chapter 7 financing correspondence course information

Chapter 7 Financing AlaskaRealEstateSchool.com

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Chapter 7 Financing

Correspondence Course Information

Please read and become familiar with this information prior to the class date. This part of the class will be taken correspondence. You will be required to take a test on this information and the test must be returned prior to taking the classroom portion of the course. The remainder of the class may be taken in the classroom or by correspondence. If you have registered for the correspondence course, the test as well as the evaluation sheet must returned for grading and issuance of you graduation certificate. You may take the tests all at once or one chapter at a time. The test may be taken open book and the answer sheet must be sent back to: Email to [email protected] Or Fax to 866-659-8458 Or Mail to: AlaskaRealEstateSchool.com Attn: Denny Wood PO Box 241727 Anchorage, Alaska 99524-1727



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Mortgages and Foreclosures Basics

A mortgage is a transfer of an interest in real estate as security for the repayment of a loan. A typical mortgage transaction involves a home purchaser borrowing money from a lender and entering into a written agreement with the lender, so that the real estate is collateral for the loan. If the homeowner defaults on the loan, the lender is entitled to foreclose on the real estate and have it sold to reduce the debt. Depending on the terms of the agreement, the lender may then be entitled to pursue the homeowner for payment of any deficiency between the real estate sale proceeds and the debt owed.

The Mortgage Loan Process

A borrower (or mortgagor) obtains a mortgage loan through a process of application and commitment. The borrower initiates the process by submitting an application to the lender (or mortgagee) and in some cases paying a nonrefundable fee. The lender conducts a risk evaluation to determine whether a mortgage loan will be granted. In the risk analysis, the lender evaluates both the borrower's financial position and the value of the real estate. If the lender determines the risk to be acceptable, the lender will issue a loan commitment detailing the loan amount, repayment terms, interest rate, and other pertinent conditions. Because the commitment will normally contain terms and conditions not found in the loan application, it typically constitutes a counteroffer to make a loan. When the borrower accepts the commitment, a binding contract for a mortgage loan is created.

Residential mortgage loans usually bear interest at a fixed annual percentage rate over a period of fifteen or thirty years. The interest rate is determined by the prevailing market conditions at the time the loan is made. A lender may increase its yield beyond the stated interest rate by requiring the borrower to pay "points" at the time the loan is made. One point equals one percent of the loan amount. It may also be beneficial for the borrower to pay points in order to reduce the interest rate over the term of the loan.

Mortgages: Key Phrases

Adjustable rate mortgages (ARMs) are also common. Under an ARM, the interest rate rises and falls over the term of the loan in accordance with prevailing market conditions. The parties may agree to hedge against extreme interest rate fluctuations by establishing ceiling and floor limits.

A balloon mortgage, less common but not unheard of in the residential mortgage market, exists when a substantial payment is required at the end of the term of the loan to cover the unamortized loan principal.

Default occurs when the mortgagor fails to perform an obligation secured by the mortgage. The most common event of default is the mortgagor's failure to timely pay monthly principal and interest installments. A mortgagor's failure to insure the property or to pay property taxes can also constitute



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an event of default. However, the use of escrow accounts has reduced the frequency with which this type of default occurs. Finally, construction difficulties or physical damage or destruction to the property by the mortgagor, constituting "waste," can also be considered an event of default.

Most mortgages and underlying promissory notes contain an acceleration clause providing that the occurrence of an event of default accelerates the debt, making the entire debt immediately due and payable. Most residential mortgage lenders are required to provide that the mortgagee must give the mortgagor notice of impending acceleration and the opportunity to avoid it by curing the default. In most states, the commencement of a foreclosure proceeding constitutes notice of impending acceleration.

Mortgages also often provide for acceleration in the event the mortgagor transfers any interest in the mortgaged property without the mortgagee's consent. These clauses, referred to as due-on-sale clauses, protect the mortgagee from being forced to do business with persons other than the mortgagor with whom the mortgagee initially contracted. When a mortgagor desires to transfer the mortgaged property, the mortgagee has the option to either accelerate the debt or consent to the transaction conditioned on the grantee's assumption of the mortgage and payment obligation, possibly also with a transfer fee requirement and/or an increased interest rate.

Foreclosure Proceedings

In general, the mortgagor can foreclose on the mortgaged property any time after an event of default. There are two types of foreclosure proceedings: foreclosure by judicial sale and foreclosure by power of sale. Foreclosure by judicial sale is available in all states, and is the required foreclosure method in a number of jurisdictions. A foreclosure by judicial sale is subject to court supervision and is not final until the court confirms the sale. Foreclosure by power of sale serves the same purpose as foreclosure by judicial sale. However, statutes delineating detailed notice and sale procedures replace court supervision. If the foreclosure sale proceeds are insufficient to satisfy the underlying debt, the mortgagee can usually obtain a deficiency judgment against the mortgagor for the deficiency. Likewise, if the foreclosure sale results in a surplus, the mortgagor is usually entitled to seek payment from the mortgagee for the amount of the surplus.

In either type of foreclosure sale, it is important to conduct the foreclosure in accordance with the applicable law so that the mortgagor's redemption rights are curtailed and whoever purchases the property at the foreclosure sale receives clear and unhindered title thereto.



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Mortgage Basics FAQ

Find the best loan option for you, plus tips on how to afford a mortgage and down payment.

Where should I shop for home loans or mortgages?

Many entities, including banks, credit unions, savings and loans, insurance companies, and mortgage bankers make home loans. Lenders and terms change frequently as new companies appear, old ones merge, and market conditions fluctuate. To get the best deal, it's a good idea to compare loans and fees with at least a half a dozen lenders -- or to get the help of an experienced mortgage broker, who can help you sift through the latest offerings.

Because many types of home loans are standardized to comply with rules established by the Federal National Mortgage Association (Fannie Mae) and other quasi-governmental corporations that purchase loans from lenders, comparison shopping is not difficult. However, you'll need to decide what type of mortgage you're interested in first, whether it's a fixed rate, adjustable rate, or one of the many hybrids available now. Once you've narrowed your sights to a particular size, type, and length of mortgage -- such as a 30-year fixed term mortgage for $300,000 -- you'll be ready to compare apples to apples.

Mortgage rates and fees are usually published in the real estate sections of metropolitan newspapers, and on online mortgage websites. It's wise to do some advance research even if you decide to work with a loan broker, so that you'll have a sense of the market. Some loan brokers charge the consumer directly, others collect a fee from the lender (though this ultimately adds a little to what you pay for your mortgage).

Be sure to check out government-subsidized mortgages, which offer both no-down-payment and low-down-payment plans. Also, ask banks and other private lenders about any "first-time buyer" programs that offer low-down-payment plans and flexible qualifying guidelines to low- and moderate-income buyers with good credit.

Finally, don't forget private sources of mortgage money -- parents, other relatives, friends, or even the seller of the house you want to buy. Borrowing money privately is usually the most cost-efficient mortgage of all. And its popularity is increasing as investors turn to real estate as a high-appreciation place to put their money.

What are low down payment options, for buyers who can't afford a 20% down payment?

Assuming you can afford (and qualify for) high monthly mortgage payments and have a high credit score, you should be able to find a low (5% to 15%) down payment loan. However, you may have to pay a higher interest rate and loan fees (points) than someone making a larger down payment.



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Also, if you put down less than 20%, you may have to either pay for private mortgage insurance (PMI) or, to avoid PMI, take out two separate loans (a first mortgage and a second mortgage).

What is private mortgage insurance?

Private mortgage insurance (PMI) policies are designed to reimburse a mortgage lender up to a certain amount if you default on your loan and your house isn't worth enough to entirely repay the lender through a foreclosure sale. Most lenders require PMI on loans where the borrower makes a down payment of less than 20%.

Premiums are usually paid monthly and typically cost around one-half of one percent of the mortgage loan. With the exception of some government and older loans, most lenders allow you to drop PMI once your equity in the house reaches 20-25% and you've made timely mortgage payments.

Can I tap into my IRA or 401(k) plan for down payment money?

Under the 1997 Taxpayer Relief Act, first-time homeowners can withdraw up to $10,000 penalty free from an individual retirement account (IRA) or 401(k) for a down payment to purchase a principal residence (though you might have to pay income tax on the amount withdrawn.) Borrowing against your 401(k) offers several advantages:

You, not a bank, receive the interest payments. The loan fees are usually less than what a bank would charge. The paperwork is less than would be required for a typical bank loan.

This $10,000 is a lifetime limit -- and the money must be used within 120 days of the date you receive it. The law defines a first-time homeowner as someone who hasn't owned a house for the past two years. If a couple is buying a home, both must be first-time homeowners. Ask your tax accountant for more information, or check IRS rules at http://www.irs.gov.

You can also take an ordinary loan from your 401(k) plan. Ask your employer or plan administrator whether your plan allows loans. If it does, the maximum loan amount under the law is one-half of your vested balance in the plan, or $50,000, whichever is less. (If, however, you have less than $20,000 in your plan, your limit is the amount of your vested balance, but no more than $10,000.) Other conditions, including the maximum term, the minimum loan amount, the interest rate, and the applicable loan fees, are set by your employer. Any loan must be repaid in a "reasonable amount of time," although the Tax Code doesn't define what is reasonable.

Be sure to find out what happens if you leave your job before fully repaying a loan from your 401(k) plan. If a loan becomes due immediately on your departure, income tax penalties may apply to the outstanding balance -- but you may be able to avoid this hassle by repaying the loan before you leave the job.



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What kinds of government loans are available to homebuyers?

Several federal, state, and local government financing programs are available to homebuyers. The two main federal programs are:

VA loans. U.S. Department of Veterans Affairs (VA) loans are available to men and women who are now in the military and to veterans with honorable discharges who meet specific eligibility rules, most of which relate to length of service. The VA doesn't make mortgage loans, but guarantees part of the house loan you get from a bank, savings and loan, or other private lender. If you default, the VA pays the lender the amount guaranteed and you in turn will owe the VA. This guarantee makes it easier for veterans to get favorable loan terms with a low down payment. For more information, check the VA's Website at http://www.va.gov or contact a regional VA office for advice.

FHA loans. The Federal Housing Administration (FHA), an agency of the Department of Housing and Urban Development (HUD), insures loans from local lenders made to all U.S. citizens, permanent residents, and noncitizens with work permits who meet financial qualification rules. Under its most popular program, if the buyer defaults and the lender forecloses, the FHA pays 100% of the amount insured. This loan insurance lets qualified people buy affordable houses. The major attraction of an FHA-insured loan is that it requires a low down payment, usually about 3% to 5%. For more information on FHA loan programs, contact a regional office of HUD or check the FHA website at http://www.hud.gov.

For information on other government loans, contact your state and local housing offices. They often have programs available for first-time homebuyers who are purchasing modestly priced properties. To find your state housing office, check the State and Local Government on the Net Directory at http://statelocalgov.net. Or, go to your state's home page, where you may find the listing for your state's housing office.

What's the difference between a fixed and adjustable rate mortgage?

With a fixed rate mortgage, the interest rate and the amount you pay each month remain the same over the entire mortgage term, traditionally 15 or 30 years. A number of variations are available, including five- and seven-year fixed rate loans with balloon payments at the end.

With an adjustable rate mortgage (ARM), the interest rate fluctuates according to the interest rates in the economy. Initial interest rates of ARMs are typically offered at a discounted ("teaser") interest rate that is lower than the rate for fixed rate mortgages. Over time, when initial discounts are filtered out, ARM rates will fluctuate as general interest rates go up and down. Different ARMs are tied to different financial indexes, some of which fluctuate up or down more quickly than others. To avoid constant and drastic changes, ARMs typically regulate (cap) how much and how often the interest rate and/or payments can change in a year and over the life of the loan. A number of variations are available for adjustable rate mortgages, including hybrids that change from a fixed to an adjustable rate after a period of years, or "option ARMs" that allow you to choose, on a monthly basis, whether to pay a



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minimum amount, an interest-only amount, an ordinary principal plus interest amount, or an accelerated payment amount.

Which is better -- a fixed or adjustable rate mortgage?

It depends. Because interest rates and mortgage options change often, your choice of a fixed or adjustable rate mortgage should depend on:

the interest rates and mortgage options available when you're buying a house your view of the future (generally, high inflation will mean ARM rates will go up and lower

inflation means that they will fall) your personal financial and investment goals, and how willing you are to take a risk.

When mortgage rates are low, a fixed rate mortgage is the best bet for many buyers. Over the next five, ten, or thirty years, interest rates are more apt to go up than further down. Even if rates could go a little lower in the short run, an ARM's teaser rate will adjust up soon and you won't gain much if you plan to stay in the house more than a few years (the broker can tell you your break-even point). In the long run, ARMs are likely to go up, meaning many buyers will be best off locking in a favorable fixed rate now and not taking the risk of much higher rates later.

Keep in mind that lenders not only lend money to purchase homes; they also lend money to refinance homes. For example, if you take out a fixed rate loan now, and several years from now interest rates have dropped, refinancing will probably be an option.

There are several downsides to refinancing. Unless you can negotiate a low-cost refi, you may have to pay the same fees and points as for an original mortgage. This means you may reduce your monthly payment right away but not actually begin to save money on the refi for several years. (Again, your broker can tell you when you will break even.) So, if you think you will be moving again soon, it may not make sense to refinance.

Second, if you default on a refinanced mortgage, your position under your state's law can get worse. In California, for instance, when a homebuyer defaults (stops paying the mortgage) on a purchase mortgage, the lender can foreclose on the house but take nothing else from the homebuyer, while on a refinanced mortgage it can go after the homebuyer's cash and other assets, after the house, to satisfy the debt.

How do I find the least costly mortgage? Does it make sense to pay more points for a lower interest rate?

You can save real money if you carefully shop for a mortgage. Everything else being equal, even a one-quarter percentage point difference in interest rates can mean savings of thousands of dollars over the life of a mortgage.



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A popular option recently has been "interest-only" loans, which allow you to pay only the interest amount each month -- not any principal -- for the first ten years of the loan. This can lower your initial monthly payments significantly, allowing you to afford more house. Most interest-only loans are adjustable, but it is possible to find fixed rate interest-only loans too.

In addition to comparing interest rates, there are many types of fees -- and fee amounts -- associated with getting a mortgage, including loan application fees, credit check fees, private mortgage insurance (if you're making a low down payment), and points.

Since points comprise the largest part of lender fees, it's important to understand how they work: One point is 1% of the loan principal. Thus, your fee for borrowing $250,000 at two points is $5,000. There is normally a direct relationship between the number of points lenders charge and the interest rates they quote for the same type of mortgage, such as a fixed rate. The more points you pay, the lower your rate of interest, and vice versa.

Comparing Loans by Annual Percentage Rate

One method to compare loans with different points is to use the Annual Percentage Rate (APR), which lenders must disclose to borrowers under federal law. The APR can be misleading, however, as its method of calculating the cost of a loan as a yearly rate assumes that the loan will not be paid off until the loan term ends. While most loans are for 30 years, people generally pay off their loans before the loan term ends because they either move or refinance sooner. Also, different lenders have various ways of calculating costs included in the APR, so that a loan for the same dollar amount and number of points may have different APRs with different lenders.

Before comparing points to interest, factor in how long you plan to own your house. The longer you live in your house (or pay on the mortgage), the better off you'll be paying more points up front in return for a lower interest rate. On the other hand, if you think you'll sell or refinance your house within two or three years, we strongly recommend that you obtain a loan with as few points as possible.

A good loan officer or loan broker can walk you through all options and tradeoffs such as higher fees or points for a lower interest rate. Or you can check a site such as http://www.homes.com to quickly compare various combinations of interest rates and points.

Ten Strategies for Buying an Affordable House

To find a good house at a comparatively reasonable price, learn about the housing market and what you can afford, make some sensible compromises as to size and amenities, and above all, be patient. Here are some proven strategies to meet these goals:

1. Buy a fixer-upper cheap (though its getting harder and harder to find ones that don't need major work).



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2. Buy a small house (with remodeling potential) and add on later. 3. Buy a house at an estate or probate sale. 4. Buy a house subject to foreclosure (when a homeowner defaults on the mortgage). 5. Buy a shared equity house, pooling resources with someone other than a spouse or partner. 6. Rent out a room or two in the house. 7. Buy a duplex, triplex, or house with an in-law unit that you can rent out for more income. 8. Lease a house you can't afford now with an option to buy later. 9. Buy a limited equity house built by a nonprofit organization. 10. Buy a house at an auction.

Mortgage Discrimination

The Equal Credit Opportunity Act (ECOA) and the Fair Housing Act (FHA) protect you against discrimination when you apply for a mortgage to purchase, refinance, or make home improvements.

Your Rights Under ECOA The ECOA prohibits discrimination in any aspect of a credit transaction based on:

race or color; religion; national origin; sex; marital status; age (provided the applicant has the capacity to contract); the applicant's receipt of income derived from any public assistance program; and the applicant's exercise, in good faith, of any right under the Consumer Credit Protection Act,

the umbrella statute that includes ECOA.

Your Rights Under FHA The FHA prohibits discrimination in all aspects of residential real-estate related transactions, including:

making loans to buy, build, repair, or improve a dwelling; selling, brokering, or appraising residential real estate; and selling or renting a dwelling. It also prohibits discrimination based on: race or color; national origin; religion; sex; familial status (defined as children under the age of 18 living with a parent or legal guardian,

pregnant women, and people securing custody of children under 18); and



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handicap.

Lender Do's and Don'ts Lenders must:

consider reliable public assistance income in the same way as other income. consider reliable income from part-time employment, Social Security, pensions, and annuities. consider reliable alimony, child support, or separate maintenance payments, if you choose to

provide this information. A lender may ask you for proof that this income is received consistently.

if a co-signer is needed, accept someone other than your spouse. If you own the property with your spouse, he or she may be asked to sign documents allowing you to mortgage the property.

Lenders cannot:

discourage you from applying for a mortgage or reject your application because of your race, national origin, religion, sex, marital status, age, or because you receive public assistance income.

consider your race, national origin, or sex, although you will be asked to voluntarily disclose this information to help federal agencies enforce anti-discrimination laws. A creditor may consider your immigration status and whether you have the right to remain in the country long enough to repay the debt.

impose different terms or conditions, such as a higher interest rate or larger down payment, on a loan based on your race, sex, or other prohibited factors.

consider the racial composition of the neighborhood where you want to live. This also applies when the property is being appraised.

ask about your plans for having a family. Questions about expenses related to your dependents are permitted.

refuse to purchase a loan or set different terms or conditions for the loan purchase based on discriminatory factors.

require a co-signer if you meet the lender's standards.

If Your Application Is Rejected If your mortgage is denied, the lender must give you specific reasons why or tell you of your right to ask for them. Under the law, you have the right to:

Know within 30 days of the date of your completed application whether your mortgage loan is approved. The lender must make a reasonable effort to obtain all necessary information, such as credit reports and property appraisals. If your application is rejected, the lender must tell you in writing.

Know specifically why your application was rejected. The lender must tell you the specific reason for the rejection or your right to learn the reason if you ask within 60 days. An acceptable response might



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be: "your income was too low" or "you haven't been employed long enough." A response of "you didn't meet our minimum standards" is not specific enough.

Learn the specific reason why you were offered less favorable terms than you applied for, but only if you reject these terms. For example, if the lender offered you a smaller mortgage or a higher interest rate, you have the right to know why if you did not accept the lender's counter offer.

Find out what is in your credit report. The lender may have rejected your application because of negative information in your credit report. If so, the lender must tell you this and give you the name, address, and phone number of the credit bureau. You can get a free copy of that report from the credit bureau if you request it within 60 days. Otherwise, the credit bureau can charge up to $8.

If your report contains inaccurate information, the credit bureau is required to investigate items that you dispute. Those companies furnishing inaccurate information to the credit bureaus also must reinvestigate items that you dispute. If you still dispute the credit bureau's account after a reinvestigation, you can include your summary of the problem in your credit report.

Get a copy of the property appraisal from the lender. Mortgage applications may be turned down because of poor appraisals. Review the appraisal. Check that it contains accurate information and determine whether the appraiser considered illegal factors, such as the racial composition of the neighborhood.

If You Suspect Discrimination Take action if you think you've been discriminated against.

Complain to the lender. Sometimes you can persuade the lender to reconsider your application. Check with your state Attorney General's office to see if the creditor violated state laws. Many

states have their own equal credit opportunity laws. Contact a local private fair housing group and report violations to the appropriate government

agency. If your mortgage application is denied, the lender must give you the name and address of the agency to contact.

Consider suing the lender in federal district court. If you win, you can recover your actual damages and be awarded punitive damages if the court finds that the lender's conduct was willful. You also may recover reasonable lawyers' fees and court costs. You also might consider joining with others to file a class action suit.

Mortgage

A mortgage is a method of using property (real or personal) as security (hypothecation) for the performance of an obligation, usually the payment of a debt proven by a promissory note or negotiable instrument.



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Hypothecation

The original use of the word hypothecation was for a pledge of property as collateral for a debt without transfer of possession to the party making the loan. The arrangement is common with modern mortgages - the borrower retains legal ownership of the property but provides the lender with a lien over the property until the debt is paid off.

Negotiable instrument

A negotiable instrument is a specialized type of contract for the payment of money that is unconditional and capable of transfer by negotiation. Common examples include checks and banknotes (paper money).

Differences from a contract

A negotiable instrument is not a contract, as contract formation requires an offer, acceptance, and consideration, none of which are elements of a negotiable instrument. Unlike ordinary contract documents, the right to the performance of a negotiable instrument is linked to the possession of the document itself (with certain exceptions such as loss or theft).

The rights of the payee (or holder in due course) are better than those provided by ordinary contracts as follows:

The rights to payment are not subject to set-off, and do not rely on the validity of the underlying contract giving rise to the debt (for example if a check was drawn for payment for goods delivered but defective, the drawer is still liable on the check)

No notice needs to be given to any prior party liable on the instrument for transfer of the rights under the instrument by negotiation

Transfer free of equities—the holder in due course can hold better title than the party he obtains it from

Negotiation enables the transferee to become the party to the contract, and to enforce the contract in his own name. Negotiation can be effected by endorsement and delivery (order instruments), or by delivery alone (bearer instruments). in addition, it includes the rule of a derivative title which does not allow a property owner to transfer rights in a piece of property greater than his own.



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Classes

The two primary classes of negotiable instruments are 'promissory notes' and 'bills of exchange.'

Promissory note

The promissory note is a written promise by the maker to pay money to the payee. The most common type of promissory note is a bank note, which is defined as a promissory note made by a bank and payable to bearer on demand.

Bill of Exchange

A bill of exchange is a written order by the drawer to the drawee to pay money to the payee. The most common type of bill of exchange is the check, which is defined as a bill of exchange drawn on a banker and payable on demand. Bills of exchange are used primarily in international trade, and are written orders by one person to his bank to pay the bearer a specific sum on a specific date sometime in the future.

Prior to the advent of paper currency, bills of exchange were a more significant part of trade. They are a rather ancient form of instrument: they were used by medieval trade fairs, such as the Frankfurt Trade Fair.

In the United States

In the United States, Article 3 and Article 4 of the Uniform Commercial Code govern the issuance and negotiation of negotiable instruments.

For a writing to be a negotiable instrument under Article 3, the following requirements must be met:

1. The promise or order to pay must be unconditional; 2. The payment must be in a specific sum of money, although interest may be added to the sum; 3. The payment must be made on demand or at a definite time; 4. The instrument must be payable to bearer or to order. 5. The instrument does not state any other undertaking or instruction by the person promising or

ordering payment to do any act in addition to the payment of money.

The latter requirement is referred to as the "words of negotiability": a writing which does not contain the words "to the order of" or indicate that it is payable to the person in possession, is not a negotiable instrument and is not governed by Article 3, even if it has all of the other features of negotiability. The only exception is that if an instrument meets the definition of a cheque (a bill of exchange payable on demand and drawn on a bank) and is not payable to order (i.e. if it just reads "pay John Doe") then it is treated as a negotiable instrument.



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Persons other than the original obligor and obligee can become parties to a negotiable instrument. The most common manner in which this is done is by placing one's signature on the instrument: if the person who signs does so with the intention of obtaining payment of the instrument or acquiring or transferring rights to the instrument, the signature is called an endorsement. An endorsement which transfers the instrument to a specified person is a special endorsement. An endorsement by the payee or holder which does not contain any additional notation (thus making the instrument payable to bearer) is a endorsement in blank. An endorsement which requires that the funds be applied in a certain manner (i.e. "for deposit only", "for collection") is a restrictive endorsement.

The most remarkable feature of a negotiable instrument is that if it is negotiated to a person who acquires the instrument in good faith for value without notice of any defenses to payment, then the transferee is a holder in due course and can enforce the instrument without being subject to defenses which the maker of the instrument would be able to assert against the original payee, except for certain real defenses which are rarely applicable.

The holder in due course rule is what makes the free transfer of negotiable instruments feasible in the modern industrial economy: a person or company who purchases such an instrument in the ordinary course of business can reasonably expect that it will be paid when presented to the maker, without involving itself in a dispute between the maker and the person to whom the instrument was first issued.

The foregoing is the theory and the letter of the law: of course, in reality the issuer of an instrument who feels he has been defrauded or otherwise rawly dealt with by the payee may nonetheless refuse to pay the holder in due course, requiring the latter to resort to litigation to recover on the instrument.

Exceptions

Under the Code, the following are not negotiable instruments, although the law governing obligations with respect to such items may be similar to or derived from the law applicable to negotiable instruments:

Letters of credit, which are governed by Article 5 of the Code Bills of lading and other documents of title, which are governed by Article 7 of the Code Securities, such as stocks and bonds, which are governed by Article 8 of the Code Deeds and other documents conveying interests in real estate, although a mortgage may secure

a promissory note which is governed by Article 3 IOUs

The term mortgage (from Anglo-Norman, lit. dead pledge) refers to the legal device used for this purpose, but it is also commonly used to refer to the debt secured by the mortgage, the mortgage loan.

In most jurisdictions mortgages are strongly associated with loans secured on real estate rather than other property (such as ships) and in some cases only land may be mortgaged. Arranging a mortgage is seen as the standard method by which individuals and businesses can purchase residential and



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commercial real estate without the need to pay the full value immediately. See mortgage loan for residential mortgage lending, and commercial mortgage for lending against commercial property.

In many countries it is normal for home purchases to be funded by a mortgage. In countries where the demand for home ownership is highest, strong domestic markets have developed, notably in Spain, the United Kingdom and the United States.

Participants and variant terminology

Legal systems tend to share certain particular concepts but vary in the terminology and jargon used.

In general terms the main participants in a mortgage are:

Creditor

The creditor or lender has legal rights to the debt or other obligation secured by the mortgage. That debt is often the obligation to repay the loan by the creditor (or its predecessor lender) who provided the purchase money to acquire the property mortgaged. Typically, creditors are banks, insurers or other financial institutions who make loans available for the purpose of real estate purchase.

A creditor is sometimes referred to as the mortgagee or lender or beneficiary of the trust deed.

A beneficiary (also, in trust law, referred to as the cestui que use) in the broadest sense is a natural person or other legal entity who receives money or other benefits from a benefactor. The beneficiary of a life insurance policy, for example, is the person who receives the payment of the amount of insurance after the death of the insured. The beneficiaries of a trust are the persons with equitable ownership of the trust assets, although legal title is held by the trustee. The term is also used in the context of a letter of credit for the party receiving the money related thereto. Beneficiaries in other contexts are known by other names: for example, the beneficiaries of a will are called devisees or legatees according to local custom.

