Real Estate Finance Spring 2016
Dean Don Weidner
• Nine sets of slides for the Spring 2016.
– Are available on my web page under “Course Materials.”
– 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 under Course Materials and on
the web Blackboard for this course under “Syllabus”.
•
Assignments.
– We shall proceed directly though the Syllabus
– The slides will take us directly through content indicated
in the Syllabus and also include additional material not in
the Text or in the Supplement.
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Donald J. Weidner
Background on Contracts and Conditions
Seller
Listing
Agreement
Contract of
Sale
Broker
“Interim Contract”
Buyer
Closing
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.
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Donald J. Weidner
Contract Conditions
• Text says conditions “are essentially substitutes
for information.”
– About legal title, physical condition, availability of
financing
• However, 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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Donald J. Weidner
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.”
– That part can have, in effect, an option
• “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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Donald J. Weidner
Illusory Contracts (cont’d)
• 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 are split on
their role in applying the “good faith”
requirement (or rubric).
• As we shall see in more detail
»Good faith can serve either as a gap
filler or as a mandatory rule
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Donald J. Weidner
Homler v. Malas
(Text p. 92)
• Seller sought to specifically enforce a buyer’s
promise to purchase a single-family residence.
• Contract, on a standard form, had a “subject to
financing” clause that conditioned Buyer’s
performance
– on Buyer’s “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.
• Should this contract be specifically enforced
against the buyer?
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Donald J. Weidner
Homler v. Malas (cont’d)
• 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 buyer’s 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?
• Especially in this case, with a single family
residence?
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Donald J. Weidner
Homler v. Malas (cont’d)
• Court said: it is not as if the contract had specified
interest at the “current prevailing rate.”
• However, the contract assumed a search for thirdparty 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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Donald J. Weidner
Homler v. Malas (cont’d)
• How would you decide this case?
• Court concluded the contract was too “vague and
indefinite” to be enforced against the buyer and ordered
the buyer’s 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 that the seller was attempting to
use good faith as more than a gap-filler?
• “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?
• Did the contract merely give Option to Buyer?
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Donald J. Weidner
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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Donald J. Weidner
Liuzza v. Panzer
(Text p. 94)
• Contract to sell and to buy for $37,500.
• 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%.”
• 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,
or $25,720, which is less than the $30,000 loan
condition mentioned in the contract.
• Can the Buyer walk away from the deal at this
point?
– That is, before refusing to close, what more, if
anything, must Buyer do to avoid breaching the
Buyer’s implied obligation to act in good faith?
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Donald J. Weidner
Kovarik v. Vesely
(Text p. 95)
• 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 Seller’s offer
of seller financing?
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Donald J. Weidner
Kovarik v. Vesely (cont’d)
• Court rejected the Buyer’s 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 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].”
– Is there one transaction or two?
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Donald J. Weidner
Kovarik v. Vesely (cont’d)
• To fill any gaps, consider 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
• However, that does not mean that the
buyer should be forced to accept purchase
money financing from the seller.
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Donald J. Weidner
Kovarik v. Vesely (cont’d)
• 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.
– Even if good faith is a mandatory rule that could be
applied to trump the language of the contract in this
case, the question is what the mandatory rule requires.
• 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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Donald J. Weidner
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 terms—the terms under which
principal is repaid
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Donald J. Weidner
Loan to Value Ratio
• May be set in statute, regulation or internal
policies.
• Examples of statutory language used to
mandate maximum loan to value ratios:
– appraised value
– estimated value
– reasonable normal value
– estimated replacement cost
– actual cost
• These terms are subject to a range of
interpretations
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Donald J. Weidner
Loan to Value Ratio (cont’d)
• Many lenders believe that the loan/value ratio is
merely an obstacle that fails to serve the stated
purpose of protecting the institution.
– They believe that there is greater protection in
exacting credit standards, increased site
scarcity, inflation or other factors
– Or, they are simply very eager to do a deal.
