January 2009 Legal Briefs

  1. Various Cost-of-Living Increases in Dollar Amounts for 2009
  2. No IRA Minimum Distributions Required for 2009
  3. Interagency Statement on Meeting Needs of Creditworthy Borrowers 

Various Cost-of-Living Increases in Dollar Amounts for 2009


Many “dollar amounts” set out in Federal regulations are adjusted annually for inflation.  Following are some examples of changes in amount, effective January 1, 2009, affecting banks’ operations in various areas.

1.  HOEPA “High-Fee” Mortgages

 Regulation Z, Section 226.32, imposes restrictions on loan terms, as well as additional disclosure requirements, for certain consumer mortgage loans that are priced either on a “high-rate” or “high-fee” basis.  Section 226.32(a)(1)(ii) treats loans as “high-fee” (and subject to HOEPA provisions) if the “total points and fees” will exceed the greater of (a) eight percent of the total loan amount, or (b) $400 (an amount to be subsequently adjusted for inflation).  (These restrictions do not apply to “residential mortgage transactions,” “reverse-mortgage transactions” and “open-end credit plans,” as those terms are defined.)

 The $400 amount has been adjusted annually for more than a dozen years.  During calendar year 2008, the applicable amount has been $561.  Beginning January 1, 2009, this amount will increase to $583.  A consumer mortgage loan made in 2009, having total points and fees not exceeding $583, will automatically fall outside of the “high-fee” mortgage category—even if the fees, as a percentage of the total loan, would exceed eight percent.  

 (Oklahoma’s Uniform Consumer Credit Code, at 14A O.S. Section 1-301(10)(a), has a parallel provision, allowing “total points and fees” equal to the greater of eight percent of the total loan amount or $400, before a mortgage is considered “high-fee.”  Like Regulation Z’s provision, Oklahoma’s $400 amount is indexed annually for inflation.  On this basis, it is appropriate simply to rely on the Federal amount. The 2008 Oklahoma amount was $561 (same as Reg Z), and the 2009 amount should be $583 (same as Reg Z).  The Oklahoma changes are sometimes made after January 1, but are always retroactive to January 1.   Oklahoma’s annual adjustments are found in Rule 160:45-9-2 of the Oklahoma Department of Consumer Credit.)  

 Of course, for consumer mortgage loans that are above a certain dollar amount and subject to the restrictions, a larger “points and fees” limit than $583 will be available (under both Reg Z and Oklahoma’s Consumer Credit Code) by multiplying eight percent times the total loan amount. For 2009, on all mortgage loans above $7,287 the “eight percent” approach will yield a higher dollar amount of allowable “total points and fees” than the $583 approach. 

2. HMDA-Reporting Banks

 Based on Regulation C (HMDA), most banks, savings associations and credit unions with a main office or at least one branch office in a metropolitan area must collect data and make a report of their housing-related lending activity.  Institutions at or below a certain asset size are exempt from these data-collection and reporting requirements.  For calendar year 2008, the exemption level was $37 million in assets or less (measured as of December 31, 2007).  For 2009, the applicable exemption amount is $39 million or less (measured as of December 31, 2008). 

 If an institution was covered in 2008 but drops out of the reporting requirement in 2009, it still must report the data it collected for 2008.  If an institution was exempt in 2008, but becomes covered for 2009, it must begin collecting data as of January 1, 2009.

 An institution can fall within the regulation’s coverage for the first time in 2009 either (1) by opening an office in 2008 in a metropolitan area (where previously it had no office) or (2) by increasing its asset size at December 31, 2008 above the applicable exemption amount for the first time.

3. Community Reinvestment Act

 The requirements imposed on a bank by Regulation BB (Community Reinvestment) vary according to whether a bank is a “small bank” (and perhaps also an “intermediate small bank”) or a larger bank.  The total-asset size of banks qualifying as “small” or “intermediate small” banks is adjusted annually for inflation.

 As of January 1, 2009, a “small bank” is any bank with assets less than $1.109 billion as of either December 31, 2007, or December 31, 2008.  In 2009 an “intermediate small bank” is a bank that is a “small bank,” and also has assets of at least $277 million as of both December 31, 2007, and December 31, 2008.
 (The amounts that applied in 2008 were $1.061 billion and $265 million, respectively.)

