BACKGROUND

BACKGROUND

Finance is the lifeblood of the real estate industry. Developers, contractors, real estate brokers (REBs) and
mortgage loan brokers (MLBs) should each understand how real estate is financed.

Traditional sources of loan funds are the financial depository institutions (depository institutions), including
savings and loan associations, savings banks, commercial banks, thrift and loans and credit unions. Other non-
institutional sources characterized as “non-banks” include mortgage bankers, finance lenders, private
individuals and entities, pension funds, mortgage trusts, investment trusts, and hedge funds. Insurance
companies are neither depository institutions nor non-banks. These entities collect premiums from
policyholders/the insured and invest some of the premium dollars in interests in real property, including equities
and mortgage loans.

Brief Overview

Over the past 15 to 20 years, enacted California legislation that characterized certain non-depository institutions
or non-banks as institutional and supervised lenders for limited, defined purposes. These include mortgage
bankers (licensed under the Residential Mortgage Lending Act), finance lenders (licensed under the California
Finance Lender Law), pension funds in excess of $15,000,000 in assets, mortgage trusts, investment trusts, and
hedge funds. The expansion of these non-depository institutions or non-banks and their growing share of the
residential mortgage market resulted in the development of a secondary market through securitization of
mortgage loans in the form of mortgage backed securities. Mortgage backed securities are qualified by
registration for intrastate and by coordination for interstate issuance of public offerings. Depending upon the
fact situation, these securities may also be qualified by exemption as private placements in accordance with
applicable federal and state law.

The secondary mortgage market (investors purchasing real estate loans originated by other lenders through
mortgage backed securities) surpassed loan sources which dominated real estate lending prior to the 1990’s.
The significant financial collapse and consolidation of the savings and loan and savings bank industry that
occurred at the end of the 1980’s and in the early 1990’s contributed to this change. At the beginning of 1980’s,
there were approximately 4,022 savings and loans and savings banks in the United States. As of December 31,
2009, approximately 1,158 remain, of which 756 are supervised by the Office of Thrift Supervision (OTS) and
402 are supervised by the Federal Deposit Insurance Corporation (FDIC). During the same period, commercial
banks reduced in number from approximately 15,000 to 6,739, of which the Office of the Comptroller of the
Currency (OCC) supervises 4,461 and the Federal Reserve Bank (the Fed or FRB) supervises 839.

The FDIC issued a public report at the end of the first quarter of 2010 that indicated 775 banks or more than
10% of remaining U.S. banks were placed on a list of “problem” depository institutions. These problem
institutions had a significant portion of non-performing commercial loans on their balance sheets. Non-
performing loans are considered to be loans that are at least 3 months past due. According to the FDIC report,
the number of non-performing commercial loans continued to increase for the 16th consecutive quarter. The
number of problem banks/depository institutions listed by the FDIC increased from 262 at the end of 2008 to
702 at the end of 2009 and to 775 at the end of the first quarter of 2010.

In addition to savings and loans, savings banks, and commercial banks, credit unions have been and remain a
significant source of residential financing. In recent years, credit unions have been merging, resulting in some
having hundreds of millions of dollars in assets. Currently, approximately 7,244 credit unions control $205
billion in assets, $181 billion in deposits, and $120 billion in loans to their members. Commercial banks control
$4.4 trillion in assets, $3.1 trillion in deposits, and $2.7 trillion in loans.

Life and health insurance companies also invest substantial resources in loans secured by real property. The
Insurance Information Institute reports that, as a percentage of total investments, the life and health insurance
industry continues to invest in mortgage loans from 9.85 to 10.87% of their total assets. As of the end of 2008,
this industry reportedly held $327.4 billion in real estate loans. While life and health insurance companies
historically invested in residential loans, during the last approximate 30 years the mortgage loans held by this

industry have been other than residential, i.e., income producing properties including apartments, office
buildings, shopping centers, malls, strip and freestanding commercial retail, industrial and the like.

Since the 1980’s, mortgage loan brokers (MLBs) have become a substantial source of residential mortgage loan
origination. The industry-wide use of MLBs to “originate” residential mortgage loans expanded until the
mortgage melt down of 2007 and 2008. Depending upon markets, MLBs “originated” from 50 to 70% of
residential mortgage loans, i.e., loans secured by 1 to 4 dwelling units.

