[Federal Register Volume 71, Number 192 (Wednesday, October 4, 2006)]
[Notices]
[Pages 58609-58618]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 06-8480]
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DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
[Docket No. 06-11]
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
[Docket No. OP-1246]
FEDERAL DEPOSIT INSURANCE CORPORATION
DEPARTMENT OF THE TREASURY
Office of Thrift Supervision
[No. 2006-35]
NATIONAL CREDIT UNION ADMINISTRATION
Interagency Guidance on Nontraditional Mortgage Product Risks
AGENCIES: Office of the Comptroller of the Currency, Treasury (OCC);
Board of Governors of the Federal Reserve System (Board); Federal
Deposit Insurance Corporation (FDIC); Office of Thrift Supervision,
Treasury (OTS); and National Credit Union Administration (NCUA).
ACTION: Final guidance.
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SUMMARY: The OCC, Board, FDIC, OTS, and NCUA (the Agencies), are
issuing final Interagency Guidance on Nontraditional Mortgage Product
Risks (guidance). This guidance has been developed to clarify how
institutions can offer nontraditional mortgage products in a safe and
sound manner, and in a way that clearly discloses the risks that
borrowers may assume.
FOR FURTHER INFORMATION CONTACT: OCC: Gregory Nagel, Credit Risk
Specialist, Credit and Market Risk, (202) 874-5170; or Michael S.
Bylsma, Director, or Stephen Van Meter, Assistant Director, Community
and Consumer Law Division, (202) 874-5750.
Board: Brian Valenti, Supervisory Financial Analyst, (202) 452-
3575; or Virginia Gibbs, Senior Supervisory Financial Analyst, (202)
452-2521; or Sabeth I. Siddique, Assistant Director, (202) 452-3861,
Division of Banking Supervision and Regulation; Kathleen C. Ryan,
Counsel, Division of Consumer and Community Affairs, (202) 452-3667; or
Andrew Miller, Counsel, Legal Division, (202) 452-3428. For users of
Telecommunications Device for the Deaf (``TDD'') only, contact (202)
263-4869.
FDIC: Suzy S. Gardner, Examination Specialist, (202) 898-3640, or
April Breslaw, Chief, Compliance Section, (202) 898-6609, Division of
Supervision and Consumer Protection; or Ruth R. Amberg, Senior Counsel,
(202) 898-3736, or Richard Foley, Counsel, (202) 898-3784, Legal
Division.
OTS: William Magrini, Senior Project Manager, Examinations and
Supervision Policy, (202) 906-5744; or Fred Phillips-Patrick, Director,
Credit Policy, (202) 906-7295; or Glenn Gimble, Senior Project Manager,
Compliance and Consumer Protection, (202) 906-7158.
NCUA: Cory Phariss, Program Officer, Examination and Insurance,
(703) 518-6618.
SUPPLEMENTARY INFORMATION:
I. Background
The Agencies developed this guidance to address risks associated
with the growing use of mortgage products that allow borrowers to defer
payment of principal and, sometimes, interest. These products, referred
to variously as ``nontraditional'', ``alternative'', or ``exotic''
mortgage loans (hereinafter referred to as nontraditional mortgage
loans), include ``interest-only'' mortgages and ``payment option''
adjustable-rate mortgages. These products allow borrowers to exchange
lower payments during an initial period for higher payments during a
later amortization period.
While similar products have been available for many years, the
number of institutions offering them has expanded rapidly. At the same
time, these products are offered to a wider spectrum of borrowers who
may not otherwise qualify for more traditional mortgages. The Agencies
are concerned that some borrowers may not fully understand the risks of
these products. While many of these risks exist in other adjustable-
rate mortgage products, the Agencies concern is elevated with
nontraditional products because of the lack of principal amortization
and potential for negative amortization. In addition, institutions are
increasingly combining these loans with other features that may
compound risk. These features include simultaneous second-lien
mortgages and the use of reduced documentation in evaluating an
applicant's creditworthiness.
In response to these concerns, the Agencies published for comment
proposed Interagency Guidance on Nontraditional Mortgage Products, 70
FR 77249 (Dec. 29, 2005). The Agencies proposed guidance in three
primary areas: ``Loan Terms and Underwriting Standards'', ``Portfolio
and Risk Management Practices'', and ``Consumer Protection Issues''. In
the first section, the Agencies sought to ensure that loan terms and
underwriting standards for
[[Page 58610]]
nontraditional mortgage loans are consistent with prudent lending
practices, including credible consideration of a borrower's repayment
capacity. The portfolio and risk management practices section outlined
the need for strong risk management standards, capital levels
commensurate with the risk, and an allowance for loan and lease losses
(ALLL) that reflects the collectibility of the portfolio. Finally, the
consumer protection issues section recommended practices to ensure
consumers have clear and balanced information prior to making a product
choice. Additionally, this section described control systems to ensure
that actual practices are consistent with policies and procedures.
The Agencies together received approximately 100 letters in
response to the proposal.\1\ Comments were received from financial
institutions, trade associations, consumer and community organizations,
state financial regulatory organizations, and other members of the
public.
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\1\ Nine of these letters requested a thirty-day extension of
the comment period, which the Agencies granted.
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II. Overview of Public Comments
The Agencies received a full range of comments. Some commenters
applauded the Agencies' initiative in proposing the guidance, while
others questioned whether guidance is needed.
A majority of the depository institutions and industry groups that
commented stated that the guidance is too prescriptive. They suggested
institutions should have more flexibility in determining appropriate
risk management practices. A number observed that nontraditional
mortgage products have been offered successfully for many years. Others
opined that the guidance would stifle innovation and result in
qualified borrowers not being approved for these loans. Further, many
questioned whether the guidance is an appropriate mechanism for
addressing the Agencies' consumer protection concerns.
A smaller subset of commenters argued that the guidance does not go
far enough in regulating or restricting nontraditional mortgage
products. These commenters included consumer organizations,
individuals, and several community bankers. Several stated these
products contribute to speculation and unsustainable appreciation in
the housing market. They expressed concern that severe problems will
occur if and when there is a downturn in the economy. Some also argued
that these products are harmful to borrowers and that borrowers may not
understand the associated risks.
Many commenters voiced concern that the guidance will not apply to
all lenders, and thus federally regulated financial institutions will
be at a competitive disadvantage. The Agencies note that both State
financial regulatory organizations that commented on the proposed
guidance--the Conference of State Bank Supervisors (CSBS) and the State
Financial Regulators Roundtable (SFRR)--committed to working with State
regulatory agencies to distribute guidance that is similar in nature
and scope to the financial service providers under their
jurisdictions.\2\ These commenters noted their interest in addressing
the potential for inconsistent regulatory treatment of lenders based on
whether or not they are supervised solely by state agencies.
Subsequently, the CSBS, along with a national organization representing
state residential mortgage regulators, issued a press release
confirming their intent to offer guidance to State regulators to apply
to their licensed residential mortgage brokers and lenders.\3\
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\2\ Letter to J. Johnson, Board Secretary, et al. from N.
Milner, President & CEO, Conference of State Bank Supervisors (Feb.
14, 2006); Letter to J. Johnson, Board Secretary, et al., from B.
Kent, Chair, State Financial Regulators Roundtable.
