible to apply the requirements of this
section, notably the close proximity and prominence requirements, to
oral advertisements. The Board also sought comment in connection with
closed-end home-secured loans on whether these or different standards
should be applied to oral advertisements for home-secured loans but
commenters did not address this issue.
The final rule also differs from the proposed rule in using the
term ``promotional'' rather than ``introductory'' to describe the rates
and payments covered by Sec. 226.16(d)(6). The final rule also does
not adopt proposed Sec. 226.16(d)(6)(ii) and proposed comment 16(d)-
5.ii which required that advertisements with promotional rates or
payments state the term ``introductory'' or ``intro'' in immediate
proximity to each listing of a promotional rate or payment. Some
industry commenters noted that consumers might be confused by the use
of the term ``introductory'' in cases where it applied to a promotional
rate or payment that was not the initial rate or payment.
The Board received similar comments in response to its earlier
proposal for open-end plans that are not home-secured, and the Board
subsequently issued a new proposal for those plans that would use the
term ``promotional'' rather than ``introductory'' and require that
advertisements state the word ``introductory'' only for promotional
rates offered in connection with an account opening. 73 FR 28866, 28892
(May 9, 2008). The Board is adopting the term ``promotional'' rather
than ``introductory'' in the rule, but the Board is not requiring open-
end home-equity plans to state the word ``introductory'' for
promotional rates or payments offered in connection with the opening of
an account. While the term ``introductory'' is common in other consumer
credit contexts, such as credit cards, it may not be as meaningful to
consumers in the context of advertisements for home-equity plans and
may be confusing to some consumers in that context. The Board believes
that the information required to be disclosed under Sec. 226.16(d)(6)
is sufficient to inform consumers that advertised promotional terms
will not apply for the full term of the plan.
Commenters also expressed confusion about the distinction between
promotional rates under Sec. 226.16(d)(6) and discounted and premium
rates under Sec. 226.16(d)(2). While some advertised rates may be
covered under both Sec. 226.16(d)(2) and Sec. 226.16(d)(6), each rule
covers some rates that the other does not. The definition of a
promotional rate under Sec. 226.16(d)(6) is not limited to initial
rates; a rate that is not based on the index and margin used to make
rate adjustments under the plan may be a promotional rate even if it is
not the first rate that applies. At the same time, Sec. 226.16(d)(6)
applies to a rate that is not based on the index and margin that will
be used to make later rate adjustments under the plan only if that rate
is less than a reasonably current annual percentage rate that would be
in effect under the index and margin used to make rate adjustments. By
contrast, Sec. 226.16(d)(2) applies to an initial annual percentage
rate that is not based on the index and margin used to make later rate
adjustments regardless of whether the later rate would be greater or
less than the initial rate.
Section 226.16(d)(6)(i)--Definitions. The Board proposed to define
the terms ``introductory rate,'' ``introductory payment,'' and
``introductory period'' in Sec. 226.16(d)(6)(i). The final rule uses
the terms ``promotional rate,'' ``promotional payment,'' and
``promotional period'' instead and the definition of ``promotional
payment'' is clarified to refer to the minimum payments under a home-
equity plan, but the final rule is otherwise as proposed. In a
variable-rate plan, the term ``promotional rate'' means any annual
percentage rate applicable to a home-equity plan that is not based on
the index and margin that will be used to make rate adjustments under
the plan, if that rate is less than a reasonably current annual
percentage rate that would be in effect based on the index and margin
that will be used to make rate adjustments under the plan. The term
``promotional payment'' means, in the case of a variable-rate plan, the
amount of any minimum payment applicable to a home-equity plan for a
promotional period that is not derived from the index and margin that
will be used to determine the amount of any other minimum payments
under the plan and, given an assumed balance, is less than any other
minimum payment that will be in effect under the plan based on a
reasonably current application of the index and margin that will be
used to determine the amount of such payments. For a non-variable-rate
plan, the term ``promotional payment'' means the amount of any minimum
payment applicable to a home-equity plan for a promotional period if
that payment is less than the amount of any other payments required
under the plan given an assumed balance. The term ``promotional
period'' means a period of time, less than the full term of the loan,
that the promotional rate or payment may be applicable.
As proposed, comment 16(d)-5.i clarifies how the concepts of
promotional rates and promotional payments apply in the context of
advertisements for variable-rate plans. Specifically, the comment
provides that if the advertised annual percentage rate or the
advertised payment is based on the index and margin that will be used
to make rate or payment adjustments over the term of the loan, then
there is no promotional rate or promotional payment. On the other hand,
if the advertised annual percentage rate, or the advertised payment, is
not based on the index and margin that will be used to make rate or
payment adjustments, and a reasonably current application of the index
and margin would result in a higher annual percentage rate or, given an
assumed balance, a higher payment, then there is a promotional rate or
promotional payment.
The revisions generally assume that a single index and margin will
be used to make rate or payment adjustments under the plan. The Board
sought comment on whether and to what extent multiple indexes and
margins are used in home-equity plans and whether additional or
different rules are needed for such products. Commenters stated that
multiple indexes and margins generally are not used within the same
plan, but requested clarification on how the requirements of Sec.
226.16(d)(6) would apply to advertisements that contain information
about rates or
[[Page 44578]]
payments based on an index and margin available under the plan to
certain consumers, such as those with certain credit scores, but where
a different margin may be offered to other consumers. The definitions
of promotional rate and promotional payment refer to the rates or
payments under the advertised plan. If rate adjustments will be based
on only one index and margin for each consumer, the fact that the
advertised rate or payment may not be available to all borrowers does
not make the advertised rate or payment a promotional one. However, an
advertisement for open-end credit may state only those terms that
actually are or will be arranged or offered by the creditor. See 12 CFR
226.16(a).
One banking industry trade group commenter sought an exception from
the definition of promotional rate and promotional payment for initial
rates that are derived by applying the index and margin used to make
rate adjustments under the loan, but calculated in a slightly different
manner than will be used to make later rate adjustments. For example,
an initial rate may be calculated based on the index in effect as of
the closing or lock-in date, rather than another date which will be
used to make other rate adjustments under the plan such as the 15th day
of the month preceding the anniversary of the closing date. The Board
is not adopting an exception from the definition of promotional rate
and promotional payment. However, the Board believes that an initial
rate in the example described above would still be ``based on'' the
index and margin used to make other rate adjustments under the plan and
therefore would not be a promotional rate.
Some industry commenters sought an exclusion from the definition of
promotional rate and promotional payment for plans that apply different
rates or payments to a draw period and to a repayment period. For
example, some plans may provide for interest-only payments during a
draw period and fully-amortizing payments during a repayment period.
