United States: High Cost Home Mortgage Loans: Proposed Revisions To Federal Reserve Regulation Z Intended To Address Predatory Lending Practices.

The Board of Governors of the Federal Reserve System (the "Federal Reserve") has published proposed amendments¹ to Regulation Z (Truth in Lending)² (the "Regulation") and the related Official Staff Commentary that implement the Home Ownership and Equity Protection Act ("HOEPA"), the federal act governing "high cost" mortgage loans (hereinafter referred to as "High Cost Loans"). The proposed amendments (the "Amendments"), for which comment has been solicited on or prior to March 9, 2001, would impose additional constraints and requirements on loan originators in connection with the origination of High Cost Loans.

This Memorandum summarizes these additional constraints, as well as the amendment to the provisions regarding assignee liability.

• Assignee Liability. Regulation Z currently extends to purchasers and other assignees of High Cost Loans all claims and defenses with respect to a mortgage that the consumer could assert against the creditor. The Official Staff Commentary to the Amendments seeks to clarify the interplay between the holder-in-due-course defenses to liability and the assignee liability provisions under HOEPA by stating that holder–in-due-course protections generally afforded under the Consumer Credit Protection Act do not apply to assignees of High Cost Loans; therefore, any defense to liability of an assignee based upon it being a holder-in-due course without any actual knowledge of the violation under HOEPA is presumed under the Amendments, to be unavailable. In essence, the Federal Reserve's Official Staff Commentary to the Amendments reflects the intention that a "strict liability" standard apply for assignees of High Cost Loans with virtually no defenses on the part of an assignee (other than the inability to determine on the face of the disclosure statement that the loan was a High Cost Loan).

• Extension of HOEPA's Applicability. HOEPA's protection applies to a class of closed-end high-cost mortgage loans identified through rate and fee triggers. The proposed Amendments would expand the definition of mortgage loans subject to HOEPA's protections (referred to herein as High Cost Loans). HOEPA currently defines a High Cost Loan as a loan in which the annual percentage rate ("APR") exceeds the yield on US Treasury securities with a comparable period of maturity by more than 10 percentage points. Under the Amendments, the threshold for a High Cost Loan would be reduced to 8 percentage points in excess of the yield on US Treasury securities with a comparable period of maturity. HOEPA also defines High Cost Loans as those for which the total non-discount points and fees payable at or before loan closing exceed the greater of 8 percent of the loan amount and an amount that adjusts yearly ($451 for 2000 or $465 for 2001). The Amendments would include in the points and fees test the cost of premiums or other charges paid at or before closing for credit life, accident, health, or loss-of-income insurance, debt-cancellation coverage (whether or not debt-cancellation coverage is insurance under applicable law), or similar products, regardless of whether any of the foregoing items are optional. Lump sum premiums or the initial charge for premiums paid periodically will be included in the "points and fees" tests only if assessed before or at closing, but regardless of whether paid in cash or financed.

In addition to extending HOEPA's provisions to more mortgage loans, the Amendments would prohibit the following practices and provisions in connection with the origination of High Cost Loans:

• Refinancing of High-Cost Loans. The Amendments would attempt to curb the practice of "loan flipping" or frequently refinancing home-secured loans to generate additional fee income for the creditor. To that end, under the Amendments, a creditor or assignee (or an affiliate of either) would not be permitted to refinance a High Cost Loan within the first twelve months after origination unless the refinancing was "in the borrower's interest." The Federal Reserve has not proposed a clear-cut definition of "the borrower's interest", but the Official Staff Commentary states that the determination of whether a benefit to the borrower exists would be based upon a totality of circumstances, including the amount of new funds advanced compared to the total loan charges on the refinancing. The Amendments also contain provisions intended to prevent creditors from evading this rule, such as prohibiting a creditor from refinancing its own High Cost Loans with an unaffiliated creditor, or by modifying the existing loan agreement or note in a manner which does not result in a benefit to the borrower and charging a fee without making a new loan. The Amendments would not prevent consumers from seeking refinancing of High Cost Loans from another lender.

• Refinancing of Low-Rate Loans. Under the Amendments, Creditors would not be permitted to replace zero-interest rate or other low-cost loans (typically offered through mortgage assistance programs), with higher-rate loans for the first five years of the low cost loans, unless the creditor could demonstrate that the refinancing is in the "interest of the borrower." For a fixed rate transaction, a low-cost loan would be defined as one that carries an interest rate of at least two percentage points below the yield on US Treasury securities with a comparable maturity. For variable-rate transactions, a low-cost loan would be defined as one that has an interest rate at least two percentage points below the index or formula used by the creditor for making rate adjustments.

• "Spurious" Open-end Credit. Because HOEPA's restrictions only apply to closed-end mortgage loans, the Amendments would make it difficult for a creditor to avoid application of HOEPA by structuring what otherwise would be a closed-ended extension of credit as an open-ended extension of credit. The Amendments would prohibit a creditor from structuring a mortgage loan as an open-end line of credit, unless there were a reasonable expectation that the consumer will engage in repeat transactions under a reusable line of credit.

• Payable on Demand Clauses or Call Provisions: Under the Amendments, no High Cost Loan could include a provision that permits the lender to unilaterally accelerate the indebtedness, other than as a result of a default, fraud, or any action or inaction by the consumer which adversely affects the creditor's security.

The Amendments also set forth additional requirements to which loan originators would be required to adhere prior to closing High Cost Loans, as described below.

• Documentation of Consumers' Repayment Ability. Under HOEPA, a lender may not make a High Cost Loan without due regard for the borrower's ability to repay such loan. To that end, the Amendments would require a lender to verify and document indicators of a consumer's ability to repay the High Cost Loan. A lender would be required to document the borrower's current or expected income, current obligations, and employment (or in the case of self-employed borrowers, other factors such as tax returns that indicate that the borrower has a source of income). Creditors who failed to document verification of a borrower's ability to repay would be presumed to be engaging in an illegal pattern of asset-based lending in violation of HOEPA.

• Disclosures. HOEPA regulations currently require creditors to provide certain disclosures to consumers three days prior the loan closing. Creditors must inform consumers that they are not obligated to consummate the transaction, and that the consumer could lose his or her home if there is a failure to repay the loan. HOEPA also requires certain "material disclosures" such as the APR and the monthly payment, which material disclosures, if not made, extend the consumer's right of rescission (with respect to loans which carry a rescission right) until such time that the material disclosures are made. The Amendments would require an additional material disclosure of any balloon payment required under the note, and the face amount of the note. The stated purpose of this additional disclosure is to alert consumers that the total amount borrowed may be substantially higher than requested, due to the financing of points, fees, and insurance.

• Home Improvement Contracts. The Official Staff Commentary to the Amendments clarifies that if the lender pays a contractor with an instrument jointly payable to the contractor and the consumer (as one of the payment options currently required under HOEPA when a contractor is involved with respect to a home improvement loan), the instrument must name as payee (along with the contractor) each consumer who is primarily obligated on the note.

As noted, the Federal Reserve has requested comments on the proposed Amendments by no later than March 9, 2001.

See Clients and Friends Memo from Cadwalader, Wickersham & Taft dated December 29, 2000 for a complete discussion of the Proposed Amendments to Regulation Z.

Comparison of Regulation Z and Proposed Amendments

165 F.R. 81438, December 26, 2000.

212 C.F.R. Part 226.