This is the accessible text file for GAO report number GAO-06-1021
entitled 'Alternative Mortgage Products: Impact on Defaults Remains
Unclear, but Disclosure of Risks to Borrowers Could Be Improved' which
was released on September 20, 2006.
This text file was formatted by the U.S. Government Accountability
Office (GAO) to be accessible to users with visual impairments, as part
of a longer term project to improve GAO products' accessibility. Every
attempt has been made to maintain the structural and data integrity of
the original printed product. Accessibility features, such as text
descriptions of tables, consecutively numbered footnotes placed at the
end of the file, and the text of agency comment letters, are provided
but may not exactly duplicate the presentation or format of the printed
version. The portable document format (PDF) file is an exact electronic
replica of the printed version. We welcome your feedback. Please E-mail
your comments regarding the contents or accessibility features of this
document to Webmaster@gao.gov.
This is a work of the U.S. government and is not subject to copyright
protection in the United States. It may be reproduced and distributed
in its entirety without further permission from GAO. Because this work
may contain copyrighted images or other material, permission from the
copyright holder may be necessary if you wish to reproduce this
material separately.
Report to the Chairman, Subcommittee on Housing and Transportation,
Committee on Banking, Housing, and Urban Affairs, U.S. Senate:
United States Government Accountability Office:
GAO:
September 2006:
Alternative Mortgage Products:
Impact on Defaults Remains Unclear, but Disclosure of Risks to
Borrowers Could Be Improved:
Alternative Mortgage Products:
GAO-06-1021:
GAO Highlights:
Highlights of GAO-06-1021, a report to the Chairman, Subcommittee on
Housing and Transportation, Committee on Banking, Housing, and Urban
Affairs, U.S. Senate
Why GAO Did This Study:
Alternative mortgage products (AMPs) can make homes more affordable by
allowing borrowers to defer repayment of principal or part of the
interest for the first few years of the mortgage. Recent growth in AMP
lending has heightened the importance of borrowers’ understanding and
lenders’ management of AMP risks. This report discusses the (1) recent
trends in the AMP market, (2) potential AMP risks for borrowers and
lenders, (3) extent to which mortgage disclosures discuss AMP risks,
and (4) federal and selected state regulatory response to AMP risks. To
address these objectives, GAO used regulatory and industry data to
analyze changes in AMP monthly payments; reviewed available studies;
and interviewed relevant federal and state regulators and mortgage
industry groups, and consumer groups.
What GAO Found:
From 2003 through 2005, AMP originations, comprising mostly interest-
only and payment-option adjustable-rate mortgages, grew from less than
10 percent of residential mortgage originations to about 30 percent.
They were highly concentrated on the East and West Coasts, especially
in California. Federally and state-regulated banks and independent
mortgage lenders and brokers market AMPs, which have been used for
years as a financial management tool by wealthy and financially
sophisticated borrowers. In recent years, however, AMPs have been
marketed as an “affordability” product to allow borrowers to purchase
homes they otherwise might not be able to afford with a conventional
fixed-rate mortgage.
Because AMP borrowers can defer repayment of principal, and sometimes
part of the interest, for several years, they may eventually face
payment increases large enough to be described as “payment shock.”
Mortgage statistics show that lenders offered AMPs to less creditworthy
and less wealthy borrowers than in the past. Some of these recent
borrowers may have more difficulty refinancing or selling their homes
to avoid higher monthly payments, particularly if interest rates have
risen or if the equity in their homes fell because they were making
only minimum monthly payments or home values did not increase. As a
result, delinquencies and defaults could rise. Officials from the
federal banking regulators stated that most banks appeared to be
managing their credit risk by diversifying their portfolios or through
loan sales or securitizations. However, because the monthly payments
for most AMPs originated between 2003 and 2005 have not reset to cover
both interest and principal, it is too soon to tell to what extent
payment shocks would result in increased delinquencies or foreclosures
for borrowers and in losses for banks and other lenders.
Regulators and others are concerned that borrowers may not be well-
informed about the risks of AMPs, due to their complexity and because
promotional materials by some lenders and brokers do not provide
balanced information on AMPs benefits and risks. Although lenders and
certain brokers are required to provide borrowers with written
disclosures at loan application and closing, federal standards on these
disclosures do not currently require specific information on AMPs that
could better help borrowers understand key terms and risks.
In December 2005, federal banking regulators issued draft interagency
guidance on AMP lending that discussed prudent underwriting, portfolio
and risk management, and consumer disclosure practices. Some lenders
commented that the recommendations were too prescriptive and could
limit consumer choices of mortgages. Consumer advocates expressed
concerns about the enforceability of these recommendations because they
are presented in guidance and not in regulation. State regulators GAO
contacted generally relied on existing regulatory structure of
licensing and examining independent mortgage lenders and brokers to
oversee AMP lending.
What GAO Recommends:
As the Federal Reserve Board reviews existing disclosure standards, GAO
recommends that it considers revising federal requirements for mortgage
disclosures to improve the clarity and comprehensiveness of AMP
disclosures. In response, the Federal Reserve noted that it will
conduct consumer testing to determine appropriate content and formats
and will use design consultants to develop model disclosure forms
intended to better communicate information.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-1021].
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Orice M. Williams at
(202) 512-8678 or williamso@gao.gov.
[End of Section]
Contents:
Letter:
Results in Brief:
Background:
AMP Lending Rapidly Grew as Borrowers Sought Mortgage Products That
Increased Affordability:
Borrowers Could Face Payment Shock; Lenders Face Credit Risk but Most
Appear to be Taking Steps to Manage the Risk:
Regulators and Others Are Concerned That Borrowers May Not Be Well-
informed About the Risks of AMPs:
Federal Banking Regulators Issued Draft Guidance and Took Other Actions
to Improve Lender Practices and Disclosures and Publicize Risks of
AMPs:
Most States in Our Sample Responded to AMP Lending Risks within
Existing Regulatory Frameworks, While Others Had Taken Additional
Actions:
Conclusions:
Recommendation for Executive Action:
Agency Comments and Our Evaluation:
Appendix I: Scope and Methodology:
Appendix II: Readability and Design Weaknesses in AMP Disclosures That
We Reviewed:
Disclosures Required Reading Levels Higher Than That of Many Adults in
the U.S.
Size and Choice of Typeface and Use of Capitalization Made Most
Disclosures Difficult to Read:
Disclosures Generally Did Not Make Effective Use of White Space or
Headings:
Appendix III: Comments from the Board of Governors of the Federal
Reserve System:
Appendix IV: GAO Contact and Staff Acknowledgments:
Table:
Table 1: Underwriting Trends of Recent Payment-Option ARM
Securitizations, January 2001 to June 2005:
Figures:
Figure 1: Increase in Minimum Monthly Payments and Outstanding Loan
Balance with an April 2004 $400,000 Payment-Option ARM, Assuming Rising
Interest Rates:
Figure 2: Example of a 2005 Broker Advertisement for a Payment-Option
ARM:
Figure 3: Example of a 2005 Interest-Only ARM Disclosure Explaining How
Monthly Payments Can Change:
Figure 4: Transaction-Specific TILA Disclosure from a 2005 Payment-
Option ARM Disclosure:
Figure 5: Examples of Serif and Sans Serif Typefaces:
Abbreviations:
AARMR: American Association of Residential Mortgage Regulators:
AMP: alternative mortgage product:
APR: annual percentage rate:
ARM: adjustable-rate mortgage:
CLTV: combined loan-to-value:
COFI: Federal Home Loan Bank of San Francisco Cost of Funds Index:
CSBS: Conference of State Bank Supervisors:
DTI: debt-to-income:
FDIC: Federal Deposit Insurance Corporation:
FICO: Fair Isaac and Company:
FRM: fixed-rate mortgage:
FTC: Federal Trade Commission:
GSE: government-sponsored enterprise:
HOEPA: Home Ownership and Equity Protection Act:
LTV: loan-to-value:
MBS: mortgage backed securities:
NAR: National Association of Realtors®:
NCUA: National Credit Union Administration:
OCC: Office of the Comptroller of the Currency:
OTS: Office of Thrift Supervision:
SEC:Securities and Exchange Commission:
TILA: Truth in Lending Act:
United States Government Accountability Office:
Washington, DC 20548:
September 19, 2006:
The Honorable Wayne Allard:
Chairman:
Subcommittee on Housing and Transportation:
Committee on Banking, Housing, and Urban Affairs:
United States Senate:
Dear Mr. Chairman:
In recent years, the residential real estate sector experienced
sustained growth in both volume and price. The National Association of
Realtors® (NAR) reported record growth in sales of existing homes from
2003 to 2005, from 6.2 to 7.1 million homes annually. During this same
period, median existing home prices increased an average of 10.9
percent a year, from $178,800 to $219,600. Further, NAR reported double-
digit percentage increases in existing home prices in 72 metropolitan
areas in 2005. To purchase homes they might not be able to afford with
a conventional fixed-rate mortgage, an increasing number of borrowers
turned to alternative mortgage products (AMPs), which offer
comparatively lower and more flexible monthly mortgage payments for an
initial period.
Two recently popular types of AMPs--interest-only and payment-option
adjustable-rate mortgages (ARMs)--allow borrowers to defer repayment of
principal and possibly part of the interest for the first few years of
the mortgage. Interest-only mortgages allow borrowers to defer
principal payments for typically the first 3 to 10 years of the
mortgage, before recasting to require higher monthly payments that
cover principal as well as interest and to pay off (amortize) the
outstanding balance over the remaining term of the loan. Payment-option
mortgages allow borrowers to make minimum payments that do not cover
principal or all accrued interest, but can result in increased loan
balances over time (negative amortization). Typically after 5 years, or
if the loan balance increases to a cap specified in the mortgage terms,
payments recast to include an amount that will fully amortize the
outstanding balance over the remaining years of the loan.
As AMP lending grew, federal banking regulators and consumer advocates
expressed concerns about loans that allow deferred repayment of
principal or negative amortization; borrowers' ability to make future,
higher payments; and lenders' underwriting practices (criteria for
issuing loans).[Footnote 1] As a result of these and other factors, we
studied the potential risks of AMPs for borrowers and lenders. This
report discusses (1) recent trends in the AMP market, (2) the impact of
AMPs on borrowers and on the safety and soundness of financial
institutions, (3) the extent to which mortgage disclosures discuss the
risks of AMPs, (4) the federal regulatory response to the risks of AMPs
for lenders and borrowers, and (5) selected state regulatory responses
to the risks of AMPs for lenders and borrowers.
To identify recent trends in the AMP market, we gathered information
from federal banking regulators and the residential mortgage lending
industry on AMP product features, customer base, and originators as
well as the reasons for the recent growth of these products. To
determine the potential risks of AMPs for borrowers and lenders, we
analyzed the changes in future monthly payments that can occur with
AMPs during periods of rising interest rates. We also interviewed
officials from the federal banking regulators (federal regulatory
officials) and representatives from the residential mortgage lending
industry and reviewed studies on the risks of these mortgages compared
with conventional fixed-rate mortgages. In addition, we obtained
information on the securitization of AMPs from federal banking
regulators, government-sponsored enterprises, and secondary mortgage
market participants. To determine the extent to which mortgage
disclosures explain the risks of AMPs, we reviewed federal laws and
regulations governing the required content of mortgage disclosures,
reviewed studies on borrowers' understanding of adjustable-rate
products, and interviewed federal regulatory officials and industry
participants. We also selected a sample of eight states to obtain state
regulators' views on these disclosures--Alaska, California, Florida,
Nevada, New Jersey, New York, North Carolina, and Ohio. We reviewed
these states' laws and regulations governing the required content of
mortgage disclosures and interviewed state officials. We selected these
states on the basis of a number of criteria, including volume of AMP
lending and geographic location. We also conducted a readability and
design analysis of a selection of written disclosures that AMP lenders
provide to borrowers. To obtain information on federal regulatory
responses to the risks of AMPs for lenders and borrowers, we reviewed
the draft interagency guidance on AMP lending issued by federal banking
regulators and interviewed regulatory officials. We also reviewed
comments written by industry participants in response to the draft
guidance. To obtain information on selected states' regulatory
responses to the risks of AMPs for lenders and borrowers, we reviewed
current laws and, where applicable, draft legislation, from the eight
states in our sample and interviewed these states' banking and mortgage
lending officials.
We performed our work between September 2005 and September 2006 in
accordance with generally accepted government auditing standards.
Appendix I provides additional information on our scope and
methodology.
Results in Brief:
From 2003 through 2005, AMP originations grew threefold, from less than
10 percent of residential mortgage originations to about 30 percent.
Most of the AMPs originated during this period consisted of interest-
only and payment-option ARMs. The initial lower payments associated
with AMPs enable borrowers to afford homes that they might not be able
to afford using conventional fixed-rate mortgages. Therefore, AMPs have
been particularly popular in higher-priced regional markets
concentrated on the East and West Coasts where prices have risen
appreciably. For example, based on data from mortgage securitizations
in 2005, about 47 percent of interest-only ARMs and 58 percent of
payment-option ARMs originated in California, where NAR reports that 7
of the 20 highest-priced metropolitan real estate markets in the
country are located. For many years lenders have marketed AMPs to
wealthy and financially sophisticated borrowers as financial management
tools. However, more recently, lenders have marketed AMPs as
affordability products that enable a wider spectrum of borrowers to
purchase homes they might not be able to afford using a conventional
fixed-rate mortgage. Lenders also have increased the variety of AMPs
offered as interest rates have risen and ARMs have become less
attractive to borrowers.
Although most AMPs originated in recent years have yet to reach the
date at which monthly payments increase to cover principal as well as
the interest, regulators have expressed concerns that some borrowers
may not be able to withstand the "payment shock" of substantially
higher monthly payments. Statistics reveal that lenders originated AMPs
to recent borrowers with lower credit scores, higher loan-to-value
(LTV) and debt-to-income (DTI) ratios, and less stringent or no income
and asset verification requirements than what they traditionally
permitted for these products. Recent AMP borrowers who have fewer
financial resources and have not benefited from appreciation in home
values may be more vulnerable to payment shock, especially if their
loan balance increased because they were making only the minimum
payment. These borrowers may lack the equity to refinance their
mortgages or sell their homes, and would have to face higher payments.
Borrowers who cannot afford the higher payments face increased risk of
default, thereby increasing credit risk for lenders, including banks.
