Real Estate Finance Spring 2013 Dean Don Weidner

1
Real Estate Finance Spring 2013Dean Don Weidner

• Eight sets of slides for the Spring 2013.
• Are available on my web page.
• Are also posted on the web blackboard for this
  course under Course Library.
• May be amended slightly.
• Course Syllabus.
• Is posted on my web page.
• Is also posted on the web blackboard for this
  course under Syllabus.
• May be amended slightly .
• Assignments.
• We shall proceed directly though the Syllabus
• The slides will also take us directly through the
  Syllabus.

2
Background on Contracts and Conditions
Contract of Sale
Seller Buyer Lender
Listing
Closing
Seller
Broker
Buyer
Agreement
Interim Contract
Consummation (Closing) of the Contract of Sale
is subject to certain conditions, which must be
satisfied within a particular period of time,
usually involving a) title b) physical
condition and c) financing.
3
Contract Conditions

• Text says conditions are essentially substitutes
  for information.
• Conditions may also be inserted by the buyer to
  postpone making a commitment.
• Conditions range from the extremely general to
  the extremely specific.
• Conditions may leave so much open that a contract
  arguably fails to satisfy the requirement of a
  writing under the Statute of Frauds.
• Even if the Statute of Frauds is satisfied, the
  contract may be too indefinite to support an
  award of specific performance.

4
Illusory Contracts

• Since conditions will characteristically be
  phrased in general terms, and their fulfillment
  left to the exclusive control of one of the
  parties, there is the added question of
  illusoriness or mutuality of obligation.
• Generally, the problem is small, for the concept
  of good faith goes far toward preventing reneging
  parties from using a financing, title or other
  condition as an excuse for nonperformance.
• In such cases the court will examine the motive
  of the party relying on the condition.
• If a written contract gives me a right, must I
  show that I am pure of heart before I may enforce
  it?
• Not everyone thinks so. Courts split on good
  faith..

5
Homler v. Malas,(Text p. 95)

• Seller sought to specifically enforce a buyers
  promise to purchase a single-family residence.
• Contract, on a standard form, had a subject to
  financing clause that conditioned Buyers
  performance.
• on Buyers obtaining a loan (ability to
  obtain had been deleted).
• For 80 of the purchase price.
• Repayable monthly over a term of no less than 30
  years.
• However, there was no mention of
• Interest rate (left blank).
• The amount of monthly payment (left blank).
• Amortization terms.

6
Homler v. Malas (contd)

• Buyer said the contract is too vague and
  indefinite to be specifically enforced because
  the terms of the financing contingency are not
  sufficiently identified.
• Georgia courts had said that a failure to specify
  a buyers interest rate causes a failure of a
  condition precedent to the enforceability of the
  contract.
• Seller said that there is no need to specify the
  interest rate in a contract that anticipates
  third-party financing.
• Can you see what the argument might be?

7
Homler v. Malas (contd)

• Court said it is not as if the contract had
  specified interest at the current prevailing
  rate.
• The contract assumed a search for third-party
  financing.
• Why not use the concept of good faith as a gap
  filler?
• That is, the concept of good faith would fill the
  interest rate gap by implying into the contract
  that interest would be at the current prevailing
  rate
• Stated differently, the default rule (which would
  apply unless the parties specified a different
  rule) would be that the unspecified interest rate
  is the current prevailing rate

8
Homler v. Malas (contd)

• How would you decide this case?
• Court concluded the contract was too vague and
  indefinite to be enforced against the buyer and
  ordered the buyers deposit to be refunded.
• Why did the court refuse to use the concept of
  good faith to fill the interest rate gap?
• Everyone agrees the buyer is under a duty to
  proceed in good faith. The split is on what that
  means.
• Does the strikeout suggest a different argument?
• Mutuality of obligation is a separate issue
  from vague and indefinite and apparently, in
  the eyes of the court, an issue that was not
  raised
• Could Buyer have enforced the contract against
  Seller?
• Option to Buyer?

9
Definitions of Good Faith

• Every contracting party is under a duty or
  obligation of good faith
• The question is what that duty requires
• UCC general definition honesty in fact in the
  conduct or transaction concerned.
• Honesty to Webster uprightness integrity,
  trustworthiness also freedom from deceit or
  fraud.
• UCC definition for a merchant honesty in fact
  and the observance of reasonable commercial
  standards of fair dealing in the trade.
• Many statutes use the term good faith without
  defining it.
• Some scholars say good faith is an excluder
  category--one defined by what is deemed to be
  outside it rather than by what is in it.

10
Liuzza v. Panzer(Text p. 98)

• Contract to sell and to buy for 37,500.
• Buyers obligation was conditioned upon the
  ability of the Buyer to borrow 30,000.00 on
  the property at an interest rate not to exceed
  9.
• Buyer applied to an S L for a 30,000 loan and
  was rejected because the appraisal was too low.
• S L appraisal was 32,150.
• S L would only lend 80 of the appraised value
  (which was less than the 30,000 loan amount
  mentioned in the contract as a condition).
• Can the Buyer walk away from the deal at this
  point?
• Before refusing to close, what more, if anything,
  must Buyer do to avoid breaching the Buyers
  implied obligation to act in good faith?

11
Kovarik v. Vesely (Text p. 99)

• Contract provided for Buyers obligation to buy
  for 11,000. Buyers were to pay
• 4,000 down, with the
• balance to be financed through a 7,000
  purchase-money mortgage from the Fort Atkinson S
  L.
• Fort Atkinson S L rejected the Buyers.
• Seller offered to provide 7,000 financing on the
  same terms that Buyers requested from Fort
  Atkinson.
• Buyers refused the offer of Seller financing
• Seller sued to specifically enforce the contract.
• Did the court correctly conclude that good faith
  required the Buyer to accept the Sellers offer
  of seller financing?

