CBA Publications >> CBA Regulatory Compliance Bulletin >> Vol 2001 No. 11 October 26, 2001

Vol 2001 No. 11 October 26, 2001

California Passes New Predatory Lending Bills

Governor Davis signed two predatory lending bills (AB489 and AB344, Migden) intended to curb certain practices associated with home mortgage loans where the rates and fees exceed specified thresholds: the APR exceeds the yield on comparable Treasury securities by more than 8%, or the points and fees exceed 6% of the loan amount. This compares to 10% and 8%, respectively, under Section 32 of Regulation Z (Home Owners Equity Protection Act or HOEPA loans). The new law applies to any person who arranges, negotiates, or makes a covered loan.

Caution. While banks not engaged in subprime lending would be largely unaffected by the new law, they should be aware of a few provisions that could unexpectedly trigger coverage. As with Section 32 loans, all compensation and fees paid to mortgage brokers, such as yield spread premiums and other broker payments, whether paid in or outside of escrow, must be included in the points and fees trigger. In addition, the new law specifically makes lenders liable for violations by brokers with whom they do business if the lender knew of the violations and disregarded them.

Also like Section 32, the new law includes in the points and fees trigger certain items listed in Section 226.4(c)(7) of Regulation Z "if the person originating the covered loan receives direct compensation in connection with the charge." Section 226.4(c)(7) is a list of real estate related charges, including property appraisal and loan documentation fees. Note that if the bank itself provides the service and charges a fee, the item should be included in the calculation of points and fees trigger, even if the fee were reasonable.

The new law includes a variety of administrative and civil enforcement provisions, and apply to covered loans applied for on or after July 1, 2002.

Q. Who is covered?
A. The new law applies to anyone who arranges, negotiates, or makes ("originates") a covered loan in California. Originators that are licensed by the Department of Real Estate, Department of Corporations, or the Department of Financial Institutions are subject to new administrative enforcement provisions discussed below, and all originators in California, regardless of where chartered or by whom, could be subject to actions by enforcement agencies and civil law suits based on violations of the new law.

Q. What loans are covered?
A. A "covered loan" is defined as a consumer credit transaction secured by real property used by the consumer as a principal dwelling (1-4 residential unit) with an original principal balance of $250,000 or less where: (i) the APR at closing exceeds the yield on Treasury securities having comparable maturity periods by more than 8 percentage points; or (ii) the points and fees exceed 6 percent of the loan amount.

• The dollar amount will be adjusted every five years to inflation.
  
  
• An originator of a covered loan will not be liable for bona fide errors committed neither willfully nor intentionally as long as the originator (i) maintains procedures to avoid those errors, and (ii) corrects the error within 45 days after receipt of a complaint or discovery of the error.
  
  
• Upon request, an originator of a covered loan must provide a licensing agency or a consumer, at no cost, documentation "regarding his or her loan that clearly demonstrates whether any loan is a covered loan." Documentation includes the principal balance, APR, and points and fees.

Q. What kinds of loans are exempted?
A. The bills do not apply to a reverse mortgage, an open line of credit as defined in Regulation Z, a transaction secured by rental property or a second home, or to a bridge loan, defined as a temporary loan with a maturity of one year or less obtained for the purpose of acquiring or constructing the consumer's principal dwelling.

• It is unclear whether the law applies to a loan secured by a sole proprietor's residence but obtained for a business purpose. The term used, "consumer credit transaction" is not defined. Thus, it could refer either to a loan obtained for a consumer purpose, as in Regulation Z, or simply a loan made to a consumer, i.e., an individual as opposed to a business entity.

Q. What fees are incorporated into the fees trigger?
A. The definition is pattered after Section 32 of Regulation Z. The included items are those required to be disclosed as finance charges under Sections 226.4(a) and 226.4(b) of Regulation Z (except interest), all compensation and fees paid to mortgage brokers, and items listed in Section 226.4(c)(7) of Regulation Z if "the person originating the covered loan receives direct compensation in connection with the charge."

Q. What restrictions are placed on covered loans?
A. The bills list fourteen specific limitations and prohibitions applicable to covered loans. These are:

Limit #1. Prepayment fees. A covered loan may include a prepayment fee only during the first 36 months of the loan under the following conditions: (i) the originator offers the consumer another product without a prepayment fee; (ii) at least three business days prior to closing a disclosure is provided describing the terms of the prepayment fee, and the rates, points, and fees that would be available to the consumer under another covered loan without the fee; and (iii) the fee is imposed only on an amount of prepayment in a 12-month period that exceeds 20 percent of the original principal amount, and the fee is no more than six months' advance interest at the contract rate of interest then in effect on the amount prepaid.

• The loan may not impose a prepayment fee that is triggered by acceleration of the loan as a result of default.
  
  
• While a lender who refinances a loan that the lender originally made to a consumer may enforce a prepayment penalty on the original loan, the lender may not finance the prepayment penalty (payable on the original loan) through a new loan.
  
  
• A prepayment fee payable more than 36 months after closing is prohibited.

Limit #2. No balloon payment is permitted for a loan with a term of 5 years or less.

• For payment schedules adjusted to account for seasonal or irregular income, the total installments in any year may not exceed one year's payments. This prohibition does not apply to a bridge loan, defined for this provision only as a loan with a maturity of less than 18 months that only requires interest payments until maturity.

Limit #3. No negative amortization is permitted unless the loan is a first mortgage and this fact is disclosed and described. No sample disclosure language is prescribed.

Limit #4. Periodic payments may not be required to be consolidated and paid in advance from the loan proceeds.

