DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
[Docket No. 05-XX]
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
[Docket No. OP-]
FEDERAL DEPOSIT INSURANCE CORPORATION
DEPARTMENT OF THE TREASURY
Office of Thrift Supervision
[Docket No. XX]
NATIONAL CREDIT UNION ADMINISTRATION
Interagency Guidance on Nontraditional Mortgage Products
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: Proposed guidance with request for comment.
SUMMARY: The OCC, Board, FDIC, OTS, and NCUA (the Agencies), request
comment on this proposed Interagency Guidance on Nontraditional Mortgage
Products (Guidance). The Agencies expect institutions to effectively assess
and manage the risks associated with their credit activities, including
those associated with nontraditional mortgage loan products. Institutions
should use this guidance in their efforts to ensure that their risk management
and consumer protection practices adequately address these risks.
DATES: Comments must be submitted on or before [INSERT DATE 60 DAYS AFTER
PUBLICATION IN THE FEDERAL REGISTER].
ADDRESSES: The Agencies will jointly review all of the comments submitted.
Therefore, interested parties may send comments to any of the Agencies and
need not send comments (or copies) to all of the Agencies. Please consider
submitting your comments by e-mail or fax since paper mail in the Washington
area and at the Agencies is subject to delay. Interested parties are invited
to submit comments to: OCC: You should include "OCC" and Docket Number
05-XX in your comment. You may submit your comment by any of the following
Mail: Office of the Comptroller of the Currency, 250 E Street, SW., Mail
Stop 1-5, Washington, DC 20219.
Hand Delivery/Courier: 250 E Street, SW., Attn: Public Information Room,
Mail Stop 1-5, Washington, DC 20219.
Instructions: All submissions received must include the agency name (OCC)
and docket number for this notice. In general, the OCC will enter all comments
received into the docket without change, including any business or personal
information that you provide.
You may review comments and other related materials by any of the following
Viewing Comments Personally: You may personally inspect
and photocopy comments at the OCC's Public Information Room, 250 E Street,
Washington, DC. You can make an appointment to inspect comments by
calling (202) 874-5043.
Viewing Comments Electronically: You may request that we send you an
electronic copy of comments via e-mail or mail you a CD-ROM containing electronic
copies by contacting the OCC at firstname.lastname@example.org.
Docket Information: You may also request available background documents and project
summaries using the methods described above.
Board: You may submit comments, identified by Docket No. OP-XX, by any of the
Mail: Jennifer J. Johnson, Secretary, Board of Governors of the Federal Reserve
System, 20th Street and Constitution Avenue, NW., Washington, DC 20551.
All public comments are available from the Board's Web site at www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfmas
submitted, unless modified for technical reasons. Accordingly, your comments
will not be edited to remove any identifying or contact information. Public
comments may also be viewed in electronic or paper form in Room MP-500 of the
Martin Building (20th and C Streets, NW.) between 9 a.m. and 5 p.m. on weekdays.
FDIC: You may submit comments by any of the following methods:
Mail: Robert E. Feldman, Executive Secretary, Attention: Comments, Federal
Deposit Insurance Corporation, 550 17th Street, NW., Washington, DC 20429.
Hand Delivery/Courier: Guard station at the rear of the 550 17th Street Building
(located on F Street) on business days between 7 a.m. and 5 p.m.
Instructions: All submissions received must include the agency name. All comments
received will be posted without change to http://www.fdic.gov/regulations/laws/federal/propose.html including any personal information provided.
OTS: You may submit comments, identified by docket number 2005-XX, by any of
the following methods:
E-mail address: email@example.com. Please include docket number XX
in the subject line of the message and include your name and telephone number
in the message.
Fax: (202) 906-6518.
Mail: Regulation Comments, Chief Counsel's Office, Office of Thrift
Supervision, 1700 G Street, NW., Washington, DC 20552, Attention: No. 2005-XX.
Hand Delivery/Courier: Guard's Desk, East Lobby Entrance, 1700
G Street, NW., from 9 a.m. to 4 p.m. on business days. Address envelope as follows:
Attention: Regulation Comments, Chief Counsel's Office, Attention: No.
