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. 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. 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. 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.