Incentive compensation: A blueprint for today’s mortgage originators
Henry Oehmann, National Executive Compensation Services Executive Director
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The landscape of the mortgage industry has changed dramatically. Legislation and regulations spurred by the financial crisis — from the Dodd-Frank Act to Regulation Z: Loan Originator Compensation and Steering — create challenges for lenders and borrowers alike. Stringent requirements designed to protect consumers will change the way mortgage originators and brokers are compensated. How can mortgage originators keep pace with a flurry of emerging (and at times, seemingly conflicting) regulations, and what do these new developments mean for the future of the industry?
Background on the rules and regulations
In response to the mortgage crisis, regulators developed rules that aim to prevent mortgage originators from steering consumers toward inappropriate loans, requiring increased disclosures of loan features and greater documentation standards. These rules also targeted compensation practices of mortgage originators as a way to further safeguard consumers. Amid the development of the Dodd-Frank Act, final rules on mortgage originator compensation became effective on April 5, 2011, when the Circuit Court of Appeals dissolved the stay on the Federal Reserve Board (FRB) Final Rule on Loan Originator Compensation and Steering (Reg Z). Reg Z prohibits a creditor or any other person from paying compensation to a mortgage originator or broker based on mortgage loan terms or provisions other than the amount of the loan. However, compensation can be based on a fixed percentage of the loan and the creditor may pay the originator on an hourly rate or on loan volume within a given time period. Reg Z also allows a lender to pay a maximum or minimum amount as a way to address compensation for smaller loans.
With these new rules, mortgage originator pay plans have been under close scrutiny and frequent revision. Creditors are challenged to ensure that their current compensation plans don’t provide mortgage originators with incentives based on interest rates, annual percentage rates, loan-to-value ratios, demand features, or other terms and conditions of the mortgage. This prohibition makes it illegal to pay incentives for originators to steer customers toward inappropriate, higher rate loans, which may be more profitable to the lender. Rather, it encourages the lending institution to pay incentives on volume, an hourly rate or fixed fee basis. While the outcome of this prohibition may aid consumers, it clearly creates a challenge for creditors whose goal is to improve the profitability of their loan portfolio. In fact, paying commissions on volume may even spur increased loan volume without regard to loan profitability or loan quality. We have heard these comments and concerns from clients who are struggling to balance incentive plan risk and reward. Providing additional incentives for loan volume may exacerbate the challenge.
Another key prohibition of Reg Z addresses the practice of steering consumers to higher rate mortgages or other terms and conditions that may be less favorable to the consumer. This “steering” behavior was frequently driven by the opportunity for mortgage originators to earn higher commissions. Under the rule, this practice is prohibited. There is a safe harbor available to lenders to demonstrate compliance with the anti-steering rule. The creditor must present the consumer with offers from a significant number of lenders (three or more). These loan alternatives should include: (1) the loan with the lowest interest rate; (2) the loan with the lowest dollar amount for points and origination fees; and (3) the lowest rate for which the consumer qualifies for a loan with no risky features such as a pre-payment penalty, negative amortization, or a balloon payment within the first seven years.
Under Dodd-Frank Act Section 1403, Prohibition on Steering Incentives, more compliance challenges may await mortgage originators once the regulations are final. The Act calls for the FRB to prescribe regulations under Section 1403; however, some expect the Consumer Financial Protection Bureau (CFPB) will have this responsibility. Despite the regulatory logjam under the Act, final regulations must be in place by January 2014, when responsibility for implementation is officially transferred to the CFPB. Without a director for the CFPB, the burden may fall on state attorneys general, adding additional confusion and conflicts as each state develops its own regulatory response.
Finally, the FRB’s Guidance on Sound Incentive Compensation Policies will further complicate the potential conflicts in regulations. This guidance, which has become incorporated into the safety and soundness exams for banks, recommends that clawback provisions be established for incentive plans when incentive compensation is erroneously paid based on performance metrics that are later revised or restated. Many regulators are emphasizing the need for clawbacks in safety and soundness audits. Also, regulators have suggested that incentives paid to executive management may be subject to the mortgage originator rules, especially incentive plans based on bank profits. Moreover, final regulations under Section 956 of the Dodd-Frank Act will also set rules for incentive compensation plans that parallel the Guidance.
