Mortgage Concepts is a recurring video series covering best practices and compliance education for California mortgage loan originators. This video discusses the elements of a nontraditional mortgage risk. For course credit toward renewing your NMLS license, visit

Guidance on Nontraditional Mortgage Product Risk

In 2006, the Federal Deposit Insurance Corporation (FDIC), and other federal government 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 same year, the Conference of State Bank Supervisors (CSBS) and the American Association of Residential Mortgage Regulators (AARMR) released parallel guidance for state regulators. This parallel guidance covers mortgage brokers and mortgage companies which are not federally regulated. In this article, we will refer to the federal agencies, the CSBS and the AARMR as the Agencies.

The 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 (now required by the Regulation Z ability-to-repay rules);
  • 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 follows.

The American Banker’s Association’s reaction to the interagency guidance:

“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.” Paul A. Smith, Senior Counsel for the American Bankers Association, March 29, 2006.

JPMorgan Chase Bank’s reaction to the interagency guidance:

“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.” Thomas L. Wind, Senior Vice President and CEO Chase Mortgage and Catherine Eckert, Senior Vice President and Sr. Credit Officer Chase Mortgage, March 29, 2006.

Lehman Brothers’ reaction to the interagency guidance:

“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.” Joseph Polizzotto, Managing Director and General Counsel, March 29, 2006.

Editor’s note — The quotes above are from 2006 and are each part of larger comment letters on the interagency guidance.  To read the complete responses, visit the FDIC’s website, and locate the Federal Register Citations — Comments on Interagency Guidance on Nontraditional Mortgage Products.

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) 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 (HELOCs);
  • home equity loans (HELOANs); 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 a provider 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… a provider’s qualifying standards should recognize the potential impact of payment shock, especially 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, a provider’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, assuming a fully amortizing repayment schedule.”

Excerpted from the CSBS/AARMR Guidance on Nontraditional Mortgage Product Risks

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 ability-to-repay and qualified mortgage rules have belatedly answered the Agencies’ call for ARMs to be underwritten on a fully-indexed rate and full amortization schedule. [12 Code of Federal Regulations §1026.43(c)(5)(i)]

Reduced documentation

“Providers 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, it is expected that a provider will 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, providers generally should be able to readily document income using recent W-2 statements, pay stubs, or tax returns.”

Excerpted from the CSBS/AARMR Guidance on Nontraditional Mortgage Product Risks

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.

Other risky factors

Reduced documentation

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.

“Providers 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 may be unfair and abusive. Providers that originate collateral-dependent mortgage loans may be subject to criticism and corrective action.”

Excerpted from the CSBS/AARMR Guidance on Nontraditional Mortgage Product Risks

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 placed a heavy dependency on the collateral. In recent years, the FHA has instituted additional borrower-based criteria for its reverse mortgages, the home equity conversion mortgages (HECMs). It also limited the total amount of money a HECM borrower is able to withdraw at once. This comes in response to data indicating many seniors were defaulting on their HECMs, or pulling out all of the equity only to find themselves unable to make the required insurance and property tax payments. In the case of reverse mortgages, a default means not just a few years’ worth of equity lost, but a lifetime’s.

The ability-to-repay requirements do not restrict negative amortization, interest-only payments or balloon payments. (Their 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 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 DTI, 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.


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.

Excerpted from the CSBS/AARMR Guidance on Nontraditional Mortgage Product Risks

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 third-party loan sales can transfer a portion of the [portfolio’s] credit risk, a provider remains exposed to reputation risk when credit losses on sold mortgage loans or securitization transactions exceed expectations. As a result, a provider may determine that it is necessary to repurchase defaulted mortgages to protect its reputation and maintain access to the markets.”

Excerpted from the CSBS/AARMR Guidance on Nontraditional Mortgage Product Risks

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 responsibility 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.