Final Rule Governing Loan Originator Compensation Practices

Background

On August 16, 2010, the Federal Reserve Board ("Board") issued two proposed rules and three final rules governing federal Truth-in-Lending Act ("TILA") requirements for residential mortgage loans. This Client Alert summarizes the Board's final rule that governs loan originator compensation practices.

Previous Client Alerts address three of the Board's issuances, and a later Client Alert will discuss the final issuance.

History and Effective Date of Final Rule

Section 129(1)(2) of TILA authorizes the Board to prohibit acts or practices relating to mortgage loans that it finds to be unfair, deceptive, or designed to evade provisions of the Home Ownership and Equity Act ("HOEPA"). This section also authorizes the Board to prohibit acts or practices relating to refinancings that the Board finds to be associated with abusive lending practices or that otherwise are not in the interests of a borrower. Section 226.36 of Regulation Z currently prohibits acts and practices in connection with credit secured by the consumer's principal dwelling. More specifically, the existing regulation prohibits certain abusive practices relating to the appraisal process and servicing. These restrictions are not affected by the Board's final rule and will remain in place. In 2008, the Board issued a proposed rule that would have prohibited a creditor from paying a mortgage broker any compensation greater than the amount the consumer previously agreed in writing that the broker would receive. The broker and consumer would have had to enter into an agreement that contained certain disclosures. As a result of the comments received and some consumer testing, the Board ultimately withdrew the proposed revisions relating to broker compensation. On August 26, 2009, the Board proposed a sweeping revision to the provisions of Regulation Z that relate to closed-end mortgages. Among other things, the Board proposed to prohibit certain compensation and steering practices relating to loan originators. That proposal provides the framework for the final rule issued on August 16th. The Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act") was enacted on July 21, 2010. Section 1403 of the Dodd-Frank Act, which enacts a new Section 129B of TILA, imposes certain restrictions on loan originator compensation practices and restricts certain steering practices by loan originators. The Board has now decided to amend Section 226.36 of Regulation Z to impose restrictions on loan originator compensation practices and restrict steering by loan originators. This amendment covers some, but not all, of the restrictions required by Section 1403 of the Dodd-Frank Act. The final rule is effective on April 1, 2011. This means that the amendments to Section 226.36 of Regulation Z will apply to loan originator compensation for any transaction relating to an application received by a creditor on or after April 1, 2011. For example, if a loan originator takes an application on December 31, 2010 but does not submit the application to the creditor until April 1, 2011, the amended regulation will apply. See Paragraph 226.36-2 of the Regulation Z Commentary ("Commentary"). Highlights of Final Rule and Analysis

