The Federal Reserve Board indicated it is scrutinizing mortgage loan pricing models that comply with Regulation Z but nonetheless, in the view of the Board, significantly increase fair lending risk.  The models set a loan revenue target—based on a higher interest rate, discretionary fees, or both—that varies by mortgage loan originator (MLO).  Regulators allege that setting different target prices for MLOs creates a risk of disparate impact if MLOs with higher target prices are concentrated in minority neighborhoods.  While not a new theory, we expect it to feature more prominently in the CFPB and other regulators’ mortgage loan examinations and enforcement actions so long as disparate impact remains a viable basis of discrimination under fair lending laws.

In remarks during a federal interagency webinar on October 22, Maureen Yap, Special Counsel/Manager in the Fair Housing Enforcement Section of the Federal Reserve Board’s Division of Consumer and Community Affairs, said that the Board has referred one such case to the Department of Justice for a possible enforcement action.  This warning shot should remind bank and non-bank mortgage lenders that compensation models compliant with Regulation Z’s loan originator compensation rule (“LO Comp Rule,” or “Rule”) may still create risks for consumers and originators.

The LO Comp Rule was adopted by the Federal Reserve Board in 2010 and then transferred to the CFPB, which amended the Rule effective in 2014 based on Dodd-Frank.  The Rule prohibits basing a loan originator’s compensation on any term of a transaction or proxy for a term, other than paying compensation based on a fixed percentage of the amount of credit extended.  Compensating MLOs through a percentage of the amount of credit extended was and remains a common practice.

According to the Federal Reserve Board, under a target pricing model, MLOs are paid a fixed percentage of the loan amount in accordance with the LO Comp Rule, but are directed to hit a revenue target on each loan through additional interest or fees, or a combination of the two.  The target is specific to the MLO and is not based on a borrower’s credit characteristics.  According to Ms. Yap, the Federal Reserve Board has found that target pricing may cause statistically significant differences in rates and fees charged to minority borrowers compared to similarly situated white borrowers, based on which MLOs serve minority neighborhoods.

The Federal Reserve Board advises that lenders setting target prices for MLOs should do the following to mitigate fair lending risk:

  • Monitor pricing by race and ethnicity across MLOs;
  • Map loans by target price to identify potential reverse redlining;
  • Review pricing models in software, including software provided by vendors; and
  • Minimize differences in target prices assigned to MLOs within the same geographic area.

The U.S. Supreme Court recently, and for the third time, granted certiorari on the issue of whether disparate impact claims are cognizable under the Fair Housing Act.  We wrote about the case, Texas Department of Housing and Community Affairs v. The Inclusive Communities Project, Inc., here and here.