12
Kovarik v. Vesely (contd)

• The majority apparently held that the obligation
  of good faith prevents the buyer from relying on
  the letter of the contract, which seems to say
  that the buyers obligation is contingent on the
  buyers ability to obtain a loan from the
  specified lender
• However, a buyer could reasonably want
• A third-party lender to provide a reality check
  on value and
• A standard institutional approach in the
  administration of the loan
• especially in the event of default.

13
Kovarik v. Vesely (contd)

• Court also rejected the Buyers argument that the
  incomplete financing clause failed to satisfy the
  Statute of Frauds requirement of a writing.
• The financing clause referred to 7,000
  purchase-money mortgage from the Fort Atkinson S
  L..
• How is this clause incomplete?
• The courts reasoning the loan application . .
  . is a separate writing which is to be construed
  together with the original contract of the
  parties, and together they constitute a
  sufficient memorandum to satisfy the Statute of
  Frauds.
• Is there one transaction or two?

14
Kovarik v. Vesely (contd)

• An alternative approach A reasonable
  interpretation of the contract would look at the
  standard practice among savings and loan
  associations with respect to this particular type
  of loan.
• That is, business practice and the rule of
  reasonableness would fill in the gaps

15
Variables that Determine Debt Service

• Debt Service is the amount of payment required
  per unit of time (usually monthly or annually) to
  service a debt. The 4 variables that determine
  debt service are
• Amount of loan
• Usually determined by
• Applying a loan/value ratio to
• An appraisal of value
• Length of loan
• Rate of interest
• Amortization termsthe terms under which
  principal is repaid

16
Loan to Value Ratio

• May be in statute, regulation or internal
  policies.
• Some legislative terms used to mandate maximum
  loan to value ratios
• appraised value
• estimated value
• reasonable normal value
• estimated replacement cost
• actual cost
• Subject to a range of interpretations

17
Loan to Value Ratio (contd)

• Many lenders believe that the loan/value ratio
  gets in their way and fails to serve as a
  meaningful protection to their shareholders.
• They believe that there is greater protection in
  exacting credit standards, increased site
  scarcity, inflation or other factors
• Or, they are simply very eager to do a deal.
• They might also be planning to sell the loan and
  thus avoid any risk attendant to it.
• Therefore, they often avoid the ratio.

18
Appraisals Three Basic Indications of (or ways
of approaching) Value

• Recent Sales of Comparable Properties
• Also known as Market Data Approach
• The approach is less valid if there is an
  inactive market or if the property is unique
• Replacement Cost
• Cost of replacing a building (and the land under
  it) minus depreciation charges on the building

19
Appraisals Three Basic Indications of (or ways
of approaching) Value (contd)

• Capitalized Value of Income (many methods)
• --Gross Rent Multipliervery rough (and less
  valid if there are little or no sales of
  comparables)
• --Apply a Capitalization Rate to current net
  cash flowonly slightly more refined
• --Derive the present value of the estimated
  stream of future cash flowsmore refined
• Reconciliation relates these three factors
  (recent sales, replacement cost and capitalized
  value of income)-- it does not simply average
  them. A reconciliation may select one factor as
  the most important.

20
GROSS MULTIPLIER ??? Derive value from gross
rentals
Assume a Recent Sale
12 Million Sales Price
6 Gross Multiplier
2 Million Gross Rental Revenue
Applying this rough method, a comparable
property with only 600,000 of Gross Rent
receipts would therefore have a 3,600,000 value
(six times gross rent receipts) (600,000 X 6
3,600,000)
21
CAPITALIZATION RATE ??? Capitalize the value of
the net rentals
How Much Will An Investor Pay for a Building that
has a 150,000 Net Cash Flow?

• If I expects an 8 cash return stated in
• fractions

• If I expects a 12 cash return stated in
• decimals

? The price
x
8/100
return 150,000
.12 return 150,000
? The price
x
1)
1)
Divide each side of the equation by 8/100
Divide each side of the equation by .12
2)
2)

• x .12/.12 150,000/.12
• 1,250,000

(? x 8/100) x 100/8 150,000 x 100/8 ?
1,875,000
22
DISCOUNTED CASH FLOW
Values property by a) estimating future cash
flows and b) discounting those future cash flows
to their present value. Discounting is the
obverse of compound interest.
Net Cash FlowRent ReceiptsReal Estate
TaxesMaintenance Insurance(Principal
Interest) 1,000 Assume
purchase of 10-year position ???10 year leasehold
HYPO What is the present value of the right
to receive a net cash flow of 1,000 at the end
of each of the next ten years? Assume the
investor requires a 20 rate of return. Because
of the spreading out of the 1,000 payments over
the next 10 years, their value today is only

• .833 x 1,000 833
• .694 x 1,000 694
• .579
• .482
• .402
• .335
• .279
• .233
• .194
• .162 x 1,000 162
• 4,193

23
Plaza Hotel Associates 340 N.Y.S.2d 796 (N. Y.
Sup. 1973)

• PLAZA
• OWNS THE BUILDING

Operating
? HOTEL CP
Agreement
BUILDING
½ ? PLAZA
½ ?
LAND
LEASE
SUBLEASE OF ? ½ FEE INTEREST
LEASE OF ? ½ FEE INTEREST
24
Plaza Hotel Facts

• Lease provided for rent to increase to 3 of the
  value of all of the land, exclusive of the
  building and improvements.
• It also provided that, if LL and T could not
  agree on value, appraisers would determine value.
  
• An appraisal valued the land alone at
  28,000,000.
• Tenant sued to set appraisal aside on ground that
  it was too high because it was based on the
  assumption that the land was vacant and available
  for its highest and best use.

25
Plaza Hotel Highlights

• Court set aside the appraisers valuation on the
  ground that the appraiser erroneously valued the
  land as available for its highest and best use,
  and not as already encumbered by the long term
  lease which restricts the use of the land to
  hotel purposes only.
• Does that seem correct?
• Consider since the fee and the building on it
  were separately owned, the fee could be sold
  separately. Hence, it is possible to ask how
  much would someone pay for the fee.
• Having set aside the appraisers determination of
  value, the court undertook to determine value.

