SAFE Act and Dodd-Frank

Introduction

The SAFE Act and Dodd-Frank rose from the ashes of the Great Recession in an effort to achieve better consumer protection by regulating careless and abusive lending practices. When these federal statutes and their state counterparts are considered alongside the 2005 amendments to the Property Code (regulating executory contracts) it is clear that the status of Texas as a free-wheeling haven for residential owner finance is now history.

Even knowledgeable lawyers and lenders can be forgiven for being confused about the rules around The SAFE Act and Dodd-Frank. It is suggested that, before deciding which rules apply in any given case, one should consult:

(1) the website of the Texas Department of Savings and Mortgage Lending (TDSML) regarding SAFE Act compliance; and

(2) the website of the federal Consumer Finance Protection Bureau (CFPB) for compliance with Dodd-Frank.

These websites may be the best source of condensed information on these complex laws.

SAFE ACT AND T-SAFE

The Federal SAFE Act

The SAFE Act, formally known as Secure and Fair Enforcement for Mortgage Licensing Act of 2008 (12 U.S.C. Sec. 5101 et seq.), is a federal consumer protection law that each state is required to implement. The intent of the law is to achieve better consumer protection by inserting a residential mortgage loan originator (RMLO) into the loan origination process.

In a sale involving seller-financing, the seller must be an RMLO or there must be a person involved in the transaction who has an RMLO license—except in sales of the seller’s homestead, sales to immediate family members, and sales below the de minimis annual threshold.

Licensing and registration are a major emphasis of the SAFE Act. On the national level, the Nationwide Mortgage Licensing System and Registry was created under the supervision of the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators. On the state level, individual states were required to devise their own licensing and registration regimes. Texas accomplished this in 2009 with the passage of T-SAFE.

T-SAFE in Texas

T-SAFE, a Texas law found at Finance Code Section 180.001 et seq., contains tighter rules than the federal law by placing a licensing requirement on certain types of residential seller financing provided by professional investors. Since traditional owner finance transactions, wraps, and land trusts are forms of owner finance, T-SAFE applies to all of these; however, a seller is required to be licensed only if the property is not the seller’s homestead and/or the sale is not to a family member.

For example, if the subject property is a rental house being sold to a non-family member, a strict reading of the law would mean that the seller is required to have an RMLO license from the TDSML in order to complete this transaction. RMLOs, who are trained in compliance with both federal and state law pertaining to mortgage loan origination, are intended to function as a buffer against recurrence of the abuses of the past.

State agencies typically have the power to issue rules and regulations designed to clarify and implement acts of the legislature. This is true both at the federal and state levels. In the case of T-SAFE, TDSML has ruled that the Act will not be applied to non-professionals—persons who make five or fewer owner-financed loans in a year, thus preserving the de minimis exemption under Finance Code Section 156.202(a)(3).

RMLOs under T-SAFE

Does T-SAFE effectively shut the door on non-homestead owner finance for persons who do more than five such deals per year? Not if an investor utilizes the services of an RMLO. These intermediary agents charge fees (usually ranging from half a point to a one percent of the loan amount) in order to insure that federal and state legal requirements are satisfied. The RMLO supplies the new form of Good Faith Estimate, the Truth-in-Lending disclosures, orders an appraisal, gives state-specific disclosures, and the like, and requires that “cooling periods” be observed in the loan process. So, while it is true that unlimited non-homestead owner-finance transactions can still be done by professional investors, it is only with the assistance of these licensed individuals.

The practical result? Owner financing deals remain feasible but at a higher net cost. Investors should probably look at the extra cost as a kind of premium that (at least potentially) reduces their future liability.

There has been a proliferation of RMLOs as a result of T-SAFE. Note that there is an exception to the licensing requirement for attorneys who as part of their drafting duties provide loan terms to the buyer, but most attorneys are steering clear of this loophole because of potential liability. And why not? Attorneys are already exposed to considerable liability and should be happy to offload at least a portion of that burden onto an RMLO. It would appear that RMLOs are here to stay.

Who is a loan originator?