Although federal regulatory officials expressed concerns about
underwriting practices related to AMP lending, they said that banks
generally have taken steps to manage the credit risk that results from
AMPs.[Footnote 2] For example, these officials said that most banks
have diversified their assets sufficiently to manage the credit risk of
AMPs held in their portfolios, or have reduced their risk through loan
sales or securitizations. However, federal regulatory officials and
industry participants agreed that it was too soon to tell whether AMPs
would result in significant delinquencies and foreclosures for
borrowers and corresponding losses for banks that hold AMPs in their
portfolios.
Because AMPs are complex products and advertising and mortgage
disclosures may not completely or effectively explain their terms and
risks, regulatory officials and others believe that some borrowers may
not fully understand the risks of AMPs. Borrowers can acquire
information on mortgage options from a variety of sources--including
loan officers and brokers, or as noted by mortgage industry
representatives, through the Internet, television, radio and
telemarketing. However, federal and state regulatory officials raised
concerns that the promotional materials some lenders and brokers
provided to borrowers might emphasize the benefits of AMPs without
explaining the associated risks. For example, some advertisements
suggested that AMPs' initial low monthly payments allow borrowers to
afford a larger house, but did not disclose that over time these
monthly payments could increase substantially. Furthermore, a recent
study by staff economists at the Federal Reserve suggested that some
borrowers (particularly some low-income and less-educated borrowers)
appeared to not understand fully how much monthly payments with
adjustable-rate products could increase. With borrowers sometimes
exposed to unbalanced information about AMPs, written disclosures that
provide clear and comprehensive information about the key terms,
conditions, and costs of the mortgage can help borrowers to make better-
informed decisions. The quality of information conveyed through
mortgage disclosures depends on both content, which is mandated by
statute and federal regulation, and presentation. Regarding content,
the Truth in Lending Act (TILA) and its implementing regulation,
Regulation Z, require certain product information to be included in
disclosures to borrowers for many types of credit products, including
mortgages.[Footnote 3] For example, Regulation Z requires creditors
(lenders and those brokers that close loans in their own name) to
provide borrowers with certain information about their ARM products.
However, these requirements are not designed to address more complex
products such as AMPs. The Federal Reserve has recently initiated a
review of Regulation Z that will include reviewing the disclosures
required for all mortgage loans, including AMPs. Regarding
presentation, current guidance developed by the Securities and Exchange
Commission (SEC) recommends practices on developing disclosures that
effectively communicate key information on financial products.[Footnote
4] Most of the AMP disclosures we reviewed did not fully or effectively
explain the key risks of payment shock or negative amortization for
these products and lacked information on some important loan features,
both because Regulation Z does not require lenders to tailor this
information to these more complex products and because lenders did not
always follow leading practices for writing disclosures that are clear,
concise, and user-friendly. Appendix II provides additional information
on our evaluation of these disclosures according to these leading
practices. According to officials from one federal banking regulator,
amending Regulation Z to require lenders to more fully and clearly
explain the key terms and risks of complex mortgages such as AMPs in
mortgage disclosures was one of several steps needed to increase
borrower understanding about these products and the mortgage process in
general--which many described as generally overwhelming and confusing
for the average borrower. Without clear and comprehensive disclosures
on AMP risks, borrowers may not understand the extent to which monthly
payments could rise and loan balances could increase.
In response to concerns about AMP risks to federally regulated banks
and their borrowers, federal banking regulators issued draft
interagency guidance in December 2005 for these institutions and have
taken other steps to monitor AMP lending. The draft guidance discusses
prudent underwriting, portfolio and risk management, and consumer
disclosure practices related to AMP lending. When finalized, the
guidance will apply to all federally regulated financial
institutions.[Footnote 5] Federal regulatory officials said they
developed the draft guidance to clarify how institutions can offer AMPs
in a safe and sound manner and clearly disclose the potential AMP risks
to borrowers. These officials told us they will request remedial action
from institutions that do not adequately measure, monitor, and control
risk exposures in loan portfolios. In commenting on the proposed
guidance, various lenders suggested that the stricter underwriting
recommendations were overly prescriptive and could result in fewer
mortgage choices for consumers. Others observed that the
recommendations for stricter underwriting and increased disclosure
might put federally and state-regulated banks at a competitive
disadvantage, because the guidance would not apply to state non-bank
mortgage lenders (independent mortgage lenders) or brokers. Consumer
advocates expressed concerns that regulators might not be able to
enforce recommendations that were not written in law or regulation to
protect consumers. Federal banking regulators currently are reviewing
all comments as they finalize the draft guidance. In addition to
issuing the draft guidance, federal regulatory officials have publicly
reinforced their concerns about AMPs and some have taken steps to
increase their monitoring of high-risk lending, including AMPs, and to
improve consumer education about AMP risks. The Federal Trade
Commission (FTC) also has given some attention to consumer protection
issues related to AMPs. For example, in May 2006, the FTC sponsored a
public workshop that explored consumer protection issues as a result of
AMP growth in the mortgage marketplace.
Officials from state banking and financial regulators in eight states
with whom we spoke shared some of the federal regulators' concerns
about AMP lending, and to varying degrees, have responded to the
increase in this lending activity among the independent mortgage
lenders and brokers they oversee. Most of the state regulators rely
upon state law to license mortgage lenders and brokers and to ensure
that these entities meet minimum experience and operations standards.
Regulatory officials from most of the states said they also
periodically examine these entities for compliance with state
licensing; mortgage lending; and consumer protection laws, including
applicable fair advertising requirements. In addition, some states have
taken action to better understand issues related to AMP lending and
expand consumer protections. For example, some regulators have gathered
data on these products, or plan to use guidance developed by state
regulatory associations to oversee AMP lending by independent mortgage
lenders and brokers.
This report includes a recommendation to the Board of Governors of the
Federal Reserve System to consider, in connection with its review and
revision of Regulation Z, amending federal mortgage disclosure
requirements to improve the clarity and comprehensiveness of AMP
disclosures. We requested comments on a draft of this report from the
Federal Reserve, FDIC, NCUA, OCC, and OTS. The Federal Reserve provided
written comments on a draft of this report that are reprinted in
appendix III. It noted that it has already initiated a comprehensive
review of Regulation Z, including its requirements for mortgage
disclosures. As part of this effort, it recently held four public
hearings on home equity lending that partly focused on AMPs, and in
particular, whether consumers receive adequate information about these
products. Furthermore, in response to our recommendation, the Federal
Reserve noted that it will be conducting consumer testing to determine
what and when information is most useful to consumers, what language
and formats work best, and how disclosures can be designed to reduce
complexity and information overload. The Federal Reserve's comments are
discussed in more detail at the end of this letter. We also provided a
draft to FTC, and selected sections of the report to the relevant state
regulators for their review. FDIC, FTC, NCUA, OCC, and OTS did not
provide written comments. FDIC, FTC, and OCC provided technical
comments, as did the Federal Reserve, which have been incorporated as
appropriate.
Background:
Borrowers arrange residential mortgages through either mortgage lenders
or brokers. The funding for mortgages can come from federally or state-
chartered banks, mortgage lending subsidiaries of these banks or
financial holding companies, or independent mortgage lenders, which are
neither banks nor affiliates of banks. Mortgage brokers act as
intermediaries between lenders and borrowers, and for a fee, help
connect borrowers with various lenders who may provide a wider
selection of mortgage products. Mortgage lenders may keep the loans
that they originated or purchased from brokers in their portfolios or
sell the loans in the secondary mortgage market. Government-sponsored
enterprises (GSEs) or investment banks pool many mortgage loans that
lenders sell to the secondary market, and these lenders or investment
banks then sell claims to these pools to investors as mortgage backed-
securities (MBS).[Footnote 6]
Lenders consider whether to accept or reject a borrower's loan
application in a process called underwriting. During underwriting, the
lender analyzes the borrower's ability to repay the debt. For example,
lenders may determine ability to repay debt by calculating a borrower's
DTI ratio, which consists of the borrowers' fixed monthly expenses
divided by gross monthly income. The higher the DTI ratio, the greater
the risk the borrower will have cash-flow problems and miss mortgage
payments. During the underwriting process, lenders usually require
documentation of borrowers' income and assets. Another important factor
lenders consider during underwriting is the amount of down payment the
borrower makes, which usually is expressed in terms of a LTV ratio (the
larger the down payment, the lower the LTV ratio). The LTV ratio is the
loan amount divided by the lesser of the selling price or appraised
value. The lower the LTV ratio, the smaller the chance that the
borrower would default, and the smaller the loss if the borrower were
to default. Additionally, lenders evaluate the borrowers' credit
history using various measures. One of these measures is the borrowers'
credit score, which is a numerical measure or score that is based on an
individual's credit payment history and outstanding debt. Mortgage
loans could be made to prime and subprime borrowers. Prime borrowers
are those with good credit histories that put them at low risk of
default. In contrast, subprime borrowers have poor or no credit
histories, and therefore cannot meet the credit standards for obtaining
a prime loan.
Chartering agencies oversee federally and state-chartered banks and
their mortgage lending subsidiaries. At the federal level, OCC, OTS,
and NCUA oversee federally chartered banks (including mortgage
operating subsidiaries), thrifts, and credit unions, respectively. The
Federal Reserve oversees insured state-chartered member banks, while
FDIC oversees insured state-chartered banks that are not members of the
Federal Reserve System. Both the Federal Reserve and FDIC share
oversight with the state regulatory authority that chartered the bank.
The Federal Reserve also oversees mortgage lending subsidiaries of
financial holding companies, although FTC is responsible for
enforcement of certain federal consumer protection laws as discussed in
the following text.
Federal banking regulators have responsibility for ensuring the safety
and soundness of the institutions they oversee and for promoting
stability in the financial markets. To achieve these goals, regulators
establish capital requirements for banks, conduct on-site examinations
and off-site monitoring to assess their financial condition, and
monitor their compliance with applicable banking laws, regulations, and
agency guidance. As part of their examinations, for example, regulators
review mortgage lending practices, including underwriting, risk
management, and portfolio management practices. Regulators also try to
determine the amount of risk lenders have assumed. From a safety and
soundness perspective, risk involves the potential that events, either
expected or unanticipated, may have an adverse impact on the bank's
capital or earnings. In mortgage lending, regulators pay close
attention to credit risk. Credit risk involves the concerns that
borrowers may become delinquent or default on their mortgages and that
lenders may not be paid in full for the loans they have originated.
Certain federal consumer protection laws, including TILA and the act's
implementing regulation, Regulation Z, apply to all mortgage lenders,
including mortgage brokers that close loans in their own name.
Implemented by the Federal Reserve, Regulation Z requires these
creditors to provide borrowers with written disclosures describing
basic information about the terms and cost of their mortgage. Each
lender's primary federal supervisory agency holds responsibility for
enforcing Regulation Z. Regulators use examinations and consumer
complaint investigations to check for compliance with both the act and
its regulation. FTC is responsible for enforcing certain federal
consumer protection laws for brokers and lenders that are not
depository institutions, including state-chartered independent mortgage
lenders and mortgage lending subsidiaries of financial holding
companies. However, FTC is not a supervisory agency; instead, it
enforces various federal consumer protection laws through enforcement
actions. The FTC uses a variety of information sources in the
enforcement process, including its own investigations, consumer
complaints, state and other federal agencies, and others.
State regulators oversee independent lenders and mortgage brokers and
do so by generally requiring business licenses that mandate meeting net
worth, funding, and liquidity thresholds. They may also mandate certain
experience, education, and operational requirements to engage in
mortgage activities. Other common requirements for licensees may
include maintaining records for certain periods, individual
prelicensure testing, posting surety bonds, and participating in
continuing education activities. States may also examine independent
lenders and mortgage brokers to ensure compliance with licensing
requirements, review their lending and brokerage functions for state-
specific and federal regulatory compliance, and look for unfair or
unethical business practices. When such practices arise, or are brought
to states' attention through consumer complaints, regulators and State
Attorneys General may pursue actions that include licensure suspension
or revocation, monetary fines, and lawsuits.
AMP Lending Rapidly Grew as Borrowers Sought Mortgage Products That
Increased Affordability:
The volume of interest-only and payment-option ARMs grew rapidly
between 2003 and 2005 as home prices increased nationwide and lenders
marketed these products as an alternative to conventional mortgage
products. During this period, AMP lending was concentrated in the
higher-priced real estate markets on the East and West Coasts. Also at
that time, a variety of federally and state-regulated lenders
participated in the AMP market, although a few large federally
regulated dominated lending. Once considered a financial management
tool for wealthier borrowers, lenders have marketed AMPs as
affordability products that enable borrowers to purchase homes they
might not be able to afford using conventional fixed-rate mortgages.
Furthermore, lenders have increased the variety of AMP products offered
to respond to changing market conditions.
AMP Share of Mortgage Originations Grew Threefold from 2003 to 2005,
with Higher Concentrations in the Coastal Markets:
As home prices increased nationally and lenders offered alternatives to
conventional mortgages, AMP originations tripled in recent years,
growing from less than 10 percent of residential mortgage originations
in 2003 to about 30 percent in 2005.[Footnote 7] Most of the AMPs
originated during this period consisted of interest-only or payment-
option ARMs. In 2005, originations of these two products totaled $400
billion and $175 billion, respectively.[Footnote 8] According to
federal regulatory officials, consumer demand for these products grew
because their low initial monthly payments enabled borrowers to
purchase homes that they otherwise might not have been able to afford
with a conventional fixed-rate mortgage.[Footnote 9]
AMP lending has been concentrated in the higher-priced regional markets
on the East and West Coasts, where homes are least affordable. For
example, based on data from mortgage securitizations in 2005, about 47
percent of interest-only ARMs and 58 percent of payment-option ARMs
that were securitized in 2005 originated in California, where NAR
reports that 7 of the 20 highest-priced metropolitan real estate
markets in the country are located.[Footnote 10] On the East Coast,
Virginia, Maryland, New Jersey, Florida and Washington, D.C., exhibited
high concentrations of AMP lending in 2005, as did Washington, Nevada,
and Arizona on the West Coast. These areas also have experienced higher
rates of house price appreciation than the rest of the United States.
A variety of federally and state-regulated lenders were involved in the
recent surge of AMP originations. Six large federally regulated lenders
dominated much of the AMP production in 2005, producing 46 percent of
interest-only and payment-option ARMs originated in the first 9 months
of that year.[Footnote 11] The six included nationally chartered banks
and thrifts under the supervision of OCC and OTS as well as mortgage
lending subsidiaries of financial holding companies under the
supervision of the Federal Reserve. Although these six large, federally-
regulated institutions accounted for a large share of AMP lending in
that year, other federally and state-regulated lenders also
participated in the AMP market, including other nationally and state
chartered banks and independent nonbank lenders. Additionally,
independent mortgage brokers have been an important source of
originations for AMP lenders. Some mortgage brokers in states with high
volumes of AMP lending told us in early 2006 that they estimated
interest-only and payment-option ARM lending accounted for as much as
35 to 50 percent of their recent business.
