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Daily Rules, Proposed Rules, and Notices of the Federal Government

BUREAU OF CONSUMER FINANCIAL PROTECTION

12 CFR Part 1026

[Docket No. CFPB-2012-0037]

RIN 3170-AA13

Truth in Lending Act (Regulation Z); Loan Originator Compensation

AGENCY: Bureau of Consumer Financial Protection.
ACTION: Proposed rule with request for public comment.
SUMMARY: The Bureau of Consumer Financial Protection is publishing for public comment a proposed rule amending Regulation Z (Truth in Lending) to implement amendments to the Truth in Lending Act (TILA) made by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The proposal would implement statutory changes made by the Dodd-Frank Act to Regulation Z's current loan originator compensation provisions, including a new additional restriction on the imposition of any upfront discount points, origination points, or fees on consumers under certain circumstances. In addition, the proposal implements additional requirements imposed by the Dodd-Frank Act concerning proper qualification and registration or licensing for loan originators. The proposal also implements Dodd-Frank Act restrictions on mandatory arbitration and the financing of certain credit insurance premiums. Finally, the proposal provides additional guidance and clarification under the existing regulation's provisions restricting loan originator compensation practices, including guidance on the application of those provisions to certain profit-sharing plans and the appropriate analysis of payments to loan originators based on factors that are not terms but that may act as proxies for a transaction's terms.
DATES: Comments must be received on or before October 16, 2012, except for comments on the Paperwork Reduction Act analysis in part IX of this document, which must be received on or before November 6, 2012.
ADDRESSES: *Electronic: http://www.regulations.gov. Follow the instructions for submitting comments.

*Mail/Hand Delivery/Courier:Monica Jackson, Office of the Executive Secretary, Consumer Financial Protection Bureau, 1700 G Street NW., Washington, DC 20552.

Instructions:All submissions should include the agency name and docket number or Regulatory Information Number (RIN) for this rulemaking. Because paper mail in the Washington, DC area and at the Bureau is subject to delay, commenters are encouraged to submit comments electronically. In general, all comments received will be posted without change tohttp://www.regulations.gov. In addition, comments will be available for public inspection and copying at 1700 G Street NW., Washington, DC 20552, on official business days between the hours of 10 a.m. and 5 p.m. Eastern Time. You can make an appointment to inspect the documents by telephoning (202) 435-7275.

All comments, including attachments and other supporting materials, will become part of the public record and subject to public disclosure. Sensitive personal information, such as account numbers or Social Security numbers, should not be included. Comments will not be edited to remove any identifying or contact information.

FOR FURTHER INFORMATION CONTACT: Daniel C. Brown and Michael G. Silver, Counsels; Krista P. Ayoub and R. Colgate Selden, Senior Counsels; Paul Mondor, Senior Counsel & Special Advisor; Charles Honig, Managing Counsel: Office of Regulations, at (202) 435-7700.
SUPPLEMENTARY INFORMATION: I. Summary of the Proposed Rule A. Background

The mortgage market crisis focused attention on the critical role that loan officers and mortgage brokers play in the loan origination process. Because consumers generally take out only a few home loans over the course of their lives, they often rely heavily on loan officers and brokers to guide them. But prior to the crisis, training and qualification standards for loan originators varied widely, and compensation was frequently structured to give loan originators strong incentives to steer consumers into more expensive loans. Often, consumers paid loan originators an upfront fee without realizing that their creditors also were paying the loan originators commissions that increased with the price of the loan.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)1 expanded on previous efforts by lawmakers and regulators to strengthen loan originator qualification requirements and regulate industry compensation practices. The Bureau is proposing new rules to implement the Dodd-Frank Act requirements, as well as to revise and clarify existing regulations and guidance on loan originator compensation.

1Public Law 111-203, 124 Stat. 1376.

The Bureau is also proposing rules to implement a new Dodd-Frank Act requirement that appears to be designed to address broader consumer confusion about the relationship between certain upfront charges and loan interest rates. Specifically, for mortgage loans in which a brokerage firm or creditor pays a loan originator a transaction-specific commission, the Dodd-Frank Act would ban the imposition on consumers of discount points, origination points, or other upfront origination fees that are retained by the creditor, broker, or an affiliate of either. Although bona fide upfront payments to independent appraisers or other third parties would still be permitted, the Act would require creditors in the vast majority of transactions in today's market to restructure their current pricing practices.

However, the Bureau is proposing to use its exception authority under the Dodd-Frank Act to allow creditors to continue making available loans with points and/or fees, so long as they also make available a comparable, alternative loan, as described below. The Bureau believes this approach would benefit consumers and industry alike. Making both options available would make it easier for consumers to evaluate different pricing options, while preserving their ability to make some upfront payments if they want to reduce their periodic payments over time. And the proposed approach would promote stability in the mortgage market, which would otherwise face radical restructuring of its existing pricing structures and practices to comply with the new Dodd-Frank Act requirement.

B. Restriction on Upfront Points and Fees

The proposed rule would generally require that, before a creditor or mortgage broker may impose upfront points and/or fees on a consumer in a closed-end mortgage transaction, the creditor must make available to the consumer a comparable, alternative loan with no upfront discount points, origination points, or origination fees that are retained by the creditor, broker, or an affiliate of either (a “zero-zero alternative”). The requirement would not be triggered by charges that are passed on to independent third parties that are not affiliated with the creditor or mortgage broker. The requirementwould not apply where the consumer is unlikely to qualify for the zero-zero alternative.

In transactions that do not involve a mortgage broker, the proposed rule would provide a safe harbor if, any time prior to application that the creditor provides a consumer an individualized quote for a loan that includes upfront points and/or fees, the creditor also provides a quote for a zero-zero alternative. In transactions that involve mortgage brokers, the proposed rule would provide a safe harbor under which creditors provide mortgage brokers with the pricing for all of their zero-zero alternatives. Mortgage brokers then would provide quotes to consumers for the zero-zero alternatives when presenting different loan options to consumers.

The Bureau is seeking comment on a number of related issues, including:

• Whether the Bureau should adopt as proposed a “bona fide” requirement to ensure that consumers receive value in return for paying upfront points and/or fees and, if so, the relative merits of several alternatives on the details of such a requirement;

• Whether additional adjustments to the proposal concerning the treatment of affiliate fees would make it easier for consumers to compare offers between two or more creditors;

• Whether to take a different approach concerning situations in which a consumer does not qualify for the zero-zero alternative; and

• Whether to require information about zero-zero alternatives to be provided not just in connection with informal quotes, but also in advertising and at the time that consumers are provided disclosures within three days after application.

