Alternative Mortgage Products: Impact on Defaults Remains Unclear, but Disclosure of Risks to Borrowers Could Be Improved
Published: 2006-09-19T00:00:00

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. 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.
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, they may eventually face payment increases large enough to be described as "payment shock." Mortgage statistics show that lenders offered AMPs to less creditworthy and less wealthy borrowers than in the past. Some of these recent borrowers may have more difficulty refinancing or selling their homes to avoid higher monthly payments, particularly if interest rates have risen or if the equity in their homes fell because they were making only minimum monthly payments or home values did not increase. As a result, delinquencies and defaults could rise. Officials from the federal banking regulators stated that most banks appeared to be managing their credit risk by diversifying their portfolios or through loan sales or securitizations. However, because the monthly payments for most AMPs originated between 2003 and 2005 have not reset to cover both interest and principal, it is too soon to tell to what extent payment shocks would result in increased delinquencies or foreclosures for borrowers and in losses for banks and other lenders. Regulators and others are concerned that borrowers may not be well-informed about the risks of AMPs, due to their complexity and because promotional materials by some lenders and brokers do not provide balanced information on AMPs benefits and risks. Although lenders and certain brokers are required to provide borrowers with written disclosures at loan application and closing, federal standards on these disclosures do not currently require specific information on AMPs that could better help borrowers understand key terms and risks. In December 2005, federal banking regulators issued draft interagency guidance on AMP lending that discussed prudent underwriting, portfolio and risk management, and consumer disclosure practices. Some lenders commented that the recommendations were too prescriptive and could limit consumer choices of mortgages. Consumer advocates expressed concerns about the enforceability of these recommendations because they are presented in guidance and not in regulation. State regulators GAO contacted generally relied on existing regulatory structure of licensing and examining independent mortgage lenders and brokers to oversee AMP lending.

section_title: Letter
paragraphs: In recent years, the residential real estate sector experienced sustained  In recent years, the residential real estate sector experienced sustained  growth in both volume and price. The National Association of Realtors®  growth in both volume and price. The National Association of Realtors®  (NAR) reported record growth in sales of existing homes from 2003 to  (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,  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,  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  from $178,800 to $219,600. Further, NAR reported double-digit percentage  increases in existing home prices in 72 metropolitan areas in 2005. To  increases in existing home prices in 72 metropolitan areas in 2005. To  purchase homes they might not be able to afford with a conventional  purchase homes they might not be able to afford with a conventional  fixed-rate mortgage, an increasing number of borrowers turned to  fixed-rate mortgage, an increasing number of borrowers turned to  alternative mortgage products (AMPs), which offer comparatively lower  alternative mortgage products (AMPs), which offer comparatively lower  and more flexible monthly mortgage payments for an initial period.  and more flexible monthly mortgage payments for an initial period.
Two recently popular types of AMPs—interest-only and payment-option  Two recently popular types of AMPs—interest-only and payment-option  adjustable-rate mortgages (ARMs)—allow borrowers to defer repayment  adjustable-rate mortgages (ARMs)—allow borrowers to defer repayment  of principal and possibly part of the interest for the first few years of the  of principal and possibly part of the interest for the first few years of the  mortgage. Interest-only mortgages allow borrowers to defer principal  mortgage. Interest-only mortgages allow borrowers to defer principal  payments for typically the first 3 to 10 years of the mortgage, before  payments for typically the first 3 to 10 years of the mortgage, before  recasting to require higher monthly payments that cover principal as well  recasting to require higher monthly payments that cover principal as well  as interest and to pay off (amortize) the outstanding balance over the  as interest and to pay off (amortize) the outstanding balance over the  remaining term of the loan. Payment-option mortgages allow borrowers to  remaining term of the loan. Payment-option mortgages allow borrowers to  make minimum payments that do not cover principal or all accrued  make minimum payments that do not cover principal or all accrued  interest, but can result in increased loan balances over time (negative  interest, but can result in increased loan balances over time (negative  amortization). Typically after 5 years, or if the loan balance increases to a  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  cap specified in the mortgage terms, payments recast to include an amount  that will fully amortize the outstanding balance over the remaining years  that will fully amortize the outstanding balance over the remaining years  of the loan.  of the loan.
As AMP lending grew, federal banking regulators and consumer advocates  As AMP lending grew, federal banking regulators and consumer advocates  expressed concerns about loans that allow deferred repayment of  expressed concerns about loans that allow deferred repayment of  principal or negative amortization; borrowers’ ability to make future,  principal or negative amortization; borrowers’ ability to make future,  higher payments; and lenders’ underwriting practices (criteria for issuing  higher payments; and lenders’ underwriting practices (criteria for issuing  loans). As a result of these and other factors, we studied the potential  risks of AMPs for borrowers and lenders. This report discusses (1) recent  trends in the AMP market, (2) the impact of AMPs on borrowers and on  the safety and soundness of financial institutions, (3) the extent to which  mortgage disclosures discuss the risks of AMPs, (4) the federal regulatory  response to the risks of AMPs for lenders and borrowers, and (5) selected  state regulatory responses to the risks of AMPs for lenders and borrowers.
To identify recent trends in the AMP market, we gathered information  from federal banking regulators and the residential mortgage lending  industry on AMP product features, customer base, and originators as well  as the reasons for the recent growth of these products. To determine the  potential risks of AMPs for borrowers and lenders, we analyzed the  changes in future monthly payments that can occur with AMPs during  periods of rising interest rates. We also interviewed officials from the  federal banking regulators (federal regulatory officials) and  representatives from the residential mortgage lending industry and  reviewed studies on the risks of these mortgages compared with  conventional fixed-rate mortgages. In addition, we obtained information  on the securitization of AMPs from federal banking regulators,  government-sponsored enterprises, and secondary mortgage market  participants. To determine the extent to which mortgage disclosures  explain the risks of AMPs, we reviewed federal laws and regulations  governing the required content of mortgage disclosures, reviewed studies  on borrowers’ understanding of adjustable-rate products, and interviewed  federal regulatory officials and industry participants. We also selected a  sample of eight states to obtain state regulators’ views on these  disclosures—Alaska, California, Florida, Nevada, New Jersey, New York,  North Carolina, and Ohio. We reviewed these states’ laws and regulations  governing the required content of mortgage disclosures and interviewed  state officials. We selected these states on the basis of a number of  criteria, including volume of AMP lending and geographic location. We  also conducted a readability and design analysis of a selection of written  disclosures that AMP lenders provide to borrowers. To obtain information  on federal regulatory responses to the risks of AMPs for lenders and  borrowers, we reviewed the draft interagency guidance on AMP lending  issued by federal banking regulators and interviewed regulatory officials.  We also reviewed comments written by industry participants in response  to the draft guidance. To obtain information on selected states’ regulatory  responses to the risks of AMPs for lenders and borrowers, we reviewed  current laws and, where applicable, draft legislation, from the eight states  in our sample and interviewed these states’ banking and mortgage lending  officials.
