The following article is reprinted from Basis Points® , Vol. 1, Issue 2, Copyright © 2002, with the permission of CounselorLibrary.com, LLC. All Rights Reserved. Further reproduction is prohibited without permission.

Just when you thought you might be getting a handle on the complex, inconsistent and sometimes incoherent set of state and federal high cost loan limitations, the Federal Reserve Board (FRB) has changed the requirements under Section 32. The changes are effective as of December 20, 2001. However, you are not required to comply until October 1, 2002. The following are the key changes:

• 1st Lien APR Test Lowered. The APR test for first lien loans has been lowered from 10 points over the equivalent Treasury yield to 8 points over the equivalent Treasury yield.
  
• Optional Credit Insurance Added to "Points and Fees" Test. Any amount paid at or before closing for credit insurance or related products is now part of the "points and fees" test, even if it is not a finance charge.
  
• Optional Credit Insurance Deducted to Get "Total Loan Amount." Any amount paid at or before closing for optional credit insurance or related products must be deducted from the Amount Financed to arrive at the "Total Loan Amount," even if it is not a finance charge.
  
• New Disclosure: "Amount Borrowed." The "Amount Borrowed" is the face amount of the Note. You must include the "Amount Borrowed" in the Section 32 notice.
  
• New Disclosure: Optional Credit Insurance. If the "Amount Borrowed" includes an amount for optional credit insurance or related products, you must include a statement to that effect in the Section 32 notice.
  
• Prohibited Acts: New "Flipping" Test. Neither the original creditor nor an assignee may refinance a Section 32 loan into a new Section 32 loan during the first year unless the new transaction is in the borrower's interest.
  
• Prohibited Acts: Underwriting Presumption. If you make loans without verifying and documenting the borrower's ability to repay, the law now "presumes" that you make loans without regard for the borrower's ability to repay.

Background

In 1994 the Congress enacted the Home Ownership and Equity Protection Act (HOEPA) in response to anecdotal evidence about abusive practices involving high cost home loans. HOEPA identifies a class of high-cost mortgage loans through rate and fee triggers, and it provides consumers entering into these transactions with special protections. HOEPA applies to closed-end, non-purchase money home loans bearing rates or fees above a specified percentage or amount.

Creditors offering HOEPA loans must give consumers an abbreviated disclosure statement at least three business days before the loan is closed, in addition to the disclosures generally required by TILA before or at closing. The HOEPA disclosure informs consumers that they are not obligated to complete the transaction and could lose their homes if they take the loans and fail to make payments. It includes a few key items of cost information, including the APR and certain payment information. In loans where consumers have three business days after closing to rescind the loan, the HOEPA disclosure thus affords consumers a minimum of six business days to consider accepting key loan terms before receiving the loan proceeds.

HOEPA restricts certain loan terms for high-cost loans because they are associated with abusive lending practices. These terms include short-term balloon notes, prepayment penalties, non-amortizing payment schedules, and higher interest rates upon default. Creditors are prohibited from engaging in a pattern or practice of making HOEPA loans based on the homeowner's equity without regard to the borrower's ability to repay the loan. Under HOEPA, assignees are generally subject to all claims and defenses with respect to a HOEPA loan that a consumer could assert against the creditor. HOEPA also authorizes the FRB to prohibit acts or practices in connection with mortgage lending under defined criteria.

The New Calculations

You will need to make four adjustments to the calculations you make to ensure compliance with the new rules. These involve the changes to the APR test and the points and fees test, the creation of a new disclosure number -- the "Amount Borrowed," and testing for refinances that occur within the first year of an existing loan that you originated or own as an assignee.

The new APR test. Under the old rules, a loan was a Section 32 loan if it was a non-purchase loan and its APR was greater than the sum of the rate for Treasury securities with a comparable maturity plus 10 points. The test was the same regardless of the loan's lien position. Now a different test applies depending on the loan's lien position. First lien mortgage loans will be Section 32 loans if the APR is greater than the sum of the rate for Treasury securities with a comparable maturity plus 8 points. Junior lien loans will continue to be subject to the 10-point test.

