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5000 - Statements of Policy
{{8-31-07 p.5495}}
Statement on Subprime Mortgage Lending
The Agencies 1
developed this Statement on Subprime Mortgage Lending (Subprime
Statement) to address emerging issues and questions relating to certain
subprime 2
mortgage lending practices. The Agencies are concerned borrowers may
not fully understand the risks and consequences of obtaining products
that can cause payment shock. 3
In particular, the Agencies are concerned with certain adjustable-rate
mortgage (ARM) products typically offered to subprime borrowers that
have one or more of the following characteristics:
• Low initial payments based on a fixed introductory rate that
expires after a short period and then adjusts to a variable index rate
plus a margin for the remaining term of the
loan; 4
• Very high or no limits on how much the payment amount or the
interest rate may increase ("payment or rate caps") on reset
dates;
• Limited or no documentation of borrowers' income;
• Product features likely to result in frequent refinancing to
maintain an affordable monthly payment; and/or
• Substantial prepayment penalties and/or prepayment penalties
that extend beyond the initial fixed interest rate period.
Products with one or more of these features present substantial
risks to both consumers and lenders. These risks are increased if
borrowers are not adequately informed of the product features and
risks, including their responsibility for paying real estate taxes and
insurance, which may be separate from their monthly mortgage payments.
The conse-quences to borrowers could include: being unable to afford
the monthly payments after the initial rate adjustment because of
payment shock; experiencing difficulty in paying real estate taxes and
insurance that were not escrowed; incurring expensive refinancing fees,
frequently due to closing costs and prepayment penalties, especially if
the prepayment penalty period extends beyond the rate adjustment date;
and losing their homes. Consequences to lenders may include unwarranted
levels of credit, legal, compliance, reputation, and liquidity risks
due to the elevated risks inherent in these products.
The Agencies note that many of these concerns are addressed in
existing interagency guidance. The most prominent are the 1993
Interagency Guidelines for Real Estate Lending
(Real
Estate Guidelines), the
1999
Interagency Guidance on Subprime Lending, and the 2001 Expanded
Guidance for Subprime Lending Programs
(Expanded
Subprime Guidance). 5
While the 2006 Interagency Guidance on Nontraditional Mortgage
Product Risks
(NTM
Guidance) may not explicitly pertain to products with the
characteristics addressed in this Statement, it outlines prudent
underwriting and consumer protection principles that institutions also
should consider with regard to subprime mortgage lending. This
Statement reiterates many of the principles addressed in existing
guidance relating to prudent risk management practices and consumer
protection laws. 6
{{8-31-07 p.5496}}
Risk Management Practices
Predatory Lending Considerations
Subprime lending is not synonymous with predatory lending, and loans
with the features described above are not necessarily predatory in
nature. However, institutions should ensure that they do not engage in
the types of predatory lending practices discussed in the Expanded
Subprime Guidance. 7
Typically, predatory lending involves at least one of the following
elements:
• Making loans based predominantly on the foreclosure or
liquidation value of a borrower's collateral rather than on the
borrower's ability to repay the mortgage according to its terms;
• Inducing a borrower to repeatedly refinance a loan in order to
charge high points and fees each time the loan is refinanced ("loan
flipping")' or
• Engaging in fraud or deception to conceal the true nature of
the mortgage loan obligation, or ancillary products, from an
unsuspecting or unsophisticated borrower.
Institutions offering mortgage loans such as these face an elevated
risk that their conduct will violate Section 5 of the Federal Trade
Commission Act (FTC Act), which prohibits unfair or deceptive acts or
practices. 8
Underwriting Standards
Institutions should refer to the Real Estate Guidelines, which
provide underwriting standards for all real estate
loans. 9
The Real Estate Guidelines state that prudently underwritten real
estate loans should reflect all relevant credit factors, including the
capacity of the borrower to adequately service the
debt. 10
The 2006 NTM Guidance details similar criteria for qualifying borrowers
for products that may result in payment shock.
Prudent qualifying standards recognize the potential effect of
payment shock in evaluating a borrower's ability to service debt. An
institution's analysis of a borrower's repayment capacity should
include an evaluation of the borrower's ability to repay the debt by
its final maturity at the fully indexed
rate, 11
assuming a fully amortizing repayment
schedule. 12
One widely accepted approach in the mortgage industry is to quantify
a borrower's repayment capacity by a debt-to-income (DTI) ratio. An
institution's DTI analysis should include, among other things, an
assessment of a borrower's total monthly housing-related payments
(e.g., principal, interest, taxes, and insurance, or what is
commonly known as PITI) as a percentage of gross monthly income.
This assessment is particularly important if the institution relies
upon reduced documentation or allows other forms of risk layering.
Risk-layering features in a subprime mortgage
{{8-31-07 p.5497}}loan may significantly increase the
risks to both the institution and the borrower. Therefore, an
institution should have clear policies governing the use of
risk-layering features, such as reduced documentation loans or
simultaneous second lien mortgages. When risk-layering features are
combined with a mortgage loan, an institution should demonstrate the
existence of effective mitigating factors that support the underwriting
decision and the borrower's repayment capacity.
