    Alternative Mortgage Products: Impact on Defaults Remains
    Unclear, but Disclosure of Risks to Borrowers Could Be Improved
    (19-SEP-06, GAO-06-1021).

    Alternative mortgage products (AMPs) can make homes more
    affordable by allowing borrowers to defer repayment of principal
    or part of the interest for the first few years of the mortgage.
    Recent growth in AMP lending has heightened the importance of
    borrowers' understanding and lenders' management of AMP risks.
    This report discusses the (1) recent trends in the AMP market,
    (2) potential AMP risks for borrowers and lenders, (3) extent to
    which mortgage disclosures discuss AMP risks, and (4) federal and
    selected state regulatory response to AMP risks. To address these
    objectives, GAO used regulatory and industry data to analyze
    changes in AMP monthly payments; reviewed available studies; and
    interviewed relevant federal and state regulators and mortgage
    industry groups, and consumer groups.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-06-1021
        ACCNO:   A61147
      TITLE:     Alternative Mortgage Products: Impact on Defaults Remains
    Unclear, but Disclosure of Risks to Borrowers Could Be Improved
         DATE:   09/19/2006
      SUBJECT:   Consumer protection
    	     Debt
    	     Federal regulations
    	     Homeowners loans
    	     Housing
    	     Information disclosure
    	     Lending institutions
    	     Loan defaults
    	     Loan repayments
    	     Mortgage interest rates
    	     Mortgage loans
    	     Risk assessment

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    GAO-06-1021

         * Results in Brief
         * Background
         * AMP Lending Rapidly Grew as Borrowers Sought Mortgage Produc
              * AMP Share of Mortgage Originations Grew Threefold from 2003
              * Once Considered a Specialized Product for the Financially So
         * Borrowers Could Face Payment Shock; Lenders Face Credit Risk
              * AMPs Create Potential for Borrowers to Face Payment Shock, P
              * In Contrast to Past Borrowers, Recent AMP Borrowers May Find
              * Most AMPs Originations Are Too Recent to Generate Sufficient
         * Regulators and Others Are Concerned That Borrowers May Not B
              * Some AMP Advertising Practices Emphasize Benefits over Risks
              * A Recent Study and Initial Complaint Data Indicated Some Bor
              * Consumers Receive Disclosures about ARMs but the Federal Res
              * Leading Practices for Financial Product Disclosures Include
              * The Disclosures That We Reviewed Generally Did Not Provide C
                   * Program-Specific Disclosures Did Not Always Clearly Discuss
                   * Disclosures Generally Did Not Prominently Present Key Inform
                   * Transaction-Specific TILA Disclosures Lacked Key Information
              * Revisions to Regulation Z May Increase Understanding of AMPs
         * Federal Banking Regulators Issued Draft Guidance and Took Ot
              * Draft Interagency Guidance on AMP Lending Recommends Tighten
              * Many Industry Groups Opposed the Draft Guidance and Some Con
              * Federal Officials Reinforced Their Messages by Publicizing T
         * Most States in Our Sample Responded to AMP Lending Risks wit
              * States in Our Sample Identified Concerns about AMP Lending b
              * States in Our Sample Generally Increased Their Attention to
         * Conclusions
         * Recommendation for Executive Action
         * Agency Comments and Our Evaluation
         * Appendix I: Scope and Methodology
         * Appendix II: Readability and Design Weaknesses in AMP Disclo
              * Disclosures Required Reading Levels Higher Than That of Many
              * Size and Choice of Typeface and Use of Capitalization Made M
              * Disclosures Generally Did Not Make Effective Use of White Sp
         * Appendix III: Comments from the Board of Governors of the Fe
         * Appendix IV: GAO Contact and Staff Acknowledgments
              * GAO Contact
              * Staff Acknowledgments
                   * Order by Mail or Phone

    Report to the Chairman, Subcommittee on Housing and Transportation,
    Committee on Banking, Housing, and Urban Affairs, U.S. Senate

    United States Government Accountability Office

    GAO

    September 2006

    ALTERNATIVE MORTGAGE PRODUCTS

    Impact on Defaults Remains Unclear, but Disclosure of Risks to Borrowers
    Could Be Improved

    GAO-06-1021

    Contents

    Letter 1

    Results in Brief 3
    Background 7
    AMP Lending Rapidly Grew as Borrowers Sought Mortgage Products That
    Increased Affordability 10
    Borrowers Could Face Payment Shock; Lenders Face Credit Risk but Most
    Appear to be Taking Steps to Manage the Risk 13
    Regulators and Others Are Concerned That Borrowers May Not Be
    Well-informed About the Risks of AMPs 21
    Federal Banking Regulators Issued Draft Guidance and Took Other Actions to
    Improve Lender Practices and Disclosures and Publicize Risks of AMPs 38
    Most States in Our Sample Responded to AMP Lending Risks within Existing
    Regulatory Frameworks, While Others Had Taken Additional Actions 42
    Conclusions 45
    Recommendation for Executive Action 46
    Agency Comments and Our Evaluation 47
    Appendix I Scope and Methodology 49
    Appendix II Readability and Design Weaknesses in AMP Disclosures That We
    Reviewed 52
    Disclosures Required Reading Levels Higher Than That of Many Adults in the
    U.S. 52
    Size and Choice of Typeface and Use of Capitalization Made Most
    Disclosures Difficult to Read 53
    Disclosures Generally Did Not Make Effective Use of White Space or
    Headings 54
    Appendix III Comments from the Board of Governors of the Federal Reserve
    System 55
    Appendix IV GAO Contact and Staff Acknowledgments 58

    Table

    Table 1: Underwriting Trends of Recent Payment-Option ARM Securitizations,
    January 2001 to June 2005 17

    Figures

    Figure 1: Increase in Minimum Monthly Payments and Outstanding Loan
    Balance with an April 2004 $400,000 Payment-Option ARM, Assuming Rising
    Interest Rates 14
    Figure 2: Example of a 2005 Broker Advertisement for a Payment-Option ARM
    24
    Figure 3: Example of a 2005 Interest-Only ARM Disclosure Explaining How
    Monthly Payments Can Change 31
    Figure 4: Transaction-Specific TILA Disclosure from a 2005 Payment-Option
    ARM Disclosure 35
    Figure 5: Examples of Serif and Sans Serif Typefaces 53

    Abbreviations

    AARMR American Association of Residential Mortgage Regulators

    AMP alternative mortgage product

    APR annual percentage rate

    ARM adjustable-rate mortgage

    CLTV combined loan-to-value

    COFI Federal Home Loan Bank of San Francisco Cost of Funds Index

    CSBS Conference of State Bank Supervisors

    DTI debt-to-income

    FDIC Federal Deposit Insurance Corporation

    FICO Fair Isaac and Company

    FRM fixed-rate mortgage

    FTC Federal Trade Commission

    GSE government-sponsored enterprise

    HOEPA Home Ownership and Equity Protection Act

    LTV loan-to-value

    MBS mortgage backed securities

    NAR National Association of Realtors(R)

    NCUA National Credit Union Administration

    OCC Office of the Comptroller of the Currency

    OTS Office of Thrift Supervision

    SEC Securities and Exchange Commission

    TILA Truth in Lending Act

    This is a work of the U.S. government and is not subject to copyright
    protection in the United States. It may be reproduced and distributed in
    its entirety without further permission from GAO. However, because this
    work may contain copyrighted images or other material, permission from the
    copyright holder may be necessary if you wish to reproduce this material
    separately.

    United States Government Accountability Office

    Washington, DC 20548

    September 19, 2006 September 19, 2006

    The Honorable Wayne Allard Chairman Subcommittee on Housing and
    Transportation Committee on Banking, Housing, and Urban Affairs United
    States Senate The Honorable Wayne Allard Chairman Subcommittee on Housing
    and Transportation Committee on Banking, Housing, and Urban Affairs United
    States Senate

    Dear Mr. Chairman: Dear Mr. Chairman:

    In recent years, the residential real estate sector experienced sustained
    growth in both volume and price. The National Association of Realtors(R)
    (NAR) reported record growth in sales of existing homes from 2003 to 2005,
    from 6.2 to 7.1 million homes annually. During this same period, median
    existing home prices increased an average of 10.9 percent a year, from
    $178,800 to $219,600. Further, NAR reported double-digit percentage
    increases in existing home prices in 72 metropolitan areas in 2005. To
    purchase homes they might not be able to afford with a conventional
    fixed-rate mortgage, an increasing number of borrowers turned to
    alternative mortgage products (AMPs), which offer comparatively lower and
    more flexible monthly mortgage payments for an initial period. In recent
    years, the residential real estate sector experienced sustained growth in
    both volume and price. The National Association of Realtors(R) (NAR)
    reported record growth in sales of existing homes from 2003 to 2005, from
    6.2 to 7.1 million homes annually. During this same period, median
    existing home prices increased an average of 10.9 percent a year, from
    $178,800 to $219,600. Further, NAR reported double-digit percentage
    increases in existing home prices in 72 metropolitan areas in 2005. To
    purchase homes they might not be able to afford with a conventional
    fixed-rate mortgage, an increasing number of borrowers turned to
    alternative mortgage products (AMPs), which offer comparatively lower and
    more flexible monthly mortgage payments for an initial period.

    Two recently popular types of AMPs-interest-only and payment-option
    adjustable-rate mortgages (ARMs)-allow borrowers to defer repayment of
    principal and possibly part of the interest for the first few years of the
    mortgage. Interest-only mortgages allow borrowers to defer principal
    payments for typically the first 3 to 10 years of the mortgage, before
    recasting to require higher monthly payments that cover principal as well
    as interest and to pay off (amortize) the outstanding balance over the
    remaining term of the loan. Payment-option mortgages allow borrowers to
    make minimum payments that do not cover principal or all accrued interest,
    but can result in increased loan balances over time (negative
    amortization). Typically after 5 years, or if the loan balance increases
    to a cap specified in the mortgage terms, payments recast to include an
    amount that will fully amortize the outstanding balance over the remaining
    years of the loan. Two recently popular types of AMPs-interest-only and
    payment-option adjustable-rate mortgages (ARMs)-allow borrowers to defer
    repayment of principal and possibly part of the interest for the first few
    years of the mortgage. Interest-only mortgages allow borrowers to defer
    principal payments for typically the first 3 to 10 years of the mortgage,
    before recasting to require higher monthly payments that cover principal
    as well as interest and to pay off (amortize) the outstanding balance over
    the remaining term of the loan. Payment-option mortgages allow borrowers
    to make minimum payments that do not cover principal or all accrued
    interest, but can result in increased loan balances over time (negative
    amortization). Typically after 5 years, or if the loan balance increases
    to a cap specified in the mortgage terms, payments recast to include an
    amount that will fully amortize the outstanding balance over the remaining
    years of the loan.

    As AMP lending grew, federal banking regulators and consumer advocates
    expressed concerns about loans that allow deferred repayment of principal
    or negative amortization; borrowers' ability to make future, higher
    payments; and lenders' underwriting practices (criteria for issuing As AMP
    lending grew, federal banking regulators and consumer advocates expressed
    concerns about loans that allow deferred repayment of principal or
    negative amortization; borrowers' ability to make future, higher payments;
    and lenders' underwriting practices (criteria for issuing loans).1 As a
    result of these and other factors, we studied the potential risks of AMPs
    for borrowers and lenders. This report discusses (1) recent trends in the
    AMP market, (2) the impact of AMPs on borrowers and on the safety and
    soundness of financial institutions, (3) the extent to which mortgage
    disclosures discuss the risks of AMPs, (4) the federal regulatory response
    to the risks of AMPs for lenders and borrowers, and (5) selected state
    regulatory responses to the risks of AMPs for lenders and borrowers.

    To identify recent trends in the AMP market, we gathered information from
    federal banking regulators and the residential mortgage lending industry
    on AMP product features, customer base, and originators as well as the
    reasons for the recent growth of these products. To determine the
    potential risks of AMPs for borrowers and lenders, we analyzed the changes
    in future monthly payments that can occur with AMPs during periods of
    rising interest rates. We also interviewed officials from the federal
    banking regulators (federal regulatory officials) and representatives from
    the residential mortgage lending industry and reviewed studies on the
    risks of these mortgages compared with conventional fixed-rate mortgages.
    In addition, we obtained information on the securitization of AMPs from
    federal banking regulators, government-sponsored enterprises, and
    secondary mortgage market participants. To determine the extent to which
    mortgage disclosures explain the risks of AMPs, we reviewed federal laws
    and regulations governing the required content of mortgage disclosures,
    reviewed studies on borrowers' understanding of adjustable-rate products,
    and interviewed federal regulatory officials and industry participants. We
    also selected a sample of eight states to obtain state regulators' views
    on these disclosures-Alaska, California, Florida, Nevada, New Jersey, New
    York, North Carolina, and Ohio. We reviewed these states' laws and
    regulations governing the required content of mortgage disclosures and
    interviewed state officials. We selected these states on the basis of a
    number of criteria, including volume of AMP lending and geographic
    location. We also conducted a readability and design analysis of a
    selection of written disclosures that AMP lenders provide to borrowers. To
    obtain information on federal regulatory responses to the risks of AMPs
    for lenders and borrowers, we reviewed the draft interagency guidance on
    AMP lending issued by federal banking regulators and interviewed
    regulatory officials. We also reviewed comments written by industry
    participants in response to the draft guidance. To obtain information on
    selected states' regulatory responses to the risks of AMPs for lenders and
    borrowers, we reviewed current laws and, where applicable, draft
    legislation, from the eight states in our sample and interviewed these
    states' banking and mortgage lending officials.

    1For the purposes of this report, we use the term "federal banking
    regulators" to refer to federal agencies that oversee federally insured
    depository institutions and their subsidiaries. These agencies are the
    Board of Governors of the Federal Reserve System (Federal Reserve), the
    Federal Deposit Insurance Corporation (FDIC), the National Credit Union
    Administration (NCUA), the Office of the Comptroller of the Currency
    (OCC), and the Office of Thrift Supervision (OTS).

    We performed our work between September 2005 and September 2006 in
    accordance with generally accepted government auditing standards. Appendix
    I provides additional information on our scope and methodology.

