Real estate finance 1


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Real estate finance 1

  1. 1. Real Estate Finance Spring 2011 Dean Don Weidner <ul><li>Eight sets of slides for the Spring 2011. </li></ul><ul><ul><li>Are available on my web page. </li></ul></ul><ul><ul><li>Are also posted on the web board for this course under “Course Library”. </li></ul></ul><ul><ul><ul><li>May be amended slightly. </li></ul></ul></ul><ul><li>Course Syllabus. </li></ul><ul><ul><li>Is posted on my web page. </li></ul></ul><ul><ul><li>Is also posted on the web board for this course under “Syllabus”. </li></ul></ul><ul><ul><ul><li>May be amended slightly . </li></ul></ul></ul><ul><li>Assignments. </li></ul><ul><ul><li>We shall proceed directly though the Syllabus. </li></ul></ul>Donald J. Weidner
  2. 2. Background on Contracts and Conditions Donald J. Weidner Seller Broker Buyer Seller Buyer Lender Listing Agreement Contract of Sale “ Interim Contract” Closing 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. 3. Contract Conditions <ul><li>Text says conditions “are essentially substitutes for information.” </li></ul><ul><li>Conditions may also be inserted by the buyer to postpone making a commitment. </li></ul><ul><li>Conditions range from the extremely general to the extremely specific. </li></ul><ul><li>Conditions may leave so much open that a contract fails to satisfy the requirement of a writing under the statute of frauds. </li></ul><ul><li>Even if the statute of frauds is satisfied, the contract may be too indefinite to support an award of specific performance. </li></ul>Donald J. Weidner
  4. 4. Illusory Contracts <ul><li>“ 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.” </li></ul><ul><li>“ 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.” </li></ul><ul><ul><li>“ In such cases the court will examine the motive of the party relying on the condition.” </li></ul></ul><ul><ul><ul><li>If a written contract gives me a right, must I show that I am pure of heart to enforce it? </li></ul></ul></ul><ul><ul><ul><ul><li>Not everyone thinks so. More anon. </li></ul></ul></ul></ul>Donald J. Weidner
  5. 5. Homler v. Malas, (Text p. 95) <ul><li>Seller sought to specifically enforce a buyer’s promise to purchase a single-family residence. </li></ul><ul><li>Contract, on a standard form, had a “subject to financing” clause that conditioned Buyer’s performance. </li></ul><ul><ul><li>on Buyer’s “obtaining a loan” (“ability to obtain” had been deleted). </li></ul></ul><ul><ul><li>For 80% of the purchase price. </li></ul></ul><ul><ul><li>Repayable monthly over a term of no less than 30 years. </li></ul></ul><ul><ul><li>However, there was no mention of: </li></ul></ul><ul><ul><ul><li>Interest rate (left blank). </li></ul></ul></ul><ul><ul><ul><li>The amount of monthly payment (left blank). </li></ul></ul></ul><ul><ul><ul><li>Amortization terms. </li></ul></ul></ul>Donald J. Weidner
  6. 6. Homler v. Malas (cont’d) <ul><li>Buyer said the contract “is too vague and indefinite” to be specifically enforced because the “terms of the financing contingency are not sufficiently identified.” </li></ul><ul><ul><li>Georgia courts had said that a failure to specify a buyer’s interest rate “causes a failure of a condition precedent to the enforceability of the contract.” </li></ul></ul><ul><li>Seller said that there is no need to specify the interest rate in a contract that anticipates third-party financing. </li></ul><ul><ul><li>Can you see what the argument might be? </li></ul></ul>Donald J. Weidner
  7. 7. Homler v. Malas (cont’d) <ul><li>Court said: it is not as if the contract had specified interest at the “current prevailing rate.” </li></ul><ul><li>The contract assumed a search for third-party financing. </li></ul><ul><li>Why not use the concept of good faith as a gap filler? </li></ul><ul><li>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” </li></ul><ul><li>Stated differently, the default rule (which would apply unless the parties specified a different rule) would be that interest is at the “current prevailing rate” </li></ul>Donald J. Weidner
  8. 8. Homler v. Malas (cont’d) <ul><li>Court concluded the contract was too “vague and indefinite” to be enforced against the buyer and ordered the buyer’s deposit to be refunded. </li></ul><ul><li>Why did the court refuse to use the concept of good faith to fill the interest rate gap? </li></ul><ul><ul><li>Everyone agrees the buyer is under a duty to proceed in good faith </li></ul></ul><ul><li>Does the strikeout suggest a different argument? </li></ul><ul><li>“ 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] </li></ul><ul><ul><li>Could Buyer have enforced the contract against Seller? </li></ul></ul>Donald J. Weidner
  9. 9. Definitions of Good Faith <ul><li>Every contracting party is under a duty of “good faith” </li></ul><ul><ul><li>The question is: what does good faith require </li></ul></ul><ul><li>UCC general definition : “honesty in fact in the conduct or transaction concerned.” </li></ul><ul><ul><li>Honesty to Webster: “uprightness; integrity, trustworthiness” also “freedom from deceit or fraud.” </li></ul></ul><ul><li>UCC definition for a merchant : “honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade .” </li></ul><ul><li>Many statutes use the term “good faith” without defining it. </li></ul><ul><li>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. </li></ul>Donald J. Weidner
  10. 10. Liuzza v. Panzer (Text p. 98) <ul><li>Contract to sell and to buy for $37,500. </li></ul><ul><li>Buyer’s 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%.” </li></ul><ul><li>Buyer applied to an S & L for a $30,000 loan and was rejected because the appraisal was too low. </li></ul><ul><li>S & L appraisal was $32,150. </li></ul><ul><li>S & L would only lend 80% of the appraised value (which was less than the $30,000 mentioned in the contract as a condition). </li></ul><ul><li>Can the Buyer walk away from the deal at this point? </li></ul><ul><ul><li>Stated differently, what more, if anything, is Buyer required to do to satisfy the Buyer’s obligation to act in good faith? </li></ul></ul>Donald J. Weidner
