As lenders, regulators, capital markets continue to assess the nearly daily developments in the subprime market, uncertainties abound. Many lenders are trying to figure out whether the current market conditions will have long-term adverse effects on their portfolios, while others are considering whether the current market reaction is an ”overcorrection” and presents a buying opportunity. Meanwhile, politicians urge regulators to “do something” and discuss adopting federal lending standards. With so many parties evaluating the situation, and no clear industry or governmental response yet articulated, we discuss below one possible source of guidance, the Statement on Subprime Mortgage Lending (the “Statement”) recently proposed by the federal banking agencies (the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the Office of the Comptroller of the Currency) and the National Credit Union Administration (together, the “Agencies”).1/
The purpose of the Statement is to address certain risk management, consumer protection, and management control issues that arise from subprime mortgage lending. As discussed in greater detail below, the Statement could have major effects on the subprime market, especially since it would apply to all banks, thrifts, and credit unions. For example, the Statement includes a requirement that financial institutions underwrite subprime mortgage loans based on full amortization and fully indexed interest rates, which some in the industry have predicted would choke off subprime mortgage lending by that segment of the lenders market.
Public comments on the proposed Statement are due not later than May 7, 2007, and may be addressed to any of the Agencies. The Federal Register notice for the proposed Statement, as well as the release of the proposal by each Agency on its website, provides complete information for submitting comments.
Subprime Lending Defined with Reference to ARMs
The definition of subprime lending in the Statement follows the definition previously used by the banking agencies in interagency guidance on subprime lending issued in 2001.2/ “Subprime lending” refers to programs that target borrowers with weakened credit histories (such as persons with previous payment delinquencies, loan charge-offs, judgments, or bankruptcies) and borrowers whose ability to repay is questionable (as indicated by low credit scores, high debt-to-income ratios, or incomplete credit histories). However, the particular concern of the Statement is the marketing of certain adjustable-rate mortgage (“ARM”) loans to those borrowers. The guidance on ARMs in the Statement relies heavily on guidance provided by the Agencies in 2006 regarding nontraditional mortgages, which included ARMs but did not single out that product for special consideration.3/
Inherent Credit Risk, Abusive Practices and Risk Layering
In the Statement, the Agencies are most concerned about ARMs that have one or more of the following features:
- A low introductory or “teaser” rate that resets relatively quickly after a loan is made to an adjustable index rate plus a margin for the loan’s remaining term. “2/28” loans are an example, which are 30-year, fully amortizing loans that reset after two years to an adjustable rate for the remaining 28 years.
- High caps or no caps on the amount by which the interest rate on a loan may increase after the teaser rate period expires or from year to year thereafter, possibly causing monthly payments to rise substantially and creating “payment shock” for borrowers unable to afford the reset monthly payments.
- Loan terms, such as those listed above, which may require a loan to be refinanced frequently in order for the borrower to maintain an affordable monthly payment.
- Substantial penalties for prepayments or for prepayments that occur after the initial interest rate adjustment period. Inadequate documentation of the borrower’s income and ability to repay the loan.
- Inadequate disclosure to borrowers of material loan terms, product risks, prepayment penalties, or borrowers’ additional obligations for such items as property taxes and insurance. ARMs with these features may lead to borrowers having difficulties in paying their loans. This is a credit risk for the lender, but the Statement points out that ARMs with these features may also create a situation in which lenders find themselves accused of predatory or abusive lending. “Predatory lending” is defined in the Statement by reference to the definition contained in the 2001 guidance. It typically involves the lender engaging in one or more of the following practices:
- Making loans that are unaffordable based on the borrower’s ability to repay and that are based instead on the foreclosure or liquidation value of the borrower’s property.
- Inducing the borrower to refinance repeatedly (“loan flipping”), charging high points and fees each time.
- Engaging in fraud or deception to conceal the true nature of the mortgage loan obligation from an unsuspecting or unsophisticated borrower.
The Agencies also expressed concern in the Statement that, when a subprime mortgage loan presents enhanced credit risk, the lender may propose additional programs or loan features to address those circumstances, but that those features have the effect of increasing, rather than decreasing, the risk. This is described as “risk layering.” For example, when a subprime mortgage loan has higher risk features, based on either loan characteristics (such as an adjustable rate) or borrower characteristics (such as little credit history), it becomes more important to verify the borrower’s income, assets, and liabilities. Reduced documentation may help a borrower in this group to obtain such a loan, but it should not be accepted unless other factors mitigate the risk of default. The Statement cautions that charging a higher interest rate is not a mitigating factor.
