Promontory Sightlines

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Promontory Sightlines: Consumer Financial Protection Developments

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November 12, 2013

Dear Clients and Friends,

The prudential banking regulators and the Consumer Financial Protection Bureau recently addressed a thorny issue in the Dodd-Frank Act: the fair-lending implications of the law’s ability-to-repay mortgage requirements. Residential mortgage lenders must decide whether they will offer only those products that meet the definition of a qualified mortgage (QM) or also offer products that do not fit that definition (non-QM). The regulators’ recent interagency statement provides a good deal of clarity about the fair-lending implications of making only QM loans, but holds few, if any, assurances about the fair-lending implications of underwriting non-QM loans to satisfy the CFPB’s ability-to-repay (ATR) rule.

Regulators said that, “absent other factors,” a lender that chose to offer only QMs would not increase the risk of noncompliance with the fair-lending provisions of the Equal Credit Opportunity Act and the Fair Housing Act. They reasoned that such a decision would not be much different than past decisions by some lenders to stop offering high-cost and higher-priced mortgages in response to heightened regulatory requirements. That business rationale has not been challenged on disparate-impact grounds, even though the decisions predictably reduced lending to some protected classes.

Mortgage lenders planning to offer only QMs must still take into consideration how they apply QM requirements when offering products to members of protected classes. That means the usual steps to monitor and mitigate fair-lending risk — including complaint management, risk assessment, testing, and corrective-action protocols — are as relevant as ever in implementing all of Dodd-Frank’s mortgage rules.

But lenders that intend to offer non-QM/ATR loans are left with a good deal of uncertainty about the fair-lending risks they face. The rules make clear that, for a non-QM loan to satisfy the ability-to-repay standard, underwriting standards must be empirically derived, demonstrably and statistically sound, and produce loans with low default rates even under adverse economic conditions. In other words, a lender’s ATR underwriting standards must be conservative.

Given the risk-aversion at the core of this regulatory framework, underwriting standards for non-QM/ATR loans will likely favor affluent borrowers. That runs counter to fair-lending disparate-impact theory, which has been used to challenge underwriting standards that favor affluent borrowers based on the way they affect minority borrowers.

The result is palpable tension between the regulatory mandate to use conservative underwriting standards for non-QM/ATR loans, while at the same time steering clear of disparate-impact risks.

Further complicating this task are the strategic decisions by lenders to offer non-QM/ATR loans with product features and underwriting benchmarks that regulators generally consider too risky for most borrowers — and that naturally carry greater legal and regulatory risk except, perhaps, when applied to a narrow population of affluent borrowers. The Dodd-Frank Act specifically excluded many of these features — balloon, interest-only or payment option — from QM treatment. Non-QM/ATR loans can be made to borrowers with debt-to-income ratios greater than the 43% threshold for QMs if justified by compensating factors, including unpredictable income streams and high net worth. This combination of risks suggests that non-QM/ATR lending initially will be offered to affluent borrowers.

The CFPB implicitly acknowledged this outcome in its rulemaking. Its supplementary information provided two examples where non-QM loans might prudently be made: where the borrower’s earning potential or total assets justify a higher debt burden and where the borrower has a demonstrated ability to pay housing expenses at or above the level of the contemplated mortgage. Neither scenario has obvious application to low- or moderate-income borrowers, but following these examples and limiting non-QM lending to affluent borrowers raises the prospect of a disparate impact challenge.

The Department of Justice pursued a disparate-impact challenge against a lender that only made loans with a principal value of at least $400,000. A minimum loan amount can be a blunt tool to favor affluent borrowers, and is an easy target for a disparate-impact case because it is difficult to identify a legitimate business justification for this practice.

More subtle factors that favor affluent borrowers are likely to be incorporated into non-QM/ATR underwriting standards, but the doctrine of disparate impact is designed to ferret out facially neutral forms of discrimination. Because the interagency statement provides no actionable guidance about how to meet expectations regarding evaluating consumers’ ability to repay non-QM loans while avoiding fair-lending risks, lenders must be prepared to explain how underwriting standards that potentially favor affluent borrowers nonetheless serve legitimate, nondiscriminatory business needs better than other standards.