  11. 11. Kovarik v. Vesely (Text p. 99) <ul><li>Contract provided for Buyers’ obligation to buy for $11,000. Buyers were to pay </li></ul><ul><ul><li>$4,000 down, with the </li></ul></ul><ul><ul><li>balance to be financed through a “$7,000 purchase-money mortgage from the Fort Atkinson S & L .” </li></ul></ul><ul><li>Fort Atkinson S & L rejected the Buyers. </li></ul><ul><li>Seller offered to provide $7,000 financing on the same terms that Buyers requested from Fort Atkinson. </li></ul><ul><li>Buyers refused the alternative financing offered by the Seller. </li></ul><ul><li>Seller sued to specifically enforce the contract. </li></ul><ul><ul><li>Did the court correctly conclude that good faith required the Buyer to accept the Seller’s offer of financing ? </li></ul></ul>Donald J. Weidner
  12. 12. Kovarik v. Vesely (cont’d) <ul><li>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 buyer’s obligation is contingent on the buyer’s ability to obtain a loan from the specified lender </li></ul><ul><li>However, a buyer could reasonably want: </li></ul><ul><ul><li>A third-party lender to provide a “reality check” on value; and </li></ul></ul><ul><ul><li>A standard institutional approach in the administration of the loan </li></ul></ul><ul><ul><ul><li>especially in the event of default. </li></ul></ul></ul>Donald J. Weidner
  13. 13. Kovarik v. Vesely (cont’d) <ul><li>Court also rejected the Buyer’s argument that the incomplete financing clause failed to satisfy the Statute of Fraud’s requirement of a writing. </li></ul><ul><ul><li>What was incomplete about the financing clause? </li></ul></ul><ul><ul><li>Recall that it referred to “$7,000 purchase-money mortgage from the Fort Atkinson S & L.”. </li></ul></ul><ul><li>The court’s 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].” </li></ul><ul><ul><li>Is there one transaction or two? </li></ul></ul>Donald J. Weidner
  14. 14. Kovarik v. Vesely (cont’d) <ul><li>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. </li></ul><ul><ul><li>That is, business practice and the rule of reasonableness would fill in the gaps </li></ul></ul>Donald J. Weidner
  15. 15. Variables that Determine Debt Service <ul><li>“ Debt Service” is the amount of the payment required per unit of time (usually monthly or annually) to service a debt. The 4 variables that determine debt service are: </li></ul><ul><li>Amount of loan </li></ul><ul><ul><li>Usually determined by </li></ul></ul><ul><ul><ul><li>Applying a loan/value ratio to </li></ul></ul></ul><ul><ul><ul><li>An appraisal of value </li></ul></ul></ul><ul><li>Length of loan </li></ul><ul><li>Rate of interest </li></ul><ul><li>Amortization terms—the terms under which principal is repaid </li></ul>Donald J. Weidner
  16. 16. Loan to Value Ratio <ul><li>May be in statute, regulation or internal policies. </li></ul><ul><li>Some legislative terms used to mandate maximum loan to value ratios: </li></ul><ul><ul><li>appraised value </li></ul></ul><ul><ul><li>estimated value </li></ul></ul><ul><ul><li>reasonable normal value </li></ul></ul><ul><ul><li>estimated replacement cost </li></ul></ul><ul><ul><li>actual cost </li></ul></ul>Donald J. Weidner
  17. 17. Loan to Value Ratio (cont’d) <ul><li>Many lenders do not believe that the loan/value ratio is a meaningful protection to their shareholders. </li></ul><ul><ul><li>They believe that there is greater protection in exacting credit standards, increased site scarcity, inflation or other factors </li></ul></ul><ul><ul><li>Or, they are simply very eager to do a deal. </li></ul></ul><ul><ul><li>They might also be eager to sell the mortgage. </li></ul></ul><ul><ul><li>Therefore, they often avoid the ratio. </li></ul></ul>Donald J. Weidner
  18. 18. Appraisals: Three Basic Indications of (or ways of approaching) Value <ul><li>Recent Sales of Comparable Properties </li></ul><ul><ul><li>Also known as “Market Data” Approach </li></ul></ul><ul><ul><li>The approach is less valid if there is an inactive market or if the property is unique </li></ul></ul><ul><li>Replacement Cost </li></ul><ul><ul><li>Cost of replacing a building (and the land under it) minus depreciation charges on the building </li></ul></ul>Donald J. Weidner
  19. 19. Appraisals: Three Basic Indications of (or ways of approaching) Value (cont’d) <ul><li>Capitalized Value of Income (many methods): </li></ul><ul><li>--Gross Rent Multiplier—very rough (and less valid if there are little or no sales of comparables) </li></ul><ul><li>--Capitalization Rate—only slightly more refined </li></ul><ul><li>--Discounted Cash Flow—more refined </li></ul><ul><li>Reconciliation relates these three factors, it does not simply average them. A reconciliation may select one factor as the most important. </li></ul>Donald J. Weidner
  20. 20. Donald J. Weidner GROSS MULTIPLIER  Derive value from gross rentals Assume a Recent Sale: 12 Million Sales Price 2 Million Gross Rental Revenue = 6 [Gross 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) Sales Price of Comparable Properties Gross Rental Revenues of Comparable Properties = Multiplier
  21. 21. Donald J. Weidner CAPITALIZATION RATE  Capitalize the value of the net rentals <ul><li>If I expects an 8% cash return [stated in </li></ul><ul><li>fractions ] </li></ul> The price x 8/100 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 <ul><li>If I expects a 12% cash return [stated in </li></ul><ul><li>decimals ] </li></ul>.12 return = $150,000  The price x Divide each side of the equation by .12 <ul><li>x .12/.12 = $150,000/.12 </li></ul><ul><li>= $1,250,000 </li></ul>1) 2) 2) 1) How Much Will An Investor Pay for a Building that has a $150,000 Net Cash Flow? Basic idea:  x 8% = $1,000 per year  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,  is $12,500