C. Restrictions on Loan Originator Compensation

The proposal would adjust existing rules governing compensation to loan officers and mortgage brokers in connection with closed-end mortgage transactions to account for the Dodd-Frank Act and to provide greater clarity and flexibility. Specifically, the proposal would:

• Continue the general ban on paying or receiving commissions or other loan originator compensation based on the terms of the transaction (other than loan amount), with some refinements:

○ The proposal would allow reductions in loan originator compensation to cover unanticipated increases in closing costs from non-affiliated third parties under certain circumstances.

○ The proposal would clarify when a factor used as a basis for compensation is prohibited as a “proxy” for a transaction term.

• Clarify and revise restrictions on pooled compensation, profit-sharing, and bonus plans for loan originators, depending on the potential incentives to steer consumers to different transaction terms.

○ The proposal would permit employers to make contributions from general profits derived from mortgage activity to 401(k) plans, employee stock plans, and other “qualified plans” under tax and employment law.

○ The proposal would permit employers to pay bonuses or make contributions to non-qualified profit-sharing or retirement plans from general profits derived from mortgage activity if either (1) the loan originator affected has originated five or fewer mortgage transactions during the last 12 months; or (2) the company's mortgage business revenues are limited. The Bureau is proposing two alternatives, 25 percent or 50 percent of total revenues, as the applicable test.

○ Even though contributions and bonuses could be funded from general mortgage profits, the amounts of such contributions and bonuses could not be based on the terms of the transactions that the individual had originated.

• Continue the general ban on loan originators being compensated by both consumers and other parties, with some refinements:

○ The proposal would allow mortgage brokerage firms that are paid by the consumer to pay their individual brokers a commission, so long as the commission is not based on the terms of the transaction.

○ The proposal would clarify that certain funds contributed toward closing costs by sellers, home builders, home-improvement contractors, or similar parties, when used to compensate a loan originator, are considered payments made directly to the loan originator by the consumer.

D. Loan Originator Qualification Requirements

The proposal would implement a Dodd-Frank Act provision requiring both individual loan originators and their employers to be “qualified” and to include their license or registration numbers on certain specified loan documents.

• Where a loan originator is not already required to be licensed under the Secure and Fair Enforcement for Mortgage Licensing Act (SAFE Act), the proposal would require his or her employer to ensure that the loan originator meets character, fitness, and criminal background check standards that are equivalent to SAFE Act requirements and receives training commensurate with the loan originator's duties.

• Employers would be required to ensure that their loan originator employees are licensed or registered under the SAFE Act where applicable.

• Employers and the individual loan originators that are primarily responsible for a particular transaction would be required to list their license or registration numbers on certain key loan documents.

E. Other Provisions

The proposal would implement certain other Dodd-Frank Act requirements applicable to both closed-end and open-end mortgage credit:

• The proposal would ban general agreements requiring consumers to submit any disputes that may arise to mandatory arbitration rather than filing suit in court.

• The proposal would generally ban the financing of premiums for credit insurance.

• In the preamble below, the Bureau describes rule text that may be included in the final rule to implement a Dodd-Frank Act requirement that the Bureau require depository institutions to establish and maintain procedures to assure and monitor compliance with many of the requirements described above and the registration procedures established under the SAFE Act.

II. Background A. The Mortgage Market Overview of the Market and the Mortgage Crisis

The mortgage market is the single largest market for consumer financial products and services in the United States, with approximately $10.3 trillion in loans outstanding.2 During the last decade, the market went through an unprecedented cycle of expansion and contraction. So many other parts of the American financial system were drawn into mortgage-related activities that, when the bubble collapsed in 2008, it sparked the most severe recession in the United States since the Great Depression.

22 Inside Mortg. Fin., The 2012 Mortgage Market Statistical Annual 7 (2012).

The expansion in the market was driven, in part, by an era of low interest rates and rising house prices. Interest rates dropped significantly—by more than 20 percent—from 2000 through2003.3 Housing prices increased dramatically—about 152 percent—between 1997 and 2006.4 Driven by the decrease in interest rates and the increase in housing prices, the volume of refinancings was increasing, from about 2.5 million loans in 2000 to more than 15 million in 2003.5

3 SeeU.S. Dep't of Hous. & Urban Dev.,An Analysis of Mortgage Refinancing, 2001-2003,at 2 (2004), available at:www.huduser.org/Publications/pdf/MortgageRefinance03.pdf; Souphala Chomsisengphet & Anthony Pennington-Cross,The Evolution of the Subprime Mortgage Market,88 Fed. Res. Bank of St. Louis Rev. 31, 48 (2006), available at:http://research.stlouisfed.org/publications/review/article/5019.

4U.S. Fin. Crisis Inquiry Comm'n,The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States156 (Official Gov't ed. 2011) (“FCIC Report”), available at:http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.

5An Analysis of Mortgage Refinancing, 2001-2003, at 1.

Growth in the mortgage loan market was particularly pronounced in what are known as “subprime” and “Alt-A” products. Subprime products were sold primarily to borrowers with poor or no credit history, although there is evidence that some borrowers who would have qualified for “prime” loans were steered into subprime loans as well.6 The Alt-A category of loans permitted borrowers to take out mortgage loans while providing little or no documentation of income or other evidence of repayment ability. Because these loans involved additional risk, they were typically more expensive to borrowers than “prime” mortgages, although many of them had very low introductory interest rates. In 2003, subprime and Alt-A origination volume was about $400 billion; in 2006, it had reached $830 billion.7

6The Federal Reserve Board on July 18, 2011 issued a consent cease and desist order and assessed an $85 million civil money penalty against Wells Fargo & Company of San Francisco, a registered bank holding company, and Wells Fargo Financial, Inc., of Des Moines. The order addresses allegations that Wells Fargo Financial employees steered potential prime borrowers into more costly subprime loans and separately falsified income information in mortgage applications. In addition to the civil money penalty, the order requires that Wells Fargo compensate affected borrowers.See http://www.federalreserve.gov/newsevents/press/enforcement/20110720a.htm.