Once Considered a Specialized Product for the Financially
Sophisticated, Lenders Have Offered AMPs Widely as Affordability
Products:
Once considered a specialized product, AMPs have entered the mainstream
marketplace in higher-priced real estate markets. According to federal
regulatory officials and a mortgage lending trade association, lenders
originally developed and marketed interest-only and payment-option ARMs
as specialized products for higher-income, financially sophisticated
borrowers who wanted to minimize mortgage payments to invest funds
elsewhere. Additionally, they said that other borrowers who found AMPs
suitable included borrowers with irregular earnings who could take
advantage of interest-only or minimum monthly payments during periods
of lower income and could pay down principal and any deferred interest
when they received an increase in income. However, according to federal
banking regulators and a range of industry participants, as home prices
increased rapidly in some areas of the country, lenders began marketing
interest-only and payment-option ARMs widely as affordability products.
They also said that in doing so, lenders emphasized the low initial
monthly payments offered by these products and made them available to
less creditworthy and less wealthy borrowers than those who
traditionally used them.
After the recent surge of interest-only and payment-option ARMs,
lenders have increased the variety of AMPs offered as market conditions
have changed. According to industry analysts, as interest rates
continued to rise, by the beginning of 2006, mortgages with adjustable
rates no longer offered the same cost-savings over fixed-rate
mortgages, and borrowers began to shift to fixed-rate
products.[Footnote 12] These analysts reported that in response to this
trend, lenders have begun to market mortgages that are less sensitive
to interest rate increases. For example, interest-only fixed-rate
mortgages (interest-only FRMs) offer borrowers interest-only payments
for up to 10 years but at a fixed interest rate over the life of the
loan. Another mortgage that has gained in popularity is the 40-year
mortgage. This product does not allow borrowers to defer interest or
principal, but offers borrowers lower monthly payments than
conventional mortgages. For example, some variations of the 40-year
mortgage have a standard 30-year loan term, but offer lower fixed
monthly payments that are based on a 40-year amortization schedule for
part or all of the loan term.[Footnote 13] According to one
professional trade publication,--37 percent of first half of 2006
mortgage originations were AMPs, and a significant number of them were
40-year mortgages.[Footnote 14]
Borrowers Could Face Payment Shock; Lenders Face Credit Risk but Most
Appear to be Taking Steps to Manage the Risk:
Depending on the particular loan product and the payment option the
borrower chooses, rising interest rates or choice of a minimum monthly
payment and corresponding negative amortization can significantly raise
future monthly payments and increase the risk of default for some
borrowers. Underwriting trends that, among other things, allowed
borrowers with fewer financial resources to qualify for these loans
have heightened this risk because such borrowers may have fewer
financial reserves against financial adversity and may be unable to
sustain future higher monthly payments in the event that they cannot
refinance their mortgages or sell their home. Higher default risk for
borrowers translates into higher credit risk for lenders, including
banks. However, federal regulatory officials and industry participants
agree that it is too soon to tell whether risks to borrowers will
result in significant delinquencies and foreclosures for borrowers and
corresponding losses for banks that hold AMPs in their portfolios.
AMPs Create Potential for Borrowers to Face Payment Shock, Particularly
as Interest Rates Rise:
AMPs such as interest-only and payment-options ARMs are initially more
affordable than conventional fixed-rate mortgages because during the
first few years of the mortgage they allow a borrower to defer
repayment of principal and, in the case of payment-option ARMs, part of
the interest as well. Specifically, borrowers with interest-only ARMs
can make monthly payments of just interest for the fixed introductory
period. Borrowers with payment-option ARMs typically have four payment
options. The first two options are fully amortizing payments that are
based on either a 30-year or 15-year payment schedule. The third option
is an interest-only payment, and the fourth is a minimum payment, which
we previously described, that does not cover all of the interest. The
interest that does not get paid gets capitalized into the loan balance
owed, resulting in negative amortization.
The deferred payments associated with interest-only and payment-option
ARMs will eventually result in higher monthly payments after the
introductory period expires. For example, for interest-only mortgages,
payments will rise at the expiration of the fixed interest-only period
to include repayment of principal. Similarly, when the payment-option
period ends for a payment-option ARM, the monthly payments will adjust
to require an amount sufficient to fully amortize the outstanding loan
balance, including any deferred interest and principal, over the
remaining life or term. Depending on the particular loan product, a
combination of rising interest rates and deferred or negative
amortization can raise monthly payments twofold or more, causing
payment shock for those borrowers who cannot avoid and are not prepared
for these larger payments.
For example, consider the borrower in the following example who took
out a $400,000 payment-option ARM in April 2004. The borrower's payment
options for the first year ranged from a minimum payment of $1,287 to a
fully amortizing payment of $2,039. Figure 1 shows how monthly payments
for the borrower who chose to make only the minimum monthly payments
during the 5-year payment-option period could increase from $1,287 to
$2,931 or 128 percent, when that period expires.
Figure 1: Increase in Minimum Monthly Payments and Outstanding Loan
Balance with an April 2004 $400,000 Payment-Option ARM, Assuming Rising
Interest Rates:
[See PDF for image]
Source: GAO.
[End of figure]
The example in figure 1 assumes loan features that were typical of
payment-option ARMs offered during 2004, including:
* a promotional "teaser" rate of 1 percent for the first month of the
loan, which set minimum monthly payments for the first year at
$1,287;[Footnote 15]
* a payment reset cap, which limits any annual increases in minimum
monthly payments due to rising interest rates to 7.5 percent for the
first five years of the loan;[Footnote 16] and:
* a negative amortization cap, which limits the amount of deferred
interest that could accrue during the first five years until the
mortgage balance reaches 110 percent of its original amount, and if
reached, triggers a loan recast to fully amortizing payments.
After the first month, the start rate of 1 percent expired and the
interest due on the loan was calculated on the basis of the fully
indexed interest rate, which was 4.55 percent in April 2004 and rose to
6.61 percent in April 2006.[Footnote 17] Minimum monthly payments were
adjusted upward every April, but only by the maximum 7.5 percent
allowed. By year 5, the minimum payments reset to $1,718, a 33 percent
increase from the initial minimum payment required in year 1.
As shown in figure 1, these minimum monthly payments were not enough to
cover the interest due on the loan after the start rate expired in the
first month of year 1, and the loan immediately began to negatively
amortize. By year 2, the loan balance increased by $3,299. As interest
rates rose, the amount of deferred interest grew more quickly, reaching
$33,446 by the beginning of year 6. Because the start of year 6 marked
the end of the 5-year payment-option period, the loan recast to require
fully amortizing monthly payments of $2,931. This payment represented a
70 percent increase from the minimum monthly payment required a year
earlier and a 128 percent increase from the initial minimum monthly
payment in year 1. Note that the largest monthly payment increase
occurred at this time, reflecting the combined effect of a fully
amortizing payment that is calculated on the basis of both the fully
indexed interest rate and the increased loan balance.
In Contrast to Past Borrowers, Recent AMP Borrowers May Find It More
Difficult to Avoid Payment Shock:
Federal regulatory officials have cautioned that the risk of default
could increase for some recent AMP borrowers. This is because lenders
have marketed these products to borrowers who are not as wealthy or
financially sophisticated as previous borrowers, and because rising
interest rates, combined with constraints on the growth in minimum
payments imposed by low teaser rates, have increased the potential for
payment shock.[Footnote 18] FDIC officials expressed particular concern
over payment-option ARMs, as they are more complex than interest-only
products and have the potential for negative amortization and bigger
payment shocks.
Mortgage statistics of recently securitized interest-only and payment-
option ARMs show a relaxation of underwriting standards regarding
credit history, income, and available assets during the years these
products increased in popularity. According to one investment bank,
interest-only mortgages that were part of subprime securitizations were
negligible in 2002, but rose to almost 29 percent of subprime
securitizations in 2005. Lenders also originated payment-option ARMs to
borrowers with increasingly lower credit scores (see table 1). In
addition, besides permitting lower credit scores, lenders increasingly
qualified borrowers with fewer financial resources. For example,
lenders allowed higher DTI ratios for some borrowers and began
combining AMPs with "piggyback" mortgages--that is, second mortgages
that allow borrowers with limited or no down payments to finance a down
payment. As table 1 shows, by June 2005, 25 percent of securitized
payment-option ARMs included piggyback mortgages--up from zero percent
5 years earlier.[Footnote 19] Furthermore, lenders increasingly have
qualified borrowers for AMPs under "low documentation" standards, which
allow for less detailed proof of income or assets than lenders
traditionally required.[Footnote 20]
Table 1: Underwriting Trends of Recent Payment-Option ARM
Securitizations, January 2001 to June 2005:
Origination year: 2001; Origination amount (in millions of dollars )[A
,B]: $2,210; Percentage of FICO scores below 700[C]: 32.4%; Average DTI
ratio[D]: 24.4; Percentage of option ARMs with piggyback mortgages:
0.0%; CLTV>80 percent[E]: 1.8%; Percentage with low documentation:
69.4%.
Origination year: 2002;
Origination amount (in millions of dollars )[A ,B]: 3,745;
Percentage of FICO scores below 700[C]: 33.4;
Average DTI ratio[D]: 29.2;
Percentage of option ARMs with piggyback mortgages: 0.3;
CLTV>80 percent[E]: 1.9;
Percentage with low documentation: 67.6.
Origination year: 2003;
Origination amount (in millions of dollars )[A ,B]: 2,098;
Percentage of FICO scores below 700[C]: 42.4;
Average DTI ratio[D]: 28.9;
Percentage of option ARMs with piggyback mortgages: 6.3;
CLTV>80 percent[E]: 10.4;
Percentage with low documentation: 74.4.
Origination year: 2004;
Origination amount (in millions of dollars )[A ,B]: 37,117;
Percentage of FICO scores below 700[C]: 43.1;
Average DTI ratio[D]: 31.6;
Percentage of option ARMs with piggyback mortgages: 11.4;
CLTV>80 percent[E]: 12.0;
Percentage with low documentation: 75.4.
Origination year: 2005;
Origination amount (in millions of dollars )[A ,B]: 13,572;
Percentage of FICO scores below 700[C]: 48.2;
Average DTI ratio[D]: 32.6;
Percentage of option ARMs with piggyback mortgages: 25.3;
CLTV>80 percent[E]: 22.2;
Percentage with low documentation: 74.7.
Source: Loan Performance and UBS.
[A] The data in this table capture only mortgages that are securitized
and sold to the private label secondary market, which do not include
mortgages guaranteed by GSEs or held by banks in their portfolios.
[B] The 2005 origination amount reflects data from the first half of
the year.
[C] FICO scores are credit scores used to evaluate a borrower's credit
history.
[D] A DTI ratio is the borrower's fixed monthly expenses divided by
gross monthly income.
[E] Combined loan-to-value (CLTV) is the percentage that the first and
second mortgages make up of the property value.
[End of table]
Federal banking regulators cautioned that "risk-layering", which
results from the combination of AMPs with one or more relaxed
underwriting practices could increase the likelihood that some
borrowers might not withstand payment shock and may go into default. In
particular, federal regulatory officials said that some recent AMP
borrowers, particularly those with low income and little equity, may
have fewer financial reserves against financial adversity, which could
impact their ability to sustain future higher monthly payments in the
event that they cannot refinance their mortgages or sell their homes.
Although concerns about the effect of risk-layering exist, OCC
officials observed that while underwriting characteristics for AMPs
have trended downward over the past few years, lenders generally
attempt to mitigate the additional credit risk of AMPs compared to
traditional mortgages by having at least one underwriting criteria
(such as LTV ratio, DTI ratio, or loan size) tighter for AMPs than for
a traditional mortgage. In addition, both OCC and Federal Reserve
officials said that most lenders qualify payment-option ARM borrowers
at the fully-indexed rate, and not the teaser rate, suggesting that
these borrowers have the financial resources to either make more than
the minimum monthly payment or to manage any future rise in monthly
payments.[Footnote 21] However, Federal Reserve officials said that
borrowers of interest-only loans are qualified on the interest-only
payment.
For borrowers who intend to refinance their mortgages to avoid higher
monthly payments, FDIC officials expressed concern that some may face
prepayment penalties that could make refinancing expensive. In
particular, they said that borrowers with payment-option ARMs that
choose the minimum payment option could reach the negative amortization
cap well before the expiration of the five-year payment option period,
triggering a loan recast to fully amortizing payments, the need to
refinance the mortgage, and the imposition of prepayment penalties.
Some recent borrowers may find that they do not have sufficient equity
in their homes to refinance or even to sell, particularly if their
loans have negatively amortized or they have borrowed with little or no
down payment. Again, consider the borrower in figure 1. To avoid the
increase in monthly payments when the loan recasts at the end of year
5, the borrower would either have to refinance the mortgage or sell the
home. However, because the borrower made only minimum payments, the
$400,000 debt would have increased to $433,446. To the extent that the
home's value has risen faster than the outstanding mortgage, or the
borrower contributed a substantial down payment, the borrower might
have enough equity to obtain refinancing or could sell the house and
pay off the loan. However, if the borrower has little or no equity and
home prices remain flat or fall, the borrower could easily have a
mortgage that exceeds the value of his or her home, thereby making the
possibility of refinancing or home sale very difficult. According to an
investment bank, as of July 2006, about 75 percent of payment-option
ARMs originated and securitized in 2004 and 2005 were negatively
amortizing, meaning that borrowers were making minimum monthly
payments, and more than 70 percent had loan balances that exceeded the
original loan balances.[Footnote 22]
Federal Reserve officials also said they are concerned that some recent
borrowers who used AMPs to purchase homes for investment purposes may
be less inclined to avoid defaulting on their loans when faced with
financial distress, on the basis that mortgage delinquency and default
rates are typically higher for these borrowers than for borrowers who
use them to purchase their primary residences. According to these
officials, borrowers who used AMPs for investment purposes may have
less incentive to try to find a way to make their mortgage payments if
confronted with payment shock or difficulties in refinancing or
selling, because they would not lose their primary residence in the
event of a default. According to FDIC officials, this is particularly
acute during instances where the borrower has made little or no down
payment. Although the majority of borrowers used AMPs to purchase their
primary residence, data on recent payment-option ARM securitizations
indicate that 14.4 percent of AMPs originated in 2005 were used by
borrowers to purchase homes for purposes other than use as a primary
residence, up from 5.3 percent in 2000.[Footnote 23] However, this data
did not show the proportion of these originations that were used to
purchase homes for investment purposes as compared to second homes.
