Comptroller Dugan Urges Improved Underwriting Standards on Third Party Loans

San Diego, CA—Comptroller of the Currency John C. Dugan said today that banks need to strengthen their underwriting standards, particularly on loans sold to third party investors.

"I am here to say that bank underwriting standards for these products, in many cases, moved too far away from what they would have been if the bank had held those loans on its own books," Mr. Dugan said in a speech to the American Bankers Association's Annual Convention.

Mr. Dugan noted the many positive aspects of the "originate-to distribute" model, but said there can be negative effects on underwriting standards, including relaxing significantly the incentives to use caution and prudence in underwriting loans sold to third parties.

"When a bank makes a loan that it plans to hold, the fundamental standard it uses to underwrite the loan is that most basic of credit standards that I've already talked about: the underwriting must be strong enough to create a reasonable expectation that the loan will be repaid," the Comptroller said. "But when a bank makes a loan that it plans to sell, then the credit evaluation shifts in an important way: the underwriting must be strong enough to create a reasonable expectation that the loan can be sold—or put another way, the bank will underwrite to whatever standard the market will bear."

Comptroller Dugan outlined what needs to be done. "I am here to say that banks need to strengthen their underwriting standards so that they move back towards the fundamental principle of maintaining a reasonable expectation that loans will be repaid, even if the loans are to be sold to third parties – and that goes for mortgage loans, leveraged loans, or any other syndicated credit," Mr. Dugan said.

Mr. Dugan said that securitization has brought tremendous liquidity to credit markets, and it has made it possible to accommodate a broader range of risk appetites, which in turn has benefited borrowers at every level. However, the "originate-to distribute" model has created real pressure to relax underwriting standards in a broad swath of credit products that banks provide and that underwriting for these products, in many cases, have moved too far away from what they would have been if the bank had held those loans on its own books, he said.

Comptroller Dugan said there are many reasons why banks should care about relaxed underwriting standards if sophisticated third parties are willing to assume the risk by purchasing loans including:

• Banks could be stuck holding a pipeline of weakly underwritten loans when markets seize up – as some banks have learned the hard way with leveraged loans over the last several months.
• Banks often retain some part of the risk when they sell loans to third parties, as is true in the syndicated loan markets.
• And reputation risk and concern for future market access may cause banks to take back loans or their risk in times of stress, as seen with some of the pools of subprime loans sold to third parties.

Mr. Dugan said that the OCC has already taken steps to address theses issues. Where subprime and nontraditional mortgage loans are originated for sale to the secondary market, "our examiners expect banks to use the guidance as their benchmark in not ceding underwriting standards to the third party purchasers of loans—they can deviate, but only so long as the risk differences are manageable."

"We have asked our large bank examiners to encourage agent banks to underwrite funding commitments in a manner that is reasonably consistent with the standards they would use if holding the loan on their own books," he said. "We have asked our examiners to review with banks the expectations we have set forth in existing supervisory guidance. We want examiners to communicate areas of noncompliance to bank management and, if appropriate, to cite them as Matters Requiring Attention in exam reports to achieve improvement in underwriting standards and risk management practices."

Mr. Dugan said there are a number of sound reasons for banks to avoid straying too far from sound underwriting, "and if that's a lesson that we take away from recent market disruptions, as simple as it sounds, then we will all have learned a great deal."

Related Links

• Remarks Before the American Bankers Association (PDF)
• Comptroller of the Currency John C. Dugan