A series of beneficiaries may be designated in many cases to designate where the assets will go if the primary beneficiary or beneficiaries are not alive or do not qualify under the restrictions in the given contract or legal instrument. Most commonly the restriction is that the beneficiary be alive, which, if not true, allows the assets to pass to the contingent beneficiaries. Other restrictions such as being married or more creative ones can be used by a benefactor to attempt to control the behavior of the beneficiaries. Some situations such as retirement accounts do not allow any restrictions beyond death of the primary beneficiaries, but trusts allow any restrictions that are not illegal or for an illegal purpose.

The concept of a "beneficiary" will also frequently figure in contracts other than insurance policies. A third party beneficiary of a contract is a person who, although not a party to the contract, the parties



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intend will benefit from its provisions. A software distributor, for example, may seek provisions protecting its customers from infringement claims. A software licensor may include provisions in its agreements which protect those who provided code to that licensor.

Origination fee

An origination fee is a fee charged by the lender for establishing a new loan. This fee is paid to the bank or your loan broker for his or her services in originating the loan.

The fee usually varies from 0.5% (half a point) to 2% (two points) of the loan amount, depending whether the loan was originated in the prime or the subprime market.

An origination fee of 2% on a $200,000 loan is $4,000. In some cases, one has to pay points plus origination fees.

Most banks/brokers charge an Origination Fee. As the name implies, it is a fee necessary to make the loan happen. Some loan structures also call for Discount Points. Discount Points differ from Origination Fees in that Discount Points are used to buy down the interest rates, temporarily or permanently. Origination Fee and Discount Points are both items listed under lender-charges on the HUD-1 Settlement Statement.

Broker or loan origination fee is paid to the person handling your loan application. This fee can be a set price or can be stated as percentage of your loan amount. The origination fee can be located at the top of the good faith estimate and should be disclosed within 3 days after applying for a home loan.

Origination fees are charged by the lender or Broker and are expressed as a percentage of the loan amount. They must be disclosed on the Good Faith Estimate and on the final closing papers, commonly called the HUD (short for "HUD-1 Settlement Statement").

In order for any lender to originate a loan without an origination fee, the interest rate must be higher to make up for that loss of revenue.

Points (real estate)

Points are a form of pre-paid interest. One point equals one percent of the loan amount. By charging a borrower points, a lender effectively increases the yield on the loan above the amount of the stated interest rate. Borrowers can offer to pay a lender points as a method to reduce the interest rate on the loan, thus obtaining a lower monthly payment in exchange for this up-front payment.

Paying Points represent a calculated gamble on the part of the buyer. There will be a specific point in the timeline of the loan where the monies spent to buy down the interest rate will be equal to the monies saved by making reduced loan payments resulting from the lower interest rate on the loan.



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Selling the property or refinancing prior to this break-even point will result in a net financial loss for the buyer while keeping the loan for longer than this break-even point will result in a net financial savings for the buyer. The longer you keep the property financed under the loan with purchased points, the more the monies spent on the points will pay off. Accordingly, If the intention is to buy and sell the property or re-finance in a rapid fashion, buying points is actually going to end up costing more than just paying the loan at the higher interest rate.

MonthlyPmtWithoutPurchasedPoints - MonthlyPmtWithPurchasedPoints = MonthlyPointsSavings

CostOfPurchasedPoints / MonthlyPointsSavings = NumberOfMonthsToBreakEvenPoint

NumberOfMonthsToBreakEvenPoint / 12 = NumberOfYearsToBreakEvenPoint

As stated, The decision to buy points based on a financial savings point of view should be based on the intended duration of the loan. Selling or refinancing prior to the break-even point render the purchase of points counter productive.

NOTE: Another perfectly valid application for the purchasing of Points is to reduce the monthly payment for the purpose of QUALIFYING for the loan. Loan qualification based on monthly income versus the monthly loan payment may sometimes only be achievable by reducing the monthly payment through the purchasing of points to buy down the interest rate thereby reducing the monthly loan payment.

Debtor

The debtor is the person or entity who owes the obligation secured by the mortgage, and may be multiple parties. Generally, the debtor must meet the conditions of the underlying loan or other obligation and the conditions of the mortgage. Otherwise, the debtor usually runs the risk of foreclosure of the mortgage by the creditor to recover the debt. Typically the debtors will be the individual home-owners, landlords or businesses who are purchasing their property by way of a loan.

A debtor is sometimes referred to as the mortgagor, borrower, or obligor.

Other participants

Due to the complicated legal exchange, or conveyance, of the property, one or both of the main participants are likely to require legal representation. The terminology varies with legal jurisdiction; see lawyer, solicitor and conveyancer.



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Because of the complex nature of many markets the debtor may approach a mortgage broker or financial adviser to help them source an appropriate creditor, typically by finding the most competitive loan.

The debt is, in civil law jurisdictions, referred to as hypothecation, which may make use of the services of a hypothecary to assist in the hypothecation.

Legal aspects

There are essentially two types of legal mortgage.

Mortgage by demise

In a mortgage by demise, the creditor becomes the owner of the mortgaged property until the loan is repaid in full (known as "redemption"). This kind of mortgage takes the form of a conveyance of the property to the creditor, with a condition that the property will be returned on redemption.

This is an older form of legal mortgage and is less common than a mortgage by legal charge. In the UK, this type of mortgage is no longer available, by virtue of the Land Registration Act 2002.

Mortgage by legal charge

In a mortgage by legal charge, the debtor remains the legal owner of the property, but the creditor gains sufficient rights over it to enable them to enforce their security, such as a right to take possession of the property or sell it.

To protect the lender, a mortgage by legal charge is usually recorded in a public register. Since mortgage debt is often the largest debt owed by the debtor, banks and other mortgage lenders run title searches of the real property to make certain that there are no mortgages already registered on the debtor's property which might have higher priority. Tax liens, in some cases, will come ahead of mortgages. For this reason, if a borrower has delinquent property taxes, the bank will often pay them to prevent the lienholder from foreclosing and wiping out the mortgage.

This type of mortgage is common in the United States and, since 1925, it has been the usual form of mortgage in England and Wales (it is now the only form - see above).

Equitable Mortgage

In an Equitable Mortgage the lender is secured by taking possession of all the original title documents of the property and by borrower's signing a Memorandum of Deposit of Title Deed (MODTD). This document is an undertaking by the borrower that he/she has deposited the title documents with the bank with his own wish and will, in order to secure the financing obtained from the bank.



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History

At common law, a mortgage was a conveyance of land that on its face was absolute and conveyed a fee simple estate, but which was in fact conditional, and would be of no effect if certain conditions were not met --- usually, but not necessarily, the repayment of a debt to the original landowner. Hence the word "mortgage," Law French for "dead pledge;" that is, it was absolute in form, and unlike a "live gage", was not conditionally dependent on its repayment solely from raising and selling crops or livestock, or of simply giving the fruits of crops and livestock coming from the land that was mortgaged. The mortgage debt remained in effect whether or not the land could successfully produce enough income to repay the debt. In theory, a mortgage required no further steps to be taken by the creditor, such as acceptance of crops and livestock, for repayment.

The difficulty with this arrangement was that the lender was absolute owner of the property and could sell it, or refuse to reconvey it to the borrower, who was in a weak position. Increasingly the courts of equity began to protect the borrower's interests, so that a borrower came to have an absolute right to insist on reconveyance on redemption. This right of the borrower is known as the "equity of redemption".

This arrangement, whereby the mortgagee (the lender) was on theory the absolute owner, but in practice had few of the practical rights of ownership, was seen in many jurisdictions as being awkwardly artificial. By statute the common law position was altered so that the mortgagor would retain ownership, but the mortgagee's rights, such as foreclosure, the power of sale and the right to take possession would be protected.

In the United States, those states that have reformed the nature of mortgages in this way are known as lien states. A similar effect was achieved in England and Wales by the Law of Property Act 1925, which abolished mortgages by the conveyance of a fee simple.

Most states require satisfaction of mortgage, release or defeasance upon payoff of the trust deed. Defeasance (Fr. défaire, to undo), or release deed, in law, is an instrument which defeats the force or operation of some other deed or estate; as distinguished from condition, that which in the same deed is called a condition is a defeasance in another deed.

"Defeasance is a clause within a loan document which allows the exchange of one type of collateral, such as real estate, for, another type of collateral such as a portfolio of United States Treasury Securities."

A defeasance should recite the deed to be defeated and its date, and it must be made between the same parties as are interested in the deed to which it is collateral. It must be of a thing defeasible, and all the conditions must be strictly carried out before the defeasance can be consummated.



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Defeasance in a bill of sale is the putting an end to the security by realizing the goods for the benefit of the mortgagee. It is not strictly a defeasance, because the stipulation is in the same deed; it is really a condition in the nature of a defeasance.

Foreclosure and non-recourse lending

In most jurisdictions, a lender may foreclose on the mortgaged property if certain conditions—principally, non-payment of the mortgage loan—apply. Subject to local legal requirements, the property may then be sold. Any amounts received from the sale (net of costs) are applied to the original debt.

Foreclosure is the equitable proceeding in which a bank or other secured creditor sells or repossesses a parcel of real property (immovable property) due to the owner's failure to comply with an agreement between the lender and borrower called a "mortgage" or "deed of trust." Commonly, the violation of the mortgage is a default in payment of a promissory note, secured by a lien on the property. When the process is complete, it is typically said that "the lender has foreclosed its mortgage or lien."

Types of foreclosure

The mortgage holder can usually initiate foreclosure anytime after a default on the mortgage. Within the United States, several types of foreclosure exist. Two are widely used, with the rest being possibilities in a few states.

The most important type of foreclosure is foreclosure by judicial sale. This is available in every state and is the required method in many. It involves the sale of the mortgaged property done under the supervision of a court, with the proceeds going first to satisfy the mortgage, and then to satisfy other lien holders, and finally to the mortgagor. Because it is a legal action, all the proper parties must be notified of the foreclosure, and there will be both pleadings and some sort of judicial decision, usually after a short trial.

The second type of foreclosure, foreclosure by power of sale, involves the sale of the property by the mortgage holder not through the supervision of a court. Where it is available, foreclosure by power of sale is generally a more expedient way of foreclosing on a property than foreclosure by judicial sale. The majority of states allow this method of foreclosure. Again, proceeds from the sale go first to the mortgage holder, then to other lien holders, and finally to the mortgagor.

Other types of foreclosure are only available in limited places and are therefore considered minor methods of foreclosure. Strict foreclosure is one example. Under strict foreclosure, when a mortgagor defaults, a court orders the mortgagor to pay the mortgage within a certain period of time. If the mortgagor fails, the mortgage holder automatically gains title, with no obligation to sell the property. Strict foreclosure was the original method of foreclosure, but today it is only available in a few states, such as Connecticut, New Hampshire and Vermont.



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Acceleration

The concept of acceleration is used to determine the amount owed under foreclosure. Acceleration allows the mortgage holder the right when the mortgagor defaults on the mortgage to declare the entire debt due and payable. In other words, if a mortgage is taken out on property for $10,000 with monthly payments required, and the mortgagor fails to make the monthly payments, the mortgage holder can demand the mortgagor make good on the entire $10,000 of the mortgage.

Virtually all mortgages today have acceleration clauses. However, they are not imposed by statute, so if a mortgage does not have an acceleration clause, the mortgage holder has no choice but to either wait to foreclose until all of the payments come due or convince a court to divide up parts of the property and sell them in order to pay the installment that is due. Alternatively, the court may order the property sold subject to the mortgage, with the proceeds from the sale going to the payments owed the mortgage holder.

Foreclosure by judicial sale

Foreclosure by judicial sale requires the mortgage holder to proceed carefully in order to ensure that all affected parties are included in the court case, so the purchaser of the foreclosed property receives valid title to the property.

Process

The process of foreclosure is lengthy and the timeframes for when the lending institution begins the process vary from state to state. Other factors, such as the increasing availability of personal loans for owners facing foreclosure, present homeowners with foreclosure avoidance options. Websites which connect individual borrowers and homeowners to individual lenders are increasingly used as mechanisms to bypass banks while meeting payment obligations for mortgage providers. The increase in the number of foreclosures in the United States has led to more loan listings which are designed to forestall or prevent foreclosure.

In the United States, there are two types of foreclosure in most common law states. Using a "deed in lieu of foreclosure," or "strict foreclosure", the bank claims the title and possession of the property back in full satisfaction of a debt, usually on contract. In the proceeding simply known as foreclosure (or, perhaps, distinguished as "judicial foreclosure"), the property is exposed to auction by the county sheriff or some other officer of the court. Many states require this latter sort of proceeding in some or all cases of foreclosure, in order to protect any equity the debtor may have in the property, in case the value of the debt being foreclosed on is substantially less than the market value of the immovable property (this also discourages strategic foreclosure). In this foreclosure, the sheriff then issues a deed to the winning bidder at auction. Banks and other institutional lenders typically bid in the amount of



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the owed debt at the sale, and if no other buyers step forward the lender receives title to the immovable property in return.

Other states have adopted non-judicial foreclosure procedures, in which the mortgagee, or more commonly the mortgagee's attorney or designated agent, gives the debtor a notice of default and the mortgagee's intent to sell the immovable property in a form prescribed by state statute. This type of foreclosure is commonly referred to as "statutory" or "non-judicial" foreclosure, as opposed to "judicial". With this "power-of-sale" type of foreclosure, if the debtor fails to cure the default, or use other lawful means (such as filing for bankruptcy which provides a temporary automatic stay to the foreclosure proceeding) to stop the sale, the mortgagee or its representative will conduct a public auction in a similar manner as the sheriff's auction described above. The highest bidder at the auction becomes the owner of the immovable property free and clear of any interest of the former owner but the property may be encumbered by any liens superior to the mortgage being foreclosed (e.g. a senior mortgage, unpaid property taxes etc). Further legal action, such as an eviction may be necessary to obtain possession of the premises.

"Strict foreclosure" is an equitable right available in some states. The strict foreclosure period arises after the foreclosure sale has taken place and is available to the foreclosure sale purchaser. The foreclosure sale purchaser must petition a court for a decree that will cut off any junior lienholder's rights to redeem the senior debt. If the junior lienholder fails to do so within the judicially established time frame, his lien is cancelled and the purchaser's title is cleared. This effect is the same as the strict foreclosure that occurred at common law in England's courts of equity as a response to the development of the equity of redemption.

In most jurisdictions, it is customary for the foreclosing lender to obtain a title search of the immovable property and to notify all other persons who may have liens on the property, whether by judgment, by contract, or by statute or other law, so that they may appear and assert their interest in the foreclosure litigation. In all US jurisdictions a lender who conducts a foreclosure sale of immovable property which is the subject of a federal tax lien must give 25 days' notice of the sale to the Internal Revenue Service: failure to give notice to the IRS will result in the lien remaining attached to the immovable property after the sale. Therefore, it is imperative that the lender obtain a search of the local Federal Tax Liens so that if the persons or companies involved in the foreclosure have a federal tax lien filed against them, the proper notice to the IRS will be given. A detailed explanation by the IRS of the Federal Tax Lien process can be found here.

Foreclosure auction

When a bank auctions a repossessed property, they will typically set the starting price as the remaining balance on the mortgage loan. Many times, however, in this market the bank will set the starting price at a lower amount if it believes the real estate securing the loan is worth less than the loan. This is not usually the case in the state of Alabama.



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In the case where the remaining mortgage balance is higher than the actual home value, known as an Upside-down mortgage, the bank is unlikely to attract auction bids at this price level. A house that went through foreclosure auction and failed to attract any bids becomes property of the bank. It is called "REO" (real estate owned). The bank will typically try to sell it at a loss later through standard channels.

Further borrower's obligations

The mortgagor is required to pay for mortgage insurance, or PMI, for as long as the principal of his primary mortgage is above 80% of the value of his property. In most situations, insurance requirements are sufficient to guarantee that the lender will get all his money back, either from foreclosure auction proceeds or from PMI.

Nevertheless, in an illiquid real estate market or following a significant drop in real estate prices, it may happen that the property being foreclosed is sold for less than the remaining balance on the primary mortgage loan, and there's no insurance to cover the loss. In this case, the court overseeing the foreclosure process may enter a deficiency judgment against the mortgagor. Deficiency judgment is a lien that obligates the mortgagor to repay the difference. It gives lender a legal right to collect the remainder of debt out of mortgagor's other assets (if any).

There are exceptions to this rule, however. If the mortgage is a non-recourse debt (which is often the case with residential mortgages), lender may not go after borrower's assets to recoup his losses. Lender's ability to pursue deficiency judgment may be restricted by state laws. In California and some other states, original mortgages (the ones taken out at the time of purchase) are typically non-recourse loans, however, refinanced loans and home equity lines of credit aren't.

If the lender chooses not to pursue deficiency judgment—or can't because the mortgage is non-recourse—and writes off the loss, the borrower may have to pay income taxes on the unrepaid amount.

Any other loans taken out against the property being foreclosed (second mortgages, HELOCs) are "wiped out" by foreclosure (in the sense that they are no longer attached to the property), but borrower is still obligated to pay them off if they are not paid out of foreclosure auction's proceeds.

Foreclosure investment

Some individuals and companies are engaged in the business of purchasing properties at foreclosure sales. Distressed assets (such as foreclosed property or equipment) are considered by some to be worthwhile investments because the bank or mortgage company is not motivated to sell the property for more than is pledged against it.

Specific procedures for foreclosure and sale of the mortgaged property almost always apply, and may be tightly regulated by the relevant government. In some jurisdictions, foreclosure and sale can occur



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quite rapidly, while in others, foreclosure may take many months or even years. In many countries, the ability of lenders to foreclose is extremely limited, and mortgage market development has been notably slower.

Mortgages in the United States

Types of Mortgage Instruments

Two types of mortgage instruments are used in the United States: the mortgage (sometimes called a mortgage deed) and the deed of trust.

The mortgage

In all but a few states, a mortgage creates a lien on the title to the mortgaged property. Foreclosure of that lien almost always requires a judicial proceeding declaring the debt to be due and in default and ordering a sale of the property to pay the debt.

The deed of trust

The deed of trust is a deed by the borrower to a trustee for the purposes of securing a debt. In most states, it also merely creates a lien on the title and not a title transfer, regardless of its terms. It differs from a mortgage in that, in many states, it can be foreclosed by a non-judicial sale held by the trustee. It is also possible to foreclose them through a judicial proceeding.

Most "mortgages" in California are actually deeds of trust. The effective difference is that the foreclosure process can be much faster for a deed of trust than for a mortgage, on the order of 3 months rather than a year. Because the foreclosure does not require actions by the court the transaction costs can be quite a bit less.

Deeds of trust to secure repayments of debts should not be confused with trust instruments that are sometimes called deeds of trust but that are used to create trusts for other purposes, such as estate planning. Though there are superficial similarities in the form, many states hold deeds of trust to secure repayment of debts do not create true trust arrangements.

Mortgage lien priority

Except in those few states in the United States that adhere to the title theory of mortgages, either a mortgage or a deed of trust will create a mortgage lien upon the title to the real property being mortgaged. The lien is said to "attach" to the title when the mortgage is signed by the mortgagor and delivered to the mortgagee and the mortgagor receives the funds whose repayment the mortgage secures. Subject to the requirements of the recording laws of the state in which the land is located, this attachment establishes the priority of the mortgage lien with respect to other liens on the property's



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title. Liens that have attached to the title before the mortgage lien are said to be senior to, or prior to, the mortgage lien. Those attaching afterward are said to be junior or subordinate. The purpose of this priority is to establish the order in which lien holders are entitled to foreclose their liens in an attempt to recover their debts. If there are multiple mortgage liens on the title to a property and the loan secured by a first mortgage is paid off, the second mortgage lien will move up in priority and become the new first mortgage lien on the title. Documenting this new priority arrangement will require the release of the mortgage securing the paid off loan.

Usury

Usury, from the Medieval Latin usuria, "interest" or "excessive interest", from Latin usura "interest") was defined originally as charging a fee for the use of money. This usually meant interest on loans, although charging a fee for changing money (as at a bureau de change) is included in the original meaning. After moderate-interest loans were made more easily available usury became an accepted part of the business world in the early modern age. Today, the word has come to refer to the charging of unreasonable or relatively high rates of interest.

The pivotal change in the English-speaking world seems to have come with the permission to charge interest on lent money: particularly the Act 'In restraint of usury' of Henry VIII in England in 1545.

Historical meaning

The historical rendition of usury as a vile enterprise stems not only from a spiritual view that charging exorbitant interest is a flagrant manifestation of unchecked greed, but carries with it social connotations of perceived "unjust" or "discriminatory" money lending practices. This is well explained by the historian Paul Johnson, who believes:

Most early religious systems in the ancient Near East, and the secular codes arising from them, did not forbid usury. These societies regarded inanimate matter as alive, like plants, animals and people, and capable of reproducing itself. Hence if you lent 'food money', or monetary tokens of any kind, it was legitimate to charge interest. Food money in the shape of olives, dates, seeds or animals was lent out as early as c. 5000 BC, if not earlier. ... Among the Mesopotamians, Hittites, Phoenicians and Egyptians, interest was legal and often fixed by the state. But the Jews took a different view of the matter.

The Torah and later sections of the Hebrew Bible criticize interest-taking, but interpretations of the Biblical prohibition vary. One common understanding is that Israelites are forbidden to charge interest upon loans made to other Israelites, but allowed to charge interest on transactions with non-Israelites. However, the Hebrew Bible itself gives numerous examples where this provision was evaded.

Johnson holds that the Hebrew Bible treats the lending as philanthropy in a poor community whose aim was collective survival, but which is not obliged to be charitable towards outsiders.



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A great deal of Jewish legal scholarship in the Dark and the Middle Ages was devoted to making business dealings fair, honest and efficient. One of the great problems was usury, or rather lending money at interest. This was a problem the Jews had created for themselves, and for the two great religions which spring from Hebrewism.

Usury (in the original sense of any interest) was denounced by a number of spiritual leaders and philosophers of ancient times, including Plato, Aristotle, Cato, Cicero, Seneca, Plutarch, Aquinas, Muhammad, Moses, Philo and Gautama Buddha.

For example, Cato in his De Re Rustica said: "And what do you think of usury?" - "What do you think of murder?"

Interest of any kind is forbidden in Islam. As such, specialized codes of banking have developed to cater to investors wishing to obey Qur'anic law.

As the Jews were ostracized from most professions by local rulers, the church and the guilds, they were pushed into marginal occupations considered socially inferior, such as tax and rent collecting and money lending. This was said to show Jews were insolent, greedy usurers. Natural tensions between creditors and debtors were added to social, political, religious, and economic strains.

... financial oppression of Jews tended to occur in areas where they were most disliked, and if Jews reacted by concentrating on money lending to non-Jews, the unpopularity - and so, of course, the pressure - would increase. Thus the Jews became an element in a vicious circle. The Christians, on the basis of the Biblical rulings, condemned interest-taking absolutely, and from 1179 those who practiced it were excommunicated. But the Christians also imposed the harshest financial burdens on the Jews. The Jews reacted by engaging in the one business where Christian laws actually discriminated in their favor, and so became identified with the hated trade of money lending.

Peasants who were forced to pay their taxes to Jews could personify them as the people taking their earnings while remaining loyal to the lords on whose behalf the Jews worked. Non-Jewish debtors may have been quick to lay charges of usury against Jewish moneylenders charging even nominal interest or fees. Thus, historically attacks on usury have often been linked to antisemitism. According to Walter Laqueur,

"The issue at stake was not really whether the Jews had entered it out of greed (as antisemites claimed) or because most other professions were barred to them... In countries where other professions were open to them, such as Muslim Spain and the Ottoman empire, one finds more Jewish blacksmiths than Jewish money lenders. The high tide of Jewish usury was before the fifteenth century; as cities grew in power and affluence, the Jews were squeezed out from money lending with the development of banking."

In England, the departing Crusaders were joined by crowds of debtors in the massacres of Jews at London and York in 1189-1190. In 1275, Edward I of England passed the Statute of Jewry which made usury illegal and linked it to blasphemy, in order to seize the assets of the violators. Scores of English Jews were arrested, 300 hanged and their property went to the Crown. In 1290, all Jews were



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expelled from England, allowed to take only what they could carry, the rest of their property became the Crown's. The usury was cited as the official reason for the Edict of Expulsion.

The growth of the Lombard banking and pawnbrokers, who moved from city to city along the pilgrim routes, was important for the development of trade and commerce. Laqueur continues:

"Following centuries of church condemnations of Jewish usury, the Jews were expelled from many countries and regions, their communities were impoverished, and very few individuals had the necessary capital to engage in money lending. Money lending continued, of course, and the Lombards took 250 percent interest (this, however, did not cause a wave of anti-Lombardism)."

In the 16th century, short-term interest rates dropped dramatically (from around 20-30% p.a. to around 9-10% p.a.). This was caused by refined commercial techniques, increased capital availability, the Reformation, and other reasons. The lower rates weakened religious scruples about lending at interest, although the debates did not abate altogether.

In 1745, the Catholic teaching on usury was expressed by Pope Benedict XIV in his encyclical Vix Pervenit, which strictly forbids charging interest on loans, although he adds that "entirely just and legitimate reasons arise to demand something over and above the amount due on the contract" through separate, parallel contracts.

Usury and the law

"When money is lent on a contract to receive not only the principal sum again, but also an increase by way of compensation for the use, the increase is called interest by those who think it lawful, and usury by those who do not." (Blackstone's Commentaries on the Laws of England, p. 1336).

In the United States, usury laws are state laws that specify the maximum legal interest rate at which loans can be made. Congress has opted not to regulate interest rates on purely private transactions, although it arguably has the power to do so under the interstate commerce clause of Article I of the Constitution.

Congress has opted to put a federal criminal limit on interest rates by the RICO definitions of "unlawful debt" which make it a federal felony to lend money at an interest rate more than two times the local state usury rate and then try to collect that "unlawful debt".

It is a federal offense to use violence or threats to collect usurious interest (or any other sort). Such activity is referred to as loan sharking, although that term is also applied to non-coercive usurious lending, or even to the practice of making consumer loans without a license in jurisdictions that require licenses.



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Usury rates in the United States

Each U.S. state has its own statute which dictates how much interest can be charged before it is considered usurious or unlawful.

If a lender charges above the lawful interest rate, a court will not allow the lender to sue to recover the debt because the interest rate was illegal anyway. In some states (such as New York) such loans are voided, meaning made void from the beginning or ab initio. Ref NY Gen Oblig 5-501 et seq. and NY 1503.

However, there are separate rules applied to most banks. In 1980, due to inflation, national banks (banks that generally include N.A. in their name), federally chartered savings banks, installment plan sellers and chartered loan companies were exempted from state usury limits by the federal government through a special law. This effectively overrode all state and local usury laws.

