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| ## Comptroller of the Currency                                        |
|                                                                       |
| > Administrator of National Banks                                     |
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Washington, DC 20219

**Interpretive Letter #1015**

**February 2005**

September 20, 2004

Subject: [Indiana Law on Balloon Payment Consumer Loans]{.underline}

Dear **\[ \]**:

This letter responds to your request for an opinion on whether **\[ *NB*
\]** and its operating subsidiaries, **\[ \]** ( ***Opsub1*** ) and **\[
\]** ( ***Opsub2*** )[^1] are subject to section 24-4.5-3-402 of the
Indiana Code (section 3-402) when originating subordinate lien
mortgages.[^2] Section 3-402 places restrictions on the terms of balloon
payment loans. For the reasons explained in this letter, we conclude
that these restrictions do not apply to **\[ *Bank&Subs* \]**.

*Background*

**\[ *NB* \]** has its main office in **\[ *City* \]**, Indiana. **\[
*OpSub1* \]** and **\[ *OpSub2* \]** are wholly owned operating
subsidiaries of the bank. All three companies originate subordinate lien
residential mortgage loans nationwide. In accordance with the national
bank usury statute and OCC regulations,[^3] **\[ *Bank&Subs* \]**
charges interest on its subordinate lien residential mortgage loans at
the rate permitted by Indiana law.

Section 3-402 provides that a debtor has the right to refinance, without
penalty, the amount of a balloon payment on a consumer loan at the time
the payment is due.[^4] If the debtor elects to refinance, the bank must
offer terms that are no less favorable than the terms in the original
loan. Section 3-402 provides as follows:

> \(1\) With respect to a consumer loan, other than one pursuant to a
> revolving loan account or one on which only loan finance charges are
> payable prior to the time that the final scheduled payment is due, if
> any scheduled payment is more than twice as large as the average of
> earlier scheduled payments, the debtor has the right to refinance the
> amount of that payment at the time it is due without penalty. The
> terms of the refinancing shall be no less favorable to the debtor than
> the terms of the original loan. This section does not apply to the
> extent that the payment schedule is adjusted to the seasonal or
> irregular income of the debtor.
>
> \(2\) For the purposes of this section, \"terms of the refinancing\"
> means:\
> (a) In the case of a fixed-rate consumer loan, the individual payment
> amounts, the charges as a result of default by the debtor, and the
> rate of the loan finance charge; and\
> (b) In the case of a variable rate consumer loan, the method used to
> determine the individual payment amounts, the charges as a result of
> default by the debtor, the method used to determine the rate of the
> loan finance charge, the circumstances under which the rate of the
> loan finance charge may increase, and any limitations on the increase
> in the rate of the loan finance charge.

The effect of these provisions is to require the lender to refinance
consumer loans, including home equity loans, that have a balloon payment
feature and to restrict the permissible terms of the refinancing to
those \"no less favorable to the debtor\" than the terms of the original
loan. To answer your question whether these restrictions apply to
**\[*Bank&Subs*\]**, we first review national banks\' authority to
engage in real estate lending, then discuss our regulation and
precedents concerning the applicability of state law restrictions on the
terms under which a national bank makes balloon loans.

*Discussion*

Federal law authorizes national banks to engage in real estate lending
activities and vests in the OCC comprehensive authority to regulate and
supervise those activities:

Any national banking association may make, arrange, purchase or sell
loans or extensions of credit secured by liens on interests in real
estate, subject to section 1828(o) of this title and such restrictions
and requirements as the Comptroller of the Currency may prescribe by
regulation or order.[^5]

The authority granted by section 371 to make loans \"secured by liens on
interests in real estate\" includes the authority to make subordinate
lien residential mortgage loans, such as home equity loans, on such
terms as are permissible under Federal law and regulations.