\3\ Media Release, CSBS & American Association of Residential
Mortgage Regulators, ``CSBS and AARMR Consider Guidance on
Nontraditional Mortgage Products for State-Licensed Entities'' (June
7, 2006), available at http://www.csbs.org/Content/NavigationMenu/PublicRelations/PressReleases/News_Releases.htm. The press release
stated:
The guidance being developed by CSBS and AARMR is based upon
proposed guidance issued in December 2005 by the Office of the
Comptroller of the Currency, the Board of Governors of the Federal
Reserve System, the Federal Deposit Insurance Corporation, the
Office of Thrift Supervision, and the National Credit Union
Administration.
The Federal guidance, when finalized, will only apply to insured
financial institutions and their affiliates. CSBS and AARMR intend
to develop a modified version of the guidance which will primarily
focus on residential mortgage underwriting and consumer protection.
The guidance will be offered to State regulators to apply to their
licensed residential mortgage brokers and lenders.
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III. Final Joint Guidance
The Agencies made a number of changes to the proposal to respond to
commenters' concerns and to provide additional clarity. Significant
comments on the specific provisions of the proposed guidance, the
Agencies'' responses, and changes to the proposed guidance are
discussed as follows.
Scope of the Guidance
Many financial institution and trade group commenters raised
concerns that the proposed guidance did not adequately define
``nontraditional mortgage products''. They requested clarification of
which products would be subject to enhanced scrutiny. Some suggested
that the guidance focus on products that allow negative amortization,
rather than interest-only loans. Others suggested excluding certain
products with nontraditional features, such as reverse mortgages and
home equity lines of credit (HELOCs). Those commenting on interest-only
loans noted that they do not present the same risks as products that
allow for negative amortization. Those that argued that HELOCs should
be excluded noted that they are already covered by interagency guidance
issued in 2005. They also noted that the principal amount of these
loans is generally lower than that for first mortgages. As for reverse
mortgages, the commenters pointed out that they were developed for a
specific market segment and do not present the same concerns as
products mentioned in the guidance.
To address these concerns, the Agencies are clarifying the types of
products covered by the guidance. In general, the guidance applies to
all residential mortgage loan products that allow borrowers to defer
repayment of principal or interest. This includes all interest-only
products and negative amortization mortgages, with the exception of
HELOCs. The Agencies decided not to include HELOCs in this guidance,
other than as discussed in the Simultaneous Second-Lien Loans section,
since they are already covered by the May 2005 Interagency Credit Risk
Management Guidance for Home Equity Lending. The Agencies are amending
the May 2005 guidance, however, to address the consumer disclosure
recommendations included in the nontraditional mortgage guidance.
The Agencies decided against focusing solely on negative
amortization products. Many of the interest-only products pose risks
similar to products that allow negative amortization, especially when
combined with high leverage and reduced documentation. Accordingly,
they present similar concerns from a risk management and consumer
protection standpoint. The Agencies did, however, agree that reverse
mortgages do not present the types of concerns that are addressed in
the guidance and should be excluded.
Loan Terms and Underwriting Standards
Qualifying Borrowers
The Agencies proposed that for all nontraditional mortgage
products, the analysis of borrowers' repayment
[[Page 58611]]
capacity should include an evaluation of their ability to repay the
debt by final maturity at the fully indexed rate, assuming a fully
amortizing repayment schedule. In addition, the proposed guidance
stated that for products that permit negative amortization, the
repayment analysis should include the initial loan amount plus any
balance increase that may accrue from negative amortization. The amount
of the balance increase is tied to the initial terms of the loan and
estimated assuming the borrower makes only the minimum payment.
Generally, banks and industry groups believed that the proposed
underwriting standards were too prescriptive and asked for more
flexibility. Consumer groups generally supported the proposed
underwriting standards, warning that deteriorating underwriting
standards are bad for individual borrowers and poor public policy.
A number of commenters suggested that industry practice is to
underwrite payment option adjustable-rate mortgages at the fully
indexed rate, assuming a fully amortizing payment. Yet several
commenters argued that this standard should not be required when risks
are adequately mitigated. Moreover, many commenters opposed assuming a
fully amortizing payment for interest-only loans with extended
interest-only periods. They argued that the average life span of most
mortgage loans makes it unlikely that many borrowers will experience
the higher payments associated with amortization. Additionally, many
commenters opposed the assumption of minimum payments during the
deferral period for products that permit negative amortization on the
ground that this assumption suggests that lenders assume a worst-case
scenario.
The Agencies believe that institutions should maintain
qualification standards that include a credible analysis of a
borrower's capacity to repay the full amount of credit that may be
extended. That analysis should consider both principal and interest at
the fully indexed rate. Using discounted payments in the qualification
process limits the ability of borrowers to demonstrate sufficient
capacity to repay under the terms of the loan. Therefore, the proposed
general guideline of qualifying borrowers at the fully indexed rate,
assuming a fully amortizing payment, including potential negative
amortization amounts, remains in the final guidance.
Regarding interest-only loans with extended interest-only periods,
the Agencies note that since the average life of a mortgage is a
function of the housing market and interest rates, the average may
fluctuate over time. Additionally, the Agencies were concerned that
excluding these loans from the underwriting standards could cause some
creditors to change their market offerings to avoid application of the
guidance. Accordingly, the final guidance does not exclude interest-
only loans with extended interest-only periods.
Finally, regarding the assumption for the amount that the balance
may increase due to negative amortization, the Agencies have revised
the language to respond to commenters' requests for clarity. The basic
standard, however, remains unchanged. The Agencies expect a borrower to
demonstrate the capacity to repay the full loan amount that may be
advanced.\4\ This includes the initial loan amount plus any balance
increase that may accrue from the negative amortization provision. The
final document contains guidance on determining the amount of any
balance increase that may accrue from the negative amortization
provision, which does not necessarily equate to the full negative
amortization cap for a particular loan.
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\4\ This is similar to the standard in the Agencies' May 2005
Credit Risk Management Guidance for Home Equity Lending recommending
that, for interest-only and variable rate HELOCs, borrowers should
demonstrate the ability to amortize the fully drawn line over the
loan term.
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The Agencies requested comment on whether the guidance should
address consideration of future income or other future events in the
qualification standards. The commenters generally agreed that there is
no reliable method for considering future income or other future events
in the underwriting process. Accordingly, the Agencies have not
modified the guidance to address these issues.
Collateral-Dependent Loans
Commenters that specifically addressed this aspect of the guidance
concurred that it is unsafe and unsound to rely solely on an individual
borrower's ability to sell or refinance once amortization commences.
However, many expressed concern about the possibility that the term
``collateral-dependent'', as it is used in the guidance, would be
interpreted to apply to stated income and other reduced documentation
loans.
To address this concern, the Agencies provided clarifying language
in a footnote to this section. The final guidance provides that a loan
will not be determined to be collateral-dependent solely because it was
underwritten using reduced documentation.
Risk Layering
Financial institution and industry group commenters were generally
critical of the risk layering provisions of the proposed guidance on
the grounds that they were too prescriptive. These commenters argued
that institutions should have flexibility in determining factors that
mitigate additional risks presented by features such as reduced
documentation and simultaneous second-lien loans. A number of
commenters, however, including community and consumer organizations,
financial institutions, and industry associations, suggested that
reduced documentation loans should not be offered to subprime
borrowers. Others questioned whether stated income loans are
appropriate under any circumstances, when used with nontraditional
mortgage products, or when used for wage earners who can readily
provide standard documentation of their wages. Several commenters
argued that simultaneous second-lien loans should be paired with
nontraditional mortgage loans only when borrowers will continue to have
substantial equity in the property.