– They might also be planning to sell the loan
and thus avoid any risk attendant to it—they
have no “skin in the game”
• Therefore, they often avoid the ratio
– OR, increase the appraisal. See slide Set #2
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Donald J. Weidner
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 benefit of lower debt service has a cost:
the longer the term, the more interest the
borrower pays.
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Donald J. Weidner
Rate of Interest
• The greater the rate of interest, the greater
the Debt Service.
• For example, consider 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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Donald J. Weidner
Points
• “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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Donald J. Weidner
SELF AMORTIZING LOANS
Loans that are fully repaid, at the end of the debt service schedule, without
the requirement of a payment larger than those that have gone before.
First type: Constant Payment
DEBT SERVICE COMPONENTS
...
PASSAGE OF TIME
Principal
Interest
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Donald J. Weidner
SELF AMORTIZING
Second Type: Constant Amortization
DEBT SERVICE COMPONENTS
...
PASSAGE OF TIME
Principal
Interest
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Donald J. Weidner
NON SELF AMORTIZING
DEBT SERVICE COMPONENTS
BALLOON
...
PASSAGE OF TIME
Principal
Interest
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Donald J. Weidner
Goebel v. First Federal (1978)
(Text p. 368)
1.
2.
3.
4.
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 & L’s 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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Donald J. Weidner
Goebel (cont’d)
• 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].
• Court’s said it construes 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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Donald J. Weidner
Goebel (cont’d)
•
As to whether the lender could increase
monthly Debt Service, court said expressio
unius controlled: The note contained provisions
to increase Debt Service in some situations but
did not exlressly 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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Donald J. Weidner
Goebel (cont’d)
•
As to whether the lender could increase
the term (the length of the loan), the court
focused on note provision 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 Borrower’s benefit.
– And, therefore, Borrower could not be
forced to continue to pay debt service for
a longer term
•
Enforcing the parties’ intent?
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Donald J. Weidner
Goebel (cont’d)
•
How else could you implement the interest
increase provisions (if you can’t increase either
the amount of the monthly payments or the term
of those payments)?
• 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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Donald J. Weidner
Note to Goebel v. First Federal
• No argument was made that an interest increase was
unconscionable or otherwise illegal.
• See also Constitution Bank (Text p. 378): “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.”
– Recall, “good faith” can be a “gap filler” to salvage an otherwise
indefinite contract, particularly by importing the general business
practice.
– Recall, too, that the borrower in Goebel had the option to prepay
without penalty upon an interest rate increase.
• Indicating that market forces would limit the lender from
exacting an increase.
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Donald J. Weidner
Pre-”Great” Depression Residential Financing
• Amount. At least theoretically, loan/value ratios were
very low, typically 50-60% of appraised value.
– Lenders stretched their appraisals.
– Borrowers took out second, third (“junior”) 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 than first mortgages.
• Amortization Terms: Balloons were common.
In the Great Depression: 1 million American families
lost their homes to foreclosure between 1930-1935
(many fewer than in years following 2006).
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Donald J. Weidner
Post-”Great” Depression Mortgage Insurance
Transformed Mortgage Terms
• 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 the debt service on the larger loan
amounts, 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 only insure
consumer loans that were fully self-amortizing.
The fundamental Lesson of Great Depression
seemed to be: never require a consumer to pay Debt
Service that escalates over time.
--We subsequently forgot or rejected that lesson.
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Donald J. Weidner
The American Dream of Home Ownership
Americans Living in their
Own Homes (text 352)
• 1940
41%
• 1950
53%
• 1960
62%
• 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 Chairman Alan Greenspan’s Federal Reserve Board for keeping
interest rates too low for too long. Later at the helm of the Fed from 2006-14, Ben
Bernanke said that he did not. From 2002-2005, he had been on the Fed Board of
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Donald J. Weidner
“NEW” TYPES OF CONSUMER MORTGAGES
(After the “Great Depression” and Before the
Crash) (Text p. 374)
1) Adjustable Rate Mortgage (ARM) (a.k.a.
