Residential mortgages fall into several loosely defined categories and encompass a range of loan products:  Prime mortgages are made to borrowers with strong credit histories and provide the most attractive interest rates and loan terms.  Near-prime mortgages (also called Alt-A mortgages) generally serve borrowers whose credit histories are close to prime but who have one or more higher-risk characteristics, such as limited documentation of income or assets.  Subprime mortgages are generally made to borrowers with blemished credit and feature higher interest rates and fees than prime loans.  Government-insured or -guaranteed mortgages primarily serve borrowers who may have difficulty qualifying for prime loans and feature interest rates similar to those for prime loans. These mortgages require insurance or charge guarantee fees. FHA and the Department of Veterans Affairs (VA) operate the two main federal programs that insure or guarantee mortgages. Across all of these market segments, two types of loans are common: fixed-rate mortgages, which have interest rates that do not change over the life of the loans and ARMs, which have interest rates that change periodically based on changes in a specified index. A number of loan features became more common in the 2000s. While these features potentially expanded access to mortgage credit, they were often associated with higher default rates. These features included the following:  Low- and no-documentation loans. Originally intended for borrowers who had difficulty documenting income, such as the self-employed, these loans were made with little or no verification of a borrower’s income or assets.  High LTV ratios. As homebuyers made smaller down payments, this ratio increased.  Prepayment penalties. Some loans contained built-in penalties for repaying part or all of a loan in advance of the regular schedule. Other mortgage types that became more prevalent during this period included different types of ARMs. Short-term hybrid ARMs had a fixed interest rate for an initial period (usually 2 or 3 years) but then “reset” to an adjustable rate for the remaining term of the loan. Interest-only or payment-option ARMs allowed borrowers to defer repayment of principal and possibly part of the interest for the first few years of the loan. Payment-option ARMs enabled mortgages to negatively amortize, meaning that the loan balance could increase over time. The secondary mortgage market, where loans are securitized, plays an important role in providing liquidity for mortgage lending. Securitization has a number of benefits for lenders. Among other things, it is typically less expensive than raising funds directly and it transfers some or all of the credit and interest rate risk from the lender to the investor. To securitize mortgage loans, mortgage lenders or originators sell their loans to third parties—either directly to securitizing institutions or loan aggregators that serve as intermediaries between originators and securitizers—generating funds that could be used to originate more loans (see fig. 1). Securitization involves a number of players. Securitizing institutions include investment banks, retail banks, mortgage companies, and real estate investment trusts (REIT). As a part of the securitization process, securitizers create a separate legal entity (“special purpose entity” or SPE) to bundle mortgages and sell them as investment products called RMBS. The purpose of creating the SPE is to help ensure that securitized assets are protected in the event of a bankruptcy of the securitizing or originating institutions. Other parties to a securitization transaction include, but are not limited to, credit rating agencies that assess the creditworthiness of the securities based on the likelihood of default and the expected value of dollar losses in the event of a default, and deal underwriters hired by the securitizers to market and sell the securities to investors. Finally, servicers are hired to collect mortgage payments from the borrowers and disburse interest and principal payments to the investors. RMBS can be structured in different ways, but one common structure involves a prespecified distribution of cash payments to investors in different slices, or tranches of the security. Tranching allows investors with different appetites for risk to invest in a security with the same underlying pool of loans. In such credit-tranched structures, also known as “senior subordinate” structures, cash from the underlying loans is generally paid to the topmost, least risky tranche first until the prespecified thresholds are met. Cash then flows to the lower tranches in what is known as a “waterfall.” Conversely, the bottom-most tranche typically absorbs the losses from defaults until it is depleted, with any additional losses flowing up toward senior securities. The secondary mortgage market consists of (1) Ginnie Mae-guaranteed RMBS, which are backed by cash flows from federally insured or guaranteed