State Interest Rates & Usury Limits Many state's laws provide that you cannot lend money at an interest rate in excess of a certain statutory maximum. This is a "usury limit." Unless Otherwise Stated, The Rates Are Simple, Not Compound Interest. Further We Are Stating The “Present” Limits, the ones applicable at the time that this research was completed. Many states have had lower limits in the past. Further, in most states a late charge or other fee exacted from someone who owes another money is also counted as interest. "But my car loan is higher than that"; "But I'm paying way more than that on my credit cards." That's right! Banks have separate rules. In fact, due to high inflation, in 1980, the federal government passed a special law which allowed national banks (the ones that have the word "national" or the term "N.A." in their name, and savings banks that are federally chartered) to ignore state usury limits and pegged the rate of interest at a certain number of points above the federal reserve discount rate. In addition, specially chartered organizations like small loan companies and installment plan sellers (like car financing companies) have their own rules. The usury limit which is stated as the general usury limit is the rate that can be charged by one person or corporation to another, in other words, if you lend your next door neighbor $ 100.00, the rate stated is the limit. To charge more you must get a banking, pawnbroking, or whatever license. This also means that special kinds of loans, like those from pawnbrokers or small loan companies are not stated. In some states we also have a "legal rate." In such states, as a general rule, if you have a contractual obligation that provides simply for interest without a specific term, or "interest at the highest legal rate" then the "legal rate" what applies. In other instances we have stated a "judgment rate." That's the rate that final judgments bear. In states without a usury limit, there still may be a federally imposed limit because at certain astronomical rates of interest "loan sharking" will be inferred by the federal government.



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Usury Is A Complicated Area Of Law. Transactions that a person would not consider to be affected by usury often are, for example, repurchase agreements, or sales with an option to repurchase are often found to be loans. A word of caution. Before trying to lend someone money or "invest" with a guaranteed return, see an attorney to make sure that you don't run afoul of the usury laws. In state's that specify one limit for consumers and one limit for non-consumers, you cannot avoid the usury limit by creating a sham business deal. In a supplement that is now being prepared and will be available soon, we will review the penalties for usury in each state and point out special circumstances in each state. ALABAMA, the legal rate of interest is 6%; the general usury limit is 8%. The judgment rate is 12%. ALASKA, the legal rate of interest is 10.5%; the general usury limit is more than 5% above the Federal Reserve interest rate on the day the loan was made. ARIZONA, the legal rate of interest is 10%. ARKANSAS, the legal rate of interest is 6%; for non-consumers the usury limit is 5% above the Federal Reserve's interest rate; for consumers the general usury limit is 17%. Judgments bear interest at the rate of 10% per annum, or the lawful agreed upon rate, whichever is greater. CALIFORNIA, the legal rate of interest is 10% for consumers; the general usury limit for non-consumers is more than 5% greater than the Federal Reserve Bank of San Francisco's rate. COLORADO, the legal rate of interest is 8%; the general usury limit is 45%. The maximum rates to consumers is 12% per annum. CONNECTICUT, the legal rate of interest is 8%; the general usury rate is 12%. In civil suits where interest is allowed, it is allowed at 10%. DELAWARE, the legal rate of interest is 5% over the Federal Reserve rate. DISTRICT OF COLUMBIA, the legal rate of interest is 6%; the general usury limit is in excess of 24%. FLORIDA, the legal rate of interest is 12%; the general usury limit is 18%. On loans above $ 500,000 the maximum rate is 25%. GEORGIA, the legal rate of interest is 7%; On loans below $ 3,000 the usury limit is 16%. On loans above $ 3,000, the limit appears to be 5% per month. As to loans below $ 250,000 the interest rate must be specified in simple interest and in writing. HAWAII, the legal rate of interest is 10%. The usury limit for consumer transactions is 12%.



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IDAHO, the legal rate of interest is 12%. Judgments bear interest at the rate of 5% above the U.S. Treasury Securities rate. ILLINOIS, the legal rate of interest is 5%. The general usury limit is 9%. The judgment rate is 9%. INDIANA, the legal rate of interest is 10%. Presently there is no usury limit; however, legislation is pending to establish limits. The judgment rate is also 10%. IOWA, the legal rate of interest is 10%. In general consumer transactions are governed at a maximum rate of 12%. KANSAS, the legal rate of interest is 10%; the general usury limit is 15%. Judgments bear interest at 4% above the federal discount rate. On consumer transactions, the maximum rate of interest for the first $ 1,000 is 18%, above $ 1,000, 14.45%. KENTUCKY, the legal rate of interest is 8%; the general usury limit is more than 4% greater than the Federal Reserve rate or 19%, whichever is less. On loans above $ 15,000 there is no limit. Judgments bear interest at the rate of 12% compounded yearly, or at such rate as is set by the Court. LOUISIANA, the legal rate of interest is one point over the average prime rate, not to exceed 14% nor be less than 7%. Usury limit for individuals is 12%, there is no limit for corporations. (As warned, you cannot evade the limit by forming a corporation when the loan is actually to an individual.) MAINE, the legal rate of interest is 6%. Judgments below $ 30,000 bear 15%, otherwise they bear interest at the 52 week average discount rate for T-Bills, plus 4%. MARYLAND, the legal rate of interest is 6%; the general usury limit is 24%. There are many nuances and exceptions to this law. Judgments bear interest at the rate of 10%. MASSACHUSETTS, the legal rate of interest is 6%; the general usury rate is 20%. Judgments bear interest at either 12% or 18% depending on whether the court finds that a defense was frivolous. MICHIGAN, the legal rate of interest is 5%; the general usury limit is 7%. Judgments bear interest at the rate of 1% above the five year T-note rate. MINNESOTA, the legal rate of interest is 6%. The judgment rate is the "secondary market yield" for one year T-Bills. Usury limit is 8%. MISSISSIPPI, the legal rate of interest is 9%; the general usury limit is more than 10%, or more than 5% above the federal reserve rate. There is no usury limit on commercial loans above $ 5,000. The judgment rate is 9% or a rate legally agreed upon in the underlying obligation.



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MISSOURI, the legal and judgment rate of interest is 9%. Corporations do not have a usury defense. (Remember that a corporation set up for the purpose of loaning money to an individual will violate the usury laws.) MONTANA, the legal rate of interest is 10%; the general usury limit is above 6% greater than New York City banks' prime rate. Judgments bear interest at the rate of 10% per annum. NEBRASKA, the legal rate of interest is 6%; the general usury limit is 16%. Accounts bear interest at the rate of 12%. Judgments bear interest at the rate of 1% above a bond yield equivalent to T-bill auction price. NEVADA, the legal rate of interest is 12%; there is no usury limit. NEW HAMPSHIRE, the legal rate of interest is 10%; there is no general usury rate. NEW JERSEY, the legal rate of interest is 6%; the general usury limit is 30% for individuals, 50% for corporations. There are a number of exceptions to this law. NEW MEXICO, the legal rate of interest is 15%. Judgment rate is fixed by the Court. NEW YORK, the legal rate of interest is 9%; the general usury limit is 16%. NORTH CAROLINA, the legal interest rate and the general usury limit is 8%. However, there is a provision for a variable rate, which is 16% or the T-Bill rate for non-competitive T-Bills. Above $ 25,000 there is no express limit. However, the law providing for 8% is still on the books- be careful and see a lawyer! NORTH DAKOTA, the legal rate of interest is 6%; the general usury limit is 5 1/2% above the six-month treasury bill interest rate. The judgment rate is the contract rate or 12%, whichever is less. A late payment charge of 1 3/4% per month may be charged to commercial accounts that are overdue provided that the charge is revealed prior to the account being opened and that the terms were less than thirty days, that is, that the account terms were net 30 or less. OKLAHOMA, the legal rate of interest is 6%. Consumer loans may not exceed 10% unless the person is licensed to make consumer loans. Maximum rate on non-consumer loans is 45%. The judgment rate is the T-Bill rate plus 4%. OREGON, the legal rate is 9%, the judgment rate is 9% or the contract rate, if lawful, whichever is higher. The general usury rate for loans below $ 50,000 is 12% or 5% above the discount rate for commercial paper. PENNSYLVANIA, the legal rate of interest is 6%, and this is the general usury limit for loans below $ 50,000, except for: loans with a lien on non-residential real estate; loans to corporations; loans that



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have no collateral above $ 35,000. Judgments bear interest at the legal rate. It is criminal usury to charge more than 25%. PUERTO RICO, the legal rate of interest is 6%; all other rates are set by the Finance Board of Office of Commissioner of Financial Institutions. Judgments bear interest at the same rate as the underlying debt. RHODE ISLAND, the legal rate of interest and judgment rate is 12%. The general usury limit is 21% or the interest rate charged for T- Bills plus 9%. SOUTH CAROLINA, the legal rate of interest is 8.75%, and judgments bear interest at the rate of 14%. Subject to federal criminal laws against loan sharking there is no general usury limit for non- consumer transactions. The South Carolina Consumer Protection code provides regulations for maximum rates of interest for consumer transactions. Please consult with counsel for the latest rates. SOUTH DAKOTA, the legal rate of interest is 15%, judgments bear interest at the rate of 12%. There is no other usury limit. There are certain limitations on consumer loans below $ 5,000.00. TENNESSEE, the legal rate and judgment rate of interest is 10%. The general usury limit is 24%, or four points above the average prime loan rate, WHICHEVER IS LESS. TEXAS, the legal rate of interest is 6%. Interest does not begin until 30 days after an account was due. The judgment rate of interest is 18% or the rate in the contract, whichever is less. There are a number of specific ceilings for different types of loans, please see counsel for information. UTAH, the legal rate of interest is 10%. Judgments bear interest at the rate of 12%, or a lawfully agreed upon rate. There are floating rates prescribed for consumer transactions. Please see counsel for information. VERMONT, the legal rate of interest and judgment rate of interest is 12%. On retail installment contracts the maximum rate is 18% on the first $ 500, 15% above $ 500. The general usury limit is 12%. VIRGINIA, the legal rate of interest is 8%. Judgments bear interest at the rate of 8%, or the lawful contract rate. Corporations and business loans do not have a usury limit, and loans over $ 5,000 for "business" or "investment" purposes are also exempt from usury laws. Consumer loans are regulated and have multiple rates. WASHINGTON, the legal rate is 12%. The general usury limit is 12%, or four points above the average T-Bill rate for the past 26 weeks, whichever is greater. (The maximum rate is announced by the State Treasurer.) Judgments bear interest at the rate of 12% or the lawful contract rate, whichever is higher.



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WEST VIRGINIA, the legal rate of interest is 6%. The maximum "contractual" rate is 8%; Commissioner of Banking issues rates for real estate loans, and, may establish maximum general usury limit based on market rates. WISCONSIN, the legal rate of interest is 5%. There are a myriad of rates for different type of loans. There is no general usury limit for corporations. Note that a loan to an individual, even if a corporation is formed, will violate the law. The judgment rate of interest is 12%, except for mortgage foreclosures, where the rate will be the lawful contract rate. WYOMING, the legal rate and judgment rate of interest is 10%. If a contract provides for a lesser rate, the judgment rate is the lesser of 10% and the contract rate.

Ethical arguments for and against usury

Freedom of trade

The primary ethical argument in defense of usury has been the argument of liberty against the "restraint of trade" since the borrower has voluntarily entered into the usury contract. Opponents note, however, that borrowers may be driven to such debts out of necessity, or economic duress. At the same time however, except for related party transactions where feelings of compassion, guilt, etc, compel the lender to lend without interest, in un-related party transactions where neither the borrower nor the lender has any predetermined attachment to one another, there is no incentive for the lender to lend, and the borrower to enjoy the (presumed) benefits of a loan without usury.

Investment

A practical argument for usury in welfare economics is that charging interest is essential to guiding the investment process, based on the claim that profits are required to direct investments to their most productive use (solving the economic calculation problem). According to this argument, interest-driven investment is essential to economic growth, and therefore to the very existence of industrial civilization. This practical argument for the utility of usury treats all "unearned" returns to capital as interest; traditionally, guaranteed interest is usurious, whereas dividends from shared ventures are less so. In this tradition, the practical case against usury does not completely apply (although replacing debt market investments with stock market savings may not always be desirable). Officially, this is how capitalist Islamic states solve the calculation problem. An example of the 'moral' difference between dividend income and interest income is found in The Merchant of Venice: Shylock lends Antonio money for trade speculation, demanding repayment in flesh should Antonio's project fail utterly (accepting none of the business risk).



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Excessive rates

In addition to the defense of interest as such, the practice of charging high interest rates is defended by those who point out that such rates reflect the very fact that the loans are being given to creditors with a high risk of default (in a competitive debt market the interest spread simply covers the credit risk). Economists of the Austrian school say that there is no such thing as a "just" interest rate separate from the free market equilibrium determined by the time-preferences of individual lenders and debtors. (Other free market theorists take a similar view on the merit of an unregulated debt market, but may not explain the subjective estimate of a worthwhile interest-rate bargain through time preference.)

Adverse selection and enforcement methods

Some have defended the threat or use of force (legal or illegal) against non-payers. This position is based on the idea that without force there will be a market failure - since very high interest loans will only be taken up by those intending to default. The need for enforcement stems from this adverse selection problem rather than any immorality inherent in moneylenders. Today's credit reporting system in industrialized countries obviates much of the need for the use of force. Since all potential lenders can quickly learn of one's delinquent status, non-payers may find an unwilling seller for many important goods, like apartment rentals, mortgages, renting of expensive equipment without a deposit, and in many cases, insurance or employment. In the minds of many debtors, such considerations outweigh fear of force brought against them.

Charities

Some low-interest charity loans (such as small business micro-loans) have made a defense on the fact that interest rates allow for the indefinite administration of the charity, the replacement of defaulted loans, and in some cases, the creation of additional loan pools in other regions. The final "ethical result" of the interest rates justifies charging them.



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Government Insured or Guaranteed Loans

Federal Housing Administration

The FHA's logo

The Federal Housing Administration (FHA) is a United States government agency created as part of the National Housing Act of 1934. The goals of this organization are: to improve housing standards and conditions; to provide an adequate home financing system through insurance of mortgage loans; and to stabilize the mortgage market..

History

During the Great Depression, the banking system failed, causing a drastic decrease in home loans and ownership. At this time, most home mortgages were short-term (three to five years), no amortization, balloon instruments at loan-to-value (LTV) ratios below fifty to sixty percent. The banking crisis of the 1930’s forced all lenders to retrieve due mortgages. Refinancing was not available, and many borrowers, now unemployed, were unable to make mortgage payments. Consequently, many homes were foreclosed, causing the housing market to plummet. Banks collected the loan collateral (foreclosed homes) but the low property values resulted in a relative lack of assets. Because there was little faith in the backing of the U.S. government, few loans were issued and few new homes were purchased.

In 1934, the federal banking system was restructured. The National Housing Act of 1934 was passed and the Federal Housing Administration was created. Its intent was to regulate the rate of interest and the terms of mortgages that it insured. These new lending practices increased the number of people who could afford a down payment on a house and monthly debt service payments on a mortgage, thereby also increasing the size of the market for single-family homes. (Garvin 2002)

The FHA calculated appraisal value based on eight criteria and directed its agents to lend more for higher appraised projects, up to a maximum cap. The two most important were "Relative Economic Stability," which constituted 40% of appraisal value, and "Protection from adverse influences," which made up another 20%. A community with even one African-American family was deemed economically unstable because the prevailing theory of housing markets was that racial integration greatly lowered home values and lead to the decline of neighborhoods. This racist point of view was



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ubiquitous amongst white Americans and explains why the FHA refused to grant mortgage loans to innumerable African-American households, as well as homeowners, who were mostly from non Anglo-Saxon backgrounds, who lived in or near African-American neighborhoods, or wanted to do so (Jackson 1985, Chapter 11).

Data on the geography of actual FHA loans was mostly kept secret, but when data has been released, scholars have found that FHA's generous programs were targeted disproportionately and almost exclusively to white Americans building homes in suburbs. Between 1935 and 1939, 220 out of 241 loans in St. Louis (91%) were located in the suburbs. From 1934 to 1960, the county of St. Louis received five times more FHA loans than the city of St. Louis, despite greater economic need in the city. Similarly, the average resident of Bronx County New York received just $10 in home mortgage loans from the FHA during its first 25 years, while the average resident in the wealthy Nassau County received $601 (Jackson 1985, Chapter 11).

Overall, the FHA has been accused of an anti-urban bias, and its practices precipitated the decline of many important American cities, by subsidizing the departure of white middle class Americans and refusing to give nearly as many loans for rental units, which would have been necessary to house low income workers. In 1968, Senator Paul Douglas of Illinois summed up the federal role in home finance: "The poor and those on the fringes of poverty have been almost completely excluded" (Jackson 1985, Chapter 11).

The FHA Today

In 1965, the Federal Housing Administration became part of the Department of Housing and Urban Development (HUD). Since 1934, the FHA and HUD have insured over 34 million home mortgages and 47,205 multifamily project mortgages. Currently, the FHA has 4.8 million insured single family mortgages and 13,000 insured multifamily projects in its portfolio. The Federal Housing Administration is the only government agency that is completely self-funded. It operates solely from its own income and comes at no cost to taxpayers. This department spurs economic growth in the form of home and community development.

During budget planning for 2013 HUD had been projecting $143,000,000 budget shortfall stemming from the FHA program. This is the first time in three decades HUD had made a request to Congress for a taxpayer subsidy. Even though FHA is statutorily required to be budget neutral, the GAO is projecting taxpayer funded subsidies of half a billion dollars over the next three years, if no changes are made to the FHA program.

Currently new budget numbers are projecting "windfall revenues" for FHA due to the collapse of the subprime market and a flood of new loans being originated with FHA.



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FHA Mortgage Insurance

FHA loans are insured through a combination of a small upfront mortgage insurance premium (UFMIP), as well as a small monthly mortgage insurance premium. The UFMIP is often financed into the loan. Unlike other forms of conventional financed mortgage insurance, the UFMIP on a FHA loan is prorated over a five year period, meaning should the homeowner refinance or sell during the first five years of his loan, he is entitled to a partial refund of the UFMIP paid at loan inception. The monthly mortgage insurance premium paid is less than that of what a borrower with a conventional mortgage and excellent credit pays per month providing the LTV is 85 is greater (in other words, providing the borrower has less than 15% equity in her home). In instances where the home owner has a poor to moderate credit history, his monthly mortgage insurance premium will be substantially less expensive with an FHA loan than with a conventional loan regardless of LTV - sometimes as little as one-ninth as much per month depending on the borrower's exact credit score, LTV, loan size, and approval status. The monthly mortgage insurance premium on an FHA loan has the ability to save a credit-challenged homeowner thousands of dollars per year depending on the size of his home loan, his credit score, and his LTV.

A borrower with an FHA loan always pays the same mortgage insurance rate regardless of her credit score. This is especially of benefit to borrowers who have less than 22% equity in their homes and credit scores under 620. Conventional mortgage insurance premium rates factor in credit scores, whereas FHA mortgage insurance premiums do not. When a borrower has a credit score under 620, conventional mortgage premiums spike dramatically. If a borrower has a credit score under 575, he may find it impossible to purchase a home for less than 20% down with a conventional loan, as the majority of mortgage insurance companies no longer write mortgage insurance policies on borrowers with credit scores under 575 due to a sharply increased risk. When they do write mortgage insurance policies for borrowers with lower credit scores, the annual premiums are sometimes as high as 4% to 5% of the loan amount. Based on this, if a consumer is considering purchasing a new home or refinancing her existing home, she would often be well-advised to look into the FHA loan program.

When a homeowner purchases a home utilizing an FHA loan, he will pay monthly mortgage insurance for a period of five years or until the loan is paid down to 78% of the appraised value - whichever comes first.

Mortgage insurance is available for housing loan lenders, protecting against homeowner mortgage default. For a small fee, lenders can obtain insurance for a value of ninety seven percent of the appraised value of the home or building. In the event of a mortgage default, this value is transferred to the FHA and the lenders receive a large percentage of their investment. The other three percent is received from the original down payment for the home.

A borrowers downpayment may come from a number of sources. The 3% requirement can be satisfied with the borrower using their own cash or receiving a gift from a family member, their employer, labor union, non-profit or government entity. Since 1998, non-profits have been providing downpayment



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gifts to borrowers that purchase homes where the seller has agreed to reimburse the non-profit and pay an additional processing fee. In May 2006, the IRS determined that this is not "charitible activity" and has moved to revoke the non-profit status of groups providing downpayment assistance in this manner.

This has led to a new downpayment program conducted by a tribal government,[The Grant America Program]. This program is exempt from IRS regulations and essentially works similarly to the non-profit programs.

FHA Mortgage Loans

The Federal Housing Administration offers various types of housing loans. These include:

Adjustable Rate Mortgages Fixed Rate Mortgage loans Energy Efficient Mortgages Graduated Payment Mortgages Mortgages for Condominium Units Growing Equity Mortgages

In order to qualify for an FHA housing loan, applicants must meet certain criteria, including employment, credit ratings and income levels. The specific requirements are:

o Steady employment history, at least two years with the same employer. o Consistent or increasing income over the past two years o Credit report should be in good standing with less than two thirty day late payments in

the past two years o Any bankruptcy on record must be at least two years old with good credit for the two

consecutive years. o Any foreclosure must be at least three years old o Mortgage payment qualified for must be approximately thirty percent of your total

monthly gross income

Effects

The creation of the Federal Housing Authority successfully increased the size of the housing market. By convincing banks to lend again, as well as changing and standardizing mortgage instruments and procedures, home ownership has increased from 40% in the 1930s to nearly 70% today. By 1938, only four years after the beginning of the Federal Housing Association, a house could be purchased for a down payment of only ten percent of the purchase price. The remaining ninety percent was financed by a twenty-five year, self amortizing, FHA-insured mortgage loan. After World War II, the FHA helped finance homes for returning veterans and families of soldiers. It has helped with purchases of both single family and multi-family homes. In the 1950s, 1960s and 1970s, the FHA helped to spark the



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production of millions of units of privately-owned apartments for elderly, handicapped and lower income Americans. When the soaring inflation and energy costs threatened the survival of thousands of private apartment buildings in the 1970s, FHA’s emergency financing kept cash-strapped properties afloat. In the 1980s, when the economy didn’t support an increase in homeowners, the FHA helped to steady falling prices, making it possible for potential homeowners to finance when private mortgage insurers pulled out of oil producing states.

The greatest effects of the Federal Housing Administration can be seen within minority populations and in cities. Nearly half of FHA’s metropolitan area business is located in central cities, a percentage that is much higher than that of conventional loans. The FHA also lends to a higher percentage of African Americans and Hispanic Americans, as well as younger, credit constrained borrowers. Because some feel that these groups include riskier borrowers, it is believed that this is part of the reason for FHA’s contribution to the homeownership increase.

As the capital markets in the United States mature, FHA has had less and less of an impact on the US Housing market. In 2006, FHA made up less than 2% of all the loans originated in the US. This has some members of Congress wondering why the Government is still in the mortgage insurance business. A vocal minority of Congressional Leaders are now calling for the end of FHA. While many Members support reforming FHA in order to make it more competitive to the for-profit industry. Several analysts question whether the taxpayers should be on the hook for a government run "for-profit" business.



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VA loan

A VA loan is a mortgage loan in the United States guaranteed by the U.S. Department of Veterans Affairs. The loan may be issued by qualified lenders.

The VA loan was designed to offer long-term financing to American veterans or their surviving spouses (provided they do not remarry). The basic intention of the VA direct home loan program is to supply home financing to eligible veterans in areas where private financing is not generally available. Eligible areas are designated by the VA as housing credit shortage areas and are generally rural areas and small cities and towns not near metropolitan or commuting areas of large cities.

The VA loan allows veterans 100% financing without private mortgage insurance or 20% second mortgage. A VA funding fee of 0 to 3.3% of the loan amount is paid to the VA and is allowed to be financed. In a purchase, veterans may borrow up to 100% of the sales price or reasonable value of the home, whichever is less. In a refinance, veterans may borrow up to 90% of reasonable value, where allowed by state laws.

As of January 1, 2006, the maximum VA loan amount with no down payment is $417,000 and can be as high as $625,500 in certain high cost areas. VA also allows the seller to pay all of the veteran's closing cost as long as the cost do not exceed 6% of the sales price of the home.

The history of VA loan

The original Servicemen's Readjustment Act, passed by the United States Congress in 1944, extended a wide variety of benefits to eligible veterans. The loan guarantee program of the Veterans Administration has been especially important to veterans[1]. Under the law, as amended, the Veterans Administration is authorized to guarantee or insure home, farm, and business loans made to veterans by lending institutions. The VA can make direct loans in certain areas for the purpose of purchasing or constructing a home or farm residence, or for repair, alteration, or improvement of the dwelling. The terms and requirements of VA farm and business loans have not induced private lenders to make such loans in volume during recent years.



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The Veterans Housing Act of 1970 removed all termination dates for applying for VA-guaranteed housing loans. This 1970 amendment also provided for VA-guaranteed loans on mobile homes.

More recently, the Veterans Housing Benefits Improvement Act of 1978 expanded and increased the benefits for millions of American veterans.

Despite a great deal of confusion and misunderstanding, the federal government generally doesn't make direct loans under the act. The government simply guarantees loans made by ordinary mortgage lenders (descriptions of which appear in subsequent sections) after veterans make their own arrangements for the loans through normal financial circles. The Veterans Administration then appraises the property in question and, if satisfied with the risk involved, guarantees the lender against loss of principal if the buyer defaults.

Funding fees

Purchase and construction loans

Note: The funding fee for regular military first time use from 1/1/04 to 9/30/04 is 2.2 percent. This figure drops to 2.15 percent on 10/1/04.

Type of Veteran Down Payment First Time

Use Subsequent Use for loans from 1/1/04 to

9/30/2011

Regular Military

None 5% or more (up to 10%) 10% or more

2.15% 1.50% 1.25%

3.3%* 1.50% 1.25%

Reserves/National Guard

None 5% or more (up to 10%) 10% or more

2.4% 1.75% 1.5%

3.3%* 1.75% 1.5%



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Cash-out refinancing loans

Type of Veteran Percentage for First Time Use Percentage for Subsequent Use

Regular Military 2.15% 3.3%*

Reserves/National Guard 2.4% 3.3%*

The higher subsequent use fee does not apply to these types of loans if the veteran’s only prior use of entitlement was for a manufactured home loan.

Other types of loans

Type of Loan Percentage for Either Type of VeteranWhether First Time or Subsequent Use

Interest Rate Reduction Refinancing Loans

.50%

Manufactured Home Loans 1.00%

Loan Assumptions .50%

The equivalents of VA loan

Private mortgage insurance

Private mortgage insurance (PMI) guarantees home mortgage loans that are conventional, that is, nongovernment loans. This private business loan program is equivalent to the FHA and the VA loan programs.

The PMI company insures a percentage of the consumer's loan to reduce the lender's risk; this percentage is paid to the lender if the consumer does not pay and the lender forecloses the loan.



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Lenders decide if they need and want private mortgage insurance. If they so decide, it becomes a requirement of the loan. PMI companies charge a fee to insure a mortgage loan; the VA insures a loan at no cost to a veteran buyer; the FHA charges a fee to guarantee the loan.

Regulation of Money and Interest Rates

Federal Reserve System

Federal Reserve System

Seal The Federal Reserve System Eccles

Building (Headquarters)

Headquarters Washington, D.C.

