In the current environment of regulatory reform and restructuring, one set of new regulations in particular, yet to become effective, is challenging an industry that has been on the brink since 2008. On April 1, 2011, the first in what is likely to be a series of rules and interpretations on loan originator compensation will become effective. While this rule from the Federal Reserve Board of Governors appears to focus on mortgage brokers and loan officers of mortgage bankers, the reality is that this rule applies to non-depository institutions and depository institutions alike ââcovered institutions.â
On Sept. 24, 2010, the Fedâs final rule regarding loan originator compensation and the prohibition of steering was officially published in the Federal Register (published a 75 Fed. Reg. 58509). However, Title XIV of the Dodd-Frank Act, signed into law on July 21, 2010, also imposes statutory restrictions on loan originator compensation and prohibitions on steering. Therefore, regulatory compliance will be a multi-tier challenge for financial institutions, beginning with the Fedâs rule, effective April 1, 2011.
The Fed, using its authority to prohibit unfair or deceptive acts or practices, determined that paying a loan originator based on the terms or conditions of the loan, other than the amount of credit extended, and steering consumers to loans that are not in their interest in order to maximize loan originator compensation, are unfair practices that could not be remedied through disclosure.
New compensation rules
Generally, for all closed-end consumer credit transactions secured by a dwelling (which need not be the consumerâs principal dwelling), and regardless of price or lien position, the final rule prohibits a loan originator from:
1. Receiving compensation that is based on the interest rate or other loan terms or conditions (other than the loan amount) or that is based on anything that serves as a âproxyâ for a term or condition of the loan (e.g. a credit score);
2. Receiving compensation from the lender or another party if the loan originator is receiving compensation directly from the consumer; or
3. Directing or âsteeringâ a consumer to accept a mortgage loan that is not in the consumerâs interest in order to increase the loan originatorâs compensation.
Broad institutional and transactional coverage
As noted, the final rule applies to all closed-end consumer loans secured by first or subordinate liens on a dwelling or real property that is subject to the Truth in Lending Act (TILA), including closed-end reverse mortgages and regardless of owner occupancy (first and second homes) or lien position. However, transactions involving home equity lines of credit, timeshares, real property that does not include a dwelling, and other transactions not covered by TILA, such as business purpose loans or rental property are not impacted by the new rule. Although, the Fed indicates that while these transactions are currently exempt, it may consider whether broader coverage is necessary in a future rulemaking.
Further, the rule applies to any person (individual or entity) that falls within the definition of a âloan originator,â which is defined in the rule as, âwith respect to a particular transaction, a person who for compensation or other monetary gain, or in expectation of compensation or other monetary gain, arranges, negotiates, or otherwise obtains an extension of consumer credit for another person.â So, a loan originator may be a natural person, a mortgage broker company, a loan officer employed by mortgage broker company, a mortgage banker, and a financial institution. The rule also applies to creditors that close a loan in their name, but use table-funding from a third party to fund the loan.
Like the provisions of the Dodd-Frank Wall Street Reform Act, a creditor that funds a transaction out of its own funds is excluded from the definition of a loan originator, as are mortgage servicers, generally. However, the Fedâs final rule does not address transactions that occur between creditors and secondary market investors.
Compensation under the final rule includes âsalaries, commissions, and any financial or similar incentives, and also includes annual or other periodic bonus, or awards of merchandise, services, trips or similar prizes.â This also includes amounts the loan originator retains, but does not include amounts the originator receives as payment for bona fide and reasonable third-party charges, such as title insurance or appraisals.
However, the Fed Board has noted specifically that compensation that is not based on the terms or conditions of the loan, and is therefore permissible, includes, but is not limited to the following:
i the loan originatorâs overall loan volume delivered to the creditor;
ii the long-term performance of the originatorâs loans;
iii an hourly rate of pay for the actual number of hours worked;
iv whether the consumer is an existing customer of the creditor or a new customer;
v a payment that is fixed in advance for every loan the originator arranges for the creditor;
vi the percentage of applications submitted by the loan originator to the creditor that result in consummated transactions;
vii the quality of the loan originatorâs loan files submitted to the creditor;
viii legitimate business expenses, such as fixed overhead costs; or
ix compensation that is based on the amount of credit extended (such as a percentage of the amount of credit extended, provided the percentage is fixed and does not vary with the amount of credit extended).
