The Impact Of Changes To Dodd-Frank Regulation Z

Thursday, December 22, 2011 - 13:05

The Editor interviews Sheryl J. Willert, Managing Director, and Daniel A. Brown, Member, both of Williams Kastner’s Seattle office.

Editor: On April 1, 2011, the new Dodd-Frank Loan Officer Rules (Reg Z) took effect. Please describe the intent of the rules and their major provisions.

Willert: The Regulation Z changes had multifaceted intent but generally sought to set the industry on the right path after the loan origination debacle. The Dodd-Frank Act focused on improving the lending process and changing originator compensation models that Congress, and indeed Americans, believe were a root cause of the debacle.

Editor: What is the business impact on lenders so far?

Willert: The business impact remains a huge question because the law is still new. For example, the industry is still trying to determine what compensation models will allow companies to be prosperous and to retain talented individuals who can generate mortgage business. On the other side, one certain impact is that mortgages are more difficult for individuals to obtain because of stricter lending standards, such as the need to show near-perfect credit records. Overall, lending activity has decreased substantially since 2007, with its complete collapse in 2009-2010.

Editor: How do the rules affect business practices, particularly due diligence?

Willert: The Dodd-Frank Act imposes very stringent due diligence requirements, including the need for every mortgage lender to confirm the borrower’s ability to repay the loan, and to review the borrower’s creditworthiness exclusive of the value of the home being purchased. Such measures are intended both to eliminate credit determinations based on illusory information and, importantly, to prevent a practice called steering.

The anti-steering provision prevents lenders and mortgage brokers from seeking to maximize their own compensation by encouraging a borrower to select a certain type of product. As such, the regulations are significantly changing how the industry is conducting business.

Editor: Given that Reg Z changes seem geared toward common-sense objectives, why haven’t the mortgage lending rules been stringent all along?

Willert: In fact, the rules have been stringent all along. Regulations including Reg Z historically have focused on requiring brokers and lenders to do the right thing with respect to reviewing mortgage candidate loan applications. Borrower information allegedly was required to be reviewed, vetted and tested for compliance with sound lending principles and existing regulations.

The breakdown occurred when certain brokers and lenders – the proverbial few bad apples – latched on to the idea of making large sums of money and were willing to subvert sound business practices in the assessment of potential borrowers. As a result, these brokers and lenders took procedural shortcuts and enlisted cooperative appraisers to report inflated property values. In some circumstances, documentation was manipulated to create the illusion that the home was going to be owner-occupied, when, in fact, the property was being purchased for the purpose of flipping it. In others, documentation was falsified to show employment and incomes that would make it appear that a borrower was qualified when, in fact, he or she was not.

Certainly, not all loan applicants and lending parties were operating with bad intentions; rather, many mortgage-seekers simply were hoping to achieve the American dream of home ownership. Unfortunately, a few nefarious characters represented to unqualified applicants that home ownership was possible – even if the borrowers didn’t have money in their pockets or clearly didn’t have the resources to make the required payments. That dishonest behavior started the breakdown.

Editor: How did the industry react to the Reg Z changes? We understand, for example, that there were complaints that the compliance standards were not clearly identified.

Willert: As they stand, the compliance standards leave many unanswered questions as to what can and cannot be done. For example, I am working with a number of clients to help them determine the best mechanism by which to pay their loan originators and still remain in compliance with the regulation. Prior to enactment of these regulations, most brokers and lenders were compensated on a straight commission basis – often directly related to loan terms, such as interest rate and loan-to-value ratio. A higher interest rate, for example, would generate a more profitable deal and a higher broker/lender commission.

Now, regulations impose a stringent requirement that the loans terms themselves cannot form the basis upon which compensation is paid to loan originators; thus, mortgage brokers are trying to figure out on what criteria they should be compensated. Possibilities include the total number of originated loans, the long-term performance of loans and the actual number of hours spent trying to originate loans – all of which are very foreign criteria for people who worked on a straight commission basis up until April 2011.

Editor: Is the economic recovery taking longer than it should?

Willert: Of course, we’ve been waiting for the economic recovery in real terms for a very long time. Some economists claim that we are no longer in a recession – that economic recovery is happening right now – and they point to the fact that many states have experienced a decrease in the number of applications for unemployment. While we may be experiencing a recovery of sorts, the more important issue for the business sector is that the recovery is not happening quickly enough.

Brown: In the context of regular commercial banking, the most accurate indicator of economic recovery can be simple anecdotal evidence – we used to say, “Look out your window and count the cranes." If there are not a lot of cranes, then there is no economic recovery. The good news is that we are seeing a few more cranes these days.

