Understanding Regulation Z: A Concise Analysis of the Amendments. Alla A. Vaynrub, CFA Director

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1 Understanding Regulation Z: A Concise Analysis of the Amendments Alla A. Vaynrub, CFA Director

2 Executive Summary Regulation Z, implementing Truth in Lending Act (TILA), has long been considered one of the most complex and broad regulations in the consumer lending space. Compliance with this regulation has become increasingly more challenging over the last few years. Since July 2008, Regulation Z saw the passage of more than a dozen amendments, spurred by the Regulators reaction to the mortgage crisis. This count will likely go higher when the Consumer Financial Protection Bureau steps up its activities later this year. While awaiting additional changes, banks should start taking steps to re-assess the continuing effectiveness of their compliance processes as they relate to Regulation Z and begin to develop strategies for addressing potential gaps. This paper has three purposes. One is to help compliance officers and senior risk managers better understand the extent of recent amendments to Regulation Z without digging through technicalities and minutiae. To make this material easier on the reader, the content of literally hundreds of pages of revised text is distilled into just a few pages. Another objective is to point out some nuances that can be overlooked and may lead (or in some case did lead) to errors or violations. Finally, the paper concludes with a list of questions that should be posed to compliance departments today as institutions are determining the readiness of their compliance programs. Introduction For many of us, the sheer number of recent rules might feel overwhelming. For the sake of conceptualizing the multitude of recent amendments, it helps to think of them as interconnected developments driven by a handful of key legislative pronouncements. These pronouncements touched on many aspects of regulation and triggered numerous changes, most of which were implemented in several stages and through a series of rules. Brief summaries of these changes are outlined in Appendix A - Summary of Regulation Z Amendments. I. Home Ownership and Equity Protection Act (HOEPA) HOEPA is a law that addresses deceptive and unfair practices and establishes requirements for certain loans with rates or fees exceeding a certain threshold ( high rate or high fee loans). Although HOEPA has been in existence since 1995, there is still a fair amount of confusion regarding some of its technical requirements. This confusion is only magnified by the requirements imposed by the recent rules. Let s take a look at those rules one at the time. 1. July 30, 2008 Final Rule: The new rule applies to all mortgage lenders and can be thought of in terms of three major topics: establishing protections for a new category of "higher-priced mortgages," providing additional protections for all closed-end loans secured by a consumer s principal dwelling, and improving advertising standards for all mortgages FIS and/or its subsidiaries. All Rights Reserved. 2

3 Before discussing the new rule in more detail, let s recall that before 2008, HOEPA loans covered high fee and/or high rate loans (refinancing or home equity) collateralized by a consumer s principal residence. These loans are also known as Section 32 Mortgages and are governed by Section 32 of Regulation Z. To be considered a HOEPA loan, two requirements have to be met: (1) the Annual Percentage Rate ( APR ) has to exceed the rates on Treasury Securities of comparable maturity by more than 8 percent (10 percent for a second-lien loan); and (2) the total fees and points need to exceed the larger of $592 (as of 2011) or 8 percent of the total loan amount. The July 30, 2008 rule establishes a new subset of loans, called higher-priced mortgage loans (HPMLs), which includes virtually all closed-end, subprime loans secured by a consumer's principal dwelling. A loan will fall into this category if it is a first-lien mortgage and has an annual percentage rate that is 1.5 percentage points (or 3.5 percentage points if it is a subordinate-lien mortgage) or more above the average prime offer rate 1 index published by the Federal Reserve. Note that the definition of higher- priced mortgage loans uses average prime offer rates, while high rate loans are indexed to Treasury rates. Another important difference in determining higher priced and high rate loans is the point of time for setting the threshold. For high rate loans, Treasury yields should be obtained as of the 15th of the month immediately preceding the month of application. In comparison, the July 30 rule requires the use of the rate lock date rather than the application date for HPMLs. Let s take a look at the key protections established by the rule: a) For higher-priced mortgage loans secured by a consumer principal dwelling: - Lenders are required to establish the consumer s ability to repay the loan from income and assets other than the home's value. Such an evaluation should be based on the highest scheduled payment in the first seven years of the loan. - The rule requires verification of income and assets that are used to determine repayment ability. - The rule bans prepayment penalties except under certain conditions. - Lenders are required to establish an escrow account for the payment of property taxes and homeowners' insurance for first-lien loans. (In February 2011, the Federal Reserve issued a final rule to implement provisions of the Dodd-Frank Act. This rule raised the APR threshold for establishing an escrow account for property taxes and insurance for first-lien "jumbo 2 mortgage loans to 2.5% or more above the index. It remains the same for non-jumbo loans). b) b) Additional protections for all consumer purpose closed-end mortgages secured by a consumer's principal dwelling: - The rule prohibits a creditor or broker from coercing or encouraging an appraiser to misrepresent the value of a home. - The rule prohibits certain servicing practices such as "pyramiding" late fees, failing to credit a payment to a consumer s account as of the date the payment is received, or failing to provide a pay-off statement within a reasonable period of time. - Creditors must provide a good faith estimate of the loan costs, including a schedule of payments, within three days after a consumer applies for any mortgage loan secured by a consumer's principal dwelling. (Note: later 2013 FIS and/or its subsidiaries. All Rights Reserved. 3

