Changes in Reg. Z Abound! Are you ready for 2014?     

For most of our clients there is a great deal of energy (worry?) being expended while getting prepared for the new mortgage rules that will come into effect at the beginning of 2014.  Chief among these are the rules that apply to higher priced mortgages also known as “qualified mortgages” or “QM”.  

Ability to Repay and Qualified Mortgages   

Since 2009, Regulation Z has required that creditors assess the ability of a borrower to repay loans that are designated higher price loans[1]  In 2010 the requirement to consider the ability to pay was greatly expanded and now includes almost all closed- in consumer transactions that are secured by a dwelling.  .  

The 2010 regulations also established “qualified loans” and along with, a presumption of compliance for creditors that make qualified loans.  As with many regulations, there is some good news and some bad news.  The good news is that if your bank makes qualified mortgages that are not high priced, there is an irrefutable presumption that the ATR requirements have been met and significantly reduced liability follows. 

When does the Rule “Kick In”?  

The complete set of rules will take effect for any application that is received on or after January 10, 2014.   The CFPB has noted that examiners will start testing for compliance “after a reasonable time” which generally means about six months after implementation. 

The rules apply to all consumer transactions that are closed end and are secured by real estate.  This means that these rules are not limited to first liens or primary residences.   There are a few exceptions to the QM/ATR rules.  These are;   

1.       HELOCS

2.       Time-Shares

3.       Reverse Mortgages

4.       Construction or temporary loans

5.       Consumer loan secured by vacant land

 

For all loan applications accepted after this date, the Bank must keep a record of its documentation of ability to pay for these from the date of receipt.  

  

Ability to Repay    

Although the rules do not specifically state the underwriting guidelines for a bank, there are 8 factors that must be included in credit analysis

                                                               i.            Current or reasonable expected income or assets (not including the property) that the borrower will use to repay

                                                             ii.            Current employment status

                                                           iii.            Monthly mortgage payment for this loan (using the fully indexed rate or full amortizing payments-whichever is higher )

                                                           iv.            Monthly payments on any simultaneous loans securing the property

                                                             v.            Monthly payments for property taxes and insurance that is required by the bank; homeowners fees

                                                           vi.            Debts, alimony and child support

                                                          vii.            Monthly debt ratio as a ration of gross monthly income

                                                        viii.            Credit history 

 

Others factors can be used, but these 8 must be included at a minimum    Verification of this information can be documented by various means, but they must be documented and maintained for three years after the receipt of the application!   There is a list of acceptable documents in the regulation guide including records from government agencies, statements provided by a cooperative or homeowners association, lease agreements, credit reports, etc.  

The guidance in this area is clear that there are many different factors that can be considered when considering whether or the determination of ATR was reasonable.    Two strong factors in determining whether or not a loan decision was reasonable are:

·       You used a standard set of underwriting standards that have been proven to show a low rate of delinquency and/or default

·       The particular borrower has paid on time for a significant part of the loan since the rate adjusted or re-set.  

On the other hand there are considerations that indicate that the ATR decision was NOT in good faith.  These include:

·       Ignored underwriting standards (a large number of exceptions to policy)

·       Inconsistent application of underwriting standards

·       Early defaults in loans (without a catastrophe)  

There are specific guidelines for the way to calculate the DTI ratios for the borrower.  In summary, these rules direct the lender to use the worst case scenario to determine ATR.  That is, use the highest payment that the borrower will have to make under the loan terms as well as the amount of income that can be reasonably established.   

Why Should I care whether the loan is Qualified or not?  

The whole “quid pro quo” in this area is powerful.  In the event that a loan is not determined to be qualified and the borrower defaults, it is the borrower who can sue the Bank.  A successful suit for not properly qualifying a borrower can result in the Bank paying the customer three years’ worth of interest and fees.  This, by the way, is the reason that records must be retained for three years from the date of the loan origination.  

On the other hand, if the loan is qualified and not a high cost loan, then there is a presumption that the Bank properly considered the borrowers ATR.  The Bank wins! 

What is a Qualified Mortgage?

There are two characteristics that qualified mortgages should have. 

·       The DTI should not exceed 43 percent

·       The points and fees should not exceed 3% [2]

Neither of these characteristics is directly required by the regulation, but these are guidelines that will be used by regulators.   In the event that the loan is considered a high-priced, loan, the presumption that the Bank has established ATR is a rebuttable one.  The borrower would have to meet a high standard to show that Bank did not properly consider ATR 

Conclusion

The CFPB is considering making exceptions for small lenders.  However, we advise that all banks should  prepare to meet the QM/ATR standard as much as possible. 

