Alston & Bird Consumer Finance Blog

Consumer Financial Protection Bureau (CFPB)

Complying with the “Consider” Requirement Under the Revised Qualified Mortgage Rules

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A&B Abstract:

Purchasers of residential mortgage loans who are conducting audits of residential mortgages that they buy in the secondary market are struggling to determine what documentation satisfies the “consider” requirement of the revised qualified mortgage (QM) standards that became mandatory on October 1, 2022. In fact, originators of residential mortgage loans are not in agreement regarding what particular written policies and procedures they must promulgate and maintain and the documentation that they should include in the loan files. We set forth what we believe are the policies and procedures and the documentation that creditors must maintain and provide to their counterparties to comply with the consider requirement.

The Revised QM Rules

As a threshold matter, on December 10, 2020, Kathy Kraninger, who was the director of the Consumer Financial Protection Bureau (CFPB), issued the revised QM rules that replaced Appendix Q and the strict 43% debt-to-income ratio (DTI) underwriting threshold with a priced-based QM loan definition. The revised QM rules also terminated the QM Patch, under which certain loans eligible for purchase by Fannie Mae and Freddie Mac do not have to be underwritten to Appendix Q or satisfy the capped 43% DTI requirement. Compliance with the new rules became mandatory on October 1, 2022.

Under the revised rules, for first-lien transactions, a loan receives a conclusive presumption that the consumer had the ability to repay (and hence receives the safe harbor presumption of QM compliance) if the annual percentage rate does not exceed the average prime offer rate (APOR) for a comparable transaction by 1.5 percentage points or more as of the date the interest rate is set. A first-lien loan receives a “rebuttable presumption” that the consumer had the ability to repay if the APR exceeds the APOR for a comparable transaction by 1.5 percentage points or more but by less than 2.25 percentage points. The revised QM rules provide for higher thresholds for loans with smaller loan amounts, for subordinate-lien transactions, and for certain manufactured housing loans.

To qualify for QM status, the loan must continue to meet the statutory requirements regarding the 3% points and fees limits, and it must not contain negative amortization, a balloon payment (except in the existing limited circumstances), or a term exceeding 30 years.

Consider and Verify Consumer Income and Assets

In lieu of underwriting to Appendix Q, the revised rule requires that the creditor consider the consumer’s current or reasonably expected income or assets other than the value of the dwelling (including any real property attached to the dwelling) that secures the loan, debt obligations, alimony, child support, and DTI ratio or residual income. The final rule also requires the creditor to verify the consumer’s current or reasonably expected income or assets other than the value of the dwelling (including any real property attached to the dwelling) that secures the loan and the consumer’s current debt obligations, alimony, and child support.

In particular, to comply with the consider requirement under the rule, the CFPB provides creditors the option to consider either the consumer’s monthly residual income or DTI. The CFPB imposes no bright-line DTI limits or residual income thresholds. As part of the consider requirement, a creditor must maintain policies and procedures for how it takes into account the underwriting factors enumerated above and retain documentation showing how it took these factors into account in its ability-to-repay determination.

The CFPB indicates that this documentation may include, for example, “an underwriter worksheet or a final automated underwriting system certification, in combination with the creditor’s applicable underwriting standards and any applicable exceptions described in its policies and procedures, that shows how these required factors were taken into account in the creditor’s ability-to-repay determination.”

CFPB Staff Commentary

Paragraph 43(e)(2)(v)(A) of the CFPB Staff Commentary to Regulation Z requires creditors to comply with the consider requirement of the new QM rule by doing the following:

a creditor must take into account current or reasonably expected income or assets other than the value of the dwelling (including any real property attached to the dwelling) that secures the loan, debt obligations, alimony, child support, and monthly debt-to-income ratio or residual income in its ability-to-repay determination. A creditor must maintain written policies and procedures for how it takes into account, pursuant to its underwriting standards, income or assets, debt obligations, alimony, child support, and monthly debt-to-income ratio or residual income in its ability-to-repay determination. A creditor must also retain documentation showing how it took into account income or assets, debt obligations, alimony, child support, and monthly debt-to-income ratio or residual income in its ability-to-repay determination, including how it applied its policies and procedures, in order to meet this requirement to consider and thereby meet the requirements for a qualified mortgage under § 1026.43(e)(2). This documentation may include, for example, an underwriter worksheet or a final automated underwriting system certification, in combination with the creditor’s applicable underwriting standards and any applicable exceptions described in its policies and procedures, that show how these required factors were taken into account in the creditor’s ability-to-repay determination [emphasis added].

