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Real Estate Finance Spring 2014 Dean Don Weidner

Eight sets of slides for the Spring 2014. 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 and on the web Blackboard for this course under Syllabus. Includes some basic material for those with no background

Assignments. We shall proceed directly though the Syllabus The slides will also take us directly through the Syllabus.
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Background on Contracts and Conditions



Contract of Sale Broker


Interim Contract



Seller Buyer Lender

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.

Donald J. Weidner

Contract Conditions
Text says conditions are essentially substitutes for information.
About legal title, physical condition, availability of financing

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.
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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.
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Illusory Contracts (contd) On the excuse issue, the text says: 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 their role in applying the good faith requirement As we shall see in more detail Gap filler versus mandatory rule
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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.
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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. Other 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?
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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 (the rule that would apply unless the parties specified a different rule) would be that the unspecified interest rate is the current prevailing rate
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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? If not, did the contract merely give Option to Buyer?
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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.

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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?
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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?
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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.
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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?
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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


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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: 1) Amount of loan Usually determined by Applying a loan/value ratio to An appraisal of value 2) Length of loan 3) Rate of interest 4) Amortization termsthe terms under which principal is repaid
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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

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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 itthey have no skin in the game Therefore, they often avoid the ratio.
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Appraisals: Three Basic Indications of (or ways of approaching) Value

1. 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 Cost of replacing a building (and the land under it) minus depreciation charges on the building

2. Replacement Cost


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Appraisals: Three Basic Indications of Value (contd)

3. Capitalized Value of Income (many methods): --Gross Rent Multipliervery rough (and less valid if there are few or no sales of comparables) --Apply a Capitalization Rate to current net operating incomeonly slightly more refined --Estimate a stream of future cash flows and reduce it to its present valuemore 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.
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GROSS MULTIPLIER Derive value from gross rentals

Sales Price of Comparable Properties Gross Rental Revenues of Comparable Properties Assume a Recent Sale: 12 Million Sales Price = 6 [Gross Multiplier] 2 Million Gross Rental Revenue = Multiplier

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)


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Capitalizing Value of Net Operating Income Begin by considering the net cash flow on a property you currently own and have financed. Net cash flow is simply the sum of all cash receipts from operations minus all cash spent (ignoring any capital improvements), including debt service. As we shall discuss more fully, to derive taxable income or loss from net cash flow, simply subtract the depreciation deduction and add back in amount paid to amortize debt.
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NCF versus NOI Net Cash Flow=Rent ReceiptsReal Estate TaxesMaintenance Insurance(Principal + Interest) Now assume you are a buyer valuing a property and you dont yet know how you will finance your acquisition. You might look at its net operating income. Net Operating Income is NCF apart from the current owners debt service (principal and interest). NOI = Rent Receipts Real Estate Taxes Maintenance Insurance
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CAPITALIZATION RATE Capitalize the value of the net operating income

Basic idea:

is how much an investor will pay for the right to receive $1,000 per year
if the investor will insist on an 8% return on his or her investment. In this example,

x 8% = $1,000 per year

is $12,500
If I expects a 12% cash return [stated in decimals]
The price

How Much Will An Investor Pay for a Building that has a $150,000 Net Cash Flow?
A. 1) 2) If I expects an 8% cash return [stated in B. fractions]
The price

x 8/100 return = $150,000


x .12 return = $150,000

Divide each side of the equation by 8/100 ( x 8/100) x 100/8 = 150,000 x 100/8 = $1,875,000

2) Divide each side of the equation by .12 x .12/.12 = $150,000/.12 = $1,250,000


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Capitalizing Value of NOI Another way of looking at Net Operating Income is as the amount of cash flow that is available to service your acquisition debt. How much would you pay for an annual NOI of a certain amount. Assume NOI of $300,000 and a 5% Cap Rate NOI of $300,000 = $6,000,000 .05
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Capitalizing Value of NOI Most of us are uncomfortable dividing by decimals. The following statement avoids dividing by decimals. Again, NOI is $300,000 and the Cap Rate is 5. NOI x 100 = Value Cap. Rate 300,000 X 100 = $6,000,000 5


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Capitalizing Value of NOI (contd)

Suppose you expect a greater return on your investment, say, 8% rather than 5%. How much would you pay for that $300,000 operating income? $300,000 x. 100 = $3,750,000 8 The higher the rate of return you expect, the less you will value the income stream.
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Capitalizing Value of NOI (contd)

Very simply (and rounded slightly) 1 cap rate is 100 x. NOI ($300) = $30,000,000 2 cap rate is 50 x. NOI ($300) = $15,000,000 3 cap rate is 33.33 x. NOI ($300)= $ 9,999,000 4 cap rate is 25 x. NOI ($300) = $ 7,500,000 5 cap rate is 20 x. NOI ($300) = $ 6,000,000 6 cap rate is 16.67 x. NOI ($300) = $ 5,001,000


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DISCOUNTED NOI (NCF Apart from Debt Service)

Values property by a) estimating future net operating income for each year and b) discounting those future flows of cash to their present value. Discounting is the obverse of compound interest.

