John P. Wiedemer and J. Keith Baker

REAL ESTATE FINANCE Ninth Edition

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Chapter 1History and Background

Circa 2000 B.C.E.

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LEARNING OBJECTIVES

At the conclusion of this chapter, students will be able to:

• Describe the origins of real estate finance and landownership

• Understand the development of and compensation for financing

• Explain the basics of the mortgage loan market

• Explain the role of financial market instruments in the development of the real estate finance industry

• Describe the future of mortgage financing

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Introduction

• Cuneiform texts from 1822–1763 B.C.E. reveal that ancient residents of Ur buried their personal financial records in the floors of their houses.

• One businessman, Dumuzi-gamil, had deeds and security instruments and sold notes to two investors, Nur-ilishu and Sin-ashared, probably the first documented secondary market transaction.

• Only in the last several hundred years has it become possible for the average person to own land.

• Many of the practices used in modern real estate financing trace their origins to earlier civilizations.

• The underlying principle of real estate finance has changed very little over the centuries.

• It involves the pledging of land as collateral to secure a loan.

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ILLUSTRATION OF ACCOUNTING RECORDS OF SECURITY TRANSACTION FROM 2900 BC

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Landownership - Allodial vs. Feudal

• In Roman times, the allodial system applied and ownership of land by individuals was absolute.

• As continental Europe developed and Roman authority disintegrated, the feudal system granted the right to occupy and use land owned by a social superior.

• While both these systems have shaped the ownership of property in the United States, the allodial concept dominates.

• Ownership of real property in the United States is considered free and absolute, subject only to governmental and voluntary restrictions.

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Background of Financing

• In Roman society, landowners were joined in the curia with tax gatherers who made funds available for loans.

• In medieval Europe, only a few wealthy individuals were capable of loaning money.

• With the Industrial Revolution more individuals became capable of producing wealth with their ideas and their machinery.

• With widespread wealth came the demand for ways to make better use of accumulated money, and the seeds of savings institutions grew.

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Financing Real Property Loans

• The pledging of land as collateral to borrow money.

• Collateral is pledged as protection for a lender to assure repayment.

• The pledge as protection for a lender is called hypothecation.

• Default is nonperformance of an obligation that is part of a contract.

• The loan itself is evidenced by a promissory note.

• A mortgage pledges property (collateral) as security for the note.

• If default occurs, the lender can take title to the property by foreclosure.

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Compensation for Borrowed Money

• Even in earlier societies, pledging rights to landownership as security for a loan meant some kind of compensation was due to the lender.

• Charging interest for the use of one’s money was considered a sin by many religious groups, including Christians, until the Middle Ages.

• Acceptable income was essentially only that earned by one’s labor.

• Even today, some societies do not permit interest to be paid.

• To bypass the religious constraint, an “up front” fee was charged for the use of money, deducted from the loan and called a discount.

• It is measured today in points and each point is 1% of the loan amount.

• Today, some borrowed money is paid for with interest only, some with discount only, and some by a combination of the two.

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The Mortgage Loan Market

• Two levels: the primary market, where loans originate, and the secondary market, where investors purchase loans made by others.

• A person seeking mortgage loan customers is called a loan originator.

• Originator may be a bank, insurance company, mortgage company, or other entity.

• The negotiation involves the loan amount, interest rate, discount, the collateral, qualification of borrower, and the terms for repayment.

• Once a loan is made, the note and security instrument become salable.

• The originator may retain the loan in its portfolio or sell it to another.

• To secondary-market purchasers it is the yield that matters.

• Yield is a combination of the interest plus the discount.

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Financial Market Instruments

• An increasing portion of the money for loans comes from the sale of securities, rather than from savings deposits.

• Sale of securities is done by investment bankers and stock brokers.

• There are two major classes of securities: (1) stocks, representing an ownership in the corporation; and (2) bonds, representing a loan to the corporation.

• Stock evidences ownership; bonds evidence indebtedness.

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Where Are We Now?

• During the Great Depression the federal government took steps to encourage lenders to make mortgage loans.

• It accomplished this aim by creating the Federal Housing Administration (FHA), which insured loans against default.

• However, there was little money available to lend.

• Deposits in banks and savings institutions historically used to make loans were virtually depleted.

• So the federal government created the Federal National Mortgage Association, which was authorized to purchase loans insured by FHA.

• This allowed lenders to make loans without depleting their deposits.

• As a result, lenders had a new source of mortgage money.

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Where Are We Now?

• The recent mortgage crisis has raised the importance of the FHA; its market share of the number of new home loans increased from 5% in 2006 to nearly 50% by June of 2010.

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Stock Certificates

• Shares of stock represent an ownership interest in a corporation

• Stocks are not relevant to the subject of real estate finance.

