Federal Deposit
Insurance Corporation

Board of Governors of the Federal Reserve System (Board); Federal

Deposit Insurance Corporation (FDIC); Office of Thrift Supervision,

Treasury (OTS); and National Credit Union Administration (NCUA)

(collectively, the Agencies).

ACTION: Final guidance--Statement on Subprime Mortgage Lending.

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SUMMARY: The Agencies are issuing a final interagency Statement on

Subprime Mortgage Lending. This guidance has been developed to clarify

how institutions can offer certain adjustable rate mortgage (ARM)

products in a safe and sound manner, and in a way that clearly

discloses the risks that borrowers may assume.

EFFECTIVE DATE: July 10, 2007.
 

FOR FURTHER INFORMATION CONTACT:

OCC: Michael Bylsma, Director, Community and Consumer Law Division,

(202) 874-5750 or Stephen Jackson, Director, Retail Credit Risk, (202)

874-5170.

Board: Division of Banking Supervision and Regulation: Brian P.

Valenti, Supervisory Financial Analyst, (202) 452-3575, Virginia M.

Gibbs, Senior Supervisory Financial Analyst, (202) 452-2521, or Sabeth

I. Siddique, Assistant Director, (202) 452-3861; Division of Consumer

and Community Affairs: Kathleen C. Ryan, Counsel, (202) 452-3667, or

Jamie Z. Goodson, Attorney, (202) 452-3667; or Legal Division: Kara L.

Handzlik, Attorney (202) 452-3852. Board of Governors of the Federal

Reserve System, 20th Street and Constitution Avenue, NW., Washington,

DC 20551. Users of Telecommunication Device for Deaf only, call (202)

263-4869.

FDIC: Beverlea S. Gardner, Examination Specialist, (202) 898-3640,

Division of Supervision and Consumer Protection; Richard B. Foley,

Counsel (202) 898-3784; Mira N. Marshall, Acting Chief Community

Reinvestment Act and Fair Lending, (202) 898-3912; April A. Breslaw,

Acting Associate Director, Compliance Policy & Exam Support Branch,

Division of Supervision and Consumer Protection, (202) 898-6609.

OTS: Tammy L. Stacy, Director of Consumer Regulation, Compliance

and Consumer Protection Division, (202) 906-6437; Glenn Gimble, Senior

Project Manager, Compliance and Consumer Protection Division, (202)

906-7158; William J. Magrini, Senior Project Manager, Credit Risk,

(202) 906-5744; or Teresa Luther, Economist, Credit Risk, (202) 906-

6798.

NCUA: Cory W. Phariss, Program Officer, Examination and Insurance,

(703) 518-6618.

SUPPLEMENTARY INFORMATION:

I. Background

The Agencies developed this Statement on Subprime Mortgage Lending

to address emerging risks associated with certain subprime mortgage

products and lending practices. In particular, the Agencies are

concerned about the growing use of ARM products \1\ that provide low

initial payments based on a fixed introductory rate that expires after

a short period, and then adjusts to a variable rate plus a margin for

the remaining term of the loan. These products could result in payment

shock to the borrower. The Agencies are concerned that these products,

typically offered to subprime borrowers, present heightened risks to

lenders and borrowers. Often, these products have additional

characteristics that increase risk. These include qualifying borrowers

based on limited or no documentation of income or imposing substantial

prepayment penalties or prepayment penalty periods that extend beyond

the initial fixed interest rate period. In addition, borrowers may not

be adequately informed of product features and risks, including their

responsibility to pay taxes and insurance, which might be separate from

their mortgage payments.

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\1\ For example, ARMs known as ``2/28'' loans feature a fixed

rate for two years and then adjust to a variable rate for the

remaining 28 years. The spread between the initial fixed interest

rate and the fully indexed interest rate in effect at loan

origination typically ranges from 300 to 600 basis points.

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These products originally were extended to customers primarily as a

temporary credit accommodation in anticipation of early sale of the

property or in expectation of future earnings growth. However, these

loans have more recently been offered to subprime borrowers as ``credit

repair'' or ``affordability'' products. The Agencies are concerned that

many subprime borrowers may not have sufficient financial capacity to

service a higher debt load, especially if they were qualified based on

a low introductory payment. The Agencies are also concerned that

subprime borrowers may not fully understand the risks and consequences

of obtaining this type of ARM loan. Borrowers who obtain these loans

may face unaffordable monthly payments after the initial rate

adjustment, difficulty in paying real estate taxes and insurance that

were not escrowed, or expensive refinancing fees, any of which could

cause borrowers to default and potentially lose their homes.

