[Federal Register Volume 72, Number 131 (Tuesday, July 10, 2007)]
[Notices]
[Pages 37569-37575]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 07-3316]


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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

[Docket No. OCC-2007-0005]

FEDERAL RESERVE SYSTEM

[Docket No. OP-1278]

FEDERAL DEPOSIT INSURANCE CORPORATION

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

[No. 2007-31]

NATIONAL CREDIT UNION ADMINISTRATION


Statement on Subprime Mortgage Lending

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) 
(collectively, the Agencies).

ACTION: Final guidance--Statement on Subprime Mortgage Lending.

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SUMMARY: The Agencies are issuing a final interagency Statement on 
Subprime Mortgage Lending. This guidance has been developed to clarify 
how institutions can offer certain adjustable rate mortgage (ARM) 
products in a safe and sound manner, and in a way that clearly 
discloses the risks that borrowers may assume.

EFFECTIVE DATE: July 10, 2007.

FOR FURTHER INFORMATION CONTACT:
    OCC: Michael Bylsma, Director, Community and Consumer Law Division, 
(202) 874-5750 or Stephen Jackson, Director, Retail Credit Risk, (202) 
874-5170.
    Board: Division of Banking Supervision and Regulation: Brian P. 
Valenti, Supervisory Financial Analyst, (202) 452-3575, Virginia M. 
Gibbs, Senior Supervisory Financial Analyst, (202) 452-2521, or Sabeth 
I. Siddique, Assistant Director, (202) 452-3861; Division of Consumer 
and Community Affairs: Kathleen C. Ryan, Counsel, (202) 452-3667, or 
Jamie Z. Goodson, Attorney, (202) 452-3667; or Legal Division: Kara L. 
Handzlik, Attorney (202) 452-3852. Board of Governors of the Federal 
Reserve System, 20th Street and Constitution Avenue, NW., Washington, 
DC 20551. Users of Telecommunication Device for Deaf only, call (202) 
263-4869.
    FDIC: Beverlea S. Gardner, Examination Specialist, (202) 898-3640, 
Division of Supervision and Consumer Protection; Richard B. Foley, 
Counsel (202) 898-3784; Mira N. Marshall, Acting Chief Community 
Reinvestment Act and Fair Lending, (202) 898-3912; April A. Breslaw, 
Acting Associate Director, Compliance Policy & Exam Support Branch, 
Division of Supervision and Consumer Protection, (202) 898-6609.
    OTS: Tammy L. Stacy, Director of Consumer Regulation, Compliance 
and Consumer Protection Division, (202) 906-6437; Glenn Gimble, Senior 
Project Manager, Compliance and Consumer Protection Division, (202) 
906-7158; William J. Magrini, Senior Project Manager, Credit Risk, 
(202) 906-5744; or Teresa Luther, Economist, Credit Risk, (202) 906-
6798.
    NCUA: Cory W. Phariss, Program Officer, Examination and Insurance, 
(703) 518-6618.

SUPPLEMENTARY INFORMATION:

I. Background

    The Agencies developed this Statement on Subprime Mortgage Lending 
to address emerging risks associated with certain subprime mortgage 
products and lending practices. In particular, the Agencies are 
concerned about the growing use of ARM products \1\ that provide low 
initial payments based on a fixed introductory rate that expires after 
a short period, and then adjusts to a variable rate plus a margin for 
the remaining term of the loan. These products could result in payment 
shock to the borrower. The Agencies are concerned that these products, 
typically offered to subprime borrowers, present heightened risks to 
lenders and borrowers. Often, these products have additional 
characteristics that increase risk. These include qualifying borrowers 
based on limited or no documentation of income or imposing substantial 
prepayment penalties or prepayment penalty periods that extend beyond 
the initial fixed interest rate period. In addition, borrowers may not 
be adequately informed of product features and risks, including their 
responsibility to pay taxes and insurance, which might be separate from 
their mortgage payments.
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    \1\ For example, ARMs known as ``2/28'' loans feature a fixed 
rate for two years and then adjust to a variable rate for the 
remaining 28 years. The spread between the initial fixed interest 
rate and the fully indexed interest rate in effect at loan 
origination typically ranges from 300 to 600 basis points.
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    These products originally were extended to customers primarily as a 
temporary credit accommodation in anticipation of early sale of the 
property or in expectation of future earnings growth. However, these 
loans have more recently been offered to subprime borrowers as ``credit 
repair'' or ``affordability'' products. The Agencies are concerned that 
many subprime borrowers may not have sufficient financial capacity to 
service a higher debt load, especially if they were qualified based on 
a low introductory payment. The Agencies are also concerned that 
subprime borrowers may not fully understand the risks and consequences 
of obtaining this type of ARM loan. Borrowers who obtain these loans 
may face unaffordable monthly payments after the initial rate 
adjustment, difficulty in paying real estate taxes and insurance that 
were not escrowed, or expensive refinancing fees, any of which could 
cause borrowers to default and potentially lose their homes.
    In response to these concerns, the Agencies published for comment 
the Proposed Statement on Subprime Mortgage Lending (proposed 
statement), 72 FR 10533 (March 8, 2007). The proposed statement 
provided guidance on the criteria and factors, including payment shock, 
that an institution should assess in determining a borrower's ability 
to repay the loan. The proposed statement also provided guidance 
intended to protect consumers from unfair, deceptive, and other 
predatory practices, and to ensure that consumers are provided with 
clear and balanced information about the risks and features of these 
loans. Finally, the proposed statement addressed the need for strong 
controls to adequately manage the risks associated with these products.
    The Agencies requested comment on all aspects of the proposed 
statement, and specifically requested comment about whether: (1) These 
products always present inappropriate risks to institutions and 
consumers, or the extent to which they may be appropriate under some 
circumstances; (2) the proposed statement would unduly restrict the 
ability of existing subprime borrowers to refinance their loans, and 
whether other forms of credit are available that would not present the 
risk of payment shock; (3) the principles of the proposed statement 
should be applied beyond the subprime ARM market; and (4) limitations 
on the use of

