Breaking New Ground in U.S. Mortgage Lending
Mortgage lending activity has been expanding in the United States for decades.
The nation has seen a substantial increase in homeownership in just the past
ten years, while the recent housing boom has further boosted the demand for
mortgage credit. A series of historical legislative and regulatory changes in
the 1970s and 1980s shaped the mortgage market, transforming it into a more
competitive marketplace. The mortgage market has again been transformed in recent
years as significant product innovation by lenders has expanded the supply of
mortgage credit to meet the rising demand.
Despite the rapid growth in credit volumes, mortgage loan performance among
financial institutions insured by the Federal Deposit Insurance Corporation
(FDIC) is favorable at present. Nevertheless, growth has not come without risk.
Widespread marketing of non-traditional products could be raising the risk profile
of some mortgage lenders and consumers. Growing unease about risk taking by
lenders and consumers recently led bank regulators to propose new supervisory
guidelines on risks of, and disclosures for, various mortgage products.
This article examines historical developments in mortgage loan volume and underwriting
trends. It also assesses the significance of recent market and institutional
innovations in light of historical trends, reviews mortgage loan performance
trends, discusses the role of regulation, and considers the near-term outlook
for the mortgage lending cycle.
A Look Back
Government involvement has played a fundamental role in shaping the U.S. mortgage
credit market. Historical legislative reforms intended to improve housing affordability
and increase homeownership have been an important factor in a strong upward
trend in mortgage loan volume. At the same time, history shows us that the volume
and quality of mortgage credit exhibit cyclical patterns as economic and housing
cycles further influence credit availability and performance. For example, periods
of high interest rates and inflation during the late 1970s and early 1980s dampened
mortgage growth. Credit quality also deteriorated considerably during this time
of economic stress. However, beginning in the late 1980s, mortgage credit volume
grew significantly, and the dramatic upswing in mortgage volume since 2000 has
been unprecedented (see Chart 1).
The recent housing boom reflects the confluence of rising borrower demand, historically
low interest rates, intense lender competition, innovations in the structure
and marketing of mortgages, and an abundance of capital from lenders and mortgage
securities investors. A look at historical milestones that helped define the
current mortgage credit landscape will assist in understanding the evolution
of the mortgage market.
Impact of Legislative Reforms
Key influences on the U.S. mortgage credit cycle during the past century are
legislative reforms and the mandates of certain government and quasi-government
institutions. For example, the establishment of the Federal Home Loan Bank system
in 1932 and the Federal Housing Administration in 1937 broadened borrower qualifications
for mortgages and paved the way for the modern mortgage market (see Chart 2).
By the beginning of the 1980s, the mortgage market was delineated such that
savings and loan associations (S&Ls) processed conventional mortgage loans,
mortgage bankers originated government mortgage loans, and mortgage brokers
handled the balance, including second mortgages and those with elevated credit
Before 1980, institutional lenders were subject to strict interest rate ceilings
on their deposits, established by the Federal Reserve’s Regulation Q.
This regulation provided for higher ceilings on thrift institution deposits
than on commercial bank deposits, securing S&Ls’ funding advantage.2
The late 1970s inflationary environment opened an unsustainable gap between
income generated by assets and short-term funding costs, thereby undermining
S&Ls’ theoretical foundation that had provided economic stability
for them in the past. Further, as inflation soared, depositors fled from S&Ls
to higher-yielding opportunities outside the regulated banking system. The resulting
disintermediation helped set the stage for the enactment of the Depository Institutions
Deregulation and Monetary Act of 1980, which mandated a six-year phase-out of
the Regulation Q interest-rate ceiling and created the money market deposit
to enable FDIC-insured institutions to compete with brokerage houses for wholesale
funds.3 Although it helped S&Ls retain deposits,
the elimination of Regulation Q ended their favored status in the U.S. mortgage
The enactment of the Alternative Mortgage Transaction Parity Act in 1982 eliminated
regulatory disparities between state- and federal-chartered mortgage banks by
granting state-chartered institutions the authority to issue alternative mortgages,
including the use of variable interest rates and balloon payments, regardless
of state mortgage lending laws.5 This legislation
increased the supply of mortgage credit. The Tax Reform Act of 1986 then stimulated
demand for mortgage debt by retaining the deduction for home mortgage interest
while eliminating the deduction for nonmortgage consumer debt, such as car loans
and educational loans. The tax-deductible status of debt secured by homes made
mortgage debt a more attractive after-tax financing option than nondeductible
consumer debt (see inset box, “Substituting Mortgage Debt for Consumer
Debt,” next page).
