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December 10, 2007

Bankers beware | Maine's new predatory lending law will limit how banks refinance loans

By Richard Hackett And Lori Desjardins<br />
Attorneys, Pierce Atwood LLP, Portland

It is estimated that two million families will lose their homes by the end of the current mortgage crisis, according to a recent congressional hearing. Foreclosure filings nearly doubled nationwide in September. At Maine banks, the phones, no doubt, are ringing with distraught homeowners looking to refinance subprime loans secured through national lenders engaging in sometimes predatory lending practices.

But effective Jan. 1, 2008, Maine has a new predatory lending law that imposes complex and difficult restrictions on local banks. For example, banks refinancing a loan must prove that the loan provided a "tangible net benefit" to the consumer. Failing to do so will expose the bank to penalties and undermine enforceability of the loan.

A typical example of a subprime mortgage is described as follows by the Center for Responsible Lending, which was the source of Maine's new law: The borrower has an annual income of $30,354 and receives a 30-year home mortgage for $180,000 under the terms of a 2/28 subprime loan, which locks in a fixed rate for two years and then adjusts higher thereafter. The "teaser" interest rate is 7.55%, with an initial monthly payment of $1,265. However, after the two-year teaser rate period, the fully indexed rate climbs to 11.25% with a corresponding monthly payment of $1,726. In this example, the homeowner initially paid 61% of income in mortgage payments. At the fully indexed rate, the debt-to-income ratio rises to 83%, a debt burden that is clearly unaffordable. In some cases, the initial payment on these loans was set below the interest due monthly. As a result, the principal balance grew until the loan was 125% of the original amount. Payments on such "exploding ARMs" could literally triple.

In this anxious climate, how should Maine bankers proceed? First, it's important to understand the key elements of the new law. Within "An Act to Protect Maine Homeowners from Predatory Lending," a critical definition is that of "tangible net benefit." The term relates to a refinance loan and is currently subject to rulemaking by Maine's banking regulators. In the proposed form, however, the rules outline certain factors to be used to determine if a borrower receives a reasonable, tangible net benefit. Some of those factors include a lower monthly payment, a reduced interest rate and a change from an adjustable to a fixed-rate loan.

However, even if Maine banks identify one or more of these benefits, they are still not assured of legality. They are "rebuttably presumed" to have satisfied the law, but there is no "safe harbor" for them. Under this regime, every refinance loan creates financial and regulatory exposure for Maine banks. Every loan is vulnerable to a potential jury trial about its "benefits." For consumers, the risk is that Maine banks may curtail or limit their refinancing loan offerings rather than face uncertain collectibility.

Consumer impact
The same rules ˆ— requiring a showing of a benefit from the refinance loan ˆ— apply to a consumer who wants to switch a home equity line of credit from one bank to another. Absent a rate reduction by the new bank, such a switch is probably illegal. If the consumer already has a competitive interest rate of prime or prime minus one percent, switching banks will be impossible.

Proving the "benefit" of a refinancing is not the only new challenge. If a consumer facing an exploding ARM still has weak credit, he may only qualify for a new "subprime" loan from a Maine lender.

A similar uncertainty exists with Maine's new rules for subprime lending. The law prohibits a lender from extending a subprime loan unless the borrower has the ability to make the scheduled payments, and the lender can prove it. Proposed rules outline certain factors to be considered, such as the borrower's income, credit history, current obligations, employment status and debt-to-income ratio. Maine banks already use these factors under their normal underwriting practices. But following this rule also does not provide Maine banks with a safe harbor from liability. A jury is free to decide later that the bank failed to adequately underwrite the loan ˆ— at the bank's expense.

It is difficult to predict the ultimate results of Maine's new predatory lending law. Adding to that difficulty is the looming likelihood of federal legislation in this area, which may create a new set of rules or an additional set of rules for Maine banks to follow. But some likely outcomes include a reduction in the supply of credit to consumers; the disappearrance of specific types of loans; and additional regulatory costs for banks to comply with the new law, which could be passed on to consumers through higher interest rates.

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