The Agencies believe that the guidance provides adequate
flexibility in the methods and approaches to mitigating risk, with
respect to risk layering. While the Agencies have not prohibited any of
the practices discussed, the guidance uniformly suggests strong quality
control and risk mitigation factors with respect to these practices.
The Agencies declined to provide guidance recommending reduced
documentation loans be limited to any particular set of circumstances.
The final guidance recognizes that mitigating factors may determine
whether such loans are appropriate but reminds institutions that a
credible analysis of both a borrower's willingness and ability to repay
is consistent with sound and prudent lending practices. The final
guidance also cautions that institutions generally should be able to
readily document income for wage earners through means such as W-2
statements, pay stubs, or tax returns.
Portfolio and Risk Management Practices
Many financial institution and industry group commenters opposed
provisions of the proposed guidance for the setting of concentration
limits. Some commenters advocated active monitoring of concentrations
of diversification strategies as more
[[Page 58612]]
appropriate approaches. The intent of the guidance was not to set hard
concentration limits for nontraditional mortgage products. Instead,
institutions with concentrations in these products should have well-
developed monitoring systems and risk management practices. The
guidance was clarified to reiterate this point.
Additionally, a number of financial institution and industry
association commenters opposed the provisions regarding third-party
originations. They argued that the proposal would force lenders to have
an awareness and control over third-party practices that is neither
realistic nor practical. In particular, many of these commenters argued
that lenders should not be responsible for overseeing the marketing and
borrower disclosure practices of third parties.
Regarding controls over third-party practices, the Agencies
clarified their expectations that institutions should have strong
systems and controls for establishing and maintaining relationships
with third parties. Reliance on third-party relationships can
significantly increase an institution's risk profile. The guidance,
therefore, emphasizes the need for institutions to exercise appropriate
due diligence prior to entering into a third-party relationship and to
provide ongoing, effective oversight and controls. In practice, an
institution's risk management system should reflect the complexity of
its third-party activities and the overall level of risk involved.
A number of commenters urged the Agencies to remove language in the
proposed guidance relating to implicit recourse for loans sold in the
secondary market. They expressed concern that the proposal added new
capital requirements. The Agencies clarified the language in the
guidance addressing this issue. The Agencies do not intend to establish
new capital requirements. Instead, the Agencies' intent is to reiterate
existing guidelines regarding implicit recourse under the Agencies'
risk-based capital rules.
Consumer Protection Issues
Communications With Consumers
Many financial institution and trade group commenters suggested
that the Agencies' consumer protection goals would be better
accomplished through generally applicable regulations, such as
Regulation Z (Truth in Lending) \5\ or Regulation X (Real Estate
Settlement Procedures).\6\ Some commenters stated that the proposed
guidance would add burdensome new disclosure requirements and cause a
confusing overlap with current Regulation Z requirements. They also
expressed concern that the guidance would contribute to an overload of
information currently provided to consumers. Additionally, some argued
that implementing the disclosure provisions might trigger Regulation Z
requirements concerning advertising.\7\ Some commenters also urged the
Agencies to adopt model disclosure forms or other descriptive materials
to assist in compliance with the guidance.
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\5\ 12 CFR part 226 (2006).
\6\ 24 CFR part 3500 (2005).
\7\ See 12 CFR part 226.24(c) (2006).
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Some commenters voiced concern that the Agencies are attempting to
establish a suitability standard similar to that used in the securities
context. These commenters argued that lenders are not in a position to
determine which products are most suitable for borrowers, and that this
decision should be left to borrowers themselves.
Finally, several community and consumer organization commenters
questioned whether additional disclosures are sufficient to protect
borrowers and suggested various additional measures, such as consumer
education and counseling.
The Agencies carefully considered the commenters' argument that
consumer protection issues--particularly, disclosures--would be better
addressed through generally applicable regulations. The Agencies
determined, however, that given the growth in this market, guidelines
are needed now to ensure that consumers will receive the information
they need about the material features of nontraditional mortgages as
soon as possible.
The Agencies also gave careful consideration to the commenters'
concerns that the guidelines will overlap with Regulation Z, add to the
disclosure burden on lenders, and contribute to information overload.
While the Agencies are sensitive to these concerns, we do not believe
they warrant significant changes to the guidance. The guidance focuses
on providing information to consumers during the pre-application
shopping phase and post-closing with any monthly statements lenders
choose to provide to consumers. Moreover, the Agencies do not
anticipate that the information outlined in the guidance will result in
additional lengthy disclosures. Rather, the Agencies contemplate that
the information can be provided in brief narrative format and through
the use of examples based on hypothetical loan transactions.\8\ We
have, however, revised the guidance to make clear that transaction-
specific disclosures are not required. Institutions will still need to
ensure that their marketing materials promoting their products comply
with Regulation Z, as applicable.
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\8\ See elsewhere in today's issue of the Federal Register.
(Proposed Illustrations of Consumer Information for Nontraditional
Mortgage Products).
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As previously discussed, some commenters, including industry trade
associations, asked the Agencies to include model or sample disclosures
or other descriptive materials as part of the guidance to assist
lenders, including smaller institutions, in following the recommended
practices for communications with consumers. The Agencies have
determined not to include required model or sample disclosures in the
guidance. Instead, the guidance provides a set of recommended practices
to assist institutions in addressing particular risks raised by
nontraditional mortgage products.
The Agencies have determined that it is desirable to first seek
public comment on potential model disclosures, and in a Federal
Register notice accompanying this guidance are seeking comment on
proposed illustrations of consumer information for nontraditional
mortgage products that are consistent with the recommendations
contained in the guidance. The Agencies appreciate that some
institutions, including community banks, following the recommendations
set forth in the guidance may prefer not to incur the costs and other
burdens of developing their own consumer information documents. The
Agencies are, therefore, requesting comment on illustrations of the
type of information contemplated by the guidance.
The Agencies disagree with the commenters who expressed concern
that the guidance appears to establish a suitability standard, under
which lenders would be required to assist borrowers in choosing
products that are suitable to their needs and circumstances. It was not
the Agencies' intent to impose such a standard, nor is there any
language in the guidance that does so. In any event, the Agencies have
revised certain statements in the proposed guidance that could have
been interpreted to suggest a requirement to ensure that borrowers
select products appropriate to their circumstances.
Control Systems
Several commenters requested more flexibility in designing
appropriate control systems. The Agencies have
[[Page 58613]]
revised the ``Control Systems'' portion of the guidance to clarify that
we are not requiring any particular means of monitoring adherence to an
institution's policies, such as call monitoring or mystery shopping.
Additional changes have also been made to clarify that the Agencies do
not expect institutions to assume an unwarranted level of
responsibility for the actions of third parties. Rather, the control
systems that are expected for loans purchased from or originated
through third parties are consistent with the Agencies' current
supervisory policies. As previously discussed, the Agencies have also
made changes to the portfolio and risk management practices portion of
the final guidance to clarify their expectations concerning oversight
and monitoring of third-party originations.
