Alston & Bird Consumer Finance Blog

Fair Lending

Correspondent Lending on the Rise: Increasing Gains Point to Increasing Risk

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A&B Abstract:

According to a recent edition of Inside Mortgage Finance, correspondent lending is the only lending channel that posted gains in Q3 2023. While it is always nice to see gains, it should also serve as a reminder to take a fresh look at your risk management program to ensure it is calibrated to address the unique risks of correspondent lending.

To level set, we define a correspondent lender as one who performs the activities necessary to originate a mortgage loan, i.e., takes and processes applications, provides required disclosures, and often, but not always, underwrites loans and makes the final credit decision. The correspondent lender closes loans in its name, funds the loans (often through a warehouse line of credit), and sells them to an investor by prior agreement.

The risk that correspondent misconduct poses to an investor falls broadly into three categories:  legal risk, reputational risk, and credit risk. Legal risk refers to the risk that the investor will be subject to legal claims based on the misconduct of the correspondent, or that the correspondent misconduct somehow will impair the investor’s rights under the loan agreements. Reputational risk refers to the risk of damage to the company’s reputation among investors, regulators, the public at large, counterparties, etc. Credit risk refers to the risk that correspondents will fail to conform to the investor’s underwriting guidelines or credit standards. We include fraud within this category.

In this post, we provide, in our assessment, an overview of the types of claims that pose the greatest legal risks, as well as best practices to mitigate such risks.

Theories of Liability on Assignees

The following laws and/or legal theories, in our assessment, pose the greatest risk of either vicarious liability or economic risk to assignees for the misconduct of correspondents:

  • Holder in Due Course:  Under the Uniform Commercial Code, if an assignee or “holder” of a mortgage loan rises to the level of a Holder in Due Course, it can enforce the borrower’s obligations notwithstanding certain defenses to repayment or claims in recoupment that the borrower may have against the original payee. If Holder in Due Course status is never attained or is lost, the purchaser of a mortgage loan will be subject to certain defenses to payment and claims in recoupment that the mortgagor may have against the original payee.
  • Truth-in-Lending Act (TILA): An assignee may be exposed to civil liability for a TILA violation that is apparent on the face of the disclosure statement.  In addition, for certain violations of TILA, a consumer may have an extended right to rescind a loan for up to three years from consummation. The consumer may exercise this right against an assignee. Moreover, amendments to TILA pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) expand the liability of assignees in connection with certain TILA violations, including violations relating to the TILA-RESPA Integrated Disclosure or TILA’s ability to repay, loan originator compensation, and anti-steering provisions.
  • Home Ownership and Equity Protection Act (“HOEPA”) / Section 32 “High Cost” Loans: Subject to certain exceptions, an assignee of a HOEPA loan is subject to all claims and defenses with respect to the mortgage that the consumer could assert against the original creditor.
  • Equal Credit Opportunity Act (“ECOA”): ECOA’s broad definition of “creditor” may place liability on assignees for the statute’s anti-discrimination and disclosure requirements where the assignee “regularly participates” in the credit decision.
  • State and Local Anti-Predatory Lending Laws: A number of states have passed anti-predatory lending laws that contain assignee liability provisions similar to those found in HOEPA with triggers that may differ from HOEPA. An assignee of a loan covered by such a state law will be subject to certain claims and defenses with respect to the mortgage that the consumer could assert against the original creditor.
  • Aiding and Abetting: Under the common law theory of aiding and abetting, loan purchasers and other parties can be held responsible for the acts of the lender that originated the loan, particularly if they (i) knew that the originating lender was engaged in “predatory” practices, and (ii) gave substantial assistance or encouragement to the originating lender. The Dodd-Frank Act also imposes aiding and abetting liability.
  • State and Federal Defenses to Foreclosure: Certain state laws expressly provide that a violation of the law may be asserted by a borrower as a defense against foreclosure, either as a bar to foreclosure or as a claim for recoupment or setoff. In addition, courts may invoke UDAP or UDAAP statutes or equitable remedies to prevent an originator or assignee from foreclosing on a loan that the court views as abusive or unfair.  Finally, as noted above, violations of TILA’s ability to repay, loan originator compensation, and anti-steering provisions may also be raised defensively to delay or prevent foreclosure.
  • State Licensing and Usury Laws: Certain state laws provide for the impairment of the mortgage loan if the originating lender was not properly licensed or the loan exceeded state usury limits.
  • Challenges to Ownership: Plaintiffs are increasingly raising concerns about investors’ or servicers’ authority to foreclose when the investor cannot produce original loan documents or otherwise verify ownership of the loan, although this risk is lessened when an investor acquires the loan directly from the original creditor.

