Federal banking regulators have issued guidance that calls for clearer disclosures and tighter underwriting on exotic loans. But mortgage bankers say the new underwriting standards will choke innovation.
The Interagency Guidance on Nontraditional Mortgage Product Risks released Friday comes almost a year after the agencies proposed the guidance in response to the rapid growth of exotic lending to a wider spectrum of borrowers who may not otherwise qualify for similar loan amounts and may not fully understand the risks involved.
The agencies included the Office of the Comptroller of the Currency, the Federal Reserve System Board of Governors, the Federal Deposit Insurance Corp., the Office of Thrift Supervision and the National Credit Union Administration.
Their concerns over exotic loans were elevated due to the lack of principal amortization and the potential for negative amortization, as well as lenders engaging in risk layering -- the combining of nontraditional loans with other features that may compound risk, including simultaneous second-lien mortgages and relying on reduced or no documentation to evaluate a prospect's creditworthiness.
In response to public comments, the final guidance defined nontraditional loans as those that allow borrowers to defer the repayment of principal or interest, including interest only mortgages and payment option adjustable-rate mortgages. Home equity lines of credit were an exception as these are already covered in another guidance.
Borrowers should be qualified for nontraditional loans using the fully indexed rate, assuming a fully amortizing payment, including potential negative amortization amounts, according to the final guidance. The agencies said they expect a borrower to demonstrate the capacity to repay the full loan amount that may be advanced, including any balance increase that may accrue from the negative amortization provision.
The Center for Responsible Lending commended the tougher standards.
"Federal financial regulators took a step toward making the mortgage market safer for borrowers today," said Michael D. Calhoun, the center's president, in the announcement, "although there is much more to do."
The center suggested the guidance should expand to a much broader piece of the mortgage market -- subprime ARMs -- and apply to state-regulated mortgage companies that make loans but don't take deposits, as "almost 60 percent of the loans in the subprime market ... are not subject to scrutiny by the federal regulators issuing these guidelines."
But the Mortgage Bankers Association believes the "guidance seems like regulatory overreach," particularly because they restrict the ability of lenders to underwrite and manage risk differently from their competitors and limits borrowers' ability to choose affordable IO products.
In a written statement, MBA Chairwoman Regina M. Lowrie said, "The guidelines propose a one-size-fits-all underwriting standard that will unnecessarily choke industry innovation and diminish consumer choice.
"Despite the concerns expressed by some regarding the increased use of 'nontraditional products,' delinquency and foreclosure rates remain well within the range of historical norms," Lowrie said. "We do not believe these products present unreasonable risk."
With respect to risk layering, the agencies did not prohibit such practices, but suggested using strong quality control and risk mitigation factors, reminded lenders that a credible analysis of both a borrower's willingness and ability to repay is consistent with prudent lending practices, and cautioned that lenders should be able to readily document income for wage earners through means such as W-2 statements.
Despite commenters arguments that consumer protection issues, particularly disclosures, would be better addressed through generally applicable regulations to avoid disclosure burdens and information overload, the agencies determined that it was necessary that consumers receive the information about the material features of nontraditional mortgages.
Rather than including required model or sample disclosures in the guidance without first seeking public comment, the agencies provided a set of recommended practices to assist lenders in communicating to consumers particular risks raised by nontraditional mortgages.
"In addition to apprising consumers of the benefits of nontraditional mortgage products, institutions should take appropriate steps to alert consumers to the risks of these products, including the likelihood of increased future payment obligations," the agencies wrote. "This information should be provided in a timely manner -- before disclosures may be required under the Truth in Lending Act or other laws -- to assist the consumer in the product selection process."
The guidance focused on providing information to consumers during the pre-application shopping phase and post-closing with any monthly statements lenders choose to provide. Lenders can provide the information in a brief narrative format and through the use of examples based on hypothetical loan transactions, and are not required to give transaction-specific disclosures, the agencies said.
Risks of potential negative amortization, applicable prepayment penalties and their consequences, as well as premiums attached to reduced documentation programs, were listed as examples of what promotional materials and product descriptions should disclose. Monthly statements for option ARM borrowers should provide insight that enables informed payment choices, including an explanation of each payment option available and the impact of that choice on loan balances, the guidance said.
Following issuance of the guidelines, Washington Mutual released a statement saying it has offered option ARMs for more than 20 years and focuses on providing clear, understandable disclosures for its customers and ongoing training for its sales force.
WaMu noted that it was still analyzing the guidance, but said "all mortgage originators should be held to the same standards," and agreed with the center that state regulatory authorities should follow suit "so that consumers receive consistent disclosures and lenders have an even playing field."
A loan will not be determined to be collateral-dependent solely because it was underwritten using reduced documentation, the agencies determined.
In regard to third-party originations or practices, the guidance emphasized that institutions need to exercise appropriate due diligence prior to entering into a relationship with the party and to provide ongoing, effective oversight and controls. The agencies clarified they do not expect institutions to assume an unwarranted level of responsibility for the actions of third parties, but do expect control systems for loans purchased from or originated through third parties to be consistent with the agencies’ current supervisory policies.
Comments on the Proposed Illustrations of Consumer Information for Nontraditional Mortgage Products the agencies issued in response to the suggestions for required or sample models are due within 60 days of the proposal's publication in the Federal Register.
The agencies also noted that they amended the May 2005 Interagency Credit Risk Management Guidance for Home Equity Lending to provide additional guidance addressing the timing and content of communications with consumers obtaining IO HELOCs.