Federal Bank Regulators Offer Guidelines For Exotic Mortgage Lending

Last Friday, as had been expected, the five federal departments or quasi-agencies charged with overseeing the nation's banking system jointly issued "guidance" to those banks regarding so-called "exotic" or non-traditional mortgages.

The recent popularity of interest only loans and option payment mortgages has raised concerns about their danger to homeowners and questions about how well their intricacies and risks are understood by borrowers. The guidelines also cautioned lenders to safeguard themselves against undue risk.

The agencies - The Board of Governors of The Federal Reserve System, The Office of Comptroller of the Currency, the Office of Thrift Supervision, the National Credit Union Administration, and the Federal Deposit Insurance Corporation - said in a joint press release that, while products such as these have long been available, the number of institutions offering them has expanded rapidly and they are being offered to a wider range of borrowers who might not be able to qualify for traditional mortgages of the same size.

In testimony before the Senate Banking Committee late last month the Government Accountability Office estimated that non-traditional mortgages rose from a ten percent market share to a 30 percent share between 2003 and 2005.

The joint press release from the five agencies states that while some of the risks concerning regulators are also found in other adjustable rate mortgages, the agencies' concern is elevated with the interest only and option payment products because of the lack of principal amortization and the potential for negative amortization. Also, institutions are now combining these non-traditional loans with other features that may compound risk, called "risk layering" such as making simultaneous second-lien mortgages (blended or piggy-back loans) and offering low or no documentation options in which borrowers are allowed to "state" their income with very little if any verification.

The final guidance - which was put forth in draft form for public comment some months ago - discusses the importance of managing the potential increased risk of these products. It suggests several steps that the management of individual institutions should take:

• Ensure that loan terms and underwriting standards are consistent with prudent lending practices including analysis of a borrower's ability to repay the loan.
• Recognize that many non-traditional products, especially when "risk layered" have never been tested in a stressed environment. Institutions should take care to insure that capital levels and allowances for loss reflect the risk of the portfolio.

The agencies also released for comment a set of illustrations for banks. These are drafts of consumer materials that institutions can voluntarily adopt as their own to save the investment necessary to create materials from scratch. One illustration is a sheet with detailed information explaining each loan product and providing suggested questions that borrowers should ask their lenders such as what the payments on the loan will be after the end of the interest only or option payment period; how interest rate increases could affect the monthly payment, and the maximum amount you could owe on the loan if only minimum payments are made. This illustration also includes cautions for borrowers about prepayment penalties, No Doc/Low Doc loans, and home equity lines of credit.

A second illustration puts forth for comparison the payments initially and through several rate increases of different loan products such as fixed rate, hybrid, interest only, and option payment loans. The most helpful part of this sheet was an analysis of where the principal balance of each loan would probably be after five years of payments.

The third proposed illustration was put forward as a possible inclusion in monthly bills for option payment mortgages. This lists the three choices the borrower can make that month - principal and interest payment, interest only payment, or minimal payment and the impact that each choice will have on the principal balance.

The guidance of course applies only to those banks and credit unions that are subject to federal supervision and not to private lenders. However, some of the big independent national mortgages companies have recently put in place their own risk reduction policies.

Not everybody was applauding the new federal guidance. Regina M. Lowrie, Chairman of the Mortgage Bankers Association (MBA) immediately issued a press release saying that while MBA believes that the regulators' efforts were well intentioned, MBA has strong concerns about their practical effects.

Ms. Lowrie stated,"Innovative, nontraditional mortgage products have allowed more people than ever to explore the possibility of homeownership, contributing to the nearly 70 percent rate of homeownership. The guidelines propose a one-size-fits-all underwriting standard that will unnecessarily choke industry innovation and diminish consumer choice.

These products provide an important option for homeowners who have used them to tap their home's increased equity for home improvements, to pay down debt and meet education and health care needs. 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. Mortgage bankers are in the business of getting people into homes, and keeping them there. Nobody gains when a loan is delinquent or a home is foreclosed upon."