4 in 2009, the Mortgage Disclosure Improvement Act ( MDIA ) broadened early disclosure requirements of the 2008 rule to include any consumer dwelling, not just a principal dwelling. More on MDIA below.) c) Improved advertising standards for all mortgages (open-end and closed-end): - Requires advertising to contain additional information about rates, monthly payments, and other loan features. The rule also bans deceptive or misleading advertising practices, including the representation of a rate or payment as "fixed," when in reality it can change. 2. September 24, 2010 Final Rule This rule deals with compensation to loan originators, and applies to mortgage brokers and the companies that employ them, as well as mortgage loan officers employed by depository institutions and other lenders. The rule effectively eliminates a previously widespread industry practice where lenders compensated loan originators if the borrower accepted an interest rate higher than the rate required by the lender (commonly referred to as a "yield spread premium"). Under the final rule, however, a loan originator may not receive compensation that is tied to the terms of the loan; the compensation can only be based on the loan amount. The rule also prohibits any person from paying compensation to a loan originator for a particular transaction if the consumer pays the loan originator s compensation directly. Finally, the rule prohibits the practice of directing or "steering" a consumer to accept a mortgage loan that is not in the consumer's interest in order to increase the originator's compensation. These final rules were effective April 1, II. Mortgage Disclosure Improvement Act (MDIA) of 2008 MDIA s main objective is to provide additional transparency for closed-end consumer mortgage transactions (subject to RESPA and Regulation Z) that are secured by a consumer s dwelling. Note that MDIA extends protections to mortgage loans secured by any consumer dwelling, and not only to those secured by a consumer s principal dwelling. MDIA is focused primarily on two topics: early disclosures for more types of transactions, and disclosures of risks associated with variable rate loans or loans with features such as balloon payments or negative amortization features. 1. May 19, 2009 Rule The rule requires creditors to give a good faith estimate of mortgage costs within three business days 3 after receiving a consumer s application for any mortgage loan (including home purchase, home equity, and refinancing closed-end loans). As mentioned above, these disclosures apply to loans secured by any dwelling, not only by the consumer s principal dwelling. So, loans secured by a vacation home are now subject to early disclosures. In addition, this rule requires creditors to: Wait seven business days 4 after providing the early disclosures before closing the loan Re-disclose if the APR and other terms subsequently changed beyond a specified tolerance Wait an additional three days after a consumer receives the corrected disclosure before closing An important distinction about the waiting periods for early disclosures and corrected disclosures: the sevenbusiness-day waiting period for early disclosures begins when the creditor delivers or places the early disclosures in 2013 FIS and/or its subsidiaries. All Rights Reserved. 4