Consistent with the requirements for application disclosures under
Sec. 226.5b, the Board is not adopting exceptions for plans with draw
periods and repayment periods. If an advertisement states a promotional
rate or payment offered during a draw period it must provide the
required disclosures about the rates or payments that apply for the
term of the plan. The Board believes that such information will help
consumers understand the full cost of the credit over the term of the
plan.
Commenters also sought to exclude advertisements for plans that
permit the consumer to repay all or part of the balance during the draw
period at a fixed rate, rather than a variable rate, from the
promotional rate and payment requirements. These commenters expressed
concern that they did not know at the advertising stage whether
consumers would choose the fixed-rate conversion option and that
disclosing plans that offer the option as though a consumer had chosen
it could lead to confusion. Regulation Z already requires fixed-rate
conversion options to be disclosed in applications for variable-rate
home-equity plans. See comment 5b(d)(5)(ii)-2. The Board believes that
requiring information about fixed-rate conversion options to be
disclosed in advertisements could confuse consumers about a feature
that is optional. New comment 16(d)-5.v states that the presence of a
fixed-rate conversion option does not, by itself, make a rate (or
payment) a promotional one.
Similarly, some industry commenters also sought an exception from
the definition of promotional rate and payment for plans with
preferred-rate provisions, where the rate will increase upon the
occurrence of some event. For example, the consumer may be given a
preferred rate for electing to make automated payments but that
preferred-rate would end if the consumer later ceases that election.
Regulation Z already requires preferred-rate provisions to be disclosed
in applications for variable-rate home-equity plans. See comment
5b(d)(12)(viii)-1. The Board believes that requiring information about
preferred-rate provisions to be disclosed at the advertising stage is
less likely to be meaningful to consumers who are usually gathering
general rate and payment information about multiple plans and are less
likely to focus on disclosures about preferred-rate terms and
conditions. New comment 16(d)-5.vi states that the presence of a
preferred-rate provision does not, by itself, make a rate (or payment)
a promotional one.
Comment 16(d)-5.iv, renumbered but otherwise adopted as proposed,
clarifies how the concept of promotional payments applies in the
context of advertisements for non-variable-rate plans. Specifically,
the comment provides that if the advertised payment is calculated in
the same way as other payments under the plan based on an assumed
balance, the fact that the minimum payment could increase solely if the
consumer made an additional draw does not make the payment a
promotional payment. For example, if a minimum payment of $500 results
from an assumed $10,000 draw, and the minimum payment would increase to
$1,000 if the consumer made an additional $10,000 draw, the payment is
not a promotional payment.
Section 226.16(d)(6)(ii)--Stating the promotional period and post-
promotional rate or payments. Section 226.16(d)(6)(ii), renumbered and
modified to exclude radio and television advertisements, but otherwise
adopted as proposed, provides that if an advertisement states a
promotional rate or promotional payment, it must also clearly and
conspicuously disclose, with equal prominence and in close proximity to
the promotional rate or payment, the following, as applicable: The
period of time during which the promotional rate or promotional payment
will apply; in the case of a promotional rate, any annual percentage
rate that will apply under the plan; and, in the case of a promotional
payment, the amount and time periods of any payments that will apply
under the plan. In variable-rate transactions, payments that will be
determined based on application of an index and margin to an assumed
balance must be disclosed based on a reasonably current index and
margin.
Proposed comment 16(d)-5.iii provided safe harbors for satisfying
the closely proximate or equally prominent requirements of proposed
Sec. 226.16(d)(6)(iii). Specifically, the required disclosures would
be deemed to be closely proximate to the promotional rate or payment if
they were in the same paragraph as the promotional rate or payment.
Information disclosed in a footnote would not be deemed to be closely
proximate to the promotional rate or payment. Some commenters noted
that the safe harbor definition of ``closely proximate'' in this
comment (that the required disclosures be in the same paragraph as the
promotional rate or payment) differed from the definition of ``closely
proximate'' in comment 16-2 (that the required disclosures be
immediately next to or directly above or below the promotional rate or
payment). The Board is modifying final comment 16(d)-5.ii, as
renumbered, to match the definition of ``closely proximate'' in comment
16-2. However, the Board is retaining the part of the safe harbor that
disallows the use of footnotes. Consumer testing of account-opening and
other disclosures undertaken in conjunction with the Board's open-end
Regulation Z proposal suggests that placing information in a footnote
makes it much less likely that the consumer
[[Page 44579]]
will notice it. As proposed, the required disclosures will be deemed
equally prominent with the promotional rate or payment if they are in
the same type size as the promotional rate or payment.
Comment 16(d)-5.iii clarifies that the requirement to disclose the
amount and time periods of any payments that will apply under the plan
may require the disclosure of several payment amounts, including any
balloon payments. The comment provides an example of a home-equity plan
with several payment amounts over the repayment period to illustrate
the disclosure requirements. The comment has been modified from the
proposal, in response to public comment, to add a clarification that
the final payment need not be disclosed if it is not greater than two
times the amount of any other minimum payments under the plan. Comment
16(d)-6, which is discussed above, provides safe harbor definitions for
the phrase ``reasonably current index and margin.''
Section 226.16(d)(6)(iii)--Envelope excluded. Section
226.16(d)(6)(iii), renumbered but otherwise adopted as proposed,
provides that the requirements of Sec. 226.16(d)(6)(ii) do not apply
to envelopes, or to banner advertisements and pop-up advertisements
that are linked to an electronic application or solicitation provided
electronically. In the Board's view, because banner advertisements and
pop-up advertisements are used to direct consumers to more detailed
advertisements, they are similar to envelopes in the direct mail
context.
Section 226.16(e)--Alternative Disclosures--Television or Radio
Advertisements
The Board is adopting Sec. 226.16(e), as renumbered, to allow for
alternative disclosures of the information required for home-equity
plans under Sec. 226.16(d)(1), where applicable. The supplementary
information to the proposal referred to these as alternative
disclosures for oral advertisements, but the proposed regulation text
did not limit the alternative disclosures to oral advertisements. The
proposed regulation text was consistent with the Board's proposal for
credit cards and other open-end plans. See proposed Sec. 226.16(f) and
72 FR 32948, 33064 (June 14, 2007). The final rule does not limit the
alternative disclosures to oral advertisements. The final rule does,
however, limit Sec. 226.16(e)'s application to advertisements for
home-equity plans and redesignates it from Sec. 226.16(f) to Sec.
226.16(e). These changes are meant to conform the rule to the existing
regulation, but the Board notes that its proposal for open-end plans
that are not home-secured, if adopted, would expand the rule to allow
for alternative disclosures for all advertisements for open-end credit.
