REAL ESTATE FINANCE 10th Edition

J. Keith Baker and John P. Wiedemer

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Chapter 3

Mortgage Money: Regulated Lenders

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LEARNING OBJECTIVES

At the conclusion of this chapter, students will be able to:

• Describe the mortgage credit market and its common sources of funding.

• Differentiate between the primary and secondary mortgage markets.

• Identify the roles of the various regulated mortgage lenders and their sources of funding.

• Explain the differences between mortgage lenders funded by FDIC-insured deposits and those not funded by insured deposits.

• Understand the role of the federal regulation commonalities and the evolution of government policies encouraging home ownership and consumer protection.

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Introduction

• Most of the money that funds mortgages comes from private sources.

• There is a common misconception that most funding for mortgages came from the federal government.

• The federal government direct-loan programs are mostly directed toward farmers.

• Most states and some cities have housing agencies that offer direct loans and subsidy assistance primarily for low-income home buyers.

• Federal government agencies offer loan guarantees rather than money.

• The federal underwriting agencies charge fees for their guarantees with the expectation of making a profit and not burdening taxpayers.

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The Mortgage Credit Market

• In the credit market, the demand for mortgage money competes with all other demands for borrowed funds.

• The mortgage share of this market normally commands 20% to 25% of the total credit available each year.

• Total mortgage debt outstanding at the end of the 3rd quarter of 2014 totaled over $13,360 billion, the second largest single class of debt in this country.

• Only the total U.S. federal debt exceeds this demand for credit.

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Analysis of Mortgage Debt

• The term mortgage debt includes all kinds of loans secured by mortgages and all types of lenders handling these loans.

• Mortgage debt includes long-term residential, short-term construction loans, and warehouse lines of credit used by mortgage companies.

• Residential loans dominate the market with more than three-fourths of the total

debt outstanding.

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Analysis of Loan Sources

• We must distinguish between those making mortgage loans and those holding mortgage loans.

• Loan originators make the loans.

• Some originators hold these loans in portfolio.

• From 2000 to 2008, most sold their loans to secondary market investors who hold them.

• Now the major source for residential loans has shifted from mortgage pools, which serve as collateral for the issuance of mortgage-backed securities.

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The Mortgage Money Market

• The market for mortgage money functions at two separate levels: - the loan origination market, called the primary

market.- the secondary market, consisting of investors who

buy mortgages.

• For the borrower the source of funds is the primary market, where many lending companies compete for business.

• The secondary market is where loan originators sell their loans, thus recovering cash to originate more loans.

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The Primary Market• The loan primary market is composed of borrowers

and lenders.

• Negotiation involves a discussion of the interest rate and discount.

• The requirements for loan qualification depend on who the lender is and whether or not the loan will be sold to secondary-market investors.

• Regulated lenders must adhere to the rules of their regulatory authority.

• Unregulated lenders are not as restricted.

• If a loan is intended for sale rather than to be held by the lender as its own investment (held “in portfolio”), the loan must meet the secondary-market purchaser’s requirements.

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Regulated Lenders• Regulated lenders are subject to government regulatory

agencies.

• About 75% of residential loans came from regulated lenders.

• Most regulated lenders retain the loan servicing function.

• The four major classes of regulated lenders are:(1) savings institutions (2) commercial banks (3) credit unions (4) life insurance companies

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Savings Institutions

• Include both savings associations and (mutual) savings banks, both referred to as thrifts.

• Initially limited to holding only time deposits.

• A time deposit is one that does not permit withdrawal on demand, but instead usually requires a waiting period of 14 to 30 days.

• This includes savings certificates and certificates of deposit as well as all passbook savings accounts.

• This access to more stable time deposits has provided justification for the practice of savings institutions making long-term mortgage loans.

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Savings Associations

• The original purpose of savings associations was to provide a source of money for home loans.

• The Federal Home Loan Bank Board required all federal charters to keep at least 80 percent of their deposit assets in residential loans.

• In 1980 Congress passed the Depository Institutions Deregulation and Monetary Control Act. No longer were savings associations committed to making mostly residential loans.

• In 1989 the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) overhauled banking practices with the primary goal of restructuring the savings and loan association system.