26
Plaza Hotel Highlights

• The court distinguished price from value
• Price is determined by short term factors and by
  the caprices of the market.
• Value . . . is dependent upon long term factors
  and is directly related to the intrinsic worth of
  the property that resists the impact of temporary
  and abnormal conditions.
• Value, even more than price, is a matter of
  judgment.

27
More from Plaza Hotel

• The concept of a fluid market such as that
  existing in regard to corporate securities, where
  one sale can indicate the value at the time, is
  just not true with respect to real estate.
• The lessees 3 appraisals of the land alone
  ranged from 8.5 million to 11.5 million.
• The lessors 3 appraisals of the land alone
  ranged from 33.3 million to 34.5 million.

28
Plaza Hotel (contd)

• Plaza Hotel noted
• In considering the opinions of the experts, the
  court is not unmindful that the appraisal of
  rental property necessarily involves the
  discretionary application of one or more accepted
  methods of computation and we must recognize
  that appraisers retained in litigated matters,
  within the limits of professional integrity, tend
  to adopt those formulae which favor their
  employers position.

29
A Different View on Free and Clear Appraisal

• Compare Taylor v. Fusco Management, 593 So.2d
  1045 (Fla. 1992) The market value of leased
  property at the time a lessee exercises an option
  to purchase the property should be computed as if
  the property were unencumbered by the lease. Any
  intent to value the property otherwise should be
  clearly stated in the lease.
• The lease was a 99-year lease. The price of the
  option to purchase, in the tenants view, was the
  present value of the rents (economically, a
  prepayment of the rent).
• That is, the discounted cash flow (Slide 22)

30
Length (Term) of Loan

• The longer the length, or term, of the loan, the
  lower the Debt Service
• Consider, for example, an 18,000 home
  improvement loan. If the interest rate is 6,
  the monthly Debt Service is
• 199.98 over 10 years
• 116.10 over 25 years
• 99.18 over 40 years
• The cost for the benefit of lower debt service
  the longer the term, the more interest is paid.

31
Rate of Interest

• The greater the rate of interest, the greater the
  Debt Service.
• Example, a 25-year 100,000 home improvement
  loan. Monthly Debt Service at
• 4 is 528
• 6 is 644
• 8 is 770
• 10 is 908
• 17 is 1,436

32
Points

• Point is one percent of the face amount of a
  contract debt.
• Points can be characterized differently, ex., as
  interest, for services, etc.
• Basic way points can work
• Buyer executes note to Seller for 40,000 (more
  terms also specified).
• Lender purchases note from Seller charging 6
  points 40,000 X 6 2,400).
• That is, Lender pays only 37,600 for the 40,000
  note 40,000 minus the 2,400.
• Buyer still pays interest on full 40,000 face
  amount of the note.

33
SELF AMORTIZING LOANS
First type Constant Payment
DEBT SERVICE COMPONENTS
DEBT SERVICE IN DOLLARS
. . .
PASSAGE OF TIME
34
SELF AMORTIZING
Second Type Constant Amortization
DEBT SERVICE COMPONENTS
DEBT SERVICE IN DOLLARS
. . .
PASSAGE OF TIME
35
NON SELF AMORTIZING
DEBT SERVICE COMPONENTS
DEBT SERVICE IN DOLLARS
BALLOON
. . .
PASSAGE OF TIME
36
Florida Statute on Balloon Mortgages(Supplement
p. 36)

• Fla. Stat. sec. 697.05(2)(a)1 has its own
  definition of balloon mortgage.
• Every mortgage in which the final payment or the
  principal balance due and payable upon maturity
  is greater than twice the amount of the regular
  monthly or periodic payment of the mortgage shall
  be deemed a balloon mortgage.

37
Florida Statute on Balloon Mortgages(Contd)

• With certain exceptions, there shall be printed
  or clearly stamped on such mortgage a legend in
  substantially the following form
• THIS IS A BALLOON MORTGAGE AND THE FINAL
  PRINCIPAL PAYMENT OR THE PRINCIPAL BALANCE DUE
  UPON MATURITY IS -----, TOGETHER WITH ACCRUED
  INTEREST, IF ANY, AND ALL ADVANCEMENTS MADE BY
  THE MORTGAGEE UNDER THE TERMS OF THIS MORTGAGE.

38
Florida Statute on Balloon Mortgages(Contd)

• The statute also has special provisions
  concerning the case of any balloon mortgage
  securing the payment of an obligation the rate of
  interest on which is variable or is to be
  adjusted or renegotiated periodically, where the
  principal balance due on maturity cannot be
  calculated with any certainty.
• Failure of a mortgagee to comply with these
  provisions shall automatically extend the
  maturity date of such mortgage.

39
Pre-Depression Residential Financing

• Amount. At least theoretically, very low
  loan/value ratios, typically 50-60 of appraised
  value.
• Lenders stretched their appraisals.
• Borrowers took out second, third, mortgage loans.
• Length. Seldom for more than 10 to 15 years. In
  1925, the average length for mortgages issued
• by life insurance companies was 6 years
• by S Ls was 11 years.
• Rate of Interest Junior mortgages were at
  higher rates of interest.
• Amortization Terms Balloons were common.
• In the Great Depression 1 million American
  families lost their homes to foreclosure between
  1930-1935. It got much worse in years following
  2006.

40
Post-Depression Mortgage Insurance

• Amount. Government undertook to insure loans
  with much higher Loan/Value Ratios (consumers
  were unable to pay big down payments coming out
  of the depression)
• Length. To decrease debt service, the government
  insured longer loans. Terms increased up to 40
  yrs. for certain projects.
• Rate of Interest. The government would not
  insure loans above a certain interest rate.
  Points became important.
• Amortization Terms. Government would insure only
  fully self-amortizing loans.
• Fundamental Lesson of Great Depression seemed to
  be never require a consumer to pay Debt
  Service that escalates.
• --We subsequently forgot or rejected that
  lesson.