Lenders planning to make non-QM/ATR loans can best mitigate fair-lending risks through underwriting standards that are relatively easy to justify as serving legitimate business needs. Doing so has become more urgent as the January 2014 implementation date for the new requirements draws close, and developing appropriate practices will remain a pressing concern as mortgage lenders iron out their business models going forward. Lenders offering non-QM/ATR loans should:

  • Implement underwriting standards that are:
    • Empirically derived, and based on demonstrably and statistically sound models
    • Designed to determine repayment ability, rather than to serve merely as proxies for affluence
    • Proven to result in comparatively low delinquency and default rates during adverse economic conditions
  • Consistently apply standards with few, if any, exceptions
  • Develop reasonable criteria for determining whether the borrower’s residual income or assets are sufficient to meet living expenses
  • Document the basis for all underwriting standards
  • Test and revalidate all underwriting standards periodically

Lenders are understandably approaching non-QM/ATR lending with caution. But the associated fair-lending risks can be mitigated through a thoughtful and informed approach to designing and implementing new underwriting standards.

Yours truly,

David Stein
Director
dstein@promontory.com
+1 202 384 1183

David Stein
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CFPD Settlement on Mortgage Steering

On Nov. 7 the CFPB announced a proposed consent order against Utah-based Castle & Cooke Mortgage for allegedly illegally steering consumers into costlier mortgages. The bureau’s complaint also alleged that the company paid bonuses to loan officers based on the interest rates offered to borrowers, in violation of the Federal Reserve Board’s loan-originator compensation rule. The consent order provides more than $9 million in restitution to consumers and assesses $4 million in civil money penalties.

CFPB Takes First Steps toward Debt-Collection Rules

The CFPB on Nov. 6 announced an advance notice of proposed rulemaking to begin collecting data “about the debt collection system, about consumer experiences with the debt collection system, and about how rules for debt collectors might protect consumers without imposing unnecessary burdens on industry.” In a press call, CFPB Director Richard Cordray outlined the three key areas in which the bureau is seeking public input: how rulemaking can help ensure that collectors are recovering the right amounts from the right people; how new rules can best help consumers understand their obligations and rights; and how rules can better regulate the “communication tactics and communication channels used in the industry.” The press release also mentioned that the bureau added about 5,000 consumer debt-collection complaints to its public consumer complaint database. “Currently, debt collection is on par with mortgages in terms of daily complaint volume, with both accounting for approximately 30 percent of consumer grievances,” the bureau said.

CFPB Accepting Payday-Loan Complaints; FTC Stops Alleged Payday-Loan Collector

The CFPB announced Nov. 6 that it has begun accepting complaints from consumers who are experiencing problems with payday loans. “Before the consumer bureau, consumers who had trouble with payday lending products had few places to turn,” said Director Cordray. “By accepting consumer complaints about payday loans, we will be giving people a greater voice in this market.”

The Federal Trade Commission announced on Oct. 24 that a U.S. District Court “halted an operation based in Atlanta and Cleveland that allegedly used deceptive and threatening tactics to collect phantom payday loan ‘debts’ that consumers either did not owe, or did not owe to the defendants.” The complaint charges the defendants (operating under a host of fictitious business names) with violations of the FTC Act and the Fair Debt Collection Practices Act.

Lawmakers Request Information on Auto-Lending Bulletin

A bipartisan group of 22 senators led by Sens. Rob Portman (R-OH) and Jeanne Shaheen (D-NH) urged the CFPB in an Oct. 30 letter to provide more transparency into the bureau’s determinations of disparate impact in auto-lending portfolios, and other explanations related to the analysis behind the bureau’s issuance of fair-lending guidance in March. “Despite promising to be a data-driven agency, the CFPB has yet to provide full information about its recent policy guidance, which may place an unnecessary burden on our nation’s auto dealers and could raise consumer costs,” said Portman in a press release. “While I support the CFPB’s goal to ensure that consumers are not subject to unlawful discrimination, I am concerned about the Bureau’s lack of transparency and unwillingness to make public the basis for its policy decisions, especially those that could negatively impact competition and consumers.” Separately, the CFPB announced an upcoming auto-finance forum at bureau headquarters in Washington, D.C., on Nov. 14.

