1. Fundamentals of Real Estate Lecture 20 Spring, 2003 Copyright © Joseph A. Petry www.cba.uiuc.edu/jpetry/Fin_264_sp03

2. 2 Market for Residential Financing The residential (home) mortgage debt exceeds $4.6trl, and represents 75% of total mortgage debt (‘99). – US debt in 1999 was $5.6trn – US corporate bond debt was $2.0trn – US consumer debt was $1.3trn Depository Lenders in the Primary Market Depository lenders--S&Ls, savings banks, credit unions, commercial banks—are financial intermediaries because they bring together depositors and borrowers A. Savings Institutions – S&Ls were highly specialized home mortgage lending institutions, they have evolved toward more general financial institutions. Chapter 16: Sources of Funds for Residential Mortgages

3. 3 – In the late 1980s, S&Ls originated ~50% of all conventional mortgage loans. By the early 1990s, this had fallen to about 25%. – The Financial Reform, Recovery, and Enforcement Act (FIRREA) was passed in 1989 to cope with the massive losses and closure of S&Ls. It affected aspects of mortgage lending, lender regulation, and real estate appraiser licensing requirements. – Saving Banks used to have wider investment powers than S&Ls, but now are indistinguishable from S&Ls. – Credit Unions charter restricts them to serving a group of people who can show a common bond (such as employees of a corporation), but have the same authority to make all kinds of loans. B.Commercial Banks involvement in housing market – Originate and sell home mortgage loans (have picked up the slack of S&Ls in this area), buy mortgage backed securities, provide short- term funds to mortgage banking companies, make short-term construction loans. Chapter 16: Sources of Funds for Residential Mortgages

4. 4 Non-depository Lenders in the Primary Market A.Mortgage Bankers – Full service mortgage companies—processing, closing, funding, servicing, and selling the loans they originate. – Increasingly displacing depository lenders as the dominant source of home mortgage loans. 1. Loan commitments and funds – Primary source of funds are bank lines of credit – Lock-in period occurs once the lender commits to a specific rate 2. Servicing – Includes collecting monthly payments and managing escrow accounts. Most mortgage bankers reserve the right to provide this service to the loan purchaser (for a fee of 0.25-0.5% of loan amnt) Chapter 16: Sources of Funds for Residential Mortgages

5. 5 Non-depository Lenders in the Primary Market 3.Sales of mortgage loans – Mortgage banks continually originate loans, take on short-term loans to finance their commitment, sell the originated loans, pay off the warehouse loans, and restart the process – If interest rates rise after they have made their loan commitment, but prior to closing, they will have to sell the newly originated loan at a discount – Forward commitments give mortgage bankers the right to sell a pre-specified amount of a certain type of loan at a pre-specified price to a secondary mortgage purchaser – Standby forward commitments give mortgage bankers the right, but not the obligation, to sell a pre-specified dollar amount of a certain loan type to the seller of the standby commitment Chapter 16: Sources of Funds for Residential Mortgages

6. 6 Non-depository Lenders in the Primary Market 4.Sources of Revenues – Mortgage bankers earn revenues from application fees, origination fees, and servicing fees. Servicing fees have been the most profitable aspect of the mortgage banking business. B.Mortgage Brokers – Serve as intermediaries between borrowers and lenders. They receive compensation for finding low cost loans for borrowers, or borrowers for lenders. C.Other Nongovernment-sponsored Lenders – As the secondary mortgage market has grown, a wide variety of non-depository lending firms have entered the market (GMAC, AT&T Capital, and some Wall Street Firms) Chapter 16: Sources of Funds for Residential Mortgages

7. 7 Government Sponsored Mortgage Programs A.FHA-Insured Loans – FHA loans are made by private lenders – FHA insurance protects lenders from all losses experienced after foreclosure and conveyance of title to HUD – FHA borrowers pay an up-front insurance premium equal to 2.20% of the loan amount, plus a monthly premium – FHA loan amounts are limited to a max of $115,200 to 208,800 depending upon the area – For properties costing < $50,000 or less, 3% downpayment is required – For properties > $50,000, 3% is required for first 25,000, with 5% required for the remaining amount of property value Chapter 16: Sources of Funds for Residential Mortgages

8. 8 Government Sponsored Mortgage Programs B.VA-Guaranteed Loans – VA loans are made by private lenders (available to US vets) – VA guarantees the lender against loss up to 100% of property’s value – VA charges a fee depending upon the LTV (2.0% w/ no down- payment, 1.5% w/ 5-9.99% down, and 1.25% with a 10% or higher down payment) – Funding fee can be financed – Closing costs cannot be included in the amount of the loan – Lenders cannot charge points; however, sellers may pay points to help enable the veterans qualify – VA sets maximum loan limits Chapter 16: Sources of Funds for Residential Mortgages

