8-6 Legal Considerations - Real Estate Contracts - Financing Basic Appraisal Principles

Other Sources of Funds

Pension Funds and Insurance Companies Pension funds and insurance companies have recently had such growth that they have been looking for new outlets for their investments. They manage huge sums of money, and traditionally have invested in ultra-conservative instruments, such as government bonds. However, the booming economy of the 1990s, and corresponding budget surpluses for the federal government, left a shortage of treasury securities for these companies to buy. They had to find other secure investments, such as mortgages, to invest their assets. The higher yields available with Mortgage Backed Securities were also a plus. The typical mortgage- backed security will carry an interest rate of 1.00% or more above a government security.

Pension funds and insurance companies will also provide direct funding for larger commercial and development loans, but will rarely loan for individual home mortgages. Pension funds are regulated by the Employee Retirement Income Security Act (1974).

Secondary Mortgage Market

The secondary mortgage market buys and sells mortgages created in the primary mortgage market (the link to Wall Street). A valid mortgage is always assignable by the mortgagee, allowing assignment or sale of the rights in the mortgage to another. The mortgage company can sell the loan, the servicing, or both. If just the loan is sold without the servicing, the original lender will continue to collect payments, and the borrower will never know the loan was sold. If the lender sells the servicing, the company collecting the payments will change, but the terms of the loan will stay the same. Such sale does not in any way affect the borrower’s rights or obligations. Loans and/or servicing are usually sold in large pools. The secondary market insures there are funds available in markets that have low savings rates and high demand for housing. If a local primary lender lacks funds to satisfy local demand, the lender sells notes on the secondary market to raise funds available for local lending. Conversely, if a local lender has funds that are not in demand locally, the lender could buy promissory notes or securities offered in the secondary market from capital-poor areas. Government Sponsored Entities (GSE’s)

The total dollar value of the secondary mortgage market now exceeds the total dollar value of the government- issued Treasury Bills, Notes, and Bonds.

Mortgages and Mortgage Backed Securities (MBS’s) may be purchased and sold by and between lending institutions, or may be sold by the lending institutions to three Government Sponsored Entities (GSE’s) that provide a market for this purpose. The GSE’s are

1. Fannie Mae (formerly Federal National Mortgage Association (FNMA))

2. Freddie Mac (formerly Federal Home Loan Mortgage Corporation (FHLMC))

3. Ginnie Mae (aka Government National Mortgage Association (GNMA)) Basic Appraisal Principles Legal Considerations - Real Estate Contracts - Financing 8-7

Fannie Mae Fannie Mae was created in 1938 as a corporation completely owned by the federal government to provide a secondary market for residential mortgages and to stabilize mortgage markets.

They bought “packages” of loans (originally FHA, later VA, and now any kind) from local lenders who needed funds and sold the mortgages to investors with plentiful funds. An Act of Congress in 1968 transformed Fannie Mae into a “private corporation with a public purpose,” a profit-making organization that is listed on the New York Stock Exchange. As a private corporation it may also purchase conventional mortgages, currently a major portion of its business.

Fannie Mae buys mortgages regularly from all primary lending institutions. They sell interest-bearing securities (backed by specific pools of mortgages it holds) to investors.

8.6 Fannie Mae is the single largest holder of home mortgages. Fannie Mae does not make loans directly to borrowers. They purchase loans from mortgage companies or mortgage bankers. Because of their size, the underwriting guidelines established by Fannie Mae are generally adopted as the industry standard. These guidelines are constantly changing, so make sure to check with efanniemae.com for the current requirements.

Some of the more common standards are as follows:

Loan Size: Fannie Mae sets the maximum loan size they will purchase. The current loan limit is $417,000 for single- family homes. Loans larger than this limit are referred to as ‘Jumbo Loans”. The limits are increased in high -cost areas, such as California and Hawaii, and for multi-unit properties.

Fannie Mae Loan Limits (2006):

Number of Units Standard Areas High Cost Areas 1 $417,000 $625,500 2 $553,850 $800,775 3 $645,300 $967,950 4 $801,950 $1,202,925

Loan to Value (LTV) and Combined Loan to Value (CLTV) limits: Minimum down payment and loan to value limits are also set by Fannie Mae. LTV and CLTV are based on either the sales price or appraised value, whichever is lower. Loans for more than 80% of the purchase price require mortgage insurance.

Additional costs for investment properties: Rates and/or fees for investment or non- owner occupied homes are higher.

Mortgage loans are underwritten based on a number of considerations include:

1. Minimum income requirements: The borrower’s income must be sufficient to pay the housing expense, along with their other monthly obligations.