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.
subsections: section_title: Background
paragraphs: Borrowers arrange residential mortgages through either mortgage lenders  or brokers. The funding for mortgages can come from federally or state- chartered banks, mortgage lending subsidiaries of these banks or financial  holding companies, or independent mortgage lenders, which are neither  banks nor affiliates of banks. Mortgage brokers act as intermediaries  between lenders and borrowers, and for a fee, help connect borrowers  with various lenders who may provide a wider selection of mortgage  products. Mortgage lenders may keep the loans that they originated or  purchased from brokers in their portfolios or sell the loans in the  secondary mortgage market. Government-sponsored enterprises (GSEs)  or investment banks pool many mortgage loans that lenders sell to the  secondary market, and these lenders or investment banks then sell claims  to these pools to investors as mortgage backed-securities (MBS).
Lenders consider whether to accept or reject a borrower’s loan application  in a process called underwriting. During underwriting, the lender analyzes  the borrower’s ability to repay the debt. For example, lenders may  determine ability to repay debt by calculating a borrower’s DTI ratio,  which consists of the borrowers’ fixed monthly expenses divided by gross  monthly income. The higher the DTI ratio, the greater the risk the  borrower will have cash-flow problems and miss mortgage payments.  During the underwriting process, lenders usually require documentation of  borrowers’ income and assets. Another important factor lenders consider  during underwriting is the amount of down payment the borrower makes,  which usually is expressed in terms of a LTV ratio (the larger the down  payment, the lower the LTV ratio). The LTV ratio is the loan amount  divided by the lesser of the selling price or appraised value. The lower the  LTV ratio, the smaller the chance that the borrower would default, and the  smaller the loss if the borrower were to default. Additionally, lenders  evaluate the borrowers’ credit history using various measures. One of  these measures is the borrowers’ credit score, which is a numerical  measure or score that is based on an individual’s credit payment history  and outstanding debt. Mortgage loans could be made to prime and  subprime borrowers. Prime borrowers are those with good credit histories  that put them at low risk of default. In contrast, subprime borrowers have  poor or no credit histories, and therefore cannot meet the credit standards  for obtaining a prime loan.
Chartering agencies oversee federally and state-chartered banks and their  mortgage lending subsidiaries. At the federal level, OCC, OTS, and NCUA  oversee federally chartered banks (including mortgage operating  subsidiaries), thrifts, and credit unions, respectively. The Federal Reserve  oversees insured state-chartered member banks, while FDIC oversees  insured state-chartered banks that are not members of the Federal Reserve  System. Both the Federal Reserve and FDIC share oversight with the state  regulatory authority that chartered the bank. The Federal Reserve also  oversees mortgage lending subsidiaries of financial holding companies,  although FTC is responsible for enforcement of certain federal consumer  protection laws as discussed in the following text.
Federal banking regulators have responsibility for ensuring the safety and  soundness of the institutions they oversee and for promoting stability in  the financial markets. To achieve these goals, regulators establish capital  requirements for banks, conduct on-site examinations and off-site  monitoring to assess their financial condition, and monitor their  compliance with applicable banking laws, regulations, and agency  guidance. As part of their examinations, for example, regulators review  mortgage lending practices, including underwriting, risk management, and  portfolio management practices. Regulators also try to determine the  amount of risk lenders have assumed. From a safety and soundness  perspective, risk involves the potential that events, either expected or  unanticipated, may have an adverse impact on the bank’s capital or  earnings. In mortgage lending, regulators pay close attention to credit risk.  Credit risk involves the concerns that borrowers may become delinquent  or default on their mortgages and that lenders may not be paid in full for  the loans they have originated.
Certain federal consumer protection laws, including TILA and the act’s  implementing regulation, Regulation Z, apply to all mortgage lenders,  including mortgage brokers that close loans in their own name.  Implemented by the Federal Reserve, Regulation Z requires these creditors  to provide borrowers with written disclosures describing basic  information about the terms and cost of their mortgage. Each lender’s  primary federal supervisory agency holds responsibility for enforcing  Regulation Z. Regulators use examinations and consumer complaint  investigations to check for compliance with both the act and its regulation.  FTC is responsible for enforcing certain federal consumer protection laws  for brokers and lenders that are not depository institutions, including  state-chartered independent mortgage lenders and mortgage lending  subsidiaries of financial holding companies. However, FTC is not a  supervisory agency; instead, it enforces various federal consumer  protection laws through enforcement actions. The FTC uses a variety of  information sources in the enforcement process, including its own  investigations, consumer complaints, state and other federal agencies, and  others.
State regulators oversee independent lenders and mortgage brokers and  do so by generally requiring business licenses that mandate meeting net  worth, funding, and liquidity thresholds. They may also mandate certain  experience, education, and operational requirements to engage in  mortgage activities. Other common requirements for licensees may  include maintaining records for certain periods, individual prelicensure  testing, posting surety bonds, and participating in continuing education  activities. States may also examine independent lenders and mortgage  brokers to ensure compliance with licensing requirements, review their  lending and brokerage functions for state-specific and federal regulatory  compliance, and look for unfair or unethical business practices. When  such practices arise, or are brought to states’ attention through consumer  complaints, regulators and State Attorneys General may pursue actions  that include licensure suspension or revocation, monetary fines, and  lawsuits.
section_title: AMP Lending Rapidly Grew as Borrowers Sought Mortgage Products That Increased Affordability
paragraphs: The volume of interest-only and payment-option ARMs grew rapidly  between 2003 and 2005 as home prices increased nationwide and lenders  marketed these products as an alternative to conventional mortgage  products. During this period, AMP lending was concentrated in the higher- priced real estate markets on the East and West Coasts. Also at that time, a  variety of federally and state-regulated lenders participated in the AMP  market, although a few large federally regulated dominated lending. Once  considered a financial management tool for wealthier borrowers, lenders  have marketed AMPs as affordability products that enable borrowers to  purchase homes they might not be able to afford using conventional fixed- rate mortgages. Furthermore, lenders have increased the variety of AMP  products offered to respond to changing market conditions.
subsections: section_title: AMP Share of Mortgage Originations Grew Threefold from 2003 to 2005, with Higher Concentrations in the Coastal Markets
paragraphs: 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. 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.  According to federal regulatory officials, consumer demand for these  products grew because their low initial monthly payments enabled  borrowers to purchase homes that they otherwise might not have been  able to afford with a conventional fixed-rate mortgage.
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. 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. 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.
section_title: Once Considered a Specialized Product for the Financially Sophisticated, Lenders Have Offered AMPs Widely as Affordability Products
paragraphs: Once considered a specialized product, AMPs have entered the  mainstream marketplace in higher-priced real estate markets. According  to federal regulatory officials and a mortgage lending trade association,  lenders originally developed and marketed interest-only and payment- option ARMs as specialized products for higher-income, financially  sophisticated borrowers who wanted to minimize mortgage payments to  invest funds elsewhere. Additionally, they said that other borrowers who  found AMPs suitable included borrowers with irregular earnings who  could take advantage of interest-only or minimum monthly payments  during periods of lower income and could pay down principal and any  deferred interest when they received an increase in income. However,  according to federal banking regulators and a range of industry  participants, as home prices increased rapidly in some areas of the  country, lenders began marketing interest-only and payment-option ARMs  widely as affordability products. They also said that in doing so, lenders  emphasized the low initial monthly payments offered by these products  and made them available to less creditworthy and less wealthy borrowers  than those who traditionally used them.
