    [Senate Hearing 109-1083]
    [From the U.S. Government Publishing Office]

                                                               Hrg.109-1083

          CALCULATED RISK: ASSESSING NON-TRADITIONAL MORTGAGE PRODUCTS

    =======================================================================

                                    HEARING

                                   before the

                   SUBCOMMITTEE ON HOUSING AND TRANSPORTATION

                                    and the

                        SUBCOMMITTEE ON ECONOMIC POLICY

                                     of the

                                  COMMITTEE ON
                       BANKING,HOUSING,AND URBAN AFFAIRS
                              UNITED STATES SENATE

                           ONE HUNDRED NINTH CONGRESS

                                 SECOND SESSION

                                       ON

      THE ISSUES SURROUNDING NON-TRADITIONAL MORTGAGES AND THEIR POSSIBLE
      IMPLICATIONS FOR CONSUMERS, FINANCIAL INSTITUTIONS, AND THE ECONOMY

                                   ----------

                         WEDNESDAY, SEPTEMBER 20, 2006

                                   ----------

      Printed for the use of the Committee on Banking, Housing, and Urban
                                    Affairs

          Available at: http: //www.access.gpo.gov /congress /senate /
                                senate05sh.html

          CALCULATED RISK: ASSESSING NON-TRADITIONAL MORTGAGE PRODUCTS

                                                            S. Hrg.109-1083

          CALCULATED RISK: ASSESSING NON-TRADITIONAL MORTGAGE PRODUCTS

    =======================================================================

                                    HEARING

                                   before the

                   SUBCOMMITTEE ON HOUSING AND TRANSPORTATION

                                    and the

                        SUBCOMMITTEE ON ECONOMIC POLICY

                                     of the

                                  COMMITTEE ON
                       BANKING,HOUSING,AND URBAN AFFAIRS
                              UNITED STATES SENATE

                           ONE HUNDRED NINTH CONGRESS

                                 SECOND SESSION

                                       ON

      THE ISSUES SURROUNDING NON-TRADITIONAL MORTGAGES AND THEIR POSSIBLE
      IMPLICATIONS FOR CONSUMERS, FINANCIAL INSTITUTIONS, AND THE ECONOMY

                                   __________

                         WEDNESDAY, SEPTEMBER 20, 2006

                                   __________

      Printed for the use of the Committee on Banking, Housing, and Urban
                                    Affairs

          Available at: http: //www.access.gpo.gov /congress /senate /
                                senate05sh.html

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                COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                      RICHARD C. SHELBY, Alabama, Chairman
    ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
    WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
    MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
    CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
    RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
    JIM BUNNING, Kentucky                EVAN BAYH, Indiana
    MIKE CRAPO, Idaho                    THOMAS R. CARPER, Delaware
    JOHN E. SUNUNU, New Hampshire        DEBBIE STABENOW, Michigan
    ELIZABETH DOLE, North Carolina       ROBERT MENENDEZ, New Jersey
    MEL MARTINEZ, Florida

                 William D. Duhnke, Staff Director and Counsel
         Steven B. Harris, Democratic Staff Director and Chief Counsel
                   Peggy R. Kuhn, Senior Financial Economist
               Mark A. Calabria, Senior Professional Staff Member
                Johnathan Miller, Democratic Professional Staff
       Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
                           George E. Whittle, Editor
                                     ------

                   Subcommittee on Housing and Transportation

                        WAYNE ALLARD, Colorado, Chairman
                    JACK REED, Rhode Island, Ranking Member
    RICK SANTORUM, Pennsylvania          DEBBIE STABENOW, Michigan
    ELIZABETH DOLE, North Carolina       ROBERT MENENDEZ, New Jersey
    MICHAEL B. ENZI, Wyoming             CHRISTOPHER J. DODD, Connecticut
    ROBERT F. BENNETT, Utah              THOMAS R. CARPER, Delaware
    MEL MARTINEZ, Florida                CHARLES E. SCHUMER, New York
    RICHARD C. SHELBY, Alabama

                        Tewana Wilkerson, Staff Director
                    Didem Nisanci, Democratic Staff Director
                       Kara Stein, Legislative Assistant
                                     ------

                        Subcommittee on Economic Policy

                        JIM BUNNING, Kentucky, Chairman
                  CHARLES E. SCHUMER, New York, Ranking Member
    RICHARD C. SHELBY, Alabama

                       William Henderson, Staff Director
                Carmencita N. Whonder, Democratic Staff Director

                                C O N T E N T S

                                  ----------

                         WEDNESDAY, SEPTEMBER 20, 2006

                                                                       Page

    Opening statement of Chairman Allard.............................     1
    Opening statement of Chairman Bunning............................     5
    Opening statements, comments, or prepared statements of:
        Senator Reed.................................................     4
        Senator Sarbanes.............................................     7
        Senator Carper...............................................     8
            Prepared statement.......................................    46
        Senator Schumer..............................................    37

                                   WITNESSES

    Orice Williams, Director, Government Accountability Office.......     9
        Prepared Statement...........................................    47
        Response to written questions of:
            Senator Bunning..........................................   294
    Kathryn E. Dick, Deputy Comptroller for Credit and Market Risk,
      Office of the Comptroller of the Currency......................    10
        Prepared Statement...........................................   111
    Sandra Braunstein, Director of the Division of Consumer and
      Community Affairs, Federal Reserve.............................    12
        Prepared Statement...........................................   125
        Response to written questions of:
            Senator Bunning..........................................   296
            Senator Reed.............................................   300
    Sandra Thompson, Director of the Division of Supervision and
      Consumer Protection, Federal Deposit Insurance Corporation.....    14
        Prepared Statement...........................................   139
        Response to written questions of:
            Senator Bunning..........................................   303
            Senator Reed.............................................   306
    Scott Albinson, Managing Director for Examinations, Supervision,
      and
      Consumer Protection, Office of Thrift Supervision..............    15
        Prepared Statement...........................................   156
        Response to written questions of:
            Senator Bunning..........................................   310
            Senator Reed.............................................   313
    Felecia A. Rotellini, Superintendent, Arizona Department of
      Financial
      Institutions...................................................    17
        Prepared Statement...........................................   174
        Response to written questions of:
            Senators Allard and Bunning..............................   315
    Robert Broeksmit, Chairman of the Residential Board of Governors,
      Mortgage Bankers Association...................................    26
        Prepared Statement...........................................   187
    George Hanzimanolis, NAMB President-Elect, Bankers First
      Mortgage, Inc..................................................    28
        Prepared Statement...........................................   210
    William Simpson, Chairman, Republic Mortgage Insurance Company...    30
        Prepared Statement...........................................   224
        Response to written questions of:
            Senator Bunning..........................................   321
            Senator Reed.............................................   322
    Michael Calhoun, President, Center for Responsible Lending.......    31
        Prepared Statement...........................................   239
        Response to written questions of:
            Senator Bunning..........................................   322
            Senator Reed.............................................   326
    Allen Fishbein, Director of Housing Policy, Consumer Federation
      of America.....................................................    33
        Prepared Statement...........................................   262

                  Additional Material Supplied for the Record

    Greg Griffin, David Olinger and Jeffrey A. Roberts, Denver Post
      Staff Writers, The Denver Post, ``FORECLOSING ON THE AMERICAN
      DREAM / Part of an occasional series / No money down: a high-
      risk gamble,'' article dated September 17, 2006................   331
    Statement from the Consumer Mortgage Coalition...................   336
    Statement from the National Association of REALTORS.............   370

          CALCULATED RISK: ASSESSING NON-TRADITIONAL MORTGAGE PRODUCTS

                                  ----------

                         WEDNESDAY, SEPTEMBER 20, 2006

                                   U.S. Senate,
            Subcommittee on Housing and Transportation,
                       Subcommittee on Economic Policy,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.
        The Subcommittees met at 10:03 a.m., in room SD-538,
    Dirksen Senate Office Building, Hon. Wayne Allard, and the Hon.
    Jim Bunning, Chairmen of the Subcommittees, presiding.

               OPENING STATEMENT OF SENATOR WAYNE ALLARD

        Chairman Allard.  I am going to call the Committee to
    order.
        This is a joint hearing of the Subcommittee on Housing and
    Transportation and the Subcommittee on Economic Policy. I will
    be joined this morning later on by Chairman Bunning on Economic
    Policy and minority side. I have a reputation of getting
    started on time. So I would like to get started on time, and my
    colleagues can drag in as they do.
        We are going to run a pretty tight hearing today because we
    have lots of witnesses and we have a lot of time constraints.
    So I am going to enforce the 5-minute rule very strictly even
    on my colleagues. I think you would agree to that, Mr.
    Chairman, to make sure that we can stay within our time line.
        Chairman Bunning, I have been informed that we have a vote,
    perhaps at eleven o'clock. So maybe you and I can switch off
    and keep the meeting going when we get to that point in time.
        I would like to welcome everyone to the joint hearing of
    the Subcommittee on Housing and Transportation and the
    Subcommittee on Economic Policy. I was pleased to co-chair the
    hearing with Senator Bunning last week to examine developments
    in the housing markets, and at that time, we heard a great deal
    of discussion regarding non-traditional mortgage products, and
    Senator Bunning and I felt that the issue was of such
    importance that we should hold a second hearing to examine it
    in greater depth.
        This is a topic that is not just inside the beltway
    conversation consideration. For example, The Denver Post, my
    State of Colorado, headlines last Sunday on ``No Money Down,
    High-Risk Gamble''. It is talking about home loans and whatnot.
    This is a topic which typical American families are following
    very closely, and the article raised many interesting points,
    and I would ask unanimous consent for the entire article to be
    entered into the record.
        Without objection, that will be so ordered.
        While these products may be considered non-traditional,
    they are certainly not new. Variations of interest only loans
    have existed at least since the 1930's and payment option
    mortgages have been in use since the 1980's, I understand.
    There has been a significant shift, however, in the consumer
    base for these mortgage products.
        Over the previous two decades, non-traditional mortgages
    were primarily utilized by wealthy financially sophisticated
    individuals looking to manage cash-flow or maximize financial
    flexibility. However, following years of dramatic increases in
    houses prices, average consumers began taking non-traditional
    mortgages in order to make home ownership more affordable or to
    increase the amount of home that they could qualify to
    purchase.
        Let us look at Chart 1. Non-traditional products have
    surged in popularity. According to the ``First American Real
    Estate Solution'', interest only and payment option loans
    comprised only 1.9 percent of the mortgage market in the year
    2000. That is reflected in the chart that you see here on your
    left. However, their share of the mortgage, market expanded to
    36.6 percent in 2005. That is reflected on the chart there on
    your right.
        An interest only loan allows the consumer to make payments
    covering only the interest on the loan balance for a period of
    time, generally three to 10 years. At that time, the consumer
    must also begin making payments which cover the principal.
    Because the period in which the principal is repaid is
    compressed, payments can jump significantly.
        I would like to go Chart No. 2, the payment shock chart.
    Payment option mortgages, which is the second type of mortgage
    we want to review today, offer consumers a choice of four
    different mortgage payments. There is a 15-year amortization
    payment, which is a traditional loan; a 30-year amortization
    payment, where you pay on the interest and you pay equity into
    the house, you pay down the house; a payment covering interest
    only or a minimum payment, which is the bottom line. Because
    consumers choosing the minimum payment are not even covering
    the interest on the loan, the loan balance actually increases,
    making the loan negatively amortizing. The loan balance can
    continue to increase until it reaches a preset cap at which
    point the loan resets and becomes fully amortizing. At this
    point, payments can jump significantly, sometimes double or
    more, which is referred to at times as just payment shock.
        As we go to Chart No. 3, why have we seen such an upsurge
    in non-traditional mortgages recently? Well, quite simply, they
    can make homeownership more affordable by lowering payments and
    allowing homeowners to potentially qualify a larger mortgage.
    As part of the Mountain Census Region, my home State of
    Colorado has been part of the highest regional home price
    increases over the past year. It is no coincidence that the
    uptick in non-traditional mortgages parallels the uptick in
    home prices.
        As this chart demonstrates, an interest only loan can allow
    a consumer to buy a 20 percent more expensive home. Non-
    traditional mortgages can also provide financial flexibility.
    For example, a buyer who doesn't intend to remain in a house
    for very long could buy more house because of initially loan
    low payments.
        These mortgage products can also be helpful for people who
    desire temporary cash-flow for investments or to pay off other
    higher interest rates and those who expect a future increase in
    earnings. Payment option loans also provide flexibility for
    those with uneven income flows such as people who receive large
    bonuses or commissions. In utilizing a non-traditional
    mortgage, borrowers bet on the fact that mortgage rates will
    remain stable and home values will continue to rise. This is
    crucial for them to be able to refinance their loan before it
    resets and payment shock kicks in.
        As we learned at the last hearing, though, the cyclical
    nature of markets dictates that past rates of appreciation and
    record low interest rates cannot continue indefinitely. If
    interest rates have increased, a consumer may not be able to
    qualify for or afford the refinancing alternatives. Similarly,
    if home values have been stagnant or decreased, homeowners may
    have difficulty refinancing or even selling their home as they
    can owe more than what it is worth.
        This is exacerbated by situations in which the buyer made
    little or no down payment or used piggy-back mortgages.
    Homeowners with little or no equity have no cushion for
    financial hardships such as an illness, job loss, or divorce.
    It is no coincidence that recent Colorado home buyers have the
    Nation's lowest home equity rate and the State also has the
    highest foreclosure rate. According to ``Business Week'',
    nationwide, more than 20 percent of the option ARM loans in
    2004 and 2005 are upside down, meaning the homes are worth less
    than their debt.
        Non-traditional mortgages are not necessarily bad products
    as long as they are carefully utilized. In order for consumers
    to decide whether these products are appropriate for them, they
    must have adequate information. The information must also be
    clear and meaningful. Consumers should understand exactly what
    risks and benefits different products represent.
        I commend the regulators for taking steps to improve
    consumer disclosure. No one should face the situation of
    Colorado's Lilly and India Hartz who thought they were
    refinancing with a 30-year fixed-rate mortgage, but instead got
    an option ARM.
        Today, we will also explore the implications of non-
    traditional mortgages for financial institutions. Because these
    are risker products, it is even more important that they are
    underwritten with care. Additionally, financial institutions
    must take appropriate steps to manage that risk.
        We have a distinguished lineup of witnesses today. While
    the witness list may be lengthy, each organization represented
    here today has an important perspective to share.
        First, we will hear from Ms. Orice Williams, the managing
    director for the GAO study on alternative mortgage products.
    She and her team have done an excellent job of researching this
    issue, and I would like to commend them for their work. I know
    we are all looking forward to hearing more about the findings
    and recommendations of the report that GAO is releasing today.
        The first panel will also include representatives from each
    of the four Federal financial regulators: Ms. Kathryn E. Dick,
    Deputy Comptroller for Credit and Market Risk at the OCC; Ms.
    Sandra F. Braunstein, Director of the Division of Consumer and
    Community Affairs at the Fed; Ms. Sandra Thompson, Director of
    Supervision and Consumer Protection at the FDIC; and Mr. Scott
    Albinson, Managing Director for Examinations, Supervision, and
    Consumer Protection at OTS.
        In December 2005, the regulators issued draft interagency
    guidance regarding non-traditional mortgage products.
    Specifically, the guidance addressed the necessity for adequate
    and meaningful consumer disclosures. The guidance also
    addressed the need for financial institutions to properly
    manage the risks posed by the products. After receiving
    extensive comments, they are now working toward issuing final
    guidance. I commend them for taking up this issue and look
    forward to an update on their process as well as their ongoing
    individual agency efforts.
        Our final witness on the panel will be Ms. Felecia A.
    Rotellini, the Superintendent of the Arizona Department of
    Financial Institutions. The Conference of State Bank
    Supervisors has also been looking at non-traditional mortgage
    products. In addition, they are developing a national licensing
    system for the residential mortgage industry. The system will
    provide a uniform application, allow access to a central
    repository of licensing and publicity and adjudicated
    enforcement actions. This will be incredibly helpful so for
    States like Colorado where mortgage fraud has been a problem,
    bad actors will no longer be able to simply move to another
    State and continue to perpetrate their fraudulent activities.
        Our second panel will explore the perspectives of industry
    and consumer groups. Witnesses will include: Mr. Robert
    Broeksmit, Chairman of the Residential Board of Governors for
    the Mortgage Bankers Association; Mr. George Hanzimanolis,
    President-Elect of the National Association of Mortgage
    Brokers; Mr. William A. Simpson, Chairman, Republic Mortgage
    Insurance Company, on behalf of the mortgage insurance
    companies of America; Mr. Michael D. Calhoun, President, Center
    for Responsible Lending; and Mr. Allen Fishbein, Director of
    Housing and Credit Policy, Consumer Federation of America.
        You can tell from this list, we have many witnesses today.
    Therefore, I will ask our witnesses to be especially mindful of
    the 5-minute time limit. Similarly, I will also ask members to
    please respect the 5-minute time limit during the question and
    answer period. While I know that we all have many issues we
    wish to explore, Chairman Bunning and I want to ensure that all
    members and witnesses have an opportunity to be heard. We will
    leave the record open so that members have an additional
    opportunity to ask questions for which they may not have time
    at the hearing. I thank all of you for your cooperation.
        Chairman Allard. Now I will turn to the ranking member,
    Senator Reed.

                     STATEMENT OF SENATOR JACK REED

        Senator Reed. Thank you very much, Chairman Allard and
    Chairman Bunning, for holding this hearing.
        Homeownership has provided Americans with an avenue toward
    prosperity. Consumer Federation of America reports that home
    equity comprises 50 to 60 percent of an average American
    household's net wealth; however, homeownership has become
    elusive for many Americans. The Joint Center for Housing
    Studies at Harvard reported, in their words, ``Affordability
    pressures are now spreading with median house prices in a
    growing number of large metropolitan areas exceeding median
    household incomes by a factor of four or more'', proving that
    with the cooling real estate market, home prices in my State of
    Rhode Island are expected to jump an additional 6.3 percent
    this year.
        As housing affordability has weakened, the mortgage
    industry has made available to the average home buyer non-
    traditional mortgage products that were historically designed
    for the high net worth and financially-savvy borrower. Two of
    the most commonly utilized non-traditional mortgage products
    are interest only and payment option loans. According to First
    American Real Solution, IO and payment option loans comprised
    only 1.9 percent of the mortgage market in 2000, but represent
    36.6 percent of the market by 2005.
        These loans pose significant dangers to the sustainability
    of homeownership for many American households. A recent
    ``Business Week'' article reported that 80 percent of the
    borrowers are making the minimum payment on their payment
    option loans, eroding their home equity with every payment. At
    a time where pricing are leveling or even decline in many parts
    of the country, many borrowers with option adjustable rate
    mortgages, ARMS, may soon be left with few options. Borrowers
    with other non-traditional product also may soon be facing
    significant higher payments in the near future, leading Goldman
    Sachs to estimate that non-traditional mortgage products are at
    a, quote, very high risk of default.
        In fact, foreclosure rates are escalating. Indeed, non-
    traditional mortgages default at a higher rate than fixed-rate
    mortgages. In Rhode Island, for example, default on prime ARMs
    are 21 percent higher than prime fixed-rate loans. Subprime
    ARMs have almost a forty percent higher default rate than
    fixed-rate loans. As a result, according to ``Fitch Ratings
    2006 Finance Outlook'', mortgage delinquencies which increased
    by 53 percent over the last year are expected to rise by an
    additional 10 to 15 percent in 2006.
        The Federal banking regulators issued proposed guidance in
    December 2005 that attempts to address the potential for
    heightened risk levels associated with non-traditional mortgage
    lending and recommended practices for communicating with and
    providing information to consumers. Guidance in this area is
    necessary to be finalized promptly to ensure that lenders and
    financial institutions take responsibility for the long-term
    sustainability of the loans they originate and ultimately to
    ensure safety and soundness of our financial system and protect
    consumers.
        I look forward to the witnesses' testimony. Thank you, Mr.
    Chairman.
        I will call on Chairman Bunning for his opening statement.

               OPENING STATEMENT OF CHAIRMAN JIM BUNNING

        Chairman Bunning.  Thank you, Chairman Allard.
        Last week, we had a very good hearing on the state of the
    housing market. I think everybody knows there are reasons to be
    concerned about the coming months in locations that have seen
    dramatic price increases over the last few years. Just
    yesterday, it was announced that housing starts declined
    another 6 percent in August for a total a 26.5 percent since
    the peak in January.
        Other indicators are continuing to show a slow-down as
    well. Hopefully, we are just seeing a pull back to a more
    reasonable growth level and not a crash.
        This week, we are going to examine non-traditional
    mortgages and how they have contributed to the housing boom. We
    are also going to look into risks posed by the popularity of
    these products over the last few years. The two mortgage
    products, as has been said before, are interest only and
    payment option adjustable rate mortgage loans. Those products
    were relatively rare. As Senator Reed said, only 1.9 percent of
    the mortgages in 2000 had those types of rates. Last year, they
    accounted for over 35 percent.
        These products were first used by wealthy and sophisticated
    borrowers as a cash-flow management tool, but today, they are
    being marketed as an affordability product to ordinary and even
    subprime borrowers. Early reports for this year showed even
    further increases in the share of non-traditional mortgages
    being written.
        These product have some benefits for consumers, such as a
    low initial payment, the ability to purchase more expensive
    homes, and more flexible repayment terms. Even Former Fed
    Chairman Greenspan suggested borrowers should get an adjustable
    rate mortgage. That is quite a few years back, and that was
    before he started raising interest rates at the Fed.
        There are significant risks that come with those benefits
    and it is not clear that borrowers understand those risks. The
    prime risk to borrowers has been described as payment shock, as
    Senator Allard said, as payments reset to a higher level. Most
    borrowers have not yet experienced significant payment shock,
    but experts believe over $2 trillion of these mortgages will
    reset in the next 2 years, and because of rising interest
    rates, those payment increases could easily total 100 percent
    by the fifth year of the loan.
        Financial institutions are at risk also. In order to write
    more loans, lenders have relaxed their underwriting standards.
    This is troubling because of payment resets. If the borrower is
    unable to make those new payments, they will have to refinance,
    sell, or default. Due to higher interest rates and a slow-down
    in the housing market, many borrowers may wind up with negative
    equity in their homes. If lenders are forced to foreclose, they
    could end up owning properties that are worth less than the
    outstanding loan value.
        While regulators have stated that banks have taken steps to
    reduce their risks, they have issued draft guidance to
    Federally regulated institutions on how to better reduce that
    risk. Further steps may be necessary by Federal and State
    regulators to ensure borrowers understand what they are getting
    into when they sign up for one of these mortgages.
        The GAO report being released at this hearing highlights
    these concerns, and I thank them for their work to raise
    awareness.
        Thank you again, Mr. Chairman. I have enjoyed working with
    you on this set of hearings, and I look forward to hearing from
    our many witnesses.
        Senator Sarbanes.

                 STATEMENT OF SENATOR PAUL S. SARBANES

        Senator Sarbanes. First of all, I want to commend the
    Chairman Allard and Chairman Bunning, respectively the heads of
    our Subcommittee on Housing and Transportation and the
    Subcommittee on Economic Policy, and Ranking Members Reed and
    Schumer for holding this second hearing to examine the housing
    markets and the economy. Last week, we have a very good hearing
    that focused on the overall housing market. Today's hearing is
    designed to explore the challenges posed by new and highly
    complex mortgage products.
        It is obvious, of course, that the mortgage market that a
    borrower confronts today is vastly different from the market
    that existed even five or 6 years ago. In 2000, 85 percent of
    all mortgages were fixed-rate obligations. Borrowers generally
    understood these mortgages and the risks, generally speaking,
    were transparent.
        Today, just 6 years later, nearly half of all loans are
    adjustable rates mortgages, 46 percent. Moreover, about 37
    percent of all loans originated in 2005, last year, are what
    many now call exotic mortgages, either interest only loans or
    option ARMs where the borrower has the option to make a payment
    that is not sufficient to cover even the interest due. Such
    loans, of course, result in negative amortization.
        Now, the regulators tell us, and I am pleased to join the
    chairman in welcoming the representatives of the various
    regulatory agencies to this panel, tell us that these exotic
    mortgages were designed as niche products for wealthier
    borrowers. As such, they may, perhaps, have been appropriate;
    however, over the past 3 years, lenders and mortgage brokers
    have been selling these more complex loans to middle class and
    lower income borrowers as affordability products. In other
    words, they are being used to enable borrowers to deal with
    steadily escalating housing prices.
        These mortgages are characterized by significant payment
    shocks that hit borrowers some years into the term of the loan.
    In my view, these new products may be helpful in expanding
    consumer choices and creating opportunities to create
    homeownership, but I think this is true only if they are used
    very judiciously. The loans must be underwritten so as to
    reasonably ensure that borrowers can afford the payments over
    the life of the loan, not just during the introductory period.
    Loans where there are new exotic programs, or a more
    traditional mortgage for that matter, should be underwritten
    with this in mind.
        Unfortunately, evidence seems to indicate that this careful
    approach has not been followed in recent years. Too often,
    according to what the regulators tell us, loans have been made
    without the careful consideration as to the long-term
    sustainability of the mortgage. Loans are being made without
    the lender documenting that the borrower will be able to afford
    the loan after the expected payment shock hits without
    depending on rising incomes or increased appreciation.
        We are seeing the consequences of this. The cover story of
    Business Week  September 11th says that more of a fifth of
    option ARM loans in 2004 and 2005 are upside down, more than a
    fifth, meaning borrowers' homes are worth less than their debt.
    If home prices drop another 10 percent, which the realtors
    expect to happen, that number will double.
        An economic report by Merrill Lynch entitled ``House of
    Horrors'', September 18th, indicates that problems are already
    beginning to surface as some of the early option ARMs are being
    reset. Merrill Lynch, citing data from ``Realty Track'' notes
    that foreclosures nationwide surged 53 percent year on year in
    August and spiked 24 percent month over month. They go on to
    say the culprit is the resets on option ARMs. The report also
    notes a high concentration of delinquencies among subprime ARM
    borrowers in States that have both hot and flat housing
    markets.
        The guidance proposed by the regulators, which requires
    that lenders carefully and fully analyze a borrower's ability
    to repay the loan by final maturity based on the fully indexed
    rate assuming a fully amortized repayment schedule, should help
    to curb some of the abuses we are seeing. I strongly support
    this guidance as an important first step to setting in proper
    perspective what I perceive to some troubling aspects of the
    mortgage industry. It is not the final step, but it is a good
    start.
        I also support the provisions of the proposed guidance that
    will require lenders to monitor third-party originators, such
    as mortgage brokers, to ensure that the loans they originate
    meet the standards of the guidance and of the regulated entity.
    These third parties originate as many as 80 percent of the
    mortgage loans made in this country. If they are not held to
    the same standard as regulated retail lenders, if that standard
    is not effectively enforced, the rules will not result in
    better outcomes for borrowers.
        Likewise, we need to urge the States and the regulators to
    act to adopt consistent rules for unregulated lenders if they
    expect progress to be made in this area. This is particularly
    true in the subprime market. According to the 2004 HMDA data,
    58 percent, 58 percent, of first lien subprime loans were made
    by unregulated lenders. These are the borrowers that are
    especially vulnerable and we need to address their situation.
        Mr. Chairman, this is an important problem that you are
    addressing, and I want to thank the chairmen, in the plural. I
    want to thank both Senator Allard and Senator Bunning for
    scheduling this hearing. Thank you very much.
        Senator Carper, do you have an opening comment?

                 STATEMENT OF SENATOR THOMAS R. CARPER

        Senator Carper.  Just very briefly.
        A couple of my colleagues have already spoken to this. When
    I read my briefing materials, I saw the number 1.9 percent of
    mortgage market in 2000 was interest only and payment option
    loans. Then I saw that it jumped to over a third in six short
    years. I said that is a pretty good reason for holding the
    hearing and I am very glad that we are doing that.
        I have to go to another hearing. I apologize to the
    witnesses. I thank you for coming today, and I especially want
    to welcome one whose mother lives in Wilmington, Delaware, only
    a few blocks from where my family now wells.
        Sandra, welcome. I am glad to hear from you and all these
    people who you brought with you. Thank you.

