10. Real Estate

Name: 10. Real Estate
Uploaded: 2012-04-05T14:53:20.000Z
Duration: 2 h 16 min 44 s

History of Mortgage Lending

Introduction to Mortgage Lending

The speaker introduces the topic by outlining a discussion on the history of mortgage lending, commercial real estate finance, and residential real estate finance.

Origins of the Term "Mortgage"

Professor Robert Shiller explains that "mortgage" comes from Latin "mortuus vadium," meaning "death pledge."

In medieval France, the term evolved with a French word for pledge. The historical context raises questions about why it was termed a death pledge.

Historical Context and Early Practices

Shiller references Yale historian Valerie Hansen's research on ancient trade documents from China's Tang Dynasty (7th-10th centuries), indicating early forms of loans but not mortgages as understood today.

Some Sogdian documents suggest that property or even slaves were mortgaged in ancient times, highlighting an early form of collateralized loans.

Development of Modern Mortgage Institutions

The modern concept of mortgages became more recognized in the late 18th century; Shiller cites an advertisement from 1778 in the Hartford Courant illustrating undeveloped mortgage practices.

An ad by Elisha Cornwell reveals complexities in property ownership and multiple mortgages on a single farm without clear title representation.

Legal Framework and Advancements

The lack of systematic title representation hindered mortgage development until government regulations improved property rights in the late 19th century.

Germany's Grundbuch law established a centralized system for property ownership records in 1872, paving the way for modern mortgage markets.

Global Perspectives on Property Rights

Understanding Property Rights and Mortgage Lending

The Importance of Established Property Rights

Many individuals rely on hearsay regarding property ownership, which is insufficient for financial transactions. Solid knowledge is essential to avoid differing opinions.

Inadequate laws in various countries hinder the establishment of property rights, affecting mortgage processes. Inefficient court systems can delay property seizure in case of non-payment.

Balancing Lender and Borrower Rights

While evicting a non-paying homeowner may seem harsh, it is crucial for maintaining the mortgage system's integrity; lenders must have recourse to reclaim properties.

The evolution of mortgage lending in the 20th and 21st centuries hinges on improving property rights definitions and lender capabilities.

Overview of Real Estate Ownership Structures

A focus on commercial real estate reveals that many properties are owned through partnerships rather than corporations due to favorable tax treatment.

Standardization in finance limits creativity; regulations often require adherence to established contracts, stifling innovation.

Tax Implications of Ownership Structures

Partnerships differ from corporations as they avoid double taxation—corporations face corporate profits tax while partners only pay personal income tax.

Direct Participation Programs (DPPs), typically available only to accredited investors, allow income from properties to flow directly as personal income without corporate taxation.

Limitations and Characteristics of DPPs

DPP structures are designed with limited lifespans, making them suitable for specific projects like single buildings rather than long-term enterprises.

Understanding Partnerships in Real Estate

Types of Partners in a Partnership

A partnership can consist of two classes of partners: general partners and limited partners. General partners manage the business and have unlimited liability, meaning they can be sued if the business incurs losses.

Limited partners are passive investors with limited liability, meaning their financial risk is capped at their investment amount.

The Role of Direct Participation Programs (DPP)

DPPs are often created by knowledgeable individuals in real estate to facilitate investments like the construction of buildings such as 360 State Street.

In real estate finance, a DPP allows investors to participate directly in profits rather than being mere shareholders.

Criticism and Limitations of DPPs

DPPs faced criticism for excluding small investors who were not accredited, limiting access to lucrative investment opportunities.

This exclusion raised concerns about double taxation on these investments, prompting discussions on why individuals couldn't invest in commercial real estate.

The Emergence of Real Estate Investment Trusts (REIT)

Introduction to REIT

In 1960, Congress established Real Estate Investment Trusts (REIT), aimed at democratizing finance by allowing small investors access to real estate investments without facing double taxation.

Requirements for REIT Qualification

To qualify as a REIT, companies must adhere to specific regulations: 75% of assets must be in real estate or cash; 90% of income must come from real estate-related sources; and 95% of income must be distributed as dividends.

