United States Government Accountability Office

GAO Report to the Chairman, Subcommittee 

on Housing and Transportation, 

Committee on Banking, Housing, and 

Urban Affairs, U.S. Senate 

ALTERNATIVE 

MORTGAGE 

PRODUCTS 

Impact on Defaults 

Remains Unclear, but 

Disclosure of Risks to 

Borrowers Could Be 

Improved 

September 2006 

 

GAO-06-1021 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

September 2006

ALTERNATIVE MORTGAGE PRODUCTS

Impact on Defaults Remains Unclear, but 

Disclosure of Risks to Borrowers Could 

Be Improved 

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 

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 wellinformed 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. 

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

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact Orice M. 

Williams at (202) 512-8678 or 

williamso@gao.gov.
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

Page i GAO-06-1021 Alternative Mortgage Products
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 PaymentOption 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 

Page ii GAO-06-1021 Alternative Mortgage Products
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® 

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 

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Page iii GAO-06-1021 Alternative Mortgage Products
United States Government Accountability Office

Washington, DC 20548 

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: 

In recent years, the residential real estate sector experienced sustained 

growth in both volume and price. The National Association of Realtors® 

(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® 

(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 

Page 1 GAO-06-1021 Alternative Mortgage Products
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 

 1

For 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). 

Page 2 GAO-06-1021 Alternative Mortgage Products
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. 

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. 

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. 

Results in Brief 

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 debtto-income (DTI) ratios, and less stringent or no income and asset 

verification requirements than what they traditionally permitted for these 

Page 3 GAO-06-1021 Alternative Mortgage Products
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, 

 2

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 issued. 

Page 4 GAO-06-1021 Alternative Mortgage Products
conditions, and costs of the mortgage can help borrowers to make betterinformed 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 

 3

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

226. 

4

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

Page 5 GAO-06-1021 Alternative Mortgage Products
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. 

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 

 5

Federally 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.

Page 6 GAO-06-1021 Alternative Mortgage Products
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. 

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. 

Borrowers arrange residential mortgages through either mortgage lenders

or brokers. The funding for mortgages can come from federally or statechartered 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 

Background 

Page 7 GAO-06-1021 Alternative Mortgage Products
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, 

 6

Housing-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. 

Page 8 GAO-06-1021 Alternative Mortgage Products
although FTC is responsible for enforcement of certain federal consumer 

protection laws as discussed in the following text. 

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 

Page 9 GAO-06-1021 Alternative Mortgage Products
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. 

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 higherpriced 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 fixedrate mortgages. Furthermore, lenders have increased the variety of AMP 

products offered to respond to changing market conditions. 

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 

AMP Lending Rapidly 

Grew as Borrowers 

Sought Mortgage 

Products That 

Increased 

Affordability 

AMP Share of Mortgage 

Originations Grew 

Threefold from 2003 to 

2005, with Higher 

Concentrations in the 

Coastal Markets 

 7

Data 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. 

8

Inside Mortgage Finance, Conventional Conforming Market Continued to Erode in 2005

as Nontraditional Mortgage Products Boomed, (February 24, 2006) 6. 

Page 10 GAO-06-1021 Alternative Mortgage Products
borrowers to purchase homes that they otherwise might not have been 

able to afford with a conventional fixed-rate mortgage.

9

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. 

 9

As 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.

Page 11 GAO-06-1021 Alternative Mortgage 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 paymentoption 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. 

Once Considered a 

Specialized Product for the 

Financially Sophisticated, 

Lenders Have Offered 

AMPs Widely as 

Affordability Products 

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 fixedrate 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 

 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. 

Page 12 GAO-06-1021 Alternative Mortgage Products
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

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 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 

Borrowers Could 

Face Payment Shock; 

Lenders Face Credit

Risk but Most Appear 

to be Taking Steps to 

Manage the Risk

AMPs Create Potential for 

Borrowers to Face 

Payment Shock, 

Particularly as Interest 

Rates Rise 

 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 StillGrowing Nontraditional Mortgage Market (July 14, 2006), 3. 

Page 13 GAO-06-1021 Alternative Mortgage Products
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. 