IV. Text of Final Joint Guidance
The text of the final Interagency Guidance on Nontraditional
Mortgage Product Risks follows:
Interagency Guidance on Nontraditional Mortgage Product Risks
Residential mortgage lending has traditionally been a
conservatively managed business with low delinquencies and losses and
reasonably stable underwriting standards. In the past few years
consumer demand has been growing, particularly in high priced real
estate markets, for closed-end residential mortgage loan products that
allow borrowers to defer repayment of principal and, sometimes,
interest. These mortgage products, herein referred to as nontraditional
mortgage loans, include such products as ``interest-only'' mortgages
where a borrower pays no loan principal for the first few years of the
loan and ``payment option'' adjustable-rate mortgages (ARMs) where a
borrower has flexible payment options with the potential for negative
amortization.\1\
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\1\ Interest-only and payment option ARMs are variations of
conventional ARMs, hybrid ARMs, and fixed rate products. Refer to
the Appendix for additional information on interest-only and payment
option ARM loans. This guidance does not apply to reverse mortgages;
home equity lines of credit (``HELOCs''), other than as discussed in
the Simultaneous Second-Lien Loans section; or fully amortizing
residential mortgage loan products.
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While some institutions have offered nontraditional mortgages for
many years with appropriate risk management and sound portfolio
performance, the market for these products and the number of
institutions offering them has expanded rapidly. Nontraditional
mortgage loan products are now offered by more lenders to a wider
spectrum of borrowers who may not otherwise qualify for more
traditional mortgage loans and may not fully understand the associated
risks.
Many of these nontraditional mortgage loans are underwritten with
less stringent income and asset verification requirements (``reduced
documentation'') and are increasingly combined with simultaneous
second-lien loans.\2\ Such risk layering, combined with the broader
marketing of nontraditional mortgage loans, exposes financial
institutions to increased risk relative to traditional mortgage loans.
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\2\ Refer to the Appendix for additional information on reduced
documentation and simultaneous second-lien loans.
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Given the potential for heightened risk levels, management should
carefully consider and appropriately mitigate exposures created by
these loans. To manage the risks associated with nontraditional
mortgage loans, management should:
Ensure that loan terms and underwriting standards are
consistent with prudent lending practices, including consideration of a
borrower's repayment capacity;
Recognize that many nontraditional mortgage loans,
particularly when they have risk-layering features, are untested in a
stressed environment. As evidenced by experienced institutions, these
products warrant strong risk management standards, capital levels
commensurate with the risk, and an allowance for loan and lease losses
that reflects the collectibility of the portfolio; and
Ensure that consumers have sufficient information to
clearly understand loan terms and associated risks prior to making a
product choice.
The Office of the Comptroller of the Currency (OCC), the Board of
Governors of the Federal Reserve System (Board), the Federal Deposit
Insurance Corporation (FDIC), the Office of Thrift Supervision (OTS)
and the National Credit Union Administration (NCUA) (collectively, the
Agencies) expect institutions to effectively assess and manage the
risks associated with nontraditional mortgage loan products.\3\
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\3\ Refer to Interagency Guidelines Establishing Standards for
Safety and Soundness. For each Agency, those respective guidelines
are addressed in: 12 CFR part 30 Appendix A (OCC); 12 CFR part 208
Appendix D-1 (Board); 12 CFR part 364 Appendix A (FDIC); 12 CFR part
570 Appendix A (OTS); and 12 U.S.C. 1786 (NCUA).
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Institutions should use this guidance to ensure that risk
management practices adequately address these risks. The Agencies will
carefully scrutinize risk management processes, policies, and
procedures in this area. Institutions that do not adequately manage
these risks will be asked to take remedial action.
The focus of this guidance is on the higher risk elements of
certain nontraditional mortgage products, not the product type itself.
Institutions with sound underwriting, adequate risk management, and
acceptable portfolio performance will not be subject to criticism
merely for offering such products.
Loan Terms and Underwriting Standards
When an institution offers nontraditional mortgage loan products,
underwriting standards should address the effect of a substantial
payment increase on the borrower's capacity to repay when loan
amortization begins. Underwriting standards should also comply with the
agencies' real estate lending standards and appraisal regulations and
associated guidelines.\4\
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\4\ Refer to 12 CFR part 34--Real Estate Lending and Appraisals,
OCC Bulletin 2005-3--Standards for National Banks' Residential
Mortgage Lending, AL 2003-7--Guidelines for Real Estate Lending
Policies and AL 2003-9--Independent Appraisal and Evaluation
Functions (OCC); 12 CFR 208.51 subpart E and Appendix C and 12 CFR
part 225 subpart G (Board); 12 CFR part 365 and Appendix A, and 12
CFR part 323 (FDIC); 12 CFR 560.101 and Appendix and 12 CFR part 564
(OTS). Also, refer to the 1999 Interagency Guidance on the
``Treatment of High LTV Residential Real Estate Loans'' and the 1994
``Interagency Appraisal and Evaluation Guidelines''. Federally
Insured Credit Unions should refer to 12 CFR part 722--Appraisals
and NCUA 03-CU-17--Appraisal and Evaluation Functions for Real
Estate Related Transactions (NCUA).
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Central to prudent lending is the internal discipline to maintain
sound loan terms and underwriting standards despite competitive
pressures. Institutions are strongly cautioned against ceding
underwriting standards to third parties that have different business
objectives, risk tolerances, and core competencies. Loan terms should
be based on a disciplined analysis of potential exposures and
compensating factors to ensure risk levels remain manageable.
Qualifying Borrowers--Payments on nontraditional loans can increase
significantly when the loans begin to amortize. Commonly referred to as
payment shock, this increase is of particular concern for payment
option ARMs where the borrower makes minimum payments that may result
in negative amortization. Some institutions manage the potential for
excessive negative amortization and payment shock by structuring the
initial terms to limit the spread between the introductory interest
rate and the fully indexed rate. Nevertheless, an institution's
qualifying standards should recognize the potential impact of payment
shock, especially for borrowers
[[Page 58614]]
with high loan-to-value (LTV) ratios, high debt-to-income (DTI) ratios,
and low credit scores. Recognizing that an institution's underwriting
criteria are based on multiple factors, an institution should consider
these factors jointly in the qualification process and may develop a
range of reasonable tolerances for each factor. However, the criteria
should be based upon prudent and appropriate underwriting standards,
considering both the borrower's characteristics and the product's
attributes.
For all nontraditional mortgage loan products, an institution's
analysis of a borrower's repayment capacity should include an
evaluation of their ability to repay the debt by final maturity at the
fully indexed rate,\5\ assuming a fully amortizing repayment
schedule.\6\ In addition, for products that permit negative
amortization, the repayment analysis should be based upon the initial
loan amount plus any balance increase that may accrue from the negative
amortization provision.\7\
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\5\ The fully indexed rate equals the index rate prevailing at
origination plus the margin that will apply after the expiration of
an introductory interest rate. The index rate is a published
interest rate to which the interest rate on an ARM is tied. Some
commonly used indices include the 1-Year Constant Maturity Treasury
Rate (CMT), the 6-Month London Interbank Offered Rate (LIBOR), the
11th District Cost of Funds (COFI), and the Moving Treasury Average
(MTA), a 12-month moving average of the monthly average yields of
U.S. Treasury securities adjusted to a constant maturity of one
year. The margin is the number of percentage points a lender adds to
the index value to calculate the ARM interest rate at each
adjustment period. In different interest rate scenarios, the fully
indexed rate for an ARM loan based on a lagging index (e.g., MTA
rate) may be significantly different from the rate on a comparable
30-year fixed-rate product. In these cases, a credible market rate
should be used to qualify the borrower and determine repayment
capacity.
