In response to perilously lax lending standards and a proliferation of risky new mortgages, bank regulators issued new guidelines on Sept. 29 to protect American home buyers. The Office of the Comptroller of the Currency (OCC), along with the Federal Reserve Board, the Office of Thrift Supervision, and other bank agencies, now requires more stringent underwriting standards and more informational sales practices surrounding nontraditional mortgages, such as interest-only mortgages and "payment option" adjustable-rate mortgages (ARMs). These so-called exotic mortgages, regulators say, have raised serious consumer protection and safety and soundness issues for banks.
The marketing of newfangled mortgages to unsophisticated borrowers swelled along with the housing market in the last several years. The low minimum-payment options they offered were seductive to potential buyers as they sought to buy more home than they could afford. Now, as real estate prices have receded, many of these same borrowers are facing "payment shock," where monthly payments and interest rates have since skyrocketed.
The higher payments associated with exotic loans are not always adequately disclosed or understood by consumers, regulators have found. Moreover, lenders are increasingly combining these loans with other risky practices, such as requiring little or no documentation of income and the ability to pay off the loan (see BusinessWeek.com, 9/11/06, "Nightmare Mortgages").
Some banks have begun to slowly change their practices: On Sept. 19, Countrywide Financial of Calabasas, Calif., sent a note to its wholesale broker force informing them that effective Sept. 21, all applicants for the Countrywide PayOption ARM loan program will receive a seven-page "Understanding the PayOption ARM" consumer handbook discussing product basics, terminology, indices on which interest rates may be based, payment options, and so on.
The OCC also announced on Sept. 29 that it was floating a new proposal to create a one-page boilerplate document for the industry that explains how negative amortization loans work for use at "the shopping around phase," not at closing, according to the agency. BusinessWeek's Banking Editor Mara Der Hovanesian talked with Comptroller of the Currency John Dugan about the changes.
When did bank regulators start to worry about the mortgage lending business?
As house prices have gone up, people wanted to get into more expensive houses with bigger mortgages. The key became the almighty monthly payment. The market tried to find ways to reduce the payment that got people into homes. With these products, you pay less now, but you pay more later. And sometimes you have to pay a lot more later, if you can hold on to the mortgage. That raised two concerns for us: Do consumers really understand that they have to pay a lot more later? And second, are lenders really underwriting the loans so that if the consumer does have to pay a lot later, they have the capacity to pay?
In a world where house prices have been going up and [homeowners] can build equity, they can refinance out of the loans. But when prices stabilize or go down, they don't have a lot of equity in the homes and they will not be able to refinance and shoulder that higher payment. That, plus some of the other things, like the widespread use of no- or low-document loans, the layering of these risks, piggybacking loans at the secondary market [where borrowers have stealthily gone back to banks for more money unbeknownst to the investor in mortgage-backed securities]…we wanted to make a point and to send an important message for banks to take more care.
A lot of this gets sold off to hedge funds and other institutional investors. It's not on the bank's balance sheet, but there is still reputational risk if there are serious problems with the product. The negative amortization feature has become more of an affordability tool, not just for subprime but for prime borrowers to get into much more expensive homes than used to be the case. Because they are being sold, mass-marketed in ways they never have been before…it's a bit of uncharted territory. We want to make sure that people are looking at this prudently. These can be good products and people's incomes can rise and they can afford it. But it's the people who can't that we are worried about.
What's going to change with these new rules?
The negative amortization feature is a lot like a line of credit that's sold with a regular mortgage. When you have a payment option and you don't pay the full amount, rather draw down a line of credit. [Banks] weren't underwriting that embedded line of credit, and we thought that was inappropriate. They need to take in account the full amount of the commitment, the full amount of the embedded line of credit. So when you underwrite a $200,000 loan and you allow the borrower to use the negative amortization feature up to $40,000, you have to underwrite a $240,000 loan. We think that's pretty basic, prudent underwriting practices, but it's different from what [banks] are typically underwriting today.
Are you going to look further into issues regarding loans that don't require income documentation?
Lenders will have to be prepared to produce documentation about income if we ask them for it. It's something we will continue to monitor.
Banks have known for about nine months that regulators were going to come up with new best practices, yet they have done little voluntarily to date.
They just wanted to wait and see what we were going to do and what form the guidelines would be. Some thought we were being too prescriptive; we're not in the business of designing products or setting standards for products. We are in the business of having expectations for prudent underwriting standards and this is one place, the qualification area, where we thought it was important to establish basic guidelines for what our expectations would be. One thing we did put in was a [new] proposed disclosure short form…one page [that] simply shows what the payment shock can be in simple scenarios.
Is the OCC going to address the accounting issue that allows banks to book the earnings of these negative amortization loans up front, though they may never get repayment on these mortgages?
That's a generally accepted accounting issue, an auditor's issue. There are lenders who have had very good experience on collecting on them in full, and so I'm not defending the practice, I'm just saying there's an argument on the other side. It's just not something that's the purview of what we're looking at.
Do you have anything you want to say about the mortgage business in general? Last year you said that most big banks had relaxed their standards across the board. Are we going to see more of this, or are they tightening up now?
We do an annual underwriting survey, which is going to be out in the next couple of weeks. There's no firecracker in there.