Bankin’ Bits

New rules clarifying the costs of a home loan will take effect on January1, 2010.  The new rules, enacted by the Department of Housing and Urban Development pursuant to the Real Estate Settlement Procedures Act, place new requirements on lenders and brokers to provide house shoppers with better estimates of the fees and charges they will incur at closing and during the life of a home loan.  Under the new rules, mortgage loan brokers and lenders:

• Must provide prospective borrowers with estimate forms within three days of receiving a mortgage loan application;
• Cannot increase the origination fee provided in the estimate;
• Can only increase non-origination charges by up to 10% (e.g. title research); and
• Use the forms that inform prospective purchasers of their right to shop around for title insurance.

Settlement firms will be required to use a new HUD-1 form, which will show the difference between initial estimates and the final charges consumers actually pay.

On December 24, 2009, the United States Department of the Treasury announced it had amended its funding commitment with Fannie Mae and Freddie Mac, removing the limit to funding guarantees between Treasury and the mortgage giants (both of which entered conservatorship in September 2008).  According to the release , Treasury removed the prior cap of $200 billion at each firm to “leave no uncertainty about the Treasury’s commitment to support these firms as they continue to play a vital role in the housing market during this current crisis.”

The move is somewhat surprising, considering Treasury’s statement that “[n]either firm is near the $200 billion per institution limit established under the [conservatorship preferred stock agreement].  Total funding provided under these agreements through the third quarter has been $51 billion to Freddie Mac and $60 billion to Fannie Mae.” 

Here are some other tidbits included in Treasury’s release:

• The short-term liquidity facility established by Treasury for Freddie and Fannie was never used.  
• Treasury also amended the conservatorship arrangement to give Freddie and Fannie more time to reduce the size of their retained mortgage portfolios.
• Treasury concluded by noting that it is reviewing issues raised the federal government’s role in the housing market and hopes to report to the President by the time the President releases his fiscal 2011 budget in February 2010. 
• Fannie Mae and Freddie Mac also revealed new compensation arrangement with Fannie CEO Michael Williams and Freddie CEO Charles Haldeman Jr.—packages packages that will pay as much as $6 million a year, including bonuses.  The packages are all cash, not surprising considering that each company’s common shares are currently trading at less than $2 apiece.

Treasury’s willingness to provide the unlimited guarantee will probably reassure investors about both firm’s financial futures, at least over the near term.  However, the cash bonuses are likely to draw intense scrutiny, especially in light of Congressional and public outrage over private sector bonuses.

The Board of Governors of the Federal Reserve System (the “Board”) recently issued proposed guidance regarding the incentive compensation policies of banking organizations (available here ). In recognition that one size does not fit all, the Board opted to center its guidance on three key principles, rather than implementing pay caps or prohibiting particular practices.

Of note, the Board chose to apply these principles to “employees,” which includes senior executives as well as other employees who, either individually or as part of a group, may expose the banking organization to material amounts of risk. The guidance made clear that the Federal Reserve expects all banking organizations to evaluate their incentive compensation arrangements for these employees and the risk management, control, and corporate governance processes related to these arrangements. Any deficiencies in these arrangements or processes that are inconsistent with safety and soundness should be addressed immediately.

These three principles and a brief summary of the Board’s explanation of how a banking organization implements each principle is provided below:

Principle 1:  Balanced Risk Taking.  Incentives should not encourage risk-taking beyond the institution’s ability to identify and manage overall risk.

• Banking organizations should consider the full range of risks associated with an employee’s activities, as well as the time horizon over which those risks may be realized, in assessing whether incentive compensation arrangements are balanced.

• An unbalanced arrangement can be moved toward balance by adding or modifying features that cause the amounts ultimately received by employees to appropriately reflect risk and risk outcomes.  Suggested methods include risk adjustment of awards, deferral of payment, longer performance periods and reduced sensitivity to short-term performance.

• The manner in which a banking organization seeks to achieve balanced incentive compensation arrangements should be tailored to account for the differences between employees–including the substantial differences between senior executives and other employees–as well as between banking organizations.

• Banking organizations should carefully consider the potential for “golden parachutes” and the vesting arrangements for deferred compensation to affect the risk-taking behavior of employees while at the organizations.

• Banking organizations should effectively communicate to employees the ways in which incentive compensation awards and payments will be reduced as risks increase.