Types of Loans Covered (Paragraph 226.36-1 of the Regulation Z Commentary) Any consumer credit transaction secured by a dwelling. The dwelling need not be the consumer's principal dwelling. In contrast, note that Section 226.36(b) and (c), governing appraisal and servicing practices, continue to apply only to consumer credit transactions secured by principal dwellings. The dwelling may, but need not, be secured by real property. A loan on real property that does not contain a dwelling is not covered, although the Board may revisit this issue at a later time. Both first and subordinate lien loans are covered. Both prime and non-prime loans are covered. The rule applies regardless of the interest rate or the dollar amount of the loan. The substantive provisions added by the amended regulation are found in Section 226.36(d) and (e) of Regulation Z. Open-end home equity lines of credit that are governed by Section 226.5b of Regulation Z ("HELOCs") are exempt from Section 226.36. Loans secured by consumers' interests in certain timeshare plans are exempt from Section 226.36(d) and (e). Section 226.36, including the new subsections, continues to apply to closed-end reverse mortgages. Types of Loan Originators Covered by the New Regulation (Section 226.36(a) of Regulation Z) A "loan originator" is a person who, for or in the expectation of compensation or other monetary gain, arranges, negotiates, or otherwise obtains an extension of consumer credit for another person. This is somewhat similar to the definition of a "mortgage originator" in Section 1401 of the Dodd-Frank Act, which adds a new §103(cc)(3) to TILA. The Dodd-Frank definition is more detailed, and also includes a person who takes a residential mortgage loan application, offers terms on a residential mortgage loan, or represents to the public that he/she/it can or will provide any of the services of a mortgage originator. Section 103(cc)(3) of TILA, as added by Dodd-Frank, contains a limited exemption from "mortgage originator" for a person that provides mortgage financing for the sale of one property in any 36- month period where the loan is fully amortizing, the seller determines in good faith and documents that the buyer has a reasonable ability to repay, has a fixed rate or an adjustable rate that is adjustable after five or more years (and is subject to reasonable annual and lifetime rate caps), and meets other criteria established by the Board. The Board's Supplementary Information confirms that persons providing such seller financing would be creditors, not "loan originators," under Section 226.36. The Board will consider whether other regulatory changes will be necessary to further implement the definition in new §103(cc)(3) to TILA. The term "loan originator" includes both individuals and entities. Third-party mortgage brokers are loan originators. For purposes of Section 226.36, a "mortgage broker" is any loan originator who is not an employee of the creditor. Employees of mortgage brokers who engage in loan originator activities are themselves treated as loan originators and mortgage brokers. Section 226.36(d)'s prohibitions on payments to loan originators (discussed below) apply both to payments made directly to mortgage brokers as well as payments made by a mortgage broker to its own employees who act as loan originators. Employees of a creditor who engage in loan originator activities are loan originators. This means that mortgage loan officers who qualify as loan originators will be covered. In a table-funded loan, the closing lender is a loan originator. Because Regulation Z generally defines the term "creditor" to mean the person to whom the credit obligation is initially payable, the closing lender also will be the creditor in the transaction for all purposes under Regulation Z other than Section 226.36. This means that, in a table-funded transaction, the closing lender is subject to the new restrictions on loan originator compensation and anti-steering and, in addition, is required to provide Regulation Z disclosures and otherwise comply with all of the provisions of Regulation Z that govern creditors. In contrast, if the closing lender closes the loan in its own name and funds the loan from a bona fide warehouse line of credit (or from its own moneys or from deposits held by the creditor), and then promptly sells the loan to a third party following closing, it is the creditor in the transaction under Regulation Z but not a "loan originator" for purposes of Section 226.36. This is similar to the rule under the Real Estate Settlement Procedures Act ("RESPA") and HUD's Regulation X, which do not treat mortgage broker transactions that are table-funded as "secondary market transactions." If a mortgage broker closes a loan in its own name and funds the loan with its own money or from a wholesale line of credit in its name in a bona fide transaction, this should qualify as a secondary market transaction (which generally is exempt from RESPA and Regulation X). See 24 C.F.R. §3500.5(b)(7) and App. B (Q&A #5). Managers and administrative staff who are employed by a creditor or loan originator, but who are not themselves engaged in loan originator activities, and whose compensation is not based on whether any particular loan is originated, are not "loan originators" for purposes of Section 226.36. If a loan servicer modifies an existing loan, and the modification does not constitute a "refinancing" under Section 226.20(a) of Regulation Z, the servicer is not acting as a "loan originator" in that transaction for purposes of Section 226.36. In general, a "refinancing" occurs when an existing closed-end transaction subject to Regulation Z is satisfied and replaced by a new obligation undertaken by the same consumer. (There are five specific situations described in Section 226.20(a) where there will be no refinancing even if the existing obligation is satisfied and replaced.) However, if the rate is increased based on a variable rate feature not previously disclosed, or a variable rate feature is added to the existing obligation, this will be treated as a refinancing, suggesting that the servicer will be treated as a loan originator in those contexts. See Paragraph 226.20(a)-3 of the Commentary. A person who performs only real estate brokerage services is not a loan originator. However, there is a "slippery slope" to watch out for here – if the real estate broker sells a home to a consumer, and assists the consumer by arranging financing in return for compensation, then he/she is a loan originator for purposes of Section 226.36. A consumer will not be a loan originator in his/her own mortgage transaction. The definition of "loan originator" under the Board's...