  22. 22. Donald J. Weidner 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 Flow=Rent Receipts–Real Estate Taxes–Maintenance– Insurance–(Principal + Interest) = $1,000 Assume purchase of 10-year position  10 year leasehold <ul><li>.833 x $1,000 = 833 </li></ul><ul><li>.694 x $1,000 = 694 </li></ul><ul><li>.579 </li></ul><ul><li>.482 </li></ul><ul><li>.402 </li></ul><ul><li>.335 </li></ul><ul><li>.279 </li></ul><ul><li>.233 </li></ul><ul><li>.194 </li></ul><ul><li>.162 x $1,000 = 162 </li></ul><ul><li>$4,193 </li></ul>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
  23. 23. Donald J. Weidner <ul><li>PLAZA </li></ul><ul><li>OWNS THE BUILDING </li></ul>BUILDING LAND ½  PLAZA ½   HOTEL CP Operating Agreement SUBLEASE OF  ½ FEE INTEREST LEASE OF  ½ FEE INTEREST LEASE Plaza Hotel Associates 340 N.Y.S.2d 796 (N. Y. Sup. 1973)
  24. 24. Plaza Hotel Facts <ul><li>Lease provided for rent to increase to 3% of the “value” of “all of the land,” exclusive of the building and improvements. </li></ul><ul><li>It also provided that, if LL and T could not agree on value, appraisers would determine value. </li></ul><ul><li>An appraisal valued the land alone at $28,000,000. </li></ul><ul><li>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 . </li></ul>Donald J. Weidner
  25. 25. Plaza Hotel Highlights <ul><li>Court set aside the appraiser’s valuation because 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.” </li></ul><ul><li>Does that seem correct? </li></ul><ul><li>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 land. </li></ul><ul><li>Next, the court determined value. </li></ul>Donald J. Weidner
  26. 26. Plaza Hotel Highlights <ul><li>The court distinguished price from value: </li></ul><ul><ul><li>“ Price is determined by short term factors and by the caprices of the market.” </li></ul></ul><ul><ul><li>“ 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.” </li></ul></ul><ul><ul><ul><li>“ [ V]alue, even more than price, is a matter of judgment .” </li></ul></ul></ul>Donald J. Weidner
  27. 27. More from Plaza Hotel <ul><li>“ 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.” </li></ul><ul><li>The lessee’s 3 appraisals of the land alone ranged from $8.5 million to $11.5 million. </li></ul><ul><li>The lessor’s 3 appraisals of the land alone ranged from $33.3 million to $34.5 million. </li></ul>Donald J. Weidner
  28. 28. Plaza Hotel (cont’d) <ul><li>Plaza Hotel noted: </li></ul><ul><ul><li>“ 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 employer’s position.” </li></ul></ul>Donald J. Weidner
  29. 29. A Different View on “Free and Clear” Appraisal <ul><li>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.” </li></ul><ul><ul><li>The lease was a 99-year lease. The price of the option to purchase, in the tenant’s view, is in effect the present value of the rents (economically, a prepayment of the rent). </li></ul></ul><ul><ul><ul><li>That is, the discounted cash flow. </li></ul></ul></ul>Donald J. Weidner
  30. 30. Length of Loan <ul><li>The longer the length, or term, of the loan, the lower the Debt Service </li></ul><ul><li>Consider, for example, an $18,000 home improvement loan. If the interest rate is 6%, the monthly Debt Service is </li></ul><ul><ul><li>$199.98 over 10 years </li></ul></ul><ul><ul><li>$116.10 over 25 years </li></ul></ul><ul><ul><li>$ 99.18 over 40 years </li></ul></ul><ul><li>The cost for the benefit of lower debt service: the longer the term, the more interest is paid. </li></ul>Donald J. Weidner
  31. 31. Rate of Interest <ul><li>The greater the rate of interest, the greater the Debt Service. </li></ul><ul><li>Example, a 25-year $100,000 home improvement loan. Monthly Debt Service at </li></ul><ul><ul><li>4% is $ 528 </li></ul></ul><ul><ul><li>6% is $ 644 </li></ul></ul><ul><ul><li>8% is $ 770 </li></ul></ul><ul><ul><li>10% is $ 908 </li></ul></ul><ul><ul><li>17% is $ 1,436 </li></ul></ul>Donald J. Weidner
  32. 32. Points <ul><li>“ Point” is one percent of the face amount of a contract debt. </li></ul><ul><li>Points can be characterized differently, ex., as interest, for services, etc. </li></ul><ul><li>Basic way points can work: </li></ul><ul><ul><li>Buyer executes note to Seller for $40,000 (more terms also specified). </li></ul></ul><ul><ul><li>Lender purchases note from Seller charging 6 points [$40,000 X 6% = $2,400]). </li></ul></ul><ul><ul><li>That is, Lender pays only $37,600 for the $40,000 note [$40,000 minus the $2,400]. </li></ul></ul><ul><ul><li>Buyer still pays “interest” on full $40,000 face amount. </li></ul></ul>Donald J. Weidner
  33. 33. Donald J. Weidner . . . PASSAGE OF TIME DEBT SERVICE IN DOLLARS SELF AMORTIZING LOANS First type: Constant Payment DEBT SERVICE COMPONENTS Principal Interest
  34. 34. Donald J. Weidner . . . PASSAGE OF TIME DEBT SERVICE IN DOLLARS SELF AMORTIZING Second Type: Constant Amortization DEBT SERVICE COMPONENTS Principal Interest
  36. 36. Florida Statute on Balloon Mortgages (Supplement p. 25) <ul><li>Fla. Stat. sec. 697.05(2)(a)1 has its own definition of balloon mortgage: </li></ul><ul><ul><li>“ 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. ” </li></ul></ul><ul><ul><li>With certain exceptions, “there shall be printed or clearly stamped on such mortgage a legend in substantially the following form: </li></ul></ul><ul><ul><ul><li>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.” </li></ul></ul></ul>Donald J. Weidner
  37. 37. Florida Statute on Balloon Mortgages (Cont’d) <ul><li>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.” </li></ul><ul><li>Failure of a mortgagee to comply with these provisions “shall automatically extend the maturity date of such mortgage.” </li></ul>Donald J. Weidner
