Federal Register / Vol. 71, No. 192 / Wednesday, October 4, 2006 / Notices 58609 

7. To determine whether Terry Keith 

Hammond willfully and/or repeatedly 

violated § 73.1015 of the Commission’s 

rules by failing to provide full and 

complete responses and documents as 

directed by letters of inquiry issued by 

the staff of the Enforcement Bureau on 

June 14, 2004, and August 10, 2004; and 

8. To determine, in light of the 

evidence adduced pursuant to the 

foregoing designated issues, whether the 

captioned application for renewal of the 

license for Station KBKH(FM) should be 

granted, or denied. 

Copies of the Order to Show Cause, 

Notice of Opportunity for Hearing, and 

Hearing Designation Order are being 

sent by certified mail, return receipt 

requested, to Terry Keith Hammond. To 

avail himself of the opportunity to be 

heard, Terry Keith Hammond, pursuant 

to § 1.91(c) and § 1.221 of the 

Commission’s rules, 47 CFR 1.91(c) and 

47 CFR 1.221, in person or by his 

attorney, must within 30 days of the 

release of this Order, file in triplicate a 

written notice of appearance stating an 

intention to appear on the date fixed for 

the hearing and present evidence on the 

issues specified in this Order. Terry 

Keith Hammond pursuant to § 73.3594 

of the Commission’s rules, 47 CFR 

73.3594, shall give notice of the hearing 

within the time and in the manner 

prescribed in 47 CFR 73.3594, and shall 

advise the Commission of the 

publication of such notice as required 

by 47 CFR 73.3594(g). 

Federal Communications Commission. 

Marlene H. Dortch, 

Secretary. 

[FR Doc. E6–16217 Filed 10–3–06; 8:45 am] 

BILLING CODE 6712–01–P 

DEPARTMENT OF THE TREASURY 

Office of the Comptroller of the 

Currency 

[Docket No. 06–11] 

BOARD OF GOVERNORS OF THE 

FEDERAL RESERVE SYSTEM 

[Docket No. OP–1246] 

FEDERAL DEPOSIT INSURANCE 

CORPORATION 

DEPARTMENT OF THE TREASURY 

Office of Thrift Supervision 

[No. 2006–35] 

NATIONAL CREDIT UNION 

ADMINISTRATION 

Interagency Guidance on 

Nontraditional Mortgage Product Risks 

AGENCIES: Office of the Comptroller of 

the Currency, Treasury (OCC); Board of 

Governors of the Federal Reserve 

System (Board); Federal Deposit 

Insurance Corporation (FDIC); Office of 

Thrift Supervision, Treasury (OTS); and 

National Credit Union Administration 

(NCUA). 

ACTION: Final guidance. 

SUMMARY: The OCC, Board, FDIC, OTS, 

and NCUA (the Agencies), are issuing 

final Interagency Guidance on 

Nontraditional Mortgage Product Risks 

(guidance). This guidance has been 

developed to clarify how institutions 

can offer nontraditional mortgage 

products in a safe and sound manner, 

and in a way that clearly discloses the 

risks that borrowers may assume. 

FOR FURTHER INFORMATION CONTACT: 

OCC: Gregory Nagel, Credit Risk 

Specialist, Credit and Market Risk, (202) 

874–5170; or Michael S. Bylsma, 

Director, or Stephen Van Meter, 

Assistant Director, Community and 

Consumer Law Division, (202) 874–

5750. 

Board: Brian Valenti, Supervisory 

Financial Analyst, (202) 452–3575; or 

Virginia Gibbs, Senior Supervisory 

Financial Analyst, (202) 452–2521; or 

Sabeth I. Siddique, Assistant Director, 

(202) 452–3861, Division of Banking 

Supervision and Regulation; Kathleen C. 

Ryan, Counsel, Division of Consumer 

and Community Affairs, (202) 452–

3667; or Andrew Miller, Counsel, Legal 

Division, (202) 452–3428. For users of 

Telecommunications Device for the Deaf 

(‘‘TDD’’) only, contact (202) 263–4869. 

FDIC: Suzy S. Gardner, Examination 

Specialist, (202) 898–3640, or April 

Breslaw, Chief, Compliance Section, 

(202) 898–6609, Division of Supervision 

and Consumer Protection; or Ruth R. 

Amberg, Senior Counsel, (202) 898–

3736, or Richard Foley, Counsel, (202) 

898–3784, Legal Division. 

OTS: William Magrini, Senior Project 

Manager, Examinations and Supervision 

Policy, (202) 906–5744; or Fred PhillipsPatrick, Director, Credit Policy, (202) 

906–7295; or Glenn Gimble, Senior 

Project Manager, Compliance and 

Consumer Protection, (202) 906–7158. 

NCUA: Cory Phariss, Program Officer, 

Examination and Insurance, (703) 518–

6618. 

SUPPLEMENTARY INFORMATION: 

I. Background 

The Agencies developed this 

guidance to address risks associated 

with the growing use of mortgage 

products that allow borrowers to defer 

payment of principal and, sometimes, 

interest. These products, referred to 

variously as ‘‘nontraditional’’, 

‘‘alternative’’, or ‘‘exotic’’ mortgage 

loans (hereinafter referred to as 

nontraditional mortgage loans), include 

‘‘interest-only’’ mortgages and ‘‘payment 

option’’ adjustable-rate mortgages. 

These products allow borrowers to 

exchange lower payments during an 

initial period for higher payments 

during a later amortization period. 

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 more traditional mortgages. 

The Agencies are concerned that some 

borrowers may not fully understand the 

risks of these products. While many of 

these risks exist in other adjustable-rate 

mortgage products, the Agencies 

concern is elevated with nontraditional 

products because of the lack of principal 

amortization and potential for negative 

amortization. In addition, institutions 

are increasingly combining these loans 

with other features that may compound 

risk. These features include 

simultaneous second-lien mortgages and 

the use of reduced documentation in 

evaluating an applicant’s 

creditworthiness. 

In response to these concerns, the 

Agencies published for comment 

proposed Interagency Guidance on 

Nontraditional Mortgage Products, 70 

FR 77249 (Dec. 29, 2005). The Agencies 

proposed guidance in three primary 

areas: ‘‘Loan Terms and Underwriting 

Standards’’, ‘‘Portfolio and Risk 

Management Practices’’, and ‘‘Consumer 

Protection Issues’’. In the first section, 

the Agencies sought to ensure that loan 

terms and underwriting standards for 


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58610 Federal Register / Vol. 71, No. 192 / Wednesday, October 4, 2006 / Notices 

1Nine of these letters requested a thirty-day 

extension of the comment period, which the 

Agencies granted. 

2Letter to J. Johnson, Board Secretary, et al. from 

N. Milner, President & CEO, Conference of State 

Bank Supervisors (Feb. 14, 2006); Letter to J. 

Johnson, Board Secretary, et al., from B. Kent, 

Chair, State Financial Regulators Roundtable. 

3Media Release, CSBS & American Association of 

Residential Mortgage Regulators, ‘‘CSBS and 

AARMR Consider Guidance on Nontraditional 

Mortgage Products for State-Licensed Entities’’

(June 7, 2006), available at http://www.csbs.org/ 

Content/NavigationMenu/PublicRelations/ 

PressReleases/News_Releases.htm. The press 

release stated: 

The guidance being developed by CSBS and 

AARMR is based upon proposed guidance issued in 

December 2005 by the Office of the Comptroller of 

the Currency, the Board of Governors of the Federal 

Reserve System, the Federal Deposit Insurance 

Corporation, the Office of Thrift Supervision, and 

the National Credit Union Administration. 

The Federal guidance, when finalized, will only 

apply to insured financial institutions and their 

affiliates. CSBS and AARMR intend to develop a 

modified version of the guidance which will 

primarily focus on residential mortgage 

underwriting and consumer protection. The 

guidance will be offered to State regulators to apply 

to their licensed residential mortgage brokers and 

lenders. 

nontraditional mortgage loans are 

consistent with prudent lending 

practices, including credible 

consideration of a borrower’s repayment 

capacity. The portfolio and risk 

management practices section outlined 

the need for strong risk management 

standards, capital levels commensurate 

with the risk, and an allowance for loan 

and lease losses (ALLL) that reflects the 

collectibility of the portfolio. Finally, 

the consumer protection issues section 

recommended practices to ensure 

consumers have clear and balanced 

information prior to making a product 

choice. Additionally, this section 

described control systems to ensure that 

actual practices are consistent with 

policies and procedures. 