Impact of Mortgage Securitizations
Following the elimination of Regulation Q, control of the mortgage market shifted
dramatically in the 1980s from savings institutions to banks and to federal
government-sponsored enterprises (GSEs), which played a major role in the creation
of mortgage-backed securities (MBS). These securitizations further opened the
U.S. mortgage market to investors, introducing considerable new liquidity.6
By 2005, almost 68 percent of home mortgage originations were securitized.7
This reliance on securitization underscores its importance as a risk-management
tool that allows lenders to shift mortgage credit risk and interest rate risk
to investors who have greater risk tolerance.
A significant development in the mortgage securities market is the recent and
dramatic expansion of “private-label” MBS, which are securitized
by entities other than the GSEs and do not carry an explicit or implicit guarantee.
Total outstanding private-label MBS represented 29 percent of total outstanding
MBS in 2005, more than double the share in 2003.8
Of total private-label MBS issuance, two-thirds comprised nonprime loans in
2005, up from 46 percent in 2003.9 With the increased
exposure to private-label MBS and a large share of higher-risk nontraditional
mortgages being securitized in this sector, investors appear willing to assume
greater risk in their search for yield.
Recent Innovations in Mortgage Products
The U.S. mortgage market, which for decades was dominated by fixed-rate mortgages,
now includes innovations such as nontraditional mortgages, simultaneous second-lien
(or piggyback) mortgages, and no-documentation or low-documentation loans.10
Nontraditional mortgages allow borrowers to defer payment of principal and,
sometimes, interest and include interest-only mortgages (IOs) and adjustable-rate
mortgages (ARMs) with flexible payment options (also called pay-option ARMs,
or POs). Although perceived as fairly new, many of these loan types are a repackaging
of existing products, marketed again in the 2000s in response to growing demand.
For example, record-high fixed rates in the late 1970s and early 1980s stimulated
innovation in the form of various types of ARMs. Some of today’s pay-option
ARMs are a reincarnation of negative amortization loans that were popular in
the 1980s, but then fell out of favor in the early 1990s when rising interest
rates and falling home prices in certain areas left some borrowers owing more
than their homes were worth.
Since 2003, strong home price appreciation and declining affordability have
helped drive growing demand for nontraditional mortgage products that can be
used to stretch home-buying power.11 Aided by new
computer models and an easing in lending standards, many lenders have accommodated
this demand by expanding the variety of nontraditional mortgage products offered
while also extending loans to borrowers with less-than-stellar credit histories.
As a result, by 2005, nonprime lending, comprised of subprime and Alt-A (low-
or no-documentation) loans, accounted for about 33 percent of all mortgage loan
originations, up from almost 11 percent in 2003.12
Rapid growth also has occurred among some of the higher-risk mortgage alternatives
within the nonprime arena. As recently as 2002, IOs and pay-option ARMs represented
only 3 percent of total nonprime mortgage originations that were securitized.
However, the IO share of credit to nonprime borrowers has soared during the
past two years to 30 percent of securitized nonprime mortgages, while the pay-option
product jumped to a similar share in less time (see Chart 3). Furthermore, the
low- or no-documentation share of subprime lending has grown significantly since
2001, from about 25 percent to just over 40 percent.
