Placing Hopes on HOEPA

Editor's Note: This article provides a perspective on changes, which were at the time in the proposal stage, to HOEPA's triggers. You can read about the actual changes the Federal Reserve recently made, which carry a mandatory compliance date of 10/1/2002, by reading the FRB press release or the final amended rule.

This latest proposal in the war on predatory lending is founded in the testimony compiled earlier this year in hearings on the subject and in requests from other agencies, including HUD and Treasury, to take some action.

Taken in the context of all the ideas put forward in the hearings, the actual proposals are moderate. The FRB is proposing a rule that has been crafted to draw a balance between the needs of predatory lending victims and the burden a rule could impose on legitimate lenders.

This proposal contains several approaches. First, the proposal would revise the triggers for high cost mortgage disclosures by lowering the APR trigger and adding charges to the finance cost trigger. Second, the rule would identify several practices as unfair and prohibit them. Finally, the rule would establish the principle that loans subject to HOEPA must be documented to prove that the lender evaluated the borrower's ability to repay before making the loan.

The concerns
The concerns about predatory lending are very real. Victims of predatory lending are the marginal home owners - those individuals or families who are just barely able to manage home ownership and are most in need of cash. This delicate balance makes them the ideal victim for an offer of cash out for "great" refinancing terms. The problem is that the "great" usually refers to how high the cost is, not how good the terms are.

The FRB and OTS have analyzed HMDA reports by sub-prime lenders to show that sub-prime lending has increased about six times in the last several years. In addition to this hard number analysis, the anecdotal evidence is growing.

Certain practices have been identified as problems, including the sale of single payment credit life insurance, loan-flipping practices, excessive prepayment penalties, and lender-paid broker compensation.

Lowering HOEPA's Triggers
The first component of the proposal would lower HOEPA's triggers for the APR from 10 percentage points to 8 percentage points above treasury securities with a comparable maturity. At current rates, this would bring in loans with APRs of approximately 14% rather than the existing trigger of approximately 16%. The FRB estimates that this would increase HOEPA's coverage from approximately 1% to 5% of sub-prime loans.

The finance charge trigger will be $465 in 2001. The definition of finance charges for purposes of HOEPA currently includes most finance charge fees except for interest. The proposal would include the cost of optional (mandatory insurance is already included) credit life, debt-cancellation or similar types of insurance. These fees are often financed, resulting in a larger principal loan amount than the borrower anticipated.

This trigger establishes coverage. Any loan that meets the trigger would be a high cost loan for purposes of Regulation Z and would be subject to all of the HOEPA protections and remedies, including the rule prohibiting unaffordable lending. The strict liability rule holds purchasers and assignees liable as well as the loans' originators.

Prohibiting unfair practices
HOEPA gives the Board fairly broad authority to prohibit practices that may be unfair or abusive. Based on testimony at the hearings, the FRB identifies loan flipping as the "most flagrant of lending abuses." The proposal would prohibit flipping loans subject to HOEPA. Board staff concluded that a prohibition against flipping loans whether or not subject to HOEPA would be overly broad.

In the area of fees, the Board was urged by some groups to place caps on fees. The Board staff rejected this idea because it could limit consumer choices in legitimate transactions. Moreover, the Board questioned whether it had authority to place such a cap.

Instead, the proposal uses a subjective test. Refinancing would only be permissible if it is to the benefit of the borrower. This applies a subjective test. Because of concerns about how subjectivity could be measured in court, the FRB proposes to limit the benefits test for a period of twelve months. Another abusive practice described in the hearings was the refinancing of 0% interest or reduced interest rate loans. Borrowers were persuaded to refinance these loans at predatory rates by the inducement of cash-out based on the owner's equity. The proposal would prohibit the refinancing of these loans with a higher cost loan for a period of five years. The proposal includes a definition of low-cost loans that is based on the yield of Treasury securities with a comparable maturity.

The proposal would also prohibit demand clauses and structuring a transaction as open-end to evade the prohibitions and disclosures of HOEPA.

On demand clauses are merely a substitute for balloon notes and may pose more risk for consumers because the loan could be called at any time rather than having a specific due date. The proposal would prohibit demand clauses in loans subject to HOEPA.

Documentation of Ability to Repay
The real damage in predatory lending is the extension of loans to individuals who are unable to repay the loan. The proposal would require creditors to document and verify the consumer's income and other information relevant to the consumer's ability to repay the loan. This, together with the written application, would provide a useful investigation and enforcement tool for fair lending as well as for predatory lending.

Documentation of the consumer's income and ability to repay also effectively requires the creditor to pay attention to this and eliminates the creditor's ability to claim ignorance. In addition, failure to document the consumer's ability to repay would generate a presumption that the creditor has violated the rule.

Additional Disclosures
In lieu of required counseling, the proposal would call for an additional disclosure. Creditors making a HOEPA loan would be required to disclose the face amount of the note in addition to the existing disclosures. This would illustrate for consumers the added costs of financing points and fees, items that low-income borrowers are usually unable to pay at closing.

ACTION STEPS

• Review your balloon loan portfolio and determine whether any of these loans would be high cost mortgages under the proposed new definitions. Consider the impact of the proposed rule on your bank's lending practices and your customers.
• Review your portfolio of refinancings. Study the fees charged and consider them in the context of the loan amount and total costs. Consider whether your bank's refinancing practices are fair and non-predatory.
• Review documentation in loan files of the borrower's income and resources and the evaluation of the borrower's ability to repay. Would these changes have any impact on your bank?
• In light of what you have found in your bank, consider whether the proposed rule would change your bank's practices or impose any new regulatory burdens. Also consider whether the proposal would make a difference to the victims of predatory lending. Then write a comment letter and share the information you have.