[[Page 37570]]

prepayment penalties would help meet borrower needs.
    The Agencies collectively received 137 unique comments on the 
proposed statement. Comments were received from financial institutions, 
industry-related trade associations (industry groups), consumer and 
community groups, government officials, and members of the public.

II. Overview of Public Comments

    The commenters were generally supportive of the Agencies' efforts 
to provide guidance in this area. However, many financial institution 
commenters expressed concern that certain aspects of the proposed 
statement were too prescriptive or could unduly restrict subprime 
borrowers' access to credit. Many consumer and community group 
commenters stated that the proposed statement did not go far enough in 
addressing their concerns about these products.
    Financial institutions and industry groups stated that they 
supported prudent underwriting, but opposed a strict requirement that 
ARM loans subject to the proposed statement be underwritten at a fully 
indexed rate with a fully amortizing repayment schedule. They also 
stated that these loan products are not always inappropriate, 
particularly because they can be a useful credit repair vehicle or a 
means to establish a favorable credit history. Many of these commenters 
expressed concern that the proposed statement would unduly restrict 
credit to subprime borrowers. They also requested that the proposed 
statement be modified to allow lenders flexibility in helping existing 
subprime borrowers refinance out of ARM loans that will reset to a 
monthly payment that they cannot afford.
    The majority of financial institutions and industry group 
commenters opposed the application of the proposed statement outside 
the subprime market. A number of these commenters requested 
clarification of the scope of the proposed statement and the definition 
of ``subprime.''
    Some industry group commenters also expressed concern that consumer 
disclosure requirements would put federally-regulated institutions at a 
disadvantage and cause consumer information overload. They also 
requested that any changes to consumer disclosure requirements be part 
of a comprehensive reform of existing disclosure regulations.
    Consumer and community group commenters generally supported the 
proposed statement. Many of these commenters expressed their concern 
that the products covered by the proposed statement present 
inappropriate risks for subprime borrowers. Many of these commenters 
supported extending the scope of the proposed statement to other 
mortgage products. These commenters supported the proposed underwriting 
criteria, though a number of them suggested stricter underwriting 
criteria. They also supported further limiting or prohibiting the use 
of reduced documentation and stated income loans, suggesting that such 
a reduction would be in the best interests of consumers.
    Both industry group and consumer and community group commenters 
expressed concern that the proposed statement will not apply to all 
lenders. Industry group commenters indicated this would put federally-
regulated financial institutions at a competitive disadvantage. 
Consumer and community group commenters encouraged the Agencies to 
continue to work with state regulators to extend the principles of the 
proposed statement to non-federally supervised institutions. Since the 
time that the Agencies announced the proposed statement, the Conference 
of State Bank Supervisors (CSBS) and the American Association of 
Residential Mortgage Regulators (AARMR) issued a press release 
confirming their intent to ``develop a parallel statement for state 
supervisors to use with state-supervised entities.'' \2\
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    \2\ Media Release, CSBS & AARMR, ``CSBS and AARMR Support 
Interagency Statement on Subprime Lending'' (March 2, 2007), 
available at http://www.csbs.org/AM/
Template.cfm?Section=Search&template=/CM/
HTMLDisplay.cfm&ContentID=10295.
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III. Agencies' Action on Final Joint Guidance

    The Agencies are issuing the Statement on Subprime Mortgage Lending 
(Statement) with some changes to respond to the comments received and 
to provide additional clarity. The Statement applies to all banks and 
their subsidiaries, bank holding companies and their nonbank 
subsidiaries, savings associations and their subsidiaries, savings and 
loan holding companies and their subsidiaries, and credit unions. 
Significant comments on specific provisions of the proposed statement, 
the Agencies' responses, and changes to the proposed statement are 
discussed below.