Instructions: All submissions received must include the agency name and docket
number for this proposed Guidance. All comments received will be posted without
change to the OTS Internet Site at http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1,
including any personal information provided.
Docket: For access to the docket to read background documents or comments received,
go to http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1.
In addition, you may inspect comments at the OTS's Public Reading Room,
1700 G Street, NW., by appointment. To make an appointment for access, call
send an e-mail to firstname.lastname@example.org, or send a facsimile transmission
to (202) 906-7755. (Prior notice identifying the materials you will be requesting
will assist us in serving you.) We schedule appointments on business days between
10 a.m. and 4 p.m. In most cases, appointments will be available the next business
day following the date we receive a request.
NCUA: You may submit comments by any of the following methods:
Address to email@example.com.
Include "[Your name] Comments on
Interagency Guidance on Nontraditional Mortgages" in the e-mail
Fax: (703) 518-6319. Use the subject line described above for e-mail.
Mail: Address to Mary Rupp, Secretary of the Board, National Credit Union
Administration, 1775 Duke Street, Alexandria, Virginia 22314-3428.
Hand Delivery/Courier: Same as mail address.
FOR FURTHER INFORMATION CONTACT:
OCC: Gregory Nagel, National Bank Examiner/Credit Risk Specialist, Credit
Risk Policy, (202) 874-5170; or Michael S. Bylsma, Director, or Stephen
Van Meter, Assistant Director, Community and Consumer Law Division, (202)
Board: Brian Valenti, Supervisory Financial Analyst, (202)
452-3575; or Virginia Gibbs, Senior Supervisory Financial Analyst, (202)
or Sabeth I. Siddique, Assistant Director, (202) 452-3871, Division of
Banking Supervision and Regulation; Minh-Duc T. Le, Senior Attorney, Division
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: James Leitner, Senior Examination Specialist, (202) 898-6790, 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, (202) 906-5744; or Maurice
McClung, Program Manager, Market Conduct, Consumer Protection and Specialized
Programs, (202) 906-6182; and Richard Bennett, Counsel, Banking and Finance,
NCUA: Cory Phariss, Program Officer, Examination and Insurance, (703)
In recent years, consumer demand and secondary market appetite have grown
rapidly for mortgage products that allow borrowers to defer payment of
principal and, sometimes, interest. These products, often referred to as
mortgage loans, including "interest-only" mortgages and "payment
option" adjustable-rate mortgages have been available in similar forms
for many years. Nontraditional mortgage loans offer payment flexibility
and are an effective and beneficial financial management tool for some borrowers.
These products allow borrowers to exchange lower payments during an initial
period for higher payments during a later amortization period as compared
to the level payment structure found in traditional fixed-rate mortgage
loans. In addition, institutions are increasingly combining these loans
with other practices, such as making simultaneous second-lien mortgages
and allowing reduced documentation in evaluating the applicant's creditworthiness.
While innovations in mortgage lending can benefit some consumers, these
layering practices can present unique risks that institutions must appropriately
measure, monitor and control.
The Agencies recognize that many of the risks associated with nontraditional
mortgage loans exist in other adjustable-rate mortgage products, but our concern
is elevated with nontraditional products due to the lack of principal amortization
and potential accumulation of negative amortization.1 The Agencies are also concerned
that these products and practices are being offered to a wider spectrum of borrowers,
including some who may not otherwise qualify for traditional fixed-rate or other
mortgage loans, and who may not fully understand the associated risks.
Regulatory experience with nontraditional mortgage lending programs has shown
that prudent management of these programs requires increased attention in product
development, underwriting, compliance, and risk management functions. As with
all activities, the Agencies expect institutions to effectively assess and manage
the risks associated with nontraditional mortgage loan products. The Agencies
have developed this proposed Guidance to clarify how institutions can offer these
products in a safe and sound manner, and in a way that clearly discloses the
potential risks that borrowers may assume. The Agencies will carefully scrutinize
institutions' lending programs, including policies and procedures, and
risk management processes in this area, recognizing that a number of different,
but prudent practices may exist. Remedial action will be requested from institutions
that do not adequately measure, monitor, and control risk exposures in loan portfolios.
Further, the agencies will seek to consistently implement the guidance.