Most AMPs Originations Are Too Recent to Generate Sufficient
Performance Data to Predict Delinquencies and Losses to Banks, but
Regulators Said Most Banks Appeared to Be Managing Credit Risk:
AMP underwriting practices may have increased the risk of payment shock
and default for some borrowers, resulting in increased credit risk for
lenders, including banks. However, federal regulatory officials said
that most banks appeared to be managing this credit risk. First, they
said that banks holding the bulk of residential mortgages, including
AMPs, are the larger, more diversified financial institutions that
would be able to better withstand losses from any one business line.
Second, they said that most banks appear to have diversified their
assets sufficiently and maintained adequate capital to manage the
credit risk of AMPs held in their portfolios or have reduced their risk
through loan sales and securitizations. Investment and mortgage banking
officials told us that hedge funds, real estate investment trusts, and
foreign investors are among the largest investors in the riskiest
classes of these securities, and that these investors largely would
bear the credit risk from any AMP defaults.[Footnote 24]
In addition, several regulatory officials noted borrowers who have
turned to interest-only FRMs are subject to less payment shock than
interest-only and payment-option ARM borrowers. As we previously
discussed, interest-only FRMs are not sensitive to interest rate
changes. For example, the amount of the initial interest-only payment
and the later fully amortizing payment are known at the time of loan
origination for an interest-only FRM and do not vary. Furthermore,
these products tend to feature a longer period of introductory payments
than did the interest-only and payment-option ARMs sold earlier, thus
giving the borrower more time to prepare financially for the increase
in monthly payments or plan to refinance or sell.[Footnote 25]
Federal regulatory officials and industry participants agree that it is
too soon to tell how many borrowers with AMPs will become delinquent or
go into foreclosure, thereby producing losses for banks that hold AMPs
in their portfolios. Most of the AMPs issued between 2003 and 2005 have
not recast; therefore, most of these borrowers have not yet experienced
payment shock or financial distress. As a result, lenders generally do
not yet have the performance data on delinquencies that would serve as
an indicator of future problems. Furthermore, the credit profile of
recent AMP borrowers is different from that of traditional AMP
borrowers, because it includes less creditworthy and less affluent
borrowers. Consequently, it would be difficult to use past performance
data to predict how many loans would be refinanced before payment shock
sets in and how many delinquencies and foreclosures could result for
those borrowers who cannot sustain larger monthly payments.
Regulators and Others Are Concerned That Borrowers May Not Be Well-
informed About the Risks of AMPs:
The information that borrowers receive about their loans through
advertisements and disclosures may not fully or effectively inform them
about the risk of AMPs. Federal and state banking regulatory officials
expressed concern that advertising practices by some lenders and
brokers emphasized the affordability of these products without
adequately describing their risks. Furthermore, a recent Federal
Reserve staff study and state complaint data indicated that some
borrowers appeared to not understand (1) the terms of their ARMs,
including AMPs, and (2) the potential magnitude of changes to their
monthly payments or loan balance. As AMPs are more complex than
conventional mortgage products and advertisements may not provide
borrowers with balanced information on these products, it is important
that written disclosures provide borrowers with clear and comprehensive
information about the key terms, conditions, and costs of these
mortgages to help them make an informed decision. That information is
conveyed both through content and presentation, including writing style
and design. With respect to content, Regulation Z, which includes
requirements for mortgage disclosures, requires all creditors (lenders
and those brokers that close loans in their own name) to provide
borrowers with information about their ARM products. However, these
requirements are not designed to address more complex products such as
AMPs. The Federal Reserve has recently initiated a review of Regulation
Z that will include reviewing the disclosures required for all mortgage
loans, including AMPs. For presentation, current guidance available in
the federal government suggests good practices on developing
disclosures that effectively communicate key information on financial
products. Most of the AMP disclosures we reviewed did not always fully
or effectively explain the risks of payment shock or negative
amortization for these products and lacked information on some
important loan features, both because Regulation Z currently does not
require lenders to tailor this information to AMPs and because lenders
do not always follow leading practices for writing disclosures that are
clear, concise, and user-friendly. According to Federal Reserve
officials, revising Regulation Z to require better disclosures of the
key terms and risks of AMPs could increase borrower understanding of
these complex mortgage products, particularly if a broader effort were
made to simplify and clarify mortgage disclosures generally. Officials
added that borrowers who do not understand their AMPs may not
anticipate the substantial increase in monthly payments or loan balance
that can occur.
Some AMP Advertising Practices Emphasize Benefits over Risks:
Borrowers can acquire information on mortgage options from a variety of
sources, including loan officers and brokers, or as noted by mortgage
industry participants, through the Internet, television, radio, and
telemarketing. However, federal regulatory officials expressed concerns
that some consumers may have difficulty understanding the terms and
risks of these complex products. These concerns have been heightened as
advertisements by some lenders and brokers emphasize the benefits of
AMPs without explaining the associated risks. For example, one print
advertisement for a payment-option ARM product we obtained stated on
the first page that the loan "started" at an interest rate of 1.25
percent, promised a reduction in the homeowner's monthly mortgage
payment of up to 45 percent, and offered three low monthly payment
options. However, the lender noted in much smaller print on the second
page that the 1.25 percent interest rate applied only to the first
month of the loan and could increase or decrease on a monthly basis
thereafter. Federal regulatory officials said that less financially
sophisticated borrowers might be drawn to the promise of initial low
monthly payments and flexible payment options and may not realize the
potential for substantial increases in monthly payments and loan
balance later.[Footnote 26]
Officials from three of the eight states we contacted reported similar
concerns with AMP advertising distributed by the nonbank lenders and
independent brokers under their supervision. For example, one official
from Ohio told us that some brokers advertised the availability of
large loans with low monthly payments and only specified in tiny print
at the bottom of the advertisements that the offer involved interest-
only products. According to this official, small print makes it more
difficult for the consumer to see these provisions and more likely for
the consumer not to read them at all. Regulatory officials in Alaska
told us some advertisements circulating in their state stated that
consumers could save money by using interest-only products, without
disclosing that over time these loans might cost more than a
conventional product. In some cases, the advertisements were
potentially misleading. For example, New Jersey officials provided us
with a copy of an AMP advertisement that promised potential borrowers
low monthly payments by suggesting that the teaser rate (termed
"payment rate" in the advertisement) on a payment-option ARM product
was the actual interest rate for the full term of the loan (see figure
2). The officials also said that advertising a rate other than the
annual percentage rate (APR), without also including the APR (as seen
in the advertisement shown in fig. 2) is contrary to the requirements
of Regulation Z.
Figure 2: Example of a 2005 Broker Advertisement for a Payment-Option
ARM:
[See PDF for image]
Source: Name withheld. Used with permission.
[End of figure]
Industry representatives also expressed concerns about AMP advertising.
In 2005, the California Association of Mortgage Brokers issued an alert
to warn the public about misleading AMP advertisements circulating in
the state. The advertisements offered low monthly payments without
clearly stating that these payments were temporary, and that the loan
could become significantly more costly over time.
A Recent Study and Initial Complaint Data Indicated Some Borrowers Did
Not Understand the Terms and Features of ARMs, Including AMPs:
A recent Federal Reserve staff study and state complaint data indicate
that some borrowers appeared to not fully understand the terms and
features of their ARMs, including AMPs, and were surprised by the
increases in monthly payments or loan balance. In January 2006, staff
economists at the Federal Reserve published the results of a study that
assessed whether homeowners understood the terms of their
mortgages.[Footnote 27] The study was based, in part, on data obtained
from the Federal Reserve's 2001 Survey of Consumer Finances, which
included questions for consumers on the terms of their ARMs. While most
homeowners reported knowing their broad mortgage terms reasonably well,
some borrowers with ARMs, particularly those from households with lower
income and less education, appeared to underestimate the amount by
which their interest rates, and thus their monthly payments, could
change. The authors suggested that this underestimation might be
explained, in part, by borrower confusion about the terms of their
mortgages. Although they found that most households in 2001 were
unlikely to experience large and unexpected changes in their mortgage
payments in the event of a rise in interest rates, some borrowers might
be surprised by the change in their payments and subsequently might
experience financial difficulties.
The Federal Reserve staff study focused on borrowers holding ARM
products in 2001--not AMPs. However, as we previously discussed, most
AMP products sold between 2003 and 2005 were interest-only and payment-
option ARMs that lenders increasingly marketed and sold to a wider
spectrum of borrowers. Federal regulatory officials and consumer
advocates said that since AMPs tend to have more complicated terms and
features than ARMs, borrowers who have these mortgages would be likely
to (1) underestimate the potential changes in their interest rates and
(2) experience confusion about the terms of their mortgages and amounts
of their payments.
Because most AMPs have not recast to fully amortizing payments, many
borrowers are still making lower monthly payments that do not cover
repayment of deferred principal. However, five of the eight states we
contacted reported receiving some complaints about AMPs from borrowers
who did not understand their loan terms and were surprised by increases
in their monthly payments or loan balances. For example, some borrowers
with payment-option ARMs complained that they did not know that their
loans could negatively amortize until they received their payment
coupons and saw that their loan balance had increased. In one case, a
borrower believed that the teaser rate would be in effect for 1 or more
years, when in fact it was in effect for only the first month.
Officials from one state said that they anticipated receiving more
consumer complaints regarding AMPs as these mortgages recast over the
next several years to require fully amortizing payments.
Consumers Receive Disclosures about ARMs but the Federal Reserve Will
Consider the Need for Additional Disclosures about AMPs in its Upcoming
Review of Regulation Z:
As AMPs are more complex than conventional mortgages and advertisements
sometimes expose borrowers to unbalanced information about them, it is
important that the written disclosures they receive about these
products from creditors provide them with comprehensive information
about the terms, conditions, and costs of these loans. Disclosures
convey that information in the following two ways: content and
presentation. Federal statute and regulation mandate a certain level of
content in mortgage disclosures through TILA and Regulation Z.
The purpose of both TILA and Regulation Z, which implements the
statutory requirements of TILA, is to promote the informed use of
credit by requiring creditors to provide consumers with disclosures
about the terms and costs of their credit products, including their
mortgages. Some of Regulation Z's mortgage disclosure requirements are
mandated by TILA. Under Regulation Z, creditors are required to provide
three disclosures for a mortgage product with an adjustable rate:
* a program-specific disclosure that describes the terms and features
of the ARM product,
* a copy of the federally authored handbook on ARMs, and:
* a transaction-specific TILA disclosure that provides the borrower
with specific information on the cost of the loan.
First, Regulation Z requires that creditors provide a program-specific
disclosure for each adjustable-rate product the borrower is interested
in when the borrower receives a loan application or has paid a
nonrefundable fee. Among other things, lenders must include:
* a statement that the interest rate, payment, or loan term may change;
* an explanation of how the interest rate and payment will be
determined;
* the frequency of interest rate and payment changes;
* any rules relating to changes in the index, interest rate, payment
amount, and outstanding loan balance--including an explanation of
negative amortization if it is permitted for the product; and:
* an example showing how monthly payments on a $10,000 loan amount
could change based on the terms of the loan.
Second, Regulation Z also requires creditors to give all borrowers
interested in an ARM a copy of the Consumer Handbook on Adjustable Rate
Mortgages or CHARM booklet. The Federal Reserve and OTS wrote the
booklet to explain how ARMs work and some of the risks and advantages
to borrowers that ARMs introduce, including payment shock, negative
amortization, and prepayment penalties.
Finally, for both fixed-rate and adjustable-rate loans for home
purchases, lenders are required to provide a transaction-specific TILA
disclosure to borrowers within 3 days of loan application for loans
used to purchase homes. For other home-secured loans this disclosure
must be provided before the loan closes. The TILA disclosure reflects
loan-specific information, such as the amount financed by the loan,
related finance charges, and the APR. Lenders also must include a
payment schedule, reflecting the number, amounts, and timing of
payments needed to repay the loan.
The Federal Reserve periodically has updated Regulation Z in response
to new mortgage features and lending practices. For example, in
December 2001, the Federal Reserve amended the Regulation Z provisions
that implement the Home Ownership and Equity Protection Act (HOEPA),
which requires additional disclosures with respect to certain high-cost
mortgage loans.[Footnote 28] The Federal Reserve has also developed
model disclosure forms to help lenders achieve compliance with the
current requirements.
According to Federal regulatory officials, current Regulation Z
requirements are designed to address traditional fixed-rate and
adjustable-rate products--not more complex products such as AMPs.
Consequently, lenders are not required to tailor the mortgage
disclosures to communicate information on the potential for payment
shock and negative amortization specific to AMPs. The Federal Reserve
has recently initiated a review of Regulation Z that will include
reviewing the disclosures required for all mortgage loans, including
AMPs. In addition, the Federal Reserve has begun taking steps to
consider revisions that would specifically address AMPs. During the
summer of 2006, the Federal Reserve held a series of four hearings
across the country on home-equity lending.[Footnote 29] Federal Reserve
officials said that a major focus of these hearings was on AMPs,
including the adequacy of consumer disclosures for these products, how
consumers shop for home-secured loans, and how to design more effective
disclosures. According to these officials, they are currently reviewing
the hearing transcripts and public comment letters as a first step in
developing plans and recommendations for revising Regulation Z. In
addition, they said that they are currently revising the CHARM booklet
to include information about AMPs and are planning to publish a
consumer education brochure concerning these products.
Leading Practices for Financial Product Disclosures Include the Use of
Clear Language to Explain Information That Is Most Relevant to the
Consumer:
As we previously noted, the presentation of information in disclosures
helps convey information. Regulation Z requires that the mortgage
disclosures lenders provide to consumers are clear and conspicuous.
Current leading practices in the federal government provide useful
guidance on developing financial product disclosures that effectively
present and communicate key information on these products. The SEC
publishes A Plain English Handbook for investment firms to use when
writing mutual fund disclosures.[Footnote 30] According to the SEC
handbook, investors need disclosures that clearly communicate key
information about their financial products so that they can make
informed decisions about their investments. SEC requires investment
firms to use "plain English" to communicate complex information clear
and logical manner so that investors have the best possible chance of
understanding the information.
A Plain English Handbook presents recommendations for both the
effective visual presentation and readability of information in
disclosure documents. For example, the handbook directs firms to
highlight information that is important to investors, presenting the
"big picture" before the details. Also, the handbook recommends
tailoring disclosures to the financial sophistication of the user by
avoiding legal and financial jargon, long sentences, and vague
"boilerplate" explanations. Furthermore, it states that the design and
layout of the document should be visually appealing, and the document
should be easy to read.