4.  Health Savings Accounts

 The maximum amount an eligible individual with self-only high-deductible health insurance coverage can contribute to a health savings account (HSA) will be $3,000 in 2009 (raised from $2,900 in 2008).  The individual’s high-deductible insurance must have a deductible amount not less than $1,150, and a maximum annual out-of-pocket amount of $5,800, in 2009.

 For family coverage, the maximum HSA contribution in 2009 will be $5,950 (raised from $5,800 in 2008).  The insurance deductible amount for family coverage must be at least $2,300, and the maximum annual out-of-pocket amount is $11,600.

 Individuals who are 55 or older (but not yet enrolled in Medicare) can make a “catch up contribution” of $1,000 to an HAS for 2009 and following years.  (Their otherwise-applicable maximum HSA contribution can be increased by $1,000.)

5.  IRAs

 The IRA contribution limit will remain at $5,000 for taxable year 2009 (no change from 2008). For persons who are at least 50 before 2010, an IRA catch-up contribution of $1,000 is allowed in taxable year 2009 (again, no change from 2008), resulting in a $6,000 combined amount.

 Of course, there is only one maximum $5,000 (or $6,000) amount available per taxpayer, to be contributed to either a traditional IRA or a Roth IRA, or some combination of both.  (If the individual is 70 ½ or older during the taxable year, a contribution can still be made to a Roth IRA but not to a traditional IRA.)  There are certain restrictions that can cut back the allowable amount of IRA contributions, depending on the individual’s marital status, tax-filing status (for example, married filing jointly, or married filing separately), participation in an employer-sponsored retirement plan (or not), and total amount of “modified adjusted gross income” (MAGI) reported on a tax return. 

 Although the maximum IRA contribution amounts ($5,000 or $6,000) will not change in 2009, the various income-based phase-out ranges (the range within which an allowed IRA contribution amount is reduced from either $5,000 or $6,000 to $0) will change in 2009, based on an inflation adjustment.  (If an individual is approaching or within the income-based phase-out ranges, he should consult a tax professional concerning his maximum allowed IRA contribution amount.)

 The IRA contribution limits for 2009, although complicated, can be summarized as follows:

 If an individual is not covered by a retirement plan at work, and also does not have a spouse who is covered by a retirement plan at work, the individual (and spouse also, if married) can make the maximum contribution to a traditional IRA, no matter how large MAGI may be (filing taxes separately, if single, or filing jointly, if married).  If this same individual is unmarried and files a single return, his ability to make a Roth IRA contribution instead of a traditional IRA contribution will phase out between $105,000 and $120,000 of MAGI.  If this person is married filing a joint return, his ability (and the spouse’s ability) to make a Roth IRA contribution instead of a traditional IRA contribution will phase out between $166,000 and $176,000 of MAGI on the joint return.

 If an individual is single, and covered by a retirement plan at work, his ability to make a (deductible) maximum traditional IRA contribution will phase out between $55,000 and $65,000 of MAGI.  His ability to make a (non-deductible) Roth IRA contribution instead of a traditional IRA contribution will phase out between $105,000 and $120,000 of MAGI.

 If an individual is married, and covered by a retirement plan at work, and files a joint return, his ability to take a maximum traditional IRA contribution will phase out between $89,000 and $109,000 of MAGI reported on the joint return.  His ability to make a Roth IRA contribution instead of a traditional IRA contribution will phase out between $166,000 and $176,000 of MAGI reported on the joint return.

 If an individual is married, and not covered by a retirement plan at work, but files a joint return with a spouse who is covered by a retirement plan at work, the ability of the spouse not covered by such plan to take a maximum traditional IRA contribution will phase out between $166,000 and $176,000 of MAGI reported on the joint return; and that person’s ability to make a Roth IRA contribution instead of a traditional IRA contribution will phase out within that same MAGI range.

No IRA Minimum Distributions Required for 2009 

 On December 23, President Bush signed into law the “Worker, Retiree, and Employer Tax Recovery Act of 2008.”  In Section 201 this Act provides that any individual who otherwise would be required to take a “required minimum distribution” from his traditional IRA during 2009 will be allowed instead to skip the 2009 distribution completely (if he wishes), or to take a smaller distribution in 2009 (if he wishes), without incurring any penalty.

 Of course, this individual is also free to take the normal distribution from his IRA in 2009, or even a larger distribution—whatever he wants to do.  (This change for 2009 applies not only to persons who are at least 70 ½, but also to those who are taking “required minimum distributions” because they have an “inherited” IRA.)

