10. Real Estate

published on July 13, 2020

I'm going to start by talking a little bit about the history of mortgage lending and then I want to talk more recently about how we do commercial real estate finance and then residential real estate finance and then it if I have time I'm going to try to get into

Discussing I have to open the blackboard here I have to I've never done that it's a massive door and someone was lecturing about astronomy so I'm going to be talking about what we talked about real estate finance it's really about

Financial contracts that involve real estate and that particularly use real estate as collateral so it's a very complicated history but I like to put things in a long-term perspective so the word I want to start with the word that

The word mortgage it actually goes back to Latin one to us valium and that means in Latin death pledge okay and then in the Middle Ages in France they substituted the French word for of audio and that's how to pronounce

It that means pledge in French or and I don't know why they call them death pledges that doesn't seem to involve death to me but it's in the long history of these institutions it became

Important so the Oxford English Dictionary says the word mortgage entered the English language in 1283 so we've got a long history here but actually I can take it back further than 1283 and I was inspired by the research

Of yale historian valerie hansen who has been reading old documents related to the silk trade and her documents are based on a trove of old documents from the Tang Dynasty in China between the 7th and 10th centuries which reflect

Loans that were made to finance trade so you had people going back and forth from the Middle East to China with silk and other items and they needed financing for the trade so she reads these old documents in Chinese and I was looking

Over her work a little bit to see whether they had mortgages she C says that in China they didn't seem that least if I'm getting her generalities right they didn't seem to mortgage property at least in these documents but

She says that among these documents are some they weren't all with all in Chinese because they were trading between China and many other countries so she found some in this sodium language you she reads all these

Languages it's an ancient language of what's modern-day Iran and the it's a it's a dead language died out in the ninth century but she finds some sodium documents that look like mortgages so

Some people borrowed money for the silk trade and they would mortgage their property or their slaves you could mortgage slaves it's an awful thought and then the contracts would additionally say that

You were obligated to maintain the property or the slaves I guess that meant feed your slaves keep them healthy but those were mortgages and from the well over a thousand years ago and so it's it's very old

Institution but I think it's formed its modern form more recently and it became a well-known term for the general public maybe in the late 18th century I was trying to confirm that I'm interested in history just out of just a passion for

Understanding origins of things so I looked up mortgage in some on ProQuest to find old what were they talking about and I found an article in The Hartford Courant dated 1778 it actually wasn't an article it was an ad that someone took

Out and I think it's kind of revealing of what the mortgage market looked like in 1778 so we here in Connecticut have did you noticed the oldest newspaper in America that's the Hartford Courant so a man by the name of Elijah Cornwell took

Out an ad in The Hartford Courant 1778 and he explains in the ad that he lent money as a mortgage on somebody's farm actually he sold his farm and was asked instead of taking the money right up front

He'd mortgaged the farm so that he sold it for 800 pounds and to another farmer and the farmer was promising to pay him and if he didn't pay him he should get back to the farm but the farmer subsequently sold the farm or the

Mortgages again he mortgaged the same farm for 880 pounds so he's made any pounds profit it would all be fine and good except he still hadn't paid back the first mortgage and then the guy's mortgaged it again for a thousand pounds

And mr corn well is protesting hey you didn't pay me for the farm in the first place so you don't own the farm how are you mortgaging at multiple times so he said I thought I better put an ad in the newspaper so that any subsequent victims

Of the of this farmer would be would be warned so that's the end of the ads that he said this is my farm because he didn't pay me but this shows how undeveloped mortgage institutions work in 1778 because he had to put an ad in

The newspaper to explain that the problem was that nobody had any systematic way of representing title the the farmer who bought it from whom who'd supposedly bought it from mr corn well really didn't and nobody would know that

You know he could fool people so I think that's partly why you didn't see so many mortgages in those days because you couldn't the law wasn't clear the the institutions were not clear about

Property and so you couldn't really do a mortgage business if you couldn't find out whether the guy mortgaging the farm really owned it or not and so it wasn't until the late 19th century that government started to get property law

Rights to property sufficiently advanced that we could develop a big national or international market in mortgages so important step is in Germany in 1872 the work Russia the government created a good book law that created a system for

Prussia that established in a book a central book who owns what exactly that was in 1872 and in 1897 they made it a national German institution still the United States did not have a green book at the time it wasn't it it developed

Throughout the 20th century in different countries of the world that property rights would be clear enough that one could do a mortgage lending business so that's why I think mortgage lending has really taken off