Why the change? Under HOEPA (the statute behind Section 32), the FRB is permitted to adjust the APR trigger every two years if it consults with consumers and lenders and determines that an increase or decrease is consistent with the purpose of consumer protection in HOEPA and is warranted by the need for credit. The FRB decided to act after holding a number of public hearings across the country as well as reviewing the testimony at other hearings held by government agencies and the Congress, comment letters, holding discussions with community groups and lenders, consulting its Consumer Advisory Council, and reviewing data from various studies and reports on the home equity lending market.

Most of the information the FRB received about predatory lending is anecdotal. The fact is that, notwithstanding all of the attention given this issue, there is no real data available on the number of loans made that are high cost loans or on the percentage of loans made that involve "abusive" brokers or lenders. In the absence of such data, no one can hazard a statistical prediction of the number of perfectly legitimate high cost loans that will go unmade because lenders are afraid to make Section 32 loans. Many lenders avoid making such loans because of the stigma attached to the business and/or because it has become increasingly difficult to find buyers for such loans in the secondary market. Secondary market investors have been largely scared off this business by negative press about the business and because minor compliance errors that may have nothing to do with abusive practices lead to large dollar remedies for consumers. You also need to keep in mind that, unlike every other error under the Truth in Lending Act, compliance errors involving Section 32 loans are not curable. In other words, many lenders and secondary market investors avoid the business because the law permits no legitimate avenue to correct simple disclosure mistakes without triggering liability under HOEPA.

Once it performed its due diligence, the FRB decided that reports of actual cases of abusive transactions were widespread enough that it had to impose some additional restrictions. The FRB explained its position as follows:

Homeowners in certain communities--frequently the elderly, minorities, and women--continue to be targeted with offers of high-cost, home-secured credit with onerous loan terms. The loans, which are typically offered by nondepository institutions, carry high up-front fees and may be based solely on the equity in the consumers' homes without regard to their ability to make the scheduled payments. When homeowners have trouble repaying the debt, they are often pressured into refinancing their loans into new unaffordable, high-fee loans that rarely provide economic benefit to the consumers. These refinancings may occur frequently. The loan balances increase primarily due to fees that are financed resulting in reductions in the consumers' equity in their homes and, in some cases, foreclosure may occur. The loan transactions also may involve fraud and other deceptive practices.

The FRB also found no evidence that the contemplated changes to the regulation would cause a reduction in the amount of credit made available to needy consumers:

There are no precise data, however, on the number of subprime loans in the market as a whole that would be affected by lowering the HOEPA rate trigger. The precise effect that lowering the APR trigger will have on creditors' business strategies is difficult to predict. It seems likely that lenders that already make HOEPA loans and have compliance systems in place would continue making them under a revised APR trigger. Some creditors that choose not to make HOEPA loans may refrain from making loans in the range of rates that would be covered by the lowered threshold. But other creditors may fill any void left by creditors that do not make HOEPA loans, either because they already make HOEPA loans or because they are willing to do so in the future. And others may have the flexibility to avoid HOEPA's coverage by lowering rates or fees for some loans at the margins, consistent with the risk involved. Data submitted by a trade association representing nondepository institution lenders suggest that there is an active market for HOEPA loans under the current APR trigger. There is no evidence that the impact on credit availability will be significant if the trigger is lowered.

The final scorecard looked like this. Expanding coverage is consistent with the legislative purpose of HOEPA and will benefit consumers who are likely to be subject to abusive pricing/lending practices. There are no data or other evidence suggesting that expanding coverage will adversely affect access to credit for consumers in the same price market.

Optional credit insurance payments are part of "points and fees." Under the old rules, a loan was a Section 32 loan if it was a non-purchase loan and the sum of its "points and fees" exceeded the greater of 8% of the "Total Loan Amount" or a flat dollar amount that is adjusted from year to year ($480 for 2002). The definition of "points and fees" has been the sum of all fees paid at or before the loan closing that fit one of the following categories:

• A finance charge (other than interest);
• Any compensation paid to a mortgage broker (other than a yield spread premium); and
• Any item excluded from the finance charge under Section 226.4(c)(7) if the item is paid to the creditor or an affiliate of the creditor.

