We had been requested to extend credit to a borrower whom our underwriter believed did not qualify based on the ability to repay the loan. I am an underwriter, but was not involved in this loan. I hate to say it, but politics got involved, and the powers-that-be took the loan into the credit committee, and the loan was approved.
Now it is eight months after closing. The borrower stopped paying four months ago, and all efforts to collect have been in vain. This loan is heading into foreclosure. But the situation could have been avoided in the first place.
We underwriters got together and decided to ask you to give us a statement of support to show the credit committee, so they know not to let this happen again.
Our question is, what happens when a lender does not comply with the Ability-to-Repay regulation?
ANSWER
I agree with you; based on your brief outline, this should not be happening. When a borrower does not have the ability to repay, it puts not only the financial institution at risk but the borrower too. In the long run, everyone fails. For a statement of support, I will provide a cursory overview of Ability-to-Repay, followed by an outline of a case that demonstrates the kind of litigation that can be engendered.
The Truth-in-Lending Act (TILA), as amended by the Dodd-Frank Act, prohibits a creditor from extending a residential mortgage loan unless the creditor makes a reasonable and good faith determination based on verified and documented information that, at the time the loan is consummated, the consumer has a reasonable ability to repay (ATR) the loan, according to its terms, along with all applicable taxes, insurance, and assessments. The applicable statute is remarkably detailed about how a lender must determine ability-to-repay. Much of these procedures stem from the challenges that arose from the 2008 financial crisis.
The statute specifies that a determination of ATR must include consideration of the consumer’s credit history, current income, expected income the consumer is reasonably assured of receiving, current obligations, debt-to-income ratio, or the residual income the consumer will have after paying non-mortgage debt and mortgage-related obligations, employment status, and financial resources other than the consumer’s equity in the property that secures the repayment of the loan. TILA also requires the creditor to determine ATR using a payment schedule that fully amortizes the loan over its term. In addition, the statute requires the creditor to verify amounts of income or assets relied on to determine ATR, including expected income or assets, by reviewing the consumer’s IRS form W-2, tax returns, payroll receipts, financial institution records, or other third-party documents that provide reasonably reliable evidence of income or assets.
The CFPB’s ATR Regulation, which is part of Regulation Z, contains even more specific requirements. For example, a lender that hopes a loan will be considered a “qualified mortgage” (QM) must ensure that the loan complies with an extensive set of criteria, including those set forth in Appendix Q to Regulation Z. A QM designation results in either a conclusive or rebuttable presumption that the lender complied with the extensive ability-to-repay requirements. I’ll discuss some observations about Appendix Q at the conclusion of this article.
Now to the case. It is a little convoluted but stick with me. I think you will benefit from an understanding of the litigation. Some of its features remind me of the situation you describe.
The U.S. Court of Appeals for the 6th Circuit recently had the opportunity to apply the ATR provisions to the circumstances of a borrower who had been an experienced real estate agent knowledgeable about mortgage products, but eventually faced some cognitive difficulties, though apparently not before negotiating the loan in question from a community bank.[i]
Husband, Elliot, submitted an application for a loan in his name alone to be secured by the home he owned with his wife, Golan. The two had been contemplating separating and had agreed to divide their real estate, with Golan relinquishing all interest in, and Elliot assuming all responsibility for, the home.
The loan application listed the amount of the loan as $315,000 to be repaid over 25 years with an interest rate of 4.875% and monthly payments of $1,818.59. The application listed Elliot's income, as follows: base employment income of $528.95 per month, spousal support of $2,300 per month, Social Security of $1,975 per month, and rental income of $1,400 per month.
To verify the spousal support income, the bank relied on representations by Elliot and Golan that they were going to sign a separation agreement requiring payment of spousal support to Elliot. The two executed a separation agreement, which provided for $2,200 per month, but not until nearly two months after Elliot's loan was consummated.
To verify rental income, the bank reviewed Elliot's tax returns. The returns showed rental income in the past, but not from the home property. Elliot leased a portion of the home property for $1,000 per month, but the bank did not know this.
ANSWER
I agree with you; based on your brief outline, this should not be happening. When a borrower does not have the ability to repay, it puts not only the financial institution at risk but the borrower too. In the long run, everyone fails. For a statement of support, I will provide a cursory overview of Ability-to-Repay, followed by an outline of a case that demonstrates the kind of litigation that can be engendered.
