Download Chapter 2 Secondary Market

Chapter 2
Real Estate Cycle and
the Secondary Market
I. The Real Estate Cycle
The Real Estate Cycle
 The REAL ESTATE CYCLE, like the business cycle, refers to the
activity of the real estate market as it reacts to the forces of
supply and demand.
 A cycle is characterized by a general expansion of real estate
activity which peaks and then begins to contract leading to a
bottoming out of activity. At this point activity again turns up
leading to a new peak of activity.
 A widely accepted rule of economics is that all business activity,
including the real estate market, reacts to the forces of supply
and demand. It is also an accepted principle that supply and
demand will always seek to balance each other.
Figure 2-1
A. SUPPLY AND DEMAND
 When demand for a product (such as housing) exceeds the
supply, the price for the product tends to increase.
SELLER’S MARKET
 Higher prices encourage the suppliers, in this case home
builders, to increase production.
 As production increases, more of the demand is satisfied until a
point is reached where production outstrips demand. At that
point, prices begin to fall and production will taper off until
demand catches up with supply, and the cycle begins again.
BUYER’S MARKET
B. BALANCE
 Economic theory holds that in a healthy economy, supply and demand
should be in balance.
 Balance is the economic principle that value is created and maintained
when opposing economic market forces are in a state of equilibrium.
 The forces that affect supply and demand are constantly changing and
thereby constantly shifting supply and demand out of balance.
II. Factors Influencing
Real Estate Cycles
Factors Influencing Real Estate
Cycles
 Imbalances in supply and demand may be
either short-term or long-term, depending on
their causes.
 Factors that influence the cycle are the
availability of mortgage funds, demographic
changes within the population, the state of
local and national economies, the cost of labor
and materials, and finally political and social
attitudes.
A. MORTGAGE FUNDS
 The availability of mortgage funding affects both
supply and demand for housing.
 For many years it was assumed that local economic
trends created the strongest influence on supply and
demand in the market place and thus on the real
estate cycle. While local economic health is still a
major factor, it is becoming more and more
overshadowed by the national economy.
DISINTERMEDIATION
 The housing market is itself very sensitive to minor
changes in the interest rate.
Example:
 Let us assume that a house has a sale price of
$100,000. The buyer puts down 20% of the sale
price as a down payment. The monthly payment for
an $80,000 thirty-year mortgage on the house at
7.5% interest is $559.37. Now let’s assume that the
price of the house increases to $150,000 and the rate
remains the same. The down payment is still
$20,000. The monthly payment for a thirty-year
mortgage on $130,000 at 7.5% will be $908.98. A
one percent increase to an 8.5% rate would make
the payment $999.59.
B. POPULATION
 Population demographics are an important factor in
the success of a local real estate market.
 DEMOGRAPHICS refer to the study and description of
the population of an area.
 Demographics include such factors as age, education,
gross income, disposable income, number of family
members, and savings and spending patterns.
 Demographic data is important to community
planners, developers, politicians, and real estate
professionals in order to recognize and plan for
changing trends in their areas and communities.
C. SOCIAL ATTITUDES
 A major factor that has impacted both the availability of
housing and mortgage funding has been the changing
social behavior patterns of the population.
 A modern example is the increase in the portion of the
population that is in its prime home buying years.