Chairman Ben Bernanke

Annual rate of inflation of the US dollar 1914-2006

US consumer price index 1913-2006



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The Federal Reserve System (also the Federal Reserve; informally The Fed) is the central banking system of the United States. Created in 1913 by the enactment of the Federal Reserve Act, it is a quasi-public (part private, part government) banking system composed of (1) the presidentially-appointed Board of Governors of the Federal Reserve System in Washington, D.C.; (2) the Federal Open Market Committee; (3) 12 regional Federal Reserve Banks located in major cities throughout the nation acting as fiscal agents for the U.S. Treasury, each with its own nine-member board of directors; (4) numerous private U.S. member banks, which subscribe to required amounts of non-transferable stock in their regional Federal Reserve Banks; and (5) various advisory councils. Currently, Ben Bernanke serves as the Chairman of the Board of Governors of the Federal Reserve System.

History

The Federal Reserve System is the third central banking system in the United States' history. The First Bank of the United States (1791-1811) and the Second Bank of the United States (1816-1836) each had 20-year charters, and both issued currency, made commercial loans, accepted deposits, purchased securities, had multiple branches, and acted as fiscal agents for the U.S. Treasury. In both banks the Federal Government was required to purchase 20% of the bank's capital stock and appoint 20% of the directors. Thus majority control was in the hands of private investors who purchased the rest of the stock. The banks were opposed by state-chartered banks, who saw them as very large competitors, and by many who thought they were engines of corruption that supported the business class over the needs of the common man. President Andrew Jackson vetoed legislation to renew the Second Bank of the United States, starting a period of free banking. In 1863, as a means to help finance the Civil War, a system of national banks was instituted by the National Currency Act. The banks each had the power to issue standardized national bank notes based on United States bonds held by the bank. The Act was totally revised in 1864 and later named as the National-Bank Act, or National Banking Act, as it is popularly known. The administration of the new national banking system was vested in the newly created Office of the Comptroller of the Currency and its chief administrator, the Comptroller of the Currency. The Office, which still exists today, examines and supervises all nationally chartered banks and is a part of the U.S. Treasury Department.

The early national banking system had two main weaknesses, an inelastic currency and a lack of liquidity. National bank currency was considered inelastic because it was based on the fluctuating value of U.S. Treasury bonds rather than the growing needs of the U.S. economy. If Treasury bond prices declined, a national bank had to reduce the amount of currency it had in circulation by either refusing to make new loans or by calling in loans it had already made. The related liquidity problem was largely caused by an immobile, pyramid reserve system, in which nationally chartered country banks were required to set aside their reserves in reserve city banks, which in turn were required to set aside reserves in central city banks. During planting season country banks needed to call in their reserves, and during the harvest season they would add to their reserves. A national bank whose reserves were being drained would replace its reserves by selling stocks and bonds, by borrowing from a clearing house or by calling in loans. As there was little in the way of deposit insurance, if a bank was rumored to be having liquidity problems then this might precipitate a run on the bank. Because of



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the crescendo effect of these and other difficulties, during the last quarter of the 19th Century and the beginning of the 20th Century the United States economy went through a series of financial panics.

A particularly severe panic in 1907 provided the backdrop of renewed calls for banking and currency reform, and the following year Congress enacted the Aldrich-Vreeland Act which provided for an emergency currency and established the National Monetary Commission to study banking and currency reform.

The head of the bipartisan National Monetary Commission was financial expert and Senate Republican leader Nelson Aldrich. Aldrich set up two commissions — one to study the American monetary system in depth and the other, headed by Aldrich himself, to study the European central-banking systems and report on them. Aldrich went to Europe opposed to centralized banking, but after viewing Germany's banking system came away believing that a centralized bank was better than the government-issued bond system that he had previously supported. Centralized banking was met with much opposition from politicians, who were suspicious of a central bank and who charged that Aldrich was biased due



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to his close ties to wealthy bankers such as J.P. Morgan and his daughter's marriage to John D. Rockefeller, Jr. In 1910, Aldrich and executives representing the banks of J.P. Morgan, Rockefeller, and Kuhn, Loeb, & Co., secluded themselves for 10 days at Jekyll Island, Georgia. The executives included Frank A. Vanderlip, president of the National City Bank of New York, associated with the Rockefellers; Henry Davison, senior partner of J.P. Morgan Company; Charles D. Norton, president of the First National Bank of New York; and Col. Edward House, who would later become President Woodrow Wilson's closest adviser and founder of the Council on Foreign Relations. There, Paul Warburg of Kuhn, Loeb, & Co. directed the proceedings and wrote the primary features of what would be called the Aldrich Plan. Warburg would later write that "The matter of a uniform discount rate (interest rate) was discussed and settled at Jekyll Island." Vanderlip wrote in his 1935 autobiography From Farmboy to Financier :

I was as secretive, indeed I was as furtive as any conspirator. Discovery, we knew, simply must not happen, or else all our time and effort would have been wasted. If it were to be exposed that our particular group had got together and written a banking bill, that bill would have no chance whatever of passage by Congress…I do not feel it is any exaggeration to speak of our secret expedition to Jekyll Island as the occasion of the actual conception of what eventually became the Federal Reserve System.”

Despite the importance of the Jekyll Island meeting, it remained a secret to both the public and the government until journalist Bertie Charles Forbes wrote an article about it in 1916, three years after the Federal Reserve Act was passed.

Aldrich fought for a private bank with little government influence, but conceded that the government should be represented on the Board of Directors. Aldrich then presented what was commonly called the "Aldrich Plan" -- which called for establishment of a "National Reserve Association" -- to the National Monetary Commission. Most Republicans and Wall Street bankers favored the Aldrich Plan, but it lacked enough support in the bipartisan Congress to pass.

Because the bill was introduced by Aldrich, considered the epitome of the "Eastern establishment", the bill received little support and was derided by southerners and westerners who believed that wealthy families and large corporations ran the country and would thus run the proposed National Reserve Association. Rural bankers also opposed the plan, believing it gave too much power to their eastern counterparts. Progressive Democrats instead favored a reserve system owned and operated by the government and out of control of the "money trust", ending Wall Street's control of American currency supply. Conservative Democrats fought for a privately owned, yet decentralized, reserve system, which would still be free of Wall Street's control. The National Board of Trade appointed Warburg as head of a committee to persuade Americans to support the plan. The committee set up offices in the then-45 states and distributed printed materials about the central bank. The Nebraskan populist and frequent Democratic presidential candidate William Jennings Bryan said of the plan: "Big financiers are back of the Aldrich currency scheme." He asserted that if it passed, big bankers would "then be in complete control of everything through the control of our national finances.".



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There was also Republican opposition to the Aldrich Plan. Republican Sen. Robert M. LaFollette and Rep. Charles Lindbergh Sr. both spoke out against the favoritism that they contended the bill granted to Wall Street. "The Aldrich Plan is the Wall Street Plan…I have alleged that there is a 'Money Trust'", said Lindbergh. "The Aldrich plan is a scheme plainly in the interest of the Trust". In response, Rep. Arsène Pujo, a Democrat from Oklahoma, obtained congressional authorization to form and chair a subcommittee (the Pujo Committee) within the House Committee Banking Committee, to conduct investigative hearings on the alleged "Money Trust." The hearings continued for a full year and were led by the Subcommittee's counsel, Democratic lawyer Samuel Untermyer, who later also assisted in preparing the Federal Reserve Act. The "Pujo hearings" convinced much of the populace that America's money largely rested in the hands of a select few on Wall Street. The Subcommittee issued a report saying:

"If by a 'money trust' is meant an established and well-defined identity and community of interest between a few leaders of finance…which has resulted in a vast and growing concentration of control of money and credit in the hands of a comparatively few men…the condition thus described exists in this country today...To us the peril is manifest...When we find...the same man a director in a half dozen or more banks and trust companies all located in the same section of the same city, doing the same class of business and with a like set of associates similarly situated all belonging to the same group and representing the same class of interests, all further pretense of competition is useless.... "

Seen as a "Money Trust" plan, the Aldrich Plan was opposed by the Democratic Party as was stated in its 1912 campaign platform, but the platform also supported a revision of banking laws that would protect the public from financial panics and "the domination of what is known as the "Money Trust." During the 1912 election the Democractic Party took control of the Presidency and both chambers of Congress. The newly elected President, Woodrow Wilson, was committed to banking and currency reform, but it took a great deal of his political influence to get an acceptable plan passed as the Federal Reserve Act in 1913. Wilson thought the Aldrich plan was perhaps "60-70% correct". When Virginia Rep. Carter Glass, chairman of the House Committee on Banking and Currency, presented his bill to President-elect Wilson, Wilson said that the plan must be amended to contain a Federal Reserve Board appointed by the executive branch to maintain control over the bankers.

After Wilson presented the bill to Congress, a group of Democratic congressmen revolted, led by Representative Robert Henry of Texas, demanding that the "Money Trust" be destroyed before it could undertake major currency reforms. They particularly objected to the idea of regional banks having to operate without the implicit government protections that large, so-called money-center banks would enjoy. The group almost succeeded in killing the bill, but were mollified by Wilson's promises to propose antitrust legislation after the bill had passed and by Bryan's support of the bill.

Congress passed the Federal Reserve Act in late 1913 on a mostly partisan basis, with most Democrats in support and most Republicans against it. The plan that passed was closer to the Aldrich Plan than to the two Democratic plans. Frank Vanderlip, one of the Jekyll Island attendees and the President of National City Bank, wrote in his autobiography:



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"Although the Aldrich Federal Reserve Plan was defeated when it bore the name Aldrich, nevertheless its essential points were all contained in the plan that was finally adopted."

This point was also made by Rep. Charles Lindbergh Sr., the most vocal opponent of the bill and a member of the House Banking and Currency Committee, who on the day before the Federal Reserve Act was passed told Congress:

"This is the Aldrich bill in disguise…The worst legislative crime of the ages is perpetrated by this banking bill…The banks have been granted the special privilege of distributing the money, and they charge as much as they wish…This is the strangest, most dangerous advantage ever placed in the hands of a special privilege class by any Government that ever existed. The system is private...There should be no legal tender other than that issued by the government…The People are the Government. Therefore the Government should, as the Constitution provides, regulate the value of money." (Congressional Record, 1913-12-22)

Congressman Victor Murdock told Congress on that same day:

"I do not blind myself to the fact that this measure will not be effectual as a remedy for a great national evil – the concentrated control of credit…The Money Trust has not [died]...He will not cease fighting…at some half-baked enactment…You struck a weak half-blow, and time will show that you have lost. You could have struck a full blow and you would have won." (Congressional Record, 12/22/1913)

In order to get the Federal Reserve Act passed, Wilson needed the support of populist William Jennings Bryan, who was credited with ensuring Wilson's nomination by dramatically throwing his support Wilson's way at the 1912 Democratic convention. Wilson appointed Bryan as his Secretary of State. Bryan served as leader of the agrarian wing of the party and had argued for unlimited coinage of silver in his "Cross of Gold Speech" at the 1896 Democratic convention. Bryan and the agrarians wanted a government-owned central bank which could print paper money whenever Congress wanted, and thought the plan gave bankers too much power to print the government's currency. Wilson sought the advice of prominent lawyer Louis Brandeis to make the plan more amenable to the agrarian wing of the party; Brandeis agreed with Bryan. Wilson convinced them that because Federal Reserve notes were obligations of the government and because the President would appoint the members of the Federal Reserve Board, the plan fit their demands. However, Bryan soon became disillusioned with the system. In the November 1923 issue of "Hearst's Magazine" Bryan wrote that "The Federal Reserve Bank that should have been the farmer's greatest protection has become his greatest foe."

Southerners and westerners learned from Wilson that the system was decentralized into 12 districts and surely would weaken New York and strengthen the hinterlands. Sen. Robert Owen of Oklahoma eventually relented to speak in favor of the bill, arguing that the nation's currency was already under too much control by New York elites, whom he alleged had singlehandedly conspired to cause the 1907 Panic.

Large bankers thought the legislation gave the government too much control over markets and private business dealings. The New York Times called the Act the "Oklahoma idea, the Nebraska idea"-- referring to Owen and Bryan's involvement.



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However, several Congressmen, including Owen, Lindbergh, LaFollette, and Murdock claimed that the New York bankers feigned their disapproval of the bill in hopes of inducing Congress to pass it. The day before the bill was passed, Murdock told Congress:

"You allowed the special interests by pretended dissatisfaction with the measure to bring about a sham battle, and the sham battle was for the purpose of diverting you people from the real remedy, and they diverted you. The Wall Street bluff has worked." (Congressional Record, 12/22/1913)

While a system of 12 regional banks was designed so as not to give eastern bankers too much influence over the new bank, in practice, the Federal Reserve Bank of New York became "first among equals". The New York Fed, for example, is solely responsible for conducting open market operations, at the direction of the Federal Open Market Committee. Democratic Congressman Carter Glass sponsored and wrote the eventual legislation, and his home of Richmond, Virginia, was made a district headquarters. Democratic Senator James A. Reed of Missouri obtained two districts for his state. To quell Elihu Root's objections to possible inflation, the passed bill included provisions that the bank must hold at least 40% of its outstanding loans in gold. (In later years, to prevent depressions and stimulate short-term economic activity, Congress would amend the act to allow more discretion in the amount of gold that must be redeemed by the Bank.) Critics of the time (later joined by economist Milton Friedman) suggested that Glass's legislation was almost entirely based on the Aldrich Plan that had been derided as giving too much power to elite bankers. Glass denied copying Aldrich's plan. In 1922, he told Congress, "no greater misconception was ever projected in this Senate Chamber."

Wilson named Warburg and other prominent experts to direct the new system, which began operations in 1915 and played a major role in financing the Allied and American war efforts. Warburg at first refused the appointment, citing America's opposition to a "Wall Street man", but when World War I broke out he accepted. He was the only appointee asked to appear before the Senate, whose members questioned him about his interests in the central bank and his ties to Kuhn, Loeb, & Co.'s "money trusts".

In July 1979, Paul Volcker was nominated, by President Carter, as Chairman of the Federal Reserve Board amid roaring inflation. He tightened the money supply, and by 1986 inflation had fallen sharply. In October 1979 the Federal Reserve announced a policy of "targeting" money aggregates and bank reserves in its struggle with double-digit inflation.

In January 1987, with retail inflation at only 1%, the Federal Reserve announced it was no longer going to use money-supply aggregates, such as M2, as guidelines for controlling inflation, even though this method had been in use from 1979, apparently with great success. Before 1980, interest rates were used as guidelines; inflation was severe. The Fed complained that the aggregates were confusing. Volcker was chairman until August 1987, whereupon Alan Greenspan assumed the mantle, seven months after monetary aggregate policy had changed.



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Legal status and position in government

The Reserve Banks opened for business on November 16, 1914. Federal Reserve Notes were created as part of the legislation, to provide a supply of currency. The notes were to be issued to the Reserve Banks for subsequent transmittal to banking institutions. The various components of the Federal Reserve System have differing legal statuses.

The Board of Governors of the Federal Reserve System is an independent federal government agency. The Board of Governors does not receive funding from Congress, and the terms of the seven members of the Board span multiple presidential and congressional terms. Once a member of the Board of Governors is appointed by the president, he or she functions mostly independently. The Board is required to make an annual report of operations to the Speaker of the U.S. House of Representatives. The law provides for the removal of a member of the Board by the President "for cause." The Board of Governors is responsible for the formulation of monetary policy. It also supervises and regulates the operations of the Federal Reserve Banks, and US banking system in general.

The Federal Reserve Banks have an intermediate status, with some features of private corporations and some features of public federal agencies. Each member bank owns nonnegotiable shares of stock in its regional Federal Reserve Bank—but these shares of stock give the member banks only limited control over the actions of the Federal Reserve Banks, and the charter of each Federal Reserve Bank is established by law and cannot be altered by the member banks. In Lewis v. United States, the United States Court of Appeals for the Ninth Circuit stated that "the Reserve Banks are not federal instrumentalities for purposes of the FTCA [the Federal Tort Claims Act], but are independent, privately owned and locally controlled corporations." The opinion also stated that "the Reserve Banks have properly been held to be federal instrumentalities for some purposes." Another decision is Scott v. Federal Reserve Bank of Kansas City in which the distinction between the Federal Reserve Banks and the Board of Governors is made.

The member banks are privately owned corporations. The stocks of many of the member banks (or their holding companies) are publicly traded.



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Organization

The basic structure of the Federal Reserve System includes:

The Federal Reserve Board of Governors

The Federal Open Market Committee

The Federal Reserve Banks

The member banks.

Each Federal Reserve Bank and each member bank of the Federal Reserve System is subject to oversight by a Board of Governors. The seven members of the board are appointed by the President and confirmed by the Senate. Members are selected to terms of 14 years (unless removed by the President), which are generally limited to one term. However, if someone is appointed to serve the remainder of another member's uncompleted term, he or she may be reappointed to serve an additional 14-year term. Conversely, a governor may serve the remainder of another governor's term even after he or she has completed a full term.

Ben Bernanke, chairman of the Board of Governors of the Federal Reserve System.

The current members of the Board of Governors are:

Ben Bernanke, Chairman Donald Kohn, Vice-Chairman Frederic Mishkin Kevin Warsh Randall Kroszner



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(*Because appointments of members are staggered there are currently only five members on the board.)

All current members of the Board of Governors have taken office during the presidency of George W. Bush.

The Federal Open Market Committee (FOMC) created under 12 U.S.C. § 263 comprises the seven members of the board of governors and five representatives selected from the regional Federal Reserve Banks. The representative from the Second District, New York, (currently Timothy Geithner) is a permanent member, while the rest of the banks rotate at two- and three-year intervals.

Control of the money supply

The Federal Reserve System tries to control the size of the money supply by conducting open market operations, in which the Federal Reserve lends or purchases specific types of securities with authorized participants, known as primary dealers, such as the United States Treasury. All open market operations in the United States are conducted by the Open Market Desk at the Federal Reserve Bank of New York, with an aim to making the federal funds rate as close to the target rate as possible.[citation needed] For a detailed look at the process by which changes to a reserve account held at the Fed affect the wider monetary supply of the economy, see money creation.

The Open Market Desk has two main tools to adjust monetary supply: repurchase agreements and outright transactions.

[Measuring the money supply

Components of US money supply (M1, M2, and M3) since 1959



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The most common measures are named M0 (narrowest), M1, M2, and M3. In the United States they are defined by the Federal Reserve as follows:

M0: The total of all physical currency, plus accounts at the central bank that can be exchanged for physical currency.

M1: M0 - those portions of M0 held as reserves or vault cash + the amount in demand accounts ("checking" or "current" accounts).

M2: M1 + most savings accounts, money market accounts, and small denomination time deposits (certificates of deposit of under $100,000).

M3: M2 + all other CDs, deposits of eurodollars and repurchase agreements.

The Federal Reserve ceased publishing M3 statistics in March 2006, explaining that it costs a lot to collect the data but doesn't provide significantly useful information. The other three money supply measures continue to be provided in detail.

Repurchase agreements

To smooth temporary or cyclical changes in the monetary supply, the desk engages in repurchase agreements (repos) with its primary dealers. Repos are essentially secured, short-term lending by the Fed. On the day of the transaction, the Fed deposits money in a primary dealer’s reserve account, and receives the promised securities as collateral. When the transaction matures, the process unwinds: the Fed returns the collateral and charges the primary dealer’s reserve account for the principal and accrued interest. The term of the repo (the time between settlement and maturity) can vary from 1 day (called an overnight repo) to 65 days.

Since there is an increase of bank reserves during the term of the repo, repos temporarily increase the money supply. The effect is temporary since all repo transactions unwind, with the only lasting net effect being a slight depletion of reserves caused by the accrued interest (think one day of interest at a 6.5% annual yield, which is 0.0178% per day). The Fed has conducted repos almost daily in 2004-05, but can also conduct reverse repos to temporarily shrink the money supply. In a reverse repo, the Fed will borrow money from the reserve accounts of primary dealers in exchange for Treasury securities as collateral. At maturity, the Fed will return the money to the reserve accounts with the accrued interest, and collect the collateral.

Outright Transactions

The other main tool available to the Open Market Desk is the outright transaction. In an outright purchase, the Fed buys Treasury securities from primary dealers and finances the purchases by depositing newly created money in the dealer’s reserve account at the Fed. Since this operation does not unwind at the end of a set period, the resulting growth in the monetary supply is permanent. That is to say that the principal growth is permanent but a yield on maturity of the security is still charged—this is usually at 12 - 18 months on outright transaction.



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The Fed also has the authority to sell Treasuries outright, but this has been exceedingly rare since the 1980s. The sale of Treasury securities results in a permanent decrease in the money supply, as the money used as payment for the securities from the primary dealers is removed from their reserve accounts, thus working the money multiplier (see Money creation) process in reverse.

On Outright Transactions, the Desk selects bids with the highest prices (lowest yields) for its sales, and offers with the lowest prices (highest yields) for its purchases.

Implementation of monetary policy

Buying and selling federal government securities. When the Federal Reserve System buys government securities, it puts money into circulation. With more money around, interest rates tend to drop, and more money is borrowed and spent. When the Fed sells government securities, it in effect takes money out of circulation, causing interest rates to rise and making borrowing more difficult.

Regulating the amount of money that a member bank must keep in hand as reserves. A member bank lends out most of the money deposited with it. If the Federal Reserve System says that a member bank must keep in reserve a larger fraction of its deposits, then the amount that the member bank can lend drops, loans become harder to obtain, and interest rates rise.

Changing the interest charged to banks that want to borrow money from the federal reserve system. Member banks borrow from the Federal Reserve System to cover short-term needs. The interest that the Fed charges for this is called the discount rate; this will have an effect, though usually rather small, on how much money the member banks will borrow.

Federal Reserve Balance Sheet

One of the keys to understanding the Federal Reserve is the Federal Reserve Balance Sheet (or Balance Statement). In accordance with Section 11 of the Federal Reserve Act, the Board of Governors of the Federal Reserve System publishes once each week the "Consolidated Statement of Condition of All Federal Reserve Banks" showing the condition of each Federal Reserve bank and a consolidated statement for all Federal Reserve banks.

Analyzing the Federal Reserve's Balance Sheet reveals many interesting things:

The Fed has over 11 billion in gold which is a holdover from the days the government used to back US Notes and Federal Reserve Notes with gold



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The Fed holds almost a billion in coinage not as a liability but as an asset. The Treasury Department is actually in charge of creating coins and US Notes. The Fed then buys coinage from the Treasury by increasing the liability assigned to the Treasury's account

The Fed holds 790 billion of the national debt.

The Fed has about 21 billion in assets from Overnight Repurchase agreements. Repurchase agreements are the primary asset of choice for the Fed in dealing in the Open Market. Repo assets are bought by creating 'Depository institution' liabilities and directed to the bank the Primary Dealer uses when they sell into the Open Market.

The 976 billion in Federal Reserve Note liabilities represents the total value of all dollar bills in existence

The 16 billion in deposit liabilities of 'Depository institutions' shows that dollar bills are not the only source of government money. Banks can swap 'Deposit Liabilities' of the Fed for 'Federal Reserve Notes' back and forth as needed to match demand from customers, and the Fed can have the 'Bureau of Engraving and Printing' create the paper bills as needed to match demand from banks for paper money. The amount of money printed has no relation to the growth of the monetary base (M0).

The 6 billion in Treasury liabilities shows that the Treasury Department doesn't use a private banker but rather uses the Fed directly (the lone exception to this rule is Treasury Tax and Loan because government worries that pulling too much money out of the private banking system during tax time could be disruptive).

The 96 million Foreign liability represents the amount of Federal Reserve deposits held by foreign central banks.

The 6 billion in 'Other liabilities and accrued dividends' represents partly the amount of money owed so far in the year to private banks as part of the 6% dividend guarantee the Fed grants banks for not loaning out a percentage of their reserves

Total capital represents the profit the Fed has earned which comes mostly from the assets they purchase with the deposit and note liabilities they create. Excess capital is then turned over to the Treasury Department and Congress to be included into the Federal Budget as "Miscellaneous Revenue".



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Federal funds rate and discount rate

The effective federal funds rate charted over fifty years

The Federal Reserve System implements monetary policy largely by targeting the federal funds rate. This is the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed. This rate is actually determined by the market and is not explicitly mandated by the Fed. The Fed therefore tries to align the effective federal funds rate with the targeted rate by adding or subtracting from the money supply through open market operations. The late economist Milton Friedman consistently criticized this reverse method of controlling inflation by seeking an ideal interest rate and enforcing it through affecting the money supply since nowhere in the widely accepted money supply equation are interest rates found.

The Federal Reserve System also directly sets the "discount rate", which is the interest rate that banks pay the Fed to borrow directly from it. This rate is generally set at a rate close to 100 points above the target federal funds rate. The idea is to encourage banks to seek alternative funding before using the "discount rate" option.

Both of these rates influence the prime rate which is usually about 3 percentage points higher than the federal funds rate.

Lower interest rates stimulate economic activity by lowering the cost of borrowing, making it easier for consumers and businesses to buy and build. Higher interest rates slow the economy by increasing the cost of borrowing. (See monetary policy for a fuller explanation.)

The Federal Reserve System usually adjusts the federal funds rate by 0.25% or 0.50% at a time. From early 2001 to mid 2003 the Federal Reserve lowered its interest rates 13 times, from 6.25 to 1.00%, to fight recession. In November 2002, rates were cut to 1.75, and many interest rates went below the inflation rate. (This is known as a negative real interest rate, because money paid back from a loan with an interest rate less than inflation has lower purchasing power than it had before the loan.) On June 25, 2003, the federal funds rate was lowered to 1.00%, its lowest nominal rate since July, 1958, when the



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overnight rate averaged 0.68%. Starting at the end of June, 2004, the Federal Reserve System raised the target interest rate and then continued to do so 17 straight times. Most recently, the Fed cut by .25% after its December 11, 2007 meeting, disappointing many invidual investors: the Dow Jones Industrial Average dropped by nearly 300 points at its close.

The Federal Reserve System might also attempt to use open market operations to change long-term interest rates, but its "buying power" on the market is significantly smaller than that of private institutions. The Fed can also attempt to "jawbone" the markets into moving towards the Fed's desired rates, but this is not always effective.

The Federal Reserve Banks and the member banks

Federal Reserve Districts

The 12 regional Federal Reserve Banks (not to be confused with the "member banks"), which were established by Congress as the operating arms of the nation's central banking system, are organized much like private corporations—possibly leading to some confusion about “ownership.” For example, the Reserve Banks issue shares of stock to "member banks." However, owning Reserve Bank stock is quite different from owning stock in a private company. The Reserve Banks are not operated for profit, and ownership of a certain amount of stock by a "member bank" is, by law, a condition of membership in the system. The stock may not be sold or traded or pledged as security for a loan; dividends are, by law, limited to 6% per year. The largest of the Reserve Banks, in terms of assets, is the Federal Reserve Bank of New York, which is responsible for the Second District covering the state of New York, the New York City region, 12 northern New Jersey counties, Puerto Rico, and the U.S. Virgin Islands.

The dividends paid by the Federal Reserve Banks to member banks are considered partial compensation for the lack of interest paid on member banks' required reserves held at the Federal Reserve Banks. By law, banks in the United States must maintain fractional reserves, most of which are kept on account at the Fed. The Federal Reserve does not pay interest on these funds.



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The basic structure of the Federal Reserve System includes:

The Board of Governors The Federal Open Market Committee The Federal Reserve Banks The member banks.

Each Federal Reserve Bank and each member bank of the Federal Reserve System is subject to oversight by the Board of Governors (see generally 12 U.S.C. § 248). The seven members of the board are appointed by the President and confirmed by the Senate. Members are selected to terms of 14 years (unless removed by the President), with the ability to serve for no more than one term. A governor may serve the remainder of another governor's term in addition to his or her own full term.