Part 34 of the OCC\'s regulations implements section 371. Part 34
authorizes national banks and their operating subsidiaries to engage in
real estate lending activities.[^6] In addition, Part 34 contains
provisions listing certain types of state laws that do not apply to a
national bank\'s conduct of such activities. In particular, section
34.4(a)(4) of the regulation provides that a national bank may make real
estate loans under 12 U.S.C. § 371 and § 34.3 of our rules without
regard to state law limitations concerning:

The terms of credit, including schedule for repayment of principal and
interest, amortization of loans, balance, payments due, minimum
payments, or term to maturity of the loan, including the circumstances
under which a loan may be called due and payable upon the passage of
time or a specified event external to the loan.[^7]

The provisions of section 3-402 fall within the scope of § 34.4(a)(4) in
that both provisions impose limitations on the terms of credit extended
by a national bank. First, the provision entitling a borrower to
refinance a loan with a balloon repayment feature in effect operates to
add a term to the original loan, that is, a guarantee to the borrower
that the original loan will be refinanced without penalty. It precludes
the lender from offering a loan that does not, in effect, include an
option to the borrower to refinance. Thus, the schedule for repayment of
principal and interest is modified and the effective maturity of the
loan is extended, at the option of the borrower, by operation of the
Indiana law. Second, the requirement that the \"terms\" of the
refinancing be \"no less favorable\" to the borrower than those of the
original loan in so many words precludes the lender from extending the
new credit on terms that reflect, for example, deterioration in credit
quality on account of changes in the borrower\'s ability to repay.
Accordingly, section 3-402 of the Indiana law is preempted.

Section 34.4(a)(4) was adopted in its current form on January 13, 2004.
It took effect on February 12, 2004. Your request was submitted during
the pendency of that rulemaking and was therefore based on the OCC\'s
rules in effect at that time and supported by prior opinion letters
issued by the OCC. While our conclusion that section 3-402 is preempted
is based on current § 34.3(a)(4), we note that the conclusion would have
been the same under our prior rules and precedents.

Before we adopted current § 34.4(a)(4), the OCC had a similar
regulation, providing that a national bank was authorized to make real
estate loans without regard to state law limitations concerning, among
other things, \"the schedule for the repayment of principal and
interest,\" or \"the term to maturity of the loan.\"[^8] These phrases
are identical to phrases that appear in current § 34.4(a)(4). We have
previously construed them to preempt state law restrictions on balloon
loans.

In 1983, we considered a Massachusetts law prohibiting mortgage loans
containing a balloon payment or demand feature, except when such feature
was at the option of the borrower.[^9] We concluded that the
Massachusetts restrictions constituted a limitation on the schedule for
repayment of the principal and interest of the loans and, therefore,
were preempted expressly by part 34. For the same reasons, we deemed
preempted the balloon payment restrictions of Colorado law, which
entitled consumers to refinance balloon payments in consumer loans,[^10]
and Pennsylvania law, which prohibited banks from making residential
loans with demand or balloon payment features.[^11] Most recently, in
the OCC's Determination and Order concerning the Georgia Fair Lending
Act (GFLA),[^12] issued to National City in August 2003, we considered
Georgia law, which requires that no scheduled payment on a high-cost
loan be more than twice as much as the average of earlier scheduled
payments, thus precluding the inclusion of a balloon repayment term for
certain types of loans. In the Determination and Order, we stated that
these restrictions on balloon lending were preempted as state laws
concerning the repayment of principal and interest because they operated
to limit the "inherent and inseparable elements of any repayment
schedule," which are (1) the timing of the expected payments, and (2)
the amount of the expected payments.[^13]

For all of these reasons, we conclude that the scope of current
§ 34.4(a)(4) covers section 3-402 of the Indiana law. Accordingly, the
provisions of Indiana\'s section 3-402 -- requiring the refinancing of a
balloon loan[^14] and restricting the terms of the refinancing to terms
no less favorable than those in the original loan -- do not apply to
**\[ *Bank&Subs* \]**. [^15]

#### *Comments by the Indiana Department of Financial Institutions (IDFI)*

Your request raises issues of Federal preemption of state law that, as
we have described, are already addressed by § 34.4 of our regulations,
which was issued pursuant to the notice and comment procedures
prescribed by the Administrative Procedure Act.[^16] These issues also
are essentially identical to issues on which the OCC has previously
issued opinion letters. Accordingly, the publication requirements of the
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 do
not apply.[^17]

However, we provided the State of Indiana with a copy of your letter and
afforded the State an opportunity to respond. The IDFI's views, [^18]
and our responses thereto, are as follows.