Growth and Popularity of REIT

Initially slow to gain traction post-establishment, REIT popularity surged due to favorable market conditions and changes in tax laws affecting traditional partnerships.

Historical Context and Evolution

Booms Influencing REIT Development

The first boom for U.S. REIT occurred when interest rates rose above deposit ceilings, making them attractive compared to savings banks.

A second boom followed the tax reform act of 1986 that reduced advantages for DPP partnerships, leading more investors towards REIT options.

Long-Term Trends in Finance Innovation

History of Mortgage Lending in the U.S.

Overview of Home Ownership

In the U.S., home ownership is prevalent, with about two-thirds of households owning their homes, a trend supported by government policies promoting mortgage lending.

High home ownership rates are also observed in other countries, indicating a global pattern influenced by similar governmental strategies.

The Great Depression and Its Impact on Mortgages

The Great Depression led to a severe housing crisis in the 1930s, following the 1929 Stock Market Crash, resulting in falling home prices and widespread mortgage defaults.

Prior to this period, mortgages typically had short terms (2-5 years) with balloon payments due at the end, creating financial instability for homeowners.

Consequences of Short-Term Mortgages

Borrowers would often take loans for half the home's value but faced challenges when needing to refinance as unemployment rose and home values plummeted during the Depression.

Many homeowners were unable to secure new loans due to job loss and decreased property values, leading to foreclosures and significant financial losses.

Government Intervention: FHA's Role

In response to the crisis, the Roosevelt Administration established the Federal Housing Administration (FHA) in 1934 to stabilize mortgage lending practices.

The FHA introduced mortgage insurance to protect lenders against borrower defaults, encouraging them to lend again amidst economic turmoil.

Innovations in Mortgage Terms

The FHA mandated that insured mortgages be at least 15 years long and prohibited balloon payments, aiming for more manageable repayment structures for borrowers.

Amortizing mortgages became standard; these allow fixed monthly payments without large sums due at maturity, reducing financial stress on families.

Evolution of Mortgage Length

Initially emphasizing 15-year terms, by the early 1950s, FHA promoted 30-year mortgages as a way to accommodate young families purchasing their first homes.

This longer term provided stability with guaranteed interest rates over three decades while ensuring predictable monthly payments for homeowners.

Understanding Monthly Payments

Understanding Mortgage Payments and Amortization

The Annuity Formula for Mortgages

The monthly payment, denoted as x, is calculated using the formula: textMortgage Balance = x/fracr12(1 - (1 + r/12)^-M) , where r is the annual interest rate. This represents the present value of a stream of payments.

Historical Context of Mortgage Calculations

Before computers, mortgage calculations were complex. Lenders had to use present value formulas to determine monthly payments based on borrowed amounts and interest rates.

Example from Historical Mortgage Tables

A 50-year-old mortgage table shows that for a 10-year mortgage at 5%, the monthly payment per $1,000 borrowed is $10.61. This amount was derived from calculations ensuring that the present value equaled the loan amount.

Breakdown of Monthly Payments

Each month’s payment consists of both principal and interest. For instance, with an initial balance of $1,000 at 5% interest, the first month's interest is $4.17 while principal repayment is $6.44.

Changes in Payment Structure Over Time

As time progresses, the portion allocated to interest decreases while principal repayment increases due to decreasing loan balances. After six years and six months, remaining balance drops significantly to $407.61.

The Unique Nature of Fixed Rate Mortgages

Global Perspective on Fixed Rate Mortgages

Conventional fixed-rate mortgages are primarily found in only two countries: the United States and Denmark, despite being available elsewhere but not commonly used.

Risks Associated with Long-Term Mortgages

Alistair Darling highlighted that countries without long-term fixed-rate mortgages risk crises similar to those experienced during the Great Depression when homeowners could lose their homes en masse.

Consumer Resistance to Long-Term Mortgages

Consumers often resist long-term mortgages due to higher associated costs; lenders charge more for guarantees over extended periods which can deter potential borrowers.

Regulatory Challenges for Banks

Understanding the Role of Government in Mortgage Markets

The Need for Coordinated Efforts

A coordinated government effort is essential to ensure regulators accept new financial concepts, which may involve public risk regarding potential bank bailouts.