Recognizing that loans to subprime borrowers present elevated credit
risk, institutions should verify and document the borrower's income
(both source and amount), assets and liabilities. Stated income and
reduced documentation loans to subprime borrowers should be accepted
only if there are mitigating factors that clearly minimize the need for
direct verification of repayment capacity. Reliance on such factors
also should be documented. Typically, mitigating factors arise when a
borrower with favorable payment performance seeks to refinance an
existing mortgage with a new loan of a similar size and with similar
terms, and the borrower's financial condition has not deteriorated.
Other mitigating factors might include situations where a borrower has
substantial liquid reserves or assets that demonstrate repayment
capacity and can be verified and documented by the lender. However, a
higher interest rate is not considered an acceptable mitigating factor.
Workout Arrangements
As discussed in the April 2007 interagency
Statement
on Working with Borrowers, the Agencies encourage financial
institutions to work constructively with residential borrowers who are
in default or whose default is reasonably foreseeable. Prudent workout
arrangements that are consistent with safe and sound lending practices
are generally in the long-term best interest of both the financial
institution and the borrower.
Financial institutions should follow prudent underwriting practices
in determining whether to consider a loan modification or a workout
arrangement. 13
Such arrangements can vary widely based on the borrower's financial
capacity. For example, an institution might consider modifying loan
terms, including converting loans with variable rates into fixed-rate
products to provide financially stressed borrowers with predictable
payment requirements.
The Agencies will not criticize financial institutions that pursue
reasonable workout arrangements with borrowers. Further, existing
supervisory guidance and applicable accounting standards do not require
institutions to immediately foreclose on the collateral underlying a
loan when the borrower exhibits repayment difficulties. Institutions
should identify and report credit risk, maintain an adequate allowance
for loan losses, and recognize credit losses in a timely manner.
Consumer Protection Principles
Fundamental consumer protection principles relevant to the
underwriting and marketing of mortgage loans include:
• Approving loans based on the borrower's ability to repay the
loan according to its terms; and
• Providing information that enables consumers to understand
material terms, costs, and risks of loan products at a time that will
help the consumer select a product.
Communications with consumers, including advertisements, oral
statements, and promotional materials, should provide clear and
balanced information about the relative benefits and risks of the
products. This information should be provided in a timely manner to
assist consumers in the product selection process, not just upon
submission of an application or at consummation of the loan.
Institutions should not use such communications to steer consumers to
these products to the exclusion of other products offered by the
institution for which the consumer may qualify.
Information provided to consumers should clearly explain the risk of
payment shock and the ramifications of prepayment penalties, balloon
payments, and the lack of escrow for taxes and insurance, as necessary.
The applicability of prepayment penalties should not exceed the initial
reset period. In general, borrowers should be provided a reasonable
period of time (typically at least 60 days prior to the reset date) to
refinance without penalty. 14
{{8-31-07 p.5498}}
Similarly, if borrowers do not understand that their monthly
mortgage payments do not include taxes and insurance, and they have not
budgeted for these essential homeownership expenses, they may be faced
with the need for significant additional funds on short
notice. 15
Therefore, mortgage product descriptions and advertisements should
provide clear, detailed information about the costs, terms, features,
and risks of the loan to the borrower. Consumers should be informed of:
• Payment Shock. Potential payment increases,
including how the new payment will be calculated when the introductory
fixed rate expires. 16
• Prepayment Penalties. The existence of any
prepayment penalty, how it will be calculated, and when it may be
imposed. 17
• Balloon Payments. The existence of any balloon
payment.
• Cost of Reduced Documentation Loans. Whether there
is a pricing premium attached to a reduced documentation or stated
income loan program.
• Responsibility for Taxes and Insurance. The
requirement to make payments for real estate taxes and insurance in
addition to their loan payments, if not escrowed, and the fact that
taxes and insurance costs can be substantial.
Control Systems
Institutions should develop strong control systems to monitor
whether actual practices are consistent with their policies and
procedures. Systems should address compliance and consumer information
concerns, as well as safety and soundness, and encompass both
institution personnel and applicable third parties, such as mortgage
brokers or correspondents.
Important controls include establishing appropriate criteria for
hiring and training loan personnel, entering into and maintaining
relationships with third parties, and conducting initial and ongoing
due diligence on third parties. Institutions also should design
compensation programs that avoid providing incentives for originations
inconsistent with sound underwriting and consumer protection
principles, and that do not result in the steering of consumers to
these products to the exclusion of other products for which the
consumer may qualify.
Institutions should have procedures and systems in place to monitor
compliance with applicable laws and regulations, third-party agreements
and internal policies. An institution's controls also should include
appropriate corrective actions in the event of failure to comply with
applicable laws, regulations, third-party agreements or internal
policies. In addition, institutions should initiate procedures to
review consumer complaints to identify potential compliance problems or
other negative trends.
