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5000 - Statements of Policy
{{4-30-99 p.5479}}
Interagency Guidance on Subprime Lending
March 1, 1999
Contents
Background and Scope
Capitalization
Risk Management
Planning and Strategy
Staff Expertise
Lending Policy
Purchase Evaluation
Loan Administration Procedures
Loan Review and Monitoring
Consumer Protection
Securitization and Sale
Reevaluation
Examination Objectives
Background and Scope
Insured depository institutions have traditionally avoided lending
to customers with poor credit histories because of the higher risk of
default and resulting loan losses. However, in recent years a number of
lenders 1
have extended their risk selection standards to attract lower credit
quality accounts, often referred to as subprime loans. Moreover, recent
turmoil in the equity and asset-backed securities market has caused
some non-bank subprime specialists to exit the market, thus creating
increased opportunities for financial institutions to enter, or expand
their participation in, the subprime lending business. The federal
banking agencies have been monitoring this development and are
providing guidance on this activity.
For the purposes of this guidance, "subprime lending" is
defined as extending credit to borrowers who exhibit characteristics
indicating a significantly higher risk of default than traditional bank
lending customers. 2
Risk of default may be measured by traditional credit risk measures
(credit/repayment history, debt to income levels, etc.) or by
alternative measures such as credit scores. Subprime borrowers
represent a broad spectrum of debtors ranging from those who have
exhibited repayment problems due to an adverse event, such as job loss
or medical emergency, to those who persistently mismanage their
finances and debt obligations. Subprime lending does not include loans
to borrowers who have had minor, temporary credit difficulties but are
now current. This guidance applies to direct extensions of credit; the
purchase of subprime loans from other lenders, including delinquent or
credit impaired loans purchased at a discount; the purchase of subprime
automobile or other financing "paper" from lenders or dealers;
and the purchase of loan companies that originate subprime loans.
Due to their higher risk, subprime loans command higher interest
rates and loan fees than those offered to standard risk borrowers.
These loans can be profitable, provided the price charged by the lender
is sufficient to cover higher loan loss rates and overhead costs
related to underwriting, servicing, and collecting the loans. Moreover,
the ability to securitize and sell subprime portfolios at a profit
while retaining the servicing rights has made subprime lending
attractive to a larger number of institutions, further increasing the
number of subprime lenders and loans. Recently, however, a number of
financial institutions have experienced losses attributable to
ill-advised or poorly structured subprime lending pro-
{{4-30-99 p.5480}}
grams. This has brought greater supervisory attention to subprime
lending and the ability of insured depository institutions to manage
the unique risks associated with this activity.
Institutions should recognize the additional risks inherent in
subprime lending and determine if these risks are acceptable and
controllable given the institution's staff, financial condition, size,
and level of capital support. Institutions that engage in subprime
lending in any significant way should have board-approved policies and
procedures, as well as internal controls that identify, measure,
monitor, and control these additional risks. Institutions that engage
in a small volume of subprime lending should have systems in place
commensurate with their level of risk. Institutions that began a
subprime lending program prior to the issuance of this guidance should
carefully consider whether their program meets the following guidelines
and should implement corrective measures for any area that falls short
of these minimum standards. If the risks associated with this activity
are not properly controlled, the agencies consider subprime lending a
high-risk activity that is unsafe and unsound.Capitalization
The federal banking agencies believe that subprime lending
activities can present a greater than normal risk for financial
institutions and the deposit insurance funds; therefore, the level of
capital institutions need to support this activity should be
commensurate with the additional risks incurred. The amount of
additional capital necessary will vary according to the volume and type
of subprime activities pursued and the adequacy of the institution's
risk management program. Institutions should determine how much
additional capital they need to offset the additional risk taken in
their subprime lending activities and document the methodology used to
determine this amount. The agencies will evaluate an institution's
overall capital adequacy on a case-by-case basis through on-site
examinations and off-site monitoring procedures considering, among
other factors, the institution's own analysis of the capital needed to
support subprime lending. Institutions determined to have insufficient
capital must correct the deficiency within a reasonable timeframe or be
subject to supervisory action. In light of the higher risks associated
with this type of lending, the agencies may impose higher minimum
capital requirements on institutions engaging in subprime lending.
Risk Management
The following items are essential components of a well-structured
risk management program for subprime lenders:
Planning and Strategy. Prior to engaging in
subprime lending, the board and management should ensure that proposed
activities are consistent with the institution's overall business
strategy and risk tolerances, and that all involved parties have
properly acknowledged and addressed critical business risk issues.
