Groping Toward Mortgage Compensation Rules


cutting-money.jpgRecently the Consumer Financial Protection Bureau (CFPB) issued a set of proposed rules on mortgage loan originations that include restrictions on compensation that will make it difficult for banks to structure bonus plans for their mortgage loan originators.

I wrote about this issue back in May, after the bureau had issued guidance stating that banks are permitted to make contributions to a mortgage loan originator’s 401(k) or some other type of qualified plan out of a profit pool derived from mortgage loan originations. However, the CFPB declined to indicate at the time whether banks could pay bonuses to originators based on the profitability of a pool of mortgage loans as part of a non-qualified incentive compensation plan. The distinction is important because in the case of a qualified plan like a 401(k) we’re talking about an individual’s future retirement income, while with a non-qualified bonus plan we’re talking about cash in their pocket today.

First a little bit of important background. Underlying this issue of mortgage originator bonuses is the focus of federal regulatory agencies—including the CFPB—on so-called compensation risk. During the subprime mortgage boom, originators often received extra compensation if they steered borrowers to higher cost loans, which often meant low-income borrowers paid more for their loans than they should have. The Federal Reserve Board proposed stricter rules on mortgage origination compensation in September 2010 under the Truth in Lending Act. Rulemaking authority for the Act was transferred to the bureau under the Dodd-Frank Act, and now the bureau is finishing what the Fed started.

Mortgage originators aren’t the only bankers impacted by all this attention on compensation risk. Banks are also being forced to change their incentive compensation practices for other kinds of lending activity, including commercial real estate and C&I lending. Generally speaking, the regulators don’t want lenders to be rewarded purely on volume; they want to see bonus payments spread out over a longer period of time than, say, just one quarter; and they want the size of the payout tied to the performance of the underlying loan portfolio over some reasonable period of time so lenders don’t get paid upfront for loans that later go bad. And in the case of mortgage originators, regulators don’t want them to be incentivized to screw their customers by pushing them unwittingly into high cost loans when they would qualify for a cheaper loan.

It was not clear last May whether the CFPB would allow banks to pay its mortgage originators any kind of bonus that wasn’t tied to a qualified plan. “Every bank is trying to do a better job of tying compensation to the profitability of the underlying business,” says Kristine Oliver, vice president at Pearl Meyer & Partners. But the bureau has now issued a proposed rule for non-qualified bonus plans that will make that goal much more difficult. Under the latest proposal, banks may pay employees a bonus derived from a pool of mortgage loans only if three conditions are met:

  • Compensation may not be based on the terms of the loans that were originated, so an employee can’t be rewarded for producing more of one kind of loan versus another.
  • The employee can’t have originated more than five mortgage transactions during the last 12 months.
  • However, if the individual’s transactions exceed five, the bonus pool can based on mortgage revenue limited to 25 or 50 percent of the overall revenue in the pool. The bureau has proposed two percentage cap alternatives, 25 percent and 50 percent.

The proposal does address the concern some people had that branch managers who originate an occasional mortgage might not be allowed to receive a bonus based on the profitability of their branches if the branch’s revenue included, say, points or mortgage origination fees. Now those individuals can receive a bonus even if the branch’s revenue includes some mortgage related revenue.

“The bureau has proposed a diminutive exemption,” says Richard Andreano, Jr., a partner in the Washington, D.C. office of Ballard Spahr LLP. “That would work for [occasional originators] but doesn’t work for someone who does more than five but still doesn’t do a whole lot of originations.” An example might be someone manages a mortgage production office and originates more than five loans a year, but is still a low volume producer compared to their rest of their team, so they don’t qualify for a bonus based on mortgage revenue.

More importantly, the proposed cap on the percentage of mortgage-derived revenue that can be included in a bonus or profit-sharing plan will make it impossible for banks to structure incentive compensation plans that will reward their originators solely on the profitability of their business. To get around the cap, banks will have to enlarge the categories of revenue that bonus payments are based on to include other kinds of loans in the mix. That would make it more of a company-wide incentive plan—especially if the cap is as low as 25 percent—which might be what the regulators prefer, but could be a less powerful incentive than a plan where mortgage originators were the only participants.

“That’s where the bureau wasn’t willing to go,” says Andreano.

Banks and other financial services companies that are impacted by the proposed rules have until Oct. 16 to submit their comments to the CFPB. Dodd-Frank requires the bureau to adopt final mortgage originator rules by Jan. 21, 2013, so banks should expect a final rule by then. Unfortunately, as Oliver points out, “People are starting to pull together their incentive plans for 2013,” so any assumptions they make now—like, for example, will the allowable cap be 25 percent or 50 percent—could be subject to change.

Confusion Reigns on Mortgage Compensation


lost.jpgYou probably thought the Consumer Financial Protection Bureau (CFPB) was just focused on, well, consumer protection, but the new agency has an important voice on certain compensation matters as well. And the beleaguered home mortgage industry, which really doesn’t need any more challenges right now, is waiting on the bureau to clarify whether mortgage loan origination compensation rules—first adopted by the Federal Reserve Board in September 2010 under Regulation Z—prevents the payment of performance bonuses to mortgage loan originators (or, to lapse into industry jargon, MLOs) as part of a non-qualified incentive compensation plan.

