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5000 - Statements of Policy
{{10-31-06 p.5485}}
Interagency Guidance on Nontraditional Mortgage Product Risks
Residential mortgage lending has traditionally been a conservatively
managed business with low deliquencies and losses and reasonably stable
underwriting standards. In the past few years consumer demand has been
growing, particularly in high priced real estate markets, for
closed-end residential mortgage loan products that allow borrowers to
defer repayment of principal and, sometimes, interest. These mortgage
products, herein referred to as nontraditional mortgage loans, include
such products as "interest-only" mortgages where a borrower pays
no loan principal for the first few yesrs of the loan and "payment
option" adjustable-rate mortgages (ARMs) where a borrower has
flexible payment options with the potential for negative
amortization. 1
While some institutions have offered nontraditional mortgages for
many years with appropriate risk management and sound portfolio
performance, the market for these products and the number of
institutions offering them has expanded rapidly. Nontraditional
mortgage loan products are now offered by more lenders to a wider
spectrum of borrowers who may not otherwise qualify for more
traditional mortgage loans and may not fully understand the associated
risks.
Many of these nontraditional mortgage loans are underwritten with
less stringent income and asset verification requirements ("reduced
documentation") and are increasingly combined with simultaneous
second-lien loans. 2
Such risk layering, combined with the broader marketing of
nontraditional mortgage loans, exposes financial institutions to
increased risk relative to traditional mortgage loans.
Given the potential for heightened risk levels, management should
carefully consider and appropriately mitigate exposures created by
these loans. To manage the risks associated with nontraditional
mortgage loans, management should:
Ensure that loan terms and underwriting standards are
consistent with prudent lending practices, including consideration of a
borrower's repayment capacity;
Recognize that many nontraditional mortgage loans, particularly
when they have risk-layering features, are untested in a stressed
environment. As evidenced by experienced institutions, these products
warrant strong risk management standards, capital levels commensurate
with the risk, and an allowance for loan and lease losses that reflects
the collectibility of the portfolio; and
Ensure that consumers have sufficient information to clearly
understand loan terms and associated risks prior to making a product
choice.
The Office of the Comptroller of the Currency (OCC), the Board of
Governors of the Federal Reserve System (Board), the Federal Deposit
Insurance Corporation (FDIC), the Office of Thrift Supervision (OTS)
and the National Credit Union Administration (NCUA) (collectively, the
Agencies) expect institutions to effectively assess and manage the
risks associated with nontraditional mortgage loan
products. 3
Institutions should use this guidance to ensure that risk management
practices adequately address these risks. The Agencies will carefully
scrutinize risk management processes, policies, and procedures in this
area. Institutions that do not adequately manage these risks will be
asked to take remedial action.
The focus of this guidance is on the higher risk elements of certain
nontraditional mortgage products, not the product type itself.
Institutions with sound underwriting, adequate risk management, and
acceptable portfolio performance will not be subject to criticism
merely for offering such products.
{{10-31-06 p.5486}}
Loan Terms and Underwriting Standards
When an institution offers nontraditional mortgage loan products,
underwriting standards should address the effect of a substantial
payment increase on the borrower's capacity to repay when loan
amortization begins. Underwriting standards should also comply with the
agencies' real estate lending standards and appraisal regulations and
associated guidelines. 4
Central to prudent lending is the internal discipline to maintain
sound loan terms and underwriting standards despite competitive
pressures. Institutions are strongly cautioned against ceding
underwriting standards to third parties that have different business
objectives, risk tolerances, and core competencies. Loan terms should
be based on a disciplined analysis of potential exposures and
compensating factors to ensure risk levels remain manageable.
Qualifying Borrowers--Payments on nontraditional loans
can increase significantly when the loans begin to amortize. Commonly
referred to as payment shock, this increase is of particular concern
for payment option ARMs where the borrower makes minimum payments that
may result in negative amortization. Some institutions manage the
potential for excessive negative amortization and payment shock by
structuring the initial terms to limit the spread between the
introductory interest rate and the fully indexed rate. Nevertheless, an
institution's qualifying standards should recognize the potential
impact of payment shock, especially for borrowers with high
loan-to-value (LTV) ratios, high debt-to-income (DTI) ratios, and low
credit scores. Recognizing that an institution's underwriting criteria
are based on multiple factors, an institution should consider these
factors jointly in the qualification process and may develop a range of
reasonable tolerances for each factor. However, the criteria should be
based upon prudent and appropriate underwriting standards, considering
both the borrower's characteristics and the product's attributes.