 Many retired IRA owners will need to take their “required minimum distribution” (or more) just to meet normal expenses.  For them, having a choice to avoid the 2009 distribution will be of little interest. 

 But some individuals–with substantial other income or sufficient other assets–do not need (or want) to take a “required minimum distribution” in order to support themselves.  (It’s generally true that persons with larger IRA balances are the ones least in need of a distribution; and the larger the IRA balance, the bigger that individual’s normal “required minimum distribution” will be.  From a standpoint of tax planning, these are the ones who will most appreciate the opportunity to take no distribution.)  

 If someone does not take an IRA distribution in 2009, a very real tax benefit can result:  That amount will not be included in 2009 taxable income.  As an additional advantage, the amount not required to be distributed from the IRA will continue to earn income inside the IRA on a tax-free basis, into the future. 

 IRA owners who are at least 70 ½ (or who have an inherited IRA) should consult their accountant or other tax professional to understand specifically how this opportunity to avoid a “required minimum distribution” in 2009 can help them.  

 The official justification for eliminating “required minimum distributions” in 2009 is this:  Many people who have their IRAs invested in stocks or mutual funds took large losses in 2008.  Forcing them to take a “required minimum distribution” from an IRA in 2009, while their funds are at a greatly reduced level, would be like “locking in” the losses on the portion of funds that they withdraw, allowing no opportunity to recoup.  By leaving their funds in the IRA (instead of taking a “required minimum distribution”) they have a shot at partially recovering their losses on stocks, through future gains—and especially if the stock market recovers quickly.

 Of course, an individual who has an IRA invested in a certificate of deposit does not have a loss because of declines in the stock market, and would not have any hardship if he were required to take a normal “required minimum distribution.”  But the Act applies equally to all IRAs—whether they have a “hardship” or not.  In this situation the person holding an IRA invested in a bank CD, who decides not to take the “required minimum distribution” in 2009, just gets a pure “tax break.” 

 The Act provides a similar advantage for “required minimum distributions” from an employer-related retirement plan—such as a 401(k).   As with IRAs, required distributions from such employer plans can be “waived” or reduced in 2009 by the individual, without penalty.   This provision may be useful for retired bank employees (70 ½ or older) who are participants in the bank’s own retirement plan.

Interagency Statement on Meeting Needs of Creditworthy Borrowers 

 In November the U.S. Treasury (OCC & OTS), FDIC and Federal Reserve issued an Interagency Statement encouraging financial institutions to continue lending—although, at least for Oklahoma banks, there hasn’t been any problem with decreased credit availability.  The interagency statement also sets out certain lending-related principles or assumptions that previously have not been emphasized so explicitly. 

 Clearly, the statement goes beyond issues of “soundness” or “regulatory compliance.”  Banks regularly adopt certain lending goals of their own, but it’s a different situation, and removes some of a bank’s discretion, when the regulators start outlining what certain aspects of a bank’s lending activities and loan-workout process should be.  
1.  Lending to Creditworthy Borrowers

 The statement notes that “the economy will likely become increasingly reliant on banking organizations to provide credit formerly provided or facilitated by purchasers of securities.”  This sentence refers to two separate situations: 

 First, until recently a variety of investors were directly purchasing huge quantities of loan-based securities (primarily packages of mortgages, and also securitized packages of car loans, credit card debt, and even student loans).  After experiencing market losses in 2008, investors are now very cautious and much less willing to purchase “securitized” loans. 

 Many lenders (including mortgage brokers) that were originating loans for sale into the secondary market now have had their funding sources cut off or greatly reduced.  Borrowers increasingly will turn to traditional bank lenders, who can “lend and hold” loans for their own portfolio, in contrast to the “lending and selling” arrangement that has operated between originators and investors.  

 Second, a lot of national companies were selling their own debt obligations (commercial paper) to investors, as a source of funding to make loans.  But investor confidence in commercial paper has significantly declined. Several large finance companies (engaged in automobile financing or credit card lending) have funded their operations with commercial paper.  Finance companies engaged in commercial lending have done the same.  Although the U.S. Treasury and FDIC have taken steps to revive the commercial paper market, many companies previously funding their operations in this way have been forced to cut back on lending.  Thus, the decline in investor appetite for commercial paper has been a second factor that will increase loan demand at local banks.  (But some of these finance companies, as well as securities firms, are converting to commercial banks to gain deposit-based funding.)

