By the Division of Banks

December 10 , 1997

TO: Chief Executive Officer of Each State-Chartered Financial Institution and Each Licensed Mortgage Lender/Broker and Small Loan Agency

SUBJECT: Subprime Lending

Recently, the Division of Banks (Division) has reviewed the growing practice known as "subprime" lending. The practice of subprime lending is generally when a lender grants a mortgage or other consumer loan to an applicant who often does not meet standard underwriting criteria, either because of previous late payments, bankruptcy filings, or an insufficient credit history. These loans are also priced according to risk with higher interest rates or higher fees than a standard credit product. It is important to distinguish between subprime lending and predatory lending. Predatory mortgage lending is extending "credit to a consumer based on the consumer's collateral if, considering the consumer's current and expected income, ...the consumer will be unable to make the scheduled payments to repay the obligation." 1 Predatory lending is a prohibited illegal act and practice and will not be tolerated by the Division. 2 Predatory lending can also have a destabilizing affect on low- and moderate-income neighborhoods.

I am writing this letter today for several reasons. First, the Division has seen an increase in the number of institutions 3 offering subprime loans. Given increased competition for sources of profits and the higher rates and fees associated with subprime loans, this growth is likely to continue. In addition, there has been an increase in the number of violations cited in examination reports relative to this type of activity as well as an increase in the number of consumer complaints received by the Division. Engaging in subprime lending presents two broad concerns for the Division: (1) issues related to safe and sound lending practices, and (2) consumer protection and compliance issues.

Safety and Soundness Issues

The risks associated with subprime lending and investing are considerable and can have serious ramifications on an institution's financial safety and soundness. This fact is evidenced by the many institutions that are experiencing unexpected losses due to a failure to recognize and manage these risks properly. 4 Therefore, the Division expects that institutions which make a strategic decision to engage in subprime activities do so in a manner that is prudent and is commensurate with the experience and expertise of those who will be making the lending and investment decisions.

It is management's responsibility to ensure that adequate policies, procedures, and internal controls are in place prior to the commencement of any new activity. In addition, management must ensure that capital is adequate to absorb any losses due to a change in economic conditions or any unanticipated events. These requirements hold true particularly with the high risks that accompany subprime lending and investing. As such, an increased level of prudence is required.

First, management must identify the various forms of risk associated with subprime activities and must fully understand their potential impact on capital and earnings. One substantial risk associated with subprime lending is compliance risk (see below). The risk most inherent in subprime activity is default risk, which is compounded by the increased costs associated with managing and collecting problem credits. However, since most loans do not begin to default immediately after origination but rather later after they have "seasoned" over time, it is difficult to measure the true delinquency and default rates, particularly if an institution has a high proportion of new versus seasoned loans in its portfolio. 5 In addition, most subprime loans have been originated during robust economic conditions and have not been tested by a downturn in the economy. Management must ensure that the institution has adequate financial and operational strength to address these concerns effectively.

Second, management must create and implement sufficient controls for these risks. Many institutions use pricing models as a control measure to ensure that the level of income from subprime activities sufficiently compensates for the increased level of risk. However, results of these models vary significantly across the industry, as do the application of the results by management. Therefore, institutions are urged to continually test these pricing models to ensure that projections do not vary significantly from actual results. Furthermore, the increased risk of loan losses must be included in management's analysis of the adequacy of the allowance for loan and lease losses.

Third, management must establish internal limits to subprime activity to ensure that the institution remains within the parameters outlined in its strategic plan. Management has to develop lending and investment limitations that are consistent with the desired level of risk. Again, the limitations set by management must be made with consideration towards the financial strength of the institution coupled with the expertise of management to manage the increased risk.

Consumer Protection Issues

As stated above, predatory lending is an illegal credit practice. The Division will take aggressive action against any institution which engages in predatory lending.

Although subprime lending is legal, it often results in an increased likelihood of delinquency and the potential for increased consumer compliance violations and therefore requires institutions to take additional precautions. Lending to borrowers with past delinquencies or bankruptcies increases the chance of future delinquent payments. This forces the lender to spend additional resources collecting delinquent credits. Institutions must ensure that all debt collection practice laws and regulations are carefully followed and that consumers are aware of their rights under fair debt collection laws and regulations. 6

Subprime lending triggers the same consumer credit disclosures as all other similar types of lending. In the area of mortgage lending, management must ensure that adequate policies and procedures are in place to provide all applicable borrowers with full disclosures as prescribed by statute and regulation. This is particularly true in the area of broker/lender relationships. Institutions should review all policies and practices for compliance with the Real Estate Settlement Procedures Act (RESPA) regarding the payment of commissions to outside brokers. Mortgage brokers and those institutions compensating brokers must pay particular attention to the fee and point disclosure requirements of G.L. c. 183, § 63 as well as to RESPA and its provisions concerning disclosure of the payment of yield spread premiums. In addition, institutions cannot deny credit applicants because they decline to choose credit insurance and this information must be clearly disclosed to consumers. 7 Failure to provide adequate consumer disclosures will trigger remedial regulatory action by the Division.