7Inside Mortg. Fin., The 2011 Mortgage Market Statistical Annual (2011).

So long as housing prices were continuing to increase, it was relatively easy for borrowers to refinance their loans to avoid interest rate resets and other adjustments. When housing prices began to decline in 2005, refinancing became more difficult and delinquency rates on these subprime and Alt-A products increased dramatically.8 The private securitization-backed subprime and Alt-A mortgage market ground to a halt in 2007 in the face of these rising delinquencies. Fannie Mae and Freddie Mac, which supported the mainstream mortgage market, experienced heavy losses and were placed in conservatorship by the Federal government in 2008.

8FCIC Report at 215-217.

Four years later, the United States continues to grapple with the fallout. Home prices are down 35 percent from the peak nationally, as the national market appears at or near its bottom.9 Mortgage markets continue to rely on extraordinary U.S. government support, and distressed homeownership and foreclosure rates remain at unprecedented levels.10

9 Standard & Poors/Case-Shiller 20-City Composite,Bloomberg, LP, available at:http://www.bloomberg.com(data service accessible only through paid subscription).

10PowerPoint Presentation, Lender Processing Servs.,LPS Mortgage Monitor: May 2012 Mortgage Performance Observations, Data as of April 2012 Month End,at 3, 11 (May 2012), available at:http://www.lpsvcs.com/LPSCorporateInformation/CommunicationCenter/DataReports/Pages/Mortgage-Monitor.aspx.

Nevertheless, even with the economic downturn, approximately $1.28 trillion in mortgage loans were originated in 2011.11 The overwhelming majority of homebuyers continue to use mortgage loans to finance at least some of the purchase price of their property. In 2011, 93 percent of all new home purchases were financed with a mortgage loan.12 Purchase loans and refinancings together produced 6.3 million new first-lien mortgage loan originations in 2011.13 Home equity loans and lines of credit resulted in an additional 1.3 million mortgage loan originations in 2011.14

11 Credit Forecast 2012,Moody's Analytics (2012), available at,http://www.economy.com/default.asp(reflects first-lien mortgage loans) (data service accessible only through paid subscription).

121 Inside Mortg. Fin., The 2012 Mortgage Market Statistical Annual 12 (2012).

13Credit Forecast 2012. The proportion of loans that are for purchases as opposed to refinancings varies with the interest rate environment. In 2011, refinance transactions comprised 65 percent of the market, and purchase money mortgage loans comprised 35 percent, by dollar volume. 1 Inside Mortg. Fin., The 2012 Mortgage Market Statistical Annual 17 (2012). Historically the distribution has been more even. In 2000, refinancings accounted for 44 percent of the market as measured by dollar volume, while purchase money mortgage loans comprised 56 percent, and in 2005 the two types of mortgage loan were split evenly.Id.

14Credit Forecast (2012). Using a home equity loan or line of credit, a homeowner uses home equity as collateral for a loan. The loan proceeds can be used, for example, to pay for home improvements or to pay off other debts.

The Mortgage Origination Process and Origination Channels

Consumers must go through a mortgage origination process to obtain a mortgage loan. There are many actors involved in a mortgage origination. In addition to the creditor and the consumer, a transaction may involve a mortgage broker, settlement agent, appraiser, multiple insurance providers, local government clerks and tax offices, and others. Purchase money loans involve additional parties such as sellers and real estate agents. These third parties typically charge fees or commissions for the services they provide.

Application.To obtain a mortgage loan, consumers must first apply through a loan originator. There are three different “channels” for mortgage loan origination in the current market:

Retail:The consumer deals with a loan officer that works directly for the mortgage creditor, such as a bank, credit union, or specialized mortgage finance company. The creditor typically operates a network of branches, but may also communicate with consumers through mail and the Internet. The entire origination transaction is conducted within the corporate structure of the creditor, and the loan is closed using funds supplied by the creditor. Depending on the type of creditor, the creditor may hold the loan in its portfolio or sell the loan to investors on the secondary market, as discussed further below.

Wholesale:The consumer deals with an independent mortgage broker, which may be an individual or a mortgage brokerage firm. The broker may seek offers from many different creditors, and then acts as a liaison between the consumer and whichever creditor ultimately makes the loan. At closing, the loan is funded using the creditor's funds and the mortgage note is written in the creditor's name.15 Again, the creditor may hold the loan in its portfolio or sell the loan on the secondary market.

15In some cases, mortgage brokers use a process called “table funding,” in which the wholesale creditor provides the funds to the settlement, but the loan is closed in the broker's name. The broker simultaneously assigns the closed loan to the creditor.

Correspondent:The consumer deals with a loan officer that works directly for a “correspondent lender” that does not deal directly with the secondary market. At closing, the correspondent lender closes the loans using its own funds, but then immediately sells the loan to an “acquiring creditor,” which in turn either holds the loan in portfolio or sells it on the secondary market.

Both loan officers and mortgage brokers generally help consumers determine what kind of loan best suits their needs, and will take theircompleted loan applications for submission to the creditor's loan underwriter. The application includes consumer credit and income information, along with information about the home to be purchased. Consumers can work with multiple loan originators to compare the loan offers that loan originators may obtain on their behalf from creditors. Once the consumer has decided to move forward with a loan, the loan originator may request additional information or documents from the consumer to support the information in the application and obtain an appraisal of the property.

Underwriting.The creditor's loan underwriter uses the application and additional information to confirm initial information provided by the consumer. The underwriter will assess whether the creditor should take on the risk of making the mortgage loan. To make this decision, the underwriter considers whether the consumer can repay the loan and whether the home is worth enough to serve as collateral for the loan. If the underwriter finds that the consumer and the home qualify, the underwriter will approve the consumer's mortgage application.

Closing.After being approved for a mortgage loan, completing any closing requirements, and receiving necessary disclosures, the consumer can close on the loan. Multiple parties participate at closing, including the consumer, the creditor, and the settlement agent.

Loan Pricing and Disposition of Closed Loans

Mortgage loan pricing is an extremely complex process that involves a series of trade-offs for both the consumer and the creditor between upfront and long-term payments. Some of the costs that borrowers pay to close the loan—such as third-party appraisal fees, title insurance, taxes, etc.—are independent of the other terms of the loan. But costs that are paid to the creditor, broker, or affiliates of either company often vary in connection with the interest rate because the consumer can choose whether to pay more money up front (through discount points, origination points, or origination fees) or over time (through the interest rate, which drives monthly payments). Borrowers face a complex set of decisions around whether to pay upfront charges to reduce the interest rate they would otherwise pay and, if so, how much to pay in such charges to receive a specific rate reduction.