                 STATEMENT OF ORICE WILLIAMS, DIRECTOR,
                    GOVERNMENT ACCOUNTABILITY OFFICE

        Ms. Williams. Chairman Allard, Chairman Bunning, and
    Subcommittee Members, I am pleased to be here this morning to
    discuss the finding of our just released report on alternative
    mortgage products. As you well know, these products can offer
    benefits from a flexibility and affordability perspective. They
    also can pose significant risks for some borrowers because of
    the potential for large increases in monthly payments or
    payment shock and features such as negative amortization.
        This morning, I will briefly discuss the findings from our
    report, specifically, trends in alternative mortgage products,
    the risks these products can pose to borrowers and lenders,
    current disclosure practices, and the actions of Federal and
    State regulator. While alternative mortgage products have been
    around for decades, interest only and payment option ARMs have
    only become part of the mainstream real estate lending
    landscape in the past few years.
        For example, in 2003, interest only and payment option ARMs
    comprised about 10 percent of mortgages originated. Today, that
    number is over 30 percent, and in certain parts of the country,
    particularly on the east and west coast, this number can be
    even higher. As housing prices have increased, so has the
    demand for mortgage products that can make the dream of home
    ownership more affordable even if only temporarily. While once
    marketed to the wealthy and financially sophisticated, these
    products are now being mass marketed to a wider range of
    potential borrowers.
        This change in focus poses risks that lenders must manage.
    In addition to the products being more complex than traditional
    mortgage products, some lenders are layering on additional
    risks by combining alternative mortgage products with
    underwriting practices such as low or no documentation loan
    features. Although banking regulators expressed some concerns
    about underwriting standards, they told us that they generally
    believe that federally-regulated institutions have generally
    managed these risks well through portfolio diversification,
    selling or securitizing these loans, and holding an adequate
    level of capital.
        For borrowers, these products raise concerns about the
    extent that current borrowers fully understand the risks they
    may face such as payment shock and negative amortization.
    Although these products pose risks, they can also provide many
    borrowers with flexibility that they would not have had with
    more conventional products. Moreover, for borrowers that
    understand the risks and are able to refinance, sell, or absorb
    the higher payments, these products can be beneficial; however,
    for other less savvy and less informed borrowers, the
    experience can be very different.
        Alternative mortgage products illustrate the importance of
    adequate disclosures to help borrowers understand the product's
    terms and risks. To gain some insight into the disclosures
    borrowers receive, we reviewed a sample of alternative mortgage
    products disclosures used by some of the largest federally-
    regulated lenders in this market. What we found was both
    troubling and revealing. While we found that these lenders
    generally complied with the letter of the law and that they
    provided the federally-required disclosures, most did not fully
    or clearly discuss the risks and the terms of these products.
        Federal and State regulators have been and are focusing
    attention on these developments in the real estate lending
    market. Specifically, Federal banking regulators are in the
    process of finalizing interagency guidance, and individually
    they have taken a variety of other steps aimed at ensuring that
    lenders are acting responsibly. Likewise, State regulators have
    begun to focus on alternative mortgage products.
        In closing, I would like to thank you for your attention to
    this issue. While we found no evidence of widespread problems
    to date, it is too soon to tell what the future holds for these
    borrowers and much will depend on a variety of economic
    factors. Finally, we would like to stress the importance of the
    interagency guidance being finalized by the bank regulators and
    hope that it is issued in the future.
        Mr. Chairman, this concludes my oral statement and I will
    be happy to answer any questions.
        Chairman Allard. Thank you.
        Ms. Kathryn Dick, Deputy Comptroller of Credit and Market
    Risk in the Office of the Comptroller of the Currency.

    STATEMENT OF KATHRYN E. DICK, DEPUTY COMPTROLLER FOR CREDIT AND
         MARKET RISK, OFFICE OF THE COMPTROLLER OF THE CURRENCY

        Ms. Dick. Chairman Allard, Ranking Member Reed, Members of
    the Subcommittees, I appreciate the opportunity to appear
    before you today to discuss non-traditional mortgage products
    and the proposed interagency guidance on those products.
        Mr. Chairman, thanks in part to the highly competitive and
    highly innovative mortgage market, we have achieved near record
    levels of homeownership across our country. Our goal as Federal
    regulators is to preserve and expand upon this important
    accomplishment while avoiding unwarranted risks to financial
    institutions and consumers.
        In recent years, a combination of market forces, especially
    the rapid increase in housing prices, has led to the increased
    popularity of so-called non-traditional mortgages. This
    category includes interest-only mortgages, where a borrower
    makes no payment on principal for the first several years of
    the loan, and payment-option adjustable-rate mortgages, where a
    borrower has several payment options each month, including one
    with a potential for negative amortization, which occurs when a
    certain portion of the interest due is deferred and added back
    to the principal balance of the loan.
        In addition, many non-traditional mortgages are made under
    relaxed underwriting standards--with less stringent income and
    asset verification requirements, and sometimes in combination
    with simultaneous second mortgage loans to reduce down payment
    requirements, frequently so that borrowers can dispense with
    private mortgage insurance.
        Non-traditional mortgages have gained a prominent place in
    the marketplace. According to one trade publication, 30 percent
    of all mortgages originated in 2005 were interest-only or
    payment-option ARMs. In the highest-price housing markets, the
    number was even higher.
        Yet despite their popularity, these loans pose special
    risks to borrowers and to lenders. Payment-option ARMs expose
    borrowers to the likelihood of payment shock, which occurs when
    the payment deferral period ends, usually after 5 years, and
    the loan resets to the market rate of interest. At that point,
    the borrower must amortize the entire amount outstanding over
    the shorter remaining term of the loan. In the example that was
    attached to my written testimony, which assumes a modest 2
    percent rise in interest rates, the monthly payment would
    double.
        In an active real estate market characterized by rapid home
    price appreciation, such a mortgage can be refinanced and paid
    off by extracting the increased equity from the appreciated
    property. But what happens if interest rates rise or home
    prices fall, or both?
        Evidence shows that these risks are often not adequately
    disclosed and less well understood in the wider population to
    which these products are increasingly marketed. Marketing
    materials we have reviewed emphasize the initial low monthly
    payment and gloss over the likelihood of the much higher
    payments later on.
        Increasingly, when borrowers opt for a payment-option ARM,
    they aren't thinking about how much their payment will be 5
    years down the road and whether they will be able to make that
    payment--or what will happen if they can't. But they should be
    thinking about it and lenders should be thinking about it, too.
    It is that kind of thinking that our proposed interagency
    guidance on non-traditional mortgages is designed to stimulate.
        It does this by directing financial institutions to ensure
    that loan terms and underwriting standards are consistent with
    prudent lending practices, with particular attention to the
    borrower's repayment capacity. It requires that when banks rely
    on reduced documentation, particularly unverified income, they
    do so with caution. It requires that banks adopt vigorous risk
    management practices that provide early warning systems on
    potential or increasing risks. And it requires that consumers
    are provided with timely, clear, and balanced information about
    the relative benefits and risks of these products, sufficiently
    early in the process to enable them to make informed decisions.
        It may be useful to think of a payment-option ARM as the
    functional equivalent of a loan coupled with a separate home
    equity line of credit, except that, instead of using a check to
    draw down the line of credit, the borrower does so by choosing
    the minimum payment option. The real difference, for our
    purposes, is in the underwriting. Whereas an applicant for a
    home equity line has to show adequate income to service the
    entire amount of the line, no similar qualification requirement
    is imposed on the payment option borrower for the additional
    debt that could be incurred by electing to make only the
    minimum monthly payment, and the minimum monthly payment is
    what most borrowers make.
        Under the proposed guidance, lenders would be required to
    conduct a credible underwriting analysis of the borrower's
    capacity to repay the entire debt, including the potential
    amount of negative amortization that the loan structure and
    initial terms permit.
        Chairman Allard. Ms. Dick, I must ask you to wrap up your
    comments, if you would, please.
        Ms. Dick. Very good.
        Chairman Allard. Thank you.
        Ms. Dick. In proposing this guidance, Mr. Chairman, we had
    two goals in mind: One, to ensure that non-traditional mortgage
    products and the risks associated with them are managed
    properly in our institutions, and, the other, to ensure that
    consumers are provided the information they need, when they
    need it, to make informed decisions about these products.
        Chairman Allard. Okay. Ms. Sandra Braunstein, Director of
    the Division of Consumer and Community Affairs, Federal
    Reserve.

      STATEMENT OF SANDRA BRAUNSTEIN, DIRECTOR OF THE DIVISION OF
            CONSUMER AND COMMUNITY AFFAIRS, FEDERAL RESERVE

        Ms. Braunstein.  Thank you.
        Chairman Allard, Chairman Bunning, Senator Reed and Members
    of the Subcommittees.
        Chairman Bunning.  Thank you for pulling your mike up.
        Ms. Braunstein.  I appreciate the opportunity to appear
    today to discuss consumer issues related to non-traditional or
    alternative mortgage products. These products have increased
    the range of financing options available to consumers and have
    grown in popularity over the past few years. Some consumers
    benefit from these products and the more flexible payment
    options, but these loan products are not appropriate for
    everyone. Thus it is important that consumer have the
    information necessary to understand the features and risks
    associated with these types of mortgages.
        The Federal Reserve engages in a variety of activities to
    ensure that consumers understand credit terms and the options
    available to them when they are shopping for mortgage credit.
    We have a role as a rule writer in which the Board issues
    regulations implementing the Truth-in-Lending Act, or TILA, and
    its required disclosures. TILA is the primary Federal law
    governing disclosures for consumer credit, including home
    mortgage loans.
        TILA requires the uniform disclosure of costs and other
    terms to consumers at various stages of the mortgage
    transaction. This allows consumers to compare more readily the
    available terms and avoid the uninformed use of credit. The
    disclosures required by TILA and its implementing Regulation Z
    are discussed in greater detail in my written testimony.
        We recognize that required disclosures alone cannot address
    these complex issues. Thus we engage in complementary
    activities to ensure that consumers understand credit terms and
    the options available to them when they are shopping for
    mortgage credit. I would like to highlight five significant
    activities that we currently have underway.
        First, we have begun a comprehensive review of the Board's
    Regulation Z which implements TILA. A review of Regulation Z
    specifically focuses on improving the format, content, and
    timing of consumer disclosures. In considering how to improve
    disclosures for alternative mortgage products, in addition to
    soliciting public comments and engaging in outreach, we will
    conduct extensive consumer testing. This testing will help us
    to determine what information is most important to consumers,
    when that information is most useful, what wording and formats
    work best, and how disclosures can be simplified, prioritized,
    and organized to reduce complexity and information overload.
        Furthermore, in reviewing the disclosure requirements, we
    will be mindful that future products might differ substantially
    from those we see today. Thus any new disclosure requirements
    must be sufficiently flexible to allow creditors to provide
    meaningful disclosures even if these products evolve over time.
        Second, the Federal Reserve and the other bank and thrift
    regulators issued draft interagency guidance on alternative
    mortgage products at the end of last year which is currently
    being finalized.
        Third, in conjunction with our Regulation Z review, the
    Federal Reserve recently held four public hearings on home
    equity lending. A significant portion of these hearings was
    devoted to discussing consumer issues regarding non-traditional
    mortgage products. Lenders testified that when loans are
    prudently underwritten, consumers are able to benefit from the
    flexibility these products provide without being at risk of
    default. On the other hand, consumer advocates and State
    officials testified that aggressive marketing and the
    complexity of these products put borrowers at additional risk
    for obtaining mortgages that they do not understand and may not
    be able to afford.
        Fourth, since 1987, the ``Consumer Handbook on Adjustable
    Rate Mortgages'', or the CHARM booklet as we refer to it, a
    product of the Federal Reserve and the Office of Thrift
    Supervision, has been required by Regulation Z to be
    distributed by all creditors to consumers with each application
    for an ARM. Board staff is currently working with OTS staff to
    update the CHARM booklet to include additional information
    about non-traditional mortgage products. This revised CHARM
    booklet will be published later this year.
        And fifth, the Federal Reserve will soon publish a consumer
    education brochure on these mortgage products, and we are
    developing an interactive mortgage calculator for the Internet.
    These items are designed to assist consumers who are shopping
    for a mortgage loan.
        In conclusion, the Federal Reserve is actively engaged in
    trying to ensure that consumers understand the terms and
    features of non-traditional mortgage products. Improving
    federally required disclosures under TILA is an important
    aspect of this endeavor, but we are also pursuing other
    opportunities, for example, through consumer education and by
    issuing industry guidance. We expect the Board will continue
    these efforts over time as mortgage products evolve in response
    to consumers' changing needs.
        Thank you very much.
        Chairman Allard.  Ms. Sandra Thompson, Director of
    Supervision and Consumer Protection, Federal Deposit Insurance
    Corporation.

       STATEMENT OF SANDRA THOMPSON, DIRECTOR OF THE DIVISION OF
    SUPERVISION AND CONSUMER PROTECTION, FEDERAL DEPOSIT INSURANCE
                              CORPORATION

        Ms. Thompson.  Chairman Allard, Chairman Bunning, Senator
    Reed, and Members of the Subcommittee, I appreciate the
    opportunity to testify on behalf of the Federal Deposit
    Insurance Corporation regarding the growth in non-traditional
    mortgage products and the Federal agencies' draft guidance to
    address this issue.
        Non-traditional mortgage products have existed for many
    years; however, they were primarily a niche product used by
    financially sophisticated borrowers as a cash-flow management
    tool. Since 2003, there has been a growing use of non-
    traditional mortgage loans among a wide range of borrowers.
    Non-traditional mortgage products have been especially popular
    in States with strong home price growth. With the surge in home
    prices, non-traditional mortgage products have been marketed as
    an affordable loan product. Some borrowers, often first-time
    home buyers, use these products to purchase higher-priced homes
    than they could have qualified for using more traditional
    mortgage loans.
        Consumers can benefit from the wide variety of financial
    products available in the marketplace; however, non-traditional
    mortgage products can present significant risks to borrowers
    because the product terms are complex and can be confusing. The
    primary risk to borrowers is payment shock, which may occur
    when a non-traditional mortgage loan is recast and the monthly
    payment increases significantly, sometimes doubling or
    tripling. The risk grows as interest rates rise and as home
    appreciation slows. This is especially true in the case of
    payment option ARMs where the loan negatively amortizes,
    sometime to the point of exceeding the value of the property.
        Because of the potential impact on their payments, it is
    critical that borrowers fully understand both the risks and the
    benefits of the mortgage products they are considering. Current
    disclosure requirements were not designed to address the
    characteristics of non-traditional mortgage products. Some
    borrowers do not receive information regarding the risks of
    non-traditional products early enough in the loan shopping
    process to allow them to fully compare available products. In
    addition, marketing materials for these loans often emphasize
    their benefit and downplay or omit the risks. Once the loan is
    made, some of the loan payment statements encourage borrowers
    to make the minimum payment by highlighting only that option.
        Borrowers will clearly benefit from receiving information
    with their payment materials that explains the various payment
    choices as well as the impact of those choices such as payment
    increases or negative amortization.
        Non-traditional mortgage loans pose risks to lenders as
    well. As these products have become more common, there have
    been indications that competition is eroding underwriting
    standards. For products that permit negative amortization, some
    lenders fail to include the full amount of credit that may be
    extended when analyzing a borrower's repayment capacity. In
    addition, there is growing evidence of non-traditional mortgage
    products being made to borrowers with little or no
    documentation to verify income sources or financial assets. In
    effect, some institutions are relying on assumptions and
    unverifiable information to analyze the borrower's repayment
    capacity.
        Financial institutions that effectively manage these risks
    do so by employing sensible underwriting standards and strong
    management information systems. Other institutions are managing
    risk by securitizing their non-traditional mortgage
    originations and spreading the risks of these products to
    investors. In light of the growing popularity of non-
    traditional mortgage products to a wider spectrum of borrowers,
    the agencies have crafted guidance to convey our expectations
    about how financial institutions should effectively address the
    risks associated with these loan products. We have been
    reviewing the comments and are near completion on the final
    guidance.
        In conclusion, the FDIC will continue to monitor insured
    institutions with significant exposures to non-traditional
    mortgage products, and we will ensure that FDIC-supervised
    institutions follow the final guidances when they are issued.
    The FDIC expects institution to maintain qualification
    standards that include a credible analysis of a borrower's
    capacity to repay the loan and they should provide borrowers
    with clear, understandable information when they are making
    mortgage products and payment decisions.
        Thank you for the opportunity to testify, and I am happy to
    answer questions.
        Chairman Allard. Thank you.
        Mr. Scott Albinson, Managing Director for Examinations,
    Supervision, and Consumer Protection, Office of Thrift
    Supervision.

          STATEMENT OF SCOTT ALBINSON, MANAGING DIRECTOR FOR
     EXAMINATIONS, SUPERVISION, AND CONSUMER PROTECTION, OFFICE OF
                           THRIFT SUPERVISION

        Mr. Albinson.  Good morning, Chairman Allard, Chairman
    Bunning, Senator Reed, and Members of the Subcommittees. Thank
    you for your continued leadership on issues affecting the
    mortgage markets and the important topic of non-traditional
    mortgage products. We appreciate the opportunity to discuss the
    views of the Office of Thrift Supervision on alternative
    mortgage products and the risks these products may present to
    consumers, financial institutions, and other financial
    intermediaries.
        Consistent with market development and the expansion of
    these products in the mortgage marketplace, OTS has implemented
    a comprehensive supervisory approach that focuses on credit,
    compliance, legal operational, reputational, and market risks
    associated with offering alternative mortgage products to
    consumers. We pay careful attention to underwriting practices,
    internal controls, portfolio and risk management, marketing,
    consumer disclosure, loan servicing, and mortgage banking
    activities. Our examination staff is well-trained to monitor
    and adjust to trends in mortgage markets to identify and ensure
    weaknesses in underwriting and risk management are promptly
    corrected and to mine consumer complaint information and to
    prevent or end abusive lending practices.
        We updated and reissued detailed examiner guidance on
    mortgage lending activities and mortgage banking operations in
    June 2005 and made it publicly available. To augment our
    existing guidance and to provide further clarity to thrift
    institutions in the broader mortgage markets, OTS has been
    actively engaged and fully supports recent interagency efforts
    to finalize and issue joint guidance addressing the range of
    safety and soundness and consumer protection concerns with
    respect to offering these products.
        I believe concerns regarding alternative mortgage products
    generally fall into two broad categories. One is consumer
    confusion as to how the products are structured and how they
    function, and two, that the products are being used as
    affordability tools to enable borrowers to become overextended
    on their debts. OTS and interagency initiatives on a variety of
    areas are designed to specifically address these areas of
    concern.
        To address the first broad area of concern, the problem of
    potentially inadequate information and consumer understanding
    of the risks of alternative mortgage products, OTS is active on
    several fronts. Together with the Federal Reserve, we are
    diligently working on updating the Consumer Handbook on
    Adjustable Rate Mortgages, the CHARM booklet, a disclosure that
    is made available to all borrowers seeking an adjustable rate
    mortgage. We feel efforts to communicate with and educate the
    consumer concerning the features, benefits, and risks are
    particularly important.
        We are steadfastly working on proposed guidance with the
    other agencies regarding supplemental consumer disclosures for
    alternative mortgage products that include recommended
    narrative descriptions of the products as well as sample
    illustrations for use by lenders. Our objective is to stimulate
    clear, balanced, and conspicuous disclosure of the benefits and
    risks of alternative mortgage products at the time the borrower
    is considering loan options, at settlement, and on monthly
    borrower statements indicating the effects of any negative
    amortization and other key aspects of the mortgage instrument.
        On a simultaneous and parallel track, we are participating
    with the other agencies in drafting a consumer information
    booklet specifically addressing features of interest only and
    pay option ARM loans. Furthermore, OTS will continue its
    efforts to promote awareness and understanding of alternative
    mortgages among consumers in a variety of venues.
        To address the second broad area of concern, that some
    products are being inappropriately used as affordability
    mechanisms to stretch borrowers beyond their means, OTS is
    focused on loan underwriting and risk management among thrift
    institutions. We expect thrift institutions to implement a
    prudentially sound system of underwriting policies, standards,
    and practices that include qualifying borrower at the fully
    indexed, fully amortizing amount for option ARM loans. This
    helps insulate borrowers from the potential for payment shock
    as well as curbs the ability of institutions to use alternative
    mortgage products as affordability products, ensuring borrowers
    have the ability and capacity to prepay the loan, including
    principal, at the outset.
        Lastly, the requisite infrastructure to support lending
    activities must be present within thrift institutions,
    including robust risk management practices and management
    information and reporting systems to screen loans and monitor
    portfolio conditions and originations made through third
    parties.
        Chairman Allard. Mr. Albinson, I must ask your to wrap up
    your testimony, please.
        Mr. Albinson. Thank you.
        The potential risks of alternative mortgage product have in
    the past and can in the future be appropriately managed by
    informed consumers and well-run institutions. We do not want to
    stifle innovation or unjustifiably restrict the flow of credit,
    especially during the current challenged housing market.
    Promptly addressing problems and poor risk management practices
    will ensure a steady flow of credit to deserving borrowers in
    the future.
        Thank you.
        Chairman Allard.  Ms. Rotellini, you are next. You are with
    States. You are the Superintendent, Arizona Department of
    Financial Institutions, and you are here on behalf of the
    Conference of State Bank Supervisors.