The Secondary Market’s Review of Creditors’ Policies and Procedures and File Documentation

The revised rules suggest that, at a minimum, to ensure that the creditor has satisfied the “consider” requirement, a creditor must promulgate and maintain policies and procedures for how it takes into account the underwriting factors enumerated above as well as retain documentation showing how it took these factors into account in its ability-to-repay determination. Ideally, the creditor should make these written policies and procedures available to the creditor’s secondary market counterparties.

Further, and more importantly, the revised rules indicate that the individual loan files should contain a worksheet, Automated Underwriting Systems (AUS) certification, or some other written evidence documenting how the enumerated factors were taken into account in meeting the enhanced ability-to-repay standards. The underwriters should document their use of applicable exceptions to the creditor’s general policies and procedures in underwriting the loan.

Notwithstanding the foregoing, it is our understanding that compliance with these requirements has been uneven in the industry and that certain creditors have not promulgated the requisite written policies and procedures related to the consideration of income, assets, and debt. In addition, documentation (i.e., worksheets and AUS certifications) of these factors in individual loan files has been haphazard and inconsistent.

In March 2023, the Structured Finance Association convened an ATR/QM Scope of Review Task Force, comprising rating agencies, diligence firms, issuers, and law firms, to develop uniform best practice testing standards for performing due diligence on QM loans. Discussion topics included the documentation of the consider requirement of the revised QM rules.

In its early meetings, the participants in the task force confirmed that creditors have not uniformly developed written policies and procedures documenting the consider requirement. Participants have focused more on the creditor’s actual documentation of income, assets, and debt in individual loan files they believe would demonstrate substantive compliance with the underwriting requirements of the revised rules.

At this early juncture (compliance with the revised rule became mandatory in October 2022), it may be premature for secondary market purchasers of residential mortgage loans to cite their sellers or servicers for substantive noncompliance with the revised QM rules if these entities have not developed robust written policies and procedures that show how they consider income, assets, and debt.

It may be more fruitful for the secondary market to focus on the actual file documentation itself and determine whether the creditors have satisfied the consider requirement by properly underwriting the loans in accordance with the requisite elements and documenting the file with the appropriate worksheets and other written evidence.

The creditor’s failure to maintain the general policies and procedures does not necessarily render the subject loans non-QM if the loan files are adequately underwritten and amply documented. Compliance with the new QM rules and the documentation of the consider requirement is still at a rudimentary stage, and the secondary market will have to periodically revisit the way it audits mortgage loans.

CFPB’s Message to Mortgage Servicers: Make Sure You Comply with RESPA’s Force-Placed Insurance Requirements

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A&B Abstract:

In Case You Missed It:  At the recent Federal Housing Finance Agency’s Symposium on Property Insurance, CFPB Director Rohit Chopra spoke about force-placed insurance and conveyed the following message: “The CFPB will be carefully monitoring mortgage market participants, especially mortgage servicers to ensure they are meeting all of their obligations to consumers under the law.”

The CFPB’s servicing rules set forth in RESPA’s Regulation X specifically regulate force-placed insurance. For purposes of those requirements, the term “force-placed insurance” means hazard insurance obtained by a servicer on behalf of the owner or assignee of a mortgage loan that insures the property securing such loan. In turn, “hazard insurance” means insurance on the property securing a residential mortgage loan that protects the property against loss caused by fire, wind, flood, earthquake, falling objects, freezing, and other similar hazards for which the owner or assignee of such loan requires assistance. However, force-placed insurance excludes, for example, hazard insurance required by the Flood Disaster Protection Act of 1973, or hazard insurance obtained by a borrower but renewed by a company in accordance with normal escrow procedures.

Given the Bureau’s announcement, now is a good time to confirm that your company has adequate controls in place to ensure compliance with all of the technical requirements of RESPA’s force-placed insurance provisions.  Set forth below are some of the many questions to consider:

Escrowed Borrowers:

  • When a borrower maintains an escrow account and is more than 30 days past due, does the company ensure that force-placed insurance is only purchased if the company is unable to disburse funds from the borrower’s escrow account?
    • A company will be considered “unable to disburse funds” when the company has a reasonable basis to believe that (i) the borrower’s hazard insurance has been canceled (or was not renewed) for reasons other than nonpayment of premium charges; or (ii) the borrower’s property is vacant.
    • However, a company will not be “unable to disburse funds” only because the escrow account does not contain sufficient funds to pay the hazards insurance charges.

Required Notices:

  • Does the company ensure that the initial, reminder, and renewal notices required for force-placed insurance strictly conform to the timing, content, format, and delivery requirements of Regulation X?