In addition, Sec. 226.16(e) permits an advertisement to provide either
a toll-free telephone number or a telephone number that allows a
consumer to reverse the telephone charges when calling for information.
The final rule also adds new commentary clarifying the alternative
disclosure option. This commentary was included in the Board's earlier
proposal for credit cards and other open-end plans, and is
substantively the same as the commentary for alternative disclosures
for advertisements for closed-end credit under Sec. 226.24(g). See 72
FR 32948, 33144 (June 14, 2007), and comments 24(g)-1 and 24(g)-2.
The Board's revision follows the general format of the Board's
earlier proposal for alternative disclosures for television and radio
advertisements. If a triggering term is stated in the advertisement,
one option is to state clearly and conspicuously each of the
disclosures required by Sec. Sec. 226.16(b)(1) and (d)(1). Another
option is for the advertisement to state clearly and conspicuously the
APR applicable to the home-equity plan, and the fact that the rate may
be increased after consummation, and provide a telephone number that
the consumer may call to receive more information. Given the space and
time constraints on television and radio advertisements, the required
disclosures may go unnoticed by consumers or be difficult for them to
retain. Thus, providing an alternative means of disclosure may be more
effective in many cases given the nature of the media.
This approach is also similar to the approach taken in the
advertising rules for consumer leases under Regulation M, which also
allows the use of toll-free numbers in television and radio
advertisements. See 12 CFR 213.7(f)(1)(ii).
B. Advertising Rules for Closed-End Credit--Sec. 226.24
Overview
The Board proposed to amend the closed-end credit advertising rules
in Sec. 226.24 to address advertisements for home-secured loans. The
three most significant aspects of the proposal related to strengthening
the clear and conspicuous standard for advertising disclosures,
regulating the disclosure of rates and payments in advertisements to
ensure that low promotional or ``teaser'' rates or payments are not
given undue emphasis, and prohibiting certain acts or practices in
advertisements as provided under TILA Section 129(l)(2), 15 U.S.C.
1639(l)(2).
The final rule is substantially similar to the proposed rule and
adopts, with some modifications, each of the proposed changes discussed
above. First, the Board is adding a provision setting forth the clear
and conspicuous standard for all closed-end advertisements and a number
of new commentary provisions applicable to advertisements for home-
secured loans. The regulation is being revised to include a clear and
conspicuous standard for advertising disclosures, consistent with the
approach taken in the advertising rules for Regulation M. See 12 CFR
213.7(b). New staff commentary provisions are added to clarify how the
clear and conspicuous standard applies to rates or payments in
advertisements for home-secured loans, and to Internet, television, and
oral advertisements of home-secured loans. The final rule also adds a
provision to allow alternative disclosures for television and radio
advertisements that is modeled after a proposed revision to the
advertising rules for open-end (not home-secured) plans. See 72 FR
32948, 33064 (June 14, 2007).
Second, the Board is amending the regulation and commentary to
address the advertisement of rates and payments for home-secured loans.
The revisions are designed to ensure that advertisements adequately
disclose all rates or payments that will apply over the term of the
loan and the time periods for which those rates or payments will apply.
Many advertisements for home-secured loans emphasize low, promotional
``teaser'' rates or payments that will apply for a limited period of
time. Such advertisements often do not give consumers accurate or
balanced information about the costs or terms of the products offered.
The revisions also prohibit advertisements from disclosing an
interest rate lower than the rate at which interest is accruing.
Instead, the only rates that may be included in advertisements for
home-secured loans are the APR and one or more simple annual rates of
interest. Many advertisements for home-secured loans promote very low
rates that do not appear to be the rates at which interest is accruing.
The advertisement of interest rates lower than the rate at which
interest is accruing is likely confusing for consumers. Taken together,
the Board believes that the changes regarding the disclosure of rates
and payments in advertisements for home-secured loans will enhance the
[[Page 44580]]
accuracy of advertising disclosures and benefit consumers.
Third, pursuant to TILA Section 129(l)(2), 15 U.S.C. 1639(l)(2),
the Board is prohibiting seven specific acts or practices in connection
with advertisements for home-secured loans that the Board finds to be
unfair, deceptive, associated with abusive lending practices, or
otherwise not in the interest of the borrower.
Bankruptcy Act changes. The Board is also making several changes to
clarify certain provisions of the closed-end advertising rules,
including the scope of certain triggering terms, and to implement
provisions of the Bankruptcy Abuse Prevention and Consumer Protection
Act of 2005 requiring disclosure of the tax implications of home-
secured loans. See Public Law 109-8, 119 Stat. 23. Technical and
conforming changes to the closed-end advertising rules are also made.
Public Comment
As discussed above, the Board received numerous, mostly positive,
comments on the proposed revisions. Specific comments requesting
modifications or clarifications to the proposed requirements for
advertisements for closed-end home-secured credit are discussed below
as applicable.
Current Statute and Regulation
TILA Section 144, implemented by the Board in Sec. 226.24, governs
advertisements of credit other than open-end plans. 15 U.S.C. 1664.
TILA Section 144 thus applies to advertisements of closed-end credit,
including advertisements for closed-end credit secured by a dwelling
(also referred to as ``home-secured loans''). The statute applies to
the advertisement itself, and therefore, the statutory and regulatory
requirements apply to any person advertising closed-end credit, whether
or not such person meets the definition of creditor. See comment
2(a)(2)-2. Under the statute, if an advertisement states the rate of a
finance charge, the advertisement must state the rate of that charge as
an APR. In addition, closed-end credit advertisements that contain
certain terms must also include additional disclosures. The specific
terms of closed-end credit that ``trigger'' additional disclosures,
which are commonly known as ``triggering terms,'' are (1) the amount of
the downpayment, if any, (2) the amount of any installment payment, (3)
the dollar amount of any finance charge, and (4) the number of
installments or the period of repayment. If an advertisement for
closed-end credit states a triggering term, then the advertisement must
also state any downpayment, the terms of repayment, and the rate of the
finance charge expressed as an APR. See 12 CFR 226.24(c)-(d) (as
redesignated from Sec. Sec. 226.24(b)-(c)) and the staff commentary
thereunder.
Authority
The Board is exercising the following authorities in promulgating
final rules. TILA Section 105(a) authorizes the Board to adopt
regulations to ensure meaningful disclosure of credit terms so that
consumers will be able to compare available credit terms and avoid the
uninformed use of credit. 15 U.S.C. 1604(a). TILA Section 122
authorizes the Board to require that information, including the
information required under Section 144, be disclosed in a clear and
conspicuous manner. 15 U.S.C. 1632. TILA Section 129(l)(2) authorizes
the Board to prohibit acts or practices in connection with mortgage
loans that the Board finds to be unfair or deceptive. TILA Section
129(l)(2) also authorizes the Board to prohibit acts or practices in
connection with the refinancing of mortgage loans that the Board finds
to be associated with abusive lending practices, or that are otherwise
not in the interest of the borrower. 15 U.S.C. 1639(l)(2).