The Agencies together received 

approximately 100 letters in response to 

the proposal.1 Comments were received 

from financial institutions, trade 

associations, consumer and community 

organizations, state financial regulatory 

organizations, and other members of the 

public. 

II. Overview of Public Comments 

The Agencies received a full range of 

comments. Some commenters 

applauded the Agencies’ initiative in 

proposing the guidance, while others 

questioned whether guidance is needed. 

A majority of the depository 

institutions and industry groups that 

commented stated that the guidance is 

too prescriptive. They suggested 

institutions should have more flexibility 

in determining appropriate risk 

management practices. A number 

observed that nontraditional mortgage 

products have been offered successfully 

for many years. Others opined that the 

guidance would stifle innovation and 

result in qualified borrowers not being 

approved for these loans. Further, many 

questioned whether the guidance is an 

appropriate mechanism for addressing 

the Agencies’ consumer protection 

concerns. 

A smaller subset of commenters 

argued that the guidance does not go far 

enough in regulating or restricting 

nontraditional mortgage products. These 

commenters included consumer 

organizations, individuals, and several 

community bankers. Several stated 

these products contribute to speculation 

and unsustainable appreciation in the 

housing market. They expressed 

concern that severe problems will occur 

if and when there is a downturn in the 

economy. Some also argued that these 

products are harmful to borrowers and 

that borrowers may not understand the 

associated risks. 

Many commenters voiced concern 

that the guidance will not apply to all 

lenders, and thus federally regulated 

financial institutions will be at a 

competitive disadvantage. The Agencies 

note that both State financial regulatory 

organizations that commented on the 

proposed guidance—the Conference of 

State Bank Supervisors (CSBS) and the 

State Financial Regulators Roundtable 

(SFRR)—committed to working with 

State regulatory agencies to distribute 

guidance that is similar in nature and 

scope to the financial service providers 

under their jurisdictions.2 These 

commenters noted their interest in 

addressing the potential for inconsistent 

regulatory treatment of lenders based on 

whether or not they are supervised 

solely by state agencies. Subsequently, 

the CSBS, along with a national 

organization representing state 

residential mortgage regulators, issued a 

press release confirming their intent to 

offer guidance to State regulators to 

apply to their licensed residential 

mortgage brokers and lenders.3

III. Final Joint Guidance 

The Agencies made a number of 

changes to the proposal to respond to 

commenters’ concerns and to provide 

additional clarity. Significant comments 

on the specific provisions of the 

proposed guidance, the Agencies’’

responses, and changes to the proposed 

guidance are discussed as follows. 

Scope of the Guidance 

Many financial institution and trade 

group commenters raised concerns that 

the proposed guidance did not 

adequately define ‘‘nontraditional 

mortgage products’’. They requested 

clarification of which products would 

be subject to enhanced scrutiny. Some 

suggested that the guidance focus on 

products that allow negative 

amortization, rather than interest-only 

loans. Others suggested excluding 

certain products with nontraditional 

features, such as reverse mortgages and 

home equity lines of credit (HELOCs). 

Those commenting on interest-only 

loans noted that they do not present the 

same risks as products that allow for 

negative amortization. Those that 

argued that HELOCs should be excluded 

noted that they are already covered by 

interagency guidance issued in 2005. 

They also noted that the principal 

amount of these loans is generally lower 

than that for first mortgages. As for 

reverse mortgages, the commenters 

pointed out that they were developed 

for a specific market segment and do not 

present the same concerns as products 

mentioned in the guidance. 

To address these concerns, the 

Agencies are clarifying the types of 

products covered by the guidance. In 

general, the guidance applies to all 

residential mortgage loan products that 

allow borrowers to defer repayment of 

principal or interest. This includes all 

interest-only products and negative 

amortization mortgages, with the 

exception of HELOCs. The Agencies 

decided not to include HELOCs in this 

guidance, other than as discussed in the 

Simultaneous Second-Lien Loans 

section, since they are already covered 

by the May 2005 Interagency Credit Risk 

Management Guidance for Home Equity 

Lending. The Agencies are amending 

the May 2005 guidance, however, to 

address the consumer disclosure 

recommendations included in the 

nontraditional mortgage guidance. 

The Agencies decided against 

focusing solely on negative amortization 

products. Many of the interest-only 

products pose risks similar to products 

that allow negative amortization, 

especially when combined with high 

leverage and reduced documentation. 

Accordingly, they present similar 

concerns from a risk management and 

consumer protection standpoint. The 

Agencies did, however, agree that 

reverse mortgages do not present the 

types of concerns that are addressed in 

the guidance and should be excluded. 

Loan Terms and Underwriting 

Standards 

Qualifying Borrowers 

The Agencies proposed that for all 

nontraditional mortgage products, the 

analysis of borrowers’ repayment 


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4This is similar to the standard in the Agencies’

May 2005 Credit Risk Management Guidance for 

Home Equity Lending recommending that, for 

interest-only and variable rate HELOCs, borrowers 

should demonstrate the ability to amortize the fully 

drawn line over the loan term. 

capacity should include an evaluation 

of their ability to repay the debt by final 

maturity at the fully indexed rate, 

assuming a fully amortizing repayment 

schedule. In addition, the proposed 

guidance stated that for products that 

permit negative amortization, the 

repayment analysis should include the 

initial loan amount plus any balance 

increase that may accrue from negative 

amortization. The amount of the balance 

increase is tied to the initial terms of the 

loan and estimated assuming the 

borrower makes only the minimum 

payment. 

Generally, banks and industry groups 

believed that the proposed underwriting 

standards were too prescriptive and 

asked for more flexibility. Consumer 

groups generally supported the 

proposed underwriting standards, 

warning that deteriorating underwriting 

standards are bad for individual 

borrowers and poor public policy. 

A number of commenters suggested 

that industry practice is to underwrite 

payment option adjustable-rate 

mortgages at the fully indexed rate, 

assuming a fully amortizing payment. 

Yet several commenters argued that this 

standard should not be required when 

risks are adequately mitigated. 

Moreover, many commenters opposed 

assuming a fully amortizing payment for 

interest-only loans with extended 

interest-only periods. They argued that 

the average life span of most mortgage 

loans makes it unlikely that many 

borrowers will experience the higher 

payments associated with amortization. 

Additionally, many commenters 

opposed the assumption of minimum 

payments during the deferral period for 

products that permit negative 

amortization on the ground that this 

assumption suggests that lenders 

assume a worst-case scenario. 

The Agencies believe that institutions 

should maintain qualification standards 

that include a credible analysis of a 

borrower’s capacity to repay the full 

amount of credit that may be extended. 

That analysis should consider both 

principal and interest at the fully 

indexed rate. Using discounted 

payments in the qualification process 

limits the ability of borrowers to 

demonstrate sufficient capacity to repay 

under the terms of the loan. Therefore, 

the proposed general guideline of 

qualifying borrowers at the fully 

indexed rate, assuming a fully 

amortizing payment, including potential 

negative amortization amounts, remains 

in the final guidance. 

Regarding interest-only loans with 

extended interest-only periods, the 

Agencies note that since the average life 

of a mortgage is a function of the 

housing market and interest rates, the 

average may fluctuate over time. 

Additionally, the Agencies were 

concerned that excluding these loans 

from the underwriting standards could 

cause some creditors to change their 

market offerings to avoid application of 

the guidance. Accordingly, the final 

guidance does not exclude interest-only 

loans with extended interest-only 

periods. 

Finally, regarding the assumption for 

the amount that the balance may 

increase due to negative amortization, 

the Agencies have revised the language 

to respond to commenters’ requests for 

clarity. The basic standard, however, 

remains unchanged. The Agencies 

expect a borrower to demonstrate the 

capacity to repay the full loan amount 

that may be advanced.4 This includes 

the initial loan amount plus any balance 

increase that may accrue from the 

negative amortization provision. The 

final document contains guidance on 

determining the amount of any balance 

increase that may accrue from the 

negative amortization provision, which 

does not necessarily equate to the full 

negative amortization cap for a 

particular loan. 

The Agencies requested comment on 

whether the guidance should address 

consideration of future income or other 

future events in the qualification 

standards. The commenters generally 

agreed that there is no reliable method 

for considering future income or other 

future events in the underwriting 

process. Accordingly, the Agencies have 

not modified the guidance to address 

these issues. 

