Download Real Estate Finance: An Overview

Topic 4: History and Regulation of Residential Real Estate Finance
(Suggested textbook reading: Chapters 4 and 7)
I. Early History
A general starting point is for us to note that lenders prefer to minimize the risks
that they face. Therefore, they tend to like

High down-payments

Credit-worthy borrowers (stable income, strong credit history)

Laws that facilitate quick and easy acquisition of collateral
Any law (statutory or common) that affects these features affects risks.
Therefore, any such law should affect the terms offered to the borrower.
II. Earliest applications of secured mortgage lending
A. Romans – initial system placed title to real estate in lender’s hands. The law
evolved such that borrower instead held title, although lender could claim title
fairly easily. Finally evolved to permit lender to claim title only if borrower
defaulted.
B. Germans – created “gage,” or pledge, system of loan collateral. Lender could
acquire title to property in the case of default, but could not seek more from
borrower. (Was a type of put option, as exists with today’s non-recourse loans.)
For small personal property items, borrower actually made a “live” pledge by
giving physical possession of collateral to lender.
C. English – German-influenced Normans expanded the gage idea to real estate
lending. But since lender can not physically possess land, the pledge was “dead”
rather than “live.” “Dead pledge” translates as “mort gage.”
III. Middle Ages practices were strongly influenced by religious views
A. Thomas Aquinas and other Christian theologians felt that charging interest was
sinful. Problem: not allowed to price the risk. So Christians who had
resources either

didn’t lend to those who needed money,

took equity interests, or

imposed harsh collateral terms (e.g., miss 1 payment, lose land)
B. Because harsh terms were common, English courts established the “equitable
right of redemption” – borrower could get lost collateral back by paying
back anything owed. This caused great uncertainty for lenders; it gave
borrower a call option on the property for an unlimited period.
C. So courts enacted “foreclosure” – after a stated time period, borrower who had
defaulted could no longer redeem property; his equitable right of
redemption was foreclosed.
D. Equitable right of redemption and foreclosure are common law principles that
still apply today. Some jurisdictions like to give borrower extra time to
redeem, even after foreclosure has been completed. This extra time is
provided under the “statutory right of redemption.” (6 months in IL.)
IV. Early U.S.
A. Pre-Civil War – There was not much home lending activity in the earliest days
of our country. The rich did not need to borrow; the poor built crude houses
themselves. (Land was often granted by the government, e.g. western
Illinois to War of 1812 veterans.) Early financial institutions called
“building societies” did crop up by the mid-1800s (small group pooled their
ongoing savings & then disbanded after all had built houses).
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B. Post-Civil War – Westward expansion. Money was needed, but nationally
chartered banks could not make real estate loans. Mortgage banking firms
were created to originate loans in the West, sell notes to investors in the
East. (State-chartered banks made loans, also.)
C. Early 1900s – Passage of Federal Reserve Act of 1913 gave federally chartered
banks the power to make loans secured by real estate. National & state
banks were joined by “building and loans” (remember George Bailey?) –
early Savings & Loans that got tax breaks for making home loans; they
sometimes competed with banks by bending the laws and paying fixed
“dividends” to attract savings.
Loans for all these lenders were typically 5-year balloons with 50% L/V ratios.
D. Depression of the 1930s – non-amortizing balloon loans left borrowers with no
equity when their home values fell (by about half) in the early 1930s; they
defaulted in large numbers when their incomes fell. One estimate shows
about half of U.S. single-family mortgage loans in default in 1933. (Some
states passed moratoria on foreclosures, but that just passed added problems
along to lenders.)
Congress saw need for a type of home loan that was (1) amortizing, to give
borrowers an equity stake, but also (2) long-term to keep payments affordable.
Lenders were afraid of long-term loans because of interest rate risk; loan values
would fall if interest rates rose. So Congress created some new federal agencies to
promote home ownership through long-term, fixed-rate, fully amortizing loans:
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1. Federal Home Loan Bank System – these banks, at one time sort of the Federal
Reserve System’s counterpart for savings and loans, came into being with passage
of the Federal Home Loan Bank Act. Regulated the S&Ls and lent money to those
that needed funds. [1932]
2. FSLIC – now merged into FDIC. Insured deposits to encourage savers to make
lendable money available to S&Ls. So the FHLB System and FSLIC provided
liquidity to lenders, thereby reducing their fear of making long-term loans
somewhat. [1934]
3. Federal Housing Administration (FHA) – imposed standards for residential
construction, and provided insurance on long-term (25 or 30 year), fixed-rate loans
so that lenders would not face default risk. But they still worried about interest
rate risk. [1934]
4. Federal National Mortgage Association (FNMA, or “Fannie Mae”) –
purchased long-term FHA loans from S&Ls so the S&Ls could sell notes if they
needed cash. To curtail fears over interest rate risk, FNMA was required to buy
the loans at face value even when interest rates fell.
V. The Early Postwar Period
Major changes have occurred between the WWII period and today in