Section 226.24(b)--Clear and Conspicuous Standard
As proposed, the Board is adding a clear and conspicuous standard
in Sec. 226.24(b) that applies to all closed-end advertising. This
provision supplements, rather than replaces, the clear and conspicuous
standard that applies to all closed-end credit disclosures under
Subpart C of Regulation Z and that requires all disclosures to be in a
reasonably understandable form. See 12 CFR 226.17(a)(1); comment
17(a)(1)-1. The new provision provides a framework for clarifying how
the clear and conspicuous standard applies to advertisements that are
not in writing or in a form that the consumer may keep, or that
emphasize promotional rates or payments.
Existing comment 24-1 explains that advertisements for closed-end
credit are subject to a clear and conspicuous standard based on Sec.
226.17(a)(1). The comment is renumbered as comment 24(b)-1 and revised
to reference the format requirements for advertisements of rates or
payments for home-secured loans. The Board is not prescribing specific
rules regarding the format of advertising disclosures generally.
However, comment 24(b)-2 elaborates on the requirement that certain
disclosures about rates or payments in advertisements for home-secured
loans be prominent and in close proximity to other information about
rates or payments in the advertisement in order to satisfy the clear
and conspicuous standard and the disclosure requirements of Sec.
226.24(f). Terms required to be disclosed in close proximity to other
rate or payment information are deemed to meet this requirement if they
appear immediately next to or directly above or below the trigger
terms, without any intervening text or graphical displays. Terms
required to be disclosed with equal prominence to other rate or payment
information are deemed to meet this requirement if they appear in the
same type size as other rates or payments. The requirements for
disclosing rates or payments are discussed in more detail below.
The equal prominence and close proximity requirements of Sec.
226.24(f) apply to all visual text advertisements except for television
advertisements. However, comment 24(b)-2 states that electronic
advertisements that disclose rates or payments in a manner that
complies with the Board's recently amended rule for electronic
advertisements under Sec. 226.24(e) are deemed to satisfy the clear
and conspicuous standard. See 72 FR 63462 (Nov. 9, 2007). Under the
existing rule for electronic advertisements, if an electronic
advertisement provides the required disclosures in a table or schedule,
any statement of triggering terms elsewhere in the advertisement must
clearly direct the consumer to the location of the table or schedule.
For example, a triggering term in an advertisement on an Internet Web
site may be accompanied by a link that takes the consumer directly to
the additional information. See comment 24(e)-4.
The Board sought comment on whether it should amend the rules for
electronic advertisements for home-secured loans to require that
information about rates or payments that apply for the term of the loan
be stated in close proximity to other rates or payments in a manner
that does not require the consumer to click on a link to access the
information. The Board also solicited comment on the costs and
practical limitations, if any, of imposing this close proximity
requirement on electronic advertisements. The majority of commenters
who addressed this issue urged the Board to adopt comment 24(b)-2 as
proposed. They noted that many electronic advertisements on the
Internet are displayed in small areas, such as in banner advertisements
or
[[Page 44581]]
next to search engine results, and requiring information about the
rates or payments that apply for the term of the loan in close
proximity to all other applicable rates or payments would not be
practical. These commenters also suggested that Internet users are
accustomed to clicking on links in order to find further information.
Commenters also expressed concern about the practicality of requiring
closely proximate disclosures in electronic advertisements that may be
displayed on devices with small screens, such as on Internet-enabled
cellular telephones or personal digital assistants, that might
necessitate scrolling or clicking on links in order to view additional
information.
The Board is adopting comment 24(b)-2 as proposed. The Board agrees
that requiring disclosures of information about rates or payments that
apply for the term of the loan to be in close proximity to information
about all other rates or payments would not be practical for many
electronic advertisements, and that the requirements of Sec. 226.24(e)
adequately ensure that consumers viewing electronic advertisements have
access to important additional information about the terms of the
advertised product.
The Board is also adopting as proposed new comments to interpret
the clear and conspicuous standards for Internet, television, and oral
advertisements of home-secured loans. Comment 24(b)-3 explains that
disclosures in the context of visual text advertisements on the
Internet must not be obscured by techniques such as graphical displays,
shading, coloration, or other devices, and must comply with all other
requirements for clear and conspicuous disclosures under Sec. 226.24.
Comment 24(b)-4 likewise explains that visual text advertisements on
television must not be obscured by techniques such as graphical
displays, shading, coloration, or other devices, must be displayed in a
manner that allows a consumer to read the information required to be
disclosed, and must comply with all other requirements for clear and
conspicuous disclosures under Sec. 226.24. The Board believes,
however, that this rule can be applied with some flexibility to account
for variations in the size of television screens. For example, a lender
would not violate the clear and conspicuous standard if the print size
used was not legible on a handheld or portable television. Comment
24(b)-5 explains that oral advertisements, such as by radio or
television, must provide the disclosures at a speed and volume
sufficient for a consumer to hear and comprehend them. In this context,
the word ``comprehend'' means that the disclosures must be intelligible
to consumers, not that advertisers must ensure that consumers
understand the meaning of the disclosures. Section 226.24(g) provides
an alternative method of disclosure for television or radio
advertisements when triggering terms are stated and is discussed more
fully below.
Section 226.24(c)--Advertisement of Rate of Finance Charge
Disclosure of simple annual rate or periodic rate. If an
advertisement states a rate of finance charge, it must state the rate
as an APR. See 12 CFR 226.24(c) (as redesignated from Sec. 226.24(b)).
An advertisement may also state, in conjunction with and not more
conspicuously than the APR, a simple annual rate or periodic rate that
is applied to an unpaid balance.
As proposed, the Board is renumbering Sec. 226.24(b) as Sec.
226.24(c), and revising it. The revised rule provides that
advertisements for home-secured loans shall not state any rate other
than an APR, except that a simple annual rate that is applied to an
unpaid balance may be stated in conjunction with, but not more
conspicuously than, the APR. Advertisement of a periodic rate, other
than the simple annual rate of interest, or any other rates, is no
longer permitted in connection with home-secured loans.
Also as proposed, comment 24(b)-2 is renumbered as comment 24(c)-2
and revised to clarify that a simple annual rate or periodic rate is
the rate at which interest is accruing. A rate lower than the rate at
which interest is accruing, such as an effective rate, payment rate, or
qualifying rate, is not a simple annual rate or periodic rate. The
example in renumbered comment 24(c)-2 also is revised to reference
Sec. 226.24(f), which contains requirements regarding the disclosure
of rates and payments in advertisements for home-secured loans.
