K&LNG
OCTOBER 2006
Mortgage Banking/Consumer Finance Commentary
Nontraditional Loan Products Require Traditional
Underwriting Under Final Interagency Guidance
A financial institution should not offer a nontraditional mortgage product to a higher-risk borrower
who would not qualify for a regularly amortizing loan. That is the overarching message in the
“Interagency Guidance on Nontraditional Mortgage Product Risks”1 (the “Guidance” or the “Final
Guidance”) issued by the federal banking agencies (the “Agencies”) on October 4, 2006. With some
notable exceptions, the Agencies did not stray far from their proposed guidance on nontraditional
mortgage loans2 (the “Proposed Guidance”). The Final Guidance continues to highlight the
heightened risk when making nontraditional mortgage loans to less creditworthy borrowers,
especially when using reduced documentation applications.
The preamble claims that the Final Guidance is less prescriptive and more flexible than the Proposed
Guidance, but the Final Guidance still contains strong cautionary language for institutions subject to
the supervision of one of the Agencies. While clarifying that nontraditional loan products are not
per se “unsafe or unsound,” the Guidance instructs financial institutions to make some relatively
pessimistic assumptions when assessing repayment ability. The result is that financial institutions
may use nontraditional mortgage loans to give borrowers payment flexibility, but not to qualify a
borrower who simply cannot afford to repay the loan.
The Agencies also asked for comments on proposed “illustrations” of information that financial
institutions can provide to consumers to comply with the Guidance. Comments on these
“illustrations” are due by December 4, 2006.
GENERAL ISSUES
Scope of Guidance
There are two aspects to the scope of the Guidance: the “what” and the “who.” In terms of products
covered, the “what” is relatively straightforward. In response to comments, the Agencies clarified in
the Final Guidance what kinds of products are covered. However, the Guidance remains unclear
about which activities relating to nontraditional mortgage loans must conform to the Guidance. The
Guidance is also unclear about the “who.”
Products and Activities Covered by the Guidance
The Proposed Guidance did not define “nontraditional mortgage loan,” although it suggested that
“nontraditional mortgage loans” include “residential mortgage loan products that allow borrowers to
defer repayment of principal and, sometimes, interest.”
According to the Agencies, many industry commenters wanted a precise definition of
“nontraditional mortgage loan.” Many industry commenters also urged the Agencies to exclude
interest-only loans, reverse mortgages, and home equity lines of credit (“HELOCs”). This would
have limited the Guidance to mortgage products that allow negative amortization (other than reverse
mortgage loans).
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In response to these comments, the Agencies clarified that the Guidance applied to any mortgage
loan that allows the borrower to defer payment of principal or interest except reverse mortgages and
HELOCs (except certain simultaneous second-lien HELOCs). The Agencies excluded reverse
mortgages because they “do not present the types of concerns that are addressed in the guidance[.]”
Most HELOCs could be excluded from the Guidance, the Agencies decided, because “they are
already covered by the May 2005 Interagency Credit Risk Management Guidance for Home Equity
Lending.” (The Agencies also decided to amend the May 2005 guidance to make its consumer
disclosure recommendations consistent with the Final Guidance.)
The Agencies did not follow the suggestion that they exclude interest-only loans, however. The
Agencies said that interest-only loans “pose risks similar to products that allow negative
amortization, especially when combined with high leverage and reduced documentation[.]” Thus,
according to the Agencies, “they present similar concerns from a risk management and consumer
protection standpoint.”
It is still unclear which activities relating to nontraditional mortgage products the Final Guidance
covers. The Guidance says that a financial institution must monitor its third-party originators to
ensure that they conform to the institution’s policies, but it does not say whether a purchaser of a
nontraditional mortgage loan that is several steps removed from the originator has similar
obligations. The Guidance also does not address what special obligations (if any) a financial
institution has if it provides a warehouse line of credit that an originator will use to make
nontraditional mortgage loans. Finally, the Guidance does not say whether it applies to investments
in securities backed by pools of nontraditional mortgage loans. Because the Guidance does not
address these issues directly, financial institutions may need to address them with their examiners.
