THE MORTGAGE MARKET

THE MORTGAGE MARKET

Money serves as a medium of exchange. The potential to exchange money for goods and services can be stored.
This is called savings. Savings are the primary source of funds for lending.

If the value of money is relatively stable, people are more inclined to save, since their stored capacity to
exchange (with interest) is not being eroded by inflation.

Credit

“Credo” is a Latin word which means “I believe.” A lender loans money believing that it will be paid back as
agreed; therefore, the lender grants, or extends, “credit” and the term “creditor” is used in federal law to
identify lenders for certain defined purposes including applying to the lender in the “creditor/borrower”
relationship.

Supply and Demand

The supply of capital is finite. Real estate borrowers must compete with government, business, and other
consumers for available capital/funds. If mortgage money is in short supply, mortgage interest rates rise. A
cause is the placement of potential capital/mortgage money in other markets that are paying higher interest
rates. Another cause is when spending authorized by the U. S. Congress exceeds current tax revenues. The
Congress and the President accomplish this spending by borrowing in the capital markets and increasing the
direct and indirect national debt that reduces available capital for private investment.

Government Intervention Can Redirect Supply

Between late 1989 and the mid-1990’s, a “credit crunch” occurred in a portion of the real estate market
primarily because the federal government, through re-regulation including capital reserve requirements imposed
on depository institutions under FIRREA, redirected available capital to residential mortgage lending.

The capital reserves then required for residential mortgage loans secured by 1 to 4 dwelling units ranged from
2% to 4%, depending primarily on whether the loan was insured or indemnified by a federal agency. The
reserve requirements for commercial properties jumped to as much as 8%.

Accordingly, lenders rushed to make residential mortgage loans and avoided loans secured by commercial
properties, including those that are characterized as industrial or as land loans. Residential income properties
were treated more favorably with reduced capital reserve requirements, although higher than the reserves
required for residential mortgage loans. The flow of capital to residential mortgages helped cause “refinance

mania” beginning in the mid-1990’s and continuing through the middle 2000’s. The Fed’s policy of holding
interest rates at historically low levels also contributed to “refinance mania”.

This flow of money mitigated the “credit crunch” that occurred in the early 1990’s. In addition, home purchase
transactions increased substantially during the period from 1999 through most of 2006, increasing the demand
for residential mortgage loans.

The “Mortgage Meltdown”

During the 1990’s, with interest rates hovering in the 5 to 6% range and with a strong national economy, a
wave of homebuyers entered the market. Housing prices rose significantly in many areas and speculators
entered the market in the expectation of “flipping” houses to make a quick profit. Subdividers, developers and
builders significantly expanded the housing supply by increasing new housing inventory through residential
subdivision development. As prices rose, new and more exotic loan products became popular such as “pay-
option” adjustable rate mortgages (ARMs), or “option ARMS”, stated income, stated asset, and other
alternative mortgages or non-traditional loan products.

With many of these non-traditional loan products, borrowers were not required to prove their income or their
ability to pay the mortgage loan debt service. Some loan products were geared to borrowers who could not
qualify for conventional loans due to low credit scores, high debt-to-income ratios, limited equity, inadequate
down payments, or other factors. But many of these “non-traditional” or “alternative mortgage” loan products
were also marketed to and used by conventional borrowers to increase their purchasing power as buyers of
residential real properties to allow home purchases that would not have conformed with the standards imposed
by conventional loan products, or to allow home purchases at higher prices than previously available to buyers
traditionally qualifying to purchase homes.

Many products had very low “start” or “teaser” interest rates, at or below 1%, followed shortly after a period by
an initial note rate that remained below market also for a short period. Lenders based the borrowers’ ability to
pay on the “initial” rate, even if this rate substantially increased pursuant to the contract terms after a relatively
short period, e.g., one to three years. The terms of the mortgage loan included the potential for large interest
rate increases, resulting in borrower payment shock and, in some cases, negative amortization increasing the
principal balance of the loan rather than decreasing the balance through amortization.