Lenders continue to diversify mortgage offerings as they compete to attract
borrowers and accommodate prospective homebuyers’ financing needs. Many
banks now offer 40-year mortgages, which are gaining in popularity as an alternative
to IOs and pay-option ARMs. The extended amortization period reduces monthly
mortgage payments, thereby stretching a buyer’s purchasing power, and
allows equity to build from the first mortgage payment.
Risk Layering among Nontraditional Mortgage Products Raises
Nontraditional loan products can be appropriate for financially savvy borrowers
with low credit risk. Indeed, many of these products have been offered for years
to such borrowers, and credit quality generally has been good. What has changed,
however, is how these loans have been marketed and used in recent years. Lenders
have targeted a wider spectrum of consumers, who may not fully understand the
embedded risks but use the loans to close the affordability gap.13
The degree to which mortgage market innovation, fueled by significant MBS liquidity,
boosted home sales last year is unknown. Anecdotal evidence suggests that affordability
and financing played a strong role in extending the volume component of the
mortgage credit cycle last year. For example, there is a correlation between
nontraditional mortgage loans and home price growth. An analysis of state-level
data from Loan Performance Corporation shows the penetration
of IOs and pay-option ARMs for nonprime borrowers into areas with strong price
appreciation and reveals a strong positive relationship between the concentration
of such loans and home price growth (see Chart 4). This analysis illustrates
the recent development of borrowers increasingly using IOs and pay-option ARMs
to purchase homes they might not otherwise have been able to afford. A June
2006 study by Harvard’s Joint Center for Housing Studies
also confirms this trend.14
Analysts are concerned that higher-risk borrowers are more likely to be affected
by a major payment shock during the life of their mortgage and may be more likely
to default. Compounding this possibility is the fact that the increasing availability
of mortgage credit is occurring at a time when mitigating controls on credit
exposures have weakened. Evidence of loosening underwriting standards was noted
in the Office of the Comptroller of the Currency’s
annual survey of credit underwriting practices at nationally chartered banks.15
A telling result of the 2005 survey was the significant extent to which banks
had relaxed underwriting standards for home equity and first mortgage loans
(notably, the first time in the survey’s 11-year history that a net easing
has been reported) by allowing lower minimum credit scores, reduced documentation
in evaluating the applicant’s creditworthiness, and simultaneous second-lien
As a result, risk layering appears to have become more prevalent. For example,
there is growing evidence of nonamortizing IOs and pay-option ARMs being made
to borrowers with little or no documentation to verify income sources or financial
assets (see Table). When one loan combines several such features, the total
risk is heightened. The risk compounds in the case of a high loan-to-value ratio
of a first-mortgage loan that is combined with a second-lien mortgage because,
historically, as combined loan-to-value ratios rise, defaults have tended to
rise as well.
Collateral Trends in Lending for Interest-Only and Pay-Option
Adjustable Rate Mortgages: Combining Higher-Risk Loan Features Results
in “Risk Layering” and Heightens the Overall Level of Credit Risk
Low or No Documentationa
Loan to Valueb
Calculated as a percentage of total interest-only or pay-option adjustable-rate
b Original combined loans to value and credit scores are weighted
c Calculated as nonowner and second home originations.
Source: LoanPerformance Corporation (Alt-A and B&C mortgage securities database).
Loan Performance Trends
Even in stressful times, mortgages have been among the best performing assets
held by banks and thrifts. In the early 1990s, a time of serious dislocation
in housing markets in California and the Northeast,
FDIC-insured institutions reported exceptionally low net charge-off rates of
less than 1 percent nationwide on home equity and residential mortgage loans
compared to other loan types, ranging up to 12 percent for commercial and industrial
loans. Mortgage charge-off rates barely budged during the 2001 recession, and
large and small banks alike survived the recession with only a slight decline
in credit quality.
