Real Estate Finance Fall 2018 Don Weidner Nine

Real Estate Finance Fall 2018 Don Weidner ØNine sets of slides for the Fall 2018. ØAre available on my web page under “Course Materials. ” ØAre also posted on Canvas under “Modules” or “Course Library”. Ø May be amended slightly. ØCourse Syllabus. ØIs posted on my web page under Course Materials and on Canvas under “Syllabus”. Ø Assignments. ØWe shall proceed directly though the Syllabus ØThe slides will take us directly through content indicated in the Syllabus. They include additional material not in the Text or in the Supplement. 1 Donald J. Weidner

Background on Contracts and Conditions Seller Listing Agreement Broker Contract of Sale “Interim Contract” Buyer Closing Seller Buyer Lender 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. 2 Donald J. Weidner

Contract Conditions ØText says conditions “are essentially substitutes for information. ” ØAbout legal title, physical condition, availability of financing ØHowever, conditions may also be inserted by the buyer to postpone making a commitment. ØConditions range from the extremely general to the extremely specific. ØConditions may leave so much open that a contract arguably fails to satisfy the requirement of a writing under the Statute of Frauds. ØEven if the Statute of Frauds is satisfied, the contract may be too indefinite to support an award of specific performance. 3 Donald J. Weidner

Illusory Contracts Ø“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. ” ØThat party has, in effect, an option Ø“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. ” 4 Donald J. Weidner

Illusory Contracts (cont’d) ØOn the “excuse” issue, the text says: “In such cases the court will examine the motive of the party relying on the condition. ” ØIf a written contract gives me a right, must I show that I am pure of heart before I may enforce it? ØNot everyone thinks so. Courts are split on their role in applying the “good faith” requirement (or rubric). Ø“Good faith” can serve either as (1) a gap filler or as (2) a mandatory rule ØWe shall discuss this topic further 5 Donald J. Weidner

Homler v. Malas (Text p. 92) ØSeller sought to specifically enforce a Buyer’s promise to purchase a single-family residence. ØContract, on a standard form, had a “subject to financing” clause that conditioned Buyer’s performance Øon Buyer’s “obtaining a loan” (“ability to obtain” had been deleted). ØFor 80% of the purchase price. ØRepayable monthly over a term of no less than 30 years. ØHowever, there was no mention of: Ø Interest rate (left blank). Ø The amount of monthly payment (left blank). Ø Amortization terms. ØShould this contract be specifically enforced against the Buyer? 6 Donald J. Weidner

Homler v. Malas (cont’d) ØBuyer said the contract “is too vague and indefinite” to be specifically enforced because the “terms of the financing contingency are not sufficiently identified. ” ØAmount and length were specified ØOther 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. ” ØSeller said that there is no need to specify the interest rate in a contract that anticipates third-party financing. ØCan you see what the argument might be? Ø Especially in this case, with a single family residence? 7 Donald J. Weidner

Homler v. Malas (cont’d) ØCourt said: it is not as if the contract had specified interest at the “current prevailing rate. ” ØHowever, the contract assumed a search for third-party financing. ØWhy not use the concept of good faith as a gap filler? ØThat 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” ØStated 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” 8 Donald J. Weidner

Homler v. Malas (cont’d) ØHow would you decide this case? ØCourt concluded the contract was too “vague and indefinite” to be enforced against the Buyer and ordered the Buyer’s deposit to be refunded. ØWhy did the court refuse to use the concept of good faith to fill the interest rate gap? ØEveryone agrees the buyer is under a duty to proceed in good faith. The split is on what that means. ØWhat was the buyer attempting to do with the strikeout? ØDid the contract merely give Option to Buyer? ØWas the seller, therefore, trying to use GFFD to strike down the express language the seller had agreed to? ØCould Buyer have enforced the contract against Seller? ØSeller might have argued the old doctrine that there was no “mutuality of obligation” 9 Donald J. Weidner

Definitions of Good Faith ØEvery contracting party is under a duty or obligation of “good faith” ØThe question is what that duty requires ØUCC general definition of GF: “honesty in fact in the conduct or transaction concerned. ” ØHonesty to Webster: “uprightness; integrity, trustworthiness” also “freedom from deceit or fraud. ” ØUCC definition of GF for a merchant: “honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade. ” ØAKA “GFFD” ØMany statutes use the term “good faith” without defining it. ØSome 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. 10 Donald J. Weidner

Liuzza v. Panzer (Text p. 94) ØContract to sell and to buy for $37, 500. ØBuyer’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%. ” ØBuyer applied to an S & L for a $30, 000 loan and was rejected because the appraisal was too low. ØS & L appraisal was $32, 150. ØBuyer may have said “oooops!” ØS & L would only lend 80% of the appraised value, or $25, 720, which is less than the $30, 000 loan condition mentioned in the contract. ØCan the Buyer walk away from the deal at this point? ØThat is, before refusing to close, what more, if anything, must Buyer do to avoid breaching the Buyer’s implied obligation to act in good faith? 11 Donald J. Weidner

Kovarik v. Vesely (Text p. 95) ØContract 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. ” ØFort Atkinson S & L rejected the Buyers. ØSeller offered to provide $7, 000 financing on the same terms that Buyers requested from Fort Atkinson. ØBuyers refused the offer of Seller financing ØSeller sued to specifically enforce the contract. ØDid the court correctly conclude that good faith required the Buyer to accept the Seller’s offer of seller financing? 12 Donald J. Weidner

Kovarik v. Vesely (cont’d) ØCourt rejected the Buyer’s argument that the incomplete financing clause failed to satisfy the Statute of Frauds requirement of a writing. ØThe financing clause referred to “$7, 000 purchasemoney mortgage from the Fort Atkinson S & L. ”. ØHow is this clause incomplete? ØThe 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]. ” ØIs there one transaction or two? 13 Donald J. Weidner

