I. INTRODUCTION
The federal financial regulatory agencies have issued a final Statement on Subprime Mortgage Lending to address issues related to certain adjustable-rate mortgage products. The statement recommends that borrowers should be informed of potential payment increases; any pre-payment penalties; the existence of balloon payments; whether a pricing premium is attached to a reduced-documentation or stated-income loan program; and requirements to make real estate tax and insurance payments in addition to loan payments.
In particular, the agencies are concerned about the growing use of ARM products that provide low initial payments based on a fixed introductory rate that expires after a short period, and then adjusts to a variable rate plus a margin for the remaining term of the loan. These products could result in payment shock to the borrower. The type of adjustable-rate mortgage products typically offered to subprime borrowers with which the agencies are concerned generally have one or more of the following characteristics:
The agencies are concerned that these products, typically offered to subprime borrowers, present heightened risks to lenders and borrowers. In addition, borrowers may not be adequately informed of product features and risks, including their responsibility to pay taxes and insurance, which might be separate from their mortgage payments.
The statement describes the prudent safety and soundness and consumer protection standards that institutions should follow to ensure borrowers obtain loans they can afford to repay.
These standards include a fully indexed, fully amortized qualification for borrowers and cautions on risk-layering features, including an expectation that stated income and reduced documentation should be accepted only if there are documented mitigating factors that clearly minimize the need for verification of a borrower’s repayment capacity. Consumer protection standards include clear and balanced product disclosures to customers and limits on prepayment penalties that allow for a reasonable period of time, typically at least 60 days, for customers to refinance prior to the expiration of the initial fixed interest rate period without penalty.
The statement reinforces the April 17, 2007, interagency Statement on Working with Borrowers, in which the agencies encouraged institutions to work constructively with residential borrowers who are financially unable or reasonable expected to be unable to meet their contractual payment obligations on their home loans. Workout arrangements that are consistent with safe and sound lending practices are generally in the long-term best interest of both the financial institution and the borrower.
The statement does not include a definition of “subprime.” Rather, the agencies determined that the reference to the subprime borrower characteristics from the 2001 Expanded Guidance for Subprime Lending Programs provides appropriate information for purposes of the statement. The Expanded Guidance provides a range of credit risk characteristics that are associated with subprime borrowers, noting that the characteristics are illustrative and are not meant to define specific parameters for all subprime borrowers. Because the term “subprime” is not consistently defined in the marketplace or among individual institutions, the agencies believe that incorporating the subprime borrower credit risk characteristics from the Expanded Guidance provides sufficient clarity.
The Statement applies 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.
II. RISK MANAGEMENT PRACTICES
A. Predatory Lending Considerations
Subprime lending is not synonymous with predatory lending, and loans with the features described above are not necessarily predatory in nature. Typically, predatory lending involves at least one of the following elements:
Institutions offering mortgage loans such as these face an elevated risk that their conduct will violate Section 5 of the Federal Trade Commission Act (FTC Act), which prohibits unfair or deceptive acts or practices.
B. Underwriting Standards
The Real Estate Guidelines applicable to financial institutions, state that prudently underwritten real estate loans should reflect all relevant credit factors, including the capacity of the borrower to adequately service the debt. Prudent qualifying standards recognize the potential effect of payment shock in evaluating a borrower’s ability to service debt. An institution’s analysis of a borrower’s repayment capacity should include an evaluation of the borrower’s ability to repay the debt by its final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule.
One widely accepted approach in the mortgage industry is to quantify a borrower’s repayment capacity by a debt-to-income (DTI) ratio. An institution’s DTI analysis should include, among other things, an assessment of a borrower’s total monthly housing-related payments (e.g., principal, interest, taxes, and insurance, or what is commonly known as PITI) as a percentage of gross monthly income.
This assessment is particularly important if the institution relies upon reduced documentation or allows other forms of risk layering. Risk-layering features in a subprime mortgage loan may significantly increase the risks to both the institution and the borrower. Therefore, an institution should have clear policies governing the use of risk-layering features, such as reduced documentation loans or simultaneous second lien mortgages. When risk-layering features are combined with a mortgage loan, an institution should demonstrate the existence of effective mitigating factors that support the underwriting decision and the borrower’s repayment capacity.