In recent years, the combination of strong home price appreciation and a low
interest rate environment has benefited homeowners and stimulated strong mortgage
demand. FDIC-insured institutions are reporting exceptionally strong asset quality,
and charge-off rates are at historic lows. On a quarterly basis, one-to-four
family mortgage charge-off rates are in the single digits (in basis points)
and considerably lower than in earlier stress periods (see Chart 5). The loss
rate also is well below historical averages. The same is true for home equity
lines of credit (HELOCs), although this may in part reflect their rapid growth
of more than 40 percent during 2004.16
The sustainability of solid mortgage performance and historically low losses
among FDIC-insured institutions is at the forefront of current industry analysis.
How long can such favorable conditions last, especially in light of recent developments?
There are growing signs that mortgage loan performance may have peaked. The
increase in risk layering in residential mortgage lending as well as recent
market and institutional developments support this perception. Lenders themselves
exhibit modest concern about nontraditional mortgage loan quality, as reported
in the Federal Reserve Board’s quarterly survey
of senior loan officers. Almost 41 percent of respondents believe credit quality
on nontraditional loans is likely to decline in 2006, compared with 12 percent
who view similar worsening in traditional mortgage loans.17
Outlook for Nontraditional Mortgages
The growing popularity of nontraditional products may have moved the mortgage
credit cycle into uncharted territory. Industry analysts are uncertain how loans
such as IOs and pay-option ARMs might perform in periods of rising rates or
in stagnant housing markets. Recent media attention has highlighted the risk
of payment shock when interest rates are adjusted, or reset, for IOs and hybrid
ARM products. Despite favorable delinquency and default trends thus far, analysts
fear that the current rising interest rate environment, combined with cooling
home price appreciation, will limit borrowers’ options when they face
large monthly payment increases. Homeowners who have not built up sufficient
equity to either cover the cost of refinancing or pay down additional debt could
face delinquency, particularly within the subprime markets.18
A recent Fitch analysis warns that the payment shock
associated with subprime IOs of 2005 vintage is strong even if rates do not
rise. When rates do reset, these loans’ high margins and low initial rates
will make the monthly payment increases significantly greater than the increase
from principal. Despite favorable performance of previous years’ subprime
IOs, the ratings agency expects subprime IO loan delinquency rates to increase,
because those borrowers may not be able to keep up with payment increases, especially
if the housing market softens.19
Although some analysts emphasize borrowers’ susceptibility to increasing
monthly payments, others foresee a more balanced outcome. A national analysis
of mortgage payment reset undertaken by First American Real Estate
Solutions suggests that mortgages originated or refinanced before
2004 have built sufficient equity as a result of strong home price appreciation
and are not as likely to default.20 This study
also puts the volume of potential loss associated with interest rate resets
into perspective, finding that the volume of ARM defaults is relatively small
compared to overall mortgage originations. The majority of homeowners will not
be significantly adversely affected by reset.
Regulatory Guidance for HELOCs and Nontraditional Products
To address potential concerns associated with risk layering and changes in mortgage
lending practices, federal bank regulators issued guidance in May 2005 on home
equity lending and proposed guidance in December 2005 on nontraditional mortgages.21
While acknowledging that nontraditional IOs and pay-option ARMs may benefit
some borrowers, the proposed guidance targets lending to borrowers who qualify
for loans according to initial minimum payments but who may have difficulty
making future payments as a result of delayed or negative amortization. Furthermore,
the proposed guidance addresses a number of specific issues—including
product development, underwriting compliance, and risk-management functions—to
help lenders and customers address the uncertainty raised by non-traditional
Some lenders contend that the loans discussed in the proposed guidance are made
only to borrowers with high credit scores and larger down payments. Comments
also suggest that the guidance, as proposed, could penalize legitimate lenders
and limit market competition.22 However, investors
at a recent housing finance symposium did not share this view—MBS investors
voiced concern about easing underwriting standards, calling them “lax”
and “too lenient,” particularly in subprime markets where the weakest
borrowers are choosing ARMs.23 These varied opinions
aside, the challenges of today’s complex mortgage market call for an approach
that encourages sound underwriting without inhibiting innovation, which regulators
recognize has created opportunities for millions of homeowners.
The mortgage credit cycle has changed dramatically during the past several decades.
