Alternative Mortgage Products: Impact on Defaults Remains Unclear, but Disclosure of Risks to Borrowers Could Be Improved
Published: 2006-09-20T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: 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. GAO's 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. GAO used regulatory and industry data to analyze changes in AMP monthly payments under various scenarios; reviewed available studies; and interviewed relevant federal and state regulators and mortgage industry groups, and consumer groups.
section_title: What GAO Found
paragraphs: 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, some 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 in an interest-rate environment where 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. Federal banking regulators stated that most banks appeared to be managing their credit risk well 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. Regulators and others are concerned that borrowers may not be well-informed about the risks of AMPs, due to their complexity and because promotional materials by some lenders and brokers do not provide balanced information on AMPs benefits and risks. Although lenders and certain brokers are required to provide borrowers with written disclosures at loan application and closing, federal standards on these disclosures do not currently require specific information on AMPs that could better help borrowers understand key terms and risks. In December 2005, federal banking regulators issued draft interagency guidance on AMP lending that discussed prudent underwriting, portfolio and risk management, and consumer disclosure practices. Some lenders commented that the recommendations were too prescriptive and could limit consumer choices of mortgages. Consumer advocates expressed concerns about the enforceability of these recommendations because they are presented in guidance and not in regulation. State regulators GAO contacted generally relied on existing regulatory structure of licensing and examining independent mortgage lenders and brokers to oversee AMP lending.

section_title: Letter
paragraphs: I am pleased to be here today to discuss our work on alternative mortgage  products (AMPs). As you know, an increasing number of borrowers have  turned to AMPs, such as interest-only and payment-option adjustable rate  mortgages (ARMs), to purchase homes they might not be able to afford  with conventional fixed-rate mortgage payments. These products initially  keep borrowers’ payments low by allowing consumers in the short term to  defer principal payments or make payments that do not cover principal or  all accrued interest. However, unless the borrower refinances the  mortgage or sells the property, the monthly payments eventually will  increase when the interest-only and deferred payment periods end and  higher, fully amortizing payments begin.
My remarks will summarize the findings from the report being released  today, which was prepared at the request of the Chairman of the  Subcommittee on Housing and Transportation. Specifically, I will discuss:  (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. We gathered information from federal and state banking  regulators, consumer groups, and the mortgage industry on AMP-lending  trends and risks to borrowers and lenders, including laws and regulations  on mortgage disclosures. We also reviewed a sample of disclosures to  determine the extent to which they addressed AMP risks.
In summary, we found the following:    AMP lending tripled over a 3-year period, and many borrowers were using  interest-only or payment-option adjustable-rate products to purchase  homes in high-priced markets. AMP lending has been concentrated in the  higher-priced regional markets on the East and West Coasts in states such  as California, Washington, Virginia, and Maryland.
Lenders may have increased risks to themselves and their customers by  relaxing underwriting standards and through “risk-layering”, which  includes combining AMPs with less stringent income and asset verification  requirements or lending to borrowers with lower credit scores and higher  debt-to-income ratios. However, it is too early to determine the extent to  which high foreclosure rates will result or whether lenders will be  affected.
A wider spectrum of borrowers that are now using AMPs may not fully  understand their risks because (1) AMP loans often have complicated  terms and features, (2) AMP advertising sometimes emphasizes the  benefits of AMPs over their risks, and (3) mortgage disclosures can be  unclearly written and may be hard to understand. Moreover, current  federal disclosure requirements do not require lenders to address AMP- specific terms and risks.
Federal banking regulators collectively responded to AMP-lending  concerns by issuing draft guidance that called for tightened underwriting,  enhanced risk-management policies, and better information for  consumers. Regulators also have individually responded by monitoring  AMP lending, beginning to update the regulation governing mortgage  disclosures, Regulation Z, and reinforcing the message about managing  AMP risks to the mortgage industry.
State regulators included in our review generally addressed concerns  about AMP lending through their licensing and examination processes,  although a few states have started to collect more AMP-specific  information as a prelude to other possible actions.