Thus, from the consumer's perspective, loan pricing depends on several elements:

Loan terms.The loan terms affect how the loan is to be repaid, including the type of loan “product,”16 the interest rate, the payment amount, and the length of the loan term.

16The meaning of loan “product” is not firmly established and varies with the person using the term, but it generally refers to various combinations of features such as the type of interest rate and the form of amortization. Feature distinctions often thought of as distinct “loan products” include, for example, fixed rate versus adjustable rate loans and fully amortizing versus interest-only or negatively amortizing loans.

Discount points and cash rebates.Discount points are paid by consumers to the creditor to purchase a lower interest rate. Conversely, creditors may offer consumers a cash rebate at closing which can help cover upfront closing costs in exchange for paying a higher rate over the life of the loan. Both discount points and creditor rebates involve an exchange of cash now (in the form of a payment or credit at closing) for cash over time (in the form of a reduced or increased interest rate).

Origination points or fees.Creditors and/or loan originators also sometimes charge origination points or fees, which are typically presented as charges to apply for the loan. Origination fees can take a number of forms: A flat dollar amount, a percentage of the loan amount (i.e.,an “origination point”), or a combination of the two. Origination points or fees may also be framed as a single lump sum or as several different fees (e.g.,application fee, underwriting fee, document preparation fee).

Closing costs.Closing costs are the additional upfront costs of completing a mortgage transaction, including appraisal fees, title insurance, recording fees, taxes, and homeowner's insurance, for example. These closing costs, as distinct from upfront discount points and origination charges, often are paid to third parties other than the creditor or loan originator.

In practice, both discount points and origination points or fees are revenue to the lender and/or loan originator, and that revenue is fungible. The existence of two types of fees and the many names lenders use for origination fees—some of which may appear to be more negotiable than others—has the potential to confuse consumers.

Determining the appropriate trade-off between payments now and payments later requires a consumer to have a clear sense of how long he or she expects to stay in the home and in the particular loan. If the consumer plans to stay in the home for a number of years without refinancing, paying points to obtain a lower rate may make sense because the consumer will save more in monthly payments than he or she pays up front in discount points. If the consumer expects to move or refinance within a few years, however, then agreeing to pay a higher rate on the loan to reduce out of pocket expenses at closing may make sense because the consumer will save more up front than he or she will pay in increased monthly payments before moving or refinancing. There is a breakeven moment in time where the present value of a reduction/increase to the rate just equals the corresponding upfront points/credits. If the consumer moves or refinances earlier (in the case of discount points) or later (in the case of creditor rebates) than the breakeven moment, then the consumer will lose money compared to a consumer that neither paid discount points nor received creditor rebates.

The creditor's assessment of pricing—and in particular what different combinations of points, fees, and interest rates it is willing to offer particular consumers—is also driven by the trade-off between upfront and long-term payments. Creditors in general would prefer to receive as much money as possible up front, because having to wait for payments to come in over the life of the loan increases the level of risk. If consumers ultimately pay off a loan earlier than expected or cannot pay off a loan due to financial distress, the creditors will not earn the overall expected return on the loan.

One mechanism that has developed to manage this risk is the creation of the secondary market, which allows creditors to sell off their loans to investors, recoup the capital they have invested in the loans and recycle that capital into new loans. The investors then benefit from the payment streams over time, as well as bearing the risk of early payment or default. And the creditor can go on to make additional money from additional loans. Thus, although some banks and credit unions hold some loans in portfolio over time, many creditors prefer not to hold loans until maturity.17

17For companies that are affiliated with securitizers, the processing fees involved in creating investment vehicles on the secondary market can itself become a distinct revenue stream. Although the secondary market was originally created by government-sponsored enterprises Fannie Mae and Freddie Mac to provide liquidity for the mortgage market, over time, Wall Street companies began packaging mortgage loans into private-label mortgage-backed securities. Subprime and Alt-A loans, in particular, were often sold into private-label securities. During the boom, a number of large creditors started securitizing the loans themselves in-house, thereby capturing the final piece of the loan's value.

When a creditor sells a loan into the secondary market, the creditor is exchanging an asset (the loan) thatproduces regular cash flows (principal and interest) for an upfront cash payment from the buyer.18 That upfront cash payment represents the buyer's present valuation of the loan's future cash flows, using assumptions about the rate of prepayments due to moves and refinancings, the rate of expected defaults, the rate of return relative to other investments, and other factors. Secondary market buyers assume considerable risk in determining the price they are willing to pay for a loan. If, for example, loans prepay faster than expected or default at higher rates than expected, the investor will receive a lower return than expected. Conversely, if loans prepay more slowly than expected, or default at lower rates than expected, the investor will earn a higher return over time than expected.19

18For simplicity, this discussion assumes that the secondary market buyer is a person other than the creditor, such as Fannie Mae, Freddie Mac, or a Wall Street investment bank. In practice, during the mortgage boom, some creditors securitized their own loans. In this case, the secondary market price for the loans was effectively determined by the price investors were willing to pay for the subsequent securities.

19For simplicity, these examples do not take into account the use of various risk mitigation techniques, such as risk-sharing counterparties and loan level mortgage or other security credit enhancements.

Secondary market mortgage prices are typically quoted as a multiple of the principal loan amount and are specific to a given interest rate. For illustrative purposes, at some point in time, a loan with an interest rate of 3.5 percent might earn 102.5 in the secondary market. This means that for every $100 in initial loan principal amount, the secondary market buyer will pay $102.50. Of that amount, $100 is to cover the principal amount and $2.50 is revenue to the creditor in exchange for the rights to the future interest payments on the loan.20 The secondary market price of a loan increases or decreases along with the loan's interest rate, but the relationship is not typically linear. In other words, using the above example at the same point in time, loans with interest rates higher than 3.5 percent will typically earn more than 102.5, and loans with interest rates less than 3.5 percent will typically earn less than 102.5. However, each subsequent 0.125 percent increment in interest rate above or below 3.5 percent may not be associated with the same size increment in secondary market price.21

20The creditor's profit is equal to secondary market revenue plus origination fees collected by the creditor (if any) plus value of the mortgage servicing rights (MSRs) less origination expenses.