More than other lending types, mortgage lending practices have been shaped by
government influence and product innovation. More recently, rapid home price
escalation has constrained housing affordability in many regions of the country,
contributing to rising demand for non-traditional mortgages as borrowers try
to maximize purchasing power. Mortgage originators have found ways to accommodate
borrower demand, offering new mortgage products and extending loans further
along the credit spectrum.
These developments in the mortgage cycle have led to increased credit risk held
by both homeowners, as they have sought to stretch affordability during an unprecedented
housing boom, and by investors seeking yield. The benign credit landscape of
recent years may have encouraged increased risk taking.
Based on historical experience, and despite recent strong performance, a gradual
rise in delinquency and foreclosure rates could occur over the next few years.
Mortgage delinquencies are likely to increase over time as rising interest rates
and the expiration of below-market teaser rates result in higher monthly payments
for many borrowers. Some households with limited financial assets, lower incomes,
or an inability to refinance due to poor credit, lack of appreciation, or high
leverage may not be able to accommodate these higher payments. Finally, if a
recession or other severe economic shock were to send local home prices and
incomes sharply lower, or interest rates sharply higher, this additional stress
could contribute to higher mortgage losses.
However, banks and thrifts will head into the next phase of the mortgage credit
cycle from a position of strength. In recent years, the industry has generated
record earnings and reached near-record capital levels. Given a gradual transition
to higher delinquency and foreclosure rates and assuming only modest potential
declines in collateral values, it does not appear at this time that deteriorating
mortgage credit performance would present unmanageable risks to most FDIC-insured
Cynthia Angell, Financial Economist
Clare D. Rowley, Economic Assistant
1 Alex Nackoul, “Mortgage Brokering: A Short History (part
1 of 2),” Scotsman Guide Residential Edition, March 2006, http://www.scotsmanguide.com/default.asp?ID=1299.
2 R. Alton Gilbert, “Will the Removal of Regulation Q Raise
Mortgage Interest Rates?” Federal Reserve Bank of St. Louis, December
3 Disintermediation is an excess of withdrawals from an FDIC-insured
institution’s interest-bearing accounts over its deposits in these accounts.
It occurs when rates on competing investments, such as Treasury bills or money
market mutual funds, offer the investor a higher return. For more information,
see: FDIC, History of the Eighties—Lessons for the Future (Washington,
DC: FDIC, 1997), http://www.fdic.gov/bank/historical/history.
4 Alan Greenspan (speech, Mortgage Markets and Economic Activity
Conference, sponsored by America’s Community Bankers, Washington, DC,
November 2, 1999).
5 Department of the Treasury and Office of Thrift Supervision, 12
CFR Parts 560, 590, and 591, No. 2002-43, Alternative Mortgage Transaction Parity
6The two main GSEs, Fannie Mae and Freddie Mac, buy mortgages to
create MBS that are then sold to investors. The GSEs help improve housing affordability
for lower- and middle-income Americans by (1) allowing originators to respond
more quickly to fluctuating mortgage demand and lower mortgage rates and (2)
passing on their risk-free funding advantage to mortgage holders.
7 John Bancroft, ed., Inside MBS & ABS, May 26, 2006,
The securitization rate includes MBS securitized by the GSEs as well as by “private”
entities such as banks, thrifts, and investment firms.
8 A growing portion of total outstanding private-label MBS is held
by FDIC-insured institutions. These holdings accounted for 19.6 percent of their
total MBS holdings in 2005, up from 12.9 percent in 2003. However, it may be
that these institutions carry only the best-rated tranches in their private-label
MBS holdings and therefore have limited risk.
9 Bancroft, Inside MBS & ABS, April 14, 2006.
10For more information, see the Appendix, “Overview of Nonprime
Mortgage Lending and Nontraditional Mortgage Product Terms.”
11 For more analysis on the recent housing boom, see the FDIC’s
FYI articles on “U.S. Home Prices: Does Bust Always Follow Boom?”
issued February 10, 2005 (revised April 8, 2005), http://www.fdic.gov/bank/analytical/fyi/2005/021005fyi.html,
and May 2005, http://www.fdic.gov/bank/analytical/fyi/2005/050205fyi.html.