                                    Results in Brief

    From 2003 through 2005, AMP originations grew threefold, from less than 10
    percent of residential mortgage originations to about 30 percent. Most of
    the AMPs originated during this period consisted of interest-only and
    payment-option ARMs. The initial lower payments associated with AMPs
    enable borrowers to afford homes that they might not be able to afford
    using conventional fixed-rate mortgages. Therefore, AMPs have been
    particularly popular in higher-priced regional markets concentrated on the
    East and West Coasts where prices have risen appreciably. For example,
    based on data from mortgage securitizations in 2005, about 47 percent of
    interest-only ARMs and 58 percent of payment-option ARMs originated in
    California, where NAR reports that 7 of the 20 highest-priced metropolitan
    real estate markets in the country are located. For many years lenders
    have marketed AMPs to wealthy and financially sophisticated borrowers as
    financial management tools. However, more recently, lenders have marketed
    AMPs as affordability products that enable a wider spectrum of borrowers
    to purchase homes they might not be able to afford using a conventional
    fixed-rate mortgage. Lenders also have increased the variety of AMPs
    offered as interest rates have risen and ARMs have become less attractive
    to borrowers.

    Although most AMPs originated in recent years have yet to reach the date
    at which monthly payments increase to cover principal as well as the
    interest, regulators have expressed concerns that some borrowers may not
    be able to withstand the "payment shock" of substantially higher monthly
    payments. Statistics reveal that lenders originated AMPs to recent
    borrowers with lower credit scores, higher loan-to-value (LTV) and
    debt-to-income (DTI) ratios, and less stringent or no income and asset
    verification requirements than what they traditionally permitted for these
    products. Recent AMP borrowers who have fewer financial resources and have
    not benefited from appreciation in home values may be more vulnerable to
    payment shock, especially if their loan balance increased because they
    were making only the minimum payment. These borrowers may lack the equity
    to refinance their mortgages or sell their homes, and would have to face
    higher payments. Borrowers who cannot afford the higher payments face
    increased risk of default, thereby increasing credit risk for lenders,
    including banks. Although federal regulatory officials expressed concerns
    about underwriting practices related to AMP lending, they said that banks
    generally have taken steps to manage the credit risk that results from
    AMPs.2 For example, these officials said that most banks have diversified
    their assets sufficiently to manage the credit risk of AMPs held in their
    portfolios, or have reduced their risk through loan sales or
    securitizations. However, federal regulatory officials and industry
    participants agreed that it was too soon to tell whether AMPs would result
    in significant delinquencies and foreclosures for borrowers and
    corresponding losses for banks that hold AMPs in their portfolios.

    Because AMPs are complex products and advertising and mortgage disclosures
    may not completely or effectively explain their terms and risks,
    regulatory officials and others believe that some borrowers may not fully
    understand the risks of AMPs. Borrowers can acquire information on
    mortgage options from a variety of sources-including loan officers and
    brokers, or as noted by mortgage industry representatives, through the
    Internet, television, radio and telemarketing. However, federal and state
    regulatory officials raised concerns that the promotional materials some
    lenders and brokers provided to borrowers might emphasize the benefits of
    AMPs without explaining the associated risks. For example, some
    advertisements suggested that AMPs' initial low monthly payments allow
    borrowers to afford a larger house, but did not disclose that over time
    these monthly payments could increase substantially. Furthermore, a recent
    study by staff economists at the Federal Reserve suggested that some
    borrowers (particularly some low-income and less-educated borrowers)
    appeared to not understand fully how much monthly payments with
    adjustable-rate products could increase. With borrowers sometimes exposed
    to unbalanced information about AMPs, written disclosures that provide
    clear and comprehensive information about the key terms,

    2Credit risk involves the concerns that borrowers may become delinquent or
    default on their mortgages, and that lenders may not be paid in full for
    the loans they have issued.

    conditions, and costs of the mortgage can help borrowers to make
    better-informed decisions. The quality of information conveyed through
    mortgage disclosures depends on both content, which is mandated by statute
    and federal regulation, and presentation. Regarding content, the Truth in
    Lending Act (TILA) and its implementing regulation, Regulation Z, require
    certain product information to be included in disclosures to borrowers for
    many types of credit products, including mortgages.3 For example,
    Regulation Z requires creditors (lenders and those brokers that close
    loans in their own name) to provide borrowers with certain information
    about their ARM products. However, these requirements are not designed to
    address more complex products such as AMPs. The Federal Reserve has
    recently initiated a review of Regulation Z that will include reviewing
    the disclosures required for all mortgage loans, including AMPs. Regarding
    presentation, current guidance developed by the Securities and Exchange
    Commission (SEC) recommends practices on developing disclosures that
    effectively communicate key information on financial products.4 Most of
    the AMP disclosures we reviewed did not fully or effectively explain the
    key risks of payment shock or negative amortization for these products and
    lacked information on some important loan features, both because
    Regulation Z does not require lenders to tailor this information to these
    more complex products and because lenders did not always follow leading
    practices for writing disclosures that are clear, concise, and
    user-friendly. Appendix II provides additional information on our
    evaluation of these disclosures according to these leading practices.
    According to officials from one federal banking regulator, amending
    Regulation Z to require lenders to more fully and clearly explain the key
    terms and risks of complex mortgages such as AMPs in mortgage disclosures
    was one of several steps needed to increase borrower understanding about
    these products and the mortgage process in general-which many described as
    generally overwhelming and confusing for the average borrower. Without
    clear and comprehensive disclosures on AMP risks, borrowers may not
    understand the extent to which monthly payments could rise and loan
    balances could increase.

    In response to concerns about AMP risks to federally regulated banks and
    their borrowers, federal banking regulators issued draft interagency
    guidance in December 2005 for these institutions and have taken other
    steps to monitor AMP lending. The draft guidance discusses prudent
    underwriting, portfolio and risk management, and consumer disclosure
    practices related to AMP lending. When finalized, the guidance will apply
    to all federally regulated financial institutions.5 Federal regulatory
    officials said they developed the draft guidance to clarify how
    institutions can offer AMPs in a safe and sound manner and clearly
    disclose the potential AMP risks to borrowers. These officials told us
    they will request remedial action from institutions that do not adequately
    measure, monitor, and control risk exposures in loan portfolios. In
    commenting on the proposed guidance, various lenders suggested that the
    stricter underwriting recommendations were overly prescriptive and could
    result in fewer mortgage choices for consumers. Others observed that the
    recommendations for stricter underwriting and increased disclosure might
    put federally and state-regulated banks at a competitive disadvantage,
    because the guidance would not apply to state non-bank mortgage lenders
    (independent mortgage lenders) or brokers. Consumer advocates expressed
    concerns that regulators might not be able to enforce recommendations that
    were not written in law or regulation to protect consumers. Federal
    banking regulators currently are reviewing all comments as they finalize
    the draft guidance. In addition to issuing the draft guidance, federal
    regulatory officials have publicly reinforced their concerns about AMPs
    and some have taken steps to increase their monitoring of high-risk
    lending, including AMPs, and to improve consumer education about AMP
    risks. The Federal Trade Commission (FTC) also has given some attention to
    consumer protection issues related to AMPs. For example, in May 2006, the
    FTC sponsored a public workshop that explored consumer protection issues
    as a result of AMP growth in the mortgage marketplace.

    3TILA is codified at 15 U.S.C. S: 1601 et seq. and Regulation Z can be
    found at 12 C.F.R. Part 226.

    4SEC is the primary overseer of the U.S. securities markets.

    Officials from state banking and financial regulators in eight states with
    whom we spoke shared some of the federal regulators' concerns about AMP
    lending, and to varying degrees, have responded to the increase in this
    lending activity among the independent mortgage lenders and brokers they
    oversee. Most of the state regulators rely upon state law to license
    mortgage lenders and brokers and to ensure that these entities meet
    minimum experience and operations standards. Regulatory officials from
    most of the states said they also periodically examine these entities for
    compliance with state licensing; mortgage lending; and consumer protection
    laws, including applicable fair advertising requirements. In addition,
    some states have taken action to better understand issues related to AMP
    lending and expand consumer protections. For example, some regulators have
    gathered data on these products, or plan to use guidance developed by
    state regulatory associations to oversee AMP lending by independent
    mortgage lenders and brokers.

    5Federally regulated financial institutions include all banks and their
    subsidiaries, bank holding companies and their nonbank subsidiaries,
    savings associations and their subsidiaries, savings and loan holding
    companies and their subsidiaries, and credit unions.

    This report includes a recommendation to the Board of Governors of the
    Federal Reserve System to consider, in connection with its review and
    revision of Regulation Z, amending federal mortgage disclosure
    requirements to improve the clarity and comprehensiveness of AMP
    disclosures. We requested comments on a draft of this report from the
    Federal Reserve, FDIC, NCUA, OCC, and OTS. The Federal Reserve provided
    written comments on a draft of this report that are reprinted in appendix
    III. It noted that it has already initiated a comprehensive review of
    Regulation Z, including its requirements for mortgage disclosures. As part
    of this effort, it recently held four public hearings on home equity
    lending that partly focused on AMPs, and in particular, whether consumers
    receive adequate information about these products. Furthermore, in
    response to our recommendation, the Federal Reserve noted that it will be
    conducting consumer testing to determine what and when information is most
    useful to consumers, what language and formats work best, and how
    disclosures can be designed to reduce complexity and information overload.
    The Federal Reserve's comments are discussed in more detail at the end of
    this letter. We also provided a draft to FTC, and selected sections of the
    report to the relevant state regulators for their review. FDIC, FTC, NCUA,
    OCC, and OTS did not provide written comments. FDIC, FTC, and OCC provided
    technical comments, as did the Federal Reserve, which have been
    incorporated as appropriate.

                                       Background

    Borrowers arrange residential mortgages through either mortgage lenders or
    brokers. The funding for mortgages can come from federally or
    state-chartered banks, mortgage lending subsidiaries of these banks or
    financial holding companies, or independent mortgage lenders, which are
    neither banks nor affiliates of banks. Mortgage brokers act as
    intermediaries between lenders and borrowers, and for a fee, help connect
    borrowers with various lenders who may provide a wider selection of
    mortgage products. Mortgage lenders may keep the loans that they
    originated or purchased from brokers in their portfolios or sell the loans
    in the secondary mortgage market. Government-sponsored enterprises (GSEs)
    or investment banks pool many mortgage loans that lenders sell to the
    secondary market, and these lenders or investment banks then sell claims
    to these pools to investors as mortgage backed-securities (MBS).6

    Lenders consider whether to accept or reject a borrower's loan application
    in a process called underwriting. During underwriting, the lender analyzes
    the borrower's ability to repay the debt. For example, lenders may
    determine ability to repay debt by calculating a borrower's DTI ratio,
    which consists of the borrowers' fixed monthly expenses divided by gross
    monthly income. The higher the DTI ratio, the greater the risk the
    borrower will have cash-flow problems and miss mortgage payments. During
    the underwriting process, lenders usually require documentation of
    borrowers' income and assets. Another important factor lenders consider
    during underwriting is the amount of down payment the borrower makes,
    which usually is expressed in terms of a LTV ratio (the larger the down
    payment, the lower the LTV ratio). The LTV ratio is the loan amount
    divided by the lesser of the selling price or appraised value. The lower
    the LTV ratio, the smaller the chance that the borrower would default, and
    the smaller the loss if the borrower were to default. Additionally,
    lenders evaluate the borrowers' credit history using various measures. One
    of these measures is the borrowers' credit score, which is a numerical
    measure or score that is based on an individual's credit payment history
    and outstanding debt. Mortgage loans could be made to prime and subprime
    borrowers. Prime borrowers are those with good credit histories that put
    them at low risk of default. In contrast, subprime borrowers have poor or
    no credit histories, and therefore cannot meet the credit standards for
    obtaining a prime loan.

    Chartering agencies oversee federally and state-chartered banks and their
    mortgage lending subsidiaries. At the federal level, OCC, OTS, and NCUA
    oversee federally chartered banks (including mortgage operating
    subsidiaries), thrifts, and credit unions, respectively. The Federal
    Reserve oversees insured state-chartered member banks, while FDIC oversees
    insured state-chartered banks that are not members of the Federal Reserve
    System. Both the Federal Reserve and FDIC share oversight with the state
    regulatory authority that chartered the bank. The Federal Reserve also
    oversees mortgage lending subsidiaries of financial holding companies,
    although FTC is responsible for enforcement of certain federal consumer
    protection laws as discussed in the following text.

    6Housing-related GSEs, such as Fannie Mae and Freddie Mac, are privately
    owned and operated corporations whose public missions are to enhance the
    availability of mortgage credit across the United States.

    Federal banking regulators have responsibility for ensuring the safety and
    soundness of the institutions they oversee and for promoting stability in
    the financial markets. To achieve these goals, regulators establish
    capital requirements for banks, conduct on-site examinations and off-site
    monitoring to assess their financial condition, and monitor their
    compliance with applicable banking laws, regulations, and agency guidance.
    As part of their examinations, for example, regulators review mortgage
    lending practices, including underwriting, risk management, and portfolio
    management practices. Regulators also try to determine the amount of risk
    lenders have assumed. From a safety and soundness perspective, risk
    involves the potential that events, either expected or unanticipated, may
    have an adverse impact on the bank's capital or earnings. In mortgage
    lending, regulators pay close attention to credit risk. Credit risk
    involves the concerns that borrowers may become delinquent or default on
    their mortgages and that lenders may not be paid in full for the loans
    they have originated.

    Certain federal consumer protection laws, including TILA and the act's
    implementing regulation, Regulation Z, apply to all mortgage lenders,
    including mortgage brokers that close loans in their own name. Implemented
    by the Federal Reserve, Regulation Z requires these creditors to provide
    borrowers with written disclosures describing basic information about the
    terms and cost of their mortgage. Each lender's primary federal
    supervisory agency holds responsibility for enforcing Regulation Z.
    Regulators use examinations and consumer complaint investigations to check
    for compliance with both the act and its regulation. FTC is responsible
    for enforcing certain federal consumer protection laws for brokers and
    lenders that are not depository institutions, including state-chartered
    independent mortgage lenders and mortgage lending subsidiaries of
    financial holding companies. However, FTC is not a supervisory agency;
    instead, it enforces various federal consumer protection laws through
    enforcement actions. The FTC uses a variety of information sources in the
    enforcement process, including its own investigations, consumer
    complaints, state and other federal agencies, and others.

    State regulators oversee independent lenders and mortgage brokers and do
    so by generally requiring business licenses that mandate meeting net
    worth, funding, and liquidity thresholds. They may also mandate certain
    experience, education, and operational requirements to engage in mortgage
    activities. Other common requirements for licensees may include
    maintaining records for certain periods, individual prelicensure testing,
    posting surety bonds, and participating in continuing education
    activities. States may also examine independent lenders and mortgage
    brokers to ensure compliance with licensing requirements, review their
    lending and brokerage functions for state-specific and federal regulatory
    compliance, and look for unfair or unethical business practices. When such
    practices arise, or are brought to states' attention through consumer
    complaints, regulators and State Attorneys General may pursue actions that
    include licensure suspension or revocation, monetary fines, and lawsuits.