      STATEMENT OF FELECIA A. ROTELLINI, SUPERINTENDENT, ARIZONA
                  DEPARTMENT OF FINANCIAL INSTITUTIONS

        Ms. Rotellini.  Yes, Mr. Chairman. Thank you.
        Good morning to both Chairman Allard and to Chairman
    Bunning, Ranking Member Senator Reed, and to the Members of the
    Committee.
        Like most of my State counterparts, in addition to
    supervising banks, I am also responsible for the regulation of
    State-licensed mortgage brokers and lenders. In fact, 49 States
    plus the District of Columbia currently provide regulatory
    oversight of the mortgage industry. Under State jurisdiction,
    there are more than 90,000 mortgage companies with 63,000
    branches and 280,000 loan officers and other professionals.
        In recent years, CSBS has been working with the American
    Association of Residential Mortgage Regulators, known as ARMOR,
    of which I am a member of the board of directors, to improve
    State supervision of the mortgage industry. Regulation of the
    mortgage industry originated at the State level, and while the
    industry has changed dramatically, State supervisors maintain a
    predominant changing role. Because of the nature of the
    industry, effective supervision now requires an unprecedented
    level of State and Federal coordination.
        State supervision of the residential mortgage industry is
    rapidly evolving to keep pace with the changes occurring in the
    marketplace. State standards for licensure are quickly
    improving and adapting. Through CSBS and ARMOR, the States are
    working together to improve coordination of State supervision
    as well as to provide best practices and more uniformity.
        The residential mortgage industry has changed dramatically
    over the past two decades. The majority of residential
    mortgages are no longer originated in Federal- and State-
    regulated savings and loans, but by mortgage brokers and State-
    licensed lenders. Risk-based pricing has allowed more consumers
    than ever to qualify for home financing by trading a lower
    credit score or down payment for a higher rate.
        Mortgage lenders have developed a number of products,
    including the non-traditional mortgage products that are the
    subject of today's hearing, that offer home buyers a wide and
    ever-expanding variety of loan choices. Increasingly, many of
    these products are quite complex, providing both opportunities
    and perils for consumers. The sophisticated nature of these
    products requires an elevated level of professionalism in
    mortgage originators and robust oversight of the companies and
    the people offering such products.
        The increasing role that brokers play in the residential
    mortgage process, concerns about predatory lending, the
    explosion of product choices offered by the private sector, and
    the realignment of the Federal role in housing finance has
    required the States to develop new tools to protect consumers
    and to ensure that mortgage markets operate in a fair and level
    manner. It is within this context that my fellow State
    regulators and I find ourselves compelled to develop policies
    and initiatives that raise professionalism and increase
    coordination.
        In order to do so, CSBS and ARMOR have created a
    residential mortgage licensing initiative designed to create
    uniform national mortgage broker and lender licensing
    applications in a centralized data base to house this
    information. The uniform applications will significantly
    streamline processing of licenses at the State level. The
    national data base will contain licensing information, final
    outcomes of enforcement actions, and background data for every
    State-licensed mortgage broker, mortgage lender, control
    person, branch location, and loan originator.
        The CSBS-ARMOR residential mortgage licensing initiative is
    the cornerstone for a new generation of coordination,
    cooperation, and effective supervision in the State system. The
    changes in the mortgage industry over the past 20 years require
    this robust licensing system. Given the changes in mortgage
    products and the increased role of broker, CSBS believes it is
    in the regulators', consumers, and mortgage industry's best
    interest to move to the coordinated oversight the CSBS-ARMOR
    licensing system and data base will provide.
        CSBS commends the Federal regulators for drafting guidance
    on non-traditional products. This guidance has done much to
    draw attention to the threats these products may pose to
    consumers, especially if the underwriting is done improperly or
    the consumer does not understand product. When the guidance is
    implemented, however, it will not apply to the majority of
    mortgage providers in the country. Therefore, CSBS and ARMOR
    are developing parallel model guidance for the State to apply
    to State-licensed residential brokers and lenders. The parallel
    guidance is intended to hold State-licensed mortgage brokers
    and lenders to effectively the same standards developed by the
    Federal regulators.
        Finally, the States have proactively worked to increase the
    expertise and knowledge of our examiners. It is critical for
    our examiners to understand the function of the mortgage market
    and its various products. These examiners are the individuals
    who will see firsthand and who do see firsthand the practices
    of the industry and its impact on consumers and have the
    opportunity to counsel and advise these companies.
        I commend the subcommittees for addressing this matter. On
    behalf of CSBS, I thank you for the opportunity to testify, and
    I look forward to any questions you may have.
        Chairman Allard.  We will now move into the question and
    response period. I am going to try to enforce the 5-minute
    rule, for the Member's benefit, very strictly. And my plan is I
    will have my 5 minutes. I should get down there to vote 5
    minutes before the vote comes up. It is scheduled for 11:15.
    Then I will have Senator Bunning run the committee, and I will
    get back and other members can go vote whenever it is
    convenient for them.
        Okay. To the Federal regulators, the question is what do
    you expect to issue the final guidance on non-traditional
    mortgage products?
        Yes, Ms. Thompson.
        Ms. Thompson.  It is my understanding our principals met
    earlier this week and they are very close to finalizing it. I
    am hopeful that we will finalize it in the very near term.
        Ms. Dick.  I would just echo the comments of my colleague
    at the FDIC. My understanding is we will have the guidance
    issued in a matter of weeks, not months.
        Chairman Allard.  OK.
        Senator Sarbanes.  How about the other two?
        Chairman Allard.  Federal regulators?
        Ms. Braunstein.  I concur with what Ms. Dick said.
        Mr. Albinson.  I concur as well.
        Chairman Allard.  Nothing too specific for the committee.
    We were hoping for something more specific.
        Consumer groups and others have questioned the extent to
    which guidance as opposed to a law or regulation can be
    enforced to truly protect consumers and bring about changes to
    non-traditional mortgage lending. What can Federal regulators
    do to ensure lenders follow guidance principles? I would like
    to have the regulators respond again.
        Yes, Ms. Thompson.
        Ms. Thompson.  Our institutions are used to guidance
    because that establishes what the regulators' expectation are.
    When our examiners go in to examine for safety and soundness or
    consumer protection issues, guidance has been very effective
    over the years in providing a specific road map as to what we
    are going to examine these institutions for.
        With regard to non-traditional mortgage loans and the
    guidance that will be issued, we will certainly issue examiner
    guidance that will be distributed to our institutions so that
    they have a very clear expectation of what we are looking for
    in our examination process.
        Chairman Allard.  So we are putting discretion in the
    examiner in your case. We feel certain that the examiner will
    treat these guidance principles almost as a regulation. Is that
    right?
        Ms. Thompson.  Well, these guidance procedures are used to
    establish what our expectations are, and we do have regulations
    that they have to adhere to, but it is very useful for the
    examiners and the institutions to quickly understand what our
    expectations are in this area.
        Chairman Allard.  Others regulators?
        Ms. Braunstein.  Yes. We think guidance can be a very
    effective starting place for having conversations on
    examinations about these issues. It is there, as Ms. Thompson
    said, to give some guidance, some direction to the financial
    institutions, and also to our examiners, in addition to the
    examiner guidance that we will develop. And that it is a very
    good place for us to have conversations about these issues and
    to see what the institutions are doing.
        Chairman Allard.  Ms. Dick.
        Ms. Dick. I would supplement the comments of my colleagues
    by first echoing the fact that at the OCC, we also use guidance
    to make our supervisory expectations very clear. However,
    certainly, if we have a situation where we believe abusive
    practices are taking place with respect to consumer lending, we
    do have a full menu of regulations and, laws that we can bring
    into play. An arsenal, if you will, to take forward an
    enforcement action. So we have safety and soundness standards
    and other directives, regulations, and laws that we can use to
    carry things forward in an enforcement capacity, if necessary.
        Chairman Allard. Mr. Albinson.
        Mr. Albinson. I would agree with everything my colleagues
    have said. The guidance establishes a baseline of supervisory
    expectations. We have a very intensive supervisory process that
    includes annual on site examinations at thrift institutions.
    Our examiners by virtue of that on-site examination process get
    to see a wide range of practice, and over time, as you might
    expect, the markets innovate. They evolve as well as
    institutions. Risk management practices evolve, and the
    examiners can take that and communicate the range of practice
    they see as well as leading and best practices within
    institutions.
        We also have internal processes within our organizations to
    be able to receive that data and assimilate it within the
    organization and update our examination guidance and the other
    supporting infrastructure that exists behind the guidance that
    we will issue on an interagency basis.
        Chairman Allard.  The way I understand guidance, it is a
    warning, that you are concerned about certain practices and
    whatnot. If they don't follow the guidance, the industry meets
    certain thresholds and it could be looking at rules and
    regulations, basically. Is that the approach? Where is that
    threshold?
        Mr. Albinson.  I think it would depend on the individual
    institutions as to what--we look in a holistic fashion at the
    risk management practices.
        Chairman Allard.  Yes, but a rule and regulation is for all
    the institutions under your purview. So I don't hear a
    threshold number. I think you need to think a little bit about
    that. I don't expect anybody can answer that.
        My time has run out, but I do think you need to think about
    where that threshold is and what is going to create that
    threshold.
        I will yield to Senator Reed, and Chairman Bunning will now
    run the committee.
        Senator Reed.  Well, thank you very much, Chairman Allard.
        First let me thank Ms. Williams for the GAO report, which
    is very insightful, and then ask the regulators each a general
    question. To what extent are these loans securitized to a
    secondary market so they are not getting held by the financial
    institutions, in a way mitigating the risk? Ms. Dick, do you
    have an idea?
        Ms. Dick.  Actually, my understanding is a large number of
    the non-traditional mortgages are, in fact, delivered into the
    securitization market. Much of that takes place through what we
    call private label securitizations, which are packages put
    together by investment firms and other dealers.
        Senator Reed.  So, in effect, in this case, the bank, the
    financial institution, regulating institution, is taken out of
    the risk as soon as they sell into the secondary market. Is
    that accurate?
        Ms. Dick.  The securitization market is used, really, as a
    liquidity vehicle for large financial institutions to sell
    assets and provide additional credit. There are risks that are
    retained by financial institutions that securitize assets.
        Senator Reed.  Right. Sometimes they have these puts.
    People can put back the security.
        Ms. Dick.  Reps and warranties, exactly, as well as
    reputational risk associated with it. A borrower generally is
    going to remember who they got the loan from, not the fact that
    that loan has been sold into a secondary market.
        Senator Reed.  Right. And you are also looking systemically
    at these reserve risks that the institutions might hold even if
    they securitize?
        Ms. Dick.  Absolutely.
        Senator Reed.  Ms. Braunstein, can you comment on that same
    question?
        Ms. Braunstein.  I concur with what Ms. Dick said. We don't
    have data on how much of it is going into the secondary marks,
    but our understanding is that a large part of it is.
        Senator Reed.  Ms. Thompson.
        Ms. Thompson.  Yes. We do know that some of these
    institutions are securitizing the mortgages, which means that
    the loans are off the books and that they are placed into the
    securities and then sold to investors. So the risk is
    dispersed.
        We are also concerned about the amount of these types of
    securitizations that banks hold. It hasn't been that much, but
    this is something that we are looking at.
        Senator Reed.  The other side is they are actually buying
    into these pools of securitized mortgages.
        Ms. Thompson.  They have the ability to, yes, sir.
        Senator Reed.  And you are going to pay attention to that?
        Ms. Thompson.  Absolutely.
        Senator Reed.  Thank you.
        Mr. Albinson.
        Mr. Albinson.  Likewise, we not only look at purchases of
    tranches of CMO instruments that our institutions may put into
    their portfolios, but we also look for those that do
    securitize, at their retained risks, and we do have rules,
    specific rules, requiring a careful analysis by the
    institution, including an analysis of the capital adequacy and
    support needed behind that retained risk; and, of course, as
    Ms. Dick indicated, the reputational risk is not insignificant
    for these institutions too.
        Senator Reed.  Thank you.
        Ms. Rotellini, from the perspective of a State regulator,
    do you have more of a problem with State institutions holding
    these themselves? Is that something or can you comment upon
    this line of questioning?
        Ms. Rotellini.  Senator Reed, most of our mortgage brokers
    would not be holding onto them. The mortgage lenders, many of
    them are using wholesale lines and do not hold onto those
    mortgages either.
        Senator Reed.  Very good.
        You have issued at least preliminary guidance and you are
    finalizing it. There are, I think, several areas which are
    critical, if you want to quickly each comment upon it. How do
    you treat negative amortization, reduced documentation, and
    then the layering of the secondary loans or special sort of
    combinations of lending, risk layering in general? And Ms.
    Dick, again, if we could go just go down. What is your advice
    right now, even though it is not is formalized, to institutions
    about these factors?
        Ms. Dick.  With respect to the negative amortization, we
    have tried to make clear that the standard in the industry
    needs to be changed such that the economic equivalent of a line
    of credit is included in the analysis that is done at
    underwriting, so the borrower understands the full amount of
    the debt they will owe and the borrower's repayment capacity is
    analyzed by the financial institution.
        Reduced documentation loans, again, introduce an element of
    risk to the financial institutions. We have provided our
    supervisory expectations in the guidance and want to make sure
    that the regulated institutions use strategies such as reduced
    documentation in underwriting in a very clear and thoughtful
    manner.
        As to the layering of risk, that is a practice that we are
    very concerned about, and certainly one that is associated with
    some of these non-traditional mortgages, because it reduces,
    potentially eliminates, the amount of equity a borrower has in
    their home. We don't do anyone any favors--not banks, not
    consumers, not our communities--if we have situations where 5
    years down the line, there is no equity left in the home and
    the borrower has excessive payments.
        Senator Reed.  Well, my time has expired, and I would ask
    for a nod of the head if you agree with Ms. Dick's comment.
        I would note one other point, Ms. Thompson, is we are lucky
    in our office to have Ken Kilber, your colleague as a fellow.
    Thank you for that.
        Thank you.
        Chairman Bunning.  Thank you, Senator Reed. I am going to
    ask my questions for 5 minutes and then yield to my colleague,
    the ranking member of the full committee.
        It seems to me there has been a race to the bottom with
    underwriting standards for non-traditional mortgages over the
    last few years. Lenders have granted larger loans to borrowers
    who are less able to afford them and based on less
    documentation. I would like to ask each of you to answer this
    question quickly, if you can.
        Over the past two or 3 years, have lenders used adequate
    underwriting standards or did they get so loose with their
    money that significant numbers of borrowers are going to
    default unless they can refinance or sell in the current
    climate, rising interest rates, less equity in their homes?
        Ms. Braunstein.  I can start and just say that at this
    point in time, we have not seen any specific signs that lead us
    to conclude that there will be huge numbers of defaults. Of
    course, a number of these loans still have not recast, and we
    will be watching very carefully in the next few years as they
    recast to see what happens.
        Chairman Bunning.
        Ms. Thompson.  I would say that we have been looking at
    some of the more vintage loans that have been originated in
    2004 and 2005, because this is when the payment option and
    interest only ARMs were prevalent in the market, and we have
    noticed that some of these loans are becoming more delinquent
    than the traditional mortgage loans. Even though the payments
    haven't reset and we don't have a real good understanding yet,
    we have noticed an increase.
        Chairman Bunning.  Some of the ARMs have not reached their
    expiration?
        Ms. Thompson.  That is exactly right, but we have noticed
    an increase in the delinquencies, very slight, in the loans
    that were originated in 2004 and 2005, and we are keeping our
    eye on them.
        Chairman Bunning.  Ms. Dick, do you have anything to add to
    that?
        Ms. Dick.  We have a process at the OCC of looking at
    underwriting standards more generally, and, certainly in the
    last few years, we have been seeing an easing in underwriting
    standards. Part of the responsibility of our examiners, then,
    is to go in on a case-by-case basis at the large lenders and
    look at how those underwriting standards have evolved and
    whether or not there are any supervisory concerns.
        Chairman Bunning.  With interest rates rising as they have
    in 17 out of the last 18 meetings of the FOMC and ARMs not
    reaching their maturity yet, the three- to five-year ARM in
    most of the mortgages, you wouldn't possibly see a great
    acceleration, but what happens when it hits? That is what I am
    interested in. What happens when the interest only and the ARMs
    hit and borrowers have to ante up and they don't enough equity
    and they surely weren't anticipating the huge increase in the
    interest rate of the original loan?
        Ms. Dick.  Chairman Bunning, I would just say, from our
    standpoint, that is exactly why we issued this guidance and are
    working diligently to get it in final form. Right now, this is
    a very small part of the mortgage market, but it clearly has
    been the area that has been growing.
        Chairman Bunning.  Mr. Albinson.
        Mr. Albinson.  I concur with my colleagues. The numbers as
    far as delinquencies and defaults for this product are rather
    low even compared to fixed-rate 30-year amortizing mortgages at
    this point in time, but one would expect that. These loans are
    relatively unseasoned. They have been originated in 2004 and
    2005, and when you look at those cohorts and begin to plot them
    out on a graph, the trajectory is a little bit higher than
    other cohorts or other vintages that we have looked at.
        The question will be based on a combination of factors as
    these loans begin to recast in the coming years. It will be
    partly dependant on where interest rates are as well as
    macroeconomics factors, employment statistics, and real estate
    values, of course, as well.
        Senator Bunning. I have a question for the Federal Reserve.
    Ms. Braunstein, in your testimony, you indicated the Fed is
    going to update the Truth-in-Lending Disclosure Regulation Z to
    address newer non-traditional mortgages once you have complete
    revision for credit cards. If I am correct, that process
    started in December of 2004 and is still not done. Can you give
    us a realistic expectation when the Fed is going to act on
    these mortgages?
        Ms. Braunstein. Well, we have already started the process,
    Senator Bunning.
        Senator Bunning. I know you have started, in 2004, but when
    are you going to finish?
        Ms. Braunstein. I don't have an exact date for you, but I
    can tell you that it is a very time-consuming process. First of
    all, when TILA was issued and passed by the Congress, these
    kind of products were not envisioned, and we did choose some
    years ago to add disclosures for adjustable rate mortgages. We
    are looking at those in light of today's marketplace, and one
    of the big things that we have to do with these is to try to
    minimize burden to the industry, while at the same time making
    sure that new disclosures are effective for consumers, because
    the worst thing we could do is to issue something that is not
    useful.
        So in order to feel comfortable we are doing that, we are
    engaging in pretty extensive consumer testing in focus groups
    to make sure that what we actually issue, consumers understand
    and can digest and utilize.
        Senator Bunning. We surely don't want to hurt the consumer
    with a regulation that is after the fact.
        Ms. Braunstein. No. I understand that. It is a lengthy
    process, and that is one of the reasons why we are doing some
    other things. Issuing the new CHARM booklet is part of the TILA
    review. That is required by Regulation Z, and that will be out
    before the end of year.
        Senator Bunning. And?
        Ms. Braunstein. We also held hearings on these, as I
    mentioned, this summer and have gathered that information. I
    don't have an exact date for you.
        Senator Bunning. Thank you very much.
        Ms. Rotellini. Chairman Bunning, may I respond to those
    questions as well from the State's perspective?
        Senator Bunning. Yes, but I want to make sure that my
    colleague from Maryland gets his time in too.
        Ms. Rotellini. First, with respect to the scenario you
    described, the States are very concerned that default will
    increase and that the train has left the station with respect
    to many of the types of loan that are on the books right now.
        Secondly, with respect to State regulation, there are many
    States, including Arizona, that have prohibitions on the books
    right now that State-licensed brokers and lenders cannot
    misrepresent, cannot engage in deceptive practices, and State-
    licensed brokers and lenders are subject to State consumer
    laws, and those laws have been enforced in the past in
    situations such as Ameriquest and Household where the State
    Attorney Generals and regulators have looked at these very
    types of non-disclosures.
        Senator Bunning. Senator Sarbanes, go right ahead.
        Senator Sarbanes. Thank you very much. I am going to put
    one question to the regulators, and then I am going to have to
    depart for the vote, but I do want to thank you all for your
    testimony and also that of the second panel.
        In looking through the proposed guidance as well as the
    witness' testimony from the second panel this morning and the
    background material, it seems to me that the very fundamental
    issue here is that each lender must ensure that a borrower has
    the ability to repay the mortgage when it first underwrites the
    loan at the fully indexed rate assuming a fully amortizing
    repayment schedule. In other words, you have to look at the
    process and ensure its sustainability.
        This is important to maintain safe and sound operations at
    the financial institutions, although someone noted they are
    selling these things off, and it is important for the borrowers
    that their ability to repay the mortgage and keep their home
    should not turn on what amounts to a throw of the dice. If we
    do finalize this guidance, in particular requirements to
    establish the ability of the borrowers to fully repay the
    mortgages, we are in effect inviting lenders and mortgage
    brokers to make collateral-based loans, a practice which the
    guidance calls unsafe and unsound.
        In fact, let me quote from Ms. Dick's testimony here this
    morning, quote: Underwriting standards that do not include a
    credible analysis of a borrower's capacity to repay their
    entire debt violate a principle of sound lending and elevate
    risks to both the lender and the borrower, end of the quote.
        I want to ask each of you, therefore, if you agree that it
    is essential to move forward with a provision of the guidance
    requiring lenders to establish a borrower's long-term ability
    to pay the mortgage. Ms. Dick, why don't we start with you and
    come right across, and if you can give succinct answers, it
    would be helpful in this circumstance.
        Ms. Dick. Yes, Senator Sarbanes, I agree with your
    statement. It is important both for the borrower and the
    financial institution that the repayment capacity be considered
    based on the full amount that that borrower will be expected to
    repay.
        Senator Sarbanes. Ms. Braunstein.
        Ms. Braunstein. Yes. I concur with that also, and say that
    that is a critical part of the guidance, but other things in
    the guidance are also critical and it is important to move
    forward with the guidance in general.
        Senator Sarbanes. I didn't mean to suggest they weren't. I
    was just focusing on that.
        Ms. Thompson.
        Ms. Thompson. Yes, Senator. That is a critical part of the
    guidance, to qualify the borrower at the fully indexed rate and
    at a fully amortized payment schedule. We want borrowers to not
    only get their homes, we want them to stay there.
        Senator Sarbanes. Mr. Albinson.
        Mr. Albinson. Yes. I concur with the prior statements of my
    colleagues. That is a critical component of the guidance.
        Senator Sarbanes. And, Ms. Rotellini, you are not a Federal
    regulator, but I am told or we have reports that you are a very
    good State regulator. What is your view on this issue?
        Ms. Rotellini. Thank you, Senator Sarbanes. The States are
    looking at this guidance and wanting to continue to make the
    playing field and the markets level, and we too are considering
    the same guidance and issuing something similar.
        Senator Sarbanes. I have a quick moment here. I am going to
    pop another question. Thank you all for that answer.
        The issue has been raised regarding the fact that the
    proposed guidance applies to federally regulated institutions
    only, obviously. Many have pointed out there are many lenders
    and other originators who are not federally regulated,
    particularly in the subprime market. So let me ask the
    regulators if they agree that the proposed guidance will be
    more effective if the States adopt similar rules.
        We will go right across.
        Ms. Dick. Again, I agree with that statement. We applaud
    the efforts of the CSBS in attempting to do exactly that, take
    the principles of this guidance and make them into something
    that the States can use as well.
        Senator Sarbanes. Ms. Braunstein.
        Ms. Braunstein. Yes. I concur and would just add that our
    data shows that even though it won't cover all regulators in
    terms of dollar amount, it will cover about 70 percent of the
    market.
        Ms. Thompson. Yes, Senator, and you know we work very
    closely with the State regulators in our examination program.
        Senator Sarbanes. Mr. Albinson.
        Mr. Albinson. Yes. We welcome CSBS's participation in this
    effort and continuing enforcement of the principles that are
    ultimately espoused in the final guidance.
        Senator Sarbanes. And, Ms. Rotellini, what is your view
    about the States upgrading the standard to jibe with the
    Federal standards in this area?
        Ms. Rotellini. Senator, the States are doing that. They are
    committed to professionalism and ethics and a lending community
    under State regulation that considers the borrower's repayment
    ability as well as all of the other concerns about disclosure.
        Senator Sarbanes. Well, I thank the panel very much.
        Thank you.
        Chairman Allard. Thank you, Senator Sarbanes, and I want to
    also thank the panel. I know it is not always easy to get away
    from your jobs to testify, but it is important to support the
    issue. Thank you for taking the time to be here.
        We will go now to panel two: Mr. Robert Broeksmit, when you
    are ready, we will proceed, Chairman of the Residential Board
    of Governors, Mortgage Bankers Association.
        We are sticking to the 5-minute rule, gentlemen.

      STATEMENT OF ROBERT BROEKSMIT, CHAIRMAN OF THE RESIDENTIAL
            BOARD OF GOVERNORS, MORTGAGE BANKERS ASSOCIATION

        Mr. Broeksmit.  Thank you, Chairman Allard and Members of
    the Committee. My name is Robert Broeksmit. I am the President
    and Chief Operating Officer of B.F. Saul Mortgage Company, a
    subsidiary of Chevy Chase Bank in Bethesda, Maryland. I also
    serve as the Chairman of the Mortgage Bankers Association's
    Residential Board of Governors and I am pleased to be here
    today on their behalf, testifying before you.
        The term ``non-traditional mortgage products'' encompasses
    a variety of financing options developed by the industry to
    increase the ability of borrowers to manage their own money and
    wealth. Borrowers have used these products to tap their home's
    increased equity to meet an array of needs ranging from
    education to health care to home improvement and to purchase
    homes in markets where home prices have quickly appreciated.
        While these products have often been characterized as new,
    many of them actually predate long-term fixed-rate mortgages.
    The market's success in making these products available is a
    positive development, although these products have been used to
    finance a relatively small portion of the Nation's housing,
    they offer useful choices for borrowers who can benefit from
    them.
        As with all mortgage products, they must be underwritten by
    lenders in a safe and sound manner and their risks must be
    appropriately managed. It is equally important that lenders
    provide consumers with adequate explanations of the loans and
    their terms so that borrowers can make an informed choice about
    whether these products match their needs.
        I would like to put the market's use of non-traditional
    products into perspective. More than a third of homeowners,
    approximately 34 percent, own their homes free and clear. Of
    the 66 percent of remaining homeowners, three-quarters have
    fixed-rate mortgages and only one-quarter, or 16 and a half
    percent, have adjustable rate mortgages. Many of the borrowers
    with adjustable rate loans have jumbo loans and many have
    extended fixed-rate periods, such as five, seven, and 10/1
    ARMs.
        You know, it wasn't all that long ago that our industry was
    addressing concerns about the availability of credit to all
    borrowers. It seems we are victims of our own success to a
    degree as the discussion now concerns whether some of the many
    credit options available to borrowers are appropriate for them.
    Some have even suggested that the industry should take on an
    undefined responsibility to determine the suitability of
    products for particularly borrowers, a very difficult and
    dangerous undertaking at best.
        We as lenders know how to determine a borrower's
    eligibility for a loan. Limiting choices to borrowers we would
    deem eligible but not suitable would not serve borrowers well,
    would increase lenders' liability, and would raise all
    borrowers' costs. Lenders have successfully offered these
    products for decades and should continue to do so.
        MBA and our members strongly believe that sound
    underwriting, risk management, and consumer information are
    essential for the public interest. It is equally critical to
    assure a regulatory environment that encourages rather than
    hinders innovation in the industry. Such an environment would
    continue to allow lenders to provide borrowers the widest array
    of credit options to purchase, maintain, and, as needed, draw
    equity from their homes to meet their financial needs. While
    expectations should be articulated, the details need not be
    proscribed, and any requirements in this area must balance all
    of these imperatives to truly serve the public interest.
        I can assure you the marketplace still works. Mortgage
    lenders want to lend money to those borrowers who are willing
    and able to pay the loan back. When a homeowner goes to
    foreclosure, everybody loses: The consumer, the community, the
    lender, and the investor. We all win when the right loan keeps
    a family in its home.
        The mortgage market works and the data demonstrate that
    fact. The market is serving more borrowers who are benefiting
    today from unparalleled choices and competition, resulting in
    lower prices and greater opportunities than ever before to
    build the wealth and well-being that homeownership brings to
    their families and communities. The market must be permitted to
    continue to do so. Any consideration of new requirements in
    this area must be judicious and any requirements very carefully
    conceived.
        We must also do our best to assure that borrowers fully
    understand and can take advantage of the choices available to
    them.
        MBA stands ready to work with you on this important topic,
    and I look forward to answering your questions.
        Chairman Allard.  Mr. Hanzimanolis, you are next. You are
    NAMB President-Elect and with Bankers First Mortgage,
    Incorporated.

    STATEMENT OF GEORGE HANZIMANOLIS, NAMB PRESIDENT-ELECT, BANKERS
                          FIRST MORTGAGE, INC.

        Mr. Hanzimanolis. Good morning, Chairman Allard. I am
    George Hanzimanolis, President-Elect of the National
    Association of Mortgage Brokers. I commend the subcommittees
    for holding this important hearing to address the concerns and
    practices relating to non-traditional mortgage products. Thank
    you for inviting us here today.
        As you just heard from the first panel, approximately 85
    percent of mortgage loans are brokered loans. With respect to
    the topic, there are a few critical points I would like to
    make.
        Today, non-traditional mortgage products can be effective
    financing tools, affording consumers the flexibility to invest,
    manage their wealth, and manage uneven income flows. We
    appreciate the concerns raised by this topic, such as risk
    layering and borrower knowledge, and welcome the opportunity to
    discuss and comment on these issues.
        Next, all mortgage originators should be knowledgeable
    about the benefits and the risks of the products they offer.
    Our lending industry has experienced significant growth,
    expanding product choice and distribution channels, adding
    robust competition, and great pricing options. In order for
    originators to keep pace with this growth, every originator
    should complete both pre-employment and continuing education
    requirements. We must also ensure that all the originators
    submit to a criminal background check so that bad actors are
    not able to move freely from one distribution channel to
    another.
        In support of this effort, NAMB has urged the States to
    implement minimum standards that call for licensing and
    education requirements for all mortgage originators. NAMB has
    taken steps to develop education courses for mortgage
    originators that focus solely on non-traditional mortgage
    products.
        While these initiatives have been largely successful in
    increasing professional standards for mortgage brokers, they
    have not increased standards for officers of banks and lenders
    who continue to be exempt from any State licensing and consumer
    protection laws, which brings me to an important point.
    Consumers don't know the difference between a broker, a bank,
    or a lender, or even a depository institution. When it comes to
    originating a mortgage, there is little difference between
    them. The large majority of loans today can be considered
    brokered loans, which includes brokers, correspondent lenders,
    and any lender that does not service a loan for a period longer
    than 3 months. In the end, they are all competing distribution
    channels, which means one channel should not be exempt from
    these important standards.
        Second is financial literacy. Regardless of how
    knowledgeable a mortgage originator is or becomes, educated
    consumers are always in a better position to make informed
    decisions when choosing a loan. NAMB urges Congress to allocate
    funds for financial literacy programs at the middle and high
    school level so that consumers are educated about the financial
    decisions they make and retain the decisionmaking ability
    throughout their life. The consumer, not the government and not
    the mortgage originator, is the best decisionmaker.
        The role of the consumer is to acquire the financial acumen
    needed to take advantage of the competitive marketplace. Shop,
    compare, ask questions, and expect answers. Consumer demand has
    driven the use of these loan products. These products can be an
    effective and useful financing tool that affords consumers
    flexibility; however, as with any loan, there is risk involved
    for both the consumer and the market.
        As a decisionmaker, the consumer decides where risk is
    appropriate and when it is not. Just as a mortgage originator
    cannot forecast the future or cannot anticipate when the
    Federal Reserve Board will raise interest rates 17 times, the
    mortgage originator cannot decide for the consumer what loan
    product is best.
        Third, to facilitate meaningful comparison shopping,
    disclosures should impart information that is useful and does
    not otherwise mislead or deceive the consumer. NAMB supports
    clear and concise consumer-tested disclosures that are accurate
    and uniform across all distribution channels. We look forward
    to working with the Federal Reserve Board to re-evaluate the
    current disclosure scheme to make it more useful for consumers,
    especially for non-traditional mortgage products.
        Last, it is also important that the government enforce
    existing laws to effectively eliminate deceptive or misleading
    marketing practices and communications with consumers with
    respect to any loan product type, traditional or non-
    traditional. We must protect the consumer choice by maintaining
    a competitive marketplace. We should not ban products from the
    market. Rather, it should be left to market forces, simple
    supply and demand, to determine the utility and longevity of
    any loan product.
        Again, thank you for the opportunity to appear before this
    joint subcommittee today to discuss this timely issue, and I am
    happy to answer any questions you may have.
        Chairman Allard. Thank you.
        Mr. Simpson, you are Chairman, Republic Mortgage Insurance
    Company.

                STATEMENT OF WILLIAM SIMPSON, CHAIRMAN,
                  REPUBLIC MORTGAGE INSURANCE COMPANY

        Mr. Simpson.  Yes, and I am currently serving as Vice
    President of the Mortgage Insurance Companies of America, and
    we are pleased to be here today. Thank you.
        Chairman Allard.  It is good to have you.
        Mr. Simpson.  Let me start by first asserting that mortgage
    insurers play an important role in the home mortgage market. We
    cover the first tier of loss on defaulted home mortgage loans
    for lenders and investors such as Fannie Mae and Freddie Mac.
    Because of the high capital requirements and stringent
    regulation imposed on mortgage insurers, the industry is well-
    positioned to take on this risk.
        Currently, the members of MICA have $635 billion of
    insurance in force and approximately $17 billion in capital.
    Since the industry was founded in 1957, we have helped over 25
    million families become homeowners usually when they could not
    otherwise afford a 20 percent down payment.
        We take a conservative view of mortgage risk because of our
    first-loss exposure and because of our unique historical
    perspective. We were there when some regional markets in this
    country were in chaos during the mid-1980's and early 1990's
    and we covered losses for mortgage investors, paying out
    approximately $15 billion in claims.
        Data that we have on the size characteristics and rate of
    growth in the non-traditional market while somewhat sparse is
    also alarming. For example, one industry publication recently
    estimated that in the first half of 2006, non-traditional
    mortgages represented 37 percent of all home mortgage
    originations, up from being almost nonexistent a few years ago.
        Second, the FDIC estimated in its testimony last week that
    interest only mortgages and option ARMs together made up as 40
    to 50 percent of all loans securitized by private issuers of
    mortgage-backed securities during 2004 and 2005. SMR, a private
    research firm, found that piggy-back mortgages comprise 48
    percent of all purchase money mortgages originated in the first
    half of 2005 and that 38 percent of those loans had a combined
    loan-to-value ratio in excess of 95 percent. By piggy-back
    mortgage, we are referring to a structure where a first
    mortgage is usually made at about 80 percent of the value of
    the property and then a 10 percent, up to a 20 percent, second
    mortgage is made on top of the first.
        One that should cause concern for the mortgage industry and
    policymakers is the combination of the size of the non-
    traditional mortgage market and the concentrated positions
    taken on these loans by some lenders such as the banks with
    holdings of piggy-back seconds and/or option ARMs. Introducing
    the inherent risk of non-traditional mortgages into a soft
    housing market could be a recipe for another housing debacle as
    occurred in the eighties and early nineties. Certainly,
    concentrations should be avoided in lieu of such a scenario.
        Having witnessed these cross currents of risky mortgage
    instruments coupled with a retracting housing market, MICA
    supports the work being done by the bank regulatory agencies to
    set prudential standards for non-traditional mortgages. We urge
    that these standards be finalized quickly and that they be
    backed by effective enforcement. We also hope that the FTC acts
    quickly to issue rules comparable to the banking agencies to
    ensure that all mortgage originators are required to operate
    under similar standards and thereby leveling the playing field.
        In addition, MICA supports the standards the banking
    agencies are setting for consumer disclosures. Vulnerable
    consumers may not know the real terms of their increasingly
    complex mortgage loans. This fact can lead to foreclosures
    which not only displace families and damage their credit, but
    also result in blighted neighborhoods with the foreclosed homes
    for sale.
        Mortgage insurers will continue to play the same role in
    the non-traditional market they have always played in the
    overall mortgage market. We are a highly capitalized, well-
    regulated intermediary who balances the interests of the
    lenders and borrowers. Mortgage insurers with capital at risk
    will continue to insert a critical underwriting discipline into
    many mortgage lending decisions, providing a safeguard against
    excessive foreclosures and evictions of sometimes innocent
    homeowners.
        Thank you for listening to our views, and I will be happy
    to answer any questions.
        Chairman Allard. Thank you.
        Mr. Calhoun, President, Center for Responsible Lending.