Institutions Subject to the Guidance
The preamble to the Proposed Guidance said that it would apply to the following:
■
all banks and their subsidiaries,
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bank holding companies and their nonbank subsidiaries,
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savings associations and their subsidiaries,
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savings and loan holding companies and their subsidiaries, and
■
credit unions.
The Final Guidance does not directly address to which institutions it applies, although a footnote in
the preamble to the Final Guidance quotes a press release from the Conference of State Bank
Supervisors (“CSBS”) and the American Association of Residential Mortgage Regulators which said
that the Guidance “when finalized, will only apply to insured financial institutions and their
affiliates.”
The short answer is that the Agencies could attempt to apply the Guidance to any entity they
supervise for safety and soundness or consumer protection. Still, the Guidance “applies” to an
institution only to the extent that the institution has a legal obligation (imposed by some federal
banking law other than the Guidance) to operate in a “safe and sound” manner and be “fair” to
consumers—and then only to the extent that a financial institution has its compliance with these
requirements supervised by one of the Agencies (or some other agency that might adopt the
Guidance). Another way to look at this is that the Guidance applies to examiners who work for the
Agencies: it tells them what kinds of practices might be “unsafe” or “unsound,” or “unfair” to
consumers. If an examiner who works for one of the Agencies will examine an institution’s
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nontraditional mortgage finance activities for safety-and-soundness or fairness to consumers, then
the institution might be well served assuming that the Guidance applies to it for all intents and
purposes. In effect, the Guidance is a statement of enforcement policy.
One concern raised in comments from institutions subject to the Guidance was that it would put
them at a competitive disadvantage with mortgage bankers that are not affiliated with financial
institutions. In response, the Agencies noted that the CSBSand the State Financial Regulators
Roundtable (“SFRR”) have said that they are committed to preparing a model guidance document
for state regulators of nondepository institutions. This model guidance, the Agencies say, will be
“similar in nature and scope” to the Guidance.
We cannot say whether this model state guidance will alleviate the concerns of federally regulated
financial institutions until we see what it says and see whether state regulators actually adopt it.
There are, however, reasons to be less optimistic than the Agencies that this model guidance will
eliminate any competitive disadvantage created by the Guidance. One of the hurdles that CSBS
and SFRR must overcome when drafting a model guidance document for multistate adoption is that
the authority of the state regulators is different in each state. This could make it difficult for CSBS
and SFRR to construct a model guidance that can be implemented in most states with relatively few
state specific modifications. Moreover, the authority of state mortgage regulators is often narrower
than the authority of the Agencies. For example, nondepository institutions not affiliated with
depository institutions generally are not subject to a “safety and soundness” requirement. Thus, it
will be difficult for CSBS and SFRR to adapt for state guidance purposes those portions of the
Guidance that are based solely on a “safety and soundness” standard. One approach might be to
have the model state guidance declare that the practices identified as “unsafe” or “unsound” in the
Guidance are “unfair” or “deceptive” to consumers, and thus violate state laws prohibiting unfair
and deceptive acts and practices (“UDAP laws”). However, UDAP laws vary from state to state, as
does the authority of individual state mortgage regulators to declare authoritatively what constitutes
an “unfair” or “deceptive” practice under these UDAP laws. In short, it may be difficult for CSBS
and SFRR to construct a model guidance that is comparable in scope to its federal counterpart.
Importance of Flexibility
Industry commenters asked the Agencies to make the Final Guidance less “prescriptive” and to give
financial institutions more flexibility to decide how to meet the goals established by the Guidance.
Many industry commenters also urged the Agencies to explain more strongly in the Final Guidance
that nontraditional mortgage loans were not impermissible per se.
The Agencies’ handling of these concerns was something of a mixed bag. Portions of the Guidance
still read like firm directives. However, the Agencies did make some cosmetic changes throughout
that make the Final Guidance “feel” less like a strict regulation than a set of general principles and
guidelines. The Agencies also added the following paragraph to the introductory discussion in the
Final Guidance:
The focus of this guidance is on the higher risk elements of certain nontraditional
mortgage products, not the product type itself. Institutions with sound
underwriting, adequate risk management, and acceptable portfolio performance
will not be subject to criticism merely for offering such products.