\6\ The fully amortizing payment schedule should be based on the
term of the loan. For example, the amortizing payment for a loan
with a 5-year interest only period and a 30-year term would be
calculated based on a 30-year amortization schedule. For balloon
mortgages that contain a borrower option for an extended
amortization period, the fully amortizing payment schedule can be
based on the full term the borrower may choose.
\7\ The balance that may accrue from the negative amortization
provision does not necessarily equate to the full negative
amortization cap for a particular loan. The spread between the
introductory or ``teaser'' rate and the accrual rate will determine
whether or not a loan balance has the potential to reach the
negative amortization cap before the end of the initial payment
option period (usually five years). For example, a loan with a 115
percent negative amortization cap but a small spread between the
introductory rate and the accrual rate may only reach a 109 percent
maximum loan balance before the end of the initial payment option
period, even if only minimum payments are made. The borrower could
be qualified based on this lower maximum loan balance.
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Furthermore, the analysis of repayment capacity should avoid over-
reliance on credit scores as a substitute for income verification in
the underwriting process. The higher a loan's credit risk, either from
loan features or borrower characteristics, the more important it is to
verify the borrower's income, assets, and outstanding liabilities.
Collateral-Dependent Loans--Institutions should avoid the use of
loan terms and underwriting practices that may heighten the need for a
borrower to rely on the sale or refinancing of the property once
amortization begins. Loans to individuals who do not demonstrate the
capacity to repay, as structured, from sources other than the
collateral pledged are generally considered unsafe and unsound.\8\
Institutions that originate collateral-dependent mortgage loans may be
subject to criticism, corrective action, and higher capital
requirements.
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\8\ A loan will not be determined to be ``collateral-dependent''
solely through the use of reduced documentation.
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Risk Layering--Institutions that originate or purchase mortgage
loans that combine nontraditional features, such as interest only loans
with reduced documentation or a simultaneous second-lien loan, face
increased risk. When features are layered, an institution should
demonstrate that mitigating factors support the underwriting decision
and the borrower's repayment capacity. Mitigating factors could include
higher credit scores, lower LTV and DTI ratios, significant liquid
assets, mortgage insurance or other credit enhancements. While higher
pricing is often used to address elevated risk levels, it does not
replace the need for sound underwriting.
Reduced Documentation--Institutions increasingly rely on reduced
documentation, particularly unverified income, to qualify borrowers for
nontraditional mortgage loans. Because these practices essentially
substitute assumptions and unverified information for analysis of a
borrower's repayment capacity and general creditworthiness, they should
be used with caution. As the level of credit risk increases, the
Agencies expect an institution to more diligently verify and document a
borrower's income and debt reduction capacity. Clear policies should
govern the use of reduced documentation. For example, stated income
should be accepted only if there are mitigating factors that clearly
minimize the need for direct verification of repayment capacity. For
many borrowers, institutions generally should be able to readily
document income using recent W-2 statements, pay stubs, or tax returns.
Simultaneous Second-Lien Loans--Simultaneous second-lien loans
reduce owner equity and increase credit risk. Historically, as combined
loan-to-value ratios rise, so do defaults. A delinquent borrower with
minimal or no equity in a property may have little incentive to work
with a lender to bring the loan current and avoid foreclosure. In
addition, second-lien home equity lines of credit (HELOCs) typically
increase borrower exposure to increasing interest rates and monthly
payment burdens. Loans with minimal or no owner equity generally should
not have a payment structure that allows for delayed or negative
amortization without other significant risk mitigating factors.
Introductory Interest Rates--Many institutions offer introductory
interest rates set well below the fully indexed rate as a marketing
tool for payment option ARM products. When developing nontraditional
mortgage product terms, an institution should consider the spread
between the introductory rate and the fully indexed rate. Since initial
and subsequent monthly payments are based on these low introductory
rates, a wide initial spread means that borrowers are more likely to
experience negative amortization, severe payment shock, and an earlier-
than-scheduled recasting of monthly payments. Institutions should
minimize the likelihood of disruptive early recastings and
extraordinary payment shock when setting introductory rates.
Lending to Subprime Borrowers--Mortgage programs that target
subprime borrowers through tailored marketing, underwriting standards,
and risk selection should follow the applicable interagency guidance on
subprime lending.\9\ Among other things, the subprime guidance
discusses circumstances under which subprime lending can become
predatory or abusive. Institutions designing nontraditional mortgage
loans for subprime borrowers should pay particular attention to this
guidance. They should also recognize that risk-layering features in
loans to subprime borrowers may significantly increase risks for both
the institution and the borrower.
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\9\ Interagency Guidance on Subprime Lending, March 1, 1999, and
Expanded Guidance for Subprime Lending Programs, January 31, 2001.
Federally insured credit unions should refer to 04-CU-12--
Specialized Lending Activities (NCUA).
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Non-Owner-Occupied Investor Loans--Borrowers financing non-owner-
occupied investment properties should qualify for loans based on their
ability to service the debt over the life of the
[[Page 58615]]
loan. Loan terms should reflect an appropriate combined LTV ratio that
considers the potential for negative amortization and maintains
sufficient borrower equity over the life of the loan. Further,
underwriting standards should require evidence that the borrower has
sufficient cash reserves to service the loan, considering the
possibility of extended periods of property vacancy and the variability
of debt service requirements associated with nontraditional mortgage
loan products.\10\
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\10\ Federally insured credit unions must comply with 12 CFR
part 723 for loans meeting the definition of member business loans.
P
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Portfolio and Risk Management Practices
Institutions should ensure that risk management practices keep pace
with the growth and changing risk profile of their nontraditional
mortgage loan portfolios and changes in the market. Active portfolio
management is especially important for institutions that project or
have already experienced significant growth or concentration levels.
Institutions that originate or invest in nontraditional mortgage loans
should adopt more robust risk management practices and manage these
exposures in a thoughtful, systematic manner. To meet these
expectations, institutions should:
Develop written policies that specify acceptable product
attributes, production and portfolio limits, sales and securitization
practices, and risk management expectations;
Design enhanced performance measures and management
reporting that provide early warning for increasing risk;
Establish appropriate ALLL levels that consider the credit
quality of the portfolio and conditions that affect collectibility; and
Maintain capital at levels that reflect portfolio
characteristics and the effect of stressed economic conditions on
collectibility. Institutions should hold capital commensurate with the
risk characteristics of their nontraditional mortgage loan portfolios.
Policies--An institution's policies for nontraditional mortgage
lending activity should set acceptable levels of risk through its
operating practices, accounting procedures, and policy exception
tolerances. Policies should reflect appropriate limits on risk layering
and should include risk management tools for risk mitigation purposes.
Further, an institution should set growth and volume limits by loan
type, with special attention for products and product combinations in
need of heightened attention due to easing terms or rapid growth.
Concentrations--Institutions with concentrations in nontraditional
mortgage products should have well-developed monitoring systems and
risk management practices. Monitoring should keep track of
concentrations in key portfolio segments such as loan types, third-
party originations, geographic area, and property occupancy status.