                STATEMENT OF MICHAEL CALHOUN, PRESIDENT,
                     CENTER FOR RESPONSIBLE LENDING

        Mr. Calhoun.  Thank you, Chairman Allard, and thank you
    also, Chairman Bunning, for holding this hearing and allowing
    us to testify.
        I appear on behalf of the Center for Responsible Lending,
    which is a non-profit, non-partisan research and public policy
    center dedicated to supporting responsible lending and
    preventing predatory lending. We are an affiliate of Self-Help,
    which is a community development lender which has provided over
    $5 billion for first-time home financing to Americans across
    the country. We operate presently in 48 States.
        We do this lending because homeownership has been the
    traditional ladder to the middle class for Americans. We are
    concerned, though, that the development of many of these non-
    traditional mortgages has created a trap door to financial ruin
    for these families.
        Much of the discussion about non-traditional mortgages is
    focused on the prime market; however, today in the subprime
    market, which is nearly one-fourth of the overall mortgage
    market, the dominant product in that market is the non-
    traditional product, and it will inflict, in our view, far more
    harm than the other types of non-traditional mortgages that you
    have heard about today. These so-called subprime hybrid ARMs
    with low teaser rates are the leading product in the subprime
    market, and that is where I will direct my testimony today. I
    am going to first describe the nature of this product, then the
    impact that we see in the market and on the borrowers, and then
    add our policy recommendations.
        A subprime hybrid ARM has an initial short fixed-rate
    period. The typical one is 2 years, and then the remaining 30
    years of the mortgage, it is an adjustable rate. So they are
    often called 2-28 mortgages. The key factor is that the initial
    payment is set far below the fully indexed payment. To give you
    an example of what typical rates would be in the market today,
    the initial payment would be based on an interest rate of maybe
    seven and a half or 8 percent; however, after the end of that
    initial 2-year fixed-rate period, the fully adjusted rate would
    be in the range of 11 and a half to 12 percent even with
    interest rates remaining the same, the market rates remaining
    the same.
        This produces a payment shock typically of 40 to 50 percent
    for the borrower, and perhaps it is most dramatic that even if
    you take a very favorable scenario, if interest rates are
    reduced, market rates, by 200 basis points, these borrowers
    still would typically face a 20 to 25 percent payment shock.
        I would think the testimony today is that one of the common
    themes of the risk of the non-traditional mortgage has been
    payment shock and how most families are very ill-equipped to
    handle that. In the subprime market, this payment shock is
    exacerbated by several factors. First of all, the underwriting
    on these loans is done at a very high debt ratio, up to 50 to
    55 percent, which means that that mortgage payment can be 50 to
    55 percent the total debt of the borrowers, 50 to 55 percent of
    the borrowers' gross income, before tax income.
        Second, the standard underwriting practice in the subprime
    market is to underwrite only to the initial payment. So they
    allow the initial payment to be 50 or 55 percent of the
    borrowers' income. When you had add a payment shock of 20 or 40
    percent, you end up with loans where the mortgage burden is
    more than the borrowers' take-home pay.
        Third, in the subprime market, the practice is in the
    majority of the loans not to escrow for insurance and taxes,
    and the reason for that is it is a way to artificially depress
    that monthly payment, make it look lower, but you leave another
    financial shock out there for these borrowers.
        The impact of this is that many borrowers are threatened
    with losing their homes, and this impact is especially felt in
    minority communities. Recent HMDA data showed that the majority
    of African Americans have high interest subprime loans. More
    than a third of Hispanic borrowers have high interest subprime
    loans.
        My time is running out. So let me give you very quickly our
    policy recommendations. First, we support the guidelines of the
    joint agencies. We would emphasize in the subprime market,
    nearly 60 percent of these are originated by non-regulated
    entities. There is already underway, though, the means to cover
    those entities. Both the FTC and the Federal Reserve held
    hearings this summer to address non-traditional mortgages. They
    both have existing authority to apply the joint guidance to the
    entire mortgage market under both the Homeownership Equity
    Protection Act and under the FTC Act.
        In conclusion, I want to thank you again for the
    opportunity to testify. We look forward to working with the
    committee on this important problem.
        Chairman Allard. Thank you. Mr. Fishbein.
        Mr. Fishbein, I see you are the Director of Housing Policy,
    Consumer Federation of America. Thank you for being here.

       STATEMENT OF ALLEN FISHBEIN, DIRECTOR OF HOUSING POLICY,
                     CONSUMER FEDERATION OF AMERICA

        Mr. Fishbein. Good morning, Chairman Allard and Chairman
    Bunning. We appreciate the fact that you have held these
    hearings on this important and timely subject. My testimony
    today is on behalf of Consumer Federation of America and also
    the National Consumer Law Center. We appreciate the opportunity
    to present our views.
        The purpose of today's hearing is to assess the impact of
    non-traditional mortgage products on borrowers and the housing
    market. A sampling of the news stories from the past few weeks
    conveys a very disquieting picture. There is a ``Business
    Week'' article that referred to ``How Toxic Is Your Mortgage?''
    9/11/06, a Bloomberg article from earlier this week that the
    ``U.S. Housing Slump May Lead to First Drop Since 1930'' 9/11/
    06, a ``USA Today'' article from last week, ``More Fall Behind
    on Mortgages'' 9/14/06. According to the story, many homeowners
    with shaky credit are falling behind on their mortgage
    payments, especially in such States as Ohio, Alabama,
    Tennessee, Michigan, and West Virginia, and the ``New York
    Times'' editorial from earlier this week, ``Who Bears the
    Risk'' 9/17/06, all of these are commenting on developments in
    the mortgage market.
        Non-traditional mortgages are complex loan products that
    have enabled lenders to maintain high numbers of loan
    originations even in a rising rate environment. Admittedly,
    this has helped additional borrowers qualify for home purchase
    in the face of rising home prices in certain areas. These
    loans, it should be indicated, also are used to refinance
    existing loans particularly in the subprime market.
        The initial low monthly payments are attractive to
    borrowers who want to leverage their purchasing power in a
    rapidly appreciating market. Unfortunately, many borrowers do
    not fully understand the changing payment schedules, especially
    the sharp monthly payment increases that are common with non-
    traditional mortgages.
        Federal banking regulators, consumer advocates, and
    increasing segments of the industry all have expressed concerns
    that non-mortgages, or exotic mortgages as they are known, may
    be too exotic for many that have taken them out. The
    delinquencies and foreclosures that result from the
    unsustainable loans will have extremely negative implications
    on the credit ratings of borrowers that could prevent or make
    refinancing of a subsequent home purchase prohibitively
    expensive.
        Although these products have been around, what has changed
    in today's market is that they are aggressively mass-marketed
    to a much broader spectrum of borrowers. These borrowers could
    be vulnerable to payment shock and rising loan balances, making
    their homes suddenly unaffordable and potentially ruining their
    finances.
        My written testimony goes into detail on this, but I do
    want to point out a few things. One, indications are of higher
    problem loans stemming from the recent lending boom. The rise
    in non-traditional and hybrid adjustable rate mortgages may
    increase defaults and foreclosures over the next few years.
    Some in the industry already are predicting that higher monthly
    payments resulting from these resets are to mean that one in
    eight or more of these loans will end up in default.
        There was a lot of talk this morning about numbers. At CFA
    and NCLC, we care also about the homeowners and the families
    behind these numbers. A recent study by First American Real
    Estate Solutions has reported that $368 billion in adjustable
    rate mortgages originated in 2004 and 2005 are sensitive to
    interest rate adjustments that would lead to default, and $110
    billion of these are expected to go into foreclosure. Now, this
    translates into 1.8 million families at risk as a result of the
    possibility of default, with half million of these likely to go
    into foreclosure. So the numbers are quite large.
        Second, indications are that many borrowers may be more
    vulnerable to payment shock resulting from non-traditional
    mortgages though often portrayed. Research cited in my
    testimony indicates that a significant percentage of people
    taking out interest only mortgages and option ARMs have credit
    scores below the median and incomes at the median or below.
        Third, it appears that many consumers do not fully
    understand the risks associated with non-traditional mortgage
    products. This is understandable given the dizzying array of
    products that are available in the marketplace. My testimony
    discusses research indicating that many borrowers who have
    taken out these loans do not fully appreciate the payment
    adjustments and the potential of payment shock that could
    occur.
        Since my time is nearing an end, let me say, in conclusion,
    we believe that more needs to be done to ensure that consumers
    are adequately aware of financial risks associated with these
    complex and potentially risky products. Yet the plain fact is
    that exotic mortgages products simply may not be appropriate
    for all borrowers who receive them. In my written testimony I
    offer a number of specific policy recommendations to address
    this problem. This quick adoption of the proposed Federal
    interagency guidance on non-traditional mortgage products and
    also the establishment of suitability standards to ensure that
    borrowers receive loans that are truly appropriate for them.
        I would be glad to answer any questions that you may have.
        Chairman Allard.  I want to thank all of you for your
    testimony.
        I think at least a lot of the consumers that take these
    exotic-type loans in order to avoid the payment shock try to
    refinance that loan before they hit the adjustment or reset
    period. According to ``The Denver Post'' article, this can be
    an expensive proposition. For example, the couple that I
    mentioned in my opening comments, Lilly and India Hartz, they
    have an option, an ARM, with a growing balance. They would like
    to refinance the loan, but face a prepayment penalty of
    $11,000.
        The question is this: What percentage of non-traditional
    mortgages include a prepayment penalty? And to follow up on
    that, what is the range and average amount of such a penalty
    and what are the terms?
        Mr. Broeksmit.
        Mr. Broeksmit. I don't have a percentage for you. I can say
    that I know the terms of most prepayment penalties are a couple
    of varieties. One is a 1-year prepayment penalty that is often
    2 percent of the loan's principal, and there are 3-year
    prepayment penalties that are typically on a sliding scale of 3
    percent, 2 percent, 1 percent. So the penalty recedes as the
    loan stays on the books. There is another variant.
        Chairman Allard.  Up to the preset date?
        Mr. Broeksmit.  It expires in the thirty-seventh month. It
    is a 3-year penalty.
        Chairman Allard.  I see. Okay.
        Mr. Broeksmit.  There are other penalties where the penalty
    is constant for the term of the penalty. A common one is 6
    months interest on 80 percent of the principal.
        So there are different flavors, and some State regulations
    affect what is given State by State. I don't have a percentage
    for you in terms of the percentage of non-traditional loans
    that have a penalty.
        Chairman Allard.  Mr. Hanzimanolis.
        Mr. Hanzimanolis.  I do not have a percentage for you
    either, unfortunately, but I can tell you my experience. I have
    seen most common prepayment penalties as probably a 3-year with
    3-2-1. Each year, it will decrease. Also keep in mind that
    there is also the option of no prepayment penalty. So the
    prepayment penalty is put out there for the consumer and they
    will have a cheaper interest rate or the margin may be cheaper
    if they have a prepayment penalty in place to ensure that the
    lender is receiving the compensation that they need, but there
    is always the option to not choose a prepayment penalty.
        Chairman Allard.  Can you give a guess on what percentage
    in your experience have a prepayment penalty? It is 90 percent?
        Mr. Hanzimanolis.  I couldn't even guess. I know in my
    daily business, if I offer a product that has a prepayment
    penalty, I will also offer the option of no prepayment penalty,
    depending on the customer's feeling of where they expect to be
    in the next year, 2 years, or 3 years. They may opt to take
    that. So across the board, I think it is probably a 50-50
    percentage is what I see.
        Chairman Allard.  Mr. Calhoun, can you cite some numbers
    for us?
        Mr. Calhoun.  Yes. There is a great disparity between the
    prime and subprime market. In the prime market, less than 10
    percent of loans have prepayment penalties, and part of that is
    because of historically, Fannie and Freddie didn't buy
    traditional loans with prepayment penalties, and that has
    carried on some. We are seeing increasing prepayment penalties
    with the non-traditional mortgage.
        In the subprime market, it is totally flipped. Over 80
    percent of those loans have prepayment penalties, and industry
    studies show that the majority of borrowers with prepayment
    penalties end up paying the penalty, and I think you really hit
    the nail on the head with how these loans really work. They
    essentially are forced flippings. The 2-28 loans that I
    described, almost all end up operating as 2-year balloon loans
    because no one can afford to make the payment when the reset
    happens.
        It is very, very difficult for a borrower to avoid the
    prepayment penalty, because to avoid the prepayment penalty and
    not get caught in the higher mortgage payment, you have to
    refinance in that 30-day period after the lower payment ends.
    If you finance it before that, if you are proactive, then you
    get the prepayment penalty, and to finance it later than that,
    you somehow had to be able to make the mortgage payments that
    have increased so dramatically.
        These loans put consumers in a real bind both with the
    payment shock and sort of the double whammy of these prepayment
    penalties.
        Chairman Allard.  What cost is the prepayment penalty
    supposed to cover? Is it the re-processing of the loan or are
    there other factors that go into that prepayment penalty?
        Mr. Calhoun.  There are several factors. Initially, it was
    supposed to be an alternative way to cover the cost of
    originating the loan. Increasingly in today's market, it is
    another fee. It adds more revenue to the whole loan package,
    and our organization did research looking at subprime loans
    throughout the country, using the largest industry data base,
    to see if consumers were getting a promised lower interest rate
    in exchange for the prepayment penalty, and our study which we
    made available to Federal regulators and everyone else found
    that in practice, they didn't, that the prepayment penalty did
    not actually lower it. It tended to be an additional expense
    for them.
        Chairman Allard.  Mr. Fishbein.
        Mr. Fishbein.  Well, I would concur with what Mike has
    said. We certainly hear of stories of prepayment penalties that
    exceed the initial preset period, particularly for loans in the
    subprime market. I do not know whether that is standard
    practice, but certainly it appears some lenders are doing this.
        Chairman Allard.  Now just one last question: How common
    are other types of refinancing penalties? For example, Monique
    and Anthony Amijo of Colorado have a mortgage that contains a
    $20,000 penalty if they refinance with anyone other than one
    particular broker. Is that common among brokers, Mr.
    Hanzimanolis?
        Mr. Hanzimanolis.  I have never heard of that before, sir.
    I can absolutely say it is not commonplace.
        Chairman Allard.  Would everybody else on the panel agree
    with that?
        Mr. Calhoun.  I will disagree. Most lenders have a practice
    of waiving prepayment penalties if you refinance with them.
    That is the common practice in the industry. A prepayment
    penalty of the size that you describe is not at all atypical.
    As described by our first witness, if you have a half-year's
    interest on a loan, that that is your prepayment penalty, most
    of your mortgage payment goes to interest, particularly in the
    early years, and it is very easy for that prepayment penalty to
    be tens of thousands of dollars, and we find and the realtors
    have found that borrowers are trapped where they can't sell the
    house because when you add on the prepayment penalty, the loan
    is upside down. They own more than what they can sell the house
    for, and so it is a concern there as well.
        Chairman Allard.  Any other comments from the panel on that
    last question?
        Mr. Broeksmit.  I would just say that it is highly unusual
    that a mortgage broker can say there is a penalty by not coming
    back to me. The mortgage broker doesn't even control the Note,
    and the prepayment penalty is an addendum to the Note. So there
    is something unusual about that circumstance.
        Chairman Allard.  We will have our staff follow up on that.
        Senator Schumer.

                STATEMENT OF SENATOR CHARLES E. SCHUMER

        Senator Schumer.  Thank you, Mr. Chairman, and thank you
    again for having this hearing on an issue of great concern to
    me, and I apologize. It is a busy time, but I want to thank you
    and Senator Bunning and Senator Reed.
        I have been troubled by alternative mortgages, which are
    often a synonym for risky mortgages, for quite a while. The
    saddest part of these mortgages is that the borrower usually
    doesn't know what hit them. I have heard this from people. They
    feel like a ton of bricks have fallen on their head, and then
    they look up at the roof and it is still there, but their life
    is shattered in a million pieces because they can't pay.
        I understand the need for these products and I understand
    when used in a responsible way, these products will help bring
    mortgages to people who don't need them, but we all know what
    is going on. Too many people who sell these mortgages are not
    looking out for the well-being of the mortgagee. They are
    looking out, rather, for just selling as many as possible, and
    then those mortgages are gone and gone far away, and it is
    really, really troubling.
        The plethora of new products that flood the housing market,
    mainly the interest only loans and the payment option
    adjustable mortgages and the 2-28 ARMs, are destroying the
    lives of a whole lot of people whose lives didn't have to be
    destroyed. In the old days, these type of loans were distinctly
    for either high net worth or sophisticated home buyers. What
    has happened is they have devolved and they are sold to people
    or the least experienced and the most vulnerable.
        So ``Business Week'' referred to these things on its
    September 11th cover as ``Nightmare Mortgages'', and that is
    what they have done. Middle income people, lower income people
    are accessing complex and risky mortgages in the name of
    affordability, but they are often mortgages that they can't
    afford.
        We also have a particular issue with young minorities being
    preyed upon. I have been involved with this issue in New York
    for a long time, and we even have some people who are
    radiologists who made $200,000 a year, but who didn't believe
    that a bank would give them a loan, going with these products
    and paying far too high a rate, and I have worked in New York
    on trying to solve this problem by having our prime rate banks
    reach out to churches and other institutions to let people come
    in, but as I said, I have been really, really troubled.
        Here is the problem: You can get a mortgage without showing
    the ability to pay for it. When the loans are issued, they
    don't look at when the rate bumps up, whether the family can
    afford it. They rely on some ridiculous projection that they
    are going to be making a whole lot more money before, and
    people just don't know what they are doing.
        So is the explosion of these exotic mortgages especially to
    borrowers who can't demonstrate their ability to sustain their
    mortgage payments through the payment shock period at least in
    part the result of overly aggressive selling by brokers whose
    compensation is not tied to the successful outcome, but merely
    to the closing of the loan?
        Mr. Hanzimanolis.  Well, let me first say that mortgage
    brokers for the most part are small business people. We live in
    the same communities where we originate loans. We shop at the
    same stores. We go to the same churches. We have the same scout
    troop and school functions. In order for us to be successful in
    business we have to reach out to our community and be fair in
    our lending.
        I can't imagine anybody would be successful being the----
        Senator Schumer.  Sir, I am sorry to interrupt you.
        Chairman Allard.  Let me interrupt both of you here. I am
    running a pretty tight time line on the members of this
    committee on their 5-minute limit. I would suggest that we go
    to--your time has expired. I would suggest that we go to
    Senator Bunning. We will get in his 5 minutes and come back to
    you.
        Senator Schumer.  OK. I will just submit questions in the
    record. All I was saying, Mr. Chairman, is that may be true in
    a small town. In a borough like Queens or Brooklyn, that is not
    true at all. I will be happy to submit questions in writing.
        Chairman Allard.  I have been treating all the members the
    same way.
        Senator Schumer.  I appreciate that. Thank you, Mr.
    Chairman, and I apologize for coming and running.
        Chairman Allard.  Thank you.
        Chairman Bunning.
        Chairman Bunning.  Mr. Simpson, mortgage insurers have an
    interest in seeing that lenders do not write loans that are too
    risky, I hope.
        Mr. Simpson. Yes, sir.
        Chairman Bunning. Over the last 3 years, do you think that
    the relaxation of underwriting standards has been too risky or
    are the risks manageable?
        Mr. Simpson. Well, on your first question, yes, we have
    seen some deterioration in the underwriting criteria for these
    non-traditional mortgages.
        Chairman Bunning. That is what we are talking about.
        Mr. Simpson. Many people have testified, and years ago, an
    option ARM was for a very high-quality borrower. Today, there
    are less than high-quality borrowers taking out these loans.
        Chairman Bunning. So when the Federal Reserve Chairman is
    recommending that people look at this as a prime option--and he
    did exactly that before the Banking Committee. He said, If I
    were going to get a mortgage, I would get an ARM, because, you
    know, the interest rates at the time, the prime was 4 percent,
    and the short-term interest rates were much shorter, much lower
    than the long, and now, obviously, they have reversed.
        Mr. Simpson. Yes.
        Chairman Bunning. So now I am talking about the risks at
    this time.
        Mr. Simpson. Yes, sir. Well, I think that depends upon your
    forecast of interest rates. If you think interest rates are
    going down, you might want to get an ARM; but having been in
    this business all these years, I still think a six and a
    quarter 30-year fixed-rate loan is a mighty good loan. I fail
    to understand the wisdom of most people who don't take that
    option rather than an option ARM.
        Chairman Bunning.  Well, most people that can do that would
    take that option.
        Mr. Simpson. Correct.
        Chairman Bunning. But we are talking about people who want
    more for less.
        Mr. Simpson. But if we are qualifying people on an option
    ARM today, that rate would be very close to the six and a
    quarter 30-year fixed-rate payment.
        Chairman Bunning. I understand that.
        Mr. Simpson. OK. The other thing I would like to point out
    that purveys all of this discussion is housing appreciation,
    and as long as homes are going up in value in your neighborhood
    or any neighborhood, you can probably get by with some relaxed
    underwriting, and that is what this mortgage finance system is
    this country tends to do. It gets more aggressive as homes are
    going up in value, but let me tell you. Today, they are not all
    going up in value. In fact, there are parts of the country
    where they are going down, and the overall rates have really
    subsided. We are looking now at 4 percent annual appreciation
    rates, not 13.
        Therefore, it only makes sense for the Federal regulators
    to come out with some reins and some tightening on the
    underwriting criteria.
        Chairman Bunning. I would hope so.
        Mr. Simpson. We don't have the appreciation to bail out
    mistakes.
        Chairman Bunning. OK. Let me ask--I can't pronounce your
    name. I am sorry.
        Mr. Hanzimanolis. That is quite all right.
        Chairman Allard. Mr. Hanzimanolis.
        Chairman Bunning. Thank you.
        In your written statement, you emphasize consumer
    education, and certainly that is an area for improvement.
    Before we see results in improvement in consumer education
    efforts, there will be a period when brokers will still be
    dealing with what many people have classified as an overwhelmed
    consumer, a confused borrower. Brokers share little of that
    risk, that borrowers and lenders assume. In fact, many have a
    financial interest in getting the borrower into a loan
    regardless of whether the borrower can afford it or not, as
    Senator Schumer has said.
        Under current laws and regulations, are there strong enough
    protections for consumers and lenders?
        Mr. Hanzimanolis. I believe that the protections are in
    place. Keep in mind, as a mortgage broker, when I originate a
    loan, it still has to go to the mortgage lender who is going to
    fund it. That lender does a very detailed underwriting job at
    looking at that. So we have qualified and processed that loan
    application to their guidelines, and they review it intently to
    make sure that everything have been gone through properly for
    that customer to be able to qualify.
        Chairman Bunning. I just am worried that the consumer
    doesn't really fully realize if they are in a sophisticated
    mortgage like we are talking about. It is easy to understand if
    it is a four and a half percent or a six and a half percent 30-
    year loan. You know what your payments are going to be and you
    know what they are going to be for 30 years, but if you get
    into a 3-year ARM or a 3-2-1 with a penalty, it is very
    difficult for some people to realize and grasp what happens at
    the end of the third year.
        Mr. Hanzimanolis. I agree, and as you know from my written
    testimony, NAMB has always suggested that we have clearer, more
    concise disclosures, disclosures where, in fact, as the
    originator sits down and explains everything to the customer,
    both the originator and the customer would initial at each
    section there.
        Chairman Bunning. Yes, sir. I just recently refinanced.
    There were, I think, 36 pages, 36 documents that I had to
    either have my wife or myself initial. Now, how many people
    understand, unless there is a lawyer present, what the heck are
    they doing?
        Mr. Hanzimanolis. I think any good originator, be it a
    broker or a bank, lender, anyone, would sit down with the
    customer and explain each form in detail.
        Senator Schumer. It didn't happen to me.
        Chairman Bunning. It happened to me because I had a lawyer
    sitting right next to me, and he made sure when the paper was
    handed to me for a signature, that he said, OK, you can
    initial, OK, you can initial, because he understood. He had sat
    in on a lot of closings. So I felt very comfortable in doing
    that, but how many people do that?
        Mr. Hanzimanolis. It is always the customer's right to
    bring an attorney.
        Chairman Bunning. I understand that, but how many people do
    that?
        Chairman Allard. Chairman Bunning, I need to go to Senator
    Schumer.
        Chairman Bunning. Go ahead. Thank you.
        Senator Schumer. I want to go back to Mr. Hanzimanolis. You
    know, you paint this apple pie picture of the mortgage broker
    who lives in the community and runs the Boy Scout Troop, goes
    to the same church. That may be true in Small Town America
    where there is one or two mortgage brokers for a thousand
    people. In the New York metropolitan area of 20 million people,
    that doesn't happen. People don't go to the same church as
    their mortgage broker 98 percent of the time or have the kid in
    the Boy Scout Troop, and we have lots of unscrupulous people
    here.
        Do you understand that we should be regulating not the best
    who don't it, but for the worst who rip people off, and have
    you heard of instances of mortgage brokers ripping people off?
        Mr. Hanzimanolis. I have heard of every business out there.
        Senator Schumer. No. I didn't ask you that. Sir, have you
    heard of mortgage brokers ripping people off?
        Mr. Hanzimanolis. Yes, I have.
        Senator Schumer. Have you heard of it rarely? Frequently?
        Mr. Hanzimanolis. I believe it is a small case, but it is
    something that happens. You hear about it.
        Senator Schumer. Let me tell you I hear about it
    frequently. OK? And I am a Senator and my job is to get to know
    all of my constituents. We all hear of it frequently. Do you
    think we should do more than simply rely on consumer education
    for those mortgage brokers, however there are, and you are
    going to have to take my word for it there are too many of
    them, who have no interest once the loan is closed in seeing
    whether the customer can pay back? Do you think we need to do
    more than customer education?
        Mr. Hanzimanolis. I think customer education is a wonderful
    start. I think helping educate the lenders regardless of the
    distribution channel----
        Senator Schumer. How about some regulations of unscrupulous
    brokers; you don't think there should be any?
        Mr. Hanzimanolis. I hope there are laws on the books
    already.
        Senator Schumer. Do you think they are adequate on the
    books?
        Mr. Hanzimanolis. I think we can always improve. It has
    always been NAMB's position that if there is anyone out there
    doing anything that is illegal----
        Senator Schumer. I can tell you that there are lots of
    people who do this and they prey on the people who know the
    least, and it would protect good brokers to have the other ones
    better regulated. So I would ask you to go back to your
    organization and tell them that there is a lot of upsetness
    here on both sides of the aisle about what is going on now, and
    a lot of it, I have found in my explorations.
        I used to think banks discriminated, but they don't. It is
    much more the mortgage brokers who go into these areas and sign
    people up without telling them the whole consequences. I
    shouldn't say the banks don't. I should say the biggest problem
    we face in New York City, why so many say minority areas are
    subprime and areas that actually the same income level that are
    only a mile away, but are white, are prime is the mortgage
    brokers, not the banks.
        I will tell you, in my view, Mr. Chairman, we need a whole
    lot more attention here, and we have gotten very little because
    the industry is grown up quicker, because more people are
    getting homes, thank God, etc.
        Here is my next question: OK. I am asking everybody here.
    How would underwriting loans to the fully indexed--wouldn't it
    be a good idea to underwrite loans to the fully indexed rate to
    make sure if the initial rate is 6 percent, but the rate 2
    years later will be 9 percent, that at the time the customer
    signs up, that we are sure that they could pay at the 9 percent
    rate, and wouldn't that help people keep people in their homes,
    particularly, as Mr. Simpson mentioned, in this uncertain time
    when housing values might be going down?
        Mr. Broeksmit. Senator Schumer, we make a lot of option ARM
    loans. We underwrite borrowers to the fully indexed rate at a
    fully amortizing payment.
        Senator Schumer. Right.
        Mr. Broeksmit. We think that is a smart idea, and we
    quibble with the guidance in some aspects of this because it
    runs the products together, and there are some interest only
    loans where I don't believe you need to qualify somebody at the
    fully amortizing payment on a 10/1 ARM. If you have got an
    interest only option for 10 years, the average life of the loan
    is probably five. We quibble, but generally speaking, that is a
    very sound practice.
        Senator Schumer. Right. What do you think, Mr.
    Hanzimanolis?
        Mr. Hanzimanolis. I think two things: One, better
    disclosures for the customers so they understand where the
    payment could possibly go; and two, you will be happy to hear
    that many of the lenders that I do business with are already
    asking the people to or requiring the people to underwrite that
    to the fully indexed and fully amortized payment.
        Senator Schumer. What about those who don't; should we do
    more from a governmental point of view to make sure that
    happens?
        Mr. Hanzimanolis. I think that we, obviously, know
    listening today and before coming here today that this is an
    issue, and if it is an issue, we want to protect people with
    better disclosures and underwriting to that.
        Senator Schumer. What about beyond disclosure? Disclosure
    for many people doesn't work, as we have all tried to make the
    point clear here. Caveat Emptor is a good concept, and about in
    1890, the country realized it was in some areas not sufficient.
        Mr. Hanzimanolis. I think you are going to see more and
    more lenders going to that, and eventually that will----
        Senator Schumer. Do you think we should regulate it or not?
        Mr. Hanzimanolis. I don't know if a regulation is required.
    I think that we will see the market is going that way on its
    own.
        Senator Schumer. Mr. Simpson.
        Mr. Simpson. I definitely think we should underwrite to the
    fully indexed accrual rate, and I do think there is more
    enforcement needed to assure that that happens. I would also,
    as an insurer, say that loan should be underwritten as having
    an additional layer of risk as a result of the uncertainty of
    the structure of loan, as we do.
        Senator Schumer. All right. Mr. Calhoun.
        Mr. Calhoun. Yes, and I am glad to hear the widespread
    agreement, but I think, more importantly, is what you have
    addressed, is how do you make that apply to the market. If it
    is just this advice, it doesn't work, because if the good
    brokers or lenders are underwriting that way, they have to
    compete with the ones who aren't. It gives the bad apples an
    unfair competitive advantage.
        Senator Schumer. That is exactly right.
        Mr. Calhoun. That hurts both the borrowers and the
    industry, because in the lenders, if a broker comes to them
    with a loan not fully unwritten, if the lender says I don't
    want it, the broker says, Well, this person down the street
    will buy it. See, you have got to make it apply to the whole
    market.
        Senator Schumer. Agreed. I agree with you.
        Mr. Fishbein.
        Mr. Fishbein. Certainly underwriting to the fully indexed
    rate is necessary, but in some cases, for some types of loans,
    it may not be sufficient. We know that the LIBOR rate, which is
    an index that is used for many subprime loans has been
    adjusting upward every month for the past 2 years. So if you
    had just underwritten a loan in a subprime market to the fully
    indexed rate, it would not necessarily mean that the borrower 6
    months or 2 years later would be in a position to be able to
    pay that loan.
        Senator Schumer. But, Mr. Fishbein, the jumps that most
    people get far exceed the change in LIBOR over the period of
    time they get the jump. Isn't that true?
        Mr. Fishbein. Well, the point----
        Senator Schumer. The early teaser rates that come in early,
    and then when it goes up to the full rate, that is usually far
    more than the LIBOR increase.
        Mr. Fishbein. That is certainly a significant part of the
    problem, and that is why I say I agree with underwriting to the
    fully-indexed. However, underwriting should also take into
    account the full extent that negative amortization is
    permitted. I would also say that, particularly in connection
    with more modest income people, it is important that
    underwriting also consider residual income, in other words,
    whether people when they pay all their debts still have income,
    regardless of how the percentages look, to be able to make the
    payments. This also should include taking into account taxes
    and insurance borrowers and be required to pay which some
    lenders do not do when deciding whether a loan is affordable to
    a borrower.
        Senator Schumer. Thank you, Mr. Chairman.
        Thank you. I thank the whole panel.
        Chairman Allard. Thank you, Senator Schumer. In fairness, I
    have given everybody their questions.
        Senator Schumer. You have been extremely fair, Mr.
    Chairman. I have no complaints with you, and we don't need any
    regulation to make you a better chairman.
        Chairman Allard. Thank you, Senator.
        Okay. I just have one question, and then we will let you
    go. During the last several years, we have seen a dramatic rise
    in the number of inter only loans and payment option ARMs. Have
    these products peaked out in being offered to consumers, or do
    you think they will continue to popular, and can we expect
    increases in these non-traditional type of loans, and if they
    are discontinuing, do you see them being replaced by some other
    type of non-traditional loan? What can we expect in the future?
        Mr. Broeksmit. I would not expect them to--I don't believe
    they have run their course. I believe they are a good product
    for a large segment of the population, but you will continue to
    see evolution. For instance, the option ARM has typically had
    four payment options, but the underlying interest rate adjusts.
    There is recently, within the past 6 months, introduced a
    product that continues to have different payment options, but
    the rate behind the scenes is fixed for 5 years. So it appeals
    to a borrower who likes the certainty of a period of fixed
    rates, but also likes the ability to match the mortgage payment
    with a fluctuating income and make a lower payment when that is
    convenient for them and then have the option to catch up later.
        So you will see an evolution, but I think we have seen a
    structural shift in consumer behavior where people don't expect
    to live in the home for 30 years. Why pay a 30-year fixed-rate
    rate when you expect to move or refinance within three or 5
    years?
        So the notion that people want to borrower on the short end
    of the yield curve to match the length they really expect to
    have the loan versus paying the premium for a 30-year rate, I
    will continue, and the notion that you are going to pay off
    your mortgage by a certain point in your life, I believe in my
    generation and younger generations is a much less prevalent one
    than it was among the older generations.
        Chairman Allard. Do you want to look in the future, Mr.
    Hanzimanolis?
        Mr. Hanzimanolis. Well, I agree with Mr. Broeksmit. I don't
    think it has peaked. I believe that there are still benefits to
    these programs. They have benefits in the right situations, and
    will other products develop? Absolutely. The needs of the
    consumer drive the market, and that is why we see the
    development of these new products. So I anticipate that we will
    see new products developing constantly.
        Chairman Allard. Mr. Simpson.
        Mr. Simpson. History shows that in the eighties when we had
    17 percent mortgage rates, that the mortgage market was very
    creative in trying to find solutions to that problem. When the
    houses depreciated in the oil patch and we had massive
    foreclosures, most of those experimental non-traditional
    mortgages of those days disappeared, and we went back to the
    fixed rate loans. Now we are back experimenting again, and I
    think essentially because houses have gotten so expensive and
    they have also appreciated so consistently that we are now
    seeing people take these non-traditional mortgages based on the
    past.
        But as I have said today and I will say it again, I think
    the past is the past. I don't see housing appreciation in the
    next 5 years anywhere near the kind of rates we have seen. So a
    lot of these structures don't make sense, but we will see
    experimentation, and as Bob was saying, I think you will see
    more flexibility in how the borrower interacts with their
    mortgage. I just hope that that is confined to people of means
    and we don't put people in houses who can't stay there.
        Chairman Allard. Mr. Calhoun.
        Mr. Calhoun. Very quickly, I think these mortgages were
    developed for people, largely, to get into houses, and now we
    see once you are in one of these mortgages, it is very hard to
    get out, that as has been mentioned today, when you refinance,
    you typically incur significant additional expenses, both
    upfront fees and often the prepayment penalty, and just the
    financial truth is for far too many families, they cannot
    convert to a standard fixed mortgage at this point because if
    you underwrite--that is, in effect, underwriting to fully
    indexed, and if they didn't qualify for that when they got the
    mortgage a couple years ago, they are probably not going to
    qualify for it now.
        I think it is incumbent on industry here to work with
    borrowers on a widespread basis for loan modifications and
    workouts that make the loans sustainable and do not extract
    additional fees which simply increase the debt load of American
    families.
        Chairman Allard. Mr. Fishbein.
        Mr. Fishbein. We have been surprised that the market
    appetite has continued for non-traditional mortgages products
    in the face of cooling house prices. As I point out in my
    written testimony, the growth of these products has contributed
    to the housing boom. Home price appreciation has continued
    because these loan products enable borrowers to stretch further
    and further. In essence, the growth of exotic mortgages has
    created a chicken and egg situation, which in turn, has
    contributed to the problem.
        And as Mike pointed out, and I think it is a very important
    point, many who get into these highly leveraged loans wind up
    on a treadmill in which they get into progressively more costly
    loans, until their remaining home equity loans are refinanced
    in which they take equity out of home equity loans home as long
    as they have equity to continue with that.
        So I suspect we will continue to see variations of these
    products. This is all the more reason to take a hard look at
    developing a comprehensive approach to protecting consumers.
    This should include, certainly, improved disclosures. However,
    it also should include suitability standards requiring that
    mortgage brokers and loan originators place people into loans
    they can afford. Such a standard is necessary to discourage bad
    practices in the marketplace.
        Chairman Allard.  Well, I would like to thank all of our
    witnesses again for testifying. We have heard a great deal of
    testimony from both panels, and Chairman Bunning and myself
    will both be watching this issue pretty closely in the
    following months.
        The record will remain open for 10 days. Should members
    wish to submit any additional questions to the witnesses, we
    would appreciate your prompt response to the question and would
    ask you to please respond to them within 10 days. I have some
    questions additionally that I will be submitting.
        I thank everyone for attending this joint hearing of the
    Housing and Transportation Subcommittee and Economic Policy
    Subcommittee. The hearing is adjourned.
        [Whereupon, at 12:38 p.m., the hearing was adjourned.]
        [Prepared statements, responses to written questions, and
    additional material supplied for the record follow:]