9. 9 Purchasers of Residential Mortgages in Secondary Mkt – Fannie Mae, and Freddie Mac are largest purchasers of residential mortgages in the secondary market – They are also the largest issuers of MBSs A.Federal National Mortgage Association (FNMA), Fannie Mae – Originated in 1938 to provide secondary mkt for FHA, then VA loans – Reorganized in 1968 into a semi-private corporation – Authorized to purchase conventional loans in 1970 – Obtains funding from sale of its stock, its MBSs, bond issuances and from its earnings – Mortgages and MBSs owned by Fannie Mae = 23% of res mkt Chapter 16: Sources of Funds for Residential Mortgages

10. 10 Purchasers of Residential Mortgages in Secondary Mkt B.Federal Home Loan Mortgage Association (FHLMC), Freddie Mac – Originally created in 1970 to provide secondary market for savings and loan association products – Currently buys both government-underwritten and conventional loans – Freddie Mac, and Fannie Mae now operationally similar – MBSs and mortgages of Freddie Mac = 17% of residential mkt C.Importance of Fannie Mae, Freddie Mac – 2 of the country’s largest financial institutions – Forward commitments they make to buy conventional loans – Served to standardize loan docs, and underwriting procedures Chapter 16: Sources of Funds for Residential Mortgages

11. 11 D.Government National Mortgage Association (GNMA), Ginnie Mae – Created in 1968, when Fannie Mae was reorganized – Guarantees timely payment of principal on MBSs (primarily FHA and VA pools) – Does not buy and sell large numbers of mortgages – Purchases below-market mortgages, at par value, from originating lenders. These mortgages generally designed by the FHA for low- and moderate-income buyers E.Life Insurance Companies – One of the largest sources of funds for commercial mortgages, almost non-existent in the home market (<1% of originations) – they do provide funds indirectly through purchase of MBSs Chapter 16: Sources of Funds for Residential Mortgages

12. 12 F.Other Secondary Market Purchasers – A variety of other government sponsored entities also active – Farm credit system – Federal Agricultural Mortgage Corporation (Farmer Mac) – Farmers Home Administration (FmHA) – Financing Corporation (FICO) – Federal Financing Bank (FFB) Chapter 16: Sources of Funds for Residential Mortgages

13. 13 The Lender’s Mortgage Loan Decisions A.Underwriting Standards – When making a mortgage loan, lenders face two types of risk with respect to the borrower and collateral: 1. The borrower will be unwilling or unable to meet their debt payment obligations 2. The value of the security for the loan (the home) is not adequate to pay off the balance in the event of default or foreclosure – The loan application process begins with the completion of an application from and the payment of a mortgage application fee. -The application form asks the applicant for information regarding the property, the borrower’s income and net worth, judgments and credit references. Chapter 16: Sources of Funds for Residential Mortgages

14. 14 The Lender’s Mortgage Loan Decisions A.Underwriting Standards (cont’d) – To judge the acceptability of the application, underwriters look at: 1. Security adequacy 2. Credit history 3. Employment outlook 4. Income adequacy, and – These items are frequently referred to as the three Cs Collateral, credit, and capacity Chapter 16: Sources of Funds for Residential Mortgages

15. 15 The Lender’s Mortgage Loan Decisions B.Affordability Ratios 1. Conventional Loans PITI*/Gross Income < = 28 percent (PITI + Other Debt Obligations) / Gross Income < = 36 percent 2. FHA Loans PITI / Gross Income < = 29 percent (PITI + Other Debt Obligations) / Gross Income < = 41 percent 3. VA Loans The VA does not employ the front-end ratio when qualifying borrowers; however, it uses the same back-end ratio as the FHA. *Note: PITI=Principal, Interest, Taxes and Insurance Chapter 16: Sources of Funds for Residential Mortgages

16. 16 The Lender’s Mortgage Loan Decisions C. The Effects of Federal Programs and Regulations The Home Mortgage Disclosure Act (HMDA) of 1975 provides disclosure of loan applications and approvals. This act serves to discourage lenders from “redlining” certain neighborhoods. The Community Reinvestment Act (CRA) of 1977 encourages lenders to actively lend in their community and evaluate their lending practices. Chapter 16: Sources of Funds for Residential Mortgages