The term “originate” has historically meant to fund or make the loan and did not include the function of
“arranging” a loan on behalf of another or others. Since the late 1980’s, mortgage lenders, state legislatures,
Congress and various federal and state governmental agencies and departments have redefined the term
“originate” to include third parties who arrange loans for lenders to fund and make. These third party
“originators” are commonly known as MLBs. Recently, the term “originate” has been extended to employees
who act as loan representatives of depository institutions and of licensed lenders. MLBs and lender
representatives who solicit and negotiate loans to be secured by 1 to 4 residential units have been re-
characterized as Mortgage Loan Originators (MLOs) in the federal Secure and Fair Enforcement for Mortgage
Licensing Act of 2008 (the SAFE Act). The Safe Act is briefly explained later in this Chapter.

California MLBs also make and arrange loans relying on funds from private individuals/entities, known as
private investors/lenders. Traditionally, these private investors/lenders funded loans secured by 1 to 4
residential units. The majority of these loans were based upon the “equity” in residential properties held by
borrowers rather than to finance the purchase of such properties. Beginning with the early 1990’s, depository
institutions and licensed lenders (non-banks) expanded their loan products to include the quality of loans that
previously had been almost an exclusive market for private investors/lenders making loans through MLBs. This
almost exclusive market consisted of mortgage loans that relied in large part on the equity in the security
property and to a lesser extent on the credit worthiness and financial standing of the borrower.

Private investors/lenders and the MLBs through whom these residential mortgage loans were funded could not
effectively compete with the expanded residential loan products that were being offered to the borrowing public
by depository institutions and non-banks. However, the historic secondary market would not purchase most of
these expanded residential loan products (alternative mortgages or non-traditional loan products). To create the
liquidity necessary to continue to fund these expanded residential loan products, a new secondary market was
established relying on the issuance of the aforementioned mortgage backed securities.

The residential mortgage loans funded by the historic depository institutions and the more recently constructed
non-bank lenders were then packaged, securitized, and sold to foreign and domestic investors in risk/yield
based “traunches” through Wall Street investment banks and broker-dealers. These historic depository
institutions and more recently constructed non-banks also sold these loan products to each other.

The Wall Street Investment Banks and broker-dealers created a parallel loan “origination” and delivery system
outside of the direct regulatory oversight of the Fed and the various federal agencies having supervisory
jurisdiction over depository institutions, e.g., FDIC, OCC, and OTS, among others. These federal agencies were
responsible for ensuring the safety and soundness of the depository institutions. The new and alternative
“origination” delivery system relied primarily on MLBs as third party “originators” of residential mortgage
loans, which were often funded through credit facilities made available by mortgage bankers, finance lenders,
or hedge funds.

Before Deregulation

Partially because of the unstable market forces prevailing over the last 30 to 35 years, depository institutions
such as savings and loan associations, savings banks, commercial banks, credit unions, and thrift and loans
experienced reductions in profitability. Largely unregulated non-depository institutions or non-banks drew
savings deposits away from regulated depository institutions by paying investors higher rates of interest on
financial instruments created for this purpose (e.g., uninsured money market funds, commercial paper, and
hedge funds).

During the late 1970’s, many depository institutions were holding low-interest loan portfolios that steadily
declined in value. At the same time, they were unable to make enough higher-interest rate loans to achieve
acceptable profit levels. This happened in part because of the decline in personal savings, appreciating property

values, and increasing interest rates paid to depositors. It was during this period the concept of brokered
deposits was first established. Wall Street broker-dealers were delivering deposits from their investor clients to
depository institutions looking for those that would pay the highest interest rates. High deposit rates resulted in
high mortgage loan interest rates. Many potential home buyers could not qualify for higher-rate mortgage loans
and/or were unable to make required down payments.

Across the country, forced postponements of home ownership occurred except for transactions involving
transferable (assumable) loans and seller-assisted financing. Subdividers, developers, and builders reduced new
home production. By the end of 1980, the prime interest rate imposed by commercial banks reached 21.5%. On
September 14, 1981, the interest rate for FHA and VA single-family insured or indemnified home loans
reached 17.5%. Tight money, stringent credit underwriting, and high interest rates made mortgage money
scarce and expensive. Potential private and government sector borrowers were forced to bid for available loan
funds.