The Truth-in-Lending Act (TILA), as amended by the Dodd-Frank Act, prohibits a creditor from extending a residential mortgage loan unless the creditor makes a reasonable and good faith determination based on verified and documented information that, at the time the loan is consummated, the consumer has a reasonable ability to repay (ATR) the loan, according to its terms, along with all applicable taxes, insurance, and assessments. The applicable statute is remarkably detailed about how a lender must determine ability-to-repay. Much of these procedures stem from the challenges that arose from the 2008 financial crisis.
The statute specifies that a determination of ATR must include consideration of the consumer’s credit history, current income, expected income the consumer is reasonably assured of receiving, current obligations, debt-to-income ratio, or the residual income the consumer will have after paying non-mortgage debt and mortgage-related obligations, employment status, and financial resources other than the consumer’s equity in the property that secures the repayment of the loan. TILA also requires the creditor to determine ATR using a payment schedule that fully amortizes the loan over its term. In addition, the statute requires the creditor to verify amounts of income or assets relied on to determine ATR, including expected income or assets, by reviewing the consumer’s IRS form W-2, tax returns, payroll receipts, financial institution records, or other third-party documents that provide reasonably reliable evidence of income or assets.
The CFPB’s ATR Regulation, which is part of Regulation Z, contains even more specific requirements. For example, a lender that hopes a loan will be considered a “qualified mortgage” (QM) must ensure that the loan complies with an extensive set of criteria, including those set forth in Appendix Q to Regulation Z. A QM designation results in either a conclusive or rebuttable presumption that the lender complied with the extensive ability-to-repay requirements. I’ll discuss some observations about Appendix Q at the conclusion of this article.
Now to the case. It is a little convoluted but stick with me. I think you will benefit from an understanding of the litigation. Some of its features remind me of the situation you describe.
The U.S. Court of Appeals for the 6th Circuit recently had the opportunity to apply the ATR provisions to the circumstances of a borrower who had been an experienced real estate agent knowledgeable about mortgage products, but eventually faced some cognitive difficulties, though apparently not before negotiating the loan in question from a community bank.[i]
Husband, Elliot, submitted an application for a loan in his name alone to be secured by the home he owned with his wife, Golan. The two had been contemplating separating and had agreed to divide their real estate, with Golan relinquishing all interest in, and Elliot assuming all responsibility for, the home.
The loan application listed the amount of the loan as $315,000 to be repaid over 25 years with an interest rate of 4.875% and monthly payments of $1,818.59. The application listed Elliot's income, as follows: base employment income of $528.95 per month, spousal support of $2,300 per month, Social Security of $1,975 per month, and rental income of $1,400 per month.
To verify the spousal support income, the bank relied on representations by Elliot and Golan that they were going to sign a separation agreement requiring payment of spousal support to Elliot. The two executed a separation agreement, which provided for $2,200 per month, but not until nearly two months after Elliot's loan was consummated.
To verify rental income, the bank reviewed Elliot's tax returns. The returns showed rental income in the past, but not from the home property. Elliot leased a portion of the home property for $1,000 per month, but the bank did not know this.
In November 2014, the bank’s loan committee rejected the loan application. After this rejection, Golan met with the bank’s president, explained it was important to her that Elliot be able to stay at the home property, indicated that she would enter into a separation agreement to cover Elliot's monthly mortgage payments, and said the separation agreement would require her to maintain a $250,000 life insurance policy with Elliot as beneficiary.
This is the point where I felt some similarity occurs between your loan and the loan involved in the lawsuit. Just as you claim that “politics” entered into the process even after your underwriter rejected the loan based on the ability-to-repay, so in the lawsuit the bank’s president intervened and reversed the loan committee’s rejection of the loan application.
Thus, the bank approved the loan, which involved a debt-to-income ratio of 37.367%, lower than the bank’s 40% minimum threshold, and credit scores of 652 and 663, which were near the bank’s guideline of 660.
But, after the loan closed, Golan paid spousal support for only a few months, then she stopped. According to Golan, she paid support until Elliot refused to perform the separation agreement. Elliot also was fired from his job.
The divorce court ordered Elliot to pay a substantial sum to Golan for real estate division and marital debt, which he would not have owed had he abided by the separation agreement. The divorce court ordered Golan to pay Elliot $250 per month for three years (not $2,300 as the Elliot's application had listed).
Now, this is where things turn for the worse, and the bank becomes embroiled in a huge loss mitigation issue. Elliot defaulted on the loan, and the bank sent him a notice of default. He sued the bank, alleging negligence in making the loan and a violation of TILA by making the loan without a reasonable and good faith determination that he had a reasonable ability to repay the loan and for failing to verify his stated income with documentation. The district court granted summary judgment for the bank.
