Under both guidances, the term “nontraditional mortgage product” refers to a closed-end residential mortgage loan product that allows a borrower to defer payment of principal and sometimes interest. This would include an interest-only mortgage, where the borrower pays no loan principal for the first few years of the loan with the potential for negative amortization. On the other hand, the SAFE Act defines a nontraditional loan as any loan that is not a 30-year fixed-rate loan (including any type of ARM, a reverse mortgage, or a 10- or 20-year fixed-rate loan). To avoid confusion, the types of loans to which the guidances apply will be referred to as interest-only ARM loans.
The intent of both guidances is to give regulators the authority to ensure that nontraditional products are offered in a way that ensures consumers have a greater understanding of all of the risks involved with such a loan, whether they are applying through a bank loan officer or a mortgage broker.
Unfortunately, the guidances did not prevent the eventual collapse of the housing market. Consumers uninformed of the true extent of the risks of the obligations undertaken agreed to risky nontraditional loans, based on risky, unwise underwriting procedures and loan originator compensation practices, which had disastrous results. These results produced changes in RESPA and TILA disclosures as well as restrictions on methods of compensating loan originators. Because of these changes, as well as losses suffered by primary mortgage market lenders and secondary market investors, many nontraditional loan products and many subprime loan underwriting practices, if not actually prohibited, may no longer be offered (e.g., payment-option ARM loans).
The CSBS-AARMR Guidance is organized around three primary topics:
- Loan terms and underwriting standards
- Risk-management practices
- Consumer protection issues, which include recommended practices and control systems
Providers are expected to effectively assess and manage the risks associated with interest-only ARM loan products and ensure that their risk-management processes, policies and procedures adequately manage these risks.
The CSBS-AARMR Guidance is very much concerned with the effect of the payment shock resulting from the sharp increase in loan payments when:
- a loan begins to amortize;
- the interest rate adjusts.
To manage the potential for payment shock in a high-risk loan, a provider:
- should avoid overreliance on credit scores as a substitute for verification of the borrower’s income, assets and outstanding liabilities in the underwriting process.
- should have underwriting criteria that recognize the potential impact of payment shock and develop a range of reasonable tolerances for a borrower with a high loan-to-value ratio (LTV), a high debt-to-income ratio (DTI) or a low credit score.
- should include an evaluation of the borrower’s ability to repay the debt by final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule based on the term of the loan.
- should base the repayment analysis on the initial loan amount plus any balance increase resulting from negative amortization.
- could limit the spread between any introductory interest rate and the fully indexed rate. This spread 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)
A loan that can be repaid only by the sale or refinancing of the property securing the loan is a collateral-dependent mortgage loan. A provider would be engaging in unfair or abusive practices if:
- its loan terms and underwriting practices heighten the need for a borrower to sell or refinance the property once amortization begins in order to repay the loan.
- it makes loans to borrowers who cannot demonstrate the capacity to repay the loan as structured from sources other than the collateral pledged.
A loan that is originated based solely on the equity available in the property and not on the borrower’s repayment capacity or credit analysis presents a high risk of default by the borrowers. This is considered a type of predatory lending.
A provider should offer an interest-only loan with reduced documentation or a simultaneous second-lien loan that combines (i.e., layers) features increasing its risk only if mitigating factors can support the underwriting decision and the borrower’s repayment capacity. Mitigating factors can include higher credit scores, lower LTV and DTI ratios, significant liquid assets, mortgage insurance or other credit enhancements, but not higher pricing.
Underwriters using full documentation to verify an applicant’s income, employment and assets will review:
- W-2 forms, pay stubs, 1099s, tax returns showing self-employment or business income, a business income statement, and proof of retirement or disability income.
- bank statements and investment and retirement account statements.
- information about other real estate and personal property assets owned.
Prior to the amending of federal law and regulations as a result of the housing market meltdown, when written verification was delayed or unobtainable, or when the borrower objected to verification, Alt-A loans were made available, at higher cost, and required no documentation or only limited documentation. Types of Alt-A loans commonly used before underwriting requirements were tightened include the following:
- No-doc loan: Employment, income and assets are not stated on a loan application; only the applicant’s credit and the property’s value are verified. Such a loan would have the highest rate.