21Susan E. Woodward, Urb. Inst.,A Study of Closing Costs for FHA Mortgages10-11 (U.S. Dep't of Hous. & Urban Dev. 2008), available at:http://www.huduser.org/publications/pdf/FHA_closing_cost.pdf.

In some cases, secondary market prices can actually be less than the principal amount of the loan. A price of 98.75, for example, means that for every $100 in principal, the selling creditor receives only $98.75. This represents a loss of $1.25 per $100 of principal just on the sale of the loan, before the creditor takes its expenses into account. This usually happens when the interest rate on the loan is below prevailing interest rates. But so long as discount points or other origination charges can cover the shortfall, the creditor will still make its expected return on the loan. The same style of pricing is used when correspondent lenders sell loans to acquiring creditors.

Discount points are also valuable to creditors (and secondary market investors) for another reason: Because payment of discount points signals the consumer's expectations about how long he or she expects to stay in the loan, they make prepayment risk easier to predict. The more discount points a consumer pays, the longer the consumer likely expects to keep the loan in place. This fact mitigates a creditor's or investor's uncertainty about how long interest payments can be expected to continue, which facilitates assigning a present value to the loan's yield and, therefore, setting the loan's price.

Loan Originator Compensation

Prior to 2010, compensation for individual loan officers and mortgage brokers was also often calculated and paid as a premium above every $100 in principal. This was typically called a “yield spread premium.” The loan originator might keep the entire yield spread premium as a commission, or he or she might provide some of the yield spread premium to the borrower as a credit against closing costs.22

22Mortgage brokers, and some retail loan officers, were compensated in this fashion. Some retail loan officers may have been paid a salary with a bonus for loan volume, rather than yield spread premium-based commissions.

While this system was in place, it was common for loan originator commissions to mirror secondary market pricing closely. The “price” that the creditor quoted to its brokers and loan officers was somewhat lower than the price that the creditor expected to receive from the secondary market—the creditor kept the difference as corporate revenue. However, the underlying mechanics of the secondary market flowed through to the loan originator's compensation. The higher the interest rate on the loan or the more in upfront charges the consumer pays to the creditor (or both), the greater the yield spread premium available to the loan originator. This created a situation in which the loan originator had a financial incentive to steer consumers into the highest interest rate possible or to impose on the consumer additional upfront charges payable to the creditor.

In a perfectly competitive and transparent market, competition would ensure that this incentive would be countered by the need to compete with other loan originators to offer attractive loan terms to consumers. However, the mortgage origination market is neither always perfectly competitive nor always transparent, and consumers (who take out a mortgage only a few times in their lives) may be uninformed about how prices work and what terms they can expect.23 Moreover, prior to 2010, mortgage brokers were free to charge consumers directly for additional origination points or fees, which were generally described as compensating for the time and expense of working with the consumer to submit the loan application. This compensation structure was problematic both because the loan originator had an incentive to steer borrowers into less favorable pricing terms and because the consumer may have paid origination fees to the loan originator believing that the loan originator was working for the borrower, without knowing that the loan originator was receiving compensation from the creditor as well.

23James Lacko and Janis Pappalardo,Improving Consumer Mortgage Disclosures: An Empirical Assessment of Current and Prototype Disclosure Forms,Federal Trade Commission, p. 26 (June 2007), available at:http://www.ftc.gov/os/2007/06/P025505MortgageDisclosureReport.pdf, Brian K. Bucks and Karen M. Pence,Do Borrowers Know their Mortgage Terms?,J. of Urban Econ. (2008), available at:http://works.bepress.com/karen_pence/5, Hall and Woodward,Diagnosing Consumer Confusion and Sub-Optimal Shopping Effort: Theory and Mortgage-Market Evidence(2012), available at:http://www.stanford.edu/∼rehall/DiagnosingConsumerConfusionJune2012.

The 2010 Loan Originator Final Rule

In the aftermath of the mortgage crisis, regulators and lawmakers began focusing on concerns about the steering of consumers into less favorable loan terms than those for which they otherwise qualified. Both the Board of Governors of the Federal Reserve System (Board) and the Department of Housing and Urban Development (HUD) had explored the use of disclosures to inform consumers about loan originator compensation practices. HUD did adopt a new disclosure regime under the Real Estate Settlement Procedures Act (RESPA), in a 2008 final rule, which addressed among other matters thedisclosure of mortgage broker compensation.24 The Board, on the other hand, first proposed a disclosure-based approach to addressing concerns with mortgage broker compensation.25 The Board later determined, however, that the proposed approach presented a significant risk of misleading consumers regarding both the relative costs of brokers and creditors and the role of brokers in their transactions and, consequently, withdrew that aspect of the 2008 proposal as part of its 2008 Home Ownership and Equity Protection Act (HOEPA) Final Rule.26

2473 FR 68204, 68222-27 (Nov. 17, 2008).

25 See73 FR 1672, 1698-1700 (Jan. 9, 2008).

2673 FR 44522, 44564 (Jul. 30, 2008). The Board indicated that it would continue to explore available options to address potential unfairness associated with loan originator compensation practices.Id.at 44565.

The Board in 2009 proposed new rules addressing in a more substantive fashion loan originator compensation practices.27 Although this proposal was prior to the enactment of the Dodd-Frank Act, Congress subsequently codified significant elements of the Board's proposal.28 Specifically, the Board's new proposal prohibited the payment and receipt of loan originator compensation based on transaction terms or conditions, and banned the receipt by a loan originator of compensation on a particular transaction from both the consumer and any other person; the Dodd-Frank Act substantially paralleled both of these provisions. The Board therefore decided in 2010 to finalize those rules, while acknowledging that some adjustments would need to be made to account for the statutory language.29 The Board's 2010 Loan Originator Final Rule took effect in April of 2011.

2774 FR 43232, 43279-286 (Aug. 26, 2009).

28Sections 1402 and 1403 of the Dodd-Frank Act, codified at 15 U.S.C. 1639b.