According to SEC, it developed these recommendations because investor
prospectuses were full of complex, legalistic language that only
financial and legal experts could understand. Because full and fair
disclosures are the basis for investor protection under federal
securities laws, SEC reasoned that investors would not receive that
basic protection if a prospectus failed to provide information clearly.
The Disclosures That We Reviewed Generally Did Not Provide Clear and
Complete Information on AMP Features and Risks:
To see how lenders implemented Regulation Z requirements for AMPs and
the extent to which they discussed AMP risks and loan terms, we
reviewed eight program-specific disclosures for three interest-only
ARMs and five payment-option ARMs, as well as transaction-specific TILA
disclosures associated with four of them. Six federally regulated
lenders, representing over 25 percent of the interest-only and payment-
option ARMs produced in 2005, provided these disclosures to borrowers
between 2004 and 2006. We found that the program-specific disclosures,
while addressing current Regulation Z requirements, did not always
provide full and clear explanations of the potential for payment shock
or negative amortization associated with AMPs. Furthermore, in
developing these program-specific disclosures, lenders did not always
adhere to "plain English" practices for designing disclosures that are
readable and visually effective, thus potentially reducing their
effectiveness. Finally, we found that Regulation Z does not require
lenders to completely disclose important loan information on the
transaction-specific TILA disclosures, and, in most cases, lenders did
not go beyond these minimum requirements when developing TILA
disclosures for AMP borrowers.
Program-Specific Disclosures Did Not Always Clearly Discuss the Risk of
Payment Shock or Negative Amortization for AMPs:
While addressing current Regulation Z requirements, the program-
specific disclosures for the eight adjustable-rate AMPs we reviewed did
not always consistently provide clear and full explanations of payment
shock and negative amortization as they related to AMPs. For example,
in describing how monthly payments could change, two of the disclosures
we reviewed closely followed the "boilerplate" language of the model
disclosure form, which included a statement that monthly payments could
"increase or decrease annually" based on changes to the interest rate,
as illustrated in figure 3.
Figure 3: Example of a 2005 Interest-Only ARM Disclosure Explaining How
Monthly Payments Can Change:
[See PDF for image]
Source: Name withheld. Used with permission; GAO (boxed comments).
[End of figure]
While factually correct, these disclosure statements do not clearly
inform the borrower about the dramatic increase in monthly payments
that could occur at the end of the introductory period for an AMP--
twofold or more as we previously discussed--particularly in a rising
interest rate environment. The remaining six disclosures more
accurately signaled this risk to the borrower by stating that the
payments could change substantially. One of these disclosures most
clearly alerted borrowers to this risk by including both a bold-faced
heading "Potential Payment Shock" on the first page of the disclosure
and the following explanatory text:
"As with all Adjustable Rate Mortgage (ARM) loans, your interest rate
can increase or decrease. In the case of a [brand name of product], the
monthly payment can increase substantially after the first 60 months or
if the loan balance rises to 110 percent of the original amount
borrowed, and this creates the potential for payment shock. Payment
shock means that the increase in the payment is so significant that it
can affect your monthly cash flow." [Emphasis added.]
In reviewing the five payment-option ARM disclosures, we also found
that they did not always clearly describe negative amortization and its
risks for the borrower. As required by Regulation Z, all of the
disclosures explained that the product allowed for negative
amortization and described how. However, the disclosures we reviewed
did not always clearly or completely explain the harmful effects that
could result from negative amortization. In the example above, where
the disclosure did link an increased loan balance with payment shock,
the effectiveness of the statement is blunted because it does not tell
the borrower early on how the loan balance could rise. Instead, in a
separate paragraph under the relatively nondescript heading, "More
Information About [product name] Payment Choices," the lender tells the
borrower that the "minimum payment probably will not be sufficient to
cover the interest due each month." [Emphasis added.]
In another case, although the disclosure does say that because of
negative amortization the borrower can owe "much more" than originally
borrowed, the effect of that disclosure may be blunted by the inclusion
of positive language about taking advantage of the negative
amortization features and by non-loan-specific examples of payment
changes, which are in separate sections of the disclosure:
"If your monthly payment is not sufficient to pay monthly interest, you
may take advantage of the negative amortization feature by letting the
interest rate defer and become part of the principle balance to be paid
by future monthly payments, or you may also choose to limit any
negative amortization by increasing the amount of your monthly payment
or by paying any deferred interest in a lump sum at any time."
[Emphasis added].
In addition, three of the five payment-option ARM disclosures did not
explain how soon the negative amortization cap could be reached in a
rising interest rate environment and trigger an early recast. Without
this information, borrowers who considered purchasing a typical 5-year
payment-option ARM for its flexibility might not realize that their
payment-option period could expire before the end of the first 5 years,
thus recasting the loan and increasing their monthly payments.
Disclosures Generally Did Not Prominently Present Key Information on
Changes to Monthly Payments and Loan Balance or Adhere to Other "Plain
English" Principles:
Although the potential for payment shock and negative amortization are
the most significant risks to an interest-only or payment-option ARM,
the program-specific disclosures we reviewed generally did not
prominently feature this key information. Instead, in keeping with the
layout suggested by the model disclosure form, most of the disclosures
we reviewed first provided lengthy discussions on the borrower's
interest rate and monthly payment and the rules related to interest
rate and payment changes, before describing how much monthly payments
could change for the borrower. One disclosure did use the heading,
"Worst Case Example," to highlight the potential for payment shock for
the borrower. However, this information could be hard to find because
it is located on the third and fourth page of an eight-page disclosure.
Furthermore, the program-specific disclosures generally did not conform
to key plain English principles for readability or design in several
key areas. In particular, we found that these disclosures were
generally written with a complexity of language too high for many
adults to understand. Also, most of the disclosures used small, hard-
to-read typeface, which when combined with an ineffective use of white
space and headings, made them even more difficult to read and hindered
identification of important information. Appendix II provides
additional information on the results of our analysis.
Transaction-Specific TILA Disclosures Lacked Key Information for AMP
Borrowers:
Regulation Z does not require lenders to completely disclose important
AMP loan information on the transaction-specific TILA disclosures,
including the interest-rate assumptions underlying the payment
schedule, the amount of deferred interest that can accrue, and the
amount and duration of any prepayment penalty. In most cases, lenders
did not go beyond minimum requirements when developing transaction-
specific disclosures for AMP borrowers. First, when the mortgage
product features an adjustable rate, Regulation Z requires lenders to
(1) include a payment schedule and (2) assume that no changes occur in
the underlying index over the life of the loan. However, it does not
require the disclosures to indicate this assumption, and the four
transaction-specific disclosures we reviewed did not include this
information. Regulation Z only requires lenders to remind borrowers in
the transaction-specific disclosure that the loan has an adjustable
rate and refer them to previously provided adjustable-rate disclosures
(see fig. 4); therefore, borrowers might not understand that the
payment schedule is not representative of their payments in a changing
interest rate environment. Figure 4 shows the payment schedule for a 5-
year payment-option ARM originated in 2005. The first 5 years show the
minimum monthly payments increasing to reflect the difference between
the teaser rate and the initial fully-indexed interest rate, but the
amount of the increase is constrained each year by the payment reset
cap in effect for the loan. The loan recasts in the 6th year to fully
amortizing payments. However, this increase could be considerably more
if the fully-indexed interest rate were to rise during the first 5
years of the loan.
Figure 4: Transaction-Specific TILA Disclosure from a 2005 Payment-
Option ARM Disclosure:
[See PDF for image]
Source: Name withheld. Used with permission; GAO (boxed comments).
[End of figure]
Second, although negative amortization increases the risk of payment
shock for the payment-option ARM borrower, Regulation Z does not
require lenders to disclose the amount of deferred interest that would
accrue each year as a result of making minimum payments. None of the
lenders whose transaction-specific disclosures for payment-option ARMs
we reviewed elected to include this information. Without it, borrowers
would not be able to see how choosing the minimum payment amount could
increase the outstanding loan balance from year to year. We reviewed
two loan payment coupons that lenders provide borrowers on a monthly
basis to see if they provided the borrower with information on negative
amortization. Although they included information showing the increased
loan balance that resulted from making the minimum monthly payment,
borrowers only would receive these coupons once they started making
payments on the loan.[Footnote 31]
Finally, Regulation Z requires lenders to disclose whether the loan
contains any prepayment penalties, but the regulation does not require
the lender to provide any details on this penalty on the transaction-
specific disclosure. Three of the four disclosures used two checkboxes
to indicate whether borrowers "may" or "will not" be subject to a
prepayment penalty if they paid off the mortgage before the end of the
term, but did not disclose any additional information, such as the
amount of the prepayment penalty (see fig. 4). One disclosure provided
information on the length of the penalty period. Without clear
prepayment information, borrowers may not understand how expensive it
could be to refinance the mortgage if they found their monthly payments
were rising and becoming unaffordable.
Revisions to Regulation Z May Increase Understanding of AMPs,
Particularly If Broader Effort Were Made to Reform the Mortgage
Disclosure Process:
According to federal banking regulators, borrowers who do not
understand their AMP may not anticipate the substantial increase in
monthly payments or loan balance that could occur, and would be at a
higher risk of experiencing financial hardship or even default. One
mortgage industry trade association told us that it is in the best
interest of lenders and brokers to provide adequate disclosures to
their customers so that they will be satisfied with their loan and
consider the lender for future business or refer others to them.
Officials from one federal banking regulator said that revising
Regulation Z requirements so that lender disclosures more clearly and
comprehensively explain the key terms and risks of AMPs would be one of
several steps needed to increase borrower understanding about these
more complex mortgage products. Federal Reserve officials said that
there is a trade-off between the goals of clarity and comprehensiveness
in mortgage disclosures. In particular, they said that there is a
desire to provide information that is both accurate and comprehensive
in order to mitigate legal risks, but that might also result in
disclosures that have too much information and therefore, are not clear
or useful to consumers. According to these officials, this highlights
the need for using consumer testing in designing model disclosures to
determine (1) what information consumers need, (2) when they need it,
and (3) which format and language that will most effectively convey the
information so that it is readily understandable. In conducting the
review of Regulation Z rules for mortgage disclosures, they said that
they plan to use extensive consumer testing and will also use design
consultants in developing model disclosure forms.
In addition, Federal Reserve officials and other industry participants
said that the benefits of amending federally required disclosures to
improve their content, usability, and readability might not be realized
if revisions were not part of a broader effort to simplify and clarify
mortgage disclosures. According to a 2000 report by the Department of
the Treasury and the Department of Housing and Urban Development,
federally required mortgage disclosures account for only 3 to 5 forms
in a process that can generate up to 50 mortgage disclosure documents,
most of which are required by the lender or state law.[Footnote 32]
According to federal and state regulatory officials and industry
representatives, existing mortgage disclosures are too voluminous and
confusing to clearly convey to borrowers the essential terms and
conditions of their mortgages, and often are provided too late in the
loan process for borrowers to sort through and read. Officials from one
federal banking regulator noted that disclosures often are given when
borrowers have committed money to apply for a loan, thereby making it
less likely that the borrowers would back out even if they did not
understand the terms of the loan.
Federal Banking Regulators Issued Draft Guidance and Took Other Actions
to Improve Lender Practices and Disclosures and Publicize Risks of
AMPs:
Federal banking regulators have responded, collectively and
individually, to concerns about the risks of AMP-lending. In December
2005, regulators collectively issued draft interagency guidance for
federally regulated lenders that suggests tightening underwriting for
AMP loans, developing policies for risk management of AMP lending, and
improving consumer understanding of these products. For instance, the
draft guidance states that lenders should provide clear and balanced
information on both the benefits and risks of AMPs to consumers,
including payment shock and negative amortization. In comments to the
regulators, some industry groups said the draft guidance would put
federally regulated lenders at a disadvantage, while some consumer
advocates questioned whether it would protect consumers because it did
not apply to all lenders or require revised disclosures. Federal
regulatory officials discussed AMP lending in a variety of public and
industry forums, widely publicizing their concerns and recommendations.
In addition, some regulators individually increased their monitoring of
AMP lending, taking such actions as issuing new guidance to examiners
and developing new review programs.
Draft Interagency Guidance on AMP Lending Recommends Tightening
Underwriting Standards, Developing Risk Management Policies, and
Improving Consumer Information:
Draft interagency guidance, which federal banking regulators released
in December 2005, responds to their concern that banks may face
heightened risks as a result of AMP lending and that borrowers may not
fully understand the terms and risks of these products.[Footnote 33]
Federal regulatory officials noted that the draft guidance did not seek
to limit the availability of AMPs, but instead sought to ensure that
they were properly underwritten and disclosed. In addition, they said
the draft guidance reflects an approach to supervision that seeks to
help banks identify emerging and growing risks as early as possible, a
process that encourages banks to develop advanced tools and techniques
to manage those risks, for their own account and for their customers.
Accordingly, the draft guidance recommends that federally regulated
financial institutions ensure that (1) loan terms and underwriting
standards are consistent with prudent lending practices, including
consideration of a borrower's repayment capacity; (2) risk management
policies and procedures appropriately mitigate any risk exposures
created by these loans; and (3) consumers are provided with balanced
information on loan products before they make a mortgage product
choice.
To address AMP underwriting practices, the draft guidance states that
lenders should consider the potential impact of payment shock on the
borrower's capacity to repay the loan. In particular, lenders should
qualify borrowers on the basis of whether they can make fully
amortizing monthly payments determined by the fully-indexed interest
rate, and not on their ability to make only interest-only payments or
minimum payments determined from lower promotional interest rates. The
draft guidance also notes increased risk to lenders associated with
combining AMPs with risk-layering features, such as reduced
documentation or the use of piggyback loans. In such cases, the draft
guidance recommends that lenders look for off-setting factors, such as
higher credit scores or lower LTV ratios to mitigate the additional
risk. Furthermore, the draft guidance recommends that lenders avoid
using loan terms and underwriting practices that may cause borrowers to
rely on the eventual sale or refinancing of their mortgages once full
amortization begins.
To manage risk associated with AMP lending, the draft guidance
recommends lenders develop written policies and procedures that
describe AMP portfolio limits, mortgage sales and securitization
practices, and risk-management expectations. The policies and
procedures also should establish performance measures and management
reporting systems that provide early warning of portfolio deterioration
and increased risk. The draft guidance also recommends policies and
procedures that require banking capital levels that adequately reflect
loan portfolio composition and credit quality, and also allow for the
effect of stressed economic conditions.