The Federal Reserve Banks

The Federal Reserve Districts are listed below along with their identifying letter and number. These are used on Federal Reserve Notes to identify the issuing bank for each note.

Federal Reserve Bank Letter Number Website President

Boston A 1 http://www.bos.frb.org/ Eric S. Rosengren

New York B 2 http://www.newyorkfed.org/ Timothy F. Geithner

Philadelphia C 3 http://www.philadelphiafed.org/ Charles I. Plosser

Cleveland D 4 http://www.clevelandfed.org/ Sandra Pianalto

Richmond E 5 http://www.richmondfed.org/ Jeffrey M. Lacker

Atlanta F 6 http://www.frbatlanta.org/ Dennis P. Lockhart

Chicago G 7 http://www.chicagofed.org/ Charles Evans



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St Louis H 8 http://www.stlouisfed.org/ William Poole

Minneapolis I 9 http://www.minneapolisfed.org/ Gary H. Stern

Kansas City J 10 http://www.kansascityfed.org/ Thomas M. Hoenig

Dallas K 11 http://www.dallasfed.org/ Richard W. Fisher

San Francisco L 12 http://www.frbsf.org/ Janet L. Yellen

The member banks

National banks are required to be member banks in the Federal Reserve System. Federal statute provides (in part):

Every national bank in any State shall, upon commencing business or within ninety days after admission into the Union of the State in which it is located, become a member bank of the Federal Reserve System by subscribing and paying for stock in the Federal Reserve bank of its district in accordance with the provisions of this chapter and shall thereupon be an insured bank under the Federal Deposit Insurance Act [. . . .]"

Other banks may elect to become member banks. According to the Federal Reserve Bank of Boston:

Any state-chartered bank (mutual or stock-formed) may become a member of the Federal Reserve System. The twelve regional Reserve Banks supervise state member banks as part of the Federal Reserve System’s mandate to assure strength and stability in the nation’s domestic markets and banking system. Reserve Bank supervision is carried out in partnership with the state regulators, assuring a consistent and unified regulatory environment. Regional and community banking organizations constitute the largest number of banking organizations supervised by the Federal Reserve System.

For example, as of October 2006 the member banks in New Hampshire included Community Guaranty Savings Bank; The Lancaster National Bank; The Pemigewasset National Bank of Plymouth; and other banks. In California, member banks (as of September 2006) included Bank of America California, National Association; The Bank of New York Trust Company, National Association; Barclays Global Investors, National Association; and many other banks.



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Regulation of fractional reserve

The Fed regulates banks' fractional reserves—the portion of their deposits that banks must keep, on hand or at the Fed, as reserves to satisfy any demands for withdrawal. This directly affects the banks' ability to make loans, since loans cannot be made out of reserves. The United States' rules and oversight are within limits and guidelines set by the Bank for International Settlements, a banking agency which pre-dates the Bretton Woods financial and monetary system and its institutions.

Criticisms

Critics charge that a cult of personality surrounded Alan Greenspan

A large and varied group of criticisms has been directed against the Federal Reserve System. One critique, typified by the Austrian School, is that the Federal Reserve is an unnecessary and counterproductive interference in the economy. Other critiques include arguments in favor of the gold standard (usually coupled with the belief that the Federal Reserve System is unconstitutional) or beliefs that the centralized banking system is doomed to fail. Some critics argue that the Fed lacks accountability and transparency or that there is a culture of secrecy within the Reserve.

Historical criticisms

Criticisms of the Federal Reserve System are not new, and some historical criticisms are reflective of current concerns.



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At one end of the spectrum are economists from the Austrian School and the Chicago School who want the Federal Reserve System abolished. They criticize the Federal Reserve System’s expansionary monetary policy in the 1920s, arguing that the policy allowed misallocations of capital resources and supported a massive stock price bubble. They also cite politically motivated expansions or tightening of currency in the 1970s and 1980s.

Milton Friedman, leader of the Chicago School, argued that the Federal Reserve System did not cause the Great Depression, but made it worse by contracting the money supply at the very moment that markets needed liquidity. Since its entire existence was predicated on its mission to prevent events like the Great Depression, it had failed in what the 1913 bill tried to enact. This is also the current conventional wisdom on the matter, as both Ben Bernanke and other economists such as the late John Kenneth Galbraith--the latter being an ardent Keynesian--have upheld this reasoning. Friedman also said that ideally he would "prefer to abolish the federal reserve system altogether" rather than try to reform it, because it was a flawed system in the first place. He later said he would like to "abolish the Federal Reserve and replace it with a computer", meaning that it would be a mechanical system in nature that would keep the quantity of money going up at a steady rate. Friedman also believed that, ideally, the issuing power of money should rest with the Government instead of private banks issuing money through fractional reserve lending.

Ben Bernanke agreed that the Fed had made the Great Depression worse, saying in a 2002 speech: "I would like to say to Milton [Friedman] and Anna [J. Schwartz]: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

Friedman also alleged that the Fed caused the high inflation of the 1970s. When asked about the greatest economic problem of the day, he said the most pressing was how to get rid of the Federal Reserve.

Opacity

Some believe the Federal Reserve System is shrouded in what its critics call excessive secrecy. Meetings of some components of the Fed are held behind closed doors, and the transcripts are released with a lag of five years. Even expert policy analysts are unsure about the logic behind Fed decisions. Critics argue that such opacity leads to greater market volatility, because the markets must guess, often with only limited information, about how the Fed is likely to change policy in the future. The jargon-laden fence-sitting opaque style of Fed communication, especially under the previous Fed Chairman Alan Greenspan, has often been called "Fed speak."

The Federal Reserve System has also been considered reserved in its relations with the media in an effort to maintain its carefully crafted image and resents any public information that runs contrary to this notion. Maria Bartiromo reported on CNBC that during a conversation at the White House Correspondents’ Dinner in April 2006, Federal Reserve Board Chairman Ben Bernanke stated investors had misinterpreted his recent congressional remarks as an indication the Fed was nearly done raising rates. This triggered a drop in stock prices just when the market was about to close.



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In 1993, Rep. Henry Gonzalez confirmed that the Fed did have tapes and transcripts of the meetings and could have complied with the FOIA requests, but had misrepresented the existence of the transcripts and chosen to ignore questions from Congress. After the existence of the transcripts was revealed, the Fed agreed to release the transcripts on a five-year time lag. The time period has been extended, so that for example 1992's transcripts were not released until 1998.

Some critics believe the Fed exacerbated this idea when the Fed decided to stop publishing the M3 aggregate of financial data, which details the total amount of money in circulation at a time. The Fed said that economists did not need M3 when they had M2. However, a journalist from the Connecticut Journal-Inquirer disagreed and saw no reason (according to his own views) to stop posting the numbers other than to keep the amount of America's debt or a pending stock market crash or worsening economy hidden. In addition, Congressman Ron Paul questioned the action of discontinuing the M3 statistic, as the move would only save the Federal Reserve less than .001% of their annual budget.

Business cycles, libertarian philosophy and free markets

Economists of the Austrian School such as Ludwig von Mises contend that the Federal Reserve's operation amounts to an artificial manipulation of the money supply and has led to the boom/bust business cycle occurring over the last century. Many economic libertarians, such as Austrian School economist Murray Rothbard, believe that the Federal Reserve's manipulation of the money supply to stop "gold flight" from England caused, or was instrumental in causing, the Great Depression. See Austrian Business Cycle Theory. In general, laissez-faire advocates of free banking argue that there is no better judge of the proper interest rate and money supply than the market.

Many libertarians also contend that the Federal Reserve Act is unconstitutional. Congressman Ron Paul (ranking member of the House Subcommittee on Domestic Monetary Policy), for example, argues that: "The United States Constitution grants to Congress the authority to coin money and regulate the value of the currency. The Constitution does not give Congress the authority to delegate control over monetary policy to a central bank. Furthermore, the Constitution certainly does not empower the federal government to erode the American standard of living via an inflationary monetary policy."

Inflation

One major area of criticism focuses on the failure of the Federal Reserve System to stop inflation; this is seen as a failure of the Fed's legislatively mandated duty to maintain stable prices. These critics focus particularly on inflation's effects on wages, since workers are hurt if their wages do not keep up with inflation. They point out that wages, as adjusted for inflation, or real wages, have dropped in the past. But other economists argue that the Fed is too much focused on inflation, which is effectively a contractionary policy that keeps the unemployment rate too high and suppresses wages, as a result.



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Congress

Congressman Louis T. McFadden, Chairman of the House Committee on Banking and Currency from 1920–31, accused the Federal Reserve of deliberately causing the Great Depression. In several speeches made shortly after he lost the chairmanship of the committee, McFadden claimed that the Federal Reserve was run by Wall Street banks and their affiliated European banking houses. On June 10, 1932, McFadden said:

Mr. Chairman, we have in this country one of the most corrupt institutions the world has ever known. I refer to the Federal Reserve Board and the Federal Reserve Banks. The Federal Reserve Board, a Government board, has cheated the Government of the United States and the people of the United States out of enough money to pay the national debt. These twelve private credit monopolies were deceitfully and disloyally foisted upon this country by the bankers who came here from Europe and repaid us for our hospitality by undermining our American institutions...The people have a valid claim against the Federal Reserve Board and the Federal Reserve banks.

Quite a few Congressmen who have been involved in the House and Senate Banking and Currency Committees have been open critics of the Federal Reserve. Senator Robert L. Owen, the Chairman of the Senate Banking and Currency Committee from 1913-19, was a sponsor of the Federal Reserve Act in 1913, but he criticized the system later in his life because he did not believe that the Federal Reserve directors were doing enough to maintain a stable price level. Congressman Wright Patman, the Chairman of the House Banking and Currency Committee from 1963-75, spent his entire Congressional career criticizing the Federal Reserve's existence, saying that the Government should manage its own money system independent of the private banks. Congressman Henry Reuss chaired the same Committee from 1975-81 and he echoed Patman's criticism that the system inherently favored the corporate and banking elite. Congressman Henry Gonzalez also chaired the same Committee from 1989-95, and he was also an ardent critic of the Federal Reserve System. Currently, Congressman Ron Paul is the ranking member of the Monetary Policy SubCommittee and he is a staunch opponent of the Federal Reserve System. Paul annually introduces a bill in Congress to abolish the Federal Reserve.

The Secondary Mortgage Market The secondary mortgage market consists on investors who purchase and hold loans as investments. These could include insurance companies, pension plans, private investors or government or quasi-government corporations.

Federal National Mortgage Association Fannie Mae (Federal National Mortgage

Association)



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Type Public

Founded 1938

Headquarters Washington, DC

Key people Daniel Mudd, President & CEO

Industry Credit Services

Products Financial Services

Revenue $53.8 billion (2003)

Employees 5,400

Slogan Our Business Is The American Dream

Website www.fanniemae.com

The Federal National Mortgage Association (FNMA) (NYSE: FNM), commonly known as Fannie Mae, is a government sponsored enterprise (GSE) of the United States government. As a GSE, it is a privately-owned corporation authorized to make loans and loan guarantees. It is not backed or funded by the U.S. government, nor do the securities it issues benefit from any explicit government guarantee or protection.

This secondary mortgage market helps to replenish the supply of lendable money for mortgages and ensures that money continues to be available for new home purchases. The name "Fannie Mae" is a creative acronym-portmanteau of the company's full name that has been adopted officially for ease of identification.

History

Fannie Mae was originally founded as a government agency in 1938 as part of Franklin Delano Roosevelt's New Deal to provide liquidity to the mortgage market. For the next 30 years, Fannie Mae held a virtual monopoly on the secondary mortgage market in the United States.

In 1968, to help balance the federal budget, Fannie Mae was converted into a private corporation. Fannie Mae ceased to be the guarantor of government-issued mortgages, and that responsibility was transferred to the new Government National Mortgage Association (Ginnie Mae).

Business

Fannie Mae's primary method for making money is by charging a guarantee fee on loans that they have securitized into mortgage-backed security bonds. Investors, or purchasers of Fannie Mae MBSs, are willing to let Fannie Mae keep this fee in exchange for assuming the credit risk, that is, Fannie Mae's



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guarantee that the principal and interest on the underlying loan will be paid regardless of whether the borrower actually repays.

Fannie Mae receives no direct government funding or backing, and it has looser restrictions placed on its activities than normal financial institutions. For example, it is allowed to sell mortgage-backed securities with half as much capital backing them up as would be required of other financial institutions.

Fannie Mae securities carry no government guarantee of being repaid. This is explicitly stated in the law that authorizes GSEs, on the securities themselves, and in many public communications issued by Fannie Mae. Despite this, there is a wide perception that these notes carry an implied government guarantee, and the vast majority of investors believe that the government would prevent them from defaulting on their debt. Whether the federal government would bail out Fannie Mae in the event of insolvency is a hypothesis that has never been tested.

Neither the certificates nor payments of principal and interest on the certificates are guaranteed by the United States government. The certificates do not constitute a debt or obligation of the United States or any of its agencies or instrumentalities other than Fannie Mae.

Alan Greenspan and Ben Bernanke have spoken publicly in favor of greater regulation of the GSEs, due to the size of their holdings and the public belief in a government guarantee that does not exist.

Conforming loans

Fannie Mae (along with Freddie Mac) annually sets the limit of the size of a conforming loan based on the October to October changes in mean home price, above which a mortgage is considered a non-conforming jumbo loan. The GSEs only buy loans that are conforming, to repackage into the secondary market, making the demand for non-conforming loans lower. By virtue of the laws of supply and demand, then, it is harder for lenders to sell the loans, thus it would cost more to the consumers (typically 1/4 to 1/2 of a percent.) The conforming loan limit is 50 percent higher in Alaska, Hawaii, Guam and the US Virgin Islands.

Accounting scandal

In late 2004, Fannie Mae was under investigation for its accounting practices. The Office of Federal Housing Enterprise Oversight released a report on September 20, 2004, alleging widespread accounting errors, including shifting of losses so senior executives could earn bonuses.

Fannie Mae was expected to spend more than $1 billion in 2006 alone to complete its internal audit and bring it closer to compliance. The anticipated restatement was estimated at $10.8 billion, however, after review resulted in $6.3 billion in restated earnings as listed in Fannie Mae's Annual Report on Form 10-K.



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Concerns with business and accounting practices at Fannie Mae predate the scandal itself. On June 15, 2000, the House Banking Subcommittee On Capital Markets, Securities And Government Sponsored Enterprises held hearings on Fannie Mae.

On December 18, 2006, U.S. regulators filed 101 civil charges against chief executive Franklin Raines; chief financial officer J. Timothy Howard; and the former controller Leanne G. Spencer. The three are accused of manipulating Fannie Mae earnings to maximize their bonuses. The lawsuit seeks to recoup more than $115 million in bonus payments, collectively accrued by the trio from 1998–2004, and about $100 million in penalties for their involvement in the accounting scandal.

Government National Mortgage Association

The Government National Mortgage Association (GNMA, also known as Ginnie Mae) is a U.S. government-owned corporation within the Department of Housing and Urban Development (HUD).

Ginnie Mae provides guarantees on mortgage-backed securities (MBS) backed by federally insured or guaranteed loans, mainly loans issued by the Federal Housing Administration, Department of Veterans Affairs, Rural Housing Service, and Office of Public and Indian Housing . Ginnie Mae securities are the only MBS that are guaranteed by the United States government.

The GNMA was created by the United States Federal Government through a 1968 partition of the Federal National Mortgage Association.

Business

GNMA securities provide a connection between the capital markets and mortgage borrowers; investors purchase mortgage-backed securities (MBS also call RMBS), and borrowers gain access to investor funds. Capital market funding though MBS is much more efficient and provides a much larger funding base than tradition deposit-funding (e.g., Savings and Loan model circa pre-1989 savings and loan crisis).



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GNMA primarily does two things. First, it provides a computer platform that efficiently pools mortgages into bonds from pre-approved lenders. Second, GNMA provides, for 6 basis points of the outstanding principal balance of a bond, a guarantee of timely payment of principal and interest; this is essentially a guarantee that the United States government will continue to pay investors even if the underlying collateral (government insured mortgages) defaults. GNMA securities thus have the same credit rating as the government of the United States and for capital purposes have risk-weighting of zero.

The GNMA said in its 2003 annual report that over its history, it had guaranteed securities on the mortgages for over 30 million homes totalling over $2 trillion. It guaranteed $215.8 billion in these securities for the purchase or refinance of 2.4 million homes in 2003.

Federal Home Loan Mortgage Corporation Freddie Mac (Federal Home Loan and Mortgage

Corporation) Type Public

Founded 1970

Headquarters McLean, VA

Key people Richard Syron, Chairman & CEO; Eugene McQuade, President & COO; Ella Lee, Executive Assistant

Industry Credit Services

Products Financial Services

Revenue $44.00 billion (2006)

Employees 5,000

Slogan We Make Home Possible

Website www.freddiemac.com



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The Federal Home Loan Mortgage Corporation ("FHLMC") NYSE: FRE, commonly known as Freddie Mac, is a government-sponsored enterprise (GSE) of the United States Government. As a GSE, it is a stockholder-owned corporation authorized to make loans and loan guarantees. It is not backed or funded by the US Government, nor do the securities it issues benefit from any government guarantee or protection.

The FHLMC was created in 1970 to expand the secondary market for mortgages in the United States. Along with other GSEs, Freddie Mac buys mortgages on the secondary market, pools them, and sells them as mortgage-backed securities to investors on the open market.

This secondary mortgage market helps to replenish the supply of lendable money for mortgages and ensures that money continues to be available for new home purchases. The name "Freddie Mac" is a creative acronym-portmanteau of the company's full name that has been adopted officially for ease of identification (see "Companies" below for other examples).

History

From 1938 to 1968, the secondary mortgage market in the United States was monopolized by the Federal National Mortgage Association (Fannie Mae), which had up until then been a government agency. In 1968, to help balance the federal budget, part of Fannie Mae was converted into a private corporation. To provide competition in the secondary mortgage market, and to prevent Fannie Mae from continuing to have a monopoly, Congress chartered Freddie Mac as a private corporation to compete in this same market.

Business

Freddie Mac's primary method for making money is by charging a guarantee fee on loans that they have purchased and securitized into Mortgage-backed security bonds. Investors, or purchasers of Freddie Mac MBS, are willing to let Freddie Mac keep this fee in exchange for assuming the credit risk, that is, Freddie Mac's guarantee that the principal and interest on the underlying loan will be paid back regardless of whether the borrower actually repays.

Freddie Mac securities carry no government guarantee of being repaid. This is explicitly stated in the law that authorizes GSEs, on the securities themselves, and in many public communications issued by Freddie Mac. Despite this, there is a wide perception that these notes carry some sort of implied federal guarantee, and a majority of investors believe that the government would prevent a disastrous default. Whether the US government would in fact bail out an insolvent Freddie Mac remains an untested hypothesis.



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“Principal and interest payments are not guaranteed by and are not debts or obligations of the United States or any federal agency or instrumentality other than Freddie Mac.”

Both Alan Greenspan and Ben Bernanke have spoken publicly in favor of greater regulation of the GSEs, due to the size of their holdings and the widespread perception that they are government backed. Freddie Mac is currently regulated by the U.S. Department of Housing and Urban Development (HUD) and its Office of Federal Housing Enterprise Oversight (OFHEO). The United States House of Representatives recently passed HR 1427 (Federal Housing Finance Reform Act of 2007) which would consolidate oversight for Freddie, Fannie, and the Federal Home Loan Banks into a single regulator.

Conforming loans

OFHEO annually sets the limit of the size of a conforming loan based on the October to October changes in mean home price, above which a mortgage is considered a non-conforming jumbo loan. The GSEs are only allowed to buy loans that are conforming, which limits secondary market competition for non-conforming loans. By virtue of the laws of supply and demand, then, it is harder for lenders to sell the non-conforming loans, thus it would cost more to the consumers (typically 1/4 to 1/2 of a percent, but can be more due to credit market conditions). The conforming loan limit is 50 percent higher in high-cost areas such as Alaska, Hawaii, Guam and the US Virgin Islands, and is also higher for 2-4 unit properties on a graduating scale.

Investigations

In 2003, the company revealed that it had understated earnings by almost five billion dollars, one of the largest corporate restatements in U.S. history. As a result, it was fined 125 million dollars in November, an amount called "peanuts" by Forbes.

A 200-page report issued by Office of Federal Housing Enterprise Oversight indicated that the company's records were manipulated to meet Wall Street earnings expectations. The firm signed a consent order promising to improve internal controls and corporate governance.

On April. 18, 2006 home loan giant Freddie Mac has agreed to pay a record $3.8 million fine to settle allegations it made illegal campaign contributions.



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New Rules for Purchasing Sub-Prime Loans in the Secondary Market

Freddie Mac announced on February 27, 2007 that they will buy subprime adjustable rate mortgages only if the borrowers qualify for the maximum rate of the loan, not just the initial low introductory (known as teaser) rate.

Sub Prime Credit Loss 2007

As reported on 11 December 2007, Freddie Mac will suffer a credit hit of $12 billion as a result of a cooldown in subprime mortgage payments in the United States. Richard Syron, chief executive of the company, told investors that 'credit losses would total approximately between $10bn and $12bn' and as a result of the news Freddie Mac share prices slid more than 5% due to speculation.

Truth in Lending Act (Regulation Z)

The Truth in Lending Act (TILA) of 1968 is a United States federal law designed to protect consumers in credit transactions by requiring clear disclosure of key terms of the lending arrangement and all costs. The statute is contained in title I of the Consumer Credit Protection Act, as amended (15 USC 1601 et seq.). The regulations implementing the statute, which are known as "Regulation Z", are codified at 12 CFR Part 226. Most of the specific requirements imposed by TILA are found in Regulation Z, so a reference to the requirements of TILA usually refers to the requirements contained in Regulation Z as well as the statute itself.

The purpose of TILA is to promote the informed use of consumer credit by requiring disclosures about its terms and cost. TILA also gives consumers the right to cancel certain credit transactions that involve a lien on a consumer's principal dwelling, regulates certain credit card practices, and provides a means for fair and timely resolution of credit billing disputes. With the exception of certain high-cost mortgage loans, TILA does not regulate the charges that may be imposed for consumer credit. Rather, it requires a maximum interest rate to be stated in variable-rate contracts secured by the consumer's dwelling. It also imposes limitations on home equity plans that are subject to the requirements of Sec. 226.5b and certain higher-cost mortgages that are subject to the requirements of Sec. 226.32. The regulation prohibits certain acts or practices in connection with credit secured by a consumer's principal dwelling.



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Organization

The regulation is divided into subparts and appendices as follows:

Subpart A contains general information. It sets forth: (i) The authority, purpose, coverage, and organization of the regulation; (ii) the definitions of basic terms; (iii) the transactions that are exempt from coverage (which would be any business purpose loan); and (iv) the method of determining the finance charge.

Subpart B contains the rules for open-end credit. It requires that initial disclosures and periodic statements be provided, as well as additional disclosures for credit and charge card applications and solicitations and for home equity plans subject to the requirements of Sec. Sec. 226.5a and 226.5b, respectively. The Subpart also covers the right of rescission requirements and the advertising restrictions for open-end credit. For example, a home equity line of credit advertisement cannot mention any tax benefits without verbiage suggesting that the consumer consult a tax advisor.

Subpart C relates to closed-end credit. It contains rules on disclosures, treatment of credit balances, annual percentage rate calculations, right of rescission requirements, and advertising.

Subpart D contains rules on oral disclosures, Spanish language disclosure in Puerto Rico, record retention, effect on state laws, state exemptions (which only apply to states that had Truth in Lending-type laws prior to the Federal Act, and rate limitations.

Subpart E contains special rules for mortgage transactions. Section 226.32 requires certain disclosures and provides limitations for loans that have rates and fees above specified amounts. Section 226.33 requires disclosures, including the total annual loan cost rate, for reverse mortgage transactions. Section 226.34 prohibits specific acts and practices in connection with mortgage transactions.

Several appendices contain information such as the procedures for determinations about state laws, state exemptions and issuance of staff interpretations, special rules for certain kinds of credit plans, a list of enforcement agencies, model disclosures which if used properly will ensure compliance with the Act, and the rules for computing annual percentage rates in closed-end credit transactions and total annual loan cost rates for reverse mortgage transactions.

Other

The lender must disclose to the borrower the annual percentage rate (APR). The APR reflects the effective yield on a loan including origination fees and discount points. All fees are considered the income of the lender regardless of any costs they are designed to cover.



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Good faith estimate

A good faith estimate must be provided by a mortgage lender or broker in the United States to a customer, as required by the Real Estate Settlement Procedures Act (RESPA). The estimate must include an itemized list of fees and costs associated with your loan and must be provided within three business days of applying for a loan.

These mortgage fees, also called settlement costs or closing costs, cover every expense associated with a home loan, including inspections, title insurance, taxes and other charges.

A good faith estimate is a standard form which is intended to be used to compare different offers (or quotes) from different lenders or brokers.

The good faith estimate is only an estimate. The final closing costs may be different – sometimes very different.

Fees and Charges

The fees included within a good faith estimate fall into six basic categories:

Loan fees Fees to be paid in advance Reserves Title charges Government charges Additional charges

The following is a list of the typical charges. Each charge starts with a number – the same number is the number of the charge on a HUD-1 Real Estate Settlement Statement. This makes it easier to compare the charges you are looking for on your good faith estimate to the HUD-1.

ITEMS PAYABLE IN CONNECTION WITH LOAN:

801 - Loan Origination Fee

This fee is a charge for originating or creating the loan

802 - Loan Discount

This is an upfront charge paid to the lender to get a lower mortgage rate – the same as “buying the rate down”



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803 - Appraisal Fee

This is the cost of the independent appraisal. It is usually paid by the buyer.

804 - Credit Report

This is the cost of the credit report

805 - Lender's Inspection Fee

This is the lender’s cost of inspecting a property – some may double check the appraisal provided by an independent appraiser

808 - Mortgage Broker Fee

This is the upfront charge that a mortgage broker charges. Brokers can also earn a “rebate” from the lender which is not listed here

809 - Tax Related Service Fee

Lender fee, usually small, for handling tax related matters

810 - Processing Fee

This is the charge for processing the loan – collecting your application, running credit, collecting pay stubs, bank statements, ordering appraisal, title, etc.

811 - Underwriting Fee

This is the cost of the loan underwriter (approver)

812 - Wire Transfer Fee

This is the cost of wiring the money around, which is usually done by escrow.

ITEMS REQUIRED BY LENDER TO BE PAID IN ADVANCE

901 - Interest for days X $ per day

This is your prepaid interest for your mortgage loan.

902 - Mortgage Insurance Premium



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This is the prepaid mortgage insurance premium, if you have one. This is the insurance premium some lenders charge for loans with little equity.

903 - Hazard Insurance Premium

This is your home’s hazard insurance being prepaid.

905 - VA Funding Fee

This is the Veterans Administration funding fee, which is something you will not incur unless you go through a VA program.