  Over several decades, various categories of loans (particularly mortgage loans, car loans, and credit cards) have been increasingly dominated by national lenders with access to substantial investor funding.  As many of these companies are now experiencing credit-quality and loan-funding problems, bank lending continues. 

 The interagency statement tells banks to keep lending if “realistic asset valuations and a balanced assessment of borrower’s repayment capabilities” will justify making a loan.  In places like Oklahoma where unemployment remains fairly low and the economy remains relatively healthy, many loan applicants’ credit quality remains satisfactory.  As other choices dry up on a national level, local lenders in Oklahoma will have an opportunity to make additional sound loans.   

 For example, car sales (and car loans) in Oklahoma are down, but Oklahoma financial institutions are increasing their percentage of total car loans because out-of-state finance companies have reduced or terminated their lending here. 

 On a national front, various lenders providing business credit cards, inventory financing, and commercial real estate mortgages are also cutting back.  Businesses will try to replace this lost funding by applying to local banks. 

 Banks probably will also see an increased level of mortgage loan applications, particularly from individuals whose credit quality has some flaws.  Most banks in Oklahoma don’t make 30-year mortgage loans for their own portfolio, and aren’t going to change that.  But out of necessity, more borrowers who would prefer a 30-year mortgage will apply instead for mortgage terms that banks typically offer.

 The interagency statement advises, “Banking organizations should strive to maintain healthy credit relationships with businesses, consumers, and other creditworthy borrowers to enhance their own financial well-being as well as to promote a sound economy.”  In other words, “Don’t back off, where people need loans.”  The statement adds, “The [regulatory] agencies have directed supervisory staffs [including examiners]. . . to encourage banking organizations to practice economically viable and appropriate lending activities.”  As I interpret this, examiners will look at whether banks are actively working to approve all “safe and sound loans” that they have an opportunity to make—but no doubt, banks will continue to be criticized for any weak loans that are made.  (All you have to do is get it right.)

2.  Shouldn’t a Bank Control Its Lending?
 Contrary to some of the things perhaps implied in the interagency statement, I have generally believed that a bank has considerable freedom, within reason, to design its own “lending plan”—through its loan policy.  For example, within certain outer limits, a bank should be able to decide what reasonable types of lending it wants to emphasize, how its loan portfolio will be weighted between various categories to achieve appropriate diversification of risk, how its loans will be priced, and what target rate of asset growth (including loans) the bank wants to achieve. 

 Certainly, a bank has a duty under CRA to meet the needs of “low and moderate income” borrowers.  Nor can a bank decline a loan based on certain discriminatory factors.  But I have never understood that a bank is somehow obligated to make as many loans as possible—particularly if the loan volume that is avoided involves individuals or businesses that are not in disadvantaged categories. 

 Can a bank legitimately set and comply with internal targets designed to control the volume of lending?  And if not, how far does a regulatory “override” in this area go?  For example, if a bank is well-capitalized at its current asset level, would it have a duty to increase lending, just because there is additional loan demand available, if a significantly increased volume of lending would cause a decreased capital ratio, and in turn would put the bank in a position of needing to raise more capital?  Maybe the interagency statement’s general principles provide some “outs” after all, by mentioning “economically viable and appropriate” lending, and lending that enhances an institution’s “own financial well-being.”

 Regardless, most banks in Oklahoma have strong capital and are actively lending.  To my knowledge, Oklahoma banks are not turning away good loans.  The interagency statement certainly is not directed primarily at banks operating under circumstances that exist in Oklahoma, and will not have much “bite” with respect to such banks.   Still, I find it somewhat disturbing (in principle) that regulators want to dictate that banks should be engaging in “more” lending.

 I believe that, within reason, banks instinctively try to respond to all attractive business opportunities that come along.  Basically, it should be unnecessary to “encourage” banks to do anything, if that is already in their economic best interest.  And the other way around, if increased lending is not in a particular bank’s economic best interest, is it actually useful or appropriate to “jawbone” a bank regarding making more loans?

3. Strengthening Capital

 The interagency statement makes several important points about capital planning, but especially emphasizes the effect of a bank’s capital level on lending.

 The regulators observe, “Maintaining a strong capital position complements and facilitates a banking organization’s capacity and willingness to lend . . . .”  They caution against paying a level of bank dividends “that could impair the bank’s ability to meet the needs of creditworthy borrowers.”  In other words, if a bank is in a position where it must choose between paying dividends or having enough capital to continue lending to good-quality borrowers, the regulators favor retention of capital and increased lending.  