41
The American Dream of Home Ownership

• Americans Living in their Own Homes
• 1940 41
• 1950 53
• 1981 65
• 2006 69

By 2008, many suggest that federal housing
officials trying to raise the homeownership rate
as high as possible helped cause the subprime
crisis by encouraging loans to high-risk
borrowers Many also fault Chariman Alan
Greenspans Federal Reserve Board for keeping
interest rates too low for too long. Ben
Bernanke does not.
42
NEW TYPES OF CONSUMER MORTGAGES(Text p. 409)

• Adjustable Rate Mortgage (ARM) (a.k.a. Variable
  Rate Mortgage or VRM)
• Graduated Payment Mortgage (GPM)
• Renegotiable Rate Mortgage (RRM)
• Shared Appreciation Mortgage (SAM)
• Price Level Adjusted Mortgage (PLAM)
• Reverse Annuity Mortgage (RAM)

43
1) ADJUSTABLE RATE MORTGAGE

• Interest rate rises and falls according to some
  predetermined standard.
• A borrower must pay for an interest rate increase
  in one of the following three ways
• --1. Debt service payments will increase or
• --2. The length of the loan will increase or
• --3. The amortization terms will change (a
  balloon will be created or increased)

44
Adjustable Rate Mortgages (contd)

• Protections provided for consumers
• Limit the frequency of interest rate increases
• Limit the magnitude of each interest rate
  increase
• Limit the total amount of interest rate increases
• Require downward adjustments if the standard
  declines.
• Offer borrowers the right to prepay without
  penalty upon an interest rate increase
• Note a borrower may not be able to refinance,
  even if rates have dropped

45
Adjustable Rate Mortgages (contd)

• Consumer protections (contd)
• Balloon disclosure rules may define a balloon
  more narrowly than simply as any payment larger
  than one before
• Ex., as any payment more than twice the size of a
  preceding payment (as in Florida).

46
2) GRADUATED PAYMENT MORTGAGE

• Monthly payments gradually rise, while the
  interest rate and the term of the loan are fixed.
• Initial concept Help the young family that
  reasonably expects its income to grow
  substantially over the years following the loan
  closing.
• Initial, low payments would not amortize the debt
  or even pay all the interest, but later payments
  make up for it.

47
GRADUATED PAYMENT MORTGAGE (contd)

• The Growing Equity Mortgage is another form of
  increasing payment mortgage.
• Text discusses it as a long term,
  self-amortizing mortgage under which the
  borrowers monthly payments increase each year by
  a predetermined amount, typically 4.
• Apparently, it never goes negative as to interest
  or principal.
• Note borrow can tailor his or her own growing
  equity provisions with prepayment privileges.

48
3) RENEGOTIABLE RATE MORTGAGE (a.k.a. Rollover
Mortgage)

• Series of renewable short-term notes, secured by
  a long-term mortgage with principal fully
  amortized over the longer term.
• As initially approved for consumer transactions,
  the interest rate could be adjusted up or down
  every 3 to 5 years and could rise or fall as much
  as 5 percentage points over the entire 30-year
  life of the mortgage.

49
Goebel v. First Federal(Text p. 403)

• The note provided
• Interest shall be paid monthly.
• Initial interest rate was 6 per annum.
• The initial interest rate may be changed from
  time to time at the S Ls option.
• There will be no interest rate change during
  first 3 years.
• Borrower will get 4 months written notice before
  any interest rate change.
• Borrower has 4 months from receipt of notice of a
  change to prepay without penalty.

50
Goebel (contd)

• Nine years later, Lender declared that the
  interest rate was being increased and that
  Borrower had the option to
• Pay increased monthly Debt Service, or
• Increase the length of the loan.
• No mention was made of balloons.
• Courts said construe the ambiguous language in
  the note against the drafter, especially
• when the drafter has much greater bargaining
  power, and
• when the drafter supplied its standard form.

51
Goebel (contd)

• As to increasing monthly Debt Service, court said
  expressio unius controlled The note contained
  provisions to increase Debt Service in some
  situations but did not mention increasing debt
  service to reflect an interest increase.
• Note stated that monthly Debt Service could be
  increased to accommodate future advances and
• Note stated that Lender had a right to payment
  for taxes, insurance and repairs on demand
• Lower court said this included the right to
  increase monthly Debt Service.
• Yet the note fails to make similar provisions
  for an increase in interest
• Therefore, the promisor could not be required pay
  an increase of monthly debt service satisfy an
  increase in interest.

52
Goebel (contd)

• As to increasing the term (the length of the
  loan), the court focused on the language that all
  Principal and Interest shall be paid in full
  within 25 years.
• Lender argued this clause was intended for its
  benefit and that it, therefore, could set it
  aside.
• The court appears to have begged the conclusion
  when it said that this clause was for the
  Borrowers benefit.
• The court said it was not nullifying the
  provisions increasing the interest rate because
  an interest increase would still be collectible
• To offset any prior interest rate declines
• In the event of a prepayment of the mortgage
• Due on sale clause was enforceable
• How does this fit with what the court said about
  a balloon (this method was not used)?

53
Note to Goebel v. First Federal

• No argument was made that an interest increase
  was either unconscionable or illegal.
• See also Constitution Bank (Text p. 413) If
  the lender may arbitrarily adjust the interest
  rate without any standard whatever, with regard
  to this borrower alone, then the note is too
  indefinite as to interest. If however the power
  to vary the interest rate is limited by the
  marketplace and requires periodic determination,
  in good faith and in the ordinary course of
  business, of the price to be charged to all of
  the banks customers similarly situated, then the
  note is not too indefinite.
• Recall, good faith can be a gap filler to
  salvage an otherwise indefinite contract
• Recall, too, that the borrower had the option to
  prepay without penalty upon an interest rate
  increase.
• Indicating that market forces would limit the
  lender from exacting an increase.