After the recent surge of interest-only and payment-option ARMs, lenders  have increased the variety of AMPs offered as market conditions have  changed. According to industry analysts, as interest rates continued to  rise, by the beginning of 2006, mortgages with adjustable rates no longer  offered the same cost-savings over fixed-rate mortgages, and borrowers  began to shift to fixed-rate products. These analysts reported that in  response to this trend, lenders have begun to market mortgages that are  less sensitive to interest rate increases. For example, interest-only fixed- rate mortgages (interest-only FRMs) offer borrowers interest-only  payments for up to 10 years but at a fixed interest rate over the life of the  loan. Another mortgage that has gained in popularity is the 40-year  mortgage. This product does not allow borrowers to defer interest or  principal, but offers borrowers lower monthly payments than conventional  mortgages. For example, some variations of the 40-year mortgage have a  standard 30-year loan term, but offer lower fixed monthly payments that  are based on a 40-year amortization schedule for part or all of the loan  term. 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.
section_title: Borrowers Could Face Payment Shock; Lenders Face Credit Risk but Most Appear to be Taking Steps to Manage the Risk
paragraphs: 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.
subsections: section_title: AMPs Create Potential for Borrowers to Face Payment Shock, Particularly as Interest Rates Rise
paragraphs: AMPs such as interest-only and payment-options ARMs are initially more  affordable than conventional fixed-rate mortgages because during the first  few years of the mortgage they allow a borrower to defer repayment of  principal and, in the case of payment-option ARMs, part of the interest as  well. Specifically, borrowers with interest-only ARMs can make monthly  payments of just interest for the fixed introductory period. Borrowers with  payment-option ARMs typically have four payment options. The first two  options are fully amortizing payments that are based on either a 30-year or  15-year payment schedule. The third option is an interest-only payment,  and the fourth is a minimum payment, which we previously described, that  does not cover all of the interest. The interest that does not get paid gets  capitalized into the loan balance owed, resulting in negative amortization.
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.
The example in figure 1 assumes loan features that were typical of  payment-option ARMs offered during 2004, including    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;   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; 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. Minimum monthly payments were adjusted upward every April, but  only by the maximum 7.5 percent allowed. By year 5, the minimum  payments reset to $1,718, a 33 percent increase from the initial minimum  payment required in year 1.
As shown in figure 1, these minimum monthly payments were not enough  to cover the interest due on the loan after the start rate expired in the first  month of year 1, and the loan immediately began to negatively amortize.  By year 2, the loan balance increased by $3,299. As interest rates rose, the  amount of deferred interest grew more quickly, reaching $33,446 by the  beginning of year 6. Because the start of year 6 marked the end of the 5- year payment-option period, the loan recast to require fully amortizing  monthly payments of $2,931. This payment represented a 70 percent  increase from the minimum monthly payment required a year earlier and a  128 percent increase from the initial minimum monthly payment in year 1.  Note that the largest monthly payment increase occurred at this time,  reflecting the combined effect of a fully amortizing payment that is  calculated on the basis of both the fully indexed interest rate and the  increased loan balance.
section_title: In Contrast to Past Borrowers, Recent AMP Borrowers May Find It More Difficult to Avoid Payment Shock
paragraphs: 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. FDIC officials expressed particular concern over  payment-option ARMs, as they are more complex than interest-only  products and have the potential for negative amortization and bigger  payment shocks.
Mortgage statistics of recently securitized interest-only and payment- option ARMs show a relaxation of underwriting standards regarding credit  history, income, and available assets during the years these products  increased in popularity. According to one investment bank, interest-only  mortgages that were part of subprime securitizations were negligible in  2002, but rose to almost 29 percent of subprime securitizations in 2005.  Lenders also originated payment-option ARMs to borrowers with  increasingly lower credit scores (see table 1). In addition, besides  permitting lower credit scores, lenders increasingly qualified borrowers  with fewer financial resources. For example, lenders allowed higher DTI  ratios for some borrowers and began combining AMPs with “piggyback”  mortgages—that is, second mortgages that allow borrowers with limited  or no down payments to finance a down payment. As table 1 shows, by  June 2005, 25 percent of securitized payment-option ARMs included  piggyback mortgages—up from zero percent 5 years earlier. 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.
Federal banking regulators cautioned that “risk-layering”, which results  from the combination of AMPs with one or more relaxed underwriting  practices could increase the likelihood that some borrowers might not  withstand payment shock and may go into default. In particular, federal  regulatory officials said that some recent AMP borrowers, particularly  those with low income and little equity, may have fewer financial reserves  against financial adversity, which could impact their ability to sustain  future higher monthly payments in the event that they cannot refinance  their mortgages or sell their homes. Although concerns about the effect of  risk-layering exist, OCC officials observed that while underwriting  characteristics for AMPs have trended downward over the past few years,  lenders generally attempt to mitigate the additional credit risk of AMPs  compared to traditional mortgages by having at least one underwriting  criteria (such as LTV ratio, DTI ratio, or loan size) tighter for AMPs than  for a traditional mortgage. In addition, both OCC and Federal Reserve  officials said that most lenders qualify payment-option ARM borrowers at  the fully-indexed rate, and not the teaser rate, suggesting that these  borrowers have the financial resources to either make more than the  minimum monthly payment or to manage any future rise in monthly  payments. 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  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.
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. 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.
section_title: 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
paragraphs: 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.
In addition, several regulatory officials noted borrowers who have turned  to interest-only FRMs are subject to less payment shock than interest-only  and payment-option ARM borrowers. As we previously discussed, interest- only FRMs are not sensitive to interest rate changes. For example, the  amount of the initial interest-only payment and the later fully amortizing  payment are known at the time of loan origination for an interest-only  FRM and do not vary. Furthermore, these products tend to feature a  longer period of introductory payments than did the interest-only and  payment-option ARMs sold earlier, thus giving the borrower more time to  prepare financially for the increase in monthly payments or plan to  refinance or sell.
Federal regulatory officials and industry participants agree that it is too  soon to tell how many borrowers with AMPs will become delinquent or go  into foreclosure, thereby producing losses for banks that hold AMPs in  their portfolios. Most of the AMPs issued between 2003 and 2005 have not  recast; therefore, most of these borrowers have not yet experienced  payment shock or financial distress. As a result, lenders generally do not  yet have the performance data on delinquencies that would serve as an  indicator of future problems. Furthermore, the credit profile of recent  AMP borrowers is different from that of traditional AMP borrowers,  because it includes less creditworthy and less affluent borrowers.  Consequently, it would be difficult to use past performance data to predict  how many loans would be refinanced before payment shock sets in and  how many delinquencies and foreclosures could result for those  borrowers who cannot sustain larger monthly payments.