How much flexibility financial institutions have under the Guidance will ultimately be determined
by how literally examiners enforce it. One could argue that the Guidance’s consistent use of the
word “should”—instead of the more forceful “shall,” “must,” or “will”—gives a financial
institution a measure of flexibility to depart judiciously from the Guidance’s directives if that
departure is, under the circumstances, consistent with the institution’s obligation to operate in a safe
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and sound manner. That being said, an agency telling you that you “should” do something does not
connote flexibility or discretion. How the examiners read the word “should” could determine how
flexible the Guidance really is.
LOAN TERMS AND UNDERWRITING STANDARDS
Maintaining Control over Underwriting Standards.
As in the Proposed Guidance, financial institutions are “strongly cautioned against ceding
underwriting standards to third parties that have different business objectives, risk tolerances, and
core competencies.” The Final Guidance also warns financial institutions not to let “competitive
pressures” interfere with their responsibility to maintain loan terms—which “should be based on a
disciplined analysis of potential exposures and compensating factors to ensure risk levels remain
manageable”—and sound underwriting standards.
Underwriting Standards and Assumptions
The primary issue in the discussion of underwriting standards is how financial institutions should
determine whether an applicant would be able to repay a nontraditional mortgage loan once the
introductory period ends and the loan begins to amortize. (We use the term “introductory period” to
refer to the period during which the borrower may defer repayment of principal and, in the case of a
payment-option ARM, payment of interest.) Like the Proposed Guidance, the Final Guidance says
that underwriting criteria must “include an evaluation of [the borrower’s] ability to repay the debt by
final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule.” The
analysis of repayment ability “should avoid over-reliance on credit scores as a substitute for income
verification in the underwriting process.” Institutions are also discouraged from making collateral
dependent nontraditional loans: “Loans to individuals who do not demonstrate the capacity to repay
[the loan], as structured, from sources other than the collateral pledged are generally considered
unsafe and unsound.”
These abstract statements of underwriting principles beg the more difficult (and controversial)
question. The borrower’s ability to repay the loan once the amortization period begins will depend
on things that will happen in the future. Broadly speaking, two factors will affect the monthly
payment amount during the amortization period: (1) if the loan has an adjustable interest rate, the
interest rate environment at the end of the introductory period; and (2) if the loan is a paymentoption ARM, the borrower’s payment history during the introductory period. The borrower’s
income at the time that the loan begins to amortize will also affect whether the borrower can repay
the loan. Since these factors are unknown when the lender underwrites the loan, the question is
what assumptions financial institutions should make when assessing whether an applicant will be
able to handle the “payment shock” at the end of the introductory period.
One extreme would be for a financial institution to assume the rosiest scenario—interest rates stay
low or go down, the borrower faithfully chooses the fully amortizing payment option each month
during the introductory period, and the borrower gets several significant raises before the
introductory period ends. The other extreme would be to assume the worst-case scenario—interest
rates increase dramatically, the borrower makes the minimum payment each month during the
introductory period, and the borrower’s income stays the same. (Actually, in the worst-case scenario
the borrower would lose his or her job, never again find gainful employment, and be reduced to
permanent penury. But if lenders had to assume that scenario when assessing repayment ability,
they would not be able to underwrite even a fixed-rate, regularly amortizing loan.)
Industry commenters urged the Agencies to adopt a flexible standard that would allow individual
institutions to determine appropriate assumptions based on empirical evidence and other generally
relevant information. The Agencies, however, concluded that financial institutions should assume
the worst-case scenario when assessing repayment ability. Concerning future income, the Agencies
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said that “[t]he commenters generally agreed that there is no reliable method for considering future
income or other future events in the underwriting process.” As a result, the Guidance says that
financial institutions must use the borrower’s income at the time of application when assessing
whether the borrower will be able to handle the higher payments during the amortization period.