12 John Bancroft, ed., Inside Mortgage Finance, February
24, 2006, http://www.imfpubs.com.
13 Pay-option ARMs have been offered for years primarily to meet
the needs of borrowers with uneven income streams during the year, such as the
self-employed or those who receive year-end bonuses. Some producers of nontraditional
mortgage loans are marketing products that may not be suitable for some borrowers.
Sales pitches appeal to a homebuyer’s affordability squeeze and highlight
the “benefits” of the minimal payment option: greater monthly cash
flow, maximized buying power, and the ability to afford a bigger house than
a buyer thought possible.
14 Joint Center for Housing Studies of Harvard University, The
State of the Nation’s Housing 2006 (Cambridge, MA: Harvard University,
June 2006), http://www.jchs.harvard.edu/publications/markets/son2006/index.htm.
15 Office of the Comptroller of the Currency, “Survey of Credit
Underwriting Practices, 2005,” http://www.occ.treas.gov/cusurvey/scup2005.pdf.
16 Rapid loan growth can mask increases in nonperforming loans. Because
delinquencies or losses generally do not appear for some time after loans are
originated, growth in the numerator of the ratio of nonperforming loans to total
loans may show up later than growth in the denominator.
17 Federal Reserve Board, Senior Loan Officer Opinion Survey
on Bank Lending Practices, January 2006.
18 James R. Hagerty, “At the Doorstep: Millions Are Facing
Monthly Squeeze on House Payments,” Wall Street Journal, March
19 Suzanne Mistretta, “Rating Subprime RMBS Backed by Interest-Only
ARMs,” Fitch Ratings Structured Finance, March 9, 2006.
20 Christopher Cagan, “Mortgage Payment Reset: The Rumor and
the Reality,” First American Real Estate Solutions, February
21 The federal bank regulatory agencies include the Office of the
Comptroller of the Currency, Federal Reserve Board, FDIC, Office of Thrift Supervision,
and National Credit Union Administration. For the home equity lending guidance,
see “Credit Risk Management Guidance for Home Equity Lending,” May
For the proposed guidance on nontraditional mortgage loans, see “Interagency
Guidance on Nontraditional Mortgage Products,” December 2005, http://www.fdic.gov/news/news/press/2005/Guidance_on_non_traditional_mortgages.pdf.
22 Kenneth R. Harney, “Should Risks Beget Rules?”
Washington Post, April 8, 2006.
23 Bancroft, Inside MBS & ABS, April 7, 2006.
Mortgage Debt for Consumer Debt
Consumer credit growth has historically been positively correlated with job
growth. However, this relationship appears to have broken down in the late 1980s
(see Chart 1). One of the factors contributing to the breakdown may be the phenomenon
of substituting mortgage debt for consumer debt. This debt substitution phenomenon
began 20 years ago when the Tax Reform Act of 1986 eliminated interest deductions
on consumer loans but retained interest deductions on mortgage debt, making
mortgage debt a more attractive source of financing.
In recent years, the combination of low interest rates and rapidly appreciating
housing values resulted in a surge of mortgage equity withdrawals. Mortgage
debt grew by nearly $4 trillion from year-end 2000 to year-end 2005, with an
estimated one-half of this growth resulting from the refinancing of existing
mortgages.1 Many homeowners who refinanced were
able to take advantage of the low mortgage interest rates, taking cash out and
still reducing their monthly payments. A 2002 Federal Reserve survey found that
approximately 25 percent of mortgage refinance funds were used to pay for consumer
expenditures.2 The switch from consumer debt to
mortgage debt is evident in that growth in home equity lines of credit (HELOCs)
outstripped growth in credit card debt, even though the average interest rate
for credit cards declined (see Chart 2).
