Mortgage Banking & Consumer Credit Alert. Final Regulation C Amendments Conform to New Regulation Z Test. Objectives

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1 November 2008 Authors: Melanie Brody Stephanie Robinson K&L Gates comprises approximately 1,700 lawyers in 28 offices located in North America, Europe and Asia, and represents capital markets participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations and public sector entities. For more information, visit Final Regulation C Amendments Conform to New Regulation Z Test On October 20, 2008, the Board of Governors of the Federal Reserve System (the Board ) amended Regulation C to revise the Home Mortgage Disclosure Act ( HMDA ) rate spread reporting threshold to correspond with Regulation Z s recently adopted definition of higher priced mortgage loans. 1 The new rule is designed to achieve more effective and consistent reporting of subprime lending activity by comparing a loan s annual percentage rate ( APR ) to the applicable average prime offer rate, a calculated annual percentage rate derived from market surveys that is intended to reflect the total cost of a prime mortgage loan. The new rule becomes effective on October 1, 2009, giving lenders a year to develop and implement the new reporting procedures. The rule, described below, may present certain programming challenges. Additionally, the more significant question may be how the new information is interpreted once it becomes publicly available and whether the data will result in heightened scrutiny of lenders for compliance with anti-predatory lending requirements. Objectives The Board had three main objectives in abandoning the use of the Treasury yield benchmark in favor of an average prime offer rate. First, the Board has always intended for Regulation C s rate spread reporting requirement to cover subprime loans, and not prime loans. But that objective was not always achieved with the Treasury yield benchmark that is currently used. The spread between Treasuries and mortgage rates changes for various reasons, and it can change so much that rate spreads for loans with identical credit risk could be reportable in some periods but not in others. The Board noted that the Treasury mortgage spread was particularly volatile in 2007 and the first half of 2008, swinging by up to 25 basis points in a week. 2 For this reason, the loans required to be reported under Regulation C were not consistently the all subprime mortgage loans only that the Board intended to cover. The new rule is intended to help the Board meet its goals of excluding coverage of prime loans and covering all subprime loans because the new benchmark more closely follows mortgage market rates than does the Treasury yield benchmark. A second, related objective is to make HMDA reporting more consistent and more predictable. 3 The rule as amended relies on benchmarks that track average rates in the prime mortgage market. The Board anticipates that comparing a loan s APR to the average prime offer rate will make reporting more consistent and predictable because both rates will reflect the total cost of credit that an APR represents. 4 Thirdly, replacing the Treasury yield benchmark with the average prime offer rate benchmark should make it easier for lenders to determine the truly comparable rate accurately. Regulation C currently approximates the comparable Treasury security based on maturity a loan is matched to a Treasury security with the same contract term to maturity. However, as the Board points out, this method does not account for the fact that very few loans reach their full maturity. 5 The amended rule matches loans to benchmark by product type rather than just by contractual term to maturity. This should serve to make the comparison more accurate.