How much would you pay to purchase a 10-year position as landlord the right to receive $1,000 yr. rent for 10 years?
1 2 3 4 5 6 7 8 9 10 .833 x $1,000 = 833 .694 x $1,000 = 694 .579 .482 .402 .335 .279 .233 .194 .162 x $1,000 = 162 $4,193

HYPO: What is the total present value of the right to receive $1,000 in cash at the end of each of the next ten years? Assume the investor requires a 20% rate of return. Because the 10, $1,000 payments are spread over the next 10 years, their total present value is the sum of the present value of each of the future payments. That Is:


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Plaza Hotel Associates

340 N.Y.S.2d 796 (N. Y. Sup. 1973)










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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.
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Plaza Hotel Highlights

Court set aside the appraisers valuation, stating 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.
Wasnt the appraisers approach based on standard wisdom?

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.
How would you value the fee? Discount the cash flow?

Having set aside the appraisers determination of value, the court undertook to determine value.
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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. [V]alue, even more than price, is a matter of judgment.


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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.


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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.


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A Different View on Free and Clear Appraisal

Compare Taylor v. Fusco Management, 593 So.2d 1045 (Fla. 1992): [T]he 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 23)
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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.


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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% 6% 8% 10% 17% is $ 528 (2012) is $ 644 is $ 770 is $ 908 is $ 1,436 (1980)
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Point is one percent of the face amount of a contract debt. Points can be characterized differently, ex., as interest, as compensation for services, etc. Basic way points can work:
Buyer executes note to Seller for $40,000 (interest, length, amortization 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.
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First type: Constant Payment

Principal Interest
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Second Type: Constant Amortization


Principal Interest
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Principal Interest
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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.


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Florida Statute on Balloon Mortgages


With certain exceptions, there shall be printed or clearly stamped on such mortgage a legend in substantially the following form:
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Florida Statute on Balloon Mortgages


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.


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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 19301935 (many fewer than in years following 2006).
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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.
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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.
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(Text p. 409)

1) Adjustable Rate Mortgage (ARM) (a.k.a. Variable Rate Mortgage or VRM) 2) Graduated Payment Mortgage (GPM) 3) Renegotiable Rate Mortgage (RRM) 4) Shared Appreciation Mortgage (SAM) 5) Price Level Adjusted Mortgage (PLAM) 6) Reverse Annuity Mortgage (RAM)


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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)
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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
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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).


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Monthly payments gradually rise, while the interest rate and the term of the loan are fixed. Initial concept (back in the Nixon administration): 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.
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GRADUATED PAYMENT MORTGAGE (contd) The Growing Equity Mortgage is another form of increasing payment mortgage. Text discusses it as a long term, selfamortizing 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.

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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.


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Goebel v. First Federal

(Text p. 403)

1. 2. 3.

5. 6.

The note to the S & L 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.
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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 amortization terms/balloons].

Courts said it would 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.

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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 increase in interest rate. 1. Note stated that monthly Debt Service could be increased to accommodate future advances; and 2. Note stated that Lender had a right to payment for taxes, insurance and repairs on demand
1. Lower court said this included the right to increase monthly Debt Service.

3. Yet the note fails to make similar provisions for an increase in interest rate
1. Therefore, the promisor could not be required to pay more monthly debt service to satisfy an increase in interest rate.
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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. 1. Lender argued this clause was intended for its benefit and that it, therefore, could set it aside. 2. The court appears to have begged the conclusion when it said that this clause was for the Borrowers benefit.
And, therefore, Borrower could not be forced to pay debt service for a longer term/
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Goebel (contd) What effect could the interest increase provisions have? The court said it was not nullifying the provisions increasing the interest rate because an interest increase would still be collectible: 1. To offset any prior interest rate declines 2. 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)?
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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 might limit the lender from exacting an increase.
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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. BUT::::if the borrower requests, the lender must refinance an amount equal to the unpaid loan balance plus the contingent interest.
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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.


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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.
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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.
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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.


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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
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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 prevent excessive risk taking.
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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 [March 2007], 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 borrowers known as subprime mortgages recently reached 12.6 percent. 35% of all mortgage securities issued in 2006 were in the subprime category.
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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 were known as liar loans.

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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.
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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.
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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
73 Donald J. Weidner

Rating Agencies
Credit rating agencies are supposed to assess risk of investment securitieshowever, the agencies 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
74 Donald J. Weidner

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.
75 Donald J. Weidner

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.
76 Donald J. Weidner

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.
77 Donald J. Weidner

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.)
78 Donald J. Weidner

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. [I]t has become very difficult to get a home mortgage without some kind of government-backed guarantee.


