Compliance Challenges from New Mortgage Products

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Compliance Challenges from New Mortgage Products

• Penny A. Paplanus
• Vice President - Compliance
• New Century Financial Corporation

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Introduction

• Alternative Products What are they???
• IO and Pay Option ARM
• Whats next?
• Federal Reserve BoardNontraditional proposed
  guidance
• Proposed Guidance on Consumer Disclosure
• Legal Risks
• Compliance with Federal Laws
• Compliance with State Laws
• Compliance with Investor Requirements
• Third Party Originations Control?
• Secondary

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Compliance Challenges from New Mortgage
Products-- Underwriting Considerations --

• Jack Konyk
• Senior Vice President, Regulatory and Compliance
  Manager
• National City

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Compliance Challenges from New Mortgage Products
/ Underwriting Considerations

• Proposed Interagency Guidance on Non-Traditional
  Mortgage Products
• Borrower repayment analysis, including debt
  service capacity
• Consideration of the effects of below market
  introductory rates
• Consideration of the effects of reduced, delayed
  or negative amortization
• Mitigation of reduced- or no-documentation
  qualification risk
• Avoidance of collateral-based lending
• Particular risks of non-traditional products in
  the sub-prime space
• Particular risks of non-traditional products for
  non-owner-occupied properties

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Compliance Challenges from New Mortgage Products
/ Underwriting Considerations

• What does that mean in the real world? Carefully
  make choices on
• Initial qualification based on
• Payment at initial rate
• Payment expected after first change date
• Payment at fully-indexed rate
• Payment at some other arbitrary rate / amount
• Additional analysis regarding future developments
• Second analysis step to estimate and evaluate
  capacity in the future
• What future developments to consider and evaluate
• Estimate expected payments at future points
  (beyond first change)
• Estimate expected income growth
• Estimate changes in overall debt load, or hold
  other debt static
• Create expectations based on worst-case
  scenarios, or most likely scenarios, or other
• What exit horizon underwriting standards are
  evaluating
• Ability of borrower to afford initial payment
  stream only
• Ability of borrower to afford expected payment
  streams to expected refinance

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Compliance Challenges from New Mortgage Products
/ Underwriting Considerations

• What does that mean in the real world? Carefully
  make choices on
• How far UP the risk curve your institution has
  the appetite to go
• How big a spread between fully-indexed and
  initial rates will you permit
• Will you permit negative amortization, and if so,
  how far
• As potential payment shock increases, will you
  require more documentation
• Will you use credit scores as a sole, primary, or
  contributing determinant
• How much will you be willing to pyramid risk
  factors
• High DTI
• High LTV
• Low credit score
• Reduced- or no-income verification (NIV or
  Stated versus NIQ)
• Number and extent of policy or guideline
  exceptions
• Non-standard properties
• What is your fallout tolerance
• Would you be willing to put the loan, as
  approved, into portfolio
• Is underwriting discipline the same for both
  pipeline and portfolio products
• Would you be comfortable facing the borrower for
  the full life of the loan

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Federal Reserve BoardNontraditional proposed
guidance

• Faith Schwartz
• Senior Vice President, Government, Housing and
  Industry Relations
• Option One Mortgage Corporation

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Overview

• OOMC
• Federal Financial Regulatory Agencies Proposed
  Guidance on Nontraditional Mortgage Products
• Guidance on Portfolio and Risk Management
  practices
• Industry feedback on guidance
• Market update
• OOMC risk management techniques

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9
Option One Mortgage Corporation

• Option One Mortgage Corporation
• Founded 1992, Subsidiary HR Block, Inc.
• Lending Channels Indirect and Direct
• Indirect, wholesale through brokers and through
  banks and financial institutions. Non-prime
  products , full service origination and
  servicing.
• Direct, retail through HR Block Mortgage, prime
  and non-prime products (retail will now report
  directly to HRB in 2006-7)
• Origination through December 2005, 44.6 Billion
• Servicing through December 2005, 79.4 billion
• Option One does not originate or purchase Option
  Arms
• Option One does originate interest only loans

