FDIC Federal Register Citations

[Federal Register: October 4, 2006 (Volume 71, Number 192)]

[Notices]

[Page 58609-58618]

From the Federal Register Online via GPO Access [wais.access.gpo.gov]

[DOCID:fr04oc06-66]

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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

[Docket No. 06-11]

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

[Docket No. OP-1246]

FEDERAL DEPOSIT INSURANCE CORPORATION

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

[No. 2006-35]

NATIONAL CREDIT UNION ADMINISTRATION

Interagency Guidance on Nontraditional Mortgage Product Risks

AGENCIES: Office of the Comptroller of the Currency, Treasury (OCC);

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).

ACTION: Final guidance.

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SUMMARY: The OCC, Board, FDIC, OTS, and NCUA (the Agencies), are

issuing final Interagency Guidance on Nontraditional Mortgage Product

Risks (guidance). This guidance has been developed to clarify how

institutions can offer nontraditional mortgage products in a safe and

sound manner, and in a way that clearly discloses the risks that

borrowers may assume.

FOR FURTHER INFORMATION CONTACT: OCC: Gregory Nagel, Credit Risk

Specialist, Credit and Market Risk, (202) 874-5170; or Michael S.

Bylsma, Director, or Stephen Van Meter, Assistant Director, Community

and Consumer Law Division, (202) 874-5750.

Board: Brian Valenti, Supervisory Financial Analyst, (202) 452-

3575; or Virginia Gibbs, Senior Supervisory Financial Analyst, (202)

452-2521; or Sabeth I. Siddique, Assistant Director, (202) 452-3861,

Division of Banking Supervision and Regulation; Kathleen C. Ryan,

Counsel, Division of Consumer and Community Affairs, (202) 452-3667; or

Andrew Miller, Counsel, Legal Division, (202) 452-3428. For users of

Telecommunications Device for the Deaf (``TDD'') only, contact (202)

263-4869.

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

April Breslaw, Chief, Compliance Section, (202) 898-6609, Division of

Supervision and Consumer Protection; or Ruth R. Amberg, Senior Counsel,

(202) 898-3736, or Richard Foley, Counsel, (202) 898-3784, Legal

Division.

OTS: William Magrini, Senior Project Manager, Examinations and

Supervision Policy, (202) 906-5744; or Fred Phillips-Patrick, Director,

Credit Policy, (202) 906-7295; or Glenn Gimble, Senior Project Manager,

Compliance and Consumer Protection, (202) 906-7158.

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

(703) 518-6618.

SUPPLEMENTARY INFORMATION:

I. Background

The Agencies developed this guidance to address risks associated

with the growing use of mortgage products that allow borrowers to defer

payment of principal and, sometimes, interest. These products, referred

to variously as ``nontraditional'', ``alternative'', or ``exotic''

mortgage loans (hereinafter referred to as nontraditional mortgage

loans), include ``interest-only'' mortgages and ``payment option''

adjustable-rate mortgages. These products allow borrowers to exchange

lower payments during an initial period for higher payments during a

later amortization period.

While similar products have been available for many years, the

number of institutions offering them has expanded rapidly. At the same

time, these products are offered to a wider spectrum of borrowers who

may not otherwise qualify for more traditional mortgages. The Agencies

are concerned that some borrowers may not fully understand the risks of

these products. While many of these risks exist in other adjustable-

rate mortgage products, the Agencies concern is elevated with

nontraditional products because of the lack of principal amortization

and potential for negative amortization. In addition, institutions are

increasingly combining these loans with other features that may

compound risk. These features include simultaneous second-lien

mortgages and the use of reduced documentation in evaluating an

applicant's creditworthiness.

In response to these concerns, the Agencies published for comment

proposed Interagency Guidance on Nontraditional Mortgage Products, 70

FR 77249 (Dec. 29, 2005). The Agencies proposed guidance in three

primary areas: ``Loan Terms and Underwriting Standards'', ``Portfolio

and Risk Management Practices'', and ``Consumer Protection Issues''. In

the first section, the Agencies sought to ensure that loan terms and

underwriting standards for

[[Page 58610]]

nontraditional mortgage loans are consistent with prudent lending

practices, including credible consideration of a borrower's repayment

capacity. The portfolio and risk management practices section outlined

the need for strong risk management standards, capital levels

commensurate with the risk, and an allowance for loan and lease losses

(ALLL) that reflects the collectibility of the portfolio. Finally, the

consumer protection issues section recommended practices to ensure

consumers have clear and balanced information prior to making a product

choice. Additionally, this section described control systems to ensure

that actual practices are consistent with policies and procedures.

The Agencies together received approximately 100 letters in

response to the proposal.\1\ Comments were received from financial

institutions, trade associations, consumer and community organizations,

state financial regulatory organizations, and other members of the

public.

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\1\ Nine of these letters requested a thirty-day extension of

the comment period, which the Agencies granted.

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II. Overview of Public Comments

The Agencies received a full range of comments. Some commenters

applauded the Agencies' initiative in proposing the guidance, while

others questioned whether guidance is needed.

A majority of the depository institutions and industry groups that

commented stated that the guidance is too prescriptive. They suggested

institutions should have more flexibility in determining appropriate

risk management practices. A number observed that nontraditional

mortgage products have been offered successfully for many years. Others

opined that the guidance would stifle innovation and result in

qualified borrowers not being approved for these loans. Further, many

questioned whether the guidance is an appropriate mechanism for

addressing the Agencies' consumer protection concerns.

A smaller subset of commenters argued that the guidance does not go

far enough in regulating or restricting nontraditional mortgage

products. These commenters included consumer organizations,

individuals, and several community bankers. Several stated these

products contribute to speculation and unsustainable appreciation in

the housing market. They expressed concern that severe problems will

occur if and when there is a downturn in the economy. Some also argued

that these products are harmful to borrowers and that borrowers may not

understand the associated risks.

Many commenters voiced concern that the guidance will not apply to

all lenders, and thus federally regulated financial institutions will

be at a competitive disadvantage. The Agencies note that both State

financial regulatory organizations that commented on the proposed

guidance--the Conference of State Bank Supervisors (CSBS) and the State

Financial Regulators Roundtable (SFRR)--committed to working with State

regulatory agencies to distribute guidance that is similar in nature

and scope to the financial service providers under their

jurisdictions.\2\ These commenters noted their interest in addressing

the potential for inconsistent regulatory treatment of lenders based on

whether or not they are supervised solely by state agencies.

Subsequently, the CSBS, along with a national organization representing

state residential mortgage regulators, issued a press release

confirming their intent to offer guidance to State regulators to apply

to their licensed residential mortgage brokers and lenders.\3\

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\2\ Letter to J. Johnson, Board Secretary, et al. from N.

Milner, President & CEO, Conference of State Bank Supervisors (Feb.

14, 2006); Letter to J. Johnson, Board Secretary, et al., from B.

Kent, Chair, State Financial Regulators Roundtable.

\3\ Media Release, CSBS & American Association of Residential

Mortgage Regulators, ``CSBS and AARMR Consider Guidance on

Nontraditional Mortgage Products for State-Licensed Entities'' (June

7, 2006), available at

http://www.csbs.org/Content/NavigationMenu/PublicRelations/PressReleases/News_Releases.htm.