“Variable Rate Mortgage” or VRM)
2) Graduated Payment Mortgage (GPM)
–
3)
4)
5)
6)
And its variant the Growing Equity Mortgage
(GEM)
Renegotiable Rate Mortgage (RRM)
Shared Appreciation Mortgage (SAM)
Price Level Adjusted Mortgage (PLAM)
Reverse Annuity Mortgage (RAM)
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Donald J. Weidner
1) ADJUSTABLE RATE MORTGAGE
• Interest rate rises and falls according to some
predetermined standard.
– Often used in commercial transactions.
• 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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Donald J. Weidner
Adjustable Rate Mortgages (cont’d)
Mechanisms to protect 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 (ex., creditworthiness, value
decline)
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Donald J. Weidner
Adjustable Rate Mortgages (cont’d)
• Mechanisms to protect Consumers
(cont’d)
“Balloon” disclosure rules may define a
balloon more narrowly than simply as a
note that requires any payment at the
end of the debt service schedule larger
than those that came before
• Ex., Florida defines it as any payment more than
twice the size of a preceding payment.
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Donald J. Weidner
2) GRADUATED PAYMENT MORTGAGE
• Monthly payments are from the outset scheduled
to gradually rise (independent of any fluctuations
in rates), while the interest rate and the term of
the loan may stay the same.
• 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 are not sufficient to
amortize the debt or even to pay all the
interest, but subsequent larger debt service
payments make up for it.
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Donald J. Weidner
GRADUATED PAYMENT MORTGAGE (cont’d)
• The Growing Equity Mortgage (p. 375) is another form of
mortgage that involves increasing debt service.
• Text discusses it as a “long term, self-amortizing
mortgage under which the borrower’s monthly payments
increase each year by a predetermined amount, typically
4%.”
– Apparently, it never goes negative as to interest or
principal.
– That is, equity “grows” throughout the life of the loan
• Note: a borrower (such as your humble servant) can tailor his or her own
growing equity provisions with prepayment privileges.
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Donald J. Weidner
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.
– Patterned after pre-depression instruments, says the
text.
• 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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Donald J. Weidner
4) SHARED APPRECIATION
MORTGAGE (p. 375)
• Lender agrees to lend, for example, at a flat rate
below the current market rate in return for
borrower’s 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 lender’s
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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Donald J. Weidner
5) PRICE LEVEL ADJUSTED MORTGAGE
• It is the loan principal, NOT the interest
rate, that varies over the term of the
mortgage.
• The principal is adjusted up or down
according to a prescribed inflation index.
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Donald J. Weidner
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 borrower’s 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 borrower’s
estate.
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Donald J. Weidner
New Mortgages (cont’d)
• The Garn-St. Germain Depository Act of 1982
“preempts state regulations of nontraditional
mortgages that are more stringent than
counterpart federal regulations.” Text p. 377.
– The Act also gave the states limited time to
reinstate their programs and very few did.
• Similarly, Congress, preempted “any state
statute or constitutional provision that limited
interest rates on first lien, residential mortgage
loans.” Id.
– Other real estate loans are not covered.
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Donald J. Weidner
Growth of Securitization of Real Estate Debt
(See p. 352)
• 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.
(“For most of its early history, it operated like a national S & L,
gathering funds by issuing its own debt, and buying mortgages that
were held in portfolio.”)
• 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. It was responsible for promoting the MBS.
– According to their 2015 web site, they do not “buy or sell loans or issue
mortgage-backed securities (MBS).” Rather, they “guarantee investors the
timely payment of principal and interest on MBS backed by federally insured or
guaranteed loans,” mainly loans insured by the FHA or VA. It also says that
“Ginnie Mae securities are the only MBS to carry the full faith and credit
guaranty of the United States government . . . .”
