Module 6: Introduction to Nontraditional Mortgage Products ...

[Pages:23]Module 6: Introduction to Nontraditional Mortgage Products, and the Adjustable Rate Mortgage

UNIT 1: NONTRADITIONAL MORTGAGE PRODUCTS (13 MIN)

PAGE 1: MOD6_GUIDANCE (3 MIN)

In this unit, you'll learn about:

a brief history behind some of the most popular nontraditional mortgage products; a review of the risks nontraditional mortgage products posed to the market; and a discussion of current laws curtailing those risks.

THE FDIC'S INTERAGENCY GUIDANCE ON NONTRADITIONAL MORTGAGE PRODUCT RISK

In 2006, the Federal Deposit Insurance Corporation (FDIC), and other federal government agencies (collectively in this unit, the Agencies) in charge of regulating mortgage lending issued a final rule: "The Interagency Guidance on Nontraditional Mortgage Product Risks." The Agencies developed the guidelines to give federal banks, credit unions, and other federally regulated financial entities a framework for managing the risk on "nontraditional mortgage products".

The interagency guidance defined "nontraditional mortgage products" as all closed-end residential mortgage loan products that allow borrower to defer repayment of principal or interest, such as interest-only products or negative amortization products. At the time of the Agencies' release of these guidelines, the market share of these types of loans had vaulted them from their position as niche products available to highly qualified borrowers to a tool by which lenders could get otherwise unqualified borrowers into homes.

Many of these products, in addition to being risky by their nature, were being provided with less stringent income, asset and credit requirements, or reduced documentation. For example, the 2000s saw the rise of the no-income, no-asset loan and the stated income loan, both of which required no verification of the borrower's income.

Additionally, many were being offered in combination with simultaneous second-lien loans, which further diluted both the borrower's ability to repay the loan and the borrower's stake in paying the loan ("skin in the game"). Taken independently, any one of these practices (reduced documentation, high debt load, exotic loan product) placed the borrower at a higher risk of default than they would experience on a traditional 30-year fixed-rate mortgage. The concentration of many different types of risk in one loan product, or loan, is known as risk layering.

"RISK? WHAT RISK?"

The Agencies guidelines called for lenders to put in place risk mitigation procedures to offset the risk layering which went along with nontraditional mortgage products. The Agencies urged lenders to:

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, and warrant strong risk management standards, capital levels commensurate with the risk, and an allowance for loan and lease losses that reflects the collectability of the portfolio; and

ensure that consumers have sufficient information to clearly understand loan terms and associated risks prior to making a product choice.

In a nutshell:

consider if the borrower can repay the loan while the loan is being underwritten; ensure, before making the loan, that the institution has adequately prepared in the likely event of the

borrower's default; and explain the products to the consumer and disclose the high risk of loss.

In today's mortgage market, these expectations are par for the course. However, in 2006 these rules were met with a different attitude. Some telling commentary in response to the Agencies' guidance:

The American Banker's Association: It's not that bad.

"While the banking industry agrees that these products need to be carefully managed, the industry has a number of concerns about the proposed Guidance. In brief, we believe that [...t]he Guidance overstates the risks of these mortgage products. [Additionally, t]he Guidance's detailed consumer protection recommendations add a layer of additional disclosure before and around the legally required Regulation Z disclosures, thereby perhaps creating significant compliance problems."

Chase Bank: They can just refinance it away.

"Chase supports an overall restriction on qualifying borrowers based solely on aggressive short term teaser rates. However, Chase also believes that the underwriting standard in the Proposed Guidance (fully indexed rate, fully amortizing term) is too conservative for many interest only products. Given the five to seven year average life of a residential mortgage loan, most borrowers using interest only products will never experience any form of payment shock."

Lehman Brothers: We know what we're doing.