Institutions should also review their pricing structures to ensure that they do not discriminate against individuals on a prohibited basis, or on the basis of the location of the property in violation of the Equal Credit Opportunity Act (ECOA), the Fair Housing Act (FHA), or Massachusetts anti-discrimination and anti-redlining statutes, including G.L. c. 151B and c. 183, s. 64. The practice of charging overages (charging a higher interest rate, origination fee, or number of points on a loan for certain borrowers than is charged for the same loan product to other borrowers in the same time period) is permitted unless the practice violates the ECOA or FHA. For example if members of a protected class under ECOA and FHA (including race, gender, age, etc.) are charged an overage more often than other borrowers, the lender would be in violation of ECOA and FHA unless the lender could show a legitimate nondiscriminatory business reason for the disparate treatment. Both the Federal Reserve Bank of Boston and the U.S Department of Housing and Urban Development have issued policy statements on the practice of overages. 8 Management should review all policies and pricing and compensation structures to ensure that these policies do not create a disparate impact, even on an unintentional basis. In addition, a review of Home Mortgage Disclosure Act (HMDA) data by the Federal Financial Institutions Examination Council indicates that minority applicants are almost twice as likely to seek a mortgage from a subprime lender as is a white borrower. For state-chartered banks and credit unions, subprime lending may also raise concerns regarding Community Reinvestment Act (CRA) compliance. 9

Institutions should be aware that certain questionable practices will be checked for and, if found, will be closely scrutinized during the Division's examination process. These include the following: repeated refinancing of loans and other debts, also known as "flipping"; high percentage of consumer acceptance of credit insurance; and unusually high debt-to-income ratios of borrowers. All cases of discrimination, or unfair or deceptive practices, will be referred to the appropriate law enforcement agency.

The Division has a strong interest in ensuring that consumers are treated fairly by the financial services industry. Many borrowers who refinance with a subprime loan have had past difficulties and seek to obtain funds in the hope of placing their financial matters in order. A subprime loan is often their only means to work toward reentering the financial mainstream. However, some borrowers who turn to the subprime lending markets are financially unsophisticated, or even desperate, and are less likely to comparison shop for the financing alternative which is best for their unique situation. Some borrowers have repeatedly refinanced their debts without improving, and in some cases having worsened their financial situation.

This raises the question of the suitability of a subprime loan for certain consumers. Even if an institution is in compliance with each of the above consumer protection laws and regulations and it underwrites loans on a safe and sound basis, its policies could still be considered unfair and deceptive practices. Unconscionable acts or practices are prohibited by G.L. c. 93A and the regulations of the Office of the Attorney General found at 904 CMR 3.00. One method of ensuring that consumers make informed choices in the credit transaction is the use of credit counseling. Credit counseling has been an effective means of preparing first-time homebuyers for the challenges of homeownership. First-time homebuyers who participate in pre-purchase counseling are also less likely to default on their loans than are buyers who have never had counseling. This type of credit counseling could also be appropriate for potential subprime borrowers. Therefore, the Division urges institutions engaging in subprime lending to consider referring borrowers to a credit counseling agency before accepting an application. As a result of such counseling, some borrowers may not refinance their loan. However, those consumers who do refinance their loans after having gone through credit counseling will be better informed and less likely to default and the institution will have performed an overall benefit.

The Division has zero tolerance for unsafe or unsound lending practices, violations of consumer protection laws and regulations, and discriminatory or unfair acts or practices. If your institution is engaged in subprime lending, the Division strongly recommends that you carefully review your underwriting policies to ensure that all risks have been identified and that there are adequate controls and limits to ensure sound lending practices and full compliance with consumer protection laws and regulations. In order to ensure that all policies are sound and fair, institutions are encouraged to consider self-testing or other internal controls.

If you have any questions, please feel free to contact me at (617) 956-1500.

Very truly yours,

Thomas J. Curry
Commissioner of Banks

1209 CMR 32.32(5)(a).
2See 940 CMR 8.00 and G.L. c. 183, s. 64.
3The use of the word "institutions" in this letter shall mean banks, credit unions, and licensed mortgage lenders and brokers and small loan agencies.
4Kathy R. Kalser & Debra L. Novak, "Subprime Lending: A Time for Caution," Federal Deposit Insurance Corporation, Regional Outlook, FDIC Boston Region, Third Quarter (Washington, DC: Federal Deposit Insurance Corporation, 1997) 3-5.
5 Kalser and Novak 5.
6 See 209 CMR 18.00 and 940 CMR 7.00.
7 G.L. c. 255, s. 12G.
8 lease see industry letter from E. Philip A. Simpson, Jr., Vice President, Federal Reserve Bank of Boston, "Equal Credit Opportunity Act and Fair Housing Act - Overages," May 26, 1994. Also see Mortgagee Letter 94-43 from Nicholas P. Retsinas, Assistant Secretary for Housing - Federal Housing Commissioner, U.S. Department of Housing and Urban Development, "Overages, Fair Lending, Tiered Pricing," September 29, 1994.
9 State-chartered banks and credit unions may be considering subprime lending for consideration under the CRA (G.L. c. 167, s. 14 and 209 CMR 46.00). Subprime lending would be considered to the extent that the institution is using the product to expand its use of flexible lending criteria within safe and sound banking practices. Subprime lending would not be considered if it is done on an unsafe or unsound basis or if the program results in disparate treatment.