II. Principal Elements of the Guidance
Prudent lending practices include the maintenance of sound loan terms and underwriting
standards. Institutions should assess current loan terms and underwriting guidelines
and implement any necessary changes to ensure prudent practices. In connection
with underwriting standards, the proposed Guidance addresses:
Appropriate borrower repayment analysis, including consideration of comprehensive
debt service in the qualification process;
The potential for collateral-dependent loans, which could arise when a
borrower is overly reliant on the sale or refinancing of the property when
loan amortization begins;
Mitigating factors that support the underwriting decision in circumstances
involving a combination of nontraditional mortgage loans and reduced documentation;
Below market introductory interest rates;
Lending to subprime borrowers; and
Loans secured by non owner-occupied properties.
The proposed Guidance also describes appropriate portfolio and risk management
practices for institutions that offer nontraditional mortgage products. These
practices include the development of policies and internal controls that address,
among other matters, product attributes, portfolio and concentration limits,
third-party originations, and secondary market activities. In connection with
risk management practices, the Guidance also proposes that institutions should:
Maintain performance measures and management reporting systems that provide
warning of potential or increasing risks;
Maintain an allowance for loan and lease losses (ALLL) at a level appropriate
for portfolio credit quality and conditions affecting collectibility;
Maintain capital levels that reflect nontraditional mortgage portfolio characteristics
and the effect of stressed economic conditions on collectibility;
Apply sound practices in valuing the mortgage servicing rights of nontraditional
Finally, the proposed Guidance describes consumer protection concerns
that may be raised by nontraditional mortgage loan products, particularly
may not fully understand the terms of these products. Nontraditional mortgage
loan products are more complex than traditional fixed-rate products and adjustable
rate products and present greater risks of payment shock and negative amortization.
Institutions should ensure that consumers are provided clear and balanced information
about the relative benefits and risks of these products, at a time that will
help consumers' decision-making processes. The proposed Guidance discusses
applicable laws and regulations and then describes recommended practices for
communications with and the provision of information to consumers. These recommended
practices address promotional materials and product descriptions, information
on monthly payment statements, and the avoidance of practices that obscure
significant risks to the consumer or raise similar concerns. The proposed Guidance
control systems that should be used to ensure that actual practices are consistent
with policies and procedures.
When finalized, the Guidance would apply to all banks and their subsidiaries,
bank holding companies and their nonbank subsidiaries, savings associations and
their subsidiaries, savings and loan holding companies and their subsidiaries,
and credit unions.
III. Request for Comment
Comment is requested on all aspects of the proposed Guidance. Interested commenters
are also asked to address specifically the proposed Guidance on comprehensive
debt service qualification standards, which provides that the analysis of borrowers' repayment
capacity should include an evaluation of their ability to repay the debt by
final maturity at
the fully indexed rate, assuming a fully amortizing repayment schedule.
For products with the potential for negative amortization, the repayment
analysis should include the initial loan amount plus any balance increase
that may accrue through the negative amortization provision. In this
regard, comment is specifically requested on the following:
(1) Should lenders analyze each borrower's capacity to repay
the loan under comprehensive debt service qualification standards that
the borrower makes only minimum payments? What are current underwriting
practices and how would they change if such prescriptive guidance is
(2) What specific circumstances would support the use of the reduced
documentation feature commonly referred to as "stated income" as
being appropriate in underwriting nontraditional mortgage loans? What
other forms of reduced documentation would be appropriate in underwriting
nontraditional mortgage loans and under what circumstances? Please include
specific comment on whether and under what circumstances "stated
income" and other forms of reduced documentation would be appropriate
for subprime borrowers.
3) Should the Guidance address the consideration of future income in
the qualification standards for nontraditional mortgage loans with deferred
principal and, sometimes, interest payments? If so, how could this be
done on a consistent basis? Also, if future events such as income growth
are considered, should other potential events also be considered, such
as increases in interest rates for adjustable rate mortgage products?