In response to these concerns, the Agencies published for comment

the Proposed Statement on Subprime Mortgage Lending (proposed

statement), 72 FR 10533 (March 8, 2007). The proposed statement

provided guidance on the criteria and factors, including payment shock,

that an institution should assess in determining a borrower's ability

to repay the loan. The proposed statement also provided guidance

intended to protect consumers from unfair, deceptive, and other

predatory practices, and to ensure that consumers are provided with

clear and balanced information about the risks and features of these

loans. Finally, the proposed statement addressed the need for strong

controls to adequately manage the risks associated with these products.

The Agencies requested comment on all aspects of the proposed

statement, and specifically requested comment about whether: (1) These

products always present inappropriate risks to institutions and

consumers, or the extent to which they may be appropriate under some

circumstances; (2) the proposed statement would unduly restrict the

ability of existing subprime borrowers to refinance their loans, and

whether other forms of credit are available that would not present the

risk of payment shock; (3) the principles of the proposed statement

should be applied beyond the subprime ARM market; and (4) limitations

on the use of

[[Page 37570]]

prepayment penalties would help meet borrower needs.

The Agencies collectively received 137 unique comments on the

proposed statement. Comments were received from financial institutions,

industry-related trade associations (industry groups), consumer and

community groups, government officials, and members of the public.

II. Overview of Public Comments

The commenters were generally supportive of the Agencies' efforts

to provide guidance in this area. However, many financial institution

commenters expressed concern that certain aspects of the proposed

statement were too prescriptive or could unduly restrict subprime

borrowers' access to credit. Many consumer and community group

commenters stated that the proposed statement did not go far enough in

addressing their concerns about these products.

Financial institutions and industry groups stated that they

supported prudent underwriting, but opposed a strict requirement that

ARM loans subject to the proposed statement be underwritten at a fully

indexed rate with a fully amortizing repayment schedule. They also

stated that these loan products are not always inappropriate,

particularly because they can be a useful credit repair vehicle or a

means to establish a favorable credit history. Many of these commenters

expressed concern that the proposed statement would unduly restrict

credit to subprime borrowers. They also requested that the proposed

statement be modified to allow lenders flexibility in helping existing

subprime borrowers refinance out of ARM loans that will reset to a

monthly payment that they cannot afford.

The majority of financial institutions and industry group

commenters opposed the application of the proposed statement outside

the subprime market. A number of these commenters requested

clarification of the scope of the proposed statement and the definition

of ``subprime.''

Some industry group commenters also expressed concern that consumer

disclosure requirements would put federally-regulated institutions at a

disadvantage and cause consumer information overload. They also

requested that any changes to consumer disclosure requirements be part

of a comprehensive reform of existing disclosure regulations.

Consumer and community group commenters generally supported the

proposed statement. Many of these commenters expressed their concern

that the products covered by the proposed statement present

inappropriate risks for subprime borrowers. Many of these commenters

supported extending the scope of the proposed statement to other

mortgage products. These commenters supported the proposed underwriting

criteria, though a number of them suggested stricter underwriting

criteria. They also supported further limiting or prohibiting the use

of reduced documentation and stated income loans, suggesting that such

a reduction would be in the best interests of consumers.

Both industry group and consumer and community group commenters

expressed concern that the proposed statement will not apply to all

lenders. Industry group commenters indicated this would put federally-

regulated financial institutions at a competitive disadvantage.

Consumer and community group commenters encouraged the Agencies to

continue to work with state regulators to extend the principles of the

proposed statement to non-federally supervised institutions. Since the

time that the Agencies announced the proposed statement, the Conference

of State Bank Supervisors (CSBS) and the American Association of

Residential Mortgage Regulators (AARMR) issued a press release

confirming their intent to ``develop a parallel statement for state

supervisors to use with state-supervised entities.'' \2\

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\2\ Media Release, CSBS & AARMR, ``CSBS and AARMR Support

Interagency Statement on Subprime Lending'' (March 2, 2007),

available at http://www.csbs.org/AM/Template.cfm?Section=Search&template=/CM/HTMLDisplay.cfm&ContentID=10295

.

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III. Agencies' Action on Final Joint Guidance

The Agencies are issuing the Statement on Subprime Mortgage Lending

(Statement) with some changes to respond to the comments received and

to provide additional clarity. The Statement applies to all banks and

their subsidiaries, bank holding companies and their nonbank

subsidiaries, savings associations and their subsidiaries, savings and

loan holding companies and their subsidiaries, and credit unions.