Under the old analysis, credit insurance premiums paid at closing would not be part of the "points and fees" so long as they were not a finance charge. Credit insurance premiums are excluded from the finance charge if:

• The insurance is not required by the creditor;
• The creditor gives written disclosure to the consumer (a) that the insurance is not required and (b) the amount of the premium; and
• After receiving the written disclosures, the consumer must sign or initial an affirmative request for the insurance.

Under the new rule, credit insurance premiums paid at or before closing are always part of the "points and fees." It does not matter whether they are voluntary or whether they are a finance charge. In addition, any such credit insurance fee must be subtracted from the loan amount to get to the "Total Loan Amount." Note that this rule applies to premiums or other charges for credit life, accident, health, or loss of income insurance. It also applies to debt cancellation coverage that provides for cancellation of some or all of the consumer's liability in the event of loss of life, accident, health or income (whether or not the coverage is insurance under state law.)

Why the change? The FRB had gotten an earful of complaints from consumers and consumer groups complaining of "insurance packing" and other abusive practices related to the sale of credit insurance. The typical charge is that the consumer does not realize until after the loan has closed that insurance is part of the loan or that he or she could have declined the coverage. Consumer groups wanted the FRB to ban the sale of such products outright. Their feeling is that, even if properly sold, the products have no real value to subprime consumers, at least in relation to the cost of the premiums. According to the FRB, single premium credit insurance premiums can be as much as 7% of the loan amount. From the perspective of consumer groups, this price, plus interest for the life of the loan (the premium is almost always financed) is too much to pay for the coverage. Obviously, the insurance industry argues strenuously that its products have value and that the premiums are almost always set by or with the blessing of state insurance commissioners.

Optional credit insurance must be subtracted from Amount Financed to get "Total Loan Amount." As noted above, the FRB has amended the Official Staff Commentary so that premiums paid at or before closing for credit insurance and related products (optional or not) must always be subtracted from the Amount Financed to arrive at the Total Loan Amount.

The New Disclosures

There are two new disclosure requirements. Both are required to appear in the HOEPA notice or Section 32 notice that must be delivered to the consumer at least three business days prior to consummation of the loan. Currently, these disclosures include:

• A statement that the consumer is not obligated to complete the transaction and could lose his or her home if the loan is consummated and the borrower fails to make payments;
• The APR;
• The amount of the regular/periodic payment;
• If the loan has a variable rate,
  • a statement that the interest rate and monthly payment may increase and
  • the amount of the maximum payment that would result if the interest rate rose to the maximum lifetime.
• If the loan has a balloon payment, the amount of that payment.

The new notices include an "Amount Borrowed" and a statement that credit insurance premiums are part of the "Amount Borrowed" if, in fact, that is the case.

Note that the new disclosures are only required if the transaction is a "mortgage refinancing." So, as a technical matter, if you have a "true" equity loan (a non-purchase money loan that does not refinance any prior loan), you need not give this disclosure. At the same time, there is nothing in the regulation that prohibits you from giving the new information on a refinance transaction. As a result, you do have the option to create a single form that will cover all transactions.

The "Amount Borrowed." It seems things have come full circle. At one time, the TILA disclosures were supposed to give information to the consumer that would help him or her understand the cost of the credit transaction at a level beyond the simple description of the interest rate and the principal amount that appeared in the promissory note. Now, it appears that we are throwing so much information at the consumer that we need to restate the loan amount. So, if you have a HOEPA loan that is also a refinancing, add the "Amount Borrowed" to the list of disclosures and plug in the principal amount reflected on the promissory note.

Where did this disclosure come from? The FRB heard the same story over and over. In that story, the innocent borrower thought that he or she was borrowing a small amount (for a medical procedure or for home repairs, for example) and ended up owing (and defaulting on) a large sum after the creditor had packed a number of other things into the loan amount, such as a refinance of a prior lien, points (usually excessive in the stories the FRB heard) and premiums for credit insurance that the consumer did not need, know of or want. At issue is an abusive lending practice: hiding the loan amount from the borrower until closing and then coercing the borrower to go through with the transaction when they first see the number and are shocked almost to death.