Kovarik v. Vesely (cont’d) ØTo fill any gaps, consider the standard practice among savings and loan associations with respect to this particular type of loan. ØThat is, business practice and the rule of reasonableness would fill in the gaps ØHowever, that does not mean that the buyer should be forced to accept purchase money financing from the seller. 14 Donald J. Weidner

Kovarik v. Vesely (cont’d) ØThe 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. ØEven if good faith is a mandatory rule that could be applied to trump the language of the contract in this case, the question is what the mandatory rule requires. ØA buyer could reasonably want: ØA third-party lender to provide a “reality check” on value; and ØA standard institutional approach in the administration of the loan Ø especially in the event of default. 15 Donald J. Weidner

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 Ø Applying a loan/value ratio to Ø An appraisal of value 2) Length of loan 3) Rate of interest 4) Amortization terms—the terms under which principal is repaid 16 Donald J. Weidner

Loan to Value Ratio ØMay be set in statute, regulation or internal portfolio or other policies. ØExamples of statutory language used to mandate maximum loan to value ratios: Øappraised value Øestimated value Øreasonable normal value Øestimated replacement cost Øactual cost ØThese terms are subject to a range of interpretations 17 Donald J. Weidner

Loan to Value Ratio (cont’d) ØMany lenders believe that the loan/value ratio is merely an obstacle that fails to serve the stated purpose of protecting the institution. ØThey believe that there is greater protection in exacting credit standards, increased site scarcity, inflation or other factors ØOr, they are simply very eager to do a deal. ØThey might also be planning to sell the loan immediately and thus avoid any risk attendant to it—they have no “skin in the game” ØTherefore, they often ignore the ratio ØOR, increase the appraisal Ø(more on appraisals in slide Set #2) 18 Donald J. Weidner

Length (“Term”) of Loan ØThe longer the length, or term, of the loan, the lower the Debt Service ØConsider, for example, an $18, 000 home improvement loan. If the interest rate is 6%, the monthly Debt Service is Ø$199. 98 if the term is 10 years Ø$116. 10 if the term is 25 years Ø$ 99. 18 if the term is 40 years ØThe benefit of lower debt service has a cost: the longer the term, the more interest the borrower pays. 19 Donald J. Weidner

Rate of Interest ØThe greater the rate of interest, the greater the Debt Service. ØFor example, consider a 25 -year $100, 000 home improvement loan. Monthly Debt Service at Ø 4% interest is $ 528 (interest rate in 2017) Ø 6% Ø 8% Ø 10% Ø 17% interest is $ 644 interest is $ 770 interest is $ 908 interest is $ 1, 436 (interest rate in 1980) 20 Donald J. Weidner

Points Ø“Point” is one percent of the face amount of a contract debt. ØPoints can be characterized differently, ex. , as interest, as compensation for services, etc. ØBasic examples of ways points can work: ØLender can charge a borrower a one “point” origination fee. ØPurchaser of a note can charge “points. ” Ex. , Buyer executes note to Seller for $40, 000 (interest, length, amortization terms also specified). ØLender purchases note from Seller charging 6 points [$40, 000 X 6% = $2, 400]). ØThat is, Lender pays only $37, 600 for the $40, 000 note [$40, 000 minus the $2, 400]. ØBuyer still pays “interest” on full $40, 000 face amount of the note (thus getting Lender more than 6% on its purchase price) 21 Donald J. Weidner

SELF AMORTIZING LOANS Loans that are fully repaid, at the end of the debt service schedule, without the requirement of a payment larger than those that have gone before. First type: Constant Payment DEBT SERVICE COMPONENTS . . . PASSAGE OF TIME Principal Interest 22 Donald J. Weidner

SELF AMORTIZING Second Type: Constant Amortization DEBT SERVICE COMPONENTS . . . PASSAGE OF TIME Principal Interest 23 Donald J. Weidner

NON SELF AMORTIZING DEBT SERVICE COMPONENTS . . . BALLOON PASSAGE OF TIME Principal Interest 24 Donald J. Weidner

Goebel v. First Federal (1978) (Text p. 368) 1. 2. 3. 4. 5. 6. The note to the S & L provided: Interest shall be paid monthly. Initial interest rate was 6% per annum. The initial interest rate may be changed from time to time at the S & L’s option. There will be no interest rate change during first 3 years. Borrower will get 4 months written notice before any interest rate change. Borrower has 4 months from receipt of notice of a change to prepay without penalty. 25 Donald J. Weidner

Goebel (cont’d) ØNine years later, Lender declared that the interest rate was being increased and that Borrower had the option to ØPay increased monthly Debt Service, or ØIncrease the length of the loan. Ø[No mention was made of amortization terms/balloons]. ØCourt said it construes ambiguous language in the note against the drafter, especially when Øthe drafter has much greater bargaining power, and Øthe drafter supplied its “standard form. ” 26 Donald J. Weidner

Goebel (cont’d) Ø As to whether the lender could increase monthly Debt Service, court said expressio unius controlled: The note contained provisions to increase Debt Service in some situations but did not expressly 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. 27 Donald J. Weidner

Goebel (cont’d) Ø As to whether the lender could increase the term (the length of the loan), the court focused on note provision 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. Ø And, therefore, Borrower could not be forced to continue to pay debt service for a longer term Ø Enforcing the parties’ intent? 28 Donald J. Weidner

Goebel (cont’d) Ø How else could you implement the interest increase provisions (if you can’t increase either the amount of the monthly payments or the term of those payments)? Ø 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 Ø “Due on sale” clause was enforceable Ø How does this fit with what the court said about a balloon (“this method was not used”)? 29 Donald J. Weidner

