Real Estate Finance

Donald J. Weidner1

Real Estate Finance Spring 2014Dean Don Weidner

• Eight sets of slides for the Spring 2014.– Are available on my web page.– 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 and on the web Blackboard

for this course under “Syllabus”.• Includes some basic material for those with no

background• Assignments.

– We shall proceed directly though the Syllabus– The slides will also take us directly through the Syllabus.

Donald J. Weidner2

Seller Broker BuyerSellerBuyerLender

ListingAgreement

Contract of Sale

“Interim Contract”

Closing

Background on Contracts and Conditions

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.

Donald J. Weidner3

Contract Conditions• Text says conditions “are essentially substitutes for

information.” – About legal title, physical condition, availability of financing

• 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.

Donald J. Weidner4

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.”

• “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.”

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 split on their role in applying the “good faith” requirement

»As we shall see in more detail»Gap filler versus mandatory rule

Donald J. Weidner5

Donald J. Weidner6

Homler v. Malas,(Text p. 95)

• 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.

Donald J. Weidner7

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?

Donald J. Weidner8

Homler v. Malas (cont’d)

• Court said: it is not as if the contract had specified interest at the “current prevailing rate.”

• The contract assumed a search for third-party 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”

Donald J. Weidner9

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 a different argument?• “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?

• If not, did the contract merely give Option to Buyer?

Donald J. Weidner10

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.

Donald J. Weidner11

Liuzza v. Panzer(Text p. 98)

• 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

(which was less than the $30,000 loan amount mentioned in the contract as a condition).

• Can the Buyer walk away from the deal at this point?– Before refusing to close, what more, if anything,

must Buyer do to avoid breaching the Buyer’s implied obligation to act in good faith?

Donald J. Weidner12

Kovarik v. Vesely (Text p. 99)

• 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?

Donald J. Weidner13

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

• However, 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.

Donald J. Weidner14

Kovarik v. Vesely (cont’d)• Court also 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?

Donald J. Weidner15

Kovarik v. Vesely (cont’d)

• An alternative approach: A reasonable interpretation of the contract would look at the standard practice among savings and loan associations with respect to this particular type of loan.– That is, business practice and the rule of

reasonableness would fill in the gaps

Donald J. Weidner16

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 loan3) Rate of interest4) Amortization terms—the terms under which

principal is repaid

Donald J. Weidner17

Loan to Value Ratio

• May be in statute, regulation or internal policies.• Some legislative terms used to mandate maximum

loan to value ratios:– appraised value– estimated value– reasonable normal value– estimated replacement cost– actual cost

• Subject to a range of interpretations

Donald J. Weidner18

Loan to Value Ratio (cont’d)

• Many lenders believe that the loan/value ratio gets in their way and fails to serve as a meaningful protection to their shareholders.– 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.

Donald J. Weidner19

Appraisals: Three Basic Indications of (or ways of approaching) Value

1. Recent Sales of Comparable Properties

• Also known as “Market Data” Approach• The approach is less valid if there is an

inactive market or if the property is unique

2. Replacement Cost• Cost of replacing a building (and the land

under it) minus depreciation charges on the building

Donald J. Weidner20

Appraisals: Three Basic Indications of Value (cont’d)

3. Capitalized Value of Income (many methods):--Gross Rent Multiplier—very rough (and less valid if there are few or no sales of comparables)--Apply a Capitalization Rate to current net operating income—only slightly more refined--Estimate a stream of future cash flows and reduce it to its present value—more refined

Reconciliation relates these three factors (recent sales, replacement cost and capitalized value of income)-- it does not simply average them. A reconciliation may select one factor as the most important.

Donald J. Weidner21

Sales Price of Comparable Properties

Gross Rental Revenues of Comparable Properties

= Multiplier

GROSS MULTIPLIER Derive value from gross rentals

Assume a Recent Sale: 12 Million Sales Price

2 Million Gross Rental Revenue

= 6 [Gross Multiplier]

Applying this rough method, a comparable property with only $600,000 of

Gross Rent receipts would therefore have a $3,600,000 value (six times gross rent receipts)

($600,000 X 6 = $3,600,000)

Capitalizing Value of Net Operating Income

Begin by considering the net cash flow on a property you currently own and have financed.

Net cash flow is simply the sum of all cash receipts from operations minus all cash spent (ignoring any capital improvements), including debt service.

As we shall discuss more fully, to derive taxable income or loss from net cash flow, simply subtract the depreciation deduction and add back in amount paid to amortize debt.

