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

Letter

Background

Borrowers obtain residential mortgages through either mortgage lenders or brokers. Mortgage lenders can be federally or state-chartered banks or mortgage lending subsidiaries of these banks or of bank holding companies. Independent lenders, which are neither banks nor affiliates of banks, also may fund home loans to borrowers. Mortgage brokers act as intermediaries between lenders and borrowers, and for a fee, help connect borrowers with various lenders that may provide a wider selection of mortgage products.

Federal banking regulators—Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Federal Reserve), Federal Deposit Insurance Corporation (FDIC), National Credit Union Administration (NCUA), and Office of Thrift Supervision (OTS)— have, among other things, responsibility for ensuring the safety and soundness of the institutions they oversee. To pursue this goal, regulators establish capital requirements for banks; conduct on-site examinations and off-site monitoring to assess their financial conditions; and monitor their compliance with applicable banking laws, regulations, and agency guidance. As part of their examinations, for example, regulators review mortgage lending practices, including underwriting, risk-management, and portfolio management practices, and try to determine the amount of risk lenders have assumed. From a safety and soundness perspective, risk involves the potential that either anticipated or unanticipated events may have an adverse impact on a bank’s capital or earnings. In mortgage lending, regulators pay close attention to credit risk—that is the concerns that borrowers may become delinquent or default on their mortgages and that lenders may not be paid in full for the loans they have issued.

Certain federal consumer protection laws, including the Truth in Lending Act and its implementing regulation, Regulation Z, apply to all mortgage lenders and brokers that close loans in their own names. Each lender’s primary federal supervisory agency has responsibility for enforcing Regulation Z and generally uses examinations and consumer complaint investigations to check for compliance with both the act and its regulation. In addition, the Federal Trade Commission (FTC) is responsible for enforcing certain federal consumer protection laws for brokers and lenders that are not depository institutions, including state-chartered independent mortgage lenders and mortgage lending subsidiaries of financial holding companies. However, FTC is not a supervisory agency. FTC uses a variety of information sources in the enforcement process, including FTC investigations, consumer complaints, and state and federal agencies.

State banking and financial regulators are responsible for overseeing independent lenders and mortgage brokers and generally do so through licensing that mandates certain experience, education, and operations requirements to engage in mortgage activities. States also may examine independent lenders and mortgage brokers to ensure compliance with licensing requirements, review their lending and brokerage functions, and look for unfair or unethical business practices. In the event such practices or consumer complaints occur, regulators and attorneys general may pursue actions that include license suspension or revocation, monetary fines, and lawsuits.

AMP Lending Rapidly Grew and Borrower Characteristics Changed as Consumers Sought Mortgage Products That Increased Affordability

From 2003 through 2005, AMP lending grew rapidly, with originations increasing threefold from less than 10 percent of residential mortgages to about 30 percent. Most of the originations during this period consisted of interest-only ARMs and payment-option ARMs, and most of this lending occurred in higher-priced regional markets concentrated on the East and West Coasts. For example, based on data from mortgage securitizations in 2005, about 47 percent of interest-only ARMs and 58 percent of payment- option ARMs were originated in California, which contained 7 of the 20 highest-priced metropolitan real estate markets in the country. On the East Coast, Virginia, Maryland, New Jersey, and Florida as well as Washington, D.C., exhibited a high concentration of AMP lending in 2005. Other examples of states with high concentrations of AMP lending include Washington, Nevada, and Arizona. These areas also experienced higher rates of home price appreciation during this period than the rest of the United States.

In addition to this growth, the characteristics of AMP borrowers have changed. Historically, AMP borrowers consisted of wealthy and financially sophisticated borrowers who used these specialized products as financial management tools. However, today a wider range of borrowers use AMPs as affordability products to purchase homes that might otherwise be unaffordable using conventional fixed-rate mortgages.