Note to Goebel v. First Federal ØNo argument was made that an interest increase was unconscionable or otherwise illegal. ØSee also Constitution Bank (Text p. 378): “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. ” ØRecall, “good faith” can be a “gap filler” to salvage an otherwise indefinite contract, particularly by importing the general business practice. ØRecall, too, that the borrower in Goebel had the option to prepay without penalty upon an interest rate increase. ØIndicating that market forces would limit the lender from exacting an increase. 30 Donald J. Weidner

Pre-”Great” Depression Residential Financing ØAmount. At least theoretically, loan/value ratios were very low, typically 50 -60% of appraised value. ØLenders stretched their appraisals. ØBorrowers took out second, third (“junior”) mortgage loans. ØLength. Seldom for more than 10 to 15 years. In 1925, the average length for mortgages issued Ø by life insurance companies was 6 years; Ø by S &Ls was 11 years. ØRate of Interest: Junior mortgages were at higher rates of interest than first mortgages. ØAmortization Terms: Balloons were common. In the “Great Depression, ” 1 million American families lost their homes to foreclosure between 1930 -1935 However, many more lost their homes in the years following 2006. 31 Donald J. Weidner

Post-”Great” Depression Mortgage Insurance Transformed Mortgage Terms ØAmount. Government undertook to insure loans with much higher Loan/Value Ratios (consumers were unable to pay big down payments coming out of the depression) ØLength. To decrease the debt service on the larger loan amounts, the government insured longer loans. Terms increased up to 40 yrs. for certain projects. ØRate of Interest. The government would not insure loans above a certain interest rate. “Points” became important. ØAmortization Terms. Government would only insure consumer loans that were fully self-amortizing. The fundamental Lesson of Great Depression seemed to be: never require a consumer to pay Debt Service that escalates over time. --We subsequently forgot, even spurned that lesson. 32 Donald J. Weidner

The American Dream of Home Ownership Americans Living in their Own Homes (text 352) Ø 1940 41% Ø 1950 53% Ø 1960 62% Ø 1981 65% Ø 2006 69%* Ø 2017 64% *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 borrowers. Many also faulted Chairman Alan Greenspan’s Federal Reserve Bank for keeping interest rates too low for too long. Later at the helm of the Fed from 2006 -14, Ben Bernanke said that it was not the Fed’s fault. From 2002 -2005, he had 33 been on the Federal Reserve Bank’s Board of Governors. Donald J. Weidner

“NEW” TYPES OF CONSUMER MORTGAGES (After the “Great Depression” and Before the Crash) (Text p. 374) 1) Adjustable Rate Mortgage (ARM) (a. k. a. “Variable Rate Mortgage” or VRM) Graduated Payment Mortgage (GPM) 2) Ø 3) 4) 5) 6) And its variant the Growing Equity Mortgage (GEM) Renegotiable Rate Mortgage (RRM) Shared Appreciation Mortgage (SAM) Price Level Adjusted Mortgage (PLAM) Reverse Annuity Mortgage (RAM) 34 Donald J. Weidner

1) ADJUSTABLE RATE MORTGAGE ØInterest rate rises and falls according to some predetermined standard (reflecting market rates). ØOften used in commercial transactions. ØCurrently, “LIBOR” (London Interbank Offer Rate) is being phased out, certainly as a mandatory standard. ØA 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) 35 Donald J. Weidner

Adjustable Rate Mortgages (cont’d) Mechanisms to protect consumers: ØLimit the frequency of interest rate increases ØLimit the magnitude of each interest rate increase ØLimit the total amount of interest rate increases ØRequire downward adjustments if the standard declines. ØOffer borrowers the right to prepay without penalty upon an interest rate increase. ØNote: a borrower may not be able to refinance, even if rates have dropped (ex. , if creditworthiness or value of the property have declined) 36 Donald J. Weidner

Adjustable Rate Mortgages (cont’d) ØMechanisms to protect Consumers (cont’d) Rules may require the disclosure of “balloons. ” Balloon disclosure rules may define a balloon more narrowly than simply as a note that requires any payment at the end of the debt service schedule larger than the payments that came before ØEx. , Florida statute defines it as any payment more than twice the size of a preceding payment. 37 Donald J. Weidner

2) GRADUATED PAYMENT MORTGAGE ØMonthly payments are from the outset scheduled to gradually rise (independent of any fluctuations in rates), while the interest rate and the term of the loan may stay the same. ØInitial concept (back in the Nixon administration): Help the young family that reasonably expects income to grow substantially over the years following the loan closing. ØInitial, low payments are not sufficient to amortize the debt or even to pay all the interest, but subsequent larger debt service payments make up for it. 38 Donald J. Weidner

GRADUATED PAYMENT MORTGAGE (cont’d) ØThe Growing Equity Mortgage (p. 375) is another form of mortgage that involves increasing debt service. ØText 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%. ” ØApparently, it never goes negative as to interest or principal. ØThat is, equity “grows” throughout the life of the loan ØNote: a borrower can tailor his or her own growing equity provisions with prepayment privileges. 39 Donald J. Weidner

3) RENEGOTIABLE RATE MORTGAGE (a. k. a. “Rollover Mortgage”) ØSeries of renewable short-term notes, secured by a long-term mortgage with principal fully amortized over the longer term. ØPatterned after pre-depression instruments, says the text. ØAs 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. 40 Donald J. Weidner

4) SHARED APPRECIATION MORTGAGE (p. 375) ØLender agrees to lend, for example, at a flat rate that is below the current market rate, perhaps well below the current market rate, in return for borrower’s agreement that: ØIf the home is sold before the end of x years, the lender will receive a percentage of the increase in value; ØIf 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. 41 Donald J. Weidner