The press release stated:

The guidance being developed by CSBS and AARMR is based upon

proposed guidance issued in December 2005 by the Office of the

Comptroller of the Currency, the Board of Governors of the Federal

Reserve System, the Federal Deposit Insurance Corporation, the

Office of Thrift Supervision, and the National Credit Union

Administration.

The Federal guidance, when finalized, will only apply to insured

financial institutions and their affiliates. CSBS and AARMR intend

to develop a modified version of the guidance which will primarily

focus on residential mortgage underwriting and consumer protection.

The guidance will be offered to State regulators to apply to their

licensed residential mortgage brokers and lenders.

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III. Final Joint Guidance

The Agencies made a number of changes to the proposal to respond to

commenters' concerns and to provide additional clarity. Significant

comments on the specific provisions of the proposed guidance, the

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

discussed as follows.

Scope of the Guidance

Many financial institution and trade group commenters raised

concerns that the proposed guidance did not adequately define

``nontraditional mortgage products''. They requested clarification of

which products would be subject to enhanced scrutiny. Some suggested

that the guidance focus on products that allow negative amortization,

rather than interest-only loans. Others suggested excluding certain

products with nontraditional features, such as reverse mortgages and

home equity lines of credit (HELOCs). Those commenting on interest-only

loans noted that they do not present the same risks as products that

allow for negative amortization. Those that argued that HELOCs should

be excluded noted that they are already covered by interagency guidance

issued in 2005. They also noted that the principal amount of these

loans is generally lower than that for first mortgages. As for reverse

mortgages, the commenters pointed out that they were developed for a

specific market segment and do not present the same concerns as

products mentioned in the guidance.

To address these concerns, the Agencies are clarifying the types of

products covered by the guidance. In general, the guidance applies to

all residential mortgage loan products that allow borrowers to defer

repayment of principal or interest. This includes all interest-only

products and negative amortization mortgages, with the exception of

HELOCs. The Agencies decided not to include HELOCs in this guidance,

other than as discussed in the Simultaneous Second-Lien Loans section,

since they are already covered by the May 2005 Interagency Credit Risk

Management Guidance for Home Equity Lending. The Agencies are amending

the May 2005 guidance, however, to address the consumer disclosure

recommendations included in the nontraditional mortgage guidance.

The Agencies decided against focusing solely on negative

amortization products. Many of the interest-only products pose risks

similar to products that allow negative amortization, especially when

combined with high leverage and reduced documentation. Accordingly,

they present similar concerns from a risk management and consumer

protection standpoint. The Agencies did, however, agree that reverse

mortgages do not present the types of concerns that are addressed in

the guidance and should be excluded.

Loan Terms and Underwriting Standards

Qualifying Borrowers

The Agencies proposed that for all nontraditional mortgage

products, the analysis of borrowers' repayment

[[Page 58611]]

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. In addition, the proposed guidance

stated that for products that permit negative amortization, the

repayment analysis should include the initial loan amount plus any

balance increase that may accrue from negative amortization. The amount

of the balance increase is tied to the initial terms of the loan and

estimated assuming the borrower makes only the minimum payment.

Generally, banks and industry groups believed that the proposed

underwriting standards were too prescriptive and asked for more

flexibility. Consumer groups generally supported the proposed

underwriting standards, warning that deteriorating underwriting

standards are bad for individual borrowers and poor public policy.

A number of commenters suggested that industry practice is to

underwrite payment option adjustable-rate mortgages at the fully

indexed rate, assuming a fully amortizing payment. Yet several

commenters argued that this standard should not be required when risks

are adequately mitigated. Moreover, many commenters opposed assuming a

fully amortizing payment for interest-only loans with extended

interest-only periods. They argued that the average life span of most

mortgage loans makes it unlikely that many borrowers will experience

the higher payments associated with amortization. Additionally, many

commenters opposed the assumption of minimum payments during the

deferral period for products that permit negative amortization on the

ground that this assumption suggests that lenders assume a worst-case

scenario.

The Agencies believe that institutions should maintain

qualification standards that include a credible analysis of a

borrower's capacity to repay the full amount of credit that may be

extended. That analysis should consider both principal and interest at

the fully indexed rate. Using discounted payments in the qualification

process limits the ability of borrowers to demonstrate sufficient

capacity to repay under the terms of the loan. Therefore, the proposed

general guideline of qualifying borrowers at the fully indexed rate,

assuming a fully amortizing payment, including potential negative

amortization amounts, remains in the final guidance.

Regarding interest-only loans with extended interest-only periods,

the Agencies note that since the average life of a mortgage is a

function of the housing market and interest rates, the average may

fluctuate over time. Additionally, the Agencies were concerned that

excluding these loans from the underwriting standards could cause some

creditors to change their market offerings to avoid application of the

guidance. Accordingly, the final guidance does not exclude interest-

only loans with extended interest-only periods.

Finally, regarding the assumption for the amount that the balance

may increase due to negative amortization, the Agencies have revised

the language to respond to commenters' requests for clarity. The basic

standard, however, remains unchanged. The Agencies expect a borrower to

demonstrate the capacity to repay the full loan amount that may be

advanced.\4\ This includes the initial loan amount plus any balance

increase that may accrue from the negative amortization provision. The

final document contains guidance on determining the amount of any

balance increase that may accrue from the negative amortization

provision, which does not necessarily equate to the full negative

amortization cap for a particular loan.

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\4\ This is similar to the standard in the Agencies' May 2005

Credit Risk Management Guidance for Home Equity Lending recommending

that, for interest-only and variable rate HELOCs, borrowers should

demonstrate the ability to amortize the fully drawn line over the

loan term.

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The Agencies requested comment on whether the guidance should

address consideration of future income or other future events in the

qualification standards. The commenters generally agreed that there is

no reliable method for considering future income or other future events

in the underwriting process. Accordingly, the Agencies have not

modified the guidance to address these issues.

Collateral-Dependent Loans

Commenters that specifically addressed this aspect of the guidance

concurred that it is unsafe and unsound to rely solely on an individual

borrower's ability to sell or refinance once amortization commences.

However, many expressed concern about the possibility that the term

``collateral-dependent'', as it is used in the guidance, would be

interpreted to apply to stated income and other reduced documentation

loans.

To address this concern, the Agencies provided clarifying language

in a footnote to this section. The final guidance provides that a loan

will not be determined to be collateral-dependent solely because it was

underwritten using reduced documentation.

Risk Layering

Financial institution and industry group commenters were generally

critical of the risk layering provisions of the proposed guidance on

the grounds that they were too prescriptive. These commenters argued

that institutions should have flexibility in determining factors that

mitigate additional risks presented by features such as reduced

documentation and simultaneous second-lien loans. A number of

commenters, however, including community and consumer organizations,

financial institutions, and industry associations, suggested that

reduced documentation loans should not be offered to subprime

borrowers. Others questioned whether stated income loans are

appropriate under any circumstances, when used with nontraditional

mortgage products, or when used for wage earners who can readily

provide standard documentation of their wages. Several commenters

argued that simultaneous second-lien loans should be paired with

nontraditional mortgage loans only when borrowers will continue to have

substantial equity in the property.