Both baby boomers and their children are now seeking
housing

High divorce rates

Later marriages
D. POLITICAL ACTIVITY
 The supply and demand for housing and credit
depends on notoriously unpredictable political forces.
 Because the national government is the largest
borrower in the country, its activities have a huge
influence on the economy.
 DEFICIT SPENDING by Congress forces the
government to borrow money, making less money
available for construction and home loans.
E. REGULATION
 Regulation by local, state, and federal governments is pervasive
in almost every activity engaged in by our citizens.
 This regulation takes the form of federal, state and local tax laws,
environmental regulations, lending laws, and local zoning and
building codes.
 The vast majority of these laws and regulations have been
enacted to protect the environment, promote public safety, or to
protect consumers from predatory loan practices.
PREDATORY LOAN PRACTICES
 At the local level, homes are subject to property taxes and
IMPACT FEES which can often deter or prevent further
development.
III. The Role of the
Secondary Mortgage
Market
The Role of the Secondary
Mortgage Market
 The supply of funds available for investment in real estate mortgages is
channeled into either the primary or secondary market.
PRIMARY MARKET
SECONDARY
 A real estate loan is an investment, just like stocks or bonds. Real estate
loans can be bought and sold just like other investments.
 The present value (cash today) of the lender’s right to receive future
payments over the life of the loan can be calculated by comparing the
rate of return on the loan to the rate of return on other investments with
the same DEGREE OF RISK.
QUALIFY A BORROWER
QUALIFY A PROPERTY
 The secondary market provides cash liquidity to primary lenders through
the purchase of mortgages.
IV. Agencies of the
Secondary Market
Agencies of the Secondary
Market
 For the purposes of our discussion, the secondary
market may be said to include three agencies:
1. Fannie Mae
2. Government National Mortgage Association (Ginnie Mae)
3. The Federal Home Loan Mortgage Corporation (FHLMC
or “Freddie Mac”)
 The secondary market is able to function as it does
because of the standardized underwriting criteria
applied by these agencies.
UNDERWRITING CRITERIA
A. Federal National Mortgage
Association (FNMA –“Fannie Mae”)
 Fannie Mae dominates the secondary mortgage
market.
 Originally it bought and sold only FHA and VA loans
deeds.
 FNMA underwent several reorganizations and is now a
privately owned and managed corporation called
“Fannie Mae.”
 Fannie Mae funds its operation by selling securities
which are backed by its pool of mortgages to the
public.
 It buys the mortgages from lenders.
B. GOVERNMENT NATIONAL
MORTGAGE ASSOCIATION (GNMA)
 The GOVERNMENT NATIONAL MORTGAGE ASSOCIATION, or
“Ginnie Mae,” was created with the passage of the Housing and
Urban Development Act (1968).
 It is a wholly-owned government corporation.
 A primary function of GNMA is to promote investment by
guaranteeing the payment of principal and interest on FHA and
VA mortgages.
 GNMA carries out this function through its mortgage-backed
securities program.
BOND-TYPE SECURITIES
PASS-THROUGH SECURITIES
FULLY MODIFIED PASS-THROUGH SECURITIES
C. FEDERAL HOME LOAN MORTGAGE
CORPORATION (FHLMC)
 The FEDERAL HOME LOAN MORTGAGE CORPORATION (FHLMC),
which is also known as “Freddie Mac,” was created through the
Emergency Home Finance Act (1970).
 The primary function of FHLMC was to aid savings and loan
associations who were hit particularly hard by the recession of
1969-1970.
 FHLMC is now regulated by the U.S. Department of Housing and
Urban Development (HUD).
 FHLMC emphasizes the purchase of conventional mortgage loans,
and also actively sells the mortgage loans from its portfolio, thus
acting as a conduit for mortgage investments.
IMMEDIATE DELIVERY PROGRAM
FORWARD COMMITMENT PURCHASE PROGRAM
NOTE:

In 2008, the federal government took control of
Fannie Mae and Freddie Mac in an effort to keep
the two mortgage giants from failing, disasters
that would have made home loans still harder to
get.
 The government agreed to pump billions of
dollars into Fannie Mae and Freddie Mac and
assume responsibility for trillions of dollars of
their debt, while handing control of the
companies to federal regulation by the Federal
Housing Finance Agency (FHFA).
V. Quality Control
V. Quality Control
 The secondary market has an enormous influence on the
primary market, not only because of the increased availability
of funds that it provides, but also because of the standards of
quality it imposes on lenders.
 Because lenders wish to be able to sell their loans to the
secondary agencies, they must follow the underwriting
guidelines of those agencies.
 The secondary market is trying to improve the quality of the
loans it purchases and ensure the reputation of residential
mortgages as a safe investment.
 The secondary market encourages lenders to implement their
own quality control programs.
VI. CHAPTER SUMMARY
 The real estate cycle has four phases, beginning with an
expansion of real estate activity that leads to a peak, and then a
decline to a bottom or trough. Expansion then begins again,
leading to another peak and the completion of the cycle.
 The cycle is driven by supply and demand. Supply and demand
for both real estate and mortgage money is affected by
economic, social, and political factors.
 Political regulation of housing and lending, while intended to
protect consumer health, safety, and quality of life, has often
tended to increase the price of housing for consumers.
 The establishment of a national secondary market to buy and sell
mortgages has worked to soften drastic swings in the real estate
cycle by insuring that mortgage money is available at all stages
within the cycle. The major players in the secondary market are
FNMA, FHLMC, and GNMA.