[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
U.S. GOVERNMENT PRINTING OFFICE
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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
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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
[email protected].
______
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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