Chapter 3 Sources of Funds: The Primary Market

I. Traditional Direct Lenders The market for real estate loans dates back to the establishment of the original building and loan societies in the 1830s. The modern market did not begin until the great depression a hundred years later. This encouraged the traditional banks and savings and loans to expand their real estate activities. The forces of disintermediation created by constantly changing economic conditions made it difficult for traditional lending institutions to maintain the stable interest rates that had formerly prevailed. The forces of disintermediation created by constantly changing economic conditions made it difficult for traditional lending institutions to maintain the stable interest rates that had formerly prevailed. They lobbied for deregulation so that they could compete with other forces in the marketplace and were successful.

A. SAVINGS AND LOANS The savings and loan associations (S&Ls) were the oldest and largest source of funds for financing residential property. Between 1945 and the late 1970s, the S&Ls expanded their mortgage loan operations aggressively. However, the surge in interest rates in the late 1970s and early 1980s turned the tables on this strategy. The result was that they lost a large portion of their deposits to competing investments. MONEY MARKET FUNDS To make matters worse, the S&Ls found themselves holding long- term, non-liquid mortgages at low rates of interest. These loans could not be liquidated into the secondary market and had to be held in portfolio. PORTFOLIO LOAN

(cont.) The S&Ls attacked the problem by asking for deregulation to compete in the money market funds. This was a green light to pour money into the most risky investments. The result was a rapid increase in the rate of failure of savings and loans. By late 1986 and early 1987, the problem had reached such epic proportions that it attracted the attention of the U.S. Congress, who held hearings to determine how to rescue the nation’s financial system. The result of these hearings was The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA).

1. Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) governs all federally related transactions. FIRREA would do more than just address the savings and loans problems. It would affect every institution and every person who deals in a federally related transaction as well as protecting the federal deposit insurance funds. FIRREA would do more than just address the savings and loans problems. It would affect every institution and every person who deals in a federally related transaction as well as protecting the federal deposit insurance funds. A FEDERALLY RELATED TRANSACTION is any transaction in which the federal government is involved. FIRREA protects the federal deposit insurance funds. The FDIC increased its deposit insurance ceiling from $100,000 to $250,000 in 2008.

B. COMMERCIAL BANKS Commercial banks remain the largest source of investment funds in the country today. As their name implies, COMMERCIAL BANKS are oriented towards commercial lending activities, supplying capital for business ventures and construction activities on a comparatively short- term basis. Until relatively recently, residential mortgages were not a major part of their business, primarily because of government limitations on the amount of long-term investments they could make. Changes in government banking regulations have also spurred commercial banks to engage in more mortgage lending activity.

C. CREDIT UNIONS CREDIT UNIONS were set up in 1970 as membership associations made up of employees who worked for individual institutions with a common association of interest. These members invested savings and could then borrow against the membership funds to finance purchases of goods and services. The deregulation of the banking industry provided a growth opportunity for credit unions to enter the field of mortgage lending. While credit unions have definitely entered the field of mortgage lending, at this time their overall share of the market remains small. While credit unions have definitely entered the field of mortgage lending, at this time their overall share of the market remains small.

II. Indirect Lenders

A. PENSION FUNDS About 50% of American workers have personal or union pension plans. About 50% of American workers have personal or union pension plans. A PENSION FUND is a fund set up by a corporation, labor union, government entity, or other organization to pay the pension benefits of retired workers. With the enactment of the Employee Retirement Income Security Act of 1974 (ERISA), all such plans became relatively well managed and safe. Traditionally, pension funds have participated in the market place in two areas. The first of these is by direct investment in commercial real estate development. The second of these are pension funds invested in the bond issues of the secondary market.

B. INSURANCE COMPANIES INSURANCE COMPANIES control vast amounts of capital, in the form of insurance premiums, which are held for relatively long terms. Money invested in insurance policies is generally not subject to early or sudden withdrawal and does not earn the high interest returns that are now common in other investment forms. For these reasons, insurance companies are able to safely invest large sums of money in long-term real estate loans. For many years, insurance companies have been major players in the secondary market through the purchase of bonds issued against mortgages issued by FHLMC, Fannie Mae, and others.

