The Dodd-Frank Wall Street Reform and Consumer Protection Act has a lot to say about banking practices. From systemic risk to consumer protection, the Act will have a major impact. But in light of the fact that many of the provisions require regulations or the completion of the Consumer Financial Protection Bureau, most of the requirements will not affect banks for a year or more. The limits on how you compensate your lenders, however, must be on your radar earlier.
Dos and Don’ts Paying Your Lending Staff
The Federal Reserve recently announced its final rule on compensation for loan originators. The rule will both implement some of the requirements of Dodd-Frank and do what the federal agencies have been anxious to do for quite a while—outlaw interest rate-based yield spread premiums. Effective April 1, 2011, the final rule will prohibit the practice of paying mortgage brokers, loan officers and others who originate mortgage loans based on the interest rate that is paid by the borrower, or any other term or condition of the loan other than the amount of credit extended. Further, while many banks may assume that the rules only apply to mortgage brokers, it is considerably broader, covering loan officers within the bank and even payments to the bank itself in table-funded transactions.
In addition to prohibiting compensation that is based on the terms of the loan, a bank also may not pay a loan originator based on a proxy for such terms. For example, a loan originator may not be paid based on loan terms, such as the interest rate, APR, or loan-to-value ratio. However, compensation that is based on proxies for the terms of the loan, such as the borrower’s credit score, debt to income ratio, or credit risk, is also prohibited. What is allowed is compensation that does not vary based on the loan’s terms and conditions, such as a fee based on:
- The total number of loans originated;
- The total amount of credit that was extended;
- The long-term performance of the loans;
- An hourly fee for the actual hours worked;
- Legitimate business expenses, such as overhead;
- Whether the borrower is a new or existing
- The percentage of applications submitted by the originator that result in closed loans;
- The quality of the loan files;
- A payment that is fixed in advance for every loan arranged; and
- A fixed percentage of the loan amount.
The new limits on compensation do not apply if a loan originator is paid by the consumer. However, the new rules prohibit an originator who is compensated by the consumer from being paid by anyone else. The Federal Reserve also explained that the final rule is not intended to prohibit creditors from changing their compensation arrangements with mortgage brokers, their loan officers, and other loan originators. However, the creditors cannot change the agreements or selectively enforce them in a way that will result in the loan originators’ payments varying based on the terms and conditions of the loan.
Lender Compensation vs. Terms of Loans Offered
The new regulation also includes an anti-steering provision that prohibits loan originators from steering a borrower to a mortgage loan based on the fact that the originator will receive higher compensation, unless the loan is also in the consumer’s interest. Loan originators may offer a loan that results in them receiving the same amount or less compensation than they would receive with other loan options. However, if they offer a loan that results in them receiving more compensation than they would with other loan options, they will be required to establish that the loan that was offered was in the consumer’s best interest. The rule provides a safe harbor that an originator may use to meet these requirements, but the documentation and procedures that will be required to rely on the safe harbor will be extensive and cumbersome.
More Compensation Rules to Come
The Federal Reserve’s final rule will significantly change the way that banks and other creditors compensate mortgage brokers and their own employees. However, it’s important to note that more changes are on the way. Under the Dodd-Frank Act, there are restrictions on the kinds of loans that a loan originator may offer, how they “steer” the consumer to loan products, and how they are compensated when the consumer pays upfront fees. As a result, the Federal Reserve’s final rule is a major change in lender compensation, but it is not by any means the last.