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   ARTICLE   |   From Scotsman Guide Residential Edition   |   December 2009

Inside the Regulation Z Maze

The Federal Reserve Board's proposed changes to the rule implementing the Truth in Lending Act punctuate a strenuous year

Inside the Regulation Z Maze

As the calendar turns, mortgage brokers put to rest one of the most-difficult years the industry has faced. Keeping up with legislative and regulatory changes presented perhaps the biggest challenge -- a test that's sure to continue in 2010 and beyond. At the forefront: proposed changes to Regulation Z and their threat to brokers. Here's more about what they could mean for your business. 

As part of the Federal Reserve Board's review of Regulation Z, which implements the Truth in Lending Act (TILA), there are new proposed guidelines for closed-end credit transactions, including mortgage loans. With respect to mortgage lending, the proposed changes are sweeping and include new definitions, standards, restrictions and disclosures.

Brokers should take time to understand some of the core changes on tap. Many brokers also will want to submit opinions and advice before the public comment period ends on Dec. 24 (comment: sctsm.in/TILAcm). After all, the future of your business could depend on what shakes out.

The main impacts of proposed TILA changes to closed-end credit transactions fall into three categories:

  1. Yield-spread premium (YSP)
  2. Annual percentage rate (APR) calculations
  3. Disclosures

Because YSP restriction would most directly affect mortgage-broker compensation, and because this change is the most controversial of the three, we'll begin there.

YSP constraints

The government believes a lack of clarity surrounds YSP. This concern comes despite the fact that mortgage brokers must disclose lender payments on good-faith estimates and U.S. Department of Housing and Urban Development (HUD)-1 settlement statements. Moreover, HUD-1 statements are closed by a third party -- often an attorney -- tasked with ensuring that consumers are informed of all terms of the loan.

Disclosure Changes

Proposed changes to Regulation Z provide for disclosures at various times in the loan process. What must be disclosed when:

At time of application:

  • "Key Questions to Ask About Your Mortgage" pamphlet
  • "Fixed vs. Adjustable Rate Mortgages" pamphlet, which would replace the "Consumer Handbook on Adjustable-Rate Mortgages" booklet
  • Revised ARM-loan-program disclosure with terms in a question-and-answer format

Within three days of application:

  • Revised early Truth in Lending Act (TILA) disclosure, which also would be required three days before charging any fees other than those for credit reports
  • New calculations for annual percentage rate and finance charges to be more inclusive of third-party charges
  • Column comparison of interest rates for borrowers with varying credit grades
  • Summary of key loan features, total settlement costs and potential changes to interest rate and monthly payment

Three days before consummation:

  • Final TILA disclosure
  • Procedures for disclosing loan changes after the final TILA

After consummation, note that the time period for notice of changes to ARMs is now 60 days, and more-detailed statements are required for payment-option ARMs.

On the other hand, similar income that goes to lenders isn't disclosed to consumers. Further, new Real Estate Settlement Procedures Act guidelines make lender premiums paid to brokers more visible to consumers but keep similar income paid to funding lenders hidden from consumers. Because of this, transparency often lacks when brokers aren't part of the picture -- not when they are.

As written, the new Regulation Z rule would prohibit lender payments to mortgage brokers and loan officers based on a loan's terms or conditions. It also would prohibit steering consumers to transactions not in their best interests in order to increase origination compensation.

(Editor's note: This past October, U.S. Rep. Gary Miller [R-Calif.] indicated Congress would address the YSP issue by merging House Resolution No. 1728, which passed the House, and House Resolution No. 3126, which passed the House Financial Services Committee. At press time, the Senate had yet to consider the bills.)

The proposed TILA change could impact mortgage lending drastically and greatly decrease the viability of small independent mortgage brokers. Consequently, the loss of wholesale brokers would lessen competition, limit consumer choice, and increase costs for lenders and borrowers.

Problem with premise

Part of the problem with this proposed revision is that it's based on the premise that YSP, which also can be thought of as lender-paid premium, incentivizes brokers to act contrary to the best interests of consumers -- and that YSP alone somehow creates a reason to steer consumers into bad loans.

This understanding of YSP fails to recognize that interest-rate-based premiums constitute a legitimate way to offset the cost of retail operations. This can be demonstrated by comparing interest rates offered by mortgage brokers who don't fund their own loans to interest rates offered by lenders who do. The offered rates are similar. But brokers generally receive a portion of the interest premium from wholesale lenders.

While wholesale lenders retain the interest premium that covers the market risk associated with servicing and selling loans, mortgage brokers receive the interest premium that covers the risk associated with the cost of maintaining retail operations. On the other hand, lenders that fund their own loans retain the full interest premium to offset their market risk and the risk associated with their retail operations. As written, the rule change would not remove the interest premium but only would change who retains the income.

The rule revision also doesn't adequately address the nature of the mortgage bond market, in which securities are priced at increments much smaller than contracted interest rates for the individual loans. The market provides pricing options for consumers, which consumers might not understand.

The interest rate is one of several loan features that determine the price a mortgage investor will pay to service a closed loan. The price becomes the premium or discount paid when the closed loan is sold to the final investor.

For example, one lender or investor might offer an interest premium to a mortgage broker of 1 percent for a 4.75-percent loan. The next-lower rate might cost a consumer a 0.5-percent discount.

