[Federal Register Volume 70, Number 249 (Thursday, December 29, 2005)]
[Notices]
[Pages 77249-77257]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-24562]
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DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
[Docket No. 05-21]
FEDERAL RESERVE SYSTEM
[Docket No. OP-1246]
FEDERAL DEPOSIT INSURANCE CORPORATION
DEPARTMENT OF THE TREASURY
Office of Thrift Supervision
[No. 2005-56]
NATIONAL CREDIT UNION ADMINISTRATION
Interagency Guidance on Nontraditional Mortgage Products
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: Proposed guidance with request for comment.
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SUMMARY: The OCC, Board, FDIC, OTS, and NCUA (the Agencies), request
comment on this proposed Interagency Guidance on Nontraditional
Mortgage Products (Guidance). The Agencies expect institutions to
effectively assess and manage the risks associated with their credit
activities, including those associated with nontraditional mortgage
loan products. Institutions should use this guidance in their efforts
to ensure that their risk management and consumer protection practices
adequately address these risks.
DATES: Comments must be submitted on or before February 27, 2006.
ADDRESSES: The Agencies will jointly review all of the comments
submitted. Therefore, interested parties may send comments to any of
the Agencies and need not send comments (or copies) to all of the
Agencies. Please consider submitting your comments by e-mail or fax
since paper mail in the Washington area and at the Agencies is subject
to delay. Interested parties are invited to submit comments to:
OCC: You should include ``OCC'' and Docket Number 05-21 in your
comment. You may submit your comment by any of the following methods:
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
OCC Web site: http://www.occ.treas.gov. Click on ``Contact
the OCC,'' scroll down and click on ``Comments on Proposed
Regulations.''
E-Mail Address: [email protected].
Fax: (202) 874-4448.
Mail: Office of the Comptroller of the Currency, 250 E
Street, SW., Mail Stop 1-5, Washington, DC 20219.
Hand Delivery/Courier: 250 E Street, SW., Attn: Public
Information Room, Mail Stop 1-5, Washington, DC 20219.
Instructions: All submissions received must include the agency name
(OCC) and docket number for this notice. In general, the OCC will enter
all comments received into the docket without change, including any
business or personal information that you provide.
You may review comments and other related materials by any of the
following methods:
Viewing Comments Personally: You may personally inspect
and photocopy comments at the OCC's Public Information Room, 250 E
Street, SW., Washington, DC. You can make an appointment to inspect
comments by calling (202) 874-5043.
Viewing Comments Electronically: You may request that we
send you an electronic copy of comments via e-mail or mail you a CD-ROM
containing electronic copies by contacting the OCC at
[email protected].
Docket Information: You may also request available
background documents and project summaries using the methods described
above.
Board: You may submit comments, identified by Docket No. OP-1246,
by any of the following methods:
Agency Web site: http://www.federalreserve.gov. Follow the
instructions for submitting comments at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
E-mail: [email protected]. Include the
docket number in the subject line of the message.
Fax: 202/452-3819 or 202/452-3102.
Mail: Jennifer J. Johnson, Secretary, Board of Governors
of the Federal Reserve System, 20th Street and Constitution Avenue,
NW., Washington, DC 20551.
All public comments are available from the Board's Web site at
www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as submitted,
unless modified for technical reasons.
[[Page 77250]]
Accordingly, your comments will not be edited to remove any identifying
or contact information. Public comments may also be viewed in
electronic or paper form in Room MP-500 of the Board's Martin Building
(20th and C Streets, NW.) between 9 a.m. and 5 p.m. on weekdays.
FDIC: You may submit comments by any of the following methods:
Agency Web site: http://www.fdic.gov/regulations/laws/federal/propose.html. Follow the instructions for submitting comments
on the Agency Web site.
E-Mail: [email protected].
Mail: Robert E. Feldman, Executive Secretary, Attention:
Comments, Federal Deposit Insurance Corporation, 550 17th Street, NW.,
Washington, DC 20429.
