Executive Essay reprinted from the September 2005 issue of Mortgage Banking magazine (pp. 101-102), with permission from the Mortgage Bankers Association (MBA).

No lender makes high-cost loans. At least that is what every lender will tell you. And that is what every lender is hoping is true. Making a predatory loan in today's environment is the surest way to destroy a mortgage company. Even if a loan officer is successful in getting a borrower to sign the paperwork, the company can't sell it. No one in the market is securitizing these loans because the ratings agencies will not rate them. One of the primary reason companies do not want to make these loans is that it is extremely dangerous from a legal perspective.

The problem is that while no lender will admit to making a predatory or high-cost loan, determining whether a loan is actually in violation of an anti-predatory lending statute can involve a very complex procedure. Legislators can build whatever they want into a high-cost loan test. Lenders must then provide the information required and perform the calculation on every loan they write in order to demonstrate compliance.

Further complicating the issue is the fact that there is very little uniformity between the laws of one state and the next. The differences between the rules can often be subtle, but that is where the danger often lies. These subtle differences can have huge implications, depending upon how a lender chooses to run the tests. It is a mistake to assume that because different anti-predatory lending laws look similar that their tests are also similar. This is rarely the case.

Only through a careful inspection of the legislation can a lender determine exactly how a jurisdiction defines a bad loan. Even if the thresholds in two different laws are the same, the way that number is derived can be vastly different.

In many cases, the exact requirements of the statute are unclear, even after careful inspection. In these cases, the lender is left to decide how it will interpret the law-which will depend in large part upon its appetite for risk.

A case in point involves tests for points and fees. Many laws have a threshold test that provides a cap, which total points and other fees must not exceed. However, many laws allow lenders to exclude certain charges from the test. In some cases, lenders can exclude discount points from these points-and-fees tests. In these cases, the points charged must be bona fide discount points.

Intuitively, a lender could make the assumption that bona fide discount points are points paid by the borrower to lower the final interest rate charged for the loan. In some cases, this could lead to an error.

Take the state of New Jersey, for example. Lenders in New Jersey are prohibited from charging borrowers for anything that is not on a short list of accepted charges. Discount points is one category of fees that is acceptable in New Jersey. Consequently, some lenders in that state use the discount points item to hold charges that are customary in most states but not allowed under a different name in New Jersey.

Meanwhile, the New Jersey high-cost loan statute allows lenders to exclude bona fide discount points from the points-and-fees test. However, since these points are not bona fide, they cannot be excluded, and lenders in New Jersey find themselves getting closer to the threshold and a violation of the law.

Many of the requirements built into the tests for high-cost loans are not intuitive. Some of the information lenders are asked to include in some of the tests is not customarily collected or calculated by lenders.

For instance, some laws require lenders to factor in the maximum possible prepayment penalty a borrower might have to pay under the terms of a loan. This can be extremely complex, especially in the case of adjustable-rate mortgages (ARMs).

Recently, we encountered a case in Massachusetts where a two-tiered prepayment penalty is allowed by law. If the loan is paid in full within the first year, a prepayment penalty equal to the lesser of three months interest or the balance of the first year's unpaid interest can be levied against the borrower. If the loan is refinanced by another lender after the first year but before the end of the third year, state law allows lenders in Massachusetts to charge an additional three months' interest as a prepayment penalty.

The problem is determining which day during the first three years will result in the highest prepayment penalty for a given loan.

Some lenders will be satisfied with an assumption or best guess. In our case, the client had a lower tolerance for risk, so we built a computer simulation that included some assumptions about interest-rate changes over time and calculated the highest resulting prepayment penalty to plug into the test.

It took a computer program to determine one element of one high-cost loan test. You can imagine how complicated it can get when more than one law comes into play. Any time multiple jurisdictions impose legislation on a lender, it gets messy. The most commonly cited example of a complicated lending environment is Chicago.

Lenders making loans in this metropolitan statistical area (MSA) must make certain that they are on the right side of at least five different lending ordinances. The city of Chicago, Cook County and the state of Illinois all have anti-predatory laws on the books. In addition to this are the controversial Illinois Interest Act (IIA) and the federal Section 32 legislation. Fannie Mae's rules may also apply.

The IIA is particularly troublesome because it has recently been tied up in the state's courts. If the act is enforced as it is currently written, it will require lenders to keep interest rates under a maximum percentage of just under 8 percent and stay below a points-and-fees threshold of about 3 percent. This is a very low threshold and could even put some A-paper lenders at risk under certain circumstances.

Conforming lenders that pay yield-spread premiums, for instance, may find that other fees and points, when added to the points paid to the originating broker, put their deals uncomfortably close to the threshold in Illinois.

There are many other MSAs across the country that have similar levels of complexity due to overlapping statutes. Lenders have learned that if they do business in more than one state, it can be difficult to stay in compliance without professional support.

Laws are changing rapidly, and as legal opinions are handed down high-cost loan tests are changing as well. It can be difficult or impossible for a lender to keep track of all of these laws and the tests required to demonstrate compliance.

Unfortunately, once a license is issued to write mortgage loans in a jurisdiction, the government requires the lender to have knowledge of all applicable laws. Lenders that fail to live up to this standard run the risk of losing their businesses in this complex lending environment.

Waiting for a national standard to do away with the complexity is not a viable option, as it will not solve lenders' problems today or anytime in the near future.

Bill Lambropoulos is the General Counsel and Director of Compliance and Legal Services at Document Systems, Inc.