The text of the proposed Interagency Guidance on Nontraditional Mortgage
Interagency Guidance on Nontraditional Mortgage Products
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, there has been
consumer demand, particularly in high priced real estate markets,
for residential mortgage loan products that allow borrowers to defer
of principal and, sometimes, interest. These mortgage products, often
referred to as nontraditional mortgage loans, include "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. More recently, nontraditional mortgage
loan products are being offered to a wider spectrum of borrowers
not otherwise qualify for more traditional mortgage loans and may
not fully understand the associated risks.
Many of these nontraditional mortgage loans are also being underwritten
with less stringent or no income and asset verification requirements
("reduced documentation") and are increasingly combined
with simultaneous second-lien loans.2 These risk-layering practices,
combined with the broader marketing of nontraditional
mortgage loans, expose financial institutions to increased risk relative
to traditional mortgage loans.
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
Ensure that loan terms and underwriting standards are consistent
with prudent lending practices, including consideration of a borrower's
Recognize that many nontraditional mortgage loans, particularly when
combined with risk-layering features, are untested in a stressed
environment and, therefore, warrant strong risk management standards, capital
commensurate with the risk, and an allowance for loan and lease losses
that reflects the collectibility of the portfolio;
Ensure that consumers have information to clearly understand loan terms
and associated risks prior to making a product choice.
As with all activities, 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 increased risks associated with nontraditional mortgage
Institutions should use this guidance in their efforts to ensure
that their risk management practices adequately address these risks.
Agencies will carefully scrutinize institutions' risk management
processes, policies, and procedures in this area. Remedial action
will be requested from institutions that do not adequately manage
risks. Further, the Agencies will seek to consistently implement
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. Moreover, the institution's underwriting standards should
comply with the agencies' real estate lending standards and
appraisal regulations and associated guidelines.4
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.
Qualification Standards – Nontraditional mortgage loans can
result in significantly higher payment requirements when the loan begins
to fully amortize. This increase in monthly mortgage payments, commonly
referred to as payment shock, 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, and that nontraditional mortgage loans often are inappropriate
for borrowers with high loan-to-value (LTV) ratios, high debt-to-income
(DTI) ratios, and low credit scores.
For all nontraditional mortgage loan products, the analysis of borrowers' repayment
capacity should include an evaluation of their ability to repay the
debt by final maturity at the fully indexed rate,5 assuming a fully
amortizing repayment schedule. In addition, for products that permit
negative amortization, the repayment analysis should include the initial
loan amount plus any balance increase that may accrue from the negative
amortization provision. The amount of the balance increase should be
tied to the initial terms of the loan and estimated assuming the borrower
makes only minimum payments during the deferral period. Institutions
should also consider the potential risks that a borrower may face in
refinancing the loan at the time it begins to fully amortize, such
as prepayment penalties. These more fully comprehensive debt service
calculations should be considered when establishing the institution's
Furthermore, the analysis of repayment capacity should avoid over-reliance
on credit scores as a substitute for income verification in the underwriting
process. As the level of credit risk increases, either from loan features
or borrower characteristics, the importance of actual verification
of the borrower's income, assets, and outstanding liabilities
Collateral-Dependent Loans – Institutions
should avoid the use of loan terms and underwriting practices that
may result in the borrower
having to rely on the sale or refinancing of the property once amortization
begins. Loans to borrowers who do not demonstrate the capacity to
repay, as structured, from sources other than the collateral pledged
considered unsafe and unsound. Institutions determined to be originating
collateral-dependent mortgage loans, may be subject to criticism,
corrective action, and higher capital requirements.
Risk Layering – Nontraditional mortgage loans combined with risk-layering
features, such as reduced documentation and/or a simultaneous second-lien
loan, pose increased risk. When risks are layered, an institution should
compensate for this increased risk with mitigating factors that support
the underwriting decision and the borrower's repayment capacity.
Mitigating factors might include higher credit scores, lower LTV
and DTI ratios, credit enhancements, and mortgage insurance. While
pricing may seem to address the increased risks associated with risk-layering
features, it raises the importance of prudent qualification standards
discussed above. Further, institutions should fully consider the
effect of these risk-layering features on estimated credit losses
their allowance for loan and lease losses (ALLL).