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

Although AMPs have increased affordability for some borrowers, they could lead to increased payments or “payment shock” for borrowers and corresponding credit risk for lenders. Unless the mortgages are refinanced or the properties sold, AMPs eventually reach points when interest-only and deferred payment periods end and higher, fully amortizing payments begin. Regulators and consumer advocates have expressed concern that some borrowers might not be able to afford these higher monthly payments. To illustrate this point, we simulated what would happen to a borrower in 2004 that made minimum monthly payments on a $400,000 payment-option ARM. As figure 1 shows, the borrower could see payments rise from $1,287 to $2,931, or 128 percent, at the end of the 5-year payment- option period. In addition, with a wider range of AMP borrowers now than in the past, those with fewer financial resources or limited equity in their homes might find refinancing their mortgages or selling their homes difficult, particularly if their loans have negatively amortized or their homes have not appreciated in value.

In addition, borrowers who cannot afford higher payments and may become delinquent or default on their mortgages may pose credit risks to lenders because these borrowers may not repay their loans in full. Lenders also may have increased risks to themselves and their customers by relaxing underwriting standards and through risk-layering. For example, some lenders combined AMPs with less stringent income and asset verification requirements than traditionally permitted for these products or lent to borrowers with lower credit scores and higher debt-to-income ratios.

Although regulatory officials have expressed concerns about AMP risks and underwriting practices, they said that banks and lenders generally have taken steps to manage the resulting credit risk. Federal and state banking regulatory officials and lenders with whom we spoke said most banks have diversified their assets to manage the credit risk of AMPs held in their portfolios, or have reduced their risk through loan sales or securitization. In addition, federal regulatory officials told us that while underwriting trends may have loosened over time, lenders have generally attempted to mitigate their risk from AMP lending. For example, OCC and Federal Reserve officials told us that most lenders qualify payment-option ARM borrowers at fully indexed rates, not at introductory interest rates, to help ensure that borrowers have financial resources to manage future mortgage increases, or to pay more on their mortgages than the minimum monthly payment. OCC officials also said that some lenders may mitigate risk by having some stricter criteria for AMPs than for traditional mortgages for some elements of their underwriting standards. Although we are encouraged by these existing risk mitigation and management strategies, most AMPs issued between 2003 and 2005, however, have not reset to require fully amortizing payments, and it is too soon to tell how many borrowers will eventually experience payment shock or financial distress. As such, in our report we agree with federal regulatory officials and industry participants that it was too soon to tell the extent to which AMP risks may result in delinquencies and foreclosures for borrowers and losses for banks that hold AMPs in their portfolios. However, we noted that past experience with these products may not be a good indicator for future AMP performance because the characteristics of AMP borrowers have changed.

Borrowers May Not Be Well-informed of AMP Risks and Mortgage Disclosures May Not Effectively Describe These Risks to Consumers

Regulatory officials and consumer advocates expressed concern that some AMP borrowers may not be well-informed about the terms and risks of their complex AMP loans. Obstacles to understanding these products include advertising that may not clearly or effectively convey AMP risks, and federal mortgage disclosure requirements that do not require lenders to tailor disclosures to the specific risks of AMPs to borrowers.

Mortgage Advertising May Not Clearly or Effectively Explain AMP Risks

Marketing materials that we reviewed indicated that advertising by lenders and brokers may not clearly provide information to inform consumers about the potential risks of AMPs. For example, one advertisement we reviewed promoted a low initial interest rate and low monthly mortgage payments without clarifying that the low interest rate would not last the full term of the loan.

In other cases, promotional materials emphasized the benefits of AMPs without effectively explaining the associated risks. Some advertising, for example, emphasized loans with low monthly payment options without effectively disclosing the possibility of interest rate changes or mortgage payment increases. One print advertisement we reviewed for a payment- option ARM emphasized the benefit of a low initial interest rate but noted in small print on its second page that the low initial rate applied only to the first month of the loan and could increase or decrease thereafter.