types of loans available, and
ultimate sources of the money lent
A. 1950s
1. Interest rates were stable, so maturity mismatch (long-term loans, short-term
savings) was not a problem for lenders, nor was loan assumability (who wants to
assume someone’s loan when they can get a rate just as low on a new loan?)
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2. Savings & Loans’ share of loans grew considerably – “Gurley-Shaw”
Hypothesis held that S&Ls would eventually grow to dominate banks in the
marketplace because of their ability to intermediate across maturities
B. 1960s
Periods of inflation and rising interest rates created some previews of the problems
to come:
1. Maturity mismatch – net returns ratcheted downward as inflows remained
about the same (assets were long-term) but operating costs rose.
2. But at least Regulation Q kept deposit costs low. (In 1966 the Fed started
allowing S&Ls to pay ¼% per year more on savings instruments than banks could,
and as a result the size of the S&L industry began growing dramatically.)
3. Still, institutions had to confront the idea of negative net worth.
VI. The 1970s
A. Inflation – rates late in the decade reached double-digit levels.
B. Disintermediation resulted as depositors took money out of banks/thrifts and
became direct investors through money market mutual funds. They gave up the
default risk protection to receive unregulated market-based interest returns.
C. So did borrowers come out ahead? To an extent they did, but don’t forget that
the inflation premium in a long-term interest rate incorporates expected inflation
over the long-term period. So borrower starts paying right away for inflation that
is not expected to kick in until later.
That situation caused borrowers to face a tilt problem – in early years of loan,
payments were extremely expensive in inflation-adjusted terms; then as years
passed and incomes rose (while payments stayed level) became much cheaper.
D. Introduction of Alternative Mortgage Instruments – AMI’s

Adjustable rate mortgage (ARM)

Graduated payment mortgage (GPM)

Shared appreciation mortgage (SAM)
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VII. The Early 1980s
A. Assumability issue – “due-on-sale” (or more technically, alienation) clause
protected lender from having buyer assume seller’s low-interest loan.
B. But borrowers tried to get around this clause by arranging their sales as
leases with options to buy, or as contracts-for-deed, or simply not notifying
lenders that sales had occurred.
Court cases, especially Wallenkamp vs. Bank of America in California, tended to
view the alienation, or “due-on-sale,” clause as enforceable only if the person
assuming the loan was a credit risk – that is, lenders could not enforce due-on-sale
clause to get a new loan on the books at a higher interest rate.
But Federal Home Loan Bank Board directed federally-chartered thrifts to enforce
due-on-sale. (Some California lenders switched from state to federal charters just
so they could enforce alienation clauses in loans.) In a case that finally made it to
the U.S. Supreme Court, Court upheld FHLBB’s directive. (Their ruling was
apparently based on solvency arguments.) Finally, Depository Institutions Act
(“Garn-St. Germain”) of 1982 allowed all federally insured thrifts to enforce dueon-sale, even if state law prohibited.
Points to note:




Courts’ lack of understanding of loan mechanics is disturbing; they
undermined lenders’ pricing based on expected average loan lives.
Law & Economics idea of “specific performance” should have been enough to
get courts to enforce – it’s improper for court to rewrite one part of a contract,
because it can’t know value that the party placed on that specific provision.
Finding ways around due-on-sale was part of the “creative financing” boom in
the early 1980s. When sellers made low-rate loans to buyers, they charged
higher prices, thereby trading ordinary income for favorably-taxed capital
gains. (Gov’t. cracked down with OID and imputed interest rules in 1984.)
Similar effect was seen in FHA and VA loans; rates were held artificially low
for borrower/buyers by passing some closing costs along to sellers. Sellers just
passed some or all of the costs back to buyers in the form of higher prices.
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VIII. The Late 1980s
Most noteworthy event was the widespread failure of S&Ls

Asset-liability mismatch

State-chartered institutions, especially in California and Arizona, with statedetermined asset powers and federal guarantees