Scope of Guidance

    A number of financial institution and industry group commenters and 
two credit reporting companies requested that the definition of 
``subprime'' be clarified. A financial institution and an industry 
group commenter requested a bright-line test to determine if a borrower 
falls into the subprime category.
    The Agencies considered commenters' requests that a definition of 
``subprime'' be included in the Statement. The Agencies determined, 
however, that the reference to the subprime borrower characteristics 
from the 2001 Expanded Guidance for Subprime Lending Programs (Expanded 
Guidance) provides appropriate information for purposes of this 
Statement. The Expanded Guidance provides a range of credit risk 
characteristics that are associated with subprime borrowers, noting 
that the characteristics are illustrative and are not meant to define 
specific parameters for all subprime borrowers.\3\ Because the term 
``subprime'' is not consistently defined in the marketplace or among 
individual institutions, the Agencies believe that incorporating the 
subprime borrower credit risk characteristics from the Expanded 
Guidance provides sufficient clarity.
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    \3\ Federally insured credit unions should refer to LCU 04-CU-
13--Specialized Lending Activities.
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    A number of commenters also requested clarification as to whether 
the proposed statement applies to all products with the features 
described. In addition, the Agencies specifically requested comment 
regarding whether the proposed statement's principles should be applied 
beyond the subprime ARM market. All consumer and community groups and 
some of the financial institutions who addressed this question 
supported application of the proposed statement beyond the subprime 
market. However, most financial institution and industry group 
commenters opposed application of the proposed statement beyond the 
subprime market. These commenters stated that the issues the proposed 
statement was designed to address are confined to the subprime market 
and expansion of the proposed statement to other markets would 
unnecessarily limit the options available to other borrowers.
    As with the proposed statement, the Statement retains a focus on 
subprime borrowers, due to concern that these consumers may not fully 
understand the risks and consequences of these loans and may not have 
the financial capacity to deal with increased obligations. The Agencies 
did revise the language to indicate that the proposed statement applies 
to certain ARM products that have one or more characteristics that can 
cause payment shock, as defined in the proposed statement. While the 
Statement has retained its focus on

[[Page 37571]]

subprime borrowers, the Agencies note that institutions generally 
should look to the principles of this Statement when such ARM products 
are offered to non-subprime borrowers.

Risk Management Practices

Predatory Lending Considerations
    Some financial institution and industry group commenters raised 
concerns that the proposed statement implied that subprime lending is 
``per se'' predatory. The Statement clarifies that subprime lending is 
not synonymous with predatory lending, and that there is no presumption 
that the loans to which the Statement applies are predatory.
Qualifying Standards
    The proposed statement provided that subprime ARMs should be 
underwritten at the fully indexed rate with a fully amortizing 
repayment schedule. Many consumer and community groups supported the 
proposed statement's underwriting standards. Other consumer and 
community groups thought that the proposed qualifying standards did not 
go far enough, and suggested that these loans should be underwritten on 
the basis of the maximum possible monthly payment. The majority of 
industry group commenters who addressed this issue opposed the proposed 
underwriting standard as overly prescriptive. Some commenters also 
requested that the Statement define ``fully indexed rate with a fully 
amortizing repayment schedule.'' All of the commenters that addressed 
the issue favored including a reasonable estimate of property taxes and 
insurance in an assessment of borrowers' debt-to-income ratios.
    The Agencies continue to believe that institutions should maintain 
qualification standards that include a credible analysis of a 
borrower's capacity to repay the loan according to its terms. This 
analysis should consider both principal and interest obligations at the 
fully indexed rate with a fully amortizing repayment schedule, plus a 
reasonable estimate for real estate taxes and insurance, whether or not 
escrowed. Qualifying consumers based on a low introductory payment does 
not provide a realistic assessment of a borrower's ability to repay the 
loan according to its terms. Therefore, the proposed general guideline 
of qualifying borrowers at the fully indexed rate, assuming a fully 
amortizing payment, remains unchanged in the final Statement. The 
Agencies did, however, provide additional information regarding the 
terms ``fully indexed rate'' and ``fully amortizing payment schedule'' 
to clarify expectations regarding how institutions should assess 
borrowers' repayment capacity.
Reduced Documentation or Stated Income Loans
    Several commenters raised concerns about reduced documentation or 
stated income loans. The majority of commenters who addressed this 
issue supported the proposed statement's position that institutions 
should be able to readily document income for many borrowers and that 
reduced documentation should be accepted only if mitigating factors are 
present. A few financial institution and industry group commenters 
urged the Agencies to allow lenders some flexibility in deciding when 
these loans are appropriate for borrowers whose income is derived from 
sources that are difficult to verify. On the other hand, some consumer 
and community group commenters stated that borrowers are not always 
given the option to document income and thereby pay a lower interest 
rate. They also indicated that stated income loans may be a vehicle for 
fraud in that borrower income may be inflated to qualify for a loan.
    The Agencies believe that verifying income is critical to 
conducting a credible analysis of borrowers' repayment capacity, 
particularly in connection with loans to subprime borrowers. Therefore, 
the final Statement provides that stated income and reduced 
documentation should be accepted only if there are mitigating factors 
that clearly minimize the need for verification of repayment capacity. 
The Statement provides some examples of mitigating factors, and sets 
forth an expectation that reliance on mitigating factors should be 
documented. The Agencies note that for many borrowers, institutions 
should be able to readily document income using recent W-2 statements, 
pay stubs, and/or tax returns.