Rulemaking authority for Regulation Z, otherwise known as the Truth in Lending Act, was transferred to the CFPB by the Dodd-Frank Act, and in December 2011 the bureau issued interim final rules that recodified the Fed’s earlier restrictions on mortgage loan origination compensation. On the face of it, those restrictions were fairly straightforward. “Subject to certain narrow restrictions, the Compensation Rules provide that no loan originator may receive (and no person may pay to a loan originator), directly or indirectly, compensation that is based on any terms or conditions of a mortgage transaction,” according to CFPB Bulletin 2012-02, released on April 2 of this year.

In an official staff commentary issued by the Fed shortly after the rule was adopted, compensation was defined to include salaries, commissions and annual or periodic bonuses. Terms and conditions were deemed to include a loan’s interest rate, loan-to-value ratio or prepayment penalty.

I suppose it makes sense in our hyper-regulated world that the CFPB’s consumer protection authority would extend to MLO compensation because one of the more pernicious industry practices is steering, where borrowers—often low income people with poor credit histories—are unknowingly directed toward a more expensive mortgage that provides higher compensation to the originator than a cheaper loan.

Rod Alba, vice president and senior regulatory counsel at the American Bankers Association in Washington, says that up to this point the Fed’s commentary—including its amplification of “compensation” and “terms and conditions”­­—was easy enough to understand. But the commentary also stated that MLO compensation may not be based on a “proxy” for a term and condition. The CFPB bulletin explained it thusly: “[C]ompensation may not be based on a factor that is a proxy for a term and condition, such as a credit score, when the factor is based on a term and condition such as the interest rate on a loan.”

For Alba and others, that statement leaves too much to the imagination. “What the hell is a proxy?” he asks. “Well, a proxy is anything that would stand in the place of a term and condition. The problem with that is no one knows what it means. It was brought up in the commentary to the rule, not in the rule itself.”

More specifically, it’s unclear how banks can structure an incentive compensation program for their MLOs that won’t end up violating the rule. Alba worries that that any plan based on a profitability metric—whether it’s the profitability of a mortgage operation or even the bank itself—could run afoul of the rule if profitability is later judged to be an impermissible proxy. The regulatory rationale, I suppose, is that MLOs might still be tempted to engage in abusive practices like steering if they stand to gain under a performance-driven bonus plan that benefits the entire bank.

“Performance-based bonuses do fall into [the] proxy [definition] because the bonuses are derived from the loans,” Alba says. “That means [performance-based] bonuses are gone.”

“When they inherited this [from the Fed], the bureau didn’t clarify it,” adds Alba. “This rule is a mess!”

The CFPB has tried to provide some clarity about the compensation rule. In Bulletin 2012-02, the bureau states that banks “may make contributions to qualified plans like for loan originators out of a pool of profits derived from loans originated by employees under the Compensation Rules.” This would include 401(k) plans, which are the primary retirement programs for most employees today.

However, the bulletin did not provide guidance about how the rules apply to non-qualified plans like the ones that Alba is worried about.

Another confusing issue is the definition of an MLO. Is it someone who underwrites home loans? Or would the MLO designation also apply to, say, a branch manager who referred the borrower to an underwriter and might have played some role in negotiating the loan? If the latter turns out to be the case, then they would also fall under the rules and might not be eligible for a bonus paid out by a non-qualified plan.

Susan O’Donnell, a managing director at New York-based Pearl Meyer & Associates, relates the case of a client bank whose CEO might not be eligible to receive a bonus based on the bank’s performance because he has a license to originate loans and thus could be considered an MLO.

“If you fall into that category, then you can’t participate in any program that is tied to the profitability of the bank,” O’Donnell says.

How soon this mess gets cleaned up is anyone’s guess. In Bulletin 2012-02, the bureau points out that Dodd-Frank contains a provision that also deals with mortgage origination compensation and it must adopt a final rule to satisfy that requirement by Jan. 21, 2013. The bureau anticipates providing “greater clarity on these arrangements” in connection with that effort. But does that mean banks will be operating in the dark in terms of their MLO incentive compensation plans until next January? We don’t know.

The CFPB did not respond to an interview request on the matter. Neither did the Office of the Comptroller of the Currency, which along with the Federal Deposit Insurance Corp. (FDIC), has enforcement authority for Regulation Z at banks under $10 billion in assets. A spokesman for the FDIC declined to make an agency official available for an interview, but he did send along a Financial Institution Letter—FIL-20-2012—that was sent out to FDIC-supervised banks on April 17, 2012.

The FDIC’s letter framed the issue in pretty much the same fashion as the CFPB bulletin, and acknowledged that the CFPB has yet to provide any guidance about non-qualified incentive compensation plans for MLOs.

The letter concluded with this vague statement, which was probably meant to clarify the FDIC’s own enforcement perspective on MLO bonus plans, but probably didn’t clarify anything: “FDIC Compliance Examiners will review institution compensation programs in light of the Compensation Rules, and consider the specific facts of the institution’s compensation program, the totality of the circumstances at each financial institution, and the institution’s efforts to comply with the Compensation Rules.”

Hmmm… Good luck bankers!