100% financing was also a popular loan product. Many of these loans layered risk upon risk, by incorporating
no down payment, negative amortization and potential interest rate increases into one mortgage loan
transaction. Many homeowners, seeing an opportunity to turn potential growth in equity into cash, refinanced
into these types of products from more traditional and safer fully amortizing, 30-year fixed rate loans. These
borrowers were lured by the prospect of lower payments and the belief that home values would continue to rise
indefinitely. In California, many homeowners failed to realize that when refinancing through “non-traditional”
or “alternative mortgage” loan products, the borrower was giving up “purchase money” mortgages (for which
no deficiency judgment may be obtained) in exchange for “non-purchase money” mortgages that carried
personal liability for the deficiency between the total amount owing the lender and the price received at a
properly conducted foreclosure or “short” sale.

By mid-2007, the housing bubble burst when many thousands of homeowners were unable to make their
mortgage loan payments that had adjusted and, in many cases, substantially increased. These homeowners had
purchased with little or no money down or had refinanced to higher loan balances using alternative mortgages
or non-traditional loan products that included adjustable interest rates resulting in monthly mortgage payments
rising to unaffordable levels. Housing prices began to fall as effective demand diminished. Homeowners with
negative amortization, 100% financing, or both were “upside down” with negative equity in their homes
compounded by their inability to make their scheduled mortgage loan payments.

Foreclosures began to skyrocket and many lenders, particularly those that specialized in exotic non-traditional
loan products failed. While the primary and secondary markets described in this chapter still exist, most lenders
and secondary market purchasers, such as Fannie Mae and Freddie Mac, have substantially tightened their
underwriting guidelines and virtually all exotic, alternative mortgage or non-traditional loan products have
disappeared from the residential mortgage market. This resulted in constricted effective demand, reduced
property sales, and in an over supply of homes on the market. Many of the homes for sale on the market were

subject to negative equities held by homeowners leading to the influx of “short sales”, loan modifications, and
forbearances or lender foreclosures.

The Primary Mortgage Market

The traditional primary mortgage market consisted of savings and loan associations, savings banks, commercial
banks, thrift and loans, credit unions, pension funds and insurance companies, as well as mortgage bankers that
originated mortgage loans by lending funds obtained from their own capital or from independent credit lines
that appear as debts in their financial statements. The foregoing depository institutions and lenders funded and
made loans directly to consumers/borrowers in residential mortgage loan transactions. These participants in the
primary mortgage market replenished their capital/funds by selling loans in the secondary mortgage market as
described later in this chapter.

Historically, residential mortgage loans sold into the secondary mortgage market were either insured by the
Federal Housing Administration (FHA) or guaranteed or indemnified by the Veteran’s Administration (VA).
Mortgage bankers that originated mortgage loans performed as loan correspondents (agents and authorized
representatives) of depository institutions. Those mortgage bankers with sizeable assets at levels acceptable and
with the mortgage experience required by government agencies qualified as “approved lenders/mortgagees” by
FHA and VA. Since the late 1960’s, conventional loans originated by these depository institutions and licensed
lenders (subsequently including mortgage bankers) were sold into the secondary mortgage market. Because of
federal legislation, the secondary mortgage market for conventional loans included the previously mentioned
quasi-government enterprises, Fannie Mae and Freddie Mac.

In addition to the federal agencies discussed, California has established its own residential mortgage loan
program for California Veterans, the Department of Veterans Affairs (DVA). However, the DVA does not
fund loans to be sold in the secondary market. Rather, it purchases residential or farm properties selected by
veterans to be “sold back” to the veterans over time with a land contract of sale authorized by the Military and
Veterans Code describing the selected property as the security property. These land contracts of sale are
retained by the DVA and are typically not sold into the secondary market.

Federal Housing Administration (FHA)

This agency insures loans made by approved lenders/mortgagees.

Veterans Administration (VA)

This agency currently indemnifies loans made to veterans for housing, farms or businesses by approved
lenders/mortgagees.

Department of Veterans Affairs (DVA)

This agency assists qualified California veterans with the purchase of housing and farms.

Mortgage Bankers

Mortgage bankers are privately-owned companies that are often subsidiaries of or affiliated with banks, savings
and loans or savings banks, or of their respective holding companies. As previously mentioned, mortgage
bankers who generally perform as loan correspondents (authorized agents and representatives of depository
institutions and of other lenders) originated from their own capital or independent credit lines conventional
loans and FHA or VA insured or indemnified residential mortgage loans. Mortgage bankers have also
participated in the more recent structuring of alternative mortgages and non-traditional loan products and
ultimately became a significant source of origination of such loans.