Workout Arrangements

    The Agencies specifically requested comment on whether the proposed 
statement would unduly restrict the ability of existing subprime 
borrowers to refinance out of certain ARMs to avoid payment shock. The 
Agencies also asked about the availability to these borrowers of other 
mortgage products that do not present the risk of payment shock. The 
majority of financial institution and industry group commenters who 
responded to this specific question believed that the proposed 
statement would unduly restrict existing subprime borrowers' ability to 
refinance. However, most consumer and community groups who addressed 
the issue expressed the view that allowing existing borrowers to 
refinance into another unaffordable ARM was not an acceptable solution 
to the problem and, therefore, that eliminating this option would not 
be an undue restriction on credit. Some commenters mentioned that 
certain government-sponsored entities and lenders have already 
committed to revise their lending program criteria and/or create new 
programs that potentially may provide alternative mortgage products for 
refinancing existing subprime loans.
    To address these issues, the Agencies incorporated a section on 
workout arrangements in the final text that references the principles 
of the April 2007 interagency Statement on Working with Borrowers. The 
Agencies believe prudent workout arrangements that are consistent with 
safe and sound lending practices are generally in the long-term best 
interest of both the financial institution and the borrower.

Consumer Protection Principles

Prepayment Penalties
    The Agencies specifically requested comment regarding whether 
prepayment penalties should be limited to the initial fixed-rate 
period; how this practice, if adopted, would assist consumers and 
affect institutions; and whether an institution's providing a window of 
90 days prior to the reset date to refinance without a prepayment 
penalty would help meet borrower needs. The overwhelming majority of 
commenters who addressed this question agreed that prepayment penalties 
should be limited to the initial fixed-rate period, and several 
commenters proposed a complete prohibition of prepayment penalties. 
Commenters suggested different time frames for expiration of the 
prepayment penalty period, ranging from 30 to 90 days prior to the 
reset date. Several industry group commenters, however, opposed such a 
limitation. They stated that prepayment fees are a legitimate means for 
lenders and investors to be compensated for origination costs when 
borrowers prepay prior to the interest rate reset. Further, these 
commenters noted that most lenders do not offer mortgage products that 
have prepayment penalty periods that extend beyond the fixed interest 
rate period and that borrowers should be allowed time to exit the loan 
prior to the reset date.
    In light of the comments received, the Agencies revised the 
Statement to state

[[Page 37572]]