Significant comments on specific provisions of the proposed statement,

the Agencies' responses, and changes to the proposed statement are

discussed below.

Scope of Guidance

A number of financial institution and industry group commenters and

two credit reporting companies requested that the definition of

``subprime'' be clarified. A financial institution and an industry

group commenter requested a bright-line test to determine if a borrower

falls into the subprime category.

The Agencies considered commenters' requests that a definition of

``subprime'' be included in the Statement. The Agencies determined,

however, that the reference to the subprime borrower characteristics

from the 2001 Expanded Guidance for Subprime Lending Programs (Expanded

Guidance) provides appropriate information for purposes of this

Statement. The Expanded Guidance provides a range of credit risk

characteristics that are associated with subprime borrowers, noting

that the characteristics are illustrative and are not meant to define

specific parameters for all subprime borrowers.\3\ Because the term

``subprime'' is not consistently defined in the marketplace or among

individual institutions, the Agencies believe that incorporating the

subprime borrower credit risk characteristics from the Expanded

Guidance provides sufficient clarity.

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\3\ Federally insured credit unions should refer to LCU 04-CU-

13--Specialized Lending Activities.

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A number of commenters also requested clarification as to whether

the proposed statement applies to all products with the features

described. In addition, the Agencies specifically requested comment

regarding whether the proposed statement's principles should be applied

beyond the subprime ARM market. All consumer and community groups and

some of the financial institutions who addressed this question

supported application of the proposed statement beyond the subprime

market. However, most financial institution and industry group

commenters opposed application of the proposed statement beyond the

subprime market. These commenters stated that the issues the proposed

statement was designed to address are confined to the subprime market

and expansion of the proposed statement to other markets would

unnecessarily limit the options available to other borrowers.

As with the proposed statement, the Statement retains a focus on

subprime borrowers, due to concern that these consumers may not fully

understand the risks and consequences of these loans and may not have

the financial capacity to deal with increased obligations. The Agencies

did revise the language to indicate that the proposed statement applies

to certain ARM products that have one or more characteristics that can

cause payment shock, as defined in the proposed statement. While the

Statement has retained its focus on

[[Page 37571]]

subprime borrowers, the Agencies note that institutions generally

should look to the principles of this Statement when such ARM products

are offered to non-subprime borrowers.

Risk Management Practices

Predatory Lending Considerations

Some financial institution and industry group commenters raised

concerns that the proposed statement implied that subprime lending is

``per se'' predatory. The Statement clarifies that subprime lending is

not synonymous with predatory lending, and that there is no presumption

that the loans to which the Statement applies are predatory.

Qualifying Standards

The proposed statement provided that subprime ARMs should be

underwritten at the fully indexed rate with a fully amortizing

repayment schedule. Many consumer and community groups supported the

proposed statement's underwriting standards. Other consumer and

community groups thought that the proposed qualifying standards did not

go far enough, and suggested that these loans should be underwritten on

the basis of the maximum possible monthly payment. The majority of

industry group commenters who addressed this issue opposed the proposed

underwriting standard as overly prescriptive. Some commenters also

requested that the Statement define ``fully indexed rate with a fully

amortizing repayment schedule.'' All of the commenters that addressed

the issue favored including a reasonable estimate of property taxes and

insurance in an assessment of borrowers' debt-to-income ratios.

The Agencies continue to believe that institutions should maintain

qualification standards that include a credible analysis of a

borrower's capacity to repay the loan according to its terms. This

analysis should consider both principal and interest obligations at the

fully indexed rate with a fully amortizing repayment schedule, plus a

reasonable estimate for real estate taxes and insurance, whether or not

escrowed. Qualifying consumers based on a low introductory payment does

not provide a realistic assessment of a borrower's ability to repay the

loan according to its terms. Therefore, the proposed general guideline

of qualifying borrowers at the fully indexed rate, assuming a fully

amortizing payment, remains unchanged in the final Statement. The

Agencies did, however, provide additional information regarding the

terms ``fully indexed rate'' and ``fully amortizing payment schedule''

to clarify expectations regarding how institutions should assess

borrowers' repayment capacity.

Reduced Documentation or Stated Income Loans

Several commenters raised concerns about reduced documentation or

stated income loans. The majority of commenters who addressed this

issue supported the proposed statement's position that institutions

should be able to readily document income for many borrowers and that

reduced documentation should be accepted only if mitigating factors are

present. A few financial institution and industry group commenters

urged the Agencies to allow lenders some flexibility in deciding when

these loans are appropriate for borrowers whose income is derived from

sources that are difficult to verify. On the other hand, some consumer

and community group commenters stated that borrowers are not always

given the option to document income and thereby pay a lower interest

rate. They also indicated that stated income loans may be a vehicle for

fraud in that borrower income may be inflated to qualify for a loan.