To help improve consumer understanding of AMPs, the draft guidance
recommends that lender communications with consumers, including
advertisements, promotional materials, and monthly statements, be
consistent with actual product terms and payment structures and provide
consumers with clear and balanced information about AMP benefits and
risks. Furthermore, the draft guidance recommends that institutions
avoid advertisement practices that obscure significant risks to the
consumer. For example, when institutions emphasize the AMP benefit of
low initial payments, they also should disclose that borrowers who make
these payments may eventually face increased loan balances and higher
monthly payments when their loans recast.
The draft guidance also recommends that lenders fully disclose AMP
terms and features to potential borrowers in their promotional
materials, and that lenders not wait until the time of loan application
or closing, when they must provide written disclosures that fulfill
Regulation Z requirements. Rather, the draft guidance states that
institutions should offer full and fair descriptions of their products
when consumers are shopping for a mortgage, so that consumers have the
appropriate information early enough to inform their decision making.
In doing so, the draft guidance urges lenders to employ a user-friendly
and readily navigable design for presenting mortgage information and to
use plain language with concrete examples of available loan products.
Further, the draft guidance states that financial institutions should
provide consumers with information about mortgage prepayment penalties
or extra costs, if any, associated with AMP loans. Finally, after loan
closing, financial institutions should provide monthly billing
statement information that explains payment options and the impact of
consumers' payment choices. According to the draft guidance, such
communication should help minimize potential consumer confusion and
complaints, foster good customer relations, and reduce legal and other
risks to lending institutions.
Federal regulatory officials said they developed the draft guidance to
clarify how institutions can offer AMPs in a safe and sound manner and
clearly disclose the potential AMP risks to borrowers. These officials
told us they will request remedial action from institutions that do not
adequately measure, monitor, and control risk exposures in their loan
portfolios.
Many Industry Groups Opposed the Draft Guidance and Some Consumer
Advocates Questioned Whether It Would Add Consumer Protections:
In response to the draft interagency guidance, federal regulators
received various responses through comment letters from various groups,
such as financial institutions, mortgage brokers, and consumer
advocates, and began reviewing comments to develop final guidance. For
example, several financial institutions such as banks and their
industry associations opposed the draft guidance, suggesting that it
put federally regulated institutions at a competitive disadvantage
because its recommendations would not apply to lenders and brokers that
were not federally regulated. Some lenders suggested implementing these
changes through Regulation Z so that they apply to the entire industry,
and not just to regulated institutions. Organizations such as the
Conference of State Bank Supervisors (CSBS) and the American
Association of Residential Mortgage Regulators (AARMR) also noted the
possibility of competitive disadvantage and have responded by
developing guidance for state- licensed mortgage lenders and brokers
who offer AMPs but were not covered by the draft federal guidance
issued in December 2005. Other financial institutions said that the
recommendations regarding borrower qualification and general
underwriting practices were too prescriptive and would have the effect
of reducing mortgage choice for consumers.
Consumer advocates supported the need for additional consumer
protections relating to AMP products, but several questioned whether
the draft guidance would add needed protections. They also contended,
as did lenders, that since the draft guidance applies only to federally
regulated institutions, independent lenders and brokers would not be
subject to recommendations aimed at informing and protecting consumers.
One advocacy organization said that the proposed guidance is only a
recommendation by the agencies regulating some lenders, and that
failure to follow the guidance neither leads to any enforceable
sanctions nor provides a means of using guidance to obtain relief for a
harmed consumer. Although not in a comment letter, another advocate
echoed these concerns by saying the draft guidance would not expand
consumer protections because it neither requires revisions to mortgage
disclosures, nor allows consumers to enforce the application of
guidance standards to individual lenders.
Federal Officials Reinforced Their Messages by Publicizing Their
Concerns, Highlighting AMP Risks, and Taking Other Actions:
Although the draft interagency guidance has not been finalized,
officials from the Federal Reserve, OCC, OTS, FDIC, and NCUA have
reinforced messages regarding AMP risks and appropriate lending
practices by publicizing their concerns in speeches, at conferences,
and the media. According to an official at the Federal Reserve, federal
regulatory officials who publicized their concerns in these outlets
raised awareness of AMP risks and reinforced the message that financial
institutions and the general public need to manage risks and understand
these products, respectively.
In addition to drafting interagency guidance and publicizing AMP
concerns, officials from each of the federal banking regulators told us
they have responded to AMP lending with intensified reviews,
monitoring, and other actions. For instance, FDIC developed a review
program to identify high-risk lending areas, adjust supervision
according to product risk levels, and evaluate risk management and
underwriting approaches. OTS staff has performed a review of its 68
most active AMP lenders to assess and respond to potential AMP lending
risks while the Federal Reserve and OCC have begun to conduct reviews
of their lenders' AMP promotional and marketing materials to assess how
well they inform consumers. As discussed earlier, the Federal Reserve
has taken several steps to address consumer protection issues
associated with AMPs, including initiating a review of Regulation Z
that includes reviewing the disclosures required for all mortgage loans
and holding public hearings that in part explored the adequacy and
effectiveness of AMP disclosures. In addition, NCUA officials told us
they informally contacted the largest credit unions under their
supervision to assess the extent of AMP lending at these institutions.
FTC also directed some attention to consumer protection issues related
to AMPs. In 2004, it charged a California mortgage broker with
misleading AMP consumers by making advertisements that contained
allegedly false promises of fixed interest rates and fixed payments for
variable rate payment option mortgages. As a result of FTC's actions, a
U.S. district court judge issued a preliminary injunction barring the
broker's allegedly illegal business practices. More recently in May
2006, FTC sponsored a public workshop that explored consumer protection
issues as a result of AMP growth in the mortgage marketplace. FTC,
along with other federal banking regulators and departments, also
helped create a consumer brochure that outlines basic mortgage
information to help consumers shop for, compare, and negotiate
mortgages.
Most States in Our Sample Responded to AMP Lending Risks within
Existing Regulatory Frameworks, While Others Had Taken Additional
Actions:
Along with federal regulatory officials, state banking and financial
regulatory officials we contacted expressed concerns about AMP lending
and some have incorporated AMP issues into their licensing and
examinations of independent lenders and brokers and worked to improve
consumer protection. While the states we reviewed had not changed
established licensing and examinations procedures to oversee AMP
lending, some currently have a greater focus on and awareness of AMP
risks. Two states also had collected AMP-specific data to identify
areas of concerns, and one state had proposed changing a consumer
protection law to cover AMP products.
States in Our Sample Identified Concerns about AMP Lending by
Independent Mortgage Lenders and Brokers:
Most regulatory officials from our sample of eight states focused their
concerns about AMP lending on the potential negative effects on
consumers. For example, many officials questioned (1) how well
consumers understood complex AMP loans, and therefore, how susceptible
consumers with AMPs therefore might be to payment shock and (2) how
likely consumers would then be to experience financial difficulties in
meeting their mortgage payments. Some state officials also said that
increased AMP borrowing heightened their concern about mortgage default
and foreclosure, and some officials expressed concern about
unscrupulous lender or broker operations and the extent to which these
entities met state licensing and operations requirements. In addition
to these general consumer protection concerns, some state officials
spoke about state-specific issues. For example, Ohio officials put AMP
concerns in the context of larger economic issues and said AMP
mortgages were part of wider economic challenges facing the state,
including an already-high rate of mortgage foreclosures and the loss of
manufacturing jobs that hurt both Ohio's consumers and the overall
economy. Officials from another state, Nevada, said they worried that
lenders and brokers sometimes took advantage of senior citizens by
offering them AMP loans that they either did not need or could not
afford.
State banking and financial regulatory officials expressed concerns
about the extent to which consumers understood AMPs and that potential
for those who used them to experience monthly mortgage payment
increases. Some state officials said that current federal disclosures
were complicated, difficult to comprehend, and often did not provide
information that could help consumers. However, these officials thought
that adding a state-developed disclosure to the already voluminous
mortgage process would add to the confusion and paperwork burden.
Officials from most states have not created their own mortgage
disclosures.
States in Our Sample Generally Increased Their Attention to AMPs
Through Licensing and Examination, and by Taking New Approaches:
State banking and financial regulators from our sample generally
responded to concerns about AMP lending by increasing their attention
to AMP issues through their existing regulatory structure of lender and
broker licensing and examination, but some states had taken additional
approaches. Most of the state officials from our sample suggested they
primarily used their own state laws and regulations to license mortgage
lenders and brokers and to ensure that these entities met minimum
experience and operations standards. While these were not AMP-specific
actions, several state officials told us these actions help ensure that
lenders had the proper experience and other qualifications to operate
within the mortgage industry. Some officials told us that these
requirements also helped ensure that those with criminal records or
histories of unscrupulous mortgage behavior would not continue to harm
consumers. Some state officials said that they were particularly
sensitive to AMP lenders' records of behavior because of the higher
risks these products entailed for consumers.
However, Alaska provided an exception. Alaska had not specifically
responded to AMP lending and Alaska officials noted that the state does
not have statutes or regulations that govern mortgage lending, nor are
mortgage lenders or brokers required to be licensed to make loans.
Many of the state banking and financial regulatory officials we
contacted also told us that they periodically examine AMP lenders and
brokers for compliance with state licensing, mortgage lending, and
general consumer protection laws, including applicable fair advertising
requirements. Because state officials perform examinations for all
licensed lenders and brokers, these regulatory processes also are not
AMP-specific. However, some state officials said they were particularly
aware of AMP risks to consumers and had begun to pay more attention to
potential lender, broker, and consumer issues during their oversight
reviews. For example, because AMP lending heightens potential risks for
consumers, several state officials said they had taken extra care
during their licensing and examination reviews to review lender and
broker qualifications and loan files.
A few states had worked outside of the existing licensing and
examination framework to identify AMP issues and protect consumers.
Officials from several states said that because they did not collect
data on AMP loans and borrowers, they did not fully understand the
level and types of AMP lending in their states. However, two states
from our sample had begun to gather AMP data to improve their
information on AMP lending. New Jersey conducted a mortgage lending
survey among its state-chartered banks that specifically collected data
on interest-only and payment-option mortgages, while Nevada implemented
annual reporting requirements for lenders and brokers on the types of
loans they originate. New Jersey and Nevada officials told us that
these efforts would provide an overview of AMP lending in each state
and would serve to help identify emerging AMP issues.
Other states reacted by focusing on consumer protection or using
guidance for independent lenders and mortgage brokers. Ohio addressed
mortgage issues, including AMP concerns, by working to improve its
consumer protection law. This law originally did not cover mortgage
lenders and brokers, but was amended to include protections found in
other states. As of June 2006, officials drafted and passed legislation
to expand the law's provisions to cover these entities and require
lenders and brokers to meet fiduciary standards to offer loans that
serve the interest of potential borrowers. Officials from another state
in our sample, New York, said they planned to use guidance developed by
the Conference of State Bank Supervisors and American Association of
Residential Mortgage Regulators to address AMP lending concerns at the
state level. In addition, they said that they were revising their
banking examination manual to address AMP concerns, reflect
recommendations made in their guidance, and provide examiners with
areas of concern on which to focus during their reviews.
Conclusions:
Historically AMPs were offered to higher-income, financially
sophisticated borrowers who wanted to minimize their mortgage payments
to better manage their cash flows. In recent years, federally and state-
regulated lenders and brokers widely marketed AMPs by touting their low
initial payments and flexible payment options, which helped borrowers
to purchase homes for which they might not have been able to qualify
with a conventional fixed-rate mortgage, particularly in some high-
priced markets. However, the growing use of these products, especially
by less informed, affluent, and creditworthy borrowers, raises concerns
about borrowers' ability to sustain their monthly mortgage payments,
and ultimately to keep their homes. When these mortgages recast and
payments increase, borrowers who cannot refinance their mortgages or
sell their homes could face substantially higher payments. If these
borrowers cannot make these payments, they could face financial
distress; delinquency; and possibly, foreclosure. Nevertheless, it is
too soon to tell the extent to which payment shock will produce
financial distress for borrowers and induce defaults that would affect
banks that hold AMPs in their portfolios.
Federal banking regulators have taken steps to address the potential
risks of AMPs to lenders and borrowers. They have drafted guidance for
lenders to strengthen underwriting standards and improve disclosure of
information to borrowers. Because the key features and terms of AMPs
may continue to evolve, it is essential for the regulators to make an
effort to respond to AMP lending growth in ways that seek to balance
market innovation and profitability for lenders with timely information
and mortgage choices for borrowers. Furthermore, with the continued
popularity of AMPs, it is important that the federal banking regulators
finalize the draft guidance in a timely manner.
The popularity and complexity of AMPs and lenders' marketing of these
products highlight the importance of mortgage disclosures in helping
borrowers make informed mortgage decisions. As lenders and brokers
increasingly market AMPs to a wider spectrum of borrowers, more
borrowers may struggle to fully understand the terms and risks of these
products. While Regulation Z requires that lenders provide certain
information on ARMs, currently lenders are not required to tailor the
mortgage disclosures to communicate to borrowers information on the
potential for payment shock and negative amortization specific to AMPs.
In particular, although they may be in compliance with Regulation Z
requirements, the disclosures we reviewed did not provide borrowers
with easily comprehensible information on the key features and risks of
their mortgage products. Furthermore, the readability and usability of
these documents were limited by the use of language that was too
complex for many adults and document designs that made the text
difficult to read and understand. As such, these documents were not
consistent with leading practices at the federal level for financial-
product disclosures that are predicated on investment firms' providing
investors with important product information clearly to further their
informed decision making. Although the draft interagency guidance by
federal banking regulators addressed some of the concerns with consumer
disclosures, the draft guidance focuses on promotional materials, not
the written disclosures required by Regulation Z at loan application
and closing. In addition, the guidance does not apply to nonbank
lenders, whereas Regulation Z applies to the entire industry. We
recognize that the Federal Reserve has begun to review disclosure
requirements for all mortgage loans, including AMPs, under Regulation Z
and has used the recent HOEPA hearings to gather public testimony on
the effectiveness of current AMP disclosures. Furthermore, we agree
with regulators and industry participants' views that revising
Regulation Z to make federally required mortgage disclosures more
useful for borrowers that use complex products like AMPs is a good
first step to addressing a mortgage disclosure process that many view
as overwhelming and confusing for the average borrower. Without
amending Regulation Z to require lenders to clearly and comprehensively
explain the terms and risks of AMPs, borrowers might not be able to
fully exercise informed judgment on what is likely a significant
investment decision.