The IDFI noted its disagreement with **\[*Bank&Subs*\]**'s proposed
position on preemption of Indiana law on balloon lending. The IDFI
maintains that neither paragraph (2) nor (3) of former § 34.4(a) refers
to the ability of national banks to make balloon loans, and that
"\[b\]anks are free to structure their loans as they see fit,"
notwithstanding section 3-402.[^19] We must disagree, since, as
previously described, section 3-402 effectively adds a term to the
original second mortgage loan guaranteeing the borrower the option to
refinance without charge. Moreover, it precludes the use of certain
terms -- those that are \"less favorable\" to the borrower than the
original loan -- in the refinancing. While a bank arguably could
continue to make balloon loans under section 3-402, section 3-402 limits
the terms on which it can do so. Accordingly, a bank is not free to
structure its loans in ways other than those permissible under the
Indiana statute.

The IDFI takes the position as well that, even if the law is preempted
as to banks, it is not preempted with respect to operating subsidiaries.
The IDFI suggests that, because § 34.4 does not explicitly refer to
operating subsidiaries, the preemption provisions set out therein apply
only to national banks.[^20] However, as we have pointed out, 12 C.F.R.
§ 34.1(b) expressly provides without qualification that \"this part\" --
that is, the whole of Part 34 -- \"applies to national banks and their
operating subsidiaries.\" In addition, § 7.4006 of our regulations says:

> Unless otherwise provided by Federal law or OCC regulation, State laws
> apply to national bank operating subsidiaries to the same extent that
> those laws apply to the parent national bank.

These regulations are based on the longstanding recognition, under
Federal law, of the functional identity of operating subsidiaries and
their parent banks. As a matter of Federal law, operating subsidiaries
conduct only activities permissible for the parent national bank,[^21]
and their activities are subject to the same terms and conditions as
apply to the parent bank.[^22] Operating subsidiaries are consolidated
with -- that is, their assets and liabilities are indistinguishable from
-- the parent bank for accounting purposes, regulatory reporting
purposes, and for purposes of applying many Federal statutory or
regulatory limits.[^23] Courts have treated operating subsidiaries as
equivalent to national banks in determining their powers and status
under Federal law,[^24] except where Federal law requires otherwise.
When established in accordance with OCC regulations and approved by the
OCC, an operating subsidiary is a federally authorized and federally
licensed means by which a national bank may conduct federally authorized
activities. Consistent with these authorities, the provisions of § 34.4
apply to real estate lending conducted by national banks either directly
in the bank or indirectly through an operating subsidiary. For the
reasons set forth in this letter, **\[*Bank&Subs*\]** may originate
subordinate lien mortgages with balloon features without regard to the
restrictions of section 3-402 of the Indiana law.

I trust that this letter responds to your inquiry.

Sincerely,

/s/ Julie L. Williams

Julie L. Williams

First Senior Deputy Comptroller and Chief Counsel

[^1]: These three companies are collectively referred to in this letter
    as \"**\[ *Bank&Subs* \]**.\"

[^2]: *See* Letter from **\[ \]**, to Coreen Arnold, District Counsel
    for the Central District, Office of the Comptroller of the Currency
    (OCC) (September 11, 2003).

[^3]: 12 U.S.C. § 85 (authorizing national banks to charge interest at
    the rate allowed by the laws of the state where it is located); 12
    C.F.R. § 7.4001 (OCC\'s regulation implementing section 85).

[^4]: For purposes of section 3-402, the term \"consumer loan\" includes
    subordinate lien residential mortgage loans. Ind. Code §
    24-4.5-3-104.

[^5]: 12 U.S.C. § 371(a). *See also* 12 U.S.C. § 24(Seventh)
    (authorizing national banks to engage in "all such incidental powers
    as shall be necessary to carry on the business of banking....").

[^6]: *See* 12 C.F.R. § 34.3 (authorizing national banks to engage in
    real estate lending activities); §  34.1(b) (expressly providing
    that Part 34 applies to national banks and their operating
    subsidiaries). *See also id*. at § 7.4006 (providing that state laws
    apply to national bank operating subsidiaries to the same extent as
    they apply to the parent national bank).

[^7]: 69 Fed. Reg. 1904, 1917 (January 13, 2004) *(codified* at 12
    C.F.R. § 34.4(a)(4)).