The provisions of the pending TILA change to restrict lender-paid premiums don't provide adequately for these market variations and fluctuations. These premiums or discounts factor into the determination of the total upfront, out-of-pocket expenses borrowers will pay.

In comparison, another lender might offer a broker a lender-paid premium of 0.125 percent for the same 4.75-percent loan, and the next-lower rate would cost the consumer a 0.9-percent discount. In this case, the lender decides to retain a larger portion of the interest premium to offset its own retail costs and profits.

In either case, the consumer has the same payment. In the second example, however, the broker receives less of the premium, which must be made up with upfront charges to offset normal expenses. When the funding lender retains the premium, it doesn't change what the borrower pays; it only changes who keeps the market premium.

Unfair advantage

Restricting lender payments to brokers could create unfair advantages for lenders and force brokers to increase upfront fees in an effort to recover lost income. If implemented as written, the rule will eliminate many brokers' ability to compete with lenders. Ultimately, the loss of competition will increase the interest rates consumers pay.

Regulators, consumer advocates and legislators point to past examples of steering from a low-rate loan to a much-higher-rate subprime (aka, nonprime) loan. Some give extreme examples of rate increases of 2 percent or more. Such steering, however, never made sense because brokers could generally earn a higher interest premium for selling lower-rate conventional or Federal Housing Administration loans than they could from selling subprime loans. Beyond this, however, there is another point worth making: The subprime loans in question are in large part no longer available.

Opponents of YSP also like to note loan-officer compensation abuses that occurred when originators increased adjustable-rate margins and prepayment penalties. Again, programs that once allowed such things are all but extinct. If the market ever does re-embrace negative amortization and pay-option ARMs, restrictions could be targeted to those specific programs.

Regardless of how you look at it, neither argument has any-thing to do with income from YSP, which long has been a legitimate part of conventional and government mortgage markets. Loss of that income will have negative impacts on consumer choice; small, independent brokers; and competitive mortgage rates.

Providing options

With regard to steering and lender-paid compensation to brokers, the Federal Reserve's provision that loans must be in consumers' best interests leaves much to be defined, which the Fed itself acknowledges.

The proposed rule allows for compliance if brokers and originators provide at least three loan options "for each type of transaction (fixed-rate or adjustable-rate loan) in which the consumer expressed an interest." In order to comply under this safe harbor, brokers "must obtain loan options from a significant number of creditors with which the originator regularly does business."

The three options must include the loan with:

  • The lowest rate;
  • The second-lowest rate; and
  • The lowest total dollar amount for origination points or fees and discount points.

In other words, if a broker offers three options meeting these criteria, and the consumer chooses the loan in which the broker receives the most creditor-paid compensation on the consumer's own accord, that's acceptable.

This is an area in which the Federal Reserve seeks specific comments.

APR changes

Proposed changes to Regulation Z also look at APR and finance-charge calculations and attempt to make them more comprehensive. Federal Reserve consumer testing revealed much consumer confusion about APR and finance charges. One of the new rules' goals is improving comprehension of the cost of credit.

Despite inherent problems explaining APR, the proposed rule intends to retain APR as the benchmark for loan comparisons. As many see it, the problem with APR is that it's an artificial number. It's not used in the calculation of the monthly payment, and it varies with loan size and loan term. In essence, APR can't accomplish the purpose for which it's intended. At best, it's a distraction.

What the Federal Reserve intends as a helpful one-number benchmark instead often adds to consumer confusion. Increasing the font type for APR, as the proposed rule intends to do, will not make the number any clearer to consumers.

The biggest proposed change to APR is the expansion of the charges to be included in the calculation. The proposed rule intends to include third-party charges in the broad category of "finance charges." The implication is that there is room for lenders to omit fees in order to lowball APR.

In practice, the present calculation enables consumers to compare accurately loan charges between different lenders. There's little to no confusion about which charges to include, much as there's little to no chance to hide a charge in a non-APR line. If the purpose of APR is to enable consumers to select between loans, then including third-party charges that will be the same regardless of lender or loan dilutes the comparison and defeats the purpose.

The Fed also has asked specifically for comment on the unintended consequences of this change.


Finally, proposed Regulation Z changes affecting closed-end credit transactions aim to include an early TILA disclosure and a final TILA disclosure. The final disclosure must come at least three days before consummation of the loan. The proposal also includes provisions for "post-consummation disclosures."

The Fed's consumer testing revealed that much of the information presented in current TILA disclosures was of secondary importance to consumers when considering a loan. Of primary importance are the contract interest rate, monthly payments and closing costs.

One of the disclosures' main purposes is to allow consumers to compare credit terms easily to make the best decision. The new disclosures should do that. Consumers have the right to expect that their broker is acting in their best interests. The new requirement that initial estimates be accurate also will help all mortgage brokers and increase their level of professionalism.

It's not in consumers' best interests, however, to lose loan-pricing flexibility or competitive choices because of unfair advantages provided to funding lenders.

•  •  •

Federal regulators and Congress appear intent on making changes to the mortgage industry. In many cases, these changes may not be practical or helpful for consumers or brokers. 

Because of this, brokers should stay up-to-date with new and proposed rules and voice their opposition when necessary. As you speak up, make sure you're also aware of comment-period timelines, starting with the Dec. 24 deadline for Regulation Z comments.


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