Collateral-Dependent Loans 

Commenters that specifically 

addressed this aspect of the guidance 

concurred that it is unsafe and unsound 

to rely solely on an individual 

borrower’s ability to sell or refinance 

once amortization commences. 

However, many expressed concern 

about the possibility that the term 

‘‘collateral-dependent’’, as it is used in 

the guidance, would be interpreted to 

apply to stated income and other 

reduced documentation loans. 

To address this concern, the Agencies 

provided clarifying language in a 

footnote to this section. The final 

guidance provides that a loan will not 

be determined to be collateraldependent solely because it was 

underwritten using reduced 

documentation. 

Risk Layering 

Financial institution and industry 

group commenters were generally 

critical of the risk layering provisions of 

the proposed guidance on the grounds 

that they were too prescriptive. These 

commenters argued that institutions 

should have flexibility in determining 

factors that mitigate additional risks 

presented by features such as reduced 

documentation and simultaneous 

second-lien loans. A number of 

commenters, however, including 

community and consumer 

organizations, financial institutions, and 

industry associations, suggested that 

reduced documentation loans should 

not be offered to subprime borrowers. 

Others questioned whether stated 

income loans are appropriate under any 

circumstances, when used with 

nontraditional mortgage products, or 

when used for wage earners who can 

readily provide standard documentation 

of their wages. Several commenters 

argued that simultaneous second-lien 

loans should be paired with 

nontraditional mortgage loans only 

when borrowers will continue to have 

substantial equity in the property. 

The Agencies believe that the 

guidance provides adequate flexibility 

in the methods and approaches to 

mitigating risk, with respect to risk 

layering. While the Agencies have not 

prohibited any of the practices 

discussed, the guidance uniformly 

suggests strong quality control and risk 

mitigation factors with respect to these 

practices. 

The Agencies declined to provide 

guidance recommending reduced 

documentation loans be limited to any 

particular set of circumstances. The 

final guidance recognizes that mitigating 

factors may determine whether such 

loans are appropriate but reminds 

institutions that a credible analysis of 

both a borrower’s willingness and 

ability to repay is consistent with sound 

and prudent lending practices. The final 

guidance also cautions that institutions 

generally should be able to readily 

document income for wage earners 

through means such as W–2 statements, 

pay stubs, or tax returns. 

Portfolio and Risk Management 

Practices 

Many financial institution and 

industry group commenters opposed 

provisions of the proposed guidance for 

the setting of concentration limits. Some 

commenters advocated active 

monitoring of concentrations of 

diversification strategies as more 


rwilkins on PROD1PC63 with NOTICES
58612 Federal Register / Vol. 71, No. 192 / Wednesday, October 4, 2006 / Notices 

5 12 CFR part 226 (2006). 

6 24 CFR part 3500 (2005). 7See 12 CFR part 226.24(c) (2006). 

8See elsewhere in today’s issue of the Federal 

Register. (Proposed Illustrations of Consumer 

Information for Nontraditional Mortgage Products). 

appropriate approaches. The intent of 

the guidance was not to set hard 

concentration limits for nontraditional 

mortgage products. Instead, institutions 

with concentrations in these products 

should have well-developed monitoring 

systems and risk management practices. 

The guidance was clarified to reiterate 

this point. 

Additionally, a number of financial 

institution and industry association 

commenters opposed the provisions 

regarding third-party originations. They 

argued that the proposal would force 

lenders to have an awareness and 

control over third-party practices that is 

neither realistic nor practical. In 

particular, many of these commenters 

argued that lenders should not be 

responsible for overseeing the marketing 

and borrower disclosure practices of 

third parties. 

Regarding controls over third-party 

practices, the Agencies clarified their 

expectations that institutions should 

have strong systems and controls for 

establishing and maintaining 

relationships with third parties. 

Reliance on third-party relationships 

can significantly increase an 

institution’s risk profile. The guidance, 

therefore, emphasizes the need for 

institutions to exercise appropriate due 

diligence prior to entering into a thirdparty relationship and to provide 

ongoing, effective oversight and 

controls. In practice, an institution’s risk 

management system should reflect the 

complexity of its third-party activities 

and the overall level of risk involved. 

A number of commenters urged the 

Agencies to remove language in the 

proposed guidance relating to implicit 

recourse for loans sold in the secondary 

market. They expressed concern that the 

proposal added new capital 

requirements. The Agencies clarified the 

language in the guidance addressing this 

issue. The Agencies do not intend to 

establish new capital requirements. 

Instead, the Agencies’ intent is to 

reiterate existing guidelines regarding 

implicit recourse under the Agencies’

risk-based capital rules. 

Consumer Protection Issues 

Communications With Consumers 

Many financial institution and trade 

group commenters suggested that the 

Agencies’ consumer protection goals 

would be better accomplished through 

generally applicable regulations, such as 

Regulation Z (Truth in Lending) 5 or 

Regulation X (Real Estate Settlement 

Procedures).6 Some commenters stated 

that the proposed guidance would add 

burdensome new disclosure 

requirements and cause a confusing 

overlap with current Regulation Z 

requirements. They also expressed 

concern that the guidance would 

contribute to an overload of information 

currently provided to consumers. 

Additionally, some argued that 

implementing the disclosure provisions 

might trigger Regulation Z requirements 

concerning advertising.7 Some 

commenters also urged the Agencies to 

adopt model disclosure forms or other 

descriptive materials to assist in 

compliance with the guidance. 

Some commenters voiced concern 

that the Agencies are attempting to 

establish a suitability standard similar 

to that used in the securities context. 

These commenters argued that lenders 

are not in a position to determine which 

products are most suitable for 

borrowers, and that this decision should 

be left to borrowers themselves. 

Finally, several community and 

consumer organization commenters 

questioned whether additional 

disclosures are sufficient to protect 

borrowers and suggested various 

additional measures, such as consumer 

education and counseling. 

The Agencies carefully considered the 

commenters’ argument that consumer 

protection issues—particularly, 

disclosures—would be better addressed 

through generally applicable 

regulations. The Agencies determined, 

however, that given the growth in this 

market, guidelines are needed now to 

ensure that consumers will receive the 

information they need about the 

material features of nontraditional 

mortgages as soon as possible. 

The Agencies also gave careful 

consideration to the commenters’

concerns that the guidelines will 

overlap with Regulation Z, add to the 

disclosure burden on lenders, and 

contribute to information overload. 

While the Agencies are sensitive to 

these concerns, we do not believe they 

warrant significant changes to the 

guidance. The guidance focuses on 

providing information to consumers 

during the pre-application shopping 

phase and post-closing with any 

monthly statements lenders choose to 

provide to consumers. Moreover, the 

Agencies do not anticipate that the 

information outlined in the guidance 

will result in additional lengthy 

disclosures. Rather, the Agencies 

contemplate that the information can be 

provided in brief narrative format and 

through the use of examples based on 

hypothetical loan transactions.8 We 

have, however, revised the guidance to 

make clear that transaction-specific 

disclosures are not required. Institutions 

will still need to ensure that their 

marketing materials promoting their 

products comply with Regulation Z, as 

applicable. 

As previously discussed, some 

commenters, including industry trade 

associations, asked the Agencies to 

include model or sample disclosures or 

other descriptive materials as part of the 

guidance to assist lenders, including 

smaller institutions, in following the 

recommended practices for 

communications with consumers. The 

Agencies have determined not to 

include required model or sample 

disclosures in the guidance. Instead, the 

guidance provides a set of 

recommended practices to assist 

institutions in addressing particular 

risks raised by nontraditional mortgage 

products. 

The Agencies have determined that it 

is desirable to first seek public comment 

on potential model disclosures, and in 

a Federal Register notice accompanying 

this guidance are seeking comment on 

proposed illustrations of consumer 

information for nontraditional mortgage 

products that are consistent with the 

recommendations contained in the 

guidance. The Agencies appreciate that 

some institutions, including community 

banks, following the recommendations 

set forth in the guidance may prefer not 

to incur the costs and other burdens of 

developing their own consumer 

information documents. The Agencies 

are, therefore, requesting comment on 

illustrations of the type of information 

contemplated by the guidance. 