     AMP Lending Rapidly Grew as Borrowers Sought Mortgage Products That Increased
                                     Affordability

    The volume of interest-only and payment-option ARMs grew rapidly between
    2003 and 2005 as home prices increased nationwide and lenders marketed
    these products as an alternative to conventional mortgage products. During
    this period, AMP lending was concentrated in the higher-priced real estate
    markets on the East and West Coasts. Also at that time, a variety of
    federally and state-regulated lenders participated in the AMP market,
    although a few large federally regulated dominated lending. Once
    considered a financial management tool for wealthier borrowers, lenders
    have marketed AMPs as affordability products that enable borrowers to
    purchase homes they might not be able to afford using conventional
    fixed-rate mortgages. Furthermore, lenders have increased the variety of
    AMP products offered to respond to changing market conditions.

    AMP Share of Mortgage Originations Grew Threefold from 2003 to 2005, with Higher
    Concentrations in the Coastal Markets

    As home prices increased nationally and lenders offered alternatives to
    conventional mortgages, AMP originations tripled in recent years, growing
    from less than 10 percent of residential mortgage originations in 2003 to
    about 30 percent in 2005.7 Most of the AMPs originated during this period
    consisted of interest-only or payment-option ARMs. In 2005, originations
    of these two products totaled $400 billion and $175 billion,
    respectively.8 According to federal regulatory officials, consumer demand
    for these products grew because their low initial monthly payments enabled
    borrowers to purchase homes that they otherwise might not have been able
    to afford with a conventional fixed-rate mortgage.9

    7Data used in this report reflect mortgages that were securitized and sold
    to the private label secondary market, which do not include mortgages
    guaranteed by the GSEs or held by banks in their portfolios.

    8Inside Mortgage Finance, Conventional Conforming Market Continued to
    Erode in 2005 as Nontraditional Mortgage Products Boomed, (February 24,
    2006) 6.

    AMP lending has been concentrated in the higher-priced regional markets on
    the East and West Coasts, where homes are least affordable. For example,
    based on data from mortgage securitizations in 2005, about 47 percent of
    interest-only ARMs and 58 percent of payment-option ARMs that were
    securitized in 2005 originated in California, where NAR reports that 7 of
    the 20 highest-priced metropolitan real estate markets in the country are
    located.10 On the East Coast, Virginia, Maryland, New Jersey, Florida and
    Washington, D.C., exhibited high concentrations of AMP lending in 2005, as
    did Washington, Nevada, and Arizona on the West Coast. These areas also
    have experienced higher rates of house price appreciation than the rest of
    the United States.

    A variety of federally and state-regulated lenders were involved in the
    recent surge of AMP originations. Six large federally regulated lenders
    dominated much of the AMP production in 2005, producing 46 percent of
    interest-only and payment-option ARMs originated in the first 9 months of
    that year.11 The six included nationally chartered banks and thrifts under
    the supervision of OCC and OTS as well as mortgage lending subsidiaries of
    financial holding companies under the supervision of the Federal Reserve.
    Although these six large, federally-regulated institutions accounted for a
    large share of AMP lending in that year, other federally and
    state-regulated lenders also participated in the AMP market, including
    other nationally and state chartered banks and independent nonbank
    lenders. Additionally, independent mortgage brokers have been an important
    source of originations for AMP lenders. Some mortgage brokers in states
    with high volumes of AMP lending told us in early 2006 that they estimated
    interest-only and payment-option ARM lending accounted for as much as 35
    to 50 percent of their recent business.

    9As many as 58 percent of interest-only ARMs and 37 percent of
    payment-option ARMs that were securitized that year were used to purchase
    homes, with the remainder percent used for refinancing purposes. David
    Liu, "Credit Implications of Affordability Mortgages," UBS (Mar. 3, 2006).

    10David Liu, 6, and David Liu, "Credit Implications-Fixed-rate, IO" UBS
    Mortgage Strategist (Mar. 28, 2006) 26.

    11Inside Alternative Mortgages, Countrywide Tops Option ARM Market at 3Q
    Mark (Dec. 23, 2005), 5; and Inside Alternative Mortgages, Wells tops
    Interest-Only Market in 3Q of 2005 (Dec. 19, 2005), 3.

    Once Considered a Specialized Product for the Financially Sophisticated, Lenders
    Have Offered AMPs Widely as Affordability Products

    Once considered a specialized product, AMPs have entered the mainstream
    marketplace in higher-priced real estate markets. According to federal
    regulatory officials and a mortgage lending trade association, lenders
    originally developed and marketed interest-only and payment-option ARMs as
    specialized products for higher-income, financially sophisticated
    borrowers who wanted to minimize mortgage payments to invest funds
    elsewhere. Additionally, they said that other borrowers who found AMPs
    suitable included borrowers with irregular earnings who could take
    advantage of interest-only or minimum monthly payments during periods of
    lower income and could pay down principal and any deferred interest when
    they received an increase in income. However, according to federal banking
    regulators and a range of industry participants, as home prices increased
    rapidly in some areas of the country, lenders began marketing
    interest-only and payment-option ARMs widely as affordability products.
    They also said that in doing so, lenders emphasized the low initial
    monthly payments offered by these products and made them available to less
    creditworthy and less wealthy borrowers than those who traditionally used
    them.

    After the recent surge of interest-only and payment-option ARMs, lenders
    have increased the variety of AMPs offered as market conditions have
    changed. According to industry analysts, as interest rates continued to
    rise, by the beginning of 2006, mortgages with adjustable rates no longer
    offered the same cost-savings over fixed-rate mortgages, and borrowers
    began to shift to fixed-rate products.12 These analysts reported that in
    response to this trend, lenders have begun to market mortgages that are
    less sensitive to interest rate increases. For example, interest-only
    fixed-rate mortgages (interest-only FRMs) offer borrowers interest-only
    payments for up to 10 years but at a fixed interest rate over the life of
    the loan. Another mortgage that has gained in popularity is the 40-year
    mortgage. This product does not allow borrowers to defer interest or
    principal, but offers borrowers lower monthly payments than conventional
    mortgages. For example, some variations of the 40-year mortgage have a
    standard 30-year loan term, but offer lower fixed monthly payments that
    are based on a 40-year amortization schedule for part or all of the loan
    term.13 According to one professional trade publication,-37 percent of
    first half of 2006 mortgage originations were AMPs, and a significant
    number of them were 40-year mortgages.14

    12As of April 2006, the interest rate on 1-year ARMs averaged 5.62
    percent, while interest rates on 30-year fixed-rate mortgages averaged
    6.51 percent.

    Borrowers Could Face Payment Shock; Lenders Face Credit Risk but Most Appear to
                           be Taking Steps to Manage the Risk

    Depending on the particular loan product and the payment option the
    borrower chooses, rising interest rates or choice of a minimum monthly
    payment and corresponding negative amortization can significantly raise
    future monthly payments and increase the risk of default for some
    borrowers. Underwriting trends that, among other things, allowed borrowers
    with fewer financial resources to qualify for these loans have heightened
    this risk because such borrowers may have fewer financial reserves against
    financial adversity and may be unable to sustain future higher monthly
    payments in the event that they cannot refinance their mortgages or sell
    their home. Higher default risk for borrowers translates into higher
    credit risk for lenders, including banks. However, federal regulatory
    officials and industry participants agree that it is too soon to tell
    whether risks to borrowers will result in significant delinquencies and
    foreclosures for borrowers and corresponding losses for banks that hold
    AMPs in their portfolios.

    AMPs Create Potential for Borrowers to Face Payment Shock, Particularly as
    Interest Rates Rise

    AMPs such as interest-only and payment-options ARMs are initially more
    affordable than conventional fixed-rate mortgages because during the first
    few years of the mortgage they allow a borrower to defer repayment of
    principal and, in the case of payment-option ARMs, part of the interest as
    well. Specifically, borrowers with interest-only ARMs can make monthly
    payments of just interest for the fixed introductory period. Borrowers
    with payment-option ARMs typically have four payment options. The first
    two options are fully amortizing payments that are based on either a
    30-year or 15-year payment schedule. The third option is an interest-only
    payment, and the fourth is a minimum payment, which we previously
    described, that does not cover all of the interest. The interest that does
    not get paid gets capitalized into the loan balance owed, resulting in
    negative amortization.

    13In the most common variation, the lower payments are in effect for the
    entire 30-year loan term, and the borrower makes a balloon payment at the
    end to pay off the remaining loan balance. In another variation, the lower
    payments are in effect for the first 10 years; then, the loan is recast to
    require higher monthly payments that fully amortize the loan over the
    remainder of the 30-year term. An increasing number of lenders are
    offering 40-year mortgages that also have a 40 year maturity.

    14Inside Mortgage Finance, Longer Amoritzation Products Gain Momentum In
    Still-Growing Nontraditional Mortgage Market (July 14, 2006), 3.

    The deferred payments associated with interest-only and payment-option
    ARMs will eventually result in higher monthly payments after the
    introductory period expires. For example, for interest-only mortgages,
    payments will rise at the expiration of the fixed interest-only period to
    include repayment of principal. Similarly, when the payment-option period
    ends for a payment-option ARM, the monthly payments will adjust to require
    an amount sufficient to fully amortize the outstanding loan balance,
    including any deferred interest and principal, over the remaining life or
    term. Depending on the particular loan product, a combination of rising
    interest rates and deferred or negative amortization can raise monthly
    payments twofold or more, causing payment shock for those borrowers who
    cannot avoid and are not prepared for these larger payments.

    For example, consider the borrower in the following example who took out a
    $400,000 payment-option ARM in April 2004. The borrower's payment options
    for the first year ranged from a minimum payment of $1,287 to a fully
    amortizing payment of $2,039. Figure 1 shows how monthly payments for the
    borrower who chose to make only the minimum monthly payments during the
    5-year payment-option period could increase from $1,287 to $2,931 or 128
    percent, when that period expires.

    Figure 1: Increase in Minimum Monthly Payments and Outstanding Loan
    Balance with an April 2004 $400,000 Payment-Option ARM, Assuming Rising
    Interest Rates

    The example in figure 1 assumes loan features that were typical of
    payment-option ARMs offered during 2004, including

               o  a promotional "teaser" rate of 1 percent for the first month of
               the loan, which set minimum monthly payments for the first year at
               $1,287;15
               o  a payment reset cap, which limits any annual increases in
               minimum monthly payments due to rising interest rates to 7.5
               percent for the first five years of the loan;16 and
               o  a negative amortization cap, which limits the amount of
               deferred interest that could accrue during the first five years
               until the mortgage balance reaches 110 percent of its original
               amount, and if reached, triggers a loan recast to fully amortizing
               payments.

               After the first month, the start rate of 1 percent expired and the
               interest due on the loan was calculated on the basis of the fully
               indexed interest rate, which was 4.55 percent in April 2004 and
               rose to 6.61 percent in April 2006.17 Minimum monthly payments
               were adjusted upward every April, but only by the maximum 7.5
               percent allowed. By year 5, the minimum payments reset to $1,718,
               a 33 percent increase from the initial minimum payment required in
               year 1.

               As shown in figure 1, these minimum monthly payments were not
               enough to cover the interest due on the loan after the start rate
               expired in the first month of year 1, and the loan immediately
               began to negatively amortize. By year 2, the loan balance
               increased by $3,299. As interest rates rose, the amount of
               deferred interest grew more quickly, reaching $33,446 by the
               beginning of year 6. Because the start of year 6 marked the end of
               the 5-year payment-option period, the loan recast to require fully
               amortizing monthly payments of $2,931. This payment represented a
               70 percent increase from the minimum monthly payment required a
               year earlier and a 128 percent increase from the initial minimum
               monthly payment in year 1. Note that the largest monthly payment
               increase occurred at this time, reflecting the combined effect of
               a fully amortizing payment that is calculated on the basis of both
               the fully indexed interest rate and the increased loan balance.

               In Contrast to Past Borrowers, Recent AMP Borrowers May Find It More
    			  Difficult to Avoid Payment Shock

               Federal regulatory officials have cautioned that the risk of
               default could increase for some recent AMP borrowers. This is
               because lenders have marketed these products to borrowers who are
               not as wealthy or financially sophisticated as previous borrowers,
               and because rising interest rates, combined with constraints on
               the growth in minimum payments imposed by low teaser rates, have
               increased the potential for payment shock.18 FDIC officials
               expressed particular concern over payment-option ARMs, as they are
               more complex than interest-only products and have the potential
               for negative amortization and bigger payment shocks.

               Mortgage statistics of recently securitized interest-only and
               payment-option ARMs show a relaxation of underwriting standards
               regarding credit history, income, and available assets during the
               years these products increased in popularity. According to one
               investment bank, interest-only mortgages that were part of
               subprime securitizations were negligible in 2002, but rose to
               almost 29 percent of subprime securitizations in 2005. Lenders
               also originated payment-option ARMs to borrowers with increasingly
               lower credit scores (see table 1). In addition, besides permitting
               lower credit scores, lenders increasingly qualified borrowers with
               fewer financial resources. For example, lenders allowed higher DTI
               ratios for some borrowers and began combining AMPs with
               "piggyback" mortgages-that is, second mortgages that allow
               borrowers with limited or no down payments to finance a down
               payment. As table 1 shows, by June 2005, 25 percent of securitized
               payment-option ARMs included piggyback mortgages-up from zero
               percent 5 years earlier.19 Furthermore, lenders increasingly have
               qualified borrowers for AMPs under "low documentation" standards,
               which allow for less detailed proof of income or assets than
               lenders traditionally required.20

    15The initial minimum monthly payment amount is derived by calculating the
    30-year, fully amortizing payment for the loan on the basis of the teaser
    rate. This initial minimum payment is in effect for the first year of the
    loan.

    16The payment reset cap keeps monthly payments affordable by protecting
    borrowers from rising interest rate during the payment-option period.
    Minimum monthly payments are adjusted annually depending on movements in
    interest rates. According to the June 2005 OTS Examination Handbook ,
    payment reset caps for payment-option ARMs are typically 7.5 percent per
    year for 5 years, unless deferred interest accrues and the loan balance
    reaches the negative amortization cap specified in the loan terms.
    According to OCC officials, caps on recently sold payment-option ARMs have
    ranged from 110 percent to 125 percent of the loan balance, although caps
    of 110 percent and 115 percent are most common.