                          STATEMENT OF SENATOR CARPER

        Thank you, Chairman Shelby and Ranking Member Sarbanes for holding
    this important hearing.
        Homeownership is a top priority for me. When people own their home,
    they are often healthier, more involved in their communities, and have
    children who do better in school.
        However, the process of buying a home can be daunting. Obtaining a
    loan is an intimidating and confusing process for the vast majority of
    people who participate in it. Today, there are many financing options
    for potential homebuyers. In our hearing today, the witnesses will
    comment on non-traditional mortgage products. While all of these
    products have helped to increase the national homeownership rate, they
    come with risks.
        While I am encouraged by increased homeownership rates, I want to
    ensure that financing options that get people into a home are not
    counterproductive. I want to see more Americans own their own homes,
    but I also want to make sure they can stay in their homes.
        An important component of increasing Americans' homeownership is
    financial literacy. We must empower consumers with the knowledge they
    need to successfully purchase a home. The state of financial literacy
    in our country is terribly low. We need to educate our children and
    young adults on basic skills, such as personal budgeting, balancing a
    check book and checking their credit score. Increasing financial
    literacy will go a long way to protecting Americans from finding
    themselves in a financial situation they cannot afford.
        Mr. Chairman, I greatly appreciate that we are holding this hearing
    today, but I hope that next year, this Committee will turn its
    attention to the broader issues of predatory lending and financial
    literacy.
        Thank you.

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      RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM ORICE
                                WILLIAMS

    Q.1. Mortgage brokers are playing a larger role in the market
    today. Recent statistics show that independent brokers are
    responsible for about 50 percent of all originations and over
    70 percent of subprime originations. Brokers definitely serve
    the overall market by helping consumers work with multiple
    lenders; however, they share little risk. Many brokers find it
    in their financial interest to get the borrower into a loan,
    regardless of whether the borrower can afford it. Are current
    laws and regulations strong enough to protect both consumers
    and lenders? What can be done to better share risk and ensure
    brokers are not just looking out for their own best interests?

    A.1. GAO response

        Certain federal consumer protection laws, including the
    Truth in Lending Act and the act's implementing regulation,
    Regulation Z, apply to all mortgage lenders and to those
    mortgage brokers that close loans in their own name. Regulation
    Z requires these creditors to provide borrowers with written
    disclosures describing basic information about the terms and
    cost of their mortgage. In our recent study on interest-only
    loans and payment-option adjustable rate mortgages (payment-
    option ARMs), we reviewed current Regulation Z requirements and
    found that they are generally not designed to address these
    complex alternative mortgage products (AMPs). For example, AMP
    disclosures that 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 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. 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 that they
    receive about these products provide them with comprehensive
    information about the terms, conditions, and costs of these
    loans. Borrowers who do not understand their AMP may not
    anticipate the substantial increase in loan balance or monthly
    payments that could occur, and would be at a higher risk of
    experiencing financial hardship or even default. The Federal
    Reserve has recently initiated a review of Regulation Z that
    will include reviewing the disclosures required for all
    mortgage loans, including AMPs. We support this initiative, and
    in our report entitled ``Alternative Mortgage Products: Impact
    on Defaults Remains Unclear, but Disclosure of Risks to
    Borrowers Could be Improved,'' (GAO-06-1021), we recommended
    that the Federal Reserve consider as part of its reforms
    requiring (1) disclosures to include language that explains key
    features and potential risks specific to AMPs, and (2)
    effective format and visual presentation.
        We did not undertake a review of other federal or state
    laws and regulations that govern broker conduct as part of our
    work. However, the Conference of State Bank Supervisors and the
    American Association of Residential Mortgage Regulators have
    publicly committed to working with state regulatory agencies to
    distribute guidance to licensed residential mortgage lenders
    and brokers that is similar to the recently issued federal
    interagency guidance on nontraditional mortgages. The state-
    based guidance will focus primarily on residential mortgage
    underwriting and consumer protection.

    Q.2. How much risk do you see from borrowers who have used
    these mortgages to speculate in the housing market? If these
    investments cease to be worthwhile because of a housing
    slowdown, are we going to see large number of defaults on these
    loans?

    A.2. GAO response

        Mortgage delinquency and default rates are typically higher
    for borrowers who use mortgages for investment purposes than
    for borrowers who use them to purchase their primary
    residences. However, we are not in a position to comment on the
    likelihood of defaults related to AMPs for these borrowers in
    the event of a housing slowdown. Federal banking regulatory
    officials said that 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, particularly in those
    instances where the borrower has made little or no down
    payment. 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. However, these
    data did not show the proportion of these originations that
    were used to purchase homes for investment purposes as compared
    to second homes and did not indicate the size of the down
    payment the borrower had made.

    Q.3. Are borrowers who have taken non-traditional mortgages in
    recent years using these products to buy bigger and better
    homes than they otherwise could afford or are they using these
    products simply to be able to get into the market? In other
    words, are the mortgages being used to finance basic needs or
    luxury desires?

    A.3. GAO response

        No data are available that would allow us to discern the
    number of borrowers that were using AMPs for one purpose or the
    other. However, officials from the Federal Deposit Insurance
    Corporation have reported anecdotally that some borrowers,
    often first time homebuyers, used these products to purchase
    higher priced homes than they could have qualified for using
    conventional mortgages. As discussed in greater detail below,
    AMP lending has been concentrated in those regional real estate
    markets where homes are least affordable.

    Q.4. In our last hearing, Mr. Brown from the FDIC suggested
    that we are unlikely to see a nationwide crisis in the housing
    market, because the housing boom is concentrated in certain
    regions, and historically most housing failures have happened
    in areas of suffering from localized recessions. As we all
    know, there is increased risk of massive defaults on these
    loans in the coming years. Due to a nationwide trend of
    nontraditional mortgages being used as affordability products,
    would you disagree with Mr. Brown that upcoming housing
    problems will be isolated in certain regions?

    A.4. GAO response

        We found that AMP lending has been concentrated in the
    higher-priced regional markets on the East and West coasts,
    where homes are least affordable and prices have appreciated
    more rapidly than in other areas of the country. Although the
    inability to make higher monthly payments could cause AMP
    borrowers to default on their loans, job loss, divorce, serious
    illness, and a death in the family are commonly identified as
    the major reasons borrowers default on their mortgages, as in
    each of these examples, the borrower can experience a major
    drop in income, or a major increase in expenses. To the extent
    that any regional markets with high concentrations of AMP
    lending experience a local recession, local AMP borrowers may
    be more vulnerable to default than other borrowers. For
    example, these borrowers may not have funds to meet the higher
    monthly payments or enough equity in their homes to refinance
    or sell if local housing prices drop and they have borrowed
    with little or no down payment or have allowed their loans to
    negatively amortize.
                                    ------

     RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM SANDRA
                               BRAUNSTEIN

    Q.1. Mortgage brokers are playing a larger role in the market
    today. Recent statistics show that independent brokers are
    responsible for about 50 percent of all originations and over
    70 percent of subprime originations. Brokers definitely serve
    the overall market by helping consumers work with multiple
    lenders; however, they share little risk. Many brokers find it
    in their financial interest to get the borrower into a loan,
    regardless of whether the borrower can afford it. Are current
    laws and regulations strong enough to protect consumers and
    lenders? What can be done to better share risk and ensure
    brokers are not just looking out for their own best interests?

    A.1. The Federal Reserve Board held hearings in 2006 on the
    home equity lending market, which included testimony from
    consumer advocates, mortgage brokers and lenders about
    consumers' view of the role mortgage brokers play in offering
    mortgage products and whether consumers' understanding of that
    role has been furthered by state-required mortgage broker
    disclosures. In answering your questions, I would like to share
    with you some highlights of the testimony and public comments
    regarding the adequacy of current and potential steps for
    improving consumer protection. Efforts to regulate mortgage
    brokers at the federal level should include a careful
    consideration of the issues raised at these hearings.
        At the hearings, many consumer advocates questioned the
    adequacy of current law governing mortgage brokers. They
    testified that while brokers may provide a valuable service to
    consumers and lenders, some brokers steer consumers to loans
    that provide the most compensation for the broker, regardless
    of the consumer's needs. Furthermore, advocates testified,
    consumers generally do not understand that brokers are
    independent agents and are not required to find the best loans
    for consumers. They stated that in the subprime market,
    consumers tend to rely on a ``trusted advisor'' when making
    decisions about which loan to select, and may follow a mortgage
    brokers' recommendation without doing independent research.
    Representatives of mortgage brokers testified that the growth
    of the mortgage broker industry has expanded product and
    pricing options for many consumers, but has also led to an
    increase in the number of uneducated and unlicensed loan
    originators, including brokers. Mortgage broker trade
    associations indicated that they have developed best practices
    and a code of ethics to address these concerns. Brokers also
    testified that state and federal agencies have not adequately
    enforced existing laws against the ``bad actors'' in the
    mortgage market, in part because funds for enforcement are
    inadequate.
        Consumer advocates offered varying solutions to revise laws
    to address concerns about mortgage brokers, including requiring
    brokers to be the exclusive agent of the borrower in all cases.
    Some advocated suitability standards to counter a broker's
    incentive to sell consumers loans that do not necessarily fit
    the consumer's needs and financial situation. Mortgage broker
    representatives rejected the notion that a broker should be the
    agent or fiduciary of the consumer and should select the best
    loan for the consumer. They noted that a broker may not have
    access to the best product available in a given market and
    argued that only consumers can determine the best loan for
    themselves.
        There was also testimony from state officials on state
    efforts to regulate and license mortgage brokers. For example,
    Pennsylvania officials described their efforts to regulate and
    license brokers and other loan originators and to cooperate
    with other states to monitor broker activity. Brokers expressed
    strong support for state licensing efforts and advocated
    criminal background checks for all mortgage loan originators
    including brokers and employees of banks and mortgage
    companies. Lenders testified that they support current efforts
    by the states to license and monitor brokers. State-required
    mortgage broker disclosures have helped somewhat, according to
    lenders who addressed the question, but they also noted that
    consumers are already confronted with too many documents
    throughout the mortgage process for disclosure to have much
    impact.
        Some lenders also stated that consumer education about the
    loan shopping process is the best way to overcome confusion
    about mortgage brokers' roles. In addressing concerns about
    mortgage brokers, some lenders emphasized the need for a
    uniform federal response rather than enacting different state
    laws.

    Q.2. How much risk do you see from borrowers who have used
    these mortgages to speculate in the housing market? If these
    investments cease to be worthwhile because of a housing
    slowdown, are we going to see large numbers of defaults on
    these loans?

    A.2. The portion of home sales accounted for by investors, as
    opposed to owner-occupants, has risen in recent years.
    According to data collected under the Home Mortgage Disclosure
    Act, the share of reported mortgage loans (both traditional and
    nontraditional) associated with nonowner-occupied properties
    hovered between 5 and 6 percent in the first half of the 1990s
    but has climbed fairly steadily since and reached 17 percent in
    2005.
        Some of the recent increase in the investor share of the
    residential housing market has undoubtedly been spurred by the
    expectation that prices would continue to rise rapidly rather
    than by an interest in retaining the property over time for
    rental income. Past loan performance has indicated that
    investors are more likely than owner-occupants to default on a
    loan when house prices decline. As a result, there may be some
    deterioration in the credit quality of mortgages extended to
    investors now that house prices are no longer rising as rapidly
    as they had been. As yet, though, delinquency rates for
    mortgages (both traditional and nontraditional) on nonowner-
    occupied properties remain low. That said, the Board is, of
    course, watching for signs of an increase in defaults among
    investors, and we have urged lenders to recognize the risks
    associated with such an increase.

    Q.3. Are borrowers who have taken nontraditional mortgages in
    recent years using these products to buy bigger and better
    homes than they could otherwise afford or are they using these
    products simply to be able to get into the market? In other
    words, are the mortgages being used to finance basic needs or
    luxury desires?

    A.3. The required monthly payment associated with a
    nontraditional mortgage can be substantially lower than the
    payments would be for a more traditional mortgage loan of
    similar size, at least for some period. Thus, as I noted in my
    testimony, nontraditional mortgage products have allowed some
    borrowers to purchase homes that they otherwise might not be
    able to afford. However, the Board is not able to judge, nor
    should it judge, whether a particular home satisfies a basic
    need for a given household or whether it represents a luxury
    item for that household, as that question involves far-reaching
    issues about appropriate standards of living in our country.
        What is important to the Board is that consumers fully
    understand the commitments they make when taking on
    nontraditional mortgages and the risks they could face in light
    of deferring principal and/or interest payments. For this
    reason, the Board is actively engaged in efforts to enhance the
    information available to borrowers regarding these loans. The
    various initiatives I discussed in my testimony--the Board's
    review of federally required disclosures on mortgages, its
    public hearings on home equity lending, its planned and
    completed revisions to consumer education publications, and
    elements of the interagency regulatory guidance on
    nontraditional mortgage products--are all examples of these
    efforts.

    Q.4. In our last hearing, Mr. Brown from the FDIC suggested
    that we are unlikely to see a nationwide crisis in the housing
    market, because the housing boom is concentrated in certain
    regions, and historically most housing failures have happened
    in areas suffering from localized recessions. As we all know,
    there is increased risk of massive defaults on these loans in
    coming years. Due to a nationwide trend of nontraditional
    mortgages being used as affordability products, would you
    disagree with Mr. Brown that upcoming housing problems will be
    isolated in certain regions?

    A.4. Many factors can contribute to borrowers defaulting on
    their mortgages, including house price declines, disruptions to
    income, and changes in required mortgage payments for which
    borrowers are unprepared. The first two of these factors are
    often concentrated in certain regions and thus mortgage-related
    distress has also often been concentrated.
        Nontraditional mortgages have become more prevalent
    throughout the nation. It is also the case that nontraditional
    mortgages are likely to lead some households into financial
    distress through the last of the channels mentioned above--
    large changes in required payments. However, changes in
    required payments on nontraditional mortgages are unlikely to
    pose a large threat to the national economy or to the financial
    system overall. One factor limiting the risks is that, in most
    cases, the payment changes will not occur for some time; for
    example, industry reports suggest that most interest-only
    mortgages do not start requiring repayment of principal for at
    least five years, if not ten or fifteen years. Many borrowers
    will have sold their homes or refinanced into a different
    mortgage by this time. In addition, efforts to raise consumer
    awareness of the terms and features of nontraditional mortgage
    payments, such as those being undertaken by the Board that I
    mentioned in my testimony, should encourage households who
    retain their nontraditional mortgages to make active efforts to
    prepare for major scheduled increases in their payments.
        Of course, certain nontraditional mortgages have not been
    tested in a stressed environment. Given this newness, the Board
    is closely watching for signs that household financial distress
    is becoming more widespread as more borrowers face increases in
    the required payments on their nontraditional mortgages.

    Q.5. Again, I would like each of you to answer this question
    quickly: Will the proposed guidance in combination with an
    update of Regulation Z be enough to stop overly risky lending
    practices? Or is something stronger needed?

    A.5. The nontraditional mortgage guidance advises institutions
    to ensure that their risk management and consumer protection
    practices adequately address the risks discussed in the
    document. Through the examination process, the Board and the
    other federal bank and thrift agencies will review
    institutions' risk management and consumer protection
    practices, and institutions that do not adequately address
    these risks will be asked to take remedial action. An
    institution that follows the principles outlined in the
    guidance should be operating within acceptable boundaries of
    risk. However, many institutions that originate residential
    mortgages are not federally regulated and are not covered by
    the guidance. In an attempt to level the playing field between
    federally and non-federally regulated institutions, the
    Conference of State Bank Supervisors and American Association
    of Residential Mortgage Regulators released similar guidance.
    Each state banking agency must decide whether or not to enforce
    those guidelines or make changes.
        The nontraditional mortgage guidance's recommended
    practices for marketing such mortgages to consumers should help
    consumers get the information they need at critical
    decisionmaking times so that consumers can make informed
    choices about mortgage products. To supplement the guidance,
    the agencies are seeking comment on proposed illustrations that
    show how an institution might inform consumers about the
    features and risks of nontraditional mortgage products.
        The Board's upcoming review of Regulation Z's mortgage
    disclosure rules will aim to improve the information that
    lenders must provide to consumers. In addition, the Board's
    staff is working with staff at the Office of Thrift Supervision
    to finalize revisions to the Consumer Handbook on Adjustable
    Rate Mortgages (the CHARM booklet) to include information about
    alternative mortgage products. The CHARM booklet is an
    effective means of delivering information to consumers, because
    Regulation Z requires that all creditors--not just those
    supervised by the bank and thrift agencies--provide the CHARM
    booklet or a suitable substitute to each consumer who receives
    an application for an ARM. The Board and the Office of Thrift
    Supervision plan to issue the revised CHARM booklet later this
    year. Finally, on October 19, 2006, the Board and the other
    federal bank and thrift agencies issued a brochure, Interest-
    Only Mortgage Payments and Payment-Option ARMs--Are They for
    You? to help consumers make more informed choices when
    considering nontraditional mortgage loans.
                                    ------

             RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                         FROM SANDRA BRAUNSTEIN

    Q.1. The importance of actual verification of a borrower's
    income, assets, and outstanding liabilities increases as the
    level of credit risk increases. When is reduced documentation
    underwriting appropriate, if at all? What mitigating factors
    should be in place?

    A.1. Mortgage lenders are increasingly relying on reduced
    documentation, particularly unverified income, to underwrite
    nontraditional mortgages as well as other types of loans. The
    industry states that automated underwriting systems that
    incorporate credit scores, employment history, loan-to-value
    (LTV) and debt-to-income (DTI) ratios, among other borrower and
    product attributes have become a strongly predictive indicator
    of creditworthiness while eliminating the potential for bias in
    the underwriting decision. Through the development of
    technology, automated underwriting systems and other credit
    scoring models have become more robust and predictive allowing
    lenders to streamline the underwriting process and lower costs
    to borrowers while effectively managing risk.
        The final nontraditional mortgage guidance provides that
    when lenders rely on reduced documentation, automated
    underwriting systems, and credit scoring models, there should
    be mitigating factors that support the decision. Mitigating
    factors could include higher credit scores, lower LTV and DTI
    ratios, significant liquid assets, mortgage insurance or other
    factors.

    Q.2. How will the federal agencies implement this guidance in a
    consistent manner and how will you coordinate with your state
    counterparts?

    A.2. I anticipate that the agencies will coordinate their
    implementation of the guidance through the Federal Financial
    Institutions Examination Council (FFIEC), which was created to
    ensure uniformity in supervision of federally supervised
    financial institutions. The Financial Services Regulatory
    Relief Act of 2006 requires the current State Liaison Committee
    to the FFIEC to elect a Chairperson, and to add this
    Chairperson as a full voting member of the FFIEC. This should
    help to ensure coordination with state agencies.

    Q.3. The proposed guidance strongly encourages institutions to
    increase monitoring and loss mitigation efforts (i.e.,
    establishing portfolio limits, measuring portfolio volume and
    performance, providing comprehensive management information
    reporting). How do you respond to lenders who argue that such
    increases would restrict lender flexibility and reduce consumer
    choice? Will these increased efforts potentially drive up
    banks' underwriting costs, which will hurt consumers?

    A.3. Because lenders do not have significant experience with
    nontraditional mortgage products in a stressed economic
    environment, they should have prudent risk management practices
    in place to ensure that these portfolios are administered in a
    safe and sound manner. As home price appreciation slows and
    interest rates increase, the potential for defaults caused by
    lack of sufficient borrower equity and payment shock is also
    increasing. Nontraditional mortgage portfolios may behave
    differently when compared to more traditional portfolios that
    do not contain as many embedded risks. Systems should be in
    place to determine how severely a stressed environment could
    affect borrowers and portfolios. Strategies should be developed
    to minimize the effect of deteriorating conditions on borrowers
    identified as at risk. Institutions involved in the origination
    and servicing of nontraditional mortgages should ensure that
    risk management practices keep pace with the growth and
    changing risk profile of their portfolios. These increased
    efforts should minimize defaults and losses which will benefit
    both lenders and borrowers and result in lower costs and
    increased product choice in the long run.

    Q.4. The GAO found federally-regulated institutions today
    already underwrite option ARMs at the fully indexed rate. That
    is good, but isn't it better to also consider the potential
    balance increase associated with the negative amortization
    feature? How many of the institutions are considering this in
    their underwriting?

    A.4. While most institutions underwrite option ARMs at the
    fully indexed rate, very few, if any, institutions also
    consider the potential balance increase associated with the
    negative amortization feature. Institutions should maintain
    qualification standards that include a credible analysis of a
    borrower's capacity to repay the full amount of credit that may
    be extended. The final nontraditional mortgage guidance advises
    institutions that their analysis of a borrower's repayment
    capacity should also be based upon the initial loan amount plus
    any balance increase that may accrue from the negative
    amortization provision.

    Q.5. Should lenders be required to underwrite the borrower's
    ability to repay the debt by final maturity at the fully
    indexed rate, assuming a fully amortizing repayment schedule?
    If not, why and what circumstances would prevent them from
    doing so?

    A.5. Payments on nontraditional loans can increase
    significantly when the loans begin to amortize. Commonly
    referred to as payment shock, this increase is of particular
    concern for payment option ARMs where the borrower makes
    minimum payments that may result in negative amortization. An
    institution's qualifying standards should recognize the
    potential impact of payment shock, especially for borrowers
    with high loan-to-value ratios, high debt-to-income ratios, and
    low credit scores. To account for this, the nontraditional
    mortgage guidance advises that an institution's analysis of a
    borrower's repayment capacity should include an evaluation of
    the borrower's ability to repay the debt by final maturity at
    the fully indexed rate, assuming a fully amortizing repayment
    schedule. Recognizing that an institution's underwriting
    criteria are based on multiple factors that may vary by a
    product's attributes and borrower characteristics, the guidance
    advises that an institution may develop a range of reasonable
    tolerances for each underwriting factor.

    Q.6. The GAO recommends improved consumer disclosure by
    requiring language with an effective format and visual
    presentation that explains key features and potential risks
    specific to nontraditional lending products. What else could be
    done to improve the clarity and comprehensiveness of
    nontraditional mortgage products to consumers?

    A.6. As part of its review of the effectiveness of closed-end
    credit disclosures under Regulation Z, including disclosures
    for nontraditional mortgages, 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 the
    Board determines that useful changes to the closed-end
    disclosures are best accomplished through legislation, the
    Board would develop suggested statutory changes for
    congressional consideration.