Cordray Speeches Promote Bureau’s Approach to Mortgage Rules and Implementation

CFPB Director Richard Cordray delivered a speech on new mortgage regulations at the Mortgage Bankers Association’s annual convention on Oct. 28. “Our oversight of the new mortgage rules in the early months will be sensitive to the progress made by those lenders and servicers who have been squarely focused on making good-faith efforts to come into substantial compliance on time — a point that we have also been discussing with our fellow regulators,” he said.

Cordray in an Oct. 21 speech at the American Bankers Association’s annual convention touted the bureau’s approach to rulemaking and implementation: “It would have been a classic governmental approach for us to say, once the mortgage rules were published, ‘Well, that’s your problem now,’” he said. “We could have left you entirely on your own. Instead, we have chosen to handle things very differently … we have made it a point to engage directly and intensively with financial institutions on a project that we call regulatory implementation.”

CFPB Sues Borders & Borders for Alleged Kickbacks

On Oct. 24, the CFPB announced a suit against Kentucky law firm Borders & Borders for allegedly paying illegal kickbacks on real estate settlement referrals. “RESPA prohibits giving and receiving kickbacks for referrals of settlement service business involving federally related mortgages,” said the bureau’s press release. “When companies pay kickbacks in exchange for referrals, it can hurt competition and inflate real estate settlement costs for consumers, while creating an uneven playing field that puts law-abiding businesses at a disadvantage.” The CFPB’s full complaint is here

Consumer Groups Ask Regulators to Crack Down on Processors

Nearly 30 consumer groups, including the Consumer Federation of America, National Consumer Law Center, and Center for Responsible Lending, sent an Oct. 24 letter asking the Federal Reserve, CFPB, Office of the Comptroller of the Currency, Federal Deposit Insurance Corp., Justice Department, National Credit Union Administration, and FTC to crack down on banks that — intentionally or unintentionally — process payments for illegal transactions, including illegal online payday loans and Internet and telemarketing scams. “Regulatory scrutiny of those who process payments for higher-risk merchants is necessary, not only to address the direct harm imposed upon consumers by the illegal transaction, but also to reduce the legal and reputational risks to insured depository financial institutions, consistent with longstanding supervisory expectations,” the groups wrote.

CFPB Publishes Exam Procedures for Institutions Offering Remittances

On Oct. 22 the CFPB announced that it has published the procedures it will use in examining institutions that make remittance transfers for consumers. The bureau’s press release highlighted three areas in particular for which examiners will ensure that remittance-transfer providers are complying with federal laws: providing required disclosures, following proper error-resolution procedures, and offering refund and cancellation rights to consumers. The examination procedures are available here. Separately, on Oct. 28 the CFPB launched an educational campaign to inform consumers about new remittance-transfer protections, including the right to cancel most transfers within 30 minutes at no cost and a 180-day window to report errors to the money-transfer company.

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Promontory's Consumer Protection Team includes:

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Konrad Alt

Konrad Alt
Managing Director
kalt@promontory.com
+1 415 986 4160

Michael Dawson

Michael Dawson
Managing Director
mdawson@promontory.com
+1 202 384 1080

Linda Gallagher

Linda Gallagher
Managing Director and Global Head
of the Consumer Protection Practice

lgallagher@promontory.com
+1 202 370 0411

Stuart King

Stuart King
Managing Director
sking@promontory.com
+44 207 997 3402

Simon McDougall

Simon McDougall
Managing Director
smcdougall@promontory.com
+44 207 377 2367

BJ Sanford

BJ Sanford
Managing Director
bsanford@promontory.com
+1 202 384 1020

Julie Williams Julie Williams
Managing Director and
Director of Domestic Advisory Practice

juwilliams@promontory.com
+1 202 384 1087
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Promontory Sightlines Consumer Financial Protection Developments

 
EDITOR IN CHIEF

P-R Stark

GLOBAL HEAD OF THE
CONSUMER PROTECTION PRACTICE

Linda Gallagher

FOUNDER AND CEO
Eugene A. Ludwig

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