    17The fully indexed interest rate comprises an adjustable interest rate
    index, such as the Federal Home Loan Bank of San Francisco Cost of Funds
    Index (COFI), plus the lender's margin. In April 2004, the COFI was 1.80
    percent, and the lender in this example added a margin of about 2.75
    percent to determine the initial fully indexed rate of 4.55 percent on the
    loan. Between April 2004 and April 2006, the COFI increased to 3.86
    percent, causing the fully-indexed interest rate to increase to 6.61
    percent. The example does not assume further interest rate increases.

    18While the inability to make higher monthly payments could cause loan
    defaults, job loss, divorce, serious illness, and a death in the family
    are commonly identified as the major reasons borrowers' default on their
    mortgages. In each of these examples, the borrower can experience a major
    drop in income, or a major increase in expenses.

    Table 1: Underwriting Trends of Recent Payment-Option ARM Securitizations,
    January 2001 to June 2005

                   Origination                    Percentage
                    amount (in Percentage          of option
                   millions of    of FICO Average  ARMs with             Percentage
    Origination  dollars )a     scores     DTI  piggyback  CLTV>80      with low
    year                 ,b below 700c  ratiod  mortgages percente documentation
    2001             $2,210      32.4%    24.4       0.0%     1.8%         69.4%
    2002              3,745       33.4    29.2        0.3      1.9          67.6
    2003              2,098       42.4    28.9        6.3     10.4          74.4
    2004             37,117       43.1    31.6       11.4     12.0          75.4
    2005             13,572       48.2    32.6       25.3     22.2          74.7

    Source: Loan Performance and UBS.

    aThe data in this table capture only mortgages that are securitized and
    sold to the private label secondary market, which do not include mortgages
    guaranteed by GSEs or held by banks in their portfolios.

    bThe 2005 origination amount reflects data from the first half of the
    year.

    cFICO scores are credit scores used to evaluate a borrower's credit
    history.

    dA DTI ratio is the borrower's fixed monthly expenses divided by gross
    monthly income.

    eCombined loan-to-value (CLTV) is the percentage that the first and second
    mortgages make up of the property value.

    Federal banking regulators cautioned that "risk-layering", which results
    from the combination of AMPs with one or more relaxed underwriting
    practices could increase the likelihood that some borrowers might not
    withstand payment shock and may go into default. In particular, federal
    regulatory officials said that some recent AMP borrowers, particularly
    those with low income and little equity, may have fewer financial reserves
    against financial adversity, which could impact their ability to sustain
    future higher monthly payments in the event that they cannot refinance
    their mortgages or sell their homes. Although concerns about the effect of
    risk-layering exist, OCC officials observed that while underwriting
    characteristics for AMPs have trended downward over the past few years,
    lenders generally attempt to mitigate the additional credit risk of AMPs
    compared to traditional mortgages by having at least one underwriting
    criteria (such as LTV ratio, DTI ratio, or loan size) tighter for AMPs
    than for a traditional mortgage. In addition, both OCC and Federal Reserve
    officials said that most lenders qualify payment-option ARM borrowers at
    the fully-indexed rate, and not the teaser rate, suggesting that these
    borrowers have the financial resources to either make more than the
    minimum monthly payment or to manage any future rise in monthly
    payments.21 However, Federal Reserve officials said that borrowers of
    interest-only loans are qualified on the interest-only payment.

    19In a typical piggyback mortgage arrangement, the borrower takes a first
    mortgage for 80 percent of the property value, and a second mortgage or a
    home equity line of credit for part or all of the remaining 20 percent of
    the property value. Piggyback mortgages typically are used to avoid the
    purchase of private mortgage insurance, which many lenders require when
    the down payment is less than 20 percent of the property value.

    20For example, with a no income/no asset verification loan, the borrower
    provides no proof of income and the lender relies on other factors such as
    the borrower's credit score.

    For borrowers who intend to refinance their mortgages to avoid higher
    monthly payments, FDIC officials expressed concern that some may face
    prepayment penalties that could make refinancing expensive. In particular,
    they said that borrowers with payment-option ARMs that choose the minimum
    payment option could reach the negative amortization cap well before the
    expiration of the five-year payment option period, triggering a loan
    recast to fully amortizing payments, the need to refinance the mortgage,
    and the imposition of prepayment penalties.

    Some recent borrowers may find that they do not have sufficient equity in
    their homes to refinance or even to sell, particularly if their loans have
    negatively amortized or they have borrowed with little or no down payment.
    Again, consider the borrower in figure 1. To avoid the increase in monthly
    payments when the loan recasts at the end of year 5, the borrower would
    either have to refinance the mortgage or sell the home. However, because
    the borrower made only minimum payments, the $400,000 debt would have
    increased to $433,446. To the extent that the home's value has risen
    faster than the outstanding mortgage, or the borrower contributed a
    substantial down payment, the borrower might have enough equity to obtain
    refinancing or could sell the house and pay off the loan. However, if the
    borrower has little or no equity and home prices remain flat or fall, the
    borrower could easily have a mortgage that exceeds the value of his or her
    home, thereby making the possibility of refinancing or home sale very
    difficult. According to an investment bank, as of July 2006, about 75
    percent of payment-option ARMs originated and securitized in 2004 and 2005
    were negatively amortizing, meaning that borrowers were making minimum
    monthly payments, and more than 70 percent had loan balances that exceeded
    the original loan balances.22

    21In the example of the $400,000 payment-option ARM discussed earlier, the
    lender likely would have qualified the borrower based on fully-indexed
    interest rate of 4.41 percent, which corresponds to the first-year's fully
    amortizing monthly payment of $2,039. Although the borrower is faced with
    a payment shock of 128 percent in year six as a result of making minimum
    payments, the increase is a smaller 44 percent greater than the monthly
    payment that was originally used to qualify the borrower.

    Federal Reserve officials also said they are concerned that some recent
    borrowers who used AMPs to purchase homes for investment purposes may be
    less inclined to avoid defaulting on their loans when faced with financial
    distress, on the basis that mortgage delinquency and default rates are
    typically higher for these borrowers than for borrowers who use them to
    purchase their primary residences. According to these officials, borrowers
    who used AMPs for investment purposes may have less incentive to try to
    find a way to make their mortgage payments if confronted with payment
    shock or difficulties in refinancing or selling, because they would not
    lose their primary residence in the event of a default. According to FDIC
    officials, this is particularly acute during instances where the borrower
    has made little or no down payment. Although the majority of borrowers
    used AMPs to purchase their primary residence, data on recent
    payment-option ARM securitizations indicate that 14.4 percent of AMPs
    originated in 2005 were used by borrowers to purchase homes for purposes
    other than use as a primary residence, up from 5.3 percent in 2000.23
    However, this data did not show the proportion of these originations that
    were used to purchase homes for investment purposes as compared to second
    homes.

    22Some borrowers, who are making minimum monthly payments now, may have
    made a number of fully amortizing payments previously. Thus, while their
    loan is now negatively amortizing, their loan balance has not yet grown to
    more than the original loan amount. According to UBS, more than 80 percent
    of borrowers with lower credit scores were making minimum monthly
    payments, compared to more than 65 percent for borrowers with high credit
    scores.

    23David Liu, "Credit Implications of Affordability Mortgages," 13.

    Most AMPs Originations Are Too Recent to Generate Sufficient Performance Data to
    Predict Delinquencies and Losses to Banks, but Regulators Said Most Banks
    Appeared to Be Managing Credit Risk

    AMP underwriting practices may have increased the risk of payment shock
    and default for some borrowers, resulting in increased credit risk for
    lenders, including banks. However, federal regulatory officials said that
    most banks appeared to be managing this credit risk. First, they said that
    banks holding the bulk of residential mortgages, including AMPs, are the
    larger, more diversified financial institutions that would be able to
    better withstand losses from any one business line. Second, they said that
    most banks appear to have diversified their assets sufficiently and
    maintained adequate capital to manage the credit risk of AMPs held in
    their portfolios or have reduced their risk through loan sales and
    securitizations. Investment and mortgage banking officials told us that
    hedge funds, real estate investment trusts, and foreign investors are
    among the largest investors in the riskiest classes of these securities,
    and that these investors largely would bear the credit risk from any AMP
    defaults.24

    In addition, several regulatory officials noted borrowers who have turned
    to interest-only FRMs are subject to less payment shock than interest-only
    and payment-option ARM borrowers. As we previously discussed,
    interest-only FRMs are not sensitive to interest rate changes. For
    example, the amount of the initial interest-only payment and the later
    fully amortizing payment are known at the time of loan origination for an
    interest-only FRM and do not vary. Furthermore, these products tend to
    feature a longer period of introductory payments than did the
    interest-only and payment-option ARMs sold earlier, thus giving the
    borrower more time to prepare financially for the increase in monthly
    payments or plan to refinance or sell.25

    Federal regulatory officials and industry participants agree that it is
    too soon to tell how many borrowers with AMPs will become delinquent or go
    into foreclosure, thereby producing losses for banks that hold AMPs in
    their portfolios. Most of the AMPs issued between 2003 and 2005 have not
    recast; therefore, most of these borrowers have not yet experienced
    payment shock or financial distress. As a result, lenders generally do not
    yet have the performance data on delinquencies that would serve as an
    indicator of future problems. Furthermore, the credit profile of recent
    AMP borrowers is different from that of traditional AMP borrowers, because
    it includes less creditworthy and less affluent borrowers. Consequently,
    it would be difficult to use past performance data to predict how many
    loans would be refinanced before payment shock sets in and how many
    delinquencies and foreclosures could result for those borrowers who cannot
    sustain larger monthly payments.

    24Fannie Mae and Freddie Mac purchased limited amounts of AMPs during
    2005. Thirteen percent of Fannie Mae loan purchases comprised
    interest-only and payment-option ARMs during 2005. These loans comprised
    10 percent of Freddie Mac loan purchases during the first 3 quarters of
    2005.

    25The majority of interest-only FRM sold in 2005 had an interest-only
    period of 10 years.

      Regulators and Others Are Concerned That Borrowers May Not Be Well-informed
                                About the Risks of AMPs

    The information that borrowers receive about their loans through
    advertisements and disclosures may not fully or effectively inform them
    about the risk of AMPs. Federal and state banking regulatory officials
    expressed concern that advertising practices by some lenders and brokers
    emphasized the affordability of these products without adequately
    describing their risks. Furthermore, a recent Federal Reserve staff study
    and state complaint data indicated that some borrowers appeared to not
    understand (1) the terms of their ARMs, including AMPs, and (2) the
    potential magnitude of changes to their monthly payments or loan balance.
    As AMPs are more complex than conventional mortgage products and
    advertisements may not provide borrowers with balanced information on
    these products, it is important that written disclosures provide borrowers
    with clear and comprehensive information about the key terms, conditions,
    and costs of these mortgages to help them make an informed decision. That
    information is conveyed both through content and presentation, including
    writing style and design. With respect to content, Regulation Z, which
    includes requirements for mortgage disclosures, requires all creditors
    (lenders and those brokers that close loans in their own name) to provide
    borrowers with information about their ARM products. However, these
    requirements are not designed to address more complex products such as
    AMPs. The Federal Reserve has recently initiated a review of Regulation Z
    that will include reviewing the disclosures required for all mortgage
    loans, including AMPs. For presentation, current guidance available in the
    federal government suggests good practices on developing disclosures that
    effectively communicate key information on financial products. Most of the
    AMP disclosures we reviewed did not always fully or effectively explain
    the risks of payment shock or negative amortization for these products and
    lacked information on some important loan features, both because
    Regulation Z currently does not require lenders to tailor this information
    to AMPs and because lenders do not always follow leading practices for
    writing disclosures that are clear, concise, and user-friendly. According
    to Federal Reserve officials, revising Regulation Z to require better
    disclosures of the key terms and risks of AMPs could increase borrower
    understanding of these complex mortgage products, particularly if a
    broader effort were made to simplify and clarify mortgage disclosures
    generally. Officials added that borrowers who do not understand their AMPs
    may not anticipate the substantial increase in monthly payments or loan
    balance that can occur.

    Some AMP Advertising Practices Emphasize Benefits over Risks

    Borrowers can acquire information on mortgage options from a variety of
    sources, including loan officers and brokers, or as noted by mortgage
    industry participants, through the Internet, television, radio, and
    telemarketing. However, federal regulatory officials expressed concerns
    that some consumers may have difficulty understanding the terms and risks
    of these complex products. These concerns have been heightened as
    advertisements by some lenders and brokers emphasize the benefits of AMPs
    without explaining the associated risks. For example, one print
    advertisement for a payment-option ARM product we obtained stated on the
    first page that the loan "started" at an interest rate of 1.25 percent,
    promised a reduction in the homeowner's monthly mortgage payment of up to
    45 percent, and offered three low monthly payment options. However, the
    lender noted in much smaller print on the second page that the 1.25
    percent interest rate applied only to the first month of the loan and
    could increase or decrease on a monthly basis thereafter. Federal
    regulatory officials said that less financially sophisticated borrowers
    might be drawn to the promise of initial low monthly payments and flexible
    payment options and may not realize the potential for substantial
    increases in monthly payments and loan balance later.26

    Officials from three of the eight states we contacted reported similar
    concerns with AMP advertising distributed by the nonbank lenders and
    independent brokers under their supervision. For example, one official
    from Ohio told us that some brokers advertised the availability of large
    loans with low monthly payments and only specified in tiny print at the
    bottom of the advertisements that the offer involved interest-only
    products. According to this official, small print makes it more difficult
    for the consumer to see these provisions and more likely for the consumer
    not to read them at all. Regulatory officials in Alaska told us some
    advertisements circulating in their state stated that consumers could save
    money by using interest-only products, without disclosing that over time
    these loans might cost more than a conventional product. In some cases,
    the advertisements were potentially misleading. For example, New Jersey
    officials provided us with a copy of an AMP advertisement that promised
    potential borrowers low monthly payments by suggesting that the teaser
    rate (termed "payment rate" in the advertisement) on a payment-option ARM
    product was the actual interest rate for the full term of the loan (see
    figure 2). The officials also said that advertising a rate other than the
    annual percentage rate (APR), without also including the APR (as seen in
    the advertisement shown in fig. 2) is contrary to the requirements of
    Regulation Z.

    26According to Federal Reserve officials, problems with AMP advertising
    represent potential violations of federal law. For example, Regulation Z
    rules governing credit advertising require that advertisements with
    certain "trigger" terms, such as the amount of any payment or finance
    charge, must also include other specified information, such as the terms
    of repayment. See 12 C.F.R. S: 226.24, and the Official Staff Commentary
    at Paragraph 24(c)(2)-2. Furthermore, Section 5 of the Federal Trade
    Commission Act prohibits unfair or deceptive practices in commerce,
    including mortgage lending. A creditor that provides the required
    Regulation Z disclosures is not immune from possible violations of the FTC
    Act if the information is so one-sided as to be misleading.