Recommendation for Executive Action:
We commend the Federal Reserve's efforts to review its existing
disclosure requirements and focus the recent HOEPA hearings in part on
AMPs. As the Federal Reserve begins to review and revise Regulation Z
as it relates to disclosure requirements for mortgage loans, we
recommend that the Board of Governors of the Federal Reserve System
consider improving the clarity and comprehensiveness of AMP disclosures
by requiring:
* language that explains key features and potential risks specific to
AMPs, and:
* effective format and visual presentation, following criteria such as
those suggested by SEC's A Plain English Handbook.
Agency Comments and Our Evaluation:
We requested comments on a draft of this report from the Federal
Reserve, FDIC, NCUA, OCC, and OTS. We also provided a draft to FTC and
selected sections of the report to the relevant state regulators for
their review. The Federal Reserve provided written comments on a draft
of this report, which have been reprinted in appendix III. The Federal
Reserve noted that it has already begun a comprehensive review of
Regulation Z, including its requirements for mortgage disclosures. The
Federal Reserve reiterated that one of the purposes of its recent
public hearings on home equity lending was to discuss AMPs, and in
particular, whether consumers receive adequate information about these
products. It intends to use this information in developing plans and
recommendations for revising Regulation Z within the existing framework
of TILA. The Federal Reserve stressed that any new disclosure
requirements relating to features and risks of today's loan products
must be sufficiently flexible to allow creditors to provide meaningful
disclosures even as those products develop over time. In response to
our recommendation to consider improving the clarity and
comprehensiveness of AMP disclosures, the Federal Reserve noted that it
plans to conduct consumer testing to determine what information is
important to consumers, what language and formats work best, and how
disclosures can be revised to reduce complexity and information
overload. To that end, the Federal Reserve said that it will use design
consultants to assist in developing model disclosures that are most
likely to be effective in communicating information to consumers. In
addition, the Federal Reserve provided examples of other efforts that
it is currently engaged in to enhance the information consumers
received about the features and risks associated with AMPs, which we
have previously discussed in the report. FDIC, FTC, NCUA, OCC, and OTS
did not provide written comments. Finally, the Federal Reserve, FDIC,
FTC, and OCC provided technical comments, which we have incorporated
into the final report.
As agreed with your office, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
after the date of this report. At that time, we will send copies of
this report to the Chairman and Ranking Minority Member of the Senate
Committee on Banking, Housing, and Urban Affairs and the Ranking
Minority Member of its Subcommittee on Housing and Transportation; the
Chairman and Ranking Minority Member of the House Committee on
Financial Services; other interested congressional committees. We will
also send copies to the Chairman, Federal Deposit Insurance
Corporation; the Chairman, Board of Governors of the Federal Reserve
System; the Chairman, National Credit Union Administration; the
Comptroller of the Currency; and the Director, Office of Thrift
Supervision. We will also make copies available to others upon request.
The report will be available at no charge on the GAO Web site at
[Hyperlink, http://www.gao.gov].
If you or your staff have any questions regarding this report, please
contact me at (202) 512-8678 or williamso@gao.gov. Contact points for
our Offices of Congressional Relations and Public Affairs may be found
on the last page of this report. Key contributors to this report are
listed in appendix IV.
Sincerely yours,
Signed by:
Orice M. Williams:
Director, Financial Markets and Community Investment:
[End of section]
Appendix I: Scope and Methodology:
To identify recent trends in the market for alternative mortgage
products (AMPs), we gathered information from federal banking
regulators and the residential mortgage lending industry on AMP product
features, customer base, and originators as well as on reasons for the
recent growth of these products.
To determine the potential risks of AMPs for lenders and borrowers, we
analyzed the changes, especially increases, in future monthly payments
that can occur with AMPs. We analyzed these data using several
scenarios, including rising interest rates and negative amortization.
We obtained data from a private investment firm on the underwriting
characteristics of recent interest-only and payment-option adjustable
rate mortgage (ARM) issuance and obtained information on the
securitization of AMPs from federal banking regulators, government-
sponsored enterprises, and the secondary mortgage market. We conducted
a limited analysis to assess the reliability of the investment firm's
data. To do so, we interviewed a firm representative and an official
from a federal banking regulator (federal regulatory official) to
identify potential data limitations and determine how the data were
collected and verified and to identify potential data limitations. On
the basis of this analysis, we concluded that the firm's data were
sufficiently reliable for our purposes. Finally, we interviewed federal
regulatory officials and representatives from the residential mortgage
lending industry and reviewed studies on the risks of these mortgages
compared with conventional fixed rate mortgages.
To determine the extent to which mortgage disclosures present the risks
of AMPs, we reviewed federal laws and regulations governing the content
of required mortgage disclosures. We obtained examples of AMP-related
advertising and mortgage disclosures, reviewed studies on borrowers'
understanding of adjustable rate products, and conducted interviews
with federal regulatory officials and industry participants. To obtain
state regulators' views on AMP mortgage disclosures, we also selected a
sample of eight states and reviewed laws and regulations related to
disclosure requirements. We obtained examples of AMP advertisements,
disclosures, and AMP-related complaint information and interviewed
state officials. We generally selected states that 1) exhibited high
volumes of AMP lending, 2) provided geographic diversity of state
locations, and 3) provided diverse regulatory records when responding
to the challenges of a growing AMP market. Because state-level data on
AMP lending volumes were not available, we determined which states had
high volumes of AMP lending by using data obtained from a Federal
Reserve Bank on states that had high levels of ARM growth and house
price appreciation in 2005, factors which this study suggested
corresponded with high volumes of AMP lending. Furthermore, we reviewed
regulatory data showing that the largest AMP lenders conducted most of
their lending in these states. We selected eight states and conducted
in-person interviews with officials from California, New Jersey, New
York, and Ohio. We conducted telephone interviews with officials from
the remainder of the sample states (Alaska, Florida, Nevada, and North
Carolina).
We also analyzed for content, readability, and usability a selected
sample of eight written disclosures that six federally regulated AMP
lenders provided to borrowers between 2004 and 2006. The sample
included program-specific disclosures for three interest-only ARMs and
for five payment-option ARMs as well as transaction-specific
disclosures associated with four of them. The six lenders represented
over 25 percent of the interest-only and payment-option ARMs produced
in the first 9 months of 2005. First, we assessed the extent to which
the disclosures described the key risks and loan features of interest-
only and payment-option ARMs. Second, we conducted a readability
assessment of these disclosures using computer-facilitated formulas to
predict the grade level required to understand the materials.
Readability formulas measure the elements of writing that can be
subjected to mathematical calculation, such as the average number of
syllables in words or number of words in sentences in the text. We
applied the following commercially available formulas to the documents:
Flesch Grade Level, Frequency of Gobbledygook (FOG), and Simplified
Measure of Gobbledygook (SMOG). Using these formulas, we measured the
grade levels at which the disclosure documents were written for
selected sections. Third, we conducted an evaluation that assessed how
well these AMP disclosures adhered to leading practices in the federal
government for usability. We used guidelines presented in the
Securities and Exchange Commission's (SEC) A Plain English Handbook:
How to Create Clear SEC Disclosure Documents (1998). SEC publishes the
handbook for investment firms to use when writing mutual fund
disclosures. The handbook presents criteria for both the effective
visual presentation and readability of information in disclosure
documents.
To obtain information on the federal regulatory response to the risks
of AMPs for lenders and borrowers, we reviewed the draft interagency
guidance on AMP lending issued in December 2005 by federal banking
regulators and interviewed regulatory officials about what actions they
could use to enforce guidance principles upon final release of the
draft. We also reviewed comments written by industry participants in
response to the draft guidance. To review industry comments, we
selected 29 of the 97 comment letters that federal regulators received.
We selected comment letters that represented a wide range of industry
participants, including lenders, brokers, trade organizations, and
consumer advocates. We analyzed the comment letters for content; sorted
them according to general comments, issues of institutional safety and
soundness, consumer protection, or other concerns; and summarized the
results of the analysis.
To obtain information on selected states' regulatory response to the
risks of AMPs for lenders and borrowers, we reviewed current laws and,
where applicable, draft legislation from the eight states in our sample
and interviewed these states' banking and mortgage lending officials.
We performed our work between September 2005 and September 2006 in
accordance with generally accepted government auditing standards.
[End of section]
Appendix II Readability and Design Weaknesses in AMP Disclosures That
We Reviewed:
The AMP disclosures that we reviewed did not always conform to key
plain English principles for readability or design. We analyzed a
selected sample of eight written AMP disclosures to determine the
extent to which they adhered to best practices for financial product
disclosures. In conducting this assessment, we used three widely used
"readability" formulas as well as guidelines from the SEC's A Plain
English Handbook. In particular, the AMP disclosures that we reviewed
were written at a level of complexity too high for many adults to
understand. Also, most of the disclosures that we reviewed used small
typeface, which when combined with an ineffective use of white space
and headings, made them more difficult to read and hindered
identification of important information.
Disclosures Required Reading Levels Higher Than That of Many Adults in
the U.S.
The AMP disclosures that we reviewed contained content that was written
at a level of complexity higher than the level at which many adults in
the United States read. To assess the reading level required for AMP
disclosures, we applied three widely used "readability" formulas to the
sections of the disclosures that discussed how monthly payments could
change. These formulas determined the reading level required for
written material on the basis of quantitative measures, such as the
average numbers of syllables in words or the number of words in
sentences.[Footnote 34]
On the basis of our analysis, the disclosures were written at reading
levels commensurate with an education level ranging from 9th to 12th
grade, with an average near the 11th grade. A nationwide assessment of
reading comprehension levels of the U.S. population reported in 2003
that 43 percent of the adult population in the United States reads at a
"basic" level or below.[Footnote 35] While certain complex terms and
phrases may be unavoidable in discussing financial material,
disclosures that are written at too high a reading level for the
majority of the population are likely to fail in clearly communicating
important information. To ensure that disclosures investment firms
provide to prospective investors are understandable, the Plain English
Handbook recommends that investment firms write their disclosures at a
6th-to 8th-grade reading level.
Size and Choice of Typeface and Use of Capitalization Made Most
Disclosures Difficult to Read:
Most of the AMP disclosures used font sizes and typeface that were
difficult to read and could hinder borrowers' ability to find
information. The disclosures extensively used small typeface in AMP
disclosures, when best practices suggest using a larger, more legible
type. A Plain English Handbook recommends use of a 10-point font size
for most investment product disclosures and a 12-point size font if the
target audience is elderly. Most of the disclosures we reviewed used a
9-point size font or smaller. Also, more than half of the disclosures
used sans serif typeface, which is generally considered more difficult
to read at length than its complement, serif typeface. Figure 5 below
provides an example of serif and sans serif typefaces.
Figure 5: Examples of Serif and Sans Serif Typefaces:
[See PDF for image]
Source: GAO.
[End of figure]
The handbook recommends the use of serif typefaces for general text
because the small connective strokes at the beginning and end of each
letter help guide the reader's eye over the text. The handbook
recommends using the sans serif typeface for short pieces of
information, such as headings or for emphasizing particular information
in the document.
In addition, some lenders' efforts to use different font types to
highlight important information made the text harder to read. Several
disclosures emphasized large portions of text in boldface and repeated
use of all capital letters for headings and subheadings. According to
the handbook, formatting large blocks of text in capital letters makes
it harder to read because the shapes of the words disappear, thereby
forcing the reader to slow down and study each letter. As a result,
readers tend to skip sentences that are written entirely in capital
letters.
Disclosures Generally Did Not Make Effective Use of White Space or
Headings:
The AMP disclosures generally did not make effective use of white
space, reducing their usefulness. According to the Plain English
Handbook, generous use of white space enhances usability, helps
emphasize important points, and lightens the overall look of the
document. However, in most of the AMP disclosures, the amount of space
between the lines of text, paragraphs, and sections was very tight,
which made the text dense and difficult to read. This difficulty was
compounded by the use of fully justified text--that is, text where both
the left and right edges are even--in half of the disclosure documents.
According to the handbook, when text is fully justified, the spacing
between words fluctuates from line to line, causing the eye to stop and
constantly readjust to the variable spacing on each line. This, coupled
with a shortage of white space, made the disclosures we reviewed
visually unappealing and difficult to read. The handbook recommends
using left-justified, ragged right text (as this report uses), which
research has shown is the easiest text to read.
Very little visual weight or emphasis was given to the content of the
disclosures other than to distinguish the headings from the text of the
section beneath it. As a result, it was difficult to readily locate
information of interest or to quickly identify the most important
information--in this case, what the maximum monthly payment could be
for a borrower considering a particular AMP. According to the handbook,
a document's hierarchy shows how its designer organized the information
and helps the reader understand the relationship between different
levels of information. A typical hierarchy might include several levels
of headings, distinguished by varying typefaces.
[End of section]
Appendix III: Comments from the Board of Governors of the Federal
Reserve System:
Board Of Governors Of The Federal Reserve System:
Washington, D.C. 20551:
Sandra F. Braunstein:
Director:
Division Of Consumer And Community Affairs:
September 6, 2006:
Ms. Orice M. Williams:
Director:
Financial Markets and Community Investment:
U.S. Government Accountability Office:
441 G Street, NW:
Washington, DC 20548:
Dear Ms. Williams:
Thank you for the opportunity to comment on the GAO's draft report
entitled Alternative Mortgage Products: Impact on Defaults Remains
Unclear, But Disclosure of Risks to Borrowers Could Be Improved. As the
report notes, the Federal Reserve Board has commenced a comprehensive
rulemaking to review the Truth in Lending Act (TILA) rules. The primary
goal of the review is to improve the effectiveness and usefulness of
consumer disclosures and the substantive protections provided under the
Board's Regulation Z, which implements TILA. To ensure that consumers
get timely information in a form that is readily understandable, the
Board will study alternatives for improving both the content and format
of disclosures, including revising the model forms published by the
Board.
The Board has already taken steps relating to its review of the
requirements for mortgage loan disclosures, even though the initial
stage of the Board's review of Regulation Z has been focused on open-
end credit accounts that are not home-secured. During the summer of
2006, the Board held a series of four public hearings on home-equity
lending. One of the principal purposes of the hearings was to gather
information to inform the Board's review of Regulation Z. A significant
portion of the Board's recent hearings was devoted to discussing
alternative or "nontraditional" mortgage products, and in particular,
whether consumers receive adequate information about these products.
The hearings explored consumer behavior in shopping for mortgage loans
and included discussions about the challenges in designing disclosures
to more effectively communicate loan terms and risks to consumers. The
Board's staff is continuing to review the transcripts of the hearings
as well as the public comment letters submitted in connection with the
hearings. Staff will consider this information in developing plans and
recommendations for revising Regulation Z.