A New Tolerance. The disclosed "Amount Borrowed" will be deemed correct if it is within $100 (plus or minus) of the true amount borrowed at consummation. By the same token, any of the disclosures that are based on the disclosed "Amount Borrowed" will be considered accurate if they are wrong only because they are based on the disclosed "Amount Borrowed" where the disclosed "Amount Borrowed" is different than the actual "Amount Borrowed," but within tolerance.

The Fact that Credit Insurance is Part of the "Amount Borrowed." Again, the evil is a loan in which the borrower has no idea that credit insurance premiums are being financed. The new cure is a disclosure delivered to the consumer at least three business days before closing. The FRB has supplied the following model language for this disclosure:

You are borrowing $ _______ (optional credit insurance is __ is not __ included in this amount.)

Prohibited Acts

The new rules add the following items to the list of acts a creditor (including, in some cases, an assignee) is prohibited from taking in connection with a HOEPA loan.

• A creditor may not exercise any right to accelerate or "call" a loan due and payable unless the borrower has defaulted.
• Neither a creditor nor an assignee may refinance an existing HOEPA loan into a new HOEPA loan during the first 12 months unless the refinancing is in the borrower's interest.
• A creditor that does not verify and document the consumer's repayment ability will be subject to a presumption that it engages in a pattern or practice of making loans without regard to the borrower's ability to repay.

Call provisions. From here on, neither the note nor the security instrument may include any provision that permits the creditor to terminate and accelerate the loan except under conditions where:

• There is fraud or material misrepresentation by the consumer in connection with the loan;
• The consumer fails to meet the repayment terms of the agreement for any outstanding balance; or
• There is any action or inaction by the consumer that adversely affects the creditor's security for the loan, or any right of the creditor in such security.

If this sounds familiar, you are remembering the limitations that are placed on the right to terminate and accelerate HELOCs under Section 226.5b of Regulation Z. New paragraphs in the Official Staff Commentary provide the following guidance on the types of actions that adversely affect the creditor's interest in the collateral:

• The consumer transfers title to the property or sells the property without the creditor's permission.
• The consumer fails to maintain required insurance on the dwelling.
• The consumer fails to pay taxes on the property.
• The consumer permits the filing of a lien senior to that held by the creditor.
• The sole consumer obligated on the credit dies.
• The property is taken through eminent domain.
• A prior lienholder forecloses.
• The consumer commits waste or otherwise destructively uses or fails to maintain the property.
• Illegal use of the property by the consumer would permit termination and acceleration if it subjects the property to seizure.
• If one of two consumers obligated on a loan dies, the creditor may terminate the loan and accelerate the balance if the security is adversely affected.
• If the consumer moves out of the dwelling that secures the loan and that action adversely affects the security, the creditor may terminate a loan and accelerate the balance.

On the other hand, a creditor could accelerate in response to a judgment filed against the consumer only if the amount of the judgment and collateral subject to the judgment is such that the creditor's security for the loan is adversely affected.

The following are examples of "failure to meet repayment terms" that do not give rise to the right to accelerate:

• A creditor may not terminate and accelerate if the consumer, in error, sends a payment to the wrong location, such as a branch rather than the main office of the creditor.
• A creditor may not accelerate simply because a borrower files for or is placed in bankruptcy.

Finally, note that these provisions do not override any state or other law that requires a creditor to notify a borrower of a right to cure, or otherwise places a duty on the creditor before it can terminate a loan and accelerate the balance.

As a compliance point, you need to pull out and look at all of the documents that you use for any high cost lending you may do. Look for events of default or rights of acceleration that are unrelated to the consumer's fraud or default in connection with this transaction. For example, things like cross default clauses have to go. This process took a lot of work back in the late 1980's when the HELOC rules first came out.

