Consumer Compliance Outlook: Second Issue 2018

Escrow Accounting Rules: Are You in Compliance?

By Richele S. Brady, Former Examiner, Federal Reserve Bank of San Francisco

This article was first published in 2009,¹ when we reviewed common compliance issues related to escrow accounting requirements under Regulation X and discussed practices that institutions could consider to help prevent escrow accounting violations.

Since the article was first published, the Federal Reserve continues to observe escrow accounting issues during compliance examinations, including violations resulting from the use of third-party software to perform escrow calculations, which was not previously discussed. Accordingly, we are refreshing the article to review common escrow violations, discuss ways to mitigate risks when relying on third-party software, and provide an overview of a 2013 amendment to Regulation X that added an escrow accounting requirement for force-placed insurance for residential mortgages.

ESCROW COMPLIANCE ISSUES

Federal Reserve System examination data for state member banks indicate that several of Regulation X's escrow requirements appear among common violations, including the following:

Understanding escrow accounting methods;
Preparing escrow disclosure statements;
Determining escrow deposit amounts;
Ensuring that annual analyses result in correct account balances; and
Complying issues resulting from using vendors.

We discuss these issues below.

Escrow Accounting Methods

When establishing and maintaining escrow accounts, financial institutions must do the following:²

Conduct an escrow account analysis, before establishing an escrow account, to determine the amount the borrower must deposit into the escrow account at inception and the amount of the borrower's periodic payments into the escrow account;³
Prepare and deliver an initial escrow account statement to the borrower;⁴
Conduct an escrow account analysis at the completion of each escrow account computation year to determine the borrower's monthly escrow account payments for the next computation year;⁵
Use the initial and annual escrow account analyses to determine whether a surplus, shortage, or deficiency exists and adjust the account;⁶ and
Prepare and submit an annual escrow account statement to the borrower.⁷

These escrow tasks must be conducted in accordance with the accounting rules set forth in Section 17 of Regulation X (12 C.F.R. §1024.17). In addition, the regulation limits the amounts that may be held in escrow accounts as well as specific requirements for the contents of the initial and annual statements. Of particular note is the requirement in §1024.17(c)(4) that lenders conduct an aggregate analysis rather than a single-item analysis when performing the account analysis. A single-item analysis accounts for each escrow item separately, while an aggregate analysis considers the account as a whole to compute the sufficiency of escrow account funds. The latter rule has engendered confusion resulting in incorrect amounts being held in escrow accounts.

Initial Escrow Account Analysis and Disclosure

The initial escrow account analysis and disclosure statement set the foundation for the escrow account. Therefore, it is important to consider the following when establishing the account:

Initial Escrow Account Analysis. Compliance with aggregate accounting rules is necessary to accurately calculate the required escrow amounts. Errors can result from a combination of over reliance on automated systems to perform the required calculations and staff not sufficiently versed in the rules. Examples of specific causes include:
Initial Escrow Deposits. The regulation requires the servicer to conduct an escrow account analysis before establishing an escrow account.⁸ Overcharges in the collection of initial escrow deposits often occur because of errors in this initial analysis. The servicer may charge the borrower an amount sufficient to pay charges for the property securing the loan, such as taxes and insurance, which are attributable to the period from the date such payment(s) were last paid until the initial payment date, with the goal of a zero balance projected for the end of the escrow account computation year. However, the servicer may not charge the borrower a cushion that is greater than one-sixth of the estimated total of annual payments from the escrow account.

Other calculation or system entry errors can result in errors in the escrow deposit amounts. Some examples include:

Using incorrect cushion amounts in excess of the regulatory limitations;
Collecting excess funds when a property tax installment is paid at settlement;
Including mortgage insurance (MI) premiums in cushion amounts when MI premiums are paid monthly;
Using incorrect disbursement dates in projecting activity, such as using the due date rather than the anticipated disbursement dates;
Failing to itemize separate escrow account items; and
Rounding adjustments to an even dollar amount.