 Banks are cautioned to “focus on effective and efficient capital planning and longer-term capital maintenance.”   Instead of just considering the short-term reason for paying a dividend, a bank should also consider whether a dividend is consistent with the bank’s need to build and maintain capital over time. 

 Before deciding to pay a dividend, a bank should consider whether its loan loss reserve is adequate or should be increased.  Additionally, a bank should review its future earnings capacity (considering all of the circumstances).  For example, if the proposed dividend is paid, is it reasonably certain that future earnings will be sufficient to maintain adequate capital? 

 If capital is decreased by paying a dividend, the bank also loses the ability to earn income on that amount, and decreases its liquidity by that amount.  (The larger the dividend, the more it’s important to consider such issues.) 

 Another matter to consider is “what it would take” to replace the dividend amount with capital from other sources, if that ever should become necessary.  If, under the bank’s own circumstances, it would be fairly expensive to replace the capital, or if additional capital is unlikely to be available at all from existing shareholders, these factors might cause a bank to “go slow” in paying dividends.

 On the other hand, if the bank has a wealthy shareholder group that easily and willingly can contribute more capital to the bank as needed, this might neutralize any serious concerns about the possible long-term effects of paying a dividend.

4. Dividends for Debt Service & Taxes

 Unlike most other areas of the country, many family-owned smaller banks are concentrated within a band of states from Texas northward through the Great Plains (including Oklahoma).  Certain characteristics are true of these banks, but not true of larger, publicly-held banks in other parts of the country:  (1) Purchase of controlling stock in family-owned smaller banks is usually financed at least partly with debt.  Very frequently it is necessary to pay dividends to service a bank-stock loan–and cutting off dividends could have severe consequences.  Also, (2) many of these smaller banks are “subchapter S” corporations—meaning that the bank pays no income tax at the entity level.  Instead, the bank’s income is reported to the shareholders, who each must pay tax on their proportionate percentage of it, whether any earnings are distributed to them in cash or not.  A “subchapter S” bank almost always needs to pay dividends to shareholders in an amount at least equal to the amount of tax these shareholders will owe on the portion of the bank’s income that is reported out to them. 

 In Oklahoma, both of these reasons for paying dividends (servicing a bank- stock loan, and helping shareholders to pay income tax on “subchapter S” income) may apply to the same bank.  When this kind of necessity collides with a general warning not to pay dividends that could have an adverse impact on capital, a bank can find itself between a rock and a hard place.

 Certainly during the mid-1980s, many banks in Oklahoma were prevented by circumstances (or by regulators) from paying dividends.  Although we might see a bit of that scenario again in the next couple of years, it hopefully will affect only a few banks here.   If a regular pattern of bank dividends is needed to service debt or to assist “subchapter S” bank shareholders in paying income tax, it’s vital for a bank to focus carefully on maintaining its asset quality, net income and adequate capital ratio.  (Of course, every bank should already be doing that.)

 But if a bank finds itself in a lower-income situation for a couple of years, and badly needs to continue paying dividends, the only way for the bank to keep doing that may be to restrict asset growth, so that ongoing net earnings will not be needed to maintain adequate capital.  In this situation, practical reality could collide with the interagency statement’s admonishment that a bank should build capital in order to be able to continue to lend.

 The good news, however, is that Oklahoma banks are now operating with record-high capital ratios, and still have near-peak income levels.  Most Oklahoma banks lack any serious asset-quality problems.  Capital is generally considerably above a level that would restrict lending or cut off the payment of dividends.  And at this time, Oklahoma is not experiencing a serious economic downturn anything like certain parts of the country.  There simply is no indication that the banking industry in Oklahoma is heading toward anything similar to the 1980s.

 I find the interagency statement somewhat troubling in its bias in favor of increased lending (even if that lending restricts badly-needed dividends).  But importantly, the main target of this regulatory statement is other regions of the U.S., not Oklahoma.  Problems in other areas where banks are already forced to reduce dividends (or eliminate them) will hopefully not show up in Oklahoma.  

5.  Working with Mortgage Borrowers

 The regulatory agencies also “expect banking organizations to work with existing borrowers to avoid preventable foreclosures.”  But let me say, first, that if a bank has a legitimate contractual right to foreclose, it has a right to foreclose.  A regulatory pronouncement does not change that fact. 