For all nontraditional mortgage loan products, an institution's
analysis of a borrower's repayment capacity should include an
evaluation of their ability to repay the debt by final maturity at the
fully indexed rate, 5
assuming a fully amortizing repayment
schedule. 6
In addition, for products that permit negative amortization, the
repayment analysis should be based upon the initial loan amount plus
any balance increase that may accrue from the negative amortization
provision. 7
{{10-31-06 p.5487}}
Furthermore, the analysis of repayment capacity should avoid
over-reliance on credit scores as a substitute for income verification
in the underwriting process. The higher a loan's credit risk, either
from the loan features or borrower characteristics, the more important
it is to verify the borrower's income, assets, and outstanding
liabilities.
Colateral-Dependent Loans.--Institutions should avoid the
use of loan terms and underwriting practices that may heighten the need
for a borrower to rely on the sale or refinancing of the property once
amortization begins. Loans to individuals who do not demonstrate the
capacity to repay, as structured, from sources other than the
collateral pledged are generally considered unsafe and
unsound. 8
Institutions that originate collateral-dependent mortgage loans may be
subject to criticism, corrective action, and higher capital
requirements.
Risk Layering--Institutions that originate or purchase
mortgage loans that combine nontraditional features, such as interest
only loans with reduced documentation or a simultaneous second-lien
loan, face increased risk. When features are layered, an institution
should demonstrate that mitigating factors support the underwriting
decision and the borrower's repayment capacity. Mitigating factors
could include higher credit scores, lower LTV and DTI ratios,
significant liquid assets, mortgage insurance or other credit
enhancements. While higher pricing is often used to address elevated
risk levels, it does not replace the need for sound underwriting.
Reduced Documentation--Institutions increasingly rely on
reduced documentation, particularly unverified income, to qualify
borrowers for nontraditional mortgage loans. Because these practices
essentially substitute assumptions and unverified information for
analysis of a borrower's repayment capacity and general
creditworthiness, they should be used with caution. As the level of
credit risk increases, the Agencies expect an institution to more
diligently verify and document a borrower's income and debt reduction
capacity. Clear policies should govern the use of reduced
documentation. For example, stated income should be accepted only if
there are mitigating factors that clearly minimize the need for direct
verification of repayment capacity. For many borrowers, institutions
generally should be able to readily document income using recent W--2
statements, pay stubs, or tax returns.
Simultaneous Second-Lien Loans--Simultaneous second-lien
loans reduce owner equity and increase credit risk. Historically, as
combined loan-to-value ratios rise, so do defaults. A delinquent
borrower with minimal or no equity in a property may have little
incentive to work with a lender to bring the loan current and avoid
foreclosure. In addition, second-lien home equity lines of credit
(HELOCs) typically increase borrower exposure to increasing interest
rates and monthly payment burdens. Loans with minimal or no owner
equity generally should not have a payment structure that allows for
delayed or negative amortization without other significant risk
mitigating factors.
Introductory Interest Rates--Many institutions offer
introductory interest rates set well below the fully indexed rate as a
marketing tool for payment option ARM products. When developing
nontraditional mortgage product terms, an institution should consider
the spread between the introductory rate and the fully indexed rate.
Since initial and subsequent monthly payments are based on these low
introductory rates, a wide initial spread means that borrowers are more
likely to experience negative amortization, severe payment shock, and
an earlier-than-scheduled recasting of monthly payments. Institutions
should minimize the likelihood of disruptive early recastings and
extraordinary payment shock when setting introductory rates.