The final rule also permits creditors to compensate their loan officers differently than mortgage brokers and to amend the compensation formulas from time to time. However, such compensation adjustments may only be made prospectively.
Proxy for a loan term or condition
Compensation that is based on anything that is a âproxyâ for a loan term or condition is also prohibited under the final rule. For example, a proxy for a loan term or condition would be a credit score, which determines loan pricing, such that compensation could not be based on the particular credit score of the borrower associated with a particular transaction. Similarly, other credit risk factors affecting the pricing of the loan also could not form the basis of any compensation that is paid to loan originators.
This âproxyâ identification may cause loan originators and their employers to be more conservative in their initial analysis and development of new compensation plans. Given the current regulatory environment and the likely addition of future rules and continued verbal clarifications from the Fed, especially in light of the Dodd-Frank provisions impacting loan originator compensation, the more conservative approach is the more prudent course in preparing for April 1.
Compensation from only one source
The final rule clearly indicates that the compensation received by a loan originator may only be received from one source. Therefore, a loan originator who is paid directly by the consumer, through a mortgage broker agreement, for example, would be prohibited from receiving any compensation from the creditor, or any other party in connection with that transaction.
While the compensation must only be received from one source, the final rule does not prohibit the loan originatorâs compensation to be based on loan terms or conditions where the loan originator is paid by the consumer. However, the relevant provisions of Dodd-Frank will close this loophole as they are implemented in the future.
Prohibition on steering
Finally, the final rule prohibits loan originators from directing or ââsteeringââ a consumer to consummate a dwelling-secured loan based on the fact that the originator will receive greater compensation from the creditor in that transaction, unless the consummated transaction is in the consumerâs interest.
In order to preserve consumer choice with respect to loan options, the Fed outlined a safe harbor where a loan originator is deemed to have complied with the anti-steering rule if the loan originator satisfies the following three requirements for each particular transaction:
1. For each type of transaction in which the consumer expresses an interest, the consumer must be presented with, and able to choose from, loan options that include a loan with the lowest interest rate, a loan with the lowest total dollar amount for origination points or fees and discount points, and a loan with the lowest rate with no risky features, such as a prepayment penalty or negative amortization;
2. The loan options presented to the consumer are obtained by the loan originator from a significant number of the creditors with whom the loan originator regularly does business; and
3. The loan originator believes in good faith that the consumer likely qualifies for the loan options presented to the consumer.
How does the Fedâs final rule compare to the relevant provisions of Dodd-Frank?
Title XIV of the Dodd-Frank Act contains the relevant provisions with respect to loan originator compensation and steering prohibitions. In large measure, the coverage of Title XIV, The Mortgage Reform and Anti-Predatory Lending Act, is similar to that of the final rule.
The provisions of Title XIV generally exempt creditors, as defined in TILA, from the provisions regarding loan originator compensation, except where they are closing, but not funding the mortgage loan. Like the final rule, the provisions of Title XIV cover both individuals and entities, such as mortgage broker companies. Also like the final rule, the provisions of Title XIV do not cover individuals engaged in administrative or clerical tasks, loan servicers or secondary market transactions.
A âmortgage originatorâ under Title XIV is defined as "any person who, for or in the expectation of, direct or indirect compensation or gain: takes a residential mortgage loan application; assists a consumer in obtaining or applying to obtain a residential mortgage loan; or offers or negotiates terms of a residential mortgage loan." This definition of a âmortgage originatorâ under Title XIV appears to be broader that the final ruleâs definition of âloan originator,â and is certainly broader than the definition of a âmortgage loan originatorâ under the Secure and Fair Enforcement for Mortgage Licensing Act (SAFE Act).
Title XIV also contains prohibitions on loan originator compensation which are similar in many ways, and in some cases, more comprehensive than the final rule. First, Title XIV prohibits a loan originator from receiving compensation that is based on any loan terms or conditions, other than the principal loan amount. This prohibition is largely the same as the prohibition in the final rule. This necessarily means that the use of a yield spread premium (YSP) as compensation is prohibited by both the final rule and Title XIV because the YSP is based on the interest rate, which is a term or condition of the loan. However, it does not prohibit permitting the borrower to use YSP as a method of financing the originator's compensation and/or bona fide third-party closing costs.