Hand Delivery/Courier: Guard station at the rear of the
550 17th Street Building (located on F Street) on business days between
7 a.m. and 5 p.m.
Instructions: All submissions received must include the agency
name. All comments received will be posted without change to http://www.fdic.gov/regulations/laws/federal/propose.html including any
personal information provided.
OTS: You may submit comments, identified by docket number 2005-56,
by any of the following methods:
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
E-mail address: [email protected]. Please
include docket number 2005-56 in the subject line of the message and
include your name and telephone number in the message.
Fax: (202) 906-6518.
Mail: Regulation Comments, Chief Counsel's Office, Office
of Thrift Supervision, 1700 G Street, NW., Washington, DC 20552,
Attention: No. 2005-56.
Hand Delivery/Courier: Guard's Desk, East Lobby Entrance,
1700 G Street, NW., from 9 a.m. to 4 p.m. on business days. Address
envelope as follows: Attention: Regulation Comments, Chief Counsel's
Office, Attention: No. 2005-56.
Instructions: All submissions received must include the agency name
and docket number for this proposed Guidance. All comments received
will be posted without change to the OTS Internet site at http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1, including any
personal information provided.
Docket: For access to the docket to read background documents or
comments received, go to http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1. In addition, you may inspect comments
at the OTS's Public Reading Room, 1700 G Street, NW., by appointment.
To make an appointment for access, call (202) 906-5922, send an e-mail
to public.info@ots.treas.gov">public.info@ots.treas.gov, or send a facsimile transmission to (202)
906-7755. (Prior notice identifying the materials you will be
requesting will assist us in serving you.) We schedule appointments on
business days between 10 a.m. and 4 p.m. In most cases, appointments
will be available the next business day following the date we receive a
request.
NCUA: You may submit comments by any of the following methods:
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
NCUA Web site: http://www.ncua.gov/RegulationsOpinionsLaws/proposed_regs/proposed_regs.html. Follow the
instructions for submitting comments.
E-mail: Address to [email protected]. Include ``[Your
name] Comments on Interagency Guidance on Nontraditional Mortgages'' in
the e-mail subject line.
Fax: (703) 518-6319. Use the subject line described above
for e-mail.
Mail: Address to Mary Rupp, Secretary of the Board,
National Credit Union Administration, 1775 Duke Street, Alexandria,
Virginia 22314-3428.
Hand Delivery/Courier: Same as mail address.
FOR FURTHER INFORMATION CONTACT: OCC: Gregory Nagel, National Bank
Examiner/Credit Risk Specialist, Credit Risk Policy, (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; Minh-Duc T. Le, Senior
Attorney, 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: James Leitner, Senior Examination Specialist, (202) 898-6790,
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, (202) 906-5744; or
Maurice McClung, Program Manager, Market Conduct, Consumer Protection
and Specialized Programs, (202) 906-6182; and Richard Bennett, Counsel,
Banking and Finance, (202) 906-7409.
NCUA: Cory Phariss, Program Officer, Examination and Insurance,
(703) 518-6618.
SUPPLEMENTARY INFORMATION:
I. Background
In recent years, consumer demand and secondary market appetite have
grown rapidly for mortgage products that allow borrowers to defer
payment of principal and, sometimes, interest. These products, often
referred to as nontraditional mortgage loans, including ``interest-
only'' mortgages and ``payment option'' adjustable-rate mortgages have
been available in similar forms for many years. Nontraditional mortgage
loans offer payment flexibility and are an effective and beneficial
financial management tool for some borrowers. These products allow
borrowers to exchange lower payments during an initial period for
higher payments during a later amortization period as compared to the
level payment structure found in traditional fixed-rate mortgage loans.
In addition, institutions are increasingly combining these loans with
other practices, such as making simultaneous second-lien mortgages and
allowing reduced documentation in evaluating the applicant's
creditworthiness. While innovations in mortgage lending can benefit
some consumers, these layering practices can present unique risks that
institutions must appropriately measure, monitor and control.
