Regulation of Nontraditional Loans Proposed

At issue is the proposed Interagency Guidance on Nontraditional Mortgage Products.

Worries of growth in less traditional loan products in a rising rate environment spurred issuance of the proposed guidelines in December by the Office of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corp., the Office of Thrift Supervision and the National Credit Union Administration. The regulators worried non-traditional mortgages could strain the finances of borrowers and banks.

The Mortgage Bankers Association’s senior vice president for government affairs, Kurt Pfotenhauer, said the group “believes the creation of guidance on nontraditional products is a positive development, but we find the proposed guidance is overly prescriptive in mandating specific underwriting standards and that some sections should be clarified, modified or removed to ensure that the proposed guidance does not stifle mortgage product innovation and hurt consumers’ access to homeownership opportunities.”

In a letter submitted to the federal banking regulators Wednesday, the mortgage bankers, citing examples of the wide acceptance adjustable-rate mortgages gained in the high interest rate environment of the 1980s and the more recent boost in hybrid ARMs, explained that the mortgage market is constantly developing loan features that may be termed “nontraditional” but are beneficial to borrowers.

Such is the case for IO and payment-option mortgages, MBA said. IO mortgages reportedly accounted for 23 percent of the volume in the first half of 2005.

Lenders “have successfully offered such products for decades, through different market cycles, without a threat to their safety and soundness,” MBA said. Therefore, it is prudent that regulators not impose prescriptive requirements that would force lenders to change proven standards and disadvantage institutions that have the longest experience in offering such products.

Additionally, IO and option mortgages “do not pose unmanageable risks,” thereby the “guidance should not start from the premise that the risks of these products are somehow more unmanageable than the risks of any other mortgage products,” the Washington, D.C.-based trade group added.

The American Bankers Association concurred, saying the guidance’s tenor that less traditional products are inherently riskier than other loans is incorrect, as “they simply present different types of risks that may be well-managed by prudent lenders. In fact a number of savings associations and national banks have managed the risks from these products for two decades.”

The mortgage bankers say reports and data indicate that borrowers of such loans generally have higher credit scores and lower loan-to-value ratios, and confirm that “lenders understand that risk-layering, as is pointed out in the Proposed Guidance, requires lenders to contemplate mitigating factors.”

“We want to ensure that guidance on these products maintains the safety and soundness of Federally-regulated institutions without disrupting mortgage market innovation or curtailing consumer access to financing,” the mortgage bankers’ Pfotenhauer said. “Secondary market investors, through pricing, have already required lenders to address many of the concerns identified by the Federal regulators.”

MBA additionally found that the guidance does not appear to recognize lenders treat IO and payment-option mortgages differently in terms of credit policy, underwriting standards, and risk management, and infers the same policies should apply to both products. For example, the guidance, reportedly asserts: “For all nontraditional mortgage loan products, the analysis of borrowers’ repayment capacity should include an evaluation of their ability to repay the debt by final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule.”

The guidance also proposes underwriting nontraditional mortgages to a worst-case scenario that is not standard practice for other variable-rate products.

“Automated tools and advanced risk modeling have allowed lenders to go beyond simple thresholds for borrowers that exhibit risk mitigating characteristics,” MBA said. Rather than regressing to adopting prescriptive and rigid underwriting standards, lenders could instead be advised to consider the length of the interest-only period in determining whether or not to qualify the borrower on the interest-only payment or the amortizing payment.

Another specific concern of the MBA is that guidance’s language creates additional disclosures that will turn out into a more fragmented system for consumers rather than using the Federal Reserve’s regulatory authority under the Truth in Lending Act and/or working with the Department of Housing and Urban Development on the Real Estate Settlement Procedures Act to improve and standardize disclosures for all consumers.

America’s Community Bankers support appropriate disclosures to potential borrowers about alternative mortgage terms, but not the proposed requirement to have lenders determine the “suitability” of mortgage products for the individual consumer.

“We do not believe it is appropriate or possible for the lender to dictate the best mortgage products for individual consumers,” the community bankers said.

ABA noted that the fact that the guidance’s consumer protections will apply only to regulated financial institutions and their affiliates is inconsistent with other consumer provisions under Regulations B and Z and Section 5 of the Federal Trade Commission Act and leaves a significant portion of the mortgage industry unaffected.

Requiring lenders to use control systems to ensure practices are consistent with their policies and procedures for loans originated internally, through brokers or other third parties and those it purchases “will result not only in uneven application of the Guidance throughout the mortgage industry but also in covered lenders being given the task of somehow policing lenders” that are not subject to the actual disclosure requirements, the ABA said.

MBA added that holding federally-regulated institutions responsible for the marketing practices of third party originators, is “significantly beyond the institutions’ control and reasonable ability to comply,” thus “such a standard is not in place for traditional mortgage products and should not be implemented for nontraditional mortgage products.”

MBA said it also disagrees with the assertion that voluntary repurchase of loans constitutes “implicit recourse” requiring risk-based capital be maintained against the entire portfolio. MBA suggested removing the concept of “implicit recourse” from the guidance and the additional risk-based capital requirement beyond that which is legally required.