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

Total increase in outstanding loan balance 

at beginning of year

N/A

3,299

10,714

19,735

27,278

33,446

Year

2

3

4

5

1

6 and beyond

1,383

1,487

1,598

1,718

1,287

2,931

Source: GAO.

Minimum monthly payment

The example in figure 1 assumes loan features that were typical of 

payment-option ARMs offered during 2004, including 

Page 14 GAO-06-1021 Alternative Mortgage Products
• 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

• 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 

• 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 

 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. 

Page 15 GAO-06-1021 Alternative Mortgage Products
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. 

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 paymentoption 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 

In Contrast to Past 

Borrowers, Recent AMP 

Borrowers May Find It 

More Difficult to Avoid 

Payment Shock 

 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. 

Page 16 GAO-06-1021 Alternative Mortgage Products
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

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

Origination 

year 

Origination 

amount (in

millions of 

dollars )a ,b

Percentage of

FICO scores 

below 700c

Average DTI 

ratiod

Percentage of

option ARMs

with piggyback 

mortgages

CLTV>80

percent

e

Percentage with low 

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. 

a

The 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. 

b

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

c

FICO scores are credit scores used to evaluate a borrower’s credit history. 

d

A DTI ratio is the borrower’s fixed monthly expenses divided by gross monthly income. 

e

Combined 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 

 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. 

Page 17 GAO-06-1021 Alternative Mortgage Products
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.

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 

 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. 

Page 18 GAO-06-1021 Alternative Mortgage Products
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

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. 

Page 19 GAO-06-1021 Alternative Mortgage Products
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

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 

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, interestonly 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 

 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.

Page 20 GAO-06-1021 Alternative Mortgage Products
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. 

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 

Regulators and Others 

Are Concerned That 

Borrowers May Not 

Be Well-informed 

About the Risks of 

AMPs 

Page 21 GAO-06-1021 Alternative Mortgage Products
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 

 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. § 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. 

Page 22 GAO-06-1021 Alternative Mortgage Products
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.

Page 23 GAO-06-1021 Alternative Mortgage Products
Figure 2: Example of a 2005 Broker Advertisement for a Payment-Option ARM 

Source: Name withheld. Used with permission.

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. 

Page 24 GAO-06-1021 Alternative Mortgage Products
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. 

A Recent Study and Initial 

Complaint Data Indicated 

Some Borrowers Did Not 

Understand the Terms and 

Features of ARMs, 

Including AMPs 

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 

 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). 

Page 25 GAO-06-1021 Alternative Mortgage Products
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. 

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: 

• a program–specific disclosure that describes the terms and features of the 

ARM product, 

• a copy of the federally authored handbook on ARMs, and 

• 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 

• a statement that the interest rate, payment, or loan term may change; 

Page 26 GAO-06-1021 Alternative Mortgage Products
• an explanation of how the interest rate and payment will be determined; 

• the frequency of interest rate and payment changes; 

• 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

• 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-

 28Congress enacted HOEPA in 1994 in response to reports of predatory home equity lending

practices in underserved markets. 

Page 27 GAO-06-1021 Alternative Mortgage Products
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. 

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. 

Leading Practices for 

Financial Product 

Disclosures Include the 

Use of Clear Language to 

Explain Information That 

Is Most Relevant to the 

Consumer 

 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). 

Page 28 GAO-06-1021 Alternative Mortgage Products
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. 

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. 

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, 

The Disclosures That We

Reviewed Generally Did 

Not Provide Clear and 

Complete Information on 

AMP Features and Risks 

Program-Specific Disclosures 

Did Not Always Clearly Discuss 

the Risk of Payment Shock or 

Negative Amortization for 

AMPs 

Page 29 GAO-06-1021 Alternative Mortgage Products
which included a statement that monthly payments could “increase or 

decrease annually” based on changes to the interest rate, as illustrated in 

figure 3. 

Page 30 GAO-06-1021 Alternative Mortgage Products
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 

Sources: Name withheld. Used with permission; GAO (boxed comments).

Potential change

in monthly payments

Page 31 GAO-06-1021 Alternative Mortgage Products
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]. 

Page 32 GAO-06-1021 Alternative Mortgage Products
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 paymentoption period could expire before the end of the first 5 years, thus 

recasting the loan and increasing their monthly payments. 

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.