Annual Escrow Account Analysis and Statement

Just as errors in the initial escrow analysis often cause errors in the initial escrow deposit, errors in the annual account analysis can also lead to incorrect calculations, which often result in incorrect surplus, shortage, or deficiency amounts. Some typical causes include:

Using incorrect disbursement dates in projecting activity for the next year (e.g., changing the dates of projected disbursements can result in account balance projections that are incorrect);
Projecting surpluses, shortages, or deficiencies based on incorrect account balances;
Analyzing an escrow account based on a computation period of more than 12 months;
Ensuring a thorough review of insurance and/or tax bills is conducted for accurate projection of the disbursement amounts for the upcoming year;
Maintaining incorrect cushion amounts in excess of regulatory requirements or lower limitations placed in mortgage loan documents; and
Failing to refund borrower(s) surplus amounts in excess of $50, where required by §1024.17(f)(2)(i). This does not apply if a payment is not received with 30 days of its due date.⁹

Similarly, incorrect annual escrow statements generally result from missing information, such as not including all the required elements, or from errors in the annual analysis. Examples of information that is often missing or incorrect on the annual statement include:

The reason the projected low balance (i.e., cushion) was not reached;
The total amounts paid into and out of the escrow account in the previous year; and
One or more estimated payments or disbursements missing from the account analysis.

Contents of Annual Escrow Account Statement

Servicers are generally required¹⁰ to provide an annual escrow account statement that includes an account history, reflecting the activity in the escrow account during the escrow account computation year, and a projection of the activity in the account for the next year.¹¹

The account history can be incomplete because of a change in servicers during the life of the loan. When servicing changes occur, it is important for the new servicer to ensure it receives the account history from the prior servicer.

Risks of Using Third-Party Software to Perform Escrow Calculations

Some financial institutions rely on third-party software to perform escrow calculations and create required disclosures. Software vendors, as with any other vendor, must be properly managed to mitigate the risk of violations. In a previous article, Outlook discussed this issue:

“Many banks use vendor software to generate consumer disclosures for various loan and deposit products. After amendments to disclosure regulations in the last several years, some vendors failed to update their software, resulting in various errors on disclosure forms. Problems of this nature occur when bank management relies solely on the vendor without conducting its own independent review of disclosure requirements to ensure that the required changes are implemented.”¹²

In addition, financial institutions can periodically verify that the vendor's software is correctly performing escrow calculations as a control.

Additional Escrow Requirements for Borrowers with Hazard Insurance: §1024.17(k)(5)

In a 2013 rulemaking implementing the Dodd–Frank Wall Street Reform and Consumer Protection Act,¹³ the Consumer Financial Protection Bureau (BCFP) added a force-placed insurance provision applying to borrowers with escrow accounts for payment of hazard insurance.¹⁴ When a borrower is more than 30 days overdue on his or her mortgage payment, the regulation generally prohibits a loan servicer from purchasing force-placed insurance. Instead, unless the servicer is a “small servicer” and meets certain conditions or is “unable to disburse funds” (both of which are discussed next), the servicer must pay the premium for the existing policy from the borrower's escrow account, even if the escrow account has insufficient funds to cover the premium.¹⁵ If a servicer advances funds under this provision, it may seek repayment from the borrower.¹⁶

Prior to this amendment, servicers could allow a hazard policy to lapse when borrowers were more than 30 days delinquent on their mortgage and replace it with a force- placed insurance policy, which is often more expensive.¹⁷ In the preamble to the final rule, the BCFP explained its concern about this practice:

Force-placed insurance generally provides substantially less coverage for a borrower's property at a substantially higher premium cost than a borrower-obtained hazard insurance policy, as discussed below in connection with §1024.37. … When a servicer is receiving bills for the borrower's hazard insurance in connection with administration of an escrow account, a servicer who elects not to advance to a delinquent borrower's escrow account to maintain the borrower's hazard insurance, allowing that insurance to lapse, and then advances a far greater amount to a borrower's escrow account to obtain a force-placed insurance policy unreasonably harms a borrower. Section 1024.17(k)(5) … protect[s] borrowers from the unwarranted force-placement of insurance when a servicer does not have a reasonable basis to impose the charge on a borrower.

— 78 Fed. Reg. at 10712

“Unable to Disburse Funds”

The prohibition in Section 1024.17(k)(5) against purchasing force-placed insurance does not apply when a servicer is “unable to disburse funds.”

This occurs when a servicer has a reasonable basis to believe that: 1) the borrower's insurance is being cancelled (or not renewed) for reasons other than nonpayment; or 2) the property is vacant. The BCFP included the carve-out for vacant properties because many hazard insurance policies do not cover losses on vacant properties.