- Limited-doc loan: Employment and/or assets are verified, but income is not.
- Stated-income (no income verification) loan: Both assets and employment are verified, but income is not. However, the underwriter still analyzes the income to determine whether the amount stated is reasonable in light of the applicant’s employment. If it is not, he may hold up approval unless the applicant can provide some sort of verification. These loans have come to be known as “liar’s loans.”
- Stated-income stated-assets loan: Employment is verified, but assets and income are not.
- Bank statement program: For a borrower who is self-employed or paid on commission, the underwriter calculates income based on deposits shown on the applicant’s personal or business bank statement for a specific number of consecutive months rather than on his pay stubs. For a wage-earning and self-employed customer, income is calculated based on average monthly deposits over a specific number of consecutive months as reflected by the borrower’s most recent bank statements for that time period. For an applicant who qualifies to submit business bank statements (i.e., a sole proprietor or self-employed customer who has 100 percent ownership of the business bank account), income is calculated based on 75 percent of gross deposits over a specific number of consecutive months as reflected by the borrower’s most recent bank statements for that period.
- No-ratio documentation loan: For all of the other no-doc or low-doc loans, the applicant must satisfy standard guideline ratios relating housing expense and living expense to income, even though the figures used might not be verified. However, with a no-ratio documentation loan, assets and employment are verified, but income is not disclosed or used in qualifying the borrower. The loan decision is based on the borrower’s credit rating and down payment or equity in the property, and standard guideline ratios relating housing expense and living expense to income are ignored. Generally, the major requirements to qualify for such a loan are that the borrower has a substantial down payment and a review of the:
- applicant’s credit score;
- amount of loan desired; and
- amount of documentation he is willing to provide.
The CSBS-AARMR Guidance suggests that:
- policies should provide for more diligent verification and documentation of income and debt-reduction capacity as the level of credit risk increases.
- stated income should be accepted only when mitigating factors clearly minimize the need for direct verification of repayment capacity. For most borrowers, income can readily be documented using recent W-2 statements, pay stubs or tax returns. Furthermore, the Truth in Lending Act (TILA) prohibits the underwriting of a higher-priced mortgage loan based on the value of the consumer’s collateral without regard to the consumer’s repayment ability as of consummation.
Simultaneous second-lien loans involve use of a closed-end second lien or a home equity line of credit originated simultaneously with a first-lien mortgage loan in order to avoid the need for a higher down payment. These loans increase credit risk, as the borrower will have little or no equity in the property and may have little incentive to avoid foreclosure if he becomes delinquent. Therefore, they generally should not allow for delayed or negative amortization without other significant risk-mitigating factors.
Lending to Subprime Borrowers
Providers targeting subprime borrowers through tailored marketing, underwriting standards and risk selection should:
- ensure the terms of these programs do not become predatory or abusive.
- recognize that risk-layering features in these loans significantly increase risks for both the provider and the borrower.
Regulation Z’s provisions relating to higher-priced/high-cost (subprime) mortgage loans prohibit:
- a prepayment penalty.
- extension of a first lien on a principal dwelling without an escrow account being established before consummation for payment of property taxes and any required mortgage-related insurance premiums.
Non-Owner-Occupied Investor Loans
For a loan to finance a non-owner-occupied investment property:
- the borrower should be qualified based on his ability to service the debt over the life of the loan.
- the combined LTV ratio should reflect the potential for negative amortization and the need to maintain sufficient equity over the life of the loan.
- 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 interest-only and payment-option ARM loan products.
To ensure that risk-management practices keep pace with changes in the market, providers 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.
Providers with concentrations in nontraditional mortgage products should:
- have well-developed monitoring systems and risk-management practices.
- consider the effect of employee and third-party incentive programs that could produce higher concentrations of loans with high-risk features.