Second, Title XIV prohibits the loan originator from receiving âdual compensation,â which is to say that the loan originator may be compensated by the creditor or the consumer, but in no case may the loan originator be compensated by both. Here, as stated above, the final rule permits the loan originator to be paid by the consumer based on loan terms or conditions, whereas Title XIV does not permit payments directly from the consumer to be based on loan terms or conditions. Ultimately, future rulemakings under Dodd-Frank will close the loophole created by the final rule in this area.
Third, Title XIV also contains a steering prohibition. Loan originators may not steer a consumer away from a âqualified mortgage,â as defined in the legislation, or to a loan for which the consumer lacks the ability to repay, or a loan with predatory characteristics. However, unlike the final rule, there appears to be no Safe Harbor to demonstrate compliance with the steering prohibitions of Title XIV. This, among other things, will be reconciled after authority for such rulemaking transfers to the Bureau of Consumer Financial Protection on July 21, 2011.
Finally, Title XIV imposes broader liabilities and penalties under TILA. In particular, Title XIV imposes individual liability on mortgage originators under TILA. Under these provisions, mortgage originators will face maximum liability which is the greater of actual damages or three times the total originator compensation.
Donât bet on a delay
The Fedâs rulemaking is an attempt to provide greater protection to consumers from unfair, abusive, or deceptive lending practices. The Fedâs goal is to ensure consumer choice when it comes to loan options. However, these protections come at a significant cost to covered institutions who have until April 1, 2011 to create and engage new compensation formulas for loan originators. These formulas must also be incorporated into the institutionâs policies and procedures, as well as any employment or other compensation-specific agreements. Covered Institutions must have a plan in place to ensure compliance. Time is of the essence. The rule applies to applications received by the creditor on or after April 1, 2011.
Although the National Association of Independent Housing Professionals (NAIHP) has filed suit against the Federal Reserve to block implementation of the final rule, and although the House Financial Services Committee has indicated an intent to examine the final rule out of concerns over an adverse impact on small businesses, the Fed insists that the final rule will not be delayed or retracted and has indicated verbally that they have moved beyond loan originator compensation, and have no intention to modify or delay this final rule.
The final rule has a number of significant effects on the mortgage market, not the least of which is the increased attention that will be paid to employment and compensation agreements in the industry. Compensation structures may initially be developed around the very specific allowances for compensating loan originators, such as a percentage of the loan amount, although the Fed has even indicated that the permissibility of compensation based on the loan amount may, in the future, be subject to a minimum or maximum dollar amount. Once the dust settles, however, it is likely that covered institutions will develop more complex compensation formulas, including very individualized compensation plans for loan originators and branch, regional and production managers.
To a certain extent, creditors are afforded some flexibility in loan pricing. Creditors can preserve the consumer benefits of compensating a loan originator, or paying for all or part of the closing costs, through the interest rate (where compensation paid by the creditor to the loan originator is not based on terms or conditions).
Mortgage market participants will be challenged, some more than others, to implement these new rules such that loan originators are properly compensated and consumers receive affordable credit to purchase homes. Moreover, brokers, in particular, may be asked or required by creditors to sign certifications or affirmations that the consumer received all required disclosures and that the loan originator did not âsteerâ the consumer to a particular loan. Once the rules are effective and the cards are showing, loan originator compensation across the market will likely become relatively streamlined and creatively limited.
Unfortunately, early reports indicate that this rule may cause the cost of obtaining credit to increase because of the fundamental changes in the origination of mortgages, especially by mortgage brokers. Indeed, many mortgage brokers and mortgage broker companies have publicly questioned the ability of small mortgage companies or mortgage brokers to survive. Traditionally, the key compensation figures have come from the interest rate obtained for the consumer. However, effective April 1, compensation structures will change and some smaller institutions may be unable to compete and will be forced to close their doors.
On the other hand, larger institutions, such as larger mortgage banks and depository institutions have an opportunity to expand their market share. The cost of their operations will likely not be significantly impaired by these compensation and steering rules, whereas smaller institutions will struggle.
While objections and calls for delay persist, this rule is going live on April Foolâs Day. This new rule is no joke; covered institutions, whether depository or non-depository, must take preemptive regulatory compliance action now. Compensation arrangements need to be revised and loan originators need to be identified. Options are available for compensating loan originators; but the final rule has already taken a lot of time and money for many to implement, and both the regulatory and consumer advocacy communities are very focused assuring that loan originators are complying with it. If youâre not ready, you really can't afford to wait any longer.