54
4) SHARED APPRECIATION MORTGAGE

• Lender agrees to lend, for example, at a flat
  rate below the current market rate in return for
  borrowers agreement that
• If the home is sold before the end of x years,
  the lender will receive a percentage of the
  increase in value
• If the home is not sold within x years, an
  appraisal will establish the value at that time
  and the borrower will pay a lump sum contingent
  interest equal to the lenders share of the
  appreciation.
• BUTif the borrower requests, the lender
  must refinance an amount equal to the unpaid loan
  balance plus the contingent interest.

55
5) PRICE LEVEL ADJUSTED MORTGAGE

• It is the loan principal, NOT the interest rate,
  that varies over the term of the mortgage.
• The principal is adjusted up or down according to
  a prescribed inflation index.

56
6) Reverse Annuity Mortgage

• Designed to enable seniors to draw cash out of
  the equity in their homes.
• The typical Reverse Annuity Mortgagee makes
  monthly payments to the borrower over the
  borrowers lifetime or over a predetermined
  period.
• With each monthly payment to the borrower, the
  debt increases.
• Typically, the debt is to be repaid at the
  earlier of death of the borrower, or x years from
  the loan origination, money to come from sale of
  the property or the borrowers estate.

57
Growth of Securitization of Real Estate Debt

• In 1934, Congress created the Federal Housing
  Administration (FHA) to induce thrift
  institutions to originate long-term loans with
  relatively low down payments by insuring those
  lenders against the risk of default.
• In 1938, the Federal National Mortgage
  Association (Fannie Mae) was created to buy and
  to sell federally insured mortgages.
• In 1968, the Government National Mortgage
  Association (Ginnie Mae) was created as a second,
  secondary market agency to take over the
  low-income housing programs previously run by
  Fannie Mae.

58
Growth of Debt Securitization in Real Estate
(contd)

• Fannie Mae was then restructured as a private
  corporation with ties to the federal government
• And given the authority to buy and sell
  conventional (non-federally insured) home
  mortgage loans.
• In 1970, Congress established the third major
  secondary mortgage market agency, the Federal
  Home Loan Mortgage Corporation (Freddie Mac),
• which is also empowered to buy and to sell
  conventional mortgages.

59
Growth of Debt Securitization in Real Estate

• In the 1970s, the secondary market agencies
  became critical in promoting the growth of
  securitization.
• Issuers of mortgage-backed securities pool
  hundreds of loans together, obtain credit
  enhancement, usually in the form of guarantees,
  from a secondary market agency, and sell their
  interests in a pool of mortgages to investors.
• 1. The first generation of mortgage-backed
  securities were pass-through certificates that
  entitled the holders to a proportionate share of
  interest and principal as these amounts were paid
  by mortgagors.
• 2. Issuers of mortgage-backed securities
  subsequently divided the flow of mortgage
  interest and principal from the pool to create
  debt instruments of varying maturities and levels
  of risk.
• These different slices are known as tranches

60
Federal Reserve Policy

• When the Federal Funds Rate was only 1, Federal
  Reserve Chairman Alan Greenspan announced that
  the FOMC would maintain an highly accommodative
  stance for as long as needed to promote
  satisfactory economic performance
• Thus, there was cheap money to help drive up
  prices
• Treasury obligations were not paying investors
  very much
• Investors turned to mortgaged-backed securities
  for higher yields than Treasury bills at, they
  thought, relatively little risk
• At the same time, Chairman Greenspan believed
  that the discipline of the markets, rather than
  regulation, would protect against excessive risk
  taking.

61
Crisis Looms in Market for Mortgages(Supplement
p. 1)

• Gretchen Morgenson, Crisis Looms in Market for
  Mortgages, New York Times, March 11, 2007.
• As of March, 2007, the nations 6.5 trillion
  mortgage securities market was even larger than
  the United States treasury market.
• Already, more than two dozen mortgage lenders
  have failed or closed their doors, and shares of
  big companies in the mortgage industry have
  declined significantly. Delinquencies on loans
  made to less creditworthy borrowersknown as
  subprime mortgages recently reached 12.6
  percent.
• 35 of all mortgage securities issued in 2006
  were in the subprime category.

62
Crisis Looms in Mortgage Market (contd)

• Subprime Lenders created affordability
  products, mortgages that
• Require little or no down payment
• Require little or no documentation of a
  borrowers income
• Extend terms to 40 or 50 years
• Begin with low teaser rates that rise later in
  the life of the loan.
• Mortgages that require little or no documentation
  are known as liar loans.

63
Crisis in Mortgage Market (contd)

• Securities backed by home mortgages have been
  traded since the 1970s, but it has been only
  since 2002 or so that investors, including
  pension funds, insurance companies, hedge funds
  and other institutions, have shown such an
  appetite for them.
• Wall Street was happy to help refashion mortgages
  into ubiquitous and frequently traded securities,
  and now dominates the market. By 2006 Wall
  Street had 60 percent of the mortgage financing
  market.

64
Crisis in Mortgage Market (contd)

• The big firms buy mortgages from issuers, put
  thousands of them into pools to spread out the
  risks and then divide them into slices, known as
  tranches, based on quality. Then they sell
  them.
• Some of the big firms even acquired companies
  that originate mortgages.
• Investors demands for mortgage-backed securities
  was insatiable
• The greater the demand, the less the investment
  banks insisted on quality loans.