[^8]: 12 C.F.R. § 34.4(a)(2) and (a)(3) (2003) (provisions in effect
    prior to the amendment of Part 34 in January 2004). In 2003, section
    34.4(a) provided in relevant part as follows:

    > A national bank may make real estate loans under section 371 and
    > 34.3 without regard to State law limitations concerning:
    >
    > \(1\) The amount of a loan in relation to the appraised value of
    > the real estate;
    >
    > \(2\) The schedule for the repayment of principal and interest;
    >
    > \(3\) The term to maturity of the loan;
    >
    > \(4\) The aggregate amount of funds that may be loaned upon the
    > security of real estate; and
    >
    > \(5\) The covenants and restrictions that must be contained in a
    > lease to qualify the leasehold as acceptable security for a real
    > estate loan.

[^9]: Letter from Peter Liebesman, Assistant Director, OCC, to **\[ \]**
    (December 8, 1983); *see also* Letter from Charles F. Byrd,
    Assistant Director, OCC, to **\[ \]** (August 24, 1987) (reaching
    same conclusion with respect to another portion of Massachusetts law
    that obligated a lender making first mortgage loans with balloon
    features to renew or extend a loan on the request of a borrower).

[^10]: Letter from Jonathan L. Levin, Senior Attorney, OCC, to **\[ \]**
    (September 27, 1984) (Levin Letter) (citing 12 C.F.R. § 34.2, which
    subsequently was relocated without substantive change to what is now
    § 34.4).

[^11]: Letter from William B. Glidden, Assistant Director, OCC, to **\[
    \]** (September 30, 1992).

[^12]: 68 Fed. Reg*.* 46264 (August 5, 2003).

[^13]: *Id*. at 46276.

[^14]: We note that the Indiana statute also is inconsistent with the
    standards in Part 34 that are designed to ensure safety and
    soundness and deter predatory lending. For example, part 34 of the
    OCC\'s regulations prohibits a national bank from making a consumer
    loan (which includes second-lien residential mortgage loans) \"based
    predominantly on the bank\'s realization of the foreclosure or
    liquidation value of the borrower\'s collateral, without regard to
    the borrower\'s ability to repay the loan according to its terms.\"
    69 Fed. Reg. at 1917 (*to be codified at* 12 C.F.R. § 34.3(b)). *See
    also* 12 C.F.R. § 34.62(b)(2)(ii) (requiring that real estate
    lending be conducted in accordance with bank lending policies that
    establish \"prudent underwriting standards\"). The Indiana law
    requires that new credit be extended with no new underwriting. Thus,
    the Indiana law precludes the lender from making a credit decision
    on the refinancing of a second-lien mortgage loan based on the
    borrower\'s ability to repay or on other applicable underwriting
    standards and from adjusting the terms of the loan to address
    changes in the borrower\'s ability to repay.

[^15]: **\[ *Bank&Subs* \]** may charge interest at the maximum rate
    allowed by the State of Indiana to any state-chartered or licensed
    lending institution. 12 C.F.R. § 7.4001(b). Given that section 3-402
    is preempted under the provisions of Part 34, the bank is under no
    legal obligation to refinance a balloon loan. Therefore, we do not
    need to reach the question of whether Indiana's restrictions on the
    terms of refinancing that relate to the rate of that refinancing,
    charges as a result of default by the borrower, and, if it is a
    variable rate loan, requirements relating to the changing of the
    rate, are applicable to **\[ *Bank&Subs* \]** under section 85. If
    **\[ *Bank&Subs* \]** voluntarily chooses to refinance a balloon
    payment, the bank could charge the most favored lender rate and not
    be bound by the preempted state law that would have imposed terms no
    less favorable than the prior loan agreement.

[^16]: 5 U.S.C. § 553.

[^17]: *See* 12 U.S.C. § 43.

[^18]: Letter from Charles W. Phillips, Director, Indiana Department of
    Financial Institutions, to Coreen Arnold, Direct Counsel, Central
    District, OCC (November 7, 2003).