    Figure 2: Example of a 2005 Broker Advertisement for a Payment-Option ARM

    Industry representatives also expressed concerns about AMP advertising. In
    2005, the California Association of Mortgage Brokers issued an alert to
    warn the public about misleading AMP advertisements circulating in the
    state. The advertisements offered low monthly payments without clearly
    stating that these payments were temporary, and that the loan could become
    significantly more costly over time.

    A Recent Study and Initial Complaint Data Indicated Some Borrowers Did Not
    Understand the Terms and Features of ARMs, Including AMPs

    A recent Federal Reserve staff study and state complaint data indicate
    that some borrowers appeared to not fully understand the terms and
    features of their ARMs, including AMPs, and were surprised by the
    increases in monthly payments or loan balance. In January 2006, staff
    economists at the Federal Reserve published the results of a study that
    assessed whether homeowners understood the terms of their mortgages.27 The
    study was based, in part, on data obtained from the Federal Reserve's 2001
    Survey of Consumer Finances, which included questions for consumers on the
    terms of their ARMs. While most homeowners reported knowing their broad
    mortgage terms reasonably well, some borrowers with ARMs, particularly
    those from households with lower income and less education, appeared to
    underestimate the amount by which their interest rates, and thus their
    monthly payments, could change. The authors suggested that this
    underestimation might be explained, in part, by borrower confusion about
    the terms of their mortgages. Although they found that most households in
    2001 were unlikely to experience large and unexpected changes in their
    mortgage payments in the event of a rise in interest rates, some borrowers
    might be surprised by the change in their payments and subsequently might
    experience financial difficulties.

    The Federal Reserve staff study focused on borrowers holding ARM products
    in 2001-not AMPs. However, as we previously discussed, most AMP products
    sold between 2003 and 2005 were interest-only and payment-option ARMs that
    lenders increasingly marketed and sold to a wider spectrum of borrowers.
    Federal regulatory officials and consumer advocates said that since AMPs
    tend to have more complicated terms and features than ARMs, borrowers who
    have these mortgages would be likely to (1) underestimate the potential
    changes in their interest rates and (2) experience confusion about the
    terms of their mortgages and amounts of their payments.

    Because most AMPs have not recast to fully amortizing payments, many
    borrowers are still making lower monthly payments that do not cover
    repayment of deferred principal. However, five of the eight states we
    contacted reported receiving some complaints about AMPs from borrowers who
    did not understand their loan terms and were surprised by increases in
    their monthly payments or loan balances. For example, some borrowers with
    payment-option ARMs complained that they did not know that their loans
    could negatively amortize until they received their payment coupons and
    saw that their loan balance had increased. In one case, a borrower
    believed that the teaser rate would be in effect for 1 or more years, when
    in fact it was in effect for only the first month. Officials from one
    state said that they anticipated receiving more consumer complaints
    regarding AMPs as these mortgages recast over the next several years to
    require fully amortizing payments.

    27Brian Bucks and Karen Pence, Do Homeowners Know Their House Values and
    Mortgage Terms?, FEDS Working Paper 2006-03, Board of Governors of the
    Federal Reserve System (Washington, D.C.: January 2006).

    Consumers Receive Disclosures about ARMs but the Federal Reserve Will Consider
    the Need for Additional Disclosures about AMPs in its Upcoming Review of
    Regulation Z

    As AMPs are more complex than conventional mortgages and advertisements
    sometimes expose borrowers to unbalanced information about them, it is
    important that the written disclosures they receive about these products
    from creditors provide them with comprehensive information about the
    terms, conditions, and costs of these loans. Disclosures convey that
    information in the following two ways: content and presentation. Federal
    statute and regulation mandate a certain level of content in mortgage
    disclosures through TILA and Regulation Z.

    The purpose of both TILA and Regulation Z, which implements the statutory
    requirements of TILA, is to promote the informed use of credit by
    requiring creditors to provide consumers with disclosures about the terms
    and costs of their credit products, including their mortgages. Some of
    Regulation Z's mortgage disclosure requirements are mandated by TILA.
    Under Regulation Z, creditors are required to provide three disclosures
    for a mortgage product with an adjustable rate:

               o  a program-specific disclosure that describes the terms and
               features of the ARM product,
               o  a copy of the federally authored handbook on ARMs, and
               o  a transaction-specific TILA disclosure that provides the
               borrower with specific information on the cost of the loan.

               First, Regulation Z requires that creditors provide a
               program-specific disclosure for each adjustable-rate product the
               borrower is interested in when the borrower receives a loan
               application or has paid a nonrefundable fee. Among other things,
               lenders must include

               o  a statement that the interest rate, payment, or loan term may
               change;
               o  an explanation of how the interest rate and payment will be
               determined;
               o  the frequency of interest rate and payment changes;
               o  any rules relating to changes in the index, interest rate,
               payment amount, and outstanding loan balance-including an
               explanation of negative amortization if it is permitted for the
               product; and
               o  an example showing how monthly payments on a $10,000 loan
               amount could change based on the terms of the loan.

               Second, Regulation Z also requires creditors to give all borrowers
               interested in an ARM a copy of the Consumer Handbook on Adjustable
               Rate Mortgages or CHARM booklet. The Federal Reserve and OTS wrote
               the booklet to explain how ARMs work and some of the risks and
               advantages to borrowers that ARMs introduce, including payment
               shock, negative amortization, and prepayment penalties.

               Finally, for both fixed-rate and adjustable-rate loans for home
               purchases, lenders are required to provide a transaction-specific
               TILA disclosure to borrowers within 3 days of loan application for
               loans used to purchase homes. For other home-secured loans this
               disclosure must be provided before the loan closes. The TILA
               disclosure reflects loan-specific information, such as the amount
               financed by the loan, related finance charges, and the APR.
               Lenders also must include a payment schedule, reflecting the
               number, amounts, and timing of payments needed to repay the loan.

               The Federal Reserve periodically has updated Regulation Z in
               response to new mortgage features and lending practices. For
               example, in December 2001, the Federal Reserve amended the
               Regulation Z provisions that implement the Home Ownership and
               Equity Protection Act (HOEPA), which requires additional
               disclosures with respect to certain high-cost mortgage loans.28
               The Federal Reserve has also developed model disclosure forms to
               help lenders achieve compliance with the current requirements.

               According to Federal regulatory officials, current Regulation Z
               requirements are designed to address traditional fixed-rate and
               adjustable-rate products-not more complex products such as AMPs.
               Consequently, lenders are not required to tailor the mortgage
               disclosures to communicate information on the potential for
               payment shock and negative amortization specific to AMPs. The
               Federal Reserve has recently initiated a review of Regulation Z
               that will include reviewing the disclosures required for all
               mortgage loans, including AMPs. In addition, the Federal Reserve
               has begun taking steps to consider revisions that would
               specifically address AMPs. During the summer of 2006, the Federal
               Reserve held a series of four hearings across the country on
               home-equity lending.29 Federal Reserve officials said that a major
               focus of these hearings was on AMPs, including the adequacy of
               consumer disclosures for these products, how consumers shop for
               home-secured loans, and how to design more effective disclosures.
               According to these officials, they are currently reviewing the
               hearing transcripts and public comment letters as a first step in
               developing plans and recommendations for revising Regulation Z. In
               addition, they said that they are currently revising the CHARM
               booklet to include information about AMPs and are planning to
               publish a consumer education brochure concerning these products.

               Leading Practices for Financial Product Disclosures Include the Use
    			  of Clear Language to Explain Information That Is Most Relevant to
    			  the Consumer

    			  As we previously noted, the presentation of information in
               disclosures helps convey information. Regulation Z requires that
               the mortgage disclosures lenders provide to consumers are clear
               and conspicuous. Current leading practices in the federal
               government provide useful guidance on developing financial product
               disclosures that effectively present and communicate key
               information on these products. The SEC publishes A Plain English
               Handbook for investment firms to use when writing mutual fund
               disclosures.30 According to the SEC handbook, investors need
               disclosures that clearly communicate key information about their
               financial products so that they can make informed decisions about
               their investments. SEC requires investment firms to use "plain
               English" to communicate complex information clear and logical
               manner so that investors have the best possible chance of
               understanding the information.

               A Plain English Handbook presents recommendations for both the
               effective visual presentation and readability of information in
               disclosure documents. For example, the handbook directs firms to
               highlight information that is important to investors, presenting
               the "big picture" before the details. Also, the handbook
               recommends tailoring disclosures to the financial sophistication
               of the user by avoiding legal and financial jargon, long
               sentences, and vague "boilerplate" explanations. Furthermore, it
               states that the design and layout of the document should be
               visually appealing, and the document should be easy to read.

               According to SEC, it developed these recommendations because
               investor prospectuses were full of complex, legalistic language
               that only financial and legal experts could understand. Because
               full and fair disclosures are the basis for investor protection
               under federal securities laws, SEC reasoned that investors would
               not receive that basic protection if a prospectus failed to
               provide information clearly.

               The Disclosures That We Reviewed Generally Did Not Provide Clear
    			  and Complete Information on AMP Features and Risks

               To see how lenders implemented Regulation Z requirements for AMPs
               and the extent to which they discussed AMP risks and loan terms,
               we reviewed eight program-specific disclosures for three
               interest-only ARMs and five payment-option ARMs, as well as
               transaction-specific TILA disclosures associated with four of
               them. Six federally regulated lenders, representing over 25
               percent of the interest-only and payment-option ARMs produced in
               2005, provided these disclosures to borrowers between 2004 and
               2006. We found that the program-specific disclosures, while
               addressing current Regulation Z requirements, did not always
               provide full and clear explanations of the potential for payment
               shock or negative amortization associated with AMPs. Furthermore,
               in developing these program-specific disclosures, lenders did not
               always adhere to "plain English" practices for designing
               disclosures that are readable and visually effective, thus
               potentially reducing their effectiveness. Finally, we found that
               Regulation Z does not require lenders to completely disclose
               important loan information on the transaction-specific TILA
               disclosures, and, in most cases, lenders did not go beyond these
               minimum requirements when developing TILA disclosures for AMP
               borrowers.

               Program-Specific Disclosures Did Not Always Clearly Discuss the
    			  Risk of Payment Shock or Negative Amortization for AMPs

    			  While addressing current Regulation Z requirements, the
               program-specific disclosures for the eight adjustable-rate AMPs we
               reviewed did not always consistently provide clear and full
               explanations of payment shock and negative amortization as they
               related to AMPs. For example, in describing how monthly payments
               could change, two of the disclosures we reviewed closely followed
               the "boilerplate" language of the model disclosure form, which
               included a statement that monthly payments could "increase or
               decrease annually" based on changes to the interest rate, as
               illustrated in figure 3.

               Figure 3: Example of a 2005 Interest-Only ARM Disclosure
               Explaining How Monthly Payments Can Change

               While factually correct, these disclosure statements do not
               clearly inform the borrower about the dramatic increase in monthly
               payments that could occur at the end of the introductory period
               for an AMP-twofold or more as we previously discussed-particularly
               in a rising interest rate environment. The remaining six
               disclosures more accurately signaled this risk to the borrower by
               stating that the payments could change substantially. One of these
               disclosures most clearly alerted borrowers to this risk by
               including both a bold-faced heading "Potential Payment Shock" on
               the first page of the disclosure and the following explanatory
               text:

               "As with all Adjustable Rate Mortgage (ARM) loans, your interest
               rate can increase or decrease. In the case of a [brand name of
               product], the monthly payment can increase substantially after the
               first 60 months or if the loan balance rises to 110 percent of the
               original amount borrowed, and this creates the potential for
               payment shock. Payment shock means that the increase in the
               payment is so significant that it can affect your monthly cash
               flow." [Emphasis added.]

               In reviewing the five payment-option ARM disclosures, we also
               found that they did not always clearly describe negative
               amortization and its risks for the borrower. As required by
               Regulation Z, all of the disclosures explained that the product
               allowed for negative amortization and described how. However, the
               disclosures we reviewed did not always clearly or completely
               explain the harmful effects that could result from negative
               amortization. In the example above, where the disclosure did link
               an increased loan balance with payment shock, the effectiveness of
               the statement is blunted because it does not tell the borrower
               early on how the loan balance could rise. Instead, in a separate
               paragraph under the relatively nondescript heading, "More
               Information About [product name] Payment Choices," the lender
               tells the borrower that the "minimum payment probably will not be
               sufficient to cover the interest due each month." [Emphasis
               added.]

               In another case, although the disclosure does say that because of
               negative amortization the borrower can owe "much more" than
               originally borrowed, the effect of that disclosure may be blunted
               by the inclusion of positive language about taking advantage of
               the negative amortization features and by non-loan-specific
               examples of payment changes, which are in separate sections of the
               disclosure:

               "If your monthly payment is not sufficient to pay monthly
               interest, you may take advantage of the negative amortization
               feature by letting the interest rate defer and become part of the
               principle balance to be paid by future monthly payments, or you
               may also choose to limit any negative amortization by increasing
               the amount of your monthly payment or by paying any deferred
               interest in a lump sum at any time." [Emphasis added].

               In addition, three of the five payment-option ARM disclosures did
               not explain how soon the negative amortization cap could be
               reached in a rising interest rate environment and trigger an early
               recast. Without this information, borrowers who considered
               purchasing a typical 5-year payment-option ARM for its flexibility
               might not realize that their payment-option period could expire
               before the end of the first 5 years, thus recasting the loan and
               increasing their monthly payments.

               Disclosures Generally Did Not Prominently Present Key Information
    			  on Changes to Monthly Payments and Loan Balance or Adhere to Other
    			  �Plain English� Principles

    			  Although the potential for payment shock and negative amortization
               are the most significant risks to an interest-only or
               payment-option ARM, the program-specific disclosures we reviewed
               generally did not prominently feature this key information.
               Instead, in keeping with the layout suggested by the model
               disclosure form, most of the disclosures we reviewed first
               provided lengthy discussions on the borrower's interest rate and
               monthly payment and the rules related to interest rate and payment
               changes, before describing how much monthly payments could change
               for the borrower. One disclosure did use the heading, "Worst Case
               Example," to highlight the potential for payment shock for the
               borrower. However, this information could be hard to find because
               it is located on the third and fourth page of an eight-page
               disclosure.

               Furthermore, the program-specific disclosures generally did not
               conform to key plain English principles for readability or design
               in several key areas. In particular, we found that these
               disclosures were generally written with a complexity of language
               too high for many adults to understand. Also, most of the
               disclosures used small, hard-to-read typeface, which when combined
               with an ineffective use of white space and headings, made them
               even more difficult to read and hindered identification of
               important information. Appendix II provides additional information
               on the results of our analysis.