Although growth in HELOCs continued to outpace that of credit cards, HELOC growth
fell from 40 percent in 2004 to 8 percent in 2005. Rising interest rates and
slowing home price appreciation may make home equity lending and cash-out refinancing
less financially advantageous, which in turn could reinvigorate growth in other
forms of consumer lending, such as credit cards.
Lynne Montgomery, Senior Financial Analyst
1 Based on data from the Federal Reserve
Board and from the 2001–2005 annual average “percent refinancing”
share of the total dollar volume of new mortgages reported by the Mortgage Bankers
2 Glenn Canner, Karen Dynan, and Wayne Passmore,
“Mortgage Refinancing in 2001 and Early 2002,” Federal Reserve
Bulletin, December 2002,
The legislative changes and increased use of securitization during the 1980s
significantly altered the mortgage market by facilitating product innovation
and expanding mortgage credit availability. The increased liquidity provided
by securitization allowed lenders to offer credit to more borrowers, because
lenders were no longer limited to lending on their deposit base. Lenders not
only could increase their underwriting of traditional mortgages, but also were
able to develop new mortgage products to appeal to borrowers seeking nontraditional
Overview of Nonprime Mortgage Lending
and Nontraditional Mortgage Product Terms
Subprime lending refers to higher-interest
loans that involve elevated credit risk. For example, borrowers with Fair Isaac
and Company (FICO) credit scores below 620 are generally viewed as higher risk
and thus ineligible for prime loans unless they make significant down payments.
While many subprime borrowers score above this threshold, they are still considered
high risk because of other issues regarding down payment, income documentation,
or credit standing. Conventional and subprime loan interest rates have a typical
spread of less than 2 percent.
An Alternative-A, or Alt-A, mortgage
can be made to borrowers who have marginal to very good credit where traditional
underwriting guidelines for standard complying loans have been expanded. Alt-A
mortgages may include those with (1) no credit score or credit scores higher
than subprime, (2) nonowner-occupied homes, (3) a loan-to-value ratio greater
than 80 percent and no mortgage insurance, or (4) high debt-to-income ratios
that are not considered subprime.
In a nontraditional, interest-only
(IO) mortgage, the borrower is required to pay only the interest due on the
loan for the first few years, during which time the rate may be fixed or fluctuate.
After the IO period, the rate may be fixed or fluctuate based on the prescribed
index; payments consist of both principal and interest.
A payment-option adjustable-rate mortgage
(ARM)—also known as a flexible-payment ARM, pay-option ARM, option ARM,
or PO—is considered nontraditional in that it allows the borrower to choose
from a number of payment options. For example, the borrower may choose either
a minimum payment option each month based on an introductory interest rate,
an IO payment option based on the fully indexed interest rate, or a fully amortizing
principal-and-interest payment option based on a 15- or 30-year loan term plus
any required escrow payments. The minimum payment option can be less than the
interest accruing on the loan, resulting in negative amortization. The IO option
avoids negative amortization but does not allow principal amortization. After
a certain number of years, or if the loan reaches a certain negative amortization
cap, the required monthly payment amount is refigured to require payments that
will fully amortize the outstanding balance over the remaining loan term.
A reduced-documentation loan feature
is commonly referred to as a “low doc/no doc,” “no income/no
asset,” “stated income,” or “stated assets” feature.
When applied to mortgages, a lender sets reduced or minimal documentation standards
to corroborate a borrower’s income and assets.
A simultaneous second-lien
loan, also referred to as a “piggyback loan,” is a lending arrangement
where either a closed-end second lien or a home equity line of credit is originated
at the same time as the first-lien mortgage loan, usually taking the place of
a larger down payment.
Sources: FDIC; Edward M. Gramlich (speech, Financial Services Roundtable
Annual Housing Policy Meeting, Federal Reserve, Chicago, Illinois, May 21, 2004);
and Office of the Comptroller of the Currency, Federal Reserve Board, FDIC,
Office of Thrift Supervision, and National Credit Union Administration, proposed
“Interagency Guidance on Nontraditional Mortgage Products,” December