 Having said that, banks obviously should try to do reasonable mortgage “workouts,” wherever that can be done.  In most cases it makes good business sense to avoid the expense and uncertainties of the foreclosure process if there is an acceptable way to get the borrower back on track.  It’s usually in the best interest of a bank and its reputation in the community, as well as the individual borrower and perhaps also the local real estate market, to try to work with a borrower who is having temporary problems of some kind. 

 The agencies state, “Lenders and servicers should first determine whether a loan modification would enhance the net present value of the loan before proceeding to foreclosure . . . .”  Hopefully, banks are already making that kind of calculation.  

 But the risks involved in foreclosure are probably greater in many states outside of Oklahoma.  In some states it takes almost six months—and much greater expense–to carry out a foreclosure.  (And where the required foreclosure process is lengthy, there’s always a risk of further decline in the local real estate market before foreclosure is completed.)
 Certain parts of the country already have too many foreclosed homes on the market, and dumping even more homes onto the market through additional foreclosures can have an undesirable outcome.  In Oklahoma only about one in fourteen homes currently listed for sale is a foreclosure.  (The level of foreclosures is not yet high enough to produce a major impact on Oklahoma’s real estate market.) 

 Oklahoma is fairly unique because there has been little or no decline (or even a slight increase) in real estate values in the past year.  This means a typical borrower is not “under water” on his mortgage–at least for first mortgage loans.  When regulators advise banks to consider a mortgage modification if that would be better for the bank than a foreclosure, they are mainly referring to a situation where a bank would write down the principal balance of a loan and re-amortize it, if that would recover more money than a foreclosure in a depressed real estate market.  But for most cases in Oklahoma, banks would “come out whole” (or nearly so) by foreclosure.  For any mortgage loan where that is the case, it is probably not more advantageous to write down the principal balance than to foreclose.

 Through news media, individuals have heard a lot about troubled borrowers getting their loan balance (and payments) reduced.  Some borrowers have been asking Oklahoma banks to do just that–because they think they can get it if they ask for it.  But what they may be missing is that lenders (1) have no legal obligation to do this, and also (2) have no financial incentive to do this, if the resale value of the home continues to be at least as high as the existing balance of the mortgage loan.

 In many cases, borrowers in higher-priced real estate markets around the U.S. took out “exotic” mortgages with extremely low payments up front, but also sharply increasing payments at a later date.  In some cases, mortgage brokers “qualified” the borrowers based only on the initial payments, which were artificially low.  Even from the beginning the design of these mortgages was “like a train wreck waiting to happen.”  These poorly-underwritten and poorly-designed mortgages seem to be the regulators’ primary concern when they say a bank “should seek to achieve modifications that result in mortgages that borrowers will be able to sustain over the remaining maturity of their loans.”  They’re saying, “If you made a mess, fix it.”

 By contrast, banks in Oklahoma that make mortgage loans for their own portfolio have generally done so on a conservative basis, and without these “exotic” or unfair provisions.  The typical small-bank first-mortgage loan has no “teaser” rates, and the borrower is qualified based on a “real” mortgage payment amount.

 The interagency statement suggests that banks should use “mortgage loan modification protocols” on a systematic and streamlined basis in dealing with borrowers facing foreclosure, but I do not assume that this legally or morally requires a bank to make drastic reductions in rates or payment amounts, if the loan was structured on a fair basis to begin with, the payment structure continues to be fair, proper underwriting was used to “qualify” the borrower, and the home’s value continues to be approximately equal to the amount owed. 

 That said, if a borrower has a temporary hardship and has a decent chance of getting back on track, it’s to the benefit of all involved to try to help the borrower to get past the problem.

 For reasons explained above, the regulators’ advice on “working with mortgage borrowers” seems primarily directed at some of the extreme situations existing in states other than Oklahoma. 

6.  Structuring Compensation

 In the final section of the interagency statement, the regulators caution against establishing a bank compensation system that creates short-term financial incentives for bank employees to take actions not in line with the bank’s long-term interests. 

 The most familiar example of this involves now-well-publicized excesses in the mortgage broker industry, where individuals are regularly compensated “per loan originated,” but the loans are sold into the secondary market.   Because the entity originating the loans does not retain the loans, it generally does not have to absorb the losses if the loans go bad.  On this basis, an originator may be very motivated to make loans, but may have much less concern about the quality of underwriting.  In some cases, mortgage brokers used a variety of “application tricks” to originate as many loans as possible, even for borrowers who really should not have qualified and could not really afford a loan.  Today we have the “subprime mortgage” crisis, partially as a result of this type of compensation system.