Who is a loan originator and thus required to have an RMLO license? Anyone who takes a loan application, arranges credit or helps a consumer apply for credit, offers or negotiates loan terms, or even refers someone to a loan originator or creditor falls within the definition of loan originator or mortgage originator. Quite a broad definition, which obviously includes mortgage brokers but would seem to be broad enough to include certain support personnel as well, even though persons who perform purely administrative or clerical tasks are expressly excluded (Note that it would be risky for a professional investor to rely on this loophole by delegating duties to his or her staff).

Real estate brokers are expressly excluded from the definition of a mortgage originator and may engage in these activities so long as they are not specifically compensated for doing so.

There are complex new rules relating to how loan originators are compensated. Also, mortgage originators are prohibited from steering borrowers to particular mortgage products in exchange for hidden fees (a popular practice before the 2008 bust) and this is backed up by a treble-damages penalty. Additionally, the previous practice by some refinance lenders of encouraging default on an existing loan before extending a new loan is banned.

Are real estate attorneys loan originators?

Real estate attorneys should be careful to avoid negotiating loan terms in residential owner financing cases since attorneys are not exempted from the definition of a loan originator. Expect to see clauses in attorney engagement letters stipulating that they have not participated in loan negotiations—which is a bit strange, is it not, since this is traditionally part of what attorneys are expected to do when negotiating? Not any more, at least for lawyers who are careful about their liability. A more prudent approach is to require investor clients who are offering residential owner financing to arrive with their financial deal points essentially complete, a significant break from past practice.

Penalties for Violation of T-SAFE

The TDSML may enforce T-SAFE by a variety of measures, including license suspension, a fine of up to $25,000, and an order to make restitution to the buyer. What does restitution mean? Likely a refund of the down payment and all monthly payments that were made. Case law will eventually clarify this.

DODD-FRANK WALL STREET REFORM
AND CONSUMER PROTECTION ACT

Dodd-Frank and Seller-Financed Transactions

The Dodd-Frank Wall Street Reform and Consumer Protection Act is a massive piece of legislation passed by Congress in 2010 as part of comprehensive reform of financial regulation. Our focus in this chapter is Title XIV entitled The Mortgage Reform and Anti-Predatory Lending Act (15 U.S.C. Sec. 1639 et seq.) which pertains to residential loans and lending practices. Title XIV will be referred to simply as Dodd-Frank or the Act. The broad intent of this legislation is to put an end to predatory lending practices, particularly the extension of loans to those who cannot afford to pay them back. Among other things, more lender disclosures and borrower protections are now involved.

Dodd-Frank achieves many of its reforms by means of amendments to the Truth-in-Lending Act (TILA) and the Real Estate Settlement Procedures Act (RESPA). The Consumer Financial Protection Bureau is charged with issuing regulations to implement Dodd-Frank. Regulations and must-use forms, as they continue to emanate from the CFPB, are presenting as great a compliance challenge as the provisions of the Act itself. Some of these are complex, if not outright baffling.

Broad Definition of Seller Finance

The terms seller finance and owner finance include:

(1) the classic owner finance where the seller delivers a warranty deed to the buyer who then executes a note in favor of the seller secured by a first-lien deed of trust);

(2) wraparounds (the buyer executes a subordinate wrap note and makes payments to the seller who then pays the underlying lender); and

(3) various forms of land trusts.

Dodd-Frank applies to all of these. An investor who argues that whatever creative device he or she has come up with or found on the Internet is not actually a form of owner financing will almost certainly lose the argument.

Determining the Borrower’s Ability to Repay

Title XIV Subchapter B, Section 1411 of Dodd-Frank requires that a seller-lender in a residential owner-financed transaction determine at the time credit is extended that the buyer-borrower has the ability to repay the loan. Specifically: “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” (12 C.F.R Sec. 1026.43(c)(1)).

Under Dodd-Frank, a lender is obligated to investigate eight specific factors relating to the borrower:

(1) current income or assets;

(2) current employment status;

(3) credit history;

(4) monthly mortgage payment;

(5) other monthly mortgage payments arising from the same purchase;

(6) monthly payment for other-mortgage-related expenses (e.g., property taxes);

(7) the borrower’s other debts; and

(8) the borrower’s debt-to-income ratio (DTI).