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Portfolio and Risk Management PracticesProposed
Guidance

• Institutions should recognize that nontraditional
  mortgage loans are untested in stressed
  environment and should receive higher levels of
  monitoring and loss mitigation.
• Develop written policies
• Enhance performance measures and management
  reporting
• Establish appropriate ALLL levels considering
  credit quality and collectibility
• Maintain capital levels reflecting portfolio
  characteristics

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Portfolio and Risk Management PracticesProposed
Guidance

• Have policies that identify
• Acceptable levels of risk for nontraditional
  mortgage lending activity through operating
  practices, accounting procedures and policy
  exceptions for tolerances.
• Appropriate layering of risk and risk management
  tools for risk mitigations.
• Growth and volume targets with attention to rapid
  growth due to easing of terms.
• Concentration limits relating to third party
  originations, geographic area and occupancy to
  maintain portfolio diversification.

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Portfolio and Risk Management PracticesProposed
Guidance

• Regulators will review
• Deficient risk management controls and practices
  will be subject to elevated supervisory
  attention.
• Compensation structure that may result in higher
  concentrations of non-traditional loans.
• Controls
• Quality control, compliance and audit procedures
  should specifically target mortgage lending
  activities with higher risk attributes
• Regularly review performance on reduced doc loans
• Strong controls over accruals, servicing and
  collections

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Portfolio and Risk Management PracticesProposed
Guidance

• Third Party originations
• Institutions should have strong approval and
  control systems to ensure quality of third party
  origination.
• Controls should ensure that loans made through
  these third party channels reflect standards and
  practices in direct lending.
• Third party compliance with all applicable laws
  and regulations, with particular emphasis on
  marketing and borrower disclosure practices.
• Institutions must have the ability to track
  performance from third party originations.

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Portfolio and Risk Management PracticesProposed
Guidance

• Secondary market activity
• Comprehensive approach to risk management
• Guidance on when an institution repurchases a
  loan beyond its normal repurchase requirements
• Repurchases from an institution for reputation or
  business reasons are viewed as implicit recourse
  and as such, the portfolio of like loans would be
  required to maintain risk based capital for the
  entire portfolio or securitization.
• Management information reporting
• Systems should allow for extensive reporting
  based on origination, risk attributes,
  performance, and tracked against expectations
• Adjustment of risk practices and policies should
  follow as needed

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Portfolio and Risk Management PracticesProposed
Guidance

• Stress Testing
• Sensitivity analysis for nontraditional products
  based on rates, employment levels, economic
  growth and housing value fluctuations
• Capital and Allowance for Loan and Lease Losses
• Institutions should allow for appropriate
  allowances for estimated credit losses in
  portfolio. Due to lack of history, should
  increase performance uncertainty.
• Pools should be segmented in to like pools.
• Distinguish among risks where mortgage payments
  make only minimum payments versus additional
  payments
• Appropriate levels of analysis on valuing
  mortgage servicing rights according to GAAP with
  conservative assumptions

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Response from Industry

• Industry applauds the regulators for highlighting
  higher risk on nontraditional products but
  cautions on being too prescriptive on guidance.
• Concentration limits are not supported with
  strict limits by loan types, third party
  originations, geographic area, property
  occupancy, LTV and DTI.
• Recommend monitoring for loans with one or more
  of risk characteristic but not to immediately
  stop pipelines. Markets with varying sales
  channels may exceed specific limits but be offset
  by other portfolio risks in another area.
• Each institution may enjoy a variety of risk
  management limits that work appropriately for
  their business model and regulators should
  continue to work with their institutions on that.

