Gov't Warns on Risky Mortgage Products

U.S. bank regulators on Tuesday recommended that mortgage lenders take caution with innovative new mortgage products that may strain the finances of borrowers and banks as interest rates rise.

"While innovations in mortgage lending can benefit some consumers, the agencies are concerned that these practices can present unique risks that institutions must appropriately manage," bank regulators said in a statement accompanying the proposal.

The guidance targets interest-only and payment option adjustable rate mortgages and the practice of pairing exotic loans with second mortgages and reduced documentation for borrowing.

The proposal was issued by the Office of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corp., the Office of Thrift Supervision and the National Credit Union Administration.

Regulators proposed that banks assess a borrower's ability to repay a loan with the higher rates and balances that kick in after an introductory "teaser" period.

They also called on banks to be sure they have adequate capital and loan loss reserves on hand as buffers against potential losses because such loans are untested in a "stressed environment."

The agencies further said banks should make certain borrowers have sufficient information to understand loan terms and risks.

Financial institutions have two months to comment on the proposals.

Interest-only mortgages, in which the borrower pays only the interest due, and option adjustable-rate mortgages, which allow borrowers to pay less than the interest due, have joined adjustable rate mortgages as ways borrowers can reduce monthly payments when they buy a house.

Some lenders are waiving detailed documentation to speed the borrowing process. Lenders are also approving second loans simultaneously to keep the primary mortgage under the rate cap for loans that can most easily be sold into secondary markets, thus ensuring a lower interest rate.