               Transaction-Specific TILA Disclosures Lacked Key Information for
    			  AMP Borrowers

    			  Regulation Z does not require lenders to completely disclose
               important AMP loan information on the transaction-specific TILA
               disclosures, including the interest-rate assumptions underlying
               the payment schedule, the amount of deferred interest that can
               accrue, and the amount and duration of any prepayment penalty. In
               most cases, lenders did not go beyond minimum requirements when
               developing transaction-specific disclosures for AMP borrowers.
               First, when the mortgage product features an adjustable rate,
               Regulation Z requires lenders to (1) include a payment schedule
               and (2) assume that no changes occur in the underlying index over
               the life of the loan. However, it does not require the disclosures
               to indicate this assumption, and the four transaction-specific
               disclosures we reviewed did not include this information.
               Regulation Z only requires lenders to remind borrowers in the
               transaction-specific disclosure that the loan has an adjustable
               rate and refer them to previously provided adjustable-rate
               disclosures (see fig. 4); therefore, borrowers might not
               understand that the payment schedule is not representative of
               their payments in a changing interest rate environment. Figure 4
               shows the payment schedule for a 5-year payment-option ARM
               originated in 2005. The first 5 years show the minimum monthly
               payments increasing to reflect the difference between the teaser
               rate and the initial fully-indexed interest rate, but the amount
               of the increase is constrained each year by the payment reset cap
               in effect for the loan. The loan recasts in the 6th year to fully
               amortizing payments. However, this increase could be considerably
               more if the fully-indexed interest rate were to rise during the
               first 5 years of the loan.

    28Congress enacted HOEPA in 1994 in response to reports of predatory home
    equity lending practices in underserved markets.

    29HOEPA directs the Federal Reserve to periodically hold public hearings
    to examine the home equity lending market and the adequacy of existing
    regulatory and legislative provisions for protecting the interests of
    consumers, particularly low-income consumers. The last hearings were held
    in 2000.

    30SEC, A Plain English Handbook: How to Create Clear SEC Disclosure
    Documents (1998).

    Figure 4: Transaction-Specific TILA Disclosure from a 2005 Payment-Option
    ARM Disclosure

    Second, although negative amortization increases the risk of payment shock
    for the payment-option ARM borrower, Regulation Z does not require lenders
    to disclose the amount of deferred interest that would accrue each year as
    a result of making minimum payments. None of the lenders whose
    transaction-specific disclosures for payment-option ARMs we reviewed
    elected to include this information. Without it, borrowers would not be
    able to see how choosing the minimum payment amount could increase the
    outstanding loan balance from year to year. We reviewed two loan payment
    coupons that lenders provide borrowers on a monthly basis to see if they
    provided the borrower with information on negative amortization. Although
    they included information showing the increased loan balance that resulted
    from making the minimum monthly payment, borrowers only would receive
    these coupons once they started making payments on the loan.31

    Finally, Regulation Z requires lenders to disclose whether the loan
    contains any prepayment penalties, but the regulation does not require the
    lender to provide any details on this penalty on the transaction-specific
    disclosure. Three of the four disclosures used two checkboxes to indicate
    whether borrowers "may" or "will not" be subject to a prepayment penalty
    if they paid off the mortgage before the end of the term, but did not
    disclose any additional information, such as the amount of the prepayment
    penalty (see fig. 4). One disclosure provided information on the length of
    the penalty period. Without clear prepayment information, borrowers may
    not understand how expensive it could be to refinance the mortgage if they
    found their monthly payments were rising and becoming unaffordable.

    Revisions to Regulation Z May Increase Understanding of AMPs, Particularly If
    Broader Effort Were Made to Reform the Mortgage Disclosure Process

    According to federal banking regulators, borrowers who do not understand
    their AMP may not anticipate the substantial increase in monthly payments
    or loan balance that could occur, and would be at a higher risk of
    experiencing financial hardship or even default. One mortgage industry
    trade association told us that it is in the best interest of lenders and
    brokers to provide adequate disclosures to their customers so that they
    will be satisfied with their loan and consider the lender for future
    business or refer others to them. Officials from one federal banking
    regulator said that revising Regulation Z requirements so that lender
    disclosures more clearly and comprehensively explain the key terms and
    risks of AMPs would be one of several steps needed to increase borrower
    understanding about these more complex mortgage products. Federal Reserve
    officials said that there is a trade-off between the goals of clarity and
    comprehensiveness in mortgage disclosures. In particular, they said that
    there is a desire to provide information that is both accurate and
    comprehensive in order to mitigate legal risks, but that might also result
    in disclosures that have too much information and therefore, are not clear
    or useful to consumers. According to these officials, this highlights the
    need for using consumer testing in designing model disclosures to
    determine (1) what information consumers need, (2) when they need it, and
    (3) which format and language that will most effectively convey the
    information so that it is readily understandable. In conducting the review
    of Regulation Z rules for mortgage disclosures, they said that they plan
    to use extensive consumer testing and will also use design consultants in
    developing model disclosure forms.

    31Regulation Z does not require creditors to send payment coupons to
    borrowers each month.

    In addition, Federal Reserve officials and other industry participants
    said that the benefits of amending federally required disclosures to
    improve their content, usability, and readability might not be realized if
    revisions were not part of a broader effort to simplify and clarify
    mortgage disclosures. According to a 2000 report by the Department of the
    Treasury and the Department of Housing and Urban Development, federally
    required mortgage disclosures account for only 3 to 5 forms in a process
    that can generate up to 50 mortgage disclosure documents, most of which
    are required by the lender or state law.32 According to federal and state
    regulatory officials and industry representatives, existing mortgage
    disclosures are too voluminous and confusing to clearly convey to
    borrowers the essential terms and conditions of their mortgages, and often
    are provided too late in the loan process for borrowers to sort through
    and read. Officials from one federal banking regulator noted that
    disclosures often are given when borrowers have committed money to apply
    for a loan, thereby making it less likely that the borrowers would back
    out even if they did not understand the terms of the loan.

    32U.S. Department of the Treasury and U.S. Department of Housing and Urban
    Development, Joint Report on Recommendations to Curb Predatory Home
    Mortgage Lending (Washington, D.C.: June 20, 2000).

    Federal Banking Regulators Issued Draft Guidance and Took Other Actions to
          Improve Lender Practices and Disclosures and Publicize Risks of AMPs

    Federal banking regulators have responded, collectively and individually,
    to concerns about the risks of AMP-lending. In December 2005, regulators
    collectively issued draft interagency guidance for federally regulated
    lenders that suggests tightening underwriting for AMP loans, developing
    policies for risk management of AMP lending, and improving consumer
    understanding of these products. For instance, the draft guidance states
    that lenders should provide clear and balanced information on both the
    benefits and risks of AMPs to consumers, including payment shock and
    negative amortization. In comments to the regulators, some industry groups
    said the draft guidance would put federally regulated lenders at a
    disadvantage, while some consumer advocates questioned whether it would
    protect consumers because it did not apply to all lenders or require
    revised disclosures. Federal regulatory officials discussed AMP lending in
    a variety of public and industry forums, widely publicizing their concerns
    and recommendations. In addition, some regulators individually increased
    their monitoring of AMP lending, taking such actions as issuing new
    guidance to examiners and developing new review programs.

    Draft Interagency Guidance on AMP Lending Recommends Tightening Underwriting
    Standards, Developing Risk Management Policies, and Improving Consumer
    Information

    Draft interagency guidance, which federal banking regulators released in
    December 2005, responds to their concern that banks may face heightened
    risks as a result of AMP lending and that borrowers may not fully
    understand the terms and risks of these products.33 Federal regulatory
    officials noted that the draft guidance did not seek to limit the
    availability of AMPs, but instead sought to ensure that they were properly
    underwritten and disclosed. In addition, they said the draft guidance
    reflects an approach to supervision that seeks to help banks identify
    emerging and growing risks as early as possible, a process that encourages
    banks to develop advanced tools and techniques to manage those risks, for
    their own account and for their customers. Accordingly, the draft guidance
    recommends that federally regulated financial institutions ensure that (1)
    loan terms and underwriting standards are consistent with prudent lending
    practices, including consideration of a borrower's repayment capacity; (2)
    risk management policies and procedures appropriately mitigate any risk
    exposures created by these loans; and (3) consumers are provided with
    balanced information on loan products before they make a mortgage product
    choice.

    33Some banking regulators have addressed risks posed by AMPs through
    guidance that precedes the 2005 interagency guidance. For example, OTS
    revised its real estate lending guidance in June 2005, and it includes
    guidance on interest-only and negative amortizing mortgages. In addition,
    in January 2001, federal banking regulators developed Expanded Guidance
    for Subprime Lending Programs, which lists certain characteristics of
    predatory or abusive lending, such as failure to adequately disclose
    mortgage terms and basing the loan on the borrower's assets and not the
    borrower's repayment ability.

    To address AMP underwriting practices, the draft guidance states that
    lenders should consider the potential impact of payment shock on the
    borrower's capacity to repay the loan. In particular, lenders should
    qualify borrowers on the basis of whether they can make fully amortizing
    monthly payments determined by the fully-indexed interest rate, and not on
    their ability to make only interest-only payments or minimum payments
    determined from lower promotional interest rates. The draft guidance also
    notes increased risk to lenders associated with combining AMPs with
    risk-layering features, such as reduced documentation or the use of
    piggyback loans. In such cases, the draft guidance recommends that lenders
    look for off-setting factors, such as higher credit scores or lower LTV
    ratios to mitigate the additional risk. Furthermore, the draft guidance
    recommends that lenders avoid using loan terms and underwriting practices
    that may cause borrowers to rely on the eventual sale or refinancing of
    their mortgages once full amortization begins.

    To manage risk associated with AMP lending, the draft guidance recommends
    lenders develop written policies and procedures that describe AMP
    portfolio limits, mortgage sales and securitization practices, and
    risk-management expectations. The policies and procedures also should
    establish performance measures and management reporting systems that
    provide early warning of portfolio deterioration and increased risk. The
    draft guidance also recommends policies and procedures that require
    banking capital levels that adequately reflect loan portfolio composition
    and credit quality, and also allow for the effect of stressed economic
    conditions.

    To help improve consumer understanding of AMPs, the draft guidance
    recommends that lender communications with consumers, including
    advertisements, promotional materials, and monthly statements, be
    consistent with actual product terms and payment structures and provide
    consumers with clear and balanced information about AMP benefits and
    risks. Furthermore, the draft guidance recommends that institutions avoid
    advertisement practices that obscure significant risks to the consumer.
    For example, when institutions emphasize the AMP benefit of low initial
    payments, they also should disclose that borrowers who make these payments
    may eventually face increased loan balances and higher monthly payments
    when their loans recast.

    The draft guidance also recommends that lenders fully disclose AMP terms
    and features to potential borrowers in their promotional materials, and
    that lenders not wait until the time of loan application or closing, when
    they must provide written disclosures that fulfill Regulation Z
    requirements. Rather, the draft guidance states that institutions should
    offer full and fair descriptions of their products when consumers are
    shopping for a mortgage, so that consumers have the appropriate
    information early enough to inform their decision making. In doing so, the
    draft guidance urges lenders to employ a user-friendly and readily
    navigable design for presenting mortgage information and to use plain
    language with concrete examples of available loan products. Further, the
    draft guidance states that financial institutions should provide consumers
    with information about mortgage prepayment penalties or extra costs, if
    any, associated with AMP loans. Finally, after loan closing, financial
    institutions should provide monthly billing statement information that
    explains payment options and the impact of consumers' payment choices.
    According to the draft guidance, such communication should help minimize
    potential consumer confusion and complaints, foster good customer
    relations, and reduce legal and other risks to lending institutions.

    Federal regulatory officials said they developed the draft guidance to
    clarify how institutions can offer AMPs in a safe and sound manner and
    clearly disclose the potential AMP risks to borrowers. These officials
    told us they will request remedial action from institutions that do not
    adequately measure, monitor, and control risk exposures in their loan
    portfolios.

    Many Industry Groups Opposed the Draft Guidance and Some Consumer Advocates
    Questioned Whether It Would Add Consumer Protections

    In response to the draft interagency guidance, federal regulators received
    various responses through comment letters from various groups, such as
    financial institutions, mortgage brokers, and consumer advocates, and
    began reviewing comments to develop final guidance. For example, several
    financial institutions such as banks and their industry associations
    opposed the draft guidance, suggesting that it put federally regulated
    institutions at a competitive disadvantage because its recommendations
    would not apply to lenders and brokers that were not federally regulated.
    Some lenders suggested implementing these changes through Regulation Z so
    that they apply to the entire industry, and not just to regulated
    institutions. Organizations such as the Conference of State Bank
    Supervisors (CSBS) and the American Association of Residential Mortgage
    Regulators (AARMR) also noted the possibility of competitive
    disadvantage and have responded by developing guidance for state-licensed
    mortgage lenders and brokers who offer AMPs but were not covered by the
    draft federal guidance issued in December 2005. Other financial
    institutions said that the recommendations regarding borrower
    qualification and general underwriting practices were too prescriptive and
    would have the effect of reducing mortgage choice for consumers.

    Consumer advocates supported the need for additional consumer protections
    relating to AMP products, but several questioned whether the draft
    guidance would add needed protections. They also contended, as did
    lenders, that since the draft guidance applies only to federally regulated
    institutions, independent lenders and brokers would not be subject to
    recommendations aimed at informing and protecting consumers. One advocacy
    organization said that the proposed guidance is only a recommendation by
    the agencies regulating some lenders, and that failure to follow the
    guidance neither leads to any enforceable sanctions nor provides a means
    of using guidance to obtain relief for a harmed consumer. Although not in
    a comment letter, another advocate echoed these concerns by saying the
    draft guidance would not expand consumer protections because it neither
    requires revisions to mortgage disclosures, nor allows consumers to
    enforce the application of guidance standards to individual lenders.

    Federal Officials Reinforced Their Messages by Publicizing Their Concerns,
    Highlighting AMP Risks, and Taking Other Actions

    Although the draft interagency guidance has not been finalized, officials
    from the Federal Reserve, OCC, OTS, FDIC, and NCUA have reinforced
    messages regarding AMP risks and appropriate lending practices by
    publicizing their concerns in speeches, at conferences, and the media.
    According to an official at the Federal Reserve, federal regulatory
    officials who publicized their concerns in these outlets raised awareness
    of AMP risks and reinforced the message that financial institutions and
    the general public need to manage risks and understand these products,
    respectively.