Reduced Documentation – Institutions are increasingly relying
on reduced documentation, particularly unverified income to qualify
borrowers for nontraditional mortgage loans. Because these practices
essentially substitute assumptions and alternate information for the
waived data in analyzing a borrower's repayment capacity and
general creditworthiness, they should be used with caution. An institution
should consider whether its verification practices are adequate. As
the level of credit risk increases, the Agencies expect that an institution
will apply more comprehensive verification and documentation procedures
to verify a borrower's income and debt reduction capacity.
Use of reduced documentation in the underwriting process should be
governed by clear policy guidelines. Reduced documentation, such as
stated income, should be accepted only if there are other mitigating
factors such as lower LTV and other more conservative underwriting
Simultaneous Second-Lien Loans – Simultaneous
second-lien loans result in reduced owner equity and higher credit
as combined loan-to-value ratios rise, defaults rise as well. A
delinquent borrower with minimal or no equity in a property may have
to work with the lender to bring the loan current to 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 owner equity should generally
not have a payment structure that allows for delayed or negative
Introductory Interest Rates – Many institutions offer introductory
interest rates that are set well below the fully indexed rate as a
marketing tool for payment option ARM products. In developing nontraditional
mortgage products, an institution should consider the spread between
the introductory rate and the fully indexed rate. Since initial monthly
mortgage payments are based on these low introductory rates, there
is a greater potential for a borrower to experience negative amortization,
increased payment shock, and earlier recasting of the borrower's
monthly payments than originally scheduled. In setting introductory
rates, institutions should consider ways to minimize the probability
of disruptive early recastings and extraordinary payment shock.
Lending to Subprime Borrowers – Mortgage programs
that target subprime borrowers through tailored marketing, underwriting
and risk selection should follow the applicable interagency guidance
on subprime lending.6 Among other things, the subprime guidance discusses
the circumstances under which subprime lending can become predatory
or abusive. Additionally, an institution's practice of risk
layering for loans to subprime borrowers may significantly increase
to both the institution and the borrower. Institutions should pay
particular attention to these circumstances, as they design nontraditional
loan products for subprime borrowers.
Non Owner-Occupied Investor Loans – Borrowers
financing non owner-occupied investment properties should be qualified
on their ability
to service the debt over the life of the loan. Loan terms should
also reflect an appropriate combined LTV ratio that considers the
for negative amortization and maintains sufficient borrower equity
over the life of the loan. Further, nontraditional mortgages to
finance non owner- occupied investor properties should require evidence
the borrower has sufficient cash reserves to service the loan in
the near term in the event that the property becomes vacant.7
PORTFOLIO AND RISK MANAGEMENT PRACTICES
Institutions should recognize that nontraditional mortgage loans are
untested in a stressed environment and, accordingly, should receive
higher levels of monitoring and loss mitigation. Moreover, institutions
should ensure that portfolio and risk management practices keep pace
with the growth and changing risk profile of their nontraditional mortgage
loan portfolios. Active portfolio management is especially important
for institutions that project or have already experienced significant
growth or concentrations of nontraditional products. 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 by:
Developing written policies that specify acceptable product
attributes, production and portfolio limits, sales and securitization
practices, and risk management expectations;
Designing enhanced performance measures and management reporting that
provide early warning for increasing risk;
Establishing appropriate ALLL levels that consider the credit quality
of the portfolio and conditions that affect collectibility; and
Maintaining 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 forth 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 – Concentration limits should
be set for loan types, third-party originations, geographic area,
and property occupancy
status, to maintain portfolio diversification. Concentration limits
should also be set on key portfolio characteristics such as loans
with high combined LTV and DTI ratios, loans with the potential for
amortization, loans to borrowers with credit scores below established
thresholds, and nontraditional mortgage loans with layered risks.
The combination of nontraditional mortgage loans with risk-layering
should be regularly analyzed to determine if excessive concentrations
or risks exist. Institutions with excessive concentrations or deficient
risk management practices will be subject to elevated supervisory
attention and potential examiner criticism to ensure timely remedial
Further, institutions should consider the effect of employee incentive
programs that may result in higher concentrations of nontraditional
Controls – An institution's quality control, compliance,
and audit procedures should specifically target those mortgage lending
activities exhibiting higher risk. For nontraditional mortgage loan
products, an institution should have appropriate controls to monitor
compliance and exceptions to underwriting standards. The institution's
quality control function should regularly review a sample of reduced
documentation 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. Since payment option ARMs require higher levels of
customer support than other mortgage loans, customer service and collections
personnel should receive product-specific training on the features
and potential customer issues.
