Fed issues Statement on Subprime Mortgage Lending

FED Issues Statement on Subprime Mortgage Lending

On June 29, 2007, the Federal Reserve Board, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, the Federal Deposit Insurance Corporation, and the National Credit Union Administration (the Agencies) issued a final interagency Statement on Subprime Mortgage Lending (the Subprime Statement) to address emerging risks associated with certain subprime mortgage products and lending practices. The Subprime Statement is available at http://www.ots.treas.gov/docs/4/480966.pdf. The Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators developed a similar Statement. Numerous states have adopted the Subprime Statement and more states are expected to follow.

The Agencies developed the Subprime Statement to address emerging risks associated with certain subprime mortgage products and lending practices. In particular, the Agencies are concerned with certain adjustable rate mortgage (ARM) products typically offered to subprime borrowers that have one or more of the following characteristics:

• Low initial payments based on a fixed introductory rate that expires after a short period and then adjusts to a variable index rate plus a margin for the remaining term of the loan;
• Very high or no limits on how much the payment amount or the interest rate may increase (“payment or rate caps”) on reset dates;
• Limited or no documentation of borrower's income;
• Product features likely to result in frequent refinancing to maintain an affordable monthly payment; and/or
• Substantial prepayment penalties and/or prepayment penalties that extend beyond the initial fixed interest rate period.

The term “subprime” is described in the 2001 Expanded Guidance for Subprime Lending Programs available at http://www.federalreserve.gov/boarddocs/press/boardacts/2001/20010131/default.htm.

The Subprime Statement addresses predatory lending considerations, underwriting standards, workout arrangements, consumer protection principles including disclosures in advertising and product descriptions and control systems. 

Statement on Subprime Mortgage Lending (the Subprime Statement)

(a) General Compliance

All mortgages subject to the Interagency Statement on Subprime Mortgage Lending (the “Subprime Statement”), issued by the Office of the Comptroller of the Currency, Treasury, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of Thrift Supervision, Treasury and the National Credit Union Administration (the "Agencies"), must comply with the Subprime Statement or any substantially similar guidance issued by any state governmental agency.

(b) Consumer Disclosure

All mortgages subject to the Subprime Statement delivered for purchase must include a copy of the disclosures provided to the Borrower in compliance with the Consumer Protection Principles section of the Subprime Statement. The disclosure must clearly explain the risk of payment shock, the ramification of prepayment penalties, balloon payments, the cost of obtaining a reduced documentation loan and the consequences of not establishing an escrow account for taxes and insurance, as applicable.

The Subprime Statement covers four areas:

• Risk Management, which includes predatory lending considerations and underwriting standards;
• Workout Arrangements;
• Consumer Protection Principles; and
• Control Systems

The Agencies state that they 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.

Risk Management

Predatory Lending Considerations

In accordance with the Subprime Statement, institutions should ensure that they do not engage in the types of predatory lending practices discussed in the Expanded Subprime Guidance. Typically, predatory lending involves at least one of the following elements:

• Making loans based predominantly on the foreclosure or liquidation value of a borrower's collateral rater than on the borrower's ability to repay the mortgage according to its terms;
• Inducing a borrower to repeatedly refinance a loan in order to charge high points and fees each time the loan is refinanced (“loan flipping”); or
• Engaging in fraud or deception to conceal the true nature of the mortgage loan obligation, or ancillary products, from an unsuspecting or unsophisticated borrower.

The Subprime Statement notes that 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 actions or practices.

Underwriting Standards

The Subprime Statement indicates that institutions should refer to the Real Estate Guidelines, which provide underwriting standards for all real estate loans. The Real Estate Guidelines state that prudently underwritten real estate loans should reflect all relevant credit factors, including the capacity of the borrower to adequately service the debt.

Payment Shock

Prudent qualifying standards recognize the potential effect of payment shock in evaluation 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 scheduled.

The fully indexed rate equals the index rate prevailing at origination plus the margin to be added to it after the expiration of an introductory interest rate. For example, assume that a loan with an initial fixed rate of 7% will reset to the six-month London InterBank Offered Rate (LIBOR) plus a margin of 6%. If the six-month LIBOR rate equals 5.5%, lenders should qualify the borrower at 11.5% (5.5% + 6%), regardless of any interest rate caps that limit how quickly the fully indexed rate may be reached.

Debt-to-Income 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.

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.

Reduced Documentation

Institutions should verify and document the borrower's income (both source and amount), assets and liabilities. The Agencies note in the introductory comments that for many borrowers, institutions should be able to readily document income using recent W-2 statements, pay stubs and/or tax returns.

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 must be documented. The Subprime Statement provides two examples of mitigating factors:

• When a borrower with a 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; and
• When a borrower has substantial liquid reserves or assets that demonstrate repayment capacity and can be verified and document by the lender.

A higher interest rate is not considered an acceptable mitigating factor.

Workout Arrangements

Use of Prudent Underwriting

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.

Foreclosure

The Agencies note that 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.

Consumer Protection Principles

Advertisements, Oral Statements and Promotional Materials

Communications with consumers, including advertisements, oral statements and promotional materials, should provide clear and balanced information about the relative benefits and risks of loan products.

Mortgage product descriptions and advertisements should provide clear, detailed information about the costs, terms, features and risks of the loan to the borrower. 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. The 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.

Required Consumer Disclosures

Consumers should be informed of:

• Payment Shock - Potential payment increases, including how the new payment will be calculated when the introductory fixed rate expires.
• Prepayment Penalties - The existence of any prepayment penalty, how it will be calculated, and when it may be imposed.
• Balloon Payments - The existence of any balloon payment.
• Cost of Reduced Documentation Loans - Whether there is a pricing premium attached to a reduced documentation or stated income loan program.
• Responsibility for Taxes and Insurance - The requirement to make payments for real estate taxes and insurance in addition to their loan payments, if not escrowed, and the fact that taxes and insurance costs can be substantial.

The 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.

Prepayment Penalties

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 rest date) to refinance without penalty.

Control Systems

Institutions should develop strong control systems to monitor whether actual practices are consistent with their policies and procedures. The control systems should address:

• Compliance and consumer information concerns;
• Safety and soundness.

Control systems should encompass both institution personnel and applicable third parties, such as mortgage brokers or correspondents.

Policies and Procedures

Institutions should:

• Establish appropriate criteria for hiring and training loan personnel;
• Establish appropriate criteria for entering into and maintaining relationships with third parties and conducting initial and ongoing due diligence on third parties;
• 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.

Monitoring

Institutions should have procedures and systems to monitor:

• Compliance with applicable laws and regulations;
• Third party agreements;
• Internal policies; and
• Complaints (to identify potential compliance problems or other negative trends).

An institution's controls should include appropriate corrective actions in the event of failure to comply with applicable laws, regulations, third-party agreements or internal policies.