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Bonds

• Debenture bonds. An unsecured promise to repay.

• Mortgage bonds. Secured by a pledge of real estate.

• Equipment bonds. Secured by assets like railroad cars or airplanes.

• Utility bonds. Secured by a pledge of assets of a state-regulated utility.

• Government bonds. Unsecured loan to the federal government.

• Municipal bonds. Can be state or municipal and often tax free.

• Mortgage-backed bonds. Secured by a large pool of mortgage loans.

Corporations can borrow money by selling different types of bonds:

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The Securities Market

• Securities must be approved by Securities & Exchange Commission.

• Approval is based on the disclosure of financial information, not value.

• Securities are bought and sold on major exchanges but sales are dominated by the New York markets.

• Mortgage-backed securities may bypass federal and state approval if underwritten by agencies such as Fannie Mae and Freddie Mac.

• Value in resale is sensitive to the fluctuation of interest rates.

• The fixed interest rate controls the price for which it may be sold.

• If bond prices rise, interest rates are falling; if bond prices fall, interest rates are rising.

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EXAMPLE

• A $10,000 bond offers an interest rate of 5%, paying $500 each year .

• Assume that the bond is sold at a discount for $9,250.

• The party paying $9,250 still receives an interest payment of $500 each year, which amounts to a return of 5.41 percent on the $9,250 invested.

• At maturity, the issuer must redeem the bond at face value of $10,000.

• The bond holder then picks up an additional $750, which is the difference between the $9,250 paid and the face amount of $10,000.

• The total yield includes both the annual interest and the price differential when the bond is redeemed.

• If the bond is sold prior to maturity, the holder could sustain a loss if the market is down.

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EXAMPLE

$10,000 x 5% = $500$500 ÷ $10,000 = .05 (5%)

$500 ÷ $9,250 = .0541 (5.41%)

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Commercial Paper

• Commercial paper is a simple promise to pay that is unsecured.

• The term is short, generally between one day and 270 days.

• Yields are usually competitive with short-term money market rates.

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Competitive Market

• A considerable variety of investments exist in the securities market.

• Each type of security must compete with other kinds based on yields.

• Both the price of a security and the interest rate affect yield.

• The yield varies with both risk and the length of time of the investment.

• The higher the risk, the higher the yield must be; the longer the term, the higher the yield required.

• Therefore interest rates on mortgage loans must be competitive with other available security investments.

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Investment Risk

• For a mortgage-backed security, the risk is low.

• Each loan carries some kind of default insurance (PMI, FHA, or VA).

• About half of mortgage-backed securities are guaranteed by a federal agency, and thus are doubly insured.

• Federal underwriting reduces risk, allowing a lower yield requirement.

• Lower yield requirements mean lower interest rates for the borrower.

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A Look at the Future

• Mortgage-backed securities convert a mortgage loan into a financial instrument that can be more easily sold to investors.

• Financial markets are now a source of money to fund mortgage loans.

• The fuel that has expanded this market is federal agency underwriting.

• Fannie Mae and Freddie Mac are the largest and fall under the oversight of the Federal Housing Finance Agency.

• The Federal Housing Administration (FHA) falls under the Department of Housing and Urban Development, or HUD.

• Ginnie Mae is limited to underwriting FHA and VA loans under HUD.

• Farmer Mac is limited to underwriting agricultural loans and rural home loans outside incorporated areas.

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A Look at the Future

• Government-Sponsored Entities (GSEs) are now under the oversight of the Federal Housing Finance Agency (FHFA).

• The establishment of FHFA is hoped to promote a stronger, safer U.S. housing finance system.

• Since Fannie Mae and Freddie Mac were placed into conservatorship in 2008, the Federal Reserve Bank has served as the purchaser of last resort for Fannie Mae and Freddie Mac MBSs.

• The Fed was still making purchases in July 2010 totaling $2.31 trillion.

• Considering the impact of these GSEs on the U.S. economy and mortgage market, it is critical that we intensify our focus on the oversight and restructuring of Fannie Mae and Freddie Mac.

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A Look at the Future

• HUD now directs lending activities into more diverse areas of lending.

• Four results are probable:

(1) an increase in home loans to minority groups, immigrants, and those in underserved urban areas;

(2) a growth in the offerings and market share of FHA mortgage loans;

(3) the rehabilitation of Fannie Mae and Freddie Mac; and

(4) the emergence of private mortgage-backed securities that have a retained loss interest by the mortgage loans’ original lenders.

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The Mortgage Crisis Development

It is important to understand how we as a society got into this position and some of the generally agreed-upon causes of the crisis.

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The Low Interest Rate Environment

• A low interest rate environment created by two destabilizing events:1. the technology stock bubble burst; and2. terrorists attacked the United States.