Charges and Fees:

  • Does the company ensure that no premium charge or fee related to force-placed insurance will be assessed to the borrower unless the company has met the waiting periods following the initial and reminder notices to the borrower that the borrower has failed to comply with the mortgage loan contract’s requirements to maintain hazard insurance, and sufficient time has elapsed?
  • Are the company’s fees and charges bona fide and reasonable? Fees and charges should:
    • Be for services actually performed;
    • Bear a reasonable relationship to the cost of providing the service(s); and
    • Not be prohibited by applicable law.
  • Does the company have an adequate basis to assess any premium charge or fee related to force-placed insurance, meaning that the company has a reasonable basis to believe that the borrower has failed to comply with the mortgage loan contract’s requirement to maintain hazard insurance because the borrower’s coverage is expiring, has expired or is insufficient?
  • Does the company have appropriate controls in place to ensure that the company will not assess any premium charge or fee related to force-place insurance to the borrower if the company receives evidence that the borrower has maintained continuous hazard insurance coverage that complies with the fee requirements of the loan contract prior to the expiration of the waiting periods (at least 45 days have elapsed since the company delivered the initial notice and at least 15 days have elapsed since the company delivered the reminder notice)?
  • Will the company accept any of the following as evidence of continuous hazard insurance coverage:
    • A copy of the borrower’s hazard insurance policy declarations page;
    • The borrower’s insurance certificate;
    • The borrower’s insurance policy; or
    • Another similar form of written confirmation?
  • Does the company recognize that the borrower will be considered to have maintained continuous coverage despite a late payment when applicable law or the borrower’s policy contemplates a grace period for the payment of the hazard insurance premium and a premium payment is made within that period and accepted by the insurance company with no lapse in coverage?
  • Within 15 days of receiving evidence (from any source) demonstrating that the borrower has maintained hazard insurance coverage that complies with the hazard insurance requirements in the loan contract, does the company:
    • Cancel any force-placed insurance that the company has purchased to insure the borrower’s property; and
    • Refund to the borrower all force-placed insurance premium charges and related fees paid by such borrower for any period of overlapping insurance coverage and remove from the borrower’s account all force-placed insurance charges and related fees that the company assessed to the borrower for such period?

And let’s not forget that companies must continue to comply with the above requirements if the company is a debt collector under the Fair Debt Collection Practices Act (“FDCPA”) with respect to a borrower and that borrower has exercised a “cease communication” right under the FDCPA.  Of course, failure to comply with the Regulation X requirements could also result in violations of UDAAP and FDCPA provisions.

Takeaway:

Given that the CFPB is telegraphing its upcoming review of servicers’ force-placed insurance practices, now is a good time for companies to ensure that their compliance management programs are robust enough to ensure compliance with all the technical requirements of RESPA’s force-placed insurance requirements. Alston & Bird’s Consumer Financial Services team is happy to assist with such a review.

FSOC Approves Analytic Framework for Financial Stability Risks and Guidance on Nonbank Financial Company Designations

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A&B Abstract:

On November 3, 2023 the Financial Stability Oversight Council (hereinafter “FSOC” or “Council”) unanimously approved final versions of: (1) the new Analytic Framework for Financial Stability Risk Identification, Assessment, and Response (“Analytic Framework”); and (2) the updated Guidance for Nonbank Financial Company Determinations (“Nonbank Designations Guidance”). The Analytic Framework was published today in the Federal Register and is effective immediately, and the Nonbank Designations Guidance will be effective 60 days after publication in the Federal Register.

Given the recent bank failures, it should come as no surprise that federal regulators are focusing on financial risks to U.S. stability across various sectors, including nonbank mortgage lenders and servicers.

Background

Following the 2007-2009 financial crisis, the Dodd-Frank Act created FSOC, an interagency panel of top U.S. financial regulators, to monitor excessive risks to U.S. financial stability and facilitate intergovernmental cooperation to effectively address those risks. Chaired by the Treasury Secretary and consisting of 10 voting members (comprised of the U.S. prudential regulators including, among others, the Consumer Financial Protection Bureau (“CFPB”)) and 5 nonvoting members, one of the Council’s statutory purposes is to specifically oversee large, interconnected bank holding companies or nonbank financial companies that pose potential risks to U.S. financial stability and, given the broad statutory mandate, the Council’s monitoring may cover an expansive range of asset classes, institutions, and activities, such as:

  • Markets for debt, loans, and other institutional and consumer financial products and services;
  • Central counterparties and payment, clearing, and settlement activities;
  • Financial entities, including banking organizations, broker-dealers, mortgage originators and services;
  • New or evolving financial products and practices; and
  • Developments affecting the resiliency of the financial system, such as cybersecurity and climate-related financial risks.

