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Compliance Corner: Fourth Quarter 2006

Compliance Alert: Agencies Issue Final Guidance on Nontraditional Mortgage Product Risks

On September 29, 2006, the federal banking agencies issued final guidance to address the risks posed by residential mortgage products that allow borrowers to defer repayment of principal and sometimes interest.1 These products, also referred to as "nontraditional," "alternative," or "exotic" mortgage loans, include "interest-only" mortgages and "payment option" adjustable-rate mortgages and allow borrowers to exchange lower payments during an initial period for higher payments later. In addition, institutions are increasingly combining these loans with other features that may compound risk ("risk layering"), including making simultaneous second-lien mortgages and relying on reduced or no documentation in evaluating an applicant's creditworthiness.

While similar products have been available for many years, the number of institutions offering them has expanded rapidly. At the same time, these products are offered to a wider spectrum of borrowers who may not otherwise qualify for a similar-size mortgage under traditional terms and underwriting standards. The agencies were concerned that some borrowers may not fully understand the risks of these products because of the lack of principal amortization and the potential for negative amortization.

The final guidance discusses the importance of carefully managing the potential heightened risk levels created by these loans and encourages management to ensure that:

  • Loan terms and underwriting standards are consistent with prudent lending practices
  • Risk management practices are strong
  • Capital levels are commensurate with risk
  • Allowances for loan and lease losses reflect the collectibility of the portfolio
  • Consumers have sufficient information to clearly understand loan terms and associated risks prior to making a product or payment choice

Please Note:
Several commenters on the proposed guidance for nontraditional mortgage products encouraged the agencies to include model or sample disclosures or other descriptive materials as part of the interagency guidance. In response, the agencies issued Proposed Illustrations of Consumer Information for Nontraditional Mortgage Products for public comment in October. The agencies believe that illustrations of consumer information may be useful to institutions as they seek to implement the consumer information recommendations of the guidance. After the comment period closes in December, the agencies will issue a final version of the document.

Additional Note:
The federal banking agencies have also released a new publication designed to aid consumers in making informed choices when selecting a mortgage loan. The publication, entitled Interest-Only Mortgage Payments and Payment-Option ARMs-Are They for You?, includes a glossary of lending terms, a mortgage shopping worksheet, and a list of additional resources. The publication is available online at www.federalreserve.gov.External Link

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.