The Agencies believe that the guidance provides adequate

flexibility in the methods and approaches to mitigating risk, with

respect to risk layering. While the Agencies have not prohibited any of

the practices discussed, the guidance uniformly suggests strong quality

control and risk mitigation factors with respect to these practices.

The Agencies declined to provide guidance recommending reduced

documentation loans be limited to any particular set of circumstances.

The final guidance recognizes that mitigating factors may determine

whether such loans are appropriate but reminds institutions that a

credible analysis of both a borrower's willingness and ability to repay

is consistent with sound and prudent lending practices. The final

guidance also cautions that institutions generally should be able to

readily document income for wage earners through means such as W-2

statements, pay stubs, or tax returns.

Portfolio and Risk Management Practices

Many financial institution and industry group commenters opposed

provisions of the proposed guidance for the setting of concentration

limits. Some commenters advocated active monitoring of concentrations

of diversification strategies as more

[[Page 58612]]

appropriate approaches. The intent of the guidance was not to set hard

concentration limits for nontraditional mortgage products. Instead,

institutions with concentrations in these products should have well-

developed monitoring systems and risk management practices. The

guidance was clarified to reiterate this point.

Additionally, a number of financial institution and industry

association commenters opposed the provisions regarding third-party

originations. They argued that the proposal would force lenders to have

an awareness and control over third-party practices that is neither

realistic nor practical. In particular, many of these commenters argued

that lenders should not be responsible for overseeing the marketing and

borrower disclosure practices of third parties.

Regarding controls over third-party practices, the Agencies

clarified their expectations that institutions should have strong

systems and controls for establishing and maintaining relationships

with third parties. Reliance on third-party relationships can

significantly increase an institution's risk profile. The guidance,

therefore, emphasizes the need for institutions to exercise appropriate

due diligence prior to entering into a third-party relationship and to

provide ongoing, effective oversight and controls. In practice, an

institution's risk management system should reflect the complexity of

its third-party activities and the overall level of risk involved.

A number of commenters urged the Agencies to remove language in the

proposed guidance relating to implicit recourse for loans sold in the

secondary market. They expressed concern that the proposal added new

capital requirements. The Agencies clarified the language in the

guidance addressing this issue. The Agencies do not intend to establish

new capital requirements. Instead, the Agencies' intent is to reiterate

existing guidelines regarding implicit recourse under the Agencies'

risk-based capital rules.

Consumer Protection Issues

Communications With Consumers

Many financial institution and trade group commenters suggested

that the Agencies' consumer protection goals would be better

accomplished through generally applicable regulations, such as

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

Settlement Procedures).\6\ Some commenters stated that the proposed

guidance would add burdensome new disclosure requirements and cause a

confusing overlap with current Regulation Z requirements. They also

expressed concern that the guidance would contribute to an overload of

information currently provided to consumers. Additionally, some argued

that implementing the disclosure provisions might trigger Regulation Z

requirements concerning advertising.\7\ Some commenters also urged the

Agencies to adopt model disclosure forms or other descriptive materials

to assist in compliance with the guidance.

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\5\ 12 CFR part 226 (2006).

\6\ 24 CFR part 3500 (2005).

\7\ See 12 CFR part 226.24(c) (2006).

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Some commenters voiced concern that the Agencies are attempting to

establish a suitability standard similar to that used in the securities

context. 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.

Finally, several community and consumer organization commenters

questioned whether additional disclosures are sufficient to protect

borrowers and suggested various additional measures, such as consumer

education and counseling.

The Agencies carefully considered the commenters' argument that

consumer protection issues--particularly, disclosures--would be better

addressed through generally applicable regulations. The Agencies

determined, however, that given the growth in this market, guidelines

are needed now to ensure that consumers will receive the information

they need about the material features of nontraditional mortgages as

soon as possible.

The Agencies also gave careful consideration to the commenters'

concerns that the guidelines will overlap with Regulation Z, add to the

disclosure burden on lenders, and contribute to information overload.

While the Agencies are sensitive to these concerns, we do not believe

they warrant significant changes to the guidance. The guidance focuses

on providing information to consumers during the pre-application

shopping phase and post-closing with any monthly statements lenders

choose to provide to consumers. Moreover, the Agencies do not

anticipate that the information outlined in the guidance will result in

additional lengthy disclosures. Rather, the Agencies contemplate that

the information can be provided in brief narrative format and through

the use of examples based on hypothetical loan transactions.\8\ We

have, however, revised the guidance to make clear that transaction-

specific disclosures are not required. Institutions will still need to

ensure that their marketing materials promoting their products comply

with Regulation Z, as applicable.

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\8\ See elsewhere in today's issue of the Federal Register.

(Proposed Illustrations of Consumer Information for Nontraditional

Mortgage Products).

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As previously discussed, some commenters, including industry trade

associations, asked the Agencies to include model or sample disclosures

or other descriptive materials as part of the guidance to assist

lenders, including smaller institutions, in following the recommended

practices for communications with consumers. The Agencies have

determined not to include required model or sample disclosures in the

guidance. Instead, the guidance provides a set of recommended practices

to assist institutions in addressing particular risks raised by

nontraditional mortgage products.

The Agencies have determined that it is desirable to first seek

public comment on potential model disclosures, and in a Federal

Register notice accompanying this guidance are seeking comment on

proposed illustrations of consumer information for nontraditional

mortgage products that are consistent with the recommendations

contained in the guidance. The Agencies appreciate that some

institutions, including community banks, following the recommendations

set forth in the guidance may prefer not to incur the costs and other

burdens of developing their own consumer information documents. The

Agencies are, therefore, requesting comment on illustrations of the

type of information contemplated by the guidance.

The Agencies disagree with the commenters who expressed concern

that the guidance appears to establish a suitability standard, under

which lenders would be required to assist borrowers in choosing

products that are suitable to their needs and circumstances. It was not

the Agencies' intent to impose such a standard, nor is there any

language in the guidance that does so. In any event, the Agencies have

revised certain statements in the proposed guidance that could have

been interpreted to suggest a requirement to ensure that borrowers

select products appropriate to their circumstances.

Control Systems

Several commenters requested more flexibility in designing

appropriate control systems. The Agencies have

[[Page 58613]]

revised the ``Control Systems'' portion of the guidance to clarify that

we are not requiring any particular means of monitoring adherence to an

institution's policies, such as call monitoring or mystery shopping.

Additional changes have also been made to clarify that the Agencies do

not expect institutions to assume an unwarranted level of

responsibility for the actions of third parties. Rather, the control

systems that are expected for loans purchased from or originated

through third parties are consistent with the Agencies' current

supervisory policies. As previously discussed, the Agencies have also

made changes to the portfolio and risk management practices portion of

the final guidance to clarify their expectations concerning oversight

and monitoring of third-party originations.