Secondary Market Activity
The sophistication of a provider’s secondary market risk-management practices should be commensurate with the nature and volume of activity. Providers with significant secondary market activities should have comprehensive, formal strategies for managing risks, including contingency plans for responding to reduced demand in the secondary market.
Third-party loan sales can transfer a portion of the credit risk, but not the provider’s:
- contingent liability risk, if it is required to repurchase defaulted mortgages.
- reputation risk, when the provider determines it needs to repurchase defaulted mortgages to protect its reputation and maintain access to the markets.
A provider’s quality control, compliance and audit procedures should focus on mortgage lending activities posing high risk, in particular by monitoring compliance with underwriting standards and exceptions to those standards.
The quality control function should regularly review:
- a sample of nontraditional loan products from all origination channels.
- 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.
Providers should have strong systems and controls to monitor the originations of any third parties (e.g., mortgage brokers or correspondents), to ensure they comply with the provider’s lending standards and applicable laws and regulations.
The quality of loans should be tracked by both origination source and key borrower characteristics in order to make it easier to identify problems such as early payment defaults, incomplete documentation and fraud. If appraisal, loan documentation or credit problems or consumer complaints are discovered, the provider should take immediate action (e.g., more thorough application reviews, more frequent re-underwriting, or even termination of the third-party relationship).
Consumer Protection Issues
Marketing and promotion of these products have emphasized potential benefits (e.g., lower initial payments) without clear and balanced information about the risk of payment shock and negative amortization. This information should be provided, even before TILA and RESPA disclosures may be required, to assist the consumer in the product selection process.
Providers must ensure that any offer of nontraditional mortgage products complies with all applicable laws and regulations, including:
- Section 5 of the Federal Trade Commission (FTC) Act, prohibiting unfair or deceptive acts or practices.
- fair lending laws.
- the Real Estate Settlement Procedures Act (RESPA).
- TILA and its implementing regulation, Regulation Z, governing disclosures that providers must provide:
- in advertisements;
- with an application;
- before loan consummation; and
- when interest rates change.
- TILA and Regulation Z prohibitions relating to loan originator compensation:
- being based on any of the transaction’s terms or conditions;
- being paid by both the consumer and some other person(s); or
- being increased by steering the consumer to one particular transaction rather than another, unless the consummated transaction was in the consumer’s interest.
|Note: Prohibitions related to loan originator compensation are now specifically addressed in the TILA-RESPA Rule.|
Moreover, the sale or securitization of a loan may not reduce a provider’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, may apply as well.
To address the risks raised by nontraditional mortgage products, providers should adhere to the following practices as well as to other recommendations from their primary regulators.
Communications with Consumers
Information promoting or describing these products should be designed, in terms of timing, content and clarity, to help a consumer make an informed decision when selecting and using them (e.g., presented at a time that will help the consumer select a product and choose among payment options).
A provider should offer clear and balanced product descriptions when a consumer inquires about a mortgage product and receives information about interest-only products or when giving marketing material relating to these products to the consumer, not just upon the submission of an application or at consummation.
Providers should strive to:
- focus on information important to consumer decision-making.
- highlight key information so that it will be noticed.
- employ a user-friendly and readily navigable format for presenting the information.
- use plain language, with concrete and realistic examples.
Comparative tables and information describing key features of available loan products may also be useful.
Promotional Materials and Product Descriptions
Promotional materials and other product descriptions should provide information about product costs, terms, features and risks that can assist consumers in their product selection decisions.
Consumers should be made aware of:
- balloon payments.
- when structural payment changes will occur (e.g., when introductory rates expire, or when amortizing payments are required) and what the new payment amount will be or how it will be calculated. Descriptions can indicate that a higher payment may be required at other points in time because of such factors as negative amortization or increases in the interest rate index.
- any potential for increases in payment obligations (e.g., when interest rates or negative amortization reach a contractual limit).
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.
When negative amortization is possible, consumers should be made aware of the potential for increasing principal balances and decreasing home equity, as well as other potential adverse consequences.
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.