Buydowns. As proposed, comment 24(b)-3, which addresses
``buydowns,'' is renumbered as comment 24(c)-3 and revised. A buydown
is where a seller or creditor offers a reduced interest rate and
reduced payments to a consumer for a limited period of time.
Previously, this comment provided that the seller or creditor, in the
case of a buydown, could advertise the reduced simple interest rate,
the limited term to which the reduced rate applies, and the simple
interest rate applicable to the balance of the term. The advertisement
also could show the effect of the buydown agreement on the payment
schedule for the buydown period. The Board is revising the comment to
explain that additional disclosures are required when an advertisement
includes information showing the effect of the buydown agreement on the
payment schedule. Such advertisements must provide the disclosures
required by Sec. 226.24(d)(2) because showing the effect of the
buydown agreement on the payment schedule is a statement about the
amount of any payment, and thus is a triggering term. See 12 CFR
226.24(d)(1)(iii). In these circumstances, the additional disclosures
are necessary for consumers to understand the costs of the loan and the
terms of repayment. Consistent with these changes, and as proposed, the
examples of statements about buydowns that an advertisement may make
without triggering additional disclosures are being removed.
Effective rates. As proposed, the Board is deleting what was
previously comment 24(b)-4. The comment had allowed the advertisement
of three rates: the APR; the rate at which interest is accruing; and an
interest rate lower than the rate at which interest is accruing, which
may be referred to as an effective rate, payment rate, or qualifying
rate. The staff commentary also contained an example of how to disclose
the three rates.
The Board proposed to delete this staff commentary for the reasons
stated below. First, the disclosure of three rates is unnecessarily
confusing for consumers and the disclosure of an interest rate lower
than the rate at which interest is accruing does not provide meaningful
information to consumers about the cost of credit. Second, when the
effective rates commentary was adopted in 1982, the Board noted that
the commentary was designed ``to address the advertisement of special
financing involving `effective rates,' `payment rates,' or `qualifying
rates.' '' See 47 FR 41338, 41342 (Sept. 20, 1982). At that time, when
interest rates were quite high, these terms were used in connection
with graduated-payment mortgages. Today, however, some advertisers
appear to rely on this comment when advertising rates for a variety of
home-secured loans, such as negative amortization loans and option
ARMs. In these circumstances, the advertisement of rates lower than the
rate at which interest is accruing for these products is not helpful to
consumers, particularly consumers who may not fully understand how
these non-traditional home-secured loans work.
Some industry commenters suggested that the advertisement of rates
lower than the rate at which interest is accruing might provide
meaningful information to some consumers.
[[Page 44582]]
Specifically, some advertisements for negative amortization loans and
option ARMs quote a payment amount that is based on an effective rate.
Commenters suggested that if the corresponding effective rate itself
was not advertised, consumers might be confused about the rate on which
the payment was based. For the reasons stated above, the Board believes
that consumers are likely to be confused by advertisements that state a
rate lower than the rate at which interest is accruing. The Board is
addressing the advertisement of payments for home-secured loans in new
Sec. 226.24(f), discussed below, to require that advertisements
contain information about the payments that apply for the term of the
loan.
Discounted variable-rate transactions. As proposed, comment 24(b)-5
is being renumbered as comment 24(c)-4 and revised to explain that an
advertisement for a discounted variable-rate transaction which
advertises a reduced or discounted simple annual rate must show with
equal prominence and in close proximity to that rate, the limited term
to which the simple annual rate applies and the annual percentage rate
that will apply after the term of the initial rate expires.
The comment is also being revised to explain that additional
disclosures are required when an advertisement includes information
showing the effect of the discount on the payment schedule. Such
advertisements must provide the disclosures required by Sec.
226.24(d)(2). Showing the effect of the discount on the payment
schedule is a statement about the number of payments or the period of
repayment, and thus is a triggering term. See 12 CFR 226.24(d)(1)(ii).
In these circumstances, the additional disclosures are necessary for
consumers to understand the costs of the loan and the terms of
repayment. Consistent with these changes, the examples of statements
about discounted variable-rate transactions that an advertisement may
make without triggering additional disclosures are being removed.
Section 226.24(d)--Advertisement of Terms That Require Additional
Disclosures
Required disclosures. As proposed, the Board is renumbering Sec.
226.24(c) as Sec. 226.24(d) and revising it. The rule clarifies the
meaning of the ``terms of repayment'' required to be disclosed.
Specifically, the terms of repayment must reflect ``the repayment
obligations over the full term of the loan, including any balloon
payment,'' not just the repayment terms that will apply for a limited
period of time. This revision is consistent with other changes and is
designed to ensure that advertisements for closed-end credit,
especially home-secured loans, adequately disclose the terms that will
apply over the full term of the loan, not just for a limited period of
time.
Consistent with these changes, and as proposed, comment 24(c)(2)-2
is renumbered as comment 24(d)(2)-2 and revised. As proposed,
commentary regarding advertisement of loans that have a graduated-
payment feature is being removed from comment 24(d)(2)-2.
The Board did not propose to make substantive changes to commentary
regarding advertisements for home-secured loans where payments may vary
because of the inclusion of mortgage insurance premiums. Under the
existing commentary, the advertisement could state the number and
timing of payments, the amounts of the largest and smallest of those
payments, and the fact that other payments will vary between those
amounts. Some industry commenters noted, however, that advertisers can
only estimate the amounts of mortgage insurance premiums at the
advertising stage, and that the requirement to show the largest and
smallest of the payments that include mortgage insurance premiums may
not be meaningful to consumers because consumers' actual payment
amounts may vary from the advertised payment amounts. For this reason,
the commentary is being revised to no longer require the advertisement
to show the amount of the largest and smallest payments reflecting
mortgage insurance premiums. Rather, the advertisement may state the
number and timing of payments, the fact that the payments do not
include amounts for mortgage insurance premiums, and that the actual
payment obligation will be higher.
In advertisements for home-secured loans with one series of low
monthly payments followed by another series of higher monthly payments,
comment 24(d)(2)-2.iii explains that the advertisement may state the
number and time period of each series of payments and the amounts of
each of those payments. However, the amount of the series of higher
payments must be based on the assumption that the consumer makes the
series of lower payments for the maximum allowable period of time. For
example, if a consumer has the option of making interest-only payments
for two years and an advertisement states the amount of the interest-
only payment, the advertisement must state the amount of the series of
higher payments based on the assumption that the consumer makes the
interest-only payments for the full two years. The Board believes that
without these disclosures consumers may not fully understand the cost
of the loan or the payment terms that may result once the higher
payments take effect.
