Straight vanilla loans may become standard

November 29, 2010
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Rodney Martin, chairman of the financial services group at Warner Norcross & Judd, sees two drastic changes ahead for the mortgage-lending industry once the Wall Street Reform and Consumer Protection Act goes into effect, which is expected to happen next summer.

Until last July, when the U.S. Senate approved House Resolution 4173, legislation governing mortgages mostly revolved around requiring lenders to make truthful disclosures to borrowers about the financial terms of their loans. The new regulation, however, will take lenders into uncharted territory as it will require them to also make “reasonable and good faith determinations” of every borrower’ ability to repay a loan.

“That is going to do a couple of things. It’s ultimately likely to limit the choice and the options that customers have because there is a great deal of risk in that standard of reasonable ability to pay. How is that going to be determined? We’re waiting to see regulations that will go to that,” said Martin.

“The act creates a safe harbor for what is called a qualified mortgage loan, and a qualified mortgage loan is a pretty straight vanilla loan. It’s a loan that has no balloon payment and has an annual percentage rate that is within a certain tolerance level.

“If you make a qualified mortgage loan, then you’re in a safe harbor, as far as the standard,” he added.

Martin said the regulation is likely to make mortgage lenders think twice before they offer customers a loan with a balloon payment or any other term that would take a loan out of the safety net. He thinks consumers will have fewer loan options offered to them, at least until lenders feel more comfortable with the regulation and are confident that their reasonable assessments of borrowers’ ability to pay complies with the law.

“I think what you’re going to see are straight vanilla mortgages being the primary vehicle that will be available to customers. I’m not an economist, but I think that’s the case,” he said.

The other major change the reform will establish is a new standard for abusive lending practices. This section of the act relates to all consumer loans and not just to home mortgages. Under existing laws, unfair and deceptive practices have been banned, but abusive practices again tread on previously unchartered territory for the lending industry.

Martin said the term “abusive practices” isn’t clearly defined in the regulation and is fairly ambiguous to interpret.

“It doesn’t have a lot of meaning. An abusive practice is one that materially interferes with the ability of the consumer to understand a term or a condition of a contract, or takes unreasonable advantage of a consumer’s lack of understanding of the risks, or the inability of the consumer to protect themselves,” he read from the act.

“So what ‘abusive’ appears to do is place a burden on a consumer financial company to know what customers actually understand. That’s going to be a challenge.

“In essence, after lenders explain something to consumers, they will have to make a determination that consumers actually understood what they told them,” he added.

Martin felt that new standards will have some interesting implications in how products are sold to consumers, and if lenders will be willing to offer anything other than standard products.

“What we’ve been through in our financial crisis obviously has been driven by home-mortgage lending and some practices by some lenders that perhaps took advantage of consumers. We’re seeing that play out. But we also saw a great faith in rising real estate prices, which was a bubble and disappeared,” said Martin.

“These things are all aimed at trying to remedy some of those abuses. And the real issue is going to be how these are enforced and how much certainty there is in how these are going to be enforced so that financial services companies can determine how to do business without incurring a great deal of risk of violation.”

Martin represents community and regional banks at the law firm. His clients are already regulated at the federal and state levels and both groups will be subject to the new act. The reform will also regulate the non-depository lenders that weren’t previously regulated, but not quite like his clients will be.

“They will be in terms of consumer protection. But banks, in general, are subject to safety and soundness regulations and a whole host of other regulations beyond consumer protection regulation that (non-depository lenders) won’t be subject to,” he said.

Martin also believes the changes will increase operating costs for lenders, who will pass the increases to their customers.

“Obviously, there will be a cost in moving to a new disclosure regime and there will be an initial cost of doing that. But then I think there will also be costs associated with increasing the level of compliance — the effort that is needed to monitor the lender’s compliance. Internally, they are going to have to do increased training and increased monitoring to make sure they comply with these things,” he said.

The act is scheduled to go into effect when the Consumer Protection Financial Bureau begins operating, which looks to be July 21. That date is subject to change because a lot has to happen between now and next summer, including transferring powers from existing bureaus to the new CPFB and hiring staff for the agency and a director, possibly Elizabeth Warren, to head it. 

“It is going to be fascinating to see how all this works out,” said Martin.

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