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Donald J. Weidner
Growth of Debt Securitization in Real Estate
(cont’d)
• In 1968, Fannie Mae “was moved off the federal budget
and set up as a private GSE, which in the 1970s
switched its focus toward conventional loans.”
– It was “given the authority to buy and sell
conventional (non-federally insured) home mortgage
loans.” (see p. 353)
• 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.
– “Like Fannie Mae, it is a private GSE and also is offbudget.” (Text at 353).
– They compete in buying and selling mortgages.
– It initiated the first MBS program for conventional
loans.
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Donald J. Weidner
Growth of Securitization in Mortgages
• In short, Fannie Mae and Freddie Mac buy
and sell mortgages, both federally insured
and conventional, and issue Mortgage
Backed Securities
– Whereas Ginnie Mae guarantees investors
that they will receive timely payment of
principal and interest on MBS backed by
federally insured or guaranteed loans
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Donald J. Weidner
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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Donald J. Weidner
Federal Reserve Policy
• When the Federal Funds Rate was only 1%, Federal
Reserve Chairman Alan Greenspan announced that the
Federal Open Market Committee 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
– When Treasury obligations were not paying investors
very much,
– They turned to mortgaged-backed securities for higher
yields 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 in mortgage backed
securities.
– He later acknowledged that he had overestimated the
discipline of the markets.
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Donald J. Weidner
“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 nation’s $6.5 trillion mortgage
securities market was even larger than the United States
treasury market.
• As of 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.”
• Yet some financial institutions were still making rosy
projections based on the assumption of no fall in home
prices.
• 35% of all mortgage securities issued in 2006 were in the
subprime category.
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Donald J. Weidner
Crisis Looms in Mortgage Market (cont’d)
• Subprime Lenders created “affordability products,”
mortgages that
– Require little or no down payment
– Require little or no documentation of a borrower’s
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.”
• Loan to value ratios increased
– with generous appraisals
51
Donald J. Weidner
Crisis in Mortgage Market (cont’d)
• “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.
• These “opaque securities” were hard to value. Their
“values” were often propped up or overstated.
– “Only when a security is downgraded by a rating agency do
investors have to mark their holdings [down] to the market value.”
• The financial statements made investors looked stronger than they were, and
people started to realize it.
52
Donald J. Weidner
Crisis in Mortgage Market (cont’d)
• 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.
53
Donald J. Weidner
Banks Sue Originators on Repurchase Agreements (Supp. p. 8)
Carrick Mollenkamp, James R. Hagerty, Randall Smith, “Banks Go on Subprime
Offensive,” The Wall Street Journal, March 13, 2007
• British bank HSBC leads the early 2007 charge to enforce
repurchase agreements.
• “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.
• “Banks like HSBC bought mortgages from ever-smaller
brokers and originators to increase their loan volume when
the subprime industry was booming in 2005 and 2006.”
54
Donald J. Weidner
Rating Agencies
• Credit rating agencies are supposed to assess
risk of investment securities—however, 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 didn’t include the newer, more risky mortgages
– Nor did it anticipate falling real estate prices
55
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 MBSs or CDOs [collateralized debt
obligations]) did not have
– “real market prices. They could be valued
according to models, which made for nice,
consistent profit reports” for the people who
bought them.
56
Donald J. Weidner
The Rating Agencies (cont’d)
• “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.”
• “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.”
57
Donald J. Weidner
The Rating Agencies (cont’d)
• “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.
58
Donald J. Weidner
The Rating Agencies (cont’d)
• The SEC began 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. [would you buy a house
and rely on an appraisal that had been paid for
by the seller?] [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.)”
59
Donald J. Weidner
The Rating Agencies (cont’d)
• By November 2007, the securitization market had
collapsed but the stock market had not yet collapsed.
• Investors in the more transparent stock market “want to
believe that the Federal Reserve can cure all problems
by cutting the overnight bank lending rate.”
• However, the collapse of securitization 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.”