III. The Role of the Correspondent

A. MORTGAGE BROKERS MORTGAGE BROKERS are financial “go-betweens” or coordinators. He is a knowledgeable real estate and loan professional who handles the origination of a loan with the consumer. The broker then “shops” the loan with a variety of primary mortgage lenders who have programs that the borrower will qualify for. A mortgage broker finds you the loan, the mortgage bank or financial institution lends you the money

B. MORTGAGE BANKER/ MORTGAGE COMPANIES Mortgager bankers, or mortgage companies, also act in the role of intermediaries in the lending of capital. MORTGAGE BANKERS/MORTGAGE COMPANIES can both originate and loan funds. They are often local in nature, and receive lending funds from large national investors, such as insurance companies and pension plans. The mortgage bankers do not keep portfolio loans. They will sell their loans into the secondary market as soon as they have “seasoned.” A SEASONED LOAN is one that has been held for a sufficient time to establish that the borrower is making their payments in a timely manner, often 6-12 months. A SEASONED LOAN is one that has been held for a sufficient time to establish that the borrower is making their payments in a timely manner, often 6-12 months.

IV. The Role of the Private Investor

A. REAL ESTATE INVESTMENT TRUST (REITs) A REAL ESTATE INVESTMENT TRUST (REIT) is an unincorporated association of real estate investors managed by a trustee. In 1960, by means of the Real Estate Investment Trust Act, Congress made it possible for investors to enjoy the flow-through tax advantages of a partnership, while retaining some of the more important qualities of a corporate operation. There are several requirements for a REIT: 1. It cannot hold property primarily for sale to customers. 2. It must have at least 100 beneficial owners. 3. No five persons or less can hold over 50% of the beneficial interest. 4. It must issue shares or certificates of interest. 5. Each share must have a proportionate vote in trust policy decisions % of its gross income must be from investments % of its income must be from real estate investments.

B. PRIVATE INDIVIDUALS Private individuals have always been a force in the world of real estate finance. The majority of these individuals are sellers who extend credit to their purchasers. This is referred to as “taking back” or “carrying back” a part of the sales price, often in the form of a second mortgage. A SECOND MORTGAGE is often a source of funds when a lender will not loan the full amount of the purchase price of a residence. Private financing becomes much more prevalent when funds from traditional lenders are scarce, too expensive, or both.

C. THE INTERNET Over the past ten years the use of both home computers and of the Internet has become available to virtually every American household. This fact has not been lost on primary lenders, who have rushed to adopt this new technology and adapt it to their purposes. The greatest effect of the Internet has been on how fast transactions can take place. Consumers use the Internet to view properties and shop for loan rates, however, many of these consumers, when they wish to obtain a loan, prefer to use their local loan broker or lender rather than some “faceless” national Internet company. The adoption of computerization and the Internet has both lowered consumer costs and increased productivity throughout the industry. The adoption of computerization and the Internet has both lowered consumer costs and increased productivity throughout the industry.

1. Online Loan Applications – A Good Start Like many aspects of the loan industry, the application process can be started online. It has been the author’s experience that most loans cannot be fully completed through the Internet. It usually takes at least one face-to-face meeting, as well as other correspondence, to complete the process. Don’t assume that loans generated online will be at the lowest net cost to the consumer. The Internet is a good starting point for the shopping around process, but other avenues should explored to find the best deal.

V. CHAPTER SUMMARY The primary market is mostly made up of local banks, savings banks, and mortgage companies. Banking deregulation had an adverse effect on the S&Ls and permitted other lenders to take over part of their market share. This same deregulation has allowed other institutions, such as credit unions, insurance companies, and pension plans to enter the primary market. Real Estate Investment Trusts allow ordinary individual investors to invest in real estate loans and provide a tax advantage for their investments. Loans by private individuals have always been a part of the primary mortgage loan market. These loans are primarily in the form of second trust mortgages. The Internet has helped to shorten the length of the loan process, reduce consumer expense, and increase industry productivity. The Internet has helped to shorten the length of the loan process, reduce consumer expense, and increase industry productivity.