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[1] Higher-priced loans are generally defined as having an annual percentage rate (APR) that, as of the date the interest rate is set, exceeds the Average Prime Offer Rate (APOR) by 1.5 percentage points or more for first-lien loans and 3.5 percentage points or more for subordinate-lien loans

[2] For loans less than $100,000 there is a schedule of points and fees that will qualify the loan

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[1] Higher-priced loans are generally defined as having an annual percentage rate (APR) that, as of the date the interest rate is set, exceeds the Average Prime Offer Rate (APOR) by 1.5 percentage points or more for first-lien loans and 3.5 percentage points or more for subordinate-lien loans

[2] For loans less than $100,000 there is a schedule of points and fees that will qualify the loan

Introduction

From time to time we find that our clients are confounded by the rules regarding the documentation necessary for beneficial owners of accounts ta their banks.  The fact of the matter is that this will be a point of emphasis in BSA/AML examinations over the next few cycles.  As always, it is our advice to be prepared for this question even if, at the moment, it may not apply to your bank.  The FFIEC has issued guidance in this area that may be helpful

Beneficial Ownership

The first question that has to be addressed is “when we say beneficial ownership, what exactly are we talking about?’   The FFIEC guidance discusses the FINCEN definition which states that the "beneficial owner" is the individual(s) who have a level of control over, or entitlement to, the funds or assets in the account that, as a practical matter, enables the individual(s), directly or indirectly, to control, manage, or direct the account.

According to this definition, what the regulators are looking for is information on anyone who can use the funds in an account for their own benefit.   For any person or entity that might benefit from the funds in an account, there should be significant information to determine what that person or entity does and will do with the funds. 

It is worth noting that this definition does NOT include a person or entity that has the right to transfer funds into the account solely or only the right to receive funds is not considered a beneficial owner for purposes of these regulations.  It is the ability of the person or entity to control, manage or direct the account that is controlling.  

The need to fully document the beneficial owners of an account presents itself in several circumstances.  Included in these are:

·         When the customer is acting as an agency for another entity

·         Where the customer is a legal entity that Is not publicly traded

·         When the customer is the trustee

·         Private Banking accounts

·         Foreign Correspondent Accounts

·         An account rated high risk at its inception

For each of these types of accounts, customer identification process should include an element of enhanced due diligence that includes information about beneficial owners and their relationship to the client.  At a minimum, there should be information about how funds may be transferred and used by the beneficial owner of the account.  

What’s the Big Deal? 

If we know our customer, why should we care so much about the beneficial owner?   We can monitor activity on the account and will research any activity that we deem to be suspicious; this is the argument that we hear from our clients.  The answer is context.  What may be totally normal for the bank’s client may be totally out of context for the beneficial owner.  For example, supposed ABC Corporation owns and operates a coin operated laundry.  It is entirely reasonable that the laundry will have regular deposits of cash.   After a reasonable time, cash deposits from this entity would not raise even the slightest suspicion.  However, if ABC Corporation is a medical supplies firm, the context changes.  Now it is important to know the relationship between the beneficial owner and the client.  It is important to actually observe the coin laundry to determine that the number of clients using the laundry matches the deposits.  While it is entirely possible and plausible that the Medical Supplies company keeps itself separate from the laundry, there must be documentation of the relationship and the manner in which the two entities remain separate.  

The FFIEC guidance points out that money launderers and criminal often use the privacy and confidentiality of banks laws covering accounts as a shield for criminal activity.   While it is impossible to know everything that a client may be doing, it is critically important to have an outline of the business model of the client and to be able to match the activity of that client with its banking activity. 

The Basics

There are some basic guidelines to follow to determine whether your CIP and CDD programs are meeting the standard for beneficial ownership.  

     Step One:   The basic CIP program must be sufficiently sophisticated to determine when a customer should require CDD.  For example, all of the customers on the list mentioned above should draw immediate EDD.   If, at the end of documenting a new account, a  private corporation does not trigger the search for information on the beneficial owners of the account, the CIP process should be enhanced.  

