By Melissa Richards Wallace, Esq.
of The Wolf Firm (Reprinted by permission from Servicing Management - June 1997 Vol 8 No. 10 )
The Focus is Usually On Originations, Yet Servicers Could Be Inadvertantly
Violating Laws. Are You Using A Credit Scoring System For Loss Mitigation?
By Melissa Richards Wallace, Esq.
of The Wolf Firm
(Reprinted by permission from Servicing Management - June 1997 Vol 8 No. 10
)
During the past several years, the mortgage industry's focus in implemting and enforcing
Federal fair lending laws has been on the origination side of mortgage lending. Regulators
and lenders have been particularly active in discussing ways to increase access to
homeownership and financing to ethnic minorities and other protected classes. However,
loan servicers must be increasingly mindful that fair lending laws also apply to their
loan servicing and foreclosure practices.
The common laws
Two of the principal fair lending laws, the Fair Housing Act and the Equal Credit Opportunity Act (ECOA) both prohibit discrimination by a lender against certain protected classes of borrowers during loan servicing, including loss mitigation/foreclosure servicing. It is well understood that the Fair Housing Act prohibits discrimination on the basis of race, color, religion, sex, national origin, age, public assistance, familial status, or handicap when making or purchasing loans. But the Fair Housing Act also prohibits discrimination when providing "other financial assistance," and appraising collateral in connection with residential real estate related transactions. In addition, the Fair Housing Act prohibits insurance redlining with a discriminatory purpose.
"Other financial assistance" is uncomfortably vague. So, HUD has promulgated regulations that give examples of loan servicing activities that HUD considers to be in violative the Fair Housing Act. They include:
The ECOA is simplier
The prohibitions under ECOA are much simpler. That law prohibits discrimination in any aspect of any credit transaction against the same protected classes of persons as the Fair Housing Act, with the exception of familial status and handicap.
The term "credit transaction" includes every aspect of an existing credit extension including, but not limited to:
"Credit transaction" includes:
The Fair Housing Act and ECOA are distinct from other federal fair lending laws, such as the Home Mortgage Disclosure Act and the Community Reinvestment Act, in that Fair Housing Act and ECOA not only focus on equal access and availability of credit for protected classes, but further require equal treatment for protected classes throughout the servicing and enforcement of their credit transaction.
Loan servicing policies and procedures should be reviewed, and their implementation continually monitored, for equal treatment of all borrowers in the areas of:
In addition, the process of educating protected classes on mortgage loan availability
does not end once they are in the home; the servicer must continue the education process
throughout the loan term in order to ensure that borrowers are availed an equal
opportunity to remain homeowners and to maintain their loans.
The discrimination tests
There are three tests that Federal regulatory and enforcement agencies use to identify
lending discrimination, and these tests also apply in loan servicing discrimination cases.
They are:
Overt discrimination is the easiest to identify - intentional, obvious, discriminatory acts. The other two tests require more analysis.
Evidence of disparate treatment exists when a servicer treats borrowers differently based on a prohibited basis. Setting different or excessively burdensome standards on a prohibited basis for cancelling private mortgage insurance, or for entertaining loss mitigation alternatives to set aside a loan default are examples of disparate treatment.
Another example of disparate treatment is setting different standards for foreclosures, such as imposing (and to what degree) accrued late charges, penalties and reinstatement fees on one class more heavily than on another. Disparate treatment usually involves a practice whose intent is to discriminate against a person based on race, gender, etc.
Evidence of disparate treatment also manifests itself in insurance redlining, whereby access to homeowner's insurance, for example, is denied or significantly curtailed in certain areas because of the predominant race, national origin, etc. of the neighborhood where the property is located.
Insurance redlining may be an issue in loan servicing when a servicer is faced with placing replacement homeowner's or hazard insurance coverage upon receiving a notice of cancellation of the borrower's insurance policy. Choosing a replacement policy with lesser coverage, or at a significantly higher cost, than the original policy for protected class borrowers than the servicer would choose for a non-protected class of borrower would give rise to a pattern or practice of disparate treatment.
It should also be noted here that disparate treatment is generally found to occur when protected class members are treated less favorably than members of a non-protected class. However, with limited exceptions of age and public assistance and marital status set forth in ECOA's implementing regulations, illegal discrimination can also occur when a protected class is given preferential treatment over a nonprotected class.
The simple rule for loan servicers is to treat all borrowers equally in the disposition and enforcement of their loan programs.
Disparate impact
Evidence of disparate impact is found when a servicer applies a facially neutral policy or practice equally to all borrowers, but the policy or practice has a disproportionate adverse impact on one or more protected classes. There need be no intent on behalf of the servicer to discriminate.
For example, if a servicer is utilizing a facially neutral credit scoring system to determine which loans in default should be earmarked for loss mitigation and which loans should go to foreclosure, but in practice the policy results in more members of a protected class being rejected for loss mitigation, the practice of using the scoring system could be found to be discriminatory (more on credit scoring systems below)
Unlike overt discrimination or disparate treatment, a servicer alleged to have been engaged in a pattern or practice of conduct bearing a disparate impact on protected classes is entitled to refute the allegation of discriminatory conduct by showing that the policy or practice is justified by "business necessity" and there is no less discriminatory alternative.