  38. 38. Pre-Depression Residential Financing <ul><li>Amount . At least theoretically, very low loan/value ratios, typically 50-60% of appraised value. </li></ul><ul><ul><li>Lenders stretched their appraisals. </li></ul></ul><ul><ul><li>Borrowers took out second, third, mortgage loans. </li></ul></ul><ul><li>Length . Seldom for more than 10 to 15 years. In 1925, the average length for mortgages issued </li></ul><ul><ul><li>by life insurance companies was 6 years; </li></ul></ul><ul><ul><li>by S &Ls was 11 years. </li></ul></ul><ul><li>Rate of Interest : Junior mortgages were at higher rates of interest. </li></ul><ul><li>Amortization Terms : Balloons were common. </li></ul><ul><li>In the Great Depression: 1 million American families lost their homes to foreclosure between 1930-1935. </li></ul>Donald J. Weidner
  39. 39. Post-Depression Mortgage Insurance <ul><li>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) </li></ul><ul><li>Length . To decrease debt service, the government insured longer loans. Terms increased up to 40 yrs. for certain projects. </li></ul><ul><li>Rate of Interest . The government would not insure loans above a certain interest rate. “Points” became important. </li></ul><ul><li>Amortization Terms . Government would insure only fully self-amortizing loans. </li></ul><ul><li>Fundamental Lesson of Great Depression seemed to be: never require a consumer to pay Debt Service that escalates. </li></ul><ul><li>--We subsequently forgot or rejected that lesson. </li></ul>Donald J. Weidner
  40. 40. The American Dream of Home Ownership <ul><li>Americans Living in their Own Homes </li></ul><ul><li>1940 41% </li></ul><ul><li>1950 53% </li></ul><ul><li>1981 65% </li></ul><ul><li>2006 69%* </li></ul>Donald J. Weidner *By 2008, many suggest that federal housing officials trying to get the homeownership rate as high as possible helped cause the “subprime” crisis by encouraging loans to high-risk borrowers Many also fault Alan Greenspan’s Federal Reserve Board for keeping interest rates too low for too long. Ben Bernanke does not.
  41. 41. <ul><li>Adjustable Rate Mortgage (ARM) (a.k.a. “Variable Rate Mortgage”) </li></ul><ul><li>Graduated Payment Mortgage (GPM) </li></ul><ul><li>Renegotiable Rate Mortgage (RRM) </li></ul><ul><li>Shared Appreciation Mortgage (SAM) </li></ul><ul><li>Price Level Adjusted Mortgage (PLAM) </li></ul><ul><li>Reverse Annuity Mortgage (RAM) </li></ul>“ NEW” TYPES OF CONSUMER MORTGAGES (Text p. 409) Donald J. Weidner
  42. 42. 1) ADJUSTABLE RATE MORTGAGE <ul><li>Interest rate rises and falls according to some predetermined standard. </li></ul><ul><li>An interest rate increase must mean at least one of the following three things: </li></ul><ul><li>--1. Debt service payments will increase; or </li></ul><ul><li>--2. The length of the loan will increase; or </li></ul><ul><li>--3. The amortization terms will change (create or increase a balloon) </li></ul>Donald J. Weidner
  43. 43. Adjustable Rate Mortgages (cont’d) <ul><li>Protections provided for consumers : </li></ul><ul><ul><li>Limit the frequency of interest rate increases </li></ul></ul><ul><ul><li>Limit the magnitude of each interest rate increase </li></ul></ul><ul><ul><li>Limit the total amount of interest rate increases </li></ul></ul><ul><ul><li>Require downward adjustments if the standard declines. </li></ul></ul><ul><ul><li>Offer borrowers the right to prepay without penalty upon interest rate increase </li></ul></ul><ul><ul><ul><li>Note: you may not be able to refinance, even if rates have dropped, if the value of the property has dropped. </li></ul></ul></ul>Donald J. Weidner
  44. 44. Adjustable Rate Mortgages (cont’d) <ul><li>Consumer protections (cont’d) </li></ul><ul><ul><li>“ Balloon” disclosure rules may define a balloon more narrowly than simply as any payment larger than one before </li></ul></ul><ul><ul><li>Ex., as any payment more than twice the size of a preceding payment (as in Florida). </li></ul></ul>Donald J. Weidner
  45. 45. 2) GRADUATED PAYMENT MORTGAGE <ul><li>Monthly payments gradually rise, while the interest rate and the term of the loan are fixed. </li></ul><ul><li>Initial concept: Help the young family that reasonably expects its income to grow substantially over the years following the loan closing. </li></ul>Donald J. Weidner
  46. 46. 3) RENEGOTIABLE RATE MORTGAGE (a.k.a. “Rollover Mortgage”) <ul><li>Series of renewable short-term notes, secured by a long-term mortgage with principal fully amortized over the longer term. </li></ul><ul><li>As initially approved, 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. </li></ul>Donald J. Weidner
  47. 47. Goebel v. First Federal (Text p. 403) <ul><li>The note provided: </li></ul><ul><li>Interest shall be paid monthly. </li></ul><ul><li>Initial interest rate was 6% per annum. </li></ul><ul><li>The initial interest rate may be changed from time to time at the S & L’s option. </li></ul><ul><li>There will be no interest rate change during first 3 years. </li></ul><ul><li>There will be no interest rate change without 4 months written notice. </li></ul><ul><li>Borrower has 4 months from notice of a change to prepay without penalty. </li></ul>Donald J. Weidner
  48. 48. Goebel (cont’d) <ul><li>Nine years later, Lender said the interest rate was being increased and that Borrower had the option to </li></ul><ul><ul><li>Make increased monthly payments of Debt Service, or </li></ul></ul><ul><ul><li>Increase the length of the loan. </li></ul></ul><ul><ul><li>[No mention was made of balloons.]. </li></ul></ul><ul><li>Court’s approach to construing the note: construe the ambiguous contract language against the drafter, especially </li></ul><ul><ul><li>when the drafter has much greater bargaining power, and </li></ul></ul><ul><ul><li>when the drafter supplied its “standard form.” </li></ul></ul>Donald J. Weidner
  49. 49. Goebel (cont’d) <ul><li>As to increasing monthly Debt Service , court said expressio unius controlled: There were provisions to increase Debt Service in some situations but not to reflect an interest increase. </li></ul><ul><li>Note stated that monthly Debt Service could be increased to accommodate future advances; and </li></ul><ul><li>Note stated that Lender had a right to payment for taxes, insurance and repairs “on demand” </li></ul><ul><ul><li>Lower court said this included the right to increase monthly Debt Service. </li></ul></ul><ul><li>Yet the note “fails to make similar provisions” for an increase in interest </li></ul><ul><ul><li>Therefore, the promisor could not be required to increase monthly debt service to pay for an increase in interest. </li></ul></ul>Donald J. Weidner