2975 FR 58509 (Sept. 24, 2010) (2010 Loan Originator Final Rule).

Most notably, the Board's 2010 Loan Originator Final Rule substantially restricted the use of yield spread premiums. Under the current regulations, creditors may not base a loan originator's compensation on the transaction's terms or conditions, other than the mortgage loan amount. In addition, the rule prohibits “dual compensation,” in which a loan originator is paid compensation by both the consumer and the creditor (or any other person).30 The existing rules, however, do not address broader consumer confusion regarding the relationship between loan originator compensation and general trade-offs between points, fees, and interest rates.

30 See generally12 CFR 226.36(d). The CFPB restated this rule at 12 CFR 1026.36(d). 76 FR 79768 (Dec. 22, 2011).

B. TILA and Regulation Z

Congress enacted the Truth in Lending Act (TILA) based on findings that the informed use of credit resulting from consumers' awareness of the cost of credit would enhance economic stability and would strengthen competition among consumer credit providers. 15 U.S.C. 1601(a). One of the purposes of TILA is to provide meaningful disclosure of credit terms to enable consumers to compare credit terms available in the marketplace more readily and avoid the uninformed use of credit.Id.TILA's disclosures differ depending on whether credit is an open-end (revolving) plan or a closed-end (installment) loan. TILA also contains procedural and substantive protections for consumers. TILA is implemented by the Bureau's Regulation Z, 12 CFR part 1026, though historically the Board's Regulation Z, 12 CFR part 226, has implemented TILA.31

31The Board's rule remains applicable to certain motor vehicle dealers.Seesection 1029 of the Dodd-Frank, 12 U.S.C. 5519.

On August 26, 2009, as discussed above, the Board published proposed amendments to Regulation Z to include new limits on loan originator compensation for all closed-end mortgages (Board's 2009 Loan Originator Proposal). 74 FR 43232 (Aug. 26, 2009). The Board considered, among other changes, prohibiting certain payments to a mortgage broker or loan officer based on the transaction's terms or conditions, prohibiting dual compensation as described above, and prohibiting a mortgage broker or loan officer from “steering” consumers to transactions not in their interest, to increase mortgage broker or loan officer compensation. The Board issued the 2009 Loan Originator Proposal using its authority to prohibit acts or practices in the mortgage market that the Board found to be unfair, deceptive, or (in the case of refinancings) abusive under TILA section 129(l)(2) (now re-designated as TILA section 129(p)(2), 15 U.S.C. 1639(p)(2)).

On September 24, 2010, the Board issued the 2010 Loan Originator Final Rule, which finalized the 2009 Loan Originator Proposal and included the above prohibitions. 75 FR 58509 (Sept. 24, 2010). The Board acknowledged, however, that further rulemaking would be required to address certain issues and adjustments made by the Dodd-Frank Act, which was signed on July 21, 2010.32 Public Law 111-203, 124 Stat. 1376.

32As the Board explained: “The Board has decided to issue this final rule on loan originator compensation and steering, even though a subsequent rulemaking will be necessary to implement Section 129B(c). The Board believes that Congress was aware of the Board's proposal and that in enacting TILA Section 129B(c), Congress sought to codify the Board's proposed prohibitions while expanding them in some respects and making other adjustments. The Board further believes that it can best effectuate the legislative purpose of the [Dodd-Frank Act] by finalizing its proposal relating to loan origination compensation and steering at this time. Allowing enactment of TILA Section 129B(c) to delay final action on the Board's prior regulatory proposal would have the opposite effect intended by the legislation by allowing the continuation of the practices that Congress sought to prohibit.” 75 FR 58509 (Sept. 24, 2010).

C. The SAFE Act

The Secure and Fair Enforcement for Mortgage Licensing Act of 2008 (SAFE Act) generally prohibits an individual from engaging in the business of a loan originator without first obtaining, and maintaining annually, a unique identifier from the Nationwide Mortgage Licensing System and Registry (NMLSR) and either a registration as a registered loan originator or a license and registration as a State-licensed loan originator. 12 U.S.C. 5103. Loan originators who are employees of depository institutions are generally subject to the registration requirement, which is implemented by the Bureau's Regulation G, 12 CFR part 1007. Other loan originators are generally subject to the State licensing requirement, which is implemented by the Bureau's Regulation H, 12 CFR part 1008, and by State law.

D. The Dodd-Frank Act

Effective July 21, 2011, the Dodd-Frank Act transferred rulemaking authority for TILA and the SAFE Act, among other laws, to the Bureau.33 Seesections 1061 and 1100A of the Dodd-Frank Act. In addition, the Dodd-Frank Act added section 129B to TILA, whichimposes two new duties on mortgage originators. The first such duty is to be “qualified” and (where applicable) registered and licensed in accordance with the SAFE Act and other applicable State or Federal law. The second new duty of mortgage originators is to include on all loan documents the originator's identifier number from the NMLSR.Seesection 1402 of the Dodd-Frank Act.

33Section 1029 of the Dodd-Frank Act excludes from this transfer of authority, subject to certain exceptions, any rulemaking authority over a motor vehicle dealer that is predominantly engaged in the sale and servicing of motor vehicles, the leasing and servicing of motor vehicles, or both. 12 U.S.C. 5519. Pursuant to the Dodd-Frank Act and TILA, as amended, the Bureau published for public comment an interim final rule establishing a new Regulation Z, 12 CFR part 1026, implementing TILA (except with respect to persons excluded from the Bureau's rulemaking authority by section 1029 of the Dodd-Frank Act). 76 FR 79768 (Dec. 22, 2011). Similarly, the Bureau's Regulations G and H are recodifications of predecessor agencies' regulations implementing the SAFE Act. 76 FR 78483 (Dec. 19, 2011). The Bureau's Regulations G, H, and Z took effect on December 30, 2011. These rules did not impose any new substantive obligations but did make certain technical, conforming, and stylistic changes to reflect the transfer of authority and certain other changes made by the Dodd-Frank Act.