The list above reflects the laws and legal theories that are most commonly used to impose liability on assignees and/or that we believe will be of increasing prominence going forward. There are other federal and state laws that might also expose assignees to liability, either expressly or by implication. There are also claims against an assignee based on the assignee’s own misconduct in connection with the origination of the loan. An example of a direct claim against an assignee related to loan origination would be a claim under fair lending laws that the underwriting criteria that the assignee established and provided to its correspondents violated fair lending laws. Of course, there are plenty of other risks that the assignee may need to manage, such as the risk of loss from fraud perpetrated against the assignee by borrowers or correspondents; the risk of correspondents’ non-compliance with the investor’s underwriting criteria; or the risk of liability from servicing violations.

Best Practices to Mitigate Correspondent Lending Risk

A financial institution should consider adopting the following best practices to mitigate against the legal, reputational, and credit risks presented by correspondent lending relationships, to the extent the institution has not done so already:

  • Ensure that its compliance management system reflects the legal and regulatory requirements relevant to correspondent lending activity and the risks presented by correspondent lending relationships, that the company has in place monitoring, testing, and audit processes commensurate with such risks, and that the company’s compliance training includes material relevant to the management of correspondent lending relationships and their associated risks.
  • Prepare written policies and procedures that explain comprehensively the steps the company takes to minimize the risk that it will be subjected to liability for violations by correspondents.
  • Conduct due diligence reviews to ensure that correspondents are properly licensed, particularly in those states in which the failure to be licensed could impair the enforceability of the loan.
  • Conduct company-level due diligence reviews of correspondents to assess whether the correspondent is willing and able to comply with applicable laws and avoid engaging in practices that might be considered predatory. This might involve reviewing the company’s policies and procedures, examination reports prepared by regulators (to the extent that such reports are not confidential), repurchase demands made against the correspondent, internal quality control reports, complaints received from consumers and regulators, and information about litigation in which the company is involved.
  • Interview correspondents regarding their policies and procedures designed to prevent predatory sales tactics and other predatory lending practices.
  • Question correspondents regarding the measures they use to oversee and monitor the brokers with whom they do business.
  • Perform loan-level reviews to ensure that loans (1) do not exceed HOEPA and state/local high cost loan law thresholds, (2) exceed state usury limits (particularly in states in which the failure to comply can impair the enforceability of the loan), (3) either are not covered by state or local anti-predatory lending laws or comply with the applicable restrictions under those laws, (4) comply with state usury restrictions, and (5) do not contain other illegal terms or predatory features.

Takeaway

With correspondent lending volume on the rise, now is a good time to review and possibly refresh your risk management approach to ensure it is commensurate with the risks presented by correspondent lending relationships.

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.

Merrily the State CRAs Roll Along

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A&B ABstract:

While we wait on the final interagency rule from the Federal Reserve, OCC, and FDIC, Illinois and New York are continuing along with their state Community Reinvestment Acts (CRA).