"We believe the key is risk layering by the institution. An institution's approach to risk layering should ideally be based upon historical performance data. If an institution can demonstrate that certain apparent risk factors (or combinations of risk factors), within definable parameters, do not lead to increased risk of delinquency, then the Agencies should accept that the institution is layering the risks properly. An open market will mean that different institutions will develop different methodologies for achieving this goal." [FDIC Federal Register Citations -- Comments on Interagency Guidance on Nontraditional Mortgage Products]

PAGE 2: MOD6_RECIPE (6 MIN)

THE AGENCIES' RECIPE FOR A STABLE MORTGAGE MARKET

The focus of the Agencies' guidance was on the specific risk elements of certain nontraditional mortgage products, not solely the product type. Two years after the Agencies released their definition of nontraditional mortgage product, the Secure and Fair Enforcement Act of 2008 (SAFE Act, reviewed in Module 1) defined a nontraditional mortgage product as any mortgage product other than a 30-year fixed-rate mortgage. [15 USC ?5102(7)]

Thus, nontraditional mortgage products include (but are not limited to):

hybrid adjustable rate mortgages (ARMs); option ARMs; reverse mortgages; balloon payment loans; home equity lines of credit; home equity loans; and 40-year mortgages.

The SAFE Act's definition, together with the Agencies' guidance, paved the way for future consumer protection measures in regards to nontraditional mortgage products. More importantly, the Agencies' commentary on nontraditional mortgage product use is still valid criticism today.

We'll go over the Agencies' rules for mitigating the risk of nontraditional mortgages, and discuss how traditional and nontraditional mortgage products differ in regards to each factor. Any new rules which have become effective since the Agencies' released these guidelines will also be discussed.

Qualification 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... an institution's qualifying standards should recognize the potential impact of payment shock, and that nontraditional mortgage loans often are inappropriate for borrowers with high loan-to-value (LTV) ratios, high debt-to-income (DTI) ratios, and low credit scores.

For all nontraditional mortgage loan products, the analysis of borrowers' repayment 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."

Payment shock is a substantial increase in a borrower's monthly mortgage payment which increases the risk of default. Payment shock is associated with adjustable rate mortgages (ARMs), since the monthly payments can adjust from the initial interest rate at which the borrower was qualified. Payment shock is less likely on a traditional fixed rate mortgage, as the monthly payments on a fixed rate mortgage do not change. (There may be payment shock on a fixed rate mortgage if the borrower's previous mortgage payment, or rent, was substantially less than the current mortgage payment.)

Payment shock is particularly pronounced when the initial interest rate is a very low teaser rate. For instance, option ARMs gave borrowers the option of choosing very low payments each month, instead of paying the full principal and interest, or even just the interest. Eventually, however, the loan payments must adjust in order for the loan to be paid off within the amortization period. The difference between the old minimum payment and the new payment which includes principal and deferred interest is what creates payment shock.

In 2006, the mortgage crisis was already at terminal velocity. The Agencies' guidance, even had it been followed to the letter, could not have stopped it. (This is not to say the Agencies were entirely blameless for the mortgage crisis. Years of laissez faire policies had plenty to do with the meltdown.) However, the recently finalized ability-torepay and qualified mortgage rules have belatedly answered the Agencies' call for ARMs to be underwritten on a fully-indexed rate and full amortization schedule. [See Module 4; 12 Code of Federal Regulations ??1026.43(c)(5)(i); 1026.43(c)(5)(i)(B)-(C)]

A more detailed explanation of option ARMs will be provided later in this module.

Reduced documentation

"Institutions are increasingly relying on reduced documentation, particularly unverified income to qualify borrowers for nontraditional mortgage loans. Because these practices essentially substitute assumptions and alternate information for the waived data in analyzing a borrower's repayment capacity and general creditworthiness, they should be used with caution. An institution should consider whether its verification practices are adequate. As the level of credit risk increases, the Agencies expect that an institution will apply more comprehensive verification and documentation procedures to verify a borrower's income and debt reduction capacity...reduced documentation, such as stated income, should be accepted only if there are other mitigating factors such as lower LTV and other more conservative underwriting standards."

In 2006, the Mortgage Brokers Association for Responsible Lending, a consumer advocacy group, testified at a Federal Reserve Board hearing. In a small sample of stated income loans it compared against IRS records, it found that almost 60% of the stated amounts were exaggerated by more than 50%. So the risk of a stated income was certainly not imagined.