Consumers should be alerted to any prepayment penalty that may be imposed for mortgage prepayment as well as the need to ask the provider about the amount of the penalty.
Cost of Reduced-Documentation Loans
If a provider offers both reduced- and full-documentation loan programs, consumers should be alerted to any pricing premium attached to the reduced-documentation program.
Practices to Avoid
Providers should avoid the following practices:
- Obscuring significant risks to the consumer
A provider advertising or promoting a high-risk mortgage by emphasizing the comparatively lower initial payments should also provide clear and comparably prominent information alerting the consumer to the risks.Such information should explain 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 because of the deferral of interest and/or principal payments.
- Promoting payment patterns that are structurally unlikely to occur
- 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 these products in comparison with amortizing mortgages
- Making misleading claims that interest rates or payment obligations for these products are “fixed”
- have strong control systems to monitor whether actual practices are consistent with their policies and procedures and address compliance and consumer information concerns as well as risk-management considerations.
- review consumer complaints to identify potential compliance, reputation and other risks.
- pay attention to appropriate legal review and use compensation programs that do not improperly encourage lending personnel to direct consumers to particular products.
Lending personnel should be:
- trained to convey information about product terms and risks in a timely, accurate and balanced manner.
- given additional training, as necessary, to continue to be able to convey information in this manner, as products evolve and new products are introduced.
- monitored to determine whether they are following these policies and procedures.
A provider making, purchasing or servicing high-risk mortgage loans using a third party (e.g., a mortgage broker, correspondent or other intermediary) should take appropriate steps to mitigate risks relating to compliance and consumer information concerns, including the following:
- Conduct due diligence and establish other criteria for entering into and maintaining relationships with those third parties
- Establish criteria for third-party compensation designed to avoid providing incentives for originations inconsistent with this CSBS-AARMR Guidance
- Set requirements for agreements with such third parties
- Establish procedures and systems to monitor compliance with applicable agreements, policies and laws
- Implement appropriate corrective actions in the event that the third party fails to comply with applicable agreements, policies or laws
The federal Interagency Guidance recommends that promotional materials and other product descriptions provide consumers with information about the costs, terms, features and risks of high-risk mortgage products that can assist consumers in their product selection decisions. The Interagency Guidance provides illustrations showing how this information could be provided in a concise and focused manner and format:
- A narrative explanation of nontraditional mortgage products
- A chart comparing interest-only loans to fixed-rate and traditional adjustable-rate loans
Providers do not have to use these illustrations. A provider may use them or provide information based on them, and it may also expand, abbreviate or otherwise tailor any information in the illustrations as appropriate to reflect:
- the provider’s product offerings (e.g., by deleting information about products and terms not being offered and by revising them to reflect specific terms currently being offered).
- the consumer’s particular loan requirements.
- current market conditions (e.g., by changing the loan amounts, interest rates and corresponding payment amounts to reflect current local market circumstances).
- other information consistent with the Guidance (e.g., the payment and loan balance information for statements or information about when a prepayment penalty may be imposed).
- the results of consumer testing of the forms.
- an alternative format for providing the information described in the Guidance.
Statement on Subprime Mortgage Lending
In June 2007, the Federal Financial Institution Regulatory Agencies (the Agencies) issued a Statement on Subprime Mortgage Lending (the Subprime Statement) to provide financial institutions with principles for prudent risk-management practices and consumer protection when dealing with subprime loans.
The Subprime Statement was issued because of the Agencies’ concern that many borrowers did not fully understand the risks and consequences of obtaining subprime loans with one or more of the following characteristics:
- Low initial payments based on a fixed introductory rate that quickly expires and adjusts to a fully indexed variable rate for the remaining loan term
- Very high or no limits on the increase in payment or interest rate (“payment or rate caps”) on reset dates
- Limited or no documentation of borrowers’ income
- Features likely to result in frequent refinancing to maintain an affordable monthly payment
- Prepayment penalties that are substantial or that extend beyond the initial fixed interest rate period
The consequences to borrowers have included:
- unaffordable monthly payments after the initial rate adjustment.
