The Federal Reserve Bank is concerned that U.S. banks’ current risk-management techniques may not be sufficient for the level of risk in nontraditional mortgages such as interest-only mortgages, a governor of the board said last week.

Speaking at the Financial Services Institute in Washington, D.C., Feb. 2, Governor Susan Schmidt Bies addressed the challenges of risk management, specifically targeting interest-only (IO) and “payment-option” adjustable-rate mortgages in which a borrower has flexible payment options (option ARMs).

“An institution’s risk-management processes should allow it to adequately identify, measure, monitor and control the risk associated with these products,” Schmidt said, citing draft guidance issued by the Fed along with other banking agencies governing such products.

Schmidt said that assessing borrowers’ ability to repay such loans, including monthly payments when amortization begins and interest rates rise, is of key importance.

The governor noted that there has been an increase in these nontraditional loans. “In 2005, option ARMs and IOs were an estimated one-third of total U.S. mortgage originations. In contrast, in 2003, these products were estimated to represent less than 10 percent of total originations,” Schmidt said.

The governor noted that although such loans still account for less than 20 percent of aggregate domestic mortgage outstandings of $8 trillion, the Fed is still concerned that current risk-management techniques “may not fully address the level of risk in nontraditional mortgages, a risk that would be heightened by the downturn in the housing market.”

Schmidt pointed out that such loans have been available for many years, but in the past were only offered to higher-income buyers. More recently, they have been offered to subprime borrowers, “who may be less suited for these types of mortgages.” Such borrowers are more likely to experience an unmanageable payment shock and hence more likely to default, Schmidt said.

In giving such loans, the governor said, bankers should ensure that borrowers have sufficient information so that they realize what they are getting into before taking out such loans.

“Before choosing a product or payment option, (consumers must know) the terms and associated risks of these loans, particularly how far monthly payments can rise and that negative amortization can increase the amount owed on the property above what was originally borrowed,” Schmidt said.

“These products warrant strong risk-management standards as well as appropriate capital and loan-loss reserves,” the governor said.

***

Send tips or a Letter to the Editor to janis@inman.com or call (510) 658-9252, ext. 140.

Show Comments Hide Comments
Sign up for Inman’s Morning Headlines
What you need to know to start your day with all the latest industry developments
By submitting your email address, you agree to receive marketing emails from Inman.
Success!
Thank you for subscribing to Morning Headlines.
Back to top
Only 3 days left to register for Inman Connect Las Vegas before prices go up! Don't miss the premier event for real estate pros.Register Now ×
Limited Time Offer: Get 1 year of Inman Select for $199SUBSCRIBE×
Log in
If you created your account with Google or Facebook
Don't have an account?
Forgot your password?
No Problem

Simply enter the email address you used to create your account and click "Reset Password". You will receive additional instructions via email.

Forgot your username? If so please contact customer support at (510) 658-9252

Password Reset Confirmation

Password Reset Instructions have been sent to

Subscribe to The Weekender
Get the week's leading headlines delivered straight to your inbox.
Top headlines from around the real estate industry. Breaking news as it happens.
15 stories covering tech, special reports, video and opinion.
Unique features from hacker profiles to portal watch and video interviews.
Unique features from hacker profiles to portal watch and video interviews.
It looks like you’re already a Select Member!
To subscribe to exclusive newsletters, visit your email preferences in the account settings.
Up-to-the-minute news and interviews in your inbox, ticket discounts for Inman events and more
1-Step CheckoutPay with a credit card
By continuing, you agree to Inman’s Terms of Use and Privacy Policy.

You will be charged . Your subscription will automatically renew for on . For more details on our payment terms and how to cancel, click here.

Interested in a group subscription?
Finish setting up your subscription
×