Lending to Subprime Borrowers--Mortgage programs that
target subprime borrowers through tailored marketing, underwriting
standards, and risk selection should follow the applicable interagency
guidance on subprime lending. 9
Among other things, the subprime guidance discusses circumstances under
which subprime lending can become predatory or
{{10-31-06 p.5488}}abusive. Institutions designing
nontraditional mortgage loans for subprime borrowers should pay
particular attention to this guidance. They should also recognize that
risk-layering features in loans to subprime borrowers may significantly
increase risks for both the institutions and the borrower.
Non-Owner-Occupied Investor Loans--Borrowers financing
non-owner-occupied investment properties should qualify for loans based
on their ability to service the debt over the life of the loan. Loan
terms should reflect an appropriate combined LTV ratio that considers
the potential for negative amortization and maintains sufficient
borrower equity over the life of the loan. Further, underwriting
standards should require evidence that the borrower has sufficient cash
reserves to service the loan, considering the possibility of extended
periods of property vacancy and the variability of debt service
requirements associated with nontraditional mortgage loan
products. 10
Portfolio and Risk Management
Institutions should ensure that risk management practices keep pace
with the growth and changing risk profile of their nontraditional
mortgage loan portfolios and changes in the market. Active portfolio
management is especially important for institutions that project or
have already experienced significant growth or concentration levels.
Institutions that originate or invest in nontraditional mortgage loans
should adopt more robust risk management practices and manage these
exposures in a thoughtful, systematic manner. To meet these
expectations, institutions should:
Develop written policies that specify acceptable product
attributes, production and portfolio limits, sales and securitization
practices, and risk management expectations;
Design enhanced performance measures and management reporting
that provide early warning for increasing risk;
Establish appropriate ALLL levels that consider the credit
quality of the portfolio and conditions that affect collectibility; and
Maintain capital at levels that reflect portfolio
characteristics and the effect of stressed economic conditions on
collectibility. Institutions should hold capital commensurate with the
risk characteristics of their nontraditional mortgage loan portfolios.
Policies--An institution's policies for nontraditional
mortgage lending activity should set acceptable levels of risk through
its operating practices, accounting procedures, and policy exception
tolerances. Policies should reflect appropriate limits on risk layering
and should include risk management tools for risk mitigation purposes.
Further, an institution should set growth and volume limits by loan
type, with special attention for products and product combinations in
need of heightened attention due to easing terms or rapid growth.
Concentrations--Institutions with concentrations in
nontraditional mortgage products should have well-developed monitoring
systems and risk management practices. Monitoring should keep track of
concentrations in key portfolio segments such as loan types,
third-party originations, geographic area, and property occupancy
status. Concentrations also should be monitored by key portfolio
characteristics such as loans with high combined LTV ratios, loans with
high DTI ratios, loans with the potential for negative amortization,
loans to borrowers with credit scores below established thresholds,
loans with risk-layered features, and non-owner-occupied investor
loans. Further, institutions should consider the effect of employee
incentive programs that could produce higher concentrations of
nontraditional mortgage loans. Concentrations that are not effectively
managed will be subject to elevated supervisory attention and potential
examiner criticism to ensure timely remedial action.
Controls--An institution's quality control, compliance,
and audit procedures should focus on mortgage lending activities posing
high risk. Controls to monitor compliance with underwriting standards
and exceptions to those standards are especially important for
nontraditional loan products. The quality control function should
regularly review a sample of nontraditional mortgage loans from all
origination channels and a representative sample of underwriters to
confirm that policies are being followed. When control systems or
operating practices are found deficient, business-line managers should
be held accountable for correcting deficiencies in a timely manner.
Since many nontraditional mortgage loans permit a borrower to defer
principal and, in some cases, interest payments for
extended
{{10-31-06 p.5489}}periods, institutions should have
strong controls over accruals, customer service and collections. Policy
exceptions made by servicing and collections personnel should be
carefully monitored to confirm that practices such as re-aging, payment
deferrals, and loan modifications are not inadvertently increasing
risk. Customer service and collections personnel should receive
product-specific training on the features and potential customer issues
with these products.
Third-Party Originations--Institutions often use third
parties, such as mortgage brokers or correspondents, to originate
nontraditional mortgage loans. Institutions should have strong systems
and controls in place for establishing and maintaining relationships
with third parties, including procedures for performing due diligence.