Recognizing that loans to subprime borrowers present elevated credit risk, institutions should verify and document the borrower’s income (both source and amount), assets and liabilities. Stated income and reduced documentation loans to subprime borrowers should be accepted only if there are mitigating factors that clearly minimize the need for direct verification of repayment capacity. Reliance on such factors also should be documented. Typically, mitigating factors arise when a borrower with favorable payment performance seeks to refinance an existing mortgage with a new loan of a similar size and with similar terms, and the borrower’s financial condition has not deteriorated. Other mitigating factors might include situations where a borrower has substantial liquid reserves or assets that demonstrate repayment capacity and can be verified and documented by the lender. However, a higher interest rate is not considered an acceptable mitigating factor.
C. Workout Arrangements
The agencies encourage financial institutions to work constructively with residential borrowers who are in default or whose default is reasonably foreseeable. Prudent workout arrangements that are consistent with safe and sound lending practices are generally in the long-term best interest of both the financial institution and the borrower.
Financial institutions should follow prudent underwriting practices in determining whether to consider a loan modification or a workout arrangement. Such arrangements can vary widely based on the borrower’s financial capacity. For example, an institution might consider modifying loan terms, including converting loans with variable rates into fixed-rate products to provide financially stressed borrowers with predictable payment requirements.
The agencies will not criticize financial institutions that pursue reasonable workout arrangements with borrowers. Further, existing supervisory guidance and applicable accounting standards do not require institutions to immediately foreclose on the collateral underlying a loan when the borrower exhibits repayment difficulties. Institutions should identify and report credit risk, maintain an adequate allowance for loan losses, and recognize credit losses in a timely manner.
D. Consumer Protection Principles
Fundamental consumer protection principles relevant to the underwriting and marketing of mortgage loans include:
Communications with consumers, including advertisements, oral statements, and promotional materials, should provide clear and balanced information about the relative benefits and risks of the products. This information should be provided in a timely manner to assist consumers in the product selection process, not just upon submission of an application or at consummation of the loan. Institutions should not use such communications to steer consumers to these products to the exclusion of other products offered by the institution for which the consumer may qualify.
Information provided to consumers should clearly explain the risk of payment shock and the ramifications of prepayment penalties, balloon payments, and the lack of escrow for taxes and insurance, as necessary. The applicability of prepayment penalties should not exceed the initial reset period. In general, borrowers should be provided a reasonable period of time (typically at least 60 days prior to the reset date) to refinance without penalty.
Similarly, if borrowers do not understand that their monthly mortgage payments do not include taxes and insurance, and they have not budgeted for these essential homeownership expenses, they may be faced with the need for significant additional funds on short notice. Therefore, mortgage product descriptions and advertisements should provide clear, detailed information about the costs, terms, features, and risks of the loan to the borrower. Consumers should be informed of:
E. Control Systems
Institutions should develop strong control systems to monitor whether actual practices are consistent with their policies and procedures. Systems should address compliance and consumer information concerns, as well as safety and soundness, and encompass both institution personnel and applicable third parties, such as mortgage brokers or correspondents.
Important controls include establishing appropriate criteria for hiring and training loan personnel, entering into and maintaining relationships with third parties, and conducting initial and ongoing due diligence on third parties. Institutions also should design compensation programs that avoid providing incentives for originations inconsistent with sound underwriting and consumer protection principles, and that do not result in the steering of consumers to these products to the exclusion of other products for which the consumer may qualify.
Institutions should have procedures and systems in place to monitor compliance with applicable laws and regulations, third-party agreements and internal policies. An institution’s controls also should include appropriate corrective actions in the event of failure to comply with applicable laws, regulations, third-party agreements or internal policies. In addition, institutions should initiate procedures to review consumer complaints to identify potential compliance problems or other negative trends.
III. CONCLUSION
The agencies will continue to carefully review risk management and consumer compliance processes, policies, and procedures. The agencies will take action against institutions that exhibit predatory lending practices, violate consumer protection laws or fair lending laws, engage in unfair or deceptive acts or practices, or otherwise engage in unsafe or unsound lending practices.