In the 20th century Hernando DeSoto was a Peruvian economist wrote a book a few years ago called mystery of capital and it's about the developing world he argued in that book that property rights the problems that

We just heard up from The Hartford Courant are still very big and alive around the world today that you can't easily establish who owns what in many or most countries of the world so that's a problem that's

Why we don't see mortgage finance developing there you can't make a loan you know if you go to some small town in some less developed country you can ask around who owns this property and they'll tell you you know that that's

Been in this such-and-such a family for a long time but if you want solid knowledge of that how do you you know if you if you're going to base up financial transactions on it you can't base it just on hearsay right I mean someone

Else might have a different opinion so even today in many countries of the world the laws are not developed well enough we don't have property rights established well enough and we have laws that might inhibit mortgages for example

In many countries if you give a mortgage on a property in other words you lend on a property then and the person doesn't pay you're supposed to be able to seize the property right but if the court system doesn't function well or if it's

Kind of left-leaning and in you know supporting the rights of the person living in the home you might not be able to get it or it might take you ten years to get the guy thrown out of the house now it seems cruel to throw someone out

Of a house who doesn't pay on their mortgage but you have to think of the other side of it if we don't throw them out of the house no one's going to make a mortgage you have to be able to get the house right that's the idea of a

Mortgage the guy doesn't pay the lender gets the house and so I think there's a general process of development improving the definition of property rights and improving the ability of lenders to get the property if it fails which is

Accounts for the advance of mortgage lending in the 20th and 21st century so that's my long history of mortgage lending but I want to get into some specific and I said I would start with commercial real estate and my before

Yeah so and then I moved to single-family homes or residential real estate and I know talk now mostly about the United States this is too many countries to to think about but what one thing about finance is that it tends to

Develop a sort of tradition and a sort of standard contract it's encouraged by laws and regulators it's you know you kind of have to do the same sort of contract that other people are doing in your country and the this

I think the standardization is is kind of a limitation we can't be creative in financing because the public and the regulators will not be receptive to new things let me talk about some of the institutions in finance in the United

States its natural to start with commercial real estate so you see a lot of buildings around okay my question is how are they owned I'm not whether you think about this who owns these buildings well in in much of the 20th

Century and still today they tend to be owned as partnerships real estate partnerships which is different from a corporation in a corporation I we talked about that yesterday you might sell shares on the stock exchange if its

Public and it's defined as a legal person and it has limited liability so that all the shareholders don't have to worry about being dude as a result but a partnership is different and most real estate that's

Not part of a larger business is owned in a partnership rather than a corporation and the reason is that they're taxed more favorably corporations have to pay a corporate profits tax okay they're double taxed

You as an individual pay an income tax and your corporation pays a corporate income tax or corporate profits tax so you're taxed twice if you incorporate yourself or you set up some friends to do business in a corporation you get

Taxed twice so you don't like that and obviously you try to avoid that the way to avoid it is not to have a partnership not to have a corporation but a partnership and you have to it the law allows you to form partnerships to own a

Building say so you're building like I don't know how 360 State Street this new building that just went up in New Haven you know this building the biggest construction anyone know who owns it it's probably a partnership I haven't

Investigated that or a or it's called a direct participation program so the the partnership is an investment that is offered only to accredited investors it's not generally available to the general public

And what is an accredited investor the Securities and Exchange Commission takes it upon itself to define who are accredited investors that don't need the protections of the SEC basically accredited investors are wealthy people

And it's defined in the SEC laws who is accredited you have to have at least a million dollars or minimum income and so if you are an accredited investor you can invest in a DPP all right

And then the income of the property flows through to you as your personal income it's not corporate income so it's taxed only once you think about that well why would anyone form a corporation because I don't want to be taxed twice

So why don't we do all business as a DPP as a partnership the problem is that the government doesn't want you to do that and so they have rules about what can form a partnership and so one of the rules is that they have to have a

Limited life so a corporation goes on forever and it derives a lot of its value from the fact that it lives forever there's no end date so we talked about that when when I brought up the first real corporation the Dutch East

India Company the reason it got so valuable is people could see that this was growing it's the first multinational is this huge company it had all kinds of deals and alliances and business arrangements and no one wanted that to

End the value came in the growth of prospects for that but a DPP has to end so what you do is it's well designed for a building you buy the building and you depreciate it over the life of the contract

And then there's an end date and at the end date you sell the building to someone else and then you close down the DPP you don't hear about these partnerships as much you hear about companies corporations all the time you