Oversight of third parties should involve monitoring the quality of
originations so that they reflect the institution's lending standards
and compliance with applicable laws and regulations.
Monitoring procedures should track the quality of loans by both
origination source and key borrower characteristics. This will help
institutions identify problems such as early payment defaults,
incomplete documentation, and fraud. If appraisal, loan documentation,
credit problems or consumer complaints are discovered, the institution
should take immediate action. Remedial action could include more
thorough application reviews, more frequent re-underwriting, or even
termination of the third-party
relationship. 11
Secondary Market Activity--The sophistication of an
institution's secondary market risk management practices should be
commensurate with the nature and volume of activity. Institutions with
significant secondary market activities should have comprehensive,
formal strategies for managing
risks. 12
Contingency planing should include how the institution will respond to
reduced demand in the secondary market.
While third-party loan sales can transfer a portion of the credit
risk, an institution remains exposed to reputation risk when credit
losses on sold mortgage loans or securitization transactions exceed
expectations. As a result, an institution may determine that it is
necessary to repurchase defaulted mortgages to protect its reputation
and maintain access to the markets. In the agencies' view, the
repurchase of mortgage loans beyond the selling institution's
contractual obligation is implicit recourse. Under the agencies'
risk-based capital rules, a repurchasing institution would be required
to maintain risk-based capital against the entire pool or
securitization. 13
Institutions should familiarize themselves with these guidelines before
deciding to support mortgage loan pools or buying back loans in
default.
Management Information and Reporting--Reporting systems
should allow management to detect changes in the risk profile of its
nontraditional mortgage loan portfolio. The structure and content
should allow the isolation of key loan products, risk-layering loan
features, and borrower characteristics. Reporting should also allow
management to recognize deteriorating performance in any of these areas
before it has progressed to far. At a minimum, information should be
available by loan type (e.g., interest-only mortgage loans
and payment option ARMs); by risk-layering features (e.g.,
payment option ARM with stated income and interest-only mortgage loans
with simultaneous second-lien mortgages); by underwriting
characteristics (e.g., LTV, DTI, and credit score); and by
borrower performance (e.g., payment patterns, delinquencies,
interest accruals, and negative amortization).
{{10-31-06 p.5490}}
Portfolio volume and performance should be tacked against
expectations, internal lending standards and policy limits. Volume and
performance expectations should be established at the subportfolio and
aggregate portfolio levels. Variance analyses should be performed
regularly to identify exceptions to policies and prescribed thresholds.
Qualitative analysis should occur when actual performance deviates from
established policies and thresholds. Variance analysis is critical to
the monitoring of a portfolio's risk characteristics and should be an
integral part of establishing and adjusting risk tolerance levels.
Stress Testing--Based on the size and complexity of their
lending operations, institutions should perform sensitivity analysis on
key portfolio segments to identify and quantify events that may
increase risks in a segment or the entire portfolio. The scope of the
analysis should generally include stress tests on key performance
drivers such as interest rates, employment levels, economic growth,
housing value fluctuations, and other factors beyond the institution's
immediate control. Stress tests typically assume rapid deterioration in
one or more factors and attempt to estimate the potential influence on
default rates and loss severity. Stress testing should aid an
institution in identifying, monitoring and managing risk, as well as
developing appropriate and cost-effective loss mitigation strategies.
The stress testing results should provide direct feedback in
determining underwriting standards, product terms, portfolio
concentration limits, and capital levels.
Capital and Allowance for Loan and Lease
Losses--Institutions should establish an appropriate allowance for
loan and lease losses (ALLL) for the estimated credit losses inherent
in their nontraditional mortgage loan portfolios. They should also
consider the higher risk of loss posed by layered risks when
establishing their ALLL.
Moreover, institutions should recognize that their limited
performance history with these products, particularly in a stressed
environment, increases performance uncertainty. Capital levels should
be commensurate with the risk characteristics of the nontraditional
mortgage loan portfolios. Lax underwriting standards or poor portfolio
performance may warrant higher capital levels.