5) PRICE LEVEL ADJUSTED MORTGAGE ØIt is the loan principal, NOT the interest rate, that varies over the term of the mortgage. ØThe principal is adjusted up or down according to a prescribed inflation index. 42 Donald J. Weidner

6) Reverse Annuity Mortgage ØDesigned to enable seniors to draw cash out of the equity in their homes. ØThe typical Reverse Annuity Mortgagee makes monthly payments to the borrower over the borrower’s lifetime or over a predetermined period. ØWith each monthly payment to the borrower, the debt increases. ØTypically, 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. 43 Donald J. Weidner

New Mortgages (cont’d) ØThe Garn-St. Germain Depository Act of 1982 “preempts state regulations of nontraditional mortgages that are more stringent than counterpart federal regulations. ” Text p. 377. ØThe Act also gave the states limited time to reinstate their programs and very few did. ØSimilarly, Congress, preempted “any state statute or constitutional provision that limited interest rates on first lien, residential mortgage loans. ” Id. ØOther real estate loans are not covered. 44 Donald J. Weidner

Growth of Securitization of Mortgage Debt (See p. 352 -355) ØIn 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. ØIn 1938, the Federal National Mortgage Association (Fannie Mae) was created to buy and to sell federally insured mortgages. Ø(“For most of its early history, it operated like a national S & L, gathering funds by issuing its own debt, and buying mortgages that were held in portfolio. ”) ØIn 1968, the Government National Mortgage Association (Ginnie Mae) was created as a second, secondary market agency to take over the lowincome housing programs previously run by Fannie Mae. It was responsible for promoting the MBS. ØAccording to their 2015 web site, they do not “buy or sell loans or issue mortgage-backed securities (MBS). ” Rather, they “guarantee investors the timely payment of principal and interest on MBS backed by federally insured or guaranteed loans, ” mainly loans insured by the FHA or VA. It also says that “Ginnie Mae securities are the only MBS to carry the full faith and credit guaranty of the United States government. . ” 45 Donald J. Weidner

Growth of Securitization in Mortgage Debt (cont’d) ØIn 1968, Fannie Mae “was moved off the federal budget and set up as a private GSE, which in the 1970 s switched its focus toward conventional loans. ” ØIt was “given the authority to buy and sell conventional (non -federally insured) home mortgage loans. ” (see p. 353) ØIn 1970, Congress established the third major secondary mortgage market agency, the Federal Home Loan Mortgage Corporation (Freddie Mac), Øwhich is also empowered to buy and to sell conventional mortgages. Ø“Like Fannie Mae, it is a private GSE and also is off-budget. ” (Text at 353). ØThey compete in buying and selling mortgages. ØIt initiated the first MBS program for conventional loans. 46 Donald J. Weidner

Growth of Securitization in Mortgage Debt (cont’d) ØIn short, Fannie Mae and Freddie Mac buy and sell mortgages, both federally insured and conventional, and issue Mortgage Backed Securities ØWhereas Ginnie Mae itself does not buy or sell loans or issue MBS, it guarantees investors that they will receive timely payment of principal and interest on MBS backed by federally insured or guaranteed loans 47 Donald J. Weidner

Growth of Securitization of Mortgage Debt (cont’d) Ø“In the 1970 s, the secondary market agencies became critical in promoting the growth of securitization. ” Ø“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 passthrough 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. ” ØThese different slices are known as “tranches” 48 Donald J. Weidner

Growth of Securitization of Real Estate Debt (2002 Eggert article at 355 -61) ØThe history of mortgaged-backed bonds stretches back to the 19 th century. ØPrivate title and mortgage insurance companies sold certificates secured by mortgage pools in the 1920 s. ØThe modern use of securitization began with the 1970 issuance of the first publicly traded mortgaged backed security by GNMA, a GSE, which securitized mortgages backed by various government entities. 49 Donald J. Weidner

Growth of Securitization of Real Estate Debt (2002 Eggert article at 355 -61)(cont’d) ØVarious definitions of securitization. ØHis: “the method of aggregating a large number of illiquid assets, such as notes secured by deeds of trust, in one large pool, then selling securities that are backed by those assets. ” ØThink, selling interests in a package of receivables. ØThrough securitization, the source of mortgage funding has shifted from depositary institutions to the capital markets. Øbroker sells to lender, lender sells to bundler, bundler transfers to seller, seller transfers to SPE (trust), which issues the securities the seller sells. 50 Donald J. Weidner

Growth of Securitization of Real Estate Debt (2002 Eggert article at 355 -61)(cont’d) ØMost simple tranches (strips): interest-only tranche and principal-only tranche. ØIf interest rates drop, refinancings will increase, giving the holders of the interest-only tranche less money and holders of the principal-only tranche more money sooner. ØQuaint: The credit “rating process efficiently allows the market to determine the value of the investment and hence the return the investors will demand for purchasing securities backed by the assets to be securitized. ” ØQualified later by concerns about complexity, inability to predict, frequent downgrades as defaults occur. ØOther “credit enhancements” are also involved. 51 Donald J. Weidner

Growth of Securitization of Real Estate Debt (2002 Eggert article at 355 -61)(cont’d) Ø“The transfer to the special purpose trust [the entity that actually issues the securities] must constitute a true sale, so that the party transferring the assets reduces its potential liability on the loans and exchanges the fairly illiquid loans for much more liquid cash. ” ØBut for any buy back an originator may have signed, the sellers along the way hope to be “out of the picture” with no “skin in the game. ” ØFor example, an originator selling a mortgage may agree to buy the mortgage back if it goes into default with 6 months of the sale. 52 Donald J. Weidner