The Agencies disagree with the 

commenters who expressed concern 

that the guidance appears to establish a 

suitability standard, under which 

lenders would be required to assist 

borrowers in choosing products that are 

suitable to their needs and 

circumstances. It was not the Agencies’

intent to impose such a standard, nor is 

there any language in the guidance that 

does so. In any event, the Agencies have 

revised certain statements in the 

proposed guidance that could have been 

interpreted to suggest a requirement to 

ensure that borrowers select products 

appropriate to their circumstances. 

Control Systems 

Several commenters requested more 

flexibility in designing appropriate 

control systems. The Agencies have 


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1 Interest-only and payment option ARMs are 

variations of conventional ARMs, hybrid ARMs, 

and fixed rate products. Refer to the Appendix for 

additional information on interest-only and 

payment option ARM loans. This guidance does not 

apply to reverse mortgages; home equity lines of 

credit (‘‘HELOCs’’), other than as discussed in the 

Simultaneous Second-Lien Loans section; or fully 

amortizing residential mortgage loan products. 

2Refer to the Appendix for additional 

information on reduced documentation and 

simultaneous second-lien loans. 

3Refer to Interagency Guidelines Establishing 

Standards for Safety and Soundness. For each 

Agency, those respective guidelines are addressed 

in: 12 CFR part 30 Appendix A (OCC); 12 CFR part 

208 Appendix D–1 (Board); 12 CFR part 364 

Appendix A (FDIC); 12 CFR part 570 Appendix A 

(OTS); and 12 U.S.C. 1786 (NCUA). 

4Refer to 12 CFR part 34—Real Estate Lending 

and Appraisals, OCC Bulletin 2005–3—Standards 

for National Banks’ Residential Mortgage Lending, 

AL 2003–7—Guidelines for Real Estate Lending 

Policies and AL 2003–9—Independent Appraisal 

and Evaluation Functions (OCC); 12 CFR 208.51 

subpart E and Appendix C and 12 CFR part 225 

subpart G (Board); 12 CFR part 365 and Appendix 

A, and 12 CFR part 323 (FDIC); 12 CFR 560.101 and 

Appendix and 12 CFR part 564 (OTS). Also, refer 

to the 1999 Interagency Guidance on the 

‘‘Treatment of High LTV Residential Real Estate 

Loans’’ and the 1994 ‘‘Interagency Appraisal and 

Evaluation Guidelines’’. Federally Insured Credit 

Unions should refer to 12 CFR part 722—Appraisals 

and NCUA 03–CU–17—Appraisal and Evaluation 

Functions for Real Estate Related Transactions 

(NCUA). 

revised the ‘‘Control Systems’’ portion 

of the guidance to clarify that we are not 

requiring any particular means of 

monitoring adherence to an institution’s 

policies, such as call monitoring or 

mystery shopping. Additional changes 

have also been made to clarify that the 

Agencies do not expect institutions to 

assume an unwarranted level of 

responsibility for the actions of third 

parties. Rather, the control systems that 

are expected for loans purchased from 

or originated through third parties are 

consistent with the Agencies’ current 

supervisory policies. As previously 

discussed, the Agencies have also made 

changes to the portfolio and risk 

management practices portion of the 

final guidance to clarify their 

expectations concerning oversight and 

monitoring of third-party originations. 

IV. Text of Final Joint Guidance 

The text of the final Interagency 

Guidance on Nontraditional Mortgage 

Product Risks follows: 

Interagency Guidance on 

Nontraditional Mortgage Product Risks 

Residential mortgage lending has 

traditionally been a conservatively 

managed business with low 

delinquencies and losses and reasonably 

stable underwriting standards. In the 

past few years consumer demand has 

been growing, particularly in high 

priced real estate markets, for closedend residential mortgage loan products 

that allow borrowers to defer repayment 

of principal and, sometimes, interest. 

These mortgage products, herein 

referred to as nontraditional mortgage 

loans, include such products as 

‘‘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.1

While some institutions have offered 

nontraditional mortgages for many years 

with appropriate risk management and 

sound portfolio performance, the market 

for these products and the number of 

institutions offering them has expanded 

rapidly. Nontraditional mortgage loan 

products are now offered by more 

lenders to a wider spectrum of 

borrowers who may not otherwise 

qualify for more traditional mortgage 

loans and may not fully understand the 

associated risks. 

Many of these nontraditional 

mortgage loans are underwritten with 

less stringent income and asset 

verification requirements (‘‘reduced 

documentation’’) and are increasingly 

combined with simultaneous secondlien loans.2 Such risk layering, 

combined with the broader marketing of 

nontraditional mortgage loans, exposes 

financial institutions to increased risk 

relative to traditional mortgage loans. 

Given the potential for heightened 

risk levels, management should 

carefully consider and appropriately 

mitigate exposures created by these 

loans. To manage the risks associated 

with nontraditional mortgage loans, 

management should: 

• Ensure that loan terms and 

underwriting standards are consistent 

with prudent lending practices, 

including consideration of a borrower’s 

repayment capacity; 

• Recognize that many nontraditional 

mortgage loans, particularly when they 

have risk-layering features, are untested 

in a stressed environment. As evidenced 

by experienced institutions, these 

products warrant strong risk 

management standards, capital levels 

commensurate with the risk, and an 

allowance for loan and lease losses that 

reflects the collectibility of the portfolio; 

and 

• Ensure that consumers have 

sufficient information to clearly 

understand loan terms and associated 

risks prior to making a product choice. 

The Office of the Comptroller of the 

Currency (OCC), the Board of Governors 

of the Federal Reserve System (Board), 

the Federal Deposit Insurance 

Corporation (FDIC), the Office of Thrift 

Supervision (OTS) and the National 

Credit Union Administration (NCUA) 

(collectively, the Agencies) expect 

institutions to effectively assess and 

manage the risks associated with 

nontraditional mortgage loan products.3

Institutions should use this guidance 

to ensure that risk management 

practices adequately address these risks. 

The Agencies will carefully scrutinize 

risk management processes, policies, 

and procedures in this area. Institutions 

that do not adequately manage these 

risks will be asked to take remedial 

action. 

The focus of this guidance is on the 

higher risk elements of certain 

nontraditional mortgage products, not 

the product type itself. Institutions with 

sound underwriting, adequate risk 

management, and acceptable portfolio 

performance will not be subject to 

criticism merely for offering such 

products. 

Loan Terms and Underwriting 

Standards 

When an institution offers 

nontraditional mortgage loan products, 

underwriting standards should address 

the effect of a substantial payment 

increase on the borrower’s capacity to 

repay when loan amortization begins. 

Underwriting standards should also 

comply with the agencies’ real estate 

lending standards and appraisal 

regulations and associated guidelines.4

Central to prudent lending is the 

internal discipline to maintain sound 

loan terms and underwriting standards 

despite competitive pressures. 

Institutions are strongly cautioned 

against ceding underwriting standards 

to third parties that have different 

business objectives, risk tolerances, and 

core competencies. Loan terms should 

be based on a disciplined analysis of 

potential exposures and compensating 

factors to ensure risk levels remain 

manageable. 

Qualifying Borrowers—Payments on 

nontraditional loans can increase 

significantly when the loans begin to 

amortize. Commonly referred to as 

payment shock, this increase is of 

particular concern for payment option 

ARMs where the borrower makes 

minimum payments that may result in 

negative amortization. Some institutions 

manage the potential for excessive 

negative amortization and payment 

shock by structuring the initial terms to 

limit the spread between the 

introductory interest rate and the fully 

indexed rate. Nevertheless, an 

institution’s qualifying standards should 

recognize the potential impact of 

payment shock, especially for borrowers 


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58614 Federal Register / Vol. 71, No. 192 / Wednesday, October 4, 2006 / Notices 

5The fully indexed rate equals the index rate 

prevailing at origination plus the margin that will 

apply after the expiration of an introductory interest 

rate. The index rate is a published interest rate to 

which the interest rate on an ARM is tied. Some 

commonly used indices include the 1-Year 

Constant Maturity Treasury Rate (CMT), the 6- 

Month London Interbank Offered Rate (LIBOR), the 

11th District Cost of Funds (COFI), and the Moving 

Treasury Average (MTA), a 12-month moving 

average of the monthly average yields of U.S. 

Treasury securities adjusted to a constant maturity 

of one year. The margin is the number of percentage 

points a lender adds to the index value to calculate 

the ARM interest rate at each adjustment period. In 

different interest rate scenarios, the fully indexed 

rate for an ARM loan based on a lagging index (e.g., 

MTA rate) may be significantly different from the 

rate on a comparable 30-year fixed-rate product. In 

these cases, a credible market rate should be used 

to qualify the borrower and determine repayment 

capacity. 

