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Lender Letter 03-07, Updates in Response to Statement on Subprime Lending

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Lender Letter 03-07, Updates in Response to Statement on Subprime Lending Date: August 15, 2007 To: All Fannie Mae Single-Family Mortgage Sellers and Servicers Subject: Lender Letter 03-07 Updates in Response to Statement on Subprime Mortgage Lending Introduction On June 29, 2007, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision and the National Credit Union Administration (collectively referred to as the Federal Banking Agencies) jointly issued the Statement on Subprime Mortgage Lending (the Statement). 1 The Statement applies to all institutions regulated by the Federal Banking Agencies, and was effective upon publication. In addition, the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators developed comparable model guidance, and encourage state agencies that regulate mortgage lenders and brokers to adopt the model guidance and apply it to those entities not already subject to the Statement. The Federal Banking Agencies issued the Statement to address concerns with certain subprime mortgage lending practices. The Federal Banking Agencies are concerned that subprime borrowers may not fully understand the risks and consequences associated with these products that may cause payment shock. In particular, the Federal Banking Agencies are concerned with certain adjustable-rate mortgage (ARM) products offered to subprime borrowers, including mortgage loans with: − Low initial payments based on a fixed introductory rate that expires after a short period and then adjusts to a variable index rate plus a margin for the remaining term of the loan; − Very high or no limits on how much the payment amount or the interest rate may increase (payment or rate caps) on reset dates; and/or − Limited or no documentation of borrowers’ income. 1 72 FR 37569 - 2 - The Office of Federal Housing Enterprise Oversight (OFHEO), our safety and soundness regulator has directed Fannie Mae to take action consistent with the practices referenced in the Statement. As a result, Fannie Mae is applying the provisions of the Statement to short- term adjustable-rate mortgages (ARMs), as defined by the seller, that are identified by the seller as subprime and that are either sold to Fannie Mae pursuant to Fannie Mae’s Single- Family Subprime bulk acquisition business or back subprime private label securities purchased by Fannie Mae. Such loans are referred to as Covered Mortgage Loans. This Lender Letter outlines requirements for Covered Mortgage Loans, and includes an additional representation and warranty. Updates in Response to the Guidance The Statement covers four areas: • Risk Management, which includes predatory lending considerations and underwriting standards; • Workout Arrangements; • Consumer Protection Principles; and • Control Systems. Risk Management The Statement outlines practices to ensure that the additional risks associated with Covered Mortgage Loans are appropriately managed. This includes a discussion on Predatory Lending Considerations and Underwriting Standards, as more fully detailed below. We expect a seller to use prudent, sound and responsible business practices in its marketing, origination, and servicing efforts, and the seller’s operating policies and procedures should provide for an effective means of identifying and avoiding predatory lending practices. Underwriting standards should confirm that the borrower has a reasonable ability to make the mortgage payments and is likely to do so in a manner that will enable him or her to successfully maintain homeownership. Predatory Lending Considerations In accordance with the Statement, institutions should ensure that they are not engaging in certain practices that typically constitute predatory lending, including the following: • Making mortgage loans based predominantly on the foreclosure or liquidation value of a borrower’s collateral rather than on the borrower’s ability to repay the mortgage according to its terms; • Inducing a borrower to repeatedly refinance a mortgage loan in order to charge high points and fees each time the mortgage loan is refinanced (“loan flipping”); or • Engaging in fraud or deception to conceal the true nature of the mortgage loan obligation, or ancillary products, from an unsuspecting or unsophisticated borrower. - 3 - Underwriting Standards Pursuant to the Statement, mortgage loan underwriting standards should recognize the potential effect of payment shock in evaluating a borrower’s ability to repay a Covered Mortgage Loan. All Covered Mortgage Loans must adhere to the following requirements of the Statement. • An analysis of a borrower’s repayment capacity must include an evaluation of the borrower’s ability to repay the debt by its final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule. The fully indexed rate generally equals the index value prevailing at the time of underwriting plus the applicable margin that will apply after the expiration of any introductory interest rate period. The fully amortizing payment schedule must be based on the term of the mortgage loans. • The assessment of a borrower’s repayment ability is particularly important if a seller relies upon reduced documentation or allows other forms of risk-layering. When risk- layering features are combined with a Covered Mortgage Loan, the seller must demonstrate the existence of effective mitigating factors that support the seller’s underwriting decision and borrower’s repayment capacity, and the seller must have clear policies governing the use of risk-layering features. Sellers should not rely solely on one factor to compensate for the risk, but instead should consider a combination of mitigating factors, such as the borrower’s credit score, the loan-to-value ratio, the borrower’s level of reserves and/or liquid assets and, as applicable, the borrower’s prior mortgage payment history. • Recognizing that loans to subprime borrowers present elevated credit risk, sellers should verify and document the borrower’s income (both source and amount), assets and liabilities, unless there are mitigating factors that clearly minimize the need for direct verification of repayment capacity. Reliance on these mitigating factors should be documented. Mitigating factors include situations where the borrower has substantial liquid reserves or assets that demonstrate repayment capacity and can be verified and documented by the seller. • The Statement references the debt-to-income ratio (DTI) as a typical method of assessing a borrower’s repayment ability. An institution’s analysis of a borrower’s DTI must include the total monthly housing-related payments, calculated to include not only principal and interest, but also taxes and insurance, as a percentage of gross monthly income. Workout Arrangements The Federal Banking Agencies issued a Statement on Working with Borrowers in April 2007 that encourages institutions to work constructively with residential borrowers who are financially unable to make the contractual payment obligations on their mortgage loans. 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. - 4 - Fannie Mae requires servicers to have policies that support borrowers’ efforts to meet their mortgage obligations so they can avoid foreclosure and retain their homes when feasible. Decisions to begin, continue or recommend foreclosure action should be made only after the servicer’s investigation and analysis supports a conclusion that foreclosure is appropriate and is the only alternative under the circumstances. Consumer Protection Principles The Statement reiterates the importance of providing adequate disclosure to the borrower about the terms of the mortgage loan, including both benefits and risks. Information provided to borrowers should clearly explain the risk of payment shock, the ramification of prepayment penalties, balloon payments, the cost of obtaining a reduced documentation loan, and the consequences of not establishing an escrow accounts for taxes and insurance, as applicable. Fannie Mae expects sellers to comply with the provisions of the Statement that relate to Consumer Protection Principles for all Covered Mortgage Loans. Prepayment Penalties In accordance with the Statement, prepayment penalties should be adequately disclosed to the borrower, and should not be applicable following the initial reset date of the Covered Mortgage Loan. The borrower should be provided a reasonable period of time (typically 60 days prior to the reset date) to refinance without penalty. Escrow Account Requirements Fannie Mae advocates the establishment of an escrow accounts for the payment of taxes and insurance. If an escrow account is not established, we encourage sellers to provide a disclosure to all borrowers advising them of the requirement to make payments for real estate taxes and insurance in additional to their loan payments, and the fact that taxes and insurance costs can be substantial. Control Systems The Statement directs institutions to develop strong control systems to monitor whether actual practices are consistent with their policies and procedures. This includes compliance with applicable laws and regulations, appropriate criteria for hiring and training loan personnel, entering into and maintaining relationships with third parties and conducting initial and ongoing due diligence on third-parties. Institutions
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