Don't hear about DPP's first of all because they don't get so big the typically one building 360 state for example all right and it only lasts for however 10 20 years then it's gone might have a different it doesn't and it

Doesn't get advertised to the public because it's not available to the public they can't go around trying to bring you in as an investor because they have to verify that you're an accredited investor so it tends to be

A project for wealthy people now I mentioned that corporations have limited liability partnerships do not in general but in a you can have a partner ship that involves two classes of partners there's general partner that runs the

Business and does not have limited liability in other words if the business goes bad and loses money the general partner can get sued but there are other partners called limited partners and they have to be passive investors and

They have limited liability so what often happens is a a DPP is created by someone who understands in those real estate lets get 360 State Street built you're going to know that eventually because once they open they're going to

Open up super market in the first floor of 360 state and I'll bet some of you will be over there because it's be the closest supermarket to Yale University but it's all part of somebody's plan there was some General Partner who

Thought up this structure and got limited partners in and is is running the managing the building or higher as a manager for the building and has a plan and a closeout plan the building won't disappear but they'll sell it to someone

Else I really don't know the financing structure of 360 state but I'm just pointing out this place it's likely what's happened there so that has been the modern structure of real estate and if they mortgage the building it would

Be of the DPP would mortgage the building on behalf of the partners so so real estate real estate finance in the United States I might as well write it down just a DPP is a direct participation program and it's direct in

The sense that you as an investor are participating directly in the profits of it you are a partner you're not a shareholder okay the DPP's became criticized in the twentieth century because small investors couldn't access

These small investors were confined because they weren't accredited they weren't big enough or important enough they were not allowed to invest in these it was supposed to be to protect them alright I guess but well how does it

Protect them to subject them to double taxation so there became it became a cause that why in the United States do we have most of our investors closed out of these lucrative investment opportunities why can't individuals

Basically individuals couldn't invest in commercial real estate and people said well people are supposed to diversify they're supposed to hold different kinds of investments so what what's the what why would this be limited to them so

Congress in the United States in 1960 created something new called a real I think the chalk is weak we trying to be gentle and the chalk can't and I'm not being rough am i it keeps collapsing I'll be very gentle real estate

Investment trust or its abbreviated Reis these were created in 1960 by an act of the US Congress and it was a democratization another example of the democratization of Finance and I believe it started here

In the United States now they are being copied all over the world they got off to kind of a slow start after 1960 but they have grown dramatically and so the idea is that we will allow a company to well it would be a trust to create

Investment for the general public for small investors and they won't be double taxed either okay so a real estate investment trust has to follow the law and then it can invest in buildings there so maybe 360 state is owned by a

REIT I don't I don't know but they are not subject to the corporate profits tax now once again once cut once Congress creates a vehicle that's not taxed everyone's going to ask what I want my company to be a REIT okay so they had to

Define it so that it isn't generally available it has it's limited to real estate so the law says 75% of the assets of the company have to be in real estate or cash 75% of the income has to be from real estate 90% of their income must be

From real estate dividend interest in capital gains 95 this is all I think in your textbook for bosey 95 percent of the income must be paid out and there has to be a long-term holder no more than 30% of the income can be

Sale of properties held less than four years they don't want you know real estate churning companies so if you define all of that you've got a REIT and so that invention which goes back to 1960 it's one of those things infinitely

It starts out slowly most people don't hear of it and then it starts to grow and reach another everywhere around the world well maybe not everywhere but in many countries we have reached the us REITs

Grew in a succession of booms the first boom was in the late 1960s when the interest rates in the United States rose above deposit ceilings they used to be ceilings that the government imposed on savings banks deposit rates and so

Suddenly the wreaths were paying better than the savings banks in the public flock to them there was a second boom after the tax reform of 1986 eliminated some tax advantages of DPP s and partnerships it used to be that the

Government allowed generous depreciation allowances for partnerships and people would invest in building just as tax dodges because if if you're allowed to depreciate the building very effectively you can you can kind of cook your profit

So that it's not taxable and so people were we're investing in buildings too much the government created a distortion that encouraged too much investment in DPP s so in 1986 the government made it harder for it eliminated a lot of the

Advantages of partnerships and that caused the second REIT boom and then it was starting in the 1990s with the real estate boom that the excitement the public got it suddenly lots of new kinds of REITs appeared and reached that

Involves specialized properties and like now they're big and everyone talks about them but it's interesting to me that it took 50 years get as big as they are now and again the theme that I'm reef recurring here

