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Real Estate Finance Spring 2013 Dean Don Weidner

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Title: 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.
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