In addition, the Dodd-Frank Act generally codified, but in some cases imposed new or different requirements than, the Board's 2009 Loan Originator Proposal. Shortly after the legislation, the Board adopted the 2010 Loan Originator Final Rule, which prohibits loan originator compensation based on transactions' terms or conditions and compensation from both the consumer and another person, as discussed above. Those regulatory provisions were consistent with some aspects of the Dodd-Frank Act. In addition, the Dodd-Frank Act generally prohibits any person from requiring consumers to pay any upfront discount points, origination points, or fees, however denominated, where a mortgage originator is being paid transaction-specific compensation by any person other than the consumer (subject to the Bureau's express authority to make an exemption from the prohibition of such upfront charges if the Bureau finds such an exemption to be in the interest of consumers and the public).Seesection 1403 of the Dodd-Frank Act. Finally, the Dodd-Frank Act also added new restrictions on the financing of single-premium credit insurance and mandatory arbitration agreements.Seesection 1414 of the Dodd-Frank Act.

E. Other Rulemakings

In addition to this proposal, the Bureau currently is engaged in six other rulemakings relating to mortgage credit to implement requirements of the Dodd-Frank Act:

TILA-RESPA Integration:On July 9, 2012, the Bureau published a proposed rule and proposed integrated forms combining the TILA mortgage loan disclosures with the Good Faith Estimate (GFE) and settlement statement required under the Real Estate Settlement Procedures Act (RESPA), pursuant to Dodd-Frank Act section 1032(f) and sections 4(a) of RESPA and 105(b) of TILA, as amended by Dodd-Frank Act sections 1098 and 1100A, respectively. 12 U.S.C. 2603(a); 15 U.S.C. 1604(b). The public has until November 6, 2012 to review and provide comments on most of this proposal, except that comments are due by September 7, 2012 for specific portions of the proposal.

HOEPA:The Bureau proposed on July 9, 2012 to implement Dodd-Frank Act requirements expanding protections for “high-cost” mortgage loans under the Home Ownership and Equity Protection Act (HOEPA), pursuant to TILA sections 103(bb) and 129, as amended by Dodd-Frank Act sections 1431 through 1433. 15 U.S.C. 1602(bb) and 1639. The public has until September 7, 2012 to review and provide comment on this proposal, except comments on the Paperwork Reduction Act.

Servicing:The Bureau proposed on August 9, 2012 to implement Dodd-Frank Act requirements regarding force-placed insurance, error resolution, and payment crediting, as well as forms for mortgage loan periodic statements and “hybrid” adjustable-rate mortgage reset disclosures, pursuant to sections 6 of RESPA and 128, 128A, 129F, and 129G of TILA, as amended or established by Dodd-Frank Act sections 1418, 1420, 1463, and 1464. 12 U.S.C. 2605; 15 U.S.C. 1638, 1638a, 1639f, and 1639g. The Bureau also proposed rules on reasonable information management, early intervention for delinquent consumers, continuity of contact, and loss mitigation, pursuant to the Bureau's authority to carry out the consumer protection purposes of RESPA in section 6 of RESPA, as amended by Dodd-Frank Act section 1463. 12 U.S.C. 2605. The public has until October 9, 2012 to review and provide comment on these proposals, except comments on the Paperwork Reduction Act.

Appraisals:The Bureau, jointly with Federal prudential regulators and other Federal agencies, on August 15, 2012 issued a proposal to implement Dodd-Frank Act requirements concerning appraisals for higher-risk mortgages, appraisal management companies, and automated valuation models, pursuant to TILA section 129H as established by Dodd-Frank Act section 1471, 15 U.S.C. 1639h, and sections 1124 and 1125 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) as established by Dodd-Frank Act sections 1473(f), 12 U.S.C. 3353, and 1473(q), 12 U.S.C. 3354, respectively. In addition, the Bureau on the same date issued rules to implement section 701(e) of the Equal Credit Opportunity Act (ECOA), as amended by Dodd-Frank Act section 1474, to require that creditors provide applicants with a free copy of written appraisals and valuations developed in connection with applications for loans secured by a first lien on a dwelling. 15 U.S.C. 1691(e).

Ability to Repay:The Bureau is in the process of finalizing a proposal issued by the Board to implement provisions of the Dodd-Frank Act requiring creditors to determine that a consumer can repay a mortgage loan and establishing standards for compliance, such as by making a “qualified mortgage,” pursuant to TILA section 129C as established by Dodd-Frank Act sections 1411 and 1412. 15 U.S.C. 1639c.

Escrows:The Bureau is in the process of finalizing a proposal issued by the Board to implement provisions of the Dodd-Frank Act requiring certain escrow account disclosures and exempting from the higher-priced mortgage loan escrow requirement loans made by certain small creditors, among other provisions, pursuant to TILA section 129D as established by Dodd-Frank Act sections 1461 and 1462. 15 U.S.C. 1639d.

With the exception of the TILA-RESPA Integration Proposal, the Dodd-Frank Act requirements will take effect on January 21, 2013 unless final rules implementing those requirements are issued on or before that date and provide for a different effective date.

The Bureau regards the foregoing rulemakings as components of a single, comprehensive undertaking; each of them affects aspects of the mortgage industry and its regulation that intersect with one or more of the others. Accordingly, the Bureau is coordinating carefully the development of the proposals and final rules identified above. Each rulemaking will adopt new regulatory provisions to implement the various Dodd-Frank Act mandates described above. In addition, each of them may include other provisions the Bureau considers necessary or appropriate to ensure that the overall undertaking is accomplished efficiently and that it ultimately yields a comprehensive regulatory scheme for mortgage credit that achieves the statutory purposes set forth by Congress, while avoiding unnecessary burdens on industry.

Thus, the Bureau intends that the rulemakings listed above function collectively as a whole. In this context, each rulemaking may raise concerns that might appear unaddressed if that rulemaking were viewed in isolation. The Bureau intends, however, to address issues raised by its mortgage rulemakings through whichever rulemaking is most appropriate, in the Bureau's judgment, for addressing each specific issue. In some cases, the Bureau expects that one rulemaking may raise an issue and yet may not be the rulemaking that is most appropriate foraddressing that issue. For example, the proposed requirement to include NMLS IDs on loan documents, discussed in Part V under § 1026.36(g), below, also is proposed to be addressed in part by the TILA-RESPA Integration Proposal.

III. Outreach Conducted for This Rulemaking A. Early Stakeholder Outreach & Feedback on Existing Rules

The Bureau conducted extensive outreach in developing the provisions in this proposed rule. Bureau staff met with and held in-depth conference calls with large and small bank and non-bank mortgage creditors, mortgage brokers, trade associations, secondary market participants, consumer groups, non-profit organizations, and State regulators. Discussions covered existing business models and compensation practices and the impact of the existing Loan Originator Rule. They also covered the Dodd-Frank Act provisions and the impact on consumers, loan originators, lenders, and secondary market participants of various options for implementing the statutory provisions. The Bureau developed several of the proposed clarifications of existing regulatory requirements in response to compliance inquiries and with input from industry participants.