• The FED lowered rates to help calm financial markets, lowering its Fed Funds rate from 6.5% at the end of 2000 to 1.75% at the end of 2001.

• The Fed continued to make other rate cuts until the target rate reached 1% in June 2003, and did not begin to raise rates until mid 2004.

• This long period of low interest rates inordinately stimulated demand for mortgage debt and housing price inflation.

• At the same time white collar crime units were shifted to Homeland Security allowing fraudsters to instigate problems with impunity.

• Even in 2012 the FBI white collar crime units have not reached 20% of their former investigative staffing levels.

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The Refinance Boom

• A renewed refinance boom occurred at a level unequaled in history.

• Lenders expanded operations to meet the refi demand along with the already increased demand for housing created by the low interest rates.

• When the refi demand ended, many lenders, accustomed to easy profits, began to offer more innovative (crazy) loan products.

• These included subprime products, interest-only, and option ARMs that allowed borrowers to qualify for larger homes or enter the housing market for the first time.

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Housing and Community Development Act of 1992

• Congress said Fannie and Freddie “have an affirmative obligation to facilitate the financing of affordable housing for low and moderate income families.”

• Fannie and Freddie were required to meet “affordable housing goals”.

• Fannie and Freddie were required to expand loans in distressed inner city areas under the CRA of 1977.

• Fannie and Freddie had to promote the use of high LTVs.

• Fannie began offering a 97% LTV program in 1994.

• Industry experts issued strong objections, citing Fannie’s early 1980s experiment allowing 5% down loans in Texas, that proved disastrous.

• Fannie and Freddie went into the subprime market with 105% LTVs.

• Thus the stage was set for these organizations’ demise.

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Falling Underwriting Standards

• The profitability of mortgages caused lenders to further reduce underwriting standards or simply ignore them.

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Fannie and Freddie Out of Control

• Lenders, Fannie, and Freddie all began to feel pressure to accept increasingly substandard loan products.

• Investors assumed that they would be bailed out in a crisis.

• The federal government is not legally required to cover these entities’ liabilities, but the belief to the contrary was a good assumption.

• The GSEs had actually been privately owned since the late 1960s and early 1970s, which drove them to maximize profits.

• Therefore Fannie and Freddie had both the incentive and the capacity to take on excessive risk, and they did so with vigor.

• Experts, regulators, and officials attempted to rein in these excesses but were stymied by some of the most well-funded lobbying in history.

• Fannie and Freddie spent $164 million on lobbying from 1999 through 2008.

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Canada’s Experience

• The general market’s acceptance of the high ratings on mortgage-backed securities belied the risk contained in these substandard products backing commercial paper issued by many major banks.

• The first banking regulator to see the danger to financial institutions in time to avert major damage was the Canadian banking regulators.

• Many firms incurred losses not thought possible just a year earlier in the United States and Europe.

• No Canadian banks went out of business during the Great Depression or during the recent financial crisis.

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What the Future Holds

• Since the creation of the Federal Housing Administration, the number of loans insured in any given year has varied dramatically.

• When high LTV loans were being readily purchased by the secondary market, the demand for FHA-insured loans virtually disappeared.

• When FNMA, FHLMC, and other players in the secondary market became insolvent, FHA became very popular again.

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What the Future Holds

• If anything has been learned from the disasters of 2008 through 2011, it is that proper oversight is critical.

• Private sector lending will always be the most important aspect of mortgage lending, but it must work in tandem with well structured, monitored, and controlled government programs.

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Home-Buyer Education Programs

• Many people are simply not familiar with normal real estate acquisition and lending procedures.

• Basic knowledge of how to acquire and finance real estate is critical.

• Prepurchase home-buyer education programs benefits many.

• Include finding more people who are eligible for home ownership.

• Education also makes borrowers more aware of their responsibilities to lenders, resulting in sound loans with fewer defaults.

• These programs have already proven their value to buyers and lenders.

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Questions for Discussion

1. Define security interest and how it has been used in real estate finance since the Industrial Revolution.2. What is meant by the term collateral? By hypothecation?3. What is the purpose of a promissory note? Of a mortgage?4. Describe the origin of a loan discount.5. What is the federal agency underwriting function and what does it do for the mortgage market, and ultimately for the borrower?6. Compare and contrast the two categories of bonds and how they differ from mortgage-backed securities and the collateral pledged for each.7. Distinguish between the functions of the primary and secondary mortgage markets.8. Discuss the effects of risk and term of a bond on the interest rate paid.9. What are some of the constraints on the recovery and growth of the GSE and private mortgage-backed securities market?10. How can pre-purchase home-buyer education programs affect the mortgage market?