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."