section_title: Regulators and Others Are Concerned That Borrowers May Not Be Well-informed About the Risks of AMPs
paragraphs: The information that borrowers receive about their loans through  advertisements and disclosures may not fully or effectively inform them  about the risk of AMPs. Federal and state banking regulatory officials  expressed concern that advertising practices by some lenders and brokers  emphasized the affordability of these products without adequately  describing their risks. Furthermore, a recent Federal Reserve staff study  and state complaint data indicated that some borrowers appeared to not  understand (1) the terms of their ARMs, including AMPs, and (2) the  potential magnitude of changes to their monthly payments or loan balance.  As AMPs are more complex than conventional mortgage products and  advertisements may not provide borrowers with balanced information on  these products, it is important that written disclosures provide borrowers  with clear and comprehensive information about the key terms,  conditions, and costs of these mortgages to help them make an informed  decision. That information is conveyed both through content and  presentation, including writing style and design. With respect to content,  Regulation Z, which includes requirements for mortgage disclosures,  requires all creditors (lenders and those brokers that close loans in their  own name) to provide borrowers with information about their ARM  products. However, these requirements are not designed to address more  complex products such as AMPs. The Federal Reserve has recently  initiated a review of Regulation Z that will include reviewing the  disclosures required for all mortgage loans, including AMPs. For  presentation, current guidance available in the federal government  suggests good practices on developing disclosures that effectively  communicate key information on financial products. Most of the AMP  disclosures we reviewed did not always fully or effectively explain the  risks of payment shock or negative amortization for these products and  lacked information on some important loan features, both because  Regulation Z currently does not require lenders to tailor this information  to AMPs and because lenders do not always follow leading practices for  writing disclosures that are clear, concise, and user-friendly. According to  Federal Reserve officials, revising Regulation Z to require better  disclosures of the key terms and risks of AMPs could increase borrower  understanding of these complex mortgage products, particularly if a  broader effort were made to simplify and clarify mortgage disclosures  generally. Officials added that borrowers who do not understand their  AMPs may not anticipate the substantial increase in monthly payments or  loan balance that can occur.
subsections: section_title: Some AMP Advertising Practices Emphasize Benefits over Risks
paragraphs: 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.
Officials from three of the eight states we contacted reported similar  concerns with AMP advertising distributed by the nonbank lenders and  independent brokers under their supervision. For example, one official  from Ohio told us that some brokers advertised the availability of large  loans with low monthly payments and only specified in tiny print at the  bottom of the advertisements that the offer involved interest-only  products. According to this official, small print makes it more difficult for  the consumer to see these provisions and more likely for the consumer not  to read them at all. Regulatory officials in Alaska told us some  advertisements circulating in their state stated that consumers could save  money by using interest-only products, without disclosing that over time  these loans might cost more than a conventional product. In some cases,  the advertisements were potentially misleading. For example, New Jersey  officials provided us with a copy of an AMP advertisement that promised  potential borrowers low monthly payments by suggesting that the teaser  rate (termed “payment rate” in the advertisement) on a payment-option  ARM product was the actual interest rate for the full term of the loan (see  figure 2). The officials also said that advertising a rate other than the  annual percentage rate (APR), without also including the APR (as seen in  the advertisement shown in fig. 2) is contrary to the requirements of  Regulation Z.
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.
section_title: A Recent Study and Initial Complaint Data Indicated Some Borrowers Did Not Understand the Terms and Features of ARMs, Including AMPs
paragraphs: 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. The study was  based, in part, on data obtained from the Federal Reserve’s 2001 Survey of  Consumer Finances, which included questions for consumers on the  terms of their ARMs. While most homeowners reported knowing their  broad mortgage terms reasonably well, some borrowers with ARMs,  particularly those from households with lower income and less education,  appeared to underestimate the amount by which their interest rates, and  thus their monthly payments, could change. The authors suggested that  this underestimation might be explained, in part, by borrower confusion  about the terms of their mortgages. Although they found that most  households in 2001 were unlikely to experience large and unexpected  changes in their mortgage payments in the event of a rise in interest rates,  some borrowers might be surprised by the change in their payments and  subsequently might experience financial difficulties.
The Federal Reserve staff study focused on borrowers holding ARM  products in 2001—not AMPs. However, as we previously discussed, most  AMP products sold between 2003 and 2005 were interest-only and  payment-option ARMs that lenders increasingly marketed and sold to a  wider spectrum of borrowers.  Federal regulatory officials and consumer  advocates said that since AMPs tend to have more complicated terms and  features than ARMs, borrowers who have these mortgages would be likely  to (1) underestimate the potential changes in their interest rates and (2)  experience confusion about the terms of their mortgages and amounts of  their payments.
Because most AMPs have not recast to fully amortizing payments, many  borrowers are still making lower monthly payments that do not cover  repayment of deferred principal. However, five of the eight states we  contacted reported receiving some complaints about AMPs from  borrowers who did not understand their loan terms and were surprised by  increases in their monthly payments or loan balances. For example, some  borrowers with payment-option ARMs complained that they did not know  that their loans could negatively amortize until they received their  payment coupons and saw that their loan balance had increased. In one  case, a borrower believed that the teaser rate would be in effect for 1 or  more years, when in fact it was in effect for only the first month. Officials  from one state said that they anticipated receiving more consumer  complaints regarding AMPs as these mortgages recast over the next  several years to require fully amortizing payments.
section_title: 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
paragraphs: 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    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;    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. The Federal Reserve has also developed model  disclosure forms to help lenders achieve compliance with the current  requirements.
According to Federal regulatory officials, current Regulation Z  requirements are designed to address traditional fixed-rate and adjustable- rate products—not more complex products such as AMPs. Consequently,  lenders are not required to tailor the mortgage disclosures to communicate  information on the potential for payment shock and negative amortization  specific to AMPs. The Federal Reserve has recently initiated a review of  Regulation Z that will include reviewing the disclosures required for all  mortgage loans, including AMPs. In addition, the Federal Reserve has  begun taking steps to consider revisions that would specifically address  AMPs. During the summer of 2006, the Federal Reserve held a series of  four hearings across the country on home-equity lending. 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.
section_title: Leading Practices for Financial Product Disclosures Include the Use of Clear Language to Explain Information That Is Most Relevant to the Consumer
paragraphs: 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. According to the SEC handbook,  investors need disclosures that clearly communicate key information  about their financial products so that they can make informed decisions  about their investments. SEC requires investment firms to use “plain  English” to communicate complex information clear and logical manner so  that investors have the best possible chance of understanding the  information.
A Plain English Handbook presents recommendations for both the  effective visual presentation and readability of information in disclosure  documents. For example, the handbook directs firms to highlight  information that is important to investors, presenting the “big picture”  before the details. Also, the handbook recommends tailoring disclosures  to the financial sophistication of the user by avoiding legal and financial  jargon, long sentences, and vague “boilerplate” explanations. Furthermore,  it states that the design and layout of the document should be visually  appealing, and the document should be easy to read.
According to SEC, it developed these recommendations because investor  prospectuses were full of complex, legalistic language that only financial  and legal experts could understand. Because full and fair disclosures are  the basis for investor protection under federal securities laws, SEC  reasoned that investors would not receive that basic protection if a  prospectus failed to provide information clearly.
section_title: The Disclosures That We Reviewed Generally Did Not Provide Clear and Complete Information on AMP Features and Risks
paragraphs: 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.
subsections: section_title: Program-Specific Disclosures Did Not Always Clearly Discuss the Risk of Payment Shock or Negative Amortization for AMPs
paragraphs: While addressing current Regulation Z requirements, the program-specific  disclosures for the eight adjustable-rate AMPs we reviewed did not always  consistently provide clear and full explanations of payment shock and  negative amortization as they related to AMPs. For example, in describing  how monthly payments could change, two of the disclosures we reviewed  closely followed the “boilerplate” language of the model disclosure form,  which included a statement that monthly payments could “increase or  decrease annually” based on changes to the interest rate, as illustrated in  figure 3. “As with all Adjustable Rate Mortgage (ARM) loans, your interest rate can increase or  decrease. In the case of a , 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.”