The Proposed Solution is Fully Indexed Underwriting
The Statement’s proposed method of avoiding the pitfalls inherent in ARMs is to evaluate borrowers’ repayment capacity based on their ability to pay off their debt by final maturity, assuming that monthly payment amounts include a full principal amortization payment and the full indexed interest rate. The 2006 guidance also offered this advice. The calculation of the borrower’s ability to repay should take into account all monthly housing-related payments (principal, interest, property taxes, and insurance).
Underwriting loans based on the borrower’s ability to repay the loan in full according to its terms also is promoted in the Statement as a means to provide consumer protection. Another consumer protection measure advocated in the Statement is full disclosure. Borrowers should receive clear and balanced information about the relative risks and benefits of subprime mortgage products at a time when the borrower could use that information to help him or her to select a loan product or choose payment options. Loan features that should be highlighted in disclosures include the risk of payment shock, the effects of prepayment penalties and balloon payments, the consequences of the absence of escrow for taxes and insurance and, if applicable, the cost of premium pricing for reduced documentation underwriting.
Examiners Will Focus on Controls
When examining a financial institution, the Agencies will consider whether it has strong control systems in place to monitor compliance with underwriting standards and with consumer information disclosure policies and procedures. Control systems should encompass third parties, such as mortgage brokers or correspondents, as applicable. Compensation programs should avoid awarding behavior that is inconsistent with program policies or encouraging the steering of loan applicants to subprime products to the exclusion of other products for which applicants might qualify. An institution’s procedures to address consumer complaints and its ability to identify potential compliance problems and take corrective action also will be considered.
Public Comments Requested on Unintended Consequences
Many have expressed concern that the requirement that financial institutions underwrite subprime mortgage loans based on full amortization and fully indexed interest rates constitutes a “worst case scenario” and that if adopted will choke off all subprime mortgage lending and deny credit to a large number of borrowers for whom an ARM provides significant assistance in achieving home ownership. The Agencies also have recognized that certain proposed measures in the Statement may have unintended consequences. For example, mortgage loans with subprime features may be part of a legitimate “credit repair” program or a short-term accommodation. The Agencies have asked for comments specifically on the following subjects:
- Whether the proposed standards will result in fewer qualifying home mortgage borrowers, and whether those borrowers will qualify for alternative loans in the same amount.
- Whether subprime loan terms are always inappropriate and should always be discouraged, or whether they are sometimes appropriate.
- Whether the Statement will unduly restrict the ability of subprime borrowers to refinance their loans and avoid payment shock.
- Whether the principles in the Statement should be applied to loans beyond the subprime ARM market.
- Whether limiting the imposition of prepayment penalties to the initial fixed rate period of a subprime ARM would permit borrowers to consider alternatives in a timely manner, and how this would affect lenders.
The Statement is not new. It incorporates policy positions taken previously by the Agencies, but rising rates of subprime mortgage defaults, pressure on subprime lenders in the secondary marketplace, and calls from some members of Congress for the Agencies to address borrower default rates have given the Agencies greater impetus to take some type of action. Even without Congressional urging, the FDIC on March 7, 2007 issued a cease and desist order to a statechartered financial institution that incorporated many of the Statement’s substantive provisions, such as requiring that ARM underwriting be based on fully indexed interest rates and full amortization of principal. In addition, Freddie Mac on February 27, 2007 announced that it will buy only subprime ARMs that qualify borrowers based on fully indexed and fully amortizing monthly payments, and will limit the use of low-documentation underwriting for those types of mortgages.
The Statement notwithstanding, many issues remain unaddressed. The dominant subprime loan originators are not federally regulated, but are supervised by state mortgage banking and mortgage brokering regulators. Yet, the states’ responses have been limited. Some in Congress are calling for federal supervision of mortgage lending. It will be interesting to see how state regulators respond to the challenge, and whether the framework of the Statement will prove useful. Will the states (or, for that matter, Congress and the Agencies) focus on specific lending practices or loan features, such as low-documentation underwriting, that may have contributed to increased early default rates, loan putbacks and lender bankruptcies? Or will they take a broader, consumeroriented approach to the problem and address practices, such as loan flipping, which may not be problems in the secondary market? Will regulators attempt to define the role that the secondary market may have played in encouraging looser lending practices, and are they able to persuade or compel that segment of the industry to contribute to a solution? It appears likely that it will not be the Agencies alone that determine the future regulatory framework for subprime lending and the role of the Statement in forming that framework.