Net worth problems became severe
Most firms prepare financial statements in accordance with GAAP. But thrift
institutions presented statements based on RAP. These standards allowed things
that aren’t really net worth to be counted as “capital.” Result was a collection of
“zombie” thrifts.
Thrift owners had “put” options to put their liabilities to FSLIC at face value while
paying an exercise price equal to the lower value of the assets given up. Bailout of
the S&L industry ended up costing U.S. taxpayers $150 billion.
Controversies continue today. In the 80s, government asked some weak-butsolvent institutions to merge with insolvent institutions, to keep losers in business
and prevent FSLIC payouts. Reward was ability to treat ”goodwill” as net worth.
Then later the rules were changed; some of the rescuers were immediately in
violation of the new law and were forced by government into bankruptcy. Then
the former owners of these thrifts sued government and, in some cases, won.
FIRREA was passed; risk-based capital standards imposed.
IX. The 1990s
Secondary mortgage market giants Fannie Mae and Freddie Mac came to dominate
U.S. residential mortgage lending – many say the result was a politicization of the
lending arena. Bonds these “government-sponsored enterprises” issued to get the
money to buy mortgage notes carried an “implicit” government guarantee, so the
firms had competitive advantages in raising capital.
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To keep that advantage, the firms hired executives with strong government ties,
and contributed richly to federal legislators who regulated them. The politicians
and executives both benefited as regulations permitted/required Fannie & Freddie
to purchase lower quality notes (“affordable housing” initiative bought good press/
votes for legislators) and allowed the firms to do more business, grow in size, pay
very high bonuses to top managers.
X. The Most Recent Years
Just as birds have to fly, lenders have to make loans. As fixed costs of information
management increased, lenders started trying to spread those fixed costs over
a larger number of transactions by relaxing the standards that borrowers had to
meet. (The result of these lower standards – one estimate showed half of U.S.
home mortgage loans to be of substandard quality in 2008 – was a worsening
of the recent mortgage market crisis. The two GSE’s, which held a high
proportion of those troubled loans, were put under federal conservatorship in Sept.
2008; cost to taxpayers estimated at $300 billion.)
For example:

Required down-payments fell from 20% to 10% to 5% to 3% to 0% over a
few decades, with a borrower being able to arrange a two-loan “piggy-back”
financing plan that allowed for the borrowing of 100% of the purchase price.

Maximum amortization periods increased from 30 to 40 years, as Fannie Mae
started purchasing both fixed-rate and variable-rate 40-year loans.

The payment of principal could be delayed for up to 15 years through interestonly loans (which converted over to amortizing loans, obviously with fairly
high payments); Fannie Mae was purchasing these loans, as well.
Also, in summer of 2012 American mortgage lenders became subject to new
international “Basel III” risk-based capital standards. Whereas under earlier riskbased capital standards all mortgage loans were generally treated as equally risky,
under Basel III the institution must follow complex guidelines in determining the
risk of each specific mortgage loan on its books.
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And the Wall Street Reform and Consumer Protection Act (“Dodd-Frank,” 2009)
financial regulation overhaul law requires mortgage-backed security issuers to
retain some of the default risk on loans they include in the securitizations, unless
the loans are low-risk “qualified mortgage” loans – a term the Consumer Financial
Protection Bureau has defined as, essentially, standard fixed interest rate, fully
amortizing loans with meaningful down-payments.
(Problems arose with mortgage loans on income-producing real estate in late 2016,
as 10-year loans made during the 2006 market peak started coming due and many
borrowers were not financially strong enough to refinance amid lower property
values – the apartment sector, which may have experienced overbuilding in the
wake of the housing crisis, was especially hard hit. Commercial mortgage-backed
security issuers had to start retaining 5% of the securities issued as of 12/24/16.)
Dodd-Frank requires a lender to estimate in good faith that a borrower has the
“ability to repay,” or else the lender can later be sued by a struggling borrower.
Lenders will protect themselves by issuing only loans that meet the “qualified
mortgage” standard.
A “Qualified Mortgage” Loan (see the 804-page description by Consumer
Financial Protection Bureau) is one with these features:







No high fees (generally ≤ 3% closing and related costs)
Borrower’s income and assets are verified
Total monthly debt payments ≤ 43% of monthly gross income
A maturity of no longer than 30 years
Generally no prepayment penalties
No balloon payments (negative, zero, partial amortization loans are history)
No artificially low “teaser” interest rates in early periods
ARM probably will no longer exist, at least unless the interest rate is fixed for a
period of 5 years or longer (CFPB calls ARM’s “risky”)
A separate idea with a similar name is the “Qualified Residential Mortgage:” one
that can be sold in the secondary market without the seller being required to retain
some default risk.
Regulatory agencies that play important roles in the post Dodd-Frank mortgage
lending environment:
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Financial Stability Oversight Council – identifies Systematically Important
Financial Institutions (SIFIs), which are those deemed “too big to fail.”
Systematic risk is seen as having been a major contributor to the financial crisis,
as the inability of one large financial institution to repay its liabilities destroyed
the values of assets at other large institutions holding the issuer’s debt securities.
Banks with more than $50 billion in assets are required to file 3-year strategic risk
management plans with the Office of the Comptroller of the Currency.
(After General Electric Capital was identified as a SIFI in 2013 the GE parent firm
simply closed it down; some say the result was to reduce the availability of credit
in the economy.)
Office of Comptroller of the Currency, Federal Reserve System, Federal Deposit
Insurance Corporation, National Credit Union Administration – regulate banks,
thrifts, credit unions. One important function is insuring deposits (FDIC and
NCUA), another is establishing real estate lending and appraisal practices that
institutions must follow, and another is setting minimum capital requirements. If
an institution has sufficient capital (equity financing) its financial problems will
not reduce asset values at other institutions (owners’ equity is reduced but debts
can be honored). Various Basel accords have set international standards for bank
capital; a general rule is that 8% of risk-adjusted assets must be paid for with nondeposit sources. Fed can impose more stringent capital requirements for SIFIs.
It is interesting that in recent years credit unions have become more prominent as
home mortgage lenders. A St. Louis Federal Reserve Bank study showed that loan
applications were far fewer at banks and mortgage brokers in 2009-2010 than they
had been in 2004 before the crisis – but at credit unions they were higher after the
crisis than before. Possible reasons were good deals offered by a few very large
credit unions (no mortgage insurance required despite low or no down-payments)
and the observation that credit union members tend to be at least as affluent and
financially sophisticated as bank customers (despite the image of credit unions as
the place for the “little guy” to get financial services) – which could give credit
unions an advantage at a time when regulators imposed tougher lending standards.
Federal Financial Institutions Examination Council – coordinates the CAMELS
(capital, assets, management, earnings, liquidity, sensitivity to interest rate risk)
system that federal examiners use in assessing financial institutions’ risk. Also
monitors lenders’ compliance with the Home Mortgage Disclosure Act (HMDA).
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Federal Housing Finance Agency – regulates Fannie Mae and Freddie Mac. The
2008 Housing and Economic Recovery Act created FHFA to replace the Office of
Federal Housing Enterprise Oversight. Among FHFA powers are requiring the
two GSEs to hold added capital, sell risky assets, and even replace their managers
if the regulator feels that financially sound practices are not being adhered to.
Consumer Financial Protection Bureau – this agency within the Federal Reserve
System enforces consumer protection laws, including those dealing with mortgage
lending. Responsible for Regulation Z (computation of effective cost of
borrowing), truth-in-lending laws. Administers 2008 Secure and Fair
Enforcement for Mortgage Licensing Act (SAFE), under which mortgage loan
originators must register with a National Mortgage and Licensing System and
Registry so that consumers can check on their backgrounds the same way they can
check on those of stock brokers.
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Creating a Zombie Savings & Loan
Strong S&L
Assets (market value):
Loan notes $1,060
Liabilities:
Deposits $1,000
True Net Worth:
$60
Weak S&L
Assets (market value):
Loan notes $400
Liabilities:
Deposits $480
True Net Worth:
($80)
 Federal regulators did not want FSLIC to have to take an $80 hit, so they
encouraged Strong to acquire/merge with Weak by assuming the obligation
to pay $480 back to Weak’s depositors.
 But Strong was worried that it would end up with a negative net worth,
because it was gaining $80 less in asset values than it was taking on in
liability obligations.
 Regulators said no; logically a business would not take on a $480 obligation
unless it got $480 in some kind of asset value in return, so since the notes
were worth only $400 Strong had to be getting $80 worth of something else
– “goodwill,” a valuable asset. That “goodwill” was explained primarily as
the value to Strong of gaining Weak’s loyal customer base.
Merged Zombie S&L
Reported Assets:
Loan notes $1,460
“Goodwill” $80
Liabilities:
Deposits $1,480
Reported Net Worth:
$60
True Net Worth:
($20)
 Now with reported assets greater than total liabilities the merged entity
could report the same positive net worth that Strong had enjoyed.
 But of course that “goodwill” value was pretty questionable; the merged
S&L’s true net worth was negative. So it was economically dead, but was
able to keep “walking” – a “zombie” – because the government recognized
the fuzzy $80 in goodwill as a genuine asset value.
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