Two Associations of State Regulators Issue Nontraditional Mortgage Lending Guidance
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In October a covey of federal agencies including the Federal Reserve, The Federal
Deposit Insurance Corporation, and the National Credit Union Administration
published what was called "final
guidance" on underwriting nontraditional mortgage products. This guidance
was designed to address risks associated with the growing use of these mortgages
(also referred to as exotic or alternative loans) such as interest
only and payment option adjustable rate mortgages. Nontraditional mortgages
allow borrowers to obtain lower payments during the early years of a loan in
exchange for higher payments later on.
As we have discussed here on several occasions the wide use of these loans have
begun to alarm consumer groups, lenders, and regulators as
interest rates have gone up - although not yet substantially - at the same time
that the explosive housing market has cooled both in terms of number of sales
and price appreciation. The fear is that customers, who were often stretching
to qualify for these mortgages in the first place will confront unmanageable
"payment shock" when the interest rates inevitably adjust and may not be able
to sell their homes or refinance into a more affordable situation.. It is entirely
possible that the principal balance upon which payments are based will, by that
time actually be larger than at origination as unpaid interest is added to the
principal.
Shortly before the agencies released the guidelines a spokesman for the Government
Accountability Office estimated, in testimony before the Senate Banking Committee
that non-traditional mortgages rose from a ten percent market share to a 30
percent share between 2003 and 2005.
There has also been concern about so-called low-document or stated
income loans in which borrowers provide little if any verification of the
income they claim in order to qualify for the loan and simultaneous second mortgages
which use proceeds from a second mortgage as a down payment in order to avoid
private mortgage insurance.
Another worry is "layering" in which a single borrower may
sign on for two or more of these risky features such as a payment
option ARM for which the borrower was also given an artificially low initial
teaser rate or a simultaneous second mortgage.
The federal agency guidelines applied only to those depository institutions,
i.e. banks, savings and loans, credit unions, and so forth that are regulated
by the participating federal agencies, and they did not meet with unanimous
approval from the mortgage industry. The Mortgage Bankers Association, for example,
criticized them for being "one size fits all," approach that "will
unnecessarily choke industry innovation and diminish consumer choice."
But the major problem with the guidelines, which were at least a start toward
official recognition of the need for regulation of risk, was that, as stated
above, they applied to only a portion of the lending industry.
Much lending, especially subprime, is now funneled through private sources.
Mortgage companies are not banks and while some place loans with banks (particularly
conventional mortgages) more and more mortgage companies receive actual funding
for their loans from large national companies with no banking affiliation or
from subsidiaries of offshore companies such as HSBC. However, the majority
of states license mortgage companies operating within their borders.
A month or so after the federal guidelines were released,
and we admit to being a bit behind the curve on this one but it still seems
worth mentioning, the Conference of State Bank Supervisors (CSBS) and the American
Association of Residential Mortgage Regulators (AARMR) issued guidance that
covers non-federally regulated institutions that are licensed by the states.
These are the same two groups that, late last week announced a new Internet-based
licensing system
that would streamline and combine licensing applications among participating
states.
The new guidelines are very close to those of the federal
agencies, calling for lenders to tweak qualifying standards so as to recognize
the potential impact of payment shock and consider the various qualifying standards
(loan to value (LTV), debt ratios (DTI), and credit scores) jointly rather than
individually. The guidelines stress that underwriters should include an evaluation
of the borrowers ability to make payments to maturity at the fully indexed rate
and avoid over- reliance on credit scores as a substitute for income verification.
The higher a loan's credit risk, the more important it is to verify the borrower's
income, assets, and outstanding liabilities.
The guidelines also urge against undue dependence on collateral which may heighten
the need for a borrower to sell or refinance the property down the line and
to avoid risk layering without evaluating mitigating factors such as higher
credit scores, lower LTV and DTI ratios, significant liquid assets, or private
mortgage insurance.
Risk management is a significant part of the guidelines with separate suggestions
as to policies, procedures, and auditing for lenders and for third party originators.
Lenders are also advised to avoid taking on concentrations of certain types
of mortgages through employee and third-party incentive programs.
Consumer protection is another issue addressed by the guidelines. Like the
federal counterpart, the CSBS/AARMR guidelines stress education and information,
particularly making sure borrowers recognize the possibility and pain of payment
shock and fully understand that their loans may result in zero or negative
amortization.
State banking commissioners and regulators are not required to adopt these guidelines
but they will at least provide a framework for constructing individual state
regulations and alert those CSBS/AARMR members and affiliates who might have
been asleep at the switch about the necessity to keep a closer eye on what is
going on in the mortgage market, particularly the sub-prime sector.
In adopting the guidelines, the Washington State Department of Financial Institutions
said, "These guidelines are designed to level the playing field in the mortgage
market in order to protect consumers from taking on high-risk mortgages without
having a full understanding of the terms of such loans. You (loan providers)
are strongly encouraged to consider the guidance as a minimum standard or benchmark
for compliance with Washington's prohibited practices sections when soliciting,
originating or making nontraditional mortgage products."
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