Given the complexity of AMPs and their more widespread use, mortgage  disclosures that can help borrowers make informed decisions are  important. Although federal banking regulators have taken a range of  proactive steps to address AMP lending, current federal standards for  disclosures do not require information on AMP-specific risks. Therefore,  we recommended in our report that as the Federal Reserve Board reviews  Regulation Z, it consider improving the clarity and comprehensiveness of  mortgage disclosures by requiring language that explains key features and  potential risks specific to AMPs.
subsections: section_title: Background
paragraphs: Borrowers obtain residential mortgages through either mortgage lenders  or brokers. Mortgage lenders can be federally or state-chartered banks or  mortgage lending subsidiaries of these banks or of bank holding  companies. Independent lenders, which are neither banks nor affiliates of  banks, also may fund home loans to borrowers. Mortgage brokers act as  intermediaries between lenders and borrowers, and for a fee, help connect  borrowers with various lenders that may provide a wider selection of  mortgage products.
Federal banking regulators—Office of the Comptroller of the Currency  (OCC), the Board of Governors of the Federal Reserve System (Federal  Reserve), Federal Deposit Insurance Corporation (FDIC), National Credit  Union Administration (NCUA), and Office of Thrift Supervision (OTS)— have, among other things, responsibility for ensuring the safety and  soundness of the institutions they oversee. To pursue this goal, regulators  establish capital requirements for banks; conduct on-site examinations  and off-site monitoring to assess their financial conditions; 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, and try to determine the amount of risk  lenders have assumed. From a safety and soundness perspective, risk  involves the potential that either anticipated or unanticipated events may  have an adverse impact on a bank’s capital or earnings. In mortgage  lending, regulators pay close attention to credit risk—that is 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.
Certain federal consumer protection laws, including the Truth in Lending  Act and its implementing regulation, Regulation Z, apply to all mortgage  lenders and brokers that close loans in their own names. Each lender’s  primary federal supervisory agency has responsibility for enforcing  Regulation Z and generally uses examinations and consumer complaint  investigations to check for compliance with both the act and its regulation.  In addition, the Federal Trade Commission (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.  FTC uses a variety of information sources in the enforcement process,  including FTC investigations, consumer complaints, and state and federal  agencies.
State banking and financial regulators are responsible for overseeing  independent lenders and mortgage brokers and generally do so through  licensing that mandates certain experience, education, and operations  requirements to engage in mortgage activities. States also may examine  independent lenders and mortgage brokers to ensure compliance with  licensing requirements, review their lending and brokerage functions, and  look for unfair or unethical business practices. In the event such practices  or consumer complaints occur, regulators and attorneys general may  pursue actions that include license suspension or revocation, monetary  fines, and lawsuits.
section_title: AMP Lending Rapidly Grew and Borrower Characteristics Changed as Consumers Sought Mortgage Products That Increased Affordability
paragraphs: From 2003 through 2005, AMP lending grew rapidly, with originations  increasing threefold from less than 10 percent of residential mortgages to  about 30 percent. Most of the originations during this period consisted of  interest-only ARMs and payment-option ARMs, and most of this lending  occurred in higher-priced regional markets concentrated on the East and  West Coasts. For example, based on data from mortgage securitizations in  2005, about 47 percent of interest-only ARMs and 58 percent of payment- option ARMs were originated in California, which contained 7 of the 20  highest-priced metropolitan real estate markets in the country. On the East  Coast, Virginia, Maryland, New Jersey, and Florida as well as Washington,  D.C., exhibited a high concentration of AMP lending in 2005. Other  examples of states with high concentrations of AMP lending include  Washington, Nevada, and Arizona. These areas also experienced higher  rates of home price appreciation during this period than the rest of the  United States.
In addition to this growth, the characteristics of AMP borrowers have  changed. Historically, AMP borrowers consisted of wealthy and financially  sophisticated borrowers who used these specialized products as financial  management tools. However, today a wider range of borrowers use AMPs  as affordability products to purchase homes that might otherwise be  unaffordable using conventional fixed-rate mortgages.