Recurring to a couple of them one is that the finance industry finds it difficult to innovate and innovations take many years to happen and secondly that there's a trend toward the democratization of Finance that if you

Go back in history you'll find these same mortgages and partnerships and the like but they were limited to a small number of wealthy people and we're moving with the intention of REITs for example more and more people are getting

Involved okay so that's commercial real estate I wanted to talk now about residential real estate which is actually bigger there are more houses than there are office buildings in this country or there's more value in houses

This is bigger in the United States about two-thirds of households own their own homes it varies across countries but there are many other countries with similarly high homeownership rates and this homeownership is a product of

Government policy that encourages mortgage lending so I wanted to talk a little bit about the history of mortgage lending and the history of problems in mortgage lending now I already took you back to the silk trade in the tang

Dynasty but I'm going to be less so far back now we're going to talk about the United States and the Great Depression so the Great Depression in the United States in the 1930s after the 1929 stock market crash was faced with a severe

Housing crisis home prices were falling and people were defaulting on their mortgages in great numbers in fact the government had to create what they call the homeowners Loan Corporation to bail people out and they ended up bailing out

20% of American homeowners it was terrible crisis and so what was happening I've been pointing this out because it's important in the history of real estate finance before the Great Depression mortgages were growing but

I'll say before the Great Depression they tended to be two to five years and they were balloon payment what do I mean by that when you bought a house in 1920 you'd go to a bank and they would give you a loan for two to five years so if

You bought a house for ten thousand dollars they would typically lend you half the money they'd lend you five thousand dollars and the loan would say you pay interest every month until two years has ended and then you repay the

Five thousand dollars okay and then you if you you could try to get another mortgage you come back to us and we'll do it again if we feel like okay that was the deal banks offered that and it was becoming

Increasingly common thing when we say a balloon payment what we mean is it's really big balloons are big all right so you're paying monthly interest but then in two years you got to come up with a whole $5,000 all right but okay people

Thought it's alright I'll just go back to the bank or maybe I go to another banks you know I go wherever I want and I can borrow $5,000 okay so this was this was the way things were done but what happened in the Great Depression

Two things happen the unemployment rate went up to 25 percent a B home prices fell in many cases by more than a half so if you borrowed $5,000 against a $10,000 home your home might be worth only $4,000 now so what do you do now

You go to a bank okay two years is up I got to refinance my mortgage I go back to the bank and I go and I show up and I say hey I'm unemployed and my house is worth $4,000 the bank says you know no dice you're not going

Get renewed so what happens you forced to dump your house on the market you declare bankruptcy you've lost everything you've lost your your $5,000 down payment well if you buy a $10,000 house and you borrow five thousand then

You're the other side is called your down payment so that's what happened it was happening to millions of Americans and so the Roosevelt administration decided that the old kind of mortgage didn't but there was something wrong

With that mortgage so in 1934 when Franklin was a year after Franklin Roosevelt became president they set up the Federal Housing Administration administration and it specified that it offered it was trying to get lenders

Back in to lend the homeowners because it was a catastrophe in the country I'm not saying writing this right so in order to get lenders back in the FHA started insuring mortgages and that meant that if you're a mortgage lender

And your mortgage the person you lent the money to doesn't repay you and the house isn't worth enough you can get the house but so you might lose money because the house has lost value the government will make it up so the

Government came in with what's called mortgage insurance and at the same time the government said all mortgages that are insured by the FHA must be 15 years or longer and so the US government imposed the long term mortgage on the

Mortgages on the mortgage industry and they said this is better because the mortgage and secondly it not be a balloon payment mortgage the government said no this is really imposing too much on ordinary people

That they have to come up with a huge sum of money at the end of the mortgage so they require that the mortgages be 15-year amortize such mortgages had been offered already by some banks in the United States in the 1920s but it was

Innovative finance and too complicated for most people they didn't never caught on let me understand to amortize means to pay down the balance okay so in C an amortized mortgage has no balloon payment at the end a 15-year amortized

Mortgage has a fixed monthly payment you make it every single month and at the end you're done you have a you take your spouse out to dinner and you say we've paid off our mortgage we're done so there's no family crisis at the end it's

A fixed monthly payment now the arithmetic of amortized mortgages is a little confusing to some people and in 1934 it took some education but I want to just describe the amortize a mortgage system all right so we're going to have

A mortgage of maturity maturity of the mortgage is in his M and that's in months okay so in 1934 they started out with 15-year mortgages which they thought was pretty aggressive but by the early 1950s the FHA was emphasizing