  50. 50. Goebel (cont’d) <ul><li>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.” </li></ul><ul><li>Lender argued this clause was intended for its benefit and that it, therefore, could set it aside. </li></ul><ul><li>The court appears to have begged the conclusion when it said that this clause was for the Borrower’s benefit. </li></ul><ul><li>The court said it was not nullifying the provisions increasing the interest rate because an interest increase would still be collectible: </li></ul><ul><ul><li>if interest rates first drop before they rise </li></ul></ul><ul><ul><li>In the event of a prepayment of the mortgage </li></ul></ul><ul><ul><ul><li>“ Due on sale” clause is enforceable </li></ul></ul></ul><ul><ul><ul><li>How does this fit with what the court said about a balloon (“this method was not used”)? </li></ul></ul></ul>Donald J. Weidner
  51. 51. Note to Goebel v. First Federal <ul><li>No argument was made that an interest increase was either unconscionable or illegal. </li></ul><ul><li>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 bank’s customers similarly situated, then the note is not too indefinite.” </li></ul><ul><li>Recall, “good faith” can solve the problem of an indefinite contract </li></ul><ul><li>Recall, too, that the borrower had the option to prepay without penalty upon an interest rate increase. </li></ul><ul><ul><ul><li>Indicating that market forces would limit the lender. </li></ul></ul></ul>Donald J. Weidner
  52. 52. 4) SHARED APPRECIATION MORTGAGE <ul><li>Lender agrees to lend at a flat rate below the current market rate in return for borrower’s agreement that: </li></ul><ul><ul><li>If the home is sold before the end of x years, the lender will receive a percentage of the increase in value; </li></ul></ul><ul><ul><li>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 lender’s share of the appreciation. </li></ul></ul><ul><li>BUT ::::if the borrower requests, the lender must refinance an amount equal to the unpaid loan balance plus the contingent interest. </li></ul>Donald J. Weidner
  53. 53. 5) PRICE LEVEL ADJUSTED MORTGAGE <ul><li>It is the loan principal, NOT the interest rate, that varies over the term of the mortgage. </li></ul><ul><li>The principal is adjusted up or down according to a prescribed inflation index. </li></ul>Donald J. Weidner
  54. 54. 6) Reverse Annuity Mortgage <ul><li>Designed to enable seniors to draw cash out of the equity in their homes. </li></ul><ul><li>The typical RAM gives the borrower monthly payments over the borrower’s lifetime or over a predetermined period. </li></ul><ul><li>With each monthly payment by the lender, the debt increases. </li></ul><ul><li>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 borrower’s estate. </li></ul>Donald J. Weidner
  55. 55. Growth of Debt Securitization in Real Estate <ul><li>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 lenders against the risk of default. </li></ul><ul><li>In 1938, the Federal National Mortgage Association (Fannie Mae) was created to buy and to sell federally insured mortgages. </li></ul><ul><ul><li>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. </li></ul></ul>Donald J. Weidner
  56. 56. Growth of Debt Securitization in Real Estate (cont’d) <ul><li>Fannie Mae “was then restructured as a private corporation with ties to the federal government” </li></ul><ul><ul><li>And “given the authority to buy and sell conventional (non-federally insured) home mortgage loans.” </li></ul></ul><ul><li>In 1970, Congress established the third major secondary mortgage market agency, the Federal Home Loan Mortgage Corporation (Freddie Mac) , </li></ul><ul><ul><li>which is also empowered to buy and to sell conventional mortgages. </li></ul></ul>Donald J. Weidner
  57. 57. Growth of Debt Securitization in Real Estate <ul><li>“ In the 1970s, the secondary market agencies became critical in promoting the growth of securitization.” </li></ul><ul><ul><li>“ 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.” </li></ul></ul><ul><li>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.” </li></ul><ul><li>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.” </li></ul><ul><ul><li>These different slices are known as “tranches” </li></ul></ul>Donald J. Weidner
  58. 58. Federal Reserve Policy <ul><li>When the Fed 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” </li></ul><ul><ul><li>Thus, there was cheap money to help drive up prices </li></ul></ul><ul><ul><li>Treasury obligations were not paying investors very much </li></ul></ul><ul><ul><li>Investors turned to mortgaged-backed securities for higher yields than Treasury bills at, they thought, relatively little risk </li></ul></ul><ul><li>At the same time, Chairman Greenspan believed that the discipline of the markets would protect against excessive risk taking. </li></ul>Donald J. Weidner
  59. 59. “ Crisis Looms in Market for Mortgages” (Supplement p. 1) <ul><li>Gretchen Morgenson, “Crisis Looms in Market for Mortgages,” New York Times, March 11, 2007. </li></ul><ul><li>As of March, 2007, the nation’s $6.5 trillion mortgage securities market was even larger than the United States treasury market. </li></ul><ul><li>“ 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 borrowers—known as subprime mortgages — recently reached 12.6 percent.” </li></ul><ul><li>35% of all mortgage securities issued in 2006 were in the subprime category . </li></ul>Donald J. Weidner