Federal Disclosures May Not Clearly and Completely Explain AMP Specific Risks

Regulatory officials noted that current Regulation Z requirements address traditional fixed-rate and adjustable-rate products, but not more complex products such as AMPs that feature risks such as negative amortization and payment shock. To better understand the quality of AMP disclosures, we reviewed eight interest-only and payment-option ARM disclosures provided to borrowers from federally regulated lenders. These disclosures were provided to borrowers between 2004 and 2006 by six federally regulated lenders that collectively made over 25 percent of the interest- only and payment option ARMs produced in 2005.We found that these disclosures addressed current Regulation Z requirements, but some did not provide full and clear explanations of AMP risks such as negative amortization or payment shock. For example, as shown in figure 2, the disclosure simply states that monthly payments could increase or decrease on the basis of interest rate changes, which may be sufficient for a traditional ARM product, but does not inform borrowers about the potential magnitude of payment change, which may be more relevant for certain AMPs. In addition, most of the disclosures we reviewed did not explain that negative amortization, particularly in a rising interest rate environment, could cause AMP loans to reset more quickly than borrowers anticipated and require higher monthly mortgage payments sooner than expected.

In addition, the AMP disclosures generally did not conform to leading practices in the federal government, such as key “plain English” principles for readability or design. For example, the Securities and Exchange Commission’s “A Plain English Handbook: How to Create Clear SEC Disclosure Documents (1998)” offered guidance for developing clearly written investment product disclosures and presenting information in visually effective and readable ways. The sample disclosures we reviewed, however, were generally written with language too complex for many adults to fully understand. Most of the disclosures also used small, hard-to- read typeface, which when combined with an ineffective use of white space and headings, made them even more difficult to read and buried key information.

Federal Banking Regulators Issued Guidance, Sought Industry Comments, and Took Other Actions to Respond to Concerns about AMP Lending

Federal banking regulators have taken a range of actions—including issuing draft interagency guidance, seeking industry comments, reinforcing messages about AMP risks and guidance principles in many forums, and taking other individual regulatory actions—to respond to concerns about the growth and risks of AMP lending. Federal banking regulators issued draft interagency guidance in December 2005 that recommended prudent underwriting, portfolio and risk management, and information disclosure practices related to AMP lending. The draft guidance calls for lenders to consider the potential impact of payment shock on borrowers’ capacity to repay their mortgages and to qualify borrowers on their ability to make fully amortizing payments on the basis of fully indexed interest rates. It also recommends that lenders develop written policies and procedures that describe portfolio limits, mortgage sales and securitization practices, and risk-management expectations. In addition, to improve consumer understanding of AMPs, the draft guidance suggests that lender communications with borrowers, including advertisements and promotional materials, be consistent with actual product terms, and that institutions avoid practices that might obscure the risks of AMPs to borrowers. When finalized, the guidance will apply to all federally regulated financial institutions.

During the public comment period for the guidance, lenders and others suggested in their letters that the stricter underwriting recommendations were overly prescriptive and might put federally and state-regulated banks at a competitive disadvantage because the guidance would not apply to independent mortgage lenders or brokers. Lenders said that this could result in fewer mortgage choices for consumers. Consumer advocates questioned whether the guidance would actually help protect consumers. They noted that guidance might be difficult to enforce because it does not carry the same force as law or regulation. Federal banking regulatory officials are using these comments as they finalize the guidance.

Even before drafting the guidance, federal regulatory officials had publicly reinforced their concerns about AMPs in speeches, at conferences, and through the media. According to a Federal Reserve official, these actions have raised awareness of AMP issues and reinforced the message that financial institutions and the general public need to manage risks and understand these products.

