Dozens of articles have been written about the CFPB’s new Ability-to-Repay Rule and the Qualified Mortgage requirements resulting from it. However, few authors have examined the heart of the issue, which is: What is the potential liability if an institution fails to verify a borrower’s ability to repay?
What Is Ability To Repay?
In 2010, when the country was responding to an unprecedented meltdown in the mortgage market, the Dodd-Frank Act amended the Truth in Lending Act (TILA) and introduced the Ability-to-Repay (ATR) Rule. TILA is designed to inform borrowers about the true terms and costs of consumer credit. Regulation Z, the regulation that implements TILA, requires disclosures that outline the annual percentage rate, the lender’s method of determining financing charges, and the total and amount of payments. Reg Z now also includes ATR requirements.
Among other provisions, ATR mandates that “a creditor shall not make a loan that is a covered transaction unless the creditor makes a reasonable and good faith determination at or before consummation that the consumer will have a reasonable ability to repay the loan according to its terms.”
If the creditor fails to verify ATR, then it might be responsible for certain penalties and damages if the borrower defaults on the loan. ATR gives borrowers more legal rights to challenge a creditor in court, but it also offers more legal protection to creditors who comply with certain conditions that go well beyond ATR requirements. If a creditor meets those conditions, then its mortgages conclusively, or in some cases presumptively, go well beyond ATR requirements and are deemed qualified mortgages (QM).
Most lenders want to limit their legal liability, or be able to sell the loan to the secondary market, so they want to make QM loans. Indeed, most ATR and QM information focuses on how originators can make qualified mortgages and avoid liability. But QM is not a fail safe-safe strategy. QM loans provide a safe harbor and legal protections, but creditors might still be susceptible to legal liability. For example, a borrower who defaults on a qualified mortgage can try to prove the loan is actually not a QM and therefore does not comply with ATR requirements.
The liability risk for QM loans is drastically lower than with non-QM loans; however, liability does exist for both, and it’s important for creditors to understand that liability.
Kinds Of Legal Liability
In order to understand non-compliance liabilities, credit unions should refer to TILA. Section 1640 of TILA lays out the civil liabilities that can result from violations. These fall under two main avenues: 1) an affirmative cause of action, and 2) a defense against foreclosure in the form of a set-off.
The first legal liability a creditor faces is an affirmative cause of action that allows a borrower to bring suit within three years against a lender that fails to verify ATR. However, borrowers can only use the affirmative cause of action against the original lender. TILA explicitly states assignees are only liable to the extent the violation is apparent on “the face of the disclosure statement.” ATR is not a disclosure rule, so the TILA language is not applicable to ATR violations.
The second legal liability a creditor faces is a defense against foreclosure that comes in the form of a set-off. This defense does not prevent foreclosure, but it does implicitly create a judicial foreclosure, which adds time to the process even in non-judicial states. If a borrower is successful in defending against foreclosure, then their penalties are offset against the creditor’s claim.
For example, if a court finds a creditor failed to verify ATR on a $200,000 loan and the damages total $50,000, then that $50,000 is offset against the $200,000, which reduces the creditor’s claim to $150,000. Unlike an affirmative cause of action, this defense has no statute of limitations and borrowers can use it against any subsequent assignee that attempts foreclosure.
Total Damages From Liabilities
Section 1640 of TILA outlines how to determine ATR violation damages (for more about damages, read 4 Types Of Damages after the page break):
Actual damages from failure to verify ATR; PLUS
Statutory damages between $400-$4,000; PLUS
Consumer’s cost of litigation plus reasonable attorney’s fees; PLUS
Sum of all finance charges and fees paid by the consumer on the loan within three years of ATR violation.
To determine a creditor’s total liability for an affirmative cause of action or to determine the damages a borrower can use in a set-off defense, it is helpful to use an example with assumptions. Assume a borrower receives a non-QM loan of $200,000 at 6.0% on a house valued at $220,000. The borrower defaults after three years and has paid 36 months of finance charges totaling $36,000 (for this example, assume the borrower made interest-only payments and paid nothing toward principal). Further assume the creditor moves to foreclose upon the property, but the borrower contests the foreclosure and wins. Using Section 1640 calculations — and assuming there are no actual damages — the court will award the borrower $4,000 in statutory damages, $30,000 in attorney fees, and $36,000 in financing charges (6% on $200,000) to total $70,000. The creditor’s original $200,000 claim is now offset by $70,000, which reduces the claim to $130,000, or by 35%.