  60. 60. Crisis Looms in Mortgage Market (cont’d) <ul><li>Subprime Lenders created “affordability products,” mortgages that </li></ul><ul><ul><li>Require little or no down payment </li></ul></ul><ul><ul><li>Require little or no documentation of a borrower’s income </li></ul></ul><ul><ul><li>Extend terms to 40 or 50 years </li></ul></ul><ul><ul><li>Begin with low “teaser” rates that rise later in the life of the loan. </li></ul></ul><ul><li>Mortgages that require little or no documentation are known as “liar loans.” </li></ul>Donald J. Weidner
  61. 61. Crisis in Mortgage Market (cont’d) <ul><li>“ 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.” </li></ul><ul><li>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. </li></ul>Donald J. Weidner
  62. 62. Crisis in Mortgage Market (cont’d) <ul><li>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.” </li></ul><ul><li>Some of the big firms even acquired companies that originate mortgages. </li></ul><ul><ul><li>Investors demands for mortgage-backed securities was insatiable </li></ul></ul><ul><ul><li>The greater the demand, the less the investment banks insisted on quality loans. </li></ul></ul>Donald J. Weidner
  63. 63. Banks Sue Originators on Repurchase Agreements (Supplement p. 7) <ul><li>Carrick Mollenkamp, James R. Hagerty, Randall Smith, “Banks Go on Subprime Offensive,” The Wall Street Journal , March 13, 2007 </li></ul><ul><li>“ 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.” </li></ul><ul><li>Billions in mortgages are covered by repurchase agreements. </li></ul><ul><li>However, many originators say that they cannot afford to buy back the loans or they are seeking bankruptcy protection. </li></ul><ul><li>Many loans went to “straw borrowers,” people who obtain the loan for another home buyer. </li></ul><ul><ul><li>In some cases, brokers wrote contracts through straw men </li></ul></ul>Donald J. Weidner
  64. 64. Rating Agencies <ul><li>Credit rating agencies are supposed to assess risk for investors </li></ul><ul><li>The rating agencies gave the mortgaged-backed securities a AAA rating, which suggested they were as safe as Treasury Obligations. </li></ul><ul><li>Data on loan performance focused on a low foreclosure rate </li></ul><ul><ul><li>That data focused only on recent history and thus suggested a foreclosure rate of perhaps 2% </li></ul></ul><ul><ul><li>It didn’t include the newer, more risky mortgages </li></ul></ul><ul><ul><li>Nor did it anticipate falling real estate prices </li></ul></ul>Donald J. Weidner
  65. 65. The Rating Agencies (Supplement p. 10) <ul><li>Floyd Norris, “Being Kept in the Dark on Wall Street.” The New York Times, November 2, 2007. </li></ul><ul><li>Securitization was extremely profitable for investment banks, and only they seemed to understand what was going on. </li></ul><ul><li>The products they sold (labeled CDO [collateralized debt obligation] or otherwise) “could be valued according to models, which made for nice, consistent profit reports” for the people who bought them. </li></ul>Donald J. Weidner
  66. 66. The Rating Agencies (cont’d) <ul><li>“ No one seemed to be bothered by the lack of public information on just what was in some of these products. If Moody’s, Standard & Poor’s or Fitch said a weird security deserved an AAA, that was enough.” </li></ul><ul><li>“ And then they blew up.” </li></ul><ul><li>“ 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 .” </li></ul>Donald J. Weidner
  67. 67. The Rating Agencies (cont’d) <ul><li>“ Rating agency downgrades do not destroy markets for corporate bonds, simply because enough information is disseminated that other analysts can reach their own conclusions.” </li></ul><ul><li>“ But the securitization markets collapsed when it became clear the rating agencies had been overly optimistic.” </li></ul><ul><ul><li>Some suggest that information shared with rating agencies should be shared with the entire market. </li></ul></ul>Donald J. Weidner
  68. 68. The Rating Agencies (cont’d) <ul><li>The SEC is investigating the rating agencies to see if their ratings complied with their own published standards. </li></ul><ul><li>Neither one of two plausible scenarios, knaves or fools, is pretty: </li></ul><ul><li>“ 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.)” </li></ul>Donald J. Weidner
  69. 69. The Rating Agencies (cont’d) <ul><li>The collapse of securitization has made credit hard to obtain for many, “and a change in the Fed funds rate will not offset that.” </li></ul><ul><li>“ [I]t has become very difficult to get a home mortgage without some kind of government-backed guarantee.” </li></ul>Donald J. Weidner
  70. 70. Collateralized Debt Obligations <ul><li>A collateralized debt obligation is a pool of different tranches (or slices) of mortgages </li></ul><ul><ul><li>Or a pool of mortgages with other receivables, such as credit card receivables </li></ul></ul><ul><li>Lower-rated tranches were called “toxic waste” </li></ul><ul><ul><li>They are so high-risk, they are “toxic” </li></ul></ul><ul><li>But the tranches were being pooled to make them appear to be less risky </li></ul><ul><ul><li>And made to appear even less risky with credit default swaps (insurance against defaults) </li></ul></ul>Donald J. Weidner
  71. 71. The Housing Bubble <ul><li>From 2000-2003, there was a speculative bubble in housing. </li></ul><ul><li>Prices kept going up, mortgage financing was available. </li></ul><ul><li>People were seeing residences as investments, and non-real estate professionals were buying multiple residences to “flip” </li></ul><ul><li>However, from 2000-2007, the median household income was flat. </li></ul>Donald J. Weidner
  72. 72. The Housing Bubble <ul><li>Therefore, the more prices rose, the more unsustainable the rise and its financing. </li></ul><ul><li>By late 2006, the average home cost nearly 4 times what the average family made </li></ul><ul><ul><li>As opposed to an historic multiple of only 2 or 3 </li></ul></ul><ul><li>People began to default on their mortgages soon after taking them out. </li></ul><ul><li>By late 2006, housing prices started going down. </li></ul><ul><li>As defaults started, more houses came on the market, prices went further down. </li></ul>Donald J. Weidner