Deregulation that Followed

The foregoing mortgage market led to a period of deregulation, the process whereby regulatory restraints upon
the financial services industry were reduced or removed. Deregulation extended to California law, and federal
legislation was pursued to level the playing field between federally licensed and chartered depository
institutions and California licensed and chartered depository institutions. This legislative deregulation included,
among others, the federal Depository Institutions Deregulation and Monetary Control Act of 1980, the
Depository Institutions Act of 1982 (also known as the Garn - St. Germain Act), and the Alternative Mortgage
Lending Act of 1982.

Re-regulation

Re-regulation occurred at the end of the 1980’s as a result of substantial losses in the savings and loan and
savings bank industry. Re-regulation began with the federal Financial Institutions Reform, Recovery and
Enforcement Act of 1989 (FIRREA). This federal re-regulation continued with a significant number of
amendments to both the Real Estate Settlement Procedures Act (RESPA) and the Consumer Credit Act, also
known as the Truth-In-Lending Act (TILA).

FIRREA was designed to “bail out” the savings and loan and savings bank industry as the Federal Savings and
Loan Insurance Corporation (FSLIC) did not have sufficient reserves to accomplish this objective. FIRREA
directly regulated federal depository institutions, and these regulations affected state licensed and chartered
depository institutions. The supervision by federal regulators over savings and loans, savings banks and
commercial banks increased during the 1990’s to include, among other changes, enhanced capital reserve ratios
required for loan losses. In addition, the OTS was structured as an office within the Fed or the FRB, replacing
the Federal Home Loan Bank Board (FHLBB) that had supervised savings and loans and savings banks since
the 1930’s. At the same time, the FSLIC was restructured from a separate entity to the Saving Associations
Insurance Fund (SAIF) as a subset of the FDIC.

More Deregulation

Following the restructuring of the savings and loan and savings bank industry in the early 1990’s and the
enhanced federal regulatory supervision that followed, Congress returned to deregulation. An example is the
federal Financial Institutions Regulatory Relief Act (FIRRA), also known as the Paper Reduction Act of 1996.
Included as part of FIRRA was the termination of SAIF, with its function of insuring deposits held by savings
and loans and savings banks being transferred to the Bankers Insurance Fund (BIF). BIF also operated under
the FDIC.

In 2006, the Federal Deposit Insurance Act became law. This Reform Act merged BIF and the deposit
insurance function of savings and loans, savings banks, and commercial banks into a fund called the Deposit
Insurance Fund (DIF). This change was made effective March 31, 2006. The Reform Act also established
capital reserve ranges from 1.15 to 1.50% within which the FDIC directors were allowed to set reserves for
member institutions, i.e., the Designated Reserve Ratio (DRR).

With this deregulation, the differences once separating the loan products, services, and the purposes of savings
and loans, savings banks, and commercial banks were reduced or eliminated. Further, the distinctions in
premiums paid to DIF by the various depository institutions were restructured. Savings institutions competed

with commercial banks for business and profits with few governmental restrictions. Some experts in the
financial world believed that depository institutions surviving this competition would become larger, more
diverse, and more efficient than the depository institutions prior to the 1990’s.

The process of diversification and integration of the financial services industry accelerated by the repeal of the
Glass-Steagall Act as part of the federal Gramm-Leach-Bliley Act of 1999. The repeal of the Glass-Steagall Act
allowed savings and loans, savings banks, and commercial banks to invest funds and integrate investment
activities with investment bankers and insurance carriers, including engaging in the issuance of mortgage-
backed securities and in the structuring and issuing of unregulated financial instruments referred to as
derivatives.

Derivatives have been defined as agreements or contracts that are not based on a real, or a concomitant
exchange, i.e., nothing tangible is currently exchanged such as money or a product. For example, a person goes
to a department store and exchanges money for merchandise. The money is currency and the merchandise is a
commodity. The exchange is concomitant and complete. Each party receives something tangible. If the
purchaser had asked the store to hold the merchandise to be delivered at a later date when future payment is
made at a predetermined price standard (based upon the movement in the retail price of the product) and the
store agrees, then a form of derivative has been created.

Derivatives are agreements derived from proposed future exchanges rather than current and concomitant
exchanges of assets, obligations, or liabilities. In financial terms, a derivative is a financial instrument between
two parties representing an agreement based on the value of an identified and underlying asset linked to the
future price movement of the asset rather than its presumed current value. Some commonplace derivatives, such
as swaps, futures, and options have a theoretical face value that can be calculated based on formulas. These
derivatives can be traded on open markets before their expiration date as if they were assets.