As previously described, California mortgage bankers are licensed as either RMLs or CFLs. Many mortgage
bankers are licensed as REBs to originate commercial loans (loans secured by other than 1 to 4 dwelling units).
However, the REB license is oriented toward the status of an agent arranging a loan on behalf of another or
others and not the status of a lender acting as a principal to fund and make loans. Notwithstanding the
foregoing, some REBs still rely on their broker’s licenses to make loans.

Mortgage bankers may retain servicing of the residential mortgage loans they have sold in the secondary
market, may release servicing rights to purchasers of loans (a “whole loan” sale), or they may sell the servicing
separately to a licensed and authorized servicer or to a servicer that is lawfully exempt from licensing.

The Secondary Mortgage Market

Lenders originating residential mortgage loans traditionally replenished their capital by selling the loans to U.S.
and foreign banks, to investors willing to hold mortgage loans on a long-term basis, or (as aforementioned) to
Fannie Mae or Freddie Mac. More recently, the secondary mortgage market expanded to include investment
banks and international investors who purchased interests in residential mortgage loans in the form of the
previously discussed mortgage backed securities.

Wall Street Investment Bankers packaged residential mortgage loans in securitized pools in the form of
mortgage-backed securities for sale to foreign and domestic investors by broker-dealers. Private companies
underwrote these mortgage-backed securities, which were then rated by recognized bond rating firms, i.e.,
Moody’s, Standard & Poor’s, and Fitch. This expanded secondary mortgage market included participants
buying and selling amongst themselves. The Wall Street expansion of the secondary mortgage market was
established to facilitate the sale of alternative mortgages or non-traditional loan products that would not have
been saleable in the historic secondary market.

Federal National Mortgage Association (FNMA or Fannie Mae)

Fannie Mae initially provided a secondary market for FHA and VA insured or indemnified loans and, since the
early 1970’s, conventional mortgages originated by approved lenders (seller/servicers). Initially FNMA
required that conventional loans were to be insured by a private mortgage insurer to be acceptable for purchase.

Fannie Mae’s sources of funds include borrowing; selling long-term notes, mortgage-backed securities (MBS)
and debentures in the capital markets; issuing and selling its own common stock; and earning from its mortgage
portfolio, including various fees imposed upon seller/servicers.

Fannie Mae purchased graduated payment mortgages (GPMs), conventional fixed-rate first and qualifying
second mortgages, and a variety of ARMs, each secured by 1 to 4 family dwellings. Fannie Mae continues to
maintain a resale/refinance program whereby approved lenders (seller/servicers) offer borrowers the
opportunity to convert ARMs to fixed interest rate loans or to obtain new mortgage loans at competitive interest
rates.

Since the early 2000’s, Fannie Mae expanded its acceptable loan products to include many of the non-
traditional or alternative mortgage loan products being originated by their approved lenders (seller/servicers).
FNMA’s mortgage-backed securities (MBS) plan included non-traditional or alternative mortgage products.
The MBS plan involved approved lenders selling blocks or pools of mortgages in exchange for a like amount of
securities that represented undivided interests or participations in a designated pool of loans that may be sold to
or retained by qualifying lenders. FNMA provides a 100% guaranty of full and timely payment of interest and
principal to the holders of the securities.

While FNMA is the largest investor in the secondary residential mortgage market, it delegates most
underwriting and servicing responsibilities to approved lenders (sellers/servicers) in accordance with FNMA’s
guidelines. FNMA has also played a major role in the development of standardized loan origination documents,
including the 1003 loan application form, promissory notes and deeds of trust (with various addendums
depending on the residential mortgage loan product), and uniform residential appraisal reports (FNMA guide
forms). These guide forms are also approved by the Federal Home loan Mortgage Corporation (FHLMC-
Freddie Mac).

Fannie Mae has a 15-member board of directors, 10 elected by shareholders, and 5 appointed by the President
of the United States. Until recently FNMA was a government enterprise primarily controlled by its shareholders
who were largely approved lenders (seller/servicers). As of this writing, FNMA has been placed into
receivership by the federal government to continue its operations through a series of financial “bail outs” as
authorized by the U. S. Congress.

