Real Estate Finance

© JR DeLisle, Ph. D.

Lecture 2: Residential Finance Overview

byJames R. DeLisle, Ph.D.

January 7, 2010

Real Estate Finance

© JR DeLisle, Ph. D.

Lecture Overview

• Risk Management– Definition of Risk– Risk Management Process

• Mortgages– Mortgage Process– Mortgage Risk Management– Legal Concepts in Mortgages

Real Estate Finance

© JR DeLisle, Ph. D.

Mortgage Process

Borrower Lender

Note &Mortgage

Release

Cash

CashRepayment

Real Estate Finance

© JR DeLisle, Ph. D.

Roman/German Foundation of Mortgage Law

• Roman Law– Transfer of title and possession until repayment– No transfer of title or possession; lender could take:

• Under suspicion of default• Under actual default

• German Law– Terminology

• Gage is a deposit made to fulfill an agreement• Mort is French for Dead• Real property (not transportable) was a dead gage

– Impact• In default the lender could take title• Could not look further for relief

Real Estate Finance

© JR DeLisle, Ph. D.

English/US Foundation of Mortgage Law

• English Law– Concept of usury in that charging interest was sinful– Equitable Right Of Redemption - Allowing borrower to redeem

the property after default• U.S. mix of Roman, German, And English law

– Early Expansion• Little need for lending• Building societies formed to consolidate funds for home loans

– Post-civil War• Increased mortgage lending to finance westward expansion• Typical loan was short-term, interest-only

Real Estate Finance

© JR DeLisle, Ph. D.

Evolution of Mortgage Finance: Pre-WWII

• Early 1900s through 1920s– In1913 Fed ok banks to write 5yr, 50%LV, non-amort. mortgages– Building and Loan Associations expanded rapidly– Real estate prices rose rapidly– After 1929 market crash, real estate prices dropped dramatically

• 1930s– Market crash in 1929 ushered in the Great Depression– Banking collapse, money supply plummeted, unemployment soared– Refinancing short-term, non-amortizing loans became a problem– Solution

• Federal agencies created• FSLIC (1934)• FHA (1934) Insurance• Fannie Mae (1938)

Real Estate Finance

© JR DeLisle, Ph. D.

Evolution of Mortgage Finance: Post-WWII

• 1940s– Preoccupied with World War Two– Veterans Administration created: Guaranty

• 1950s – Decade of S&L expansion and stability– 30-Yr Fixed Mortgages: Maturity mismatch; interest rate risk

• 1960s – Creeping inflation– Disintermediation– Expansion of secondary mortgage market– 1968 Government National Mortgage Association (Ginnie Mae)

Real Estate Finance

© JR DeLisle, Ph. D.

Evolution of Mortgage Finance: 70s – 80s

• 1970s: Inflationary Period/High Interest Rates– 1970 Federal Home Loan Mortgage Corporation (Freddie Mac)– Approval of new mortgage designs: VRM, GPM, and RAM

• 1980s – Legislative Interventions

• 1981 Deregulation of Financial Institutions Act; Reg Q, S&L Dev• 1981 ERTA in 1981 produced ACRS; 1986 TRA took away

– Market Reactions• S&L debacle• 1989 Financial Institutions Reform, Recovery, and Enforcement Act

• Summary– FHA and VA Assumable loan advantages– Creative Financing: WRAP, PMM

Real Estate Finance

© JR DeLisle, Ph. D.

Evolution of Mortgage Finance: 1990s

• 1990s– Subsiding inflation resulted in lower mortgage rates– Refinancing craze– Baby boomers trading up increasing demand for up-scale housing– Internet made mortgage lending national in scope

• 1990s– Rapid growth of secondary market, Fannie Mae/Freddie Mac– Tax Act of 1993 eased passive loss rules and extended non-

residential depreciation from 31.5 years to 39 years– Taxpayer Relief Act of 1997 set long-term capital gains tax

rate at 20% and maximum depreciation recovery rate at 25%

Real Estate Finance

© JR DeLisle, Ph. D.

Revolution of Mortgage Finance: 2000s

• Early 2000s– Housing craze: 1-family entered spec investment market– Rapid rise in house prices through first half of decade– 2006 house prices up 87% from 2000 level– Mortgage lending standards relaxed– Rapid growth of secondary market Fannie, Freddie & Wall– Massive bailouts of Fannie Mae, Freddie Mac, and Wall Street

• Latter 2000s– Housing bust of 2007 resulted in deluge of mortgage defaults– Sept 2008 Treasury took control of Fannie & Freddie– Changing market; prices fell, lenders tightened standards– Borrowers began to walk away from speculative housing– S&P downgrade RMS poisoned the global financial system

Real Estate Finance

© JR DeLisle, Ph. D.