These issues include the costs associated with attracting and retaining
qualified personnel, investments in the technology necessary to manage
a more complex portfolio, a clear solicitation and origination strategy
that allows for after-the-fact assessment of underwriting performance,
and the establishment of appropriate feedback and control systems. The
risk assessment process should extend beyond credit risk and
appropriately incorporate operating, compliance, and legal risks.
Finally, the planning process should set clear objectives for
performance, including the identification and segmentation of target
markets and/or customers, and performance expectations and benchmarks
for each segment and the portfolio as a whole. Institutions
establishing a subprime lending program should proceed slowly and
cautiously into this activity to minimize the impact of unforeseen
personnel, technology, or internal control problems and to determine if
favorable initial profitability estimates are realistic and
sustainable.
Staff Expertise. Subprime lending requires
specialized knowledge and skills that many financial institutions may
not possess. Marketing, account origination, and collections strategies
and techniques often differ from those employed for prime credit; thus
it may not be sufficient to have the same lending staff responsible for
both subprime loans and other loans. Additionally, servicing and
collecting subprime loans can be very labor intensive. If necessary,
the institution should implement programs to train staff. The board
should ensure
{{4-30-99 p.5481}}
that staff possesses sufficient expertise to appropriately
manage the risks in subprime lending and that staffing levels are
adequate for the planned volume of subprime activity. Seasoning of
staff and loans should be taken into account as performance is assessed
over time.
Lending Policy. A subprime lending policy should
be appropriate to the size and complexity of the institution's
operations and should clearly state the goals of the subprime lending
program. While not exhaustive, the following lending standards should
be addressed in any subprime lending policy:
Types of products offered as well as those that are not
authorized;
Portfolio targets and limits for each credit grade or
class;
Lending and investment authority clearly stated for
individual officers, supervisors, and loan committees; A
framework for pricing decisions and profitability analysis that
considers all costs associated with the loan, including origination
costs, administrative/servicing costs, expected charge-offs, and
capital;
Collateral evaluation and appraisal standards;
Well defined and specific underwriting parameters (i.e.,
acceptable loan term, debt to income ratios, loan to collateral value
ratios for each credit grade, and minimum acceptable credit score) that
are consistent with any applicable supervisory
guidelines; 3
Procedures for separate tracking and monitoring of loans
approved as exceptions to stated policy guidelines;
Credit file documentation requirements such as
applications, offering sheets, loan and collateral documents, financial
statements, credit reports, and credit memoranda to support the loan
decision; and
Correspondent/broker/dealer approval process, including
measures to ensure that loans originated through this process meet the
institution's lending standards.
If the institution elects to use credit scoring (including
applications scoring) for approvals or pricing, the scoring model
should be based on a development population that captures the
behavioral and credit characteristics of the subprime population
targeted for the products offered. Because of the significant variance
in characteristics between the subprime and prime populations,
institutions should not rely on models developed solely for products
offered to prime borrowers. Further, the model should be reviewed
frequently and updated as necessary to ensure that assumptions remain
valid.
Purchase Evaluation. Institutions that purchase
subprime loans from other lenders or dealers must give due
consideration to the cost of servicing these assets and the loan losses
that may be experienced as they evaluate expected profits. For
instance, some lenders who sell subprime loans charge borrowers high
up-front fees, which are usually financed into the loan. This provides
incentive for originators to produce a high volume of loans with little
emphasis on quality, to the detriment of a potential purchaser.
Further, subprime loans, especially those purchased from outside the
institution's lending area, are at special risk for fraud or
misrepresentation (i.e., the quality of the loan may be less than the
loan documents indicate).
Institutions should perform a thorough due diligence review prior to
committing to purchase subprime loans. Institutions should not accept
loans from originators that do not meet their underwriting criteria,
and should regularly review loans offered to ensure that loans
purchased continue to meet those criteria. Deterioration in the quality
of purchased loans or in the portfolio's actual performance versus
expectations requires a thorough reevaluation of the lenders or dealers
who originated or sold the loans, as well as
{{4-30-99 p.5482}}reevaluation of the institution's
criteria for underwriting loans and selecting dealers and lenders. Any
such deterioration may also highlight the need to modify or terminate
the correspondent relationship or make adjustments to underwriting and
dealer/lender selection criteria.
Loan Administration Procedure. After the loan is
made or purchased, loan administration procedures should provide for
the diligent monitoring of loan performance and establish sound
collection efforts. To minimize loan losses, successful subprime
lenders have historically employed stronger collection efforts such as
calling delinquent borrowers frequently, investing in technology (e.g.,
using automatic dialing for follow-up telephone calls on delinquent
accounts), assigning more experienced collection personnel to seriously
delinquent accounts, moving quickly to foreclose or repossess
collateral, and allowing few loan extensions. This aspect of subprime
lending is very labor intensive but critical to the program's success.