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   Payment Choices,” the lender tells the borrower that the “minimum  payment probably will not be sufficient to cover the interest due each  month.” “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.” .
In addition, three of the five payment-option ARM disclosures did not  explain how soon the negative amortization cap could be reached in a  rising interest rate environment and trigger an early recast. Without this  information, borrowers who considered purchasing a typical 5-year  payment-option ARM for its flexibility might not realize that their payment- option period could expire before the end of the first 5 years, thus  recasting the loan and increasing their monthly payments.
section_title: Disclosures Generally Did Not Prominently Present Key Information on Changes to Monthly Payments and Loan Balance or Adhere to Other “Plain English” Principles
paragraphs: 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.
section_title: Transaction-Specific TILA Disclosures Lacked Key Information for AMP Borrowers
paragraphs: Regulation Z does not require lenders to completely disclose important  AMP loan information on the transaction-specific TILA disclosures,  including the interest-rate assumptions underlying the payment schedule,  the amount of deferred interest that can accrue, and the amount and  duration of any prepayment penalty. In most cases, lenders did not go  beyond minimum requirements when developing transaction-specific  disclosures for AMP borrowers. First, when the mortgage product features  an adjustable rate, Regulation Z requires lenders to (1) include a payment  schedule and (2) assume that no changes occur in the underlying index  over the life of the loan. However, it does not require the disclosures to  indicate this assumption, and the four transaction-specific disclosures we  reviewed did not include this information. Regulation Z only requires  lenders to remind borrowers in the transaction-specific disclosure that the  loan has an adjustable rate and refer them to previously provided  adjustable-rate disclosures (see fig. 4); therefore, borrowers might not  understand that the payment schedule is not representative of their  payments in a changing interest rate environment. Figure 4 shows the  payment schedule for a 5-year payment-option ARM originated in 2005.  The first 5 years show the minimum monthly payments increasing to  reflect the difference between the teaser rate and the initial fully-indexed  interest rate, but the amount of the increase is constrained each year by  the payment reset cap in effect for the loan. The loan recasts in the 6th  year to fully amortizing payments. However, this increase could be  considerably more if the fully-indexed interest rate were to rise during the  first 5 years of the loan.
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.
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.
section_title: Revisions to Regulation Z May Increase Understanding of AMPs, Particularly If Broader Effort Were Made to Reform the Mortgage Disclosure Process
paragraphs: According to federal banking regulators, borrowers who do not  understand their AMP may not anticipate the substantial increase in  monthly payments or loan balance that could occur, and would be at a  higher risk of experiencing financial hardship or even default. One  mortgage industry trade association told us that it is in the best interest of  lenders and brokers to provide adequate disclosures to their customers so  that they will be satisfied with their loan and consider the lender for future  business or refer others to them. Officials from one federal banking  regulator said that revising Regulation Z requirements so that lender  disclosures more clearly and comprehensively explain the key terms and  risks of AMPs would be one of several steps needed to increase borrower  understanding about these more complex mortgage products. Federal  Reserve officials said that there is a trade-off between the goals of clarity  and comprehensiveness in mortgage disclosures. In particular, they said  that there is a desire to provide information that is both accurate and  comprehensive in order to mitigate legal risks, but that might also result in  disclosures that have too much information and therefore, are not clear or  useful to consumers. According to these officials, this highlights the need  for using consumer testing in designing model disclosures to determine (1)  what information consumers need, (2) when they need it, and (3) which  format and language that will most effectively convey the information so  that it is readily understandable. In conducting the review of Regulation Z  rules for mortgage disclosures, they said that they plan to use extensive  consumer testing and will also use design consultants in developing model  disclosure forms.
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. 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.
section_title: Federal Banking Regulators Issued Draft Guidance and Took Other Actions to Improve Lender Practices and Disclosures and Publicize Risks of AMPs
paragraphs: 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.
subsections: section_title: Draft Interagency Guidance on AMP Lending Recommends Tightening Underwriting Standards, Developing Risk Management Policies, and Improving Consumer Information
paragraphs: 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. Federal regulatory  officials noted that the draft guidance did not seek to limit the availability  of AMPs, but instead sought to ensure that they were properly  underwritten and disclosed. In addition, they said the draft guidance  reflects an approach to supervision that seeks to help banks identify  emerging and growing risks as early as possible, a process that encourages  banks to develop advanced tools and techniques to manage those risks, for  their own account and for their customers. Accordingly, the draft guidance  recommends that federally regulated financial institutions ensure that (1)  loan terms and underwriting standards are consistent with prudent lending  practices, including consideration of a borrower’s repayment capacity; (2)  risk management policies and procedures appropriately mitigate any risk  exposures created by these loans; and (3) consumers are provided with  balanced information on loan products before they make a mortgage  product choice.
To address AMP underwriting practices, the draft guidance states that  lenders should consider the potential impact of payment shock on the  borrower’s capacity to repay the loan. In particular, lenders should qualify  borrowers on the basis of whether they can make fully amortizing monthly  payments determined by the fully-indexed interest rate, and not on their  ability to make only interest-only payments or minimum payments  determined from lower promotional interest rates. The draft guidance also  notes increased risk to lenders associated with combining AMPs with risk- layering features, such as reduced documentation or the use of piggyback  loans. In such cases, the draft guidance recommends that lenders look for  off-setting factors, such as higher credit scores or lower LTV ratios to  mitigate the additional risk. Furthermore, the draft guidance recommends  that lenders avoid using loan terms and underwriting practices that may  cause borrowers to rely on the eventual sale or refinancing of their  mortgages once full amortization begins.
To manage risk associated with AMP lending, the draft guidance  recommends lenders develop written policies and procedures that  describe AMP portfolio limits, mortgage sales and securitization practices,  and risk-management expectations. The policies and procedures also  should establish performance measures and management reporting  systems that provide early warning of portfolio deterioration and  increased risk. The draft guidance also recommends policies and  procedures that require banking capital levels that adequately reflect loan  portfolio composition and credit quality, and also allow for the effect of  stressed economic conditions.
To help improve consumer understanding of AMPs, the draft guidance  recommends that lender communications with consumers, including  advertisements, promotional materials, and monthly statements, be  consistent with actual product terms and payment structures and provide  consumers with clear and balanced information about AMP benefits and  risks. Furthermore, the draft guidance recommends that institutions avoid  advertisement practices that obscure significant risks to the consumer.  For example, when institutions emphasize the AMP benefit of low initial  payments, they also should disclose that borrowers who make these  payments may eventually face increased loan balances and higher monthly  payments when their loans recast.