Limit #5. No increased default rate of interest rate is permitted.

Limit #6. The loan must be based on the ability to repay, not on the amount of equity in the secured property. The originator must reasonably believe that the consumer will be able to make the loan payments based on the consumer's income, current obligations, employment status, and other financial resources.

• If the loan is an adjustable rate mortgage with an introductory rate, the assessment of ability to repay must be based on the fully indexed rate if the adjustment is to be made within the first 37 months after the date of application.
  
  
• A safe harbor is provided: the consumer's ability to repay will be presumed if total monthly debts, including amounts owed under the loan, do not exceed 55 percent of the consumer's monthly gross income. No presumption of inability to repay may arise solely from the fact that this ratio exceeds 55 percent.
  
  
• The originator may satisfy the reasonable belief standard by relying on the stated income of the consumer and other information in the originator's possession if the originator has solicited all information that he or she customarily solicits in connection with such a loan. A person may not treat a covered loan as a stated income loan in order to evade the provisions of the new law.

Limit #7. Payment of loan proceeds may not be made directly to a home improvement contractor. Payment may be made to the consumer, jointly to the consumer and contractor, or (at the consumer's election) paid to an escrow agent. If a progress payment is by a joint check or through an escrow, the originator, before issuing payment, must receive from the consumer with a signed and dated certificate indicating that the home improvement work is completed satisfactorily.

Limit #8. An originator may not recommend that a consumer default on an existing debt in connection with soliciting or making a covered loan that refinances all or a portion of the existing debt.

• Note that, unlike other provisions of the new laws a violation may arise here even where a covered loan is not made, but simply solicited.

Limit #9. A loan provision may not allow acceleration of the debt at the lender's sole discretion. This restriction does not affect a creditor's rights to accelerate upon default or pursuant to a due on sale clause.

Limit #10. A loan may not be refinanced such that the new loan is a covered loan that does not result in an "identifiable benefit" to the consumer, considering the consumer's stated purpose for obtaining the loan. No helpful guidance or examples are provided.

Limit #11. A statutory disclosure on consumer caution and credit counseling, written in 12-point font or larger, must be provided to the consumer no later than three business days before execution of the loan documents. Please see the appendix to this Bulletin for the text of the statutory notice.

• A licensed person will be presumed to have has met its obligation to provide the disclosure if the consumer provides a signed acknowledgment of receipt. The use of the term, licensed person, rather than "originator" suggests that this provision is aimed more at regulatory supervision rather than evidence in a civil matter.

Limit #12. An originator may not advise a consumer to accept a loan with either a higher risk rating or higher cost than that which the consumer would "qualify for."

• The terms that the consumer could qualify for will be based on a reasonable application of the originator's then current underwriting guidelines, considering available information. A broker may not steer a consumer to a less favorable loan based on the loan products offered by the persons with whom the broker regularly does business.
  
  
• Note that this prohibition appears to apply to the steering of a consumer to a product whose terms are less favorable than another product that is offered by the originator, or in the case of a broker, offered by the broker or another lender for whom it brokers loans. If the originator offers only a subprime product sought by the consumer, this provision does not explicitly prohibit the person from offering that product even if the consumer might qualify for a prime product offered by another, unrelated lender.
  

• This provision makes more sense if it read, "orshowed reckless disregard" rather than "and." Apparently, it is insufficient to show that the lender simply knew of a violation, but rather that the lender also showed a reckless disregard for the violation.
  
  
• This section does not impose or transfer liability for a breach of the broker's fiduciary duty.

• Lenders who originate covered loans have an obligation to inform their employees involved in making originations of the penalties for a violation of the new law. No details are offered about how this must be communicated or documented.
  
  
• It is not necessary for a civil litigant to exhaust administrative remedies before bringing a suit in court.

Appendix (Mandatory Predatory Lending Notice)

CONSUMER CAUTION AND HOME OWNERSHIP COUNSELING NOTICE

If you obtain this loan, the lender will have a mortgage on your home. You could lose your home, and any money you have put into it, if you do not meet your obligations under the loan.

Mortgage loan rates and closing costs and fees vary based on many other factors, including your particular credit and financial circumstances, your earnings history, the loan-to-value requested, and the type of property that will secure your loan. Higher rates and fees may be justified depending on the individual circumstances of a particular consumer's application. You should shop around and compare loan rates and fees.

This particular loan may have a higher rate and total points and fees than other mortgage loans and is, or may be, subject to the additional disclosure and substantive protections under Division 1.6 (commencing with Section 4970 of the Financial Code. You should consider consulting a qualified independent credit counselor or other experienced financial adviser regarding the rate, fees, and provisions of this mortgage loan before you proceed. For information on contacting a qualified credit counselor, ask your lender or call the United States Department of Housing and Urban Development's counseling hotline at 1-888-466-3487 or go to www.hud.gov/fha/sfh/hcc for a list of counselors.

You are not required to complete any loan agreement merely because you have received these disclosures or have signed a loan application.

If you proceed with this mortgage loan, you should also remember that you may face serious financial risks if you use this loan to pay off credit card debts and other debts in connection with this transaction and then subsequently incur significant new credit card charges or other debts. If you continue to accumulate debt after this loan is closed and then experience financial difficulties, you could lose your home and any equity you have in it if you do not meet your mortgage loan obligations.

Property taxes and homeowner's insurance are your responsibility. Not all lenders provide escrow services for these payments. You should ask your lender about these services.

Your payments on existing debts contribute to your credit ratings.

You should not accept any advice to ignore your regular payments to your existing creditors.