  73. 73. The Housing Bubble <ul><li>While prices were rising, people were taking out “Home Equity Lines of Credit” </li></ul><ul><ul><li>They were borrowing to pay off their mortgage and other debts. </li></ul></ul><ul><li>When the Investment Bankers saw the defaults start increasing, they stopped buying the risky loans </li></ul><ul><ul><li>Credit became tight for homeowners </li></ul></ul><ul><ul><li>The mortgage companies that specialized in buying up and packaging these loans to investment banks started going out of business </li></ul></ul><ul><ul><ul><li>They were highly leveraged </li></ul></ul></ul>Donald J. Weidner
  74. 74. Foreclosures: 2008-2010 Number of Homes Repossessed Donald J. Weidner <ul><li>2008 – 862,000 </li></ul><ul><li>2009 – 918,000 </li></ul><ul><li>2010 – 1,050,000 </li></ul>Donald J. Weidner
  75. 75. Securitisation, When it goes wrong . . . . (Supplement p. 13) <ul><li>“ Securitisation, When it goes wrong . . . ., The Economist (September 20, 2007) </li></ul><ul><li>“ Securitisation” is “the process that transforms mortgages, credit-card receivables and other financial assets into marketable securities </li></ul><ul><ul><li>Brought huge gains </li></ul></ul><ul><ul><li>Also brought costs that are only now becoming clear. </li></ul></ul><ul><li>“ Thanks largely to securitisation, global private-debt securities are now far bigger than stockmarkets.” </li></ul>Donald J. Weidner
  76. 76. Securitisation, When it goes wrong . . . . (cont’d) <ul><li>Benefits of securitization: </li></ul><ul><ul><li>“ Global lenders use it to manage their balance sheets, since selling loans frees up capital for new businesses or for return to shareholders.” </li></ul></ul><ul><ul><li>Small regional banks no longer need to place all their bets on local housing markets—”they can offload credits to far-away investors such as insurers or hedge funds.” </li></ul></ul><ul><ul><li>3. Reduces borrowing costs for consumers and businesses. </li></ul></ul>Donald J. Weidner
  77. 77. Securitisation, When it goes wrong . . . . (cont’d) <ul><ul><li>4. One “systemic” gain was said to be: “Subjecting bank </li></ul></ul><ul><ul><li>loans to valuation by capital markets </li></ul></ul><ul><ul><li>encourages the efficient use of capital.” </li></ul></ul><ul><ul><li>--But, did this really work? </li></ul></ul><ul><ul><li>Broadens the distribution of credit risk. </li></ul></ul><ul><ul><li>However, there are three cracks in the new model: </li></ul></ul><ul><ul><li>1. A high level of complexity and confusion. </li></ul></ul><ul><ul><li>2. Fragmentation of responsibility warped incentives. </li></ul></ul><ul><ul><li>3. Regulations came to be gamed. </li></ul></ul>Donald J. Weidner
  78. 78. Securitisation, When it goes wrong . . . . (cont’d) <ul><li>1. Problem # 1: complexity: “financiers did not fully understand what they were trading.” </li></ul><ul><ul><li>Schwarcz says some contracts “are so convoluted that it would be impractical for investors to try to understand them” </li></ul></ul><ul><ul><li>Skel and Partnoy concluded that CDOs “are being used to transform existing debt instruments that are accurately priced into new ones that are overvalued.” </li></ul></ul><ul><li>2. Problem #2: “securitisation has warped financiers’ incentives.” </li></ul><ul><ul><li>“ Securitisations are generally structured as ‘true sales’: the seller wipes its hands of the risks.” </li></ul></ul><ul><ul><li>One middleman has been replaced with several. </li></ul></ul>Donald J. Weidner
  79. 79. Securitisation, When it goes wrong . . . . (cont’d) <ul><li>In mortgage securitisation, the lender is supplanted by </li></ul><ul><li>--the broker </li></ul><ul><li>--the loan originator </li></ul><ul><li>--the servicer (who collects payments) </li></ul><ul><li>--the arranger </li></ul><ul><li>--the rating agencies </li></ul><ul><li>--the mortgage-bond insurers </li></ul><ul><li>-- the investor </li></ul><ul><li>By January of 2008, there was widespread concern over the stability of the bond insurers. </li></ul>Donald J. Weidner
  80. 80. Securitisation, When it goes wrong . . . . (cont’d) <ul><li>“ This creates what economists call a principal-agent problem.” </li></ul><ul><ul><li>“ The loan originator has little incentive to vet borrowers carefully because it knows the risk will soon be off its books.” </li></ul></ul><ul><ul><li>“ 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.” </li></ul></ul><ul><ul><ul><li>Most investors were sophisticated institutions too taken with alluring yields to push for tougher monitoring </li></ul></ul></ul>Donald J. Weidner
  81. 81. Securitisation, When it goes wrong . . . . (cont’d) <ul><li>3. Problem #3: Regulations were gamed. </li></ul><ul><ul><li>Only now are the politicians looking at the rating agencies. </li></ul></ul><ul><ul><li>“ Regulatory dependence on ratings has grown across the board.” </li></ul></ul><ul><ul><ul><li>Banks can reduce the amount of capital they are required to set aside if they hold highly-rated paper. </li></ul></ul></ul><ul><ul><ul><li>Some investors, such as money-market funds, are required to stick to AAA-rated securities. </li></ul></ul></ul>Donald J. Weidner
  82. 82. Securitisation, When it goes wrong . . . . (cont’d) <ul><li>Looking forward: </li></ul><ul><li>“ Investors need to know who is holding what and how it should be valued.” </li></ul><ul><li>There will be calls for greater standardization of “structured products.” </li></ul><ul><li>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.” </li></ul><ul><ul><li>“ [Securities Rating Agency] is one of the few businesses where the appraiser is paid by the seller, not the buyer .” </li></ul></ul>Donald J. Weidner