California Law

Consolidation of the licensing of lenders other than depository institutions has occurred in California. As of
July 1, 1995, the Finance Lender Law established a single license, the California Finance Lender (CFL) which
replaced three licenses including personal property brokers, consumer finance lenders, and commercial finance
lenders. These three licenses were merged into the CFL license.

Effective January 1, 1996, the California Legislature created a new license category for mortgage bankers either
originating or servicing residential loans in this state. These licensees are known as residential mortgage lenders
(RMLs), each of which is licensed under the Residential Mortgage Lending Act (RMLA). CFLs and RMLs are
licensed and regulated by the Department of Corporations (DOC).

Some mortgage bankers remain licensed as real estate brokers (REBs) and continue to operate their non-
residential commercial loan business (loans secured by other than 1 to 4 dwelling units) under the regulation of
the Department of Real Estate (DRE). RMLs are not to use an REB license to make, arrange or to service
residential loans.

During 1996, the California Legislature consolidated regulation of depository institutions into a Department of
Financial Institutions (DFI). This department replaced the Department of Banking and the Department of
Savings and Loans and acquired from the DOC’s regulatory oversight the state-chartered thrift and loans
(industrial loan companies) and the credit unions.

California industrial loan companies have also experienced significant restructuring. These institutions were
legislatively required to switch from a California-based insurance fund to the FDIC. With this switch came
more regulatory oversight, including stricter loan underwriting guidelines. Reported diminished profits
followed this restructuring and the result was the merger of many of these institutions into larger institutions
that were able to profitably function within the regulatory climate and competitive market of the 1990’s through
the middle of 2007.

Restructuring of the Residential Loan Market

Deregulation and the proliferation of alternative mortgage instruments or non-traditional loan products were
each responsible for the restructuring of the housing finance system. These alternative mortgage instruments or
non-traditional loan products were responsible for redefining the underwriting guidelines and the standards for

borrower qualifications applied by depository institutions and by non-banks (including licensed lenders). The
purpose was to facilitate the expansion of homeownership as a stated public policy and also as a means of
pursuing the objectives of the federal Community Reinvestment Act.

As always, the most important issue facing both mortgage lenders and borrowers is the availability and
affordability of mortgage funds. As legislators, regulators, lenders, brokers (including MLBs) and consumer
interests addressed complex risks, challenges and opportunities, more changes occurred in the lending process.
For example, electronic loan originations became readily acceptable to depository institutions and non-banks as
well as to the secondary market.

The foregoing changes increased involvement of licensed lenders and brokers, including RMLs, CFLs, and
MLBs in residential mortgage loan originations. Since the mortgage meltdown of 2007 (to be discussed later in
this Chapter), what remains to be seen is how much consolidation will occur among these licensees, and if not
consolidation, how many of these licensees will become subsidiaries of or affiliates horizontally associated with
depository institutions. The result of these business relationships will require acknowledgement and disclosure
of Affiliated Business Arrangements (ABAs) to be discussed later in this Chapter.

Extensive federal and state re-regulation of lenders and mortgage brokers making and arranging residential
mortgage loans (including the SAFE Act) will likely reduce the ability for small independent licensed firms to
survive. Accordingly, many of these firms will be forced to merge or, as previously mentioned, may become
subsidiaries or affiliates of depository institutions or their holding companies.

Acquisition of state licensed firms may also be considered by federally licensed and chartered savings and
loans, savings banks, and commercial banks following a decision of the U.S. Supreme Court issued in April
2007. The decision is Watters, Commissioner, Michigan Office of Insurance and Financial Services v.
Wachovia Bank, N.A. et al., No. 05–1342 (argued November 29, 2006, decided April 17, 2007). The U. S.
Supreme Court held that subsidiaries of federally licensed and chartered depository institutions or their holding
companies did not require licensing under state law. This decision abrogated in part the opinion of the
California Attorney General, 84-903, which was issued in October 1985 and had concluded that entities,
whether subsidiaries or affiliates, could not rely on exemption from state licensure that extends to the parent or
to the employees of the parent entity. The remaining opinions of the Attorney General remain operative.

Essentially, the Attorney General’s opinions require separate licensing of entities that fund or make loans,
purchase promissory notes, or service loans/promissory notes held by the entities. The U. S. Supreme Court
decision will likely facilitate the acquisition of a number of RMLs, CFLs, and MLBs by federally licensed and
chartered depository institutions.