section_title: Borrowers Could Face Payment Shock; Lenders Face Credit Risk but Appear to Be Taking Steps to Manage the Risk
paragraphs: Although AMPs have increased affordability for some borrowers, they  could lead to increased payments or “payment shock” for borrowers and  corresponding credit risk for lenders. Unless the mortgages are refinanced  or the properties sold, AMPs eventually reach points when interest-only  and deferred payment periods end and higher, fully amortizing payments  begin. Regulators and consumer advocates have expressed concern that  some borrowers might not be able to afford these higher monthly  payments. To illustrate this point, we simulated what would happen to a  borrower in 2004 that made minimum monthly payments on a $400,000  payment-option ARM. As figure 1 shows, the borrower could see payments  rise from $1,287 to $2,931, or 128 percent, at the end of the 5-year payment- option period. In addition, with a wider range of AMP borrowers now than  in the past, those with fewer financial resources or limited equity in their  homes might find refinancing their mortgages or selling their homes  difficult, particularly if their loans have negatively amortized or their  homes have not appreciated in value.
In addition, borrowers who cannot afford higher payments and may  become delinquent or default on their mortgages may pose credit risks to  lenders because these borrowers may not repay their loans in full. Lenders  also may have increased risks to themselves and their customers by  relaxing underwriting standards and through risk-layering. For example,  some lenders combined AMPs with less stringent income and asset  verification requirements than traditionally permitted for these products  or lent to borrowers with lower credit scores and higher debt-to-income  ratios.
Although regulatory officials have expressed concerns about AMP risks  and underwriting practices, they said that banks and lenders generally  have taken steps to manage the resulting credit risk. Federal and state  banking regulatory officials and lenders with whom we spoke said most  banks have diversified their assets to manage the credit risk of AMPs held  in their portfolios, or have reduced their risk through loan sales or  securitization. In addition, federal regulatory officials told us that while  underwriting trends may have loosened over time, lenders have generally  attempted to mitigate their risk from AMP lending. For example, OCC and  Federal Reserve officials told us that most lenders qualify payment-option  ARM borrowers at fully indexed rates, not at introductory interest rates, to  help ensure that borrowers have financial resources to manage future  mortgage increases, or to pay more on their mortgages than the minimum  monthly payment. OCC officials also said that some lenders may mitigate  risk by having some stricter criteria for AMPs than for traditional  mortgages for some elements of their underwriting standards. Although  we are encouraged by these existing risk mitigation and management  strategies, most AMPs issued between 2003 and 2005, however, have not  reset to require fully amortizing payments, and it is too soon to tell how  many borrowers will eventually experience payment shock or financial  distress. As such, in our report we agree with federal regulatory officials  and industry participants that it was too soon to tell the extent to which  AMP risks may result in delinquencies and foreclosures for borrowers and  losses for banks that hold AMPs in their portfolios. However, we noted  that past experience with these products may not be a good indicator for  future AMP performance because the characteristics of AMP borrowers  have changed.
section_title: Borrowers May Not Be Well-informed of AMP Risks and Mortgage Disclosures May Not Effectively Describe These Risks to Consumers
paragraphs: Regulatory officials and consumer advocates expressed concern that some  AMP borrowers may not be well-informed about the terms and risks of  their complex AMP loans. Obstacles to understanding these products  include advertising that may not clearly or effectively convey AMP risks,  and federal mortgage disclosure requirements that do not require lenders  to tailor disclosures to the specific risks of AMPs to borrowers.
subsections: section_title: Mortgage Advertising May Not Clearly or Effectively Explain AMP Risks
paragraphs: Marketing materials that we reviewed indicated that advertising by lenders  and brokers may not clearly provide information to inform consumers  about the potential risks of AMPs. For example, one advertisement we  reviewed promoted a low initial interest rate and low monthly mortgage  payments without clarifying that the low interest rate would not last the  full term of the loan.
In other cases, promotional materials emphasized the benefits of AMPs  without effectively explaining the associated risks. Some advertising, for  example, emphasized loans with low monthly payment options without  effectively disclosing the possibility of interest rate changes or mortgage  payment increases. One print advertisement we reviewed for a payment- option ARM emphasized the benefit of a low initial interest rate but noted  in small print on its second page that the low initial rate applied only to the  first month of the loan and could increase or decrease thereafter.