mortgages; (2) enterprise RMBS, which are backed by mortgages that meet the criteria for purchase by Fannie Mae and Freddie Mac; and (3) private-label RMBS, which are backed by mortgages that do not conform to enterprise purchase requirements because they are too large (i.e., jumbo mortgages) or otherwise do not meet enterprise underwriting criteria. Most subprime and near-prime mortgages, and many prime jumbo mortgages, were securitized into private-label RMBS. However, the private-label market, which accounted for most of the RMBS issuances in 2005 and 2006, collapsed in 2008 and has not recovered. As a result, almost all RMBS issuances in recent years are backed by the full guarantees of the enterprises and Ginnie Mae. RMBS represent the biggest single piece of the larger securitization market, accounting for over one-third of all new asset-backed issuances from 2005 through the third quarter of 2010. The composition of the mortgage market has changed dramatically in recent years. In the early to mid-2000s, the volume of subprime and near- prime mortgage originations grew rapidly and peaked in 2006, accounting for nearly 40 percent of mortgage originations that year. These market segments contracted sharply in mid-2007, partly in response to increasing defaults and foreclosures, including mortgages defaulting within a few months of origination, and a lack of investor demand. The market segments comprising mortgages backed by the enterprises and FHA had the opposite experience: a decline in market share in the early to mid- 2000s, followed by rapid growth beginning in 2007 and 2008, respectively. For example, the enterprises’ share of the mortgage market decreased from about one-half in 2003 to about one-third in 2006. By 2009 and 2010, enterprise-backed mortgages had increased to more than 65 percent of the market. Similarly, FHA-insured mortgages grew from about 2 percent of the market in 2006 to about 20 percent in 2009 and 2010. Congress and the administration are currently considering options to scale back the role of the enterprises and FHA in the mortgage market and increase the role of private capital. In addition to these potential changes, a recovery from constrained credit conditions in the mortgage market could expand the volume of mortgages extended to borrowers and therefore subject to the Dodd-Frank Act’s provisions. The Dodd-Frank Act enacts numerous provisions intended to reform the mortgage lending industry with an eye toward consumer protection. Many of these provisions are contained in Title XIV of the act, which amends provisions of the Truth in Lending Act (TILA) to reform and provide accountability for consumer mortgage practices. TILA, enacted in 1968, and HOEPA, which amended TILA in 1994, are among the primary federal laws governing mortgage lending. TILA was designed to provide consumers with accurate information about the cost of credit. Among other things, TILA requires lenders to disclose information about the terms of loans—including the amount financed, the finance charge, and the annual percentage rate (APR)—that can help borrowers understand the overall costs of their loans. Congress enacted HOEPA in response to concerns about predatory lending. HOEPA regulates and restricts the terms and characteristics of certain kinds of “high-cost” mortgages—that is, those that exceed certain thresholds in their APRs or fees (often referred to as “rate and fee triggers”). The Dodd-Frank Act expands the definition of high-cost loans to include mortgages for purchasing a home; reduces the APR and points and fees triggers; and requires mandatory preloan counseling for borrowers of high-cost mortgages, among other things. The Federal Reserve Board implements TILA and HOEPA, but this responsibility will transfer to the Bureau of Consumer Financial Protection (also known as the Consumer Financial Protection Bureau or CFPB) on July 21, 2011. The Dodd-Frank Act reforms mortgage lending by amending TILA to prohibit lenders from making mortgage loans without regard to consumers’ ability to repay them. As previously noted, lenders can comply with the ability-to-repay standard by originating a QM. Lenders are not prohibited from originating non-QMs, however. The Dodd-Frank Act specifies nine QM criteria, but gives the Federal Reserve Board the authority to add to, subtract from, or modify the criteria as it develops implementing regulations (see table 1). The Dodd-Frank Act requires securitizers of RMBS to retain no less than 5 percent of the credit risk of any residential mortgage they securitize that does not meet specified criteria. The purpose of the requirement is to help align the interests of participants in the securitization process and encourage sound loan underwriting. The Dodd-Frank Act exempts government-insured or -guaranteed mortgages from the risk retention requirement (excluding mortgages backed by the enterprises, which are in government conservatorship), and as noted previously, loans that meet the QRM criteria.