Illinois CRA Developments

Illinois announced that it would hold public hearings, two on March 2, 2023 and a third on March 8, 2023, to discuss revisions to its proposed rulemaking.  The comment period was extended to March 16 to accommodate these hearings and invite further public engagement on their final rule.  The Illinois final rule, unlike the federal final rule, will not only apply to state-chartered banks, but also to state-licensed nonbank lenders and state-chartered credit unions.  To that end, the three hearings are split among the three groups: the Bank Community Reinvestment hearing at 10 a.m. C.T. on March 2, the Mortgage Community Reinvestment hearing at 2 p.m. C.T. on March 2, and the Credit Union Community Reinvestment hearing will be at 1 p.m. C.T. on March 8.  The hearings are to be conducted in person, with dial-in and WebEx accessibility.  The IDFPR published the details for interested attendees in the Illinois Register here.

New York CRA Developments

New York, meanwhile, has updated the New York CRA regulations with additional data collection and reporting obligations in connection with minority- and women-owned businesses (“MWBEs”).  New York revised its CRA statute effective January 2020 to underscore its commitment to serving MWBEs as well as low- and moderate-income communities.  In furtherance to that revision, New York’s Department of Financial Services will now collect data concerning whether a loan or investment benefits MWBEs, in a manner consistent with fair lending laws.  This record collection will enable institutions serving these communities to receive CRA consideration for their activities in their state CRA examinations.  The NY CRA was amended in 2021 to apply to both state-chartered banks and state-licensed non-depository lenders.

Takeaway

It remains to be seen whether Illinois or New York will issue anything further before the prudential regulators come out with the much-anticipated final CRA rule.  Conventional wisdom would anticipate their waiting, but with potential legal challenges to the final CRA rule under consideration by certain banking trade groups, the states may be ready to continue moving forward independently for now and synching back up again once the final federal CRA rules are in effect.

District Court Dismisses CFPB’s Redlining Case Against Townstone Financial

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A&B ABstract:

On Friday, in the CFPB v. Townstone Financial fair lending case, the U.S. District Court for the Northern District of Illinois dismissed with prejudice the complaint filed by the Consumer Financial Protection Bureau (CFPB), holding that the plain language of the Equal Credit Opportunity Act (ECOA) does not prohibit discrimination against prospective applicants.

Complaint

 The complaint, filed by the CFPB in July 2020, alleged that Townstone Financial, Inc., a nonbank retail-mortgage creditor and broker based in Chicago, engaged in discriminatory acts or practices in violation of ECOA, including: (1) making statements during its weekly radio shows and podcasts through which it marketed its services, that discouraged prospective African-American applicants from applying for mortgage loans; (2) discouraging prospective applicants living in African-American neighborhoods from applying for mortgage loans; and (3) discouraged prospective applicants living in other areas from applying for mortgage loans for properties located in African-American neighborhoods.

Court Opinion

The court, in its opinion, summarized the allegations as follows: “The CFPB alleges that Townstone’s acts and practices would discourage African-American prospective applicants, as well as prospective applicants in majority- and high-African-American neighborhoods in the Chicago MSA from seeking credit.” To determine whether the CFPB’s allegation of discrimination against “prospective applicants” was permissible under ECOA, the court applied the framework set forth in Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).

The court found, upon applying the first step of the Chevron analysis, that “Congress has directly and unambiguously spoken on the issue at hand and [that ECOA] only prohibits discrimination against applicants” (emphasis added). In granting Townstone’s motion to dismiss, the court reasoned that the plain text of the ECOA applies to “applicants,” which the ECOA “clearly and unambiguously defines as a person who applies to a creditor for credit” – and not to “prospective applicants.” Given this, the court was not required to move on to the second step of the Chevron analysis and consider the CFPB’s interpretation of the statute. Accordingly, the CFPB’s claim under ECOA was dismissed with prejudice, as “the CFPB cannot amend its pleading in a way that would change the language of the ECOA.”

Notably, the fact that the anti-discouragement provision of Regulation B refers to “prospective applicants” was not sufficient to convince the court. Further, because the court found that ECOA unambiguously applies only to “applicants,” the court did not analyze whether the ECOA’s prohibition on “discrimination” encompasses “discouragement.” The court likewise did not reach Townstone’s argument that the CFPB is attempting to create affirmative obligations with respect to marketing and the hiring of loan officers, nor its arguments under the First and Fifth Amendments.