This is a non-exclusive list, a minimum standard that lenders must follow. Prospective lenders should also consider how much a borrower will have left over for life’s necessities at the end of the month, after all bills have been paid. All of this must be based on verified and documented information in the loan file. This is commonly referred to as the ATR rule (ability to repay requirement). Result? No doc, low doc, and other “liar loans” are effectively banned. So are teaser-rate loans.

Additionally, an owner-financed note must have a fixed rate or, if adjustable, may adjust only after five or more years and be subject to reasonable annual and lifetime limitations on interest rate increases. If the interest rate is adjustable, the lender must consider the highest rate the borrower will have to pay in order to establish compliance with the ATR rule. Negative amortization loans (always risky) must be accompanied by disclosure and counseling for first-time buyers. Prepayment penalties are banned.

Mandatory arbitration provisions in loan documents (which always, in practice, favor the creditor) are prohibited.

UDAAPs: Unfair, Deceptive, or Abusive Acts and Practices

In addition to regulation of seller-financed transactions, Dodd-Frank broadly prohibits unfair, deceptive, or abusive acts and practices (UDAAPs) in in the area of financial products and services that are rendered to consumers (15 U.S. Code Sec. 45). Violations might include a lender refusing to release a lien on real estate after final payment; making misleading cost or price claims (“no money down” claims that do not disclose the presence of large upfront fees); using bait and switch techniques in financial or mortgage products; failing to provide services as promised; and offering inadequate disclosure or clarity in the communication of material contract terms.

Dodd-Frank 2.0: The Economic Growth, Regulatory Relief, and Consumer Protection Act

Signed into law in 2018, Dodd-Frank 2.0 contains six titles that modify the original Dodd-Frank. Generally, the Act is (unsurprisingly) mostly about reducing regulations on banks and mortgage lenders. Lenders under $10 billion in assets are now exempt from the Volcker Rule based on the theory that these institutions are too small to cause the entire system to fail. This is a dubious conclusion, especially considering that $10 billion is not really a small number, nor does this approach take into account the tendency of failing institutions to cascade.

Two titles, however, Title III and Title IV, actually expand consumer protections in the areas of credit reporting and student loans. Even so, it is difficult to see Dodd-Frank 2.0 as anything other than a gift to big banks.

CONSUMER FINANCE PROTECTION BOARD

CFPB Regulations

Complex laws such as Dodd-Frank are nearly always passed in bare-bones form. They are skeletal structures requiring an administrative agency to issue rules and guidance in order to implement the law. In the case of Dodd-Frank, the rulemaking and implementing agency is the Consumer Finance Protection Board. The CFPB derives its authority to do this from Section 1053 of the Dodd-Frank Act, 12 U.S.C. 5563(e), as well as its general rulemaking authority to promulgate rules necessary or appropriate to carry out federal consumer financial laws (12 U.S.C. 5512(b)(1)).

The CFPB has been aggressive about rulemaking and has taken significant liberties in its interpretation of both the statute and the intent of Congress. For example, Subtitle B, Sec. 1411(a)(2) appears to frown on non-standard loans such as balloon notes. The CFPB, however, has focused on the ATR rule as the heart of the owner financing part of the law, rather than deciding that any particular type of loan (balloons for example) should be prohibited. Note that certain types of loans—home equity lines of credit, timeshare plans, reverse mortgages, and temporary or bridge loans—are exempt from the ATR rule.

The CFPB may enforce the Dodd-Frank law by issuing cease and orders, assessing civil penalties of up to $10,000 per violation, and bringing civil actions against violators in federal district court (15 U.S. Code Sec. 45(l) and (m)).

De Minimis Origination Exception to Dodd-Frank

CFPB Regulations Sections 1026.36(a)(4) and (5) provide a de minimis exception for individuals who do only one transaction in any twelve-month period; and for entities (such as LLCs) who do three or fewer owner-financed transactions in any twelve-month period. (Recall that, legally speaking, entities are also considered persons.) The exception is accomplished by stating that such persons are not included within the definition of loan originators:

CFPB Regs. Sec.1026.36(a)(4). Seller Financers; Three Properties

A person (as defined in Sec. 1026.2(a)(22)) that meets all of the following criteria is not a loan originator under paragraph (a)(1) of this section:

The person provides seller financing for the sale of three or fewer properties in any 12-month period to purchasers of such properties, each of which is owned by the person and serves as security for the financing.