Financial institutions must also use the fully indexed rate—defined in the Guidance as “the index
rate prevailing at origination plus the margin that will apply after the expiration of an introductory
interest rate”—when predicting monthly payment amounts during the amortization period. Perhaps
the harshest requirement imposed by the Guidance is that financial institutions determine the fully
amortizing monthly payment amount “based upon the initial loan amount plus any balance increase
that may accrue from the negative amortization provision.” (Emphasis added.) Notably, however,
the Agencies did not say that financial institutions could not change other aspects of their
underwriting criteria, such as maximum debt-to-income ratios.
If financial institutions make these assumptions, they will not be able to qualify a borrower for a
nontraditional mortgage loan if that borrower could not qualify for a regularly amortizing, fixed-rate
loan in the same amount (assuming that the lender’s debt-to-income requirements are the same for
nontraditional and fully amortizing loans). In fact, it might even be more difficult for an applicant
to qualify for a payment option ARM than for a regularly amortizing loan—when determining
repayment ability for the payment-option ARM, the lender will assume negative amortization during
the introductory period, which means that the fully amortizing payment for the payment option
ARM will be based on a higher principal amount.
The Agencies’ stringent stance on underwriting assumptions might have the greatest impact on the
market for interest-only loans with very long interest-only periods. A growing number of lenders
offer loans with interest-only periods as long as fifteen years. Some commenters suggested that the
payment shock risk for these products is substantially mitigated by the fact that many of these loans
will not be in existence when amortization periods are scheduled to commence, and that even if they
are, the likelihood that the property value and the borrower’s income will have increased during that
time mitigates the risk that the borrower will be unable to handle the higher monthly payments or
refinance the loan. The Agencies responded with the cryptic statement that “since the average life
of a mortgage is a function of the housing market and interest rates, the average may fluctuate over
time.” The Agencies said they were also “concerned that excluding these loans from the
underwriting standards could cause some creditors to change their market offerings to avoid
application of the guidance.” (It is difficult to understand why this is a concern—if long interestonly periods mitigate the risks addressed by the Guidance, then financial institutions avoiding the
Guidance through the use of long interestonly periods should not be a concern.)
The Guidance also has a confusing message about balloon loans. It mentions in a footnote that
“[f]or balloon mortgages that contain a borrower option for an extended amortization period, the
fully amortizing payment schedule can be based on the full term the borrower may choose.” The
negative inference from this statement is that if the borrower does not have the option of extending
the amortization period, the lender should fix the qualifying monthly payment amount using an
amortization schedule that matches the term of the loan, even though actual monthly payments
would be calculated with an amortization schedule that is much longer than the loan term. If
examiners imposed this requirement on financial institutions that they supervise, then it might be
difficult to include “true” balloon features in nontraditional mortgage loans.
Stated Income and Reduced Documentation Applications
The preamble to the Proposed Guidance asked commenters to discuss whether and under what
circumstances it is appropriate for lenders to use “stated income” procedures in connection with
subprime loans. Many industry commenters responded that while the borrower’s credit history
should factor into the decision whether to allow a stated income or reduced documentation
application, the Agencies should not adopt a bright-line rule based on only one factor. The Agencies
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appeared to agree. They “declined to provide guidance recommending reduced documentation
loans be limited to any particular set of circumstances. The Final Guidance recognizes that
mitigating factors may determine whether such loans are appropriate, but reminds institutions that a
credible analysis of both a borrower’s willingness and ability to repay is consistent with sound and
prudent lending practices.” Specifically, the Final Guidance says that “[a]s the level of credit risk
increases, the Agencies expect an institution to more diligently verify and document a borrower’s
income and debt reduction capacity. . . . [S]tated income should be accepted only if there are
mitigating factors that clearly minimize the need for direct verification of repayment capacity.”
The Final Guidance also says that “[f]or many borrowers, institutions generally should be able to
readily document income using recent W–2 statements, pay stubs, or tax returns.” This seems to
suggest that the Agencies will take a dim view of financial institutions allowing stated income or
reduced documentation applications if a full documentation application is possible, at least in the
absence of mitigating factors.