Growth of Securitization of Real Estate Debt (2002 Eggert article at 355 -61) Ø“The true sale also acts to separate the assets from any potential bankruptcy. . . or other risk associated with the original lender or pooler of the loans. ” Øto make the assets “bankruptcy remote. ” ØThat is, if the originator has truly sold the mortgages, if the originator subsequently goes bankrupt, the originator’s creditors cannot pursue the mortgages (unless the transfer were somehow deemed fraudulent) Øcompanies with bad credit ratings transfer their most valuable assets to an SPV, which issues bonds that cost the companies less because they carry investment grade ratings. ØThe collection and distribution of payments of principal and interest are made by servicers employed by the SPV. ØOriginally by the originators or packagers of the loans, often by specialized servicing firms. ØOn default, the servicer may begin foreclosure proceedings. ØIn general, early prepayment and foreclosure are the two biggest risks to investors. 53 Donald J. Weidner

Federal Reserve Policy ØWhen the Federal Funds Rate was only 1%, Federal Reserve Chairman Alan Greenspan announced that the Federal Open Market Committee would maintain an “highly accommodative stance” for as long as needed to promote “satisfactory economic performance” ØThus, there was cheap money to help drive up prices ØWhen Treasury obligations were not paying investors very much, they turned to mortgaged-backed securities for higher yields at, they thought, relatively little risk ØAt the same time, Chairman Greenspan believed that the discipline of the markets, rather than regulation, would prevent excessive risk taking in mortgage-backed securities. ØHe later acknowledged that he had overestimated the discipline of the markets. 54 Donald J. Weidner

“Crisis Looms in Market for Mortgages” (Supplement p. 1) Gretchen Morgenson, “Crisis Looms in Market for Mortgages, ” New York Times, March 11, 2007. ØAs of March, 2007, the nation’s $6. 5 trillion mortgage securities market was even larger than the United States treasury market. ØAs of 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. ” ØYet some financial institutions were still making rosy projections based on the assumption that home prices would not fall. Ø 35% of all mortgage securities issued in 2006 were in the subprime category. 55 Donald J. Weidner

Crisis Looms in Mortgage Market (cont’d) ØSubprime Lenders created “affordability products, ” mortgages that ØRequire little or no down payment ØRequire little or no documentation of a borrower’s income ØMortgages that require little or no documentation were known as “liar loans. ” ØExtend terms to 40 or 50 years ØBegin with low “teaser” rates that rise later in the life of the loan. ØLoan to value ratios increased Øwith “generous” appraisals 56 Donald J. Weidner

Crisis in Mortgage Market (cont’d) Ø“Securities backed by home mortgages have been [publicly] traded since the 1970 s, 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. ” ØWall 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. ØThese “opaque securities” were hard to value. Their “values” were often propped up or overstated. Ø“Only when a security is downgraded by a rating agency do investors have to mark their holdings [down] to the market value. ” ØThe financial statements of investors, which were not marked-to-market, made investors looked stronger than they were, and people started to realize it. 57 Donald J. Weidner

Crisis in Mortgage Market (cont’d) ØThe 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. ” ØSome of the big firms even acquired companies that originate mortgages. ØInvestors demands for mortgage-backed securities was insatiable ØThe greater the demand, the less the investment banks insisted on quality loans. 58 Donald J. Weidner

Banks Sue Originators on Repurchase Agreements (Supp. p. 8) Carrick Mollenkamp, James R. Hagerty, Randall Smith, “Banks Go on Subprime Offensive, ” The Wall Street Journal, March 13, 2007 ØBritish bank HSBC leads the early 2007 charge to enforce repurchase agreements. Ø“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. ” ØBillions in mortgages are covered by repurchase agreements. ØHowever, many originators say that they cannot afford to buy back the loans or they are seeking bankruptcy protection. Ø“Banks like HSBC bought mortgages from ever-smaller brokers and originators to increase their loan volume when the subprime industry was booming in 2005 and 2006. ” 59 Donald J. Weidner

Rating Agencies ØCredit rating agencies are supposed to assess risk of investment securities—however, the agencies are paid by the issuer of the security. ØHomeowners selling their houses, by contrast, do not hire the person who appraises them for the benefit of the buyer. ØThe rating agencies gave the mortgaged-backed securities a AAA rating, which suggested they were as safe as Treasury Obligations. ØThe projections they made about loan performance assumed a low foreclosure rate ØThat data focused only on recent history and thus suggested a foreclosure rate of perhaps only 2% ØThey didn’t include the newer, more risky mortgages ØNor did they anticipate falling real estate prices 60 Donald J. Weidner

The Rating Agencies (Supplement p. 11) ØFloyd Norris, “Being Kept in the Dark on Wall Street. ” The New York Times, November 2, 2007. ØSecuritization was extremely profitable for investment banks, and only they seemed to understand what was going on. ØThe products they sold (sometimes labeled MBSs or CDOs [collateralized debt obligations]) did not have Ø“real market prices. They could be valued according to models, which made for nice, consistent profit reports” for the people who bought them. 61 Donald J. Weidner

The Rating Agencies (cont’d) Ø“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. ” Ø“And then they blew up. ” Ø“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. ” 62 Donald J. Weidner

The Rating Agencies (cont’d) Ø“Rating agency downgrades do not destroy markets for corporate bonds, simply because enough information is disseminated that other analysts can reach their own conclusions. ” Ø“But the securitization markets collapsed when it became clear the rating agencies had been overly optimistic. ” ØSome suggest that information shared with rating agencies should be shared with the entire market. 63 Donald J. Weidner

The Rating Agencies (cont’d) ØThe SEC began investigating the rating agencies to see if their ratings complied with their own published standards. ØNeither one of two plausible scenarios, knaves or fools, is pretty: Ø“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. [would you buy a house and rely on an appraisal that had been paid for by the seller? ] [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. )” 64 Donald J. Weidner

