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Predatory Lending: FRB Issues Final Rules Under HOEPA

It's official. The Federal Reserve plans to stop predatory lending by making the disclosures for high-cost mortgages more complex. The Board decided to amend Regulation Z by extending the HOEPA protections (disclosures) to more loans. This is accomplished by lowering the triggers for high-cost loan disclosures.

The Board also took steps to prohibit specific acts or practices that are considered predatory, including loan flipping, certain demand features, and requiring enhanced documentation. The changes will take final effect on October 1, 2002.

Predatory Lending Defined
For the first time, we have an official explanation of predatory lending. The FRB's issuance does not specifically define predatory lending, but does give some clear explanations of the areas of concern. The term is used to identify "abusive lending practices involving fraud, deception, or unfairness."

The difficulty in producing a hard and fast definition of predatory lending is that loan terms that are predatory in some situations may be appropriate in others. The FRB concludes that predatory lending is best regulated by disclosures to protect and inform borrowers rather than restrict specific lending terms.

Lending that is predatory can include practices such as making loans based on the borrower's equity that the borrower cannot afford to repay; inducing the borrower to refinance repeatedly, triggering extra points and fees; and engaging in fraud or deception to conceal the true nature or cost of the loan from the borrower. Each of these practices is designed to take advantage of less sophisticated customers and provide substantial profits to the lender.

HOEPA Triggers
The extra disclosures, including the disclosures provided three days before closing, are triggered by an APR measurement and a finance charge measurement. The final rule makes slight changes to both requirements.

The APR trigger, which has been 10 percentage points above Treasury securities with a comparable maturity, is reduced to 8 percentage points for first liens only. Subordinate liens will continue to use the 10 percentage point measurement.

The current dollar trigger for points and fees is 8 percent of the total loan amount or $465, whichever is greater. The $465 trigger will move up to $480 beginning in 2002. Fees for this calculation include more than the fees included in the finance charge calculation, but there are some settlement costs that are not included in the HOEPA calculation.

The leading concern raised by consumers was sales practices relating to credit insurance. Referred to as "insurance packing" the practices of automatically including "voluntary" insurance in the loan and financing the single premium deceives the consumer into purchasing insurance that benefits only the lender and also adds to the amount financed. This would be remedied by requiring the disclosure to state whether optional credit insurance is included in the amount financed.

Amount Borrowed
This rule includes a new term and a new disclosures: amount borrowed. This is different from the amount financed. The amount borrowed is the face amount of the note. The purpose of this disclosure is to flag for the borrower the note amount so that the customer will be aware of added costs that are financed.

The typical situation that the amount borrowed would reveal is that additional costs such as points and fees or pre-paid credit insurance had been added to the amount that the consumer is actually borrowing. And yes, it does amount to an admission that the amount financed and the APR don't get the point across to an unsophisticated borrower. This additional disclosure is placed to make sure the consumer understands that this is an expensive loan.

There is also a tolerance for the HOEPA disclosure. Much like the redisclosure requirement for mortgage loans, the creditor will have to redisclose if there has been a change in terms that makes the 3-days-before-closing disclosures off by more than $100.

Unfair Practices
The HOEPA rules are fundamentally rules designed to restrict or prohibit unfair and deceptive trade practices. Much of the Board's explanatory material specifically discusses unfair practices. The rule includes prohibitions of some classic unfair trade practices such as loan flipping and cutting off consumer claims and defenses.

Consumer claims and defenses are preserved by the new rule, not only against the creditor but also against purchasers and assignees of the note. This includes all claims, not merely violations of Truth in Lending.

The new rule deals with the practice of loan flipping by prohibiting lenders from refinancing any HOEPA loan with another HOEPA loan. Flipping induces the customer to pay a new set of fees in connection with the new loan. In effect, flipping contributes to the lender's bottom line at the expense of the consumer and without any true benefit to the consumer.

The final rule also protects HOEPA loans from demand and acceleration clauses unless the clause is exercised in connection with the consumer's default. A practice that can cause considerable consumer harm is calling the loan early in the loan's term, and forcing the consumer to refinance. The refinancing triggers fees that the consumer need not have paid if the loan had been allowed to stand. This rule is similar to the demand restrictions contained in the rules governing home equity lines of credit.The rule prohibits documenting closed-end loans as open-end loans to evade the HOEPA disclosures. The key measurement will be the reasonable expectation of repeated transactions. Absent that, the open-end loan will be considered an evasion of the HOEPA disclosures.

In the spirit of documentation, creditors must be able to provide documentation proof that the lender verified and documented the consumer's repayment ability. If this doesn't convince lenders to document their decisions, nothing will. The new rule shifts the burden of proof to lenders to show that they did in fact underwrite the loan properly. Documentation should show how the lender verified income and what income the lender actually considered. If a loan is made without supporting income to pay the loan, the loan would be considered predatory.

Ultimate cost to the consumer is a key factor in identifying lending as predatory. Some creditors respond to applications for debt consolidation by wrapping all debts, including the first mortgage, into a new first mortgage. The result is a single debt for the consumer but, because points and fees are calculated on the loan amount, much higher costs for the loan.

Similarly, the final rule includes a test for whether the refinancing is in the consumer's interest. As with the standard for waiver or rescission, the borrower should have a bona fide personal financial emergency. Although the test is non-specific, the rule clearly contains the concept that the lender has responsibility to consider the best interests of the consumer, not merely the creditor's bottom line.

ACTION STEPS

  • Review a sample of refinanced mortgage loans using the new HOEPA triggers to identify the impact of the new rule on your institution.
  • Review the same loan files to identify the practices and results with regard to the sale of credit insurance.
  • Brief your consumer and mortgage lenders on the new rule. Highlight the types of loan transactions that could fall subject to this rule.
  • Work with selected lending staff to establish standards for documentation of loan underwriting, particularly income considered and verified.
  • Schedule training on predatory lending and the new HOEPA disclosures so that everyone is ready by October 1, 2002.
  • Hold training or discussions on unfair and deceptive trade practices, including those identified in the new HOEPA rule.
  • Establish a protocol for considering each new product or product change in the context of fairness to the customer.

Copyright © 2002 Compliance Action. Originally appeared in Compliance Action, Vol. 6, No. 16, 1/02

First published on 01/01/2002

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