that the period during which prepayment penalties apply should not 
exceed the initial reset period, and that institutions generally should 
provide borrowers with a reasonable period of time (typically, at least 
60 days prior to the reset date) to refinance their loans without 
penalty. There is no supervisory expectation for institutions to waive 
contractual terms with regard to prepayment penalties on existing 
loans.\4\
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    \4\ Federal credit unions are prohibited from charging 
prepayment penalties. 12 CFR 701.21.
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Consumer Disclosure Issues
    Many financial institution and industry group commenters suggested 
that the Agencies' consumer protection goals would be better 
accomplished through amendments to generally applicable regulations, 
such as Regulation Z (Truth in Lending) \5\ or Regulation X (Real 
Estate Settlement Procedures).\6\ Some financial institution and 
consumer and community group commenters questioned the value of 
additional disclosures and expressed concern that the proposed 
statement would contribute to consumer information overload. A few 
commenters stated that the proposed statement would add burdensome new 
disclosure requirements and would result in the provision of confusing 
information to consumers.
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    \5\ 12 CFR part 226 (2006).
    \6\ 24 CFR part 3500 (2005).
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    Some industry group commenters asked the Agencies to provide 
uniform disclosures for these products, or to publish illustrations of 
the consumer information contemplated by the proposed statement similar 
to those previously proposed by the Agencies in connection with 
nontraditional mortgage products.\7\ Several commenters also requested 
that any disclosures include the maximum possible monthly payment under 
the terms of the loan.
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    \7\ 71 FR 58673 (October 4, 2006).
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    The Agencies have determined that, given the growth in the market 
for the products covered by the Statement and the heightened legal, 
compliance, and reputation risks associated with these products, 
guidelines are needed now to ensure that consumers will receive the 
information they need about the material features of these loans. In 
addition, while the Agencies are sensitive to commenters' concerns 
regarding disclosure burden, we do not anticipate that the information 
outlined in the Statement will result in additional lengthy 
disclosures. Rather, the Agencies contemplate that the information can 
be provided in a brief narrative format and through the use of examples 
based on hypothetical loan transactions. In response to requests by 
commenters, the Agencies are working on and expect to publish for 
comment proposed illustrations of the type of consumer information 
contemplated in the Statement.
    The Agencies disagree with the commenters who expressed concern 
that the proposed statement appears to establish a suitability standard 
under which lenders would be required to assist borrowers in choosing 
products that are appropriate to their needs and circumstances. 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. It is not the Agencies' intent to 
impose such a standard, nor is there any language in the Statement that 
does so.

Control Systems

    While some commenters who addressed the control systems portion of 
the proposed statement supported the Agencies' proposal, some industry 
group commenters expressed concern that these provisions were neither 
realistic nor practical. A few industry group commenters requested 
clarification of the scope of a financial institution's 
responsibilities with regard to third parties. Some consumer and 
community group commenters requested uniform regulation of and 
increased enforcement against third parties.
    The Agencies have carefully considered these comments, but have not 
revised this portion of the proposed statement. The Agencies do not 
expect institutions to assume an unwarranted level of responsibility 
for the actions of third parties. Moreover, the control systems 
discussed in the Statement are consistent with the Agencies' current 
supervisory authority and policies.

Supervisory Review

    The Agencies received no comments on the supervisory review portion 
of the proposed statement. However, minor changes have been made to 
clarify the circumstances under which the Agencies will take action 
against institutions in connection with the products addressed in the 
Statement.

IV. Text of Final Joint Guidance

    The final interagency Statement on Subprime Mortgage Lending 
appears below.

Statement on Subprime Mortgage Lending

    The Agencies \8\ developed this Statement on Subprime Mortgage 
Lending (Subprime Statement) to address emerging issues and questions 
relating to certain subprime \9\ mortgage lending practices. The 
Agencies are concerned borrowers may not fully understand the risks and 
consequences of obtaining products that can cause payment shock.\10\ In 
particular, the Agencies are concerned with certain adjustable-rate 
mortgage (ARM) products typically offered to subprime borrowers that 
have one or more of the following characteristics:
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    \8\ The Agencies consist of the Board of Governors of the 
Federal Reserve System (the Board), the Federal Deposit Insurance 
Corporation (FDIC), the National Credit Union Administration (NCUA), 
the Office of the Comptroller of the Currency (OCC), and the Office 
of Thrift Supervision (OTS).
    \9\ The term ``subprime'' is described in the 2001 Expanded 
Guidance for Subprime Lending Programs. Federally insured credit 
unions should refer to LCU 04-CU-13--Specialized Lending Activities.
    \10\ Payment shock refers to a significant increase in the 
amount of the monthly payment that generally occurs as the interest 
rate adjusts to a fully indexed basis. Products with a wide spread 
between the initial interest rate and the fully indexed rate that do 
not have payment caps or periodic interest rate caps, or that 
contain very high caps, can produce significant payment shock.
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     Low initial payments based on a fixed introductory rate 
that expires after a short period and then adjusts to a variable index 
rate plus a margin for the remaining term of the loan; \11\
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    \11\ For example, ARMs known as ``2/28'' loans feature a fixed 
rate for two years and then adjust to a variable rate for the 
remaining 28 years. The spread between the initial fixed interest 
rate and the fully indexed interest rate in effect at loan 
origination typically ranges from 300 to 600 basis points.
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     Very high or no limits on how much the payment amount or 
the interest rate may increase (``payment or rate caps'') on reset 
dates;
     Limited or no documentation of borrowers' income;
     Product features likely to result in frequent refinancing 
to maintain an affordable monthly payment; and/or
     Substantial prepayment penalties and/or prepayment 
penalties that extend beyond the initial fixed interest rate period.
    Products with one or more of these features present substantial 
risks to both consumers and lenders. These risks are increased if 
borrowers are not adequately informed of the product features and 
risks, including their responsibility for paying real estate taxes and 
insurance, which may be separate from their monthly mortgage payments. 
The consequences to borrowers could include: being unable