B. Small Business Review Panel

In May 2012, the Bureau convened a Small Business Review Panel with the Chief Counsel for Advocacy of the Small Business Administration (SBA) and the Administrator of the Office of Information and Regulatory Affairs (OIRA) within the Office of Management and Budget (OMB).34 As part of this process, the Bureau prepared an outline of the proposals then under consideration and the alternatives considered (Small Business Review Panel Outline), which the Bureau posted on its Web site for review by the general public as well as the small entities participating in the panel process.35 The Small Business Review Panel gathered information from representatives of small creditors, mortgage brokers, and not-for-profit organizations and made findings and recommendations regarding the potential compliance costs and other impacts of the proposed rule on those entities. These findings and recommendations are set forth in the Small Business Review Panel Report, which will be made part of the administrative record in this rulemaking.36 The Bureau has carefully considered these findings and recommendations in preparing this proposal and has addressed certain specific ones below.

34The Small Business Regulatory Enforcement Fairness Act of 1996 (SBREFA) requires the Bureau to convene a Small Business Review Panel before proposing a rule that may have a substantial economic impact on a significant number of small entities.SeePublic Law 104-121, tit. II, 110 Stat. 847, 857 (1996) (as amended by Pub. L. 110-28, section 8302 (2007)).

35U.S. Consumer Fin. Prot. Bureau,Outline of Proposals under Consideration and Alternatives Considered(May 9, 2012), available at:http://files.consumerfinance.gov/f/201205_cfpb_MLO_SBREFA_Outline_of_Proposals.pdf.

36U.S. Consumer Fin. Prot. Bureau, U.S. Small Bus. Admin., and U.S. Office of Mgmt. and Budget,Final Report of the Small Business Review Panel on CFPB's Proposals Under Consideration for Residential Mortgage Loan Origination Standards Rulemaking(July 11, 2012) (Small Business Review Panel Final Report), available at:http://files.consumerfinance.gov/f/201208_cfpb_LO_comp_SBREFA.pdf.

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In addition, the Bureau held roundtable meetings with other Federal banking and housing regulators, consumer advocacy groups, and industry representatives regarding the Small Business Review Panel Outline. At the Bureau's request, many of the participants provided feedback, which the Bureau has considered in preparing this proposal.

IV. Legal Authority

The Bureau is issuing this proposed rule pursuant to its authority under TILA and the Dodd-Frank Act. On July 21, 2011, section 1061 of the Dodd-Frank Act transferred to the Bureau the “consumer financial protection functions” previously vested in certain other Federal agencies, including the Board. The term “consumer financial protection function” is defined to include “all authority to prescribe rules or issue orders or guidelines pursuant to any Federal consumer financial law, including performing appropriate functions to promulgate and review such rules, orders, and guidelines.” 12 U.S.C. 5581(a)(1). TILA and title X of the Dodd-Frank Act are Federal consumer financial laws. Dodd-Frank Act section 1002(14), 12 U.S.C. 5481(14) (defining “Federal consumer financial law” to include the “enumerated consumer laws” and the provisions of title X of the Dodd-Frank Act); Dodd-Frank Act section 1002(12), 12 U.S.C. 5481(12) (defining “enumerated consumer laws” to include TILA). Accordingly, the Bureau has authority to issue regulations pursuant to TILA, as well as title X of the Dodd-Frank Act.

A. The Truth in Lending Act TILA Section 105(a)

As amended by the Dodd-Frank Act, TILA section 105(a), 15 U.S.C. 1604(a), directs the Bureau to prescribe regulations to carry out the purposes of TILA, and provides that such regulations may contain additional requirements, classifications, differentiations, or other provisions, and may provide for such adjustments and exceptions for all or any class of transactions, that the Bureau judges are necessary or proper to effectuate the purposes of TILA, to prevent circumvention or evasion thereof, or to facilitate compliance. The purpose of TILA is “to assure a meaningful disclosure of credit terms so that the consumer will be able to compare more readily the various credit terms available to him and avoid the uninformed use of credit.” TILA section 102(a); 15 U.S.C. 1601(a). These stated purposes are tied to Congress's finding that “economic stabilization would be enhanced and the competition among the various financial institutions and other firms engaged in the extension of consumer credit would be strengthened by the informed use of credit.” TILA section 102(a). Thus, strengthened competition among financial institutions is a goal of TILA, achieved through the effectuation of TILA's purposes. In addition, TILA section 129B(a)(2) establishes a purpose of TILA sections 129B and 129C to “assure consumers are offered and receive residential mortgage loans on terms that reasonably reflect their ability to repay the loans and that are understandable and not unfair, deceptive or abusive.” 15 U.S.C. 1639b(a)(2).

Historically, TILA section 105(a) has served as a broad source of authority for rules that promote the informed use of credit through required disclosures and substantive regulation of certain practices. However, Dodd-Frank Act section 1100A clarified the Bureau's section 105(a) authority by amending that section to provide express authority to prescribe regulations that contain “additional requirements” that the Bureau finds are necessary or proper to effectuate the purposes of TILA, to prevent circumvention or evasion thereof, or to facilitate compliance. This amendment clarified the authority to exercise TILA section 105(a) to prescribe requirements beyond those specifically listed in the statute that meet the standards outlined in section 105(a). The Dodd-Frank Act also clarified the Bureau's rulemaking authority over certain high-cost mortgages pursuant to section 105(a). Asamended by the Dodd-Frank Act, the Bureau's TILA section 105(a) authority to make adjustments and exceptions to the requirements of TILA applies to all transactions subject to TILA, except with respect to the substantive protections of TILA section 129, 15 U.S.C. 1639,37 which apply to the high-cost mortgages referred to in TILA section 103(bb), 15 U.S.C. 1602(bb).

37TILA section 129 contains requirements for certain high-cost mortgages, established by the Home Ownership and Equity Protection Act (HOEPA), which are commonly called HOEPA loans.

For the reasons discussed in this notice, the Bureau is proposing regulations to carry out TILA's purposes and is proposing such additional