The commentary to the rule provides examples of situations in which a servicer has a reasonable basis to believe that a borrower's insurance is being cancelled for reasons other than nonpayment: (1) when a borrower notifies a servicer that the borrower has cancelled the hazard insurance coverage and the servicer has not received notification of other hazard insurance coverage, (2) when a servicer receives a notification of cancellation or nonrenewal from the borrower's insurance company before payment is due on the borrower's hazard insurance, or (3) when a servicer does not receive a payment notice by the expiration date of the borrower's hazard insurance policy.¹⁸ When any of these conditions are present, a servicer would be able to purchase force-placed insurance under §1024.17(k)(5).

Small Servicer Exception

A limited exception applies to “small servicers,” as defined in 12 C.F.R. §1026.41(e)(4)(ii). Small servicers may obtain force-placed insurance, even if the small servicer is able to disburse funds from a borrower's escrow account, provided the cost to the borrower is less than the amount the small servicer would need to disburse to maintain the borrower's existing hazard insurance policy.

Managing Escrow Risks

Institutions offering escrow accounts can manage risks by reviewing escrow accounting systems and disclosures to ensure compliance with the requirements of 12 C.F.R. §1024.17. Analyzing the escrow accounting issues discussed in this article and their causes as you begin this process will help ensure that you do not make the same mistakes. Lenders holding or servicing loans with escrow accounts may also want to consider the following practices to help manage risks:

Understand the differences between single-item and aggregate analyses. This distinction is a key factor in complying with the escrow accounting requirements.
Conduct regular staff training on escrow requirements and include training on the proper usage of the software platform used to generate escrow account disclosures.
Perform periodic system testing to ensure systems are accurately performing escrow account analyses.
Review mortgage loan documents for wording regarding cushion limits and ensure that systems comply with either the regulatory or the contractual cushion limitations, whichever are lower.
Develop policies and procedures for escrow account requirements.
Conduct periodic compliance reviews and audits that include escrow accounting as well as escrow account statements.
Periodically verifying that vendor's calculations are correct and that the vendor is implementing regulatory changes to escrow requirements.
Similarly, following up after a system refresh or software upgrade to ensure parameters were not inadvertently changed resulting in a previously nonexistent issue.

CONCLUSION

The potential impact on consumers and the associated risks to lenders make compliance with the requirements for initial and annual escrow account statements particularly important. While this article provides some practical information to help institutions manage risks, it does not exhaustively address all escrow-related rules, nor all of the complexities of the escrow accounting rules. Specific issues and questions should be raised with the consumer compliance contact at your Reserve Bank or with your primary regulator.

Endnote

1 Richele Brady, “Escrow Accounting Rules: Are You in Compliance?” (Consumer Compliance Outlook, Second Quarter2009)

2 The escrow requirements appear in 12 C.F.R. §1024.17

3 12 C.F.R. §1024.17(c)(2)

4 12 C.F.R. §1024.17(c)(2)

5 12 C.F.R. §1024.17(c)(3)

6 12 C.F.R. §1024.17(c)(3)

7 12 C.F.R. §1024.17(1)

8 12 C.F.R. §1024.17(c)(2)

9 12 C.F.R. §1024.17(f)(1)(ii)

¹⁰ 12 C.F.R. §1024.17(i)(l)

¹¹ The escrow statement requirement does not apply if the loan is in default or foreclosure or the borrower has filed bankruptcy. 12 C.F.R. §1024.17(i)(2)

¹² Cathryn Judd and Mark Jennings, “Vendor Risk Management— Compliance Considerations,” Consumer Compliance Outlook, Fourth Quarter 2012.

¹³ 78 Fed. Reg. 10696 (February 14, 2013)

¹⁴ 78 Fed. Reg. at 10714

¹⁵ 12 C.F.R. §1024.17(k)(5)(ii)(B))

¹⁶ 12 C.F.R. §1024.17(k)(5)(ii)(C)

¹⁷ 78 Fed. Reg. at 10712 (“Force-placed insurance generally provides substantially less coverage for a borrower’s property at a substantially higher premium cost than a borrower-obtained hazard insurance policy …”)

¹⁸ Comment 17(k)(5)(ii)(A)-1