Risk Layering
The Guidance directs lenders to be cautious about adding to the risk inherent in these loans by
engaging in other risk-enhancing practices. The Guidance identifies two practices in particular that,
when paired with nontraditional mortgage terms, could result in unacceptable risk-layering: reduced
documentation application procedures (such as “stated income” or “no income” loans or limited or
reduced asset verification) and simultaneous second-lien mortgages. Although the Guidance does
not outright prohibit any of these practices, “[w]hen features are layered, an institution should
demonstrate that mitigating factors support the underwriting decision and the borrower’s repayment
capacity.” Examples of mitigating factors include “higher credit scores, lower LTV and DTI ratios,
significant liquid assets, mortgage insurance[,] or other credit enhancements.” The Guidance also
warns that risk-based pricing cannot replace the need for sound underwriting.
Subprime Lending
The Proposed Guidance said that “nontraditional mortgage loans often are inappropriate for
borrowers with high loan-to-value (LTV) ratios, high debt-to-income (DTI) ratios, and low credit
scores.” The Final Guidance tempers this a bit: it says that financial institutions should be especially
cognizant of the risk of payment shock “for borrowers with high loan-to-value (LTV) ratios, high
debt-to-income (DTI) ratios, and low credit scores.” This change appears to recognize that
nontraditional mortgage loans are not inappropriate per se for subprime borrowers. The Final
Guidance also cautions financial institutions to review prior interagency guidance that discusses
when lending practices involving subprime borrowers can become “predatory or abusive.” The Final
Guidance also reminds lenders that they should follow the applicable agency guidance on subprime
lending in general when they “target subprime borrowers through tailored marketing, underwriting
standards, and risk selection[.]”
PORTFOLIO AND RISK MANAGEMENT PRACTICES
Portfolio and Risk Management Strategies
The Guidance directs financial institutions to regularly evaluate the risk profiles for nontraditional
mortgage products to be sure that their “risk management practices keep pace with the growth and
changing risk profile of their nontraditional mortgage loan portfolios and changes in the market.”
Reporting systems should “allow the isolation of key loan products, risk-layering loan features, and
borrower characteristics.” This means that reporting systems should, at the very least, allow
management to obtain information by:
■
Loan type (e.g., interest only or payment option);
■
Risk-layering features (e.g., payment option ARM with stated income and interest-only
mortgage loans with simultaneous second-lien mortgages);
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■
Characteristics (e.g., LTV, DTI, and credit score); and
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Borrower performance (e.g., payment patterns, delinquencies, interest accruals, and negative
amortization).
Third-Party Originations
The Proposed Guidance would have required financial institutions that originate nontraditional
mortgages through third-party channels to “have strong approval and control systems to ensure the
quality of third-party originations and compliance with all applicable laws and regulations, with
particular emphasis on marketing and borrower disclosure practices.” The Proposed Guidance also
said that “[c]ontrols over third parties should be designed to ensure that loans made through these
channels reflect the standards and practices used by an institution in its direct lending activities.”
There was a serious concern that if certain portions of the Proposed Guidance were read in
conjunction with the discussion about managing third-party risk, financial institutions subject to the
Guidance might have concluded that they could not rely on third-party originators for nontraditional
mortgage products. Financial institutions can use loan file reviews to verify that third-party
originators are complying with certain loan-level requirements (such as written disclosure
requirements), but it would have been impossible for a financial institution to verify that third-party
originators are complying with many of the Proposed Guidance’s requirements. Industry
commenters urged the Agencies to provide financial institutions more flexibility in monitoring the
activities of third-party originators.