[[Page 37573]]

to afford the monthly payments after the initial rate adjustment 
because of payment shock; experiencing difficulty in paying real estate 
taxes and insurance that were not escrowed; incurring expensive 
refinancing fees, frequently due to closing costs and prepayment 
penalties, especially if the prepayment penalty period extends beyond 
the rate adjustment date; and losing their homes. Consequences to 
lenders may include unwarranted levels of credit, legal, compliance, 
reputation, and liquidity risks due to the elevated risks inherent in 
these products.
    The Agencies note that many of these concerns are addressed in 
existing interagency guidance. The most prominent are the 1993 
Interagency Guidelines for Real Estate Lending (Real Estate 
Guidelines), the 1999 Interagency Guidance on Subprime Lending, and the 
2001 Expanded Guidance for Subprime Lending Programs (Expanded Subprime 
Guidance).\12\
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    \12\ Federally insured credit unions should refer to LCU 04-CU-
13--Specialized Lending Activities. National banks also should refer 
to 12 CFR 34.3(b) and (c), as well as 12 CFR part 30, Appendix C.
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    While the 2006 Interagency Guidance on Nontraditional Mortgage 
Product Risks (NTM Guidance) may not explicitly pertain to products 
with the characteristics addressed in this Statement, it outlines 
prudent underwriting and consumer protection principles that 
institutions also should consider with regard to subprime mortgage 
lending. This Statement reiterates many of the principles addressed in 
existing guidance relating to prudent risk management practices and 
consumer protection laws.\13\
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    \13\ As with the Interagency Guidance on Nontraditional Mortgage 
Product Risks, 71 FR 58609 (October 4, 2006), this Statement applies 
to all banks and their subsidiaries, bank holding companies and 
their nonbank subsidiaries, savings associations and their 
subsidiaries, savings and loan holding companies and their 
subsidiaries, and credit unions.
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Risk Management Practices