Donald J. Weidner22

NCF versus NOINet Cash Flow=Rent Receipts–Real Estate

Taxes–Maintenance– Insurance–(Principal + Interest)

Now assume you are a buyer valuing a property and you don’t yet know how you will finance your acquisition. You might look at its net operating income.

Net Operating Income is NCF apart from the current owner’s debt service (principal and interest).

NOI = Rent Receipts – Real Estate Taxes – Maintenance – Insurance

Donald J. Weidner23

Donald J. Weidner24

CAPITALIZATION RATE Capitalize the value of the net operating income

Basic idea: x 8% = $1,000 per year

is how much an investor will pay for the right to receive $1,000 per year if the investor will insist on an 8% return on his or her investment.

In this example, is $12,500

A. If I expects an 8% cash return [stated in fractions]

The price

x 8/100 return = $150,000

Divide each side of the equation by 8/100

( x 8/100) x 100/8 = 150,000 x 100/8 = $1,875,000

B. If I expects a 12% cash return [stated in decimals]

.12 return = $150,000The price

x

Divide each side of the equation by .12

x .12/.12 = $150,000/.12 = $1,250,000

1)

2) 2)

1)

How Much Will An Investor Pay for a Building that has a $150,000 Net Cash Flow?

Capitalizing Value of NOI

• Another way of looking at Net Operating Income is as the amount of cash flow that is available to service your acquisition debt.

• How much would you pay for an annual NOI of a certain amount. Assume NOI of $300,000 and a 5% Cap Rate

• NOI of $300,000 = $6,000,000 .05

Donald J. Weidner25

Capitalizing Value of NOI

• Most of us are uncomfortable dividing by decimals. The following statement avoids dividing by decimals. Again, NOI is $300,000 and the Cap Rate is 5.

NOI x 100 = Value Cap. Rate300,000 X 100 = $6,000,000 5

Donald J. Weidner26

Capitalizing Value of NOI (cont’d)

• Suppose you expect a greater return on your investment, say, 8% rather than 5%. How much would you pay for that $300,000 operating income?

• $300,000 x. 100 = $3,750,000 8The higher the rate of return you expect, the

less you will value the income stream.

Donald J. Weidner27

Capitalizing Value of NOI (cont’d)

• Very simply (and rounded slightly)1 cap rate is 100 x. NOI ($300) = $30,000,0002 cap rate is 50 x. NOI ($300) = $15,000,0003 cap rate is 33.33 x. NOI ($300)= $ 9,999,0004 cap rate is 25 x. NOI ($300) = $ 7,500,0005 cap rate is 20 x. NOI ($300) = $ 6,000,0006 cap rate is 16.67 x. NOI ($300) = $ 5,001,000

Donald J. Weidner28

Donald J. Weidner29

DISCOUNTED NOI (NCF Apart from Debt Service)

Values property by a) estimating future net operating income for each year and b) discounting those future flows of cash to their present value. Discounting is the obverse of compound interest.

How much would you pay to purchase a 10-year position as landlord the right to receive $1,000 yr. rent for 10 years?

1 .833 x $1,000 = 8332 .694 x $1,000 = 6943 .5794 .4825 .4026 .3357 .2798 .2339 .19410 .162 x $1,000 = 162 $4,193

HYPO: What is the total present value of the right to receive $1,000 in cash at the end of each of the next ten years? Assume the investor requires a 20% rate of return. Because the 10, $1,000 payments are spread over the next 10 years, their total present value is the sum of the present value of each of the future payments. That Is:

Donald J. Weidner30

PLAZAOWNS THE BUILDINGBUILDING

LAND½

PLAZA½

HOTEL

CP

Operating

Agreement

SUBLEASE OF ½ FEE INTEREST

LEASE OF ½ FEE INTEREST

LEASE

Plaza Hotel Associates340 N.Y.S.2d 796 (N. Y. Sup. 1973)

Donald J. Weidner31

Plaza Hotel Facts• Lease provided for rent to increase to 3% of

the “value” of “all of the land,” exclusive of the building and improvements.

• It also provided that, if LL and T could not agree on value, appraisers would determine value.

• An appraisal valued the land alone at $28,000,000.

• Tenant sued to set appraisal aside on ground that it was too high because it was based on the assumption that the land was vacant and available for its highest and best use.

Donald J. Weidner32

Plaza Hotel Highlights• Court set aside the appraiser’s valuation, stating

that the appraiser “erroneously valued the land as available for its highest and best use, and not as already encumbered by the long term lease which restricts the use of the land to hotel purposes only.”– Wasn’t the appraiser’s approach based on standard

wisdom?• Consider: since the fee and the building on it

were separately owned, the fee could be sold separately. Hence, it is possible to ask: how much would someone pay for the fee.– How would you value the fee? Discount the cash flow?