The Dodd-Frank Act empowers the Council to designate a nonbank financial company subject to certain prudential standards and supervision by the Federal Reserve’s Board of Governors. The Dodd-Frank Act lists 10 factors that Council must consider before making such designation.  To date, the Council has used this authority sparingly.  According to Treasury Secretary Janet Yellen, the Council’s updated Nonbank Designations Guidance will make it easier to use its nonbank designation authority, eliminating “several prerequisites to designation … that were not contemplated by the Dodd-Frank Act and that are based on a flawed view of how financial risks develop and spread” that exist under the previous guidance issued in 2019.

As the country experienced a regional bank crisis earlier this year, it would not be unreasonable to conclude that the Council may use its authorities less sparingly than in the past. The Council’s annual reports specifically address the potential risks of nonbank companies, support the updated requirements issued by the Federal Housing Finance Authority, Ginnie Mae and the CSBS Model State Regulatory Prudential Standards for Nonbank Mortgage Servicers, and recommend that relevant federal and state regulators continue to enhance or establish information sharing in responding to distress at a mortgage servicer.  Indeed, in June 2022, FSOC restarted its Nonbank Mortgage Servicing Task Force, an interagency group to facilitate coordination and additional market monitoring of nonbank servicers.

The Finalized Analytic Framework

The finalized Analytic Framework, which is not a formal rule, broadly describes the approach FSOC expects to take in “identifying, assessing, and responding to certain potential risks to U.S. financial stability,” and interprets “financial stability” to mean the “financial system being resilient to events or conditions that could impair its ability to support economic activity, such as by intermediating financial transactions, facilitating payments, allocating resources, and managing risks.”  The Council’s statutory mandate includes the duty to monitor a wide class of assets, such as new or evolving financial products and practices, and nonbank financial companies, such as mortgage originators and servicers, at several key pressure points.

Following consideration of public comments on the proposed Analytic Framework, which we previously discussed, the finalized Analytic Framework reflects several key changes from the proposed Analytic Framework, which include:

  • A description of the term “threat to financial stability” that builds on the proposed interpretation, specifically, to mean events or conditions that could “substantially impair” the financial system’s ability to support economic activity;
  • Additional examples of the types of quantitative metrics FSOC will consider to assess vulnerabilities that contribute to risks to financial stability;
  • Clarification on the relationship between the vulnerabilities and the four transmission channels (discussed below) by highlighting vulnerabilities that may be particularly relevant to a channel; and
  • An emphasis on the importance of FSOC’s engagement with state and federal financial regulatory agencies as it assesses potential risks and the extent to which existing regulation may mitigate those risks.

Under the finalized Analytic Framework, a non-exhaustive list of potential risk factors and the indicators that FSOC intends to monitor includes:

  • Leverage, assessed by levels of debt and other off-balance sheet obligations that may create instability in the face of sudden liquidity restraints.
  • Liquidity Risks & Maturity Mismatches, measured by the ratios of short-term debt to unencumbered liquid assets and the amount of additional funding available to meet unexpected reductions in available short-term funds.
  • Interconnections, measured by the extent of exposure to certain derivatives, potential requirements to post margin or collateral, and overall health of the balance sheet.
  • Operational Risks, measured by the failure to implement proper controls related to financial market infrastructures and the vulnerability of cybersecurity incidents.
  • Complexity or Opacity, such as the extent to which transactions occur outside of regulated sectors, in a grey area of overlapping or indefinite jurisdiction, or are structured in such a way that cannot be readily observed due to complexity or lack of disclosure.
  • Inadequate Risk Management, such as the failure to maintain adequate controls and policies or the absence of existing regulatory oversight.
  • Concentration, measured by the market share for the provision of important services within segments of applicable financial markets and the risk associated with high concentration in a small number of firms.
  • Destabilizing Activities, such as trading practices that substantially increase volatility in a particular market, especially when a moral hazard is present.

Just as FSOC will consider all the factors listed above as sources of potential financial risk contagion, it will also assess the transmission of those risks to broader market sectors and other specific entities based on certain metrics. This non-exhaustive list of transmission risk factors includes:

  • Exposures: The level of direct and indirect exposure of creditors, investors, counterparties, and others to particular instruments or asset classes.
  • Asset liquidation: Rapid asset liquidation and the snowball effect of a widespread asset sell off across sectors.
  • Critical function or service: The potential consequences of interruption to critical functions or services that are relied upon by market participants for which there is no substitute.
  • Contagion: The potential for financial contagion arising from public perceptions of vulnerability and loss of confidence in widely held financial instruments.