    Q.7. Most recently issued nontraditional lending products do
    not reset until 3 to 5 years after origination and have not yet
    reached their reset period. The payment shock for option ARMs
    can be substantial if interest rates stay flat and much worse
    if rates increase. When underwriting, what interest rate
    scenarios are banks using: flat, rising, declining, or all
    combinations? How are the various rate scenarios described to
    consumers during both the origination and repayment phases?

    A.7. Currently, our supervisory experience and research show
    that most institutions that originate option ARMs are
    underwriting these loans at the fully indexed interest rate.
    The rate is determined using data available at the time of
    origination with no projection of future interest rates.
    However, and with respect to all types of ARMs, this practice
    can change based on lenders' view of the future path of
    interest rates. In the past, during times of rapidly increasing
    interest rates, many lenders chose to underwrite ARMs at a rate
    above the then current fully indexed rate. Their decisions with
    respect to the appropriate underwriting rate are based on a
    number of factors including capital market preferences, the
    outlook for interest rate increases or decreases, and other
    lenders' practices. Over time, underwriting practices have
    changed to conform to market conditions and it is reasonable to
    expect that this will continue.

    Q.8. What issues regarding nontraditional mortgage products
    have come up since your draft guidance was issued or do you
    believe have not been addressed by your guidance? What, if any,
    plans do you have to address these issues in the future?

    A.8. Following your hearing, the agencies issued final guidance
    on September 29, 2006. The agencies also supplemented the
    guidance by publishing for comment illustrations showing how
    institutions might provide consumers with information
    recommended in the guidance. The public comment period ended on
    December 4, 2006, and the agencies are reviewing the public
    comment letters.
        Since the guidance and illustrations were published,
    lenders and community groups have expressed concerns about
    whether the guidance applies to certain hybrid ARM products
    that are prevalent in the subprime market (i.e., ``2/28'' and
    ``3/27'' loans in which the rate is fixed for two or three
    years at a discount substantially below the current index and
    margin). The agencies are discussing whether those products
    warrant further guidance.
                                    ------

            RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING
                          FROM SANDRA THOMPSON

    Q.1. Mortgage brokers are playing a larger role in the market
    today. Recent statistics show that independent brokers are
    responsible for about 50 percent of all originations and over
    70 percent of subprime originations. Brokers definitely serve
    the overall market by helping consumers work with multiple
    lenders; however, they share little risk. Many brokers find it
    in their financial interest to get the borrower into a loan,
    regardless of whether the borrower can afford it. Are current
    laws and regulations strong enough to protect consumers and
    lenders? What can be done to better share the risk and ensure
    brokers are not just looking out for their own best interest?

    A.1. The FDIC also is concerned about protecting the interests
    of consumers and lenders. It is troubling that a broker may
    benefit from placing a borrower into a loan that he/she cannot
    afford, while both the borrower and the lender may suffer a
    loss.
        The Interagency Guidance on Nontraditional Mortgage
    Products (NTM Guidance) stresses, among other things, the need
    for federally regulated lenders to implement strong control
    systems over third parties involved in the lending process.
    Undertaking due diligence to ensure that mortgage brokers are
    properly licensed is a basic step in a control system. Also,
    oversight of third parties should involve monitoring the
    quality of originations so that they reflect the institution's
    own internal lending standards and are in compliance with
    applicable laws and regulations. To do this, institutions
    should track the quality of loans by mortgage broker, which
    will help management identify problems with a particular
    broker. If loan documentation, credit problems, or consumer
    complaints are discovered, the institution should take
    immediate action. Corrective action could include more thorough
    application reviews, more frequent re-underwriting, or even
    termination of the third party relationship. Finally,
    institutions are expected to design their third party
    compensation agreements in a way that will avoid providing
    incentives for originations that are inconsistent with the
    applicable guidance, laws, and the institution's own lending
    standards.
        Mortgage brokers do not come under the purview of the
    federal banking agencies, but they are regulated by certain
    state organizations. The Conference of State Bank Supervisors
    (CSBS) and the American Association of Residential Mortgage
    Regulators (AARMR) have distributed guidance to state agencies
    that regulate residential mortgage brokers. The CSBS/AARMR
    guidance substantially mirrors the interagency NTM Guidance,
    except for the deletion of sections not applicable to non-
    depository institutions.
        This guidance will help state regulators promote consistent
    regulation in the mortgage market and clarify how non-
    depository institution providers, including mortgage brokers,
    can offer nontraditional mortgage products in a way that
    clearly discloses the risks that borrowers may assume. CSBS is
    working with the state regulatory agencies to adopt this
    guidance for the non-federally insured organizations they
    regulate.
        CSBS and AARMR also are developing a national licensing
    system for the residential mortgage industry that will enhance
    consumer protection and streamline the licensing process for
    regulators and the industry. Among other things, this system
    will provide public access to a central repository of licensing
    and publicly adjudicated enforcement actions. The system will
    increase the accountability of mortgage companies and mortgage
    professionals and assist the regulatory agencies in keeping bad
    actors out of the mortgage business.

    Q.2. How much risk do you see from borrowers who have used
    these mortgages to speculate in the housing market? If these
    investments cease to be worthwhile because of a housing
    slowdown, are we going to see large numbers of defaults on
    these loans?

    A.2. At this point, it is impossible to predict which of these
    loans may default since many factors affect loan performance.
    To date, these types of loans have not resulted in large
    numbers of defaults. However, many of the loans have low
    initial interest rates and reset dates in later years that may
    create payment stress for some borrowers in the future. There
    is a greater risk of default by investors than by individuals
    financing their residence.

    Q.3. Are borrowers who have taken non-traditional mortgages in
    recent years using these products to buy bigger and better
    homes than they otherwise could afford or are they using these
    products simply to be able to get into the market? In other
    words, are the mortgages being used to finance basic needs or
    luxury desires?

    A.3. Both the rate of homeownership and levels of new home
    construction have reached all-time highs in recent years. It is
    reasonable to conclude that low mortgage interest rates and
    greater flexibility in mortgage terms and structures allowed
    more households to buy their first homes and allowed others to
    afford larger and higher-quality homes than would otherwise
    have been the case. However, trying to differentiate these
    purchases into ``needs'' versus ``wants'' is a more difficult
    question.

    Q.4. In our last hearing, Mr. Brown from the FDIC suggested
    that we are unlikely to see a nationwide crisis in the housing
    market, because the housing boom is concentrated in certain
    regions, and historically most housing failures have happened
    in areas suffering from localized recessions. As we all know,
    there is increased risk of massive defaults on these loans in
    the coming years. Due to a nationwide trend of nontraditional
    mortgages being used as affordability products, would you
    disagree with Mr. Brown that upcoming housing problems will be
    isolated in certain regions?

    A.4. As Mr. Brown testified, FDIC analysts have found that true
    metro-area housing price ``busts'' resulting in severe credit
    losses for mortgage lenders have been relatively rare
    historical events. Almost exclusively, these episodes occurred
    in areas that have experienced severe local economic distress,
    such as the ``oil patch'' in the late 1980s. There is some
    indication that this historical trend is continuing. While the
    prevalence of nontraditional mortgages has generally been
    higher in the coastal boom markets, the most significant credit
    distress to this point has been observed in the upper Midwest,
    where home prices have not boomed and where nontraditional
    mortgages remain less prevalent. These observations tend to
    support the notion that local economic conditions will continue
    to be the most important determinants of home prices and
    mortgage credit defaults.
        The most common aftermath of local housing booms has been
    an extended period of price stagnation. This period of
    stagnation may be associated with small price declines and is
    usually stressful for homeowners, home builders, and real
    estate professionals. But stagnation is not usually associated
    with severe losses for mortgage lenders. In such an
    environment, most homeowners have little incentive to sell
    their home at a loss or default on their mortgage and will
    typically wait out the down market.
        While a further increase in delinquency and foreclosure
    rates can reasonably be expected over the next few years,
    massive defaults appear unlikely. A national analysis of
    mortgage payment resets undertaken by First American Real
    Estate Solutions puts the volume of potential loss associated
    with interest rate resets into perspective, finding that the
    volume of ARM defaults is likely to remain relatively small
    compared to overall mortgage originations.

    Q.5. Again, I would like each of you to respond quickly: Will
    the proposed guidance in combination with an update in
    Regulation Z be enough to stop overly risky lending practices?
    Or is something stronger needed?

    A.5. The NTM Guidance clarifies the federal banking agencies'
    expectations with respect to underwriting these mortgages, as
    well as the information that consumers should receive so that
    they understand the potential risks. In addition to the NTM
    Guidance, the agencies proposed Illustrations of Consumer
    Information for Nontraditional Mortgage Product Risks for
    comment. The Illustrations are intended to assist institutions
    in implementing the consumer information portion of the NTM
    Guidance. Coupled with strong supervisory oversight, the
    Illustrations, the NTM Guidance, and an updated Regulation Z
    should preclude the need for additional legislation or
    regulation,

    Q.6. In your testimony, you talk about lenders reducing their
    risk by selling mortgages on the secondary market. First, who
    has been buying these non-traditional mortgages on the
    secondary market? And second, have insured institutions reduced
    their risk to a safe-enough level?

    A.6. A strong appetite for U.S. mortgage instruments on the
    part of U.S. and global investors has been a key to the
    expansion of this market. These investors have been willing to
    purchase mortgage asset-backed security issues all along the
    risk spectrum, which has been critical to banks' ability to
    securitize nontraditional mortgage debt. This securitization
    has done a great deal to diversify the risks of nontraditional
    mortgage loans to investors around the world, including
    investors who are better able to bear these risks than are
    FDIC-insured institutions. At the same time, there is a risk
    that at some point this strong appetite for U.S. nontraditional
    mortgage paper could wane, which may make these mortgages less
    available to consumers.
        Banks and thrifts are actively engaged in virtually every
    facet of mortgage lending, as originators, as servicers, and as
    holders of mortgage loans. In this latter capacity, lending
    institutions can face significant challenges in managing both
    credit risk and interest rate risk. They typically address
    these challenges by applying strong underwriting guidelines,
    seeking geographic diversification, and, in some cases, by
    using interest-rate swaps and other tools to manage interest
    rate risk.
        Securitization represents an important tool that mortgage
    lenders can use to manage credit and interest rate risks.
    Moving mortgage assets off the balance sheet into structured
    pools allows securitizers to create credit enhancements,
    achieve geographic diversification, and more finely manage the
    maturity structure of mortgage obligations.
                                    ------

             RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                          FROM SANDRA THOMPSON

    Q.1. The importance of actual verification of the borrower's
    income, assets, and outstanding liabilities Increases as the
    level of credit risk increases. When is reduced document
    underwriting appropriate, if at all? What mitigating factors
    should be in place?

    A.1. The NTM guidance does not limit reduced documentation
    loans to any particular set of circumstances. The final
    guidance recognizes that mitigating factors, such as higher
    credit scores, lower loan-to-value and debt-to-income ratios,
    significant liquid assets, mortgage insurance, or other credit
    enhancements may determine whether such loans are appropriate.

    Q.2. How will the federal agencies implement this guidance in a
    consistent manner and how will you coordinate with your state
    counterparts?

    A.2. As deposit insurer, the FDIC works with all of the
    agencies to ensure that risk to the deposit insurance fund is
    minimized. We regularly coordinate our examinations closely
    with state banking supervisors and we are able to participate
    in any examination where risk to the fluid may be elevated.
    This close coordination with the other agencies allows us to
    ensure that the NTM Guidance is implemented consistently.
        Further, the FDIC, the Federal Reserve, and the state
    banking authorities utilize common examination procedures and
    documentation tools, which will aid in the consistent
    application of this guidance. Additionally, the Conference of
    State Bank Supervisors (CSBS) and the American Association of
    Residential Mortgage Regulators (AARMR) have issued similar
    guidance for non-bank financial service providers under state
    jurisdiction to address the potential for inconsistent
    regulatory treatment of lenders based on whether or not they
    are federally regulated. CSBS is working with states to adopt
    the guidance for the non-federally insured organizations they
    regulate

    Q.3. The proposed guidance strongly encourages institutions to
    increase monitoring and loss mitigation efforts (i.e.
    establishing portfolio limits, measuring portfolio volume and
    performance, providing comprehensive management information
    reporting). How do you respond to lenders who argue that such
    increases would restrict lender flexibility and reduce consumer
    choice? Will these increased efforts potentially drive up
    banks' underwriting costs, which will hurt consumers?

    A.3. The regulatory agencies believe that the NTM Guidance
    provides adequate flexibility in the methods and approaches to
    mitigating risk while simultaneously promoting prudent
    underwriting practices and informed consumer decision-making.
    The principles in the guidance are basic tenets of sound
    underwriting, which the agencies have long emphasized.
        The NTM Guidance is intended to encourage institutions to
    communicate clearly with consumers. These increased efforts
    should not drive up underwriting costs and may minimize
    consumer complaints and foster good customer relations. In the
    long run, accurate communication may translate into reduced
    overall costs.

    Q.4. The GAO found federally-regulated institutions today
    underwrite option ARMS at the My-indexed rate. This is good,
    but isn't it better to also consider the potential balance
    increase associated with the negative amortization feature? How
    many of the institutions are considering this in their
    underwriting?

    A.4. The NTM Guidance specifies that federally regulated
    institutions should qualify borrowers at the maximum amount of
    principal that could accrue through negative amortization. The
    amount of potential negative amortization depends on the spread
    between the introductory rate and the index or accrual rate. A
    small spread could cause the potential negative amortization to
    be less than the limit established by the negative amortization
    cap. The borrower should be qualified based on this lower
    maximum loan balance than the full amount specified per the
    negative amortization cap.
        The Call Report information that institutions provide on a
    quarterly basis does not distinguish between traditional and
    nontraditional adjustable rate mortgage (ARM) home loans.
    Therefore, it is not feasible to identify with absolute
    certainty how many banks are offering these products. Beginning
    in March 2007, the Call Report will be changed to include
    information on payment option ARMs, which will allow us to
    identify with certainty the institutions that are offering
    those products.
        Based on examination activities, the FDIC has very few
    institutions offering payment option ARMs. A recent review of
    institutions with total assets of $1 billion or more and
    located in areas experiencing rapid home price appreciation
    identified only two FDIC supervised institutions that offer
    payment option ARMS. Both of these banks have conservative
    underwriting standards, adequate compliance programs, and
    overall satisfactory ratings.

    Q.5. Should lenders be required to underwrite the borrowers'
    ability to repay the debt by final maturity at the fully
    indexed rate, assuming a fully amortizing repayment schedule?
    If not, why and what circumstances would circumvent them from
    doing so?

    A.5. Prudent lending practices generally dictate that borrowers
    should be qualified for a loan on the fully-indexed interest
    rate and on a fully amortizing basis. However, it also is
    reasonable to qualify borrowers for products and terms that
    meet their specific financial needs. For example, institutions
    may want to qualify borrowers with unique cash flow
    circumstances or short-term residency needs (i.e., anticipate
    moving in two to three years), on an interest-only basis.

    Q.6. The GAO recommends improved consumer disclosure by
    requiring language with an effective formal and visual
    presentation that explains key features and potential risks
    specific to nontraditional lending products. What else could be
    done to improve the clarity and comprehensiveness of
    nontraditional mortgage products to consumers?

    A.6. Efforts in several areas could help improve the clarity of
    information that consumers receive about nontraditional
    mortgages. The Federal Reserve Board's review and update of the
    Truth in Lending regulation (Regulation B) will be a critical
    component for ensuring that consumers receive clear information
    about key features of these and other mortgage products. The
    current regulation was designed at a time when products were
    much simpler. An updated regulation is needed to address the
    complexities of new mortgage products and to provide for
    changes in the future.
        In addition, state regulation of mortgage brokers is
    essential. Many consumers rely on brokers for advice and
    assistance in obtaining and understanding home loans. The FDIC
    and other banking regulators will work with our state
    regulatory counterparts to find ways to ensure that brokers
    provide fair and accurate information. In addition, as we
    indicated in the NTM Guidance, we will ensure that banks
    properly oversee third parties with which they do business -
    including molt e brokers--to ensure that those parties adhere
    to the same standards we expect of banks.

    Q.7. Most recently issued nontraditional lending products do
    not reset until 3 to 5 years after origination and have not yet
    reached their reset period. The payment shock for option ARMs
    can be substantial If Interest rates stay fiat and much worse
    if rates increase. When underwriting, what interest rate
    scenarios are banks using: Hat, rising, declining, or all
    combinations? How are the various rate senarios described to
    consumers during both the origination and repayment phases?

    A.7. Loan originators use current market interest rates when
    underwriting borrowers and do not forecast what the index rate
    will equal at the time the loan recasts. The NTM guidance
    specifies that federally-insured institutions should qualify
    borrowers on a fully-indexed, fully amortizing basis. This
    prudent underwriting practice ensures a borrower has the
    capacity to repay the loan based on the current index rate
    rather than the introductory rate rather than the introductory
    rate or a projected index rate.

          Pursuant to the Truth in Lending Act, lenders
    must provide ARM pro disclosures when borrowers receive an
    application form or before they pay on-refundable application
    fee and then again during the repayment period.

          An institution's ARM program disclosures must
    provide an historical example (based on a $10,000 loan amount)
    illustrating how the payments and loan balance would have been
    affected by interest rate changes under the terms of the
    particular loan program. The illustration must be based on the
    program's index values over the previous 15 years.

          During the repayment period, disclosures must be
    provided when the interest rate adjusts, whether or not there
    is a payment change. Disclosures must be provided annually if
    there is not a payment adjustment. If there is a payment
    adjustment, disclosures must be provided at least 25 but no
    more than 120 days before a different payment amount is due.

          These disclosures provide the current and prior
    interest rates, the index values on which he interest rates are
    based, the extent to which the lender may have foregone rate
    increases, and the contractual effects of the interest rate
    adjustment (including the new payment due and the loan
    balance).

          If the payment due after the interest rate
    adjustment will not fully amortize the loan over the remainder
    of the loan team at the new interest rate, then there must be a
    statement of went would fully amortize the loan.

    Q.8. What issues regarding nontraditional mortgage products
    have come up since your draft guidance was issued or do you
    believe have not been addressed by your guidance? What, if any,
    plans do you have to address these issues in the future?

    A.8. At the September 20 hearing, the Center for Responsible
    Lending testified that certain loan products, particularly
    hybrid ARMs like so-called 2/28s, may carry the same potential
    for payment shock as nontraditional mortgages. While some of
    these loans do not seem to be included in our definition of
    nontraditional mortgages because there is some principal
    amortization, we nevertheless expect to direct our examiners to
    be alert for such products. The agencies also are considering
    whether to issue additional guidance or other communications to
    address subprime products with the potential for significant
    payment shock such as 2/28s.
                                    ------

      RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM SCOTT
                                ALBINSON

    Q.1. Mortgage brokers are playing a larger role in the market
    today. Recent statistics show that independent brokers are
    responsible for about 50 percent of all originations and over
    70 percent of subprime originations. Brokers definitely serve
    the overall market by helping consumers work with multiple
    lenders; however, they share little risk. Many brokers find it
    in their financial interest to get the borrower into a loan,
    regardless of whether the borrower can afford it. Are current
    laws and regulations strong enough to protect consumers and
    lenders? What can be done to better share risk and ensure
    brokers are not just looking out for their own best interests?

    A.1. Brokers are often the primary contact borrowers have when
    seeking a mortgage loan. Many federally regulated financial
    institutions rely on them to supplement their own loan
    production, and for some institutions, brokers are the primary
    production source. OTS requires savings associations to
    establish prudent written lending standards and to underwrite
    all loans in accordance with those standards. This is the
    requirement regardless of the origination source of a loan.
        For loans originated by mortgage brokers, institutions are
    also expected to monitor broker performance and consumer
    complaint activity associated with individual brokers on an
    ongoing basis. Federally-regulated financial institutions are
    expected to evaluate all loans supplied to them by brokers. For
    loans purchased from a broker, we expect institutions to ensure
    that the broker has abided by all applicable laws, regulations,
    and policy guidelines, including prudent underwriting standards
    as well as consumer protection and disclosure information
    (Regulation Z, RESPA, Fair Lending, and other disclosure
    requirements that all mortgage lenders must abide by).
        While we expect thrifts to monitor the lending activity of
    brokers with respect to the loans they purchase from a broker,
    institutions cannot monitor or control loans a broker
    originates for nonregulated lenders and brokers. State
    regulatory authorities typically supervise these activities.
    Better coordination between Federal and state regulators may be
    helpful in ensuring greater consistency in regulatory oversight
    and control of predatory mortgage brokers and serve to reign in
    self-serving brokers. To this end, OTS maintains working
    relationships with state regulatory authorities and frequently
    consults with the Conference of State Bank Supervisors in this
    and similar areas of regulatory and supervisory overlap.

    Q.2. How much risk do you see from borrowers who have used
    these mortgages to speculate in the housing market? If these
    investments cease to be worthwhile because of a housing
    slowdown, are we going to see large numbers of defaults on
    these loans?

    A.2. Investors have played a role in the housing market for
    many years. In recent years, however, there has been an
    increase in less sophisticated investors purchasing properties
    with the intention of flipping them as prices increase. In some
    markets, this influx of ``new'' investors has reportedly fueled
    part of the rise in home prices over the past few years.
    Although investor-owned mortgages have remained steady since
    1991 at approximately 4 percent of total mortgages, that level
    has gradually increased from 3.93 percent in June 2002 to 4.76
    percent in June 2006.
        Loan performance data show that investor-owned mortgages
    have performed on par with owner-occupied mortgages. For
    example, before the 2000-2006 real estate boom, owner-occupied
    properties performed somewhat better than investor properties.
    Since the boom, investor mortgages have outperformed owner-
    occupied mortgages. In June 2006, the ratio of seriously
    delinquent investor-owned mortgages was 0.41 percent, and
    seriously delinquent owner-occupied mortgages was 0.46 percent
    of total mortgages, respectively. While the levels have varied
    since 1991, the variance has remained very low.
        The highest levels of investor-owned mortgages are in
    several Western states. The largest increases were in Nevada,
    Hawaii and Idaho. California investor-owned mortgages grew from
    5.7 percent to 6.4 percent since 2000. Nevada, however, went
    from 4.7 percent to 8 percent in the same period. The Midwest
    region of the U.S. had the lowest overall levels of investor-
    owned mortgages.
        The states with the highest levels of investor-owned
    properties all experienced the lowest delinquencies. Nevada's
    investor-owned mortgage delinquency was at 0.13 percent,
    Idaho's was at 0.14 percent, Hawaii's was at 0.05 percent, and
    California's was at 0.07 percent.
        While this data may seem counterintuitive, most federally
    regulated financial institutions, including thrifts, maintain
    more stringent underwriting requirements for loans secured by
    investor-owned properties than they require for owner occupant
    properties. These may include requirements for higher down
    payments, higher minimum credit scores, higher interest rates,
    and higher borrower income and liquidity.
        Thus, on an industry wide perspective, we see minimal
    overall risk from investor-owed mortgages. Nevertheless, there
    are some regional variances and we are monitoring this activity
    carefully.

    Q.3. Are borrowers who have taken non-traditional mortgages in
    recent years using these products to buy bigger and better
    homes than they otherwise could afford or are they using these
    products simply to be able to get into the market? In other
    words, are the mortgages being used to finance basic needs or
    luxury desires?

    A.3. We do not have specific data that addresses borrower
    motivation. Loan documents typically only indicate the loan
    purpose (``purchase'' or ``refinance''). Borrowers have used
    non-traditional mortgages for different reasons:

          To provide payment flexibility when borrower
    income is not evenly distributed throughout the year;

          To purchase a more expensive home they would not
    have otherwise been able to afford;

          To purchase their first home in an expensive
    housing market; and

          To refinance an existing mortgage and possibly
    roll into the new first mortgage a second mortgage or other
    household debt.

        The advantage to borrowers of most nontraditional mortgage
    loan products is the low initial monthly payments that can help
    with the borrower's cash flow and give the impression that the
    loan is more affordable. A large portion of option ARM loans
    are secured by expensive homes. Since 2000, 76.8 percent of
    option ARMs, 66.3 percent of ARMs, and 28.7 percent of fixed-
    rate mortgages were greater than $400,000, which is above the
    national median home price.

    Q.4. In our last hearing, Mr. Brown from the FDIC suggested
    that we are unlikely to see a nationwide crisis in the housing
    market, because the housing boom is concentrated in certain
    regions, and historically most housing failures have happened
    in areas suffering from localized recessions. As we all know,
    there is increased risk of massive defaults on these loans in
    the coming years. Due to a nationwide trend of nontraditional
    mortgages being used as affordability products, would you
    disagree with Mr. Brown that upcoming housing problems will be
    isolated in certain regions?

    A.4. To date, the economic data available to us support Mr.
    Brown's statement that it is unlikely that we have a nationwide
    crisis in the housing market. Historically, systemic market
    crashes have been preceded by high interest rates, high
    unemployment, and decreasing home prices. High unemployment
    reduces consumer demand; high interest rates make homes less
    affordable; and both contribute to the lower demand for new and
    existing homes. While such a confluence of events is possible,
    there are no current indicators that it is likely to occur on a
    nationwide basis.
        Instead, it appears more likely that any upcoming housing
    market weakness will be limited to regions of the country where
    local housing prices have advanced beyond personal incomes and/
    or have overheated beyond where current buyers are willing to
    enter the market. Our loan performance data validates this.
    Except for the subprime mortgage market, mortgage loan
    performance has remained very strong throughout 2005 and 2006.
    For example, during the first half of 2006, delinquencies in
    prime mortgages were 0.47 percent, the lowest point in our
    1991-2006 database. However, subprime mortgage delinquencies
    were 5.2 percent in September 2006, up from 3.6 percent a year
    ago.

    Q.5. Again, I would like each of you to answer this question
    quickly: Will the proposed guidance in combination with an
    update of Regulation Z be enough to stop overly risky lending
    practices? Or is something stronger needed?

    A.5. The Agencies issued the nontraditional mortgage guidance
    on October 4, 2006. It applies to all federally regulated
    financial institutions as well as their subsidiaries and
    affiliates. We believe the guidance, together with improved
    consumer disclosure and close supervision, will stem overly
    risky lending practices at federally-regulated financial
    institutions. The Conference of State Bank Supervisors (CSBS),
    whose members regulate state-licensed mortgage companies,
    issued similar guidance, along with the American Association of
    Residential Mortgage Regulators (AARMR), to its members on
    November 13, 2006. Thus, guidance on nontraditional mortgage
    lending products has been issued and is applicable to both
    state- and federally-regulated mortgage originators. The
    effectiveness of the guidance, of course, will depend on the
    application of the guidance by all regulators. It is our hope
    that similar guidance issued by both federal and state
    regulatory authorities will be effective in curtailing overly
    risky lending by all mortgage lenders.
                                    ------

             RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                          FROM SCOTT ALBINSON

    Q.1. The importance of actual verification of the borrower's
    income, assets, and outstanding liabilities increases as the
    level of credit risk increases. When is reduced documentation
    underwriting appropriate, if at all? What mitigating factors
    should be in place?

    A.1. We do not feel that reduced documentation loans are
    appropriate for many borrowers, especially salaried individuals
    and those with easily documented incomes. Reduced documentation
    was originally used for self-employed borrowers and those with
    irregular incomes who find it difficult to provide three years
    of tax returns, financial statements, and other documents
    typically needed for fully documented loans. Lenders found that
    it was less time consuming and less expensive to underwrite
    loans with less documentation, relying primarily on a
    borrower's stated income, credit history and credit score, in
    addition to other risk factors, such as the loan-to-value
    ratio, loan purpose, and debt-to-income ratios. Some
    institutions also require minimal documents such as the
    borrower's most recent payroll statement.
        We are concerned that some borrowers may be pushed into
    reduced documentation loans because it is easier (and more
    lucrative) for brokers. And if reduced documentation loans will
    cost more than full documentation loans, borrowers should be
    informed of the difference and given the option to select which
    is best option for them.

    Q.2. How will the federal agencies implement this guidance in a
    consistent manner and how will you coordinate with your state
    counterparts?

    A.2. The guidance will be applied consistently among all the
    Federal financial institution supervisory agencies. In
    addition, CSBS and the AARMR have adopted similar guidance for
    the lenders their members supervise.

    Q.3. The proposed guidance strongly encourages institutions to
    increase monitoring and loss mitigation efforts (i.e.
    establishing portfolio limits, measuring portfolio volume and
    performance, providing comprehensive management information
    reporting). How do you respond to lenders who argue that such
    increases would restrict lender flexibility and reduce consumer
    choice? Will these increased efforts potentially drive up
    banks' underwriting costs, which will hurt consumers?

    A.3. These measures are typically required for most lenders
    based on the size, risk and complexity of their lending
    programs. Depending on how the loans are underwritten and
    structured, nontraditional loans could add an extra element of
    risk. Such risk management measures are necessary to allow
    institutions to identify, measure, monitor and control these
    additional risks.

    Q.4. The GAO found federally regulated institutions today
    already underwrite option ARMS at the fully indexed rate. That
    is good, but isn't it better to also consider the potential
    balance increase associated with the negative amortization
    feature? How many of the institutions are considering this in
    their underwriting?

