A lender's duty to investigate.

Author:Bailey, Adam Lehman

New rules at the federal and state level impose strict burdens on lenders to carefully review a borrower's ability to repay before granting a mortgage. Here's a state-by-state review of some of the requirements.

Until recently, a mortgage lender preparing to make a loan needed only to conduct a basic search of the title and records of the subject property. A lender was not required to search into the background and financial status of a borrower to ensure that the borrower was legitimate and would be able to repay the loan. [paragraph] As long as the borrower had recorded title and there were no senior recorded liens or notices of pendency, the lender was free to give out such loans knowing its interest in the property , was protected. [paragraph] The lender was what is referred to as a "bona fide encumbrancer for value," which meant that if the borrower's ability to repay had been overstated and/or if the transaction was tainted by outright fraud, the lender's interest in the property was still secure. [paragraph] Beginning in 2008, the United States became mired in an unprecedented foreclosure crisis, and large numbers of homeowners were stuck with loans they could not repay. This eventually had a disastrous snowball effect on the economy. It also opened the door to widespread foreclosure-rescue schemes, in which scam artists induced homeowners who faced foreclosure to convey title by falsely promising to help them refinance. [paragraph] In response, the federal government enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act ability-to-repay/Qualified Mortgage (QM) amendments to the Truth in Lending Act (TILA) designed to protect borrowers from entering into risky loan agreements, and many states also enacted similar legislation.

The new federal and state legislation not only imposes a new duty upon all lenders to verify the ability of their borrowers to repay the loans, but also creates a duty for lenders to investigate situations that arouse suspicion about the integrity of the borrowers. In such cases, if a lender fails to investigate, the lender may not be entitled to "bona fide" status and, if it makes the loan, its interest in the property will not be protected.

Moreover, the federal government requires bank mortgage lenders to file suspicious activity reports (SARs) if signs of a foreclosure-rescue scheme or other fraudulent activity is suspected.

Although both the new federal and state regulatory schemes are well intentioned, the new rules only currently apply to a minority of borrowers otherwise qualified to apply for loans and, therefore, the loan market is only marginally affected by the lenders' new duty to investigate their borrowers' ability to repay.

Under the Dodd-Frank amendments, TILA requires mortgage lenders to verify a borrower's ability to repay for only a small subset of particularly risky loans. Eight states have enacted legislation that mirror the federal approach and limit the duty of lenders in those states to investigate only certain specified categories of risky loans.

Only 12 states and the District of Columbia require lenders to determine a borrower's ability to repay in connection with all mortgage loans. However, despite the limited scope of mortgage loans generally affected by the new legislation, the new rules are a fact of life to which lenders must adapt their loan application processes.

For this article, we reviewed the legislation in the 22 states that have ability-to-repay requirements and also the recent court decisions in the nine states that have addressed a lender's duty to investigate suspicious transactions.

We also looked at relevant federal laws and regulations. Our research shows that there is a variety of different approaches being implemented in this area, but nevertheless a general trend toward an increased duty for lenders to know their borrowers. The observance of this duty by lenders will protect their interest in ensuring the repayment of their loans, either by the borrowers in accordance with specified mortgage terms or upon issuance of court judgments obtained in any necessary foreclosure proceedings.

The federal approach

Congress passed the Dodd-Frank amendments in 2010 in the wake of the financial crisis as a way to prevent the kind of predatory lending practices that were at the root of the problem.

TILA, as implemented through Regulation Z of the Code of Federal Regulations (CFR), requires lenders to verify a buyer's ability to repay respecting certain types of particularly risky loans--interest-only loans, loans with balloon payments, loans whose principal increases over time and loans for a period of more than 30 years. However, the vast majority of loans--92 percent, according to the Consumer Financial Protection Bureau (CFPB)--meet the requirements of a Qualified Mortgage as defined in TILA. In addition, loans sold to Fannie Mae and Freddie Mac are presumptively QM-eligible, except as to matters wholly unrelated to ability to repay. Similarly, loans sold to the Department of Housing and Urban Development (HUD), the Department of Veterans Affairs (VA) and the U.S. Department of Agriculture are also presumptively QM-eligible for transactions consummated on or before Jan. 10, 2021, or on such other date as each agency may designate under its own regulations.

In addition to not containing any of the aforementioned risky features, a loan meets the requirements of a Qualified Mortgage if the lender complies with certain basic underwriting requirements, such as calculating monthly payments...

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