section_title: Federal Disclosures May Not Clearly and Completely Explain AMP Specific Risks
paragraphs: Regulatory officials noted that current Regulation Z requirements address  traditional fixed-rate and adjustable-rate products, but not more complex  products such as AMPs that feature risks such as negative amortization  and payment shock. To better understand the quality of AMP disclosures,  we reviewed eight interest-only and payment-option ARM disclosures  provided to borrowers from federally regulated lenders. These disclosures  were provided to borrowers between 2004 and 2006 by six federally  regulated lenders that collectively made over 25 percent of the interest- only and payment option ARMs produced in 2005.We found that these  disclosures addressed current Regulation Z requirements, but some did  not provide full and clear explanations of AMP risks such as negative   amortization or payment shock. For example, as shown in figure 2, the  disclosure simply states that monthly payments could increase or decrease  on the basis of interest rate changes, which may be sufficient for a  traditional ARM product, but does not inform borrowers about the  potential magnitude of payment change, which may be more relevant for  certain AMPs. In addition, most of the disclosures we reviewed did not  explain that negative amortization, particularly in a rising interest rate  environment, could cause AMP loans to reset more quickly than borrowers  anticipated and require higher monthly mortgage payments sooner than  expected.
In addition, the AMP disclosures generally did not conform to leading  practices in the federal government, such as key “plain English” principles  for readability or design. For example, the Securities and Exchange  Commission’s “A Plain English Handbook: How to Create Clear SEC  Disclosure Documents (1998)” offered guidance for developing clearly  written investment product disclosures and presenting information in  visually effective and readable ways. The sample disclosures we reviewed,  however, were generally written with language too complex for many  adults to fully understand. Most of the disclosures also 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 buried key  information.
section_title: Federal Banking Regulators Issued Guidance, Sought Industry Comments, and Took Other Actions to Respond to Concerns about AMP Lending
paragraphs: Federal banking regulators have taken a range of actions—including  issuing draft interagency guidance, seeking industry comments,  reinforcing messages about AMP risks and guidance principles in many  forums, and taking other individual regulatory actions—to respond to  concerns about the growth and risks of AMP lending. Federal banking  regulators issued draft interagency guidance in December 2005 that  recommended prudent underwriting, portfolio and risk management, and  information disclosure practices related to AMP lending. The draft  guidance calls for lenders to consider the potential impact of payment  shock on borrowers’ capacity to repay their mortgages and to qualify  borrowers on their ability to make fully amortizing payments on the basis  of fully indexed interest rates. It also recommends that lenders develop  written policies and procedures that describe portfolio limits, mortgage  sales and securitization practices, and risk-management expectations. In  addition, to improve consumer understanding of AMPs, the draft guidance  suggests that lender communications with borrowers, including  advertisements and promotional materials, be consistent with actual  product terms, and that institutions avoid practices that might obscure the  risks of AMPs to borrowers. When finalized, the guidance will apply to all  federally regulated financial institutions.
During the public comment period for the guidance, lenders and others  suggested in their letters that the stricter underwriting recommendations  were overly prescriptive and might put federally and state-regulated banks  at a competitive disadvantage because the guidance would not apply to  independent mortgage lenders or brokers. Lenders said that this could  result in fewer mortgage choices for consumers. Consumer advocates  questioned whether the guidance would actually help protect consumers.  They noted that guidance might be difficult to enforce because it does not  carry the same force as law or regulation. Federal banking regulatory  officials are using these comments as they finalize the guidance.
Even before drafting the guidance, federal regulatory officials had publicly  reinforced their concerns about AMPs in speeches, at conferences, and  through the media. According to a Federal Reserve official, these actions  have raised awareness of AMP issues and reinforced the message that  financial institutions and the general public need to manage risks and  understand these products.
Some regulatory officials have also taken agency-specific steps to address  AMP lending, including reviewing high-risk lending, which would include  AMPs, and improving consumer education about AMP risks. For example,  FDIC officials told us that they have developed a review program to  identify high-risk lending areas and evaluate risk management and  underwriting approaches. NCUA officials said that they have informally  contacted their largest credit unions to assess the extent of AMP lending at  these institutions. OTS officials said that they have performed a review of  OTS’s 68 most active AMP lenders to assess and respond to potential AMP  lending risks and OCC have begun to conduct reviews of their lenders’  AMP promotional and marketing materials to assess how well they inform  consumers. In response to concerns about disclosures, the Federal  Reserve officials told us that they initiated a review of Regulation Z that  includes reviewing the disclosures required for all mortgage loans,  including AMPs, and have begun taking steps to consider disclosure  revisions. During the summer of 2006, the Federal Reserve held hearings  across the country on home-equity lending, AMP issues, and the adequacy  of consumer disclosures for mortgage products. According to Federal  Reserve officials, the Federal Reserve is currently reviewing the hearing  transcripts and public comment letters to help develop plans and  recommendations for revising Regulation Z. In addition, they said that they  are currently revising their consumer handbook on ARM loans, known as  the CHARM booklet, to include information about AMPs. Finally, in May  2006, FTC officials said that they sponsored a public workshop that  explored consumer protection issues as a result of AMP growth in the  mortgage marketplace and worked with federal banking regulators and  other federal departments to create a brochure to assist consumers with  mortgage information.