The 6th Circuit reversed regarding TILA but affirmed as to the negligence claim: The bank had not complied with TILA’s ability-to-repay requirements.
The bank did not explain how it had verified Elliot's spousal support income with reliable third-party documents.[ii] Regulation Z’s specificity extends to the meaning of “third-party records,” which the regulation requires a lender to use “to provide reasonably reliable evidence of the consumer’s income or assets.”
A “third-party record” means “[a] document or other record prepared or reviewed by an appropriate person other than the consumer, the creditor, or the mortgage broker…, or an agent of the creditor or mortgage broker” or a copy of a filed tax return or a record the creditor maintains for an account of the consumer held by the creditor or if the consumer is an employee of the creditor or mortgage broker, a document or other record maintained by the creditor or mortgage broker regarding the consumer’s employment.
The bank requested a copy of the separation agreement, thereby suggesting it understood the need to verify and document the spousal support with a reliable third-party document such as an executed separation agreement. And the bank did not dispute that it had not reviewed the executed separation agreement, which it obviously could not have done because the parties did not sign the document until nearly two months after the loan closed.
Furthermore, to make matters even more egregious, the bank did not comply with Regulation Z,[iii] because it had not verified the listed rental income with any documents that established that income.
All things considered, exclusion of the spousal support and rental income would have resulted in a debt-to-income ratio of over 90% (sic), which under the bank’s own standard was too high to repay the loan.
The 6th Circuit agreed that the district court had properly granted summary judgment to the bank on the negligence claim because Elliot had not established that the bank owed him a duty. The prevailing state law provided that lenders owed no duty to prospective borrowers during negotiations about the terms and conditions of a loan. The court rejected his argument that the bank owed him a duty imposed by TILA because no state case law supported this argument.
Now, I will share a few observations.
The bank argued that it had complied with Regulation Z’s Appendix Q because, although Appendix Q generally requires a creditor to verify that spousal support payments “have been received during the last 12 months” to include those payments in an income calculation, Appendix Q authorizes a lender to
rely on “evidence that [spousal support] payments have been received” for “[p]eriods less than 12 months…, provided the creditor can adequately document the payer’s ability and willingness to make timely payments.”
The 6th Circuit looked askance at this reliance on Appendix Q because the bank had never argued or alleged that Elliot's loan was a QM or that the bank was entitled to a presumption that it had satisfied the ATR requirements.
In any event, the bank had failed to comply with Appendix Q because it had no evidence of any spousal support payments, obviously, because Golan had not yet begun making them. For spousal support income to be considered, Appendix Q requires the consumer to provide required documentation such as a final divorce decree, legal separation agreement, court order, or voluntary payment agreement. Certainly, verbal assertions by Golan did not comply with Appendix Q.
The 6th Circuit noted that the bank’s arguments were “sympathetic.” I’ll take this term with salt around the rim and an olive in the martini! This “sympathetic” argument was based on the fact that the bank had initially denied the loan application and only changed course after the bank president met with Golan. The bank also pointed out that it planned to hold the loan in portfolio (and not sell it on the secondary market), meaning the bank had not approved a risky loan to collect closing costs and then sell the loan, leaving another servicer to deal with the risk of default.
Finally, the bank’s trust in Golan had been validated; after all, she and Elliot had executed a separation agreement providing for Golan to pay approximately the amount stated in the loan application, and she had paid that amount for several months. As the bank argued, he would have continued to receive that money, and presumably paid his mortgage, if he had chosen to comply with the separation agreement.
The district court did not address the matter of damages because it had found no violation, so the 6th Circuit left it to the district court to determine damages on remand, either through a supplemental summary judgment briefing or a trial.
Bottom Line: In the end, the bank still had an underperforming loan on its hands because it ignored the ability-to-repay rules. And, as if that was not bad enough, it was caught up in extensive and costly litigation.
Jonathan Foxx, Ph.D., MBA
Chairman & Managing Director
Lenders Compliance Group
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[i] G. Elliott v. First Federal Community Bank, U.S. Court of App., 6th Circuit, No. 19-3690, Filed 7/8/20
[ii] As required by Regulation Z § 1026.43(c)(4)
[iii] § 1026.43(c)(3) and (4)
[i] G. Elliott v. First Federal Community Bank, U.S. Court of App., 6th Circuit, No. 19-3690, Filed 7/8/20
[ii] As required by Regulation Z § 1026.43(c)(4)
[iii] § 1026.43(c)(3) and (4)
