Last Friday, as had been expected, the five federal departments or quasi-agencies
charged with overseeing the nation's banking system jointly issued "guidance"
to those banks regarding so-called "exotic" or non-traditional
The recent popularity of interest only loans and option payment mortgages has
raised concerns about their danger to homeowners and questions about how well
their intricacies and risks are understood by borrowers. The guidelines also
cautioned lenders to safeguard themselves against undue risk.
The agencies - The Board of Governors of The Federal Reserve System, The
Office of Comptroller of the Currency, the Office of Thrift Supervision, the National
Credit Union Administration, and the Federal Deposit Insurance Corporation - said
in a joint press release that, while products such as these have long been available,
the number of institutions offering them has expanded rapidly and they are being
offered to a wider range of borrowers who might not be able to qualify for traditional
mortgages of the same size.
In testimony before the Senate Banking Committee late last month the Government
Accountability Office estimated that non-traditional mortgages rose from a ten
percent market share to a 30 percent share between
2003 and 2005.
The joint press release from the five agencies states that while some of the
risks concerning regulators are also found in other adjustable rate mortgages,
the agencies' concern is elevated with the interest only and option payment
products because of the lack of principal amortization and the potential for
amortization. Also, institutions are now combining these non-traditional
loans with other features that may compound risk, called "risk layering" such
as making simultaneous second-lien mortgages (blended or piggy-back
loans) and offering low
or no documentation options in which borrowers are allowed to "state" their
income with very little if any verification.
The final guidance - which was put forth in draft form for public comment
some months ago - discusses the importance of managing the potential increased
risk of these products. It suggests several steps that the management of individual
institutions should take:
- Ensure that loan terms and underwriting standards are consistent with
prudent lending practices including analysis of a borrower's ability to
repay the loan.
- Recognize that many non-traditional products, especially when "risk
layered" have never been tested in a stressed environment. Institutions
should take care to insure that capital levels and allowances for loss reflect
the risk of the portfolio.
The agencies also released for comment a set of illustrations for banks. These
are drafts of consumer materials that institutions can voluntarily adopt as their
own to save the investment necessary to create materials from scratch. One illustration
is a sheet with detailed information explaining each loan product and providing
suggested questions that borrowers should ask their lenders such as what the payments
on the loan will be after the end of the interest only or option payment period;
how interest rate increases could affect the monthly payment, and the maximum
amount you could owe on the loan if only minimum payments are made. This illustration
also includes cautions for borrowers about prepayment penalties, No Doc/Low Doc
loans, and home equity lines of credit.
A second illustration puts forth for comparison the payments initially and
through several rate increases of different loan products such as fixed rate,
only, and option
payment loans. The most helpful part of this sheet was an analysis of where
the principal balance of each loan would probably be after five years of payments.
The third proposed illustration was put forward as a possible inclusion in monthly
bills for option payment mortgages. This lists the three choices the borrower
can make that month - principal and interest payment, interest only payment,
or minimal payment and the impact that each choice will have on the principal
The guidance of course applies only to those banks and credit
unions that are subject to federal supervision and not to private lenders. However,
some of the big independent national mortgages companies have recently put in
place their own risk reduction policies.
Not everybody was applauding the new federal guidance. Regina M. Lowrie, Chairman
of the Mortgage Bankers Association (MBA) immediately issued
a press release saying that while MBA believes that the regulators' efforts
were well intentioned, MBA has strong concerns about their practical effects.
Ms. Lowrie stated,"Innovative, nontraditional mortgage products have allowed
more people than ever to explore the possibility of homeownership, contributing
to the nearly 70 percent rate of homeownership. The guidelines propose a one-size-fits-all
underwriting standard that will unnecessarily choke industry innovation and diminish
These products provide an important option for homeowners who have used
them to tap their home's increased equity for home improvements, to pay down debt
and meet education and health care needs. Despite the concerns expressed by some
regarding the increased use of 'nontraditional products,' delinquency and foreclosure
rates remain well within the range of historical norms. Mortgage bankers are in
the business of getting people into homes, and keeping them there. Nobody gains
when a loan is delinquent or a home is foreclosed upon."