New guidelines that would require banks to tighten underwriting standards and track portfolio risks on nontraditional mortgages while providing more comprehensive disclosures to borrowers will be finalized this fall, a federal regulator told members of the Senate Banking Committee Wednesday.
Kathryn E. Dick, deputy comptroller of the Office of the Comptroller of the Currency, said that interest-only and payment-option adjustable-rate mortgages (ARMs) are complex products that are often marketed to people who don’t understand their risks. Guidelines instructing banks to do a better job informing consumers of those risks will be finalized in “weeks, not months,” she said.
“Our … fundamental concern is: Do borrowers who use these products understand the very real possibility of dramatically increased payments in the future?” Dick said in written testimony at a Senate Banking Committee hearing this week. To answer that question, the OCC looked at marketing materials used by lenders to market payment options.
“In many cases we found that such materials focused primarily on the initial low monthly payment and gave relatively little attention to the likelihood of much higher payments later. This exercise led us to conclude, at least initially, that nontraditional mortgages are relatively complex, and borrowers unfamiliar with them — which means most borrowers — would benefit greatly from improvements in both the content and timing of disclosures.”
Banks “should spell out exactly what the consequences of the borrower’s decisions will be — both the benefits and the risks. There should be no equivocation about the risks of negative amortization and payment shock, if that’s what the product entails,” Dick said.
George Hanzimanolis, president-elect of the National Association of Mortgage Brokers, said nontraditional mortgages are a response to a lack of affordable housing, “affording consumers the flexibility to invest, manage their wealth, manage uneven income flows, and lower their monthly payments if necessary.”
The banking industry has expressed its reservations about the proposed guidelines, saying they are too restrictive or unclear. Because the OCC’s proposed guidelines would only apply to federally insured banks and their affiliates and subsidiaries, bankers say they would give unregulated institutions a competitive advantage — even though those lenders are largely to blame for the perception that underwriting standards have been relaxed.
Bankers want any new disclosure requirements incorporated into rules that apply to all lenders, such as the Truth-in-Lending Act or the Real Estate Settlement Procedures Act. Hanzimanolis called for establishing minimum education requirements for all loan originators and improving financial literacy among consumers.
“No law or regulation should ever require any mortgage originator to supplant the consumer’s ability to decide for him or herself what is or is not an appropriate loan product,” Hanzimanolis said. “As the decision-maker, the role of the consumer is to acquire the financial acumen necessary and take advantage of the competitive marketplace, shop, compare, ask questions and expect answers.”
Dick said state agencies that regulate mortgage brokers and lenders are expected to adopt similar guidelines, citing a recent announcement by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators. If guidelines similar to those proposed by the OCC are adopted at the state level, that should help address the issue of “a level regulatory playing field,” Dick said.
In a separate report and in testimony before the Committee, the Government Accountability Office also recommended more comprehensive disclosure to borrowers.
Orice M. Williams, the GAO’s director for financial markets and community investment, said mortgage statistics show that lenders offered non-traditional mortgages to less creditworthy and less wealthy borrowers than in the past.
“Some of these recent borrowers may have more difficulty refinancing or selling their homes to avoid higher monthly payments, particularly in an interest-rate environment where interest rates have risen or if the equity in their homes fell because they were making only minimum monthly payments or home values did not increase,” Williams said. “As a result, delinquencies and defaults could rise.”
Although federal banking regulators think most banks appear to be managing their credit risk well by diversifying their portfolios or through loan sales or securitizations, Williams said, the monthly payments for most non-traditional mortgages originated between 2003 and 2005 have not reset to cover both interest and principal. It’s too soon to tell to what extent payment shocks would result in increased delinquencies or foreclosures for borrowers and in losses for banks, Williams said.
The new guidelines proposed by the OCC would tighten underwriting standards, requiring lenders to analyze a borrower’s ability to repay not only the initial loan amount, but any additional principal that may accrue in the case of a payment-option loan with negative amortization.
Dick said a payment-option loan that allows negative amortization is essentially the same thing as a traditional mortgage loan coupled with a separate home equity line of credit (HELOC). Instead of getting a check to put in the bank, the payment-option borrower is allowed to make smaller monthly payments that are too small to even cover all of the interest due on the loan. Instead of building up equity in the home, the borrower’s debt increases.
When lenders underwrite separate HELOC loans, the borrower must demonstrate they have enough income to pay off all the additional debt they would take on if they drew on their entire line of credit. But lenders don’t require borrowers who take payment-option loans to prove that they can handle the debt they will accrue beyond the initial loan amount if they choose to make the minimum payments.
The OCC believes that “underwriting standards that do not include a credible analysis of a borrower’s capacity to repay their entire debt violate a fundamental principle of sound lending and elevate risks to both the lender and the borrower,” Dick said.
The new guidelines will require that lenders base their underwriting analysis on the initial loan amount, plus any balance increase that may accrue over time if borrowers repeatedly choose the minimum monthly payment.
The new guidelines will also address the practice of issuing nontraditional loans with reduced documentation, especially unverified income. Banks will be directed not to approve loans with reduced documentation unless there are “other mitigating factors such as lower loan-to-value limits and other more conservative underwriting standards,” Dick said.
The OCC also expects banks offering non-traditional mortgages to adopt “robust risk management practices, including policies and internal controls that address product attributes, portfolio and concentration limits, third-party originations, and secondary market activities.” The proposed guidelines call for institutions to maintain performance measures that would provide early warning of potential or increasing risks.
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