Supervisory Review
The Agencies will continue to carefully review risk management and
consumer compliance processes, policies, and procedures. The Agencies
will take action against institutions that exhibit predatory lending
practices, violate consumer protection laws or fair lending laws,
engage in unfair or deceptive acts or practices, or otherwise engage in
unsafe or unsound lending practices.
[Source:
72
Fed. Reg. 37572, July 10, 2007]
1 The Agencies consist of the Board of Governors of the
Federal Reserve System (the Board), the Federal Deposit Insurance
Corporation (FDIC), the National Credit Union Administration (NCUA),
the Office of the Comptroller of the Currency (OCC), and the Office of
Thrift Supervision (OTS). Go Back to Text
2 The term "subprime" is described in the 2001 Expanded
Guidance for Subprime Lending Programs. Federally insured credit unions
should refer to LCU 04--CU--13--Specialized Lending Activities. Go Back to Text
3 Payment shock refers to a significant increase in the amount
of the monthly payment that generally occurs as the interest rate
adjusts to a fully indexed basis. Products with a wide spread between
the initial interest rate and the fully indexed rate that do not have
payment caps or periodic interest rate caps, or that contain very high
caps, can produce significant payment shock. Go Back to Text
4 For example, ARMs known as "2/28" loans feature a
fixed rate for two years and then adjust to a variable rate for the
remaining 28 years. The spread between the initial fixed interest rate
and the fully indexed interest rate in effect at loan origination
typically ranges from 300 to 600 basis points. Go Back to Text
5 Federally insured credit unions should refer to LCU
04--CU--13--Specialized Lending Activities. National banks also should
refer to 12 CFR 34.3(b) and (c), as well as 12 CFR part 30, Appendix
C. Go Back to Text
6 As with the Interagency Guidance on Nontraditional Mortgage
Product Risks, 71 FR 58609 (October 4, 2006), this Statement applies 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. Go Back to Text
7 Federal credit unions should refer to 12 CFR 740.2 and 12
CFR 706 for information on prohibited practices. Go Back to Text
8 The OCC, the Board, the OTS, and the FDIC enforce this
provision under section 8 of the Federal Deposit Insurance Act. The
OCC, Board, and FDIC also have 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, and 12 CFR
part 30, Appendix C; Joint Board and FDIC Guidance on Unfair or
Deceptive Acts or Practices by State-Chartered Banks, March 11, 2004.
The OTS also has issued 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). The NCUA prohibits federally insured credit unions 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). Go Back to Text
9 Refer to 12 CFR part 34, subpart D (OCC); 12 CFR part 208,
subpart C (Board); 12 CFR part 365 (FDIC); 12 CFR 560.100 and 12 CFR
560.101 (OTS); and 12 CFR 701.21 (NCUA). Go Back to Text
10 OTS Examination Handbook Section 212, 1--4 Family
Residential Mortgage Lending, also discusses borrower qualification
standards. Federally insured credit unions should refer to LCU
04--CU--13--Specialized Lending Activities. Go Back to Text
11 The fully indexed rate equals the index rate prevailing at
origination plus the margin to be added to it after the expiration of
an introductory interest rate. For example, assume that a loan with an
initial fixed rate of 7% will reset to the six-month London Interbank
Offered Rate (LIBOR) plus a margin of 6%. If the six-month LIBOR rate
equals 5.5%, lenders should qualify the borrower at 11.5% (5.5% +
6%), regardless of any interest rate caps that limit how quickly the
fully indexed rate may be reached. Go Back to Text
12 The fully amortizing payment schedule should be based on
the term of the loan. For example, the amortizing payment for a
"2/28" loan 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
13 Institutions may need to account for workout arrangements
as troubled debt restructurings and should follow generally accepted
accounting principles in accounting for these transactions. Go Back to Text
14 Federal credit unions are prohibited from charging
prepayment penalties. 12 CFR 701.21. Go Back to Text
15 Institutions generally can address these concerns most
directly by requiring borrowers to escrow funds for real estate taxes
and insurance. Go Back to Text
16 To illustrate: a borrower earning $42,000 per year obtains
a $200,000 "2/28" mortgage loan. The loan's two-year
introductory fixed interest rate of 7% requires a principal and
interest payment of $1,331. Escrowing $200 per month for taxes and
insurance results in a total monthly payment of $1,531 ($1,331 + $200),
representing a 44% DTI ratio. A fully indexed interest rate of 11.5%
(based on a six-month LIBOR index rate of 5.5% plus a 6% margin)
would cause the borrower's principal and interest payment to increase
to $1,956. The adjusted total monthly payment of $2,156 ($1,956 + $200
for taxes and insurance) represents a 41% increase in the payment
amount and results in a 62% DTI ratio. Go Back to Text
17 See footnote 14. Go Back to Text
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