Public resistance must be addressed by clarifying that fixed-rate mortgages are straightforward contracts, providing stability over 30 years.

Historical Context of Mortgage Issues

In Canada during the 1980 crisis, rising interest rates led to widespread mortgage refinancing issues, resulting in significant home losses.

Despite past problems, Canada has not focused on fixed-rate mortgages as a solution even today.

Innovations in Mortgage Financing

Securitization of mortgages and government support were pivotal innovations; the Federal National Mortgage Association (Fannie Mae) was established in 1938 under Roosevelt's administration to bolster the mortgage market.

Transition from Government to Private Corporations

Fannie Mae was privatized in 1968 but continued buying mortgages from banks to stimulate lending and housing construction post-Great Depression.

Freddie Mac was created in 1970 as another entity similar to Fannie Mae, tasked with purchasing and repackaging mortgages into securities.

The Role of Fannie Mae and Freddie Mac

Both organizations operate as private companies despite their government origins; they buy loans from lenders and repackage them into securities with guarantees against defaults.

These securities provide investors with a safety net due to guarantees from Fannie or Freddie while also involving complex insurance agreements.

Concerns Over Government Backing

There were concerns about whether taxpayers would ultimately bear the cost if these corporations failed despite being labeled private entities by the government.

Government Securities and the Role of U.S. Government

Misleading Information in Financial Reporting

The Wall Street Journal published an article titled "Government Securities," which misled Chinese investors into believing they were investing in government-backed securities.

George Bush faced a dilemma regarding the potential bankruptcy of agencies like Fannie Mae and Freddie Mac, as it could damage the U.S.'s reputation for financial safety.

Government Intervention and Conservatorship

To prevent global investor backlash, the U.S. government placed Fannie Mae and Freddie Mac under conservatorship to ensure their debts were paid and avoid defaults.

This situation illustrates that despite claims of non-guarantee, the government often ends up backing these entities.

Comparison with Canadian Housing Finance

Canada has a similar entity called the Canada Housing and Mortgage Corporation, which is government-owned unlike its U.S. counterparts.

The Canadian system is smaller than Fannie Mae and Freddie Mac, leading to less visibility in international markets.

Economic Resilience and Differences

Despite similarities between Canada and the U.S., Canada did not experience a housing bubble due to more conservative mortgage support policies.

Canada's economy was somewhat insulated from housing issues during global recessions because it benefited from being an oil exporter.

Factors Contributing to Housing Bubbles

The U.S. housing bubble was exacerbated by governmental pressure on agencies to increase lending to low-income communities.

In contrast, Canadian institutions did not face similar pressures, resulting in less severe housing market fluctuations.

Understanding Mortgage Securities

Types of Mortgage Securities

Collateralized Mortgage Obligations (CMOs) are structured securities that divide mortgage risks into different tranches based on prepayment risk.

CMOs can have varying ratings; some may be rated AAA while others carry higher risks depending on their structure.

Risks Associated with CDO Investments

Collateralized Debt Obligations (CDOs), often containing subprime mortgages, were marketed as low-risk investments but many defaulted during economic downturns.

Rating agencies like Moody's provided high ratings for these securities, misleading global investors about their safety.

Complexity of Mortgage Origination Process

Understanding Mortgage Securitization and Reforms

The Complexity of the Financial System

The mortgage servicer operates as a separate entity, indicating the complexity of the financial system involving various originators like CMO and CDO.

Following the collapse of this complex system, discussions arose about potential reforms to prevent future crises, with some advocating for a complete overhaul.

Key Legislative Changes

A significant reform in both Europe and the U.S. mandates that mortgage originators retain 5% of the mortgage balance in their portfolios, aimed at reducing moral hazard.

This requirement was incorporated into the Dodd-Frank Act in the U.S., reflecting efforts to maintain mortgage securitization while addressing issues that led to past crises.

Addressing Moral Hazard

There were instances where mortgage brokers encouraged families to inflate their income figures, demonstrating a lack of accountability among originators.

New laws aim to discourage unethical practices by ensuring that brokers have a vested interest in the mortgages they originate.

Licensing and Regulation Improvements