The Agencies recognize that many of the risks associated with
nontraditional mortgage loans exist in other adjustable-rate mortgage
products, but our concern is elevated with nontraditional products due
to the lack of principal amortization and potential accumulation of
negative amortization. The Agencies are also concerned that these
products and practices are being offered to a wider spectrum of
borrowers, including some who may not otherwise qualify for traditional
fixed-rate or other adjustable-rate mortgage loans, and who may not
fully understand the associated risks.
Regulatory experience with nontraditional mortgage lending programs
has shown that prudent management of these programs requires increased
attention in product
[[Page 77251]]
development, underwriting, compliance, and risk management functions.
As with all activities, the Agencies expect institutions to effectively
assess and manage the risks associated with nontraditional mortgage
loan products. The Agencies have developed this proposed Guidance to
clarify how institutions can offer these products in a safe and sound
manner, and in a way that clearly discloses the potential risks that
borrowers may assume. The Agencies will carefully scrutinize
institutions' lending programs, including policies and procedures, and
risk management processes in this area, recognizing that a number of
different, but prudent practices may exist. Remedial action will be
requested from institutions that do not adequately measure, monitor,
and control risk exposures in loan portfolios. Further, the agencies
will seek to consistently implement the guidance.
II. Principal Elements of the Guidance
Prudent lending practices include the maintenance of sound loan
terms and underwriting standards. Institutions should assess current
loan terms and underwriting guidelines and implement any necessary
changes to ensure prudent practices. In connection with underwriting
standards, the proposed Guidance addresses:
Appropriate borrower repayment analysis, including
consideration of comprehensive debt service in the qualification
process;
The potential for collateral-dependent loans, which could
arise when a borrower is overly reliant on the sale or refinancing of
the property when loan amortization begins;
Mitigating factors that support the underwriting decision
in circumstances involving a combination of nontraditional mortgage
loans and reduced documentation;
Below market introductory interest rates;
Lending to subprime borrowers; and
Loans secured by non owner-occupied properties.
The proposed Guidance also describes appropriate portfolio and risk
management practices for institutions that offer nontraditional
mortgage products. These practices include the development of policies
and internal controls that address, among other matters, product
attributes, portfolio and concentration limits, third-party
originations, and secondary market activities. In connection with risk
management practices, the Guidance also proposes that institutions
should:
Maintain performance measures and management reporting
systems that provide warning of potential or increasing risks;
Maintain an allowance for loan and lease losses (ALLL) at
a level appropriate for portfolio credit quality and conditions
affecting collectibility;
Maintain capital levels that reflect nontraditional
mortgage portfolio characteristics and the effect of stressed economic
conditions on collectibility; and
Apply sound practices in valuing the mortgage servicing
rights of nontraditional mortgages.
Finally, the proposed Guidance describes consumer protection
concerns that may be raised by nontraditional mortgage loan products,
particularly that borrowers may not fully understand the terms of these
products. Nontraditional mortgage loan products are more complex than
traditional fixed-rate products and adjustable rate products and
present greater risks of payment shock and negative amortization.
Institutions should ensure that consumers are provided clear and
balanced information about the relative benefits and risks of these
products, at a time that will help consumers' decision-making
processes. The proposed Guidance discusses applicable laws and
regulations and then describes recommended practices for communications
with and the provision of information to consumers. These recommended
practices address promotional materials and product descriptions,
information on monthly payment statements, and the avoidance of
practices that obscure significant risks to the consumer or raise
similar concerns. The proposed Guidance also describes control systems
that should be used to ensure that actual practices are consistent with
policies and procedures.
When finalized, the Guidance would apply to all banks and their
subsidiaries, bank holding companies and their nonbank subsidiaries,
savings associations and their subsidiaries, savings and loan holding
companies and their subsidiaries, and credit unions.
III. Request for Comment
Comment is requested on all aspects of the proposed Guidance.