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 

Disclosures Generally Did Not 

Prominently Present Key 

Information on Changes to 

Monthly Payments and Loan 

Balance or Adhere to Other 

“Plain English” Principles 

Transaction-Specific TILA 

Disclosures Lacked Key 

Information for AMP 

Borrowers 

Page 33 GAO-06-1021 Alternative Mortgage Products
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. 

Page 34 GAO-06-1021 Alternative Mortgage Products
Figure 4: Transaction-Specific TILA Disclosure from a 2005 Payment-Option ARM Disclosure 

Sources: Name withheld. Used with permission; GAO (boxed comments).

ANNUAL PERCENTAGE

RATE

PAYMENT SCHEDULE:

DEMAND FEATURE:

VARIABLE RATE FEATURE:

SECURITY: You are giving a security interest in the property located at:

ASSUMPTION: Someone buying this property

PROPERTY INSURANCE: Hazard insurance, including flood insurance if the property is in a Special Flood Hazard Area is required as a condition of the loan. 

You may obttain the insurance coverage from any insurance company acceptable to the lender. Complete details concerning insurance requirements

will be provided prior to loan closing.

LATE CHARGES: If your payment is more than 15 days late, you will be charged a late charge of 5.000% of the

 overdue payment

PREPAYMENT: If you pay off your loan early, you

NUMBER OF PAYMENTS

12

12

12

12

12

299

1

813.97

875.02

940.65

1,011.20

1,087.04

1,885.21

1,886.16

MONTHLY BEGINNING 10/01/2005

MONTHLY BEGINNING 10/01/2006

MONTHLY BEGINNING 10/01/2007

MONTHLY BEGINNING 10/01/2008

MONTHLY BEGINNING 10/01/2009

MONTHLY BEGINNING 10/01/2010

LAST PAYMENT DUE 09/01/2035

AMOUNT OF PAYMENTS WHEN PAYMENTS ARE DUE

FINANCE CHARGE Amount Financed

The cost of your credit

as a yearly rate.

 6.876%

This loan does not have a Demand Feature.

This loan has a Variable Rate Feature. Variable Rate Disclosures have been provided to you earlier.

may assume, subject to lender’s conditions, the remaining balance due under original mortgage terms.

See your contract documents for any additional information regarding non-payment, default, required payment in full before scheduled date

and prepayment refunds and penalties.

• means estimate

may

may

will not

will not

have to pay a penalty.

be entitled to a refund of part of the finance charge.

cannot assume the remaining balance due under original mortgage terms.

x This loan does have a Demand Feature.

The dollar amount the

credit will cost you. 

The amount of credit

provided to you or on 

your behalf. $ 383,433.59 $ 238,864.92

Total of Payments

The amount you will have

paid after you have made

all payments as scheduled. 

$ 622,298.51

x

x

x

x

Minimum monthly

payment option

Fully amortizing

monthly payment

Variable rate loan feature

Possible prepayment penalty

Page 35 GAO-06-1021 Alternative Mortgage Products
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 

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

month. 

Page 36 GAO-06-1021 Alternative Mortgage Products
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. 

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). 

Page 37 GAO-06-1021 Alternative Mortgage Products
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, 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 

Federal Banking 

Regulators Issued 

Draft Guidance and 

Took Other Actions to 

Improve Lender 

Practices and 

Disclosures and 

Publicize Risks of 

AMPs 

Draft Interagency 

Guidance on AMP Lending 

Recommends Tightening 

Underwriting Standards, 

Developing Risk 

Management Policies, and 

Improving Consumer 

Information 

 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. 

Page 38 GAO-06-1021 Alternative Mortgage Products
exposures created by these loans; and (3) consumers are provided with 

balanced information on loan products before they make a mortgage 

product choice. 

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 risklayering 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. 

Page 39 GAO-06-1021 Alternative Mortgage Products
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 

Page 40 GAO-06-1021 Alternative Mortgage Products
disadvantage and have responded by developing guidance for statelicensed 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 

Page 41 GAO-06-1021 Alternative Mortgage Products
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. 

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. 