The Rating Agencies (cont’d) ØBy November 2007, the securitization market had collapsed but the stock market had not yet collapsed. ØInvestors in the more transparent stock market “want to believe that the Federal Reserve can cure all problems by cutting the overnight bank lending rate. ” ØHowever, the collapse of securitization made credit hard to obtain for many, “and a change in the Fed funds rate will not offset that. ” Ø“[I]t has become very difficult to get a home mortgage without some kind of government-backed guarantee. ” ØIronically, the Dodd Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”), passed in 2010 in the wake of the financial crisis, had to provide that governmental agencies could no longer require the imprimatur of a rating agency. 65 Donald J. Weidner

The Rating Agencies— 2015 Update ØIn February of 2015, Standard & Poor’s agreed to pay $1. 375 billion to settle civil charges brought by the U. S. Department of Justice and by 19 state Attorneys General that it inflated its ratings on the mortgagebacked securities that were at the heart of the financial crisis. ØSeparately, S & P agreed to pay CALPERS (the California Public Employee’s Retirement System) $125 million. 66 Donald J. Weidner

Collateralized Debt Obligations ØSecuritization is essentially the sale of an interest in a package of receivables (such as the right to receive payments to service a mortgage or pay credit card debt). ØA collateralized debt obligation is a pool of different tranches (or slices) of mortgages ØOr a pool of mortgages mixed with other receivables, such as credit card receivables ØLower-rated tranches were called “toxic waste” ØThat is, they are so high-risk, they are “toxic” ØBut the tranches were being pooled to make them appear to be less risky ØAnd made to appear even less risky with credit default swaps (contracts allegedly to insure investors against defaults) 67 Donald J. Weidner

Securitisation, When it goes wrong. . (Supplement p. 13) Ø “Securitisation, When it goes wrong. . , The Economist (September 20, 2007) Ø “Securitisation” is “the process that transforms mortgages, credit-card receivables and other financial assets into marketable securities Ø Brought huge gains Ø Also brought costs that are only now becoming clear. Ø “Thanks largely to securitisation, global private-debt securities are now far bigger than stockmarkets. ” 68 Donald J. Weidner

Securitisation, When it goes wrong. . (cont’d) ØBenefits 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. Studies suggest the “secondary market” for bank debt “has helped to push down borrowing costs for consumers and companies alike. ” 69 Donald J. Weidner

Securitisation, When it goes wrong. . (cont’d) 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 ultimately admitted that the Fed was mistaken to assume that the capital markets were efficient]. 5. Broadens the distribution of credit risk “reduces the risk of any one holder going bust. ” By 2007, the Economist reported the crisis had exposed three cracks in the new model: 1. A high level of complexity and confusion. 2. Fragmentation of responsibility warped incentives. 3. Regulations were gamed. 70 Donald J. Weidner

Securitisation, When it goes wrong. . (cont’d) 1. Problem # 1: complexity: “financiers did not fully understand what they were trading. ” Ø “[F]inancial engineering raced ahead of back offices and riskmanagement departments, ” “leaving them struggling to value or account for their holdings. ” Ø Duke’s Steve Schwarcz says some contracts “are so convoluted that it would be impractical for investors to try to understand them” Ø 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. ” Ø “Securitisations are generally structured as ‘true sales’: the seller wipes its hands of the risks. ” Ø One middleman has been replaced with several. 71 Donald J. Weidner

Securitisation, When it goes wrong. . (cont’d) In mortgage securitisation, the lender is supplanted by --the broker [who brings the borrower to the originator] [charging fee] --the loan originator [charging fee] --the servicer (who collects payments) [charging fee] --the arranger [who bundles the mortgages] [charging fee] --the rating agencies [that rate the bundles] [charging fee] --the mortgage-bond insurers [charging fee] [by January of 2008, there was widespread concern over their stability] --the investor (the “ultimate holder of the risk”) 72 Donald J. Weidner

Securitisation, When it goes wrong. . (cont’d) Ø “This creates what economists call a principal-agent problem. ” Ø The principal-agent problem occurs when one person (the agent) is able to make decisions on behalf of, or that impact, another person or entity (the principal). The problem exists because the agent may be motivated to act in its own best interests rather than in the interests of the principal. Ø “The loan originator has little incentive to vet borrowers carefully because it knows the risk will soon be off its books. ” Ø “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. ” Ø Most investors were sophisticated institutions too taken with alluring yields to push for tougher monitoring (some institutions were pressured to sell after things went bad and there was no market) 73 Donald J. Weidner

Securitisation, When it goes wrong. . (cont’d) 3. Problem #3: Regulations were gamed. ØOnly now are the politicians looking at the rating agencies. Ø“The agencies appear to have been too free in giving out AAA badges to structured products, especially CDOs. ” Ø“[T]heirs is one of the few businesses where the appraiser is paid by the seller, not the buyer. ” ØThe agencies had little incentive to monitor their ratings after issuing them. Ø“Regulatory dependence on ratings has grown across the board. ” ØBanks can reduce the amount of capital they are required to set aside if they hold highly-rated paper. ØSome investors, such as money-market funds, are required to stick to AAA-rated securities. 74 Donald J. Weidner

Securitisation, When it goes wrong. . (cont’d) Looking forward: Ø“Investors need to know who is holding what and how it should be valued. ” ØRegulators may call for consistent evaluation of assets across firms. ØThere will be calls for greater standardization of “structured products. ” ØRegulators 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. ” Ø[The 2015 settlements with the Justice Department and with CALPERS more closely align the interests of the rating agencies and investors]. Ø“[T]he transformation of sticky debt into something more tradeable, for all its imperfections, has forged hugely beneficial links between individual borrowers and vast capital markets that were previously out of reach. ” 75 Donald J. Weidner