When establishing an appropriate ALLL and considering the adequacy
of capital, institutions should segment their nontraditional mortgage
loan portfolios into pools with similar credit risk characteristics.
The basic segments typically include collateral and loan
characteristics, geographic concentrations, and borrower qualifying
attributes. Segments could also differentiate loans by payment and
portfolio characteristics, such as loans on which borrowers usually
make only minimum payments, mortgages with existing balances above
original balances, and mortgages subject to sizable payment shock. The
objective is to identify credit quality indicators that affect
collectibility for ALLL measurement purposes. In addition,
understanding characteristics that influence expected performance also
provides meaningful information about future loss exposure that would
aid in determining adequate capital levels.
Institutions with material mortgage banking activities and mortgage
servicing assets should apply sound practices in valuing the mortgage
servicing rights for nontraditional mortgages. In accordance with
interagency guidance, the valuation process should follow generally
accepted accounting principles and use reasonable and supportable
assumptions. 14
Consumer Protection Issues
While nontraditional mortgage loans provide flexibility for
consumers, the Agencies are concerned that consumers may enter into
these transactions without fully understanding the product terms.
Nontraditional mortgage products have been advertised and promoted
based on their affordability in the near term; that is, their lower
initial monthly payments compared with traditional types of mortgages.
In addition to apprising consumers of the benefits of nontraditional
mortgage products, institutions should take appropriate steps to alert
consumers to the risk of these products, including the likelihood of
increased future payment obligations. This information should be
provided in a timely manner--before
{{10-31-06 p.5491}}disclosures may be required under
the Truth in Lending Act or other laws--to assist the consumer in the
product selection process.
Concerns and Objectives--More than traditional ARMs,
mortgage products such as payment option ARMs and interest-only
mortgages can carry a significant risk of payment shock and negative
amortization that may not be fully understood by consumers. For
example, consumer payment obligations may increase substantially at the
end of an interest-only period or upon the "recast" of a payment
option ARM. The magnitude of these payment increases may be affected by
factors such as the expiration of promotional interest rates, increases
in the interest rate index, and negative amortization. Negative
amortization also results in lower levels of home equity as compared to
a traditional amortizing mortgage product. When borrowers go to sell or
refinance the property, they may find that negative amortization has
substantially reduced or eliminated their equity in it even when the
property has appreciated. The concern that consumers may not fully
understand these products would be exacerbated by marketing and
promotional practices that emphasize potential benefits without also
providing clear and balanced information about material risks.
In light of these considerations, communications with consumers,
including advertisements, oral statements, promotional materials, and
monthly statements, should provide clear and balanced information about
the relative benefits and risks of these products, including the risk
of payment shock and the risk of negative amortization. Clear,
balanced, and timely communication to consumers of the risks of these
products will provide consumers with useful information at crucial
decision-making points, such as when they are shopping for loans or
deciding which monthly payment amount to make. Such communication
should help minimize potential consumer confusion and complaints,
foster good customer relations, and reduce legal and other risks to the
institution.
Legal Risks--Institutions that offer nontraditional
mortgage products must ensure that they do so in a manner that complies
with all applicable laws and regulations. With respect to the
disclosures and other information provided to consumers, applicable
laws and regulations include the following:
Truth in Lending Act (TILA) and its implementing regulation,
Regulation Z.
Section 5 of the Federal Trade Commission Act (FTC Act).
TILA
and
Regulation
Z contain rules governing disclosures that institutions must
provide for closed-end mortgages in advertisements, with an
application, 15
before loan consummation, and when interest rates change.
Section
5 of the FTC Act prohibits unfair or deceptive acts or
practices. 16
Other Federal laws, including the fair lending laws and the Real
Estate Settlement Procedures Act
(RESPA),
also apply to these transactions. Moreover, the Agencies note that the
sale or securitization of a loan may not affect an institution's
potential liability for violations of TILA, RESPA, the FTC Act, or
other laws in connection with its origination of the loan. State laws,
including laws regarding unfair or deceptive acts or practices, also
may apply.