65
Banks Sue Originators on Repurchase
Agreements(Supplement p. 8)

• Carrick Mollenkamp, James R. Hagerty, Randall
  Smith, Banks Go on Subprime Offensive, The
  Wall Street Journal, March 13, 2007
• Although the specifics vary from deal to deal,
  repurchase agreements obligate the mortgage
  originator, under some circumstances, to buy back
  a troubled loan sold to a bank or investor. That
  obligation sometimes kicks in if the borrower
  fails to make payments on the loan within the
  first few months or if there was fraud involved
  in obtaining the original mortgage.
• Billions in mortgages are covered by repurchase
  agreements.
• However, many originators say that they cannot
  afford to buy back the loans or they are seeking
  bankruptcy protection.
• Many loans went to straw borrowers, people who
  obtain the loan for another home buyer.
• In some cases, brokers wrote contracts through
  straw men

66
Rating Agencies

• Credit rating agencies are supposed to assess
  risk of investment securities but are paid by the
  issuer of the security.
• The rating agencies gave the mortgaged-backed
  securities a AAA rating, which suggested they
  were as safe as Treasury Obligations.
• The projections they made about loan performance
  assumed a low foreclosure rate
• That data focused only on recent history and thus
  suggested a foreclosure rate of perhaps only 2
• It didnt include the newer, more risky mortgages
• Nor did it anticipate falling real estate prices

67
The Rating Agencies(Supplement p. 11)

• Floyd Norris, Being Kept in the Dark on Wall
  Street. The New York Times, November 2, 2007.
• Securitization was extremely profitable for
  investment banks, and only they seemed to
  understand what was going on.
• The products they sold (sometimes labeled CDOs
  collateralized debt obligations) could be
  valued according to models, which made for nice,
  consistent profit reports for the people who
  bought them.

68
The Rating Agencies (contd)

• No one seemed to be bothered by the lack of
  public information on just what was in some of
  these products. If Moodys, Standard Poors or
  Fitch said a weird security deserved an AAA, that
  was enough.
• And then they blew up.
• Now we are learning that the investment banks
  did not know what was going on either, and they
  ended up with huge pools of securities whose
  values are, at best, uncertain.

69
The Rating Agencies (contd)

• Rating agency downgrades do not destroy markets
  for corporate bonds, simply because enough
  information is disseminated that other analysts
  can reach their own conclusions.
• But the securitization markets collapsed when it
  became clear the rating agencies had been overly
  optimistic.
• Some suggest that information shared with rating
  agencies should be shared with the entire market.

70
The Rating Agencies (contd)

• The SEC is investigating the rating agencies to
  see if their ratings complied with their own
  published standards.
• Neither one of two plausible scenarios, knaves or
  fools, is pretty
• It is hard to know which conclusion would be
  worse. 1 If the agencies violated their own
  policies, they will be vilified for the conflicts
  of interest inherent in their being paid by the
  issuers of the securities. 2 If they did not,
  they will be derided as fools who could not see
  how risky the securities clearly were. (In
  hindsight, of course.)

71
The Rating Agencies (contd)

• The collapse of securitization has made credit
  hard to obtain for many, and a change in the Fed
  funds rate will not offset that.
• It has become very difficult to get a home
  mortgage without some kind of government-backed
  guarantee.

72
Collateralized Debt Obligations

• A collateralized debt obligation is a pool of
  different tranches (or slices) of mortgages
• Or a pool of mortgages mixed with other
  receivables, such as credit card receivables
• Lower-rated tranches were called toxic waste
• They are so high-risk, they are toxic
• But the tranches were being pooled to make them
  appear to be less risky
• And made to appear even less risky with credit
  default swaps (insurance against defaults)

73
The Housing Bubble

• From 2000-2003, there was a speculative bubble in
  housing.
• Prices kept going up, mortgage financing was
  available.
• People were seeing residences as investments, and
  non-real estate professionals were buying
  multiple residences to flip
• However, from 2000-2007, the median household
  income was flat.

74
The Housing Bubble

• Therefore, the more prices rose, the more
  unsustainable the rise and its financing.
• By late 2006, the average home cost nearly 4
  times what the average family made
• As opposed to an historic multiple of only 2 or 3
• People began to default on their mortgages soon
  after taking them out.
• By late 2006, housing prices started going down.
• As defaults started, more houses came on the
  market, prices went further down.

75
The Housing Bubble

• While prices were rising, people were taking out
  Home Equity Lines of Credit
• They were borrowing to pay off their mortgage and
  other debts.
• When the Investment Bankers saw the defaults
  start increasing, they stopped buying the risky
  loans
• Credit became tight for homeowners
• The mortgage companies that specialized in buying
  up and packaging these loans to investment banks
  started going out of business
• They were highly leveraged

76
Foreclosures 2008-2010Number of Homes
Repossessed

• 2008 862,000
• 2009 918,000
• 2010 1,050,000

76
Donald J. Weidner
77
Securitisation, When it goes wrong . . .
.(Supplement p. 13)

• Securitisation, When it goes wrong . . . ., The
  Economist (September 20, 2007)
• Securitisation is the process that transforms
  mortgages, credit-card receivables and other
  financial assets into marketable securities
• Brought huge gains
• Also brought costs that are only now becoming
  clear.
• Thanks largely to securitisation, global
  private-debt securities are now far bigger than
  stockmarkets.

78
Securitisation, When it goes wrong . . .
.(contd)

• Benefits of securitization
• Global lenders use it to manage their balance
  sheets, since selling loans frees up capital for
  new businesses or for return to shareholders.
• Small regional banks no longer need to place all
  their bets on local housing marketsthey can
  offload credits to far-away investors such as
  insurers or hedge funds.
• 3. Reduces borrowing costs for consumers and
  businesses.

79
Securitisation, When it goes wrong . . .
.(contd)

• 4. One systemic gain was said to be
  Subjecting bank loans to valuation by capital
  markets encourages the efficient use of capital.
• --However, the capital markets were not making
  their own valuations (Allan Greenspan and the Fed
  got it wrong).
• Broadens the distribution of credit risk.
• However, there are three cracks in the new model
• 1. A high level of complexity and confusion.
• 2. Fragmentation of responsibility warped
  incentives.
• 3. Regulations came to be gamed.