In the Final Guidance, the Agencies replaced the stringent third-party monitoring requirements with
a more flexible standard. The Proposed Guidance required financial institutions to “have strong
approval and control systems to ensure the quality of third-party originations and compliance with
all applicable laws and regulations, with particular emphasis on marketing and borrower disclosure
practices.” The Final Guidance requires financial institutions only to “have strong systems and
controls in place for establishing and maintaining relationships with third parties, including
procedures for performing due diligence.” The Final Guidance also does not require financial
institutions to have “controls over third parties” that are “designed to ensure that loans made through
these channels reflect the standards and practices used by an institution in its direct lending
activities,” as the Proposed Guidance did. Instead, the Final Guidance contains the more
manageable requirement that “[o]versight of third parties should involve monitoring the quality of
originations so that they reflect the institution’s lending standards and compliance with applicable
laws and regulations.”
These revised provisions in the Final Guidance are a substantial improvement over the provisions in
the Proposed Guidance. With these changes, financial institutions should be able confidently to
continue originating nontraditional mortgage loans through third-party channels.
Role of the Secondary Market
In the Proposed Guidance, the Agencies took the position that selling a loan on the secondary
market provides a financial institution with negligible protection from the credit risk associated with
that loan. The Agencies reasoned that, in order to protect its “reputation” in the secondary market,
“an institution may determine that it is necessary to repurchase defaulted mortgages,” even in the
absence of a contractual obligation to do so. The Proposed Guidance referred to this as “implicit
recourse,” which carries implications for an institution’s risk-based capital requirements. In effect,
the Proposed Guidance seemed to say that for purposes of risk-based capital requirements,
institutions (and examiners) should assume that a significant portion of the credit risk for a loan
remains with the institution even after the financial institution has transferred all of its interests in
the loan to a third party.
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Industry commenters objected to this portion of the Proposed Guidance. The Agencies left the crux
of the “implicit recourse” argument in the Final Guidance, but they offered industry commenters a
few concessions. The Agencies stated in the preamble that their “intent is to reiterate existing
guidelines regarding implicit recourse under the Agencies’ risk-based capital rules,” not to establish
new capital requirements. The Agencies also softened some of the language of the secondary
market discussion in the Final Guidance a bit. The secondary market discussion in the Proposed
Guidance had ended by saying that “institutions involved in securitization transactions should
consider the potential origination-related risks arising from nontraditional mortgage loans, including
the adequacy of disclosures to investors.” The Final Guidance says only that “[i]nstitutions should
familiarize themselves with these [risk-based capital] guidelines before deciding to support
mortgage loan pools or buying back loans in default.” The revised conclusion appears to concede
that financial institutions might be able to remove credit risk from their books by selling
nontraditional mortgage loans to investors. The revised language seems to recognize that a financial
institution need not elect to repurchase loans to manage reputation risk when they are not required
to do so under the purchase contracts—and that if a financial institutions does not do so, it is not
required to treat the loans as having been sold with implicit recourse if they underperform.
CONSUMER PROTECTION ISSUES
Suitability Standard
While the Proposed Guidance did not say that a financial institution is obligated to ensure that a
nontraditional mortgage loan is “suitable” for the particular borrower, suitability requirements are
unfortunately becoming so common at the state level that many industry commenters asked the
Agencies to state expressly that they did not intend to impose such a requirement on financial
institutions. The preamble to the Final Guidance said that the Agencies “disagree with commenters
who expressed concern that the guidance appears to establish a suitability standard, under which
lenders would be required to assist borrowers in choosing products that are suitable to their needs
and circumstances.” However, the preamble did expressly say that “[i]t was not the Agencies’ intent
to impose such a standard, nor is there any language in the guidance that does so.” The Agencies
also said in the preamble that they had made some changes to the language of the Final Guidance
that would lessen the risk that examiners or courts would interpret the Final Guidance to impose a
suitability requirement on financial institutions.
Communications With Consumers
The bulk of the consumer protection discussion in both the Proposed Guidance and the Final
Guidance addressed communications with consumers. Many industry commenters suggested to the
Agencies that these issues would be better addressed through generally applicable regulations (such
as Regulation Z to TILA or Regulation X to RESPA), rather than a guidance document that targets
only a segment of the mortgage industry. Many industry commenters also were concerned that the
disclosure requirements in the new rules would overlap with existing TILA disclosure requirements
and create consumer confusion.
