Document Systems, Inc. ("DSI") is pleased to introduce the first state-specific predatory lending/high cost loan analysis and display to be incorporated into DSI's flagship "DocMagic" loan document preparation software. As most of you already know, California Assembly Bill 489 amended the California Financial Code to add Division 1.6 (commencing with Section 4970) (the "California Covered Loan Law") effective for all loan applications received on or after July 1, 2002. To view a copy of the California Covered Loan Law, click here. DSI's California Covered Loan computation display screen is designed to assist you in making your California "Covered Loan" determinations. This memo briefly describes the provisions of the California Covered Loan Law and DSI's automated "Covered Loan" determination process.

What is a California "Covered Loan"?

The California Covered Loan Law applies to all applications for "covered loans" received on or after July 1, 2002. A "covered loan" is defined as a "consumer loan" in which the original principal balance does not exceed the most current conforming loan limit for a single-family first mortgage loan established by Fannie Mae, and either:

(i) The APR at consummation will exceed by more than 8% the yield on Treasury securities having comparable periods of maturity on the 15th day of the month immediately preceding the month in which the application is received by the creditor (the "CA APR Test"); or
(ii) Total points and fees payable by the consumer at or before closing will exceed 6% of the total loan amount (the "CA Points and Fees Test").

A "consumer loan" is defined generally as a closed-end consumer credit transaction secured by a 1- to 4-family dwelling that is or will be the consumer's principal dwelling, regardless of lien position; excluded from coverage are reverse mortgages, open-end loans, loans secured by rental properties or second homes, or bridge loans with terms of one (1) year or less. Please note that while the application of Regulation Z Section 226.32 ("Section 32") expressly excludes "residential mortgage transactions" (defined generally as purchase money and construction loan transactions secured by a consumer's principal dwelling), the California Covered Loan Law does not contain a comparable exclusion and on its face applies to purchase and construction loans otherwise fitting within the definition of a consumer loan. Accordingly, the DocMagic Covered Loan computation will apply to any purchase money and construction loan that otherwise falls within the definition of consumer loan.

The DocMagic California Covered Loan Computation and Display

The California Covered Loan computation display screen is vertically divided into two parts, corresponding to the CA APR Test and CA Points and Fees Test; the bottom right hand corner displays the actual determination with a short explanation. The display screen is comparable to the DocMagic computation display screen currently utilized in connection with determinations made under Section 32, but there are differences.

CA APR Test - The CA APR Test is comparable to the APR Test under Section 32; however, the threshold has been reduced from 10% to 8% for all loans regardless of lien position. (Currently, the Section 32 threshold is 10%; effective mandatory on October 1, 2002, the APR threshold for Section 32 loans will be reduced from 10% to 8% for first lien loans, while the APR threshold for junior lien loans will remain at 10%).

CA Points and Fees Test - The display screen is divided into three subparts: "Total Points and Fees"; "Total Loan Amount"; and "CA Covered Loan Percentage," with each component individually computed and automatically appearing in its own separate data field.

Total Points and Fees: Points and fees under the California Covered Loan Law are defined generally as follows:

	Prepaid Finance Charge - the total amount of prepaid finance charges
-	Prepaid Interest - to be deducted from prepaid finance charge
+	Other Mortgage Broker Compensation - the total amount of all non-prepaid finance charges paid by a borrower to a mortgage broker
+	Other Charges Paid to Creditor - the total amount of all Regulation Z Section 226.4(c)(7)1 charges not included as a part of the Prepaid Finance Charge, if paid by a borrower directly to the creditor
+/-	CA Covered Loan Adjustments2 - the total amount of all overrides to our automatic California Covered Loan Law determination that you specifically request
=	Total Points and Fees - the sum of the above components

The definition of points and fees under the California Covered Loan Law is comparable to the current definition of points and fees for purposes of Section 32 (12 CFR 226.32(b)(1)), except that unlike Section 32, 226.4(c)(7) fees paid to creditor affiliates or indirectly to the creditor are not included in the California definition of points and fees.

A word about yield spread premiums and other "back end" compensation paid by the lender to a mortgage broker. The California Covered Loan Law uses language to describe mortgage broker compensation that is similar to that used in Section 32, and the commentary to Section 32 is clear that yield spread premiums and other "back end" compensation paid by the lender to the broker are not included in the Section 32 analysis. However, there are conflicting reports as to the treatment of such compensation by the law's sponsor and, more important, the applicable regulators. For example, DSI has been advised that the bill's author intended and currently believes that mortgage broker compensation does in fact include all such yield spread premiums and other "back end" compensation paid by the lender to the broker. To make matters worse, the applicable regulators (the California DRE, Department of Corporations and Department of Financial Institutions) take no position currently on the treatment of yield spread premiums and other "back end" compensation paid by the lender to the broker. Indeed, the Department of Corporations has taken the position that they will not take any position except through the normal audit review function; that is, they are offering no advance guidance to licensees under their jurisdiction, and instead will address the matter as it arises during the course of individual audits. DSI has decided to exclude yield spread premiums and other "back end" compensation paid by the lender to the mortgage broker from the California Covered Loan computation and display. DSI's position is based on the clear language of the California Covered Loan Law itself (indeed, the CA Points and Fees Test specifically states that a covered loan is one in which "total points and fees payable by the consumer at or before closing will exceed 6% of the total loan amount") and is consistent with the approach under Section 32. However, if you or an investor determine otherwise, please contact our customer service department.3