This example, however, is a worst-case scenario. In the real world, different probabilities will affect the equation. For example, what is the likelihood of a borrower defaulting? Default rates vary widely, but this example will use a 25% default probability, which is likely on the high end. It is important to note that default probabilities are not significantly higher than before ATR went into effect because the statutory cap on damages is $4,000, which means there’s no material incentive for a strategic default, and as such, no reason why defaults would increase.
Next, what is the probability the creditor will need to foreclose, and what is the likelihood the borrower will contest a foreclosure? A high percentage of creditors would likely foreclose on a defaulted loan, so this probability could be as high as 90%. The likelihood of whether a borrower will contest a foreclosure depends on if the jurisdiction is in a judicial or non-judicial state. In a Methodology and Assumptions Report, S&P assumes that 35% of foreclosure in a judicial state would be contested; in non-judicial states, it is closer to 25%.
Finally, what percentage of borrowers would be successful in defending a foreclosure? Based on a CFPB study published in the Federal Register when it proposed ATR, TILA defenses on non-QMs have a 50% success rate compared to 20% for qualified mortgages with a higher priced mortgage loan (QM/HPML).
These probabilities are exaggerated for illustrative purposes, and the chances of these events occurring is less likely than modeled. However, planning for 25% of borrowers to default on their mortgages, foreclosing on 90% of those defaults, facing contests in 35% of those foreclosures, and losing 50% of the contestations still results in a loss probability of only 3.9% (0.25 X 0.90 X 0.35 X 0.50 = 0.039).
If a creditor multiplies that 3.9% loss probability by the 35% loss severity (aka, the worst case-scenario), then the average set-off loss from a non-QM would cost 1.37% (0.35 X 0.039). On a loan portfolio with an average balance of $200,000, the average liability risk for a non-QM loan would be approximately $2,740 per loan. Creditors can cover this with a 25-basis-point premium in less than six years.
Additional Legal Liabilities
In addition to borrowers, TILA allows for the CFPB and states’ attorneys general to bring an affirmative cause of action against the original lender. However, these actions would likely be less prevalent than the foreclosure set-off defense because there’s not likely to be a systemic problem in a creditor’s ATR determination like there would be in a faulty disclosures, and even if there was a systemic deficiency in a creditor’s ability to determine ATR, loan defaults and foreclosures would be the most likely avenue to discovery. TILA also allows for class action suits. But section 1640(a)(2) of TILA caps class action suits at the lesser of $1 million or 1% of the defendants’ net-worth, which would be less damaging to a creditor than the sum total of individual set-off defenses.
4 Types Of Damages
Section 1640 of TILA uses the following damage types to calculate the total amount of damages arising from a violation of ATR.
ACTUAL DAMAGES Actual damages are but for the failure of the creditor to verify ATR, the borrower would not have incurred damages. TILA allows borrowers to recover the full amount of any actual damage they sustain from a TILA or Reg Z violation. Most courts will limit actual damages to an amount awarded to a complainant to compensate for a proven injury or loss. However, it’s a very high burden of proof for borrowers to meet, and most experts agree that actual damages are too difficult to prove and won’t likely be included in total damages calculation.
STATUTORY DAMAGES Because of the difficulty of proving actual damages, Congress also established statutory damages for violations of TILA, regardless of whether the borrower suffered any harm. These statutory damages range from $400-$4,000.
ATTORNEY'S FEES The consumer’s cost of litigation plus attorney’s fees can widely vary, but the CFPB estimated the 60 hours of borrower attorney time and 150 hours of creditor attorney time, both at $150/hour, totals approximately $30,000.
FINANCE CHARGES Finance charges include the principal and interest paid to the creditor within the first three years of the ATR violation. This also can widely vary, but can be determined using an assumption for modeling purposes.