- difficulty in paying real estate taxes and insurance that were not escrowed.
- expensive refinancing fees, frequently due to closing costs and prepayment penalties.
The consequences to lenders have included unwarranted levels of credit, legal, compliance, reputation and liquidity risks due to the elevated risks.
Predatory Lending Considerations
Institutions risk being charged with commission of unfair or deceptive acts or practices in violation of Section 5 of the FTC Act if they engage in predatory lending. A predatory loan may have many of the features of a subprime loan but will also involve at least one of the following elements:
- It is based predominantly on the foreclosure or liquidation value of a borrower’s collateral rather than on his ability to repay the mortgage.
- The borrower has been induced to repeatedly refinance a loan so the lender can repeatedly charge high points and fees (“loan flipping”).
- Fraud or deception was used to conceal the true nature of the loan or ancillary products.
Underwriting of subprime loans should include:
- evaluation of a borrower’s ability to repay the debt by its final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule (e.g., by using a DTI that includes the borrower’s total monthly housing-related payments [the PITI] as a percentage of gross monthly income).
- verification and documentation of the borrowers’ assets, liabilities and income. Stated-income loans and reduced-documentation loans should not be accepted unless there are documented mitigating factors that clearly minimize the need for such verification, such as the following:
- The borrower has a favorable payment performance and a financial condition that has not deteriorated and wants to refinance an existing mortgage with a new loan of a similar size and with similar terms.
- The borrower has substantial verified and documented liquid reserves or assets that demonstrate repayment capacity.
A higher interest rate, charged to cover additional anticipated losses, is not considered an acceptable mitigating factor.
Financial institutions are not required to foreclose on loan collateral as soon as the borrower exhibits repayment difficulties. They are encouraged to work with the borrower to determine whether a loan modification or a workout arrangement will be beneficial to both parties.
Consumer Protection Principles
To protect the consumer, institutions should approve loans based on the borrower’s ability to repay the loan according to its terms.
Communications with a consumer, including advertisements, oral statements and promotional materials, should:
- provide clear and balanced information about the relative benefits and risks of the products.
- be provided in time for the consumer to use them in selecting a product, not provided just upon submission of an application or at consummation of the loan.
- not be used to steer the consumer to subprime loan products to the exclusion of other products for which the consumer may qualify.
Consumer Protection Principles
Mortgage product descriptions and advertisements should provide clear, detailed information about the costs, material terms, features, and risks of the loan to the borrower. Consumers should be informed of:
- payment shock (i.e., potential payment increases, including how the new payment will be calculated when the introductory fixed rate expires).
- prepayment penalties (i.e., the existence of any prepayment penalty, how it will be calculated, and when it may be imposed). Prepayment penalties should not apply past the initial reset period, and borrowers should be provided a reasonable period of time (typically at least 60 days prior to the reset date) to refinance without penalty.
- balloon payments (i.e., the existence of one).
- cost of reduced-documentation loans (i.e., whether there is a pricing premium attached to a reduced-documentation or stated-income loan program).
- responsibility for taxes and insurance (i.e., the requirement to make payments for real estate taxes and insurance in addition to their loan payments, if not escrowed, and the fact that taxes and insurance costs can be substantial).
Strong control systems need to be established to monitor whether actual practices are consistent with the institution’s policies and procedures. These systems should:
- apply to institutional personnel and applicable third parties (i.e., mortgage brokers and correspondents) and include appropriate criteria for:
- hiring and training loan personnel;
- entering into and maintaining relationships with third parties;
- conducting initial and ongoing due diligence on third parties; and
- ensuring compensation plans do not encourage origination of loans that violate sound underwriting and consumer protection principles or steer consumers to subprime products to the exclusion of other products for which the consumer may qualify.
- address compliance and consumer information concerns and safety and soundness by providing for:
- monitoring of compliance with applicable laws and regulations, third-party agreements and internal policies;
- appropriate corrective actions when there is noncompliance; and
- review of consumer complaints to identify potential compliance problems or other negative trends.