Total Loan Amount: "Total loan amount" is not defined in the California Covered Loan Law, nor is any reference made to the commentary to Section 32 where the phrase is in fact defined for purposes of Section. DSI has decided to follow the definition of "total loan amount" provided in the Section 32 commentary (with modifications as explained below):

	Amount Financed - calculated in accordance with Regulation Z
-	Other Charges Paid to Creditor and Financed - the total amount of any Section 226.4(c)(7) charges not included as a part of the Prepaid Finance Charge, if paid by a borrower to the creditor, and financed
+/-	CA Covered Loan Adjustments - the total of all overrides to our automatic California Covered Loan Law determination that you request
=	Total Loan Amount - the sum of the above components

Under Section 32, the "total loan amount" is defined generally as the amount financed minus 4(c)(7) charges paid to the creditor or an affiliate and financed. This description tracks the definition of points and fees found in Section 32 as it applies to 4(c)(7) charges paid to the creditor or an affiliate; however, as noted above, the California definition of points and fees excludes 4(c)(7) charges paid to creditor affiliates or indirectly to the creditor. Accordingly, no adjustment to the total loan amount is made if a 4(c)(7) charge is paid to a creditor affiliate or indirectly to the creditor; 4(c)(7) charges paid to the creditor will continue to be deducted from the amount financed only if they are also financed.

California Covered Loan Percentage: The Points and Fees threshold under Section 32 is the greater of 8% of the Total Loan Amount or $480 (for the year 2002). The CA Points and Fees Test threshold is 6% of the Total Loan Amount; there is no comparable dollar amount trigger as under Section 32. The actual computation of the Total Points and Fees divided by the Total Loan Amount is shown in the display. The resulting CA Covered Loan Percentage, and the amount by which the loan's Total Points and Fees exceeds or falls short of the Points and Fees Test trigger, are indicated.

Prohibited Activities Under the California Covered Loan Law

Here is a brief recap of a list of prohibited activities under the California Covered Loan Law:

• Prepayment Penalty: No prepayment fee or penalty is permitted after the first 36 months after the date of the loan (a covered loan may include a prepayment fee within the first 36 months if the consumer is also offered a choice of another product without a prepayment fee or penalty, a written disclosure is given to the consumer at least three (3) business days prior to consummation containing (a) the terms of the prepayment fee or penalty; (b) the rates, points and fees available for accepting a covered loan without a prepayment penalty; and (c) the prepayment fee or penalty is limited to six months' advance interest at the contract rate then in effect on the amount prepaid in any 12­month period in excess of 20% of the original principal amount). Furthermore, no prepayment fee or penalty is permitted if the covered loan is accelerated because of default, and a person who originates a covered loan may not finance a prepayment penalty through a new loan by the same originator. (To "originate" means to arrange, negotiate, or make a consumer loan and thus encompasses brokering as well as lending activities.)
• A person who originates a covered loan shall not make a covered loan that finances points and fees in excess of $1,000 or 6% of the original principal balance, exclusive of points and fees, whichever is greater.
• No balloon loans with terms of five years or less, subject to certain limited exceptions applicable to consumers with seasonal or irregular income, and bridge loans of less than 18 months.
• No negative amortization is permitted unless the covered loan is a first lien loan and the licensee discloses to the consumer that the loan contains a negative amortization provision.
• A covered loan shall not include terms under which periodic payments are consolidated and paid in advance from the loan proceeds.
• No default rates of interest rate are permitted.
• A person who originates covered loans shall not make or arrange a covered loan unless at the time the loan is made, the person reasonably believes the consumer, when considered collectively in the case of multiple consumers, will be able to make the scheduled payments to repay the loan based on current and expected income, current obligations, employment status and other financial resources other than the consumer's equity in the dwelling. For adjustable rate loans, step rate loans, and any other loans with rate increase provisions occurring within 37 months from date of application, this evaluation is based on the fully indexed rate calculated at the time of application. The consumer is presumed to be able to repay the loan if at the time the loan is made, the consumer's total monthly debts, including loan payments, do not exceed 55% of the consumer's monthly gross income, as verified by the consumer's credit application, financial statement, credit report, information provided to the originator by or on behalf of the consumer, or "any other reasonable means." There is no presumption of inability of the consumer to repay the loan if these debts/payments exceed the 55%. For "stated income loans," the requisite "reasonable belief" may be based on the income stated by the consumer, and other information in the possession of the person originating the loan after the solicitation of all information that the person customarily solicits in connection with loans of this type.
• A person who originates a covered loan shall not pay a contractor under a home improvement contract from the proceeds of a covered loan other than by an instrument payable to the consumer or jointly to the consumer and the contractor or, at the election of the consumer, to a third party escrow agent pursuant to joint escrow instructions. Signed, dated completion certificates for completed work must be presented to the originator by the consumer prior to any payment, including progress payments.
• A person who originates a covered loan shall not encourage a consumer to default on an existing consumer loan or other debt in connection with solicitation or making of a covered loan that refinances all or any portion of the existing loan or debt.
• A person who originates a covered loan shall not steer, counsel or direct any prospective consumer to accept a loan product with a risk grade less favorable than the risk grade the consumer would qualify for based on that person's then current underwriting guidelines. A broker who originates a covered loan shall not steer a prospective consumer to accept a loan at a higher cost than that for which the consumer could qualify based on loan products offered by persons with whom the broker regularly does business.
• No "call provision" is permitted unless pursuant to due on sale provisions, or due to consumer fraud or material misrepresentations. A licensed person shall not refinance or arrange for a refinance of a consumer loan with a covered loan that does not result in an identifiable benefit to the consumer considering the consumer's stated purpose for seeking the loan, and fees, interest rates, finance charges and points.
• A 12­point type disclosure entitled "CONSUMER CAUTION AND HOME OWNERSHIP COUNSELING NOTICE'" with required text must be provided to the consumer no later than three (3) business days before loan documents are signed.
• A person who originates a covered loan shall not avoid, or attempt to avoid, the application of the California Covered Loan Law by (1) structuring a loan transaction as an open-end credit plan for the purpose of evading the laws when the loan would have been a covered loan if it had been structured as a closed-end loan, or (2) dividing any loan into separate parts for the purpose of evading these laws.
• A person who originates a covered loan shall not act in any manner that constitutes fraud. The statute specifically provides that anyone that provides brokerage services for a covered loan is the fiduciary of the consumer, regardless of who else the broker may be acting as an agent for in the course of the loan transaction.
• Financing of Single-Premium Insurance Products: In addition to the forgoing provisions applicable to covered loans, a person who originates a consumer loan may not finance in the loan or within 30 days after the loan is made any credit life, credit disability, credit property or credit unemployment insurance premiums, or any debt cancellation or suspension agreement or contract fees (except such insurance premiums calculated and paid on a monthly basis). PMI insurance or a contract issued by a government agency to insure the lender against loss as a result of the borrower's default is permitted.