Many stated income loans and no-income, no-asset loans were technically 30-year fixed rate mortgages, we'll speak to the Agencies' intent in curtailing risk, rather than just the product. Stated income loans allowed the borrower to state the income, rather than have the lender verify it. Some stated income products required a verification of assets. Others were flat-out no-income, no-asset (NINA) loans (also called liar loans), meaning the lender did not verify the income or assets of the borrower.

Lenders played up the stated income loans as a way for self-employed borrowers (whose incomes generally take more time for underwriters to verify) with good credit to bypass the income verification process. This is an example of risky, but still justifiable mitigation: a higher credit score and lower LTV requirements offset the risk of taking a borrower's income at their word.

However, the stated income programs did not stop with prime borrowers. As the entire industry began believing that housing prices would rise perpetually, stated income loans became more prevalent in the subprime market. The logic went like this: if the collateral (the property) was going to keep appreciating, the borrower's income mattered less and less. They could just refinance out of it. (See the Chase Bank comment from the last page.)

Accordingly, the ability-to-repay rules prohibit the use of no-income, no-asset or stated income loans. All income and assets must be verified. [12 CFR ?1026.43(c)(4)]

COLLATERAL DEPENDENCY AND RISK LAYERING

Collateral dependency

Which brings us to our next bit of Agency guidance, on collateral dependency.

"Institutions should avoid the use of loan terms and underwriting practices that may result in the borrower having to rely on the sale or refinancing of the property once amortization begins. Loans to borrowers who do not demonstrate the capacity to repay, as structured, from sources other than the collateral pledged are generally considered unsafe and unsound. Institutions determined to be originating collateral-dependent mortgage loans, may be subject to criticism, corrective action, and higher capital requirements."

The culprits here: the short-term, teaser rate arms, interest only products, and negative amortization products. Again, it's a matter of payment shock. Assuming property does not appreciate forever (it doesn't), relying on the property as a means of bailing out the borrower is like relying on a match to put out a fire: it doesn't make much sense.

Likewise, reverse mortgages also pose a similar, but slightly different risk for borrowers, lenders, and the Federal Housing Administration's insurance coffers. Like these short-term adjustable rate time-bombs, the reverse mortgage places a heavy dependency on the collateral. Too little scrutiny is given to the elderly borrower's ability to make tax and insurance payments to avoid default. In the case of reverse mortgages, a default means not just a few years' worth of equity lost, but a lifetime's. We'll discuss revere mortgages in the next module.

The ability-to-repay requirements do not restrict negative amortization, interest-only payments or balloon payments. (Its safe harbor provision, the qualified mortgage, does.) However, that doesn't mean those loan features aren't limited -- the ability-to-repay rules require, well, the lender to prove the borrower's ability to repay the loan, regardless of the presence of these features.

Let's get back to the risk layering that we started this unit with. The proper way to mitigate the many risks of nontraditional mortgage products is to offset the risks with more rigorous standards. For instance, if a borrower has a high debt-to-income ratio, the lender must be able to mitigate that risk with, say, extensive assets. But instead, what lenders did with nontraditional mortgage products was add risk on top of risk, and charge higher fees for the products. Charging extra fees may have greased the way for lenders to feel better about offering the product up front, but it did nothing to offset the risk of the borrower's default. Or, for that matter, the lender's risk of default, a few years down the line.

PAGE 3: MOD6_OVERENC (4 MIN)

OVER-ENCUMBERED

Simultaneous second-lien loans

"Simultaneous second-lien loans result in reduced owner equity and higher credit risk. Historically, as combined loan-to-value ratios rise, defaults rise as well. A delinquent borrower with minimal or no equity in a property may have little incentive to work with the lender to bring the loan current to 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 owner equity should generally not have a payment structure that allows for delayed or negative amortization."

Piggyback loans were common during the Boom. Many borrowers sought to avoid paying private mortgage insurance on conventional loans, and opted to get simultaneous seconds. With so little invested in the property,

borrowers had little insulation against price fluctuations -- especially ones as violently corrective as we had after the housing bubble burst. Millions of borrowers lost all of their equity, and went underwater.