Takeaway

Ultimately, the court’s dismissal of the CFPB’s case against Townstone casts significant doubt on the agency’s ECOA discouragement theory and its approach to fair lending enforcement, particularly the agency’s redlining investigations. We expect the CFPB to appeal the court’s order, though it is possible that existing investigations based on allegations of discouragement may experience a temporary slowdown in the interim.

Is the DOJ (De Facto) Enforcing the Community Reinvestment Act?

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A&B Abstract:

Furthering the Justice Department’s Combating Redlining Initiative, the Department of Justice has announced another redlining settlement.  But this settlement is different – this one involves a bank that has received top marks by its prudential regulator, the Federal Deposit Insurance Corporation (FDIC), for its compliance with the Community Reinvestment Act (CRA), a statute enacted to reduce redlining, for the same years that the DOJ alleged the bank engaged in redlining.

The DOJ’s Allegations

Lakeland Bank is a northern New Jersey-based, state chartered bank with more than $10 billion in assets.  The DOJ alleged violations of the Fair Housing Act and Equal Credit Opportunity Act (ECOA)/Regulation B, and specifically “that Lakeland engaged in illegal redlining by avoiding providing home loans and other mortgage services, and engaged in discrimination and conduct that would discourage mortgage applications from prospective applicants who are residents of or seeking credit in majority Black and Hispanic census tracts” located in its northern New Jersey assessment area.  In entering the more than $13 million settlement, the Bank did not admit to any of the DOJ’s allegations.  It agreed to various requirements to strengthen its fair lending compliance program, including investing in a loan subsidy fund, opening additional branches, and expanding its CRA assessment area.

The FDIC’s Findings

What is curious, however, is that in its latest CRA performance evaluation, the FDIC determined that Lakeland “exhibits a good record of serving the credit needs of the most economically disadvantaged areas of its assessment area, low-income individuals, and/or very small businesses, consistent with safe and sound banking practices.”  It determined that there is in fact strong competition for lending in the area, but that the bank nonetheless showed good penetration to borrowers of low- and moderate-income levels and in low- and moderate-income areas.  Further, the FDIC determined that the bank “makes extensive use of innovative and/or flexible lending practices in order to serve assessment area credit needs,” noting that the bank’s programs provide lower down payments, lower interest rates, down payment assistance, first-time homebuyer programs, and unsecured small dollar loan programs, for lower-income individuals and small businesses.  The FDIC also called Lakeland “a leader in making community development loans.”  In fact, Lakeland received a rating of “Outstanding,” the highest rating which only a small number of banks achieve, in each of its CRA exams for more than a decade.

CRA versus Fair Lending Laws

The rub is that the CRA is not a fair lending statute, as it focuses on income disparity and not racial disparity, though it often goes hand in glove with the fair lending laws.  For example, a failure to comply with fair lending laws (e.g., the Fair Housing Act, ECOA/Regulation B) can result in a downgrade of a bank’s CRA rating, despite its satisfactory or better performance in its CRA evaluation.  The CRA is enforced by the OCC, FDIC, and Federal Reserve Board.  The fair lending laws are typically enforced by the OCC, FDIC, Federal Reserve, CFPB, NCUA, FTC, and HUD (along with state regulators).  The threshold for an agency’s referral to DOJ for enforcement proceedings is low, requiring reason to believe there is a pattern or practice of discrimination.

Takeaway

In practice, the Lakeland settlement shows how a bank can be susceptible to fair lending risk with respect to redlining, and yet still pass its (anti-redlining) CRA examination with flying colors.  Maybe that is a reason to revise the CRA regulations (spoiler alert: that’s already in the works).  Or maybe it is a reminder to banks to mind the forest and the trees.  Focusing on CRA is necessary but not sufficient, and a bank needs to ensure it is regularly monitoring its lending activity for potential redlining.