Fannie Mae and Freddie Mac: End of Illusions (Supp. P. 22) ØFannie Mae and Freddie Mac: End of Illusions, The Economist, July 19, 2008, p. 79. ØIn August, 2007, Lehman Brothers closed its subprime mortgage lender, BNC Mortgage. ØAccording to the Economist, as far into the mortgage crisis as early 2008, politicians “were counting on Fannie Mae and Freddie Mac. . . to bolster the housing market by buying more mortgages. ” ØBy July 2008, it was clear that “the rescuers themselves have needed rescuing. ” ØThe stock in both Fannie and Freddie had crashed. ØOn July 13, 2008, Treasury Secretary Hank Paulsen said he would ask Congress to [1] extend the Treasury’s credit lines to Fannie and Freddie and even [2] buy their shares if necessary. ØSeparately, the Fed said it would [3] give Fannie and Freddie financing at its discount window (as if they were banks). • In September, 2008, Lehman Brothers filed for bankruptcy protection. ØOn October 3, 2008, Congress [4] passed the TARP rescue package (see a subsequent slide). 76 Donald J. Weidner

Fannie Mae and Freddie Mac: End of Illusions (Supp. P. 22) As we have seen, Fannie (Federal National Mortgage Association and Freddie (Federal Home Mortgage Corporation) [aka, the “GSEs”] [Government Sponsored Entities] Ø Ø Ø “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. ” Investors saw through the illusion that the debt issued by Fannie and Freddie was not backed by the government. 77 Donald J. Weidner

Fannie Mae and Freddie Mac: End of Illusions (Cont’d) ØThe belief in the implicit government guarantee of the obligations of Fannie and Freddie: 1. Permitted them to borrow cheaply. ØThey 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! Ø$5 trillion of debt and guarantees! ØTheir 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. ” 78 Donald J. Weidner

Fannie Mae and Freddie Mac: End of Illusions (Cont’d) ØHowever, in the late 1990 s, they moved into another area: buying the mortgage-backed securities that others had issued. ØFannie and Freddie were operating as hedge funds. Ø“Again, this was a version of the carry trade; they used their cheap debt financing to buy higher-yielding assets. ” ØFannie’s outside portfolio grew to $127 billion by the end of 2007. ØLeaving them exposed to the subprime assets they were supposed to avoid. ØInvestors fell for the illusion that American house prices would not fall throughout the country. 79 Donald J. Weidner

The Housing Bubble ØFrom 2000 -2003, there was a speculative bubble in housing. ØPrices kept going up, mortgage financing was available. ØPeople were treating residences as investment vehicles, and non-real estate professionals were buying multiple residences to “flip” ØDespite the rise in prices, the median household income was flat between 2000 -2007. 80 Donald J. Weidner

The Housing Bubble ØTherefore, the more prices rose, the more unsustainable the rise of prices and increased financing costs. ØBy late 2006, the average home cost nearly 4 times what the average family earned ØAs opposed to an historic multiple of only 2 or 3 ØPeople began to default on their mortgages soon after taking them out. ØBy late 2006, housing prices started going down. ØAs defaults started, more houses came on the market, prices went further down. 81 Donald J. Weidner

The Housing Bubble ØWhile prices were rising, people were taking out “Home Equity Lines of Credit” ØThey were borrowing to pay off their mortgage and other debts. ØWhen the Investment Bankers saw the defaults start increasing, they stopped buying the risky loans ØCredit became tight for homeowners ØThe mortgage companies that specialized in buying up and packaging these loans to investment banks started going out of business ØThey were highly leveraged and hence less stable 82 Donald J. Weidner

Foreclosure Filings: 2008 -2012 (2012 figures projected) Ø 2008 – 2, 350, 000 Ø 2009 – 2, 920, 000 Ø 2010 - 3, 500, 000 Ø 2011 - 3, 580, 000 Ø 2012 – 2, 100, 000 Source: Realty. Trac, Federal Reserve, Equifax 83 Donald J. Weidner

TARP: “Troubled Asset Relief Program” Ø$700 billion rescue package approved by Congress October 3, 2008. ØThe 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. ØThe 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. 84 Donald J. Weidner

TARP (cont’d) ØAfter much criticism, the announced plan shifted from the core mission of buying distressed mortgage assets and Øtoward purchasing ownership stakes in banks ØEngland led the way with this solution, suggesting that the federal government may put $250 billion in banks in return for shares. ØWith some restraints on executive compensation. Øand toward bailouts of Fannie and Freddie, automotive companies (Chrysler, GM), AIG and other financial institutions ØAIG had experienced its own financial crisis because of the credit default swaps (CDSs) it issued ØIt went far beyond its successful core insurance business to sell massive amounts of Credit Default Swaps ØInvestment banks and other financial institutions has also issued CDSs 85 Donald J. Weidner

Credit Default Swap (CDS) ØA credit default swap is a contract under which the seller of the contract agrees to compensate the buyer of the contract in the event of a loan default in a referenced loan. ØSimply, the purchaser of a MBS (for example) could buy a CDS from a seller (ex. , AIG), that the seller of the CDS would pay the purchaser in the event of a default on the MBS, or on some other credit event. ØHowever, anyone could buy a CDS. You did not have to own the MBS or have an insurable interest. These were “naked” CDSs, or bets. ØBy the end of 2007, there were an estimated $62 trillion in outstanding CDSs. ØCompared to the $18 trillion 2015 U. S. A. GDP 86 Donald J. Weidner

The Federal Reserve Response In 2008, the Federal Reserve: 1. cut the discount rate, the rate on loans to banks, to near zero; and 2. 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. Ø The more money chasing an asset the more its price will go up. The more the price of a bond goes up, the less it yields. ØStarting at $600 billion and increasing to $1. 8 trillion 87 Donald J. Weidner