[^19]: The IDFI\'s letter was prepared before the OCC adopted § 34.4 in
    its current form. The references in the IDFI\'s letter are thus to
    the provisions of the former rule providing that Federal law
    preempts state law limitations concerning the schedule for the
    repayment of principal and interest and concerning the term to
    maturity of a loan. For the text of former § 34.4, *see supra* note
    8.

[^20]: The IDFI supports its position by referring to the Conference
    Report on the Riegle-Neal Interstate Branching and Bank Efficiency
    Act of 1994 (Riegle-Neal), in which the conferees discussed the
    interest of the states in the activities and operations of banks.
    While we disagree with the IDFI's construction of Riegle-Neal and
    its legislative history (*e.g.,* as the conferees indicated,
    Riegle-Neal did not alter established standards for preemption,
    *see* H.R. Conf. Rep. No. 103-651 at 53 (1994)), we need not reach
    Riegle-Neal, given that the it concerns application of state laws to
    interstate branches. In the case at hand, Indiana is the home state
    of **\[*Bank&Subs*\]** .

[^21]: 12 C.F.R. § 5.34(e)(1). The rule specifies the licensing process
    through which national banks seek OCC permission to conduct business
    by means of an operating subsidiary. 12 C.F.R. § 5.34(b).

[^22]: In conducting permissible activities on behalf of its parent
    bank, the operating subsidiary is acting "pursuant to the same
    authorization, terms and conditions that apply to the conduct of
    such activities by its parent national bank." 12 C.F.R.
    § 5.34(e)(3). This text echoes a Congressional characterization in
    recent legislation, where Congress made reference to national bank
    operating subsidiaries as engaged "solely in activities that
    national banks are permitted to engage in directly and are conducted
    subject to the same terms and conditions that govern the conduct of
    such activities by national banks." Section 121 of the
    Gramm-Leach-Bliley Act (GLBA), Pub. L. 106-102, section 121, 113
    Stat. 1338, 1373 (1999), *codified at* 12 U.S.C. 24a(g)(3)(A). *See
    Wachovia Bank v. Burke*, 319 F. Supp.2d 275, 280 (D. Conn. 2004)
    (ability of national bank to conduct activities through operating
    subsidiary implicitly recognized by Congress); *see also Wachovia
    Bank v. Watters,* 2004 WL 1948655, at \*5 (W.D. Mich. Aug. 30, 2004)

    (upholding OCC rule providing that state laws apply to operating
    subsidiaries to the same extent that those laws apply to the parent
    national bank in context of assertion of visitorial powers by the
    State of Michigan); *Wells Fargo Bank v. Boutris,* 265 F. Supp. 2d
    1162, 1167-1170 (E.D. Cal. 2003) (same in case concerning assertion
    of visitorial powers by the State of California); *National City
    Bank of Indiana v. Boutris,* 2003 WL 21536818 at \*3 (E.D. Cal. July
    2, 2003) (same).

[^23]: *See, e.g.,* 12 C.F.R. § 5.34(e)(4) (requiring application of,
    *e.g.,* statutory lending limit and limit on investment in bank
    premises to a national bank and its operating subsidiaries on a
    consolidated basis); 12 U.S.C. §371c(b)(2)(A); 12 C.F.R. § 223.3(w)
    (exclusion of operating subsidiaries from restrictions on
    transactions with affiliate).

[^24]: *NationsBank of North Carolina, N.A. v. Variable Annuity Life
    Ins. Co.,* 513 U.S. 251 (1995) (sale of annuities by operating
    subsidiary); *Clarke v. Securities Industry Ass'n*, 479 U.S. 388
    (1987) (securities brokerage operating subsidiary); *American Ins.
    Ass'n v. Clarke*, 865 F.2d 278 (D.C. Cir. 1988) (bond insurance
    subsidiary); *M & M Leasing Corp. v. Seattle First Nat\'l Bank,* 563
    F.2d 1377 (9^th^ Cir. 1977), *cert. denied,* 436 U.S. 956
    (1978)(auto leasing subsidiary); and *Valley Nat\'l Bank v.
    Lavecchia*, 59 F. Supp. 2d 432 (D. N.J. 1999) (title insurance
    subsidiary); *Budnik v. Bank of America Mortgage,* 2003 U.S. Dist.
    LEXIS 22542 (N.D. IL 2003) (mortgage subsidiary).