The Agencies believe that verifying income is critical to

conducting a credible analysis of borrowers' repayment capacity,

particularly in connection with loans to subprime borrowers. Therefore,

the final Statement provides that stated income and reduced

documentation should be accepted only if there are mitigating factors

that clearly minimize the need for verification of repayment capacity.

The Statement provides some examples of mitigating factors, and sets

forth an expectation that reliance on mitigating factors should be

documented. The Agencies note that for many borrowers, institutions

should be able to readily document income using recent W-2 statements,

pay stubs, and/or tax returns.

Workout Arrangements

The Agencies specifically requested comment on whether the proposed

statement would unduly restrict the ability of existing subprime

borrowers to refinance out of certain ARMs to avoid payment shock. The

Agencies also asked about the availability to these borrowers of other

mortgage products that do not present the risk of payment shock. The

majority of financial institution and industry group commenters who

responded to this specific question believed that the proposed

statement would unduly restrict existing subprime borrowers' ability to

refinance. However, most consumer and community groups who addressed

the issue expressed the view that allowing existing borrowers to

refinance into another unaffordable ARM was not an acceptable solution

to the problem and, therefore, that eliminating this option would not

be an undue restriction on credit. Some commenters mentioned that

certain government-sponsored entities and lenders have already

committed to revise their lending program criteria and/or create new

programs that potentially may provide alternative mortgage products for

refinancing existing subprime loans.

To address these issues, the Agencies incorporated a section on

workout arrangements in the final text that references the principles

of the April 2007 interagency Statement on Working with Borrowers. The

Agencies believe prudent workout arrangements that are consistent with

safe and sound lending practices are generally in the long-term best

interest of both the financial institution and the borrower.

Consumer Protection Principles

Prepayment Penalties

The Agencies specifically requested comment regarding whether

prepayment penalties should be limited to the initial fixed-rate

period; how this practice, if adopted, would assist consumers and

affect institutions; and whether an institution's providing a window of

90 days prior to the reset date to refinance without a prepayment

penalty would help meet borrower needs. The overwhelming majority of

commenters who addressed this question agreed that prepayment penalties

should be limited to the initial fixed-rate period, and several

commenters proposed a complete prohibition of prepayment penalties.

Commenters suggested different time frames for expiration of the

prepayment penalty period, ranging from 30 to 90 days prior to the

reset date. Several industry group commenters, however, opposed such a

limitation. They stated that prepayment fees are a legitimate means for

lenders and investors to be compensated for origination costs when

borrowers prepay prior to the interest rate reset. Further, these

commenters noted that most lenders do not offer mortgage products that

have prepayment penalty periods that extend beyond the fixed interest

rate period and that borrowers should be allowed time to exit the loan

prior to the reset date.

In light of the comments received, the Agencies revised the

Statement to state

[[Page 37572]]

that the period during which prepayment penalties apply should not

exceed the initial reset period, and that institutions generally should

provide borrowers with a reasonable period of time (typically, at least

60 days prior to the reset date) to refinance their loans without

penalty. There is no supervisory expectation for institutions to waive

contractual terms with regard to prepayment penalties on existing

loans.\4\

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\4\ Federal credit unions are prohibited from charging

prepayment penalties. 12 CFR 701.21.

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Consumer Disclosure Issues

Many financial institution and industry group commenters suggested

that the Agencies' consumer protection goals would be better

accomplished through amendments to generally applicable regulations,

such as Regulation Z (Truth in Lending) \5\ or Regulation X (Real

Estate Settlement Procedures).\6\ Some financial institution and

consumer and community group commenters questioned the value of

additional disclosures and expressed concern that the proposed

statement would contribute to consumer information overload. A few

commenters stated that the proposed statement would add burdensome new

disclosure requirements and would result in the provision of confusing

information to consumers.

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\5\ 12 CFR part 226 (2006).

\6\ 24 CFR part 3500 (2005).

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Some industry group commenters asked the Agencies to provide

uniform disclosures for these products, or to publish illustrations of

the consumer information contemplated by the proposed statement similar

to those previously proposed by the Agencies in connection with

nontraditional mortgage products.\7\ Several commenters also requested

that any disclosures include the maximum possible monthly payment under

the terms of the loan.