5 the mail. For corrected disclosures, the waiting period starts when the consumer receives or is deemed to receive the corrected disclosures (the consumer is considered to receive the disclosure three business days after mailing). Failure to re-disclose may occur in situations where system defaults are set on not re-disclosing overstated APRs. As a reminder, re-disclosures are now required if the overstatement of APRs is not caused by an overstatement of finance charges. In the past, overstated APRs did not need to be re-disclosed. While it is tempting to simply redisclose all changes beyond the tolerance level, it is also important to remember that re-disclosures come hand in hand with additional waiting periods, which may not be in the best interest of consumers. 1. September and December 2010 Interim Rules The Federal Reserve September 2010 Interim Rule revised the disclosure requirement for closed-end mortgages. In line with the MDIA s objective to alert borrowers about risks associated with variable rates and other special features, the rule requires lenders to disclose how borrowers regular payments can change over time. These disclosures now have to be done in a tabular format and state the following: the initial interest rate (with the corresponding monthly payment, for adjustable rates or step-rate loans) the maximum interest rate and payment that can occur during the first five years, and a worst case example demonstrating the maximum rate and payment possible over the life of the loan. There are also additional disclosures required for loans with negative amortization options, introductory interest rates, interestonly payments, and/or balloon payments. Interestingly enough, the disclosure needs to contain a reminder to the borrowers that they may not be able to refinance their loans to avoid higher payments - The December 2010 Interim Rule clarifies certain provisions of the September Rule. More specifically, it now requires disclosures for adjustable-rate 5/1 ARM loans to be based on the first five years following the first regular periodic payment due date, rather than the first five years after consummation as required in the September Rule. III. Credit Accountability Responsibility and Disclosure Act of 2009 (Credit Card Act) The Credit Card Act provides additional protections for credit card users and helps ensure that credit card issuers act fairly. The Credit Card Act amendments to TILA were implemented in three stages via rules listed below: 1. July 22, 2009 Interim Rule The amount of time given to consumers before the rate increases or a significant change to an account can be made has been increased to 45 days. Creditors now need to inform their customers about the right to cancel the account before the increase goes into effect. Finally, the rule requires creditors to mail or deliver a periodic statement for credit card and other open end credit consumer accounts at least 21 days before the/a payment is due. 2. February 22, 2010 Final Rule This final rule represents the second stage of the Federal Reserve s implementation of the Credit Card Act. It finalizes the interim July 22, 2009 rule and implements a long list of additional consumer protections. While it would not be feasible to list them all here, some of the more prominent changes are: Prohibition regarding the increase of annual percentage rates and certain fees on existing credit card balances Ban on the two-cycle billing method 2013 FIS and/or its subsidiaries. All Rights Reserved. 5

6 Prohibition of unexpected credit card interest rates during the first year after the account opening Requirement to evaluate the customer s ability to make payments prior to issuing credit cards or increasing the credit limit Restrictions regarding the issuing of a credit card to a consumer under the age of 21 and additional protections for underage customers Restriction on over-limit charges Limitation on high fees associated with subprime credit cards Limitations on the total of all fees to 25% of the initial credit limit. 3. June 15, 2010 Rule This rule represents the third stage of the Credit Card Act. Among some additional significant limitations are the following: Setting a limit on a penalty fee to $25 unless there are repeated violations Prohibition of charging penalty fees that exceed the amount associated with the consumer s violation Elimination of bank inactivity fees, and multiple penalty fees Requirement for issuers to evaluate the reasons for rate increases IV. Higher Education Opportunity Act (HEOA) The HEOA act, which was signed into law on August 14, 2008, requires new disclosures and prohibits certain practices related to private education loans. HEOA s most critical impact on Regulation Z is to expressly include private education loans of any amount, eliminating the exempt threshold. Under HEOA, disclosure requirements apply to loans made for post-secondary educational expenses, with the exception of situations where educational expenses are funded by credit card advances, real estate secured loans, or loans made, insured, or guaranteed by the federal government. HEOA also requires applicable disclosures to be made at three different points - at the time of application, when the loan is approved, and when the loan is consummated. In addition, the amendments implement certain restrictions on using the name or emblem of an educational institution. HEOA s Amendments to TILA Substantive Restrictions Creditors must give the consumer 30 days after approval of a private education loan to decide whether to accept the loan offered. During that time, the creditor may not change the rates or terms of the loan offered, except for rate changes based on changes in the index used for rate adjustments on the loan. Creditors are prohibited from disbursing funds until the three-day cancellation period has run. HEOA s Amendments to TILA Disclosure Requirements 2013 FIS and/or its subsidiaries. All Rights Reserved. 6