Interested commenters are also asked to address specifically the
proposed Guidance on comprehensive debt service qualification
standards, which provides that the analysis of borrowers' repayment
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. For products with the potential for
negative amortization, the repayment analysis should include the
initial loan amount plus any balance increase that may accrue through
the negative amortization provision. In this regard, comment is
specifically requested on the following:
(1) Should lenders analyze each borrower's capacity to repay the
loan under comprehensive debt service qualification standards that
assume the borrower makes only minimum payments? What are current
underwriting practices and how would they change if such prescriptive
guidance is adopted?
(2) What specific circumstances would support the use of the
reduced documentation feature commonly referred to as ``stated income''
as being appropriate in underwriting nontraditional mortgage loans?
What other forms of reduced documentation would be appropriate in
underwriting nontraditional mortgage loans and under what
circumstances? Please include specific comment on whether and under
what circumstances ``stated income'' and other forms of reduced
documentation would be appropriate for subprime borrowers.
(3) Should the Guidance address the consideration of future income
in the qualification standards for nontraditional mortgage loans with
deferred principal and, sometimes, interest payments? If so, how could
this be done on a consistent basis? Also, if future events such as
income growth are considered, should other potential events also be
considered, such as increases in interest rates for adjustable rate
mortgage products?
The text of the proposed Interagency Guidance on Nontraditional
Mortgage Products follows:
Interagency Guidance on Nontraditional Mortgage Products
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, there
has been a growing consumer demand, particularly in high priced real
estate markets, for residential mortgage loan products that allow
borrowers to defer repayment of principal and, sometimes, interest.
These mortgage products, often referred to as nontraditional mortgage
loans, include ``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
[[Page 77252]]
flexible payment options with the potential for negative
amortization.\1\ More recently, nontraditional mortgage loan products
are being offered to a wider spectrum of borrowers who may not
otherwise qualify for more traditional mortgage loans and may not fully
understand the associated risks.
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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.
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Many of these nontraditional mortgage loans are also being
underwritten with less stringent or no income and asset verification
requirements (``reduced documentation'') and are increasingly combined
with simultaneous second-lien loans.\2\ These risk-layering practices,
combined with the broader marketing of nontraditional mortgage loans,
expose 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 combined with risk-layering features, are untested in
a stressed environment and, therefore, 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 information to clearly
understand loan terms and associated risks prior to making a product
choice.
As with all activities, 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 increased 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 in their efforts to ensure
that their risk management practices adequately address these risks.
The Agencies will carefully scrutinize institutions' risk management
processes, policies, and procedures in this area. Remedial action will
be requested from institutions that do not adequately manage these
risks. Further, the Agencies will seek to consistently implement this
guidance.
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. Moreover, the institution's underwriting standards
should 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.
Qualification Standards--Nontraditional mortgage loans can result
in significantly higher payment requirements when the loan begins to
fully amortize. This increase in monthly mortgage payments, commonly
referred to as payment shock, 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, and that nontraditional mortgage loans often are inappropriate
for borrowers with high loan-to-value (LTV) ratios, high debt-to-income
(DTI) ratios, and low credit scores.
For all nontraditional mortgage loan products, the analysis of
borrowers' 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. In addition,
for products that permit negative amortization, the repayment analysis
should include the initial loan amount plus any balance increase that
may accrue from the negative amortization provision. The amount of the
balance increase should be tied to the initial terms of the loan and
estimated assuming the borrower makes only minimum payments during the
deferral period. Institutions should also consider the potential risks
that a borrower may face in refinancing the loan at the time it begins
to fully amortize, such as prepayment penalties. These more fully
comprehensive debt service calculations should be considered when
establishing the institution's qualifying criteria.
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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.
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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. As the level of credit risk increases, either
from loan features or borrower characteristics, the importance of
actual verification of the borrower's income, assets, and outstanding
liabilities also increases.