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Response from Industry

• Controls
• There is a general agreement that there should be
  adequate controls and nontraditional mortgages
  may require more controls. There are some
  requests for clarification on what the controls
  look like as they related to loans sold without
  recourse.
• Third party origination
• Strong approval and control systems should be in
  place for quality of third party originations
• Specific concerns were shared with regulators
  over what they man by ensuring counterparties are
  originating in compliance with all applicable
  laws and regulations

18
Response from Industry

• Third party originations continued
• Particular emphasis was noted on third party
  marketing and compliance.
• Mortgage brokers and many loan correspondents are
  governed by state law and regulated by state
  agencies. Federally regulated institutions
  should not be held responsible for the actions of
  unrelated third parties who may be one of many
  counterparties.
• It may put regulated institutions at a
  disadvantage to non-regulated lenders for third
  party business (this is a concern across all
  guidance)
• Secondary Market Activity
• There is pushback on guidance that voluntary
  repurchase of loans constitutes implicit
  recourse.
• Suggestion to remove implicit recourse or an
  institution will be prohibited from buying back
  the loan for good reason due to holding the whole
  portfolio sold to an additional risk based
  capital standard.

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Indication of Market Activity

• UBS performance review of IO loans, March 27th
  information seminar
• The rise of FRM IO
• Inverted yield curve
• Rising house prices and declining housing
  affordability
• IO 5 yr. fixed rate delinquency in prime, alt a
  and non-prime, 2005, is lower than standard fixed
  rate product.
• Collateral profile and credit performance
• Higher in FICO scores, CA , and purchase
• Strong credit performance to date
• Stable to favorable performance outlook
• FRM IO mostly have long IO terms (5 to 10 years)
  and longer IO terms gtlower impact of payment
  shocks (especially for non-prime borrowers)

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Market activityOption One

• Offers interest only and does not offer Option
  arms (two very different products)
• Interest only-Developed in response to lack of
  affordable products, most demand in coastal high
  balance states.
• Introduced competing product with less perceived
  risk but as an option to meet borrower demand (40
  year am loan)
• Variety of product controls using DTI, LTV and
  FICO
• Rating agencies recognized lack of performance on
  IO products in non-prime and added 20-25
  multiple in coverage for uncertainty
• Companies offering IO product have a rate add
  on for this risk of performance
• What was once a substantial amount of portfolio,
  now in single digits of portfolio

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OOMC Risk Management Efforts

• Risk management efforts are numerous, some noted
  below
• Management reports, daily to monthly,
  performance reports, which are presented to the
  credit committee each month for review.
• Special plain language disclosures, re-disclosure
  on all brokered loans, and monitoring and
  control of product percentage as book of
  business.
• Production trend report
• Performance trend report
• Branch level performance trend report
• Loss and severity trend report
• Nationwide analysis economic report on housing
• Rating agencies also look to diversification of
  portfolio/pools and best execution of loans
  requires various limits and diversification of
  risk

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Proposed Guidance on Consumer Disclosure

• Michaela Albon
• Senior Vice President Senior Counsel
• Washington Mutual Bank
• Seattle, Washington

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Disclosure Provisions within the Proposed
Guidance

• Application of current Regulation Z
• Disclosures required by the FTC Act???
• Potential liability to lenders
• Proposal is overly vague
• Proposal provides no guidance with respect to
• assumptions
• Mandate worst case scenario?

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Best Practices

• Interest Only vs. Pay Option ARMs
• Additional consumer disclosure being made today
• Payment shock
• Potential for negative amortization
• Potential for balloon
• Federal Reserve Boards Initiative

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MBA LEGAL ISSUES/REGULATORY COMPLIANCE CONFERENCE

• Michael Brady OConnor
• Slaten OConnor, P.C.
• 105 Tallapoosa Street, Suite 101
• Montgomery, Alabama 36104
• Office [phone]
• Fax [phone]
• Email mbo_at_slatenlaw.com

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Compliance Challenges from New Mortgage
Products
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Guidance and Legal Risks
28
Checklist for New Mortgage Products

• Compliance with Federal Laws
• Compliance with State Laws
• Compliance with Investor Requirements
• Wholesale Lender Review of Broker Agreement and
  Guidelines

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Issues with Current Group of New Mortgage
Products
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Federal Oversight and Guidance
31
States Response to New Mortgage Products

32
Investors Response to New Mortgage Products
33
Industry Response
34
Litigation Risks
35
Questions from the Audience
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