6The fully amortizing payment schedule should 

be based on the term of the loan. For example, the 

amortizing payment for a loan with a 5-year interest 

only period and a 30-year term would be calculated 

based on a 30-year amortization schedule. For 

balloon mortgages that contain a borrower option 

for an extended amortization period, the fully 

amortizing payment schedule can be based on the 

full term the borrower may choose. 

7The balance that may accrue from the negative 

amortization provision does not necessarily equate 

to the full negative amortization cap for a particular 

loan. The spread between the introductory or 

‘‘teaser’’ rate and the accrual rate will determine 

whether or not a loan balance has the potential to 

reach the negative amortization cap before the end 

of the initial payment option period (usually five 

years). For example, a loan with a 115 percent 

negative amortization cap but a small spread 

between the introductory rate and the accrual rate 

may only reach a 109 percent maximum loan 

balance before the end of the initial payment option 

period, even if only minimum payments are made. 

The borrower could be qualified based on this 

lower maximum loan balance. 

8A loan will not be determined to be ‘‘collateraldependent’’ solely through the use of reduced 

documentation. 

9 Interagency Guidance on Subprime Lending, 

March 1, 1999, and Expanded Guidance for 

Subprime Lending Programs, January 31, 2001. 

Federally insured credit unions should refer to 04–

CU–12—Specialized Lending Activities (NCUA). 

with high loan-to-value (LTV) ratios, 

high debt-to-income (DTI) ratios, and 

low credit scores. Recognizing that an 

institution’s underwriting criteria are 

based on multiple factors, an institution 

should consider these factors jointly in 

the qualification process and may 

develop a range of reasonable tolerances 

for each factor. However, the criteria 

should be based upon prudent and 

appropriate underwriting standards, 

considering both the borrower’s 

characteristics and the product’s 

attributes. 

For all nontraditional mortgage loan 

products, an institution’s analysis of a 

borrower’s repayment capacity should 

include an evaluation of their ability to 

repay the debt by final maturity at the 

fully indexed rate,5 assuming a fully 

amortizing repayment schedule.6 In 

addition, for products that permit 

negative amortization, the repayment 

analysis should be based upon the 

initial loan amount plus any balance 

increase that may accrue from the 

negative amortization provision.7

Furthermore, the analysis of 

repayment capacity should avoid overreliance on credit scores as a substitute 

for income verification in the 

underwriting process. The higher a 

loan’s credit risk, either from loan 

features or borrower characteristics, the 

more important it is to verify the 

borrower’s income, assets, and 

outstanding liabilities. 

Collateral-Dependent Loans—

Institutions should avoid the use of loan 

terms and underwriting practices that 

may heighten the need for a borrower to 

rely on the sale or refinancing of the 

property once amortization begins. 

Loans to individuals who do not 

demonstrate the capacity to repay, as 

structured, from sources other than the 

collateral pledged are generally 

considered unsafe and unsound.8

Institutions that originate collateraldependent mortgage loans may be 

subject to criticism, corrective action, 

and higher capital requirements. 

Risk Layering—Institutions that 

originate or purchase mortgage loans 

that combine nontraditional features, 

such as interest only loans with reduced 

documentation or a simultaneous 

second-lien loan, face increased risk. 

When features are layered, an 

institution should demonstrate that 

mitigating factors support the 

underwriting decision and the 

borrower’s repayment capacity. 

Mitigating factors could include higher 

credit scores, lower LTV and DTI ratios, 

significant liquid assets, mortgage 

insurance or other credit enhancements. 

While higher pricing is often used to 

address elevated risk levels, it does not 

replace the need for sound 

underwriting. 

Reduced Documentation—Institutions 

increasingly rely on reduced 

documentation, particularly unverified 

income, to qualify borrowers for 

nontraditional mortgage loans. Because 

these practices essentially substitute 

assumptions and unverified information 

for analysis of a borrower’s repayment 

capacity and general creditworthiness, 

they should be used with caution. As 

the level of credit risk increases, the 

Agencies expect an institution to more 

diligently verify and document a 

borrower’s income and debt reduction 

capacity. Clear policies should govern 

the use of reduced documentation. For 

example, stated income should be 

accepted only if there are mitigating 

factors that clearly minimize the need 

for direct verification of repayment 

capacity. For many borrowers, 

institutions generally should be able to 

readily document income using recent 

W–2 statements, pay stubs, or tax 

returns. 

Simultaneous Second-Lien Loans—

Simultaneous second-lien loans reduce 

owner equity and increase credit risk. 

Historically, as combined loan-to-value 

ratios rise, so do defaults. A delinquent 

borrower with minimal or no equity in 

a property may have little incentive to 

work with a lender to bring the loan 

current and avoid foreclosure. In 

addition, second-lien home equity lines 

of credit (HELOCs) typically increase 

borrower exposure to increasing interest 

rates and monthly payment burdens. 

Loans with minimal or no owner equity 

generally should not have a payment 

structure that allows for delayed or 

negative amortization without other 

significant risk mitigating factors. 

Introductory Interest Rates—Many 

institutions offer introductory interest 

rates set well below the fully indexed 

rate as a marketing tool for payment 

option ARM products. When developing 

nontraditional mortgage product terms, 

an institution should consider the 

spread between the introductory rate 

and the fully indexed rate. Since initial 

and subsequent monthly payments are 

based on these low introductory rates, a 

wide initial spread means that 

borrowers are more likely to experience 

negative amortization, severe payment 

shock, and an earlier-than-scheduled 

recasting of monthly payments. 

Institutions should minimize the 

likelihood of disruptive early recastings 

and extraordinary payment shock when 

setting introductory rates. 

Lending to Subprime Borrowers—

Mortgage programs that target subprime 

borrowers through tailored marketing, 

underwriting standards, and risk 

selection should follow the applicable 

interagency guidance on subprime 

lending.9 Among other things, the 

subprime guidance discusses 

circumstances under which subprime 

lending can become predatory or 

abusive. Institutions designing 

nontraditional mortgage loans for 

subprime borrowers should pay 

particular attention to this guidance. 

They should also recognize that risklayering features in loans to subprime 

borrowers may significantly increase 

risks for both the institution and the 

borrower. 

Non-Owner-Occupied Investor 

Loans—Borrowers financing non-owneroccupied investment properties should 

qualify for loans based on their ability 

to service the debt over the life of the 


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Federal Register / Vol. 71, No. 192 / Wednesday, October 4, 2006 / Notices 58615 

10Federally insured credit unions must comply 

with 12 CFR part 723 for loans meeting the 

definition of member business loans. 

11Refer to OCC Bulletin 2001–47—Third-Party 

Relationships and AL 2000–9—Third-Party Risk 

(OCC). Federally insured credit unions should refer 

to 01–CU–20 (NCUA), Due Diligence over Third 

Party Service Providers. Savings associations 

should refer to OTS Thrift Bulletin 82a—Third 

Party Arrangements. 

12Refer to ‘‘Interagency Questions and Answers 

on Capital Treatment of Recourse, Direct Credit 

Substitutes, and Residual Interests in Asset 

Securitizations’’, May 23, 2002; OCC Bulletin 2002–

22 (OCC); SR letter 02–16 (Board); Financial 

Institution Letter (FIL–54–2002) (FDIC); and CEO 

Letter 163 (OTS). See OCC’s Comptroller Handbook 

for Asset Securitization, November 1997. See OTS 

Examination Handbook Section 221, Asset-Backed 

Securitization. The Board also addressed risk 

management and capital adequacy of exposures 

arising from secondary market credit activities in 

SR letter 97–21. Federally insured credit unions 

should refer to 12 CFR Part 702 (NCUA). 

loan. Loan terms should reflect an 

appropriate combined LTV ratio that 

considers the potential for negative 

amortization and maintains sufficient 

borrower equity over the life of the loan. 

Further, underwriting standards should 

require evidence that the borrower has 

sufficient cash reserves to service the 

loan, considering the possibility of 

extended periods of property vacancy 

and the variability of debt service 

requirements associated with 

nontraditional mortgage loan 

products.10

Portfolio and Risk Management 

Practices 

Institutions should ensure that risk 

management practices keep pace with 

the growth and changing risk profile of 

their nontraditional mortgage loan 

portfolios and changes in the market. 