Recommended Practices
Recommended practices for addressing the risks raised by
nontraditional mortgage products include the
following: 17
{{10-31-06 p.5492}}
Communications with Consumers--When promoting or
describing nontraditional mortgage products, institutions should
provide consumers with information that is designed to help them make
informed decisions when selecting and using these products. Meeting
this objective requires appropriate attention to the timing, content,
and clarity of information presented to consumers. Thus, institutions
should provide consumers with information at a time that will help
consumers select products and choose among payment options. For
example, institutions should offer clear and balanced product
descriptions when a consumer is shopping for a mortgage--such as when
the consumer makes an inquiry to the institution about a mortgage
product and receives information about nontraditional mortgage
products, or when marketing relating to nontraditional mortgage
products is provided by the institution to the consumer--not just upon
the submission of an application or at
consummation. 18
The provisions of such information would serve as an important
supplement to the disclosures currently required under TILA and
Regulation Z or other laws. 19
Promotional Materials and Product Descriptions.
Promotional materials and other product descriptions should provide
information about the costs, terms, features, and risks of
nontraditional mortgages that can assist consumers in their product
selection decisions, including information about the matters discussed
below.
Payment Shock. Institutions should apprise consumers
of potential increases in payment obligations for these products,
including circumstances in which interest rates or negative
amortization reach a contractual limit. For example, product
descriptions could state the maximum monthly payment a consumer would
be required to pay under a hypothetical loan example once amortizing
payments are required and the interest rate and negative amortization
caps have been reached. 20
Such information also could describe when structural payment changes
will occur (e.g., when introductory rates expire, or when
amortizing payments are required), and what the new payment amount
would be or how it would be calculated. As applicable, these
descriptions could indicate that a higher payment may be required at
other points in time due to factors such as negative amortization or
increases in the interest rate index.
Negative Amortization. When negative amortization is
possible under the terms of a nontraditional mortgage product,
consumers should be apprised of the potential for increasing principal
balances and decreasing home equity, as well as other potential adverse
consequences of negative amortization. For example, product
descriptions should disclose the effect of negative amortization on
loan balances and home equity, and could describe the potential
consequences to the consumer of making minimum payments that cause the
loan to negatively amortize. (One possible consequence is that it could
be more difficult to refinance the loan or to obtain cash upon a sale
of the home).
Prepayment Penalties. If the institution may impose
a penalty in the event that the consumer prepays the mortgage,
consumers should be alerted to this fact and to the need to ask the
lender about the amount of any such
penalty. 21
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 on Payment Option ARMs. Monthly
statements that are provided to consumers on payment option ARMs should
provide information that enables consumers to make informed payment
choices, including an explanation of each payment option
available
{{8-31-07 p.5493}}and the impact of that choice on
loan balances. For example, the monthly payment statement should
contain an explanation, as applicable, next to the minimum payment
amount that making this payment would result in an increase to the
consumer's outstanding loan balance. Payment statements also could
provide the consumer's current loan balance, what portion of the
consumer's previous payment was allocated to principal and to
interest, and, if applicable, the amount by which the principal balance
increased. Institutions should avoid leading payment option ARM
borrowers to select a non-amortizing or negatively-amortizing payment
(for example, through the format or content of monthly statements).
Practices to Avoid. Institutions also should avoid
practices that obscure significant risks to the consumer. For example,
if an institution advertises or promotes a nontraditional mortgage by
emphasizing the comparatively lower initial payments permitted for
these loans, the institution also should provide clear and comparably
prominent information alerting the consumer to the risks. Such
information should explain, as relevant, that these payment amounts
will increase, that a balloon payment may be due, and that the loan
balance will not decrease and may even increase due to the deferral of
interest and/or principal payments. Similarly, institutions should
avoid promoting payment patterns that are structurally unlikely to
occur. 22
Such practices could raise legal and other risks for institutions, as
described more fully above.
Institutions also should avoid such practices as: Giving consumers
unwarranted assurances or predictions about the future direction of
interest rates (and, consequently, the borrower's future obligations);
making one-sided representations about the cash savings or expanded
buying power to be realized from nontraditional mortgage products in
comparison with amortizing mortgages; suggesting that initial minimum
payments in a payment option ARM will cover accrued interest (or
principal and interest) charges; and making misleading claims that
interest rates or payment obligations for these products are
"fixed".