80
Securitisation, When it goes wrong . . .
.(contd)

• 1. Problem 1 complexity financiers did
  not fully understand what they were trading.
• Schwarcz says some contracts are so convoluted
  that it would be impractical for investors to try
  to understand them
• Skel and Partnoy concluded that CDOs are being
  used to transform existing debt instruments that
  are accurately priced into new ones that are
  overvalued.
• 2. Problem 2 securitisation has warped
  financiers incentives.
• Securitisations are generally structured as
  true sales the seller wipes its hands of the
  risks.
• One middleman has been replaced with several.

81
Securitisation, When it goes wrong . . .
.(contd)

• In mortgage securitisation, the lender is
  supplanted by
• --the broker
• --the loan originator
• --the servicer (who collects payments)
• --the arranger
• --the rating agencies
• --the mortgage-bond insurers
• -- the investor
• By January of 2008, there was widespread concern
  over the stability of the bond insurers.

82
Securitisation, When it goes wrong . . .
.(contd)

• This creates what economists call a
  principal-agent problem.
• The loan originator has little incentive to vet
  borrowers carefully because it knows the risk
  will soon be off its books.
• The ultimate holder of the risk, the investor,
  has more reason to care but owns a complex
  product and is too far down the chain for
  monitoring to work.
• Most investors were sophisticated institutions
  too taken with alluring yields to push for
  tougher monitoring

83
Securitisation, When it goes wrong . . .
.(contd)

• 3. Problem 3 Regulations were gamed.
• Only now are the politicians looking at the
  rating agencies.
• Regulatory dependence on ratings has grown
  across the board.
• Banks can reduce the amount of capital they are
  required to set aside if they hold highly-rated
  paper.
• Some investors, such as money-market funds, are
  required to stick to AAA-rated securities.

84
Securitisation, When it goes wrong . . .
.(contd)

• Looking forward
• Investors need to know who is holding what and
  how it should be valued.
• There will be calls for greater standardization
  of structured products.
• Regulators will want to see the interests of
  rating agencies aligned more closely with
  investors, and to ensure that they are quicker
  and more thorough in reviewing past ratings.
• Securities Rating Agency is one of the few
  businesses where the appraiser is paid by the
  seller, not the buyer.

85
Servicers and Tranche Warfare

• See Jody Shenn, Wilbur Ross Defies Bruce Rose in
  Battle Over Housing Villains, March 2009
  Bloomberg
• When the pool of mortgages goes into default, the
  holders of different tranches in it have
  divergent interests.
• The holders of the A piece, the top-rated
  tranche, are more comfortable having the
  defaulting borrowers foreclosed upon, and perhaps
  even eager for it, often hoping to foreclose
  before any further decline in asset prices.
• The holders of the B piece, lower rated tranches,
  are more likely to favor
• delay
• modifying the loan to reduce debt service so the
  borrower can carry the payments
• renting out homes until better prices can be
  obtained on foreclosure

86
Servicers and Tranche Warfare (contd)

• The servicers are in the middle in the tranche
  warfare.
• The servicers often have incentives to hasten
  foreclosure. Jody Shenn writes
• When a loan goes into default, servicers . . .
  are obligated to front the missed monthly
  interest and principal payments to bond
  investors. Servicers have little incentives to
  rework loans because they are reimbursed more for
  foreclosure-related expenses . . . . The quicker
  a servicer sells a home, the sooner it can stop
  making those monthly payments.

87
Servicers and Tranche Warfare (contd)

• The Obama Administrations plan was to have the
  government
• cover some costs of reducing homeowner payments
• cover some investor losses from further home
  price declines
• pay servicers to hire the staff needed to contact
  borrowers and modify loans

88
Fannie Mae and Freddie Mac End of
Illusions(Supp. P. 22)

• Fannie Mae and Freddie Mac End of Illusions,
  The Economist, July 19, 2008, p. 79.
• Fannie and Freddie were set up to provide
  liquidity for the housing market by buying
  mortgages from the banks. They repackaged these
  loans and used them as collateral for bonds
  called mortgage-backed securities they
  guaranteed buyers of those securities against
  default.

89
Fannie Mae and Freddie Mac End of
Illusions(Contd)

• The belief in the implicit government guarantee
  of the obligations of Fannie and Freddie
• Permitted them to borrow cheaply.
• They engaged in a carry tradethey earned more
  on the mortgages they bought than they paid for
  the money they raised.
• Allowed them to operate with tiny amounts of
  capital and they became extremely leveraged
  (geared) 65 to 1!
• 5 trillion of debt and guarantees!
• Their core portfolio had been fine, with an
  average Loan/Value ratio of 68 at the end of
  2007 in other words, they could survive a 30
  fall in house prices.

90
Fannie Mae and Freddie Mac End of
Illusions(Contd)

• However, in the late 1990s, they moved into
  another area buying the mortgage-backed
  securities that others had issued.
• Fannie and Freddie were operating as hedge funds.
• Again, this was a version of the carry trade
  they used their cheap debt financing to buy
  higher-yielding assets.
• Fannies outside portfolio grew to 127 billion
  by the end of 2007.
• Leaving them exposed to the subprime assets they
  were supposed to avoid.

91
TARP Troubled Asset Relief Program

• 700 billion rescue package approved by Congress
  October 3, 2008.
• The original idea was to free banks and other
  financial institutions of the most toxic loans
  and securities on their books by purchasing them
  in auctions.
• The thought was that the government would pay
  more than the nominal amount that they could be
  sold for but an amount that might yield a profit
  if the government held them to term.

92
TARP (contd)

• After much criticism, the announced plan shifted
  from the core mission of buying distressed
  mortgage assets and toward purchasing ownership
  stakes in banks.
• England led the way with this solution,
  suggesting that the federal government may put
  250 billion in banks in return for shares.
• With some restraints on executive compensation.

93
Potential Foreclosure Relief Through TARP

• Lawmakers discussed how to allocate funds between
  institutional relief and relief to individual
  homeowners.
• Some in Congress pressed to give consumers more
  of the rights that businesses have in bankruptcy.
• For example, to give bankruptcy judges new cram
  down powers to force lenders to accept revised
  home loans.