Concentrations also should be monitored by key portfolio
characteristics such as loans with high combined LTV ratios, loans with
high DTI ratios, loans with the potential for negative amortization,
loans to borrowers with credit scores below established thresholds,
loans with risk-layered features, and non-owner-occupied investor
loans. Further, institutions should consider the effect of employee
incentive programs that could produce higher concentrations of
nontraditional mortgage loans. Concentrations that are not effectively
managed will be subject to elevated supervisory attention and potential
examiner criticism to ensure timely remedial action.
Controls--An institution's quality control, compliance, and audit
procedures should focus on mortgage lending activities posing high
risk. Controls to monitor compliance with underwriting standards and
exceptions to those standards are especially important for
nontraditional loan products. The quality control function should
regularly review a sample of nontraditional mortgage loans from all
origination channels and a representative sample of underwriters to
confirm that policies are being followed. When control systems or
operating practices are found deficient, business-line managers should
be held accountable for correcting deficiencies in a timely manner.
Since many nontraditional mortgage loans permit a borrower to defer
principal and, in some cases, interest payments for extended periods,
institutions should have strong controls over accruals, customer
service and collections. Policy exceptions made by servicing and
collections personnel should be carefully monitored to confirm that
practices such as re-aging, payment deferrals, and loan modifications
are not inadvertently increasing risk. Customer service and collections
personnel should receive product-specific training on the features and
potential customer issues with these products.
Third-Party Originations--Institutions often use third parties,
such as mortgage brokers or correspondents, to originate nontraditional
mortgage loans. Institutions should have strong systems and controls in
place for establishing and maintaining relationships with third
parties, including procedures for performing due diligence. Oversight
of third parties should involve monitoring the quality of originations
so that they reflect the institution's lending standards and compliance
with applicable laws and regulations.
Monitoring procedures should track the quality of loans by both
origination source and key borrower characteristics. This will help
institutions identify problems such as early payment defaults,
incomplete documentation, and fraud. If appraisal, loan documentation,
credit problems or consumer complaints are discovered, the institution
should take immediate action. Remedial action could include more
thorough application reviews, more frequent re-underwriting, or even
termination of the third-party relationship.\11\
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\11\ Refer to OCC Bulletin 2001-47--Third-Party Relationships
and AL 2000-9--Third-Party Risk (OCC). Federally insured credit
unions should refer to 01-CU-20 (NCUA), Due Diligence over Third
Party Service Providers. Savings associations should refer to OTS
Thrift Bulletin 82a--Third Party Arrangements.
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Secondary Market Activity--The sophistication of an institution's
secondary market risk management practices should be commensurate with
the nature and volume of activity. Institutions with significant
secondary market activities should have comprehensive, formal
strategies for managing risks.\12\ Contingency planning should include
how the institution will respond to reduced demand in the secondary
market.
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\12\ Refer to ``Interagency Questions and Answers on Capital
Treatment of Recourse, Direct Credit Substitutes, and Residual
Interests in Asset Securitizations'', May 23, 2002; OCC Bulletin
2002-22 (OCC); SR letter 02-16 (Board); Financial Institution Letter
(FIL-54-2002) (FDIC); and CEO Letter 163 (OTS). See OCC's
Comptroller Handbook for Asset Securitization, November 1997. See
OTS Examination Handbook Section 221, Asset-Backed Securitization.
The Board also addressed risk management and capital adequacy of
exposures arising from secondary market credit activities in SR
letter 97-21. Federally insured credit unions should refer to 12 CFR
Part 702 (NCUA).
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While third-party loan sales can transfer a portion of the credit
risk, an institution remains exposed to reputation risk when credit
losses on sold mortgage loans or securitization transactions exceed
expectations. As a result, an institution may determine that it is
necessary to repurchase defaulted mortgages to protect its reputation
and maintain access to the markets. In the agencies' view, the
repurchase of mortgage loans beyond the selling institution's
contractual obligation is
[[Page 58616]]
implicit recourse. Under the agencies' risk-based capital rules, a
repurchasing institution would be required to maintain risk-based
capital against the entire pool or securitization.\13\ Institutions
should familiarize themselves with these guidelines before deciding to
support mortgage loan pools or buying back loans in default.
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\13\ Refer to 12 CFR part 3 Appendix A, Section 4 (OCC); 12 CFR
parts 208 and 225, Appendix A, III.B.3 (FRB); 12 CFR part 325,
Appendix A, II.B (FDIC); 12 CFR 567 (OTS); and 12 CFR part 702
(NCUA) for each Agency's capital treatment of recourse.
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Management Information and Reporting--Reporting systems should
allow management to detect changes in the risk profile of its
nontraditional mortgage loan portfolio. The structure and content
should allow the isolation of key loan products, risk-layering loan
features, and borrower characteristics. Reporting should also allow
management to recognize deteriorating performance in any of these areas
before it has progressed too far. At a minimum, information should be
available by loan type (e.g., interest-only mortgage loans and payment
option ARMs); by risk-layering features (e.g., payment option ARM with
stated income and interest-only mortgage loans with simultaneous
second-lien mortgages); by underwriting characteristics (e.g., LTV,
DTI, and credit score); and by borrower performance (e.g., payment
patterns, delinquencies, interest accruals, and negative amortization).
Portfolio volume and performance should be tracked against
expectations, internal lending standards and policy limits. Volume and
performance expectations should be established at the subportfolio and
aggregate portfolio levels. Variance analyses should be performed
regularly to identify exceptions to policies and prescribed thresholds.
Qualitative analysis should occur when actual performance deviates from
established policies and thresholds. Variance analysis is critical to
the monitoring of a portfolio's risk characteristics and should be an
integral part of establishing and adjusting risk tolerance levels.
Stress Testing--Based on the size and complexity of their lending
operations, institutions should perform sensitivity analysis on key
portfolio segments to identify and quantify events that may increase
risks in a segment or the entire portfolio. The scope of the analysis
should generally include stress tests on key performance drivers such
as interest rates, employment levels, economic growth, housing value
fluctuations, and other factors beyond the institution's immediate
control. Stress tests typically assume rapid deterioration in one or
more factors and attempt to estimate the potential influence on default
rates and loss severity. Stress testing should aid an institution in
identifying, monitoring and managing risk, as well as developing
appropriate and cost-effective loss mitigation strategies. The stress
testing results should provide direct feedback in determining
underwriting standards, product terms, portfolio concentration limits,
and capital levels.
Capital and Allowance for Loan and Lease Losses--Institutions
should establish an appropriate allowance for loan and lease losses
(ALLL) for the estimated credit losses inherent in their nontraditional
mortgage loan portfolios. They should also consider the higher risk of
loss posed by layered risks when establishing their ALLL.
Moreover, institutions should recognize that their limited
performance history with these products, particularly in a stressed
environment, increases performance uncertainty. Capital levels should
be commensurate with the risk characteristics of the nontraditional
mortgage loan portfolios. Lax underwriting standards or poor portfolio
performance may warrant higher capital levels.
When establishing an appropriate ALLL and considering the adequacy
of capital, institutions should segment their nontraditional mortgage
loan portfolios into pools with similar credit risk characteristics.
