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. 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. 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. 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. 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. 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.