– Ironically, the Dodd Frank Wall Street Reform and Consumer
Protection Act (“Dodd Frank”), passed in 2010 in the wake of
the financial crisis, provided that governmental agencies could
no longer require the imprimatur of a rating agency.
60
Donald J. Weidner
The Rating Agencies—2015 Update
• In February of 2015, Standard & Poor’s agreed
to pay $1.375 billion to settle civil charges
brought by the U. S. Department of Justice and
by 19 state Attorneys General that it inflated its
ratings on the mortgage-backed securities that
were at the heart of the financial crisis.
• Separately, S & P agreed to pay CALPERS (the
California Public Employee’s Retirement
System) $125 million.
61
Donald J. Weidner
Collateralized Debt Obligations
• Securitization is essentially the sale of an interest in a
package of receivables (such as the right to receive
payments to service mortgage or credit card debt).
• 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 (contracts allegedly to insure investors against
defaults)
62
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.”
63
Donald J. Weidner
Securitisation, When it goes wrong . . . .
(cont’d)
• 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 markets—”they can offload
credits to far-away investors such as insurers or hedge
funds.”
3. Studies suggest the “secondary market” for bank debt
“has helped to push down borrowing costs for
consumers and companies alike.”
64
Donald J. Weidner
Securitisation, When it goes wrong . . . .
(cont’d)
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 ultimately admitted that the
Fed was mistaken to assume efficient capital markets].
5. Broadens the distribution of credit risk “reduces the
risk of any one holder going bust.”
By 2007, the Economist reported the crisis had exposed
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.
65
Donald J. Weidner
Securitisation, When it goes wrong . . . .
(cont’d)
1.
Problem # 1: complexity: “financiers did not fully understand what
they were trading.”
– “[F]inancial engineering raced ahead of back offices and riskmanagement departments”
• “leaving them struggling to value or account for their
holdings.”
– Duke’s Steve 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.
66
Donald J. Weidner
Securitisation, When it goes wrong . . . .
(cont’d)
In mortgage securitisation, the lender is supplanted by
--the broker [who brings the borrower to the originator]
[charging fee]
--the loan originator [charging fee]
--the servicer (who collects payments) [charging fee]
--the arranger [who bundles the mortgages] [charging fee]
--the rating agencies [that rate the bundles] [charging fee]
--the mortgage-bond insurers [charging fee] [by January of
2008, there was widespread concern over their stability]
--the investor (the “ultimate holder of the risk”)
67
Donald J. Weidner
•
Securitisation, When it goes wrong . . . .
(cont’d)
“This creates what economists call a principal-agent
problem.”
– The principal-agent problem occurs when one person (the
agent) is able to make decisions on behalf of, or that
impact, another person or entity (the principal). The
problem exists because the agent may be motivated to
act in its own best interests rather than in the interests of
the principal.
– “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
(some institutions were pressured to sell after things
went bad and there was no market)
68
Donald J. Weidner
Securitisation, When it goes wrong . . . .
(cont’d)
3. Problem #3: Regulations were gamed.
• Only now are the politicians looking at the rating agencies.
• “The agencies appear to have been too free in giving out
AAA badges to structured products, especially CDOs.”
– “[T]heirs is one of the few businesses where the appraiser
is paid by the seller, not the buyer.”
– The agencies had little incentive to monitor their ratings
after issuing them.
• “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.
69
Donald J. Weidner
Securitisation, When it goes wrong . . . .
(cont’d)
Looking forward:
• “Investors need to know who is holding what and how it should be
valued.”
• Regulators may call for consistent evaluation of assets across firms.
• 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.”
– [The 2015 settlements with the Justice Department and with
CALPERS more closely align the interests of the rating agencies
and investors].
• “[T]he transformation of sticky debt into something more tradeable,
for all its imperfections, has forged hugely beneficial links between
individual borrowers and vast capital markets that were previously
out of reach.”
70
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.