RESERVES DEPOSITED WITH LENDER

1001 - Hazard Insurance Premiums # months @ $ per month

This is any prepayment of your future hazard insurance expense

1002 - Mortgage Ins. Premium Reserves months @ $ per month

This is any prepayment of your future mortgage insurance expense

1003 - School Tax months @ $ per month

This is any prepayment of your future school tax expense

1004 - Taxes and Assessment Reserves months @ $ per month

This is any prepayment of your future tax expenses, such as property taxes

1005 - Flood Insurance Reserves months @ $ per month months

This is any prepayment of your future flood insurance expense

TITLE CHARGES

1101 - Closing or Escrow Fee

This is the cost of escrow. This is the service of a neutral party that actually handles the money between all the different parties in a real estate transaction, including: the lender, the buyer, the seller, the agents, notary, etc. This is often done by the “Title Company” – a related entity in the same office that provides title insurance



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1105 - Document Preparation Fee

This is the charge for preparing the loan documents. Lenders often email the loan documents to the escrow company, which in turn prints them out and reviews them before signing

1106 - Notary Fees

This is the cost of the notary. This is to have all of the legal documents surrounding this transaction notarized

1107 - Attorney Fees

Any legal charges

1108 - Title Insurance

This is the cost of insuring the title of the property. If there is a question about title (who really owned the property), after the transaction is done then this insurance protects the lender from future problems

1200 GOVERNMENT RECORDING & TRANSFER CHARGES

1201 - Recording Fees

This is the cost of updating relevant government records

1202 - City/County Tax/Stamps

Unavoidable government charge

1203 - State Tax/Stamps

Unavoidable government charge

1300 ADDITIONAL SETTLEMENT CHARGES

1302 - Pest Inspection

This is the cost of the pest inspector. Their purpose is to document the state of the property that the lender is making the loan on.



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Equal Credit Opportunity Act

The Equal Credit Opportunity Act (ECOA) is a United States law that states that creditors must evaluate candidates based on credit worthiness only, not on factors that have nothing to do with their ability to repay the debt. The law applies to any creditor who regularly extends credit to consumers, including banks, retailers, bankcard companies, finance companies, and credit unions.

Real Estate Settlement Procedures Act

The Real Estate Settlement Procedures Act, (known as "RESPA"), was an Act passed by the United States Congress in 1974. It is codified at Title 12, Chapter 27 of the United States Code, 12 U.S.C. § 2601–2617.

Purpose

It was created because various companies associated with the buying and selling of real estate, such as lenders, realtors, and title insurance companies were often engaging in providing undisclosed kickbacks to each other, inflating the costs of real estate transactions and obscuring price competition by facilitating bait and switch tactics.

For example, a lender advertising a home loan might have advertised the loan with a 5% interest rate, but then when one applies for the loan one is told that one must use the lender's affiliated title insurance company and pay $5,000 for the service (whereas the normal rate is $1,000). The title company would then have paid $4,000 to the lender. This was made illegal.

Restrictions

The Act prohibits kickbacks between lenders and third-party settlement service agents in the real estate settlement process (Section 8 of RESPA), requires lenders to provide a good faith estimate for all the approximate costs of a particular loan and finally a HUD-1 (for purchase real estate loans) or a HUD-1A (for refinances of real estate loans) at the closing of the real estate loan. The final HUD-1 or HUD-1A allows the borrower to know specifically the costs of the loan and to whom the fees are being allotted.

Account Inquiries

If the borrower believes there is an error in the mortgage account, he or she can make a "qualified written request" to the loan servicer. The request must be in writing, identify the borrower by name and account, and include a statement of reasons why the borrower believes the account is in error. The request should include the words "qualified written request". It cannot be written on the payment



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coupon, but must be on a separate piece of paper. The Department of Housing and Urban Development provides a sample letter.

The servicer must acknowledge receipt of the request within 20 days. The servicer then has 60 days (from the request) to take action on the request. The servicer has to either provide a written notification that the error has been corrected, or provide a written explanation as to why the servicer believes the account is correct. Either way, the servicer has to provide the name and telephone number of a person with whom the borrower can discuss the matter. The servicer cannot provide information to any credit agency regarding any overdue payment during the 60 day period.

If the servicer fails to comply with the "qualified written request", the borrower is entitled to actual damages, up to $1000 of additional damages if there is a pattern of noncompliance, costs and attorneys fees.

Criticisms

Critics say however that various kickbacks still occur. For example, lenders often provide captive insurance to the title insurance companies they work with, which critics say is essentially a kickback mechanism. Others counter that economically the transaction is a zero sum game, where if the kickback were forbidden, a lender would simply charge higher prices. One of the core elements of the debate is the fact that customers overwhelmingly go with the default service providers associated with a lender or a realtor, even though they sign documents explicitly stating that they can choose to use any service provider. Some say that if the profits of the service providers were truly excessive or if the prices of the service were excessively inflated because of illegal or quasi-legal kickbacks, then at some point non affiliated service providers would attempt to target consumers directly with lower prices to entice them to choose the unaffiliated provider.

There have been various proposals to modify the Real Estate Settlement Procedures Act. One proposal is to change the "open architecture" system currently in place, where a customer can choose to use any service provider for each service, to one where the services are bundled, but where the realtor or lender must pay directly for all other costs. Under this system, lenders, who have more buying power and would more savvily seek for the lowest price for the various real estate settlement services.

Savings and Loan Crisis

The Savings and Loan crisis of the 1980s was a wave of savings and loan association failures in the United States in which over 1,000 savings and loan institutions failed in "the largest and costliest venture in public misfeasance, malfeasance and larceny of all time." The ultimate cost of the crisis is estimated to have totaled around USD$150 billion, about $125 billion of which was consequently and directly subsidized by the U.S. government, which contributed to the large budget deficits of the early 1990s.



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The resulting taxpayer bailout ended up being even larger than it would have been because Moral hazard and adverse-selection incentives compounded the system’s losses.

A taxpayer funded government bailout related to mortgages during the Savings and Loan crisis may have created a Moral hazard and acted as encouragement to lenders to make similar higher risk loans during the 2007 subprime mortgage financial crisis.

The concomitant slowdown in the finance industry and the real estate market may have been a contributing cause of the 1990-1991 economic recession.

The background

Savings and loan institutions (also known as S&Ls or thrifts) have existed since the 1800s. They originally served as community-based institutions for savings and mortgages. In the United States, S&Ls were tightly regulated until the late 1970s. For example, there was a ceiling on the interest rates they could offer to depositors.

In the 1970s, many banks, but particularly S&Ls, were experiencing a significant outflow of low-rate deposits, as interest rates were driven up by the high inflation rate of the late 1970s and as depositors moved their money to the new high-interest money-market funds. At the same time, the institutions had much of their money tied up in long-term mortgage loans that were written at fixed interest rates, and with market rates rising, were worth far less than face value. That is, in order to sell a 5% mortgage to pay requests from depositors for their funds in a market asking 10%, a savings and loan would have to discount their asking price on the mortgage. This meant that the value of these loans, which were the institution's assets, was less than the deposits used to make them and the savings and loan's net worth was being eroded.

Under financial institution regulation which had its roots in the Depression era, federally chartered S&Ls were only allowed to make a narrowly limited range of loan types. Late in the administration of President Jimmy Carter caps were lifted on rates and the amounts insured per account to $100,000. In addition to raising the amounts covered by insurance the amount of the accounts that would be repaid was increased from 70% to 100%. Increasing FDIC coverage also permitted managers to take more risk to try to work their way out of insolvency so that the government would not have to take over an institution. When Ronald Reagan took office in January 1981, 3,300 out of 3,800 S&Ls lost money that year. In 1982 the combined tangible net capital of this industry was $4 billion. The chartering of federally-regulated S&Ls accelerated rapidly with the Garn - St Germain Depository Institutions Act of 1982, which was designed to make S&Ls more competitive and more solvent. S&Ls could now pay higher market rates for deposits, borrow money from the Federal Reserve, make commercial loans, and issue credit cards. They were also allowed to take an ownership position in the real estate and other projects to which they made loans and they began to rely on brokered funds to a considerable extent. This was a departure from their original mission of providing savings and mortgages.



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Deregulation and some other causes

Although the deregulation of S&Ls gave them many of the capabilities of banks, it did not bring them under the same regulations as banks. First, thrifts could choose to be under either a state or a federal charter. Immediately after deregulation of the federally chartered thrifts, the state-chartered thrifts rushed to become federally chartered, because of the advantages associated with a federal charter. In response, states (notably, California and Texas) changed their regulations so that they would be similar to the federal regulations. States changed their regulations because state regulators were paid by the thrifts they regulated, and they didn't want to lose that money.

In an effort to take advantage of the real estate boom (outstanding US mortgage loans: 1950 $55bn; 1976 $700bn; 1980 $1.2tn) and high interest rates of the late 1970s and early 1980s, many S&Ls lent far more money than was prudent, and to risky ventures which many S&Ls were not qualified to assess. Whereas insolvent banks in the United States were typically detected and shut down quickly by bank regulators, Congress sought to change regulatory rules so S&Ls would not have some acknowledge insolvency and the FHLB would not have to close them down.

One of the most important contributors to the problem was deposit brokerage. Deposit brokers, somewhat like stockbrokers, are paid a commission by the customer to find the best certificate of deposit (CD) rates and place their customers' money in those CDs. These CDs, however, are usually short-term $100,000.00 CDs. Previously banks and thrifts could only have five percent of their deposits be brokered deposits; the race to the bottom caused this limit to be lifted. A small one-branch thrift could then attract a large number of deposits simply by offering the highest rate. In order to make money off this expensive money, it had to lend at even higher rates, meaning that it had to make more risky investments. This system was made even more damaging when certain deposit brokers instituted a scam known as "linked financing." In "linked financing" a deposit broker would approach a thrift and say that they would steer a large amount of deposits to that thrift if the thrift would loan certain people money (the people however were paid a fee to apply for the loans and told to give the loan proceeds to the deposit broker). This caused the thrifts to be tricked into taking on bad loans. Michael Milken of Drexel, Burnham and Lambert packaged brokered funds for several savings and loans on the condition that the institutions would invest in the junk bonds of his clients.

Another factor was the efforts of the federal government to wring inflation out of the economy, marked by Paul Volcker's speech of October 6, 1979, with a series of rises in short-term interest. This led to increases in the short-term cost of funding to be higher than the return on portfolios of mortgage loans, a large proportion of which may have been fixed rate mortgages (a problem that is known as an asset-liability mismatch). This effort failed and interest rates continued to skyrocket, placing even more pressure on S&Ls as the 1980s dawned and led to increased focus on high interest rate transactions. Zvi Bodie, professor of finance and economics at Boston University School of Management, writing in the St. Louis Federal Reserve Review wrote that "asset-liability mismatch was a principal cause of the Savings and Loan Crisis"



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Fallout

The damage to S&L operations led Congress to act, passing a bill in [September 1981 ?] allowing S&Ls to sell their mortgage loans and use the cash generated to seek better returns; the losses created by the sales were to be amortized over the life of the loan and any losses could also be offset against taxes paid over the preceding ten years. This all made S&Ls eager to sell their loans. The buyers - major Wall Street firms - were quick to take advantage of the S&Ls lack of expertise, buying at 60-90% of value and then transforming the loans by bundling them as, effectively, government backed bonds (by virtue of Ginnie Mae, Freddie Mac, or Fannie Mae guarantees). S&Ls were one group buying these bonds, holding $150bn by 1986, and being charged substantial fees for the transactions.

A large number of S&L customers' defaults and bankruptcies ensued, and the S&Ls that had overextended themselves were forced into insolvency proceedings themselves. In 1980 there were 4002 S&Ls trading, by 1983 962 of them had collapsed

For example, in March 1985, it came to public knowledge that the large Cincinnati, Ohio-based Home State Savings Bank was about to collapse. Ohio Gov. Richard F. Celeste declared a bank holiday in the state as Home State depositors lined up in a "run" on the bank's branches in order to withdraw their deposits. Celeste ordered the closure of all the state's S&Ls. Only those that were able to qualify for membership in the FDIC were allowed to reopen. Claims by Ohio S&L depositors drained the state's deposit insurance funds. A similar event also took place in Maryland.

The U.S. government agency Federal Savings and Loan Insurance Corporation, which at the time insured S&L accounts in the same way the Federal Deposit Insurance Corporation insures commercial bank accounts, then had to repay all the depositors whose money was lost.

Charles Keating and Lincoln Savings

The most notorious figure in the S&L crisis was probably Charles Keating, who headed Lincoln Savings of Phoenix, Arizona. Keating was convicted of fraud, racketeering, and conspiracy in 1993, and spent 4 1/2 years in prison before his convictions were overturned. In a subsequent plea agreement, Keating admitted committing bankruptcy fraud by extracting $1 million from the parent corporation of Lincoln Savings, despite having the knowledge that the corporation would collapse within weeks. Keating's attempts to escape regulatory sanctions led to the Keating five political scandal, in which five U.S. senators were implicated in an influence-peddling scheme to assist Keating. Three of those senators - Alan Cranston, Don Riegle, and Dennis DeConcini - found their political careers cut short as a result. Two others - John Glenn and John McCain - were exonerated of all charges and escaped relatively unscathed.



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Herman K. Beebe

Another character who was just as instrumental in the failure of S&Ls was Herman K. Beebe. He was a convicted felon and Mafia associate. He had many connections to the intelligence community and was considered godfather of the dirty Texas S&Ls. He initially started his career in the insurance business and eventually banking, specifically savings and loan banks. Houston Post reporter Pete Brewton linked Beebe to a dozen failed S&Ls. Altogether, Herman Beebe controlled, directly or indirectly, at least 55 banks and 29 S&Ls in eight states. What is particularly interesting about Beebe's participation in these banks and savings and loans is his unique background. Herman Beebe had served nine months in federal prison for bank fraud and had impeccable credentials as a financier for New Orleans-based organized crime figures, including Vincent and Carlos Marcello.

Neil Bush and Silverado Savings and Loan

Neil Bush was director of Silverado Savings and Loan when the institution collapsed in 1988, costing taxpayers $1.6 billion. Neil Bush was accused of giving himself a loan from Silverado with the cooperation of Ken Good, of Good International, although Bush denied all wrongdoing Neil Bush is a brother of President George W. Bush.

Reform legislation

The Federal Home Loan Bank Board reported in 1988 that fraud and insider abuse were the worst aggravating factors in the wave of S&L failures.

Financial Institutions Reform, Recovery and Enforcement Act of 1989

The Financial Institutions Reform Recovery and Enforcement Act of 1989 (FIRREA) is a United States federal law enacted in the wake of the savings and loan crisis of the 1980s. It established the Resolution Trust Corporation (RTC) to close hundreds of insolvent thrifts and provided funds pay out insurance to their depositors. It moved thrift regulatory authority from the Federal Home Loan Bank Board to the Office of Thrift Supervision (OTS) (within the United States Department of the Treasury) to regulate thrifts.

Deposit insurance

FIRREA created two new deposit insurance funds. It abolished the Federal Savings and Loan Insurance Corporation (FSLIC); the fund originially administered by FSLIC became the Savings Association Insurance Fund (SAIF). It also created the Bank Insurance Fund (BIF). Both of these funds were to be administered by the Federal Deposit Insurance Corporation. This section of FIRREA was amended by the Federal Deposit Insurance Reform Act of 2005, which consolidated the two funds.



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Other regulations

FIRREA allowed bank holding companies to acquire thrifts. It established new regulations for real estate appraisals. In addition, the Act established Appraisal Subcommittee (ASC) within the Examination Council of the Federal Financial Institutions Examination Council.

It also established new capital reserve requirements.

Appraisal standards

Title XI of FIRREA empowered federal mortgage regualtors to adopt standards for real estate appraisal and promulgate licensing requirements to the states. To accomplish this, the Appraisal Subcommittee (ASC) was formed, with representatives from the various Federal mortgage regulatory agencies. The ASC provides oversight and input to the Appraisal Foundation, which in turn promulgates the Uniform Standards of Professional Appraisal Practice and the minimum standards for appraisal licensure.

Resolution Trust Corporation

The Resolution Trust Corporation was a US government-owned asset management company mandated to liquidate assets (primarily real estate-related assets, including mortgage loans) that had been assets of savings and loan associations ("S&Ls") declared insolvent by the Office of Thrift Supervision, as a consequence of the Savings and Loan crisis of the 1980s. It also took over the insurance functions of the former Federal Home Loan Bank Board. It was created by the Financial Institutions Reform Recovery and Enforcement Act (FIRREA), adopted in 1989. In 1995, its duties were transferred to the Savings Association Insurance Fund of the Federal Deposit Insurance Corporation.

According to Joseph E. Stiglitz in his book, Towards a New Paradigm in Monetary Economics, page 243, the real reason behind the need of this company was to allow the United States government to subsidize the banking sector in a way that wasn't very transparent and therefore avoid the possible resistance. This is supported by the fact that the banks had better information related to the loans than the RTC.

For an in-depth discussion of the RTC's development, its unique structure and personnel practices, and the impact its structure had on its performance see Mark Cassell's book, "How Governments Privatize: the Politics of Divestment in the United States and Germany" (Georgetown University Press, 2002)



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Equity Partnerships

The Resolution Trust Corporation (“RTC”) pioneered the use of so-called “equity partnerships” to help liquidate real estate and financial assets which it inherited from insolvent thrift institutions. While a number of different structures were used, all of the equity partnerships involved a private sector partner acquiring a partial interest in a pool of assets, controlling the management and sale of the assets in the pool, and making distributions to the RTC reflective of the RTC’s retained interest.

The RTC used equity partnerships to achieve a superior execution through maintaining upside participation in the portfolios. Prior to introducing the equity partnership program, the RTC had engaged in “bulk sales” of asset portfolios. The pricing on certain types of assets often proved to be disappointing because the purchasers discounted heavily for “unknowns” regarding the assets, and to reflect uncertainty at the time regarding the real estate market. By retaining an interest in asset portfolios, the RTC was able to participate in the extremely strong returns being realized by portfolio investors. Additionally, the equity partnerships enabled the RTC to benefit by the management and liquidation efforts of their private sector partners, and the structure helped assure an alignment of incentives superior to that which typically exists in a principal/contractor relationship.

The following is a summary description of RTC Equity Partnership Programs:

Multiple Investor Fund (“MIF”)

Under the MIF Program, the RTC established limited partnerships (each known as a “Multiple Investor Fund” or “MIF”) and selected private sector entities to be the general partner of each MIF. The MIF structure contemplated the following:

The RTC conveyed to the MIF a portfolio of assets (principally commercial non- and sub-performing mortgage loans) which were described generically, but which had not been identified at the time the MIF general partners were selected. The assets were delivered in separate pools over time, and there were separate closings for each pool.

The selected general partner paid the RTC for its general partnership interest in the assets. The price was determined by the so-called Derived Investment Value (“DIV”) of the assets (an estimate of the liquidation value of assets based on a valuation formula developed by the RTC), multiplied by a percentage of DIV based on the bid of the selected general partner. The general partner paid its equity share relating to each pool at the closing on the pool. The RTC retained a limited partnership interest in the MIF.

The MIF asset portfolio was leveraged by RTC-provided seller financing. The RTC offered up to 75% seller financing, and one element of the bid was the amount of seller financing required by the bidder. Because of the leverage, the amount required to be paid by the MIF general



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partner on account of its interest was less than it would have been if the MIF had been an all-equity transaction.

The MIF general partner, on behalf of the MIF, engaged an asset manager (one or more entities of the MIF general partner team) to manage and liquidate the asset pool. The asset manager was paid a servicing fee out of MIF funds, and used MIF funds to improve, manage and market the assets. The asset manager was responsible for day-to-day management of the MIF, but the general partner controlled major budgetary and liquidation decisions. The RTC had no management role.

After repayment of the RTC seller financing debt, net cash flow was divided between the RTC (as limited partner) and general partner in accordance with their respective percentage interests (the general partner had at least a 50% interest).

Each of the MIF general partners was a joint venture among an asset manager with experience in managing and liquidating distressed real estate assets, and a capital source. There were two MIF transactions involving over 1000 loans having an aggregate book value of slightly over $2 billion and an aggregate DIV of $982 million .

N-Series and S-Series Mortgage Trusts

The “N-Series” and “S-Series” programs were successor programs to the MIF program. The N-Series and S-Series structure was different from that of the MIF in that (i) the subject assets were pre-identified by the RTC—under the MIF, the specific assets had not been identified in advance of the bidding—and (ii) the interests in the asset portfolios were competitively bid on by pre-qualified investors and the highest bid won (the RTC’s process for selecting MIF general partners, in contrast, took into account non-price factors).

N-Series

The N-Series structure contemplated the following:

The RTC would convey to a Delaware business trust (the “Trust”) a pre-identified portfolio of assets, mostly commercial non- and sub- performing mortgage loans. (The “N” of “N-Series” stood for “nonperforming.”)

Pre-qualified investor teams competitively bid for a 49% interest in the Trust, and the equity for this interest was payable to the RTC by the winning bidder when it closed on the acquisition of its interest.

The Trust, at its creation, issued a “Class A Certificate” to the private sector investor evidencing its ownership interest in the Trust, and a “Class B Certificate” to the RTC evidencing its ownership interest. The Class A Certificate holder exercised those management



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powers typically associated with a general partner (that is, it controlled the operation of the Trust), and the RTC, as the Class B Certificate holder, had a passive interest typical of a limited partner.

The Class A Certificate holder, on behalf of the Trust, engaged an asset manager (sometimes referred to as the “servicer”) to manage and liquidate the asset pool. The servicer was paid a servicing fee out of Trust funds. Typically, the servicer was a joint venture partner in the Class A Certificate Holder. The servicer used Trust funds to improve, maintain and liquidate Trust assets, and had day-to-day management control. The Class A Certificate Holder exercised control over major budgetary and disposition decisions.

The Trust, through a pre-determined placement agent designated by the RTC, leveraged its asset portfolio by issuing commercial mortgage backed securities (“CMBS”), the proceeds of which went to the RTC. Because of the leverage, the amount required to be paid by the Class A Certificate Holder on account of its interest was less than it would have been if the N-Trust had been an all-equity transaction.

Net cash flow was first used to repay the CMBS debt, after which it was divided between the RTC and Class A Certificate Holder at their respective equity percentages (51% RTC, 49% Class A).

Each of the N-Series bid teams was a joint venture between an asset manager with experience in managing and liquidating distressed real estate assets, and a capital source. There were a total of six N-Series partnership transactions in which the RTC placed 2,600 loans with an approximate book value of $2.8 billion and a DIV of $1.3 billion. A total of $975 million of CMBS bonds were issued for the six N-Series transaction, representing 60% of the value of N-Series trust assets as determined by the competitive bid process (the value of the assets implied by the investor bids was substantially greater than the DIV values calculated by the RTC). While the original bond maturity was 10 years from the transaction, the average bond was retired in 21 months from the transaction date, and all bonds were retired within 28 months.

S-Series

The S-Series program was similar to the N-Series program, and contained the same profile of assets as the N-Series transactions. The S-Series was designed to appeal to investors who might lack the resources necessary to undertake an N-Series transaction, and differed from the N-Series program in the following respects:

The S-Series portfolios were smaller. The “S” of “S-Series” stands for “small” -- the average S-Series portfolio had a book value of $113 million and a DIV of $52 million, whereas the N-Series average portfolio had a book value of $464 million and a DIV of $220 million. As a consequence, it required an equity investment of $4 to $9 million for investor to undertake an S-Series transaction, versus $30 - $70 million for an N-Series transaction.



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The S-Series portfolio was not leveraged through the issuance of CMBS, although it was leveraged through a 60% RTC purchase money financing. It should be noted that in the N-Series program where CMBS were issued, the servicers/asset managers had to be qualified by debt rating agencies (e.g., Standard and Poors) as a condition to the agencies’ giving a rating to the CMBS. This was not necessary in the S-Series program

Assets in the S-Series portfolios were grouped geographically, so as to reduce the investors’ due diligence costs.

There were nine S-Series transactions, into which the RTC contributed more than 1,100 loans having a total book value of approximately $1 billion and a DIV of $466 million. The RTC purchase money loans, aggregating $284 million for the nine S-transactions, were all paid off within 22 months of the respective transaction closing dates (on average, the purchase money loans were retired in 16 months).

Land Fund

The RTC Land fund program was created to enable the RTC to share in the profit from longer term recovery and development of land. Under the Land Fund Program, the RTC selected private sector entities to be the general partners of 30-year term limited partnerships known as “Land Funds.” The Land Fund program was different from the MIF and N/S-Series programs in that the Land Fund general partner had the authority to engage in long-term development, whereas the MIFs and N/S-Series Trusts were focused on asset liquidation. The Land Fund structure contemplated the following:

The RTC conveyed to the Land Fund certain pre-identified land parcels, and non/sub-performing mortgage loans secured by land parcels.

The selected general partner paid the RTC for its general partnership interest in the Land Fund. The winning bid for each Land Fund pool would determine the implied value of the pool, and the winning bidder, at closing, would pay to the RTC 25% of the implied value. (The land fund investors were given the option of contributing 25%, 30%, 35% or 40% of the equity for commensurate interest, but all chose to contribute 25% of the equity.)

The Land Fund general partner could, at its discretion, transfer assets in Land Fund pools to special-purpose entities, and those entities could then borrow money collateralized by the asset to fund development. Furthermore, a third-party developer or financing source could acquire an equity interest in the special purpose entity in exchange for services or funding.

The general partner was authorized to develop the land parcels on a long term basis, and had comprehensive authority concerning the operation of the Land Fund. Costs to improve, manage and liquidate the assets were borne by the Land Fund.

Net cash flow from the Land Fund was distributable in proportion to the respective contributions of the general partner (25%) and RTC (75%). If and when the Land Fund



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partnership distributed to the RTC an amount equal to the RTC’s “capital investment” (i.e., 75% of the implied value of the Land Fund pool), from and after such point, net cash flow would be divided on a 50/50 basis.

Land Fund general partners were joint ventures between asset managers, developers and capital sources. There were three land fund programs, giving rise to 12 land fund partnerships for different land asset portfolios. These funds received 815 assets with a total book value of $2 billion and DIV of $614 million.

JDC Program

Under the JDC Program, the RTC established limited partnerships and selected private sector entities to be the general partner of each JDC Partnership. The JDC program was different from the MIF, N/S Series and Land Fund programs in that (i) the general partner paid only a nominal price for the assets and was selected on a “beauty-contest” basis, and (ii) the general partner (rather than the partnership itself) had to absorb most operating costs. The JDC Partnership structure contemplated the following:

The RTC would convey to the limited partnership (the “JDC Partnership”) certain judgments, deficiency actions, and charged-off indebtedness (“JDCs”) and other claims which typically were unsecured and considered of questionable value. The assets were not identified in advance, and were transferred to the JDC Partnership in a series of conveyances over time.

The general partner was selected purely on the basis of perceived competence. It made payments to the RTC in the amount of one basis point (0.01%) of the book value of the assets conveyed.

The general partner exercised comprehensive control in managing and resolving the assets. Proceeds typically were split 50/50 with the RTC. Operating costs (except under special circumstances) were absorbed by the general partner, not the JDC partnership.

JDC general partners consisted of asset managers and collection firms. The JDC program was adopted by the FDIC and is still in existence.