Predatory Lending Considerations
    Subprime lending is not synonymous with predatory lending, and 
loans with the features described above are not necessarily predatory 
in nature. However, institutions should ensure that they do not engage 
in the types of predatory lending practices discussed in the Expanded 
Subprime Guidance.\14\ Typically, predatory lending involves at least 
one of the following elements:
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    \14\ Federal credit unions should refer to 12 CFR 740.2 and 12 
CFR 706 for information on prohibited practices.
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     Making loans based predominantly on the foreclosure or 
liquidation value of a borrower's collateral rather than on the 
borrower's ability to repay the mortgage according to its terms;
     Inducing a borrower to repeatedly refinance a loan in 
order to charge high points and fees each time the loan is refinanced 
(``loan flipping''); or
     Engaging in fraud or deception to conceal the true nature 
of the mortgage loan obligation, or ancillary products, from an 
unsuspecting or unsophisticated borrower.
    Institutions offering mortgage loans such as these face an elevated 
risk that their conduct will violate Section 5 of the Federal Trade 
Commission Act (FTC Act), which prohibits unfair or deceptive acts or 
practices.\15\
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    \15\ The OCC, the Board, the OTS, and the FDIC enforce this 
provision under section 8 of the Federal Deposit Insurance Act. The 
OCC, Board, and FDIC also have 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, 
and 12 CFR part 30, Appendix C; Joint Board and FDIC Guidance on 
Unfair or Deceptive Acts or Practices by State-Chartered Banks, 
March 11, 2004. The OTS also has issued 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). The NCUA prohibits federally 
insured credit unions 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).
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Underwriting Standards
    Institutions should refer to the Real Estate Guidelines, which 
provide underwriting standards for all real estate loans.\16\ The Real 
Estate Guidelines state that prudently underwritten real estate loans 
should reflect all relevant credit factors, including the capacity of 
the borrower to adequately service the debt.\17\ The 2006 NTM Guidance 
details similar criteria for qualifying borrowers for products that may 
result in payment shock.
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    \16\ Refer to 12 CFR part 34, subpart D (OCC); 12 CFR part 208, 
subpart C (Board); 12 CFR part 365 (FDIC); 12 CFR 560.100 and 12 CFR 
560.101 (OTS); and 12 CFR 701.21 (NCUA).
    \17\ OTS Examination Handbook Section 212, 1-4 Family 
Residential Mortgage Lending, also discusses borrower qualification 
standards. Federally insured credit unions should refer to LCU 04-
CU-13--Specialized Lending Activities.
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    Prudent qualifying standards recognize the potential effect of 
payment shock in evaluating a borrower's ability to service debt. An 
institution's analysis of a borrower's repayment capacity should 
include an evaluation of the borrower's ability to repay the debt by 
its final maturity at the fully indexed rate,\18\ assuming a fully 
amortizing repayment schedule.\19\
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    \18\ The fully indexed rate equals the index rate prevailing at 
origination plus the margin to be added to it after the expiration 
of an introductory interest rate. For example, assume that a loan 
with an initial fixed rate of 7% will reset to the six-month London 
Interbank Offered Rate (LIBOR) plus a margin of 6%. If the six-month 
LIBOR rate equals 5.5%, lenders should qualify the borrower at 11.5% 
(5.5% + 6%), regardless of any interest rate caps that limit how 
quickly the fully indexed rate may be reached.
    \19\ The fully amortizing payment schedule should be based on 
the term of the loan. For example, the amortizing payment for a ``2/
28'' loan 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.
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    One widely accepted approach in the mortgage industry is to 
quantify a borrower's repayment capacity by a debt-to-income (DTI) 
ratio. An institution's DTI analysis should include, among other 
things, an assessment of a borrower's total monthly housing-related 
payments (e.g., principal, interest, taxes, and insurance, or what is 
commonly known as PITI) as a percentage of gross monthly income.
    This assessment is particularly important if the institution relies 
upon reduced documentation or allows other forms of risk layering. 
Risk-layering features in a subprime mortgage loan may significantly 
increase the risks to both the institution and the borrower. Therefore, 
an institution should have clear policies governing the use of risk-
layering features, such as reduced documentation loans or simultaneous 
second lien mortgages. When risk-layering features are combined with a 
mortgage loan, an institution should demonstrate the existence of 
effective mitigating factors that support the underwriting decision and 
the borrower's repayment capacity.
    Recognizing that loans to subprime borrowers present elevated 
credit risk, institutions should verify and document the borrower's 
income (both source and amount), assets and liabilities. Stated income 
and reduced documentation loans to subprime borrowers should be 
accepted only if there are mitigating factors that clearly minimize the 
need for direct verification of repayment capacity. Reliance on such 
factors also should be documented. Typically, mitigating factors arise 
when a borrower with favorable payment performance seeks to refinance 
an existing mortgage with a new loan of a similar size and with similar 
terms, and the borrower's financial condition has not deteriorated. 
Other mitigating factors might include situations where a borrower has 
substantial liquid reserves or assets that

[[Page 37574]]

demonstrate repayment capacity and can be verified and documented by 
the lender. However, a higher interest rate is not considered an 
acceptable mitigating factor.

Workout Arrangements

    As discussed in the April 2007 interagency Statement on Working 
with Borrowers, the Agencies encourage financial institutions to work 
constructively with residential borrowers who are in default or whose 
default is reasonably foreseeable. Prudent workout arrangements that 
are consistent with safe and sound lending practices are generally in 
the long-term best interest of both the financial institution and the 
borrower.
    Financial institutions should follow prudent underwriting practices 
in determining whether to consider a loan modification or a workout 
arrangement.\20\ Such arrangements can vary widely based on the 
borrower's financial capacity. For example, an institution might 
consider modifying loan terms, including converting loans with variable 
rates into fixed-rate products to provide financially stressed 
borrowers with predictable payment requirements.
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    \20\ Institutions may need to account for workout arrangements 
as troubled debt restructurings and should follow generally accepted 
accounting principles in accounting for these transactions.
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    The Agencies will not criticize financial institutions that pursue 
reasonable workout arrangements with borrowers. Further, existing 
supervisory guidance and applicable accounting standards do not require 
institutions to immediately foreclose on the collateral underlying a 
loan when the borrower exhibits repayment difficulties. Institutions 
should identify and report credit risk, maintain an adequate allowance 
for loan losses, and recognize credit losses in a timely manner.