2. Credit Quality: Fannie Mae will use both the credit score and the debt obligations to judge the creditworthiness of a borrower. Other factors used include previous 8-8 Legal Considerations - Real Estate Contracts - Financing Basic Appraisal Principles

bankruptcies, judgments, collections, and pending lawsuits.

3. Source of Funds: Most borrowers need to provide all or part of their down payment from their own funds. Gifts, sale of assets, and other loans are considered.

4. Market Value: Fannie Mae uses an appraisal to establish the market value of the property. The appraisal will also note deficiencies in the property and whether it meets the minimum standards required by Fannie Mae . Fannie Mae is the largest purchaser of conventional loans. When a lender refers to a ‘conventional’ mortgage, they are talking about loans that will be, or are eligible to be, sold to Fannie Mae. However, there are many conventional mortgage that are not eligible to be purchased by anyone and the lender must keep them in their portfolio.

Freddie Mac Freddie Mac was created by Congress in 1970, primarily to establish a reliable secondary market for the sale of conventional mortgages by and for Savings & Loans.

Freddie Mac sells mortgage-participation certificates (PCs) and guaranteed-mortgage certificates (GMCs).

PCs and GMCs are securities that represent an undivided interest in specific pools of mortgages. Freddie Mac guarantees payment of principal and interest to purchasers.

Freddie Mac adopts most of the underwriting requirements and loan limits established by Fannie Mae. There are some minor differences that may be beneficial for some buyers, so make sure to check with your mortgage professional for current Freddie Mac guidelines.

Freddie Mac will also purchase loans from Banks, Savings and Loans, and Mortgage Companies.

Ginnie Mae

Ginnie Mae (aka Government National Mortgage Association (GNMA))

Ginnie Mae was created in 1968 when Fannie Mae was converted to a private corporation. It is an agency of the Department of Housing and Urban Development (HUD). This agency purchases only government- backed or insured loans (VA and FHA).

Mortgage Backed Securities (MBS) Many commercial banks, brokerage houses, and large mortgage companies issue their own securities, backed by mortgages, which are sold on the secondary market. These securities provide funds for mortgages that may not meet the underwriting guidelines imposed by Fannie Mae and Freddie Mac. As the lending industry became more competitive, lenders realized there were many financially viable and secure loans that did not fit the parameters set by Fannie Mae. Mortgage Companies wanted to increase their market share, and their subsequent profits, so they devised mortgage instruments to fill various niches. These include, but are not limited to: Basic Appraisal Principles Legal Considerations - Real Estate Contracts - Financing 8-9

--Loan Size: The increase in home values across the country has made many homes too expensive for FNMA financing. These loans are called jumbo loans. Most jumbo loans meet the same credit and income guidelines that have been established by FNMA.

--Alternative Income Guidelines: Many borrowers may not have verifiable income. Often, with good credit and down payment, lenders will provide loans without proving income. These may be stated income loans, where the borrowers state their employment and income, no- ratio loans where the job is listed without any reference to income, or no- doc loans, where there is no mention of employment or income. These are referred to as ‘Alt A’ loans, ‘limited doc’ loans, or ‘no doc’ loans.

8.5 --Lower Credit Standards: Some lenders will provide high risk loans to customers who have poor credit or no credit. These loans carry a higher interest rate, usually based on the degree of bad credit. The interest rate increases as the quality of the credit decreases. These loans are referred to as non-conforming loans, sub-prime loans, or B & C loans.

--Unique Properties: Many properties are ineligible for FNMA financing because they are unique. These include vacation condominiums that don’t meet FNMA guidelines (called non-warrantable condominiums), gentleman farms, mixed used properties, acreages, etc.

Mortgage backed securities are sold in the secondary market to various investors; these include pension funds, insurance companies, banks, foreign governments, and individual investors. The issuer will include warrants (guarantees) regarding the loan quality and credit standards of the particular security. These may include, but are not limited to, minimum credit scores, maximum loan size, property type, etc. All loans in an individual pool must meet the minimum standards warranted by the issuer. For this reason, many of these loan programs have unique underwriting standards that cannot be waived because of the warranties provided with the pool.

The interest rates offered on these securities will vary, based on the credit quality of the loans pledged as collateral for the security. Filling the pool with loans made to borrowers with low credit scores or questionable income sources will have a higher risk of default, thus a higher interest rate. This goes back to the risk vs. reward on investment decisions previously discussed.

CLASSIFICATION OF LOANS According to Method of Payment The Fixed Rate Loan

This is the most common real estate financing vehicle. This loan will have a fixed interest rate and fixed payments for the entire term of the loan. The payments are usually collected monthly, but they can be collected bi-weekly, quarterly, or yearly. The payments include both principal and interest. By making equal payments over a period of time, the amount owed (principal) is eventually paid off. This is considered a budget loan because the borrower is never faced with one big payment due.