    A.4. The Nontraditional Mortgage Guidance issued in October 4,
    2006 requires all institutions to underwrite option ARM loans
    based on the potential balance increase that could occur if the
    borrower chose only to make minimum payments during the option
    period. As such, all institutions should now be taking steps to
    implement this standard into their underwriting policies.

    Q.5. Should lenders be required to underwrite the borrowers'
    ability to repay the debt by final maturity at the fully
    indexed rate, assuming a fully amortizing repayment schedule?
    If not, why and what circumstances would circumvent them from
    doing so?

    A.5. Yes. This requirement is a longstanding OTS policy.

    Q.6. The GAO recommends improved consumer disclosure by
    requiring language with an effective format and visual
    presentation that explains key features and potential risks
    specific to nontraditional lending products. What else could be
    done to improve the clarity and comprehensiveness of
    nontraditional mortgage products to consumers?

    A.6. The OTS and the other federal banking agencies continue
    work on important consumer protection standards for lenders,
    advising institutions to provide information to consumers that:
    (1) aligns with actual product terms and payment structures;
    (2) covers risks areas (such as payment shock and negative
    amortization) and potential benefits (such as lower initial
    monthly payments) in a clear and balanced way; and (3) provides
    clear, balanced, and timely information to consumers at crucial
    decision making points.
        Beyond the interagency guidance, the agencies are working
    on providing additional direction on ways financial
    institutions can provide useful information about the benefits
    and risks of alternative mortgages. Regulation X requires all
    lenders to provide the Consumer Handbook on Adjustable Rate
    Mortgages (CHARM brochure), which is published by the Federal
    Reserve Board and OTS. The OTS is collaborating with the
    Federal Reserve Board to update the CHARM brochures, which
    should be issued shortly. The updated brochure will continue to
    inform consumers about ARMs, including issues such as negative
    amortization and payment shock, and it will provide additional
    information on specific types of alternative mortgages, such as
    payment option and interest-only ARMs designed to help
    consumers make informed choices.
        OTS is also working closely with all the federal bank
    regulatory agencies to develop a consumer publication focused
    on interest-only and option ARMs mortgages. This publication
    advises consumers on how these products work, the potential for
    large payment increases, and the impact of negative
    amortization. Additionally, we expect that the publication will
    provide consumers with a series of questions they can ask their
    lender to ensure that they clearly understand the terms of a
    mortgage loan product before agreeing to the mortgage.
        Together, these initiatives should improve consumer
    understanding of the risks and benefits nontraditional mortgage
    products.

    Q.7. Most recently issued nontraditional lending products do
    not reset until 3 to 5 years after origination and have not yet
    reached their reset period. The payment shock for option ARMS
    can be substantial if interest rates stay flat and much worse
    if rates increase. When underwriting, what interest rate
    scenarios are banks using: flat, rising, declining, or all
    combinations? How are the various rate scenarios described to
    consumers during both the origination and repayment phases?

    A.7. Institutions should underwrite adjustable-rate mortgages
    based on current interest rates. Regulation Z requires lenders
    to disclose interest rates and loan fees to borrowers based on
    current interest rate assumptions; however, disclosures inform
    borrowers of the adjustable rate nature of the loan, the index
    that adjustments will be based on, the margin above the index,
    and the historical performance of the index. Borrowers are also
    informed of any per year or maximum interest rate caps that
    apply.

    Q.8. What issues regarding nontraditional mortgage products
    have come up since your draft guidance was issued or do you
    believe have not been addressed by your guidance? What, if any,
    plans do you have to address these issues in the future?

    A.8. The guidance does not specifically address certain loans,
    such as 2-28 ARMs, which have a low interest rate for the first
    two years, then an adjustable market rate for the remaining 28
    years of the 30-year term. We are currently discussing this
    issue with the other federal banking agencies and are
    considering a range of supervisory responses appropriate to
    address this concern.
                                    ------

     RESPONSE TO WRITTEN QUESTIONS OF SENATORS ALLARD AND BUNNING
                         FROM FELECIA ROTELLINI

    Q.1. Mortgage brokers are playing a larger role in the market
    today. Recent statistics show that independent brokers are
    responsible for about 50 percent of all originations and over
    70 percent of subprime originations. Brokers definitely serve
    the overall market by helping consumers work with multiple
    lenders; however, they share little risk. Many brokers find it
    in their financial interest to get the borrower into a loan,
    regardless of whether the borrower can afford it. Are current
    laws and regulations strong enough to protect consumers and
    lenders? What can be done to better share risk and ensure
    brokers are not just looking out for their own interests?

    A.1. Regulation of the mortgage industry is rapidly evolving
    and improving. In addition to regulating banks, 49 states and
    D.C. currently provide regulatory oversight of the mortgage
    industry (Alaska has introduced legislation to license mortgage
    providers, and it is expected to pass in 2007). The Conference
    of State Bank Supervisors (CSBS) has been working in close
    coordination with the American Association of Residential
    Mortgage Regulators (AARMR) to improve state supervision. State
    supervision of the residential mortgage industry is evolving to
    keep pace with the rapid changes occurring in the market place.
    At present, state regulation is limited in its consistency.
    CSBS, however, is spearheading the effort to improve
    supervision to ensure that both consumers and lenders are
    protected.
        The federal financial agencies released guidance on
    September 29, 2006 that will help ensure that consumers better
    understand some of the nontraditional mortgage products that
    are in the marketplace today and help to curb some of the more
    abusive practices. CSBS and AARMR partnered together to issue
    parallel guidance on November 14, 2006. As of February 21, 26
    states and D.C. have adopted the guidance. All 50 states are
    expected to adopt the guidance in some form.
        Additionally, CSBS and AARMR have been working together
    over the past two years to develop a national Residential
    Mortgage Licensing System that will create uniformity in
    mortgage licensing across states and improve state regulators'
    ability to identify and track mortgage brokers, lenders, and
    individuals across states. In this effort, states are working
    together to be an effective gatekeeper on behalf of the
    mortgage brokerage industry and to counter the effects of
    currently inadequate private market controls. This effort will
    raise the professionalism in the mortgage brokerage industry
    and keep out those who wish to slip easily into the industry to
    harm consumers in the pursuit of short-term financial gain.
        Effective supervision, however, requires a coordinated
    effort among the federal financial agencies and the states. It
    is vital that the states are involved with coordinating policy,
    regulation and guidance. Therefore, the Regulatory Relief Bill
    which was recently signed into law is incredibly important,
    since it gave the states a vote on the FFIEC.
        Further, we believe a dialogue on suitability is worth
    having. For example, what does suitability mean in the mortgage
    industry? Currently, we do not have a policy position on this
    issue, but we believe further discussion among the industry and
    our fellow regulators would be beneficial.

    Q.2.  How much risk do you see from borrowers who have used
    these mortgages to speculate in the housing market? If these
    investments cease to be worthwhile because of a housing
    slowdown, are we going to see large numbers of defaults on
    these loans?

    A.2. The borrowers who have used nontraditional mortgage
    products as speculative tools have made an investment decision,
    which is different than a consumer making a housing decision.
    If there is a housing slowdown, I believe the market will
    adjust to ultimately correct this problem.

    Q.3. Are borrowers who have taken nontraditional mortgages in
    recent years using these products to buy bigger and better
    homes than they otherwise could afford or are they using these
    products simply to be able to get into the market? In other
    words, are the mortgages being used to finance basic needs or
    luxury desires?

    A.3. I think the products are being used for both purposes. In
    certain markets like D.C. where home prices are high, these
    products can legitimately be used to purchase a home.
    Certainly, some savvy and more knowledgeable consumers have
    used the nontraditional mortgage products to their advantage
    and have purchased larger homes. These consumers are aware of
    the inherent risks of nontraditional mortgage products, and
    have planned accordingly. A good portion of borrowers, however,
    have utilized nontraditional mortgage products to purchase
    their first homes, or homes that may be more expensive than
    they could afford with more traditional products.

    Q.4. In our last hearing, Mr. Brown from the FDIC suggested
    that we are unlikely to see a nationwide crisis in the housing
    market, because the housing boom is concentrated in certain
    regions, and historically most housing failures have happened
    in areas suffering from localized recessions. As we all know,
    there is increased risk of massive defaults on these loans in
    the coming years. Due to a nationwide trend of nontraditional
    mortgages being used as affordability products, would you
    disagree with Mr. Brown that upcoming housing problems will be
    isolated in certain regions?

    A.4. My fellow state supervisors and I are very concerned about
    the health and strength of the local economies of the
    communities we serve. A nationwide crisis in the housing market
    is a concern, of course, but my first priority is to the state
    of Arizona. I do not necessarily disagree with Mr. Brown
    regarding the possibility of a nationwide crisis, but my fellow
    supervisors and I are primarily concerned with localized
    recessions. It is the goal of CSBS to preserve the economic
    vigor of the local communities we serve. I believe we share
    that goal with every member of the Senate Committee on Banking,
    Housing, and Urban Affairs.

    Q.5. Again, I would like each of you to answer this question
    quickly: Will the proposed guidance in combination with an
    update of Regulation Z be enough to stop overly risky lending
    practices? Or is something stronger needed?

    A.5. The states recognize that something stronger than the
    guidance and an update of Reg. Z is needed. The interagency
    guidance and the parallel guidance developed by CSBS and AARMR
    and an update of Reg. Z are definitely steps in the right
    direction toward stopping risky lending practices, but more
    effective regulation of the mortgage industry is required.
    Industry licensing, effective supervision, examiner education,
    and improved disclosures are necessary to improve regulation.
        State supervision of the residential mortgage industry is
    evolving to keep pace with the rapid changes occurring in the
    market place. At present, state regulation is limited in its
    consistency. CSBS, however, is spearheading the effort to
    improve supervision to ensure that both consumers and lenders
    are protected.
        The parallel guidance released by CSBS and AARMR is one
    example of how the two organizations are working to improve
    supervision of the mortgage industry. As of January 25, 24
    states and D.C. have adopted the guidance. All 50 states are
    expected to adopt the guidance in some form.
        CSBS believes that the guidance, along with an update to
    Regulation Z, will be a major step towards protecting
    consumers. But these steps alone will only protect consumers if
    mortgage companies and loan officers abide by them. They will
    do nothing to stop those few bad actors who would knowingly
    ignore the guidance or Reg. Z or would intentionally manipulate
    consumers for financial gain. These bad actors require a
    mechanism that limits their entry to the industry, tracks them
    while they're in the industry, and when identified as a bad
    actor, kicks them out of the industry and informs the public of
    this action.
        For this reason, the CSBS/AARMR Residential Mortgage
    Licensing System is crucial if consumers and communities are
    going to be afforded the protections they deserve when
    financing a home. The System will create a more level playing
    field in applying for a license, will track state-licensed
    lenders over time and across states, and will allow consumers
    to check the license status of any company or individual in the
    system and research any actions taken against them.
        This kind of information is completely lacking in today's
    mortgage market. CSBS and AARMR are proud to be developing this
    project and providing state regulators and consumers with
    better information about the companies and individuals that
    finance one of the most important financial decisions families
    make. Such an effort ensures that those who decide to ignore
    the guidance or Reg. Z will have pay consequences that will
    stick with them for the rest of their corporate or professional
    life.
        CSBS also offers a Residential Mortgage Examiner School
    designed for inexperienced state personnel who are responsible
    for licensing, examining, and investigating state mortgage
    company licensees and three additional education programs to
    state regulatory personnel, including Basic Examiner Training
    School: Fundamentals of Mortgage Banking; Advanced Examiner
    Training School: Federal Regulation Update; and Fraud School.
    In addition, CSBS is developing a certification program for
    state personnel who perform examinations of state mortgage
    company licensees.
        Effective supervision, however, requires a coordinated
    effort among the federal financial agencies and the states. It
    is vital that the states are involved with coordinating policy,
    regulation and guidance. Therefore, the Regulatory Relief Bill
    which was recently signed into law is incredibly important,
    since it gave the states a vote on the FFIEC.

    Q.6. The importance of actual verification of the borrower's
    income, assets, and outstanding liabilities increases as the
    level of credit risk increases. When is reduced documentation
    underwriting appropriate, if at all? What mitigating factors
    should be in place?

    A.6. Historically, reduced verification was used for a certain
    type of specialized borrower. It should not be used as a method
    to evade underwriting standards for borrowers who may not
    otherwise qualify to own a home. Reduced documentation should
    be accepted only if there are mitigating factors, such as high
    credit scores, lower LTV and DTI ratios, significant liquid
    assets, mortgage insurance or other credit enhancements. Also,
    borrowers should be aware that they are very likely paying a
    higher rate for stated income loans and should consider if this
    higher rate is worth the cost.

    Q.7. How do you envision the federal agencies will implement
    their guidance in a consistent manner with their state
    counterparts?

    A.7. The CSBS-AARMR parallel guidance was developed to promote
    consistent supervision of the residential mortgage industry.
    Since the majority of mortgages are originated by state-
    regulated entities, it is of vital importance that the lenders
    originating mortgages are all held to the same supervisory
    standards. Effective supervision of the mortgage industry
    requires a coordinated effort among the federal agencies and
    the states. Therefore, we see recent legislation that made the
    states a voting member of the FFIEC as absolutely necessary to
    promote consistent, reasonable and effective supervision of all
    financial service providers.

    Q.8. The proposed guidance strongly encourages institutions to
    increase monitoring and loss mitigation efforts (i.e.,
    establishing portfolio limits, measuring portfolio volume and
    performance, providing comprehensive management information
    reporting). How do you respond to lenders who argue that such
    increases would restrict lender flexibility and reduce consumer
    choice? Will these increased efforts potentially drive up
    banks' underwriting costs, which will hurt consumers?

    A.8. The interagency guidance asserts sound lending principles
    that should be followed, not only to provide consumer
    protection, but for the institution's benefit, as well. The
    guidance does not negatively impact consumer choice but will
    help to educate the consumer so they can make more informed
    choices and understand the risks associated with nontraditional
    mortgage products. It also encourages lenders to utilize sound
    lending practices.

    Q.9. The GAO found federally-regulated institutions today
    already underwrite option ARMS at the fully-indexed rate. That
    is good, but isn't it better to also consider the potential
    balance increase associated with the negative amortization
    feature? How many of the institutions are considering this in
    their underwriting?

    A.9. I believe the guidance makes it clear the potential
    balance increases associated with negatively amortizing loans
    should be considered by lenders when underwriting a loan.
    Consumers must be fully aware of the characteristics of the
    product they are purchasing. The intent of the guidance is not
    to restrict consumer choice, but to ensure that lenders are
    providing information to consumers in a clear, concise manner
    and are utilizing sound underwriting principles.

    Q.10. Should lenders be required to underwrite the borrowers'
    ability to repay the debt by final maturity at the fully
    indexed rate, assuming a fully amortizing repayment schedule?
    If not, why and what circumstances would circumvent them from
    doing so?

    A.10. The guidance asserts that a lender should underwrite the
    borrower's ability to repay the debt by final maturity at the
    fully indexed rate. Ultimately, however, the consumer must have
    the ability to choose their product. In order to do so, it is
    vital that the lender provides the consumer with information
    they can utilize to make a decision that is beneficial for
    their unique situation.

    Q.11. The GAO recommends improved consumer disclosure by
    requiring language with an effective format and visual
    presentation that explains key features and potential risks
    specific to nontraditional lending products. What else could be
    done to improve the clarity and comprehensiveness of
    nontraditional mortgage products to consumers?

    A.11. At the same time the federal agencies released the final
    guidance, they published proposed illustrations of consumer
    information for nontraditional products. CSBS, AARMR and NACCA
    support the proposed illustrations and believe they are a good
    first step towards improved disclosures across the financial
    industry. If the illustrations are finalized, CSBS, AARMR and
    NACCA believe they will also be suitable for use by state-
    supervised mortgage providers, and will encourage states to
    adopt the illustrations for use by their licensed entities.
    This is consistent with our determination to provide uniform
    supervision of mortgage lenders industry wide. Ultimately,
    however, the states hope to work with the federal agencies to
    develop a new system of disclosures that provides clear, easy
    to understand information to consumers.

    Q.12. Most recently issued nontraditional lending products do
    not reset until 3 to 5 years after origination and have not yet
    reached their reset period. The payment shock for option ARMS
    can be substantial if interest rates stay flat and much worse
    if rates increase. When underwriting, what interest rate
    scenarios are banks using: flat, rising, declining, or all
    combinations? How are the various rate scenarios described to
    consumers during both the origination and repayment phases?

    A.12. Consumers must be fully informed of the characteristics
    of their mortgage. Therefore, disclosures must be beneficial
    and should provide information regarding the possibility of
    payment shock, which would be magnified by an increase in the
    interest rate.

    Q.13. What issues regarding nontraditional mortgage products
    have come up since your draft guidance was issued or do you
    believe have not been addressed by your guidance? What, if any,
    plans do you have to address these issues in the future?

    A.13. 2/28s and similar types of loans were not specifically
    named in the guidance, and have recently received a great
    amount of attention. The mortgage industry is constantly
    changing and releasing new products. Trying to provide guidance
    for specific product-types would be inadequate and quickly
    outdated. Therefore, we believe that the guidance discusses
    principles which may be applied to all consumer credit
    products, especially those products that may incur payment
    shock. It is our intent to work together with the federal
    agencies to issue a declaration of principles that would
    encourage institutions and mortgage providers to carefully
    underwrite and provide clear information to consumers on any
    loan that has certain characteristics.
                                    ------

     RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM WILLIAM
                                SIMPSON

    Q.1. In your written statement, you emphasize consumer
    education. Certainly that is an area for improvement. Before we
    seek the results of improved consumer education efforts, there
    will be a period when brokers will still be dealing with what
    many people have classified as an overwhelmed, confused
    borrower. Brokers share little of the risk that the borrowers
    or lenders assume. In fact, many have a financial interest in
    getting the borrower into a loan regardless of whether the
    borrower can afford it. Are current laws and regulations strong
    enough to protect consumers and lenders? What can be done to
    better share the risk and make sure brokers are not just
    looking out for their own best interests?

    A.1. The non-traditional mortgage guidance recently finalized
    by the banking agencies is an important step in addressing
    these concerns. However, as I noted during the hearing, it is
    important that state regulated institutions have similar
    standards applied to them. In this regard the state bank and
    mortgage lender supervisors announced this morning that they
    will take these needed steps. These efforts, if forcefully
    implemented by the respective regulators, should go a long way
    to protecting consumers.

    Q.2. Can you tell if borrowers who have taken non-traditional
    mortgages in recent years are using the mortgages more often to
    buy bigger and better homes that they otherwise could or are
    they simply using these products to be able to get into any
    housing?

    A.2. I have not seen any information breaking out these
    numbers. However, to an extent, these risky mortgages act to
    artificially stimulate the demand for housing, raising the
    price of housing for all home buyers regardless of whether or
    not they use a non-traditional mortgage. We know that in areas
    where house prices have been rising at very rapid rates at
    least some of the rapid price increases have been stimulated by
    greater demand from borrowers using these mortgages to qualify
    for larger loan amounts than they otherwise could afford. The
    problem arises when prices stop rising and the borrower is
    faced with higher mortgage costs resulting from the inherent
    risky nature of the non-traditional mortgage product.

    Q.3. How much risk do you see from borrowers who have used
    these mortgages to speculate in the housing market? Should
    these investments cease to be worthwhile because of a housing
    slowdown, are we going to see large numbers of defaults on
    these loans?

    A.3. Inevitably non-traditional mortgages pose risks to some
    borrowers when house prices stagnate or drop. When a borrower
    can no longer meet their mortgage payment because of
    readjustments built into the mortgage product itself--combined,
    perhaps, with personal hardship or loss of a job--then the
    market value of the house becomes a critical factor in
    determining whether a house sale or a mortgage default occurs.
    When the cost of keeping a mortgage becomes prohibitive to the
    borrower and the amount of the mortgage exceeds the market
    value of the house then mortgage defaults occur. To the extent
    that some high-risk non-traditional mortgages incorporate
    significantly higher interest rates or deferred payments for
    which a borrower may not be prepared means that these borrowers
    will be at risk of losing their homes and any home equity they
    may have accumulated over time.
                                    ------

              RESPONSE TO WRITTEN QUESTION OF SENATOR REED
                          FROM WILLIAM SIMPSON

    Q.1. In your comments to the proposed guidance, you indicated
    that additional enforcement mechanisms could be added to
    strengthen the guidance. What mechanisms would you recommend?

    A.1. First, as I noted in my testimony, I believe it important
    that state regulators quickly apply similar standards on state-
    regulated entities offering non-traditional mortgages to
    borrowers. The state bank and mortgage lender supervisors today
    released a similar guidance on non-traditional mortgages for
    the state institutions they regulate. Second, it is important
    that the bank and state regulators issue instructions to their
    examiners setting forth how the guidance should be enforced at
    the examiner level. Ambiguity exists in all government
    regulations and effective enforcement of the non-traditional
    mortgage guidance requires that bank and state examiners be
    given the necessary direction. Finally, I would hope that the
    banking agencies and state regulators effectively enforce the
    new guidance by bringing enforcement actions when a financial
    institution fails to comply with the details of the guidance as
    requested by its examiners.
                                    ------

     RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM MICHAEL
                                CALHOUN

    Q.1. In your written statement, you emphasize consumer
    education. Certainly that is an area for improvement. Before we
    see the results of improved consumer education efforts, there
    will be a period when brokers will still be dealing with what
    many people have classified as an overwhelmed, confused
    borrower. Brokers share little of the risk that the borrowers
    or lenders assume. In fact, many have a financial interest in
    getting the borrower into a loan regardless of whether the
    borrower can afford it. Are current laws and regulations strong
    enough to protect consumers and lenders? What can be done to
    better share the risk and make sure brokers are not just
    looking out for their own best interests?

    A.1. The Home Ownership and Equity Protection Act of 1994
    (HOEPA) was initially intended to address financial incentives
    that encourage lenders to put borrowers in home loans that they
    cannot afford and that strip equity from the home. In the
    twelve years since HOEPA was enacted, it has become clear that
    the law's application needs to be broadened and its provisions
    strengthened. Fortunately, HOEPA permits states to build upon
    minimum federal protections to tailor laws that suit the needs
    of their citizens. Those state laws have protected consumers
    while permitting the explosion in subprime lending that has
    occurred in recent years. HOEPA should be amended to adopt the
    measures that states have employed successfully. One of the
    most vital provisions, critical provisions, is a prohibition on
    loan flipping, or refinances that lack a reasonable, tangible
    net benefit to the borrower. Another critical element is a
    comprehensive definition of points and fees that includes the
    maximum prepayment penalty that the holder may charge a
    borrower and the yield spread premium--the amount the lender
    pays a broker in connection with an increase in the interest
    rate the borrower receives. In addition, new practices in the
    mortgage market require additional consumer protections in
    three key areas: (1) making it clear that mortgage
    professionals, including brokers, have a duty of good faith and
    fair dealing towards their customers; (2) requiring that loan
    originators ensure that a borrower is reasonably likely to be
    able to repay a loan as structured, without having to sell the
    home or refinance the loan; and (3) prohibiting brokers and
    lenders from steering borrowers into loans that are less
    advantageous than those for which the borrower qualifies.

    Q.2. Can you tell if borrowers who have taken non-traditional
    mortgages in recent years are using the mortgages more often to
    buy bigger and better homes than they otherwise could or are
    they simply using [these] products to be able to get into any
    housing?

    A.2. Housing affordability certainly is a concern nationwide.
    It is important to note, however, that much of the home loan
    market is a refinance market. In 2005, as many as 58% of
    securitized interest-only ARM originations were purchase loans,
    meaning 42% were refinance loans; 37% of securitized payment
    option ARMs were purchase loans, meaning 63% were refinance
    loans.\1\ Through the third quarter of 2006, 55.6% of
    securitized subprime originations were refinance loans.\2\
    Though we do not know what percentage of these refinance loans
    provided a borrower with a reasonable, tangible net benefit, we
    do know that inappropriate refinance loans threaten, rather
    than promote, homeownership.
    ---------------------------------------------------------------------------
        \1\ Gov't Accountability Office, Alternative Mortgage Products:
    Impact on Defaults Remain Unclear, but Disclosure of Risks to Borrowers
    Could Be Improved, GAO-06-1210, 11 (Sept. 2006) (citing David Liu,
    Credit Implications of Affordability Mortgages (UBS Mar. 3, 2006)).
        \2\ Inside Mortgage Finance Mortgage-Backed Securities Database
    (Oct. 27, 2006).
    ---------------------------------------------------------------------------
        Note that weak underwriting contributes to skyrocketing
    housing prices. Mortgage professionals distort home prices when
    they originate unsustainable loans with a higher principal
    amount than the borrower could qualify for using a 30-year
    fixed rate mortgage. As lenders comply with guidance on prudent
    underwriting of nontraditional mortgages and as the housing
    market ``corrects,'' borrowers may find that their homes are
    worth less than they owe on their home mortgage. This is
    especially the case for those consumers victimized by appraisal
    fraud. Unfortunately, the home loan market does not always
    operate at optimal efficiency. Reasonable regulation and
    oversight is necessary to ensure that consumers and the housing
    market as a whole are functioning appropriately.

    Q.3. The National Association of Mortgage Brokers has taken the
    stance that instead of limiting risk to consumers, regulators
    and lenders should better educate consumers about risk. To a
    certain degree, do you think that consumers have chosen not to
    educate themselves about these products focusing instead on
    that low initial payment?

    A.3. Certainly, the promise of low monthly payments is a key
    selling point for home loans. Still, CRL would not place blame
    for the proliferation of unsustainable or abusive loans at the
    feet of consumers. The Government Accountability Office (GAO)
    reported recently that the ``alternative mortgage product''
    disclosures it 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.\3\
    ---------------------------------------------------------------------------
        \3\ Id. at 21.

        Furthermore, the GAO also has reported that its ``review of
    literature and interviews with consumer and federal officials
    suggest that while tools such as consumer education, mortgage
    counseling, and disclosures are useful, they may be of limited
    effectiveness in reducing predatory lending.'' \4\
    ---------------------------------------------------------------------------
        \4\ Government Accountability Office, Consumer Protection: Federal
    and State Agencies Face Challenges in Combating Predatory Lending, GAO-
    04-280 at 6 (2004).
    ---------------------------------------------------------------------------
        CRL is pleased that the staff of the Board of Governors of
    the Federal Reserve System is working to revise Regulation Z's
    disclosure requirements to better inform consumers about
    products they are offered. In the meantime, however, loan
    originators should act responsibly and fairly by clearly
    informing borrowers about the costs and benefits of the various
    loans available to them. Furthermore, loan originators should
    give borrowers loans that are appropriate given their goals,
    credit history, and other relevant characteristics.
        Consumers should be able to trust mortgage professionals to
    direct them to suitable loans. A consumer could read constantly
    and continuously without knowing all relevant information about
    the new products that financial institutions develop. Mortgage
    professionals themselves have trouble keeping up with the
    tremendous variety of products available on the market. Many
    such professionals learn to deal with a select few products--
    sometimes those that are most personally lucrative rather than
    most appropriate for a borrower--and deal only with those
    products. If we do not expect loan originators to know the
    intricacies of all available products, how can we expect more
    of consumers? Furthermore, loan officers and mortgage brokers
    use rate sheets to which the consumer lacks access, creating an
    information imbalance that leaves consumers at a disadvantage.
        Also, a consumer who receives a solicitation for a loan
    rather than seeking a loan is less likely to have prepared for
    a loan transaction. Understandably, since the consumer did not
    initiate a search for a loan, he or she may rely unduly on the
    representations of the party marketing a product or products.
    Push-marketing is particularly common with refinance loans.
    Data collected pursuant to the Home Mortgage Disclosure Act
    showed that 53.6% of reported conventional first lien home
    loans originated in 2005 were refinance loans, compared to
    42.6% home purchase loans and 3.9% home improvement loans.\5\
    Refinancing abuses hurt not only borrowers but also responsible
    lenders who see their borrowers refinance into riskier loans
    with worse terms based on misrepresentations by untrustworthy
    lenders. It is important for consumers to have a general
    understanding of home loans; it is critical for mortgage
    professionals to use their knowledge to assist borrowers rather
    than mislead them.
    ---------------------------------------------------------------------------
        \5\ Calculated based on data provided in Glenn Canner et al.,
    Higher-Priced Home Lending and the 2005 HMDA Data, Federal Reserve
    Bulletin at A135, tbl. 4 (2006) (Fed Bulletin).

    Q.4. In our last hearing, Mr. Brown from the FDIC suggested
    that we are unlikely to see a nationwide crisis in the housing
    market because the housing boom is concentrated in certain
    regions, and historically most housing failures have happened
    in areas suffering from localized recessions. As we all know,
    there is increased risk of massive defaults on these loans in
    coming years. Due to a nationwide trend of nontraditional
    mortgages being used as affordability products, would you
    disagree with Mr. Brown that upcoming housing problems will be
    ---------------------------------------------------------------------------
    isolated in certain regions?

    A.4. The FDIC recently reported that five out of six Regional
    Risk Committees expressed concern that slowing housing
    appreciation would impact future performance of prime
    residential loans.\6\ With respect to subprime home loans, the
    FDIC's recent report stated the following:
    ---------------------------------------------------------------------------
        \6\ Economic Conditions and Emerging Risks in Banking: Report to
    the FDIC Board of Directors (FDIC, Nov. 2, 2006) (FDIC Risk Report) at
    6, available at http://www.fdic.gov/news/board/nov062memo.pdf.