[[Page 77253]]
Collateral-Dependent Loans--Institutions should avoid the use of
loan terms and underwriting practices that may result in the borrower
having to rely on the sale or refinancing of the property once
amortization begins. Loans to borrowers who do not demonstrate the
capacity to repay, as structured, from sources other than the
collateral pledged are generally considered unsafe and unsound.
Institutions determined to be originating collateral-dependent mortgage
loans, may be subject to criticism, corrective action, and higher
capital requirements.
Risk Layering--Nontraditional mortgage loans combined with risk-
layering features, such as reduced documentation and/or a simultaneous
second-lien loan, pose increased risk. When risks are layered, an
institution should compensate for this increased risk with mitigating
factors that support the underwriting decision and the borrower's
repayment capacity. Mitigating factors might include higher credit
scores, lower LTV and DTI ratios, credit enhancements, and mortgage
insurance. While higher pricing may seem to address the increased risks
associated with risk-layering features, it raises the importance of
prudent qualification standards discussed above. Further, institutions
should fully consider the effect of these risk-layering features on
estimated credit losses when establishing their allowance for loan and
lease losses (ALLL).
Reduced Documentation--Institutions are increasingly relying on
reduced documentation, particularly unverified income to qualify
borrowers for nontraditional mortgage loans. Because these practices
essentially substitute assumptions and alternate information for the
waived data in analyzing a borrower's repayment capacity and general
creditworthiness, they should be used with caution. An institution
should consider whether its verification practices are adequate. As the
level of credit risk increases, the Agencies expect that an institution
will apply more comprehensive verification and documentation procedures
to verify a borrower's income and debt reduction capacity.
Use of reduced documentation in the underwriting process should be
governed by clear policy guidelines. Reduced documentation, such as
stated income, should be accepted only if there are other mitigating
factors such as lower LTV and other more conservative underwriting
standards.
Simultaneous Second-Lien Loans--Simultaneous second-lien loans
result in reduced owner equity and higher credit risk. Historically, as
combined loan-to-value ratios rise, defaults rise as well. A delinquent
borrower with minimal or no equity in a property may have little
incentive to work with the lender to bring the loan current to 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 owner equity
should generally not have a payment structure that allows for delayed
or negative amortization.
Introductory Interest Rates--Many institutions offer introductory
interest rates that are set well below the fully indexed rate as a
marketing tool for payment option ARM products. In developing
nontraditional mortgage products, an institution should consider the
spread between the introductory rate and the fully indexed rate. Since
initial monthly mortgage payments are based on these low introductory
rates, there is a greater potential for a borrower to experience
negative amortization, increased payment shock, and earlier recasting
of the borrower's monthly payments than originally scheduled. In
setting introductory rates, institutions should consider ways to
minimize the probability of disruptive early recastings and
extraordinary payment shock.
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.\6\ Among other things, the subprime guidance
discusses the circumstances under which subprime lending can become
predatory or abusive. Additionally, an institution's practice of risk
layering for loans to subprime borrowers may significantly increase the
risk to both the institution and the borrower. Institutions should pay
particular attention to these circumstances, as they design
nontraditional mortgage loan products for subprime borrowers.
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\6\ 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 be qualified on their ability to
service the debt over the life of the loan. Loan terms should also
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, nontraditional mortgages to finance non
owner-occupied investor properties should require evidence that the
borrower has sufficient cash reserves to service the loan in the near
term in the event that the property becomes vacant.\7\
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\7\ Federally Insured Credit Unions must comply with 12 CFR Part
723 for loans meeting the definition of member business loans.
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Portfolio and Risk Management Practices
Institutions should recognize that nontraditional mortgage loans
are untested in a stressed environment and, accordingly, should receive
higher levels of monitoring and loss mitigation. Moreover, institutions
should ensure that portfolio and risk management practices keep pace
with the growth and changing risk profile of their nontraditional
mortgage loan portfolios. Active portfolio management is especially
important for institutions that project or have already experienced
significant growth or concentrations of nontraditional products.