Principle 2: Compatibility with Effective Controls and Risk Management.

• Banking organizations should have appropriate controls to ensure that their processes for achieving balanced compensation arrangements are followed and to maintain the integrity of their risk management and other functions.

• Appropriate personnel, including risk-management personnel, should have input into the organization’s processes for designing incentive compensation arrangements and assessing their effectiveness in restraining excessive risk-taking.

• Compensation for employees in risk management and control functions should be sufficient to attract and retain qualified personnel and should avoid conflicts of interest.

• Banking organizations should monitor the performance of their incentive compensation arrangements and should revise the arrangements as needed if payments do not appropriately reflect risk.

Principle 3:  Effective and Active Corporate Governance.

• The board of directors of a banking organization should actively oversee incentive compensation arrangements.

• The board of directors should monitor the performance, and regularly review the design and function, of incentive compensation arrangements.

• The organization, composition, and resources of the board of directors should permit effective oversight of incentive compensation.

• A banking organization’s disclosure practices should support safe and sound incentive compensation arrangements.

• Identify employees who are eligible to receive incentive compensation and whose activities may expose the organization to material risks.

The New Year will mark the beginning of a new accounting regime for securitizations and special purpose entities.  Starting on January 1, 2010, financial institutions ending their fiscal year on December 31 will be required to abide the standards set forth in recent amendments to Financial Accounting Statement Nos. 166 (Transfers of Financial Assets) and 167 (Amendments to FASB Interpretation of No. 46(R)). (The amendments will be effective for financial institutions with a fiscal year end other than December 31 at the start of the institution’s first fiscal year beginning after November 15, 2009.)

Statement 166 revises Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.  For most financial institutions, the key aspect of Statement 166 relates to the accounting treatment of loan participations.   Statement 166 will prohibit an institution that sells a loan participation from removing the participation interest from its books unless the participation is sold on a strictly pro rata basis, as to both payments and default.  

Participations not sold on a pro rata basis will be considered secured loans and will remain on the institution’s balance sheet, leading to possible violations of legal lending limits and increasing the amount of capital and loan loss reserves that financial institutions must hold.

Statement 166 will also require financial institutions to report more information about transfers of financial assets, including securitization transactions and other transferred financial assets for which the institution continues to hold risk exposures.

Statement 166 also eliminates the concept of a “qualifying special-purpose entity.”

Statement 167 will require financial institutions to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure caused by such involvement.  Institutions will also be required to discuss the impact of this additional risk exposure on the institution’s balance sheets.

Statement 167 revises FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities, and changes how financial institutions determine when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. Among other things, the decision to consolidate in accordance with Statement 167 is based on the entity`s purpose and design and a company`s ability to direct the activities of the entity that most significantly impact the entity`s economic performance.

Both Statements can be accessed here .

On December 1, the Supreme Court considered whether a discharge of student loan debt by a bankruptcy court  is valid without an adversarial hearing to prove “undue hardship” as required by bankruptcy court rules.  The defendant in United Student Aid Funds, Inc. v. Espinosa borrowed $13,000 to go to technical school in 1988 and 1989.  In 1992 he filed for bankruptcy, identifying the student loans as his only debt.  United Student Aid Funds, Inc. (USAF) filed a proof of claim with the court for $17,832.15, representing the principal and interest on the loans.  The bankruptcy court entered a confirmation order requiring Espinosa to pay back the principal only, not the approximately $4,000 of interest and sent USAF a form notice of their judgment.  The court did not make an undue hardship finding as required by the Bankruptcy Code, nor did Espinosa initiate an adversary proceeding as required by bankruptcy court rules.

 Three years later, USAF sought to collect the additional money owed by Espinosa by garnishing his federal income tax refunds.  Espinosa reopened his bankruptcy case, which eventually reached the Supreme Court last Tuesday.  The justices appeared skeptical of USAF’s arguments that the bankruptcy court judgment was void and that a lender cannot waive the undue hardship determination, even if the lender’s lawyer was in the courtroom.  However, the justices also questioned Espinosa’s argument for switching the burden that Congress put on the debtor to the creditor. 

Student loan debt, like child support and tax debt, is generally not dischargeable in bankruptcy.  If the Supreme Court sides with for Espinosa, the new rule could be extremely burdensome and costly for student loan lenders.  A decision on the case is expected next year.