As the mortgage and foreclosure crisis continues, federal and state regulatory agencies have attempted to provide key guidance to all financial institutions, including credit unions, in an effort to help them and their borrowers better understand the realities and risks of sub-prime lending activities. Questions regarding this guidance are addressed below.
Q: What is considered sub-prime lending and what is the major concern?
A: Generally, sub-prime lending is the practice of extending credit to borrowers who have weak credit histories (delinquent payments, charge-offs, judgments, bankruptcies) or reduced payment capacity represented by high debt ratios or low credit scores. These are legitimate loans, however, these factors may increase the risk of non-payment to the lender, resulting in default and foreclosure. This is especially true if the borrower experiences a job layoff or other situations that place a strain on the borrower’s financial resources.
Q: What kinds of sub-prime loan features and other practices contribute to the mortgage foreclosure crisis?
A: Mortgage loans with one or more of the following characteristics:
- Low initial fixed, introductory, short-period payments that adjust to a variable index rate plus a margin for the remaining term of the loan;
- Very high payment-amount or no interest-rate cap limits 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 repayment penalties that extend beyond the initial fixed interest rate period.
Adjustable rate mortgages (ARMs), are designed to reset their rates to higher levels thus potentially resulting in payment amounts that are beyond the abilities of borrowers to repay. Borrowers may not fully understand these loan features as well as the risks and consequences of obtaining products that can result in payment shock.
Q: Do the regulatory agencies require special handling of these riskier loans?
A: Yes. The Agencies require credit unions (and banks) engaging in sub-prime lending activities to have clear risk management practices to adequately manage the risks associated with these products including adequate underwriting standards and control systems adherance to consumer protection principles and prudent workout arrangement policies.
“Adequate Underwriting Standards” — Strong loan policies and prudent underwriting standards and practices for all real estate lending, but especially for riskier sub-prime lending programs that guard against the additional risks as well as the potential for predatory lending practices. Prudently written real estate loans should reflect all relevant credit risk factors. Agencies are expecting financial institutions to take stronger steps to verify the borrower’s ability to repay the debt by its final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule; use debt-to-income ratios properly; and verify and document the borrower’s income (source and amount), assets and liabilities. Not verifying and adequately documenting sources of income (i.e. stated income) should be used only if factors exist, which clearly minimize the need for direct verification.
“Control Systems” — Systems to monitor whether credit unions’ actual practices are consistent with their policies and the procedures that address compliance and consumer information concerns, safety and soundness, appropriate criteria for hiring and training loan personnel, third party relationships and compensation systems that encourage sound underwriting and consumer protection principles. Appropriate corrective actions should be included in the event of failure to comply.
“Consumer Protection Principles” — Fundamental consumer protection principles including approving loans based on the borrower’s ability to repay the loan according to its terms; and providing clear and balanced information that enables consumers to understand material terms, costs, and risks of loan products (i.e. payment shock, prepayment penalties, balloon payments, reduced documentation or stated income program pricing premiums and the lack of tax and insurance escrows) at a time that will help the consumer select a product.
“Workout Arrangement Policies” — The Agencies encourage credit unions to consider prudent workout arrangements, following prudent underwriting practices. They note that they will continue to examine and supervise financial institutions according to existing standards, but will not penalize those that do so and also identify and report credit risk, maintain an adequate allowance for loan losses, and recognize credit losses in a timely manner. Delinquent borrowers should be informed about the availability of homeownership counseling under the Homeownership Counseling Act and that loans involving service members are governed by the Servicemembers Civil Relief Act (SCRA).
Regulatory Affairs