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 by:
Developing written policies that specify acceptable
product attributes, production and portfolio limits, sales and
securitization practices, and risk management expectations;
Designing enhanced performance measures and management
reporting that provide early warning for increasing risk;
Establishing appropriate ALLL levels that consider the
credit quality of the portfolio and conditions that affect
collectibility; and
Maintaining 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 forth 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--Concentration limits should be set for loan types,
third-party
[[Page 77254]]
originations, geographic area, and property occupancy status, to
maintain portfolio diversification. Concentration limits should also be
set on key portfolio characteristics such as loans with high combined
LTV and DTI ratios, loans with the potential for negative amortization,
loans to borrowers with credit scores below established thresholds, and
nontraditional mortgage loans with layered risks. The combination of
nontraditional mortgage loans with risk-layering features should be
regularly analyzed to determine if excessive concentrations or risks
exist. Institutions with excessive concentrations or deficient risk
management practices will be subject to elevated supervisory attention
and potential examiner criticism to ensure timely remedial action.
Further, institutions should consider the effect of employee incentive
programs that may result in higher concentrations of nontraditional
mortgage loans.
Controls--An institution's quality control, compliance, and audit
procedures should specifically target those mortgage lending activities
exhibiting higher risk. For nontraditional mortgage loan products, an
institution should have appropriate controls to monitor compliance and
exceptions to underwriting standards. The institution's quality control
function should regularly review a sample of reduced documentation
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. Since payment option ARMs
require higher levels of customer support than other mortgage loans,
customer service and collections personnel should receive product-
specific training on the features and potential customer issues.
Third-Party Originations--Institutions often use third-party
channels, such as mortgage brokers or correspondents, to originate
nontraditional mortgage loans. When doing so, an institution should
have strong approval and control systems to ensure the quality of
third-party originations and compliance with all applicable laws and
regulations, with particular emphasis on marketing and borrower
disclosure practices. Controls over third parties should be designed to
ensure that loans made through these channels reflect the standards and
practices used by an institution in its direct lending activities.
Monitoring procedures should track the quality of loans by both
origination source and key borrower characteristics in order to
identify problems, such as early payment defaults, incomplete
documentation, and fraud. A strong monitoring process should enable
management to determine whether third-party originators are producing
quality loans. If appraisal, loan documentation, or credit problems are
discovered, the institution should take immediate action, which could
include terminating its relationship with the third-party.\8\
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\8\ 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.
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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 reliance should have comprehensive, formal approaches
to risk management.\9\ This should include consideration of the risks
to the institution should demand in the secondary markets dissipate.
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\9\ 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. 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 sale of loans to third parties can transfer a portion of the
portfolio's credit risk, an institution continues to be exposed to
reputation risk that arises when the credit losses on sold loans or
securitization transactions exceed expected losses. In order to protect
its reputation in the market, an institution may determine that it is
necessary to repurchase defaulted mortgages. It should be noted that
the repurchase of mortgage loans beyond the selling institution's
contractual obligations is, in the Agencies' view, implicit recourse.
Under the Agencies' risk-based capital standards, repurchasing mortgage
loans from a sold portfolio or from a securitization in this manner
would require that risk-based capital be maintained against the entire
portfolio or securitization.\10\ Further, loans sold to third parties
typically carry representations and warranties from the institution
that these loans were underwritten properly and all legal requirements
were satisfied. Therefore, institutions involved in securitization
transactions should consider the potential origination-related risks
arising from nontraditional mortgage loans, including the adequacy of
disclosures to investors.
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\10\ Federally Insured Credit Unions should refer to 12 CFR Part
702 for their risk based net worth requirements.
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Management Information and Reporting--An institution should have
the reporting capability to detect changes in the risk profile of its
nontraditional mortgage loan portfolio. Reporting systems should allow
management to isolate key loan products, risk-layering loan features,
and borrower characteristics to allow early identification of
performance deterioration. At a minimum, information should be
available by loan type (e.g., interest-only mortgage loans and payment
option ARMs); the combination of these loans with risk-layering
features (e.g., payment option ARM with stated income and interest-only
mortgage loans with simultaneous second-lien mortgages); underwriting
characteristics (e.g., LTV, DTI, and credit score); and borrower
performance (e.g., payment patterns, delinquencies, interest accruals,
and negative amortization).