As proposed, the revisions to renumbered comment 24(d)(2)-2 apply
to all closed-end advertisements. The Board believes that the terms of
repayment for any closed-end credit product should be disclosed for the
full term of the loan, not just for a limited period of time. The Board
also does not believe that this change will significantly impact
advertising practices for closed-end credit products such as auto loans
and installment loans that ordinarily have shorter terms than home-
secured loans.
As proposed, new comment 24(d)(2)-3 is added to address the
disclosure of balloon payments as part of the repayment terms. The
commentary notes that in some transactions, a balloon payment will
occur when the consumer only makes the minimum payments specified in an
advertisement. A balloon payment results if paying the minimum payments
does not fully amortize the outstanding balance by a specified date or
time, usually the end of the term of the loan, and the consumer must
repay the entire outstanding balance at such time. The commentary
explains that if a balloon payment will occur if the consumer only
makes the minimum payments specified in an advertisement, the
advertisement must state with equal prominence and in close proximity
to the minimum payment statement the amount and timing of the balloon
payment that will result if the consumer makes only the minimum
payments for the maximum period of time that the consumer is permitted
to make such minimum payments. The Board believes that disclosure of
the balloon payment in advertisements that promote such minimum
payments is necessary to inform consumers about the repayment terms
that will apply over the full term of the loan.
As proposed, comments 24(c)(2)-3 and -4 are renumbered as comments
24(d)(2)-4 and -5 without substantive change.
Section 226.24(e)--Catalogs or Other Multiple-Page Advertisements;
Electronic Advertisements
The Board is renumbering Sec. 226.24(d) as Sec. 226.24(e) and
making technical changes to reflect the renumbering of certain sections
of the regulation and commentary, as proposed.
[[Page 44583]]
Section 226.24(f)--Disclosure of Rates and Payments in Advertisements
for Credit Secured by a Dwelling
The Board proposed to add a new subsection (f) to Sec. 226.24 to
address the disclosure of rates and payments in advertisements for
home-secured loans. The primary purpose of these provisions is to
ensure that advertisements do not place undue emphasis on low
promotional ``teaser'' rates or payments, but adequately disclose the
rates and payments that the will apply over the term of the loan. The
final rule is adopted as proposed, but adds a number of new commentary
provisions to clarify the rule in response to public comment.
One banking industry trade group commenter sought an exception from
Sec. Sec. 226.24(f)(2) and (f)(3)(i)(A) for variable-rate loans with
initial rates that are derived by applying the index and margin used to
make rate adjustments under the loan, but calculated in a slightly
different manner than will be used to make later rate adjustments. For
example, an initial rate may be calculated based on the index in effect
as of the closing or lock-in date, rather than another date which will
be used to make other rate adjustments under the plan such as the 15th
day of the month preceding the anniversary of the closing date. The
Board is not adopting an exception from Sec. Sec. 226.24(f)(2) and
(f)(3)(i)(A). However, the Board believes that an initial rate in the
example described above would still be ``based on'' the index and
margin used to make other rate adjustments under the plan and therefore
it would not, by itself, trigger the required disclosures in Sec.
226.24(f)(2). Likewise, an advertisement need not disclose a separate
payment amount under Sec. 226.24(f)(3)(i)(A) for payments that are
based on the same index and margin, if even calculated differently.
Commenters also sought to exclude advertisements for variable-rate
loans that permit the consumer to convert the loan into a fixed rate
loan. These commenters expressed concern that creditors do not know at
the advertising stage whether consumers would choose the fixed-rate
conversion option and that disclosing loans that offer the option as
though a consumer had chosen it could lead to confusion. Regulation Z
already requires fixed-rate conversion options be disclosed before
consummation. See comment 19(b)(2)(vii)-3. The Board believes that
requiring information about fixed-rate conversion options be disclosed
in advertisements could confuse consumers about a feature that is
optional. New comment 24(f)-1.i states that the creditor need not
assume that a fixed-rate conversion option, by itself, means that more
than one simple annual rate of interest will apply under Sec.
226.24(f)(2) and the payments that would apply if a consumer opted to
convert the loan to a fixed rate need not be disclosed as separate
payments under Sec. 226.24(f)(3)(i)(A).
Similarly, some industry commenters also sought an exception for
loans with preferred-rate provisions, where the rate will increase upon
the occurrence of some event. For example, the consumer may be given a
preferred rate for electing to make automated payments but that
preferred-rate would end if the consumer later ceases that election.
Regulation Z already requires preferred-rate provisions be disclosed
before consummation. See comment 19(b)(2)(vii)-4. The Board believes
that requiring information about preferred-rate provisions to be
disclosed at the advertising stage is less likely to be meaningful to
consumers who are usually gathering general rate and payment
information about multiple loans and are less likely to focus on
disclosures about preferred-rate terms and conditions. New comment
24(f)-1.ii states that the creditor need not assume a preferred-rate
provision, by itself, means that more than one simple annual rate of
interest will apply under Sec. 226.24(f)(2) and need not disclose as
separate payments under Sec. 226.24(f)(3)(i)(A) the payments that
would result upon the occurrence of the event that causes a rate
increase under the preferred-rate provision.
Also, comment 24(f)-1.iii excludes loan programs that offer a rate
reduction to consumers after the occurrence of a specified event, such
as the consumer making a series of on-time payments. Some industry
commenters suggested, and the Board agrees, that information about
decreases in rates or payments upon the occurrence of a specified event
need not be disclosed with equal prominence and in close proximity to
information about other rates and payments. The advertisement may
disclose only the initial rate or payment and it need not disclose the
effect of the rate reduction feature. Alternatively, the advertisement
may also disclose the effect of the rate reduction feature, but it
would then have to comply with the requirements of Sec. 226.24(f).
Section 226.24(f)(1)--Scope. Section 226.24(f)(1), as proposed,
provides that the new section applies to any advertisement for credit
secured by a dwelling, other than television or radio advertisements,
including promotional materials accompanying applications. The Board
does not believe it is feasible to apply the requirements of this
section, notably the close proximity and prominence requirements, to
oral advertisements. The Board sought comment on whether these or
different standards should be applied to oral advertisements for home-
secured loans but commenters did not address this issue.
Section 226.24(f)(2)--Disclosure of rates. As proposed, Sec.
226.24(f)(2) addresses the disclosure of rates. Under the rule, if an
advertisement for credit secured by a dwelling states a simple annual
rate of interest and more than one simple annual rate of interest will
apply over the term of the advertised loan, the advertisement must
disclose the following information in a clear and conspicuous manner:
(a) Each simple annual rate of interest that will apply. In variable-
rate transactions, a rate determined by an index and margin must be
disclosed based on a reasonably current index and margin; (b) the
period of time during which each simple annual rate of interest will
apply; and (c) the annual percentage rate for the loan. If the rate is
variable, the annual percentage rate must comply with the accuracy
standards in Sec. Sec. 226.17(c) and 226.22.
