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



                                                           Hrg.109-1083

 
      CALCULATED RISK: ASSESSING NON-TRADITIONAL MORTGAGE PRODUCTS

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

                                HEARING

                               before the

               SUBCOMMITTEE ON HOUSING AND TRANSPORTATION

                                and the

                    SUBCOMMITTEE ON ECONOMIC POLICY

                                 of the

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

                       ONE HUNDRED NINTH CONGRESS

                             SECOND SESSION

                                   ON

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


                               ----------                              

                     WEDNESDAY, SEPTEMBER 20, 2006

                               ----------                              

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


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

      CALCULATED RISK: ASSESSING NON-TRADITIONAL MORTGAGE PRODUCTS

                                                        S. Hrg.109-1083


      CALCULATED RISK: ASSESSING NON-TRADITIONAL MORTGAGE PRODUCTS

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

                                HEARING

                               before the

               SUBCOMMITTEE ON HOUSING AND TRANSPORTATION

                                and the

                    SUBCOMMITTEE ON ECONOMIC POLICY

                                 of the

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

                       ONE HUNDRED NINTH CONGRESS

                             SECOND SESSION

                                   ON

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


                               __________

                     WEDNESDAY, SEPTEMBER 20, 2006

                               __________

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


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


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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

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

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

               Subcommittee on Housing and Transportation

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

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

                    Subcommittee on Economic Policy

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

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


                            C O N T E N T S

                              ----------                              

                     WEDNESDAY, SEPTEMBER 20, 2006

                                                                   Page

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

                               WITNESSES

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

              Additional Material Supplied for the Record

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


      CALCULATED RISK: ASSESSING NON-TRADITIONAL MORTGAGE PRODUCTS

                              ----------                              


                     WEDNESDAY, SEPTEMBER 20, 2006

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

           OPENING STATEMENT OF SENATOR WAYNE ALLARD

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

                 STATEMENT OF SENATOR JACK REED

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

           OPENING STATEMENT OF CHAIRMAN JIM BUNNING

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

             STATEMENT OF SENATOR PAUL S. SARBANES

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

             STATEMENT OF SENATOR THOMAS R. CARPER

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

             STATEMENT OF ORICE WILLIAMS, DIRECTOR,
                GOVERNMENT ACCOUNTABILITY OFFICE

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

            STATEMENT OF WILLIAM SIMPSON, CHAIRMAN,
              REPUBLIC MORTGAGE INSURANCE COMPANY

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

            STATEMENT OF MICHAEL CALHOUN, PRESIDENT,
                 CENTER FOR RESPONSIBLE LENDING

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

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

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

            STATEMENT OF SENATOR CHARLES E. SCHUMER

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

                      STATEMENT OF SENATOR CARPER

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

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  RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM ORICE 
                            WILLIAMS

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

A.1. GAO response

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

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

A.2. GAO response

    Mortgage delinquency and default rates are typically higher 
for borrowers who use mortgages for investment purposes than 
for borrowers who use them to purchase their primary 
residences. However, we are not in a position to comment on the 
likelihood of defaults related to AMPs for these borrowers in 
the event of a housing slowdown. Federal banking regulatory 
officials said that they are concerned that some recent 
borrowers who used AMPs to purchase homes for investment 
purposes may be less inclined to avoid defaulting on their 
loans when faced with financial distress, particularly in those 
instances where the borrower has made little or no down 
payment. Data on recent payment-option ARM securitizations 
indicate that 14.4 percent of AMPs originated in 2005 were used 
by borrowers to purchase homes for purposes other than use as a 
primary residence, up from 5.3 percent in 2000. However, these 
data did not show the proportion of these originations that 
were used to purchase homes for investment purposes as compared 
to second homes and did not indicate the size of the down 
payment the borrower had made.

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

A.3. GAO response

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

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

A.4. GAO response

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


 RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM SANDRA 
                           BRAUNSTEIN

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

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

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

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

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

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

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

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

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

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


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                     FROM SANDRA BRAUNSTEIN

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

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

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

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

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

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

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

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

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

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

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

A.6. As part of its review of the effectiveness of closed-end 
credit disclosures under Regulation Z, including disclosures 
for nontraditional mortgages, the Board will be conducting 
extensive consumer testing to determine what information is 
most important to consumers, when that information is most 
useful, what language and formats work best, and how 
disclosures can be simplified, prioritized, and organized to 
reduce complexity and information overload. To that end, the 
Board will be using design consultants to assist in developing 
model disclosures that are most likely to be effective in 
communicating information to consumers. The Board also plans to 
use consumer testing to assist in developing model disclosure 
forms. Based on this review and testing, the Board will revise 
Regulation Z within the existing framework of TILA. If the 
Board determines that useful changes to the closed-end 
disclosures are best accomplished through legislation, the 
Board would develop suggested statutory changes for 
congressional consideration.

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

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

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

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


        RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING
                      FROM SANDRA THOMPSON

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

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

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

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

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

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

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

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

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

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

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

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


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                      FROM SANDRA THOMPSON

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


  RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM SCOTT 
                            ALBINSON

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                      FROM SCOTT ALBINSON

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


 RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM WILLIAM 
                            SIMPSON

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

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

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

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

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

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


          RESPONSE TO WRITTEN QUESTION OF SENATOR REED
                      FROM WILLIAM SIMPSON

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

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


 RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM MICHAEL 
                            CALHOUN

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

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

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

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

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

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

        did not always fully or effectively explain the risks of 
        payment shock or negative amortization for these products and 
        lacked information on some important loan features, both 
        because Regulation Z currently does not require lenders to 
        tailor this information to AMPs and because lenders do not 
        always follow leading practices for writing disclosures that 
        are clear, concise, and user-friendly.\3\
---------------------------------------------------------------------------
    \3\ Id. at 21.

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

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

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

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

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

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

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


         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                      FROM MICHAEL CALHOUN

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

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

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

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

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

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

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

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

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

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

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

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

              Additional Material Submitted for the Record

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

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

Staff writer Aldo Svaldi contributed to this report.

Staff writer Greg Griffin can be reached at 303-954-1241 or 
[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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