Wrong Borrowers Using Option ARMs, OCC Warns

Comptroller of the Currency John C. Dugan addressed option ARMs Thursday at a conference for the Consumer Federation of America.

“In the last two years, we have seen a spike in the volume of payment-option ARMs, which are no longer largely confined to well-heeled borrowers who can clearly afford them,” Dugan said in a prepared remarks statement. “Increasingly, they are being mass marketed as ‘affordability products’ to borrowers who appear to be counting on the fixed period of exceptionally low minimum payments — typically lasting the first five years of the loan — as the primary way to afford the large mortgages necessary to buy homes in many housing markets across the country.

“And as the loans become more popular, the prospect of using them to penetrate the subprime lending market cannot be far behind.”

Option ARMs let borrowers decide whether they want to make a minimum monthly payment that is less than the monthly interest due — causing the principal loan balance to increase. But until recently, these exotic programs were primarily only available to a narrow group that included borrowers with strong credit who use the loan as a ‘cash management’ tool and generally “had the wherewithal and sophistication to handle temporary periods of negative amortization without jeopardizing their ultimate repayment of principle,” the statement read.

“Too many consumers have been attracted to products by the seductive prospect of low minimum payments that delay the day of reckoning, but often make ultimate repayment of growing principal far more difficult,” Dugan said.

Other than an increasing principal balance, the comptroller said the fundamental problem with payment-option ARMs is payment shock.

In the case of a typical $360,000 payment-option ARM with an initial 6 percent interest, monthly payments could increase by 50 percent in the sixth year if interest rates do not change. In the event of just a two-percentage-point increase, monthly payments could double, according to the prepared remarks.

Negative amortization “loans raise substantial — and intertwined — consumer protection and safety and soundness issues,” the comptroller continued.

With some real estate markets softening recently, borrowers could face loan balances greater than value of the underlying properties — leaving them unable to refinance out of an Option ARM, he added.

Dugan questioned whether option ARMs were an appropriate loan for those borrowers who are only looking for a way to qualify for a larger loan. “And are lenders really prepared to deal with the consequences — including litigation risk — of providing such products in markets where real estate prices soften or decline, or where interest rates substantially increase?”

Federal bank and thrift regulatory agencies are working on guidance that will deal with negative amortization, among other issues, that “should draw clear lines about appropriate standards for qualifying borrowers for payment option ARMs that explicitly take into account potential payment shock,” the OCC reported. The guidance could be issued by year-end.

“Put another way, lenders should not encourage or accept applications from borrowers who clearly cannot afford the dramatically increased payments that are likely to result at the end of the five-year, low minimum payment period,” Dugan said. “Disclosures should also be clear, timely, and meaningful. And lenders should have very substantial controls in place to manage the potential risk of such loans.“