ALTERNATIVE FINANCING

ALTERNATIVE FINANCING

In a stable economic environment (i.e., one involving low inflation and relatively constant market interest
rates), the long-term, fixed-rate conventional loan was the typical financing vehicle for the purchase of
residential real property. Uncertainty regarding future inflation and interest rates can complicate matters for

both lenders and borrowers. As people continue to build, sell and purchase homes, the terms of home
mortgages reflect economic realities and expectations including the periodic reluctance of lenders, investors,
and some borrowers to accept long-term, fixed-rate loans.

Loans that involve balloon payments, interest reset options, shared appreciation at resale, etc., have
ramifications that are not readily apparent to most people. This section discusses some of the alternatives to the
fixed-rate conventional loan that have been offered by lenders to borrowers.

The Fixed-Rate Conventional Loan

The use of alternative financing instruments (non-traditional loan products) authorized under preemptive
federal law constituted a major change in the traditional lender-borrower relationship in that the risk of changes
in the market rate of interest shifted from lenders to borrowers. However, marketplace competition, including
FHA insured or VA indemnified loans, resulted in continued availability of fully amortized, long-term, fixed-
interest rate mortgages. The Federal National Mortgage Corporation (FNMA or Fannie Mae) and the Federal
Home Loan Mortgage Corporation (FHLMC or Freddie Mac) also contributed and continue to contribute to the
availability of fixed interest rate mortgages.

Redesigned Mortgage Instruments

During the 1970’s and the early 1980’s unstable economic conditions caused Congress, California legislators,
consumers, lenders, and real estate and mortgage industry representatives to explore a whole catalog of issues
regarding the use of alternative mortgage instruments or non-traditional loan products that were being made
available to homeowners and purchasers. In 1970, legislation was passed and regulations adopted in California
authorizing the use of variable rate mortgages (VRMs). The interest rate of a VRM changes within a range as
increases or decreases in an identified published index occurs. In 1980, California legislation authorized the use
of renegotiable rate mortgages (RRMs) in which the borrower has an option to either prepay or renew the
residential loan, typically at five year intervals. Generally, renewal of such loans is subject to renegotiation of
the interest rate. Lenders were required to offer a fixed-rate mortgage as an option to the RRM.

In 1981, the California Legislature also authorized the use of adjustable rate mortgages (ARMs). These
mortgages allowed for the nominal interest rate to adjust periodically by a set margin in relationship to a
defined index. Again, lenders were required to offer fixed rate mortgages as an option.

In response to the foregoing California legislation, state depository institutions sought federal legislation to
level the playing field among state licensed and chartered and federally licensed and chartered depository
institutions. As previously mentioned, the Alternative Mortgage Lending Act was passed by Congress in 1982
to preempt state law to the contrary allowing state licensed and chartered institutions to make residential
mortgage loans pursuant to federal law. State depository institutions thereafter followed federal regulations
when express preemption of state law was included in federal law. Otherwise, state depository institutions were
obligated to follow the more stringent of the applicable state or federal law.

Basically, alternative mortgages also known as non-traditional loan products, resulted in an expansion of the
residential mortgage market. These alternative or non-traditional loan products shifted to borrowers some of
the risks inherent in market changes to enhance the inflow of funds to lenders during periods of tight money
and of high interest rates.

Adjustable Rate Mortgages (ARMs)

As mentioned, an ARM is a mortgage loan that provides for adjustment of its interest rate as market interest
rates change. Interest rates are linked to an index (typically representing short term interest rates) which
fluctuates as market interest rates change. Following an initial contract period as defined in the loan documents
and at predetermined periods (monthly, quarterly, or annually depending upon the terms of the loan); lenders
would adjust the interest rates on residential mortgage loans based upon a pre-agreed margin added to an
identified current index to arrive at the borrowers’ new interest rates for the next period. The new interest rates
would remain operative until subsequent adjustments occurred.