The basic segments typically include collateral and loan
characteristics, geographic concentrations, and borrower qualifying
attributes. Segments could also differentiate loans by payment and
portfolio characteristics, such as loans on which borrowers usually
make only minimum payments, mortgages with existing balances above
original balances, and mortgages subject to sizable payment shock. The
objective is to identify credit quality indicators that affect
collectibility for ALLL measurement purposes. In addition,
understanding characteristics that influence expected performance also
provides meaningful information about future loss exposure that would
aid in determining adequate capital levels.
Institutions with material mortgage banking activities and mortgage
servicing assets should apply sound practices in valuing the mortgage
servicing rights for nontraditional mortgages. In accordance with
interagency guidance, the valuation process should follow generally
accepted accounting principles and use reasonable and supportable
assumptions.\14\
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\14\ Refer to the ``Interagency Advisory on Mortgage Banking'',
February 25, 2003, issued by the bank and thrift regulatory
agencies. Federally Insured Credit Unions with assets of $10 million
or more are reminded they must report and value nontraditional
mortgages and related mortgage servicing rights, if any, consistent
with generally accepted accounting principles in the Call Reports
they file with the NCUA Board.
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Consumer Protection Issues
While nontraditional mortgage loans provide flexibility for
consumers, the Agencies are concerned that consumers may enter into
these transactions without fully understanding the product terms.
Nontraditional mortgage products have been advertised and promoted
based on their affordability in the near term; that is, their lower
initial monthly payments compared with traditional types of mortgages.
In addition to apprising consumers of the benefits of nontraditional
mortgage products, institutions should take appropriate steps to alert
consumers to the risks of these products, including the likelihood of
increased future payment obligations. This information should be
provided in a timely manner--before disclosures may be required under
the Truth in Lending Act or other laws--to assist the consumer in the
product selection process.
Concerns and Objectives--More than traditional ARMs, mortgage
products such as payment option ARMs and interest-only mortgages can
carry a significant risk of payment shock and negative amortization
that may not be fully understood by consumers. For example, consumer
payment obligations may increase substantially at the end of an
interest-only period or upon the ``recast'' of a payment option ARM.
The magnitude of these payment increases may be affected by factors
such as the expiration of promotional interest rates, increases in the
interest rate index, and negative amortization. Negative amortization
also results in lower levels of home equity as compared to a
traditional amortizing mortgage product. When borrowers go to sell or
refinance the property, they may find that negative amortization has
substantially reduced or eliminated their equity in it even when the
property has appreciated. The concern that consumers may not fully
understand these products would be exacerbated by marketing and
promotional practices that emphasize potential benefits without also
providing clear and balanced information about material risks.
In light of these considerations, communications with consumers,
[[Page 58617]]
including advertisements, oral statements, promotional materials, and
monthly statements, should provide clear and balanced information about
the relative benefits and risks of these products, including the risk
of payment shock and the risk of negative amortization. Clear,
balanced, and timely communication to consumers of the risks of these
products will provide consumers with useful information at crucial
decision-making points, such as when they are shopping for loans or
deciding which monthly payment amount to make. Such communication
should help minimize potential consumer confusion and complaints,
foster good customer relations, and reduce legal and other risks to the
institution.
Legal Risks--Institutions that offer nontraditional mortgage
products must ensure that they do so in a manner that complies with all
applicable laws and regulations. With respect to the disclosures and
other information provided to consumers, applicable laws and
regulations include the following:
Truth in Lending Act (TILA) and its implementing
regulation, Regulation Z.
Section 5 of the Federal Trade Commission Act (FTC Act).
TILA and Regulation Z contain rules governing disclosures that
institutions must provide for closed-end mortgages in advertisements,
with an application,\15\ before loan consummation, and when interest
rates change. Section 5 of the FTC Act prohibits unfair or deceptive
acts or practices.\16\
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\15\ These program disclosures apply to ARM products and must be
provided at the time an application is provided or before the
consumer pays a nonrefundable fee, whichever is earlier.
\16\ The OCC, the Board, and the FDIC enforce this provision
under the FTC Act and section 8 of the FDI Act. Each of these
agencies has also issued supervisory guidance to the institutions
under their respective jurisdictions concerning unfair or deceptive
acts or practices. See OCC Advisory Letter 2002-3--Guidance on
Unfair or Deceptive Acts or Practices, March 22, 2002; Joint Board
and FDIC Guidance on Unfair or Deceptive Acts or Practices by State-
Chartered Banks, March 11, 2004. Federally insured credit unions are
prohibited from using any advertising or promotional material that
is inaccurate, misleading, or deceptive in any way concerning its
products, services, or financial condition. 12 CFR 740.2. The OTS
also has a regulation that prohibits savings associations from using
advertisements or other representations that are inaccurate or
misrepresent the services or contracts offered. 12 CFR 563.27. This
regulation supplements its authority under the FTC Act.
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Other Federal laws, including the fair lending laws and the Real
Estate Settlement Procedures Act (RESPA), also apply to these
transactions. Moreover, the Agencies note that the sale or
securitization of a loan may not affect an institution's potential
liability for violations of TILA, RESPA, the FTC Act, or other laws in
connection with its origination of the loan. State laws, including laws
regarding unfair or deceptive acts or practices, also may apply.
Recommended Practices
Recommended practices for addressing the risks raised by
nontraditional mortgage products include the following:\17\
Communications with Consumers--When promoting or describing
nontraditional mortgage products, institutions should provide consumers
with information that is designed to help them make informed decisions
when selecting and using these products. Meeting this objective
requires appropriate attention to the timing, content, and clarity of
information presented to consumers. Thus, institutions should provide
consumers with information at a time that will help consumers select
products and choose among payment options. For example, institutions
should offer clear and balanced product descriptions when a consumer is
shopping for a mortgage--such as when the consumer makes an inquiry to
the institution about a mortgage product and receives information about
nontraditional mortgage products, or when marketing relating to
nontraditional mortgage products is provided by the institution to the
consumer--not just upon the submission of an application or at
consummation.\18\ The provision of such information would serve as an
important supplement to the disclosures currently required under TILA
and Regulation Z or other laws.\19\
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\17\ Institutions also should review the recommendations
relating to mortgage lending practices set forth in other
supervisory guidance from their respective primary regulators, as
applicable, including guidance on abusive lending practices.
\18\ Institutions also should strive to: (1) Focus on
information important to consumer decision making; (2) highlight key
information so that it will be noticed; (3) employ a user-friendly
and readily navigable format for presenting the information; and (4)
use plain language, with concrete and realistic examples.
Comparative tables and information describing key features of
available loan products, including reduced documentation programs,
also may be useful for consumers considering the nontraditional
mortgage products and other loan features described in this
guidance.
\19\ Institutions may not be able to incorporate all of the
practices recommended in this guidance when advertising
nontraditional mortgages through certain forms of media, such as
radio, television, or billboards. Nevertheless, institutions should
provide clear and balanced information about the risks of these
products in all forms of advertising.
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Promotional Materials and Product Descriptions. Promotional
materials and other product descriptions should provide information
about the costs, terms, features, and risks of nontraditional mortgages
that can assist consumers in their product selection decisions,
including information about the matters discussed below.