An interesting illustration of the possible use of the business necessity defense was raised in the Interagency commentary to the final financial institution flood insurance regulations, published on August 29, 1996 in the Federal Register.
The Federal Flood Disaster Protection Act prohibits the making, increase, extension or renewal of a federally-related loan secured by real estate located in a flood zone without adequate flood insurance coverage. If, at any one of these tripwire events after the making of a loan, the lender/servicer determines the required flood insurance coverage is lacking, the lender/servicer is required to initiate forced placement procedures. The effects of force placing insurance, although not intentionally discriminatory, could have a disproportionately adverse impact on protected classes, in terms of overall cost and availability of continued credit. For instance protected persons might predominately reside in flood zone areas.
The Federal banking agencies in a commentary gave language regarding the requirements for flood insurance that might be used as part of the business necessity defense. Based on the requisite "safety and soundness" of Federally insured financial institutions, the commentary said, in part:
Depending on the location and activities of a lender, adequate flood insurance coverage may be important from a safety and soundness perspective as a component of prudent underwriting and as a means of protecting the lender's ongoing interest in its collateral...[E]ach lender is in the best position to tailor its flood insurance policies and procedures to suit its business. Lenders should evaluate and, when necessary, modify their flood insurance programs to comport with both the requirements of Federal flood insurance statutes and regulations and principles of safe and sound banking. 61 Federal Register No. 169, p. 45693.
While Federal fair lending laws were not specifically addressed in this commentary, the Federal banking agencies' "safety and soundness" posture does raise an interesting "business necessity" defense for discrimination cases involving financial institution loan servicers.
Whether it be allegations of disparate treatment or disparate impact, the complaining party or government enforcement agency will likely base its allegations of a "pattern or practice" of discriminatory conduct on statistical samplings of loan file or foreclosure trustee data.
Servicers, too can compile statistical data to monitor their ongoing compliance with fair lending laws in order either to correct violations on their own or to refute allegations of discriminatory conduct. Servicers' analysis of statistical data and conclusions derived there-from should always involve legal counsel in order to attempt to preserve confidentiality under the attorney-client privilege.
Credit Scoring Systems
Loan servicers are increasingly utilizing credit scoring systems (also referred to as
"behavior models") in assessing the likelihood of a delinquent mortgage loan
returning to current status through loss mitigation techniques (e.g., loan forbearance,
modification, short sale) or continuing through to foreclosure.
Proponents of these systems believe that they will reduce the risk of fair lending violations by removing the subjective judgment of a loan/collections/foreclosure officer. Cynics, on the other hand, caution that the use of these systems might increase the incidence of disparate impact on protected classes by replacing or downplaying the judgment, practicality and sense of fairness that humans can bring to the decision making process, particularly when the delinquent loan in question is marginal as to loss mitigation vs. foreclosure.
While the jury is out as to whether these systems will become a more effective tool in creating opportunity for delinquent borrowers to retain financing for their homes, the Federal Reserve Board ("FRB") has issued an amended Official Staff Interpretation to its Regulation B (ECOA) to require continued monitoring of the performance of credit scoring systems, in any aspect of the credit transaction, to ensure its predictive ability in a manner consistent with ECOA. If monitoring data reveals that the system is no longer identifying risk as predicted with statistical soundness, loan servicers must revalidate the system and adjust the variables for each score interval accordingly.
Until further definitive reports are published on the impact credit scoring systems have on protected classes, servicers should approach utilizing these systems as a useful and efficient tool for dealing with delinquent borrowers, and not as a final, definitive statement on eligibility for loss mitigation, particularly with respect to loans given marginal scores.
Addressing Compliance With Fair Lending Laws
To reduce the risk of fair lending violations, servicers should develop and implement policies and procedures covering these areas:
Lenders should develop training programs for loan servicing/loss mitigation/foreclosure staff in compliance with the Fair Housing Act, ECOA and their respective implementing regulations. Training programs should include ways of addressing actual and anticipated stereotype assumptions which might arise during all stages of loan servicing.
In understanding the impact that Federal fair lending laws have on loan servicing, we
as an industry can utilize those laws and related resources as a constructive tool in
educating the general public on retaining homeownership and truly realizing the
"American dream."
For further information please contact:
The Wolf Firm, A Law Corporation, is an "AV" rated law firm which concentrates on providing superior legal services to the mortgage banking industry. The firm's national clientele includes many of the largest mortgage bankers in the country, as well as a variety of savings banks, commercial banks, commercial finance companies, credit unions, and the Resolution Trust Corporation. With a staff of approximately forty individuals, including attorneys, certified paralegals, legal secretaries, administrators, clerical personnel, and a full time computer systems analyst, the firm represents its clients on a wide range of matters including all aspects of both residential and commercial/multifamily mortgage loan origination and servicing, securitization, regulatory compliance, bankruptcy, and litigation related to the foregoing in both federal and state courts throughout California. For more routine matters, such as residential bankruptcies, evictions and receiverships, The Wolf Firm has developed extremely cost-effective and efficient programs using specially trained paralegals and computer technology to assist its attorneys in handling these matters at rates that are the most competitive in the State of California and, through its membership in the USFN, the Firm is able to arrange similar services in virtually every state in the nation.
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