30-year mortgages that's a long time to pay off in your house but the idea is you know your typical family they get married and they're buying their first house they're 25 years old so let's give him a full 30 years to pay

Off the mortgage it'll be 55 kids will be going off to college they they'll still be working that's a comfortable length of time why not give them 30 years and we guarantee the interest rate for 30 years no

Surprises you just know you have this monthly payment and you've got it the question now is how do we decide on the monthly payment okay what with the idea of a amortized mortgage is that you have a fixed payment every month you have an

Interest rate and you want to make sure that the int that the present value have the monthly payments equals the mortgage balance at the beginning so the initial mortgage balance that's the amount you borrowed has to equal the present

Discounted value of all the monthly payments so what I call the monthly payment let's call the monthly payment X is the monthly payment in dollars okay so the mortgage balance is equal to X all over R over 12 where R is the annual

Interest rate times 1 minus 1 all over 1 plus R over 12 to the M power that's just the annuity formula okay so that's the formula that's used to compute is make sure so you have shown you that formula before it's the present value of

A stream of payments equal to X that I write R over 2 twelve so what you have to do if you are calculating an amortized mortgage if the person is borrowing the amount was about mortgage balance and I quote a rate R

Per year I have to plug that into the present value formula and find out what monthly payment ex makes the present value equal to the amount loaned now that is a little bit of arithmetic that mortgage lenders would have had trouble

Doing it's not that hard to do right but I have here a page from a mortgage table from I found this in the Yale library can you read that that this is from a fifty year old book this is before they had computers and so it was too hard to

Do this calculation but I just wanted to can you read it in back sort of this is for a ten year mortgage I just picked ten years that was uncommon that's rather short some people would get shorter mortgages especially

Older people you know if you're 16 years old you don't want a 30-year mortgage you probably won't live that long so they did give out shorter mortgages as well so this is a page from a mortgage book for ten years and this is

For 5% mortgage so it shows the the monthly payment for a thousand dollars if someone's borrowing $5,000 you'd multiply this by five all right but they show it for around $1,000 and the monthly payment it says monthly payment

Per $1,000 is 10 dollars and 61 cents so what they've done is they've they found out X 106 T 1 cents is the X that makes this present value for R equal 5% equal to $1,000 they've done exactly this calculation now they show the

The payment schedule in the payment every month is 10 dollars and 61 cents but what this table shows is the breakdown between amortization and interest so it shows the principal for each month so you borrow at the

Beginning you borrow $1,000 on this mortgage and you're paying 10 dollars and 61 cents per month all right so each month your balance goes down this balance column they subtract well the question is how do you figure it out

You're paying $10 and 61 cents per month but part of that is interest what part of that is into it's five percent of five percent divided by 12 of the one thousand dollar of balance at the beginning so your initial interest is

Four dollars and 17 cents so your principal is the ten dollars and 61 cents minus the interest so then that reduces your balance the principal the initial interest is four dollars and seventeen the principal is 644 sent to

The balance is nine hundred ninety three dollars and fifty six cents after one month the next month they figure what fraction of your payment is interest by multiplying five percent over twelve times the balance $993 and 56 cents and

Then that comes out to be four dollars and fourteen cents interest you see the interest is going to be going down because you're paying off the loan but your payment is fixed so the payment against principal is going up so the

First month was four dollars and seventeen cents interest the next month is four dollars and fourteen cents interest offsetting that is the first month with its 644 since being used to pay off your mortgage the second month

It's more six dollars and forty-seven cents okay and this goes all the way I couldn't show the whole page here but here after six years six months your interest is down to a dollar seventy four because

Balance is down to 407 61 but yeah and so your payment of principal is much higher so the reason this table is important is that people move and they sell their house early they don't hold it for the full 10 years so you have to

Figure out when someone sells his house after 6 years 6 months what do they still owe will they now owe instead of $1,000 they owe four hundred and seven dollars and 61 cents so that's the idea of a long-term mortgage your interest

Payments are changing all the time your principal payments are changing all the time but your total payment is fixed that was an invention a financial innovation in 1934 and it is now often this is called a conventional fixed-rate

Mortgage and it's now offered in many countries of the world however there's only two countries where it's the major kind of mortgage the United States and Denmark and this is a strange strange thing this invention has not caught on

Around the world it's it's unique to only two countries other you can get it in other countries it's not available in Canada and any number I guess you could find it you but it's not common elsewhere every time I go to a foreign