Comment 24(f)-5, renumbered but otherwise as proposed, specifically
addresses how this requirement applies in the context of advertisements
for variable-rate transactions. For such transactions, if the simple
annual rate that applies at consummation is based on the index and
margin that will be used to make subsequent rate adjustments over the
term of the loan, then there is only one simple annual rate and the
requirements of Sec. 226.24(f)(2) do not apply. If, however, the
simple annual rate that applies at consummation is not based on the
index and margin that will be used to make subsequent rate adjustments
over the term of the loan, then there is more than one simple annual
rate and the requirements of Sec. 226.24(f)(2) apply.
The revisions generally assume that a single index and margin will
be used to make rate or payment adjustments under the loan. The Board
solicited comment on whether and to what extent multiple indexes and
margins are used in home-secured loans and whether additional or
different rules are needed for such products. Commenters stated that
multiple indexes and margins are not used within the same loan, but
requested clarification on how the requirements of Sec. 226.24(f)
apply to advertisements that contain information about rates or
payments based on the index and margin available under the loan to
certain consumers, such as those
[[Page 44584]]
with certain credit scores, but where a different margin may be offered
to other consumers. Section 226.24(f) applies to advertisements for
variable-rate loans if the simple annual rate of interest (or the
payment) that applies at consummation is not based on the index and
margin used to make subsequent rate (or payment) adjustments over the
term of the loan. See comment Sec. Sec. 226.24(f)-5 and 24(f)(3)-2. If
a loan's rate or payment adjustments will be based on only one index
and margin for each consumer, the fact that the advertised rate or
payment may not be available to all consumers does trigger the
requirements of Sec. 226.24(f). However, an advertisement for open-end
credit may state only those terms that actually are or will be arranged
or offered by the creditor. See 12 CFR 226.24(a).
Finally, as proposed, the rule establishes a clear and conspicuous
standard for the disclosure of rates in advertisements for home-secured
loans. Under this standard, the information required to be disclosed by
Sec. 226.24(f)(2) must be disclosed with equal prominence and in close
proximity to any advertised rate that triggered the required
disclosures, except that the annual percentage rate may be disclosed
with greater prominence than the other information.
Proposed comment 24(f)-1 provided safe harbors for compliance with
the equal prominence and close proximity standards. Specifically, the
required disclosures would be deemed to be closely proximate to the
advertised rate or payment if they were in the same paragraph as the
advertised rate or payment. Information disclosed in a footnote would
not be deemed to be closely proximate to the advertised rate or
payment. Some commenters noted that the safe harbor definition of
``closely proximate'' in this comment (that the required disclosures be
in the same paragraph as the advertised rate or payment) differed from
the definition of ``closely proximate'' in comment 24-2 (that the
required disclosures be immediately next to or directly above or below
the advertised rate or payment). The Board is renumbering and modifying
final comment 24(f)-2 to match the definition of ``closely proximate''
in comment 24-2. However, the Board is retaining the part of the safe
harbor that disallows the use of footnotes. Consumer testing of
account-opening and other disclosures undertaken in conjunction with
the Board's open-end Regulation Z proposal suggests that placing
information in a footnote makes it much less likely that the consumer
will notice it. As proposed, the required disclosures will be deemed
equally prominent with the advertised rate or payment if they are in
the same type size as the advertised rate or payment.
Comment 24(f)-3, renumbered but otherwise as proposed, provides a
cross-reference to comment 24(b)-2, which provides further guidance on
the clear and conspicuous standard in this context.
Section 226.24(f)(3)--Disclosure of payments. New Sec.
226.24(f)(3) addresses the disclosure of payments. As under the
proposed rule, if an advertisement for credit secured by a dwelling
states the amount of any payment, the advertisement must disclose the
following information in a clear and conspicuous manner: (a) The amount
of each payment that will apply over the term of the loan, including
any balloon payment. In variable-rate transactions, payments that will
be determined based on application of an index and margin must be
disclosed based on a reasonably current index and margin; (b) the
period of time during which each payment will apply; and (c) in an
advertisement for credit secured by a first lien on a dwelling, the
fact that the payments do not include amounts for taxes and insurance
premiums, if applicable, and that the actual payment obligation will be
greater. These requirements are in addition to the disclosure
requirements of Sec. 226.24(d).
As proposed, comment 24(f)(3)-2 specifically addresses how this
requirement applies in the context of advertisements for variable-rate
transactions. For such transactions, if the payment that applies at
consummation is based on the index and margin that will be used to make
subsequent payment adjustments over the term of the loan, then there is
only one payment that must be disclosed and the requirements of Sec.
226.24(f)(3) do not apply. If, however, the payment that applies at
consummation is not based on the index and margin that will be used to
make subsequent payment adjustments over the term of the loan, then
there is more than one payment that must be disclosed and the
requirements of Sec. 226.24(f)(3) apply.
As discussed above in regard to Sec. 226.24(f)(2), the revisions
in Sec. 226.24(f)(3) generally assume that a single index and margin
will be used to make rate or payment adjustments under the loan. If a
loan's rate or payment adjustments will be based on only one index and
margin for each consumer, the fact that the advertised rate or payment
may not be available to all consumers does trigger the requirements of
Sec. 226.24(f).
The rule adopts the clear and conspicuous standard for the
disclosure of payments in advertisements for home-secured loans as
proposed. Under this standard, the information required to be disclosed
under Sec. 226.24(f)(3) regarding the amounts and time periods of
payments must be disclosed with equal prominence and in close proximity
to any advertised payment that triggered the required disclosures. The
information required to be disclosed under Sec. 226.24(f)(3) regarding
the fact that taxes and insurance premiums are not included in the
payment must be prominently disclosed and in close proximity to the
advertised payments. The Board believes that requiring the disclosure
about taxes and insurance premiums to be equally prominent could
distract consumers from the key payment and time period information. As
noted above, comment 24(f)-2 provides safe harbors for compliance with
the equal prominence and close proximity standards. Comment 24(f)-3
provides a cross-reference to the comment 24(b)-2, which provides
further guidance regarding the application of the clear and conspicuous
standard in this context.
Comment 24(f)-4, renumbered but otherwise as proposed, clarifies
how the rules on disclosures of rates and payments in advertisements
apply to the use of comparisons in advertisements. This commentary
covers both rate and payment comparisons, but in practice, comparisons
in advertisements usually focus on payments.