Portfolio volume and performance results 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 be undertaken when actual performance
deviates from established policies and thresholds. Variance analysis is
critical to the monitoring of the portfolio's risk characteristics and
should be an integral part of an institution's forecasting process to
establish and adjust risk tolerance levels.
Stress Testing--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. This
[[Page 77255]]
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. Through stress testing, an institution should
be able to identify, monitor and manage risk, as well as develop
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 appropriate allowances for the estimated credit losses
in their nontraditional mortgage loan portfolios and hold capital
commensurate with the risk characteristics of these portfolios.
Moreover, institutions should recognize that the limited performance
history of these products, particularly in a stressed environment,
increases performance uncertainty. As loan terms evolve and
underwriting practices ease, this lack of seasoning may warrant higher
capital levels.
In 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. Credit
risk segments should also distinguish among loans with differing
payment and portfolio characteristics, such as borrowers who habitually
make only minimum payments, mortgages with existing balances above
original balances due to negative amortization, and mortgages subject
to sizable payment shock. The objective is to identify key credit
quality indicators that affect collectibility for ALLL measurement
purposes and important risk characteristics that influence expected
performance so that migration into or out of key segments provides
meaningful information about future loss exposure for purposes of
determining the level of capital to be maintained.
Further, those institutions with material mortgage banking
activities and mortgage servicing assets should apply sound practices
in valuing the mortgage servicing rights of nontraditional mortgages in
accordance with interagency guidance.\11\ This guidance requires
institutions to follow generally accepted accounting principles and
conservatively treat assumptions used in valuing mortgage-servicing
rights.
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\11\ 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 near-term monthly payment affordability, and consumers
have been encouraged to select nontraditional mortgage products based
on the lower monthly payments that such products permit compared with
traditional types of mortgages. In addition to apprising consumers of
the benefits of nontraditional mortgage products, institutions should
ensure that they also appropriately alert consumers to the risks of
these products, including the likelihood of increased future payment
obligations. Institutions should also ensure that consumers have
information that is timely and sufficient for making a sound product
selection decision.\12\
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\12\ Institutions also should review the recommendations
relating to mortgage lending practices set forth in other sections
of this guidance and any other supervisory guidance from their
respective primary regulators, including the discussion in the
Subprime Lending Guidance referenced in footnote 6 about abusive
lending practices.
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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. As a result, it may be more
difficult for consumers to refinance these loans. In addition, in the
event of a refinancing or a sale of the property, negative amortization
may result in the reduction or elimination of home equity, 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
effectively providing complete information about material risks.
In light of these considerations, institutions should ensure that
communications with consumers, including advertisements, oral
statements, promotional materials, and monthly statements, are
consistent with product terms and payment structures. These
communications should also 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 is important to ensuring that consumers have appropriate
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,\13\ before loan consummation, and when interest
rates change. Section 5 of the FTC Act prohibits unfair or deceptive
acts or practices.\14\
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\13\ 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.
\14\ 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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[[Page 77256]]
Institutions should also ensure that they comply with fair lending
laws and the Real Estate Settlement Procedures Act (RESPA). Other
federal laws also apply to these loan products. 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 be applicable. It is important that institutions
have their communications and other acts and practices reviewed by
counsel for compliance with all applicable laws. Institutions also
should monitor applicable laws and regulations for revisions to ensure
that communications continue to be fully compliant.
Recommended Practices
Recommended practices for addressing the risks raised by
nontraditional mortgage products include the following:
Communications with Consumers--As with all communications with
consumers, institutions should present important information in a clear
manner and format such that consumers will notice it, can understand it
to be material, and will be able to use it in their decision-making
processes.\15\ Furthermore, when promoting or describing nontraditional
mortgage products, institutions should provide consumers with
information that will enable them to make informed decisions and to use
these products responsibly. 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 make product selection
and payment decisions. For example, institutions should offer full and
fair product descriptions when a consumer is shopping for a mortgage,
not just upon the submission of an application or at consummation.