Control Systems--Institutions should develop and use
strong control systems to monitor whether actual practices are
consistent with their policies and procedures relating to
nontraditional mortgage products. Institutions should design control
systems to address compliance and consumer information concerns as well
as the safety and soundness considerations discussed in this guidance.
Lending personnel should be trained so that they are able to convey
information to consumers about product terms and risks in a timely,
accurate, and balanced manner. As products evolve and new products are
introduced, lending personnel should receive additional training, as
necessary, to continue to be able to convey information to consumers in
this manner. Lending personnel should be monitored to determine whether
they are following these policies and procedures. Institutions should
review consumer complaints to identify potential compliance,
reputation, and other risks. Attention should be paid to appropriate
legal review and to using compensation programs that do not improperly
encourage lending personnel to direct consumers to particular products.
With respect to nontraditional mortgage loans that an institution
makes, purchases, or services using a third party, such as a mortgage
broker, correspondent, or other intermediary, the institution should
take appropriate steps to mitigate risks relating to compliance and
consumer information concerns discussed in this guidance. These steps
would ordinarily include, among other things, (1) Conducting due
diligence and establishing other criteria for entering into and
maintaining relationships with such third parties, (2) establishing
criteria for third-party compensation designed to avoid providing
incentives for originations inconsistent with this guidance, (3)
setting requirements for agreements with such third parties, (4)
establishing procedures and systems to monitor compliance with
applicable agreements, bank policies, and laws, and (5) implementing
appropriate corrective actions in the event that the third party fails
to comply with applicable agreements, bank policies, or
laws.
{{8-31-07 p.5494}}
Appendix: Terms Used in This Document
Interest-only Mortgage Loan--A nontraditional mortgage on
which, for a specified number of years (e.g., three or five
years), the borrower is required to pay only the interest due on the
loan during which time the rate may fluctuate or may be fixed. After
the interest-only period, the rate may be fixed or fluctuate based on
the prescribed index and payments include both principal and interest.
Payment Option ARM--A nontraditional mortgage that allows
the borrower to choose from a number of different payment options. For
example, each month, the borrower may choose a minimum payment option
based on a "start" or introductory interest rate, an
interest-only payment option based on the fully indexed interest rate,
or a fully amortizing principal and interest payment option based on a
15-year or 30-year loan term, plus any required escrow payments. The
minimum payment option can be less than the interest accruing on the
loan, resulting in negative amortization. The interest-only option
avoids negative amortization but does not provide for principal
amortization. After a specified number of years, or if the loan reaches
a certain negative amortization cap, the required monthly payment
amount is recast to require payments that will fully amortize the
outstanding balance over the remaining loan term.
Reduced Documentation--A loan feature that is commonly
referred to as "low doc/no doc", "no income/no asset",
"stated income" or "stated assets". For mortgage loans with
this feature, an institution sets reduced or minimal documentation
standards to substantiate the borrower's income and assets.
Simultaneous Second-Lien Loan--A lending arrangement
where either a closed-end second-lien or a home equity line of credit
(HELOC) is originated simultaneously with the first lien mortgage loan,
typically in lieu of a higher down payment.