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\7\ 71 FR 58673 (October 4, 2006).

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The Agencies have determined that, given the growth in the market

for the products covered by the Statement and the heightened legal,

compliance, and reputation risks associated with these products,

guidelines are needed now to ensure that consumers will receive the

information they need about the material features of these loans. In

addition, while the Agencies are sensitive to commenters' concerns

regarding disclosure burden, we do not anticipate that the information

outlined in the Statement will result in additional lengthy

disclosures. Rather, the Agencies contemplate that the information can

be provided in a brief narrative format and through the use of examples

based on hypothetical loan transactions. In response to requests by

commenters, the Agencies are working on and expect to publish for

comment proposed illustrations of the type of consumer information

contemplated in the Statement.

The Agencies disagree with the commenters who expressed concern

that the proposed statement appears to establish a suitability standard

under which lenders would be required to assist borrowers in choosing

products that are appropriate to their needs and circumstances. These

commenters argued that lenders are not in a position to determine which

products are most suitable for borrowers, and that this decision should

be left to borrowers themselves. It is not the Agencies' intent to

impose such a standard, nor is there any language in the Statement that

does so.

Control Systems

While some commenters who addressed the control systems portion of

the proposed statement supported the Agencies' proposal, some industry

group commenters expressed concern that these provisions were neither

realistic nor practical. A few industry group commenters requested

clarification of the scope of a financial institution's

responsibilities with regard to third parties. Some consumer and

community group commenters requested uniform regulation of and

increased enforcement against third parties.

The Agencies have carefully considered these comments, but have not

revised this portion of the proposed statement. The Agencies do not

expect institutions to assume an unwarranted level of responsibility

for the actions of third parties. Moreover, the control systems

discussed in the Statement are consistent with the Agencies' current

supervisory authority and policies.

Supervisory Review

The Agencies received no comments on the supervisory review portion

of the proposed statement. However, minor changes have been made to

clarify the circumstances under which the Agencies will take action

against institutions in connection with the products addressed in the

Statement.

IV. Text of Final Joint Guidance

The final interagency Statement on Subprime Mortgage Lending

appears below.

Statement on Subprime Mortgage Lending

The Agencies \8\ developed this Statement on Subprime Mortgage

Lending (Subprime Statement) to address emerging issues and questions

relating to certain subprime \9\ mortgage lending practices. The

Agencies are concerned borrowers may not fully understand the risks and

consequences of obtaining products that can cause payment shock.\10\ In

particular, the Agencies are concerned with certain adjustable-rate

mortgage (ARM) products typically offered to subprime borrowers that

have one or more of the following characteristics:

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\8\ The Agencies consist of the Board of Governors of the

Federal Reserve System (the Board), the Federal Deposit Insurance

Corporation (FDIC), the National Credit Union Administration (NCUA),

the Office of the Comptroller of the Currency (OCC), and the Office

of Thrift Supervision (OTS).

\9\ The term ``subprime'' is described in the 2001 Expanded

Guidance for Subprime Lending Programs. Federally insured credit

unions should refer to LCU 04-CU-13--Specialized Lending Activities.

\10\ Payment shock refers to a significant increase in the

amount of the monthly payment that generally occurs as the interest

rate adjusts to a fully indexed basis. Products with a wide spread

between the initial interest rate and the fully indexed rate that do

not have payment caps or periodic interest rate caps, or that

contain very high caps, can produce significant payment shock.

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Low initial payments based on a fixed introductory rate

that expires after a short period and then adjusts to a variable index

rate plus a margin for the remaining term of the loan; \11\

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\11\ For example, ARMs known as ``2/28'' loans feature a fixed

rate for two years and then adjust to a variable rate for the

remaining 28 years. The spread between the initial fixed interest

rate and the fully indexed interest rate in effect at loan

origination typically ranges from 300 to 600 basis points.

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Very high or no limits on how much the payment amount or

the interest rate may increase (``payment or rate caps'') on reset

dates;

Limited or no documentation of borrowers' income;

Product features likely to result in frequent refinancing

to maintain an affordable monthly payment; and/or

Substantial prepayment penalties and/or prepayment

penalties that extend beyond the initial fixed interest rate period.

Products with one or more of these features present substantial

risks to both consumers and lenders. These risks are increased if

borrowers are not adequately informed of the product features and

risks, including their responsibility for paying real estate taxes and

insurance, which may be separate from their monthly mortgage payments.

