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it to adequately identify, measure, monitor and control the risk associated with these products,” Schmidt said, citing draft guidance issued by the Fed along with other banking agencies governing such products.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.


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