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Reg Z changes clarified re: balloon mortgage notes

Fed clarifies balloon note issues

Over the past two months we've heard from many Oklahoma banks about the Federal Reserves new"Reg Z" provisions that were effective October 1, 2009, It appeared that these new provisions elimiinated three- and five-year balloon mortgage notes which are an important part of a traditional community bank's business.  In many cases, it's the only way community banks can meet their customers' needs.
The new provisions added to Reg Z created a new category of loans dubbed "High Priced Mortgage Loans" or "HPMLs". It simply wasn't clear at all whether banks would be permitted to make a HPML balloon note which was less than seven years to maturity.
(For a complete discussion of these changes, please read our September 2009 Legal Update, printed in the Oklahoma Banker newspaper, and also available online under the Legal/Compliance tab at www.oba.com.)
On November 9, the Federal Reserve Board published Consumer Affairs Letter 09-12 providing much-needed clarification as to when it is permissible for banks to make HPML balloon notes of less than seven years. Although a balloon note can still not meet the "presumption of compliance" provided for in Reg Z, the new guidance clarifies what the rules really are:  
  • Reg Z does not prohibit HPML balloon notes of less than seven years
  • A bank does not have to determine that a consumer will be able to pay the balloon payment when it comes due
  • In order to be in compliance, a bank should verify that the consumer would likely be able to satisfy the balloon payment obligation by refinancing the loan or through income or assets other than the collateral (based upon information available at the time of making the balloon loan)
  • In determining whether a consumer will be able to refinance a balloon payment, a bank should exercise "prudent underwriting," including considering factors such as the loan-to-value ratio and the borrower's debt-to-income ratio or residual income (as of the time of loan consummation).
A caveat: The reach of this letter is somewhat limited. Strictly speaking, it is guidance only from the Federal Reserve to its own regulators. We have received unofficial word that the OCC and OTS have distributed this letter to their regulators as well. However, no word has been forthcoming from the FDIC as of yet. We will provide a complete update in the December 2009 Legal Update.
Although this Letter does not provide absolute clarity, it goes a long way toward providing comfort for banks that have offered short-term balloon notes to their customers – this is excellent news!
Call Byron Linkous or Pauli Loefler at the OBA with any questions you may have.

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