Country I ask the people there why why do you have why don't you have fixed-rate mortgages and I don't necessarily get good answer I've been trying to understand why it hasn't caught on then I recently saw that

Alastair darling who is uh who was under the Labour government Chancellor I'm trying to be gentle here Alastair darling was chancellor of the exchequer in the United Kingdom until the

Conservative government took over and he issued a statement saying that UK should finally adopt the long term mortgage and the reason the problem is is that any country that doesn't have a long-term fixed-rate mortgage runs the risk of

Following into the same problem that the United States did in the Great Depression some kind of crisis like that could mean that people would lose their homes and great numbers so he said he'd like to see the UK get people borrowing

At 10 20 or even 25 years for their mortgages but instead what happened was the Conservative government took over but there are you can in the UK get long term mortgages that I think it's true in most countries of the world they're just

Not common there and it's a bit of a puzzle why is it that only two countries do this generally I have a couple of reasons offered why it is one of them is that the general public is resistant to long term mortgages because they charge

A higher interest if the government is going to guarantee a rate for 30 years not the government the bank the lender is going to guarantee it for 30 years they're going to have to charge you a higher rate because that guarantee costs

Something for them and and consumers are resistant to paying the higher rate and that's part of the problem the other part of the problem is that bank regulators might not encourage banks to make these loans because it's risky for

Banks if banks make Tye their money up for 30 years and then they have depositors who can withdraw their money at any time the banks could go under if there was ever a run on the banks they can't liquidate these mortgages fast at

All so you need a coordinated effort of a government to first make sure the regulator's the regulator's accept these concepts and it puts some risk on the public of a possible bailout of the banking system

But and then you have to get past public resistance to the you have to make the public understand that when you get a fixed-rate mortgage it's a it's a clean contract we have no worries for 30 years as opposed to there are problems that

Have sometimes occurred in Canada in 1980 the government the interest rate shot way up and we had a kind of a duplicate of the problem that we saw in the US people couldn't afford to refinance their mortgages and a lot of

People lost their homes and so it was a big problem but that they somehow got through that and they're not really thinking about fixed-rate mortgages in Canada even now today so I wanted to go on talking about innovation in finance

Another very important innovation is securitization of mortgages and government support of mortgage markets so in the United States in 1938 the federal government this is also Roosevelt administration set up the

Federal National Mortgage Administration which was a government agency that would buy mortgages to support the mortgage market the on Wall Street they couldn't they couldn't pronounce federal National Mortgage or is it association it's the

Heart of administration does it Association its association not administration the you know what they called it on Wall Street they called it Fannie Mae that was just a irreverent shortened name for the association it

Was run by the government and however it was in the year 1968 the US government privatized Fannie Mae and became a private corporation so what did Fannie Mae do it would buy mortgages from banks they were trying to encourage the

Mortgage market so a bank would lend money to someone to buy a house and then they were done they can't lend any more money unless they raise more deposit well Fannie Mae would buy the mortgage from them and get they'd have money

Again to lend again and so they did this in 38 because we were still in the depression and the housing in the housing market was still depressed they weren't building home there are lots of unemployed construction workers and so

Rosa was just thinking how can we stimulate the economy and this was their one of their ideas so Fannie Mae was the Mortgage Finance diet that was created in 1968 I can shut this off here so in 1970 government created another

Many may like institution called its official name was Federal Home Loan Mortgage Corporation and the wall stre had to invent a name for it so they called it Freddie Mac okay they thought well we gave a girl's name to Fannie Mae

Let's give a boy's name I guess that's a boy's name now both of these organizations call them but they're both private companies now but created by the government they both use these names officially now so that's their name now

Fannie Mae and Freddie Mac the Freddie Mac was initially different because what the government asked Freddie Mac to do is buy mortgages and then repackage them as mortgage securities and sell them off with a guarantee of Freddie Mac

Guaranteed and so once Freddie Mac started doing this Fannie Mae said well can't we do that too so they both do it so what the government had done is create two private corporations you kind of wonder well private corporations why

Did the government even do that anyone can create remember we have a corporate law I can start my own Freddie Mac okay my own Fannie Mae but the government did create that well by privatizing Fannie Mae and by creating Freddie Mac and they

Are both in the mortgage securitization business so they would buy from mortgage originators people who lend the money they'd buy the mortgages in other words they take the IOU from someone they'd repackage them into securities and sell

Them off to the public with a guarantee from Fannie or Freddie that the mortgage if there were default the mortgage would extra balance would be made up by Fannie or Freddie okay well they might then they did then get other companies called

