• Federal Agencies Caution Lenders Regarding Non-traditional Mortgage Products
  • March 30, 2006
  • Law Firm: Blank Rome LLP - Philadelphia Office
  • In order to make home ownership more accessible to a wider range of borrowers, mortgage lenders in recent years have become increasingly creative with respect to the variety of mortgage products they offer. Interest-only mortgages and flexible payment option mortgages have become particularly popular, as have simultaneous second-lien mortgages. However, federal regulators are concerned that these well-intentioned products may present risks that lenders have failed to consider in making such products widely available, particularly to borrowers who would not qualify for traditional mortgage products or who do not fully understand the risks associated with interest-only or adjustable rate mortgages that carry the potential for negative amortization. To that end, the federal financial regulatory agencies have proposed interagency guidance concerning these non-traditional mortgage products.

    Issues Covered In The Proposed Guidance

    The proposed guidance does not discourage lenders from offering non-traditional mortgage products; rather, it specifies certain issues that lenders should consider when evaluating a borrower's eligibility for such products. Specifically, the guidance urges management to:

    • Consider the borrower's ability to repay the loan, including any balances added through negative amortization, at the fully indexed rate applicable after the expiration of any introductory period rate.
    • Recognize that certain non-traditional mortgage loans have not been tested in an environment of greater financial stress, and that strong risk management standards and appropriate capital and loan loss reserves will be necessary in anticipation of higher default rates that could occur if the economic climate changes.
    • Ensure that borrowers have sufficient information to clearly understand loan terms and associated risks prior to making a product or payment choice.

    The Agencies' Concerns

    With respect to underwriting standards, the agencies remind lending institutions that, especially where non-traditional mortgage loan products are concerned, it is important to maintain sound standards regardless of market pressures that might influence the lender to make riskier loans and more of them. Allowing third party decision-makers too much leeway in terms of determining underwriting standards is a practice of particular concern to the agencies, who remind lenders that such third parties often have different business objectives and risk tolerances.

    Payment shock, another notable concern of the federal banking agencies, applies most frequently to payment option adjustable rate mortgages, particularly those with introductory interest rates set far below the fully indexed rate. The agencies encourage lenders to recognize the impact of payment shock when qualifying borrowers for loans where an increase in monthly mortgage payments is expected, as such programs are often not appropriate for borrowers with high LTV or DTI ratios. Over-reliance on credit scores when determining repayment capacity can be a dangerous practice when the level of credit risk increases in connection with non-traditional mortgage loan products. Likewise, the agencies urge lenders to avoid loan terms that result in the borrower having to rely on sale or refinancing of the security property, reminding lenders that the practice of making collateral-dependent mortgage loans is not considered compliant with safety and soundness standards.

    Of major concern in connection with non-traditional mortgage products is the combination of such products with other risk-layering practices. Sufficient documentation of income and employment, combined with mitigating factors such as higher credit scores, lower LTV and DTI ratios, and mortgage insurance, should assist in cushioning the increased risk naturally associated with non-traditional mortgage products. Although reduced documentation in the underwriting process appears to be a growing trend in the industry, the agencies remind lenders that clear policy guidelines are necessary if such practices are to be used.

    The proposed guidance also addresses mortgage programs that target subprime borrowers and borrowers who finance non owner-occupied investment properties. Calling for active portfolio management and enhanced risk management practices, the agencies have provided specific recommendations to assist lenders in developing a safer approach to using non-traditional mortgage loan products as a competitive tool in the marketplace.

    Comment Period Extended

    The agencies have solicited comment on these proposed best practices, particularly the underwriting standards employed by various lenders, as these practices vary widely in the industry. The comment period has been extended to March 29, 2006. Please advise if you would like us to keep you apprised of any future rulemaking or guidance published on this issue.