Major indices used in ARMs include: the Prime or Reference Rate of major commercial banks, as published in
the Wall Street Journal (Prime Rate); the London Interbank Offered Rate (LIBOR), as published in the Wall
Street Journal or by Fannie Mae; United States Treasury Securities adjusted to a constant maturity (TCM), as
published by the Federal Reserve in its Statistical Release H.15; and the 11th District Cost of Funds (COFI), as

published by the Federal Home Loan Bank of San Francisco. There are many variations in methods of
calculation for the aforementioned indices as well as other indices available for different types of ARMs. A
Home Equity Line of Credit (HELOC) is a revolving line of credit typically featuring an adjustable rate tied to
the Prime Rate of major commercial banks, as published in the Wall Street Journal.

Because ARM interest rates can increase over the term of the loan, ARM borrowers share with lenders the risk
that interest rates will increase; therefore, it is important for borrowers to not only fully understand how their
loan may react to changes in market conditions, but also to minimize their exposure by selecting loan programs
with low margins and reasonable caps or limits on interest rate changes. Selecting a less volatile index is also
important to borrowers.

Some ARM products also include an interest rate floor limiting decreases in the promissory note interest rates
regardless of the downward movement of the selected index. Typically, interest rate floors have been set at
either the start (teaser) or the initial rate. More recently, the difference between the start or teaser rates and the
initial rates has diminished.

Lenders benefit from ARMs in that they are able to more closely match the maturities of assets and liabilities
and minimize their exposure to the risk of rising interest rates. This results in lower initial rates on ARMs than
on fixed rate loans. ARMs that include negative amortization or payment options have proven to be more
troubling to borrowers as they often result in loan balances exceeding the then value of the security property
(particularly in a declining market) or in borrower payment shock.

Renegotiable Rate Mortgages (RRMs)

An RRM is a long-term mortgage (amortized up to 30 years) comprised of a series of short-term loans. The
loans are renewable after specified periods (e.g., every three to five years). Both the interest rates and the
monthly payments remain fixed during periods between renegotiation/renewal.

Any change in the interest rate, as limited by law, is based on changes in an identified index. If the borrower
declines renewal after any specified period, the remaining balance of the loan including any interest remaining
unpaid and accrued thereon becomes due and payable.

Rollover Mortgages (ROMs)

ROMs (used extensively in Canada) are a renegotiated loan wherein the interest rate (and hence, the monthly
payment) is renegotiated, typically every five years. Consequently, the mortgage rate is adjusted every five
years consistent with the then current or prevailing mortgage rates, although monthly payments are amortized
on a 25 or 30-year basis. Monthly payments are calculated in the same manner as conventional mortgage loans,
with the term decreasing in increments of five years to permit full payment at maturity date specified at loan
origination.

Reverse Mortgages (RMs)

Elderly or retired homeowners often rely on limited or fixed incomes while at the same time owning their
homes free and clear or with relatively small mortgage loan balances. For many of these homeowners the
choices are limited because of reduced fixed income during retirement years. The choices available to these
homeowners include either selling their home to access the equity as a means of supplementing their living
expenses or to consider obtaining a reverse mortgage.

The reverse mortgage loan that is available today is known as a Home Equity Conversion Mortgage (HECM),
an FHA insured product. Under a HECM reverse mortgage, the homeowner is not required to make loan
payments. Instead the homeowner has a choice of receiving monthly income/cash flow from the lender or
receiving a lump sum payment at the time the loan is originated. The amount of income/cash flow or the initial
lump sum paid to the borrower is determined through an analysis of the current and expected future value of the
security property; the current and future expected accruing interest rates to be applied to the principal
distributions made to the homeowner during the term of the reverse mortgage (based upon the selection by the
lender of one of two HECM authorized adjustable rate programs); and upon the remaining life expectancy of
the homeowner.