7 Disclosures with applications (or solicitations that require no application): creditors must provide general information about loan rates, fees, and terms, including an example of the total cost of a loan based on the maximum interest rate the creditor can charge. In addition, disclosures must contain a statement regarding federal student loan programs as potentially less costly alternatives to a private education loan. Disclosures when the loan is approved: creditors are required to give the consumer a set of transaction specific disclosures, including information about the current and maximum interest rate, total repayment amounts, fees and other terms of the loan, as well as provide relevant examples of such disclosures. Disclosures at consummation: at consummation, the creditor must provide updated cost disclosures substantially similar to those provided at approval. The consumer s three-day right to cancel the transaction must also be disclosed. V. Helping Families save their Homes Act The Act s requirements are implemented in two Rules: November 20, 2009 Interim Final Rule and the September 24, 2010 Final Rule (replacing Interim Final Rule). The rule(s) implement the Act s requirement to issue disclosures to consumers when their mortgage has been sold or transferred. Under the Act, such disclosures must be issued in writing within 30 days by a purchaser or assignee that acquires a mortgage loan. VI. Dodd-Frank Wall Street Reform and Consumer Protection Act The April 4, 2011 Final Rule implements the Dodd-Frank Act provision of increasing the threshold for exempt consumer credit transactions. Until recently, a consumer transaction was subject to TILA disclosures if the amount financed or credit limit did not exceed $25,000. This amount has now been increased to $50, 000 and will be adjusted annually for inflation based on an annual percentage increase in the Consumer Price Index 5. The new threshold amount is in effect as of July 21, The exemption threshold for 2012 is $51,800, effective January 1, As a reminder, private education loans and loans secured by real property (as well as a personal property that is or will be used as the consumer s principle dwelling) are subject to TILA regardless of the loan amount. Taking a Second Look at Existing Compliance Programs Over the last couple of years, compliance departments have been inundated with putting operational processes in place to comply with new rules, and it is likely that the governance and compliance quality controls have not completely kept pace with these operational changes. If this is the case, many organizations will find it necessary to tweak, strengthen, and, in some situations, revamp their Regulation Z compliance framework Obviously, each institution will approach these tasks based on their individual circumstances, but as a starting point, there are some common questions that need to be addressed: Is the governance structure for compliance with Regulation Z still adequate? Is there a need to establish, at least on a short-term basis, a more formal and centralized oversight function to ensure that compliance processes and procedures are consistent across the firm? Some more complex institutions chose to have a centralized program and 2013 FIS and/or its subsidiaries. All Rights Reserved. 7

8 oversight over regulations that are deemed to be more involved, such as Regulation W. Should Regulation Z be treated similarly? Are the compliance testing and monitoring processes appropriately risk-focused? As with any other risk-focused approach, one would expect that the higher priority and deeper scrutiny be placed on the areas impacted by recent amendments, where the processes are less mature and more vulnerable to errors. It is important to remember that while the more salient points of amended or new requirements appear unambiguous, some of the nuances, if not well understood and tested, increase the odds of violations. Are the institution s computer systems appropriately tuned up? Are there any default assumptions that need to be revisited (such as re-disclosing overstated APRs, as mentioned earlier)? Do computer systems use the correct criteria for determining higher-priced mortgage loans? Are the system calculations appropriately tested? Is there an effective process to timely communicate and implement all new requirements and procedures across all departments? Is training fully up-to-date and does it cover all regulation changes? Does Internal Audit conduct comprehensive testing surrounding new or amended requirements? Is there a dialogue and knowledge transfer between Compliance and Internal Audit to ensure appropriate coverage? At this stage, it may be unrealistic to expect that most of these questions will be answered with a yes; however, having definitive answers will be one of the first steps in laying down a foundation for effective compliance and in developing strategies to bridge potential gaps. Related Law/Reg Home Ownership and Equity Protection Act (HOEPA) No. Issue Date 12 CFR Part 226 Docket No. Interim/Final Effective Date Regulatory Change 1 07/30/2008 R-1305 Final Rule 10/01/ /24/2010 R-1366 Final Rule 04/01/2011 Protections for higher priced mortgage loans and additional protections for loans secured by a consumer s principal dwelling Prohibits loan originators from basing their compensation on the interest rate or other loan terms. Additional restrictions on the originator s compensation practices and prohibition of steering practices leading to the increase in the originator s compensation FIS and/or its subsidiaries. All Rights Reserved. 8