    In addition to drafting interagency guidance and publicizing AMP concerns,
    officials from each of the federal banking regulators told us they have
    responded to AMP lending with intensified reviews, monitoring, and other
    actions. For instance, FDIC developed a review program to identify
    high-risk lending areas, adjust supervision according to product risk
    levels, and evaluate risk management and underwriting approaches. OTS
    staff has performed a review of its 68 most active AMP lenders to assess
    and respond to potential AMP lending risks while the Federal Reserve and
    OCC have begun to conduct reviews of their lenders' AMP promotional and
    marketing materials to assess how well they inform consumers. As discussed
    earlier, the Federal Reserve has taken several steps to address consumer
    protection issues associated with AMPs, including initiating a review of
    Regulation Z that includes reviewing the disclosures required for all
    mortgage loans and holding public hearings that in part explored the
    adequacy and effectiveness of AMP disclosures. In addition, NCUA officials
    told us they informally contacted the largest credit unions under their
    supervision to assess the extent of AMP lending at these institutions.

    FTC also directed some attention to consumer protection issues related to
    AMPs. In 2004, it charged a California mortgage broker with misleading AMP
    consumers by making advertisements that contained allegedly false promises
    of fixed interest rates and fixed payments for variable rate payment
    option mortgages. As a result of FTC's actions, a U.S. district court
    judge issued a preliminary injunction barring the broker's allegedly
    illegal business practices. More recently in May 2006, FTC sponsored a
    public workshop that explored consumer protection issues as a result of
    AMP growth in the mortgage marketplace. FTC, along with other federal
    banking regulators and departments, also helped create a consumer brochure
    that outlines basic mortgage information to help consumers shop for,
    compare, and negotiate mortgages.

        Most States in Our Sample Responded to AMP Lending Risks within Existing
            Regulatory Frameworks, While Others Had Taken Additional Actions

    Along with federal regulatory officials, state banking and financial
    regulatory officials we contacted expressed concerns about AMP lending and
    some have incorporated AMP issues into their licensing and examinations of
    independent lenders and brokers and worked to improve consumer protection.
    While the states we reviewed had not changed established licensing and
    examinations procedures to oversee AMP lending, some currently have a
    greater focus on and awareness of AMP risks. Two states also had collected
    AMP-specific data to identify areas of concerns, and one state had
    proposed changing a consumer protection law to cover AMP products.

    States in Our Sample Identified Concerns about AMP Lending by Independent
    Mortgage Lenders and Brokers

    Most regulatory officials from our sample of eight states focused their
    concerns about AMP lending on the potential negative effects on consumers.
    For example, many officials questioned (1) how well consumers understood
    complex AMP loans, and therefore, how susceptible consumers with AMPs
    therefore might be to payment shock and (2) how likely consumers would
    then be to experience financial difficulties in meeting their mortgage
    payments. Some state officials also said that increased AMP borrowing
    heightened their concern about mortgage default and foreclosure, and some
    officials expressed concern about unscrupulous lender or broker operations
    and the extent to which these entities met state licensing and operations
    requirements. In addition to these general consumer protection concerns,
    some state officials spoke about state-specific issues. For example, Ohio
    officials put AMP concerns in the context of larger economic issues and
    said AMP mortgages were part of wider economic challenges facing the
    state, including an already-high rate of mortgage foreclosures and the
    loss of manufacturing jobs that hurt both Ohio's consumers and the overall
    economy. Officials from another state, Nevada, said they worried that
    lenders and brokers sometimes took advantage of senior citizens by
    offering them AMP loans that they either did not need or could not afford.

    State banking and financial regulatory officials expressed concerns about
    the extent to which consumers understood AMPs and that potential for those
    who used them to experience monthly mortgage payment increases. Some state
    officials said that current federal disclosures were complicated,
    difficult to comprehend, and often did not provide information that could
    help consumers. However, these officials thought that adding a
    state-developed disclosure to the already voluminous mortgage process
    would add to the confusion and paperwork burden. Officials from most
    states have not created their own mortgage disclosures.

    States in Our Sample Generally Increased Their Attention to AMPs Through
    Licensing and Examination, and by Taking New Approaches

    State banking and financial regulators from our sample generally responded
    to concerns about AMP lending by increasing their attention to AMP issues
    through their existing regulatory structure of lender and broker licensing
    and examination, but some states had taken additional approaches. Most of
    the state officials from our sample suggested they primarily used their
    own state laws and regulations to license mortgage lenders and brokers and
    to ensure that these entities met minimum experience and operations
    standards. While these were not AMP-specific actions, several state
    officials told us these actions help ensure that lenders had the proper
    experience and other qualifications to operate within the mortgage
    industry. Some officials told us that these requirements also helped
    ensure that those with criminal records or histories of unscrupulous
    mortgage behavior would not continue to harm consumers. Some state
    officials said that they were particularly sensitive to AMP lenders'
    records of behavior because of the higher risks these products entailed
    for consumers.

    However, Alaska provided an exception. Alaska had not specifically
    responded to AMP lending and Alaska officials noted that the state does
    not have statutes or regulations that govern mortgage lending, nor are
    mortgage lenders or brokers required to be licensed to make loans.

    Many of the state banking and financial regulatory officials we contacted
    also told us that they periodically examine AMP lenders and brokers for
    compliance with state licensing, mortgage lending, and general consumer
    protection laws, including applicable fair advertising requirements.
    Because state officials perform examinations for all licensed lenders and
    brokers, these regulatory processes also are not AMP-specific. However,
    some state officials said they were particularly aware of AMP risks to
    consumers and had begun to pay more attention to potential lender, broker,
    and consumer issues during their oversight reviews. For example, because
    AMP lending heightens potential risks for consumers, several state
    officials said they had taken extra care during their licensing and
    examination reviews to review lender and broker qualifications and loan
    files.

    A few states had worked outside of the existing licensing and examination
    framework to identify AMP issues and protect consumers. Officials from
    several states said that because they did not collect data on AMP loans
    and borrowers, they did not fully understand the level and types of AMP
    lending in their states. However, two states from our sample had begun to
    gather AMP data to improve their information on AMP lending. New Jersey
    conducted a mortgage lending survey among its state-chartered banks that
    specifically collected data on interest-only and payment-option mortgages,
    while Nevada implemented annual reporting requirements for lenders and
    brokers on the types of loans they originate. New Jersey and Nevada
    officials told us that these efforts would provide an overview of AMP
    lending in each state and would serve to help identify emerging AMP
    issues.

    Other states reacted by focusing on consumer protection or using guidance
    for independent lenders and mortgage brokers. Ohio addressed mortgage
    issues, including AMP concerns, by working to improve its consumer
    protection law. This law originally did not cover mortgage lenders and
    brokers, but was amended to include protections found in other states. As
    of June 2006, officials drafted and passed legislation to expand the law's
    provisions to cover these entities and require lenders and brokers to meet
    fiduciary standards to offer loans that serve the interest of potential
    borrowers. Officials from another state in our sample, New York, said they
    planned to use guidance developed by the Conference of State Bank
    Supervisors and American Association of Residential Mortgage Regulators to
    address AMP lending concerns at the state level. In addition, they said
    that they were revising their banking examination manual to address AMP
    concerns, reflect recommendations made in their guidance, and provide
    examiners with areas of concern on which to focus during their reviews.

                                      Conclusions

    Historically AMPs were offered to higher-income, financially sophisticated
    borrowers who wanted to minimize their mortgage payments to better manage
    their cash flows. In recent years, federally and state-regulated lenders
    and brokers widely marketed AMPs by touting their low initial payments and
    flexible payment options, which helped borrowers to purchase homes for
    which they might not have been able to qualify with a conventional
    fixed-rate mortgage, particularly in some high-priced markets. However,
    the growing use of these products, especially by less informed, affluent,
    and creditworthy borrowers, raises concerns about borrowers' ability to
    sustain their monthly mortgage payments, and ultimately to keep their
    homes. When these mortgages recast and payments increase, borrowers who
    cannot refinance their mortgages or sell their homes could face
    substantially higher payments. If these borrowers cannot make these
    payments, they could face financial distress; delinquency; and possibly,
    foreclosure. Nevertheless, it is too soon to tell the extent to which
    payment shock will produce financial distress for borrowers and induce
    defaults that would affect banks that hold AMPs in their portfolios.

    Federal banking regulators have taken steps to address the potential risks
    of AMPs to lenders and borrowers. They have drafted guidance for lenders
    to strengthen underwriting standards and improve disclosure of information
    to borrowers. Because the key features and terms of AMPs may continue to
    evolve, it is essential for the regulators to make an effort to respond to
    AMP lending growth in ways that seek to balance market innovation and
    profitability for lenders with timely information and mortgage choices for
    borrowers. Furthermore, with the continued popularity of AMPs, it is
    important that the federal banking regulators finalize the draft guidance
    in a timely manner.

    The popularity and complexity of AMPs and lenders' marketing of these
    products highlight the importance of mortgage disclosures in helping
    borrowers make informed mortgage decisions. As lenders and brokers
    increasingly market AMPs to a wider spectrum of borrowers, more borrowers
    may struggle to fully understand the terms and risks of these products.
    While Regulation Z requires that lenders provide certain information on
    ARMs, currently lenders are not required to tailor the mortgage
    disclosures to communicate to borrowers information on the potential for
    payment shock and negative amortization specific to AMPs. In particular,
    although they may be in compliance with Regulation Z requirements, the
    disclosures we reviewed did not provide borrowers with easily
    comprehensible information on the key features and risks of their mortgage
    products. Furthermore, the readability and usability of these documents
    were limited by the use of language that was too complex for many adults
    and document designs that made the text difficult to read and understand.
    As such, these documents were not consistent with leading practices at the
    federal level for financial-product disclosures that are predicated on
    investment firms' providing investors with important product information
    clearly to further their informed decision making. Although the draft
    interagency guidance by federal banking regulators addressed some of the
    concerns with consumer disclosures, the draft guidance focuses on
    promotional materials, not the written disclosures required by Regulation
    Z at loan application and closing. In addition, the guidance does not
    apply to nonbank lenders, whereas Regulation Z applies to the entire
    industry. We recognize that the Federal Reserve has begun to review
    disclosure requirements for all mortgage loans, including AMPs, under
    Regulation Z and has used the recent HOEPA hearings to gather public
    testimony on the effectiveness of current AMP disclosures. Furthermore, we
    agree with regulators and industry participants' views that revising
    Regulation Z to make federally required mortgage disclosures more useful
    for borrowers that use complex products like AMPs is a good first step to
    addressing a mortgage disclosure process that many view as overwhelming
    and confusing for the average borrower. Without amending Regulation Z to
    require lenders to clearly and comprehensively explain the terms and risks
    of AMPs, borrowers might not be able to fully exercise informed judgment
    on what is likely a significant investment decision.

                          Recommendation for Executive Action

    We commend the Federal Reserve's efforts to review its existing disclosure
    requirements and focus the recent HOEPA hearings in part on AMPs. As the
    Federal Reserve begins to review and revise Regulation Z as it relates to
    disclosure requirements for mortgage loans, we recommend that the Board of
    Governors of the Federal Reserve System consider improving the clarity and
    comprehensiveness of AMP disclosures by requiring

               o  language that explains key features and potential risks
               specific to AMPs, and
               o  effective format and visual presentation, following criteria
               such as those suggested by SEC's A Plain English Handbook.

               Agency Comments and Our Evaluation

    			  We requested comments on a draft of this report from the Federal
               Reserve, FDIC, NCUA, OCC, and OTS. We also provided a draft to FTC
               and selected sections of the report to the relevant state
               regulators for their review. The Federal Reserve provided written
               comments on a draft of this report, which have been reprinted in
               appendix III. The Federal Reserve noted that it has already begun
               a comprehensive review of Regulation Z, including its requirements
               for mortgage disclosures. The Federal Reserve reiterated that one
               of the purposes of its recent public hearings on home equity
               lending was to discuss AMPs, and in particular, whether consumers
               receive adequate information about these products. It intends to
               use this information in developing plans and recommendations for
               revising Regulation Z within the existing framework of TILA. The
               Federal Reserve stressed that any new disclosure requirements
               relating to features and risks of today's loan products must be
               sufficiently flexible to allow creditors to provide meaningful
               disclosures even as those products develop over time. In response
               to our recommendation to consider improving the clarity and
               comprehensiveness of AMP disclosures, the Federal Reserve noted
               that it plans to conduct consumer testing to determine what
               information is important to consumers, what language and formats
               work best, and how disclosures can be revised to reduce complexity
               and information overload. To that end, the Federal Reserve said
               that it will use design consultants to assist in developing model
               disclosures that are most likely to be effective in communicating
               information to consumers. In addition, the Federal Reserve
               provided examples of other efforts that it is currently engaged in
               to enhance the information consumers received about the features
               and risks associated with AMPs, which we have previously discussed
               in the report. FDIC, FTC, NCUA, OCC, and OTS did not provide
               written comments. Finally, the Federal Reserve, FDIC, FTC, and OCC
               provided technical comments, which we have incorporated into the
               final report.

               As agreed with your office, unless you publicly announce its
               contents earlier, we plan no further distribution of this report
               until 30 days after the date of this report. At that time, we will
               send copies of this report to the Chairman and Ranking Minority
               Member of the Senate Committee on Banking, Housing, and Urban
               Affairs and the Ranking Minority Member of its Subcommittee on
               Housing and Transportation; the Chairman and Ranking Minority
               Member of the House Committee on Financial Services; other
               interested congressional committees. We will also send copies to
               the Chairman, Federal Deposit Insurance Corporation; the Chairman,
               Board of Governors of the Federal Reserve System; the Chairman,
               National Credit Union Administration; the Comptroller of the
               Currency; and the Director, Office of Thrift Supervision. We will
               also make copies available to others upon request. The report will
               be available at no charge on the GAO Web site at
               http://www.gao.gov .

               If you or your staff have any questions regarding this report,
               please contact me at (202) 512-8678 or williamso@gao.gov . Contact
               points for our Offices of Congressional Relations and Public
               Affairs may be found on the last page of this report. Key
               contributors to this report are listed in appendix IV.

               Sincerely yours,

               Orice M. Williams Director, Financial Markets and Community
               Investment

               Appendix I: Scope and Methodology

    			  To identify recent trends in the market for alternative mortgage
               products (AMPs), we gathered information from federal banking
               regulators and the residential mortgage lending industry on AMP
               product features, customer base, and originators as well as on
               reasons for the recent growth of these products.