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Types of Loans

There are numerous variables to conventional loans available for home purchases:

Adjustable rate mortgage

An adjustable rate mortgage (ARM) is a mortgage loan where the interest rate on the note is periodically adjusted based on a variety of indexes.[1]. Among the most common indexes are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). A few lenders use their own cost of funds as an index, rather than using other indexes. This is done to ensure a steady margin for the lender, whose own cost of funding will usually be related to the index. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change). This is not to be confused with the graduated payment mortage, which offers changing payment amounts but a fixed interest rate. Other forms of mortgage loan include interest only mortgage, fixed rate mortgage, negative amortization mortgage, and balloon payment mortgage. Adjustable rates transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls and loses out if interest rates rise.

Adjustable rate mortgages are characterized by their index and limitations on charges (caps). In many countries, adjustable rate mortgages are the norm, and in such places, may simply be referred to as mortgages.

Characteristics

Index

All adjustable rate mortgages have an adjusting interest rate tied to an index.[1]

Six common indices in the United States are:

11th District Cost of Funds Index (COFI) London Interbank Offered Rate (LIBOR) 12-month Treasury Average Index (MTA) Constant Maturity Treasury (CMT) National Average Contract Mortgage Rate Bank Bill Swap Rate (BBSW)



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In some countries, banks may publish a prime lending rate which is used as the index. The index may be applied in one of three ways: directly, on a rate plus margin basis, or based on index movement.

A directly applied index means that the interest rate changes exactly with the index. In other words, the interest rate on the note exactly equals the index. Of the above indices, only the contract rate index is applied directly.

To apply an index on a rate plus margin basis means that the interest rate will equal the underlying index plus a margin. The margin is specified in the note and remains fixed over the life of the loan. For example, a mortgage interest rate may be specified in the note as being LIBOR plus 2%, 2% being the margin and LIBOR being the index.

The final way to apply an index is on a movement basis. In this scheme, the mortgage is originated at an agreed upon rate, then adjusted based on the movement of the index.[1] Unlike direct or index plus margin, the initial rate is not explicitly tied to any index; the adjustments are tied to an index.

Limitations on charges (caps)

Any mortgage where payments made by the borrower may increase over time brings with it the risk of financial hardship to the borrower. To limit this risk, limitations on charges—known as caps in the industry—are a common feature of adjustable rate mortgages. Caps typically apply to three characteristics of the mortgage:

frequency of the interest rate change periodic change in interest rate total change in interest rate over the life of the loan, sometimes called life cap

For example, a given ARM might have the following types of caps:

Interest rate adjustment caps:

interest adjustments made every 6 months, typically 1% per adjustment, 2% total per year interest adjustments made only once a year, typically 2% maximum interest rate may adjust no more than 1% in a year

Mortgage payment adjustment caps:

maximum mortgage payment adjustments of 5% a year, which is common with pay-option / negative amortization loans



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Life of loan interest rate adjustment caps:

total interest rate adjustment limited to 5% of the life of the loan. Most common is 6% lifetime caps.

Caps on the periodic change in interest rate may be broken up into one limit on the first periodic change and a separate limit on subsequent periodic change, for example 5% on the initial adjustment and 2% on subsequent adjustments.

Another common cap is a limitation on the maximum monthly payment expressed in absolute rather than relative terms, for example $1000 a month.

ARMs which allow negative amortization may have a payment adjustment frequency which differs from the interest rate adjustment frequency. For example, the interest rate may be adjusted every six months, but the payment amount only once every 12 months.

Cap structure is sometimes expressed as initial adjustment cap / subsequent adjustment cap / life cap, for example 2/2/5 for a loan with a 2% cap on the inital adjustment, a 2% cap on subsequent adjustments, and a 5% cap on total interest rate adjustments. When only two values are given, this indicates that the initial change cap and periodic cap are the same. For example, a 2/2/5 cap structure may sometimes be written simply 2/5.

Reasons for ARMs

ARMs generally permit borrowers to lower their payments if they are willing to assume the risk of interest rate changes. In many countries, banks or similar financial institutions are the primary originators of mortgages. For banks that are funded from customer deposits, the customer deposits will typically have much shorter terms than residential mortgages. If a bank were to offer large volumes of mortgages at fixed rates but to derive most of its funding from deposits (or other short-term sources of funds), the bank would have an asset-liability mismatch: in this case, it would be running the risk that the interest income from its mortgage portfolio would be less than it needed to pay its depositors. In the United States, some argue that the savings and loan crisis was in part caused by this problem, that the savings and loans companies had short-term deposits and long-term, fixed rate mortgages, and were caught when Paul Volcker raised interest rates in the early 1980s.

To avoid this risk, many mortgage originators will sell or securitize their mortgages. Banking regulators pay close attention to asset-liability mismatches to avoid such problems, and place tight restrictions on the amount of long-term fixed-rate mortgages that banks may hold (in relation to their other assets).

In this perspective, banks and other financial institutions offer adjustable rate mortgages because it reduces risk and matches their sources of funding.



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For the borrower, adjustable rate mortgages may be less expensive, but at the price of higher risk borne by the borrower. In most situations, when looking at a single period (e.g. a year) short-term borrowing appears less expensive than long-term borrowing, due to the slope of the yield curve. Yet, this difference is likely founded on the expectations of increases in the short term interest rate, hence the risk over many periods.

ARM Variants

Hybrid ARMs

A hybrid adjustable-rate mortgage (ARM) is one where the interest rate on the note is fixed for a period of time, then floats thereafter. The "hybrid" refers to the blend of fixed rate and adjustable rate characteristics found in hybrid ARMs. Hybrid ARMs are referred to by their initial fixed period and adjustment periods, for example 3/1 for an ARM with a 3-year fixed period and subsequent 1-year rate adjustment periods. The date that a hybrid ARM shifts from a fixed-rate payment schedule to an adjusting payment schedule is known as the reset date. After the reset date, a hybrid ARM floats at a margin over a specified index just like any ordinary ARM.

The popularity of hybrid ARMs has significantly increased in recent years. In 1998, the percentage of hybrids relative to 30-year fixed rate mortgages was less than 2%; within 6 years, this increased to 27.5%.

Like other adjustable-rate products, hybrid ARMs transfer some interest rate risk from the lender to the borrower, thus allowing the lender to offer a lower note rate.

Option ARMs

An "option ARM" is a loan where the borrower has the option of making either a specified minimum payment, an interest-only payment, or a 15-year or 30-year fixed rate payment in a given month.

This type of loan is also known and advertised as the "pick a payment" or "pay-option" loan.

When a borrower makes a payment that is less than the interest payment, there is negative amortization, where the unpaid interest is added back onto the principal balance. Which is usually the difference between the interest-only payment and the minimum payment. If the minimum payment is $1,000 and the interest only payment is $1,500 then $500 will be added on to the back of the borrower's loan.

Option ARMs are popular because they are usually offered with a very low initial interest rate (a so-called "teaser rate") and a low minimum payment, which permits borrowers to qualify for a much larger loan than would otherwise be possible. When pricing an Option ARM, never focus on the Start



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Rate of 1% or 2%, consider only the Fully Indexed Rate (FIR) which is the Margin and the current Index being used (12-MTA, LIBOR, etc.).

Option ARMs are best suited to people in fields with sporadic income, such as some self-employed people or those in a highly seasonal business. For example, someone who makes the majority of their income around the winter holiday season, but who earns minimal income during the following few months may wish to pay the full payment during their busy season, but drop back to the interest-only payment or the minimum during a period of reduced earnings. This gives greater flexibility to how the mortgage is paid. With a fixed-payment loan, if the borrower was unable to meet the fixed payment, they would risk late fees or foreclosure.

The main risk of an Option ARM is "payment shock", when the negative amortization reaches a stated maximum, at which point the minimum payment will be raised to a level that amortizes the loan balance.

The function of the loan that can cause this payment shock is called the "Recast" cap. The recast will happen when the original loan balance reaches 110% to 125% of the original loan balance due to negative amortization of making the minimum payment.

For example: a $200,000 with a 110% recast cap will adjust to a fully indexed, fully amortized payment based on the remaining term of the loan when the negative amortization add to the loan balance reaches $220,000. For a 125% recast, this will happen when loan balance reaches $250,000.

Obviously the higher the recast cap the longer it will take for the recast to take place and the more negative amortization can be added to the loan balance.

Another risk, as with any loan with potential negative amortization, is that the increased loan balance will reduce or eliminate the borrower's equity in the financed property, or if the value of the property declines, increase the chance that he won't be able to sell the property for an amount that will repay the loan.

Historically, option ARM mortgages have been used effectively to minimize income taxes and maximize mortgage interest deductions by high net worth homeowners whose earnings are primarily derived from passive or investment income. By making minimum payments over the course of a year, these borrowers are able to defer the majority of the income required to service their mortgage debt to the end of the year, allowing income brought in as a long term capital gain, and taxable at a favorable rate, to be used in making lump sum interest payments. High net worth individuals and real estate investors also have a long history of utilizing the negative amortization characteristics of these mortgages to their advantage to avoid taxation entirely on gains in real estate, by refinancing regularly to "take profits" from illiquid residential and commercial real estate equity.

Option ARM mortgages are increasingly available in Hybrid, or temporarily Fixed Rate varieties, from 3 to 10 years, mitigating certain negative amortization characteristics of the popular Adjustable Rate



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variety. Largely as a result of yield curve inversion, a handful of banks have introduced 30 year fixed rate mortgages with option ARM style minimum payments.

Terminology

X/Y - Hybrid ARMs are often referred to in this format, where X is the number of years during which the initial interest rate applies prior to first adjustment (common terms are 3, 5, 7, and 10 years), and Y is the interval between adjustments (common terms are 1 for one year and 6 for six months). As an example, a 5/1 ARM means that the initial interest rate applies for five years (or 60 months, in terms of payments), after which the interest rate is adjusted annually. (Adjustments for escrow accounts, however, do not follow the 5/1 schedule; these are done annually.)

Fully Indexed Rate - The price of the ARM as calculated by adding Index + Margin = Fully Indexed Rate. This is the interest rate your loan would be at without a Start Rate (the introductory special rate for the initial fixed period). This means the loan would be higher if adjusting, typically, 1-3% higher than the fixed rate. Calculating this is important for ARM buyers, since it helps predict the future interest rate of the loan.

Margin - For ARMs where the index is applied to the interest rate of the note on an "index plus margin" basis, the margin is the difference between the note rate and the index on which the note rate is based expressed in percentage terms.[1] This is not to be confused with profit margin. The lower the margin the better the loan is as the maximum rate will increase less at each adjustment. Margins will vary between 2%-7%.

Index - A published financial index such as LIBOR used to periodically adjust the interest rate of the ARM.

Start Rate - The introductory rate provided to purchasers of ARM loans for the initial fixed interest period.

Period - The length of time between interest rate adjustments. In times of falling interest rates, a shorter period benefits the borrower. On the other hand, in times of rising interest rates, a longer period benefits the lender.

Floor - A clause that sets the minimum rate for the interest rate of an ARM loan. Loans may come with a Start Rate = Floor feature, but this is primarily for Non-Conforming (aka Sub-Prime or Program Lending) loan products. This prevents an ARM loan from ever adjusting lower than the Start Rate. An "A Paper" loan typically has either no Floor or 2% below start.



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Payment Shock - Industry term to describe the severe (unexpected or planned for by borrower) upward movement of mortgage loan interest rates and its effect on borrowers. This is the major risk of an ARM, as this can lead to severe financial hardship for the borrower.

Cap - Any clause that sets a limitation on the amount or frequency of rate changes.

Loan Caps

Loan caps provide payment protection against payment shock, and allow a measure of interest rate certainty to those who gamble with initial fixed rates on ARM loans. There are three types of Caps on a typical First Lien Adjustable Rate Mortgage or First Lien Hybrid Adjustable Rate Mortgage.

Initial Adjustment Rate Cap: The majority of loans have a higher cap for initial adjustments that's indexed to the initial fixed period. In other words, the longer the initial fixed term, the more the bank would like to potentially adjust your loan. Typically, this cap is 2-3% above the Start Rate on a loan with an initial fixed rate term of 3 years or lower and 5-6% above the Start Rate on a loan with an initial fixed rate term of 5 years or greater.

Rate Adjustment Cap: This is the maximum amount by which an Adjustable Rate Mortgage may increase on each successive adjustment. Similar to the initial cap, this cap is usually 1% above the Start Rate for loans with an initial fixed term of 3 years or greater and usually 2% above the Start Rate for loans that have an initial fixed term of 5 years or greater

Lifetime Cap: Most First Mortgage loans have a 5% or 6% Life Cap above the Start Rate (this ultimately varies by the lender and credit grade).

Industry Shorthand for ARM Caps

Inside the business caps are expressed most often by simply the 3 numbers involved that signify each cap. For example, a 5/1 Hybrid ARM may have a cap structure of 5/2/5 (5% initial cap, 2% adjustment cap and 5% lifetime cap) and insiders would call this a 5-2-5 cap. Alternately a 1 year arm might have a 1/1/6 cap (1% initial cap, 1% adjustment cap and 6% lifetime cap) known as a 1-1-6, or alternately expressed as a 1/6 cap (leaving out one digit signifies that the initial and adjustment caps are identical).

Negative amortization ARM caps

See the complete article for the type of ARM that Negative amortization loans are by nature. Higher risk products, such as First Lien Monthly Adjustable loans with Negative amortization and Home Equity Lines of Credit aka HELOC have different ways of structuring the Cap than a typical First Lien Mortgage. The typical First Lien Monthly Adjustable loans with Negative amortization loan has a life cap for the underlying rate (aka "Fully Indexed Rate") between 9.95% and 12% (maximum assessed interest rate). Some of these loans can have much higher rate ceilings. The fully indexed rate is always



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listed on the statement, but borrowers are shielded from the full effect of rate increases by the minimum payment, until the loan is recast, which is when principal and interest payments are due that will fully amortize the loan at the fully indexed rate.

Home Equity Lines of Credit HELOC

Since HELOCs are intended by banks to primarily sit in second lien position, they normally are only capped by the maximum interest rate allowed by law in the state wherein they are issued. For example, Florida currently has an 18% cap on interest rate charges. These loans are risky in the sense that to lenders, they are practically a credit card issued to the borrower, with minimal security in the event of default. They are risky to the borrower in the sense that they are mostly indexed to the Wall Street Journal Prime Rate, which is considered a Spot Index, or a financial indicator that is subject to immediate change (as are the loans based upon the Prime Rate). The risk to borrower being that a financial situation causing the Federal Reserve to raise rates dramatically would effect an immediate rise in obligation to the borrower, up to the capped rate.

Popularity

Variable rate mortgages are the most common form of loan for house purchase in the United Kingdom and Canada but are unpopular in some other countries. Variable rate mortgages are very common in Australia and New Zealand. In some countries, true fixed-rate mortgages are not available except for shorter-term loans; in Canada, the longest term for which a mortgage rate can be fixed is typically no more than ten years, while mortgage maturities are commonly 25 years.

In many countries, it is not feasible for banks to borrow at fixed rates for very long terms; in these cases, the only feasible type of mortgage for banks to offer may be adjustable rate mortgages (barring some form of government intervention).

For those who plan to move within a relatively short period of time (three to seven years), they are attractive because they often include a lower, fixed rate of interest for the first three, five, or seven years of the loan, after which the interest rate fluctuates.

Pricing

Adjustable rate mortgages are typically, but not always, less expensive than fixed-rate mortgages. Due to the inherent interest rate risk, long-term fixed rates will tend to be higher than short-term rates (which are the basis for variable-rate loans and mortgages). The difference in interest rates between short and long-term loans is known as the yield curve, which generally slopes upward (longer terms are more expensive). The opposite circumstance is known as an inverted yield curve and is relatively infrequent.



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The fact that an adjustable rate mortgage has a lower starting interest rate does not indicate what the future cost of borrowing will be (when rates change). If rates rise, the cost will be higher; if rates go down, the rate will be lower. In effect, the borrower has agreed to take the interest rate risk. Some studies have shown that on average, the majority of borrowers with adjustable rate mortgages save money in the long term; but they have also demonstrated that some borrowers pay more. The price of potentially saving money, in other words, is balanced by the risk of potentially higher costs.

Prepayment

Adjustable rate mortgages, like other types of mortgage, may offer the ability to prepay principal (or capital) early without penalty. Early payments of part of the principal will reduce the total cost of the loan (total interest paid), and will shorten the amount of time needed to pay off the loan. Early payoff of the entire loan amount through refinancing is sometimes done when interest rates drop significantly.

Criticism

Adjustable rate mortgages are sometimes sold to unsophisticated consumers who are unlikely to be able to repay the loan should interest rates rise. In the United States, extreme cases are characterized by the Consumer Federation of America as predatory loans. Protections against interest rate rises include (a) a possible initial period with a fixed rate (which gives the borrower a chance to increase his/her annual earnings before payments rise); (b) a maximum (cap) that interest rates can rise in any year (if there is a cap, it must be specified in the loan document); and (c) a maximum (cap) that interest rates can rise over the life of the mortgage (this also must be specified in the loan document).

Wraparound mortgage

A wraparound is a way of lowering the barriers of entry to a junior lien or subordinate mortgage; it also expedites process of purchasing a home. A junior lien or subordinate mortgage is a second mortgage that generally sits behind larger first mortgage. Here is an example of wraparound:

The seller, who has the original mortgage sells his home with the existing first mortgage in place and a second mortgage which he "carries back" from the buyer. The mortgage he takes from the buyer is for the amount of the first mortgage, plus a negotiated amount less than or up to the sales price minus the down payment and closing costs. The seller then continues to pay the first mortgage with the proceeds of the second. Once the second mortgage is satisfied, the seller is out, but this is rarely the case.

Typically, the seller also charges a "middle" on the first mortgage. For example, one has a first mortgage at 6% and sell the whole property with a rate of 8% on a wraparound mortgage. He/she make a 2% middle on the first mortgage amount, using other people's money to make money. So, it is in the best interests of a seller to keep the wrap, rather than allow the buyer to assume the first mortgage.



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There are relatively few wraparounds today because the first mortgage must be assumable, or the mortgagee must permit this type of assumption to occur on the loan. Today, only the FHA writes assumable loans, as most mortgage bankers have found that the main expenses (and profits) of a transaction occur at origination. Most mortgages have a due on sale clause to prevent the use of wraparounds.

Package Mortgage Covers both real and personal property.

A Mortgage is Not a Home Loan

Home Buying Tips: What is a Mortgage?

Most of us are accustomed to calling our home loan a mortgage, but that isn't an accurate definition of the term. A mortgage is not a loan, and it is not something that the lender gives you. It is a security instrument that you give to the lender, a document that protects the lender's interests in your property.

How a Mortgage Works

There are two parties to a mortgage. You are the mortgagor, or borrower, and the lender is the mortgagee.

A mortgage document creates a lien on the property, which serves as a lender's security for the debt. The lien is recorded in public records, probably at your county courthouse.

Ownership cannot be transferred to someone else until you pay the debt to release the lien. Even if your loan is secured by a mortgage, you still have full title to the property.

No one else has rights of ownership.

A mortgage gives the lender the right to sell the secured property to recover funds if you do not pay the debt. The sales process is called foreclosure.

When a mortgage is used for security, foreclosure must usually progress through the court system. That type of foreclosure is called a judicial foreclosure.

Deed of Trust

Over half of the states in the United States use mortgages as security instruments. The other states use a deed of trust, which serves the same purpose, but with a few important differences.

A deed of trust is a special kind of deed that is recorded in public records, where it tells everyone that there is a lien on your property.

A deed of trust involves three parties. You are the trustor, the lender is the beneficiary, and a third party is the trustee--someone who holds temporary (but not full) title until the lien is paid.



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The trustee should be a neutral third party, someone who won't favor either you or the lender if problems crop up. In some states, attorneys act as trustees, and in others, title insurance companies often provide the service.

The trustee cannot take your property for no reason--documents are in place to protect against that.

The deed of trust is cancelled when the debt is paid.

The Bottom Line

The differences between a mortgage and a deed of trust affect home buyers only when foreclosure is an issue, because the trustee has the power to sell the house if your loan becomes delinquent. The lender must give the trustee proof of the delinquency and ask the trustee to initiate foreclosure proceedings.

The trustee must progress as allowed by law and as dictated in your deed of trust, but the process bypasses the court system, making it a much faster and cheaper way for the lender to foreclose.

You cannot choose the way your loan is secured, that's determined by where you live, but it's important to have an understanding of the type of lien that secures the debt for your home.

Security interest

A security interest is a property interest created by agreement or by operation of law over assets to secure the performance of an obligation (usually but not always the payment of a debt) which gives the beneficiary of the security interest certain preferential rights in relation to the assets. The rights vary according to the type of security interest, but in most cases (and in most countries) the main rights and purpose of the security interest is to allow the holder to seize, and usually sell, the property to discharge the debt that the security interest secures.

Rationale

The principal purpose for taking a security interest over some assets is almost invariably to ensure that, if the debtor goes into bankruptcy, then the secured creditor can enforce its rights against the collateral rather than participating in the distribution to unsecured creditors in the bankruptcy, and thereby either get paid in full, or receive more in the way of payment than it would have as an unsecured creditor.

There are other reasons that people sometimes take security over assets. In shareholders' agreements involving two parties (such as a joint venture), sometimes the shareholders will each charge their shares in favor the other as security for the performance of their obligations under the agreement to prevent the other shareholder selling their shares to a third party. It is sometimes suggested that banks



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may take floating charges over companies by way of security - not so much for the security for payment of their own debts, but because this ensures that no other bank will, ordinarily, lend to the company, thereby almost granting a monopoly in favor of the bank holding the floating charge on lending to the company.

Despite security interests being a firm feature of commercial law in almost every jurisdiction in the world, not all economists are certain of the benefit of security interests and secured lending generally. Proponents argue that by having security for a debt, this lowers the commercial risk for the lender, and in turn allows the lender to charge lower interest, thereby easing the cost of capital for business and consumers - compare for example the rates of interest that any high street bank charges for a mortgage loan and for a credit card debt. However, detractors argue that creditors having security over certain assets can destroy companies that are in financial difficulty, but which might still recover and be profitable, when the secured lenders get nervous and enforce their security early, repossessing key assets and forcing the company into bankruptcy. Further, the general principle of most insolvency regimes is that creditors should be treated equally, and allowing secured creditors a preference to certain assets upsets the conceptual basis of an insolvency.

But the most frequently used criticism of security and secured lending is that, if secured creditors are allowed to seize and sell key assets, then any liquidator or bankruptcy trustee loses the ability to sell off the business as a going concern, and may be forced to sell the business on a break-up basis. This may mean realizing a much smaller return for the unsecured creditors, and will invariably mean that all the employees will be made redundant.

For this last reason, many jurisdictions restrict the ability of secured creditors to enforce their rights in a bankruptcy situation. In the U.S.A. the Chapter 11 creditor protection, which completely prevents enforcement of security interests, is specifically designed to try and keep enterprises running at the expense of creditors' rights, and is often heavily criticized for that reason. In the United Kingdom, an administration order has a similar effect, but are less expansive in scope and restriction in terms of creditors rights. European systems are often touted as being pro-creditor, but many European jurisdictions also impose restrictions upon time limits that must be observed before secured creditors can enforce their rights. The most draconian jurisdictions in favor of creditor's rights tend to be in offshore financial centers, who hope that, by having a legal system heavily biased towards secured creditors, they will encourage banks to lend at cheaper rates to offshore structures, and thus in turn encourage business to use them to obtain cheaper funds.

Security

Under English law and in common law jurisdictions derived from English law, there are broadly eight types of proprietary security interest that can arise. These are:

1. 'true' legal mortgage 2. equitable mortgage



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3. statutory mortgage 4. fixed equitable charge, or bill of sale 5. floating equitable charge 6. pledge, or pawn 7. legal lien 8. equitable lien 9. hypothecation, or trust receipt

Traditionally security interests in common law can be divided either of two ways.

They can be categorized as either possessory or non-possessory (depending upon whether the secured party actually needs to have possession of the collateral).

Alternatively, they can be characterized whether they arise by consent between the parties (usually by executing a security agreement), or by operation of law.

In practice, some security interests can arise either by operation of law or by agreement, and so the preferred categorization is between possessory and non-possessory security interests.

For simplicity, the discussion of the various forms of security interest that follows is principally based upon the English law position. This has been followed in most common law countries, and most common law countries have similar property statutes regulating the common law rules.

Types of Security

The following is a summary of the main types of security interests and some of the differences between them.

"True" legal Mortgage

A legal mortgage arises when the assets are conveyed to the secured party as security for the obligations, but subject to a right to have the assets reconveyed when the obligations are performed.[6] This right is referred to as the "equity of redemption". The law has historically taken a dim view of provisions which might impede this right to have the assets reconveyed (referred to as being a "clog" on the equity of redemption), although the position has become more relaxed in recent years in relation to sophisticated financial transactions.

References to "true" legal mortgages mean mortgages by the traditional common law method of transfer subject to a proviso in this manner, and references are usually made in contradistinction to either equitable mortgages or statutory mortgages. True legal mortgages are relatively rare in modern commerce, outside of occasionally with respect to shares in companies.



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To complete a legal mortgage it is normally necessary that title to the assets is conveyed into the name of the secured party such that the secured party (or its nominee) becomes the legal titleholder to the asset. If a legal mortgage is not completed in this manner it will normally take effect as an equitable mortgage. Because of the requirement to transfer title, it is not possible to take a legal mortgage over future property, or to take more than one legal mortgage over the same assets. However, mortgages (legal and equitable) are non-possessory security interests. Normally the party granting the mortgage (the mortgagor) will remain in possession of the mortgaged asset.

The holder of a legal mortgage has three primary remedies in the event that there is a default on the secured obligations: they can foreclose on the assets, they can sell the assets or they can appoint a receiver over the assets. The holder of a mortgage can also usually sue upon the covenant to pay which appears in most mortgage instruments. There are a range of other remedies available to the holder of a mortgage, but they relate predominantly to land, and accordingly have been superseded by statute, and they are rarely exercised in practice in relation to other assets. The beneficiary of a mortgage (the mortgagee) is entitled to pursue all of its remedies concurrently or consecutively.

Foreclosure is rarely exercised as a remedy. In order to exercise the remedy of foreclosure the secured party needs to make an application to the court, and the order is made in two stages (nisi and absolut), making the process slow and cumbersome. Courts are historically reluctant to grant orders for foreclosure, and will often instead order a judicial sale. If the asset is worth more than the secured obligations, the secured party will normally have to account for the surplus. Even if a court makes a decree absolut and orders foreclosure, the court retains an absolute discretion to reopen the foreclosure after the making of the order, although this would not affect the title of any third party purchaser.

The holder of a legal mortgage also has a power of sale over the assets. Every mortgage contains an implied power of sale. This implied power exists even if the mortgage is not under seal. All mortgages which are made by way of deed also ordinarily contain a power of sale implied by statute, but the exercise of the statutory power is limited by the terms of the statute. Neither implied power of sale requires a court order, although the court can usually also order a judicial sale. The secured party has a duty to get the best price reasonably obtainable, however, this does not require the sale to be conducted in any particular fashion (ie. by auction or sealed bids). What the best price reasonably obtainable will be will depend upon the market available for the assets and related considerations. The sale must be a true sale - a mortgagee cannot sell to himself, either alone or with others, even for fair value; such a sale may be restrained or set aside or ignored. However, if the court orders a sale pursuant to statute, the mortgagee may be expressly permitted to buy.

The third remedy is to appoint a receiver. Technically the right to appoint a receiver can arise two different ways - under the terms of the mortgage instrument, and (where the mortgage instrument is executed as a deed) by statute.