     Step Two:  When an account triggers EDD, there should be policies and procedures in place for each type of account.    For example, 

·      There should be minimal procedures for documenting the source of wealth of a private banking customer;

·       In the case of a privately held corporation there should be a background check that includes an internet search;

·        For a trustee, information about the relationship between the trustee and he beneficiary should be collected;

·         In the case of an agency, the agreement between the customer and the agency should be obtained;

·         For foreign correspondent accounts there are minimum policies and procedures that are fully described in the BSA/AML examination manual

      Step Three:  Once the EDD information is collected, it should be used as a regular part of monitoring accounts for suspicious activity.  This is an area where we see a great deal of concern.  Many times, once the EDD information is collected, it is placed in a file and stored for posterity.  However, it is his information that adds the proper context to the activity that is being reviewed.   As a best practice EDD which includes information from loan and relationship managers is critical for a complete and proper review for suspicious activity. 

     Step Four:  Develop systematic sharing across all business lines.  Too often information about loan customers and other commercial customers does not get shared with the BSA department and vice versa.  In many cases, this information could be used to significantly reduce the risk of loss or alternatively the risk of a BSA/AML violation.  The sharing of information on an enterprise wide basis will significantly reduce risk at a bank.  

Conclusion

The more you know about beneficial owners of accounts, the lower the risk.  Remember, the hand that controls the funds, rules the result! 

CRA Update:  The ever expanding possibilities for Meeting Community Development Needs 

 

One of the more interesting recent developments in the area of Community Reinvestment Act (“CRA”) compliance was the publishing of the Interagency Questions and Answers proposing to clarify issues around how community development loans and investments are treated for purposes of CRA ratings.      While these propose changes received little fanfare, they represent both significant change in the manner in which community development and community service can be considered.  We believe further, that these Q & A’s represented the beginning of something bigger and better for CRA in the near future. 

Community Development - Immediate and Direct Impact

Community development activities are considered for large banks and intermediate small bank CRA reviews.  As an aside, small banks cans can have their community development activities considered for the purpose of receiving an “outstanding rating”; although we are aware of very few institutions that actually pursue this course.  

One of the areas of confusion for community development has come with organizations that operate statewide, or regionally.  In many cases, the services these organizations provide do not necessary confer an immediate and direct benefit on the assessment area of the bank.  The original answer to this question said that these investments would be considered if the bank had “adequately addressed the community developments needs of its immediate community.    It was this language that seems to cause our clients to hesitate.  How do we know whether we have adequately addressed the community development needs of our assessment area?   

The changes to the answer to the questions attempt to address this.  Going forward, community development investments that do not give immediate direct impact to the assessment area must:

·       Be conducted in a safe and sound manner;

·       May not be conducted in lieu of, or to the detriment of activities within the assessment area. 

The FFIEC goes on to state that when agencies examine whether or not activities are being conducted in lieu of or to the detriment  of activities within the assessment area, the performance context and opportunities within the assessment area will be examined. 

Meeting the Test for Activities Not in Lieu or to the Detriment

It is clear form this language that Banks will need to do a clear and convincing job of showing research that indicates that they

·       Know the credit needs of the local assessment area;

·       Have researched the opportunities for community development investments and loans; and

·       Can demonstrate that these opportunities do not exist in significant numbers within the assessment area. 

We advise our clients to ensure that there is ongoing dialogue with community groups, documentation of the dialogue and substantial economic research on the needs of the community.   In addition, it is a best practice to ensure that the strategic plan of the Bank matches with the economic research that is being performed.  For example, when the strategic plan calls for home equity loans minimums that start at $130K, there should be research that shows that this minimum would not arbitrarily exclude significant portions of the population with the assessment area.   

The upshot here is that you can clearly investment in community development agencies that do not directly and immediately impact the assessment area as long as you can prove that there aren’t viable options. 

Investments in National Funds

A second area that was addressed by the Questions and Answers was the question about community development credit for investing in national of regional CD Funds.  Because these funds tend to provide economies of scale and efficiencies, it is clear that the FFIEC would like to encourage investment in the community development work of these funds.   As a result, the new question and answers give a very similar treatment to these funds above. In those circumstances where a Bank can show that it has researched and considered the credit needs of its assessment area and has gone as far as it can within that area, investments in national funds can be a good alternative. 

The real rub is in documenting your research in the local assessment area first.  You cannot replace local investment with national unless you can demonstrate that there simply are not appropriate opportunities in the local area. 

Regional Area

A final question that was addressed was the definition of “regional area”.  The answer here was expanded to include areas that have some economic interdependency.  Therefore regional areas can include multistate and interstate areas.   

More Changes Coming

We believe that these questions and answers demonstrate that there are positive changes coming in the manner in the area of CRA evaluations.  Stay tuned!