section_title: Most States in Our Sample Responded to AMP-Lending Risks within Existing Regulatory Frameworks, While Others Have Taken Additional Actions
paragraphs: State banking and financial regulatory officials from the eight states in our  sample expressed concerns about AMP lending in their states; however,  most relied on their existing regulatory system of licensing and examining  mortgage lenders and brokers to stay abreast of and react to AMP issues.  Most of the officials in our sample expressed concern about AMP lending  and the negative effects it could have on consumers, including how well  consumers understood complex AMP loans and the potential impact of  payment shock, financial difficulties, or default and foreclosure. Other  officials expressed concern about whether consumers received complete  information about AMPs, saying that federal disclosures were  complicated, difficult to comprehend, and often were not very useful to  consumers.
In addition to these general consumer protection concerns, some state  officials spoke about state-specific issues. For example, Ohio officials  expressed AMP concerns in the context of larger economic concerns,  noting that AMP mortgages were part of wider economic challenges facing  the state. Ohio already has high rates of mortgage foreclosures and  unemployment that have hurt both Ohio’s consumers and its overall  economy. In Nevada, officials worried that lenders and brokers have  engaged in practices that sometimes take advantage of senior citizens by  offering them AMP loans that they either did not need or could not afford.
Most of the state regulatory officials said that they have relied upon state  law to license mortgage lenders and brokers and ensure they meet  minimum experience and operations standards. Most said they also  periodically examine these entities for compliance with state licensing,  mortgage lending, and consumer protection laws, including applicable fair  advertising requirements. As such, most of the regulatory officials relied  on systems already in place to investigate AMP issues or complaints and,  when needed, used applicable licensing and consumer protection laws to  respond to problems such as unfair and deceptive trade practices.
Some state regulatory officials with whom we spoke said they have taken  other actions to better understand the issues associated with AMP lending  and expand consumer protections. For example, some states such as New  Jersey and Nevada have gathered data on AMPs to better understand AMP  lending and risks. Others, such as New York, plan to use guidance  developed by regulatory associations to help oversee AMP lending by  independent mortgage lenders and brokers.
In summary, it is too soon to tell the extent to which payment shock will  produce financial distress for some borrowers and induce defaults that  would affect banks that hold AMPs in their portfolios. However, the  popularity, complexity, and widespread marketing of AMPs highlight the  importance of mortgage disclosures to help borrowers make informed  mortgage decisions. As a result, while we commend the Federal Reserve’s  efforts to review and revise Regulation Z, we recommended in our report  that the Board of Governors of the Federal Reserve System consider  amending federal mortgage disclosure requirements to improve the clarity  and comprehensiveness of AMP disclosures. In response to our  recommendation, the Federal Reserve said that it will conduct consumer  testing to determine appropriate content and formats and use design  consultants to develop model disclosure forms intended to better  communicate information.
Chairmen of the subcommittees, this completes my prepared statement. I  would be pleased to respond to any questions you or other Members may  have at this time.
section_title: GAO Contact and Staff Acknowledgments
paragraphs: For additional information about this testimony, please contact Orice M.  Williams on (202) 512-5837 or at williamso@gao.gov. Contact points for  our Offices of Congressional Relations and Public Affairs may be found on  the last page of this statement. Individuals making key contributions to  this testimony include Karen Tremba, Assistant Director; Tania Calhoun;  Bethany Claus Widick; Stefanie Jonkman; Marc Molino; Robert Pollard;  Barbara Roesmann; and Steve Ruszczyk.
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