94
Opposition to Cram Down Authority

• Treasury Secretary Paulson and others in the Bush
  administration opposed the proposal, saying it
  would frighten even more investors away from the
  mortgage market.
• Lenders also argue that write-downs of mortgages
  by bankruptcy judges will increase the risk of
  mortgage lending at a time when the market is
  already struggling, and this could harm consumers.

95
Other TARP Issues

• Policymakers also considered standardized loan
  modification practices to be used by firms that
  service mortgages.
• Loans modified under these principles would
  qualify for at least a partial federal guarantee.
  
• It is unclear who would be required to pay
  premiums for that protection.
• 2012 began with discussions of a financial
  transactions tax in Europe

96
The Federal Reserve Response

• In 2008, the Federal Reserve cut the discount
  rate, the rate on loans to banks, to near zero.
• The Fed also initiated a program of quantitative
  easingasset purchases that drive down the yield
  on that type of asset.
• It began purchasing 500 billion in
  mortgage-backed securities.
• It also began purchasing 100 billion in debt
  obligations of Fannie, Freddie, Ginnie, and Fed
  Home Loan Banks.

97
The Federal Reserve Response

• On November 3, 2010, the Federal Reserve
  announced it would purchase an additional 600
  billion in long-term treasure notes over the
  following eight months.
• This was dubbed QE 2a second round of
  quantitative easing that followed a first round
  that began at 600 billion and increased to 1.8
  trillion.
• The Fed also said it would invest an addition
  250-300 billion in Treasuries with the proceeds
  of its earlier investments.
• At the same time indicating it would continue to
  hold the federal funds rate at close to zero.
• Critics expressed concerns about inflation and
  about asset bubbles.

98
Federal Reserve Response (contd)

• In 2011, the Fed undertook operation twist,
  extending the maturity of the obligations it was
  purchasing
• Some referred to this as stealth quantitative
  easing
• Further tending to drive down long-term interest
  rates
• Continuing stated policy of making the equity
  markets more attractive

99
Federal Reserve Response (contd)

• QE 3 (aka QE Infinity) was announced in
  September 2012
• For the indefinite future, the Fed will purchase
  40 billion a month of agency mortgage-backed
  securities
• Tending to further reduce mortgage interest rates

100
Federal Reserve Response (contd)

• Easier financial conditions will promote
  economic growth. For example, lower mortgage
  rates will make housing more affordable and allow
  more homeowners to refinance. Lower corporate
  bond rates will encourage investment. And higher
  stock prices will boost consumer wealth and help
  increase confidence, which can also spur
  spending. Increased spending will lead to higher
  incomes and profits that, in a virtuous circle,
  will further support economic expansion. Ben
  Bernanke November 5, 2010

101
Federal Reserve Response (contd)

• On September 21, 2011, the Fed undertook
  operation twist, extending the maturity of the
  obligations it was purchasing
• It replaced purchases of short-term Treasuries
  with purchases of long-term treasuries
• Some referred to this as stealth quantitative
  easing
• Further driving down yields and interest rates

102
Federal Reserve Response (contd)

• QE3 was announced on 13 September 2012
• Fed will purchase 40 billion a month of agency
  mortgage-backed securities
• Known also as QE Infinity because the bond
  purchases were to go on indefinitely
• At the same time, the Fed said it would continue
  lending banks at rates near zero until at least
  mid-2015

103
Federal Reserve Response (contd)

• In December 11, 2012, the Fed also announced it
  would 45 billion a month on long-term Treasury
  purchases.
• Some have referred to this as QE 4
• This plus the mortgage bond purchasing program
  equals 85 billion a month!

104
Federal Reserve Response (contd)

• Also on December 11, 2012 in an unprecedented
  move the Fed said it plans to keep its key
  short-term rate near zero until the unemployment
  rate reaches 6.5 percent or less -- as long as
  expected inflation remains tame.
• First time Fed has publically pegged interest
  rate policy to the unemployment rate
• U.S. unemployment as of January 2013 is 7.7
  percent.

105
Representations and Warranties by Mortgage Sellers

• When banks sell mortgages to investors or bundle
  them into securities, they typically offer
  representations and warranties, in which they
  guarantee that information backing the loans is
  accurate. Examples include borrowers income and
  the appraised worth of the home. If the data is
  proven wrong, the bank may buy back the loan or
  reimburse investors for the lost value.
• Hugh Son and Dawn Kopecki, Bank of America Sees
  2 Billion Charge on Home Loans, Bloomberg,
  1/3/11.

106
Representations and Warranties by Mortgage
Sellers (contd)

• On January 3, 2011, Bank of America Corp. agreed
  to pay 2.8 billion to Freddie Mac and Fannie May
  after Fannie and Freddie demanded the Bank buy
  back mortgages they said were based on faulty
  data.
• Largely traced to its acquisition of Countrywide.
• Some analysts said BOA got off easy.
• The Bank exited the TARP program in December of
  2009.

107
Representations and Warranties by Mortgage
Sellers (contd)

• In January of 2013, Bank of America announced
  roughly 11.6 billion of settlements with Fannie
  Mae.
• B of A is paying 3.6 billion to Fannie Mae and
  buying back 6.75 billion of bad loans from the
  mortgage company to clear up all claims Fannie
  Mae had against B of A.
• Under a separate settlement, B of A will pay
  Fannie Mae because of foreclousure delays.

108
Robo-Signing Settlement

• In January of 2013, ten banks agreed with federal
  regulators to pay 8.5 billion to borrowers for
  so-called robo signing, which involved
  fraudulent mortgage foreclosure proceedings.
• Part of the money will go to direct payments to
  parties who have been foreclosed upon, part to
  forgiveness of deficiencies and part to loan
  modifications.
• This follows a 25 billion settlement in 2012
  with many state attorneys general.