Government National Mortgage Association (GNMA or Ginnie Mae)

Ginnie Mae is a government corporation which administers mortgage support programs that could not be
carried out in the private market place. Ginnie Mae increases liquidity in the secondary mortgage market and
attracts new sources of funds for residential loans. Ginnie Mae does not purchase mortgages. Rather, it adds its
guarantee to mortgage-backed securities (MBS) issued by approved lenders (seller/servicers). GNMA’s three
major activities include:

■ Mortgage-backed securities (MBS) Program;

■ Special assistance functions; and

■ Management and liquidation functions.

Through the MBS Program, GNMA guarantees securities issued by financial intermediaries that are backed by
pools of mortgages. Mortgage bankers, savings institutions, commercial banks and other approved types of
financial intermediaries are issuers of securities. Holders of these securities receive a pass-through of principal
and interest payments on the pool of mortgages, less amounts to cover servicing costs and certain GNMA fees.
Ginnie Mae guarantees that the holders of the securities will receive payments of principal and interest as
scheduled, as well as unscheduled recoveries of principal due to prepayments. Because of the federal guaranty
(pledge of full faith and credit of the U.S. Government), GNMA mortgage-backed securities are considered by
many to be as safe, as liquid, and as easy to hold as securities issued directly by the U. S. Treasury.

The MBS programs of FNMA and GNMA have benefited all regions of the country by increasing the flow of
capital/funds from the securities market to the residential mortgage loan market and from capital-surplus to
capital-short geographical areas.

Under the special assistance functions, GNMA purchases certain types of mortgages to provide support for
low-income housing and to counter declines in mortgage lending and in housing construction. Under the
management and liquidation functions, GNMA manages and liquidates (sells) portfolios of federally-owned
mortgages.

The President of the United States appoints the President of GNMA, who acts under the direction of the
Secretary of the Department of Housing and Urban Development (HUD).

Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)

Freddie Mac was established to increase the availability of mortgage credit for the financing of urgently needed
housing by developing, expanding and maintaining a nationwide secondary market primarily for conventional
loans originated by savings and loans, savings banks, thrift institutions, commercial banks, mortgage bankers
and other HUD-approved lenders/mortgagees.

Freddie Mac finances most of its mortgage purchases through the sale of mortgage participation certificates
(PCs) that require issuance and acquisition by qualified investment buyers (QIBs).

Through its standard programs, Freddie Mac buys:

■ Whole loans and participation interests in conventional l to 4 family dwelling loans with both fixed
and adjustable rates;

■ Home improvement loans; and,

■ Multifamily whole loans and participation interests therein.

The mortgages purchased in the standard programs are generally less than one year old. FHLMC underwrites
the loans delivered under its purchase commitments and rejects loans that do not meet its underwriting
guidelines. Residential mortgage loans secured by 1 to 4 dwelling units with loan-to-value ratios above 80
percent must carry private mortgage insurance coverage.

Freddie Mac’s guarantor or “Swap” program gives primary mortgage lenders an added source of liquidity
during periods when the yield on mortgage portfolios of predominantly older loans is lower than the lenders’
cost of funds. Lenders may thus convert a low yield portfolio into highly liquid securities that can be sold or
used as collateral for the lenders’ borrowing of funds.

Until recently, Freddie Mac was an independent stock company and functions in direct competition with
FNMA. Freddie Mac has an 18-member board of directors, 13 are elected by Freddie Mac’s stockholders; and
5 are appointed by the President of the United States. As of this writing, FHLMC was placed into receivership
by the United States government to facilitate “bail outs” as authorized by Congress to be able to continue its
residential mortgage loan programs.

Secondary Market for Non-Traditional Mortgage Products

As previously discussed in this Chapter, securitization of non-traditional mortgage products into pools
underwritten by Wall Street investment bankers were added to the secondary market. These securitized pools
consist of alternative mortgages or non-traditional mortgage products. Some industry representatives refer to
these products as “subprime” while others define the term “subprime” to mean a specific category within the
class of mortgage products identified as alternative or non-traditional loans. These loan products would not
have historically qualified for sale to FNMA or FHLMC and still cannot be securitized into mortgage pools
guaranteed by GNMA.