The draft guidance also recommends that lenders fully disclose AMP terms  and features to potential borrowers in their promotional materials, and  that lenders not wait until the time of loan application or closing, when  they must provide written disclosures that fulfill Regulation Z  requirements. Rather, the draft guidance states that institutions should  offer full and fair descriptions of their products when consumers are  shopping for a mortgage, so that consumers have the appropriate  information early enough to inform their decision making. In doing so, the  draft guidance urges lenders to employ a user-friendly and readily  navigable design for presenting mortgage information and to use plain  language with concrete examples of available loan products. Further, the  draft guidance states that financial institutions should provide consumers  with information about mortgage prepayment penalties or extra costs, if  any, associated with AMP loans. Finally, after loan closing, financial  institutions should provide monthly billing statement information that  explains payment options and the impact of consumers’ payment choices.  According to the draft guidance, such communication should help  minimize potential consumer confusion and complaints, foster good  customer relations, and reduce legal and other risks to lending  institutions.
Federal regulatory officials said they developed the draft guidance to  clarify how institutions can offer AMPs in a safe and sound manner and  clearly disclose the potential AMP risks to borrowers. These officials told  us they will request remedial action from institutions that do not  adequately measure, monitor, and control risk exposures in their loan  portfolios.
section_title: Many Industry Groups Opposed the Draft Guidance and Some Consumer Advocates Questioned Whether It Would Add Consumer Protections
paragraphs: In response to the draft interagency guidance, federal regulators received  various responses through comment letters from various groups, such as  financial institutions, mortgage brokers, and consumer advocates, and  began reviewing comments to develop final guidance. For example,  several financial institutions such as banks and their industry associations  opposed the draft guidance, suggesting that it put federally regulated  institutions at a competitive disadvantage because its recommendations  would not apply to lenders and brokers that were not federally regulated.  Some lenders suggested implementing these changes through Regulation Z  so that they apply to the entire industry, and not just to regulated  institutions. Organizations such as the Conference of State Bank  Supervisors (CSBS) and the American Association of Residential Mortgage  Regulators (AARMR) also noted the possibility of competitive   disadvantage and have responded by developing guidance for state- licensed mortgage lenders and brokers who offer AMPs but were not  covered by the draft federal guidance issued in December 2005. Other  financial institutions said that the recommendations regarding borrower  qualification and general underwriting practices were too prescriptive and  would have the effect of reducing mortgage choice for consumers.
Consumer advocates supported the need for additional consumer  protections relating to AMP products, but several questioned whether the  draft guidance would add needed protections. They also contended, as did  lenders, that since the draft guidance applies only to federally regulated  institutions, independent lenders and brokers would not be subject to  recommendations aimed at informing and protecting consumers. One  advocacy organization said that the proposed guidance is only a  recommendation by the agencies regulating some lenders, and that failure  to follow the guidance neither leads to any enforceable sanctions nor  provides a means of using guidance to obtain relief for a harmed  consumer. Although not in a comment letter, another advocate echoed  these concerns by saying the draft guidance would not expand consumer  protections because it neither requires revisions to mortgage disclosures,  nor allows consumers to enforce the application of guidance standards to  individual lenders.
section_title: Federal Officials Reinforced Their Messages by Publicizing Their Concerns, Highlighting AMP Risks, and Taking Other Actions
paragraphs: Although the draft interagency guidance has not been finalized, officials  from the Federal Reserve, OCC, OTS, FDIC, and NCUA have reinforced  messages regarding AMP risks and appropriate lending practices by  publicizing their concerns in speeches, at conferences, and the media.  According to an official at the Federal Reserve, federal regulatory officials  who publicized their concerns in these outlets raised awareness of AMP  risks and reinforced the message that financial institutions and the general  public need to manage risks and understand these products, respectively.
In addition to drafting interagency guidance and publicizing AMP  concerns, officials from each of the federal banking regulators told us they  have responded to AMP lending with intensified reviews, monitoring, and  other actions. For instance, FDIC developed a review program to identify  high-risk lending areas, adjust supervision according to product risk levels,  and evaluate risk management and underwriting approaches. OTS staff has  performed a review of its 68 most active AMP lenders to assess and  respond to potential AMP lending risks while the Federal Reserve and  OCC have begun to conduct reviews of their lenders’ AMP promotional  and marketing materials to assess how well they inform consumers. As  discussed earlier, the Federal Reserve has taken several steps to address  consumer protection issues associated with AMPs, including initiating a  review of Regulation Z that includes reviewing the disclosures required for  all mortgage loans and holding public hearings that in part explored the  adequacy and effectiveness of AMP disclosures. In addition, NCUA  officials told us they informally contacted the largest credit unions under  their supervision to assess the extent of AMP lending at these institutions.
FTC also directed some attention to consumer protection issues related to  AMPs. In 2004, it charged a California mortgage broker with misleading  AMP consumers by making advertisements that contained allegedly false  promises of fixed interest rates and fixed payments for variable rate  payment option mortgages. As a result of FTC’s actions, a U.S. district  court judge issued a preliminary injunction barring the broker’s allegedly  illegal business practices. More recently in May 2006, FTC sponsored a  public workshop that explored consumer protection issues as a result of  AMP growth in the mortgage marketplace. FTC, along with other federal  banking regulators and departments, also helped create a consumer  brochure that outlines basic mortgage information to help consumers shop  for, compare, and negotiate mortgages.
section_title: Most States in Our Sample Responded to AMP Lending Risks within Existing Regulatory Frameworks, While Others Had Taken Additional Actions
paragraphs: 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.
subsections: section_title: States in Our Sample Identified Concerns about AMP Lending by Independent Mortgage Lenders and Brokers
paragraphs: Most regulatory officials from our sample of eight states focused their  concerns about AMP lending on the potential negative effects on  consumers. For example, many officials questioned (1) how well  consumers understood complex AMP loans, and therefore, how  susceptible consumers with AMPs therefore might be to payment shock  and (2) how likely consumers would then be to experience financial  difficulties in meeting their mortgage payments. Some state officials also  said that increased AMP borrowing heightened their concern about  mortgage default and foreclosure, and some officials expressed concern  about unscrupulous lender or broker operations and the extent to which  these entities met state licensing and operations requirements. In addition  to these general consumer protection concerns, some state officials spoke  about state-specific issues. For example, Ohio officials put AMP concerns  in the context of larger economic issues and said AMP mortgages were  part of wider economic challenges facing the state, including an already- high rate of mortgage foreclosures and the loss of manufacturing jobs that  hurt both Ohio’s consumers and the overall economy. Officials from  another state, Nevada, said they worried that lenders and brokers  sometimes took advantage of senior citizens by offering them AMP loans  that they either did not need or could not afford.
State banking and financial regulatory officials expressed concerns about  the extent to which consumers understood AMPs and that potential for  those who used them to experience monthly mortgage payment increases.  Some state officials said that current federal disclosures were  complicated, difficult to comprehend, and often did not provide  information that could help consumers. However, these officials thought  that adding a state-developed disclosure to the already voluminous  mortgage process would add to the confusion and paperwork burden.  Officials from most states have not created their own mortgage  disclosures.
section_title: States in Our Sample Generally Increased Their Attention to AMPs Through Licensing and Examination, and by Taking New Approaches
paragraphs: State banking and financial regulators from our sample generally  responded to concerns about AMP lending by increasing their attention to  AMP issues through their existing regulatory structure of lender and  broker licensing and examination, but some states had taken additional  approaches. Most of the state officials from our sample suggested they  primarily used their own state laws and regulations to license mortgage  lenders and brokers and to ensure that these entities met minimum  experience and operations standards. While these were not AMP-specific  actions, several state officials told us these actions help ensure that  lenders had the proper experience and other qualifications to operate  within the mortgage industry. Some officials told us that these  requirements also helped ensure that those with criminal records or  histories of unscrupulous mortgage behavior would not continue to harm  consumers. Some state officials said that they were particularly sensitive  to AMP lenders’ records of behavior because of the higher risks these  products entailed for consumers.