Third-Party Originations – Institutions often
use third-party channels, such as mortgage brokers or correspondents,
nontraditional mortgage loans. When doing so, an institution should
have strong approval and control systems to ensure the quality of third-party
originations and compliance with all applicable laws and regulations,
with particular emphasis on marketing and borrower disclosure practices.
Controls over third parties should be designed to ensure that loans
made through these channels reflect the standards and practices used
by an institution in its direct lending activities.
Monitoring procedures should track the quality of loans by both origination
source and key borrower characteristics in order to identify problems,
such as early payment defaults, incomplete documentation, and fraud.
A strong monitoring process should enable management to determine whether
third-party originators are producing quality loans. If appraisal, loan
documentation, or credit problems are discovered, the institution should
take immediate action, which could include terminating its relationship
with the third-party.8
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 reliance should have comprehensive, formal approaches to risk
management.9 This should include consideration of the risks to the institution
should demand in the secondary markets dissipate.
While sale of loans to third parties can transfer a portion of the
portfolio's credit risk, an institution continues to be exposed
to reputation risk that arises when the credit losses on sold loans
or securitization transactions exceed expected losses. In order to
protect its reputation in the market, an institution may determine
that it is necessary to repurchase defaulted mortgages. It should be
noted that the repurchase of mortgage loans beyond the selling institution's
contractual obligations is, in the Agencies' view, implicit recourse.
Under the Agencies' risk-based capital standards, repurchasing
mortgage loans from a sold portfolio or from a securitization in this
manner would require that risk-based capital be maintained against the
entire portfolio or securitization.10 Further, loans sold to third parties
typically carry representations and warranties from the institution
that these loans were underwritten properly and all legal requirements
were satisfied. Therefore, institutions involved in securitization
transactions should consider the potential origination-related risks
arising from nontraditional mortgage loans, including the adequacy
of disclosures to investors.
Management Information and Reporting – An
institution should have the reporting capability to detect changes
in the risk profile
of its nontraditional mortgage loan portfolio. Reporting systems should
allow management to isolate key loan products, risk-layering loan features,
and borrower characteristics to allow early identification of performance
deterioration. At a minimum, information should be available by loan
type (e.g., interest-only mortgage loans and payment option ARMs);
the combination of these loans with risk-layering features (e.g., payment
option ARM with stated income and interest-only mortgage loans with
simultaneous second-lien mortgages); underwriting characteristics (e.g.,
LTV, DTI, and credit score); and borrower performance (e.g., payment
patterns, delinquencies, interest accruals, and negative amortization).
Portfolio volume and performance results 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 be undertaken when actual performance deviates
from established policies and thresholds. Variance analysis is critical
to the monitoring of the portfolio's risk characteristics and
should be an integral part of an institution's forecasting process
to establish and adjust risk tolerance levels.
Stress Testing – 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. This 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. Through stress testing, an institution should be able to
identify, monitor and manage risk, as well as develop 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 appropriate allowances for the estimated credit
losses in their nontraditional mortgage loan portfolios and hold
with the risk characteristics of these portfolios. Moreover, institutions
should recognize that the limited performance history of these products,
particularly in a stressed environment, increases performance uncertainty.
As loan terms evolve and underwriting practices ease, this lack of
seasoning may warrant higher capital levels.
In 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. Credit
risk segments should also distinguish among loans with differing payment
and portfolio characteristics, such as borrowers who habitually make
only minimum payments, mortgages with existing balances above original
balances due to negative amortization, and mortgages subject to sizable
payment shock. The objective is to identify key credit quality indicators
that affect collectibility for ALLL measurement purposes and important
risk characteristics that influence expected performance so that migration
into or out of key segments provides meaningful information about future
loss exposure for purposes of determining the level of capital to be
Further, those institutions with material mortgage banking activities
and mortgage servicing assets should apply sound practices in valuing
the mortgage servicing rights of nontraditional mortgages in accordance
with interagency guidance.11 This guidance requires institutions to follow
generally accepted accounting principles and conservatively treat assumptions
used in valuing mortgage-servicing rights.