Despite receiving comments recommending that the Analytic Framework specifically address climate-related risk, FSOC declined to do so, explaining that it believes potential risks related to climate change may be assessed under other factors such as through the “interconnections” vulnerability factor and the “exposures” transmission channel.  Similarly, FSOC declined to specifically discuss risks to the financial needs of underserved families and communities because it expects that such risks would be considered under the “critical function or service” transmission channel.

Once a financial risk has been identified, FSOC may use various tools to mitigate such risk depending on the circumstances.  For instance, FSOC may work with the relevant federal or state regulator to seek to address the risk. Where a regulator can sufficiently address such risk in a timely manner, FSOC will encourage regulators to do so.  Through formal channels, the Council can make a public recommendation to Congress or regulatory agencies to apply new standards or heightened scrutiny to a known risk within their jurisdiction. Where no clear-cut regulatory oversight exists, the Council may make legislative recommendations to Congress to address the risk. These formal recommendations to agencies or Congress, made pursuant to section 120 of the Dodd-Frank Act, are also subject public notice and comment.

In addition to making nonbinding recommendations for action to the appropriate financial regulatory authorities, FSOC is empowered to make a “nonbank financial company determination,” by a two-thirds vote, that a specific company shall be supervised by the Federal Reserve Board of Governors and subject to enhanced prudential standards. This designation can be made upon FSOC’s finding that:

  • Material financial distress at the nonbank financial company could pose a threat to the financial stability of the United States; or
  • The nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the nonbank financial company could pose a threat to the financial stability in the United States.

Nonbank Financial Company Designation Final Interpretative Guidance

The finalized Nonbank Designations Guidance is procedural in nature relating to nonbank financial company designation.  It defines a two-stage process FSOC will use to make a firm-specific “nonbank financial company determination” discussed in FSOC’s Analytic Framework. In the proposed interpretive guidance issued for public comment in April 2023, the Council recognized that in the past, it “has used this authority sparingly, but to mitigate the risks of future financial crises, the Council must be able to use each of its statutory authorities as appropriate to address potential threats to U.S. financial stability.”  The Nonbank Designations Guidance will change the 2019 guidance in the following three ways:

  • First, under the current guidance, FSOC is committed to relying on federal and state regulators to address problematic nonbank financial company activity before considering whether a designation is appropriate. The new guidance removes this prioritization and allows FSOC to consider an entity for a designation proactively, without first relying on regulators to act before FSOC begins deliberating.
  • Second, FSOC has finalized the Analytic Framework discussed above to revise its process for monitoring risks to U.S. financial stability. This comprehensive new framework replaces that found in Section III of the 2019 interpretive guidance. Because the new guidance is focused on the procedural process for making nonbank financial company designations, the substantive analytic factors applied by FSOC in its assessments will be contained in the separate Analytic Framework document.
  • Third, FSOC has reversed course and is eliminating its current practice of conducting a cost-benefit analysis and an assessment of the likelihood of material financial distress prior to making its determination. FSOC has concluded that these processes are not required by Section 113 of the Dodd-Frank Act. FSOC defines “material financial distress” as a nonbank financial company “being in imminent danger of insolvency or defaulting on its financial obligations.” In eliminating the “likelihood” assessment required by the 2019 guidance, the Council will now presuppose a company’s material financial distress and then evaluate what consequences could follow for U.S. financial stability.

With respect to the formal process for nonbank financial company determinations, the finalized Nonbank Designations Guidance describes a two-stage process that FSOC will use once they decide to review a company for a potential designation.

Stage One:  FSOC will conduct a preliminary analysis of a company that has been identified for review based on quantitative and qualitative information available publicly and regulatory sources. FSOC will notify the company no later than 60 days before a vote is held to evaluate the company for Stage Two.  A company under review may submit information for FSOC’s review and may request to meet with FSOC staff and members agencies responsible for the analysis.  When evaluating a company in Stage One, the Council’s Nonbank Designations Committee may decide whether to analyze the risk profile of the company as a whole or to consider the risk posed by its subsidiaries as separate entities, depending on which entity the Council believes poses a threat to financial stability. At Stage One, FSOC is statutorily obligated to collect information from any relevant, existing regulators that oversee the company’s activities concerning the specific risks the Council has identified.

Stage Two: Any nonbank financial company selected for additional review will receive notice that the company is being considered for supervision by the Federal Reserve and enhanced prudential standards. The Nonbank Designations Guidance says that “[t]he review will focus on whether material financial distress at the nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the company, could pose a threat to U.S. financial stability.” At this point, if a company is under consideration for a Proposed Determination it will receive a formal Notice of Consideration from the Council.