• In 1996 Congress passed legislation that set the stage for elimination of savings institutions, which would be re-chartered as banks.

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Savings Association Regulatory Authorities

Office of Thrift Supervision (OTS)

• The OTS was merged with the OCC, FDIC, and CFPB in July 2011 into the Office of the Comptroller of Currency. It ceased to exist on October 19, 2011.

• Its authority extended to both federal- and state-chartered institutions that carried federal deposit insurance.

Federal Housing Finance Board (FHFB)

• The new Federal Housing Finance Board was assigned as overseer of mortgage lending for the 12 regional Federal Home Loan Banks.

• In addition, the FHFB is responsible for handling statistical data for the housing industry.

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Federal Deposit Insurance Corporation (FDIC)

• The FDIC has authority to manage both the bank deposit insurance fund and the savings association insurance fund.

• In 2008 the basic limit on federal deposit insurance coverage was raised from $100,000 to $250,000 per depositor.

• In 2010 the coverage became unlimited for noninterest-bearing accounts until the end of 2012.

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Federal Deposit Insurance Corporation (FDIC)(continued)

• This temporary unlimited coverage is separate from the coverage of at least $250,000 available under FDIC’s general deposit insurance rules.

• “Noninterest-bearing transaction account” includes a checking account or demand deposit account on which no interest is paid.

• It does not include checking or demand deposit accounts that may earn interest, NOW accounts, and money-market deposit accounts.

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Resolution Trust Corporation (RTC)

• The RTC filled an important role in handling the liquidation of failed savings associations in the late 1980s and into the mid 1990s.

• RTC was given authority to take the necessary steps to sell or liquidate failing thrifts.

• The remaining problems of this agency were transferred to the FDIC in July 1995, and the RTC was dissolved.

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Savings Banks

• Originated during the early years of the U.S. when most people traded in cash and needed a place to deposit their surplus for safekeeping.

• Savings banks operated with good success in the northeastern part of the country.

• Many savings banks favored FHA and VA loans.

• The 1980 Depository Institutions Deregulation Act altered the way the banking system could serve the public.

• The result was that savings banks could offer services very similar to those of commercial banks.

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Commercial Banks

• Originally served the business community and government.

• They provided checking accounts and transfers of money.

• States chartered their own banks and, prior to the Civil War, granted commercial banks the authority to issue their own currency.

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Commercial Banks(continued)

• In 1913 nationally chartered banks were brought under the Fed.

• The regulatory authority over commercial banks is a separate system from those regulating savings associations and is also a dual system, with both federal and state governments issuing charters and regs.

• FIRREA placed all depository institutions that carry federal deposit insurance under federal regulation.

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Limits on Real Estate Loans

• There is no ceiling on one- to four-family loans except that loans over 80% of the market value must have private mortgage insurance.

• Certain loans are exempt from limits, such as those guaranteed by the federal government; problem loans that must be renewed, refinanced, or restructured; and loans to facilitate the sale of foreclosed properties.

• Other limits are:Loan Category Loan-to-ValueImproved property

85%One to four family construction 85%Nonresidential construction 80%Land development

75%Raw land

65%

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Investment Policies

• Banks’ lending policies favor short-term loans for business purposes.

• Banks have not been very active in the long-term home loan market.

• Some make mortgage loans through subsidiary mortgage companies.

• A commercial bank’s deposits are demand-type (checking accounts) and banks are limited in allowing such money to fund long-term loans.

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Investment Policies(continued)

• This is changing through the ability of banks to originate long-term residential loans and then fund them through the sale of securities.

• Shorter-term mortgage loans are more suited to commercial banks, as are lines of credit for mortgage companies and construction loans.

• Banks may handle some medium-term mortgage loans as needed by their business customers.

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Investment Policies

The four kinds of lending activities that can be found in a commercial bank’s mortgage operations are as follows.

Direct loans. 10-to-15-year loans for good commercial customers.

Construction loans. Shorter-term, two- to three-year construction loans.

Warehouse lines of credit. A short-term revolving line of credit secured by recently closed residential loans that allows mortgage bankers to fund loans in their own names.

Loan origination. Banks can initially fund these loans with their own deposit assets and then sell them to secondary-market investors.

