PROPOSED GUIDANCE ON NONTRADITIONAL MORTGAGES
Nontraditional mortgage products—including interest-only and payment option adjustable rate mortgages (ARMs)—have grown in popularity over recent years because they allow borrowers to defer payment of principal and sometimes interest.
However, due to the lack of principal amortization and the potential for negative amortization, the risk associated with these types of loans is heightened.
Therefore, on December 29, 2005, proposed Interagency Guidance was developed to address prudent lending practices, appropriate risk management practices, and consumer protection concerns. The Guidance was proposed by a group collectively referred to as the Agencies, which includes the:
- Office of the Comptroller of the Currency (OCC)
- Board of Governors of the Federal Reserve System (Board)
- Federal Deposit Insurance Corporation (FDIC)
- Office of Thrift Supervision (OTS)
- National Credit Union Administration (NCUA)
The following paragraphs discuss some of the highlights in the proposed Guidance.
Loan Terms and Underwriting Standards
According to the Agencies, loan terms and underwriting standards should address the effect of a substantial payment increase, also known as payment shock. The qualifying standards should recognize the potential for payment shock, as well as identify that nontraditional mortgage loans are often inappropriate for borrowers with high loan-to-value (LTV) ratios, high debt-to-income (DTI) ratios, and low credit scores. The Agencies also warn that institutions should not rely on underwriting practices that are dependent upon the value of the collateral pledged.
Layering of Risk
Layering of risk by an institution—for example, offering a nontraditional mortgage product with a reduced documentation feature and/or a simultaneous second-lien loan—is also addressed by the Agencies in the proposed Guidance. Institutions should compensate for this layered risk with requirements for higher credit scores, lower LTV and DTI ratios, and mortgage insurance.
If an institution is offering introductory interest rates, they should also consider the spread between the initial rate and the fully indexed rate when developing a nontraditional mortgage product.
Risk Management Practices
The proposed Guidance also advises institutions to adopt risk management practices that absorb the increased risk exposure associated with nontraditional mortgage products. For example, setting concentration limits based on loan types, third-party originations, and property occupancy status to maintain a diversified portfolio. Limits should also be set on key characteristics of nontraditional mortgage loans, such as the potential for negative amortization and layered risk.
Compliance and Audit Controls
Another way that an institution can mitigate risk is through their controls, such as compliance and audit. Procedures should specifically target the mortgage lending activities that exhibit higher risk, which includes exceptions to underwriting standards. Customer service and collections personnel should also receive specific product training relative to features of loan products, especially payment option ARMs and potential customer issues surrounding these types of products.
Consumer Protection and Communication
Finally, the Agencies address consumer protection issues, including recommended practices. Nontraditional mortgage loans carry significant risks, including payment shock and potential negative amortization, which may not be fully understood by consumers.
To ensure that these risks are communicated in a way that minimizes confusion, the Agencies propose that clear, balanced, and timely communication be given at crucial times throughout the loan transaction.
The Guidance also proposes that the communication be provided through different mediums, such as promotional materials that give a description of the product’s loan terms, as well as costs associated with the product and various features of the loan (such as negative amortization, payment shock, and prepayment penalties).
Monthly mortgage statements were also proposed as a way to communicate the payment choices associated with payment option ARMs, along with the consequences of the various payment options.
Comment Deadline
The comment deadline for the Interagency Guidance on Nontraditional Mortgage Products in the Federal Register was February 27, 2006. The Agencies will jointly review all of the comments submitted. To read the Guidance in full, click here.
SECURE COMMUNICATION EXCHANGE
Integration Options Provide Best Fit
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SDX-Onsite
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