However, Alaska provided an exception. Alaska had not specifically  responded to AMP lending and Alaska officials noted that the state does  not have statutes or regulations that govern mortgage lending, nor are  mortgage lenders or brokers required to be licensed to make loans.
Many of the state banking and financial regulatory officials we contacted  also told us that they periodically examine AMP lenders and brokers for  compliance with state licensing, mortgage lending, and general consumer  protection laws, including applicable fair advertising requirements.  Because state officials perform examinations for all licensed lenders and  brokers, these regulatory processes also are not AMP-specific. However,  some state officials said they were particularly aware of AMP risks to  consumers and had begun to pay more attention to potential lender,  broker, and consumer issues during their oversight reviews. For example,  because AMP lending heightens potential risks for consumers, several  state officials said they had taken extra care during their licensing and  examination reviews to review lender and broker qualifications and loan  files.
A few states had worked outside of the existing licensing and examination  framework to identify AMP issues and protect consumers. Officials from  several states said that because they did not collect data on AMP loans and  borrowers, they did not fully understand the level and types of AMP  lending in their states. However, two states from our sample had begun to  gather AMP data to improve their information on AMP lending. New Jersey  conducted a mortgage lending survey among its state-chartered banks that  specifically collected data on interest-only and payment-option mortgages,  while Nevada implemented annual reporting requirements for lenders and  brokers on the types of loans they originate. New Jersey and Nevada  officials told us that these efforts would provide an overview of AMP  lending in each state and would serve to help identify emerging AMP  issues.
Other states reacted by focusing on consumer protection or using  guidance for independent lenders and mortgage brokers. Ohio addressed  mortgage issues, including AMP concerns, by working to improve its  consumer protection law. This law originally did not cover mortgage  lenders and brokers, but was amended to include protections found in  other states. As of June 2006, officials drafted and passed legislation to  expand the law’s provisions to cover these entities and require lenders and  brokers to meet fiduciary standards to offer loans that serve the interest of  potential borrowers. Officials from another state in our sample, New York,  said they planned to use guidance developed by the Conference of State  Bank Supervisors and American Association of Residential Mortgage  Regulators to address AMP lending concerns at the state level. In addition,  they said that they were revising their banking examination manual to  address AMP concerns, reflect recommendations made in their guidance,  and provide examiners with areas of concern on which to focus during  their reviews.
section_title: Conclusions
paragraphs: Historically AMPs were offered to higher-income, financially sophisticated  borrowers who wanted to minimize their mortgage payments to better  manage their cash flows. In recent years, federally and state-regulated  lenders and brokers widely marketed AMPs by touting their low initial  payments and flexible payment options, which helped borrowers to  purchase homes for which they might not have been able to qualify with a  conventional fixed-rate mortgage, particularly in some high-priced  markets. However, the growing use of these products, especially by less  informed, affluent, and creditworthy borrowers, raises concerns about  borrowers’ ability to sustain their monthly mortgage payments, and  ultimately to keep their homes. When these mortgages recast and  payments increase, borrowers who cannot refinance their mortgages or  sell their homes could face substantially higher payments. If these  borrowers cannot make these payments, they could face financial distress;  delinquency; and possibly, foreclosure. Nevertheless, it is too soon to tell  the extent to which payment shock will produce financial distress for  borrowers and induce defaults that would affect banks that hold AMPs in  their portfolios.
Federal banking regulators have taken steps to address the potential risks  of AMPs to lenders and borrowers. They have drafted guidance for lenders  to strengthen underwriting standards and improve disclosure of  information to borrowers. Because the key features and terms of AMPs  may continue to evolve, it is essential for the regulators to make an effort  to respond to AMP lending growth in ways that seek to balance market  innovation and profitability for lenders with timely information and  mortgage choices for borrowers. Furthermore, with the continued  popularity of AMPs, it is important that the federal banking regulators  finalize the draft guidance in a timely manner.
The popularity and complexity of AMPs and lenders’ marketing of these  products highlight the importance of mortgage disclosures in helping  borrowers make informed mortgage decisions. As lenders and brokers  increasingly market AMPs to a wider spectrum of borrowers, more  borrowers may struggle to fully understand the terms and risks of these  products. While Regulation Z requires that lenders provide certain  information on ARMs, currently lenders are not required to tailor the  mortgage disclosures to communicate to borrowers information on the  potential for payment shock and negative amortization specific to AMPs.  In particular, although they may be in compliance with Regulation Z  requirements, the disclosures we reviewed did not provide borrowers with  easily comprehensible information on the key features and risks of their  mortgage products. Furthermore, the readability and usability of these  documents were limited by the use of language that was too complex for  many adults and document designs that made the text difficult to read and  understand. As such, these documents were not consistent with leading  practices at the federal level for financial-product disclosures that are  predicated on investment firms’ providing investors with important  product information clearly to further their informed decision making.  Although the draft interagency guidance by federal banking regulators  addressed some of the concerns with consumer disclosures, the draft  guidance focuses on promotional materials, not the written disclosures  required by Regulation Z at loan application and closing. In addition, the  guidance does not apply to nonbank lenders, whereas Regulation Z applies  to the entire industry. We recognize that the Federal Reserve has begun to  review disclosure requirements for all mortgage loans, including AMPs,  under Regulation Z and has used the recent HOEPA hearings to gather  public testimony on the effectiveness of current AMP disclosures.  Furthermore, we agree with regulators and industry participants’ views  that revising Regulation Z to make federally required mortgage disclosures  more useful for borrowers that use complex products like AMPs is a good  first step to addressing a mortgage disclosure process that many view as  overwhelming and confusing for the average borrower. Without amending  Regulation Z to require lenders to clearly and comprehensively explain the  terms and risks of AMPs, borrowers might not be able to fully exercise  informed judgment on what is likely a significant investment decision.
section_title: Recommendation for Executive Action
paragraphs: 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  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.
section_title: Agency Comments and Our Evaluation
paragraphs: We requested comments on a draft of this report from the Federal  Reserve, FDIC, NCUA, OCC, and OTS. We also provided a draft to FTC and  selected sections of the report to the relevant state regulators for their  review. The Federal Reserve provided written comments on a draft of this  report, which have been reprinted in appendix III. The Federal Reserve  noted that it has already begun a comprehensive review of Regulation Z,  including its requirements for mortgage disclosures. The Federal Reserve  reiterated that one of the purposes of its recent public hearings on home  equity lending was to discuss AMPs, and in particular, whether consumers  receive adequate information about these products. It intends to use this  information in developing plans and recommendations for revising  Regulation Z within the existing framework of TILA. The Federal Reserve  stressed that any new disclosure requirements relating to features and  risks of today’s loan products must be sufficiently flexible to allow  creditors to provide meaningful disclosures even as those products  develop over time. In response to our recommendation to consider  improving the clarity and comprehensiveness of AMP disclosures, the  Federal Reserve noted that it plans to conduct consumer testing to  determine what information is important to consumers, what language and  formats work best, and how disclosures can be revised to reduce  complexity and information overload. To that end, the Federal Reserve  said that it will use design consultants to assist in developing model  disclosures that are most likely to be effective in communicating  information to consumers. In addition, the Federal Reserve provided  examples of other efforts that it is currently engaged in to enhance the  information consumers received about the features and risks associated  with AMPs, which we have previously discussed in the report. FDIC, FTC,  NCUA, OCC, and OTS did not provide written comments. Finally, the  Federal Reserve, FDIC, FTC, and OCC provided technical comments,  which we have incorporated into the final report.