• Having set aside the appraiser’s determination of value, the court undertook to determine value.

Donald J. Weidner33

Plaza Hotel Highlights• The court distinguished price from

value:– “Price is determined by short term factors

and by the caprices of the market.” – “Value . . . is dependent upon long term

factors and is directly related to the intrinsic worth of the property that resists the impact of temporary and abnormal conditions.”• “[V]alue, even more than price, is a

matter of judgment.”

Donald J. Weidner34

More from Plaza Hotel

• “The concept of a fluid market such as that existing in regard to corporate securities, where one sale can indicate the value at the time, is just not true with respect to real estate.”

• The lessee’s 3 appraisals of the land alone ranged from $8.5 million to $11.5 million.

• The lessor’s 3 appraisals of the land alone ranged from $33.3 million to $34.5 million.

Donald J. Weidner35

Plaza Hotel (cont’d)

• Plaza Hotel noted: – “In considering the opinions of the experts, the

court is not unmindful that ‘the appraisal of rental property necessarily involves the discretionary application of one or more accepted methods of computation’ and we must recognize that appraisers retained in litigated matters, within the limits of professional integrity, tend to adopt those formulae which favor their employer’s position.”

Donald J. Weidner36

A Different View on “Free and Clear” Appraisal

• Compare Taylor v. Fusco Management, 593 So.2d 1045 (Fla. 1992): “[T]he market value of leased property at the time a lessee exercises an option to purchase the property should be computed as if the property were unencumbered by the lease. Any intent to value the property otherwise should be clearly stated in the lease.”

• The lease was a 99-year lease. The price of the option to purchase, in the tenant’s view, was the present value of the rents (economically, a prepayment of the rent).– That is, the discounted cash flow (Slide 23)

Donald J. Weidner37

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 cost for the benefit of lower debt service: the longer the term, the more interest is paid.

Donald J. Weidner38

Rate of Interest• The greater the rate of interest, the greater

the Debt Service.• Example, a 25-year $100,000 home

improvement loan. Monthly Debt Service at– 4% is $ 528 (2012)– 6% is $ 644– 8% is $ 770– 10% is $ 908– 17% is $ 1,436 (1980)

Donald J. Weidner39

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.

Donald J. Weidner40

. . .PASSAGE OF TIME

SELF AMORTIZING LOANS

First type: Constant Payment

DEBT SERVICE COMPONENTS

Principal Interest

Donald J. Weidner41


SELF AMORTIZINGSecond Type: Constant Amortization


Principal Interest

Donald J. Weidner42


NON SELF AMORTIZING


BALLOON

Principal Interest

Donald J. Weidner43

Florida Statute on Balloon Mortgages(Supplement p. 36)

• Fla. Stat. sec. 697.05(2)(a)1 has its own definition of balloon mortgage.

• “Every mortgage in which the final payment or the principal balance due and payable upon maturity is greater than twice the amount of the regular monthly or periodic payment of the mortgage shall be deemed a balloon mortgage.”

Florida Statute on Balloon Mortgages(Cont’d)

• With certain exceptions, “there shall be printed or clearly stamped on such mortgage a legend in substantially the following form:– THIS IS A BALLOON MORTGAGE AND THE

FINAL PRINCIPAL PAYMENT OR THE PRINCIPAL BALANCE DUE UPON MATURITY IS $-----, TOGETHER WITH ACCRUED INTEREST, IF ANY, AND ALL ADVANCEMENTS MADE BY THE MORTGAGEE UNDER THE TERMS OF THIS MORTGAGE.”

Donald J. Weidner44

Donald J. Weidner45

Florida Statute on Balloon Mortgages(Cont’d)

• The statute also has special provisions concerning “the case of any balloon mortgage securing the payment of an obligation the rate of interest on which is variable or is to be adjusted or renegotiated periodically, where the principal balance due on maturity cannot be calculated with any certainty.”

• Failure of a mortgagee to comply with these provisions “shall automatically extend the maturity date of such mortgage.”

Donald J. Weidner46

Pre-Depression Residential Financing • Amount. At least theoretically, very low loan/value ratios,

typically 50-60% of appraised value. – Lenders stretched their appraisals. – Borrowers took out second, third, 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.

• 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).

Donald J. Weidner47

Post-Depression Mortgage Insurance• 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 debt service, 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 insure only fully self-amortizing loans. Fundamental Lesson of Great Depression seemed to be: never require a consumer to pay Debt Service that escalates.--We subsequently forgot or rejected that lesson.