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 near-term
monthly payment affordability, and consumers have been encouraged to
select nontraditional mortgage products based on the lower monthly
payments that such products permit compared with traditional types
of mortgages. In addition to apprising consumers of the benefits of
nontraditional mortgage products, institutions should ensure that they
also appropriately alert consumers to the risks of these products,
including the likelihood of increased future payment obligations. Institutions
should also ensure that consumers have information that is timely and
sufficient for making a sound product selection decision.12
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. As a result, it may be more difficult for consumers
to refinance these loans. In addition, in the event of a refinancing
or a sale of the property, negative amortization may result in the
reduction or elimination of home equity, 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 effectively providing
complete information about material risks.
In light of these considerations, institutions should ensure that communications
with consumers, including advertisements, oral statements, promotional
materials, and monthly statements, are consistent with product terms
and payment structures. These communications should also 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 is important to ensuring that consumers
have appropriate 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
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,
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,
before loan consummation, and when interest rates change. Section 5
of the FTC Act prohibits unfair or deceptive acts or practices.14
Institutions should also ensure that they comply with fair lending
laws and the Real Estate Settlement Procedures Act (RESPA). Other federal
laws also apply to these loan products. 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 be applicable. It is important that institutions have their communications
and other acts and practices reviewed by counsel for compliance with
all applicable laws. Institutions also should monitor applicable laws
and regulations for revisions to ensure that communications continue
to be fully compliant.
Recommended practices for addressing the risks raised by nontraditional
mortgage products include the following:
Communications with Consumers – As with all
communications with consumers, institutions should present important
information in a clear
manner and format such that consumers will notice it, can understand
it to be material, and will be able to use it in their decision-making
processes.15 Furthermore, when promoting or describing nontraditional
mortgage products, institutions should provide consumers with information
that will enable them to make informed decisions and to use these
products responsibly. Meeting this objective requires appropriate
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 make product selection and payment
For example, institutions should offer full and fair product descriptions
when a consumer is shopping for a mortgage, not just upon the submission
of an application or at consummation.
Promotional materials and descriptions of these products should provide
information that enables consumers to prudently consider the costs,
terms, features, and risks of these mortgages in their product selection
decisions, including information about:
- Payment Shock. Institutions should apprise consumers of potential
increases in their payment obligations (e.g., in both dollar and percentage
terms), including situations in which interest rates or negative amortization
reach a contractual limit. For example, product descriptions could
specifically 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.16 Information provided to consumers also could clearly
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 the new payment amount may be
required sooner, and may be even higher than the amount indicated,
due to factors such as negative amortization or increases in the interest
- Negative Amortization. When negative amortization is possible
under the terms of the loan, consumers should be apprised of the potential
consequences of increasing principal balances and decreasing home equity.
For example, product descriptions should include, with sample payment
schedules, corresponding examples showing the effect of those payments
on the consumer's loan balance and home equity.
- 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 amount of any such
- Cost of Reduced Documentation Loans. If an institution
offers both reduced and full documentation loan programs and there
a pricing premium attached to the reduced documentation program,
consumers should be alerted to this fact.
Monthly statements that
are provided to consumers on payment option ARMs should provide
information that enables consumers
to make responsible payment choices, including information about
the consequences of selecting various payment options on the current
principal balance. Institutions should present each payment option
available, explain each option, and note the impact of each choice.
For example, the monthly payment statement should contain an explanation,
as applicable, next to the minimum payment amount that this payment
would result in an increase to the consumer's outstanding
loan balance due to negative amortization. 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 the minimum payment
(for example, through the format or content of monthly statements).
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, 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 such practices as promoting payment patterns that are structurally
unlikely to occur.18 Such practices could raise legal and other risks for institutions,
as described more fully above.
Institutions also should
avoid such practices as: unwarranted assurances or predictions about
the future direction of interest rates (and,
consequently, the borrower's future obligations); inappropriate
representations about the "cash savings" to be realized
from nontraditional mortgage products in comparison with amortizing
mortgages; statements suggesting that initial minimum payments in
a payment option ARM will cover accrued interest (or principal and
interest) charges; and misleading claims that interest rates or
payment obligations for these products are "fixed."