The Agencies decided not to wait for amendments to Regulation Z or Regulation X because, “given
the growth in this market, guidelines are needed now to ensure that consumers will receive the
information they need about the material features of nontraditional mortgages as soon as possible.”
The Agencies were also not persuaded that the information requirements in the Guidance would
result in additional lengthy disclosures.
In response to requests from industry commenters, the Agencies issued “proposed illustrations of
consumer information for nontraditional mortgage products that are consistent with the
recommendations contained in the guidance.” These “illustrations” are discussed further below.
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Although the Agencies made some revisions, most of the consumer protection requirements in the
Proposed Guidance were retained in the Final Guidance. They included:
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Provide Balanced Information in Promotional Materials and Product Descriptions. When
promoting or describing nontraditional mortgage products, financial institutions are directed to
ensure that they “provide consumers with information that is designed to help them make
informed decisions when selecting and using these products.” Institutions are warned against
waiting until the consumer submits an application or takes out the loan to provide the consumer
with “clear and balanced” information about the product. Institutions should offer “clear and
balanced product descriptions when a consumer is shopping for a mortgage—such as when the
consumer makes an inquiry to the institution about a mortgage product and receives
information about nontraditional mortgage products, or when marketing relating to
nontraditional mortgage products is provided by the institution to the consumer[.]”
■
Be Sure that Consumers Understand the Risk of Payment Shock. Institutions should apprise
consumers of the risk that the monthly payment amounts could increase in the future. This
includes providing consumers with information about how the new payment amount will be
determined, and hypothetical examples of what new payment amounts might be.
■
Explain the Possibility of Negative Amortization. When negative amortization is possible
under the terms of the loan, consumers should be apprised of the potential consequences of
increasing principal balances and decreasing home equity, as well as other potential adverse
consequences of negative amortization. For example, product descriptions should include, with
sample payment schedules, corresponding examples showing the effect of those payments on
the consumer’s loan balance and home equity.
■
Prepayment Fees. If the product might contain a prepayment fee, financial institutions should
advise consumers of this fact.
■
Pricing Premiums for Reduced Documentation Loans. If an institution offers both reduced
and full documentation loan programs and charges more in connection with the former, then the
institution should “alert” the consumer to this fact.
■
Billing Statements. Monthly statements for payment option loans should “provide information
that enables consumers to make responsible payment choices, including an explanation of each
payment option available and the impact of that choice on loan balances.” In particular, the
monthly payment statement should contain an explanation next to the minimum payment
amount explaining that making this payment will result in an increase to the consumer’s
outstanding loan balance. The monthly payment statement also should not be designed in a
way that encourages payment-option ARM borrowers to select a non-amortizing or negatively
amortizing payment amount.
■
Misleading Practices. The Guidance identifies a handful of practices that could be misleading
and that institutions should avoid. These include making “unwarranted” assurances or
predictions about the future direction of interest rates and making “one sided” representations
about the “cash savings” or expanded buying power associated with nontraditional products
vis-à-vis more traditional products.
■
Control Systems. The Guidance also instructs lenders to adopt compliance control systems to
ensure that loan officers, mortgage brokers, and other employees are complying with the
institution’s policies on marketing nontraditional mortgage products.
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ILLUSTRATIVE COMMUNICATIONS
The Agencies issued draft “illustrations” of practices recommended in the consumer protection
portion of the Guidance. The Agencies emphasized that “[u]se of the proposed illustrations would
be entirely voluntary[,]” and that “there is no Agency requirement or expectation that institutions
must use the illustrations in their communications with consumers.” (Emphasis in original.)
Even institutions that plan to prepare their own disclosures and guidelines for communicating with
consumers should review the illustrations carefully and submit comments if they have any concerns
or suggestions. Although use of the “illustrations” will be voluntary, experience with “sample”
disclosures under other laws suggests that these illustrations could become the benchmarks against
which all other disclosures and communications with consumers will be judged. Further, many
financial institutions may want their own disclosures and communications to match the illustrations
as closely as possible to avoid fighting with examiners. Even institutions that are not directly subject
to the Guidance might wish to review and comment on the illustrations since they could become the
industry standard, and might be adopted by CSBS and SFRR in their model guidance for institutions
not governed by the Guidance.