9 Mortgage Disclosure Improvement Act (MDIA) Credit Accountability Responsibility and Disclosure Act 3 03/02/2011 R 1392 Final Rule 04/01/ /19/2009 R-1340 Final Rules 07/30/ /24/2010 R-1366 Interim Rule 10/25/ /29/2010 R-1366 Interim Rule 01/30/ /29/2009 R-1286 Final Rules (Withdrawn & replaced by 02/22/2010 Rule) 07/10/ /22/2009 R-1364 Interim Rule 08/20/2009 Implements Section 1461 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 1461 amends TILA to provide a separate, higher rate threshold for determining when the Board s escrow requirement applies to higher-priced mortgage loans that exceed the maximum principal obligation eligible for purchase by Freddie Mac. Revises disclosure requirements for mortgage loans under Reg. Z. Requires lenders to provide cost disclosures early in the process which also apply to loans secured by dwellings other than the consumer s principal dwelling. Revises disclosures for closedend mortgages and requires lenders to disclose, in a tabular format, how borrower s regular mortgage payments can change over time. Amends the Board s September 24, 2010 Interim Rule and clarifies certain aspects of this rule. Prohibits certain credit card practices. Additional protections and improved disclosures for credit card users. First stage of the Federal Reserve implementation of the Credit Card Act. Includes the increase in the amount of notice before the rate is increased or a significant change is made to the account s terms FIS and/or its subsidiaries. All Rights Reserved. 9

10 Higher Education Oppty Act (HEOA) Helping Families Save Their Homes Act Dodd - Frank Act 9 02/22/2010 R-1370 Final Rule (Replaces 01/29/2010 Final Rule) 02/22/ /15/2010 R-1384 Final Rule 08/22/ /14/2009 R-1353 Final Amendments 12 11/20/2009 R-1378 Interim Final Rule 09/14/2009; compliance optional till 02/14/ /20/2009, compliances optional for 60 days 13 09/24/2010 R-1378 Final Rule 01/11/ /04/2011 R-1424 Final Rule 07/21/2011 Second Stage of the Federal Reserve s implementation of the Credit Card Act. Replaces the January 29, 2009 rule and implements the provisions of the Credit Card Act. Bans several harmful practices and requires greater transparency in the disclosures. Third stage of the Federal Reserve s implementation of the Credit Card Act. Protects credit card users from unreasonable late payment and other penalty fees and requires creditors to reevaluate recent interest rate increases. Revisions for disclosure requirements for private education loans Notice to consumers whose loans have been sold or transferred Replaces 11/20/2009 Interim Final Rule Increases threshold for exempt credit transactions from $25,000 to $50, FIS and/or its subsidiaries. All Rights Reserved. 10

11 1 The Board obtains or derives average prime offer rates for a wide variety of transactions from the Primary Mortgage Market Survey (PMMS) conducted by Freddie Mac, and publishes it on a weekly basis. 2 Jumbo loans are loans exceeding the conforming loan-size limit for purchase by Freddie Mac. 3 Business days are defined as all calendar days except Sundays and specified legal public holidays. 4 The same business day definition is used for the purposes of the seven business day waiting period and the three business day business period. 5 Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) Contact us FIS Enterprise Governance, Risk and Compliance (EGRC) Solutions FIS and/or its subsidiaries. All Rights Reserved. 11