Federal Reserve Wants to Inflate Asset Prices (and create a “wealth effect”) Ø“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 ØThe “wealth effect” 88 Donald J. Weidner

The Federal Reserve Response (cont’d) ØOn 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. ØThe basic idea is that, if the Federal Reserve Bank buys Treasury obligations (or mortgage-backed securities), it bids up the price of those securities, and hence lowers the yield on them. ØAt the same time indicating it would continue to hold the federal funds interest rate at close to zero. ØCritics expressed concerns about inflation and about asset bubbles. 89 Donald J. Weidner

Federal Reserve Response (cont’d) ØIn 2011, the Fed undertook “operation twist, ” extending the maturity of the obligations it was purchasing ØSome referred to this as “stealth” quantitative easing ØFurther tending to drive down long-term interest rates ØContinuing its stated policy of making the equity markets more attractive than the low-yielding debt markets 90 Donald J. Weidner

Federal Reserve Response (cont’d) ØQE 3 (aka “QE Infinity) was announced in September 13, 2012 ØFed said that, for the indefinite future, it would purchase $40 billion a month of agency mortgage-backed securities ØIncluding apparently some less-desirable mortgages from member banks ØTending to further reduce mortgage interest rates and inflate asset prices 91 Donald J. Weidner

Federal Reserve Response (cont’d) ØIn December 11, 2012, the Fed also announced it would spend $45 billion a month on long-term Treasury purchases. ØThe mortgage bond purchasing program, plus this treasury obligation purchasing program, equaled $85 billion a month in securities being purchased by the Fed. ØAgain, as the Fed drove down yields on debt, investors were forced to buy other assets to get yield ØReflecting its success at driving up asset prices, the stock markets started hitting all-time highs in March of 2013. ØAlso, corporate profits were strong ØAnd, the economy was on a slow but steady recovery 92 Donald J. Weidner

Federal Reserve Response (cont’d) ØAlso on December 11, 2012, in an unprecedented move the Fed said it planned 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%). ØThis is the first time Fed has publically pegged interest rate policy to the unemployment rate ØU. S. unemployment as of October 2015 was 5 percent. ØWith still no increase in interest rates. ØAnd none of the inflation that critics predicted. 93 Donald J. Weidner

The “Taper” ØIn December 2013, the Fed announced that it would begin to reduce (“taper”) its monthly purchases by $10 billion a month Ø$5 billion less a month for mortgage-backed securities and Ø$5 billion less a month for treasury obligations ØAt the same time it said that it would continue to hold short-term interest rates near zero for the foreseeable future. ØIn January 2014, it said it would do so “well past” a 6. 5% unemployment rate ØThe “taper” was concluded in October 2014. 94 Donald J. Weidner

Where to Next? ØIn December 2015, the Fed raised the key rate for the first time since 2006, by. 25%. ØUnemployment rate at 5%. Intermediate term objective of at least 2% inflation. ØThey said they will watch to make sure that unemployment remains low and that inflation stays high enough. ØWhile central banks around the world are still keeping rates extremely low. Ø“We frontloaded, at the Federal Reserve, an enormous rally, in order to accomplish a wealth effect. ” Former President of the Federal Reserve Bank of Dallas, Richard Fisher, on CNBC, 1/6/16. He would have raised rates long ago. 95 Donald J. Weidner

The Return of Securitization (Supp. P. 29) ØFrom: Return of Securitization: Back from the Dead, THE ECONOMIST, January 11, 2014, p. 59. ØThe essence of securitization is “transforming a future income stream into a lump sum today. ” ØThe ECB (European Central Bank) “is a fan, as are global banking regulators who last month watered down rules that threatened to stifle securitization. ” ØEconomic growth and investors “desperate for yield” are stimulating supply, especially outside the area of residential mortgages. ØPolicy makers want to get more credit flowing in the economy, particularly in Europe. 96 Donald J. Weidner

The Return of Securitization (cont’d) Ø“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. ” ØIn part because European regulators want banks to be less risky. ØBanks bundle up loans on their books and sell them. 97 Donald J. Weidner

The Return of Securitization (cont’d) Ø“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. ’” ØSee also Section 941 of Dodd Frank, the “credit risk retention rule, ” which requires mortgage securitzers to keep certain “skin in the game. ” ØOr, in the words of the Senate Report, it requires “those who issue, organize, or initiate asset-backed securities, to retain an economic interest in a material portion of the credit risk for any asset that securitizers transfer, sell, or convey to a third party. ” ØThere is an exception for “qualified residential mortgages” Ø“Another tightening of the rules makes ‘re-securitizations’, where income from securitised products was itself securitised, more difficult. ” ØDodd Frank also addressed this problem. 98 Donald J. Weidner

Post Mortgage Meltdown (Text p. 382) ØIn 2008, the Federal Reserve Board adopted a rule under the Truth in Lending Act that prohibits creditors from making “higher-price mortgage loans” without assessing consumers’ ability to repay! ØCompliance is presumed if certain underwriting practices followed. 99 Donald J. Weidner

Dodd Frank ØIn 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act required that, “for residential mortgages, creditors must make a reasonable and good faith determination. . . that the consumer has a reasonability to repay the loan according to its terms. ” ØWith a presumption of compliance for “qualified mortgages. ” ØCreditors encouraged to refinance “non-standard mortgages. ” 100 Donald J. Weidner

Dodd-Frank (cont’d) ØDodd-Frank puts the new Consumer Financial Protection Bureau in charge of consumer fraud and protection issues. The new Bureau took over management of the Federal Reserve Board rules requiring assessment of ability to pay. Ø“In the commercial arena, originators of mortgage backed securities will be required to retain five percent of the credit risk on mortgages placed into pools, reducing incentives to sell weak mortgages to investors. ” Text at 389. 101 Donald J. Weidner