2 Average Prime Offer Rate The average prime offer rate under the new rule will consist of an annual percentage rate derived from average interest rates, points, and other loan pricing terms currently offered to consumers by a representative sample of creditors for mortgage loans that have low-risk pricing characteristics. 6 The Board will publish the average prime offer rates on the FFIEC web site on a weekly basis. The rates will include one table for fixed-rate loans (for eight products) and another table for variable-rate loans (for six products). Generally, every Friday the Board will publish rates that become effective on the following Monday. The Board plans to derive average prime offer rates from the Freddie Mac Primary Mortgage Market Survey ( PMMS ). 7 The PMMS surveys approximately 125 mortgage lenders each week on the rates and points associated with their first-lien prime conventional conforming mortgages with a loan-to-value ratio of 80 percent. Freddie Mac also asks lenders to provide, for adjustable-rate mortgage ( ARM ) products, the initial coupon rate and points and the margin. The survey includes rates and points for four single-family mortgage loan products: (i) 30-year fixed rate; (ii) 15- year fixed rate; (iii) 5/1 hybrid amortizing ARM; and (iv) 1-year amortizing ARM. 8 The Board will use this information to calculate an annual percentage rate for each of the four types of transactions. For other types of transactions, the Board will derive annual percentage rates from the loan pricing terms available in the PMMS. The Board s methodology, which is published as an attachment to the new rule, is complex and will be published on the FFIEC s web site along with the average prime offer rates. However, the Board said that it might make further revisions to the methodology before posting it on the FFIEC web site, in the event that it needs to make any clarifications. Rate Spread Reporting Threshold The rule adopts a rate spread reporting threshold of 1.5 percentage points above the average prime offer rate for a comparable transaction for first-lien loans and 3.5 percentage points for subordinate-lien loans, matching the coverage test for Regulation Z. These thresholds may mean that some alt-a loans are captured along with subprime loans; the Board decided it is better to err on the side of over-inclusiveness. Prime jumbo loans are also likely to be captured with these thresholds, but the Board determined that establishing different thresholds for a myriad of different product types would make the rule unwieldy. Methodology As described above, the PMMS data only covers two fixed-rate products and two ARM products. The Board therefore will use interpolation techniques to estimate APRs for ten additional products: one-, two-, three-, five-, seven-, and ten-year fixed-rate loans, and two-, three-, seven-, and ten-year variable-rate loans. 9 Comparable transactions will be determined by the term to maturity for fixed-rate loans and by the initial fixed-rate period for ARM loans. The first step for estimating APRs for loan products for which PMMS data is not available is to calculate the difference between PMMS-reported rates and corresponding Treasury yields ( Treasury spreads ). The Board will use weighted averages to come up with the margin and points for these other variablerate products, and will calculate the initial interest rate by adding together the Treasury spread to the average Treasury rate for the appropriate initial, fixed-rate period. The Board s methodology also includes assignment rules for loans for which an APR of the same term to maturity or initial, fixed-rate period is not included among the fourteen products for which the Board will publish average prime offer rates. The assignment rules track the existing assignment rules for Treasury yields. Effective Date The Board pushed back its proposed implementation date for the new reporting rule after industry commenters expressed concerns about the time and costs of implementing the necessary systems changes by January 1, Regulation C amendments become effective on October 1, 2009, as do the Regulation Z amendments concerning higher-priced mortgage loans. Lenders must use the new rate spread reporting test on loans for which applications are taken on and after October 1, Lenders also must use the new test on all loans consummated on or after January 1, 2010, regardless of their application dates. The Board plans to publish the tables and methodology on the FFIEC web site by January 1, November

3 Necessary Systems Changes Commenters on the proposed rule pointed out, and the Board acknowledged, that lenders will have to capture two additional data elements in order to match their mortgage loans to comparable transactions and apply the new test: (1) whether the loan has a variable rate, and (2) if so, the length of the initial fixed-rate period. It may be difficult to integrate these additional data elements with existing HMDA compliance systems. For many lenders, capturing the data and importing it into their HMDA compliance systems may involve extensive system changes. Moreover, lenders will have to update their systems and train their employees to input the effective rates correctly. They must use the most recently available (meaning currently effective) average prime offer rate as of the loan s rate-lock date. The new reporting requirements impact on lenders remains to be seen. Although implementing the rule may present certain programming challenges, the more significant issue is likely to be how the new information is interpreted once it becomes publicly available. If the rule works as the Board intends, it will allow government agencies and other analysts of HMDA data to more accurately identify which lenders are making subprime loans. This may result in heightened scrutiny of those lenders for compliance with antipredatory lending requirements. It also could result in additional fair lending scrutiny for lenders that appear to make a disproportionate volume of subprime loans to minority borrowers. If you have any questions about the new requirements, please contact any member of K&L Gates mortgage banking and consumer finance group. Endnotes 1 The rule was published in the Federal Register on October 24, Home Mortgage Disclosure, 73 Fed. Reg. 63,329. The Regulation Z amendments (the bulk of which become effective on October 1, 2009) were published in the Federal Register on July 30, Fed. Reg. 44,552. Regulation Z s new restrictions for higher-priced mortgage loans include provisions that: (a) prohibit a lender from making a loan without regard to a borrower s ability to repay; (b) prohibit prepayment penalties if the payment can change during the loan s first four years (and in all other cases the prepayment penalty period must not last for more than two years and may not be imposed on a same creditor refinance ); and (c) require a lender to establish an escrow account for the payment of property taxes and homeowners insurance for first-lien, higher-priced loans, although it may offer the borrower the opportunity to cancel the escrow account after one year. For a fuller description of the changes to Regulation Z, see Kristie D. Kully & Laurence E. Platt, Satisficing Subprime: New HOEPA Rules Might Just Be Good Enough, K&L Gates Mortgage Banking and Consumer Credit Alert, Aug. 5, 2008, com/newsstand/detail.aspx?publication= Fed. Reg. 63,330 (Oct. 24, 2008). 3 For a discussion of the 2007 HMDA data, see Paul F. Hancock, Melanie H. Brody, & Elena Grigera, The 2007 HMDA Data: Market Turmoil but Little Change in Racial and Ethnic Disparities, K&L Gates Mortgage Banking and Consumer Credit Alert, Oct. 10, 2008, klgates.com/newsstand/detail.aspx?publication= Fed. Reg. 63, Fed. Reg. 63, Fed. Reg. 63,335, to be codified at 12 C.F.R Freddie Mac publishes the PMMS data on its web site at PMMSOutputYr.jsp. The Board has indicated that while it will rely on the PMMS data for the foreseeable future, it will conduct its own survey if it becomes necessary or appropriate to do so. 73 Fed. Reg. 63, The 30-year and 15-year fixed rate product designations refer to those products terms to maturity. The five-year and one-year variable-rate product designations refer to those products initial, fixed-rate period. 9 Interpolation essentially means using known data values to estimate unknown data values. November

