Editor's note: On May 29, 2013, the Consumer Financial Protection Bureau amended its new rule to delay implementation of the balloon payment injunction for two years for small lenders with less than $2 billion in assets who make fewer than 500 first-lien mortgages per year. The delay lasts for two years after the implementation date of January, 2014.
Among the many sea changes within the Consumer Financial Protection Bureau’s new mortgage regulations, the rules’ harsh view of the balloon-payment loan is among the most disappointing for community banks. The CFPB clearly does not like these loans and has taken a major swing at them. Beginning in 2014, creditors will be prohibited under the Truth in Lending Act from making covered loans absent a good faith review of the borrower’s repayment ability. The risks of non-compliance with this rule are grave and include a defense in foreclosure that essentially has no statute of limitations. So-called “qualified mortgages” will enjoy a presumption of compliance with this new Ability-to-Repay (ATR) standard, but balloon notes are not generally favored. Here is a five-step roadmap for coping with these new restrictions.
First, assess the damage. Start by determining how many of your existing loans are within the scope of these rules. Be careful to separate true consumer loans from others. It bears emphasizing that commercial-purpose balloons are not covered, in most cases even if they are secured by the borrower’s principal dwelling. On the other hand, there is no general small creditor exemption for covered transactions. And while the rules do not apply to home equity lines of credit, they do apply to closed-end home equity loans so long as they are secured by a dwelling and constitute consumer credit.
Of course, your bank may be among the few small creditors that will qualify to make “rural balloon-payment qualified mortgages.” If so, even these loans will need to have at least 5-year terms. Under the general ATR rule, loans may include a balloon payment, but consumers must be deemed capable of making any balloon payment due within the first 5 years of a loan (or at any time during the loan if it is higher-priced).
Second, expect ALCO excellence. For creditors, the demise of balloons under these new rules is primarily an interest rate risk (IRR) story. Short-term balloon loans are popular because they are a simple means of managing IRR. The CFPB acknowledged as much but believes only a limited class of rural creditors should be encouraged to continue making such loans, notwithstanding evidence that consumers understand and like them. Thus, your bank’s asset/liability management committee (ALCO) or other IRR management body should be springing into action right now if balloons are a material part of your portfolio. Among other things, the effective date of these new rules—January 10, 2014—should be circled on the ALCO’s calendar; laid over existing internal policies, procedures, and limits; and entered into IRR models and simulations.
Third, renew or modify certain loans. Depending on what strategies emerge from your ALCO’s deliberation, you may end up trying to renew or modify a certain number of existing mortgages before the new rules take effect. This is because, while existing balloon mortgages are not covered by the new origination rules, their renewal could be. To understand this, fast-forward to 2014: the CFPB has specifically noted that “any change to an existing loan that is not treated as a refinancing” under the Truth in Lending Act is not subject to its new ATR restrictions. This means that, even in 2014, you might be able to modify certain loans and retain their balloon-payment features. The viability of this prospect turns on whether, under applicable state law, the existing obligation has been merely amended or, rather, “satisfied and replaced” by a new one. There has long been variability under state law on this issue.
One thing that is clear under the new rules is that existing balloons will not qualify for the “non-standard mortgage” refinancing exemption from the general ATR requirements. This Dodd-Frank concept exempts creditors from the strict new ATR underwriting requirements when they are refinancing borrowers into conventional mortgages from certain existing loans that pose a risk of “payment shock” (e.g., certain adjustable-rate loans). The CFPB concluded that balloon mortgages do not pose the sort of risk targeted by this exemption and thus will not qualify to be “streamline” refinanced this way.
Fourth, ramp up to make ARMs. To compete in 2014 and beyond, creditors may need to offer some form of adjustable-rate mortgage (ARM). This obviously presents a challenge if ARMs are new to your organization. Even the CFPB has acknowledged that many creditors would prefer to offer balloons as a means of managing interest rate risk “without having to undertake the compliance burdens involved in administering adjustable rate mortgages over time.” In 2014, these burdens will include not only new underwriting mandates but also a new rate adjustment notice (under the CFPB’s new servicing rules). It will also be important that loan officers understand ARMs well enough to describe them to consumers.
Fifth, and finally, demand help from your systems vendors. These service providers can not only walk you through add-ons and modules that will help you comply with the new rules, but they can also help train your loan officers and underwriters. While more complicated than balloons, ARM loans are conducive to a variety of systems solutions. These tools should put you well on your way to making a smooth transition away from balloons.
The CFPB’s sweeping mortgage reforms will have a major impact on product terms and offerings. Given the CFPB’s stated views, don’t expect further regulatory relief for balloon-payment mortgages. With proper planning, however, your institution should be ready to live without them and to distinguish yourself in the crowded mortgage marketplace on efficiency and customer service.