While commercial lenders have loosened the reins to a certain degree, their practices had become very tight during prior years because collateral values for land and buildings, which constitute the bread and butter of loan security, were no longer sufficient. The number of troubled loans currently in bank portfolios on a commercial basis certainly exceeds those on the books during or since the savings and loan debacle and, based on dollar values, may be the highest in U.S. banking history. While that burden is not lessening, banks are working through those troubled assets. Eventually, banks will write down bad loans, balance their books and forge ahead; however, such activity will result in less capital available to lend. Banks will take significant losses because there is no real economic recovery, and they are reluctant to spend “good money after bad.” Thus, until troubled assets are eliminated from bank portfolios, there will be continued tightening of credit and further delays in the economic recovery overall.

Editor: What is the current state of troubled assets, and how has the tightening of credit affected the commercial market overall?

Brown: I don’t know of a single bank of significant size – and I work with many – that doesn’t have a larger current portfolio of troubled assets than ever in its past. While there remains value in their loan collateral, banks are filing an increasing number of lawsuits on note after note, and there are more judicial foreclosures than ever before. Before the debacle, there were many second and third loan positions on properties, but now lenders need to be in first position in order to have any security.

Banks also are dealing with heightened scrutiny from the FDIC and the Department of Financial Institutions, which means lenders have to monitor their debt-to-capital ratios and deal with troubled assets. Even small banks that formerly employed just a compliance or chief credit officer are now hiring professional asset officers to handle troubled portfolios and to try to recover some portion of the asset, if possible. Lending is restricted by a bank’s capital base, so it is critical to determine if the troubled assets have any true value.

Editor: What is the new profit model for the mortgage lending industry? Did regulatory failures spawn the housing market crash?

Willert: As mentioned above, the mortgage lenders are struggling to determine a compliant compensation model for the industry. In April 2010, the administration declared that mortgage lenders were no longer exempt employees under the Fair Labor Standards Act, which caused a great deal of scrambling within the industry to determine whether and how to pay people who had always considered themselves to be exempt professionals. Suddenly, the industry had to manage the concept of overtime or a fluctuating work week, and as of April 2011, there is another set of regulations that change the model yet again.

Clearly, the model has shifted away from a straight commission base, where the most important factors include interest rates, a borrower’s credit scores and debt-to-income ratios. Instead, in setting compensation, lenders should focus on factors such as  the number of loans originated, the quality of loans, the long term performance of loans, whether the borrowers are new or repeat customers and other factors, such as the percentage of applications submitted that result in closed loans. Currently, there is no consistency across banks and other mortgage lenders with respect to compensation models, and this fact alone reflects that the industry is struggling with the regulatory environment.

Editor: Was the regulatory process somehow at fault for the original breakdown of the industry?

Willert: It is not clear that the regulatory process itself was a contributing factor. A convergence of factors caused the failure of an entire system, although chief among these factors was a lack of sufficient administrative oversight of the industry. The administration was not sufficiently analyzing the industry with an affirmative goal to ensure that mortgage lenders were operating in compliance with existing regulations; thus, the administration was not able to discover the egregious offenders before bad lending practices infiltrated the system.

While this laissez-faire attitude fit well with the prevailing desire to reduce regulation and to maximize compensation – particularly in a stretched economy – it has created a bad situation in the mortgage lending sector, which is a vital industry for our economy.

Finally, outsourcing of U.S. jobs is another negative factor in this convergence of issues that caused regulatory and banking industry failures that have an impact to this day. Without question, regulatory failures will continue to have a negative effect, although the degree of that impact is still a huge unresolved question.

Editor: What is the impact of the new rules on consumers and on the housing market going forward?

Willert: In Seattle, as with the rest of the country, houses either are not selling or remain on the market for a long time. Because of the significant failure of large public entities that invested in real estate, the consumer will continue to have difficulty borrowing money from lending institutions until we see significant change in the financial industry, both domestically and globally.

Brown: For first-time home buyers with good credit and secure employment, there are some great programs available – better than those available for the last 20 years. However, most buyers are not first-time homeowners but rather are current owners who need to refinance because they are over-extended with their current mortgage payments.

Most of these programs are offered through Fannie Mae and Freddie Mac and do not offer assistance to higher-income markets, such as the housing market in Seattle, where there are many houses in the jumbo range of $500,000 and up. Refinancing for these homeowners is still difficult, even though they also may need a lower rate in order to continue to make mortgage payments.

Editor: Do our current problems originate from the buyer side in terms of qualifying for credit or from the seller side?

Brown: Both are factors and work together to create the current situation. Obviously, no one wants to sell a house if there is no viable market and if properties are not commanding top-dollar prices. People on both sides of the transaction are experiencing financial difficulties, and while it is easy to see the problem, it is not easy to resolve these issues.

Editor: Are there any current or anticipated legal challenges to the new rules?

Willert: Anticipated challenges likely will come in two different arenas. First, there will be an increase in litigation related to compensation for mortgage brokers because fundamental questions persist about determining the best compensation model that complies with current regulations. On the business side, we likely will see litigation addressing the legality of these regulations. There is some belief in the industry that current rules favor large, mainstream institutions and may eliminate smaller institutions that seek to create borrowing opportunities for their specific market. Thus, we anticipate legal challenges to the regulations themselves.

Please email the interviewees at or with questions about this interview.