Consumer Protection Principles

    Fundamental consumer protection principles relevant to the 
underwriting and marketing of mortgage loans include:
     Approving loans based on the borrower's ability to repay 
the loan according to its terms; and
     Providing information that enables consumers to understand 
material terms, costs, and risks of loan products at a time that will 
help the consumer select a product.
    Communications with consumers, including advertisements, oral 
statements, and promotional materials, should provide clear and 
balanced information about the relative benefits and risks of the 
products. This information should be provided in a timely manner to 
assist consumers in the product selection process, not just upon 
submission of an application or at consummation of the loan. 
Institutions should not use such communications to steer consumers to 
these products to the exclusion of other products offered by the 
institution for which the consumer may qualify.
    Information provided to consumers should clearly explain the risk 
of payment shock and the ramifications of prepayment penalties, balloon 
payments, and the lack of escrow for taxes and insurance, as necessary. 
The applicability of prepayment penalties should not exceed the initial 
reset period. In general, borrowers should be provided a reasonable 
period of time (typically at least 60 days prior to the reset date) to 
refinance without penalty.\21\
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    \21\ Federal credit unions are prohibited from charging 
prepayment penalties. 12 CFR 701.21.
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    Similarly, if borrowers do not understand that their monthly 
mortgage payments do not include taxes and insurance, and they have not 
budgeted for these essential homeownership expenses, they may be faced 
with the need for significant additional funds on short notice.\22\ 
Therefore, mortgage product descriptions and advertisements should 
provide clear, detailed information about the costs, terms, features, 
and risks of the loan to the borrower. Consumers should be informed of:
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    \22\ Institutions generally can address these concerns most 
directly by requiring borrowers to escrow funds for real estate 
taxes and insurance.
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     Payment Shock. Potential payment increases, including how 
the new payment will be calculated when the introductory fixed rate 
expires.\23\
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    \23\ To illustrate: a borrower earning $42,000 per year obtains 
a $200,000 ``2/28'' mortgage loan. The loan's two-year introductory 
fixed interest rate of 7% requires a principal and interest payment 
of $1,331. Escrowing $200 per month for taxes and insurance results 
in a total monthly payment of $1,531 ($1,331 + $200), representing a 
44% DTI ratio. A fully indexed interest rate of 11.5% (based on a 
six-month LIBOR index rate of 5.5% plus a 6% margin) would cause the 
borrower's principal and interest payment to increase to $1,956. The 
adjusted total monthly payment of $2,156 ($1,956 + $200 for taxes 
and insurance) represents a 41% increase in the payment amount and 
results in a 62% DTI ratio.
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     Prepayment Penalties. The existence of any prepayment 
penalty, how it will be calculated, and when it may be imposed.\24\
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    \24\ See footnote 21.
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     Balloon Payments. The existence of any balloon payment.
     Cost of Reduced Documentation Loans. Whether there is a 
pricing premium attached to a reduced documentation or stated income 
loan program.
     Responsibility for Taxes and Insurance. The requirement to 
make payments for real estate taxes and insurance in addition to their 
loan payments, if not escrowed, and the fact that taxes and insurance 
costs can be substantial.

Control Systems

    Institutions should develop strong control systems to monitor 
whether actual practices are consistent with their policies and 
procedures. Systems should address compliance and consumer information 
concerns, as well as safety and soundness, and encompass both 
institution personnel and applicable third parties, such as mortgage 
brokers or correspondents.
    Important controls include establishing appropriate criteria for 
hiring and training loan personnel, entering into and maintaining 
relationships with third parties, and conducting initial and ongoing 
due diligence on third parties. Institutions also should design 
compensation programs that avoid providing incentives for originations 
inconsistent with sound underwriting and consumer protection 
principles, and that do not result in the steering of consumers to 
these products to the exclusion of other products for which the 
consumer may qualify.
    Institutions should have procedures and systems in place to monitor 
compliance with applicable laws and regulations, third-party agreements 
and internal policies. An institution's controls also should include 
appropriate corrective actions in the event of failure to comply with 
applicable laws, regulations, third-party agreements or internal 
policies. In addition, institutions should initiate procedures to 
review consumer complaints to identify potential compliance problems or 
other negative trends.

Supervisory Review

    The Agencies will continue to carefully review risk management and 
consumer compliance processes, policies, and procedures. The Agencies 
will take action against institutions that exhibit predatory lending 
practices, violate consumer protection laws or fair lending laws, 
engage in unfair or deceptive acts or practices, or otherwise engage in 
unsafe or unsound lending practices.


[[Page 37575]]


    Dated: June 28, 2007.
John C. Dugan,
Comptroller of the Currency.
    By order of the Board of Governors of the Federal Reserve 
System, June 28, 2007.
Jennifer J. Johnson,
Secretary of the Board.
    Dated at Washington, DC, the 27th day of June, 2007.

    By order of the Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary.
    Dated: June 28, 2007.

    By the Office of Thrift Supervision.
John Reich,
Director.
    Dated: June 28, 2007.

    By the National Credit Union Administration.
JoAnn M. Johnson,
Chairman.
[FR Doc. 07-3316 Filed 7-9-07; 8:45 am]
BILLING CODE 4810-33-P (20%); 6210-01-P (20%); 6714-01-P (20%); 6720-
01-P (20%) 7535-01-P (20%)