Nontraditional Mortgage Products: New Guidance

The financial regulatory agencies have issued joint guidance on nontraditional mortgage products. The guidance is based on agency concerns about risk to both safety and soundness and to compliance. While many elements have been raised in a variety of setting and contexts, the guidance brings all these regulatory concerns together into a document that will serve as guidance for institutions and for examiners.

The target of this guidance is mortgage loans that are designed to have affordable payments but which may have serious consequences with respect to amortization. Both the lender and the borrower must know what they are doing and understand whether the approach is sound.

Principle Elements
The proposed guidance focuses on several issues: whether there is an adequate analysis of the borrower's ability to repay, whether the loan is dependent on the collateral rather than the borrower, whether and when it may be appropriate to make such loans without full documentation, when and how below-market introductory rates are used and what rate is used to qualify the borrower, whether nontraditional mortgage loans are made to subprime borrowers, and whether such loans are secured by non owner-occupied properties.

These concerns effectively summarize what the agencies identify as risk. Non-amortization is a risk for the borrower who may never acquire equity. It is also a risk for the lender as well as the borrower in the event that the security property does not hold its value. Proper underwriting procedures and adequate documentation of the decision-making process is important not only to ensure sound reasoning and decisions, but to establish whether the decision was reasonable at the time it was made.

Other concerns go to the role that could be played by deceptive marketing of such practices. The predatory lending issues arise from the possibility that the borrower does not have the full information needed to make a sound decision. The agencies stress the importance of clear and balanced information about the relative benefits and risks of the product.

Safety and Soundness
In providing guidance on safety and soundness, the guidelines discuss appropriate practices for documentation, product mix and risk, and dealing with brokers and investors.

The guidelines make clear that no institution should offer non-traditional mortgages without first setting out clear policies and specific procedures. Institutions should also consider how lenders are incented to make non-traditional loans. Finally, the institution should have tight controls and systems for monitoring and reporting.

Compliance
The first message is fair marketing. The agencies are concerned that institutions do more than market the immediate or short-term benefits of nontraditional mortgages. They want to be sure that institutions provide their applicants with clear information about the risks and consequences. In particular, lenders should make clear to borrowers that future payments are likely to increase.

Accompanying the marketing concern is guidance that all communications with the borrower should be clear on the risks such as negative amortization or payment increases, even monthly statements. The proposed guidance specifically refers to advertisements, oral statements, promotional materials and monthly statements. All information should be "clear, balanced, and timely."

The proposed guidance draws a parallel to the ARM rules in terms of information that should be given to the consumer, but points out that these instruments carry greater risks for the consumer. When the agencies make this kind of statement about a product, you should sit up and pay close attention.

The specific compliance risks that the guidance identifies are Truth in Lending disclosures and Section 5 of the FTC Act (unfair or deceptive trade practices). The guidance also warns that lenders should look beyond these specific laws and consider the impact of others, such as RESPA.

Guidance
Much of the compliance guidance calls for clear and timely communication. The guidance reaches beyond the required disclosures which must be considered an absolute minimum. The fundamental test for adequacy of information is how it was received and understood by the consumer.

Promotions should be designed to give clear and fair information on payment changes, amortization consequences, prepayment penalties, and pricing differences between low-documentation and full-documentation loans.

The guidance recommends that promotional materials could include examples to illustrate payment changes for a hypothetical loan. A good example would include how rate changes would affect payments and how a negative amortization cap would affect payments.

Monthly statements on payment option ARMs should provide enough information so that the borrower can understand the options. Understanding options refers to understanding the choices and understanding the consequences of each choice.

The suggestions for effective monthly statement disclosures are very much like HELOC statements. The agencies believe that borrowers need information, such as the consequences of a minimum payment, to make appropriate decisions. One suggestion is to state the consequence of making only a minimum payment in a disclosure next to the minimum payment amount. The agencies suggest providing the current loan balance and showing the amount of payment that was credited to principal and to interest.

Included in the guidance is what could be described as "make no promises." These items deal with concerns about unfair or deceptive communications about the product to the consumer, beginning with marketing and extending through anything the loan officer might say to the applicant. For example, an "assurance" that rates probably won't go that high is a statement that could put the borrower at risk. Because the statement is made by a person the applicant considers to be knowledgeable, the risk is high that the consumer would rely on it in making choices.

Finally, any lender offering non-traditional products should have control systems to ensure that what lenders and marketers are really doing is consistent with the policies and procedures. The agencies have requested comment, which is due no later than 60 days after publication of the notice in the federal register.

ACTION STEPS

Alert lenders and senior management to the pending agency guidance and be sure they understand the legal and compliance consequences of offering non-traditional mortgages.
Share this guidance with your marketers. Together, review all recent marketing for consistency or inconsistency with these proposed guidelines.
Review monthly statements as they are presently designed. Compare the information with information that the guidelines suggest.