With standard HELOCs, the risk is based on the overreliance on collateral. On the one hand, the borrower is able to tap into equity ? on the other, the equity depletes, and the borrower is exposed to economic shocks.

Several studies by various Federal Reserve Banks point to negative equity as a significant factor in a borrower's decision to walk away from their homes. [Payment Size, Negative Equity and Mortgage Default, the Federal Bank of New York; The Depth of Negative Equity and Mortgage Default Decisions, Federal Reserve Board of Governors]

"WATCH YOUR ASSETS"

"While sale of loans to third parties can transfer a portion of the portfolio's credit risk, an institution continues to be exposed to reputation risk that arises when the credit losses on sold loans or securitization transactions exceed expected losses. In order to protect its reputation in the market, an institution may determine that it is necessary to repurchase defaulted mortgages. [...] Institutions involved in securitization transactions should consider the potential origination-related risks arising from nontraditional mortgage loans, including the adequacy of disclosures to investors."

While this is not itself a type of nontraditional mortgage product, the secondary market demands for mortgage products -- any, and all, and ever more nontraditional mortgage product! -- played a role in how lenders treated nontraditional mortgage programs. Securitization was the underlying drive behind it. The risk of these nontraditional mortgage products was diluted by the flow of the money downstream, away from the lender. Risk layering would not have happened to the same degree if lenders had stake in the mortgages they made. Look around the market today, for evidence. These products haven't disappeared altogether. Ask enough loan originators and someone knows someone who can do almost any type of nontraditional, or even subprime, mortgage loan. But they aren't being sold to Fannie Mae or Freddie Mac, and Wall Street isn't quite ready to take on that task again (or rather, yet.)

Securitization was part of the reason nontraditional risk was what it was. It is a matter of degree, and regulation. The more demand for something, such as nontraditional mortgage products, the more suppliers will scramble to make it. If Newton had made a first law of mortgages, this would be it: a market in motion stays in motion unless acted upon by a force ? in this case, regulators. The ability-to-repay rules effectively draw a line in the sand for what Fannie and Freddie (or their successor) will buy. And there goes most of the demand.

PROTECT THE CONSUMER

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 near-term monthly payment affordability, and consumers have been encouraged to select nontraditional mortgage products based on the lower monthly payments that such products permit compared with traditional types of mortgages. In addition to apprising consumers of the benefits of nontraditional mortgage products, institutions should ensure that they also appropriately alert consumers to the risks of these products, including the likelihood of increased future payment

obligations. Institutions should also ensure that consumers have information that is timely and sufficient for making a sound product selection decision."

The last risk, and perhaps the first risk, of nontraditional mortgage products is its effect on consumers. Consumers, who, it's true ? ought to know better than to sign something which indentures them to a property under terms they cannot pay. However ? if they ought to know that, lenders and loan originators similarly ought to know that they are also responsible for the products and services they sell. The nature of the product and service must be disclosed to make it a fair, and equitable transaction. Unfortunately, asymmetry of information is often the norm with financial products and services. Mortgages ? even traditional 30-year fixed mortgages, but especially nontraditional mortgages that change in function and form from month to month -- are complex. The function of disclosures is to unravel the complexity so parties on both sides can agree to the same terms, for the same product.

Since the Agencies released this guidance, myriad disclosure laws have been passed, mostly involving the Truth-inLending disclosures and the Good Faith Estimate. The Dodd-Frank Wall Street Reform and Consumer Protection Act also established several new disclosure requirements, and the Consumer Financial Protection Bureau to advocate on behalf of and inform consumers.

Since so many of these changes to protect consumers are pending, and the mortgage market is still recovering, it remains to be seen how nontraditional mortgage products will fare in the coming years.

UNIT 2: INTRODUCING ARMS (15 MIN)

PAGE 1: MOD6_ARM1 (4 MIN)

In this unit, you'll learn about:

the history of the adjustable rate mortgage in the United States; and how adjustable rate mortgages work.

THE BIRTH OF THE ADJUSTABLE RATE MORTGAGE

In the United States, the most common type of home financing is the 30-year fixed rate mortgage (FRM). Up until the early 1980s, the fixed rate mortgage was just about the only type of mortgage available to borrowers. Adjustable rate mortgages (ARMs) were not (yet) authorized by the federal regulators.