The Council will begin its Stage Two review by consulting with the U.S. Treasury Department’s Office of Financial Research (OFR) and relevant financial regulators to ascertain the risk profile of the company. This information would remain confidential throughout the process, and, once interagency coordination has produced all available information, the company will be invited to submit any relevant information to the Council. These submissions may include “details regarding the company’s financial activities, legal structure, liabilities, counterparty exposures, resolvability, and existing regulatory oversight. . . . Information relevant to the Council’s analysis may include confidential business information such as detailed information regarding financial assets, terms of funding arrangements, counterparty exposure or position data, strategic plans, and interaffiliate transactions.” Council staff from the FSOC Deputies Committee will be available to meet with representatives of the company and will disclose the specific focus of the Council’s analysis, although the areas of analytic focus may change based on the ongoing analysis.

Finally, if FSOC preliminarily designates the company for supervision by the Federal Reserve and subjects it to enhanced prudential standards, the company will be able to request a nonpublic hearing after which FSOC may vote to make a final designation. FSOC will conduct an annual review for any company designated by the Council to determine whether continued Federal Reserve supervision and enhanced prudential standards are still appropriate. This annual review period will afford the company the opportunity to meet with Council representatives and present information or make a written submission to the Council about its efforts to mitigate risk. If the Council decides to sustain the designation, it will present the company with a written explanation for its decision.

Takeaway

Given the 2023 regional banking crisis, it is no surprise that federal regulators are focusing on potential risks to financial stability.  In FSOC’s 2021 and 2022 annual reports, nonbank mortgage companies have been identified as a potential risk.  The Federal Housing Finance Agency and Ginnie Mae have both updated their minimum financial eligibility requirements for seller/servicers and issuers with such requirements taking effect with varying effective dates later in 2023 and 2024.  States also have started to adopt prudential regulatory standards for nonbank mortgage servicers.  By voting through the Analytic Framework and Nonbank Designations Guidance, the Council signals that it remains vigilant to weaknesses in the financial system and will utilize a variety of tools and approaches to strengthen its supervision over companies if existing protections do not adequately mitigate financial stability risks.  Indeed, CFPB Director and voting member of the Council, Rohit Chopra, has expressed strong support for the actions taken and points out that the Council currently has “a total of zero shadow banks” designated as systemically important and that could pose a threat to financial stability which, according to Director Chopra, will most likely change once the Council implements the new guidance and conducts evaluations to identify shadow banks that meet the statutory threshold for enhanced oversight.

Affirmative Action in Lending: The Implications of the Harvard Decision on Financial Institutions

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Early this summer, the U.S. Supreme Court’s ruling in Students for Fair Admissions v. President and Fellow of Harvard College effectively ended race-conscious admission programs at colleges and universities across the country. Specifically, the Supreme Court held that decisions made “on the basis of race” do nothing more than further “stereotypes that treat individuals as the product of their race, evaluating their thoughts and efforts—their very worth as citizens—according to a criterion barred to the Government by history and the Constitution.”

In particular, the Supreme Court reasoned that “when a university admits students ‘on the basis of race, it engages in the offensive and demeaning assumption that [students] of a particular race, because of their race, think alike.’” Such stereotyping purportedly only causes “continued hurt and injury,” contrary as it is to the “core purpose” of the Equal Protection Clause. Ultimately, the Supreme Court reminded us that “ameliorating societal discrimination does not constitute a compelling interest that justifies race-based state action.”

In the context of lending, federal regulatory agencies expect and encourage financial institutions to explicitly consider race in their lending activities. While the Community Reinvestment Act has required banks to affirmatively consider the needs of low-to-moderate-income neighborhoods, regulatory enforcement actions over the last few years have required both bank and nonbank mortgage lenders to explicitly consider an applicant’s protected characteristics such as race and ethnicity—conduct plainly prohibited by fair lending laws.

Could the impact of the Supreme Court holding extend beyond education to lending and housing? Will the Harvard decision serve to undercut federal regulators’ legal theories for demonstrating redlining and present a challenge for special purpose credit programs that explicitly consider race or other protected characteristics?

Fair Lending Laws Prohibit Consideration of Race

The Equal Credit Opportunity Act (ECOA) prohibits a creditor from discriminating against any applicant, in any aspect of a credit transaction, on the basis of race, color, religion, national origin, sex or marital status, or age (provided the applicant has the capacity to contract). Similarly, the Fair Housing Act prohibits discrimination against any person in making available a residential real-estate-related transaction, or in the terms or conditions of such a transaction, because of race, color, religion, sex, handicap, familial status, or national origin.

