Fed Governor Bies Jawboning Lenders

From Reuters:
US regulators to issue bank market risk rules-Bies

Bies also reiterated concerns U.S. regulators have about the proliferation of non-traditional mortgage products, such as interest-only loans, and the easing of underwriting standards.

"While the credit quality of residential mortgages generally remains strong, the Federal Reserve and other banking supervisors are concerned that current risk-management techniques may not fully address the level of risk inherent in nontraditional mortgages, a risk that would be heightened by a downturn in the housing market," she said.

She also discussed proposed guidance on commercial real estate lending, which she said should be finalized within the "next several weeks."

The transcript of this speech is available here:
Supervisory Perspective on Current Bank Capital, Market Risk, and Loan Product Issues

Over the past few years, the agencies have observed an increase in the number of residential mortgage loans that allow borrowers to defer repayment of principal and, sometimes, interest. These loans, often referred to as nontraditional mortgage loans, include "interest-only" (IO) mortgage loans, on which the borrower pays no loan principal for the first few years of the loan, and "payment-option" adjustable-rate mortgages (option ARMs), for which the borrower has flexible payment options--and which could also result in negative amortization.

IOs and option ARMs are estimated to have accounted for almost one-third of all U.S. mortgage originations in 2005, compared with less than 10 percent in 2003. Despite their recent growth, however, these products, it is estimated, still account for less than 20 percent of aggregate domestic mortgages outstanding of $8 trillion. While the credit quality of residential mortgages generally remains strong, the Federal Reserve and other banking supervisors are concerned that current risk-management techniques may not fully address the level of risk inherent in nontraditional mortgages, a risk that would be heightened by a downturn in the housing market.

Mortgages with some of the characteristics of nontraditional mortgage products have been available for many years; however, they have historically been offered to higher-income borrowers. More recently, they have been offered to a wider spectrum of consumers, including subprime borrowers, who may be less suited for these types of mortgages and may not fully recognize the embedded risks. These borrowers are more likely to experience an unmanageable payment shock during the life of the loan, meaning that they may be more likely to default on the loan. Further, nontraditional mortgage loans are becoming more prevalent in the subprime market at the same time risk tolerances in the capital markets have increased. Banks need to be prepared for the resulting impact on liquidity and pricing if and when risk spreads return to more "normal" levels and competition in the mortgage banking industry intensifies.

Supervisors have also observed that lenders are increasingly combining nontraditional mortgage loans with weaker mitigating controls on credit exposures--for example, by accepting less documentation in evaluating an applicant's creditworthiness and not evaluating the borrower's ability to meet increasing monthly payments when amortization begins or when interest rates rise. These "risk layering" practices have become more and more prevalent in mortgage originations. Thus, while some banks may have used elements of the product structure successfully in the past, the easing of traditional underwriting controls and sales of products to subprime borrowers may have unforeseen effects on losses realized in these products.

Caveat Emptor!
Grim

Hat tip goes out to Calculated Risk for this piece..