Donald J. Weidner48

The American Dream of Home Ownership

Americans Living in their Own Homes

• 1940 41%• 1950 53%• 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 borrowersMany also fault Chariman Alan Greenspan’s Federal Reserve Board for

keeping interest rates too low for too long. Ben Bernanke does not.

Donald J. Weidner49

1) Adjustable Rate Mortgage (ARM) (a.k.a. “Variable Rate Mortgage” or VRM)

2) Graduated Payment Mortgage (GPM)3) Renegotiable Rate Mortgage (RRM)4) Shared Appreciation Mortgage (SAM)5) Price Level Adjusted Mortgage (PLAM)6) Reverse Annuity Mortgage (RAM)

“NEW” TYPES OF CONSUMER MORTGAGES(Text p. 409)

Donald J. Weidner50

1) ADJUSTABLE RATE MORTGAGE• Interest rate rises and falls according to

some predetermined standard.• 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)

Donald J. Weidner51

Adjustable Rate Mortgages (cont’d)

Protections provided for consumers:Limit the frequency of interest rate increasesLimit the magnitude of each interest rate increaseLimit the total amount of interest rate increasesRequire 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

Donald J. Weidner52

Adjustable Rate Mortgages (cont’d)

• Consumer protections (cont’d)“Balloon” disclosure rules may define a

balloon more narrowly than simply as any payment larger than one before

– Ex., as any payment more than twice the size of a preceding payment (as in Florida).

Donald J. Weidner53

2) GRADUATED PAYMENT MORTGAGE

• Monthly payments gradually rise, while the interest rate and the term of the loan are fixed.

• 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 would not amortize the debt or

even pay all the interest, but later payments make up for it.

GRADUATED PAYMENT MORTGAGE (cont’d)

• The Growing Equity Mortgage is another form of increasing payment mortgage.

• 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.• Note: borrow can tailor his or her own growing

equity provisions with prepayment privileges.

Donald J. Weidner54

Donald J. Weidner55

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.

• 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.

Donald J. Weidner56

Goebel v. First Federal(Text p. 403)

The note to the S & L provided:1. Interest shall be paid monthly.2. Initial interest rate was 6% per annum.3. The initial interest rate may be changed

from time to time at the S & L’s option.4. There will be no interest rate change during

first 3 years.5. Borrower will get 4 months written notice

before any interest rate change.6. Borrower has 4 months from receipt of

notice of a change to prepay without penalty.

Donald J. Weidner57

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 would construe the

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.”

Donald J. Weidner58

Goebel (cont’d)• As to increasing monthly Debt Service, court

said expressio unius controlled: The note contained provisions to increase Debt Service in some situations but did not 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.

Donald J. Weidner59

Goebel (cont’d)• As to increasing the term (the length

of the loan), the court focused on the language that all Principal and Interest “shall be paid in full within 25 years.”

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 pay debt service for a longer term/

Goebel (cont’d)• What effect could the interest increase

provisions have?• 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”)?

Donald J. Weidner60

Donald J. Weidner61

Note to Goebel v. First Federal• No argument was made that an interest increase was either

unconscionable or illegal.• See also Constitution Bank (Text p. 413): “If the lender may

arbitrarily adjust the interest rate without any standard whatever, with regard to this borrower alone, then the note is too indefinite as to interest. If however the power to vary the interest rate is limited by the marketplace and requires periodic determination, in good faith and in the ordinary course of business, of the price to be charged to all of the bank’s customers similarly situated, then the note is not too indefinite.”

• Recall, “good faith” can be a “gap filler” to salvage an otherwise indefinite contract

• Recall, too, that the borrower had the option to prepay without penalty upon an interest rate increase.– Indicating that market forces might limit the lender

from exacting an increase.

Donald J. Weidner62

4) SHARED APPRECIATION MORTGAGE

• 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.

Donald J. Weidner63

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.

Donald J. Weidner64

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.

Donald J. Weidner65

Growth of Securitization of Real Estate Debt• 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.– 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.

Donald J. Weidner66

Growth of Debt Securitization in Real Estate (cont’d)

• Fannie Mae “was then restructured as a private corporation with ties to the federal government”– And “given the authority to buy and sell

conventional (non-federally insured) home mortgage loans.”

• 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.