Control Systems – Institutions also should
develop and use strong control systems to ensure that actual
consistent with their policies and procedures, for loans that
the institution originates internally, those that it originates
through mortgage brokers and other third parties, and those
that it purchases. Institutions should design control systems
compliance and fair disclosure concerns as well as the safety
and soundness considerations discussed above. 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. Lending personnel should be monitored through,
for example, call monitoring or mystery shopping, to determine
whether they are conveying appropriate information. Institutions
should review consumer complaints to identify potential compliance,
reputation, and other risks. Attention also should be paid to
appropriate legal review and to using compensation programs
that do not improperly encourage originators to direct consumers
APPENDIX: Terms Used in this Document
Interest-only Mortgage Loan – A nontraditional
mortgage on which, for a specified number of years (e.g., three
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
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 either 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.
This concludes the text of the proposed Interagency Guidance
on Nontraditional Mortgage Products.
[THIS SIGNATURE PAGE PERTAINS TO THE NOTICE AND REQUEST FOR COMMENT
GUIDANCE ON NONTRADITIONAL MORTGAGE PRODUCTS."]
Dated: December __, 2005.
John C. Dugan,
Comptroller of the Currency.
[THIS SIGNATURE PAGE PERTAINS TO THE NOTICE AND REQUEST FOR COMMENT
TITLED, "INTERAGENCY GUIDANCE ON NONTRADITIONAL MORTGAGE
By order of the Board of Governors of the Federal Reserve System,
December __, 2005.
Jennifer J. Johnson,
Secretary of the Board.
[THIS SIGNATURE PAGE
PERTAINS TO THE NOTICE AND REQUEST FOR COMMENT TITLED, "INTERAGENCY
GUIDANCE ON NONTRADITIONAL MORTGAGE PRODUCTS."]
Dated at Washington, D.C., the __ day of December, 2005.
By order of the Federal Deposit Insurance Corporation.
Robert E. Feldman,
[THIS SIGNATURE PAGE PERTAINS
TO THE NOTICE AND REQUEST FOR COMMENT TITLED, "INTERAGENCY GUIDANCE ON NONTRADITIONAL MORTGAGE PRODUCTS."]
Dated: December __, 2005
By the Office of Thrift Supervision.
John M. Reich,
[THIS SIGNATURE PAGE PERTAINS
TO THE NOTICE AND REQUEST FOR COMMENT TITLED, "INTERAGENCY GUIDANCE ON NONTRADITIONAL MORTGAGE PRODUCTS."]
By the National Credit Union Administration Board on December __, 2005.
Secretary of the Board.
and payment option ARMs are variations of conventional ARMs, hybrid ARMs,
rate products. Refer to the Appendix for additional information on
interest-only and payment option ARM loans.
2 Refer to the Appendix for additional information on reduced
documentation and simultaneous second-lien loans.
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).
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
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
Guidance on Subprime Lending, March 1, 1999, and Expanded Guidance for
Lending Programs, January 31, 2001. Federally Insured
Credit Unions should refer to 04-CU-12 – Specialized Lending Activities
7 Federally Insured Credit Unions must comply with 12 CFR Part 723 for loans
meeting the definition of member business loans.
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.
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. 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
10 Federally Insured Credit Unions should refer to 12 CFR Part 702 for their
risk based net worth requirements.
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.
12 Institutions also should review the recommendations relating to mortgage
lending practices set forth in other sections of this guidance and any other
supervisory guidance from their respective primary regulators, including
the discussion in the Subprime Lending Guidance referenced in footnote 6
about abusive lending practices.
13 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.
14 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.
15 In this regard, institutions 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 these nontraditional
mortgage products and other loan features described in this guidance.
16 Consumers also should be apprised of other material changes in payment
obligations, such as balloon payments.
17 Federal credit unions are prohibited from imposing prepayment penalties.
12 CFR 701.21(c)(6).
18 For example, marketing materials for payment option ARMs may promote low
predictable payments until the recast date. At the same time, the minimum
payments may be 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.