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Regulation of Commercial Banks

• Banks can be chartered by states or the federal government.

• National charters must belong to the FDIC.

• State-chartered banks may join the FDIC system if they qualify and accept federal regulations.

• Banks are also under the jurisdiction of the Federal Reserve.

• The Federal Reserve is responsible for setting reserve requirements for all depository institutions.

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Credit Unions

• Credit unions may be chartered by any group of people who can show a common bond.

• The bond has generally been that of a labor union, a company’s employees, or a trade association.

• However, a recent interpretation of this rule allowed the American Association of Retired Persons (AARP), which has some 37 million members, to form a credit union.

• Credit unions pay no income taxes since they are classed as nonprofit organizations.

• The larger unions do make long-term mortgage loans.

• These institutions have expanded the services to include safe deposit boxes, credit cards, and money market accounts.

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Regulation of Credit Unions

• Credit unions can be either state or federally chartered.

• The National Credit Union Administration (NCUA) charters, regulates, and supervises federal credit unions.

• State charters adhere to their own state rules and laws.

• The federally chartered National Credit Union Share Insurance Fund covers deposits up to $250,000.

• Federal charters must offer this coverage and state charters that qualify are eligible to join.

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Reserve Requirements for Depository Institutions

• Depository institutions are required to hold a certain percentage of their deposits in reserve.

• State-chartered institutions followed state laws governing reserve requirements, and national charters adhered to federal requirements.

• These regulations often differed on amount and if interest was allowed.

• The Fed could alter reserve requirements for its own member banks, but not for nonmember state charters.

• Consequently, the application of reserve requirements was not uniform.

• Members of the Fed can borrow from the Fed at the discount rate.

• But the money cannot be used for ordinary lending purposes. • Many exceptions to this last guideline have been made

during the recent financial crisis.

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Deposit Insurance

• Savings associations, savings banks, commercial banks, and credit unions are all classed as depository institutions.

• Governments treat this activity as a special kind of trust.

• The Great Depression of the 1930s destroyed depositor confidence.

• To restore trust the federal government created a deposit insurance system.

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Deposit Insurance(continued)

• In 1934 Congress established the FDIC to insure deposits in banks.

• At the same time, Congress established the FSLIC to insure deposits in savings associations.

• Later the National Credit Union Share Insurance Fund was set up to insure credit union deposits.

• Life insurance companies are not considered depository institutions and are not federally insured.

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Reorganization of Deposit Insurance Funds

• In 1989 a new Deposit Insurance Fund (DIF) was created.

• Under the DIF there are two separate insurance funds.

• The Savings Association Insurance Fund (SAIF) replaced FSLIC.

• The Bank Insurance Fund (BIF) is the old FDIC fund under a new name.

• In 1994 Congress prohibited the FDIC from reimbursing depositors for accounts in excess of the $100,000 limit.

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Reorganization of Deposit Insurance Funds(continued)

• In 2008 the limit was temporarily raised to $250,000 per depositor.

• In 2010 the Dodd-Frank Act permanently raised the limit to $250,000.

• Congress merged BIF and SAIF, retaining the FDIC as administrator.

• In addition, savings associations are re-chartered as banks.

• This provision simplified some of the regulatory confusion.

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COMMUNITY REINVESTMENT ACT (CRA)

• Ensures depository institutions serve the needs of their communities.

• The act requires that each institution undertake four procedures:

1. Define the lender’s community.

2. List types of credit offered.

3. Post public notice and public comments.

4. Report on efforts to meet community needs.

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CRA Amended by FIRREA

• FIRREA amended the CRA, sharpening the performance ratings for regulated institutions and requiring public disclosure of what each is doing to meet local needs.

• Also amended the Home Mortgage Disclosure Act, expanding reporting requirements to include all mortgage lenders, regulated and unregulated.

• The purpose is to encourage greater participation in buyer assistance programs through increased publicity of lenders’ performance.

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CRA Grading of Regulated Lenders

CRA ratings be made public, evaluating how well the entity:1. Knows the credit needs of its community.2. Involves its board of directors in CRA programs.3. Informs the community about its credit services.4. Offers residential mortgages, housing rehab, and

small business loans5. Participates in government insured/guaranteed/

subsidized loans.6. Distributes credit apps, approvals, and rejections

across geographic areas.7. Avoids discrimination in its lending practices.