The person has not constructed, or acted as a contractor for the construction of, a residence on the property in the ordinary course of business of the person.

The person provides seller financing that meets the following requirements:

The financing is fully amortizing.

The financing is one that the person determines in good faith the consumer has a reasonable ability to repay.

The financing has a fixed rate or an adjustable rate that is adjustable after five or more years, subject to reasonable annual and lifetime limitations on interest rate increases. If the financing agreement has an adjustable rate, the rate is determined by the addition of a margin to an index rate and is subject to reasonable rate adjustment limitations. The index the adjustable rate is based on is a widely available index such as indices for U.S. Treasury securities or LIBOR.

The important item to note about this exemption is that the lender, exempted or not, must still comply with the ATR rule.

Since the foregoing exception applies only if the seller has not constructed a residence on the property in the ordinary course of business, professional builders who want to owner finance their new homes do not fall within the scope of the exception, no matter how many or how few homes they build.

LENDERS AND LOANS

Categories of Lenders

Lenders are categorized, with creditor and small creditor being defined terms. Creditors are those who make 5 or more home loans per year, unless the loan in question is a higher-priced mortgage loan (HPML), in which case the lender is a creditor regardless. Small creditors are those who make 500 loans or less per year and do not have more than two billion dollars in assets. Different rules apply.

Categories of Loans

Loans have been divided into two groups, with qualified mortgages (considered to be more stable loans) in the first group; and all others in the second group, which would include any loan with risky features. QMs (or at least those that are not higher-priced) are expressly designed to be a safe harbor from lender liability. ATR compliance, a landmine of liability in this context, is presumed.

What disqualifies a loan from being a QM? Examples would be interest-only provisions; negative amortization; higher than average interest rates; balloon payments; loan terms longer than thirty years; and loans with points and fees that exceed 3% of the loan amount. These riskier loans are not banned, but the ATR rule must be strictly applied.

Any lender offering non-qualified mortgages should, as a liability-avoidance strategy, literally stuff its loan file with documentary evidence that the borrower can in fact repay the debt as provided in the note. This file must be kept for a minimum of three years. Five is better.

The CFPB website states “Qualified Mortgages generally require that your monthly debt, including the mortgage, isn’t more than 43% of your monthly pre-tax income. In some circumstances, certain small lenders may also decide that debt of more than 43% is appropriate.”

HUD and FHA loans are automatically considered to be QMs.

It is not only stability and low risk that allow classification as a QM. Loans made in certain designated rural areas of the country qualify. The CFPB publishes a list of eligible counties on its website.

Are balloon notes legal in seller finance?

Dodd-Frank, at least as interpreted and implemented by the CFPB, does not ban balloon mortgages. The CFPB website states “You can still opt for a balloon-payment mortgage when the lender meets the requirements to be considered a ‘small creditor,’ and your mortgage meets other criteria.” For those concerned with the potential liability of making a risky loan and/or violating the ATR rule, this is rather vague; it creates a significant challenge for investors who want to include balloon provisions in their owner-financed notes.

Balloon notes originated by small creditors are classified as qualified mortgages only if the small creditor does business primarily in rural or underserved areas. All other balloon notes will be strictly subject to the ATR rule.

Until the CFPB rules reach a higher level of clarity, real estate investors should exercise caution in selling properties using balloon notes.

Higher-Priced Mortgage Loans (HPMLs)

Owner-financing investors should not push the envelope on interest rates, even if a proposed loan is otherwise a QM. Higher-priced loans only receive a rebuttable presumption that the loan is a QM—not an absolute certainty. And there are extensive pre-loan disclosures required. The borrower must also get a certification from a housing counselor that he or she has received counseling on the high-cost mortgage being offered.

The CFPB offers two criteria for what constitutes an HPML: “a first-lien mortgage for which, at the time the interest rate on the loan was set, the APR was 1.5 percentage points or more over the Average Prime Offer Rate (APOR);” or “a subordinate-lien mortgage with an APR that, when the interest rate was set, exceeded the APOR by 3.5 percentage points or more.”

