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. 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. AMP Share of Mortgage Originations Grew Threefold from 2003 to 2005, with Higher Concentrations in the Coastal Markets

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. AMP lending has been concentrated in the higher-priced regional markets  on the East and West Coasts, where homes are least affordable. Additionally, independent mortgage brokers have been an  important source of originations for AMP lenders. However, federal  regulatory officials and industry participants agree that it is too soon to tell  whether risks to borrowers will result in significant delinquencies and  foreclosures for borrowers and corresponding losses for banks that hold  AMPs in their portfolios. AMPs Create Potential for Borrowers to Face Payment Shock, Particularly as Interest Rates Rise

AMPs such as interest-only and payment-options ARMs are initially more  affordable than conventional fixed-rate mortgages because during the first  few years of the mortgage they allow a borrower to defer repayment of  principal and, in the case of payment-option ARMs, part of the interest as  well. Specifically, borrowers with interest-only ARMs can make monthly  payments of just interest for the fixed introductory period. Most AMPs Originations Are Too Recent to Generate Sufficient Performance Data to Predict Delinquencies and Losses to Banks, but Regulators Said Most Banks Appeared to Be Managing Credit Risk

AMP underwriting practices may have increased the risk of payment shock  and default for some borrowers, resulting in increased credit risk for  lenders, including banks. Regulators and Others Are Concerned That Borrowers May Not Be Well-informed About the Risks of AMPs

The information that borrowers receive about their loans through  advertisements and disclosures may not fully or effectively inform them  about the risk of AMPs. Federal and state banking regulatory officials  expressed concern that advertising practices by some lenders and brokers  emphasized the affordability of these products without adequately  describing their risks. Because most AMPs have not recast to fully amortizing payments, many  borrowers are still making lower monthly payments that do not cover  repayment of deferred principal. 4). For instance, the draft guidance states  that lenders should provide clear and balanced information on both the  benefits and risks of AMPs to consumers, including payment shock and  negative amortization. Draft Interagency Guidance on AMP Lending Recommends Tightening Underwriting Standards, Developing Risk Management Policies, and Improving Consumer Information

Draft interagency guidance, which federal banking regulators released in  December 2005, responds to their concern that banks may face heightened  risks as a result of AMP lending and that borrowers may not fully  understand the terms and risks of these products. Other  financial institutions said that the recommendations regarding borrower  qualification and general underwriting practices were too prescriptive and  would have the effect of reducing mortgage choice for consumers. Officials from most states have not created their own mortgage  disclosures. In recent years, federally and state-regulated  lenders and brokers widely marketed AMPs by touting their low initial  payments and flexible payment options, which helped borrowers to  purchase homes for which they might not have been able to qualify with a  conventional fixed-rate mortgage, particularly in some high-priced  markets. Although the draft interagency guidance by federal banking regulators  addressed some of the concerns with consumer disclosures, the draft  guidance focuses on promotional materials, not the written disclosures  required by Regulation Z at loan application and closing. FDIC, FTC,  NCUA, OCC, and OTS did not provide written comments. To obtain information on the federal regulatory response to the risks of  AMPs for lenders and borrowers, we reviewed the draft interagency  guidance on AMP lending issued in December 2005 by federal banking  regulators and interviewed regulatory officials about what actions they  could use to enforce guidance principles upon final release of the draft.
Why GAO Did This Study

Alternative mortgage products (AMPs) can make homes more affordable by allowing borrowers to defer repayment of principal or part of the interest for the first few years of the mortgage. Recent growth in AMP lending has heightened the importance of borrowers' understanding and lenders' management of AMP risks. This report discusses the (1) recent trends in the AMP market, (2) potential AMP risks for borrowers and lenders, (3) extent to which mortgage disclosures discuss AMP risks, and (4) federal and selected state regulatory response to AMP risks. To address these objectives, GAO used regulatory and industry data to analyze changes in AMP monthly payments; reviewed available studies; and interviewed relevant federal and state regulators and mortgage industry groups, and consumer groups.

What GAO Found

From 2003 through 2005, AMP originations, comprising mostly interest-only and payment-option adjustable-rate mortgages, grew from less than 10 percent of residential mortgage originations to about 30 percent. They were highly concentrated on the East and West Coasts, especially in California. Federally and state-regulated banks and independent mortgage lenders and brokers market AMPs, which have been used for years as a financial management tool by wealthy and financially sophisticated borrowers. In recent years, however, AMPs have been marketed as an "affordability" product to allow borrowers to purchase homes they otherwise might not be able to afford with a conventional fixed-rate mortgage. Because AMP borrowers can defer repayment of principal, and sometimes part of the interest, for several years, they may eventually face payment increases large enough to be described as "payment shock." Mortgage statistics show that lenders offered AMPs to less creditworthy and less wealthy borrowers than in the past. Some of these recent borrowers may have more difficulty refinancing or selling their homes to avoid higher monthly payments, particularly if interest rates have risen or if the equity in their homes fell because they were making only minimum monthly payments or home values did not increase. As a result, delinquencies and defaults could rise. Officials from the federal banking regulators stated that most banks appeared to be managing their credit risk by diversifying their portfolios or through loan sales or securitizations. However, because the monthly payments for most AMPs originated between 2003 and 2005 have not reset to cover both interest and principal, it is too soon to tell to what extent payment shocks would result in increased delinquencies or foreclosures for borrowers and in losses for banks and other lenders. Regulators and others are concerned that borrowers may not be well-informed about the risks of AMPs, due to their complexity and because promotional materials by some lenders and brokers do not provide balanced information on AMPs benefits and risks. Although lenders and certain brokers are required to provide borrowers with written disclosures at loan application and closing, federal standards on these disclosures do not currently require specific information on AMPs that could better help borrowers understand key terms and risks. In December 2005, federal banking regulators issued draft interagency guidance on AMP lending that discussed prudent underwriting, portfolio and risk management, and consumer disclosure practices. Some lenders commented that the recommendations were too prescriptive and could limit consumer choices of mortgages. Consumer advocates expressed concerns about the enforceability of these recommendations because they are presented in guidance and not in regulation. State regulators GAO contacted generally relied on existing regulatory structure of licensing and examining independent mortgage lenders and brokers to oversee AMP lending.