– In August, 2007, Lehman Brothers closed its subprime mortgage lender, BNC
Mortgage.
• According to the Economist, as far into the mortgage crisis as early
2008, politicians “were counting on Fannie Mae and Freddie Mac . .
. to bolster the housing market by buying more mortgages.”
• By July 2008, it was clear that “the rescuers themselves have
needed rescuing.”
– The stock in both Fannie and Freddie had crashed.
• On July 13, 2008, Treasury Secretary Hank Paulsen said he would
ask Congress to [1] extend the Treasury’s credit lines to Fannie and
Freddie and even [2] buy their shares if necessary.
• Separately, the Fed said it would [3] give Fannie and Freddie
financing at its discount window (as if they were banks).
•
In September, 2008, Lehman Brothers filed for bankruptcy protection.
• On October 3, 2008, Congress [4] passed the TARP rescue
package (see subsequent slide).
71
Donald J. Weidner
Fannie Mae and Freddie Mac: End of Illusions
(Supp. P. 22)
•
As we have seen, Fannie (Federal National Mortgage
Association and Freddie (Federal Home Mortgage
Corporation) [aka, the “GSEs” [Government Sponsored
Entities]
–
•
“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 mortgagebacked securities; they guaranteed buyers of those securities
against default.”
Investors saw through the illusion that the debt issued
by Fannie and Freddie was not backed by the
government.
72
Donald J. Weidner
Fannie Mae and Freddie Mac: End of
Illusions
(Cont’d)
• The belief in the implicit government guarantee of the
obligations of Fannie and Freddie:
1. Permitted them to borrow cheaply.
• They engaged in a “carry trade”—they 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!
• $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.”
73
Donald J. Weidner
Fannie Mae and Freddie Mac: End of Illusions
(Cont’d)
• However, in the late 1990s, they moved into
another area: buying the mortgage-backed
securities that others had issued.
– Fannie and Freddie were operating as hedge funds.
– “Again, this was a version of the carry trade; they
used their cheap debt financing to buy higher-yielding
assets.”
– Fannie’s outside portfolio grew to $127 billion by the
end of 2007.
• Leaving them exposed to the subprime assets they
were supposed to avoid.
• Investors fell for the illusion that American house
prices would not fall throughout the country.
74
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 treating residences as
investment vehicles, and non-real estate
professionals were buying multiple
residences to “flip”
• Despite the rise in prices, the median
household income was flat between 20002007.
75
Donald J. Weidner
The Housing Bubble
• Therefore, the more prices rose, the more
unsustainable the rise of prices and increased
financing costs.
• By late 2006, the average home cost nearly 4
times what the average family earned
– 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.
76
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 and hence less
stable
77
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
78
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.
79
Donald J. Weidner
TARP (cont’d)
• 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), AIG and other financial institutions
• AIG had experienced its own financial crisis because of the
credit default swaps (CDSs) it issued
– It went far beyond its successful core insurance business
to sell massive amounts of Credit Default Swaps
– Investment banks and other financial institutions has also
issued CDSs
80
Donald J. Weidner
Credit Default Swap (CDS)
• A credit default swap is a contract under which the seller
of the contract agrees to compensate the buyer of the
contract in the event of a loan default in a referenced
loan.
– Simply, the purchaser of an MBS (for example) could
buy a CDS from a seller (ex., AIG), to pay the
purchaser in the event of a default on the MBS or
other credit event.
• However, anyone could buy a CDS. You did not have to
own the MBS or have an insurable interest. These were
“naked” CDSs, or bets.
• By the end of 2007, there were an estimated $62 trillion
in outstanding CDSs.
– Compared to the $18 trillion 2015 U.S.A. GDP
81
Donald J. Weidner
The Federal Reserve Response
In 2008, the Federal Reserve:
1.cut the discount rate, the rate on loans to
banks, to near zero; and
2.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
82
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
83
Donald J. Weidner
The Federal Reserve Response (cont’d)
• 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.