Mortgage insurers to in at least part of the balance so it's complicated financial agreement but what we had was private companies created by the US government that created securities for investors that were

Guaranteed against default and based on the based on mortgages so the government then also stated that these are private companies and the US government does not stand behind them people started to say the government created these two

Corporations and now they're their securitizing and guaranteeing trillions of dollars of mortgages and is this going to come back and end up being paid for by the taxpayer so the government stated clearly these are now private

Corporations Fannie Mae started out as part of the government but no longer now it's a private corporation and if Fannie Mae goes bankrupt woe betide anyone who bought their securities because their guarantee is not backed up by the

Federal government so people complain though they said it's your steer saying that it's not backed up by the federal government but do you really mean that if Fannie or Freddie goes bankrupt well the US government just let them go under

Well the official statement was yes the government will let them go under guess what happened okay in 2008 the real estate market crashed and we had our first housing crisis that was similar to the Great Depression and in

That housing crisis both Fannie and Freddie went bankrupt okay and now what do we do we're in the Bush administration Republican they don't particularly like bailouts okay so you'd think of course george w bush would just

It's the law right the federal government is not going to bail them out but then some people said wait a minute you know all over the world people are investing in these thinking that well Fannie Mae was

Created by the US government in particular a lot of Chinese those poor innocent Chinese for trusting the Americans and they put many billions of dollars into Fannie Mae are you going to go and tell the Chinese

Sorry you know we won't back it well someone could say sure go tell them that it's what we've been saying all along but then the Chinese could come back and say well you've been saying that but nobody believed you everyone

Knew that that wasn't right and and you the federal government didn't take all the right steps to make it really clear for example the Wall Street Journal used to list Fannie Mae bonds and Freddie Mac bonds in a section of the newspaper

Entitled government securities and see and that's the Wall Street Journal that's not the government talking but you know the US government should have come in and told them no those are not government so we poor innocent Chinese

Investors we read your paper and it said government securities now George Bush could have said tough luck you know you guys you should have read the fine print but he didn't all right why not because it jeopardizes too much if the US

Government lets these agencies that it created go bankrupt and it lets all those people all over the world who invested in those securities they're going to be mad right and you know we just we have a reputation the United

States is able to raise so much money from all over the world because they think that it's safe here and if we just let these fail it's not going to look right so the US government took them both under conservatorship and is paying

Their debts paying off so those did not default what we've learned from this lesson is that you can say a million times that you're not going to guarantee something but when it comes eventually you end up guaranteeing

It I want to just say something about other countries a little bit Canada has something like Fannie Mae and Freddie called the canada housing and mortgage corporation and so i just talk about other countries the canada housing and

Mortgage corporation and it was created in adesh they don't have the year but it was created by the government of canada and it does work that resembles FHA and it resembles fannie mae but it's owned by the canadian government it's not

Privatized and so you might say well it's the same in canada but the big difference is it's smaller they didn't let it get as big as fannie and freddie and so it isn't heard as much from i was a keynote speaker at a conference

February 3 that the Financial Times organized in New York called focus on Canada and I had to give a talk about Canada to New York investors they told me there were hardly any Canadians in the audience what are we doing here in

New York talking about Canada well it's because the Americans invest heavily in Canada so I was up talking to all these American people and I said I was looking at Canada and Canada banking system and the I said to the group you know Canada

In America are just so similar I can't see much of a difference and that the the recent financial Canada had didn't have Fannie and Freddie it didn't have these housing problems but the the worldwide recession hit Canada pretty

Hard and so I said Canada and us are kind of like two peas in a pod that's what I they're so similar people like to make much of differences but the Canadian economy is just move up and down in lockstep and I also said Canada

Was saved by the oil crisis being an oil exporter and if it did have the oil in 2008 remember when the oil prices shot up but little to my knowledge there was a reporter for the Financial Post in Canada and the

Audience and my talk got reported in the Financial Post and then I went on their website and there's blogs angry blogs from Canadians I don't think it's so insulting to candidate to say that we're just basically similar I didn't but but

I what I'm and I'll to say this for Canada they did not get so gung-ho on supporting mortgages as the United States did so they didn't have such a big housing bubble that the us did part of the reason the US had a housing

Bubble as big as it did is that the US government see these guys really want independent they were taking orders from the government and the government was telling them to increase their lending to low income or to underserved

Communities they wanted they were promoting the bubble and so Fannie and Freddie were told to promote lending to houses during the real estate bubble that preceded the crisis that didn't happen at least not so much in Canada so