IV. Text of Final Joint Guidance

The text of the final Interagency Guidance on Nontraditional

Mortgage Product Risks follows:

Interagency Guidance on Nontraditional Mortgage Product Risks

Residential mortgage lending has traditionally been a

conservatively managed business with low delinquencies and losses and

reasonably stable underwriting standards. In the past few years

consumer demand has been growing, particularly in high priced real

estate markets, for closed-end residential mortgage loan products that

allow borrowers to defer repayment of principal and, sometimes,

interest. These mortgage products, herein referred to as nontraditional

mortgage loans, include such products as ``interest-only'' mortgages

where a borrower pays no loan principal for the first few years of the

loan and ``payment option'' adjustable-rate mortgages (ARMs) where a

borrower has flexible payment options with the potential for negative

amortization.\1\

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\1\ Interest-only and payment option ARMs are variations of

conventional ARMs, hybrid ARMs, and fixed rate products. Refer to

the Appendix for additional information on interest-only and payment

option ARM loans. This guidance does not apply to reverse mortgages;

home equity lines of credit (``HELOCs''), other than as discussed in

the Simultaneous Second-Lien Loans section; or fully amortizing

residential mortgage loan products.

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While some institutions have offered nontraditional mortgages for

many years with appropriate risk management and sound portfolio

performance, the market for these products and the number of

institutions offering them has expanded rapidly. Nontraditional

mortgage loan products are now offered by more lenders to a wider

spectrum of borrowers who may not otherwise qualify for more

traditional mortgage loans and may not fully understand the associated

risks.

Many of these nontraditional mortgage loans are underwritten with

less stringent income and asset verification requirements (``reduced

documentation'') and are increasingly combined with simultaneous

second-lien loans.\2\ Such risk layering, combined with the broader

marketing of nontraditional mortgage loans, exposes financial

institutions to increased risk relative to traditional mortgage loans.

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\2\ Refer to the Appendix for additional information on reduced

documentation and simultaneous second-lien loans.

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Given the potential for heightened risk levels, management should

carefully consider and appropriately mitigate exposures created by

these loans. To manage the risks associated with nontraditional

mortgage loans, management should:

Ensure that loan terms and underwriting standards are

consistent with prudent lending practices, including consideration of a

borrower's repayment capacity;

Recognize that many nontraditional mortgage loans,

particularly when they have risk-layering features, are untested in a

stressed environment. As evidenced by experienced institutions, these

products warrant strong risk management standards, capital levels

commensurate with the risk, and an allowance for loan and lease losses

that reflects the collectibility of the portfolio; and

Ensure that consumers have sufficient information to

clearly understand loan terms and associated risks prior to making a

product choice.

The Office of the Comptroller of the Currency (OCC), the Board of

Governors of the Federal Reserve System (Board), the Federal Deposit

Insurance Corporation (FDIC), the Office of Thrift Supervision (OTS)

and the National Credit Union Administration (NCUA) (collectively, the

Agencies) expect institutions to effectively assess and manage the

risks associated with nontraditional mortgage loan products.\3\

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\3\ Refer to Interagency Guidelines Establishing Standards for

Safety and Soundness. For each Agency, those respective guidelines

are addressed in: 12 CFR part 30 Appendix A (OCC); 12 CFR part 208

Appendix D-1 (Board); 12 CFR part 364 Appendix A (FDIC); 12 CFR part

570 Appendix A (OTS); and 12 U.S.C. 1786 (NCUA).

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Institutions should use this guidance to ensure that risk

management practices adequately address these risks. The Agencies will

carefully scrutinize risk management processes, policies, and

procedures in this area. Institutions that do not adequately manage

these risks will be asked to take remedial action.

The focus of this guidance is on the higher risk elements of

certain nontraditional mortgage products, not the product type itself.

Institutions with sound underwriting, adequate risk management, and

acceptable portfolio performance will not be subject to criticism

merely for offering such products.

Loan Terms and Underwriting Standards

When an institution offers nontraditional mortgage loan products,

underwriting standards should address the effect of a substantial

payment increase on the borrower's capacity to repay when loan

amortization begins. Underwriting standards should also comply with the

agencies' real estate lending standards and appraisal regulations and

associated guidelines.\4\

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\4\ Refer to 12 CFR part 34--Real Estate Lending and Appraisals,

OCC Bulletin 2005-3--Standards for National Banks' Residential

Mortgage Lending, AL 2003-7--Guidelines for Real Estate Lending

Policies and AL 2003-9--Independent Appraisal and Evaluation

Functions (OCC); 12 CFR 208.51 subpart E and Appendix C and 12 CFR

part 225 subpart G (Board); 12 CFR part 365 and Appendix A, and 12

CFR part 323 (FDIC); 12 CFR 560.101 and Appendix and 12 CFR part 564

(OTS). Also, refer to the 1999 Interagency Guidance on the

``Treatment of High LTV Residential Real Estate Loans'' and the 1994

``Interagency Appraisal and Evaluation Guidelines''. Federally

Insured Credit Unions should refer to 12 CFR part 722--Appraisals

and NCUA 03-CU-17--Appraisal and Evaluation Functions for Real

Estate Related Transactions (NCUA).

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Central to prudent lending is the internal discipline to maintain

sound loan terms and underwriting standards despite competitive

pressures. Institutions are strongly cautioned against ceding

underwriting standards to third parties that have different business

objectives, risk tolerances, and core competencies. Loan terms should

be based on a disciplined analysis of potential exposures and

compensating factors to ensure risk levels remain manageable.

Qualifying Borrowers--Payments on nontraditional loans can increase

significantly when the loans begin to amortize. Commonly referred to as

payment shock, this increase is of particular concern for payment

option ARMs where the borrower makes minimum payments that may result

in negative amortization. Some institutions manage the potential for

excessive negative amortization and payment shock by structuring the

initial terms to limit the spread between the introductory interest

rate and the fully indexed rate. Nevertheless, an institution's

qualifying standards should recognize the potential impact of payment

shock, especially for borrowers

[[Page 58614]]

with high loan-to-value (LTV) ratios, high debt-to-income (DTI) ratios,

and low credit scores. Recognizing that an institution's underwriting

criteria are based on multiple factors, an institution should consider

these factors jointly in the qualification process and may develop a

range of reasonable tolerances for each factor. However, the criteria

should be based upon prudent and appropriate underwriting standards,

considering both the borrower's characteristics and the product's

attributes.

For all nontraditional mortgage loan products, an institution's

analysis of a borrower's repayment capacity should include an

evaluation of their ability to repay the debt by final maturity at the

fully indexed rate,\5\ assuming a fully amortizing repayment

schedule.\6\ In addition, for products that permit negative

amortization, the repayment analysis should be based upon the initial

loan amount plus any balance increase that may accrue from the negative

amortization provision.\7\

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\5\ The fully indexed rate equals the index rate prevailing at

origination plus the margin that will apply after the expiration of

an introductory interest rate. The index rate is a published

interest rate to which the interest rate on an ARM is tied. Some

commonly used indices include the 1-Year Constant Maturity Treasury

Rate (CMT), the 6-Month London Interbank Offered Rate (LIBOR), the

11th District Cost of Funds (COFI), and the Moving Treasury Average

(MTA), a 12-month moving average of the monthly average yields of

U.S. Treasury securities adjusted to a constant maturity of one

year. The margin is the number of percentage points a lender adds to

the index value to calculate the ARM interest rate at each

adjustment period. In different interest rate scenarios, the fully

indexed rate for an ARM loan based on a lagging index (e.g., MTA

rate) may be significantly different from the rate on a comparable

30-year fixed-rate product. In these cases, a credible market rate

should be used to qualify the borrower and determine repayment

capacity.