To a large extent, the cost of such efforts can represent a tradeoff
relative to future loss expectations when an institution analyzes the
profitability of subprime lending and assesses its appetite to expand
or continue this line of business.
Subprime loan administration procedures should be in writing and at
a minimum should detail:
Billing and statement procedures;
Collection procedures;
Content, format, and frequency of management reports;
Asset classification criteria;
Methodology to evaluate the adequacy of the allowance for
loan and lease losses (ALLL);
Criteria for allowing loan extensions, deferrals, and
re-agings;
Foreclosure and repossession policies and procedures; and
Loss recognition policies and procedures.
Loan Review and Monitoring. Once loans are booked,
institutions must perform an ongoing analysis of subprime loans, not
only on an aggregate basis but also for sub-portfolios. Institutions
should have information systems in place to segment and stratify their
portfolio (e.g., by originator, loan-to-value, debt-to-income ratios,
credit scores) and produce reports for management to evaluate the
performance of subprime loans. The review process should focus on
whether performance meets expectations. Institutions then need to
consider the source and characteristics of loans that do not meet
expectations and make changes in their underwriting policies and loan
administration procedures to restore performance to acceptable levels.
When evaluating actual performance against expectations, it is
particularly important that management review credit scoring, pricing,
and ALLL adequacy models. Models driven by the volume and severity of
historical losses experienced during an economic expansion may have
little relevance in an economic slowdown, particularly in the subprime
market. Management should ensure that models used to estimate credit
losses or to set pricing allow for fluctuations in the economic cycle
and are adjusted to account for other unexpected events.
Consumer Protection. Institutions that originate
or purchase subprime loans must take special care to avoid violating
fair lending and consumer protection laws and regulations. Higher fees
and interest rates combined with compensation incentives can foster
predatory pricing or discriminatory "steering" of borrowers to
subprime products for reasons other than the borrower's underlying
creditworthiness. An adequate compliance management program must
identify, monitor and control the consumer protection hazards
associated with subprime lending. Subprime mortgage lending may trigger
the special protections of "The Home Ownership and Equity Protection
Act of 1994," Subtitle B of Title I of the Riegle Community
Development and Regulatory Improvement Act of 1994. This Act amended
the Truth-in-Lending Act to provide certain consumer protections in
transactions involving a class of non-purchase, closed-end home
mortgage loans. Institutions engaging in this type of
{{4-30-99 p.5483}}lending must also be thoroughly
familiar with obligations set forth in Regulation Z,
12 C.F.R. § 226.32, and
Regulation X, the Real Estate Settlement Procedures Act (RESPA),
12 USC § 2601, and adopt
policies and implement practices that ensure compliance.
The Equal Credit Opportunity Act makes it unlawful for a creditor to
discriminate against an applicant on a prohibited basis regarding any
aspect of a credit transaction. Similarly, the Fair Housing Act
prohibits discrimination in connection with residential real
estate-related transactions. Loan officers and brokers must treat all
similarly situated applicants equally and without regard to any
prohibited basis characteristic (e.g., race, sex, age, etc.). This is
especially important with respect to how loan officers or brokers
assist customers in preparing their applications or otherwise help them
to qualify for loan approval.
Securitization and Sale. Some subprime lenders
have increased their loan production and servicing income by
securitizing and selling the loans they originate in the asset-backed
securities market. Strong demand from investors and favorable
accounting rules often allow securitization pools to be sold at a gain,
providing further incentive for lenders to expand their subprime
lending program. However, the securitization of subprime loans carries
inherent risks, including interim credit risk and liquidity risk, that
are potentially greater than those for securitizing prime loans.
Accounting for the sale of subprime pools requires assumptions that can
be difficult to quantify, and erroneous assumptions could lead to the
significant overstatement of an institution's assets. Moreover, the
practice of providing support and substituting performing loans for
nonperforming loans to maintain the desired level of performance on
securitized pools has the effect of masking credit quality problems.
Recent turmoil in the financial markets illustrates the volatility
of the secondary market for subprime loans and the significant
liquidity risk incurred when originating a large volume of loans
intended for securitization and sale. Investors can quickly lose their
appetite for risk in an economic downturn or when financial markets
become volatile. As a result, institutions that have originated, but
have not yet sold, pools of subprime loans may be forced to sell the
pools at deep discounts. If an institution lacks adequate personnel,
risk management procedures, or capital support to hold subprime loans
originally intended for sale, these loans may strain an institution's
liquidity, asset quality, earnings, and capital. Consequently,
institutions actively involved in the securitization and sale of
subprime loans should develop a contingency plan that addresses back-up
purchasers of the securities or the attendant servicing functions,
alternate funding sources, and measures for raising additional capital.