Active portfolio management is 

especially important for institutions that 

project or have already experienced 

significant growth or concentration 

levels. Institutions that originate or 

invest in nontraditional mortgage loans 

should adopt more robust risk 

management practices and manage these 

exposures in a thoughtful, systematic 

manner. To meet these expectations, 

institutions should: 

• Develop written policies that 

specify acceptable product attributes, 

production and portfolio limits, sales 

and securitization practices, and risk 

management expectations; 

• Design enhanced performance 

measures and management reporting 

that provide early warning for 

increasing risk; 

• Establish appropriate ALLL levels 

that consider the credit quality of the 

portfolio and conditions that affect 

collectibility; and 

• Maintain capital at levels that 

reflect portfolio characteristics and the 

effect of stressed economic conditions 

on collectibility. Institutions should 

hold capital commensurate with the risk 

characteristics of their nontraditional 

mortgage loan portfolios. 

Policies—An institution’s policies for 

nontraditional mortgage lending activity 

should set acceptable levels of risk 

through its operating practices, 

accounting procedures, and policy 

exception tolerances. Policies should 

reflect appropriate limits on risk 

layering and should include risk 

management tools for risk mitigation 

purposes. Further, an institution should 

set growth and volume limits by loan 

type, with special attention for products 

and product combinations in need of 

heightened attention due to easing terms 

or rapid growth. 

Concentrations—Institutions with 

concentrations in nontraditional 

mortgage products should have welldeveloped monitoring systems and risk 

management practices. Monitoring 

should keep track of concentrations in 

key portfolio segments such as loan 

types, third-party originations, 

geographic area, and property 

occupancy status. Concentrations also 

should be monitored by key portfolio 

characteristics such as loans with high 

combined LTV ratios, loans with high 

DTI ratios, loans with the potential for 

negative amortization, loans to 

borrowers with credit scores below 

established thresholds, loans with risklayered features, and non-owneroccupied investor loans. Further, 

institutions should consider the effect of 

employee incentive programs that could 

produce higher concentrations of 

nontraditional mortgage loans. 

Concentrations that are not effectively 

managed will be subject to elevated 

supervisory attention and potential 

examiner criticism to ensure timely 

remedial action. 

Controls—An institution’s quality 

control, compliance, and audit 

procedures should focus on mortgage 

lending activities posing high risk. 

Controls to monitor compliance with 

underwriting standards and exceptions 

to those standards are especially 

important for nontraditional loan 

products. The quality control function 

should regularly review a sample of 

nontraditional mortgage loans from all 

origination channels and a 

representative sample of underwriters to 

confirm that policies are being followed. 

When control systems or operating 

practices are found deficient, businessline managers should be held 

accountable for correcting deficiencies 

in a timely manner. Since many 

nontraditional mortgage loans permit a 

borrower to defer principal and, in some 

cases, interest payments for extended 

periods, institutions should have strong 

controls over accruals, customer service 

and collections. Policy exceptions made 

by servicing and collections personnel 

should be carefully monitored to 

confirm that practices such as re-aging, 

payment deferrals, and loan 

modifications are not inadvertently 

increasing risk. Customer service and 

collections personnel should receive 

product-specific training on the features 

and potential customer issues with 

these products. 

Third-Party Originations—Institutions 

often use third parties, such as mortgage 

brokers or correspondents, to originate 

nontraditional mortgage loans. 

Institutions should have strong systems 

and controls in place for establishing 

and maintaining relationships with 

third parties, including procedures for 

performing due diligence. Oversight of 

third parties should involve monitoring 

the quality of originations so that they 

reflect the institution’s lending 

standards and compliance with 

applicable laws and regulations. 

Monitoring procedures should track 

the quality of loans by both origination 

source and key borrower characteristics. 

This will help institutions identify 

problems such as early payment 

defaults, incomplete documentation, 

and fraud. If appraisal, loan 

documentation, credit problems or 

consumer complaints are discovered, 

the institution should take immediate 

action. Remedial action could include 

more thorough application reviews, 

more frequent re-underwriting, or even 

termination of the third-party 

relationship.11

Secondary Market Activity—The 

sophistication of an institution’s 

secondary market risk management 

practices should be commensurate with 

the nature and volume of activity. 

Institutions with significant secondary 

market activities should have 

comprehensive, formal strategies for 

managing risks.12 Contingency planning 

should include how the institution will 

respond to reduced demand in the 

secondary market. 

While third-party loan sales can 

transfer a portion of the credit risk, an 

institution remains exposed to 

reputation risk when credit losses on 

sold mortgage loans or securitization 

transactions exceed expectations. As a 

result, an institution may determine that 

it is necessary to repurchase defaulted 

mortgages to protect its reputation and 

maintain access to the markets. In the 

agencies’ view, the repurchase of 

mortgage loans beyond the selling 

institution’s contractual obligation is 


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58616 Federal Register / Vol. 71, No. 192 / Wednesday, October 4, 2006 / Notices 

13Refer to 12 CFR part 3 Appendix A, Section 4 

(OCC); 12 CFR parts 208 and 225, Appendix A, 

III.B.3 (FRB); 12 CFR part 325, Appendix A, II.B 

(FDIC); 12 CFR 567 (OTS); and 12 CFR part 702 

(NCUA) for each Agency’s capital treatment of 

recourse. 

14Refer to the ‘‘Interagency Advisory on Mortgage 

Banking’’, February 25, 2003, issued by the bank 

and thrift regulatory agencies. Federally Insured 

Credit Unions with assets of $10 million or more 

are reminded they must report and value 

nontraditional mortgages and related mortgage 

servicing rights, if any, consistent with generally 

accepted accounting principles in the Call Reports 

they file with the NCUA Board. 

implicit recourse. Under the agencies’

risk-based capital rules, a repurchasing 

institution would be required to 

maintain risk-based capital against the 

entire pool or securitization.13

Institutions should familiarize 

themselves with these guidelines before 

deciding to support mortgage loan pools 

or buying back loans in default. 

Management Information and 

Reporting—Reporting systems should 

allow management to detect changes in 

the risk profile of its nontraditional 

mortgage loan portfolio. The structure 

and content should allow the isolation 

of key loan products, risk-layering loan 

features, and borrower characteristics. 

Reporting should also allow 

management to recognize deteriorating 

performance in any of these areas before 

it has progressed too far. At a minimum, 

information should be available by loan 

type (e.g., interest-only mortgage loans 

and payment option ARMs); by risklayering features (e.g., payment option 

ARM with stated income and interestonly mortgage loans with simultaneous 

second-lien mortgages); by underwriting 

characteristics (e.g., LTV, DTI, and 

credit score); and by borrower 

performance (e.g., payment patterns, 

delinquencies, interest accruals, and 

negative amortization). 

Portfolio volume and performance 

should be tracked against expectations, 

internal lending standards and policy 

limits. Volume and performance 

expectations should be established at 

the subportfolio and aggregate portfolio 

levels. Variance analyses should be 

performed regularly to identify 

exceptions to policies and prescribed 

thresholds. Qualitative analysis should 

occur when actual performance deviates 

from established policies and 

thresholds. Variance analysis is critical 

to the monitoring of a portfolio’s risk 

characteristics and should be an integral 

part of establishing and adjusting risk 

tolerance levels. 

Stress Testing—Based on the size and 

complexity of their lending operations, 

institutions should perform sensitivity 

analysis on key portfolio segments to 

identify and quantify events that may 

increase risks in a segment or the entire 

portfolio. The scope of the analysis 

should generally include stress tests on 

key performance drivers such as interest 

rates, employment levels, economic 

growth, housing value fluctuations, and 

other factors beyond the institution’s 

immediate control. Stress tests typically 

assume rapid deterioration in one or 

more factors and attempt to estimate the 

potential influence on default rates and 

loss severity. Stress testing should aid 

an institution in identifying, monitoring 

and managing risk, as well as 

developing appropriate and costeffective loss mitigation strategies. The 

stress testing results should provide 

direct feedback in determining 

underwriting standards, product terms, 

portfolio concentration limits, and 

capital levels. 

Capital and Allowance for Loan and 

Lease Losses—Institutions should 

establish an appropriate allowance for 

loan and lease losses (ALLL) for the 

estimated credit losses inherent in their 

nontraditional mortgage loan portfolios. 

They should also consider the higher 

risk of loss posed by layered risks when 

establishing their ALLL. 

