On June 29, 2007, the Federal Reserve and the other federal financial institutions regulatory agencies (the agencies) issued the attached final Statement on Subprime Mortgage Lending (Subprime Statement) to address issues and questions related to certain adjustable-rate mortgage (ARM) products marketed to subprime borrowers. This statement applies to all banks and their subsidiaries and bank holding companies and their nonbank subsidiaries. The attachment provides the Subprime Statement.
The Subprime Statement emphasizes the need for prudent underwriting standards and clear and balanced consumer information so that institutions and consumers can assess the risks arising from certain ARM products with discounted or low introductory rates. The statement is focused on these types of ARMs and uses the interagency Expanded Guidance for Subprime Lending (Expanded Guidance)1 issued in 2001 to determine subprime borrower characteristics. While the Statement is focused on subprime borrowers, the principles in the statement are also relevant to ARM products offered to non-subprime borrowers.
The risk management practices discussed in the Subprime Statement are generally consistent with existing interagency guidance regarding real estate lending, subprime lending, and nontraditional mortgage products.2 Like the nontraditional mortgage guidance issued in 2006, this Subprime Statement encourages institutions to evaluate the borrower’s repayment capacity and ability to repay the loan by final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule.3 Further, the Subprime Statement emphasizes that an institution’s assessment of a borrower’s repayment capacity should include an evaluation of the borrower’s debt-to-income ratio and states that this assessment should include total monthly housing-related payments (i.e., principal, interest, taxes, and insurance).
The Subprime Statement also emphasizes the risks of stated income or reduced documentation loans in the subprime sector and indicates institutions should document any factors relied upon to mitigate the risk inherent in extending such loans. Such factors could include a borrower’s favorable payment performance or substantial liquid reserves. A higher interest rate is not considered an acceptable mitigating factor. The statement emphasizes the importance of an institution verifying and documenting a borrower’s income in order to adequately analyze repayment capacity, particularly for subprime borrowers. Typically, an institution should be able to readily document income using a borrower’s recent W-2 statements, pay stubs, or tax returns. In addition, institutions should develop strong control systems to monitor whether actual practices are consistent with internal policies and procedures, and to ensure appropriate corrective action in the event the institution fails to comply with applicable laws, regulations, internal policies, and third-party agreements.
The Subprime Statement reiterates the principles in the interagency Statement on Working with Borrowers (April 2007) in which the agencies encouraged institutions to work constructively with residential borrowers who are in default or whose default is reasonably foreseeable. Both documents indicate that 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. The Federal Reserve will not criticize institutions that pursue reasonable workout arrangements with borrowers.
The Subprime Statement outlines certain aspects of the covered lending practices that are considered predatory in nature and provides that institutions should not engage in these practices regardless of loan features. Further, the Subprime Statement clarifies that subprime lending is not synonymous with predatory lending and, therefore, there is no presumption that the ARM products discussed in the Subprime Statement are predatory in nature.
The Subprime Statement states that institutions should ensure that communications with consumers, including advertisements, oral statements, and promotional materials provide clear and balanced information about the relative benefits and risks of the products offered. These communications should provide information about the costs, terms, features, and risks of the loan to the borrower, and should be provided in a timely manner, to assist consumers during the product selection process. Communications should include information on payment shock, prepayment penalties, balloon payments, cost of reduced documentation loans, and responsibility for taxes and insurance. With respect to prepayment penalties, borrowers should be provided a reasonable period of time (typically, at least 60 days prior to the reset date) to refinance without penalty.4
Federal Reserve examiners are expected to carefully review for the risk management and consumer compliance concerns contained in this guidance as a part of ongoing examination activities. Examiners will take action against institutions that exhibit predatory lending practices, violate consumer protection or fair lending laws, engage in unfair or deceptive acts or practices, or otherwise engage in unsafe or unsound lending practices.
Federal Reserve Banks are asked to distribute this letter and the interagency statement to banking organizations supervised by the Federal Reserve, as well as to their own supervisory and examination staff. For questions concerning the safety and soundness sections of this guidance, please contact in the Board’s Division of Banking Supervision and Regulation: Sabeth Siddique, Assistant Director, at (202) 452-3861; Virginia Gibbs, Senior Supervisory Financial Analyst, at (202) 452-2521; or Brian Valenti, Supervisory Financial Analyst, at (202) 452-3575. For questions related to consumer disclosure practices or predatory lending considerations, please contact Kathleen Ryan, Counsel, or Jamie Goodson, Attorney, at (202) 452-3667 in the Board’s Division of Consumer and Community Affairs.