FRB: Supervisory Letter SR 06-15/CA 06-12 on Interagency Guidance on Nontraditional Mortgage Product Risks -- October 10, 2006

On September 29, 2006, the Federal Reserve and the other federal financial institutions regulatory agencies issued the attached Interagency Guidance on Nontraditional Mortgage Product Risks. This guidance addresses both risk management and consumer disclosure practices that institutions should employ to effectively assess and manage the risks associated with residential mortgage loans that allow borrowers to defer repayment of principal and sometimes interest (referred to as nontraditional mortgage loans). Attachment 1 provides the Federal Register notice.¹ Attachment 2 provides the interagency guidance. At the same time, the agencies are also issuing an addendum to the 2005 Interagency Credit Risk Management Guidance for Home Equity Lending² to provide additional guidance to regulated institutions on consumer disclosure practices for open-end home equity lines of credit that contain interest only features. Refer to Attachment 3.

Given the potential risks associated with nontraditional mortgage products, the guidance addresses both risk management and consumer disclosure practices that institutions should consider in their mortgage lending activity. For purposes of this guidance, nontraditional mortgage loans include both "interest-only" mortgages, where a borrower pays no loan principal for the first few years of the loan, and "payment option" adjustable-rate mortgages (ARMs), where a borrower has flexible payment options with the potential for negative amortization. A borrower's payment on a nontraditional mortgage loan can increase significantly when the loan begins to amortize, leading to what is commonly referred to as "payment shock." Payment option ARMs carry greater potential payment shock if a borrower makes only minimum payments, resulting in negative amortization.

Risk Management Practices: The guidance highlights the key risk areas that should be addressed by an institution in its underwriting standards, loan terms, borrower qualification standards, documentation requirements, and portfolio and risk management practices. In particular, the agencies expect an institution's borrower qualification criteria to include an evaluation of a borrower's repayment capacity and ability to repay the debt by final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule. The criteria should include a credible analysis of a borrower's capacity to repay the full amount of the credit extended, including potential negative amortization. Recognizing that an institution's underwriting criteria are based on multiple factors, an institution may develop a range of reasonable tolerances for each factor used in the borrower qualification process, such as loan-to-value ratios, debt-to-income ratios, and credit scores. These tolerances should be based on prudent and appropriate underwriting standards, taking into account both the borrower's characteristics and the loan product's attributes.

Consumer Disclosure Practices: Institutions are reminded that consumer disclosures on these types of mortgage products must comply with applicable consumer laws. In light of the risks that these products pose to consumers, the guidance also contains recommended practices for an institution to consider when providing information to consumers on the product's terms (including the existence of any prepayment penalty or premium to be paid for reduced documentation loans) and risks (including the risk of payment shock and negative amortization). Such information should be provided to consumers at critical decision-making points, such as when a consumer is shopping for a mortgage or is deciding which monthly payment option to choose in a particular month. Since open-end home equity lines of credit (HELOC) with an interest-only feature may pose risks to consumers similar to those of closed-end mortgages, the agencies are also issuing an addendum to the 2005 Interagency Credit Risk Management Guidance for Home Equity Lending to address the timing and content of consumer communications for interest-only HELOCs.

Federal Reserve Banks are asked to distribute this letter, the interagency guidance, and addendum to the HELOC guidance to banking organizations supervised by the Federal Reserve, as well as to their supervisory and examination staff. If you have any questions concerning the safety and soundness sections of this guidance, please contact Sabeth Siddique at (202) 452-3861, Virginia Gibbs at (202) 452-2521, or Brian Valenti at (202) 452-3575 in the Board's Division of Banking Supervision and Regulation. For questions related to consumer disclosure practices, please contact Anjanette Kichline at (202) 785-6054 or Kathleen Ryan at (202) 452-3667 in the Board's Division of Consumer and Community Affairs.