Institutions should refer to Statement of Financial Accounting
Standards No. 125 (FAS 125), "Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities," for
guidance on accounting for these transactions. If a securitization
transaction meets FAS 125 sale or servicing criteria, the seller must
recognize any gain or loss on the sale of the pool immediately and
carry any retained interests in the assets sold (including servicing
rights/obligations and interest-only strips) at fair value. Management
should ensure that the key assumptions used to value these retained
interests are reasonable and well supported, both for the initial
valuation and for subsequent quarterly revaluations. In particular,
management should consider the appropriate discount rates, credit loss
rates, and prepayment rates associated with subprime pools when valuing
these assets. Since the relative importance of each assumption varies
with the underlying characteristics of the product types, management
should segment securitized assets by specific pool, as well as
predominant risk and cash flow characteristics, when making the
underlying valuation assumptions. In all cases, however, institutions
should take a conservative approach when developing securitization
assumptions and capitalizing expected future income from subprime
lending pools. Institutions should also consult with their auditors as
necessary to ensure their accounting for securitizations is accurate.
Reevaluation. Institutions should periodically
evaluate whether the subprime lending program has met profitability,
risk, and performance goals. Whenever the program falls short of
original objectives, an analysis should be performed to determine the
cause and the program should be modified appropriately. If the program
falls far short of the institution's
{{4-30-99 p.5484}}expectations, management should
consider terminating it. Questions that management and the board need
to ask may include:
Have cost and profit projections been met?
Have projected loss estimates been accurate?
Has the institution been called upon to provide support
to enhance the quality and performance of loan pools it has
securitized?
Were the risks inherent to subprime lending properly
identified, measured, monitored and controlled?
Has the program met the credit needs of the community
that it was designed to address?Examination Objectives
Due to the high-risk nature of subprime lending, examiners will
carefully evaluate this activity during regular and special
examinations. Examiners will:
Evaluate the extent of subprime lending activities and
whether management has adequately planned for this activity.
Assess whether the institution has the financial capacity
to conduct this high-risk activity safely without an undue
concentration of credit and without overextending capital resources.
Ascertain if management has committed the necessary
resources in terms of technology and skilled personnel to manage the
program.
Evaluate whether management has established adequate
lending standards and is maintaining proper controls over the program.
Determine whether the institution's contingency plans
are adequate to address the issues of alternative funding sources,
back-up purchasers of the securities or the attendant servicing
functions, and methods of raising additional capital during a period of
an economic downturn or when financial markets become volatile.
Review securitization transactions for compliance with
FAS 125 and this guidance, including whether the institution has
provided any support to maintain the credit quality of loans pools it
has securitized.
Analyze the performance of the program, including
profitability, delinquency, and loss experience.
Consider management's response to adverse performance
trends, such as higher than expected prepayments, delinquencies,
charge-offs, customer complaints, and expenses.
Determine if the institution's compliance program
effectively manages the fair lending and consumer protection compliance
risks associated with subprime lending
operations.
SIGNED:
RICHARD C. SPILLENKOTHEN |
SIGNED: JAMES L.
SEXTON |
Director, Division of Banking |
Director, Division of
Supervision |
Supervision and Regulation |
Federal Deposit
Insurance Corporation |
Board of Governors of the Federal
Reserve System |
|
SIGNED: EMORY W.
RUSHTON |
SIGNED: RICHARD M. RICCOBONO |
Senior Deputy
Comptroller for |
Deputy Director |
Bank Supervision
Policy |
Office of Thrift Supervision
|
[Source: FDIC Financial Institutions Letter
(FIL--20--99), dated March 4, 1999]
1The terms "lenders," "financial institutions," and
"institutions," in this document refer to insured depository
institutions and their subsidiaries. Go Back to Text
2For purposes of this paper, loans to customers who are not
subprime borrowers are referred to as "prime." Go Back to Text
3Extensions of credit secured by real estate, whether subprime
or otherwise, are subject to the Interagency Guidelines for Real Estate
Lending Policies, which establish supervisory Loan-to-Value (LTV)
limits on various types of real estate loans and impose limits on an
institution's aggregate investment in loans that exceed the
supervisory LTV limits. See 12 CFR Part 34, subpart D (OCC); 12 CFR
Part 208, appendix C (FRB); 12 CFR
Part 365 (FDIC); and 12 CFR 560.100--101 (OTS) for further
information. Go Back to Text
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