4 K&L Gates Mortgage Banking & Consumer Finance practice provides a comprehensive range of transactional, regulatory compliance, enforcement and litigation services to the lending and settlement service industry. Our focus includes first- and subordinate-lien, open- and closed-end residential mortgage loans, as well as multi-family and commercial mortgage loans. We also advise clients on direct and indirect automobile, and manufactured housing finance relationships. In addition, we handle unsecured consumer and commercial lending. In all areas, our practice includes traditional and e-commerce applications of current law governing the fields of mortgage banking and consumer finance. For more information, please contact one of the professionals listed below. LAWYERS Boston R. Bruce Allensworth bruce.allensworth@klgates.com Irene C. Freidel irene.freidel@klgates.com Stephen E. Moore stephen.moore@klgates.com Stanley V. Ragalevsky stan.ragalevsky@klgates.com Nadya N. Fitisenko nadya.fitisenko@klgates.com Brian M. Forbes brian.forbes@klgates.com Andrew Glass andrew.glass@klgates.com Phoebe Winder phoebe.winder@klgates.com Charlotte John H. Culver III john.culver@klgates.com Los Angeles Thomas J. Poletti thomas.poletti@klgates.com Miami Paul F. Hancock paul.hancock@klgates.com New York Philip M. Cedar phil.cedar@klgates.com Elwood F. Collins elwood.collins@klgates.com Steve H. Epstein steve.epstein@klgates.com Drew A. Malakoff drew.malakoff@klgates.com San Francisco Jonathan Jaffe jonathan.jaffe@klgates.com Erin Murphy erin.murphy@klgates.com Seattle Holly K. Towle holly.towle@klgates.com Costas A. Avrakotos costas.avrakotos@klgates.com Melanie Hibbs Brody melanie.brody@klgates.com Eric J. Edwardson eric.edwardson@klgates.com Anthony C. Green anthony.green@klgates.com Steven M. Kaplan steven.kaplan@klgates.com Phillip John Kardis II phillip.kardis@klgates.com Rebecca H. Laird rebecca.laird@klgates.com Laurence E. Platt larry.platt@klgates.com November

5 Phillip L. Schulman H. John Steele Ira L. Tannenbaum Nanci L. Weissgold Kris D. Kully Morey E. Barnes David L. Beam Emily J. Booth Holly Spencer Bunting Krista Cooley Elena Grigera Melissa S. Malpass David G. McDonough, Jr Stephanie C. Robinson Kerri M. Smith David Tallman Director of Licensing Stacey L. Riggin Regulatory Compliance Analysts Dameian L. Buncum Teresa Diaz Jennifer Early Robin L. Gieseke Allison Hamad Joann Kim Brenda R. Kittrell Dana L. Lopez Patricia E. Mesa Jeffrey Prost K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the U.S., in Berlin, in Beijing (K&L Gates LLP Beijing Representative Office), and in Shanghai (K&L Gates LLP Shanghai Representative Office); a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining our London and Paris offices; a Taiwan general partnership (K&L Gates) which practices from our Taipei office; and a Hong Kong general partnership (K&L Gates, Solicitors) which practices from our Hong Kong office. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office. This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Data Protection Act 1998 We may contact you from time to time with information on K&L Gates LLP seminars and with our regular newsletters, which may be of interest to you. We will not provide your details to any third parties. Please london@klgates.com if you would prefer not to receive this information K&L Gates LLP. All Rights Reserved. November