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
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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 [email protected] . 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, [email protected]
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 .
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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. ***