Payment Shock. Institutions should apprise consumers of
potential increases in payment obligations for these products,
including circumstances in which interest rates or negative
amortization reach a contractual limit. For example, product
descriptions could state the maximum monthly payment a consumer would
be required to pay under a hypothetical loan example once amortizing
payments are required and the interest rate and negative amortization
caps have been reached.\20\ Such information also could describe when
structural payment changes will occur (e.g., when introductory rates
expire, or when amortizing payments are required), and what the new
payment amount would be or how it would be calculated. As applicable,
these descriptions could indicate that a higher payment may be required
at other points in time due to factors such as negative amortization or
increases in the interest rate index.
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\20\ Consumers also should be apprised of other material changes
in payment obligations, such as balloon payments.
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Negative Amortization. When negative amortization is
possible under the terms of a nontraditional mortgage product,
consumers should be apprised of the potential for increasing principal
balances and decreasing home equity, as well as other potential adverse
consequences of negative amortization. For example, product
descriptions should disclose the effect of negative amortization on
loan balances and home equity, and could describe the potential
consequences to the consumer of making minimum payments that cause the
loan to negatively amortize. (One possible consequence is that it could
be more difficult to refinance the loan or to obtain cash upon a sale
of the home).
Prepayment Penalties. If the institution may impose a
penalty in the event that the consumer prepays the mortgage, consumers
should be alerted to this fact and to the need to ask the lender about
the amount of any such penalty.\21\
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\21\ Federal credit unions are prohibited from imposing
prepayment penalties. 12 CFR 701.21(c)(6).
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Cost of Reduced Documentation Loans. If an institution
offers both reduced and full documentation loan programs and there is a
pricing premium attached to the reduced documentation program,
consumers should be alerted to this fact.
[[Page 58618]]
Monthly Statements on Payment Option ARMs. Monthly statements that
are provided to consumers on payment option ARMs should provide
information that enables consumers to make informed payment choices,
including an explanation of each payment option available and the
impact of that choice on loan balances. For example, the monthly
payment statement should contain an explanation, as applicable, next to
the minimum payment amount that making this payment would result in an
increase to the consumer's outstanding loan balance. Payment statements
also could provide the consumer's current loan balance, what portion of
the consumer's previous payment was allocated to principal and to
interest, and, if applicable, the amount by which the principal balance
increased. Institutions should avoid leading payment option ARM
borrowers to select a non-amortizing or negatively-amortizing payment
(for example, through the format or content of monthly statements).
Practices to Avoid. Institutions also should avoid practices that
obscure significant risks to the consumer. For example, if an
institution advertises or promotes a nontraditional mortgage by
emphasizing the comparatively lower initial payments permitted for
these loans, the institution also should provide clear and comparably
prominent information alerting the consumer to the risks. Such
information should explain, as relevant, that these payment amounts
will increase, that a balloon payment may be due, and that the loan
balance will not decrease and may even increase due to the deferral of
interest and/or principal payments. Similarly, institutions should
avoid promoting payment patterns that are structurally unlikely to
occur.\22\ Such practices could raise legal and other risks for
institutions, as described more fully above.
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\22\ For example, marketing materials for payment option ARMs
may promote low predictable payments until the recast date. Such
marketing should be avoided in circumstances in which the minimum
payments are so low that negative amortization caps would be reached
and higher payment obligations would be triggered before the
scheduled recast, even if interest rates remain constant.
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Institutions also should avoid such practices as: Giving consumers
unwarranted assurances or predictions about the future direction of
interest rates (and, consequently, the borrower's future obligations);
making one-sided representations about the cash savings or expanded
buying power to be realized from nontraditional mortgage products in
comparison with amortizing mortgages; suggesting that initial minimum
payments in a payment option ARM will cover accrued interest (or
principal and interest) charges; and making misleading claims that
interest rates or payment obligations for these products are ``fixed''.
Control Systems--Institutions should develop and use strong control
systems to monitor whether actual practices are consistent with their
policies and procedures relating to nontraditional mortgage products.
Institutions should design control systems to address compliance and
consumer information concerns as well as the safety and soundness
considerations discussed in this guidance. Lending personnel should be
trained so that they are able to convey information to consumers about
product terms and risks in a timely, accurate, and balanced manner. As
products evolve and new products are introduced, lending personnel
should receive additional training, as necessary, to continue to be
able to convey information to consumers in this manner. Lending
personnel should be monitored to determine whether they are following
these policies and procedures. Institutions should review consumer
complaints to identify potential compliance, reputation, and other
risks. Attention should be paid to appropriate legal review and to
using compensation programs that do not improperly encourage lending
personnel to direct consumers to particular products.
With respect to nontraditional mortgage loans that an institution
makes, purchases, or services using a third party, such as a mortgage
broker, correspondent, or other intermediary, the institution should
take appropriate steps to mitigate risks relating to compliance and
consumer information concerns discussed in this guidance. These steps
would ordinarily include, among other things, (1) Conducting due
diligence and establishing other criteria for entering into and
maintaining relationships with such third parties, (2) establishing
criteria for third-party compensation designed to avoid providing
incentives for originations inconsistent with this guidance, (3)
setting requirements for agreements with such third parties, (4)
establishing procedures and systems to monitor compliance with
applicable agreements, bank policies, and laws, and (5) implementing
appropriate corrective actions in the event that the third party fails
to comply with applicable agreements, bank policies, or laws.
Appendix: Terms Used in This Document
Interest-only Mortgage Loan--A nontraditional mortgage on which,
for a specified number of years (e.g., three or five years), the
borrower is required to pay only the interest due on the loan during
which time the rate may fluctuate or may be fixed. After the
interest-only period, the rate may be fixed or fluctuate based on
the prescribed index and payments include both principal and
interest.
Payment Option ARM--A nontraditional mortgage that allows the
borrower to choose from a number of different payment options. For
example, each month, the borrower may choose a minimum payment
option based on a ``start'' or introductory interest rate, an
interest-only payment option based on the fully indexed interest
rate, or a fully amortizing principal and interest payment option
based on a 15-year or 30-year loan term, plus any required escrow
payments. The minimum payment option can be less than the interest
accruing on the loan, resulting in negative amortization. The
interest-only option avoids negative amortization but does not
provide for principal amortization. After a specified number of
years, or if the loan reaches a certain negative amortization cap,
the required monthly payment amount is recast to require payments
that will fully amortize the outstanding balance over the remaining
loan term.
Reduced Documentation--A loan feature that is commonly referred
to as ``low doc/no doc'', ``no income/no asset'', ``stated income''
or ``stated assets''. For mortgage loans with this feature, an
institution sets reduced or minimal documentation standards to
substantiate the borrower's income and assets.
Simultaneous Second-Lien Loan--A lending arrangement where
either a closed-end second-lien or a home equity line of credit
(HELOC) is originated simultaneously with the first lien mortgage
loan, typically in lieu of a higher down payment.
Dated: September 25, 2006.
John C. Dugan,
Comptroller of the Currency.
By order of the Board of Governors of the Federal Reserve
System, September 27, 2006.
Jennifer J. Johnson,
Secretary of the Board.
Dated at Washington, DC, this 27th day of September, 2006.
Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary.
Dated: September 28, 2006.
By the Office of Thrift Supervision.
John M. Reich,
Director.
By the National Credit Union Administration on September 28,
2006.
JoAnn M. Johnson,
Chairman.
[FR Doc. 06-8480 Filed 10-3-06; 8:45 am]
BILLING CODE 4810-33-P, 6210-01-P, 6714-01-P, 6720-01-P, 7535-01-P