\6\ The fully amortizing payment schedule should be based on the

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

with a 5-year interest only period and a 30-year term 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.

\7\ The balance that may accrue from the negative amortization

provision does not necessarily equate to the full negative

amortization cap for a particular loan. The spread between the

introductory or ``teaser'' rate and the accrual rate will determine

whether or not a loan balance has the potential to reach the

negative amortization cap before the end of the initial payment

option period (usually five years). For example, a loan with a 115

percent negative amortization cap but a small spread between the

introductory rate and the accrual rate may only reach a 109 percent

maximum loan balance before the end of the initial payment option

period, even if only minimum payments are made. The borrower could

be qualified based on this lower maximum loan balance.

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Furthermore, the analysis of repayment capacity should avoid over-

reliance on credit scores as a substitute for income verification in

the underwriting process. The higher a loan's credit risk, either from

loan features or borrower characteristics, the more important it is to

verify the borrower's income, assets, and outstanding liabilities.

Collateral-Dependent Loans--Institutions should avoid the use of

loan terms and underwriting practices that may heighten the need for a

borrower to rely on the sale or refinancing of the property once

amortization begins. Loans to individuals who do not demonstrate the

capacity to repay, as structured, from sources other than the

collateral pledged are generally considered unsafe and unsound.\8\

Institutions that originate collateral-dependent mortgage loans may be

subject to criticism, corrective action, and higher capital

requirements.

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\8\ A loan will not be determined to be ``collateral-dependent''

solely through the use of reduced documentation.

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Risk Layering--Institutions that originate or purchase mortgage

loans that combine nontraditional features, such as interest only loans

with reduced documentation or a simultaneous second-lien loan, face

increased risk. When features are layered, an institution should

demonstrate that mitigating factors support the underwriting decision

and the borrower's repayment capacity. Mitigating factors could include

higher credit scores, lower LTV and DTI ratios, significant liquid

assets, mortgage insurance or other credit enhancements. While higher

pricing is often used to address elevated risk levels, it does not

replace the need for sound underwriting.

Reduced Documentation--Institutions increasingly rely on reduced

documentation, particularly unverified income, to qualify borrowers for

nontraditional mortgage loans. Because these practices essentially

substitute assumptions and unverified information for analysis of a

borrower's repayment capacity and general creditworthiness, they should

be used with caution. As the level of credit risk increases, the

Agencies expect an institution to more diligently verify and document a

borrower's income and debt reduction capacity. Clear policies should

govern the use of reduced documentation. For example, stated income

should be accepted only if there are mitigating factors that clearly

minimize the need for direct verification of repayment capacity. For

many borrowers, institutions generally should be able to readily

document income using recent W-2 statements, pay stubs, or tax returns.

Simultaneous Second-Lien Loans--Simultaneous second-lien loans

reduce owner equity and increase credit risk. Historically, as combined

loan-to-value ratios rise, so do defaults. A delinquent borrower with

minimal or no equity in a property may have little incentive to work

with a lender to bring the loan current and avoid foreclosure. In

addition, second-lien home equity lines of credit (HELOCs) typically

increase borrower exposure to increasing interest rates and monthly

payment burdens. Loans with minimal or no owner equity generally should

not have a payment structure that allows for delayed or negative

amortization without other significant risk mitigating factors.

Introductory Interest Rates--Many institutions offer introductory

interest rates set well below the fully indexed rate as a marketing

tool for payment option ARM products. When developing nontraditional

mortgage product terms, an institution should consider the spread

between the introductory rate and the fully indexed rate. Since initial

and subsequent monthly payments are based on these low introductory

rates, a wide initial spread means that borrowers are more likely to

experience negative amortization, severe payment shock, and an earlier-

than-scheduled recasting of monthly payments. Institutions should

minimize the likelihood of disruptive early recastings and

extraordinary payment shock when setting introductory rates.

Lending to Subprime Borrowers--Mortgage programs that target

subprime borrowers through tailored marketing, underwriting standards,

and risk selection should follow the applicable interagency guidance on

subprime lending.\9\ Among other things, the subprime guidance

discusses circumstances under which subprime lending can become

predatory or abusive. Institutions designing nontraditional mortgage

loans for subprime borrowers should pay particular attention to this

guidance. They should also recognize that risk-layering features in

loans to subprime borrowers may significantly increase risks for both

the institution and the borrower.

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\9\ Interagency Guidance on Subprime Lending, March 1, 1999, and

Expanded Guidance for Subprime Lending Programs, January 31, 2001.

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

Specialized Lending Activities (NCUA).

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Non-Owner-Occupied Investor Loans--Borrowers financing non-owner-

occupied investment properties should qualify for loans based on their

ability to service the debt over the life of the

[[Page 58615]]

loan. Loan terms should reflect an appropriate combined LTV ratio that

considers the potential for negative amortization and maintains

sufficient borrower equity over the life of the loan. Further,

underwriting standards should require evidence that the borrower has

sufficient cash reserves to service the loan, considering the

possibility of extended periods of property vacancy and the variability

of debt service requirements associated with nontraditional mortgage

loan products.\10\

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\10\ Federally insured credit unions must comply with 12 CFR

part 723 for loans meeting the definition of member business loans.

P

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Portfolio and Risk Management Practices

Institutions should ensure that risk management practices keep pace

with the growth and changing risk profile of their nontraditional

mortgage loan portfolios and changes in the market. Active portfolio

management is especially important for institutions that project or

have already experienced significant growth or concentration levels.

Institutions that originate or invest in nontraditional mortgage loans

should adopt more robust risk management practices and manage these

exposures in a thoughtful, systematic manner. To meet these

expectations, institutions should:

Develop written policies that specify acceptable product

attributes, production and portfolio limits, sales and securitization

practices, and risk management expectations;

Design enhanced performance measures and management

reporting that provide early warning for increasing risk;

Establish appropriate ALLL levels that consider the credit

quality of the portfolio and conditions that affect collectibility; and

Maintain capital at levels that reflect portfolio

characteristics and the effect of stressed economic conditions on

collectibility. Institutions should hold capital commensurate with the

risk characteristics of their nontraditional mortgage loan portfolios.

Policies--An institution's policies for nontraditional mortgage

lending activity should set acceptable levels of risk through its

operating practices, accounting procedures, and policy exception

tolerances. Policies should reflect appropriate limits on risk layering

and should include risk management tools for risk mitigation purposes.

Further, an institution should set growth and volume limits by loan

type, with special attention for products and product combinations in

need of heightened attention due to easing terms or rapid growth.

Concentrations--Institutions with concentrations in nontraditional

mortgage products should have well-developed monitoring systems and

risk management practices. Monitoring should keep track of

concentrations in key portfolio segments such as loan types, third-

party originations, geographic area, and property occupancy status.