Beginning in the early 2000’s, FNMA and FHLMC lowered their standards to include alternative mortgages or
non-traditional loan products in portfolios owned, participated in, or securitized by each of these government
enterprises. This expanded secondary market facilitated much of the growth in alternative mortgages or non-
traditional loan products made to residential borrowers that otherwise would be unable to qualify to purchase or
refinance their homes. This opened the door for conventional lenders, who traditionally ignored these
borrowers, to make and deliver alternative mortgage or non-traditional loan products to FNMA and FHLMC, as
well as directly to investment bankers for securitization through Wall Street.

In response to the major increase in the use of exotic alternative mortgages or non-traditional loan products and
the consumer protection issues that followed, on November 7, 2006, the Fed and its member agencies,
promulgated the “Interagency Guidance on Non-Traditional Mortgage Product Risks.” On June 29, 2007, the
same agencies issued the “Statement on Subprime Mortgage Lending”. These guidelines and standards were
adopted and issued to apply to federally related mortgage loans. The Conference of State Bank Supervisors
(CSBS) and the American Association of Residential Mortgage Regulators (AARMR) also adopted these
documents to guide state supervised lenders and mortgage brokers (MLBs).

These documents established risk management practices, consumer protection principles, and control systems
for lenders and brokers when offering or advertising alternative mortgage and non-traditional loan products.
The purpose was to address the particular risks associated with ARMs, stated income, limited documentation
and other loan products where the borrowers typically received a low credit score, as defined. The objective
was to control borrower payment shock, and limit the use of prepayment penalties and other material loan terms
that were anti-consumer. An additional objective wass to ensure that borrowers received full and complete
disclosures of all material loan terms.

It is noteworthy that following the publication of the guidelines and standards referred to above, the secondary
market for alternative mortgages or non-traditional loan products established by Wall Street froze and, within a
short period, became largely inactive. By mid to late summer 2007, delivery systems for alternative mortgages
or non-traditional loan products became largely inoperative and the secondary market for these products almost
entirely shut down. As of this writing, approximately 390 lenders originating these products have exited the
mortgage industry.

Effective January 1, 2008, California law was amended to require the Commissioners of the Department of
Real Estate (DRE), Department of Corporations (DOC), and of the Department of Financial Institutions (DFI)
to ensure that lenders and brokers were aware of the existence and contents of the 2006 and 2007 federal
guidance and statement referred to above. The Legislature authorized the Commissioners of the DRE, DOC,
and DFI to adopt regulations to ensure compliance by their respective licensees with these federal mandates.
The DRE promulgated regulations in 2008 to require increased disclosure of material loan terms when offering
alternative mortgages and non-traditional loan products and to require specific underwriting guidelines for DRE
licensed lenders when making these loans. The DOC and DFI also adopted regulations in regard to their
licensees.

Private Mortgage Insurance

Private Mortgage Insurance Companies (MICs) provide mortgage insurance for residential conventional
mortgage loans, making these loans more attractive in the secondary mortgage market. Private mortgage
insurance enables residential borrowers to obtain loans with higher loan-to-value ratios and to purchase homes
with smaller down payments. Private mortgage insurance is typically required when loan-to-value ratios exceed
80% in connection with residential mortgage loans. This concept was advanced in the 1960’s with the first firm
to offer such coverage being Mortgage Guaranty Insurance Corporation (MGIC).

Private mortgage insurance reduces the monetary risk of loss to originating lenders and to subsequent investors.
MICs have underwriting standards that conventional lenders must meet to qualify for the insurance coverage.
MIC insured loans are typically more saleable in the secondary market.

California and the Mortgage Market

The following characteristics make California attractive to suppliers of mortgage money from foreign and
domestic investors:

1. High demand for mortgage money;

2. A large, and usually growing, population;

3. Traditionally wide diversification of industry;

4. Historically high employment and prosperity;

5. Large depository institutions maintaining facilities or branches in California;

6. Experienced and highly efficient mortgage loan correspondents (mortgage bankers);

7. Common usage of title insurance companies and public escrows rather than settlements;

8. Predominant use of trust deeds with power of sale rather than mortgages with or without power of sale
as security instruments;

9. The existence of licensed mortgage brokers that package mortgages for funding by authorized lenders
and for subsequent sale to investors in the secondary market; and,

10. Numerous qualified and independent fee appraisers licensed or certified by the Office of Real Estate
Appraisers (OREA).