supplemented and supported by revisions in the areas of supervisory review ( pillar 2 ) and market discipline ( pillar 3 ), just as are the revisions for credit risk and operational risk. the pillar 2 changes seek to strengthen firms'assessments of their internal capital adequacy in the area of market risk, taking into account the output of their var models, valuation adjustments, and stress tests. internal capital assessments must factor in : illiquidity ; concentrated positions ; nonlinear and deep out - of - the - money products ; events and jumps - to - default ; and significant shifts in correlations. the pillar 3 changes increase the robustness of trading book disclosures ; specifically, firms must demonstrate how they combine their risk measurement approaches to arrive at an overall internal capital assessment. we expect to issue this npr sometime this summer. innovations in capital instruments naturally, in determining capital adequacy ratios, supervisors focus not just on defining risk positions - the denominator - - but also on defining the components of capital - - the numerator. over the years there have been a number of innovations in capital instruments ; one particularly innovative area has been the structuring of preferred stock and hybrid securities for inclusion in tier 1 capital. the federal reserve refined its framework for the components of tier 1 capital in a final rule issued in march 2005. the final rule allows bank holding companies to continue to include trust preferred securities in tier 1 capital, much of which they invest in the common stock of their depository institution subsidiaries. however, the final rule also imposes stricter quantitative limits and qualitative standards on trust preferred securities and on other restricted core capital elements included in tier 1 capital. the federal reserve's goal in framing the final rule was to allow innovation and adaptation in capital funding for bank holding companies - - much of which are aimed at increased cost effectiveness - - while ensuring consistency with the federal reserve's focus on the quality and strength of institutions'capital bases. to this end, the final rule states that common stock and noncumulative perpetual preferred stock should make up no less than three quarters of a banking organization's tier 1 capital. we believe that the continued strength of the capital base of u. s. bank holding companies is a critical component of the safety and soundness of the industry we supervise. the federal reserve considers many factors when it evaluates eligible capital for bhcs, especially for innovative capital instruments. thus, our decision to allow bhcs to continue

intelligence. in recent years, supervisors have observed banks, in order to maintain a customer relationship, going beyond their established footprint and lending in real estate markets with which they have less experience. the challenge can be even greater when the borrower is also venturing into a new market. in prior cre credit downturns, such practices have led to significant losses. nontraditional mortgage products over the past few years, the agencies have observed an increase in the number of residential mortgage loans that allow borrowers to defer repayment of principal and, sometimes, interest. these loans, often referred to as nontraditional mortgage loans, include " interest - only " ( io ) mortgage loans, on which the borrower pays no loan principal for the first few years of the loan, and " payment - option " adjustable - rate mortgages ( option arms ), for which the borrower has flexible payment options - - and which could also result in negative amortization. ios and option arms are estimated to have accounted for almost one - third of all u. s. mortgage originations in 2005, compared with less than 10 percent in 2003. despite their recent growth, however, these products, it is estimated, still account for less than 20 percent of aggregate domestic mortgages outstanding of $ 8 trillion. while the credit quality of residential mortgages generally remains strong, the federal reserve and other banking supervisors are concerned that current riskmanagement techniques may not fully address the level of risk inherent in nontraditional mortgages, a risk that would be heightened by a downturn in the housing market. mortgages with some of the characteristics of nontraditional mortgage products have been available for many years ; however, they have historically been offered to higher - income borrowers. more recently, they have been offered to a wider spectrum of consumers, including subprime borrowers, who may be less suited for these types of mortgages and may not fully recognize the embedded risks. these borrowers are more likely to experience an unmanageable payment shock during the life of the loan, meaning that they may be more likely to default on the loan. further, nontraditional mortgage loans are becoming more prevalent in the subprime market at the same time risk tolerances in the capital markets have increased. banks need to be prepared for the resulting impact on liquidity and pricing if and when risk spreads return to more " normal " levels and competition in the mortgage banking industry intensifies. supervisors have