In England, a third remedy, "appropriation" may exist under The Financial Collateral Arrangements (No.2) Regulations 2003 where the assets subject to the mortgage are 'financial collateral' and the mortgage instrument provides that the regulations apply. Appropriation is a means whereby the



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mortgagee can take title to the assets, but must account to the mortgagor for their fair market value (which must be specified in the mortgage instrument), but without the need to obtain any court order.

If the mortgagee takes possession then under the common law they owe strict duties to the mortgagor to safeguard the value of the property (although the terms of the mortgage instrument will usually limit this obligation). However, the common law rules relate principally to physical property, and there is a shortage of authority as to how they might apply to taking "possession" of rights, such as shares. Nonetheless, a mortgagee is well advised to remain respectful of their duty to preserve the value of the mortgaged property both for their own interests and under their potential liability to the mortgagor.

Equitable Mortgage

An equitable mortgage can arise in two different ways - either as a legal mortgage which was never perfected by conveying the underlying assets, or by specifically creating a mortgage as an equitable mortgage. A mortgage over equitable rights (such as a beneficiary's interests under a trust) will necessarily exist in equity only in any event.

Under the laws of some jurisdictions, a mere deposit of title documents can give rise to an equitable mortgage. With respect to land this has now been abolished in England, although in many jurisdictions company shares can still be mortgaged by deposit of share certificates in this manner.

Generally speaking, an equitable mortgage has the same effect as a perfected legal mortgage except in two respects. Firstly, being an equitable right, it will be extinguished by a bona fide purchaser for value who did not have notice of the mortgage. Secondly, because the legal title to the mortgaged property is not actually vested in the secured party, it means that a necessary additional step is imposed in relation to the exercise of remedies such as foreclosure.

Statutory Mortgage

Many jurisdictions permit specific assets to be mortgaged without transferring title to the assets to the mortgagee. Principally, statutory mortgages relate to land, registered aircraft and registered ships. Generally speaking, the mortgagee will have the same rights as they would have had under a traditional true legal mortgage, but the manner of enforcement is usually regulated by the statute.

Equitable Charge

A fixed equitable charge confers a right on the secured party to look to a particular asset in the event of the debtor's default, which is enforceable by either power of sale or appointment of a receiver. It is probably the most common form of security taken over assets.

An equitable charge is also a non-possessory form of security, and the beneficiary of the charge (the chargee) does not need to retain possession of the charged property.



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Where security equivalent to a charge is given by a natural person (as opposed to a corporate entity) it is usually expressed to be a bill of sale, and is regulated under applicable bills of sale legislation. Difficulties with the Bills of Sale Acts in Ireland, England and Wales have made it virtually impossible for individuals to create floating charges.

Floating Charge

Floating charges are similar in effect to fixed equitable charges once they crystallise (usually upon the commencement of liquidation proceedings against the chargor), but prior to that they "float" and do not attach to any of the chargor's assets, and the chargor remains free to deal with or dispose of them.

Pledge

A pledge (also sometimes called a pawn) is a form of possessory security, and accordingly, the assets which are being pledged need to be physically delivered to the beneficiary of the pledge (the pledgee). Pledges are rarely used in commercial contexts, but are still used by pawnbrokers, which, contrary to their old world image, remain a regulated credit industry.

The pledgee has a common law power of sale in the event of a default on the secured obligations which arises if the secured obligations are not satisfied by the agreed time (or, in default of agreement, within a reasonable period of time). If the power of sale is exercised, then the holder of the pledge must account to the pledgor for any surplus after payment of the secured obligations.

A pledge does not confer a right to appoint a receiver or foreclose. If the holder of pledge sells or disposes of the pledged assets when not entitled to do so, they may be liable in conversion to the pledgor.

Legal Lien

A legal lien, in most common law systems, is a right to retain physical possession of tangible assets as security for the underlying obligations. It is a form of possessory security, and possession of the assets must be transferred to (and maintained by) the secured party. The right is purely passive; the secured party (the lienee) has no right to sell the assets - merely a right to refuse to return them until paid.

Most legal liens arise as a matter of law (mostly by common law, but also by statute), however, it is possible to create a legal lien by contract. The courts have confirmed that it is possible to also give the secured party a power of sale in such a contract, but case law on such a power is limited and it is difficult to know what limitations and duties would be imposed on the exercise of such a power.



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Equitable Lien

Equitable liens are slightly amorphous forms of security interest that only arise by operation of law in certain circumstances. Academically it has been noted that there seems to be no real unifying principle behind the circumstances that give rise to them.

An equitable lien takes effect essentially as an equitable charge, and they arise only in specified situations, (e.g. an unpaid vendor's lien in relation to property is an equitable lien; a maritime lien is sometimes thought to be an equitable lien). It is sometimes argued that where the constitutional documents of a company provide that the company has a lien over its own shares, this take effect as an equitable lien, and if that analysis is correct, then it is probably the one exception to the rule that equitable liens arise by operation of law rather than by agreement.

Hypothecation

Hypothecation, or "trust receipts" are relatively uncommon forms of security interest whereby the underlying assets are pledged, not by delivery of the assets as in a conventional pledge, but by delivery of a document or other evidence of title. Hypothecation is usually seen in relation to bills of lading, whereby the bill of lading is endorsed the secured party, who, unless the security is redeemed, can claim the property by delivery of the bill.

Security interest vs. general obligation

Some obligations are backed only by a security interest against specific designated property, and liability for repayment of the debt is limited to the property itself, with no further claim against the obligor. These are referred to as "nonrecourse obligations".

Other obligations (i.e., recourse obligations) are backed by the full credit of the borrower. If the borrower defaults, then the creditor can force the obligor into bankruptcy and the creditors will divide all assets of the obligor.

Depending on the relative credit of the obligor, the quality of the asset, and the availability of a structure to separate the obligations of the asset from the obligations of the obligor, the interest rate charged on one may be higher or lower than the other.

Perfection

Perfection of security interests means different things to lawyers in different jurisdictions.

in English law, perfection has no defined statutory or judicial meaning, but academics have pressed the view that it refers to the attachment of the security interest to the underlying asset. Others have argued cogently that attachment is a separate legal concept, and that perfection



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refers to any steps required to ensure that the security interest is enforceable against third parties.

in American law, perfection is generally taken to refer to any steps required to ensure that the security interest remains enforceable on the debtor's bankruptcy.

With the Americanization of the world's legal profession, the second definition is becoming more frequently used commercially, and arguably is to be preferred, as the traditional English legal usage has little purpose except in relation to the comparatively rare true legal mortgage (very few other security interests require additional steps to attach to the asset, but security interests frequently require some form of registration to be enforceable on the charger’s insolvency).

"Quasi-security"

There are a number of other arrangements which parties can put in place which have the effect of conferring security in a commercial sense, but do not actually create a proprietary security interest in the assets. For example, it is possible to grant a power of attorney or conditional option in favor of the secured party relating to the subject matter, or to utilize a retention of title arrangement, or execute undated transfer instruments. Whilst these techniques may provide protection for the secured party, they do not confer a proprietary interest in the assets which the arrangements relate to, and their effectiveness may be limited if the debtor goes into bankruptcy.

It is also possible to replicate the effect of security by making an outright transfer of the asset, with a provision that the asset is re-transferred once the secured obligations are repaid. In some jurisdictions, these arrangements may be recharacterized as the grant of a mortgage, but most jurisdictions tend to allow the parties freedom to characterize their transactions as they see fit.[26] Common examples of this are financings using a stock loan or repo agreement to collateralize the cash advance, and title transfer arrangements (for example, under the "Transfer" form English Law credit support annex to an ISDA Master Agreement (as distinguished from the other forms of CSA, which grant security)).

United States – the U.C.C.

In the United States, under Article 9 of the Uniform Commercial Code, a security interest is a proprietary right in a debtor's property that secures payment or performance of an obligation. A security interest is created by a security agreement, under which the debtor grants a security interest in the debtor's property as collateral for a loan or other obligation.

A security interest grants the holder thereof a right to take remedial action with respect to the property that is subject to the security interest upon the occurrence of certain events -- the classic example being the non-payment of a loan. The holder may take possession of such property in satisfaction of the underlying obligation, or, more common, the holder will sell such property (either by means of public auction or private transfer) and apply the proceeds of such sale to the underlying obligation. To the extent that the proceeds of the sale exceed the amount of the underlying obligation, the debtor is



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entitled to the excess; and, to the extent that the proceeds of the sale do not exceed the amount of the underlying obligation, the holder of the security interest is entitled to a deficiency judgment pursuant to which the holder can institute additional legal proceedings aimed at recovering the full amount of the underlying obligation from the debtor.

In the U.S. the term "security interest" is often used interchangeably with "lien"; that being said, the term "lien" is more often associated with real property collateral than with personal property collateral.

Security interests in most types of personal property are governed in the United States by Article 9 of the Uniform Commercial Code. A security interest is typically granted by a contract called a "security agreement". Upon execution of such contract by the debtor, the security interest exists with respect to the property in question assuming that the debtor has an ownership interest or ownership-like interest therein and assuming that some form of value has been conferred by the holder of the security interest to the debtor (such as a loan). Also, upon execution of such contract, the security interest becomes enforceable between the holder thereof and debtor; however, in order for the rights of the holder of the security interest to become enforceable against third parties, the holder must "perfect" the security interest. Perfection is typically achieved by filing a document called a "financing statement" with a governmental authority (often, the secretary of state in which a corporate debtor is incorporated -- although there are various rules applicable to natural persons and certain types of corporate debtors), however, perfection can also be obtained by taking possession of the collateral in question (assuming the collateral in question is tangible property). Absent "perfection", the holder of the security interest will not be able to enforce its rights in the collateral vis-á-vis third parties, such as other creditors who claim a security interest in the same collateral or a trustee in bankruptcy.

Real estate investment trust

A Real Estate Investment Trust or REIT is a tax designation for a corporation investing in real estate that reduces or eliminates corporate income taxes. In return, REITs are required to distribute 90% of their income, which may be taxable in the hands of the investors. The REIT structure was designed to provide a similar structure for investment in real estate as mutual funds provide for investment in stocks.

Like other corporations, REITs can be publicly or privately held. Public REITs may be listed on public stock exchanges like shares of common stock in other firms.

REITs can be classified as equity, mortgage or hybrid.

The key statistics to look at in REIT are its NAV (Net Asset Value), AFFO (Adjusted Funds From Operations) and CAD (Cash Available for Distribution).



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United States REITs

In the U.S., REITs generally pay little or no federal income tax, but are subject to a number of special requirements set forth in the Internal Revenue Code, one of which is the requirement to annually distribute at least 90% of its taxable income in the form of dividends to its shareholders.

Qualification

In order to qualify for the advantages of being a pass-through entity for U.S. corporate income tax, a REIT must:

Be structured as corporation, trust, or association Be managed by a board of directors or trustees Have transferable shares or transferable certificates of interest Otherwise be taxable as a domestic corporation Not be a financial institution or an insurance company Be jointly owned by 100 persons or more Have 95 percent of its income derived from dividends, interest, and property income Pay dividends of at least 90% of REIT's taxable income No more than 50% of the shares can be held by five or fewer individuals during the last half of

each taxable year At least 75% of total investment assets must be in real estate Derive at least 75% of gross income from rents or mortgage interest Have no more than 20% of its assets consist of stocks in taxable REIT subsidiaries.

Trends and Statistics

In recent practice, many REITs distribute all of or even more than their current earnings, often resulting in dividend yields comparable to bond yields. If an investment company such as a REIT distributes more than its taxable income, the excess distribution is considered "return of capital" for tax purposes (not taxed as ordinary income, but first reduces basis in REIT stock; if this brings the basis to zero, then remaining amount of the return on capital is taxed at capital gain rates). The distribution requirement may hamper a REIT's ability to retain earnings and generate growth from internal resources. This and other restrictions imposed by the Internal Revenue Code generally limit a REIT's suitability for growth-oriented investors. However, other considerations may result in potential for stock price appreciation, such as improvements in the REITs underlying leasing markets, changes in interest rates or increasing demand for REIT stocks.

As of early 2005, there were nearly 200 publicly traded REITs operating in the United States. Their assets included a combined $500 billion, and approximately two-thirds of them were trading on national stock exchanges. The number of REITs not registered with the Securities Exchange Commission and not publicly traded is about 800.



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Real estate appraisal

Real estate appraisal is the practice of developing an opinion of the value of real property, usually its Market Value. (Real estate appraisal is American usage; many other countries use the terms property valuation or land valuation.) The need for appraisals arises from the heterogeneous nature of property as an investment class: no two properties are identical, and all properties differ from each other in their location - which is the most important determinant of their value. The absence of a market-based pricing mechanism determines the need for an expert appraisal/valuation of real estate/property.

A real estate appraisal is performed by a licensed or certified appraiser (in many countries known as a property valuer or land valuer). If the appraiser's opinion is based on Market Value, then it must also be based on the Highest and Best Use of the real property. For mortgage valuations of improved residential property in the US, the appraisal is most often reported on a standardized form, such as the Uniform Residential Appraisal Report. Appraisals of more complex property (e.g. -- income producing, raw land) are usually reported in a narrative appraisal report.

Types of value

There are several types and definitions of value sought by a real estate appraisal. Some of the most common are:

Market Value – The price at which an asset would trade in a competitive market setting. Market Value is usually interchangeable with Open Market Value or Fair Value. International Valuation Standards (IVS) define Market Value as:

Market Value is the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arms-length transaction after proper marketing wherein the parties had each acted knowledgably, prudently, and without compulsion.

Value-in-use – The net present value (NPV) of a cash flow that an asset generates for a specific owner under a specific use. Value-in-use is the value to one particular user, and is usually below the market value of a property.

Investment value - is the value to one particular investor, and is usually higher than the market value of a property.

Insurable value - is the value of real property covered by an insurance policy. Generally it does not include the site value.



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Liquidation value -- may be analyzed as either a forced liquidation or an orderly liquidation and is a commonly sought standard of value in bankruptcy proceedings. It assumes a seller who is compelled to sell after an exposure period which is less than the market-normal timeframe.

Price versus value

It is important to distinguish between Market Value and Price. A price obtained for a specific property under a specific transaction may or may not represent that property's market value: special considerations may have been present, such as a special relationship between the buyer and the seller, or else the transaction may have been part of a larger set of transactions in which the parties had engaged. Another possibility is that a special buyer may have been willing to pay a premium over and above the market value, if his subjective valuation of the property (its investment value for him) was higher than the Market Value. An example of this would be the owner of a neighboring property who, by combining his own property with the subject property, could thereby obtain economies-of-scale. Such situations often arise in corporate finance, as for example when a merger or acquisition is concluded at a price which is higher than the value represented by the price of the underlying stock. The usual rationale for these valuations would be that the 'sum is greater than its parts', since full ownership of a company entails special privileges for which a potential purchaser would be willing to pay. Such situations arise in real estate/property markets as well. It is the task of the real estate appraiser/property valuer to judge whether a specific price obtained under a specific transaction is indicative of Market Value.

Market value definitions in the US

In the US, appraisals are performed to a certain standard of value (e.g. -- foreclosure value, fair market value, distressed sale value, investment value). The most commonly used definition of value is Market Value. While USPAP does not define Market Value, it provides general guidance for how Market Value should be defined:

...a type of value, stated as an opinion, that presumes the transfer of a property (i.e., a right of ownership or a bundle of such rights), as of a certain date, under specific conditions set forth in the definition of the term identified by the appraiser as applicable in an appraisal.

Thus, the definition of value used in an appraisal analysis and report is a set of assumptions about the market in which the subject property may transact. It becomes the basis for selecting comparable data for use in the analysis. These assumptions will vary from definition to definition but generally fall into three categories:

1. The relationship, knowledge, and motivation of the parties (i.e., seller and buyer); 2. The terms of sale (e.g., cash, cash equivalent, or other terms); and 3. The conditions of sale (e.g., exposure in a competitive market for a reasonable time prior to

sale).



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In the US, the most common definition of Market Value is the one promulgated for use in Federally regulated residential mortgage financing:

The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller, each acting prudently, knowledgeably and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby: (1) buyer and seller are typically motivated; (2) both parties are well informed or well advised, and each acting in what he or she considers his or her own best interest; (3) a reasonable time is allowed for exposure in the open market; (4) payment is made in terms of cash in U. S. dollars or in terms of financial arrangements comparable thereto; and (5) the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.

For example, adjustments must be made to the comparables sales prices for special or creative financing or sales concessions. No adjustments are necessary for those costs which are normally paid by sellers as a result of tradition or law in a market area; these costs are readily identifiable since the seller pays these costs in virtually all sales transactions. Special or creative financing adjustments can be made to the comparable property by comparisons to financing terms offered by a third party institutional lender that is not already involved in the property or transaction. Any adjustment should not be calculated on a mechanical dollar for dollar cost of the financing or concession but the dollar amount of any adjustment should approximate the market’s reaction to the financing or concessions based on the appraiser’s judgment.

Three approaches to value

There are three general groups of methodologies for determining value. These are usually referred to as the "three approaches to value":

The cost approach The sales comparison approach and The income approach

The appraiser will determine which one or more of these approaches may be applicable, based on the scope of work determination, and from that develop an appraisal analysis. Costs, income, and sales vary widely from one situation to the next, and particular importance is given to the specific characteristics of the subject.

Consideration is also given to the market for the property appraised. Appraisals of properties that are typically purchased by investors (e.g. - skyscrapers) may give greater weight to the income approach, while small retail or office properties, often purchased by owner-users, may give greater weighting to



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the sales comparison approach. While this may seem simple, it is not always obvious. For example, apartment complexes of a given quality tend to sell at a price per apartment, and as such the sales comparison approach may be more applicable. Single family residences are most commonly valued with greatest weighting to the sales comparison approach, but if a single family dwelling is in a neighborhood where all or most of the dwellings are rental units, then some variant of the income approach may be more useful.

The cost approach

The cost approach was formerly called the summation approach. The theory is that the value of a property can be estimated by summing the land value and the depreciated value of any improvements. The value of the improvements is often referred to by the abbreviation RCNLD (reproduction cost new less depreciation or replacement cost new less deprecation). Reproduction refers to reproducing an exact replica. Replacement cost refers to the cost of building a house or other improvement which has the same utility, but using modern design, workmanship and materials. In practice, appraisers use replacement cost and then deduct a factor for any functional disutility associated with the age of the subject property.

In most instances when the cost approach is involved, the overall methodology is a hybrid of the cost and sales comparison approaches. For example, while the replacement cost to construct a building can be determined by adding the labor, material, and other costs, land values and depreciation must be derived from an analysis of comparable data.

Maximum value is limited to what it would cost to build a substitute property.

The cost approach is considered reliable when used on newer structures, but the method tends to become less reliable for older properties. The cost approach is often the only reliable approach when dealing with special use properties (e.g. -- public assembly, marinas).

The sales comparison approach

The sales comparison approach examines the price or price per unit area of similar properties being sold in the marketplace. Simply put, the sales of properties similar to the subject are analyzed and the sale prices adjusted to account for differences in the comparables to the subject to determine the value of the subject. This approach is generally considered the most reliable if adequate comparable sales exist. In any event, it is the only independent check on the reasonability of an appraisal opinion.

Note that this approach develops value from a purely pricing scheme, and as such is an example of a revealed preference model. An interesting perspective on the relationship between relatively subjective human estimation as compared with that obtained by purely mathematic modeling is contained in "Simple Heuristics That Make Us Smart" by Gerd Gigerenzer. Dr. Gigerenzer, a psychologist, asked people to estimate some real world facts based simply on their knowledge, experience and impressions. Common knowledge and some simple rules created models which were close to those produced by



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multiple regression analysis (MRA) and neural networks. The predictive value of the human models applied to a new sample was a bit better than the mathematical models, suggesting that the mathematical models may have described the data better but missed the predictive relationships. Similarly automated valuation models frequently find building size (square feet or meters) predictive of value, even when that information is not explicitly advertised. This is similar to the example in "The Wisdom of Crowds", Surowiecki, in which the scientist Francis Galton observed a crowd at a fair to, on average, accurately estimate the size of an ox.

The income capitalization approach

The income capitalization approach is used to value commercial and investment properties.

In a commercial income producing property this approach capitalizes an income stream into a present value. This can be done using revenue multipliers or single-year capitalization rates of the Net Operating Income. The Net Operating Income (NOI) is gross potential income (GPI), less vacancy (= Effective Gross Income) less operating expenses (but excluding debt service or depreciation charges applied by accountants).

Alternatively, multiple years of net operating income can be valued by a discounted cash flow analysis (DCF) model. The DCF model is widely used to value larger and more expensive income-producing properties, such as large office towers.

Further considerations

Highest and best use

Highest and Best Use (HABU) is a term of art in the appraisal process. It is a process to determine the use of the property which produces the highest value for the land, as if vacant. There are four steps to the process. First, the appraiser determines all uses which are legally permissible for the property. Second, of the uses which are legally permissible, which ones are physically possible. Of those, which ones are financially feasible (sometimes referred to as economically supported). Of those uses which are feasible, which one and only use is maximally productive for the site. In a simple context, the appraiser must do this twice, comparing the results -- as if the land is vacant and in the as-is-improved state, taking into account the costs of demolishing any existing improvements. The outcome of this process is the highest and best use for the site. An appraisal of market value must explicitly assume that the owner or buyer would employ the property in its highest and best use, and therefore value the site accordingly.

In more complex appraisal assignments (e.g. -- contract disputes, litigation, brownfield or contaminated property valuation), the determination of highest and best use may be much more complex, and may need to take into account the various intermediate or temporary uses of the site, the contamination remediation process, and the timing of various legal issues.



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Types of ownership interest

Implicit in the analysis of the subject property is a determination of the interest in the property being appraised. For most common situations (e.g. -- mortgage finance) the fee simple interest is explicitly assumed since it is the most complete bundle of rights available. However, in many situations, and in many societies which do not follow English Common Law or the Napoleanic Code, some other interest may be more common. While there are many different possible interests in real estate, the three most common are:

Fee simple value - The most complete ownership in real estate, subject in common law countries to the powers reserved to the state (taxation, escheat, eminent domain, and police power)

Leased fee value - This is simply the fee simple interest encumbered by a lease. If the lease is at market rent, then the leased fee value and the fee simple value are equal. However, if the tenant pays more or less than market, the residual owned by the leased fee holder, plus the market value of the tenancy, may be more or less than the fee simple value.

Leasehold value - The interest held by a tenant. If the tenant pays market rent, then the leasehold has no market value. However, if the tenant pays less than market, the difference between the present value of what is paid and the present value of market rents would be a positive leasehold value. For example, a major chain retailer may be able to negotiate a below-market lease to serve as the anchor tenant for a shopping center. This leasehold value may be transferable to another anchor tenant, and if so the retail tenant has a positive interest in the real estate.

Scope of work

While USPAP has always required appraisers to identify the scope of work needed to produce credible results, it became clear in recent years that appraisers did not fully understand the process for developing this adequately. In formulating the scope of work for a credible appraisal, the concept of a limited versus complete appraisal and the use of the Departure Rule caused confusion to clients, appraisers, and appraisal reviewers. In order to deal with this, USPAP was updated in 2006 with what came to be known as the Scope of Work project. In short, USPAP eliminated the Departure Rule and the concept of a limited appraisal and created a new Scope of Work rule. In this, appraisers were to identify six key parts of the appraisal problem at the beginning of each assignment:

Client and other intended users Intended use of the appraisal and appraisal report Definition of value (e.g. -- market, foreclosure, investment) Any hypothetical conditions or extraordinary assumptions The effective date of the appraisal analysis The salient features of the subject property



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Based on these factors, the appraiser must identify the scope of work needed, including the methodologies to be used, the extent of investigation, and the applicable approaches to value. The rule provided the explicit requirement that the minimum standards for scope of work were:

Expectations of the client and other users The actions of the appraiser's peers who carry out similar assignments

Mass appraisal and automated valuation models

Automated valuation models (AVMs) are growing in acceptance. These rely on statistical models such as multiple regression analysis or geographic information systems (GIS). While AVMs can be quite accurate, particularly when used in a very homogeneous area, there is also evidence that AVMs are not accurate in other instances such as when they are used in rural areas, or when the appraised property does not conform well to the neighborhood. AVM's have also gained favor in class action litigation, and have been substantiated in numerous cases, both in Federal and state courts, as the appropriate method for dealing with large-scale real estate litigation problems, such as contaminated neighborhoods.



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CORRESPONDENCE EVALUATION QUESTIONS 1. The clause in a trust deed or mortgage that permits the mortgagee to declare the entire unpaid due and payable? a. an acceleration clause b. an elevator clause. c. an escalator clause. d. a forfeiture clause. 2. When property fails to sell at a court foreclosure sale for an amount sufficient to satisfy the unpaid mortgage debt, the mortgagee may sue for: a. a judgment by default. b. a deficiency judgment, c. satisfaction of mortgage. d .damages. 3. A house is listed for $150,000. Luke buys it for $130,000. He makes a down payment of 20 percent and borrows the rest on a mortgage. His lender charges four points. If there were no other closing costs, how much should he bring to the closing? a. $4,160 c. $26,000 b. $61000 d. $30,160 4. FHA-insured mortgage loans are originated from funds furnished by: a. the federal government. b. the lending institutions themselves. c. the Federal Housing Administration. d. Fannie Mae. 5. When an amortized payment remains constant over the entire term of the loan but an outstanding balance must be paid at the end of the term, the payment is called a(n): a. acceleration. c. satisfaction b. balloon. d. escalation. 6. The type, of mortgage loan that includes not only the real estate but also all personal property and appliances on the premises is a(n): a. package mortgage. c. blanket mortgage. b. open-end mortgage. d. wraparound mortgage.



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7. The Real Estate Settlement Procedures Act (RESPA) provides: a. a secondary market for mortgage loans. b. that advertisements must include the annual percentage rate. c. that real estate syndicates must obey "blue sky" laws, d. that the mortgagor must be given an estimate of closing costs before closing. 8. The Federal Truth-in-Lending Law: a. requires a lender to estimate a borrower’s approximate loan closing costs on residential mortgages. b. forbids use of the term "annual percentage rate." c. prevents a broker from saying "FHA financing available" in a classified ad. d. requires all mortgage loan applications to be made on standard government forms. 9. In appraising a property, one should first consider the: a. asking price. c. original cost, b. highest and best use. d. selling prices of similar properties. 10. The maximum value of a property tends to be set by the cost of producing an equally desirable a. supply and demand. c. anticipation b. conformity. d. Substitution 11. The income approach is most important in determining the value of which of the following? a. A condominium c. A residence b. An office building d. A vacant residential lot 12. An appraiser reconciles the differences in value estimates obtained from the three basic approaches to value by: a. averaging middle figures obtained for each of the three approaches. b. adding all the figures obtained from the best approach. c. averaging all the figures obtained from all three approaches. d. using the estimate of value of the most appropriate approach.



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Answer Sheet

A B C D 1. 2. I certify that I, _________________________ 3. (print name) 4. personally answered these questions. 5. 6. 7. 8. Student Signature: ______________________ 9. 10. 11. 12. Please Print this answer sheet and after finishing, email to [email protected] or FAX to 866-659-8458 or mail to: AlaskaRealEstateSchool.com Attn: Denny Wood PO Box 241727 Anchorage, Alaska 99524-1727

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