2010s: A Return to Mortgage Fundamentals

• Definitions– Mortgage: Pledge of real estate as collateral– Note: Promise to pay and honor covenants

• Direct Parties– Mortgagee: lender– Mortgagor: borrower

• Motivations– Mortgagee: receive attractive risk-adjusted returns through

origination, operation and disposition– Mortgagor: capture capital to acquire real estate

Real Estate Finance

© JR DeLisle, Ph. D.Traditional Mortgage Amortization Patterns

Real Estate Finance

© JR DeLisle, Ph. D.Traditional Mortgage Assumptions

PP* LV

Pi

PMT

INT PRIN

Interest vs. Principal Share of Payments

0%

20%

40%

60%

80%

100%

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

Term

Tot

al P

aym

ent

INT vs. PRIN Total Payment

Amortization Schedule

$0

$50,000

$100,000

$150,000

$200,000

$250,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Time

Dol

lars

Principal Balance

Amortization Schedule

$0

$50,000

$100,000

$150,000

$200,000

$250,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Time

Dol

lars

Principal Balance Total Payment Interest

Real Estate Finance

© JR DeLisle, Ph. D.

Types of Residential Loans

• Conventional Loan– Does not carry government guarantee– May have private insurance

• PMI if over 80%• Insures excess only;; if 85% LV, 5% coverage

• Government Insured– FHA Loan

• Government insurance; 100% coverage• Loan limits set by city and cost of housing• Borrower pays insurance premium

– VA Loan• Max loan limits; no downpayment• Government guarantee to lenders• Limits: generally 25% of loan amount

Real Estate Finance

© JR DeLisle, Ph. D.

Other types of Mortgages/Financing

• Supplemental funding for mortgaged properties– Second Mortgage– Line of Credit

• Seller Financing– Purchase Money Mortgage– Use of Subordination Clause

• Land Contract– Seller retains title– Purchaser has equitable title– Seller conveys title when purchaser completes the performance

obligations

Real Estate Finance

© JR DeLisle, Ph. D.

Risk Management and Residential Mortgages

• Risk Defined– Definition: variation between expectations and realizations– Nature: unavoidable due to temporal nature of real estate

• Sources– Lack of understanding of market and individual behavior– Inadequate information– Inaccurate data– Invalid predictive model– Unforeseen change in environment– Other externalities

Real Estate Finance

© JR DeLisle, Ph. D.

Real Estate Risk Management Approaches• Avoidance

• Geographic or Product• Entity types/individuals

• Improve decision-making & Price• Information• Models

• Control• Via contingency plans: foreclosure• Transfer: insurance, contract, sale

• Limit• Hold harmless clauses• Form of entity, pool, co-endorsement

• Hedge:• Take opposite positions;• Buy-sell contracts, futures

Real Estate Finance

© JR DeLisle, Ph. D.Mortgage Risk Management:The Pleasure, Pain and Bailout Principle

• Overview– Voluntary relationships need controls– Goal: alignment of interest– Mortgage is a “Put” Option

• Pleasure, Pain and Bailout Concepts– Pleasure: some form of economic or qualitative satisfaction– Pain: compromises or payments to compensate– Bailout: ability to exit, terminate

• Mortgage Application of PPB– Pleasure: exchange of capital for promise to pay– Pain: loan servicing, delinquency, inspection and management– Bailout: in essence, mortgage is a “put” to the lender, foreclosure

Pleasure, Pain and Bailout Principle

Overview

Mortgages as a "Put

Option"

Real Estate Finance

© JR DeLisle, Ph. D.

Application of PPB: Mortgagee & Mortgagor

Concept

Pleasure

Pain

Bailout

Mortgagee Mortgagor

Income: stable with positive spread for arbitrageFees: origination, servicing

Capital: access to debt to purchase real estate beyond own sourcesRisk transfer: cap potential lossTax: Interest deduction

Give up cashCommitmentRisks

Sell mortgageSecuritize mortgages

Liability: obligation to payCredit line: reduces capacityRisks: ownership, maintenance

Sell and repayAssumption: transfer debtWalk away

Real Estate Finance

© JR DeLisle, Ph. D.

Major Risks in Residential Mortgage Lending

• Temporal Risks– Long term Loan: interest rate/disintermediation risk– Periodic Payments: Timing and receipt of payments– Repayment: Early Termination, either voluntary or involuntary

• Default Risks– Causes: inability or unwillingness– Economic Event: failure to make payments– Contractual Event: Violations of covenants

• Collateral Risks– Loss/erosion of value– Lack/loss of access to claim collateral

Real Estate Finance

© JR DeLisle, Ph. D.

Options Embedded in Mortgages

• Put Option: Option to Default– Borrower can “put” the property to the lender– When

• If the property value is less than the loan balance

• If the loan is non-recourse

• Call Option: Option to Prepay– Borrower can “call” the loan from the lender by paying off loan

balance– When

• If sell the property

• If refinance early when market rate below contract interest rate

Real Estate Finance

© JR DeLisle, Ph. D.

Lecture Review

• Risk Management– Definition of Risk– Risk Management Process

• Mortgages– Mortgage Process– Mortgage Risk Management– Mortgage Concepts– Mortgage Transfer, Foreclosure & Bankruptcy