The consequences to borrowers could include: being unable

[[Page 37573]]

to afford the monthly payments after the initial rate adjustment

because of payment shock; experiencing difficulty in paying real estate

taxes and insurance that were not escrowed; incurring expensive

refinancing fees, frequently due to closing costs and prepayment

penalties, especially if the prepayment penalty period extends beyond

the rate adjustment date; and losing their homes. Consequences to

lenders may include unwarranted levels of credit, legal, compliance,

reputation, and liquidity risks due to the elevated risks inherent in

these products.

The Agencies note that many of these concerns are addressed in

existing interagency guidance. The most prominent are the 1993

Interagency Guidelines for Real Estate Lending (Real Estate

Guidelines), the 1999 Interagency Guidance on Subprime Lending, and the

2001 Expanded Guidance for Subprime Lending Programs (Expanded Subprime

Guidance).\12\

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\12\ Federally insured credit unions should refer to LCU 04-CU-

13--Specialized Lending Activities. National banks also should refer

to 12 CFR 34.3(b) and (c), as well as 12 CFR part 30, Appendix C.

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While the 2006 Interagency Guidance on Nontraditional Mortgage

Product Risks (NTM Guidance) may not explicitly pertain to products

with the characteristics addressed in this Statement, it outlines

prudent underwriting and consumer protection principles that

institutions also should consider with regard to subprime mortgage

lending. This Statement reiterates many of the principles addressed in

existing guidance relating to prudent risk management practices and

consumer protection laws.\13\

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\13\ As with the Interagency Guidance on Nontraditional Mortgage

Product Risks, 71 FR 58609 (October 4, 2006), this Statement applies

to all banks and their subsidiaries, bank holding companies and

their nonbank subsidiaries, savings associations and their

subsidiaries, savings and loan holding companies and their

subsidiaries, and credit unions.

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Risk Management Practices

Predatory Lending Considerations

Subprime lending is not synonymous with predatory lending, and

loans with the features described above are not necessarily predatory

in nature. However, institutions should ensure that they do not engage

in the types of predatory lending practices discussed in the Expanded

Subprime Guidance.\14\ Typically, predatory lending involves at least

one of the following elements:

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\14\ Federal credit unions should refer to 12 CFR 740.2 and 12

CFR 706 for information on prohibited practices.

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Making loans based predominantly on the foreclosure or

liquidation value of a borrower's collateral rather than on the

borrower's ability to repay the mortgage according to its terms;

Inducing a borrower to repeatedly refinance a loan in

order to charge high points and fees each time the loan is refinanced

(``loan flipping''); or

Engaging in fraud or deception to conceal the true nature

of the mortgage loan obligation, or ancillary products, from an

unsuspecting or unsophisticated borrower.

Institutions offering mortgage loans such as these face an elevated

risk that their conduct will violate Section 5 of the Federal Trade

Commission Act (FTC Act), which prohibits unfair or deceptive acts or

practices.\15\

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\15\ The OCC, the Board, the OTS, and the FDIC enforce this

provision under section 8 of the Federal Deposit Insurance Act. The

OCC, Board, and FDIC also have issued supervisory guidance to the

institutions under their respective jurisdictions concerning unfair

or deceptive acts or practices. See OCC Advisory Letter 2002-3--

Guidance on Unfair or Deceptive Acts or Practices, March 22, 2002,

and 12 CFR part 30, Appendix C; Joint Board and FDIC Guidance on

Unfair or Deceptive Acts or Practices by State-Chartered Banks,

March 11, 2004. The OTS also has issued a regulation that prohibits

savings associations from using advertisements or other

representations that are inaccurate or misrepresent the services or

contracts offered (12 CFR 563.27). The NCUA prohibits federally

insured credit unions from using any advertising or promotional

material that is inaccurate, misleading, or deceptive in any way

concerning its products, services, or financial condition (12 CFR

740.2).

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Underwriting Standards

Institutions should refer to the Real Estate Guidelines, which

provide underwriting standards for all real estate loans.\16\ The Real

Estate Guidelines state that prudently underwritten real estate loans

should reflect all relevant credit factors, including the capacity of

the borrower to adequately service the debt.\17\ The 2006 NTM Guidance

details similar criteria for qualifying borrowers for products that may

result in payment shock.

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\16\ Refer to 12 CFR part 34, subpart D (OCC); 12 CFR part 208,

subpart C (Board); 12 CFR part 365 (FDIC); 12 CFR 560.100 and 12 CFR

560.101 (OTS); and 12 CFR 701.21 (NCUA).