– The basic idea is that, if the Federal Reserve
Bank buys Treasury obligations (or
mortgage-backed securities), it bids up the
price of those securities, and hence lowers
the yield on them.
• 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.
84
Donald J. Weidner
Federal Reserve Response (cont’d)
• 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 its stated policy of making the equity
markets more attractive than the low-yielding debt
markets
85
Donald J. Weidner
Federal Reserve Response (cont’d)
• 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
86
Donald J. Weidner
Federal Reserve Response (cont’d)
• In December 11, 2012, the Fed also announced it would
spend $45 billion a month on long-term Treasury
purchases.
• The mortgage bond purchasing program, plus this
treasury obligation purchasing program, equaled $85
billion a month in securities being purchased by the Fed.
– Again, as the Fed drove down yields on debt,
investors were forced to buy other assets to get yield
• 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
87
Donald J. Weidner
Federal Reserve Response (cont’d)
• Also on December 11, 2012, in an unprecedented
move the Fed said it planned to keep its key shortterm 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 October 2015 was 5
percent.
– With still no increase in interest rates.
– And none of the inflation that critics predicted.
88
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
• The “taper” was concluded in October 2014.
89
Donald J. Weidner
Where to Next?
• In December 2015, the Fed raised the key rate for
the first time since 2006, by .25%.
– Unemployment rate at 5%. Intermediate term objective
of at least 2% inflation.
• They now say they will watch to make sure that
unemployment remains low and that inflation stays
high enough.
• While central banks around the world are still
keeping rates extremely low.
• “We frontloaded, at the Federal Reserve, an
enormous rally, in order to accomplish a wealth
effect.” Former President of the Federal Reserve Bank of Dallas, Richard
Fisher, on CNBC, 1/6/16. He would have raised rates long ago.
90
Donald J. Weidner
The Return of Securitization (Supp. P. 29)
•
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 (European Central Bank) “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.
91
Donald J. Weidner
The Return of Securitization (cont’d)
• “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.
92
Donald J. Weidner
The Return of Securitization (cont’d)
• “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.’”
– See also Section 941 of Dodd Frank, the “credit risk
retention rule,” which requires mortgage securitzers to keep
certain “skin in the game.”
• Or, in the words of the Senate Report, it requires “those
who issue, organize, or initiate asset-backed securities,
to retain an economic interest in a material portion of the
credit risk for any asset that securitizers transfer, sell, or
convey to a third party.”
– There is an exception for “qualified residential
mortgages”
• “Another tightening of the rules makes ‘re-securitizations’, where
income from securitised products was itself securitised, more
difficult.”
– Dodd Frank also addressed this problem.
93
Donald J. Weidner
Post Mortgage Meltdown (Text p. 382)
• In 2008, the Federal Reserve Board
adopted a rule under the Truth in Lending
Act that prohibits creditors from making
“higher-price mortgage loans” without
assessing consumers’ ability to repay.
– Compliance is presumed if certain
underwriting practices followed.
94
Donald J. Weidner
Dodd Frank
• In 2010, the Dodd-Frank Wall Street Reform and
Consumer Protection Act required that, “for
residential mortgages, creditors must make a
reasonable and good faith determination . . . that
the consumer has a reasonability ability to repay
the loan according to its terms.”
– With a presumption of compliance for
“qualified mortgages.”
– Creditors encouraged to refinance “nonstandard mortgages.”
95
Donald J. Weidner
Dodd-Frank (cont’d)
• Dodd-Frank puts the new Consumer Financial
Protection Bureau in charge of consumer fraud
and protection issues. The new Bureau took
over management of the Federal Reserve Board
rules requiring assessment of ability to pay.
• “In the commercial arena, originators of
mortgage backed securities will be required to
retain five percent of the credit risk on
mortgages placed into pools, reducing
incentives to sell weak mortgages to investors.”
Text at 389.
96
Donald J. Weidner