The days when an owner-financing seller could determine the note’s optimal interest rate solely by reference to the market and the state usury rate are behind us.

Loan Service Providers

Among regulations issued by the CFPB is the requirement that those who provide services in connection with residential real estate loans be subjected to scrutiny as to qualifications, character, and E&O insurance coverage. Lenders are effecting this requirement by means of increased vetting of all participants in the loan process, including real estate lawyers who act as fee attorneys in the closing of transactions.

Integrated Disclosures (the TRID Rule)

The CFPB is now the common regulator for Truth in Lending TIL and the RESPA, prescribing the form and content of the Loan Estimate and the Closing Disclosure which have replaced the old Good Faith Estimate and HUD-1 forms. The forms now used—a significant advance in simplicity—are sometimes referred to as know before you owe.

The Loan Estimate (LE), which describes the proposed loan’s costs and terms, must be provided to the borrower within 3 days of receipt of the application. There is now a disclosure of the estimated cash to close. Also, itemization of all loan origination charges is required.

The Closing Disclosure (CD) which combines the old HUD-1 and final TIL is 5 pages long and designed to track the format of the Loan Estimate in order to make side-by-side comparison easier. Separate Closing Disclosures must be given to buyer and seller. There are a couple of other significant changes from past practice: the Closing Disclosure is now prepared by the lender (not the title company, as was the case with the HUD-1) and it must be received by the borrower at least 3 business days prior to closing, giving the borrower ample time to review (and perhaps question) what it says. Lenders must also offer a borrower a list of Settlement Services Providers.

Investors who seller-finance five or fewer properties per year are exempt from the TRID rule.

BORROWER LITIGATION

Lawsuits for Damages

Violation of the ATR/QM rules allow a consumer to sue for actual damages, statutory damages (including all finance charges and fees), attorney’s fees and court costs. The burden of proving that the ATR determination was reasonable and made in good faith falls upon the lender. Consider this: if the borrower defaults early in the loan, but not as a result of a serious financial or other setback, then this is considered possible evidence that the lender was unreasonable!

The statute of limitations is three years from the date of the violation by the creditor. A defense to foreclosure in the form of a set-off is also provided. After three years, the consumer can bring ATR claims only as setoff/recoupment claims in a defense to foreclosure.

Investors should anticipate that borrower suits against lenders based on the evolving CFPB rules (the ATR/QM rules specifically) will be a growth industry in coming years, particularly since lenders are now prohibited from including mandatory arbitration clauses in their notes. Prudence dictates that one avoid being on the wrong side of this trend, so owner financing of all types should be approached with caution and strict compliance.

There is also the possibility of enforcement by regulators. Even though the CFPB under Republican leadership backed off its more aggressive rulemaking and enforcement actions, state attorneys general are more and more stepping into the gap.

Real estate investors are often viewed by jurors as unscrupulous predators. It is a safe bet that future juries will, on the whole, not hesitate to find investors who are also lenders to be unreasonable under Dodd-Frank and therefore liable for substantial verdicts.

Borrower Defense to Foreclosure

Subchapter B Sec.1413 permits the borrower to assert a defense to foreclosure if the lender or mortgage originator violated the anti-steering rules or the ability-to-repay provisions of the law. This is clearly designed to penalize the formerly-widespread practice of putting under-qualified borrowers into loans that they could not afford to repay.

CONCLUSION

Dodd-Frank is an extremely complex law subject to substantial evolution by rules that are intended to implement it. The text of the original statute is easy to find online. It can be a challenging read. The ensuing regulations (both existing and proposed), which are at least as convoluted as the statute, can be examined at the website of the CFPB (www.consumerfinance.gov).

The reader should check current regulations before relying on information provided in this chapter. Consult a real estate attorney who is specifically knowledgeable about the SAFE Act Dodd-Frank before entering into a sales contract calling for owner finance. And never use forms from non-lawyer seminar gurus or the Internet. These are likely to be non-Texas specific and inadequate under the many state and federal laws and regulations that now govern seller financing.