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\15\ In this regard, institutions 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 these nontraditional
mortgage products and other loan features described in this
guidance.
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Promotional materials and descriptions of these products
should provide information that enables consumers to prudently consider
the costs, terms, features, and risks of these mortgages in their
product selection decisions, including information about:
--Payment Shock. Institutions should apprise consumers of potential
increases in their payment obligations (e.g., in both dollar and
percentage terms), including situations in which interest rates or
negative amortization reach a contractual limit. For example, product
descriptions could specifically 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.\16\ Information provided
to consumers also could clearly 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 the new payment amount may be required
sooner, and may be even higher than the amount indicated, due to
factors such as negative amortization or increases in the interest rate
index.
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\16\ 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 the loan, consumers should be apprised of the potential
consequences of increasing principal balances and decreasing home
equity. For example, product descriptions should include, with sample
payment schedules, corresponding examples showing the effect of those
payments on the consumer's loan balance and home equity.
--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 amount of any such penalty.\17\
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\17\ 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.
Monthly statements that are provided to consumers on
payment option ARMs should provide information that enables consumers
to make responsible payment choices, including information about the
consequences of selecting various payment options on the current
principal balance. Institutions should present each payment option
available, explain each option, and note the impact of each choice. For
example, the monthly payment statement should contain an explanation,
as applicable, next to the minimum payment amount that this payment
would result in an increase to the consumer's outstanding loan balance
due to negative amortization. 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 the minimum payment (for example, through the format or content
of monthly statements).
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, 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 such practices as promoting payment patterns that are
structurally unlikely to occur.\18\ Such practices could raise legal
and other risks for institutions, as described more fully above.
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\18\ For example, marketing materials for payment option ARMs
may promote low predictable payments until the recast date. At the
same time, the minimum payments may be 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:
Unwarranted assurances or
[[Page 77257]]
predictions about the future direction of interest rates (and,
consequently, the borrower's future obligations); inappropriate
representations about the ``cash savings'' to be realized from
nontraditional mortgage products in comparison with amortizing
mortgages; statements suggesting that initial minimum payments in a
payment option ARM will cover accrued interest (or principal and
interest) charges; and misleading claims that interest rates or payment
obligations for these products are ``fixed.''
Control Systems--Institutions also should develop and use strong
control systems to ensure that actual practices are consistent with
their policies and procedures, for loans that the institution
originates internally, those that it originates through mortgage
brokers and other third parties, and those that it purchases.
Institutions should design control systems to address compliance and
fair disclosure concerns as well as the safety and soundness
considerations discussed above. 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. Lending
personnel should be monitored through, for example, call monitoring or
mystery shopping, to determine whether they are conveying appropriate
information. Institutions should review consumer complaints to identify
potential compliance, reputation, and other risks. Attention also
should be paid to appropriate legal review and to using compensation
programs that do not improperly encourage originators to direct
consumers to particular products.
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 either 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.
This concludes the text of the proposed Interagency Guidance on
Nontraditional Mortgage Products.
Dated: December 19, 2005.
John C. Dugan,
Comptroller of the Currency.
By order of the Board of Governors of the Federal Reserve
System, December 19, 2005.
Jennifer J. Johnson,
Secretary of the Board.
Dated at Washington, DC, the 19th day of December, 2005.
By order of the Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary.
Dated: December 19, 2005.
By the Office of Thrift Supervision.
John M. Reich,
Director.
By the National Credit Union Administration on December 20,
2005.
Rodney E. Hood,
Vice Chairman.
[FR Doc. 05-24562 Filed 12-28-05; 8:45 am]
BILLING CODE 4810-33-P, 6210-01-P, 6714-01-P, 6720-01-P, 7535-01-P