John P. Wiedemer and J. Keith Baker - PowerPoint Presentation

Slide1

John P. Wiedemer and J. Keith Baker

REAL ESTATE FINANCE

Ninth EditionSlide2

2Chapter 1

History and Background

Circa 2000 B.C.E.Slide3

3LEARNING 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 financingSlide4

4Introduction

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.

O

ne

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.

O

nly

in the last several

hundred years

has it become possible for the average person to own land.

M

any

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. Slide5

5

ILLUSTRATION OF ACCOUNTING RECORDS

OF

SECURITY

TRANSACTION FROM 2900

BCSlide6

6Landownership - Allodial vs. Feudal

In Roman times, the allodial system

applied and ownership

of land by individuals was absolute.

A

s

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. Slide7

7Background 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.

Roman

Denarius

Medieval

FlorinSlide8

8Financing 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

. Slide9

9Compensation 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.

C

harging

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.

T

oday

, some borrowed money is paid for

with interest

only, some with discount only, and some by a combination of the two

.Slide10

10The 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. Slide11

11Financial Market Instruments

An increasing portion of the money for loans comes from the sale

of

securities,

rather than from

savings deposits.

S

ale

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.Slide12

12Where 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.Slide13

13Where 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.Slide14

14Stock Certificates

Shares of stock represent an ownership interest in a corporation

Stocks are

not

relevant to

the subject of real estate

finance.Slide15

15Bonds

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

. S

ecured

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:Slide16

16The Securities Market

Securities must be approved by Securities & Exchange Commission.

Approval

is

based on

the disclosure of

financial

information, not

value

.

S

ecurities

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.Slide17

17EXAMPLE

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.

I

f

the bond is sold prior

to maturity

, the holder could sustain a loss if the market is

down.Slide18

18EXAMPLE

$10,000 x 5% = $500$500 ÷ $10,000 = .05 (5%)$500 ÷ $9,250 = .0541 (5.41%)Slide19

19Commercial 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. Slide20

20Competitive 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.Slide21

21Investment Risk

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

E

ach

loan

carries some kind of default insurance

(PMI, FHA, or

VA).

A

bout

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.

L

ower

yield

requirements mean lower interest rates for the borrower.Slide22

22A Look at the Future

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

F

inancial 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.Slide23

23A 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.Slide24

24A 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.Slide25

25The 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.Slide26

26The Low Interest Rate Environment

A low interest rate environment created by two destabilizing events:

1. the technology stock bubble burst; and

2. terrorists attacked the United States.

T

he 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.Slide27

27The Refinance Boom

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

L

enders 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.

8%

4

%Slide28

28Housing 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. Slide29

29Falling Underwriting Standards

The profitability of mortgages caused lenders to further reduce underwriting

standards or simply ignore them. Slide30

30Fannie 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.Slide31

31Canada’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

.

M

any

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.Slide32

32What 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

.

W

hen

FNMA, FHLMC, and other players in the secondary market became

insolvent,

FHA became

very popular

again. Slide33

33What 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.Slide34

34Home-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.

P

repurchase

home-buyer

education programs benefits

many.

I

nclude 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. Slide35

35Questions 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?