The analysis considers the amount of any existing mortgage loans encumbering the homeowner’s property that
must be paid in full at the time of origination of the reverse mortgage loan. This may require the selection of the

option for a lump sum payment at the time of loan origination or that the loan program include both a lump sum
payment sufficient to payoff the existing encumbrance(s) and to thereafter provide a monthly income/cash flow
to the homeowner. If the amount owing in connection with the existing mortgage loans is in excess of the
calculated maximum amount available from the selected HECM loan program, the homeowner may not be
entitled to obtain a reverse mortgage.

These homeowners are qualified for a reverse mortgage loan in a maximum amount that can be sustained by the
equity in the security property (based upon the analysis previously discussed) and not on their retirement
income, or their credit worthiness and financial standing. The homeowner’s equity must also sustain the
mortgage premiums imposed by HUD/FHA both at the time of origination and throughout the term of the
reverse mortgage loan, among other fees, costs, and expenses. The fees, costs, and expenses to originate a
reverse mortgage are typically much higher than to originate a conventional loan; therefore, it is ill-advised to
consider a reverse mortgage for a short period. The selection of a reverse mortgage loan by a homeowner
requires a long-term commitment to occupy the security property.

The FHA insurance coverage protects homeowners by insuring the monthly income/cash flow will continue
even if the lender becomes insolvent or subject to a regulatory enforcement action. The insurance coverage also
protects the lender and the homeowner in the event the amount owing at the time of the maturity of the reverse
mortgage loan exceeds the then market value of the security property. The difference is subject to a claim
against the insurance coverage by the reverse mortgage lender thus protecting the estate of the homeowner from
any shortfall in principal balance and accrued interest that might otherwise be due.

HECM reverse mortgages are due and payable when then last qualified borrower permanently leaves the
property or until a specified event, such as death of the homeowner or a sale of the security property. In effect,
a reverse mortgage enables the homeowner to draw on the equity of their home by increasing their loan balance
each month. No cash payment of interest is involved, as the increase in the loan balance each month represents
the cash advanced, plus interest on the outstanding principal balance.

Shared Appreciation Mortgages (SAMs)

SAMs give the lender the right to an agreed percentage of the appreciation in the market value of the security
property in exchange for an initial below market interest rate. These loans are usually unavailable in markets
where real property is not appreciating in value.

Graduated Payment Mortgages (GPMs)

GPMs provide for partially deferred payments of principal at the start of the loan term. There are a variety of
plans. Usually, after the first five years of the term, the principal and interest payments increase substantially to
pay off the loan during the remainder of the term (e.g., 25 years). This loan may be appropriate for borrowers
who expect salary or income increases in future years. A GPM may involve negative amortization (i.e.,
increases in principal) in the early years of the loan, although some GPM products do not provide for negative
amortization. If negative amortization is included, the early sale of the home could require the borrower repay
more than the original principal amount of the loan. This could be a significant problem if the property has not
increased or has even declined in market value.

In Summary

Alternative mortgages also known as non-traditional loan products are not suitable for everyone. It is very
important that those who recommend such products, or who contemplate using them personally, have a good
understanding of the potential risks and drawbacks as well as the benefits. A temporary solution to a financing
problem may turn out to be a long-term detriment to the borrower and/or lender. When the party recommending
such products is an MLB/MLO, the understanding of and the explanation regarding the use of alternative
mortgages or non-traditional loan products occurs within the context of the fiduciary duties owed to the
intended borrower.

Real estate licensees, including MLBs/MLOs should use caution when advocating the use of innovative or
creative financing techniques and products in residential loan transactions. These licensees (as agents and
fiduciaries) should be prepared to explain the benefits and risks to their clients throughout the anticipated term
of the residential mortgage loan when using alternative mortgages or non-traditional loan products. Alternative
mortgages or non-traditional loan products are not something that licensees and their principals should learn

together through trial and error. Innovative or creative financing techniques and products generally are to be
avoided without the advice of knowledgeable legal counsel.