Concentrations also should be monitored by key portfolio

characteristics such as loans with high combined LTV ratios, loans with

high DTI ratios, loans with the potential for negative amortization,

loans to borrowers with credit scores below established thresholds,

loans with risk-layered features, and non-owner-occupied investor

loans. Further, institutions should consider the effect of employee

incentive programs that could produce higher concentrations of

nontraditional mortgage loans. Concentrations that are not effectively

managed will be subject to elevated supervisory attention and potential

examiner criticism to ensure timely remedial action.

Controls--An institution's quality control, compliance, and audit

procedures should focus on mortgage lending activities posing high

risk. Controls to monitor compliance with underwriting standards and

exceptions to those standards are especially important for

nontraditional loan products. The quality control function should

regularly review a sample of nontraditional mortgage loans from all

origination channels and a representative sample of underwriters to

confirm that policies are being followed. When control systems or

operating practices are found deficient, business-line managers should

be held accountable for correcting deficiencies in a timely manner.

Since many nontraditional mortgage loans permit a borrower to defer

principal and, in some cases, interest payments for extended periods,

institutions should have strong controls over accruals, customer

service and collections. Policy exceptions made by servicing and

collections personnel should be carefully monitored to confirm that

practices such as re-aging, payment deferrals, and loan modifications

are not inadvertently increasing risk. Customer service and collections

personnel should receive product-specific training on the features and

potential customer issues with these products.

Third-Party Originations--Institutions often use third parties,

such as mortgage brokers or correspondents, to originate nontraditional

mortgage loans. Institutions should have strong systems and controls in

place for establishing and maintaining relationships with third

parties, including procedures for performing due diligence. Oversight

of third parties should involve monitoring the quality of originations

so that they reflect the institution's lending standards and compliance

with applicable laws and regulations.

Monitoring procedures should track the quality of loans by both

origination source and key borrower characteristics. This will help

institutions identify problems such as early payment defaults,

incomplete documentation, and fraud. If appraisal, loan documentation,

credit problems or consumer complaints are discovered, the institution

should take immediate action. Remedial action could include more

thorough application reviews, more frequent re-underwriting, or even

termination of the third-party relationship.\11\

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\11\ Refer to OCC Bulletin 2001-47--Third-Party Relationships

and AL 2000-9--Third-Party Risk (OCC). Federally insured credit

unions should refer to 01-CU-20 (NCUA), Due Diligence over Third

Party Service Providers. Savings associations should refer to OTS

Thrift Bulletin 82a--Third Party Arrangements.

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Secondary Market Activity--The sophistication of an institution's

secondary market risk management practices should be commensurate with

the nature and volume of activity. Institutions with significant

secondary market activities should have comprehensive, formal

strategies for managing risks.\12\ Contingency planning should include

how the institution will respond to reduced demand in the secondary

market.

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\12\ Refer to ``Interagency Questions and Answers on Capital

Treatment of Recourse, Direct Credit Substitutes, and Residual

Interests in Asset Securitizations'', May 23, 2002; OCC Bulletin

2002-22 (OCC); SR letter 02-16 (Board); Financial Institution Letter

(FIL-54-2002) (FDIC); and CEO Letter 163 (OTS). See OCC's

Comptroller Handbook for Asset Securitization, November 1997. See

OTS Examination Handbook Section 221, Asset-Backed Securitization.

The Board also addressed risk management and capital adequacy of

exposures arising from secondary market credit activities in SR

letter 97-21. Federally insured credit unions should refer to 12 CFR

Part 702 (NCUA).

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While third-party loan sales can transfer a portion of the credit

risk, an institution remains exposed to reputation risk when credit

losses on sold mortgage loans or securitization transactions exceed

expectations. As a result, an institution may determine that it is

necessary to repurchase defaulted mortgages to protect its reputation

and maintain access to the markets. In the agencies' view, the

repurchase of mortgage loans beyond the selling institution's

contractual obligation is

[[Page 58616]]

implicit recourse. Under the agencies' risk-based capital rules, a

repurchasing institution would be required to maintain risk-based

capital against the entire pool or securitization.\13\ Institutions

should familiarize themselves with these guidelines before deciding to

support mortgage loan pools or buying back loans in default.

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\13\ Refer to 12 CFR part 3 Appendix A, Section 4 (OCC); 12 CFR

parts 208 and 225, Appendix A, III.B.3 (FRB); 12 CFR part 325,

Appendix A, II.B (FDIC); 12 CFR 567 (OTS); and 12 CFR part 702

(NCUA) for each Agency's capital treatment of recourse.

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Management Information and Reporting--Reporting systems should

allow management to detect changes in the risk profile of its

nontraditional mortgage loan portfolio. The structure and content

should allow the isolation of key loan products, risk-layering loan

features, and borrower characteristics. Reporting should also allow

management to recognize deteriorating performance in any of these areas

before it has progressed too far. At a minimum, information should be

available by loan type (e.g., interest-only mortgage loans and payment

option ARMs); by risk-layering features (e.g., payment option ARM with

stated income and interest-only mortgage loans with simultaneous

second-lien mortgages); by underwriting characteristics (e.g., LTV,

DTI, and credit score); and by borrower performance (e.g., payment

patterns, delinquencies, interest accruals, and negative amortization).

Portfolio volume and performance should be tracked against

expectations, internal lending standards and policy limits. Volume and

performance expectations should be established at the subportfolio and

aggregate portfolio levels. Variance analyses should be performed

regularly to identify exceptions to policies and prescribed thresholds.

Qualitative analysis should occur when actual performance deviates from

established policies and thresholds. Variance analysis is critical to

the monitoring of a portfolio's risk characteristics and should be an

integral part of establishing and adjusting risk tolerance levels.

Stress Testing--Based on the size and complexity of their lending

operations, institutions should perform sensitivity analysis on key

portfolio segments to identify and quantify events that may increase

risks in a segment or the entire portfolio. The scope of the analysis

should generally include stress tests on key performance drivers such

as interest rates, employment levels, economic growth, housing value

fluctuations, and other factors beyond the institution's immediate

control. Stress tests typically assume rapid deterioration in one or

more factors and attempt to estimate the potential influence on default

rates and loss severity. Stress testing should aid an institution in

identifying, monitoring and managing risk, as well as developing

appropriate and cost-effective loss mitigation strategies. The stress

testing results should provide direct feedback in determining

underwriting standards, product terms, portfolio concentration limits,

and capital levels.

Capital and Allowance for Loan and Lease Losses--Institutions

should establish an appropriate allowance for loan and lease losses

(ALLL) for the estimated credit losses inherent in their nontraditional

mortgage loan portfolios. They should also consider the higher risk of

loss posed by layered risks when establishing their ALLL.

Moreover, institutions should recognize that their limited

performance history with these products, particularly in a stressed

environment, increases performance uncertainty. Capital levels should

be commensurate with the risk characteristics of the nontraditional

mortgage loan portfolios. Lax underwriting standards or poor portfolio

performance may warrant higher capital levels.