If you have any questions or comments, please do not hesitate to contact our customer service or compliance departments at (800) 649-1362. Thank you for making DocMagic #1.

DISCLAIMER: DIVISION 1.6 OF CALIFORNIA FINANCIAL CODE (COMMENCING WITH SECTION 4790) IS A NEW LAW AND MANY OF ITS PROVISIONS ARE AMBIGUOUS OR UNDEFINED AND SUBJECT TO INTERPRETATION. WHILE DOCUMENT SYSTEMS, INC. ("DSI") HAS ATTEMPTED TO ENSURE THE ACCURACY OF THE INFORMATION CONTAINED HEREIN, THE INFORMATION HEREIN IS OFFERED "AS IS" AND DSI EXPRESSLY DISCLAIMS ANY AND ALL WARRANTIES, EXPRESS OR IMPLIED, INCLUDING WITHOUT LIMITATION WARRANTIES OF MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE, WITH RESPECT TO SUCH INFORMATION. IN NO EVENT SHALL DSI BE LIABLE FOR ANY DIRECT, INDIRECT, INCIDENTAL, PUNITIVE, OR CONSEQUENTIAL DAMAGES OF ANY KIND WHATSOEVER WITH RESPECT TO SUCH INFORMATION AND/OR YOUR USE THEREOF.

1 We've identified all potential Section 226.4(c)(7) charges in our database of charges. These charges include title related fees (title exam, title abstract, title insurance, survey and similar fees), document preparation fees, notary fees, credit report fees, appraisal fees, and inspection fees (including pest inspections and flood hazard determinations).  Please note that if you input a miscellaneous fee that is not included as a part of the Prepaid Finance Charge, and the borrower pays the miscellaneous fee to the creditor, the charge will be treated as a Section 226.4(c)(7) charge for all California Covered Loan calculations.
2 Flexibility has always been one of DocMagic's strong suits.  Accordingly, we have given you the power to override of our standard California Covered Loan settings simply by speaking with one of our customer service representatives.
3 In a recent California appellate court case, the court reached the conclusion yield spread premiums should not be included as points and fees under the Covered Loan Law. Wolski v. Fremont Investment & Loan (2004) 127 Cal. App. 4th 347).  For additional information on this case, please click here.  Furthermore, in a recently published release, the California Department of Corporations has concluded that under current law (specifically the decision in Wolski), yield spread premiums are not part of points and fees under California's Covered Loan Law. We believe this is the first written statement by a California governmental agency regarding whether or not yield spread premiums are included as points and fees under California's Covered Loan Law.  To view a copy of the release, click here.