In March 2022, the Consumer Financial Protection Bureau (CFPB) went as far as to update its Examination Manual to provide that unfair, deceptive, or abusive acts and practices (UDAAPs) “include discrimination” and signaled that the CFPB will examine whether companies are adequately “testing for” discrimination in their advertising, pricing, and other activities. When challenged by various trade organizations, the U.S. District Court for the Eastern District of Texas ruled that the CFPB’s update exceeded the agency’s authority under the Dodd–Frank Act. This decision is limited, however, and enjoins the CFPB from pursuing its theory against those financial institutions that are members of the trade association plaintiffs. It is also unclear if the verdict will be appealed by the CFPB.

Despite federal prohibitions, regulators such as the CFPB and the U.S. Department of Justice (DOJ) expect, and at times even require, lenders to affirmatively target their marketing and lending efforts to certain borrowers and communities based on race and/or ethnicity.

Race-Based Decisions Are Encouraged and Even Required by Regulators

CFPB examiners often ask lenders to describe their affirmative, specialized efforts to target their lending to minority communities. If there have been no such explicit efforts by the institution, the CFPB penalizes these lenders for not explicitly considering race in their marketing and lending decisions. For example, in the CFPB’s redlining complaint against Townstone Financial, the CFPB alleged that “Townstone made no effort to market directly to African-Americans during the relevant period,” and that “Townstone has not specifically targeted any marketing toward African-Americans.”

What’s more, if enforcement culminates in a consent order, the CFPB and DOJ effectively impose race- based action by requiring lenders to fund loan subsidies or discounts that will be offered exclusively to consumers based on the predominant race or ethnicity of their neighborhood. In the CFPB/DOJ settlement with nonbank Trident Mortgage, the lender was required to set aside over $18 million toward offering residents of majority-minority neighborhoods “home mortgage loans on a more affordable basis than otherwise available.”

And in the more recent DOJ settlement with Washington Trust, the consent order required the lender to subsidize only those mortgage loans made to “qualified applicants,” defined in the settlement as consumers who either reside, or apply for a mortgage for a residential property located, in a majority-Black and Hispanic census tract. Such subsidies are a common feature of recent redlining settlements, which have been occurring with increased frequency since the DOJ announced its Combating Redlining Initiative in October 2021.

Not only do the CFPB and DOJ encourage, and in certain cases, even require, race-based lending in potential contravention of fair lending laws, but federal regulators also expect some degree of race-based hiring by lenders. This expectation is based on the stereotypical assumption that lenders need racial and ethnic minorities in their consumer-facing workforce to attract racial and ethnic minority loan applicants. In the Townstone complaint, for example, the CFPB chastised the lender for failing to “employ an African-American loan officer during the relevant period, even though it was aware that hiring a loan officer from a particular racial or ethnic group could increase the number of applications from members of that racial or ethnic group.”

Ultimately, all the recent redlining consent orders announced by the CFPB and DOJ impose at least some race-based requirement, which would seem to run afoul of fair lending laws and Supreme Court precedent.

Racial Quota-Based Metrics Used by Regulators

Further, when assessing whether a lender may have engaged in redlining against a particular racial or ethnic group, the CFPB and DOJ, as a matter of course, employ quota-based metrics to evaluate the “rates” or “percentages” of a lender’s activity in majority-minority geographic areas, specifically majority-minority census tracts (MMCTs). Then the regulators compare such rates or percentages of the lender’s loan applications or originations in MMCTs to those of other lenders. For example, in its complaint against Lakeland Bank, the DOJ focused on the alleged “disparity between the rate of applications generated by Lakeland and the rate generated by its peer lenders from majority-Black and Hispanic areas.” The agency criticized the bank’s “shortfalls in applications from individuals identifying as Black or Hispanic compared to the local demographics and aggregate HMDA averages.”

Undoubtedly, this approach utilizes nothing more than a quota-based metric, which the Supreme Court in Harvard squarely rejected. Indeed, the Supreme Court reasoned that race-based programs amount to little more than determining how “the breakdown of the [incoming] class compares to the prior year in terms of racial identities,” or comparing the racial makeup of the incoming class to the general population, to see whether some proportional goal or benchmark has been reached.

While the goal of meaningful representation and diversity is commendable, the Supreme Court emphasized that “outright racial balancing and quota systems remain patently unconstitutional.” And such a focus on racial quotas means that lenders could attempt to minimize or even eliminate their fair lending risk simply by decreasing their lending in majority-non-Hispanic-White neighborhoods—without ever increasing their loan applications or originations in majority-minority neighborhoods. Of course, this frustrates the essential purpose of ECOA and other fair lending laws.