Moreover, institutions should 

recognize that their limited performance 

history with these products, particularly 

in a stressed environment, increases 

performance uncertainty. Capital levels 

should be commensurate with the risk 

characteristics of the nontraditional 

mortgage loan portfolios. Lax 

underwriting standards or poor portfolio 

performance may warrant higher capital 

levels. 

When establishing an appropriate 

ALLL and considering the adequacy of 

capital, institutions should segment 

their nontraditional mortgage loan 

portfolios into pools with similar credit 

risk characteristics. The basic segments 

typically include collateral and loan 

characteristics, geographic 

concentrations, and borrower qualifying 

attributes. Segments could also 

differentiate loans by payment and 

portfolio characteristics, such as loans 

on which borrowers usually make only 

minimum payments, mortgages with 

existing balances above original 

balances, and mortgages subject to 

sizable payment shock. The objective is 

to identify credit quality indicators that 

affect collectibility for ALLL 

measurement purposes. In addition, 

understanding characteristics that 

influence expected performance also 

provides meaningful information about 

future loss exposure that would aid in 

determining adequate capital levels. 

Institutions with material mortgage 

banking activities and mortgage 

servicing assets should apply sound 

practices in valuing the mortgage 

servicing rights for nontraditional 

mortgages. In accordance with 

interagency guidance, the valuation 

process should follow generally 

accepted accounting principles and use 

reasonable and supportable 

assumptions.14

Consumer Protection Issues 

While nontraditional mortgage loans 

provide flexibility for consumers, the 

Agencies are concerned that consumers 

may enter into these transactions 

without fully understanding the product 

terms. Nontraditional mortgage products 

have been advertised and promoted 

based on their affordability in the near 

term; that is, their lower initial monthly 

payments compared with traditional 

types of mortgages. In addition to 

apprising consumers of the benefits of 

nontraditional mortgage products, 

institutions should take appropriate 

steps to alert consumers to the risks of 

these products, including the likelihood 

of increased future payment obligations. 

This information should be provided in 

a timely manner—before disclosures 

may be required under the Truth in 

Lending Act or other laws—to assist the 

consumer in the product selection 

process. 

Concerns and Objectives—More than 

traditional ARMs, mortgage products 

such as payment option ARMs and 

interest-only mortgages can carry a 

significant risk of payment shock and 

negative amortization that may not be 

fully understood by consumers. For 

example, consumer payment obligations 

may increase substantially at the end of 

an interest-only period or upon the 

‘‘recast’’ of a payment option ARM. The 

magnitude of these payment increases 

may be affected by factors such as the 

expiration of promotional interest rates, 

increases in the interest rate index, and 

negative amortization. Negative 

amortization also results in lower levels 

of home equity as compared to a 

traditional amortizing mortgage product. 

When borrowers go to sell or refinance 

the property, they may find that 

negative amortization has substantially 

reduced or eliminated their equity in it 

even when the property has 

appreciated. The concern that 

consumers may not fully understand 

these products would be exacerbated by 

marketing and promotional practices 

that emphasize potential benefits 

without also providing clear and 

balanced information about material 

risks. 

In light of these considerations, 

communications with consumers, 


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Federal Register / Vol. 71, No. 192 / Wednesday, October 4, 2006 / Notices 58617 

15These program disclosures apply to ARM 

products and must be provided at the time an 

application is provided or before the consumer pays 

a nonrefundable fee, whichever is earlier. 

16The OCC, the Board, and the FDIC enforce this 

provision under the FTC Act and section 8 of the 

FDI Act. Each of these agencies has also issued 

supervisory guidance to the institutions under their 

respective jurisdictions concerning unfair or 

deceptive acts or practices. See OCC Advisory 

Letter 2002–3—Guidance on Unfair or Deceptive 

Acts or Practices, March 22, 2002; Joint Board and 

FDIC Guidance on Unfair or Deceptive Acts or 

Practices by State-Chartered Banks, March 11, 2004. 

Federally insured credit unions are prohibited from 

using any advertising or promotional material that 

is inaccurate, misleading, or deceptive in any way 

concerning its products, services, or financial 

condition. 12 CFR 740.2. The OTS also has a 

regulation that prohibits savings associations from 

using advertisements or other representations that 

are inaccurate or misrepresent the services or 

contracts offered. 12 CFR 563.27. This regulation 

supplements its authority under the FTC Act. 

17 Institutions also should review the 

recommendations relating to mortgage lending 

practices set forth in other supervisory guidance 

from their respective primary regulators, as 

applicable, including guidance on abusive lending 

practices. 

18 Institutions also should strive to: (1) Focus on 

information important to consumer decision 

making; (2) highlight key information so that it will 

be noticed; (3) employ a user-friendly and readily 

navigable format for presenting the information; 

and (4) use plain language, with concrete and 

realistic examples. Comparative tables and 

information describing key features of available 

loan products, including reduced documentation 

programs, also may be useful for consumers 

considering the nontraditional mortgage products 

and other loan features described in this guidance. 

19 Institutions may not be able to incorporate all 

of the practices recommended in this guidance 

when advertising nontraditional mortgages through 

certain forms of media, such as radio, television, or 

billboards. Nevertheless, institutions should 

provide clear and balanced information about the 

risks of these products in all forms of advertising. 

20Consumers also should be apprised of other 

material changes in payment obligations, such as 

balloon payments. 

21Federal credit unions are prohibited from 

imposing prepayment penalties. 12 CFR 

701.21(c)(6). 

including advertisements, oral 

statements, promotional materials, and 

monthly statements, should provide 

clear and balanced information about 

the relative benefits and risks of these 

products, including the risk of payment 

shock and the risk of negative 

amortization. Clear, balanced, and 

timely communication to consumers of 

the risks of these products will provide 

consumers with useful information at 

crucial decision-making points, such as 

when they are shopping for loans or 

deciding which monthly payment 

amount to make. Such communication 

should help minimize potential 

consumer confusion and complaints, 

foster good customer relations, and 

reduce legal and other risks to the 

institution. 

Legal Risks—Institutions that offer 

nontraditional mortgage products must 

ensure that they do so in a manner that 

complies with all applicable laws and 

regulations. With respect to the 

disclosures and other information 

provided to consumers, applicable laws 

and regulations include the following: 

• Truth in Lending Act (TILA) and its 

implementing regulation, Regulation Z. 

• Section 5 of the Federal Trade 

Commission Act (FTC Act). TILA and 

Regulation Z contain rules governing 

disclosures that institutions must 

provide for closed-end mortgages in 

advertisements, with an application,15

before loan consummation, and when 

interest rates change. Section 5 of the 

FTC Act prohibits unfair or deceptive 

acts or practices.16

Other Federal laws, including the fair 

lending laws and the Real Estate 

Settlement Procedures Act (RESPA), 

also apply to these transactions. 

Moreover, the Agencies note that the 

sale or securitization of a loan may not 

affect an institution’s potential liability 

for violations of TILA, RESPA, the FTC 

Act, or other laws in connection with its 

origination of the loan. State laws, 

including laws regarding unfair or 

deceptive acts or practices, also may 

apply. 

Recommended Practices 

Recommended practices for 

addressing the risks raised by 

nontraditional mortgage products 

include the following:17

Communications with Consumers—

When promoting or describing 

nontraditional mortgage products, 

institutions should provide consumers 

with information that is designed to 

help them make informed decisions 

when selecting and using these 

products. Meeting this objective 

requires appropriate attention to the 

timing, content, and clarity of 

information presented to consumers. 

Thus, institutions should provide 

consumers with information at a time 

that will help consumers select products 

and choose among payment options. For 

example, institutions should offer clear 

and balanced product descriptions 

when a consumer is shopping for a 

mortgage—such as when the consumer 

makes an inquiry to the institution 

about a mortgage product and receives 

information about nontraditional 

mortgage products, or when marketing 

relating to nontraditional mortgage 

products is provided by the institution 

to the consumer—not just upon the 

submission of an application or at 

consummation.18 The provision of such 

information would serve as an 

important supplement to the disclosures 

currently required under TILA and 

Regulation Z or other laws.19

Promotional Materials and Product 

Descriptions. Promotional materials and 

other product descriptions should 

provide information about the costs, 

terms, features, and risks of 

nontraditional mortgages that can assist 

consumers in their product selection 

decisions, including information about 

the matters discussed below. 

• Payment Shock. Institutions should 

apprise consumers of potential increases 

in payment obligations for these 

products, including circumstances in 

which interest rates or negative 

amortization reach a contractual limit. 