            There are emerging signs of potential credit distress among
            holders of subprime adjustable-rate mortgages (ARMs).
            Nationwide, foreclosures started on subprime ARMs made up 2.0
            percent of loans in the second quarter, up from 1.3% in mid-
            2004. Subprime ARMs are experiencing stress in states as
            diverse as California, which has had rapid home price gains and
            solid economic performance, and Michigan, where house prices
            have been stagnant and the economy is weaker. This suggests
            that national factors, like interest rate increases, are
            important factors behind subprime mortgage credit stress, in
            addition to local economic or housing market conditions.\7\
    ---------------------------------------------------------------------------
        \7\ FDIC Risk Report at 6.

        The report also noted that households' high-leverage
    mortgages and use of nontraditional mortgage products could
    amplify the effects of a housing slowdown.\8\
    ---------------------------------------------------------------------------
        \8\ FDIC Risk Report at 2.
    ---------------------------------------------------------------------------
        In areas with housing appreciation, it may be possible for
    families with unaffordable loans to refinance if they have
    sufficient equity in their home. Such refinances are not
    costless, however; any prepayment penalties to exit one loan
    and points and fees paid to obtain a new loan are paid either
    out of borrowers' cash or their home equity. In areas with
    little or no appreciation in housing values, CRL expects that
    distressed borrowers will be less able to refinance and more
    likely to enter foreclosure.

    Q.5. You both share a gloomy view of what is going to happen to
    many borrowers. Are the changes in the marketplace,
    particularly the rise of brokers and non-traditional mortgages,
    here to stay, and should we be worried about that?

    A.5. We need not worry not about brokers and nontraditional
    loans per se, but rather about brokers who do not deal fairly
    with borrowers and with mortgage professionals who originate
    loans--traditional or nontraditional--even though a borrower
    cannot repay the loan as structured.
        The recently issued Interagency Guidance on Nontraditional
    Mortgage Product Risks directed institutions to avoid loan
    terms and underwriting practices that could heighten the need
    for a borrower to sell or refinance a loan when payments
    increase. The Conference of State Bank Supervisors and the
    American Association of Residential Mortgage Regulators issued
    similar guidance as a model for state banking regulators.
    Without stifling innovation or preventing borrowers from
    obtaining nontraditional mortgages, banking regulators
    highlighted commonsense, prudent lending practices that are
    critical to the sustained viability of the home loan industry.
    Both safety and soundness and consumer protection
    considerations demand that mortgage professionals act in
    accordance with the level of trust that consumers and
    regulators place in them. Mortgage brokers who care more about
    commissions than about a loan's sustainability and those
    lenders who turn a blind eye to--or promote--abuses by brokers
    share blame for the loss of home equity or of a home itself
    that borrowers with an unaffordable loan experience.
        It is likely that subprime borrowers will experience the
    greatest losses from unsustainable loans. Adjustable rate
    mortgages whose rates are fixed for 2 or 3 years dominate the
    subprime market. Those who originate these loans generally
    underwrite loans to an interest rate far below the actual rate
    a borrower reasonably can expect to pay when the interest rate
    adjusts. Weak underwriting and a loan structure normally
    inappropriate for troubled borrowers thus add an unnecessary
    layer of risk to these borrowers' loans. CRL urges regulators
    to require brokers and lenders to originate subprime loans that
    are sustainable and suitable for the borrower's purposes. Such
    a requirement would lead to the origination of far fewer
    subprime 2/28 and 3/37 adjustable rate mortgages.
                                    ------

             RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                          FROM MICHAEL CALHOUN

    Q.1. Please comment on the assertion made during testimony at
    the hearing that interest only and option ARMs do not
    constitute greater risk for consumers than other mortgage
    products.

    A.1. As the federal agencies noted in their recent guidance on
    nontraditional mortgages, interest-only and option ARMs pose
    ``concerns from a risk management and consumer protection
    standpoint.'' The initial low monthly payment associated with
    these loans means that once the loan adjusts, the borrower can
    face significant payment shock. Additionally, the lack of
    principal amortization as well as the potential for negative
    amortization means that borrowers fail to build equity in their
    home. Taken together, these products present significant risk
    for borrowers in a slowing housing market, where a lack of
    equity will mean that borrowers cannot refinance in the face of
    payment increases. Of course, many of these risks exist with
    adjustable-rate mortgages that are not structured to allow
    deferment of principal or interest payments. Particularly risky
    are subprime 2/28 and 3/27 hybrid ARMs that are underwritten
    using weak standards that jeopardize subprime borrowers'
    ability to sustain homeownership and its benefits.

    Q.2. What approximate percentage of nontraditional loan
    products are underwritten to the value of the home, rather than
    to the borrower's ability to repay? Is this practice restricted
    to the subprime market?

    A.2. Current underwriting for nontraditional mortgages often is
    based on the value of the home, rather than the borrower's
    ability to repay the mortgage when payment increases occur.
    This presents serious risks, especially in a stagnant or
    declining real estate market, when home resale proceeds may not
    be sufficient to pay off the loan. Of even more concern is the
    fact that the majority of subprime lenders making ARM and/or
    interest-only loans underwrite only to the initial rate and not
    to the fully indexed and/or fully amortizing rate. Lenders who
    make these exploding ARMs often do not consider whether the
    borrower will be able to pay when the loan's interest rate
    resets, setting the borrower up for failure. Subprime lenders'
    public disclosures indicate that they are qualifying borrowers
    at or near the initial start rate, even when it is clear from
    the terms of the loan that the interest rate, and therefore the
    monthly payment, will rise significantly. For example, a recent
    prospectus shows that a large subprime lender, Option One,
    underwrites to the lesser of the fully indexed rate or one
    percentage point over the start rate.\9\ For a loan with a
    typical 2/28 structure, the latter would always apply. This
    practice means that at the end of the introductory teaser rate
    on an ARM, borrowers face a shocking increase in costs, even if
    interest rates remain constant.
    ---------------------------------------------------------------------------
        \9\ Option One Prospectus, Option One MTG LN TR ASSET BK SER 2005 2
    424B5, S.E.C. Filing 05794712 at S-50 (May 3, 2005).

    Q.3. Approximately 15 percent of borrowers with interest-only
    and option ARMs earn less than $48,000. How do you expect the
    borrowers with lower incomes to be affected by the resets we
    ---------------------------------------------------------------------------
    expect to see over the next several years?

    A.3. Generally, low-income homeowners are less able to
    withstand increases in home loan payments. Even if the debt-to-
    income ratio is the same in a loan to a higher-income borrower
    and a loan to a lower-income borrower, high debt-to-income
    ratios may leave the lower-income borrower with insufficient
    residual income to pay for basic necessities. Furthermore,
    according to 2005 Home Mortgage Disclosure Act data, lower
    income borrowers were more likely than other borrowers to have
    high-cost loans.\10\ A Federal Reserve study found that 40% of
    borrowers with income less than $50,000 did not know the per-
    period caps for the interest rate changes on their ARMs and 53%
    did not know the lifetime cap.\11\ Low-income borrowers
    therefore may be more surprised by sharp payment increases.
    ---------------------------------------------------------------------------
        \10\ Fed Bulletin at A156.
        \11\ Brian Bucks & Karen Pence, Do Homeowners Know Their House
    Values and Mortgage Terms? (Federal Reserve Board of Governors Jan.
    2006) at 36 tbl. 5.
    ---------------------------------------------------------------------------
        The Consumer Federation of America has noted that ``the
    homeowners who will be most severely hurt by any downturn in
    the housing market are the nontraditional borrowers who have
    purchased the most recently with the least equity in their
    homes.'' \12\ Presumably, lower-income borrowers who have taken
    advantage of programs that allow lower down payments and higher
    loan-to-value ratios will have less equity to use to pay the
    costs of refinance or of real estate commissions and other
    costs associated with home sales. If housing values decline,
    low-income and higher-income homeowners may find that their
    homes are worth less than they owe. A study commissioned by the
    U.S. Department of Housing and Urban Development found a high
    likelihood that low-income families would return to renting
    after owning a home.\13\ Given those findings, the authors
    concluded that ``policies designed to ensure that once
    households achieve homeownership, they remain homeowners
    (rather than reverting to rental tenure), and policies that
    enable families to transition to higher valued owned units over
    time will increase substantially their potential housing wealth
    accumulation.'' The study focused on data gathered before the
    proliferation of nontraditional mortgage products and the
    increased use of ARMs in the subprime market. Homeownership
    remains just as important as before, but as the use of
    adjustable rate mortgages and nontraditional mortgage products
    increases, homeowners bear more of the risks associated with
    home loans.
    ---------------------------------------------------------------------------
        \12\ Allen Fishbein & Patrick Woodall, Exotic or Toxic? An
    Examination of the Non-Traditional Mortgage Market for Consumers and
    Lenders 28-29 (May 2006).
        \13\ Thomas P. Boehm & Alan Schlottmann, Wealth Accumulation and
    Homeownership: Evidence for Low-Income Households 33 (U.S. Dept. of
    Housing and Urban Development Dec. 2004).

    Q.4. What can Congress potentially do to protect consumers who
    ---------------------------------------------------------------------------
    may be unable to make their payments, refinance or sell?

    A.4. Congress should require all lenders and mortgage brokers
    to adhere to the principle of the Interagency Guidance on
    Nontraditional Mortgage Product Risks--that borrowers be
    provided loans they can reasonably repay over the life of the
    loan without having to refinance or sell the house.
        Second, Congress can ensure that any federal predatory
    lending law retains the assignee liability provisions of HOEPA.
    In 2005, almost 70% of HMDA-reported home loans originated were
    sold on the secondary market.\14\ Assignee liability entitles
    victimized borrowers to recourse even if the original lender
    has sold the loan to another party. Without assignee liability,
    borrowers who were abused would not be able to defend against
    foreclosure.
    ---------------------------------------------------------------------------
        \14\ Fed Bulletin at A139. The bulletin notes that HMDA data tends
    to understate secondary market sales, in part because some sales will
    occur in years subsequent to the reporting year.
    ---------------------------------------------------------------------------
        Congress can also develop incentives that encourage lenders
    to provide loan modifications to borrowers who have received
    loans with significant payment shock, in lieu of foreclosing on
    or refinancing such loans. In conjunction with such incentives,
    it would be helpful to ensure that servicers do not impose
    unfair costs on borrowers when providing workout options.
        In addition, Congress could create a homeowner assistance
    program to assist borrowers who cannot repay their loans.
    Pennsylvania has implemented a successful program to help
    borrowers who are facing foreclosure through no fault of their
    own. The commonwealth's Homeowners' Emergency Mortgage
    Assistance Program (HEMAP) provides loans to borrowers who show
    a reasonable prospect of being able to resume full mortgage
    payments. The program is funded through a small fee on all
    residential mortgage loans. Assistance is available for 24
    months or until a certain dollar cap is reached, whichever
    comes first. Congress could develop a program similar to the
    Pennsylvania HEMAP program to assist borrowers in need.

    Q.5. What has been the effect of the recent changes in the
    bankruptcy laws on a consumer's ability to pay their reset
    mortgage payments?

    A.5. According to a recent survey of members of the National
    Association of Consumer Bankruptcy Attorneys, the new
    bankruptcy provisions have increased the costs and paperwork
    required to file for bankruptcy without resulting in
    significant increases in the number of filers put into Chapter
    13 repayment plans.\15\ The creation of additional barriers to
    bankruptcy may push desperate people to deal with unscrupulous
    parties, such as those who perpetuate ``foreclosure rescue''
    scams or lenders who refinance borrowers into less advantageous
    loans. In addition, the new law makes it much harder for
    families to use their limited resources to keep their mortgage
    current. Instead, credit cards and other unsecured debt require
    much of the families' income. To date, however, we have not
    formally studied a link between the 2005 bankruptcy amendments
    and an increase in abuses of homeowners in dire straits.
    ---------------------------------------------------------------------------
        \15\ Press Release, National Association of Consumer Bankruptcy
    Attorneys, Survey: Bankruptcy Filings on the Rise Again, Likely to
    Return to Pre-2005 Law Levels During Next Year (Oct. 4, 2006),
    available at http://nacba.com/files/main_page/
    100406NACBAsurveynewsrelease.doc.
    ---------------------------------------------------------------------------
        Even prior to the 2005 amendments, the Bankruptcy Code gave
    home mortgage lenders special treatment. Though bankrupt
    debtors have the right to modification of many secured claims,
    with some exceptions, they do not have a right to modification
    if the claim is secured by an interest in the debtor's
    principal residence. Congress intended for the home mortgage
    preference to promote constructive, not destructive lending.
    Home mortgage lenders who abuse consumers should not be given
    preferential treatment over responsible non-mortgage lenders
    when their victims are pushed into bankruptcy.

    Q.6. Regarding non-traditional mortgage products, what issues
    do you believe have not been addressed in the proposed
    Guidance?

    A.6. Now final, the nontraditional guidance represents a clear
    statement of prudent lending practices for home mortgages that
    permit deferment of principal or interest. However, borrowers
    with fully-amortizing ARMs, such as subprime 2/28 ARMs (fixed
    rate for 2 years and adjustable thereafter) and 3/27 ARMs
    (fixed for 3 years and adjustable thereafter), also can
    experience payment shock that leaves them unable to repay the
    loan. Likewise, subprime borrowers are vulnerable to risk
    layering through such practices as reduced documentation
    requirements. We urge the federal financial institution
    regulators to clarify the application of the underwriting
    standards set forth in the nontraditional mortgage guidance to
    subprime ``exploding'' ARMs such as 2/28s and 3/27s.
        In addition, we note that, in contrast to common practice
    in the prime market, in the subprime market, loan originators
    tend not to provide for escrow of payments for property taxes
    and insurance. Excluding the cost of property taxes and hazard
    insurance from estimates of monthly payments misleadingly
    lowers the monthly payments such lenders quote. This trick may
    enable a loan originator to close a deal, but will leave
    borrowers who have not saved enough money to cover those costs
    with no option but to refinance or sell their home. Refinancing
    can cost homeowners valuable home equity, increasing the loan-
    to-value ratio on subsequent loans and thus increasing the
    interest rate, or even leaving borrowers unable to refinance.
    Frequent housing turnover destabilizes communities and
    increases opportunities for appraisal fraud.

                  Additional Material Submitted for the Record

     FORECLOSING ON THE AMERICAN DREAM / Part of an occasional series / No
                         money down: a high-risk gamble
                   The Denver Post, Sunday, September 17, 2006
       By Greg Griffin, David Olinger and Jeffrey A. Roberts, Denver Post
                                 Staff Writers

        Monique Armijo expects to give birth to her fourth child, a girl,
    next month. She also expects to lose the house her family moved into
    just last year at an October foreclosure sale in Jefferson County.
        She cannot bear to tell her three children, two 7-year-old boys and
    a 5-year-old girl, about the auction.
        ``When we moved in, I told them, `We're never going to move again;
    this is where we'll stay,' '' she said. ``I love this neighborhood.''
        Monique and her husband, Anthony, are among the many Colorado
    residents who managed to acquire a house without a down payment, only
    to see it foreclosed on a year or two later.
        Anthony, an independent carpet installer, met a real estate agent
    who assured the couple that shaky credit and lack of cash for a down
    payment were no longer barriers to homeownership. They ended up signing
    a loan that required them to pay off a $44,000 second mortgage in 14
    months.
        Once rare in the mortgage industry, nothing-down loans have become
    wildly popular in Colorado, where home prices rose rapidly during the
    late 1990s. And according to a computer-assisted Denver Post analysis,
    they are a leading cause of the state's foreclosure epidemic.
        The Post examined nearly 1,000 foreclosures--every notice filed in
    August in three Colorado counties racked by troubled mortgages.
        In Adams, Arapahoe and Jefferson counties, more than half of all
    foreclosures on home purchases involved no-down-payment loans.
    Excluding federally insured loans that require a small down payment,
    no-money-down loans accounted for more than 70 percent.
    ``Exotics'' go mainstream
        Nothing-down loans lead the list of higher-risk, alternative
    mortgages that many Coloradans are substituting for traditional 30-year
    fixed loans with at least 10 percent down. Buyers often compound their
    risk by combining 100 percent financing packages with interest-only
    loans, adjustable-rate loans that allow the borrower's debt to grow
    rather than decline and loans that require no proof of income.
        These loans, known among lenders as ``exotics,'' have moved from
    the fringes of the mortgage industry to the mainstream and now account
    for more than a third of all loans.
        The growth has fulfilled a desire of lenders, borrowers and
    regulators alike to make homeownership accessible to more people. But
    the risks--some have relatively high monthly payments, while others
    start low and adjust rapidly upward--are more than many homeowners can
    manage.
        In interviews with dozens of homeowners in foreclosure, The Post
    found that life events such as job loss, medical problems and divorce
    often precipitate a default. But lack of equity, which gives homeowners
    options when they face financial problems, was a factor in nearly all
    cases.
        For the past six months, Colorado has had the highest foreclosure
    rate in the nation, according to RealtyTrac, a California firm that
    tracks foreclosures. Repossession proceedings were underway for one of
    every 158 Colorado homes during the second quarter.
        It's no coincidence that Colorado homeowners have less equity in
    their properties, on a percentage basis, than nearly any other state--
    the result of a number of factors including the popularity of 100
    percent financing.
        ``The bottom line is, people in Colorado are borrowing too much
    money on their homes,'' said Stuart Feldstein, president of SMR
    Research Corp., which tracks lending-industry trends.
        Aggressive lending practices and poor consumer education also play
    a role, consumer advocates say.
        ``Seventy percent of the people who come in here got the wrong
    loan,'' said Zachary Urban, a counselor with Denver-based Brothers
    Redevelopment Inc., which helps people keep their homes.
        Lenders say they're simply meeting customer demand for less
    restrictive loans.
        ``There are very few people who have 5 or 10 or 20 percent cash to
    put down. Or if they do, who want to,'' said Colorado Mortgage Lenders
    Association president Chris Holbert. ``If you want 100 percent
    financing, and you qualify, can they turn you down because it's not a
    good idea?''
    Many left second-guessing
        Jose Garcia and Maria Vanderhorst put no money down in October when
    they bought a $200,000 patio home in a quiet central Aurora
    neighborhood.
        Now fighting for their home as a foreclosure auction looms, the
    couple questions that decision.
        ``I had money to put down, but they came out with the idea of no
    money down. I did some research, and it looked good,'' Garcia said.
    ``Maybe it wasn't the smartest decision.''
        Garcia and Vanderhorst, who immigrated to Colorado from the
    Dominican Republic in 2003, obtained what's called an ``80-20''
    mortgage package.
        One loan covered 80 percent of the purchase price, and the other
    covered 20 percent. The second loan carried a 9.7 percent interest
    rate--high, but not unusual for a second loan--and a monthly payment of
    $340, bringing the total to nearly $1,500.
        The couple, who have three children--13, 11 and 5--used their
    savings to finish their basement and send money to their parents.
        But Garcia, a car salesman, took a big pay cut in March when his
    dealership was bought out by a competitor. The family also didn't
    receive an expected tax refund and faced some unexpected medical bills.
        Behind on their payments, they received a foreclosure notice from
    their bank in June.
        Garcia negotiated a deal with the current mortgage holder,
    Countrywide Home Loans, giving him eight months to pay the $7,000 he
    owes, including a $2,200 foreclosure fee.
        With some belt-tightening, he thinks the family can keep the house.
        ``When we went into foreclosure, it was like someone taking my
    dreams away,'' Garcia said. ``There was no way I was going to lose my
    house. It's about pride.''
        The future is bleaker for Monique and Anthony Armijo. Their two
    loans came with a high interest rate and some unusual terms.
        Spectrum Funding, a Utah-based lender, supplied the $176,000 first
    mortgage toward the $220,000 purchase of a middle-class home in Arvada.
    Ad Two Inc., the company selling the house, provided the $44,000 second
    mortgage.
        The first started at 9.67 percent--more than $1,400 a month in
    interest alone--and can jump 3 percent after two years. The second let
    the Armijos pay just $100 a month for a year--but required them to pay
    the entire balance in January 2007. They could refinance that loan but
    faced a $20,000 penalty if they didn't use a particular broker.
        The Armijos' sole source of income: about $30,000 a year from
    Anthony's carpet work. Within months, they were behind on the first
    mortgage.
        Ad Two Inc. is an independent franchise of HomeVestors, which buys,
    repairs and resells houses. Terri Gallmeier, Ad Two's president, said
    the Armijos' real estate agent asked her to carry a second mortgage
    that could be refinanced a year later.
        ``I had nothing to do with the loan,'' she said, ``and I wasn't
    privy to all the financial information'' about the buyers.
        The foreclosure notice that came to the Armijos' home was followed
    by a flood of mail from people offering everything from counseling to
    taking the house off their hands. Monique called one, Doug Ravdin, who
    explained the terms of their two home mortgage loans.
        ``He told me, `You're going to be in debt for the rest of your life
    if you stay in that property.' He was like, 'The best thing for you
    guys to do is get out of the house.' ''
        She thanked him, hung up and wept.
        ``We run into this all the time,'' Ravdin said. The Armijos bought
    a fix-and-flip house and ``got loaded into it horribly, I mean
    horribly.'' Housing counselors say borrowers need to be very careful
    when choosing a loan and to read the papers before signing.
        ``If it sounds too good to be true, then it probably is,'' said
    Donald May, executive director of the Adams County Housing Authority.
    ``The buyer has to be a lot more sophisticated and educated with all
    the mortgages available today.''
    Loans' door wide open
        More choice and lower lending standards have made it easier than
    ever to buy a home, but has the trend gone too far?
        The jury is still out. The U.S. rate of homeownership--the
    percentage of homes occupied by the owner--was 68.9 percent last year,
    up from 63.9 percent two decades ago, according to the Federal Deposit
    Insurance Corp.
        But foreclosures rose 39 percent from January to July compared with
    the same period of 2005, RealtyTrac reports.
        Beginning in the early 1980s, regulators allowed banks to sell
    their loans and offer homebuyers variable interest rates, stimulating
    capital investment and consumer demand.
        Securitization of mortgages helped lenders get the riskiest loans
    off their books. Investors were shielded because those mortgages were
    typically held in diversified loan portfolios.
        High-risk loans such as option-ARMs, in which payments on principal
    and some interest can be deferred, were introduced by savings-and-loan
    associations in the 1980s to serve high-income borrowers. Only recently
    have they spread to less creditworthy consumers.
        Since 2003, the height of the refinancing boom, competition has
    stiffened among lenders fighting for a declining number of loans.
        Mainstream lenders and mortgage brokers say they've had to offer
    all of the alternative loans, at competitive terms, or risk losing
    business.
        ``If we don't do it, they will go down the street,'' said mortgage
    broker Mike Thomas of Hyperion Capital Group in Aurora.
        Loans without down payments have been around for a long time, but
    they've taken off in the past three years.
        In 2005, 43 percent of first-time homebuyers surveyed by the
    National Association of Realtors said they put no money down. Before
    last year, the group had never tracked that category.
        A common choice is the 80-20 because it allows buyers to avoid the
    costly mortgage insurance typically required when they put down less
    than 20 percent.Standard & Poor's reported in July that 80-20s and
    other two-loan packages known as ``piggybacks'' are up to 50 percent
    more likely to go into default than comparable one-loan transactions.
        In Adams, Denver and Arapahoe counties, piggybacks were used in
    more than 50 percent of home purchases in the second quarter of 2006,
    well above the national average of less than 40 percent, according to
    Hackettstown, N.J.-based SMR Research.
        As state housing prices doubled in the 1990s, homebuyers saw less
    need to invest their own money, said Holbert of the Colorado Mortgage
    Lenders Association. Equity accrued automatically.
        Now, if homeowners put no money down and prices remain stagnant,
    ``what other option than foreclosure do they have if their income drops
    and they can't make their payments?'' Holbert said.
    ``The place was a mess''
        Mark Williford says his house in Northglenn was unsafe from the day
    he moved in. Yet he managed to borrow more than 100 percent of the sale
    price in 2003 from a bank that threw in $33,000 for renovations and
    accepted his shaky finances.
        Williford's only steady source of income: permanent disability
    checks from a 1993 neck injury. His mortgage was co-signed by a
    girlfriend he had never lived with before, and their loan application
    counted $809 a month in tips from her casino job as household income.
        ``Somehow we pulled it off,'' said Williford, a 47-year-old
    disabled plumber who obtained a $161,000 loan from Wells Fargo Home
    Mortgage Inc. on a house Northglenn later tagged as uninhabitable.
        The city responded to a 2005 engineering report that a second-floor
    addition rests on decorative metal columns and its windows could
    shatter and fall out.When Williford and his girlfriend split up months
    after moving in, his mortgage payments exceeded his total income. In
    October he lost his first home.
        ``I bought a condemned house, which is all I could afford,'' he
    said. ``I was trying to save my house, my mortgage, my self-worth.''
        A mortgage expert said the bank should have known better.
        ``Bottom line, Wells Fargo should never have made the loan. The
    borrowers did not have the provable income and the property was
    unsafe,'' said Jim Spray, a consumer-oriented mortgage broker Williford
    called for help.
        Dick Yoswa, the Wells Fargo loan officer, remembers ``the place was
    a mess'' when Williford bought it. ``It was a borderline case,'' he
    said.
        But Williford's disability income and his girlfriend's casino job
    were verifiable, a contractor estimated the house could be repaired for
    $33,000, and the appraiser sounded no alarms, Yoswa said.
        ``From the information we received from everyone, we closed the
    loan,'' he said.
        Today, Williford lives in a tiny portable trailer with a
    refrigerator, stove, bunkbed and a flat-screen TV he squeezed in after
    dismantling the door. ``It could be worse. I'm just grateful that I
    have this,'' he said.
    Option-ARMs next wave?
        Though 100 percent financing is involved in many Colorado
    foreclosures, the next wave of defaults may come from option-ARMs,
    experts say. Troubling stories about these loans are mounting.
        Louis and India Harts of east Park Hill refinanced last year into a
    loan they thought was a 30-year fixed-rate mortgage.
        But instead of a 30-year fixed, the couple in their 80s got an
    option-ARM with a low teaser rate of 2.6 percent that quickly shot up.
    They're making a minimal monthly payment of $919 on the $180,000 loan,
    but that doesn't even cover the interest. Since March 2005, the
    principal has grown to more than $183,000.
        The interest rate is now 8.1 percent, and according to their loan
    documents, can go as high as 9.95 percent.
        When the principal hits 115 percent of the original loan in a few
    years, the bank will force them to begin paying it off.
        ``I don't know how we're going to do it,'' said Louis, a retired
    worker for Public Service Co. of Colorado.
        The loan has a ``prepayment penalty'' clause, making it difficult
    to sell or refinance during the first three years. When they called the
    lender, Countrywide Home Loans, they learned it would cost $11,000 to
    get out of the loan.
        The Hartses blame their mortgage broker, Team Lending Concepts in
    Greenwood Village, for putting them into a loan they didn't
    understand--though they admit they signed papers spelling out the
    terms.
        Team Lending president Jeff Lowrey said the loan was the best
    option for the Hartses because it guarantees a low payment for four to
    five years until they refinance again.
        ``That type of minimum-payment option definitely helps those kinds
    of people,'' Lowrey said. ``We minimized their payment so they could
    afford things like medical expenses and gas.''
        Team Lending collected $3,900 in fees at closing and $4,200 more
    from the mortgage company for originating the loan. Lowrey said the
    fees are within the permissible range for such loans.
        Option-ARMs and other adjustable-rate mortgages could fuel a surge
    in foreclosures in the next few years as adjustable rates begin moving
    up on billions of dollars in loans, consumer advocates and public
    officials warn.
        ``We are just starting to hear about ARMs,'' said Adams County
    trustee Jeannie Reeser. ``That is what is going to drive foreclosures
    next year.''

    Staff writer Aldo Svaldi contributed to this report.

    Staff writer Greg Griffin can be reached at 303-954-1241 or
    ggriffin@denverpost.com.
                                     ______

    In trouble? Here's what to do
        Foreclosure can cost you your home and your credit. Here's what to
    do if you're in financial trouble or have received a foreclosure
    notice.
    Act quickly
        Lenders usually are willing to help you devise a plan to keep your
    home. They may agree to a reduced or delayed payment schedule. Call as
    soon as you can. The further behind you are, the less your lender can
    help.
    Get help
        Housing counseling agencies approved by the Department of Housing
    and Urban Development can help you assess your financial situation and
    help you negotiate with your lender. Call HUD at 800-569-4287 to find
    counseling agencies near you.
    Consider your options
        If you simply can't afford to keep your home, your lender may give
    you the time to sell it, even if the sales price is below what you owe.
    Beware of scams
        Homeowners in foreclosure are often targets of fraud. ``Equity
    skimming'' is when a buyer offers to repay the mortgage or sell the
    property if you sign over the deed and move out. Phony counseling
    agencies also may offer help for a fee you don't need to pay.
    Help on the web
        For more information about foreclosure, go http://www.hud.gov/
    foreclosure/index.cfm

    Source: U.S. Department of Housing and Urban Development

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