The CRA grading consists of four categories: 8. Outstanding 9. Satisfactory10.Needs to improve 11.Substandard compliance

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Additional Federal Regulation of Home Mortgage Lending

• The Home Mortgage Disclosure Act requires financial institutions to disclose the number and dollar amount of loans by geographic area.

• The 1992 Federal Housing Enterprises, Financial Safety, and Soundness Act requires federal secondary-market agencies to purchase at least 30% of their mortgages in central city areas.

• The Housing and Economic Recovery Act, or “HERA,” enacted in July 2008, authorized the FHA to guarantee up to $300 billion in new 30-year fixed-rate mortgages for subprime borrowers if lenders write-down principal loan balances to 90% of current appraisal value.

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Additional Federal Regulation of Home Mortgage Lending (continued)

• It also gave states the authority to refinance subprime loans using mortgage revenue bonds.

• HERA was passed with the intention of restoring confidence in Fannie Mae and Freddie Mac, but it did not achieve this aim.

• Fannie Mae and Freddie Mac were put into conservatorship.

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Wall Street Reform and Consumer Protection Act of 2010

• In 2010, Congress passed the Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).

• It made changes in all federal regulatory agencies and every segment of the financial service industry.

• Before 2010, many consumer protection and mortgage banking regulations were enforced and monitored by several different agencies.

• Dodd-Frank transferred rulemaking authority to a new independent bureau, the Consumer Financial Protection Bureau.

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Wall Street Reform and Consumer Protection Act of 2010 (continued)

Dodd-Frank was passed to address several objectives:

1. Regulatory gaps—grants power to a single regulator.

2. Structural concerns—deals with additional structural issues.

3. Liquidity issues—focuses on liquidity concerns caused by leverage used by firms and concern over regulation of nonbank activities.

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Wall Street Reform and Consumer Protection Act of 2010 (continued)

4. Establish the CFPB and make it responsible for:a. Conducting rule-making, supervision, and enforcement

for Federal consumer financial protection laws.b. Restricting unfair, deceptive, or abusive practices.c. Taking consumer complaints.d. Promoting financial education.e. Researching consumer behavior.f. Monitoring financial markets for new risks.g. Enforcing laws that outlaw discrimination and unfair

treatment.

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Life Insurance Companies

• Not considered depository institutions but are fully regulated by the various states that charter them.

• The cash that life insurance companies hold are not subject to demand withdrawal so life insurance companies have long favored the long-term nature of mortgage loans as investments.

• At one time, life insurance companies and savings associations held equal total investments in mortgage loans.

• But life insurance companies were not chartered for the purpose of providing mortgage money.

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Investment Policies• Although insurance companies invest most of their reserves

in high-grade securities, they also make mortgage loans. • Larger companies have confined their real estate activity to

large commercial ventures in which they acquire a participating interest.

• Smaller companies look upon individual home loans as good business and a way to make contacts for the sale of life insurance.

• This kind of loan is held in the insurance company’s own portfolio.

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Regulation of Life Insurance Companies

• All insurance companies are chartered and operate under state regulatory authorities.

• State regulations usually set limits on the types of investment; the percentage of total portfolio that may be kept in stock, bonds, or mortgage loans; and the amount of liquidity that must be maintained.

• Most states establish limits on the maximum amount of any one loan or for any one property.

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Questions for Discussion

1. How would you define the term primary mortgage market?

2. Identify the classes of regulated lenders.

3. How does the government intend to simplify the banking system?

4. What is the present status of federal deposit insurance?

5. Explain why the Federal Reserve Bank places reserve requirements on depository institutions.

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Questions for Discussion (continued)

6. In what way has the Community Reinvestment Act affected the operation of regulated institutions?

7. What is the general policy of life insurance companies toward mortgage lending?

8. Identify the basic responsibility of each of the following four banking regulators: the Federal Reserve Bank Board, the Comptroller of the Currency, Consumer Financial Protection Bureau, and the Federal Deposit Insurance Corporation.

9. What advantages do credit unions have that banks consider unfair?

10. Identify at least two kinds of shorter-term mortgage loans made by commercial banks.