  83. 83. Servicers and Tranche Warfare <ul><li>See Jody Shenn, Wilbur Ross Defies Bruce Rose in Battle Over Housing Villains, March 2009 Bloomberg </li></ul><ul><li>When the pool of mortgages goes into default, the holders of different tranches in it have divergent interests. </li></ul><ul><li>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 there is any more decline in asset prices. </li></ul><ul><li>The holders of the B piece, lower rated tranches, are more likely to favor </li></ul><ul><ul><li>delay </li></ul></ul><ul><ul><li>modifying the loan to reduce debt service so the borrower can carry the payments </li></ul></ul><ul><ul><li>renting out homes until better prices can be obtained on foreclosure </li></ul></ul>Donald J. Weidner
  84. 84. Servicers and Tranche Warfare (cont’d) <ul><li>The servicers are in the middle in the tranche warfare. </li></ul><ul><li>The servicers often have incentives to hasten foreclosure. Jody Shenn writes: </li></ul><ul><li>“ 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.” </li></ul>Donald J. Weidner
  85. 85. Servicers and Tranche Warfare (cont’d) <ul><li>The Obama Administration’s plan was to have the government </li></ul><ul><ul><li>cover some costs of reducing homeowner payments </li></ul></ul><ul><ul><li>cover some investor losses from further home price declines </li></ul></ul><ul><ul><li>pay servicers to hire the staff needed to contact borrowers and modify loans </li></ul></ul>Donald J. Weidner
  86. 86. Fannie Mae and Freddie Mac: End of Illusions (Supp. P. 19) <ul><li>Fannie Mae and Freddie Mac: End of Illusions, The Economist, July 19, 2008, p. 79. </li></ul><ul><li>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 .” </li></ul>Donald J. Weidner
  87. 87. Fannie Mae and Freddie Mac: End of Illusions (Cont’d) <ul><li>The belief in the implicit government guarantee of the obligations of Fannie and Freddie: </li></ul><ul><ul><li>Permitted them to borrow cheaply. </li></ul></ul><ul><ul><ul><li>They engaged in a “carry trade”—they earned more on the mortgages they bought than they paid for the money they raised. </li></ul></ul></ul><ul><ul><li>Allowed them to operate with tiny amounts of capital and they became extremely leveraged (“geared”): 65 to 1! </li></ul></ul><ul><ul><ul><li>$5 trillion of debt and guarantees! </li></ul></ul></ul><ul><li>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.” </li></ul>Donald J. Weidner
  88. 88. Fannie Mae and Freddie Mac: End of Illusions (Cont’d) <ul><li>However, in the late 1990s, they moved into another area: buying the mortgage-backed securities that others had issued . </li></ul><ul><ul><li>Fannie and Freddie were operating as hedge funds. </li></ul></ul><ul><ul><li>“ Again, this was a version of the carry trade; they used their cheap debt financing to buy higher-yielding assets.” </li></ul></ul><ul><ul><li>Fannie’s outside portfolio grew to $127 billion by the end of 2007. </li></ul></ul><ul><ul><ul><li>Leaving them exposed to the subprime assets they were supposed to avoid. </li></ul></ul></ul>Donald J. Weidner
  89. 89. TARP: “Troubled Asset Relief Program” <ul><li>$700 billion rescue package approved by Congress October 3, 2008. </li></ul><ul><li>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. </li></ul><ul><li>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 . </li></ul>Donald J. Weidner
  90. 90. TARP (cont’d) <ul><li>After much criticism, the announced plan shifted from the core mission of buying distressed mortgage assets and toward purchasing ownership stakes in banks . </li></ul><ul><li>England led the way with this solution, suggesting that the federal government may put $250 billion in banks in return for shares. </li></ul><ul><ul><li>With some restraints on executive compensation. </li></ul></ul>Donald J. Weidner
  91. 91. Potential Foreclosure Relief Through TARP <ul><li>Lawmakers discussed how to allocate funds between institutional relief and relief to individual homeowners. </li></ul><ul><li>Some in Congress pressed to give consumers more of the rights that businesses have in bankruptcy. </li></ul><ul><ul><li>For example, to give bankruptcy judges new “cram down” powers to force lenders to accept revised home loans. </li></ul></ul>Donald J. Weidner
  92. 92. Opposition to “Cram Down” Authority <ul><li>Treasury Secretary Paulson and others in the Bush administration opposed the proposal, saying it would frighten even more investors away from the mortgage market. </li></ul><ul><li>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. </li></ul>Donald J. Weidner
  93. 93. Other TARP Issues <ul><li>Policymakers also considered standardized loan modification practices to be used by firms that service mortgages. </li></ul><ul><ul><li>Loans modified under these principles would qualify for at least a partial federal guarantee. </li></ul></ul><ul><ul><li>It is unclear who would be required to pay premiums for that protection. </li></ul></ul>Donald J. Weidner
  94. 94. Quantitative Easing <ul><li>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. </li></ul><ul><li>This was dubbed “QE 2”—a second round of “quantitative easing” that followed a first round that began at $600 billion and increased to $1.8 trillion. </li></ul><ul><li>The Fed also said it would invest an addition $250-$300 billion in Treasuries with the proceeds of its earlier investments. </li></ul><ul><li>At the same time indicating it would continue to hold the federal funds rate at close to zero. </li></ul><ul><li>Critics expressed concerns about inflation and about asset bubbles. </li></ul>Donald J. Weidner
  95. 95. Representations and Warranties by Mortgage Sellers <ul><li>“ 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.” </li></ul><ul><ul><li>Hugh Son and Dawn Kopecki, Bank of America Sees $2 Billion Charge on Home Loans, Bloomberg, 1/3/11. </li></ul></ul>Donald J. Weidner
  96. 96. Representations and Warranties by Mortgage Sellers (cont’d) <ul><li>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. </li></ul><ul><ul><li>Largely traced to its acquisition of Countrywide. </li></ul></ul><ul><ul><li>Some analysts said BOA got off easy. </li></ul></ul><ul><li>The Bank exited the TARP program in December of 2009. </li></ul>Donald J. Weidner
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