Comment 24(f)(3)-1, clarifies that the requirement to disclose the
amounts and time periods of all payments that will apply over the term
of the loan may require the disclosure of several payment amounts,
including any balloon payment. The comment provides an illustrative
example. The commentary has been modified from the proposal, in
response to comment, to add a clarification that the final scheduled
payment in a fully amortizing loan need not be disclosed if the final
scheduled payment is not greater than two times the amount of any other
regularly scheduled payment.
Comment 24(f)-6, renumbered but otherwise as proposed, provides
safe harbors for what constitutes a ``reasonably current index and
margin'' as used in Sec. 226.24(f). Under the commentary, the time
period during which an index and margin is considered reasonably
current depends on the medium in which the advertisement was
distributed. For direct mail advertisements, a reasonably current index
and margin is one that
[[Page 44585]]
was in effect within 60 days before mailing. For printed advertisements
made available to the general public and for advertisements in
electronic form, a reasonably current index and margin is one that was
in effect within 30 days before printing, or before the advertisement
was sent to a consumer's e-mail address, or for advertisements made on
an Internet Web site, when viewed by the public.
Section 226.24(f)(4)--Envelope excluded. As proposed, Sec.
226.24(f)(4) provides that the requirements of Sec. Sec. 226.24(f)(2)
and (3) do not apply to envelopes or to banner advertisements and pop-
up advertisements that are linked to an electronic application or
solicitation provided electronically. In the Board's view, banner
advertisements and pop-up advertisements are similar to envelopes in
the direct mail context.
Section 226.24(g)--Alternative Disclosures--Television or Radio
Advertisements
The Board proposed to add a new Sec. 226.24(g) to allow
alternative disclosures to be provided in oral television and radio
advertisements pursuant to its authority under TILA Sec. Sec. 105(a),
122, and 144. The final rule is modified from the proposal in that it
allows alternative disclosures not only for information provided
orally, but also for information provided in visual text in television
advertisements. Some commenters noted a discrepancy between the Board's
proposed Sec. 226.24(g), which would not allow the alternative
disclosures for visual text in television advertisements for closed-end
credit, and proposed Sec. 226.16(f), which would allow the alternative
disclosures for visual text in television advertisements for open-end
credit, and urged the Board to follow the approach found in Sec.
226.16(f). The Board believes that the same reasoning that applies to
allowing alternative disclosures in oral radio and television
advertisements also applies to allowing alternative disclosures for
visual text television advertisements and the final rule is revised
accordingly. With one modification, Sec. 226.24(g) follows the
proposal for allowing alternative disclosures in radio and television
advertisements. One option is to state clearly and conspicuously each
of the disclosures required by Sec. 226.24(d)(2) if a triggering term
is stated in the advertisement. Another option is for the advertisement
to state clearly and conspicuously the APR applicable to the loan, and
the fact that the rate may be increased after consummation, if
applicable. However, instead of disclosing the required information
about the amount or percentage of the downpayment and the terms of
repayment, the advertisement could provide a toll-free telephone
number, or a telephone number that allows a consumer to reverse the
phone charges, that the consumer may call to receive more information.
(The language from proposed comment 24(g)-1, which permitted the use of
a telephone number that allows a consumer to reverse the phone charges,
has been incorporated into the text of Sec. 226.24(g), and proposed
comment 24(g)-1 has been removed.) Given the space and time constraints
on television and radio advertisements, the required disclosures may go
unnoticed by consumers or be difficult for them to retain. Thus,
providing an alternative means of disclosure is more effective in many
cases given the nature of television and radio media.
This approach is consistent with the approach taken in the proposed
revisions to the advertising rules for open-end plans (other than home-
secured plans). See 72 FR 32948, 33064 (June 14, 2007). This approach
is also similar, but not identical, to the approach taken in the
advertising rules under Regulation M. See 12 CFR 213.7(f). Section
213.7(f)(1)(ii) of Regulation M permits a leasing advertisement made
through television or radio to direct the consumer to a written
advertisement in a publication of general circulation in a community
served by the media station. The Board has not proposed this option
because it may not provide sufficient, readily-accessible information
to consumers who are shopping for a home-secured loan and because
advertisers, particularly those advertising on a regional or national
scale, are not likely to use this option.
Section 226.24(h)--Tax Implications
Section 1302 of the Bankruptcy Act amends TILA Section 144(e) to
address advertisements that are disseminated in paper form to the
public or through the Internet, as opposed to by radio or television,
and that relate to an extension of credit secured by a consumer's
principal dwelling that may exceed the fair market value of the
dwelling. Such advertisements must include a statement that the
interest on the portion of the credit extension that is greater than
the fair market value of the dwelling is not tax deductible for Federal
income tax purposes. 15 U.S.C. 1664(e). For such advertisements, the
statute also requires inclusion of a statement that the consumer should
consult a tax adviser for further information on the deductibility of
the interest.
The Bankruptcy Act also requires that disclosures be provided at
the time of application in cases where the extension of credit may
exceed the fair market value of the dwelling. See 15 U.S.C.
1638(a)(15). The Board intends to implement the application disclosure
portion of the Bankruptcy Act during its forthcoming review of closed-
end and HELOC disclosures under TILA. However, the Board requested
comment on the implementation of both the advertising and application
disclosures under this provision of the Bankruptcy Act for open-end
credit in its October 17, 2005, ANPR. 70 FR 60235, 60244 (Oct. 17,
2005). A majority of comments on this issue addressed only the
application disclosure requirement, but some commenters specifically
addressed the advertising disclosure requirement. One industry
commenter suggested that the advertising disclosure requirement apply
only in cases where the advertised product allows for the credit to
exceed the fair market value of the dwelling. Other industry commenters
suggested that the requirement apply only to advertisements for
products that are intended to exceed the fair market value of the
dwelling.
The Board proposed to add Sec. 226.24(h) and comment 24(h)-1 to
implement TILA Section 144(e). The Board's proposal applied the new
requirements to advertisements for home-secured loans where the
advertised extension of credit may, by its terms, exceed the fair
market value of the dwelling. The Board sought comment on whether the
new requirements should instead apply to only advertisements that state
or imply that the creditor provides extensions of credit greater than
the fair market value of the dwelling. Of the few commenters who
addressed this issue, the majority were in favor of the alternative
approach because many home-secured loans may, in some circumstances,
allow for extensions of credit greater than the fair market value of
the dwelling and advertisers would likely include the disclosure in
nearly all advertisements.
The final rule differs from the proposed rule and requires that the
additional tax implication disclosures be given only when an
advertisement states that extensions of credit greater than the fair
market value of the dwelling are available. The rule does not apply to
advertisements that merely imply that extensions of credit greater than
the fair market value of the d