As agreed with your office, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days after the  date of this report. At that time, we will send copies of this report to the  Chairman and Ranking Minority Member of the Senate Committee on  Banking, Housing, and Urban Affairs and the Ranking Minority Member of  its Subcommittee on Housing and Transportation; the Chairman and  Ranking Minority Member of the House Committee on Financial Services;  other interested congressional committees. We will also send copies to the  Chairman, Federal Deposit Insurance Corporation; the Chairman, Board of  Governors of the Federal Reserve System; the Chairman, National Credit  Union Administration; the Comptroller of the Currency; and the Director,  Office of Thrift Supervision. We will also make copies available to others  upon request. The report will be available at no charge on the GAO Web  site at http://www.gao.gov.
If you or your staff have any questions regarding this report, please  contact me at (202) 512-8678 or williamso@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on the  last page of this report. Key contributors to this report are listed in  appendix IV.
section_title: Appendix I: Scope and Methodology
paragraphs: To identify recent trends in the market for alternative mortgage products  (AMPs), we gathered information from federal banking regulators and the  residential mortgage lending industry on AMP product features, customer  base, and originators as well as on reasons for the recent growth of these  products.
To determine the potential risks of AMPs for lenders and borrowers, we  analyzed the changes, especially increases, in future monthly payments  that can occur with AMPs. We analyzed these data using several scenarios,  including rising interest rates and negative amortization. We obtained data  from a private investment firm on the underwriting characteristics of  recent interest-only and payment-option adjustable rate mortgage (ARM)  issuance and obtained information on the securitization of AMPs from  federal banking regulators, government-sponsored enterprises, and the  secondary mortgage market. We conducted a limited analysis to assess the  reliability of the investment firm’s data. To do so, we interviewed a firm  representative and an official from a federal banking regulator (federal  regulatory official) to identify potential data limitations and determine  how the data were collected and verified and to identify potential data  limitations. On the basis of this analysis, we concluded that the firm’s data  were sufficiently reliable for our purposes. Finally, we interviewed federal  regulatory officials and representatives from the residential mortgage  lending industry and reviewed studies on the risks of these mortgages  compared with conventional fixed rate mortgages.
To determine the extent to which mortgage disclosures present the risks  of AMPs, we reviewed federal laws and regulations governing the content  of required mortgage disclosures. We obtained examples of AMP-related  advertising and mortgage disclosures, reviewed studies on borrowers’  understanding of adjustable rate products, and conducted interviews with  federal regulatory officials and industry participants. To obtain state  regulators’ views on AMP mortgage disclosures, we also selected a sample  of eight states and reviewed laws and regulations related to disclosure  requirements. We obtained examples of AMP advertisements, disclosures,  and AMP-related complaint information and interviewed state officials. We  generally selected states that 1) exhibited high volumes of AMP lending, 2)  provided geographic diversity of state locations, and 3) provided diverse  regulatory records when responding to the challenges of a growing AMP  market. Because state-level data on AMP lending volumes were not  available, we determined which states had high volumes of AMP lending  by using data obtained from a Federal Reserve Bank on states that had  high levels of ARM growth and house price appreciation in 2005, factors  which this study suggested corresponded with high volumes of AMP  lending. Furthermore, we reviewed regulatory data showing that the  largest AMP lenders conducted most of their lending in these states. We  selected eight states and conducted in-person interviews with officials  from California, New Jersey, New York, and Ohio. We conducted  telephone interviews with officials from the remainder of the sample  states (Alaska, Florida, Nevada, and North Carolina).
We also analyzed for content, readability, and usability a selected sample  of eight written disclosures that six federally regulated AMP lenders  provided to borrowers between 2004 and 2006. The sample included  program-specific disclosures for three interest-only ARMs and for five  payment-option ARMs as well as transaction-specific disclosures  associated with four of them. The six lenders represented over 25 percent  of the interest-only and payment-option ARMs produced in the first 9  months of 2005. First, we assessed the extent to which the disclosures  described the key risks and loan features of interest-only and payment- option ARMs. Second, we conducted a readability assessment of these  disclosures using computer-facilitated formulas to predict the grade level  required to understand the materials. Readability formulas measure the  elements of writing that can be subjected to mathematical calculation,  such as the average number of syllables in words or number of words in  sentences in the text. We applied the following commercially available  formulas to the documents: Flesch Grade Level, Frequency of  Gobbledygook (FOG), and Simplified Measure of Gobbledygook (SMOG).  Using these formulas, we measured the grade levels at which the  disclosure documents were written for selected sections. Third, we  conducted an evaluation that assessed how well these AMP disclosures  adhered to leading practices in the federal government for usability. We  used guidelines presented in the Securities and Exchange Commission’s  (SEC) A Plain English Handbook: How to Create Clear SEC Disclosure  Documents (1998). SEC publishes the handbook for investment firms to  use when writing mutual fund disclosures. The handbook presents criteria  for both the effective visual presentation and readability of information in  disclosure documents.
To obtain information on the federal regulatory response to the risks of  AMPs for lenders and borrowers, we reviewed the draft interagency  guidance on AMP lending issued in December 2005 by federal banking  regulators and interviewed regulatory officials about what actions they  could use to enforce guidance principles upon final release of the draft.  We also reviewed comments written by industry participants in response  to the draft guidance. To review industry comments, we selected 29 of the  97 comment letters that federal regulators received. We selected comment  letters that represented a wide range of industry participants, including  lenders, brokers, trade organizations, and consumer advocates. We  analyzed the comment letters for content; sorted them according to  general comments, issues of institutional safety and soundness, consumer  protection, or other concerns; and summarized the results of the analysis.
To obtain information on selected states’ regulatory response to the risks  of AMPs for lenders and borrowers, we reviewed current laws and, where  applicable, draft legislation from the eight states in our sample and  interviewed these states’ banking and mortgage lending officials.
We performed our work between September 2005 and September 2006 in  accordance with generally accepted government auditing standards.
section_title: Appendix II: Readability and Design Weaknesses in AMP Disclosures That We Reviewed
paragraphs: 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.
subsections: section_title: Disclosures Required Reading Levels Higher Than That of Many Adults in the U.S.
paragraphs: 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.
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. 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.
section_title: Size and Choice of Typeface and Use of Capitalization Made Most Disclosures Difficult to Read
paragraphs: 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.
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.
section_title: Disclosures Generally Did Not Make Effective Use of White Space or Headings
paragraphs: 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.
section_title: Appendix III: Comments from the Board of Governors of the Federal Reserve System
section_title: Appendix IV: GAO Contact and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: 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.