Should Payday Lenders Prove Customers Can Afford Loans?

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4-9-14-Naomi-payday.pngPayday lenders are one of the last financial players in the U.S. market to escape new regulations protecting consumers, but that may not be for long. Banks and other lenders are now operating under new mortgage rules that force them to verify a borrower’s ability to repay the loan. A new set of standards also creates a safeguard against lawsuits for banks and other lenders that stick to a strict debt-to-income ratio and other qualifications for a mortgage loan.

Even banks that offer small dollar, non-residential loans have to worry about federal rules that could come back to bite them. A few banks pulled away recently from offering high interest, small-dollar loans after regulators issued a warning and said they would scrutinize such loans for their affordability and the consumers’ ability to repay.

Payday lenders may soon find themselves falling under regulatory rules designed to protect consumers as well.

At a hearing in Nashville recently hosted by the Consumer Financial Protection Bureau, more than 400 people showed up, many of them employees of payday lending firms hoping to defend the industry against the very real threat of regulation.

They wore yellow stickers, some of which said: “My credit. My choice.”

Freedom to choose, access to credit for all, and innovation in the financial marketplace was the theme for payday lenders that day. It might not carry much weight with regulators since it was the same argument made on behalf of subprime residential loans and creative products such as interest-only and no-doc mortgage loans.

Richard Cordray, the director of the CFPB, said in prepared remarks that the agency is in the final stages of considerations in formulating new rules to bring “needed reforms to this market.” He said the agency intends to make sure consumers who can afford to take out small-dollar loans get the credit they need without jeopardizing or undermining their financial futures.

Payday lenders are not the only source of small dollar, high cost credit (automobile title lenders are another), but they have proliferated in recent years with a fairly successful business model predicated on getting direct access to a borrower’s bank account, taking money before other creditors such as the landlord or the electric company are paid. The CFPB has been collecting thousands of complaints from payday borrowers and released a study it conducted for the past year of payday lending companies’ records showing that 80 percent of payday loans are rolled over, or renewed, by the borrowers in 14 days. Three out of five payday loans are made to borrowers who end up paying more in fees and interest than the amount borrowed, the agency said.

Cordray used the example of a woman named Lisa who lost her job at a hospital and got a payday loan to help pay her rent. She ended up taking out $800 in loans and paying $1,400 back, but still hasn’t paid off all the loans and fees.

Molly Fleming-Pierre, the policy director for Missouri Faith Voices, a non-profit in Jefferson City, Missouri, came to the hearing to talk about a disabled woman with a third grade education she said was targeted for a payday loan outside her workplace. She ended up paying $15,000 to payday lenders before an advocate intervened. A disabled veteran whose wife could no longer work paid $30,000 to payday lenders and yet the couple still lost their home, she said.

An oversupply of bad mortgages made to borrowers who couldn’t afford their loans, which were ultimately packaged into supposedly top notch securities and sold to investors around the world, was blamed in large part for the financial crisis. It’s arguable whether payday lenders could sink the U.S. economy, but the CFPB’s mission isn’t to worry about the U.S. economy, it’s to worry about consumers.

Now, payday lenders may have to start worrying about them, too.

Bankers’ View: Thoughts on Qualified Mortgages and Basel III

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12-30-13-Emily.pngThe Consumer Financial Protection Bureau’s ability-to-repay rules go into effect on January 10, 2014, and many community bank heads believe that the qualified mortgages (QM) required by the law will have a negative impact on their bank’s business strategy.

Mark Field, president of Liberty, Illinois-based Farmers Bank of Liberty, with $85 million in assets, thinks the new rule could prompt consumer lawsuits against community banks, targeting those that offer non-qualified mortgages.

“The CFPB tells us, ‘Oh, it’s OK, go ahead and make a loan even if it’s not QM’,” Field says, but “what a bank would be doing in that case is painting a big target on its bank.”

Bank Director polled 24 chief executive officers of community banks by phone in December 2013, asking for their insight on the regulatory issues facing their banks in 2014. When asked about the impact of QM on their institutions, half of those polled feel the impact will be negative, forcing changes to the bank’s mortgage business strategy. Twenty-nine percent expect to see little impact on the way they do business. Community bankers were also asked about how they plan to prepare for the Basel III standards in 2014.

When asked for his opinion on QM, Field believes the rules are too restrictive, and will result in harm to the very consumers the new rule aims to protect, like those in his rural community. “My main office is in a town of 600 people. We try to help people, and there are times when it makes perfectly good sense to help someone with a home loan based on things you know,” he says. “They’re removing the bank’s ability to use the borrower’s character [and] the personal knowledge that the loan officer has of the situation or the borrower.”

“The net effect will be that they will hurt more consumers than they will help by implementing these rules,” says Field. “Most community banks were not the cause of the mortgage meltdown.”

The home loans offered at Farmers Bank of Liberty are typically balloon mortgages with three-year terms, which stay in the bank’s portfolio. The bank’s mortgages are funded by certificates of deposit, which, due to consumer preference in the continued low interest rate environment, typically mature within 12 months. The CFPB will temporarily allow balloon mortgages for banks with less than $2 billion in assets that do fewer than 500 first lien mortgages per year, but the agency requires a term of at least five years for a balloon mortgage to be a qualified mortgage. Field says that places the bank at odds with regulators like the Federal Deposit Insurance Corp. that have renewed concerns about interest rate risk.

“The CFPB is forcing us to do one thing, and the FDIC and the Fed and the OCC [Office of the Comptroller of Currency] are beating banks down [in] the other direction. So I don’t know what the net effect will be, [whether] banks will have to scale back on their portfolio loans in order to monitor their interest rate risk,” Field says.

A survey by the Independent Community Bankers of America (ICBA) conducted in February of 2013 found that 73 percent of community banks offer balloon mortgages. Most community banks offer balloon mortgages that don’t have the onerous terms that got balloon mortgages such as bad rap before the financial crisis. Community bankers typically refinance the loans without fees at the end of the three- or five-year terms.

In the meantime, will the new international standards for bank and thrift capital, Basel III, be a hardship for community institutions, who have to get ready next year? Almost all banks and thrifts except those with more than $250 billion in assets were given until January 1, 2015, to comply with the capital standards, and all community bank CEOs polled by Bank Director in December say they’re ready. However, feeling ready and being ready may be two different things. Field feels that his bank is prepared for Basel III, though he remains uncertain about the capital conservation buffer of 2.5 percent, which the standards require on top of the 8 percent minimum total capital requirement. The buffer will be phased in beginning in 2016. According to the FDIC, banks not meeting the buffer could be penalized and certain payments, like dividends, could be restricted.

Regal Financial Bank, a $102-million asset institution based in Seattle, Washington, is ready for Basel III, says Randy James, the bank’s chairman and CEO, but he thinks many community banks may be caught unprepared. “If they’re not preparing for it, I think they’ll be caught short. It’s very difficult for a community bank to change its [capital] ratios quickly,” he says. “If they’re close, if they think they’re scratching by the guidelines, then I think they need to be better prepared.”

No More Balloon-Payment Mortgages? No Problem

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5-24-13_Bryan_Cave.pngEditor’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. 

Conclusion

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.