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 

Most States in Our 

Sample Responded to 

AMP Lending Risks 

within Existing 

Regulatory 

Frameworks, While 

Others Had Taken 

Additional Actions 

States in Our Sample 

Identified Concerns about 

AMP Lending by 

Independent Mortgage 

Lenders and Brokers 

Page 42 GAO-06-1021 Alternative Mortgage Products
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 alreadyhigh 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. 

Page 43 GAO-06-1021 Alternative Mortgage Products
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 

Page 44 GAO-06-1021 Alternative Mortgage Products
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. 

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. 

Conclusions 

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 

Page 45 GAO-06-1021 Alternative Mortgage Products
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.

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 

Recommendation for 

Executive Action 

Page 46 GAO-06-1021 Alternative Mortgage Products
• language that explains key features and potential risks specific to AMPs, 

and 

• effective format and visual presentation, following criteria such as those 

suggested by SEC’s A Plain English Handbook. 

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 

Agency Comments 

and Our Evaluation 

Page 47 GAO-06-1021 Alternative Mortgage Products
Banking, Housing, and Urban Affairs and the Ranking Minority Member of 

its Subcommittee on Housing and Transportation; the Chairman and 

Ranking Minority Member of the House Committee on Financial Services; 

other interested congressional committees. We will also send copies to the 

Chairman, Federal Deposit Insurance Corporation; the Chairman, Board of 

Governors of the Federal Reserve System; the Chairman, National Credit 

Union Administration; the Comptroller of the Currency; and the Director, 

Office of Thrift Supervision. We will also make copies available to others

upon request. The report will be available at no charge on the GAO Web 

site at http://www.gao.gov. 

If you or your staff have any questions regarding this report, please 

contact me at (202) 512-8678 or williamso@gao.gov. Contact points for our 

Offices of Congressional Relations and Public Affairs may be found on the 

last page of this report. Key contributors to this report are listed in 

appendix IV.

Sincerely yours, 

Orice M. Williams 

Director, Financial Markets 

 and Community Investment 

Page 48 GAO-06-1021 Alternative Mortgage Products
Appendix I: Scope and Methodology 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 

Page 49 GAO-06-1021 Alternative Mortgage Products
Appendix I: Scope and Methodology 

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 paymentoption 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 

Page 50 GAO-06-1021 Alternative Mortgage Products
Appendix I: Scope and Methodology 

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. 

Page 51 GAO-06-1021 Alternative Mortgage Products
A

W

Rev

ppendix II: Readability and Design

eaknesses in AMP Disclosures That We

iewed 

Page 52 GAO-06-1021

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. 

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. 

Disclosures Required 

Reading Levels Higher 

Than That of Many 

Adults in the U.S. 

 1

These 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.

2

See the 2003 National Assessment of Adult Literacy. The study evaluated adults’ reading 

skills according to four levels: below basic, basic, intermediate, and proficient. 

Alternative Mortgage Products
Appendix II: Readability and Design

Weaknesses in AMP Disclosures That We

Reviewed 

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. 

Size and Choice of 

Typeface and Use of 

Capitalization Made 

Most Disclosures 

Difficult to Read 

This is an example of serif typeface.

This is an example of sans serif typeface.

Serifs

Source: GAO.

Page 53 GAO-06-1021 Alternative Mortgage Products
Appendix II: Readability and Design

Weaknesses in AMP Disclosures That We

Reviewed 

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. 

Disclosures Generally 

Did Not Make 

Effective Use of White 

Space or Headings 

Page 54 GAO-06-1021 Alternative Mortgage Products
Appendix III: Comments from the Board of Appendix III: Comments from the Board of Governors of the Federal Reserve System 

Governors of the Federal Reserve System 

Page 55 GAO-06-1021 Alternative Mortgage Products
Appendix III: Comments from the Board of 

Governors of the Federal Reserve System 

Page 56 GAO-06-1021 Alternative Mortgage Products
Appendix III: Comments from the Board of 

Governors of the Federal Reserve System 

Page 57 GAO-06-1021 Alternative Mortgage Products
Appendix IV: 

A

GAO Contact and Staff 

cknowledgments 

Page 58 GAO-06-1021

Appendix IV: GAO Contact and Staff 

Acknowledgments 

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

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. 

Alternative Mortgage Products

GAO Contact 

Staff 

Acknowledgments 

(250261) 
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