When establishing an appropriate ALLL and considering the adequacy

of capital, institutions should segment their nontraditional mortgage

loan portfolios into pools with similar credit risk characteristics.

The basic segments typically include collateral and loan

characteristics, geographic concentrations, and borrower qualifying

attributes. Segments could also differentiate loans by payment and

portfolio characteristics, such as loans on which borrowers usually

make only minimum payments, mortgages with existing balances above

original balances, and mortgages subject to sizable payment shock. The

objective is to identify credit quality indicators that affect

collectibility for ALLL measurement purposes. In addition,

understanding characteristics that influence expected performance also

provides meaningful information about future loss exposure that would

aid in determining adequate capital levels.

Institutions with material mortgage banking activities and mortgage

servicing assets should apply sound practices in valuing the mortgage

servicing rights for nontraditional mortgages. In accordance with

interagency guidance, the valuation process should follow generally

accepted accounting principles and use reasonable and supportable

assumptions.\14\

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\14\ Refer to the ``Interagency Advisory on Mortgage Banking'',

February 25, 2003, issued by the bank and thrift regulatory

agencies. Federally Insured Credit Unions with assets of $10 million

or more are reminded they must report and value nontraditional

mortgages and related mortgage servicing rights, if any, consistent

with generally accepted accounting principles in the Call Reports

they file with the NCUA Board.

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Consumer Protection Issues

While nontraditional mortgage loans provide flexibility for

consumers, the Agencies are concerned that consumers may enter into

these transactions without fully understanding the product terms.

Nontraditional mortgage products have been advertised and promoted

based on their affordability in the near term; that is, their lower

initial monthly payments compared with traditional types of mortgages.

In addition to apprising consumers of the benefits of nontraditional

mortgage products, institutions should take appropriate steps to alert

consumers to the risks of these products, including the likelihood of

increased future payment obligations. This information should be

provided in a timely manner--before disclosures may be required under

the Truth in Lending Act or other laws--to assist the consumer in the

product selection process.

Concerns and Objectives--More than traditional ARMs, mortgage

products such as payment option ARMs and interest-only mortgages can

carry a significant risk of payment shock and negative amortization

that may not be fully understood by consumers. For example, consumer

payment obligations may increase substantially at the end of an

interest-only period or upon the ``recast'' of a payment option ARM.

The magnitude of these payment increases may be affected by factors

such as the expiration of promotional interest rates, increases in the

interest rate index, and negative amortization. Negative amortization

also results in lower levels of home equity as compared to a

traditional amortizing mortgage product. When borrowers go to sell or

refinance the property, they may find that negative amortization has

substantially reduced or eliminated their equity in it even when the

property has appreciated. The concern that consumers may not fully

understand these products would be exacerbated by marketing and

promotional practices that emphasize potential benefits without also

providing clear and balanced information about material risks.

In light of these considerations, communications with consumers,

[[Page 58617]]

including advertisements, oral statements, promotional materials, and

monthly statements, should provide 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. Clear,

balanced, and timely communication to consumers of the risks of these

products will provide consumers with useful information at crucial

decision-making points, such as when they are shopping for loans or

deciding which monthly payment amount to make. Such communication

should help minimize potential consumer confusion and complaints,

foster good customer relations, and reduce legal and other risks to the

institution.

Legal Risks--Institutions that offer nontraditional mortgage

products must ensure that they do so in a manner that complies with all

applicable laws and regulations. With respect to the disclosures and

other information provided to consumers, applicable laws and

regulations include the following:

Truth in Lending Act (TILA) and its implementing

regulation, Regulation Z.

Section 5 of the Federal Trade Commission Act (FTC Act).

TILA and Regulation Z contain rules governing disclosures that

institutions must provide for closed-end mortgages in advertisements,

with an application,\15\ before loan consummation, and when interest

rates change. Section 5 of the FTC Act prohibits unfair or deceptive

acts or practices.\16\

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\15\ These program disclosures apply to ARM products and must be

provided at the time an application is provided or before the

consumer pays a nonrefundable fee, whichever is earlier.

\16\ The OCC, the Board, and the FDIC enforce this provision

under the FTC Act and section 8 of the FDI Act. Each of these

agencies has also 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; Joint Board

and FDIC Guidance on Unfair or Deceptive Acts or Practices by State-

Chartered Banks, March 11, 2004. Federally insured credit unions are

prohibited 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. The OTS

also has 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. This

regulation supplements its authority under the FTC Act.

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Other Federal laws, including the fair lending laws and the Real

Estate Settlement Procedures Act (RESPA), also apply to these

transactions. Moreover, the Agencies note that the sale or

securitization of a loan may not affect an institution's potential

liability for violations of TILA, RESPA, the FTC Act, or other laws in

connection with its origination of the loan. State laws, including laws

regarding unfair or deceptive acts or practices, also may apply.

Recommended Practices

Recommended practices for addressing the risks raised by

nontraditional mortgage products include the following:\17\

Communications with Consumers--When promoting or describing

nontraditional mortgage products, institutions should provide consumers

with information that is designed to help them make informed decisions

when selecting and using these products. Meeting this objective

requires appropriate attention to the timing, content, and clarity of

information presented to consumers. Thus, institutions should provide

consumers with information at a time that will help consumers select

products and choose among payment options. For example, institutions

should offer clear and balanced product descriptions when a consumer is

shopping for a mortgage--such as when the consumer makes an inquiry to

the institution about a mortgage product and receives information about

nontraditional mortgage products, or when marketing relating to

nontraditional mortgage products is provided by the institution to the

consumer--not just upon the submission of an application or at

consummation.\18\ The provision of such information would serve as an

important supplement to the disclosures currently required under TILA

and Regulation Z or other laws.\19\

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\17\ Institutions also should review the recommendations

relating to mortgage lending practices set forth in other

supervisory guidance from their respective primary regulators, as

applicable, including guidance on abusive lending practices.

\18\ Institutions also should strive to: (1) Focus on

information important to consumer decision making; (2) highlight key

information so that it will be noticed; (3) employ a user-friendly

and readily navigable format for presenting the information; and (4)

use plain language, with concrete and realistic examples.

Comparative tables and information describing key features of

available loan products, including reduced documentation programs,

also may be useful for consumers considering the nontraditional

mortgage products and other loan features described in this

guidance.

\19\ Institutions may not be able to incorporate all of the

practices recommended in this guidance when advertising

nontraditional mortgages through certain forms of media, such as

radio, television, or billboards. Nevertheless, institutions should

provide clear and balanced information about the risks of these

products in all forms of advertising.

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Promotional Materials and Product Descriptions. Promotional

materials and other product descriptions should provide information

about the costs, terms, features, and risks of nontraditional mortgages

that can assist consumers in their product selection decisions,

including information about the matters discussed below.

Payment Shock. Institutions should apprise consumers of

potential increases in payment obligations for these products,

including circumstances in which interest rates or negative

amortization reach a contractual limit. For example, product

descriptions could state the maximum monthly payment a consumer would

be required to pay under a hypothetical loan example once amortizing

payments are required and the interest rate and negative amortization

caps have been reached.\20\ Such information also could describe when

structural payment changes will occur (e.g., when introductory rates

expire, or when amortizing payments are required), and what the new

payment amount would be or how it would be calculated. As applicable,

these descriptions could indicate that a higher payment may be required

at other points in time due to factors such as negative amortization or

increases in the interest rate index.