For example, product descriptions 

could state the maximum monthly 

payment a consumer would be required 

to pay under a hypothetical loan 

example once amortizing payments are 

required and the interest rate and 

negative amortization caps have been 

reached.20 Such information also could 

describe when structural payment 

changes will occur (e.g., when 

introductory rates expire, or when 

amortizing payments are required), and 

what the new payment amount would 

be or how it would be calculated. As 

applicable, these descriptions could 

indicate that a higher payment may be 

required at other points in time due to 

factors such as negative amortization or 

increases in the interest rate index. 

• Negative Amortization. When 

negative amortization is possible under 

the terms of a nontraditional mortgage 

product, consumers should be apprised 

of the potential for increasing principal 

balances and decreasing home equity, as 

well as other potential adverse 

consequences of negative amortization. 

For example, product descriptions 

should disclose the effect of negative 

amortization on loan balances and home 

equity, and could describe the potential 

consequences to the consumer of 

making minimum payments that cause 

the loan to negatively amortize. (One 

possible consequence is that it could be 

more difficult to refinance the loan or to 

obtain cash upon a sale of the home). 

• Prepayment Penalties. If the 

institution may impose a penalty in the 

event that the consumer prepays the 

mortgage, consumers should be alerted 

to this fact and to the need to ask the 

lender about the amount of any such 

penalty.21

• Cost of Reduced Documentation 

Loans. If an institution offers both 

reduced and full documentation loan 

programs and there is a pricing 

premium attached to the reduced 

documentation program, consumers 

should be alerted to this fact. 


rwilkins on PROD1PC63 with NOTICES
58618 Federal Register / Vol. 71, No. 192 / Wednesday, October 4, 2006 / Notices 

22For example, marketing materials for payment 

option ARMs may promote low predictable 

payments until the recast date. Such marketing 

should be avoided in circumstances in which the 

minimum payments are so low that negative 

amortization caps would be reached and higher 

payment obligations would be triggered before the 

scheduled recast, even if interest rates remain 

constant. 

Monthly Statements on Payment 

Option ARMs. Monthly statements that 

are provided to consumers on payment 

option ARMs should provide 

information that enables consumers to 

make informed payment choices, 

including an explanation of each 

payment option available and the 

impact of that choice on loan balances. 

For example, the monthly payment 

statement should contain an 

explanation, as applicable, next to the 

minimum payment amount that making 

this payment would result in an 

increase to the consumer’s outstanding 

loan balance. Payment statements also 

could provide the consumer’s current 

loan balance, what portion of the 

consumer’s previous payment was 

allocated to principal and to interest, 

and, if applicable, the amount by which 

the principal balance increased. 

Institutions should avoid leading 

payment option ARM borrowers to 

select a non-amortizing or negativelyamortizing payment (for example, 

through the format or content of 

monthly statements). 

Practices to Avoid. Institutions also 

should avoid practices that obscure 

significant risks to the consumer. For 

example, if an institution advertises or 

promotes a nontraditional mortgage by 

emphasizing the comparatively lower 

initial payments permitted for these 

loans, the institution also should 

provide clear and comparably 

prominent information alerting the 

consumer to the risks. Such information 

should explain, as relevant, that these 

payment amounts will increase, that a 

balloon payment may be due, and that 

the loan balance will not decrease and 

may even increase due to the deferral of 

interest and/or principal payments. 

Similarly, institutions should avoid 

promoting payment patterns that are 

structurally unlikely to occur.22 Such 

practices could raise legal and other 

risks for institutions, as described more 

fully above. 

Institutions also should avoid such 

practices as: Giving consumers 

unwarranted assurances or predictions 

about the future direction of interest 

rates (and, consequently, the borrower’s 

future obligations); making one-sided 

representations about the cash savings 

or expanded buying power to be 

realized from nontraditional mortgage 

products in comparison with amortizing 

mortgages; suggesting that initial 

minimum payments in a payment 

option ARM will cover accrued interest 

(or principal and interest) charges; and 

making misleading claims that interest 

rates or payment obligations for these 

products are ‘‘fixed’’. 

Control Systems—Institutions should 

develop and use strong control systems 

to monitor whether actual practices are 

consistent with their policies and 

procedures relating to nontraditional 

mortgage products. Institutions should 

design control systems to address 

compliance and consumer information 

concerns as well as the safety and 

soundness considerations discussed in 

this guidance. Lending personnel 

should be trained so that they are able 

to convey information to consumers 

about product terms and risks in a 

timely, accurate, and balanced manner. 

As products evolve and new products 

are introduced, lending personnel 

should receive additional training, as 

necessary, to continue to be able to 

convey information to consumers in this 

manner. Lending personnel should be 

monitored to determine whether they 

are following these policies and 

procedures. Institutions should review 

consumer complaints to identify 

potential compliance, reputation, and 

other risks. Attention should be paid to 

appropriate legal review and to using 

compensation programs that do not 

improperly encourage lending 

personnel to direct consumers to 

particular products. 

With respect to nontraditional 

mortgage loans that an institution 

makes, purchases, or services using a 

third party, such as a mortgage broker, 

correspondent, or other intermediary, 

the institution should take appropriate 

steps to mitigate risks relating to 

compliance and consumer information 

concerns discussed in this guidance. 

These steps would ordinarily include, 

among other things, (1) Conducting due 

diligence and establishing other criteria 

for entering into and maintaining 

relationships with such third parties, (2) 

establishing criteria for third-party 

compensation designed to avoid 

providing incentives for originations 

inconsistent with this guidance, (3) 

setting requirements for agreements 

with such third parties, (4) establishing 

procedures and systems to monitor 

compliance with applicable agreements, 

bank policies, and laws, and (5) 

implementing appropriate corrective 

actions in the event that the third party 

fails to comply with applicable 

agreements, bank policies, or laws. 

Appendix: Terms Used in This 

Document 

Interest-only Mortgage Loan—A 

nontraditional mortgage on which, for a 

specified number of years (e.g., three or five 

years), the borrower is required to pay only 

the interest due on the loan during which 

time the rate may fluctuate or may be fixed. 

After the interest-only period, the rate may be 

fixed or fluctuate based on the prescribed 

index and payments include both principal 

and interest. 

Payment Option ARM—A nontraditional 

mortgage that allows the borrower to choose 

from a number of different payment options. 

For example, each month, the borrower may 

choose a minimum payment option based on 

a ‘‘start’’ or introductory interest rate, an 

interest-only payment option based on the 

fully indexed interest rate, or a fully 

amortizing principal and interest payment 

option based on a 15-year or 30-year loan 

term, plus any required escrow payments. 

The minimum payment option can be less 

than the interest accruing on the loan, 

resulting in negative amortization. The 

interest-only option avoids negative 

amortization but does not provide for 

principal amortization. After a specified 

number of years, or if the loan reaches a 

certain negative amortization cap, the 

required monthly payment amount is recast 

to require payments that will fully amortize 

the outstanding balance over the remaining 

loan term. 

Reduced Documentation—A loan feature 

that is commonly referred to as ‘‘low doc/no 

doc’’, ‘‘no income/no asset’’, ‘‘stated income’’

or ‘‘stated assets’’. For mortgage loans with 

this feature, an institution sets reduced or 

minimal documentation standards to 

substantiate the borrower’s income and 

assets. 

Simultaneous Second-Lien Loan—A 

lending arrangement where either a closedend second-lien or a home equity line of 

credit (HELOC) is originated simultaneously 

with the first lien mortgage loan, typically in 

lieu of a higher down payment. 

Dated: September 25, 2006. 

John C. Dugan, 

Comptroller of the Currency. 

By order of the Board of Governors of the 

Federal Reserve System, September 27, 2006. 

Jennifer J. Johnson, 

Secretary of the Board. 

Dated at Washington, DC, this 27th day of 

September, 2006. 

Federal Deposit Insurance Corporation. 

Robert E. Feldman, 

Executive Secretary. 

Dated: September 28, 2006. 

By the Office of Thrift Supervision. 

John M. Reich, 

Director. 

By the National Credit Union 

Administration on September 28, 2006. 

JoAnn M. Johnson, 

Chairman. 

[FR Doc. 06–8480 Filed 10–3–06; 8:45 am] 

BILLING CODE 4810–33–P, 6210–01–P, 6714–01–P, 

6720–01–P, 7535–01–P 


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