Potential Constitutional Scrutiny of Race-Based Lending Efforts

If race-based state action, including the use of racial quotas, violates the Equal Protection Clause, it is possible that the race-based lending measures recently encouraged and even required by federal regulators may be constitutionally problematic. In addition to racially targeted loan subsidies and racially motivated loan officer hiring, regulators continue to encourage lenders to implement special purpose credit programs (SPCPs) to meet the credit needs of specific racial or ethnic groups. As the CFPB noted in its advisory opinion, “[b]y permitting the consideration of a prohibited basis such as race, national origin, or sex in connection with a special purpose credit program, Congress protected a broad array of programs ‘specifically designed to prefer members of economically disadvantaged classes’ and ‘to increase access to the credit market by persons previously foreclosed from it.’”

While SPCPs are explicitly permitted by the language of ECOA and its implementing regulation, Regulation B, as an exception to the statute’s mandate against considering a credit applicant’s protected characteristics, it is uncertain whether these provisions, if challenged, would survive constitutional scrutiny by the current Supreme Court.

Takeaways for Lenders

For the time being, lenders that offer SPCPs based on a protected characteristic should ensure that their written plans continue to meet the requirements of Section 1002.8(a)(3). As always, the justifications for lending decisions that could disproportionately affect consumers based on their race, ethnicity, or other protected characteristic should be well documented and justified by legitimate business needs. And if faced with a fair lending investigation or potential enforcement action, lenders should consider presenting to regulators any alternate data findings or conclusions that demonstrate the institution’s record of lending in MMCTs rather than focusing on the rates or percentages of other lenders in the geographic area.

Oh Snap! CFPB Sues Fintech Company under CFPA and TILA

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A&B Abstract:

On July 19, 2023, the Consumer Financial Protection Bureau (CFPB) sued a Utah-based fintech company and several of its affiliates (the Company) for allegedly deceiving consumers and obscuring the terms of its financing agreements in violation of the Consumer Financial Protection Act (CFPA), the Truth in Lending Act (TILA), and other federal regulations.

The Allegations

The Company provides lease-to-own financing, through which consumers finance purchases from merchants though the Company’s “Purchase Agreements,” and, in turn, make payments back to the Company.  The Company allegedly provides the merchants with advertisement materials and involves them heavily in the application and contracting process.

According to the CFPB, the Company’s advertising and servicing efforts were deceptive.  As part of its marketing efforts, the Company allegedly provided its merchant partners with display advertisements that featured the phrase “100 Day Cash Payoff” without further explanation of the terms of financing.  Consumers who received financing from the Company reasonably believed they had entered into a 100-day financing agreement, where their automatically scheduled payments would fulfill their payment obligations after 100 days.  But, in fact, consumers had to affirmatively exercise the 100-day early payment discount option, and if they missed the deadline pay significantly more than the “cash” price under the terms of their Purchase Agreements.  Additionally, as part of its servicing efforts, the Company allegedly threatened consumers with collection actions that it does not bring.

From the CFPB’s perspective, these efforts constituted deceptive acts or practices under the CFPA.  The marketing efforts were deceptive because the Company’s use of this featured phrase was a (1) representation or practice; (2) material to consumers’ decision to take out financing; and (3) was likely to mislead reasonable consumers as to the nature of the financing agreement, while the servicing efforts were deceptive because the Company threatened actions it does not take.

The CFPB also alleges that the Company’s application and contracting process was abusive.  The Company allegedly designed and implemented a Merchant Portal application and contracting process that frequently resulted in merchants signing and submitting Purchase Agreements on behalf of consumers without the consumer’s prior review of the agreement.  Further, the Company relied on merchants to explain the terms of the agreements but provided them with no written guidance for doing so.  And as part of the process, the Company required consumers to pay a processing fee before receiving a summary of the terms of their agreement and before seeing or signing their final agreement.

Altogether, the CFPB views these acts and practices as abusive under the CFPA because they “materially interfered” with consumers’ ability to understand the terms and conditions of the Purchase Agreements.

Lastly, the CFPB alleges that the Company’s Purchase Agreements did not meet TILA and its implementing Regulation Z’s disclosure requirements.  On this point, the CFPB is careful in alleging that the Purchase Agreements are not typical rent-to-own agreements to which TILA does not apply.  Rather, the CFPB alleges they are actually “credit sales” because the agreements permitted consumers to terminate only at the conclusion of an automatically renewing 60-day term, and only if consumers were current on their payment obligations through the end of that term.

Takeaways

This suit serves as a good reminder to every lending program to: (i) have counsel carefully vet all advertisements to ensure that they are not inadvertently deceptive or misleading to consumers; (ii) ensure that the mechanics of its application process facilitate rather than interfere with consumers’ ability to understand the terms and conditions; and (iii) consult with counsel regarding whether their agreements are subject to TILA and Regulation Z’s disclosure requirements.