The future of incentive plans for loan originators is difficult to predict, but they will be vastly different from those of the past decade. Here are some key questions and answers that may help mortgage originators understand what is on the horizon.
1. How will the new regulatory environment change the mortgage industry’s ability to recruit and attract top mortgage originators?
For current mortgage originators who have invested heavily in their lending careers, it’s unlikely that they will change jobs and pursue other careers. In the meantime, they will likely receive less commissions and more paperwork until better opportunities become available. However, in the long term and as alternatives are more readily available, we expect to see fewer new entrants into this industry, and the skills and talents of new entrants will be quite different from those of the current mortgage brokers.
2. Will 100 percent commission plans be abandoned?
It is unlikely that 100 percent commission plans will be scrapped completely. However, commissions paid based on any yield spread premium will be eliminated. Future commission plans will be primarily based on loan volume, with the elimination of paying commissions based on the terms and conditions of the loan. It remains to be seen whether new bonus plans will include other performance measures, such as quality of the mortgage origination process, mortgage retention, process turnaround time or other efficiency objectives. It is likely that some financial institutions will abandon their current commission structure and move toward a base salary plus bonus in lieu of commissions.
3. Will banks rely exclusively on loan volume goals to ensure they avoid steerage and interest rate prohibitions?
We think that this will be the standard plan design for the future. However, measures of loan quality or other loan processing performance features (e.g., proper documentation of the loan or thoroughness in completing the required paperwork) may provide additional measures to track in future incentive compensation arrangements. Using loan volume as the single goal may result in loans that lack quality or are potentially risky for the lender.
4. Are clawback provisions required for mortgage originators?
Reg Z doesn’t specifically require that commissions for mortgage originators be subject to clawbacks; however, the FRB guidance does require clawbacks to be implemented whenever the behavior of an individual or a group of individuals is deemed to present a material risk to the financial institution. On this basis, residential mortgage divisions may meet these criteria and be required to implement clawback provisions. Section 1403 of the Dodd-Frank Act may also establish clawback requirements.
New clawback features may be similar to the “recapture features” used by lenders to mitigate losses resulting when mortgage brokers closed loans that went bad within the first six months or a year following closing. We are also aware that regulators have required lenders to add clawback features to their mortgage originator practices in safety and soundness exams. These clawbacks are unpopular with mortgage originators and may compound their challenge to motivate their workforce.
5. Will the mortgage originator rules reach up to the executive suite?
Historically, executive compensation bonuses have been based on some form of profitability. Certainly, one component of profitability will be profits generated by the residential mortgage division or business unit. The definition of “mortgage originator” under Reg Z is fairly broad; it’s likely that most of the “line of management” in a mortgage unit will be covered by this broad definition and, in turn, will prohibit any bonus pay based on profits from residential mortgages. It is doubtful that these prohibitions will be extended to top management bonus plans, although certain federal regulators believe that the prohibition could reach to the top echelon of some institutions.
Mortgage lenders should take an active role in modifying their lender compensation plans to ensure that current plans are compliant. The first step is to eliminate all incentive arrangements that pay commissions or bonuses based on any of the terms or conditions of the loans such as interest rates, demand features, prepayment penalties or proxies for these loan terms. If lenders want to keep commissions or bonuses as key components of their compensation plans, they will need to carefully choose the payment trigger — loan volume, payment per loan, total credit extended or loan origination volume — for the loan originators. Double triggers that relate to volume and qualitative factors (e.g., quality of loan documentation or long-term loan performance) in addition to quantitative performance measures can be a way to reward employees without rewarding high-risk practices.
Compensation plans should document the bonus and/or pay structure for each loan originator in order to help avoid discretionary arrangements, which could be deemed problematic by regulators. The compensation plans should also address clawbacks in the event that performance metrics are later restated. In addition, lenders should track all employees who accept applications (such as branch managers or heads of residential mortgage) to make sure that their compensation plans adhere to the new regulatory guidance. Senior management, the board and internal auditors must all take active roles in making sure mortgage originator compensation plans have the building blocks of compliance in place.
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Content in this publication is not intended to answer specific questions or suggest suitability of action in a particular case. For additional information on the issues discussed, consult a Grant Thornton client service partner.