The draft GAO report specifically recommends, in connection with the
review and revision of Regulation Z, that the Board consider improving
the clarity and comprehensiveness of disclosures for alternative
mortgage products by requiring more effective formatting and visual
presentation as well as additional language explaining the key features
and potential risks specific to these products. As part of its review
of the effectiveness of closed-end credit disclosures under Regulation
Z, the Board will be conducting extensive consumer testing to determine
what information is most important to consumers, when that information
is most useful, what language and formats work best, and how
disclosures can be simplified, prioritized, and organized to reduce
complexity and information overload. To that end, the Board will be
using design consultants to assist in developing model disclosures that
are most likely to be effective in communicating information to
consumers. The Board also plans to use consumer testing to assist in
developing model disclosure forms. Based on this review and testing,
the Board will revise Regulation Z within the existing framework of
TILA. If we determine that useful changes to the closed-end disclosures
are best accomplished through legislation, the Board would develop
suggested statutory changes for congressional consideration.
Furthermore, in reviewing the disclosure requirements for closed-end
credit transactions, the Board must also be mindful that the loan
products offered today might differ substantially from products offered
in the future. Thus, any new disclosure requirements relating to
features and risks of today's loan products must be sufficiently
flexible to allow creditors to provide meaningful disclosures even as
those products develop over time.
The Board is also engaged in other efforts to enhance the information
consumers receive about the features and risks associated with
alternative mortgage products. The Board's staff is currently working
with staff of the Office of Thrift Supervision to revise the Consumer
Handbook on Adjustable Rate Mortgages (CHARM) to include additional
information about these products. The CHARM booklet is an effective
means of delivering to consumers information about alternative
adjustable rate mortgage products because creditors are required to
provide a copy of the booklet to each consumer that receives an
application for an ARM. Staff is planning to publish the revised CHARM
booklet later this year. The Board is also planning to publish a
consumer education brochure titled: Interest-Only Mortgage Payments and
Option-Payment ARMs-Are They for You? The brochure is designed to
assist consumers who are shopping for a mortgage loan, and will be
available in printed form and in electronic form on the Board's
Internet web site. The educational brochure is expected to be published
within the next several weeks.
In addition, as the GAO draft report notes, the Board and other federal
bank and thrift regulators issued draft interagency guidance on
alternative mortgage products in December 2005. The proposed guidance
addresses both safety and soundness and consumer protection concerns.
The proposed guidance focuses on the need to provide consumers with
clear and balanced information, at crucial decision-making points,
about the relative benefits and risks of nontraditional mortgage
products. Accordingly, the draft interagency guidance describes
recommended practices for financial institutions in communicating with
consumers while they are shopping, not just upon submission of an
application or at loan consummation. Specifically, the proposed
guidance recommends that institutions' promotional materials and
descriptions of these products include information about, among other
things, potential increases in consumers' payment obligations ("payment
shock") and the potential consequences of increasing principal loan
balances and decreasing home equity (negative amortization). The
proposed guidance also recommends that institutions alert consumers to
the amount of any prepayment penalty that may be imposed if the
consumer refinances the mortgage. The agencies have reviewed the public
comments received on the draft guidance and they are currently working
towards finalizing the document.
The Board's staff has provided technical comments on the draft GAO
report separately. We appreciate the efforts of your staff to respond
to our comments.
Sincerely,
Signed by:
Sandra F. Braunstein:
c: Karen Tremba, Assistant Director, GAO:
[End of section]
Appendix IV: GAO Contact and Staff Acknowledgments:
GAO Contact:
Orice M. Williams, (202) 512-5837, Williamso@gao.gov:
Staff Acknowledgments:
In addition to those named above, Karen Tremba, Assistant Director;
Tania Calhoun; Bethany Claus Widick; Stefanie Jonkman; Mark Molino;
Robert Pollard; Barbara Roesmann; and Steve Ruszczyk made key
contributions to this report.
FOOTNOTES
[1] For the purposes of this report, we use the term "federal banking
regulators" to refer to federal agencies that oversee federally insured
depository institutions and their subsidiaries. These agencies are the
Board of Governors of the Federal Reserve System (Federal Reserve), the
Federal Deposit Insurance Corporation (FDIC), the National Credit Union
Administration (NCUA), the Office of the Comptroller of the Currency
(OCC), and the Office of Thrift Supervision (OTS).
[2] Credit risk involves the concerns that borrowers may become
delinquent or default on their mortgages, and that lenders may not be
paid in full for the loans they have issued.
[3] TILA is codified at 15 U.S.C. § 1601 et seq. and Regulation Z can
be found at 12 C.F.R. Part 226.
[4] SEC is the primary overseer of the U.S. securities markets.
[5] Federally regulated financial institutions include all banks and
their subsidiaries, bank holding companies and their nonbank
subsidiaries, savings associations and their subsidiaries, savings and
loan holding companies and their subsidiaries, and credit unions.
[6] Housing-related GSEs, such as Fannie Mae and Freddie Mac, are
privately owned and operated corporations whose public missions are to
enhance the availability of mortgage credit across the United States.
[7] Data used in this report reflect mortgages that were securitized
and sold to the private label secondary market, which do not include
mortgages guaranteed by the GSEs or held by banks in their portfolios.
[8] Inside Mortgage Finance, Conventional Conforming Market Continued
to Erode in 2005 as Nontraditional Mortgage Products Boomed, (February
24, 2006) 6.
[9] As many as 58 percent of interest-only ARMs and 37 percent of
payment-option ARMs that were securitized that year were used to
purchase homes, with the remainder percent used for refinancing
purposes. David Liu, "Credit Implications of Affordability Mortgages,"
UBS (Mar. 3, 2006).
[10] David Liu, 6, and David Liu, "Credit Implications--Fixed-rate, IO"
UBS Mortgage Strategist (Mar. 28, 2006) 26.
[11] Inside Alternative Mortgages, Countrywide Tops Option ARM Market
at 3Q Mark (Dec. 23, 2005), 5; and Inside Alternative Mortgages, Wells
tops Interest-Only Market in 3Q of 2005 (Dec. 19, 2005), 3.
[12] As of April 2006, the interest rate on 1-year ARMs averaged 5.62
percent, while interest rates on 30-year fixed-rate mortgages averaged
6.51 percent.
[13] In the most common variation, the lower payments are in effect for
the entire 30-year loan term, and the borrower makes a balloon payment
at the end to pay off the remaining loan balance. In another variation,
the lower payments are in effect for the first 10 years; then, the loan
is recast to require higher monthly payments that fully amortize the
loan over the remainder of the 30-year term. An increasing number of
lenders are offering 40-year mortgages that also have a 40 year
maturity.
[14] Inside Mortgage Finance, Longer Amoritzation Products Gain
Momentum In Still-Growing Nontraditional Mortgage Market (July 14,
2006), 3.
[15] The initial minimum monthly payment amount is derived by
calculating the 30-year, fully amortizing payment for the loan on the
basis of the teaser rate. This initial minimum payment is in effect for
the first year of the loan.
[16] The payment reset cap keeps monthly payments affordable by
protecting borrowers from rising interest rate during the payment-
option period. Minimum monthly payments are adjusted annually depending
on movements in interest rates. According to the June 2005 OTS
Examination Handbook , payment reset caps for payment-option ARMs are
typically 7.5 percent per year for 5 years, unless deferred interest
accrues and the loan balance reaches the negative amortization cap
specified in the loan terms. According to OCC officials, caps on
recently sold payment-option ARMs have ranged from 110 percent to 125
percent of the loan balance, although caps of 110 percent and 115
percent are most common.
[17] The fully indexed interest rate comprises an adjustable interest
rate index, such as the Federal Home Loan Bank of San Francisco Cost of
Funds Index (COFI), plus the lender's margin. In April 2004, the COFI
was 1.80 percent, and the lender in this example added a margin of
about 2.75 percent to determine the initial fully indexed rate of 4.55
percent on the loan. Between April 2004 and April 2006, the COFI
increased to 3.86 percent, causing the fully-indexed interest rate to
increase to 6.61 percent. The example does not assume further interest
rate increases.
[18] While the inability to make higher monthly payments could cause
loan defaults, job loss, divorce, serious illness, and a death in the
family are commonly identified as the major reasons borrowers' default
on their mortgages. In each of these examples, the borrower can
experience a major drop in income, or a major increase in expenses.
[19] In a typical piggyback mortgage arrangement, the borrower takes a
first mortgage for 80 percent of the property value, and a second
mortgage or a home equity line of credit for part or all of the
remaining 20 percent of the property value. Piggyback mortgages
typically are used to avoid the purchase of private mortgage insurance,
which many lenders require when the down payment is less than 20
percent of the property value.
[20] For example, with a no income/no asset verification loan, the
borrower provides no proof of income and the lender relies on other
factors such as the borrower's credit score.
[21] In the example of the $400,000 payment-option ARM discussed
earlier, the lender likely would have qualified the borrower based on
fully-indexed interest rate of 4.41 percent, which corresponds to the
first-year's fully amortizing monthly payment of $2,039. Although the
borrower is faced with a payment shock of 128 percent in year six as a
result of making minimum payments, the increase is a smaller 44 percent
greater than the monthly payment that was originally used to qualify
the borrower.
[22] Some borrowers, who are making minimum monthly payments now, may
have made a number of fully amortizing payments previously. Thus, while
their loan is now negatively amortizing, their loan balance has not yet
grown to more than the original loan amount. According to UBS, more
than 80 percent of borrowers with lower credit scores were making
minimum monthly payments, compared to more than 65 percent for
borrowers with high credit scores.
[23] David Liu, "Credit Implications of Affordability Mortgages," 13.
[24] Fannie Mae and Freddie Mac purchased limited amounts of AMPs
during 2005. Thirteen percent of Fannie Mae loan purchases comprised
interest-only and payment-option ARMs during 2005. These loans
comprised 10 percent of Freddie Mac loan purchases during the first 3
quarters of 2005.
[25] The majority of interest-only FRM sold in 2005 had an interest-
only period of 10 years.
[26] According to Federal Reserve officials, problems with AMP
advertising represent potential violations of federal law. For example,
Regulation Z rules governing credit advertising require that
advertisements with certain "trigger" terms, such as the amount of any
payment or finance charge, must also include other specified
information, such as the terms of repayment. See 12 C.F.R. § 226.24,
and the Official Staff Commentary at Paragraph 24(c)(2)-2. Furthermore,
Section 5 of the Federal Trade Commission Act prohibits unfair or
deceptive practices in commerce, including mortgage lending. A creditor
that provides the required Regulation Z disclosures is not immune from
possible violations of the FTC Act if the information is so one-sided
as to be misleading.
[27] Brian Bucks and Karen Pence, Do Homeowners Know Their House Values
and Mortgage Terms?, FEDS Working Paper 2006-03, Board of Governors of
the Federal Reserve System (Washington, D.C.: January 2006).
[28] Congress enacted HOEPA in 1994 in response to reports of predatory
home equity lending practices in underserved markets.
[29] HOEPA directs the Federal Reserve to periodically hold public
hearings to examine the home equity lending market and the adequacy of
existing regulatory and legislative provisions for protecting the
interests of consumers, particularly low-income consumers. The last
hearings were held in 2000.
[30] SEC, A Plain English Handbook: How to Create Clear SEC Disclosure
Documents (1998).
[31] Regulation Z does not require creditors to send payment coupons to
borrowers each month.
[32] U.S. Department of the Treasury and U.S. Department of Housing and
Urban Development, Joint Report on Recommendations to Curb Predatory
Home Mortgage Lending (Washington, D.C.: June 20, 2000).
[33] Some banking regulators have addressed risks posed by AMPs through
guidance that precedes the 2005 interagency guidance. For example, OTS
revised its real estate lending guidance in June 2005, and it includes
guidance on interest-only and negative amortizing mortgages. In
addition, in January 2001, federal banking regulators developed
Expanded Guidance for Subprime Lending Programs, which lists certain
characteristics of predatory or abusive lending, such as failure to
adequately disclose mortgage terms and basing the loan on the
borrower's assets and not the borrower's repayment ability.
[34] These readability formulas did not evaluate the content of the
disclosures or assess whether the information was conveyed clearly. For
more information on this topic, see appendix I.
[35] See the 2003 National Assessment of Adult Literacy. The study
evaluated adults' reading skills according to four levels: below basic,
basic, intermediate, and proficient.
GAO's Mission:
The Government Accountability Office, the investigative arm of
Congress, exists to support Congress in meeting its constitutional
responsibilities and to help improve the performance and accountability
of the federal government for the American people. GAO examines the use
of public funds; evaluates federal programs and policies; and provides
analyses, recommendations, and other assistance to help Congress make
informed oversight, policy, and funding decisions. GAO's commitment to
good government is reflected in its core values of accountability,
integrity, and reliability.
Obtaining Copies of GAO Reports and Testimony:
The fastest and easiest way to obtain copies of GAO documents at no
cost is through the Internet. GAO's Web site ( www.gao.gov ) contains
abstracts and full-text files of current reports and testimony and an
expanding archive of older products. The Web site features a search
engine to help you locate documents using key words and phrases. You
can print these documents in their entirety, including charts and other
graphics.
Each day, GAO issues a list of newly released reports, testimony, and
correspondence. GAO posts this list, known as "Today's Reports," on its
Web site daily. The list contains links to the full-text document
files. To have GAO e-mail this list to you every afternoon, go to
www.gao.gov and select "Subscribe to e-mail alerts" under the "Order
GAO Products" heading.
Order by Mail or Phone:
The first copy of each printed report is free. Additional copies are $2
each. A check or money order should be made out to the Superintendent
of Documents. GAO also accepts VISA and Mastercard. Orders for 100 or
more copies mailed to a single address are discounted 25 percent.
Orders should be sent to:
U.S. Government Accountability Office
441 G Street NW, Room LM
Washington, D.C. 20548:
To order by Phone:
Voice: (202) 512-6000:
TDD: (202) 512-2537:
Fax: (202) 512-6061:
To Report Fraud, Waste, and Abuse in Federal Programs:
Contact:
Web site: www.gao.gov/fraudnet/fraudnet.htm
E-mail: fraudnet@gao.gov
Automated answering system: (800) 424-5454 or (202) 512-7470:
Public Affairs:
Jeff Nelligan, managing director,
NelliganJ@gao.gov
(202) 512-4800
U.S. Government Accountability Office,
441 G Street NW, Room 7149
Washington, D.C. 20548: