FDIC, FRB, OCC, OTS: Proposed Guidance on Nontraditional Mortgages

ABA Contact: Compliance staff
Published: 70 Federal Register 77249; December 29, 2005
Comments Due: March 29, 2006
Disposition: Filed


On January 25, 2006, ABA filed a request for at least a 30 day extension in the comment period. The extension request was granted.

The Agencies have published in the December 29, 2005, Federal Register a highly prescriptive new Guidance on non-traditional mortgages that defer payment of interest or interest and principal (such as interest only mortgages and option ARMs) that appears to raise significantly the requirements on banks to offer or deal in these products. Comments on the proposed Guidance are due February 27, 2006. ABA is seeking guidance from its bankers on what to comment on the Guidance, as set out in the questions below.

Please send your comments to Paul Smith. The proposed Guidance has both strong safety and soundness requirements for (1) loan terms and underwriting, and (2) portfolio and risk management monitoring and controls, including criticism of layering of risks by combining these mortgages with simultaneous second mortgages or by making these loans to subprime borrowers. Examiners will require additional risk monitoring and may require higher reserving for losses and/or higher capital. The Guidance also details necessary consumer protections, including urging banks to fully disclose any potential payment shock, negative amortization and triggering terms for recasting the payments under the mortgage. One significant aspect of the proposal is that it will apply not only to depository institutions and their subsidiaries but also to BHCs and their nonbank subsidiaries. See a detailed summary of the Guidance.

1. In discussing loan terms and underwriting, the Guidance places great emphasis on evaluating the borrower's ability to repay, suggesting 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. Underwriting should assume minimum performance in any negative amortization product in qualifying the borrower. The Guidance criticizes layering of risk, such as using a simultaneous second mortgage, lending to a subprime borrower, and/or using low documentation procedures. The Guidance specifically warns against making these loans so that they are "collateral dependent" and therefore possibly predatory. The Guidance prescribes even higher underwriting standards for loans on non owner-occupied investor loans.

(a) ABA asks if these underwriting standards are more conservative than your current practice, and, if so, are they overly prescriptive or unjustifiably conservative?

(b) The Guidance suggests that higher pricing of the loan does not offset the higher credit risk of these loans. The Guidance instead suggests that higher credit risk must be offset by lower LTV, higher borrower credit scores, private mortgage insurance and/or other risk mitigation. ABA asks if this is consistent with your current practices or if this requires significant changes in your underwriting?

(c) The Agencies specifically ask:

(i) 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?

(ii) What are current underwriting practices and how would they change if such prescriptive guidance is adopted?

(d) The Agencies specifically ask:

(i) 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?

(ii) What other forms of reduced documentation would be appropriate in underwriting nontraditional mortgage loans and under what circumstances?

(iii) Whether and under what circumstances ''stated income'' and other forms of reduced documentation would be appropriate for subprime borrowers.

(e) The Agencies also specifically ask:

(i) 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?

(ii) 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?

2. In discussing portfolio and risk management policies, the Agencies require higher levels of monitoring and more detailed policies to manage the risks. The Agencies direct banks to develop written policies that specify acceptable product attributes, production and portfolio limits, concentration limits, sales and securitization practices, and risk management expectations; to design enhanced performance measures and management reporting; to carefully consider whether higher ALLL levels are required; and to consider whether significant portfolios require higher capital.

(a) Are these requirements consistent with your current practice, and if not, what parts are new? What parts are unexpected? What parts are unjustified and why?

The Agencies also caution strongly that banks must carefully monitor third-parties with strong approval and control systems to ensure and compliance with all applicable laws and regulations, with particular emphasis on marketing and borrower disclosure practices. 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. 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.

(b) Are these requirements consistent with your current practice, and if not, what parts are new? What parts are unexpected? What parts are unjustified and why?

3. In discussing consumer protection concerns, the Agencies are concerned that consumers may enter into these transactions without fully understanding the product terms, partly because of a lack of sufficient disclosure by lenders. "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." The Agencies list a number of product "features" that must be appropriately disclosed, warn of legal risks under TILA and Section 5 of the FTC Act (unfair and deceptive practices), and "recommend" a number of practices. The Agencies also state that institutions should have strong control systems that monitor third-party originators or brokers, carefully review loans purchased for compliance with these consumer protections, and train and monitor their own lending personnel, such as through call monitoring or mystery shopping.

(a) Are the recommended practices consistent with your current practices, and if not, what parts are new? What parts are unexpected? What parts appear excessive or difficult to follow, and why?

(b) Do your control systems meet the standards of the Guidance? If not, what controls appear difficult to implement, and why?

2006 Regulatory Chart
Federal Register
ABA Comment Letter