ARM’d & Dangerous

The federal financial regulatory agencies announced Tuesday they issued for comment proposed guidance on nontraditional mortgage products, including interest-only mortgages and payment-option adjustable-rate mortgages.

While the regulators acknowledge innovations in the mortgage market benefit some consumers, they worry that nontraditional products are being offered to a wider spectrum of borrowers, including subprime borrowers and others who may not otherwise qualify for traditional fixed-rate or adjustable-rate mortgages or who may not fully understand the associated risks of nontraditional loans, according to the proposed guidance report.

“The Agencies recognize that many of the risks associated with nontraditional mortgage loans exist in other adjustable-rate mortgage products, but our concern is elevated with nontraditional products due to the lack of principal amortization and potential accumulation of negative amortization,” they said in the report.

“In addition, institutions are increasingly combining these loans with other practices, such as making simultaneous second-lien mortgages and allowing reduced documentation in evaluating the applicant’s creditworthiness,” the agencies added.

The agencies expressed concern regarding the potential heightened risk levels nontraditional mortgages create for lenders, as regulatory experience with nontraditional mortgages has shown that “prudent management of these programs requires increased attention in product development, underwriting, compliance, and risk management functions.”

The proposed guidance seeks to clarify how institutions can offer untraditional mortgages in a safe and sound manner, and in a way that clearly discloses the potential risks that borrowers may assume, the agencies said, adding that they “will carefully scrutinize institutions’ lending programs, including policies and procedures, and risk management processes in this area.”

The regulators specifically request comment on the proposed comprehensive debt service qualification standards, which would have lenders assess a borrower’s ability to repay the debt by final maturity at the fully-indexed rate, assuming a fully-amortizing repayment schedule. For mortgages with potential negative amortization, the agencies suggest lenders’ repayment analysis include the initial loan amount plus any balance increase that may accrue through the negative amortization provision, according to the report.

The proposed guidance also suggests lenders avoid using loan terms and underwriting practices that may result in the borrower having to rely on the sale or refinancing of the property once amortization begins. “Institutions determined to be originating collateral-dependent mortgage loans, may be subject to criticism, corrective action, and higher capital requirements,” the agencies said.

Reduced documentation in underwriting, such as stated income, should be accepted only if there are other mitigating factors such as lower loan-to-value, the regulators proposed. Among other questions listed for comment, the agencies ask what specific circumstances would make using reduced doc appropriate in underwriting.

Because nontraditional mortgages have been marketed based on their near-term monthly payment affordability, prior to the consumer making a decision on a loan product or payment, lenders should communicate “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.” Advertisements, oral statements, promotional materials, and monthly statements, should be consistent with product terms and payment structures, the report said.

Among other things, the proposed guidance emphasizes that lenders recognize “certain nontraditional mortgage loans are untested in a stressed environment and warrant strong risk management standards as well as appropriate capital and loan loss reserves,” according to an announcement.

Lenders that originate or invest in nontraditional mortgage loans were advised to adopt more robust risk management practices and manage exposures in systematic manner by developing written policies that specify acceptable product attributes, production and portfolio limits, sales and securitization practices, and risk management expectations; enhancing performance measures and management reporting that provide early warning for increasing risk; establishing appropriate allowance for loan and lease loss levels that consider the credit quality of the portfolio, as well as conditions that affect collectibility; and maintaining capital at levels that reflect portfolio characteristics, the proposed guidance report said.

The commentary period that will expire 60 days after publication in the Federal Register, said the agencies, comprised of the Federal Reserve, the Federal Deposit Insurance Corp., National Credit Union Administration, Office of the Comptroller of the Currency and the Office of Thrift Supervision.