Daily Development for Thursday, March 15, 2001

MORTGAGES; PREPAYMENT; PREEMPTION: Courts uphold Federal preemption of "Alternative Mortgage Loan" regulations for prepayment penalties: (Two Cases) (1) Shinn v. Encore Mortg.

Services, 96 F.Supp.2d 419 (D.N.J.2000) (2) National Home Equity Mortg. Ass'n v. Face, 239 F.3d 633 (4th Cir.2001)

(1) Shinn: A residential variable rate note and mortgage provided for a prepayment fee during the first thirtysix months of the loan term.

Approximately fortyfive days after closing, the homeowners refinanced the mortgage, paying a prepayment fee. They then filed a complaint alleging that the prepayment fee violated N.J.S. 4610B1, the Prepayment Law, which generally prohibits residential mortgage lenders from charging prepayment fees. The lender asserted that its contractual right to collect the prepayment fee was not affected by the Prepayment Law. It argued that the Prepayment Law was preempted by the express provisions of the federal Alternative Mortgage Transactions Parity Act of 1982.

The Court held that the Prepayment Law was, in fact, preempted by the Alternative Mortgage Transactions Parity Act. That Act expressly preempts state laws which seek to regulate "alternative mortgages, on residential real estate" i.e., loans other than traditional, fully amortized, fixed rate loans. Most lenders under the Act are subject the Office of Thrift Supervision's (OTS's) regulations governing federal savings and loans associations. The OTS "has clearly expressed its intent to preempt state laws which limit state creditors' ability to charge prepayment penalties in connection with" alternative mortgage transactions. Banks are subject to similar regulations promulgated by the Comptroller of the Currency, and credit unions to the regulations of the NCUA.

The homeowners argued that the OTS's authority to issue regulations was limited to a 60day period immediately following passage of the Parity Act. States were given three years to opt out of the Parity Act.

Consequently, the homeowners argued that when the OTS did not issue its regulations within 60 days, it, in effect, "sandbagged" New Jersey into accepting the Parity Act without realizing its true effects. The lender argued that the 60day limitation on the OTS's rulemaking authority would defeat the purposes of the Parity Act because regulations applicable to the state would diverge over time from those applicable to federally chartered housing creditors, thereby eliminating the parity created by the Act.

The Court accepted that reasoning and rejected the homeowners' argument that New Jersey was "sandbagged." In agreeing to the Parity Act, New Jersey accepted not only that state housing creditors would be governed by OTS's regulations, but that the OTS would have the power to issue regulations in the future.

(2) National Home Equity This case addressed many of the same issues that had been raised in Shinn, discussed above, and resolved them the same way. In addition, the Fourth Circuit noted that it really didn't matter that prepayment penalties were not unique to alternative mortgage instruments. The bottom line is simply whether the regulatory agencies chose to confer preemptive authority upon lenders subject to their jurisdiction to engage in these practices in connection with alternative mortgage instruments.

Comment 1: The Parity Act is not news. It was part of the Deregulation and Monetary Control Act of 1982 (known as DIDIMAC). But the various federal agencies empowered with the right to enact preemptive regulations did not enact such regulations until more recently, and did not expand them to cover the range of provisions they now cover until even more recently. The news is that people are just now figuring out that they can shelter under these regulations.

The definition of who is a "lender" under DIDIMAC is very broad anyone who is a lender within that definition for purposes of Truth in Lending qualifies all you have to do is be regularly in the business of making residential mortgage loans. Mortgage bankers are included. Of course, those lenders that were federally regulated already had the benefit of preemptive federal regulation prior to 1982 but nobody realized it until that year, when the Supreme Court, in the De La Cuesta case, 458 U.S. 664 (1982) upheld the FHLBB's preemption of local due on sale clause regulation. The Parity Act was an attempt to "level the field" for nonfederally regulated lenders so that there could be an adequate "test market" for the thennewly developed concept of "alternative mortgage instruments."

Folks who were watching this area in the early 1980's know that the watchword was "disintermediation" the difficulty that institutional lenders were having performing their function as financial intermediaries in the face of massive inflation sparked by the Arab Oil Embargo (among other things). Alternative mortgage instruments which by and large shifted the risk of changes in the cost of money away from lenders and to borrowers (who else?), were perceived to be the answer to this problem, and everyone was anxious to discover which approaches to "risk shifting" would eventually prove palatable to the mortgage marketplace.

So the Parity Act defined "alternative mortgages very broadly basically anything that is not a traditional fixed rate amortizing loan. Probably graduated payment loans were covered. Certainly balloon loans, adjustable rate mortgage loans, roll over devices, and many other loan types also would be included. But, of course, it means nothing to be an "alternative mortgage instrument" under the Act unless that type of instrument is one that one of the entitle federal agencies chooses to regulate.

All three of the designated agencies, the OTS (successor to the FHLBB for these purposes), the Comptroller, and the National Credit Union Administration, now have alternative rate mortgage regulations, but the editor isn't certain whether there are any other preemptive regulations out there.

Comment 2: Professor Dale Whitman, who has commented on these cases, has questioned whether is was the original purpose of the drafters to preemptive consumer regulation that does not appear to relate to those parts. He points out that the application of the Act to issues other than those central to the "rate adjustment" feature that makes alternative mortgages really different can eliminate numerous other sorts of "pro consumer" state statutory and regulatory provisions, such as those prevent loan lockouts, limiting late fees, and the like, whenever an adjustablerate or other "alternative" mortgage is involved. The OTS regulations are highly prolender, authorizing practices that are often prohibited by state law.

But the editor believes that the intent of Congress in 1982 was to authorize the federal agencies, if they so desired, to sweep the boards clean and give the marketplace for alternative mortgages a chance to operate. Who knows which aspects of a given mortgage loan will make that loan desirable to borrowers or to loan purchasers? To permit federally regulated lenders to experiment with various combinations of loan features and to deny that ability to unregulated lenders would deprive the market of the opportunity to operate in the expansive mode that was considered optimal. Remember that in this same enactment, Congress wiped out the most aggressive of consumer protection provisions usury laws for first lien residential mortgages based on a similar rationale.

If the federal regulations inappropriately interfere with legitimate consumer protection concerns, the problem is not with the Parity Act, but with the federal regulators themselves!! In the meantime, lenders, relax and enjoy.

Comment 3: Note that, as we have pointed out in the past, there are numerous other preemptive federal laws protecting various classes of lenders in their use of prepayment penalties, so these Parity Act decisions have somewhat limited reach. National Banks and federally regulated thrifts are free to ignore local restrictions on prepayment penalties even in fixed rate mortgages.

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