Some regulatory officials have also taken agency-specific steps to address AMP lending, including reviewing high-risk lending, which would include AMPs, and improving consumer education about AMP risks. For example, FDIC officials told us that they have developed a review program to identify high-risk lending areas and evaluate risk management and underwriting approaches. NCUA officials said that they have informally contacted their largest credit unions to assess the extent of AMP lending at these institutions. OTS officials said that they have performed a review of OTS’s 68 most active AMP lenders to assess and respond to potential AMP lending risks and OCC have begun to conduct reviews of their lenders’ AMP promotional and marketing materials to assess how well they inform consumers. In response to concerns about disclosures, the Federal Reserve officials told us that they initiated a review of Regulation Z that includes reviewing the disclosures required for all mortgage loans, including AMPs, and have begun taking steps to consider disclosure revisions. During the summer of 2006, the Federal Reserve held hearings across the country on home-equity lending, AMP issues, and the adequacy of consumer disclosures for mortgage products. According to Federal Reserve officials, the Federal Reserve is currently reviewing the hearing transcripts and public comment letters to help develop plans and recommendations for revising Regulation Z. In addition, they said that they are currently revising their consumer handbook on ARM loans, known as the CHARM booklet, to include information about AMPs. Finally, in May 2006, FTC officials said that they sponsored a public workshop that explored consumer protection issues as a result of AMP growth in the mortgage marketplace and worked with federal banking regulators and other federal departments to create a brochure to assist consumers with mortgage information.

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

State banking and financial regulatory officials from the eight states in our sample expressed concerns about AMP lending in their states; however, most relied on their existing regulatory system of licensing and examining mortgage lenders and brokers to stay abreast of and react to AMP issues. Most of the officials in our sample expressed concern about AMP lending and the negative effects it could have on consumers, including how well consumers understood complex AMP loans and the potential impact of payment shock, financial difficulties, or default and foreclosure. Other officials expressed concern about whether consumers received complete information about AMPs, saying that federal disclosures were complicated, difficult to comprehend, and often were not very useful to consumers.

In addition to these general consumer protection concerns, some state officials spoke about state-specific issues. For example, Ohio officials expressed AMP concerns in the context of larger economic concerns, noting that AMP mortgages were part of wider economic challenges facing the state. Ohio already has high rates of mortgage foreclosures and unemployment that have hurt both Ohio’s consumers and its overall economy. In Nevada, officials worried that lenders and brokers have engaged in practices that sometimes take advantage of senior citizens by offering them AMP loans that they either did not need or could not afford.

Most of the state regulatory officials said that they have relied upon state law to license mortgage lenders and brokers and ensure they meet minimum experience and operations standards. Most said they also periodically examine these entities for compliance with state licensing, mortgage lending, and consumer protection laws, including applicable fair advertising requirements. As such, most of the regulatory officials relied on systems already in place to investigate AMP issues or complaints and, when needed, used applicable licensing and consumer protection laws to respond to problems such as unfair and deceptive trade practices.

Some state regulatory officials with whom we spoke said they have taken other actions to better understand the issues associated with AMP lending and expand consumer protections. For example, some states such as New Jersey and Nevada have gathered data on AMPs to better understand AMP lending and risks. Others, such as New York, plan to use guidance developed by regulatory associations to help oversee AMP lending by independent mortgage lenders and brokers.

In summary, it is too soon to tell the extent to which payment shock will produce financial distress for some borrowers and induce defaults that would affect banks that hold AMPs in their portfolios. However, the popularity, complexity, and widespread marketing of AMPs highlight the importance of mortgage disclosures to help borrowers make informed mortgage decisions. As a result, while we commend the Federal Reserve’s efforts to review and revise Regulation Z, we recommended in our report that the Board of Governors of the Federal Reserve System consider amending federal mortgage disclosure requirements to improve the clarity and comprehensiveness of AMP disclosures. In response to our recommendation, the Federal Reserve said that it will conduct consumer testing to determine appropriate content and formats and use design consultants to develop model disclosure forms intended to better communicate information.

Chairmen of the subcommittees, this completes my prepared statement. I would be pleased to respond to any questions you or other Members may have at this time.

GAO Contact and Staff Acknowledgments

For additional information about this testimony, please contact Orice M. Williams on (202) 512-5837 or at williamso@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this statement. Individuals making key contributions to this testimony include Karen Tremba, Assistant Director; Tania Calhoun; Bethany Claus Widick; Stefanie Jonkman; Marc Molino; Robert Pollard; Barbara Roesmann; and Steve Ruszczyk.

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