 In banks, it’s more likely that loans will be retained rather than sold, and the bank will have to absorb loan losses, if any.  If a loan officer has an “add-on” compensation component based on total dollars of loans generated, but a particular loan application is “borderline,” this compensation system might influence the loan officer to approve the loan, in a situation where it might better serve the bank’s interest to decline it.  Or a loan officer might price a loan somewhat more in the customer’s favor, to be sure that a loan applicant will take the loan, resulting in more loan volume generated, instead of pricing the loan more in the bank’s favor, to ensure an adequate spread.

 Consider whether paying a bonus based simply on total dollars of loans generated may actually be telling the officer (1) to focus on generating larger loans, and to give little attention to applications for smaller loans, (2) to view total loans being generated as more important than time spent on careful documentation, and (3) to downplay “customer service” issues for existing borrowers (after a loan is made) because spending time in this way will not earn any additional bonus.

  I have seen a variation of this “volume of loans” compensation system, where the loan officer will also have his loan-origination compensation reduced based on volume of loan losses later taken by the bank on loans he has originated.  This is probably a somewhat better compensation structure than the first one, because it tries to give the loan officer an incentive to make “good” loans.  (The “bonus” received for generating a loan will later be wiped out by a “deduction from bonus” if the loan goes bad.)

 But there are still a couple of flaws with a system like this.  First, there is a “time lag” between when a loan is originated and when it goes bad.  A loan officer is still motivated to get as much bonus as possible “up front” by generating a high volume of loans, if “pay-back” probably will not kick in until a couple of years later.  “I’ll worry about that tomorrow.”

 Second, this system over-rewards loan officers during a good economy, when few loans go bad anyway, and tends to over-punish loan officers during a bad economy, when more of any loan officer’s loans will go bad.  During a good economy, this compensation system may attract experienced lenders who have a lot of business contacts.  During a bad economy, the same experienced lenders may decide that they are being unduly punished by “deductions from bonus,” so they may move to another bank with a different compensation system.  But during a bad economy the bank needs experienced loan officers who are familiar with collections and workouts.  (If a compensation system pushes experienced lenders out the door during a bad economy, that’s not in the overall financial interest of the bank either.)

 Although, as suggested, it may seem unfair to penalize a loan officer for the results of a bad economy, there are things a loan officer can do deliberately during a good economy, if “incentivized” to do so.  For example, requiring 150% collateral on many categories of loans, whether the bank thinks it needs it or not, will later help to minimize losses during a bad economy and (although some would call it too conservative) can turn out to be in the best interest of both the loan officer and the bank. 

 As a different slant, I think it might be useful to compensate loan officers more favorably for making loans in line with the bank’s credit-quality, pricing and collateral guidelines, than for making loans that involve exceptions from policy. 

 I think it might also be beneficial to design a system that compensates compliance officers (and loan officers) based on a consistent pattern of loan files that are in complete compliance with all regulatory requirements.  (Particularly in a weaker economy, when more loans go into default, a loan’s collectability—and therefore avoidance of loss—can be highly dependent on the condition of the loan file.)  But most banks will not compensate in this way, because hardly anyone receives proper credit for “disasters that never happened because they were well prevented.”

 The interagency statement adds, “The agencies expect banking organizations to regularly review their management compensation policies to ensure they are consistent with the longer-run objectives of the organization and sound lending and risk management practices.”

7. All Banks Must Adhere

 The final paragraph of the statement refers to the government agencies’ recent “programs that foster financial stability and mitigate procyclical effects of the current market conditions.”  (Translation:  U.S. Treasury’s “TARP”—providing capital to banks—and FDIC’s “Temporary Liquidity Guarantee Program.”)  Then the interagency statement states that “regardless of their participation in particular programs, all banking organizations are expected to adhere to the principles in this statement.” 

 Certainly, as everyone already understood, selling preferred stock to the U.S. Treasury or selling “senior unsecured debt” under FDIC’s Temporary Liquidity Guarantee Program creates an expectation that the funds received will be used to facilitate lending.  But the interagency statement goes farther, clarifying that even if a bank did not participate in these programs the regulators will be concerned about whether the bank is maintaining adequate capital to meet loan demand; keeping dividends within prudent limits; working with mortgage borrowers to avoid preventable foreclosures and to modify their loans; and structuring officer compensation in line with the bank’s long-term best interests.