Donald J. Weidner

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

That is, 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)
80 Donald J. Weidner

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.
81 Donald J. Weidner

The Housing Bubble

Therefore, the more prices rose, the more unsustainable the rise of prices and the increased financing costs. 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.
82 Donald J. Weidner

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
83 Donald J. Weidner

Foreclosure Filings: 2008-2012 (2012 figures projected)

2008 2,350,000 2009 2,920,000 2010 - 3,500,000 2011 - 3,580,000 2012 2,100,000

Source: RealtyTrac, Federal Reserve, Equifax

84 Donald J. Weidner

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 privatedebt securities are now far bigger than stockmarkets.


Donald J. Weidner

Securitisation, When it goes wrong . . . .


Benefits of securitization:
1. Global lenders use it to manage their balance sheets, since selling loans frees up capital for new businesses or for return to shareholders. 2. 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.
86 Donald J. Weidner

Securitisation, When it goes wrong . . . .


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 admits that the Fed got it wrong on this point). 5. 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.
87 Donald J. Weidner

Securitisation, When it goes wrong . . . .


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.
88 Donald J. Weidner

Securitisation, When it goes wrong . . . .


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.
89 Donald J. Weidner

Securitisation, When it goes wrong . . . .


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
90 Donald J. Weidner

Securitisation, When it goes wrong . . . .


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.
91 Donald J. Weidner

Securitisation, When it goes wrong . . . .


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.
92 Donald J. Weidner

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.
93 Donald J. Weidner

Fannie Mae and Freddie Mac: End of Illusions


The belief in the implicit government guarantee of the obligations of Fannie and Freddie: 1. Permitted them to borrow cheaply. 1.They engaged in a carry tradethey earned more on the mortgages they bought than they paid for the money they raised. 2. Allowed them to operate with tiny amounts of capital and they became extremely leveraged (geared): 65 to 1! 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.
94 Donald J. Weidner

Fannie Mae and Freddie Mac: End of Illusions


However, in the late 1990s, they moved into another area: buying the mortgagebacked 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.
95 Donald J. Weidner

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.
96 Donald J. Weidner

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.

and toward bailouts of Fannie and Freddie, automotive companies (Chrysler, GM) and AIG (which had gone down because of its credit default swaps)
97 Donald J. Weidner

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 easing, or QE, purchasing assets, such as treasuries and mortgage-backed securities, thus driving down the yield on that type of asset.
Starting at $600 billion and increasing to $1.8 trillion
98 Donald J. Weidner

Federal Reserve Wants to Inflate Asset Prices (and create a wealth effect)
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
99 Donald J. Weidner

The Federal Reserve Response On November 3, 2010, the Federal Reserve announced QE 2, a second round of quantitative easing, during which it would purchase an additional $600 billion in long-term treasury obligations over the following eight months. 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.
100 Donald J. Weidner

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
101 Donald J. Weidner

Federal Reserve Response (contd)

QE 3 (aka QE Infinity) was announced in September 13, 2012
Fed said that, for the indefinite future, it would purchase $40 billion a month of agency mortgage-backed securities
Including apparently some less-desirable mortgages from member banks

Tending to further reduce mortgage interest rates and inflate asset prices


Donald J. Weidner

Federal Reserve Response (contd)

In December 11, 2012, the Fed also announced it would spend $45 billion a month on long-term Treasury purchases. This plus the mortgage bond purchasing program equals $85 billion a month in securities being purchased by the Fed! Reflecting its success at driving up asset prices, the stock markets started hitting all-time highs in March of 2013.
Also, corporate profits were strong And, the economy was on a slow but steady recovery
103 Donald J. Weidner

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 (under 2.5%). This is the first time Fed has publically pegged interest rate policy to the unemployment rate
U.S. unemployment as of December 2013 was 6.7 percent.
104 Donald J. Weidner

The Taper
In December 2013, the Fed announced that it would begin to reduce (taper) its monthly purchases by $10 billion a month
$5 billion less a month for mortgage-backed securities and $5 billion less a month for treasury obligations

At the same time it said that it would continue to hold short-term interest rates near zero for the foreseeable future.
In January 2014, it said it would do so well past a 6.5% unemployment rate
105 Donald J. Weidner

The Return of Securitization (contd)

From: Return of Securitization: Back from the Dead, THE ECONOMIST, January 11, 2014, p. 59.

The essence of securitization is transforming a future income stream into a lump sum today. The ECB is a fan, as are global banking regulators who last month watered down rules that threatened to stifle securitization. Economic growth and investors desperate for yield are stimulating supply, especially outside the area of residential mortgages. Policy makers want to get more credit flowing in the economy, particularly in Europe.
106 Donald J. Weidner

The Return of Securitization (contd)

Whereas in America capital markets are on hand to finance companies (through bonds), the old continent remains far more dependent on bank lending to fuel economic growth. In part because European regulators want banks to be less risky. Banks bundle up loans on their books and sell them.
107 Donald J. Weidner

The Return of Securitization (contd)

One improvement is that those involved in creating securitized products will have to retain some of the risk linked to the original loan, thus keeping skin in the game. Another tightening of the rules makes resecuritizations, where income from securitised products was itself securitised, more difficult
108 Donald J. Weidner