They've had less of a bubble but still the two countries are basically very similar so I think the textbook talks a lot about mortgage securities and there's a major correct you to read this out of Fabozzi I actually got complaints

I'll tell you in past years students found this the least enjoyable part of the readings for this course but you should know about these things so we have securities called collateralized mortgage obligations

These are mortgage securities that hold that they're securities that are sold off to investors and they they hold mortgages but the as it's explained in they will divide them in the separate tranches or separate securities in terms

Of prepayment risk that is that there's a risk that the mortgages will be paid off early in times when it's adverse to the investor interest so they would divide up the risks into different classes of securities and some of them

Were rated triple-a by the rating agencies because they thought there was almost no risk to those securities and others were rated different differently and these were these CMOS were sold to investors all over the world another

Kind of security which the textbook talks about is a CDO which is a collateralized debt obligation and these are issued to investors and they typically hold mortgage securities as their assets many of them held subprime

Mortgages in recent years mortgages that were issued against subprime borrowers and a lot of these securities that were rated very highly by the rating agencies rated triple-a ended up defaulting and losing money for their investors and the

Investors were all over the world the United States is a leader in mortgage finance and it was issuing companies in the United States were issuing not just Fannie and Freddie but lots of companies were issuing mortgage securities that

Had triple-a ratings which meant that Moody's and Standard and Poor's and the other rating agencies were telling you basically there was no risk to them and so people in Europe in Asia were investing in these and they thought they

Were perfectly safe and then they went under and part of it was bad faith dealings by some of the issuers some of the issuers themselves doubted that these mortgages were so safe but what do I care I this

Is what happened somebody originated it's gotten subjective a complicated set of steps yeah if somebody originates the mortgage okay that means I talked to the homeowner I have the promoter fill out the papers then after they've originated

The mortgage they sell it to an investor okay like Fannie or Freddie or some private mortgage securitizer and the private mortgage securitizer finds a mortgage servicer it may be the originator who will then service the

Mortgage and what does it mean to service a mortgage it means to call you on the phone if you missed your payment for example or if you have questions about the mortgage there should be someone you call so the mortgage

Servicer does that so that's a separate entity and then we have the CMO organizer the originator then we have the CDO originator it's gotten to be a very complicated financial system and then the whole thing collapsed so

There's been a lot of reform to try to see what can we do to prevent this kind of collapse some people would say let's end the whole thing let's go back to 1778 let's not have mortgage securitizers but

That's not the steps that have been taken and I think that we are making progress and I want to just conclude with just a little reference to one important change that was made in both Europe and the United States so the

European Parliament passed a new directive that requires or incentivizes mortgage originators to keep 5% of the mortgage balance in their own portfolio so that means if you originate a portfolio you can sell off if you

Originate mortgages you can sell off ninety five percent of the mortgages to investors but you have to keep five percent so this five percent limit was and later incorporated into the dodd-frank back in the United States so

We again have the same requirement and this is supposed to reduce the moral hazard problem that created the crisis and retain the mortgage securitization process so the the idea is this you and I know I heard people tell me mortgage

Originators sometimes got cynical they thought okay I'm helping this family fill out a mortgage what do I care you know I think this family doesn't look they're not going to pay this back there's something but what do I care

I'll fill it out I'll sell the mortgage to someone else and I'm out of here in fact it got bad in some cases some mortgage brokers my family would come in offering to wanted to buy a house and the mortgage broker would say that well

What is your income anyway and they would tell them the income and he said say what you're trying to buy a $300,000 house on that income as I don't know if I can do this but then he would say wait a minute think about this again is that

Really your income you told me your income is 40,000 a year are you sure I don't you have some other why don't we say 50,000 a year or I'll say 60,000 a year and the couple would look at him in disbelief and say no we don't hit we

Only have 40,000 he said well think about it you have other sources don't you and they say no everybody does this you know so okay we have 60,000 he says fine and he and he and they thought well organs work gave me permission to do

This and he doesn't care because he's not going to take the loss so the new law is supposed to discourage that kind of thing and there's lots of new laws that are trying to tighten up for example mortgage brokers in the United

States now have to be licensed it used to be just five years ago you could be an ex-con fresh out of jail and you can take up a business as mortgage broker you can't anymore so what's happening all over the world

That we've learned from this experience but we're retaining this basic system of mortgage securitization mortgage lenders that are professional the the basic industry has been retained and we're hoping and thinking that maybe we have a

Better system so I will stop there and I'll see you on Monday

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