               To determine the potential risks of AMPs for lenders and
               borrowers, we analyzed the changes, especially increases, in
               future monthly payments that can occur with AMPs. We analyzed
               these data using several scenarios, including rising interest
               rates and negative amortization. We obtained data from a private
               investment firm on the underwriting characteristics of recent
               interest-only and payment-option adjustable rate mortgage (ARM)
               issuance and obtained information on the securitization of AMPs
               from federal banking regulators, government-sponsored enterprises,
               and the secondary mortgage market. We conducted a limited analysis
               to assess the reliability of the investment firm's data. To do so,
               we interviewed a firm representative and an official from a
               federal banking regulator (federal regulatory official) to
               identify potential data limitations and determine how the data
               were collected and verified and to identify potential data
               limitations. On the basis of this analysis, we concluded that the
               firm's data were sufficiently reliable for our purposes. Finally,
               we interviewed federal regulatory officials and representatives
               from the residential mortgage lending industry and reviewed
               studies on the risks of these mortgages compared with conventional
               fixed rate mortgages.

               To determine the extent to which mortgage disclosures present the
               risks of AMPs, we reviewed federal laws and regulations governing
               the content of required mortgage disclosures. We obtained examples
               of AMP-related advertising and mortgage disclosures, reviewed
               studies on borrowers' understanding of adjustable rate products,
               and conducted interviews with federal regulatory officials and
               industry participants. To obtain state regulators' views on AMP
               mortgage disclosures, we also selected a sample of eight states
               and reviewed laws and regulations related to disclosure
               requirements. We obtained examples of AMP advertisements,
               disclosures, and AMP-related complaint information and interviewed
               state officials. We generally selected states that 1) exhibited
               high volumes of AMP lending, 2) provided geographic diversity of
               state locations, and 3) provided diverse regulatory records when
               responding to the challenges of a growing AMP market. Because
               state-level data on AMP lending volumes were not available, we
               determined which states had high volumes of AMP lending by using
               data obtained from a Federal Reserve Bank on states that had high
               levels of ARM growth and house price appreciation in 2005, factors
               which this study suggested corresponded with high volumes of AMP
               lending. Furthermore, we reviewed regulatory data showing that the
               largest AMP lenders conducted most of their lending in these
               states. We selected eight states and conducted in-person
               interviews with officials from California, New Jersey, New York,
               and Ohio. We conducted telephone interviews with officials from
               the remainder of the sample states (Alaska, Florida, Nevada, and
               North Carolina).

               We also analyzed for content, readability, and usability a
               selected sample of eight written disclosures that six federally
               regulated AMP lenders provided to borrowers between 2004 and 2006.
               The sample included program-specific disclosures for three
               interest-only ARMs and for five payment-option ARMs as well as
               transaction-specific disclosures associated with four of them. The
               six lenders represented over 25 percent of the interest-only and
               payment-option ARMs produced in the first 9 months of 2005. First,
               we assessed the extent to which the disclosures described the key
               risks and loan features of interest-only and payment-option ARMs.
               Second, we conducted a readability assessment of these disclosures
               using computer-facilitated formulas to predict the grade level
               required to understand the materials. Readability formulas measure
               the elements of writing that can be subjected to mathematical
               calculation, such as the average number of syllables in words or
               number of words in sentences in the text. We applied the following
               commercially available formulas to the documents: Flesch Grade
               Level, Frequency of Gobbledygook (FOG), and Simplified Measure of
               Gobbledygook (SMOG). Using these formulas, we measured the grade
               levels at which the disclosure documents were written for selected
               sections. Third, we conducted an evaluation that assessed how well
               these AMP disclosures adhered to leading practices in the federal
               government for usability. We used guidelines presented in the
               Securities and Exchange Commission's (SEC) A Plain English
               Handbook: How to Create Clear SEC Disclosure Documents (1998). SEC
               publishes the handbook for investment firms to use when writing
               mutual fund disclosures. The handbook presents criteria for both
               the effective visual presentation and readability of information
               in disclosure documents.

               To obtain information on the federal regulatory response to the
               risks of AMPs for lenders and borrowers, we reviewed the draft
               interagency guidance on AMP lending issued in December 2005 by
               federal banking regulators and interviewed regulatory officials
               about what actions they could use to enforce guidance principles
               upon final release of the draft. We also reviewed comments written
               by industry participants in response to the draft guidance. To
               review industry comments, we selected 29 of the 97 comment letters
               that federal regulators received. We selected comment letters that
               represented a wide range of industry participants, including
               lenders, brokers, trade organizations, and consumer advocates. We
               analyzed the comment letters for content; sorted them according to
               general comments, issues of institutional safety and soundness,
               consumer protection, or other concerns; and summarized the results
               of the analysis.

               To obtain information on selected states' regulatory response to
               the risks of AMPs for lenders and borrowers, we reviewed current
               laws and, where applicable, draft legislation from the eight
               states in our sample and interviewed these states' banking and
               mortgage lending officials.

               We performed our work between September 2005 and September 2006 in
               accordance with generally accepted government auditing standards.

               Appendix II: Readability and Design Weaknesses in AMP Disclosures
    			  That We Reviewed

    			  The AMP disclosures that we reviewed did not always conform to key
               plain English principles for readability or design. We analyzed a
               selected sample of eight written AMP disclosures to determine the
               extent to which they adhered to best practices for financial
               product disclosures. In conducting this assessment, we used three
               widely used "readability" formulas as well as guidelines from the
               SEC's A Plain English Handbook. In particular, the AMP disclosures
               that we reviewed were written at a level of complexity too high
               for many adults to understand. Also, most of the disclosures that
               we reviewed used small typeface, which when combined with an
               ineffective use of white space and headings, made them more
               difficult to read and hindered identification of important
               information.

               Disclosures Required Reading Levels Higher Than That of Many Adults
    			  in the U.S.

    			  The AMP disclosures that we reviewed contained content that was
               written at a level of complexity higher than the level at which
               many adults in the United States read. To assess the reading level
               required for AMP disclosures, we applied three widely used
               "readability" formulas to the sections of the disclosures that
               discussed how monthly payments could change. These formulas
               determined the reading level required for written material on the
               basis of quantitative measures, such as the average numbers of
               syllables in words or the number of words in sentences.1

               On the basis of our analysis, the disclosures were written at
               reading levels commensurate with an education level ranging from
               9th to 12th grade, with an average near the 11th grade. A
               nationwide assessment of reading comprehension levels of the U.S.
               population reported in 2003 that 43 percent of the adult
               population in the United States reads at a "basic" level or
               below.2 While certain complex terms and phrases may be unavoidable
               in discussing financial material, disclosures that are written at
               too high a reading level for the majority of the population are
               likely to fail in clearly communicating important information. To
               ensure that disclosures investment firms provide to prospective
               investors are understandable, the Plain English Handbook
               recommends that investment firms write their disclosures at a 6th-
               to 8th-grade reading level.

               Size and Choice of Typeface and Use of Capitalization Made Most
    			  Disclosures Difficult to Read

    			  Most of the AMP disclosures used font sizes and typeface that were
               difficult to read and could hinder borrowers' ability to find
               information. The disclosures extensively used small typeface in
               AMP disclosures, when best practices suggest using a larger, more
               legible type. A Plain English Handbook recommends use of a
               10-point font size for most investment product disclosures and a
               12-point size font if the target audience is elderly. Most of the
               disclosures we reviewed used a 9-point size font or smaller. Also,
               more than half of the disclosures used sans serif typeface, which
               is generally considered more difficult to read at length than its
               complement, serif typeface. Figure 5 below provides an example of
               serif and sans serif typefaces.

               Figure 5: Examples of Serif and Sans Serif Typefaces

               The handbook recommends the use of serif typefaces for general
               text because the small connective strokes at the beginning and end
               of each letter help guide the reader's eye over the text. The
               handbook recommends using the sans serif typeface for short pieces
               of information, such as headings or for emphasizing particular
               information in the document.

               In addition, some lenders' efforts to use different font types to
               highlight important information made the text harder to read.
               Several disclosures emphasized large portions of text in boldface
               and repeated use of all capital letters for headings and
               subheadings. According to the handbook, formatting large blocks of
               text in capital letters makes it harder to read because the shapes
               of the words disappear, thereby forcing the reader to slow down
               and study each letter. As a result, readers tend to skip sentences
               that are written entirely in capital letters.

               Disclosures Generally Did Not Make Effective Use of White Space
    			  or Headings

    			  The AMP disclosures generally did not make effective use of white
               space, reducing their usefulness. According to the Plain English
               Handbook, generous use of white space enhances usability, helps
               emphasize important points, and lightens the overall look of the
               document. However, in most of the AMP disclosures, the amount of
               space between the lines of text, paragraphs, and sections was very
               tight, which made the text dense and difficult to read. This
               difficulty was compounded by the use of fully justified text-that
               is, text where both the left and right edges are even-in half of
               the disclosure documents. According to the handbook, when text is
               fully justified, the spacing between words fluctuates from line to
               line, causing the eye to stop and constantly readjust to the
               variable spacing on each line. This, coupled with a shortage of
               white space, made the disclosures we reviewed visually unappealing
               and difficult to read. The handbook recommends using
               left-justified, ragged right text (as this report uses), which
               research has shown is the easiest text to read.

               Very little visual weight or emphasis was given to the content of
               the disclosures other than to distinguish the headings from the
               text of the section beneath it. As a result, it was difficult to
               readily locate information of interest or to quickly identify the
               most important information-in this case, what the maximum monthly
               payment could be for a borrower considering a particular AMP.
               According to the handbook, a document's hierarchy shows how its
               designer organized the information and helps the reader understand
               the relationship between different levels of information. A
               typical hierarchy might include several levels of headings,
               distinguished by varying typefaces.

               Appendix III: Comments from the Board of Governors of the Federal
    			  Reserve System

    			  Appendix IV:  GAO Contact and Staff Acknowledgements

    			  GAO Contact

    			  Orice M. Williams, (202) 512-5837, Williamso@gao.gov

               Staff Acknowledgements

    			  In addition to those named above, Karen Tremba, Assistant
               Director; Tania Calhoun; Bethany Claus Widick; Stefanie Jonkman;
               Mark Molino; Robert Pollard; Barbara Roesmann; and Steve Ruszczyk
               made key contributions to this report.

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    1These readability formulas did not evaluate the content of the
    disclosures or assess whether the information was conveyed clearly. For
    more information on this topic, see appendix I.

    2See the 2003 National Assessment of Adult Literacy. The study evaluated
    adults' reading skills according to four levels: below basic, basic,
    intermediate, and proficient.

    (250261)

    www.gao.gov/cgi-bin/getrpt? GAO-06-1021 .

    To view the full product, including the scope
    and methodology, click on the link above.

    For more information, contact Orice M. Williams at (202) 512-8678 or
    williamso@gao.gov.

    Highlights of GAO-06-1021 , a report to the Chairman, Subcommittee on
    Housing and Transportation, Committee on Banking, Housing, and Urban
    Affairs, U.S. Senate

    September 2006

    ALTERNATIVE MORTGAGE PRODUCTS

    Impact on Defaults Remains Unclear, but Disclosure of Risks to Borrowers
    Could Be Improved

    Alternative mortgage products (AMPs) can make homes more affordable by
    allowing borrowers to defer repayment of principal or part of the interest
    for the first few years of the mortgage. Recent growth in AMP lending has
    heightened the importance of borrowers' understanding and lenders'
    management of AMP risks. This report discusses the (1) recent trends in
    the AMP market,

    (2) potential AMP risks for borrowers and lenders, (3) extent to which
    mortgage disclosures discuss AMP risks, and (4) federal and selected state
    regulatory response to AMP risks.

    To address these objectives, GAO used regulatory and industry data to
    analyze changes in AMP monthly payments; reviewed available studies; and
    interviewed relevant federal and state regulators and mortgage industry
    groups, and consumer groups.

    What GAO Recommends

    As the Federal Reserve Board reviews existing disclosure standards, GAO
    recommends that it considers revising federal requirements for mortgage
    disclosures to improve the clarity and comprehensiveness of AMP
    disclosures. In response, the Federal Reserve noted that it will conduct
    consumer testing to determine appropriate content and formats and will use
    design consultants to develop model disclosure forms intended to better
    communicate information.

    From 2003 through 2005, AMP originations, comprising mostly interest-only
    and payment-option adjustable-rate mortgages, grew from less than 10
    percent of residential mortgage originations to about 30 percent. They
    were highly concentrated on the East and West Coasts, especially in
    California. Federally and state-regulated banks and independent mortgage
    lenders and brokers market AMPs, which have been used for years as a
    financial management tool by wealthy and financially sophisticated
    borrowers. In recent years, however, AMPs have been marketed as an
    "affordability" product to allow borrowers to purchase homes they
    otherwise might not be able to afford with a conventional fixed-rate
    mortgage.

    Because AMP borrowers can defer repayment of principal, and sometimes part
    of the interest, for several years, they may eventually face payment
    increases large enough to be described as "payment shock." Mortgage
    statistics show that lenders offered AMPs to less creditworthy and less
    wealthy borrowers than in the past. Some of these recent borrowers may
    have more difficulty refinancing or selling their homes to avoid higher
    monthly payments, particularly if interest rates have risen or if the
    equity in their homes fell because they were making only minimum monthly
    payments or home values did not increase. As a result, delinquencies and
    defaults could rise. Officials from the federal banking regulators stated
    that most banks appeared to be managing their credit risk by diversifying
    their portfolios or through loan sales or securitizations. However,
    because the monthly payments for most AMPs originated between 2003 and
    2005 have not reset to cover both interest and principal, it is too soon
    to tell to what extent payment shocks would result in increased
    delinquencies or foreclosures for borrowers and in losses for banks and
    other lenders.

    Regulators and others are concerned that borrowers may not be
    well-informed about the risks of AMPs, due to their complexity and because
    promotional materials by some lenders and brokers do not provide balanced
    information on AMPs benefits and risks. Although lenders and certain
    brokers are required to provide borrowers with written disclosures at loan
    application and closing, federal standards on these disclosures do not
    currently require specific information on AMPs that could better help
    borrowers understand key terms and risks.

    In December 2005, federal banking regulators issued draft interagency
    guidance on AMP lending that discussed prudent underwriting, portfolio and
    risk management, and consumer disclosure practices. Some lenders commented
    that the recommendations were too prescriptive and could limit consumer
    choices of mortgages. Consumer advocates expressed concerns about the
    enforceability of these recommendations because they are presented in
    guidance and not in regulation. State regulators GAO contacted generally
    relied on existing regulatory structure of licensing and examining
    independent mortgage lenders and brokers to oversee AMP lending.
    *** End of document. ***