Donald J. Weidner67

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”

Donald J. Weidner68

Federal Reserve Policy• When the Federal Funds Rate was only 1%,

Federal Reserve Chairman Alan Greenspan announced that the FOMC would maintain an “highly accommodative stance” for as long as needed to promote “satisfactory economic performance”– Thus, there was cheap money to help drive up

prices– Treasury obligations were not paying investors

very much– Investors turned to mortgaged-backed

securities for higher yields than Treasury bills 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.

Donald J. Weidner69

“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.

• “Already [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.”

• 35% of all mortgage securities issued in 2006 were in the subprime category.

Donald J. Weidner70

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.”

Donald J. Weidner71

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.

Donald J. Weidner72

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.

Donald J. Weidner73

Banks Sue Originators on Repurchase Agreements(Supplement p. 8)

Carrick Mollenkamp, James R. Hagerty, Randall Smith, “Banks Go on Subprime Offensive,” The Wall Street Journal, March 13, 2007

• “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.

• Many loans went to “straw borrowers,” people who obtain the loan for another home buyer.– In some cases, brokers wrote contracts through straw men

Donald J. Weidner74

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

Donald J. Weidner75

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 CDOs [collateralized debt obligations]) “could be valued according to models, which made for nice, consistent profit reports” for the people who bought them.

Donald J. Weidner76

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.”

Donald J. Weidner77

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.

Donald J. Weidner78


• The SEC is 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. [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.)”

Donald J. Weidner79


• The collapse of securitization has 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.”

Donald J. Weidner80

Collateralized Debt Obligations

• 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 (insurance against defaults)

Donald J. Weidner81

The Housing Bubble

• From 2000-2003, there was a speculative bubble in housing.

• Prices kept going up, mortgage financing was available.

• People were seeing residences as investments, and non-real estate professionals were buying multiple residences to “flip”

• However, from 2000-2007, the median household income was flat.

Donald J. Weidner82

The Housing Bubble

• Therefore, the more prices rose, the more unsustainable the rise of prices and the increased financing costs.

• By late 2006, the average home cost nearly 4 times what the average family made– 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.

Donald J. Weidner83

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

Foreclosure Filings: 2008-2012(2012 figures projected)

Donald J. Weidner84

• 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

Donald J. Weidner85

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 private-debt securities are now far bigger than stockmarkets.”

Donald J. Weidner86

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. Reduces borrowing costs for consumers and businesses.

Donald J. Weidner87


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 admits that the Fed got it wrong on this point).

5. Broadens the distribution of credit risk.However, there are 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.

Donald J. Weidner88


1. Problem # 1: complexity: “financiers did not fully understand what they were trading.”– 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.

Donald J. Weidner89


In mortgage securitisation, the lender is supplanted by--the broker--the loan originator--the servicer (who collects payments)--the arranger--the rating agencies--the mortgage-bond insurers-- the investor

By January of 2008, there was widespread concern over the stability of the bond insurers.

Donald J. Weidner90


• “This creates what economists call a principal-agent problem.”– “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

Donald J. Weidner91


3. Problem #3: Regulations were gamed.• Only now are the politicians looking at the

rating agencies.• “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.

Donald J. Weidner92


Looking forward:• “Investors need to know who is holding what and

how it should be valued.”• 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.”– “[Securities Rating Agency] is one of the few

businesses where the appraiser is paid by the seller, not the buyer.”

Donald J. Weidner93

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.

• Fannie and Freddie “were set up to provide liquidity for the housing market by buying mortgages from the banks. They repackaged these loans and used them as collateral for bonds called mortgage-backed securities; they guaranteed buyers of those securities against default.”

Donald J. Weidner94

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.

1.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!

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.”

Donald J. Weidner95

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.

Donald J. Weidner96

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.

Donald J. Weidner97

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) and AIG (which had gone down because of its credit default swaps)

The Federal Reserve Response

• In 2008, the Federal Reserve cut the discount rate, the rate on loans to banks, to near zero.

• The Fed also 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

Donald J. Weidner98

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

Donald J. Weidner99

Donald J. Weidner100

The Federal Reserve Response• 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.

• 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.

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 stated policy of making the equity

markets more attractive



• 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




• In December 11, 2012, the Fed also announced it would spend $45 billion a month on long-term Treasury purchases.

• This plus the mortgage bond purchasing program equals $85 billion a month in securities being purchased by the Fed!

• 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


• Also on December 11, 2012, in an unprecedented move the Fed said it plans to keep its key short-term 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 December 2013 was 6.7

percent.


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 rateDonald J. Weidner105

The Return of Securitization (cont’d)• 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 “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.


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.


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.’”

• “Another tightening of the rules makes ‘re-securitizations’, where income from securitised products was itself securitised, more difficult”


Documents

Real Estate Finance