At the time, the main sources of mortgage funds were financial entities known as savings-and-loans. Savings-andloans operated by offering depositors interest on their deposits (that's the "savings" part), and in turn using the deposits to lend mortgage money at slightly higher interest rates (the "loans" part) than those paid to the depositors. For instance, the savings-and-loans would pay a 5.5% interest rate to depositors, and then turn around and charge 6.5% to a mortgage borrower for a 30-year fixed rate mortgage. The savings-and-loans kept the spread between the two interest rates as profit, and continued the savings-and-loan cycle.

Prior to the 1980s, federal laws prohibited savings-and-loans from dabbling in other types of consumer finance, so their sole source of income was mortgage lending. (The one-stop-shop mega banks we're so familiar with today were unlawful then.) Thus, by their very structures, savings-and-loans were highly dependent on depositors' funds as a source of funds to make loans and stay in business.

However, as we've stated, the loans made were 30-year fixed rate mortgages. A lender making a 30-year fixed rate mortgage is making a commitment to lend money at a fixed interest rate over a long period of time. Depositors, on the other hand, were being paid interest rates at market rates. Everything worked fine for the savings-and-loans while their expenses (the interest paid on deposits) were less than their income (interest rate charged on mortgage loans), but it left savings-and-loans highly vulnerable to interest rate fluctuations. Congress attempted to mitigate this vulnerability in 1966 by placing caps on the amount of interest a savings-and-loan was able to pay to depositors. They set this cap higher than the cap placed on commercial banks to encourage depositors to place their money with savings-and-loans, to ensure the mortgage money continued to flow.

Then, economic conditions in the `70s drove inflation sky-high. Savings-and-loans remained restricted by the interest rate cap. Other financial companies which were not subject to interest rate caps set by the federal government paid true market level interest. Savings-and-loans depositors began pulling funds from savings-andloans in droves, to place their funds in higher-yield investments.

In an attempt to save the moribund savings-and-loans, Congress and regulatory agencies did two things in the early 1980s:

passed the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA), which: o allowed savings-and-loans to diversify their investments, i.e., make money through means other than 30-year fixed rate mortgages; and o removed interest rate caps on depositor funds; and

adopted regulations allowing savings-and-loans to offer adjustable rate mortgage (ARMs).

In contrast to fixed-rate mortgages, ARMs allowed lenders to float interest rates to the market after a certain amount of time. By allowing mortgage rates to change according to the market, ARMs shifted inflationary and economic risk from the savings-and-loan to the borrower. Regulators hoped this would equalize the expenses and incomes of savings-and-loans, and pull them out of the red.

It didn't work. Ultimately, savings-and-loans went the way of the dodo; but the ARMs remained. From 1980s and onwards, the ARM has been available to consumers. It has largely been as deleterious to uninformed borrowers as it was ineffective in rescuing savings-and-loans.

Editor's note -- The impact of ARMs on borrowers has been memorialized in some colorful language over the years. Veteran loan originators may remember when ARMs were called "topless mortgages" as it seemed their ceiling rates were set so high as to be meaningless. Other equally colorful names included the "Reverse Interest and Principal for Optimum Fast Foreclosure (RIPOFF) loan" and the "Zero Ability to Pay (ZAP) loan."

The face of the ARM has changed over the years, most markedly during the Millennium Boom.

20 years after ARMs became part of the American mortgage landscape, the housing market was experiencing an unprecedented boom. Fueled by low interest rates and speculative fever, housing prices were skyrocketing. Mortgage lending standards are lax, in part due to demand from investors for ever more securitized mortgages, and in part due to the hubristic belief that prices would always rise, and therefore the collateral (the property), rather than the borrower, would carry the loan.

When demand for mortgages peaked in mid-2005, Wall Street had perfected its vertically expanded system for gathering, bundling and reselling mortgages through the MBB market to millions of investors worldwide. Of course, all these bonds were dependent on new mortgages. The most infamous of these new mortgage products

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