\17\ OTS Examination Handbook Section 212, 1-4 Family

Residential Mortgage Lending, also discusses borrower qualification

standards. Federally insured credit unions should refer to LCU 04-

CU-13--Specialized Lending Activities.

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Prudent qualifying standards recognize the potential effect of

payment shock in evaluating a borrower's ability to service debt. An

institution's analysis of a borrower's repayment capacity should

include an evaluation of the borrower's ability to repay the debt by

its final maturity at the fully indexed rate,\18\ assuming a fully

amortizing repayment schedule.\19\

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\18\ The fully indexed rate equals the index rate prevailing at

origination plus the margin to be added to it after the expiration

of an introductory interest rate. For example, assume that a loan

with an initial fixed rate of 7% will reset to the six-month London

Interbank Offered Rate (LIBOR) plus a margin of 6%. If the six-month

LIBOR rate equals 5.5%, lenders should qualify the borrower at 11.5%

(5.5% + 6%), regardless of any interest rate caps that limit how

quickly the fully indexed rate may be reached.

\19\ The fully amortizing payment schedule should be based on

the term of the loan. For example, the amortizing payment for a ``2/

28'' loan would be calculated based on a 30-year amortization

schedule. For balloon mortgages that contain a borrower option for

an extended amortization period, the fully amortizing payment

schedule can be based on the full term the borrower may choose.

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One widely accepted approach in the mortgage industry is to

quantify a borrower's repayment capacity by a debt-to-income (DTI)

ratio. An institution's DTI analysis should include, among other

things, an assessment of a borrower's total monthly housing-related

payments (e.g., principal, interest, taxes, and insurance, or what is

commonly known as PITI) as a percentage of gross monthly income.

This assessment is particularly important if the institution relies

upon reduced documentation or allows other forms of risk layering.

Risk-layering features in a subprime mortgage loan may significantly

increase the risks to both the institution and the borrower. Therefore,

an institution should have clear policies governing the use of risk-

layering features, such as reduced documentation loans or simultaneous

second lien mortgages. When risk-layering features are combined with a

mortgage loan, an institution should demonstrate the existence of

effective mitigating factors that support the underwriting decision and

the borrower's repayment capacity.

Recognizing that loans to subprime borrowers present elevated

credit risk, institutions should verify and document the borrower's

income (both source and amount), assets and liabilities. Stated income

and reduced documentation loans to subprime borrowers should be

accepted only if there are mitigating factors that clearly minimize the

need for direct verification of repayment capacity. Reliance on such

factors also should be documented. Typically, mitigating factors arise

when a borrower with favorable payment performance seeks to refinance

an existing mortgage with a new loan of a similar size and with similar

terms, and the borrower's financial condition has not deteriorated.

Other mitigating factors might include situations where a borrower has

substantial liquid reserves or assets that

[[Page 37574]]

demonstrate repayment capacity and can be verified and documented by

the lender. However, a higher interest rate is not considered an

acceptable mitigating factor.

Workout Arrangements

As discussed in the April 2007 interagency Statement on Working

with Borrowers, the Agencies encourage financial institutions to work

constructively with residential borrowers who are in default or whose

default is reasonably foreseeable. Prudent workout arrangements that

are consistent with safe and sound lending practices are generally in

the long-term best interest of both the financial institution and the

borrower.

Financial institutions should follow prudent underwriting practices

in determining whether to consider a loan modification or a workout

arrangement.\20\ Such arrangements can vary widely based on the

borrower's financial capacity. For example, an institution might

consider modifying loan terms, including converting loans with variable

rates into fixed-rate products to provide financially stressed

borrowers with predictable payment requirements.

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\20\ Institutions may need to account for workout arrangements

as troubled debt restructurings and should follow generally accepted

accounting principles in accounting for these transactions.

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The Agencies will not criticize financial institutions that pursue

reasonable workout arrangements with borrowers. Further, existing

supervisory guidance and applicable accounting standards do not require

institutions to immediately foreclose on the collateral underlying a

loan when the borrower exhibits repayment difficulties. Institutions

should identify and report credit risk, maintain an adequate allowance

for loan losses, and recognize credit losses in a timely manner.

Consumer Protection Principles

Fundamental consumer protection principles relevant to the

underwriting and marketing of mortgage loans include:

Approving loans based on the borrower's ability to repay

the loan according to its terms; and

Providing information that enables consumers to understand

material terms, costs, and risks of loan products at a time that will

help the consumer select a product.

Communications with consumers, including advertisements, oral

statements, and promotional materials, should provide clear and

balanced information about the relative benefits and risks of the

products. This information should be provided in a timely manner to

assist consumers in the product selection process, not just upon

submission of an application or at consummation of the loan.