Loan flipping. The rule establishes a one-year moratorium on a creditor who has entered into a HOEPA transaction. During that one-year period, a creditor may not enter into a new HOEPA transaction with the same borrower who refinances an existing HOEPA transaction into a new HOEPA transaction unless the new loan is in the borrower's interest. Why does that sentence sound like it is being so careful? Because the limitation on refinancing is not limited to loans made by the creditor. It includes HOEPA loans made by other creditors. In effect, the rule stops the creditor from poaching on the borrower once the creditor has obtained a bunch of confidential information about the customer's financial condition. So, restated in full, the rule works like this: a one-year clock starts running on the day Creditor A makes a HOEPA loan to a borrower. During that year, Creditor A cannot refinance any HOEPA loan involving the same borrower into a new HOEPA loan, whether Creditor A was the original lender or not, unless the new HOEPA loan is in the borrower's interest. What happens if someone else refinances the customer? Nothing. Creditor A is barred from refinancing any HOEPA loan involving that customer into a new HOEPA loan until the one-year clock has run, unless the new loan is in the borrower's interest.

Now, assume that Creditor A assigns the loan to X, the Assignee. What happens to Creditor A? Nothing. Its obligation not to flip its customer remains until the one-year clock stops ticking. What about X, the Assignee? The answer is that as soon as X, the Assignee acquires the loan, X is subject to the same "no flipping" limitation. The only difference is that it is subject to Creditor A's clock. For the portion of the year remaining on Creditor A's clock, X the Assignee may not refinance the HOEPA loan it purchased, or any other HOEPA loan the borrower may have entered into with any other creditor, into a new HOEPA loan unless the new HOEPA loan is in the borrower's interest. Note that if X, the Assignee assigns the loan to Y, the Next Assignee, X the Assignee is released from the moratorium.

Now, add one more complication. Sometimes a loan servicer is an assignee. An assignee includes any person who acquires the loan in a voluntary transaction. It also includes anyone who was an owner of the loan and continues to service the loan. For example, assume that X the Assignee serviced the loan while an owner. X the Assignee sells the loan to Y, the Next Assignee, but continues to service the loan. X the Assignee continues to be an assignee for purposes of the no-flipping rule. So, the rule for assignees is that they are subject to the moratorium until (a) one year from the date the loan was consummated or (b) the moment they assign the loan to someone else, servicing released. On the other hand, if an assignee retains servicing rights after selling the loan, it remains tethered to whatever is left on the original one-year moratorium. If an assignment to Y, the next Assignee takes place, Y the Next Assignee steps into the remaining moratorium time period (measured by Creditor A's clock.)

What, you may ask, is the meaning of the "borrower's interest?" By now, you should know better than to ask such questions. The Commentary to this section says that "the determination of whether or not a refinancing is in the borrower's interest is based on the totality of the circumstances, at the time the credit is extended. A written statement by the borrower that 'this loan is in my interest' alone does not meet this standard." Raise your hand if you think creditors are likely to win this argument very often.

You are also permitted to follow the procedure set out for establishing a "bona fide personal financial emergency" sufficient to permit waiving the three day right to rescind under TILA. Note that the rescission sections require the borrower to provide a hand written, signed and dated statement that asserts a personal financial emergency and requests waiver of any applicable right to cancel.

Finally, you will get some "consideration" if you refinance a transaction involving "new money," and the closing costs are all reasonable in relation to the amount of new money extended. Although, note well: even here you have no safe harbor.

Failing to verify and document income: the Presumption. Under TILA, a creditor may not engage in a pattern and practice of making HOEPA loans based solely on the collateral and not on the borrower's ability to repay. The policy behind this rule is clear. It is indefensible to make loans to borrowers when there is an expectation that the borrower cannot repay. Under those circumstances, the loan is nothing more than a contract to foreclose and evict. Under HOEPA, creditors can get into trouble even where they have no actual knowledge of the borrower's inability to pay. Under HOEPA, you have to ask reasonable questions to confirm the borrower's ability to repay and you must document the information you relied to reach that conclusion. If you do not verify and document, you are presumed to engage in a pattern and practice of making HOEPA loans without regard to the borrowers' ability to repay.

You can verify and document a consumer's income and current obligations through any reliable source that provides you with a reasonable basis for believing that there are sufficient funds to support the loan. Reliable sources include, but are not limited to, a credit report, tax returns, pension statements, and payment records for employment income.

If you want more information about these rules, look at 66 FR 65604 (December 20, 2001).

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