The proposed illustrations are available at http://a257.g.akamaitech.net/7/257/2422/01jan20061800/
edocket.access.gpo.gov/2006/pdf/06-8479.pdf. We encourage you to review and consider providing
comments if you originate nontraditional mortgage loans. Comments are due by December 4, 2006.
Please contact Larry Platt, Steve Kaplan, or David Beam if you have any questions
about the Guidance or would like K&LNG to assist you in preparing comments on
the illustrations.
ENDNOTES
1 71 Fed. Reg. 58609 (October 4, 2006) (available at http://a257.g.akamaitech.net/7/257/2422/01jan20061800/edocket.access.gpo.gov/2006/pdf/068480.pdf).
2 Interagency Guidance on Nontraditional Mortgage Products, 70 Fed. Reg. 77249 (proposed
December 29, 2005) (available at http://a257.g.akamaitech.net/7/257/2422/01jan20051800/
edocket.access.gpo.gov/2005/pdf/05-24562.pdf).
For a summary of the Proposed Guidance, see Laurence E. Platt and David L. Beam, “The Risk
that Broke the Camel’s Back: Federal Banking Agencies Target the Layering of Risk,” Mortgage
Banking/Consumer Finance Commentary (January 2006) (available at http://www.klng.com/
newsstand/Search.aspx?attorneys=93c7db58 1ed9 4c93 8501 78bd5dd00e2b).
10
Kirkpatrick & Lockhart Nicholson Graham
LLP
|
OCTOBER 2006
MORTGAGE BANKING/CONSUMER FINANCE PRACTICE
Kirkpatrick & Lockhart Nicholson Graham LLP has approximately 1,000 lawyers who practice in offices located in Boston, Dallas,
Harrisburg, London, Los Angeles, Miami, Newark, New York, Palo Alto, Pittsburgh, San Francisco, and Washington. K&LNG
represents entrepreneurs, growth and middle market companies, capital markets participants, and leading FORTUNE 100 and
FTSE 100 global corporations, nationally and internationally.
For more information, please visit our website at www.klng.com or contact one of the lawyers listed below.
ATTORNEYS
Laurence E. Platt
Phillip L. Schulman
Costas A. Avrakotos
Melanie Hibbs Brody
Steven M. Kaplan
Jonathan Jaffe
H. John Steele
R. Bruce Allensworth
Irene C. Freidel
Nanci L. Weissgold
Paul F. Hancock
Phillip John Kardis II
Stephen E. Moore
Stanley V. Ragalevsky
David L. Beam
Emily J. Booth
Krista Cooley
Eric J. Edwardson
Suzanne F. Garwood
Anthony C. Green
Laura A. Johnson
Kris D. Kully
Drew A. Malakoff
David G. McDonough, Jr.
Erin Murphy
Lorna M. Neill
202.778.9034
202.778.9027
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415.249.1023
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Stephanie C. Robinson
Kerri M. Smith
Holly M. Spencer
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DIRECTOR OF LICENSING
Stacey L. Riggin
202.778.9202 [email protected]
REGULATORY COMPLIANCE ANALYSTS
Dana L. Lopez
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Kirkpatrick & Lockhart Nicholson Graham (K&LNG) has approximately 1,000 lawyers and represents entrepreneurs, growth and middle market companies, capital
markets participants, and leading FORTUNE 100 and FTSE 100 global corporations nationally and internationally.
K&LNG is a combination of two limited liability partnerships, each named Kirkpatrick & Lockhart Nicholson Graham LLP, one qualified in Delaware, U.S.A. and
practicing from offices in Boston, Dallas, Harrisburg, Los Angeles, Miami, Newark, New York, Palo Alto, Pittsburgh, San Francisco and Washington and one
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