[Source:
71
Fed. Reg. 58613, October 4, 2006]
1Interest-only and payment option ARMs are variations of
conventional ARMs, hybrid ARMs, and fixed rate products. Refer to the
Appendix for additional information on interest-only and payment option
ARM loans. This guidance does not apply to reverse mortgages; home
equity lines of credit ("HELOCs"), other than as discussed in the
Simultaneous Second-Lien Loans section; or fully amortizing residential
mortgage loan products. Go Back to Text
2Refer to the Appendix for additional information on reduced
documentation and simultaneous second-lien loans. Go Back to Text
3Refer 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). Go Back to Text
4Refer 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). Go Back to Text
5The 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. Go Back to Text
6The fully amortizing payment schedule should be based on the
term of the loan. For example, the amortizing payment for a loan with a
5-year interest only period and a 30-year term would be calculated
based on a 30-year amortization schedule. For balloon mortgages that
contain a borrower option for an extended amortization period, the
fully amortizing payment schedule can be based on the full term the
borrower may choose. Go Back to Text
7The balance that may accrue from the negative amortization
provision does not necessarily equate to the full negative amortization
cap for a particular loan. The spread between the introductory or
"teaser" rate and the accrual rate will determine whether or not
a loan balance has the potential to reach the negative amortization cap
before the end of the initial payment option period (usually five
years). For example, a loan with a 115 percent negative amortization
cap but a small spread between the introductory rate and the accrual
rate may only reach a 109 percent maximum loan balance before the end of the initial payment option period, even if only
minimum payments are made. The borrower could be qualified based on
this lower maximum loan balance. Go Back to Text
8A loan will not be determined to be
"collateral-dependent" solely through the use of reduced
documentation. Go Back to Text
9Interagency
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). Go Back to Text
10Federally insured credit unions must comply with 12 CFR part
723 for loans meeting the definition of member business loans. Go Back to Text
11Refer to OCC Bulletin 2001--47--Third-Party Relationships and
AL 2000--9--Third-Party Risk (OCC). Federally insured credit unions
should refer to 01--CU--20 (NCUA), Due Diligence over Third Party
Service Providers. Savings associations should refer to OTS Thrift
Bulletin 82a--Third Party Arrangements. Go Back to Text
12Refer to "Interagency Questions and Answers on Capital
Treatment of Recourse, Direct Credit Substitutes, and Residual
Interests in Asset Securitizations", May 23, 2002; OCC Bulletin
2002--22 (OCC); SR letter 02--16 (Board); Financial Institution Letter
(FIL--54--2002)
(FDIC); and CEO Letter 163 (OTS). See OCC's Comptroller
Handbook for Asset Securitization, November 1997. See OTS
Examination Handbook Section 221, Asset-Backed Securitization. The
Board also addressed risk management and capital adequacy of exposures
arising from secondary market credit activities in SR letter 97--21.
Federally insured credit unions should refer to 12 CFR Part 702
(NCUA). Go Back to Text
13Refer to 12 CFR part 3 Appendix A, Section 4 (OCC); 12 CFR
parts 208 and 225, Appendix A, III.B.3 (FRB); 12 CFR part 325, Appendix
A, II.B (FDIC); 12 CFR 567 (OTS); and 12 CFR part 702 (NCUA) for each
Agency's capital treatment of recourse. Go Back to Text
14Refer 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. Go Back to Text
15These 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. Go Back to Text
16The 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. Go Back to Text
17Institutions also should review the recommendations relating
to mortgage lending practices set forth in other supervisory guidance
from their respective primary regulators, as applicable, including
guidance on abusive lending practices. Go Back to Text
18Institutions also should strive to: (1) Focus on information
important to consumer decision making; (2) highlight key information so
that it will be noticed; (3) employ a user-friendly and readily
navigable format for presenting the information; and (4) use plain
language, with concrete and realistic examples. Comparative tables and
information describing key features of available loan products,
including reduced documentation programs, also may be useful for
consumers considering the nontraditional mortgage products and other
loan features described in this guidance. Go Back to Text
19Institutions may not be able to incorporate all of the
practices recommended in this guidance when advertising nontraditional
mortgages through certain forms of media, such as radio, television, or
billboards. Nevertheless, institutions should provide clear and
balanced information about the risks of these products in all forms of
advertising. Go Back to Text
20Consumers also should be apprised of other material changes
in payment obligations, such as balloon payments. Go Back to Text
21Federal credit unions are prohibited from imposing prepayment
penalties. 12 CFR 701.21(c)(6). Go Back to Text
22For example, marketing materials for payment option ARMs may
promote low predictable payments until the recast date. Such marketing
should be avoided in circumstances in which the minimum payments are so
low that negative amortization caps would be reached and higher payment
obligations would be triggered before the scheduled recast, even if
interest rates remain constant. Go Back to Text
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