December 1, 2005
Comptroller Dugan Expresses Concern about Negative Amortization
WASHINGTON – Comptroller of the Currency John C. Dugan expressed strong concern in a speech today about negative amortization in consumer loan products, particularly in the areas of credit cards and mortgages.
Mr. Dugan also took issue with the notion that national bank preemption has created a "regulatory gap" in consumer protection, citing the strong protections in federal law and the OCC's extensive enforcement powers and strong supervisory oversight, along with differences in state and federal regulation that result from federalism and the dual banking system.
In a speech to the Consumer Federation of America, Mr. Dugan said that negative amortization of consumer loans "raise substantial and intertwined consumer protection and safety and soundness issues.
"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," he added. "At the same time, too many lenders have been attracted to the product by the prospect of booking immediate revenue without receiving cash in hand, a process that often masks underlying credit problems that could ultimately produce substantial losses."
In a payment option mortgage, which allows the borrower to select from a menu of payment possibilities, the initial lower monthly payment means that less principal is being paid. As a result, the loan balance grows, or amortizes negatively until the sixth year when payments are adjusted to ensure the principal is paid off over the remaining 25 years of the loan.
In the case of a typical $360,000 payment option mortgage that starts at 6 percent interest, monthly payments could increase by 50 percent in the sixth year if interest rates do not change. If rates jump two percentage points, to 8 percent, monthly payments could double.
"Is this an appropriate product to mass market to customers who may be looking at the less than fully amortizing minimum payment as the only way to afford a larger mortgage – at least for the five years before the onset of payment shock?" Mr. Dugan asked. "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?"
The Comptroller said the federal bank and thrift regulatory agencies are working on guidance that will deal with negative amortization, among other issues. The guidance, which could be issued by the end of the year "should draw clear lines about appropriate standards for qualifying borrowers for payment option ARMs that explicitly take into account potential payment shock."
"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," he added. "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."
The Comptroller noted that the issue of negative amortization in mortgages is similar to an issue that arose in the credit card industry, where monthly payment requirements had been set so low that borrowers who paid the minimum might see their balances increase, even if they made no new charges.
Regulators responded by requiring that minimum payments be sufficiently large to amortize credit card loans over a reasonable period of time. Most banks are expected to be in compliance by the end of the year.
"We recognize that the change in required minimum payments will make it more difficult for some existing credit card borrowers to pay the full amount of the increased minimum payments due," the Comptroller said. "We have encouraged lenders to work with these borrowers to the maximum extent possible to avoid writing down the loan and cutting off the customer's credit."
Mr. Dugan said lenders have a variety of tools to do this, including restructuring or deferring payments and, in appropriate circumstances, re-aging accounts.
"In addition, lenders always have the option of reducing high interest rates charged to delinquent borrowers – sometimes exceeding 30 percent of the outstanding loan balance – and/or waiving fees in order to reduce a minimum payment while still amortizing a modest amount of the outstanding principal," he added.
In discussing the OCC's approach to consumer protection, Mr. Dugan noted that recently released data collected under the Home Mortgage Disclosure Act (HMDA) show that national banks and their operating subsidiaries made far fewer high cost loans than state-chartered lenders. That demonstrates that the OCC’s history of rigorous supervisory oversight has deterred lenders from using the national bank charter as the primary vehicle for higher-cost loans.
"We recognize our responsibility to enforce federal and applicable state laws for the national banking system, and we expect to be held accountable for how well we do that job," Mr. Dugan said. "The same should be true at the state level."
Mr. Dugan noted that there are thousands of non-bank lenders and brokers that are not subject to bank-like examination and supervision, and these institutions are commonly cited as a significant source of abusive lending practices. Consequently, the argument that states also should be allowed to enforce non-preempted state consumer protection laws applicable to national banks is wrong, Mr. Dugan said.
"Enforcement resources are not infinite. It makes no sense for both federal and state officials to focus their limited supervisory resources on redundant enforcement actions against nationally chartered banks or their subsidiaries, especially when those institutions are already extensively examined and supervised by the OCC," he added.
"Indeed, I worry that, if there is a gap, it is created when state resources are diverted from areas where problems are known to exist, and where state authorities clearly have jurisdiction to achieve corrective measures."