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\20\ Consumers also should be apprised of other material changes

in payment obligations, such as balloon payments.

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Negative Amortization. When negative amortization is

possible under the terms of a nontraditional mortgage product,

consumers should be apprised of the potential for increasing principal

balances and decreasing home equity, as well as other potential adverse

consequences of negative amortization. For example, product

descriptions should disclose the effect of negative amortization on

loan balances and home equity, and could describe the potential

consequences to the consumer of making minimum payments that cause the

loan to negatively amortize. (One possible consequence is that it could

be more difficult to refinance the loan or to obtain cash upon a sale

of the home).

Prepayment Penalties. If the institution may impose a

penalty in the event that the consumer prepays the mortgage, consumers

should be alerted to this fact and to the need to ask the lender about

the amount of any such penalty.\21\

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\21\ Federal credit unions are prohibited from imposing

prepayment penalties. 12 CFR 701.21(c)(6).

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Cost of Reduced Documentation Loans. If an institution

offers both reduced and full documentation loan programs and there is a

pricing premium attached to the reduced documentation program,

consumers should be alerted to this fact.

[[Page 58618]]

Monthly Statements on Payment Option ARMs. Monthly statements that

are provided to consumers on payment option ARMs should provide

information that enables consumers to make informed payment choices,

including an explanation of each payment option available and the

impact of that choice on loan balances. For example, the monthly

payment statement should contain an explanation, as applicable, next to

the minimum payment amount that making this payment would result in an

increase to the consumer's outstanding loan balance. Payment statements

also could provide the consumer's current loan balance, what portion of

the consumer's previous payment was allocated to principal and to

interest, and, if applicable, the amount by which the principal balance

increased. Institutions should avoid leading payment option ARM

borrowers to select a non-amortizing or negatively-amortizing payment

(for example, through the format or content of monthly statements).

Practices to Avoid. Institutions also should avoid practices that

obscure significant risks to the consumer. For example, if an

institution advertises or promotes a nontraditional mortgage by

emphasizing the comparatively lower initial payments permitted for

these loans, the institution also should provide clear and comparably

prominent information alerting the consumer to the risks. Such

information should explain, as relevant, that these payment amounts

will increase, that a balloon payment may be due, and that the loan

balance will not decrease and may even increase due to the deferral of

interest and/or principal payments. Similarly, institutions should

avoid promoting payment patterns that are structurally unlikely to

occur.\22\ Such practices could raise legal and other risks for

institutions, as described more fully above.

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\22\ For example, marketing materials for payment option ARMs

may promote low predictable payments until the recast date. Such

marketing should be avoided in circumstances in which the minimum

payments are so low that negative amortization caps would be reached

and higher payment obligations would be triggered before the

scheduled recast, even if interest rates remain constant.

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Institutions also should avoid such practices as: Giving consumers

unwarranted assurances or predictions about the future direction of

interest rates (and, consequently, the borrower's future obligations);

making one-sided representations about the cash savings or expanded

buying power to be realized from nontraditional mortgage products in

comparison with amortizing mortgages; suggesting that initial minimum

payments in a payment option ARM will cover accrued interest (or

principal and interest) charges; and making misleading claims that

interest rates or payment obligations for these products are ``fixed''.

Control Systems--Institutions should develop and use strong control

systems to monitor whether actual practices are consistent with their

policies and procedures relating to nontraditional mortgage products.

Institutions should design control systems to address compliance and

consumer information concerns as well as the safety and soundness

considerations discussed in this guidance. Lending personnel should be

trained so that they are able to convey information to consumers about

product terms and risks in a timely, accurate, and balanced manner. As

products evolve and new products are introduced, lending personnel

should receive additional training, as necessary, to continue to be

able to convey information to consumers in this manner. Lending

personnel should be monitored to determine whether they are following

these policies and procedures. Institutions should review consumer

complaints to identify potential compliance, reputation, and other

risks. Attention should be paid to appropriate legal review and to

using compensation programs that do not improperly encourage lending

personnel to direct consumers to particular products.

With respect to nontraditional mortgage loans that an institution

makes, purchases, or services using a third party, such as a mortgage

broker, correspondent, or other intermediary, the institution should

take appropriate steps to mitigate risks relating to compliance and

consumer information concerns discussed in this guidance. These steps

would ordinarily include, among other things, (1) Conducting due

diligence and establishing other criteria for entering into and

maintaining relationships with such third parties, (2) establishing

criteria for third-party compensation designed to avoid providing

incentives for originations inconsistent with this guidance, (3)

setting requirements for agreements with such third parties, (4)

establishing procedures and systems to monitor compliance with

applicable agreements, bank policies, and laws, and (5) implementing

appropriate corrective actions in the event that the third party fails

to comply with applicable agreements, bank policies, or laws.

Appendix: Terms Used in This Document

Interest-only Mortgage Loan--A nontraditional mortgage on which,

for a specified number of years (e.g., three or five years), the

borrower is required to pay only the interest due on the loan during

which time the rate may fluctuate or may be fixed. After the

interest-only period, the rate may be fixed or fluctuate based on

the prescribed index and payments include both principal and

interest.

Payment Option ARM--A nontraditional mortgage that allows the

borrower to choose from a number of different payment options. For

example, each month, the borrower may choose a minimum payment

option based on a ``start'' or introductory interest rate, an

interest-only payment option based on the fully indexed interest

rate, or a fully amortizing principal and interest payment option

based on a 15-year 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

interest-only option avoids negative amortization but does not

provide for principal amortization. After a specified number of

years, or if the loan reaches a certain negative amortization cap,

the required monthly payment amount is recast to require payments

that will fully amortize the outstanding balance over the remaining

loan term.

Reduced Documentation--A loan feature that is commonly referred

to as ``low doc/no doc'', ``no income/no asset'', ``stated income''

or ``stated assets''. For mortgage loans with this feature, an

institution sets reduced or minimal documentation standards to

substantiate the borrower's income and assets.

Simultaneous Second-Lien Loan--A lending arrangement where

either a closed-end second-lien or a home equity line of credit

(HELOC) is originated simultaneously with the first lien mortgage

loan, typically in lieu of a higher down payment.

Dated: September 25, 2006.

John C. Dugan,

Comptroller of the Currency.

By order of the Board of Governors of the Federal Reserve

System, September 27, 2006.

Jennifer J. Johnson,

Secretary of the Board.

Dated at Washington, DC, this 27th day of September, 2006.

Federal Deposit Insurance Corporation.

Robert E. Feldman,

Executive Secretary.

Dated: September 28, 2006.

By the Office of Thrift Supervision.

John M. Reich,

Director.

By the National Credit Union Administration on September 28,

2006.

JoAnn M. Johnson,

Chairman.

[FR Doc. 06-8480 Filed 10-3-06; 8:45 am]

BILLING CODE 4810-33-P, 6210-01-P, 6714-01-P, 6720-01-P, 7535-01-P