Institutions should not use such communications to steer consumers to

these products to the exclusion of other products offered by the

institution for which the consumer may qualify.

Information provided to consumers should clearly explain the risk

of payment shock and the ramifications of prepayment penalties, balloon

payments, and the lack of escrow for taxes and insurance, as necessary.

The applicability of prepayment penalties should not exceed the initial

reset period. In general, borrowers should be provided a reasonable

period of time (typically at least 60 days prior to the reset date) to

refinance without penalty.\21\

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\21\ Federal credit unions are prohibited from charging

prepayment penalties. 12 CFR 701.21.

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Similarly, if borrowers do not understand that their monthly

mortgage payments do not include taxes and insurance, and they have not

budgeted for these essential homeownership expenses, they may be faced

with the need for significant additional funds on short notice.\22\

Therefore, mortgage product descriptions and advertisements should

provide clear, detailed information about the costs, terms, features,

and risks of the loan to the borrower. Consumers should be informed of:

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\22\ Institutions generally can address these concerns most

directly by requiring borrowers to escrow funds for real estate

taxes and insurance.

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Payment Shock. Potential payment increases, including how

the new payment will be calculated when the introductory fixed rate

expires.\23\

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\23\ To illustrate: a borrower earning $42,000 per year obtains

a $200,000 ``2/28'' mortgage loan. The loan's two-year introductory

fixed interest rate of 7% requires a principal and interest payment

of $1,331. Escrowing $200 per month for taxes and insurance results

in a total monthly payment of $1,531 ($1,331 + $200), representing a

44% DTI ratio. A fully indexed interest rate of 11.5% (based on a

six-month LIBOR index rate of 5.5% plus a 6% margin) would cause the

borrower's principal and interest payment to increase to $1,956. The

adjusted total monthly payment of $2,156 ($1,956 + $200 for taxes

and insurance) represents a 41% increase in the payment amount and

results in a 62% DTI ratio.

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Prepayment Penalties. The existence of any prepayment

penalty, how it will be calculated, and when it may be imposed.\24\

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\24\ See footnote 21.

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Balloon Payments. The existence of any balloon payment.

Cost of Reduced Documentation Loans. Whether there is a

pricing premium attached to a reduced documentation or stated income

loan program.

Responsibility for Taxes and Insurance. The requirement to

make payments for real estate taxes and insurance in addition to their

loan payments, if not escrowed, and the fact that taxes and insurance

costs can be substantial.

Control Systems

Institutions should develop strong control systems to monitor

whether actual practices are consistent with their policies and

procedures. Systems should address compliance and consumer information

concerns, as well as safety and soundness, and encompass both

institution personnel and applicable third parties, such as mortgage

brokers or correspondents.

Important controls include establishing appropriate criteria for

hiring and training loan personnel, entering into and maintaining

relationships with third parties, and conducting initial and ongoing

due diligence on third parties. Institutions also should design

compensation programs that avoid providing incentives for originations

inconsistent with sound underwriting and consumer protection

principles, and that do not result in the steering of consumers to

these products to the exclusion of other products for which the

consumer may qualify.

Institutions should have procedures and systems in place to monitor

compliance with applicable laws and regulations, third-party agreements

and internal policies. An institution's controls also should include

appropriate corrective actions in the event of failure to comply with

applicable laws, regulations, third-party agreements or internal

policies. In addition, institutions should initiate procedures to

review consumer complaints to identify potential compliance problems or

other negative trends.

Supervisory Review

The Agencies will continue to carefully review risk management and

consumer compliance processes, policies, and procedures. The Agencies

will take action against institutions that exhibit predatory lending

practices, violate consumer protection laws or fair lending laws,

engage in unfair or deceptive acts or practices, or otherwise engage in

unsafe or unsound lending practices.


[[Page 37575]]

Dated: June 28, 2007.

John C. Dugan,
Comptroller of the Currency.

By order of the Board of Governors of the Federal Reserve
System, June 28, 2007.
Jennifer J. Johnson,
Secretary of the Board.

Dated at Washington, DC, the 27th day of June, 2007.

By order of the Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary.

Dated: June 28, 2007.

By the Office of Thrift Supervision.
John Reich,
Director.

Dated: June 28, 2007.

By the National Credit Union Administration.
JoAnn M. Johnson,
Chairman.

[FR Doc. 07-3316 Filed 7-9-07; 8:45 am]
BILLING CODE 4810-33-P