Lecture 10 Real Estate
Real estate finance has been crucially important throughout its very long and complex history. Describing the history of mortgage financing, Professor Shiller highlights the historical development of well-institutionalized property rights for mortgage contracts. Subsequently, he focuses on modern financial institutions for commercial real estate, elaborating on Direct Participation Programs and Real Estate Investment Trusts as means for its financing. The distinction between short-term, balloon-payment mortgages before the Great Depression and long-term, amortizing mortgages thereafter shapes the discussion of residential real estate. His discussion of mortgage securitization and government support of mortgage markets centers around Fannie Mae and Freddie Mac, from their inception in 1938 and 1970, respectively, to the U.S. government’s decision to put them into federal conservatorship in 2008. Finally, Professor Shiller covers collateralized mortgage obligations (CMOs) and elaborates on moral hazard in the mortgage origination process.
- Early History of Real Estate Finance & the Role of Property Rights [00:00:00]
- Commercial Real Estate and Investment Partnerships [00:13:39]
- Residential Real Estate Financing before the Great Depression [00:28:12]
- Residential Real Estate Financing after the Great Depression [00:32:19]
- Mortgage Securitization & Government Support of Mortgage Markets [00:48:02]
- Mortgage Securities & the Financial Crisis from 2007-2008 [01:01:06]
10.1 Early History of Real Estate Finance & the Role of Property Rights
Professor Robert Shiller: 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, if I have time, I’m going to try to get into discussing–
Professor Robert Shiller: So when we talk 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’d like to put things in a long-term perspective.
I want to start with the word mortgage. It actually goes back to Latin. Mortuus vadium. And that means in Latin, death pledge, OK? And then, in the Middle Ages in France, they substituted the French word for vadium. And that’s [circles “Gage” on blackboard]. I don’t know how to pronounce it. That means pledge in French. And I don’t know why they called them death pledges. That doesn’t seem to involve death to me. But in the long history of these institutions, it became important. The Oxford English Dictionary says the word mortgage entered the English language in 1283. So, we’ve got a long history here.
Actually, I can take it back further than 1283. 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’d read these old documents in Chinese. And I was looking over her work a little bit to see whether they had mortgages. She says that in China, it didn’t seem, at 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 in Chinese because they were trading between China and many other countries. So, she found some in the Sogdian language. She reads all these languages. It’s an ancient language of what’s modern day Iran. And it’s a dead language. It died out in the ninth century. But she finds some Sogdian documents that look like mortgages. So, some people borrowed money for their 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. Those were mortgages from over 1,000 years ago. So it’s a 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 a passion for understanding origins of things. So, I looked up mortgage on ProQuest to find, what were they talking about. And I found an article in the Hartford Courant, dated 1778. Actually, it 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. We here in Connecticut, have–did you know this?–the oldest newspaper in America. That’s the Hartford Courant.
So, a man by the name of Elisha Cornwell took out an ad in the Hartford Courant in 1778. And he explains in the ad, that he sold his farm, and, instead of taking the money right up front, he’d mortgaged the farm, so that he sold it for GBP 800 to another farmer. And the farmer was promising to pay him. And if he didn’t pay him, he should get back the farm. The farmer subsequently mortgaged the same farm for GBP 880. So he made GBP 80 profit. Would all be fine and good, except he still hadn’t paid back the first mortgage. And then the guy mortgaged it again for GBP 1,000. And Mr. Cornwell 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 it multiple times?” So he said, “I thought I better put an ad in the newspaper so that any subsequent victims of this farmer, would be warned.” So that’s the end of the ad. He said, “This is my farm because he didn’t pay me.”
But this shows how undeveloped mortgage institutions were 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 farmer, who supposedly bought it from Mr. Cornwell, really didn’t, and nobody would know that. You know, he could fool people.
I think that’s partly why you didn’t see so many mortgages in those days. Because the law wasn’t clear. 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 rights to property sufficiently advanced that we could develop a big national or international market in mortgages. So, an important step is in Germany, in 1872, or Prussia, the government created a Grundbuch law that created a system for Prussia that established in 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 Grundbuch at the time.
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 de Soto 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 about 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, “that’s been in the such-and-such a family for a long time.” But if you want solid knowledge of that, if you’re going to base financial transactions on it, you can’t base it just on hearsay. 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, if you lend on a property, 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 supporting the rights of the person living in the home, you might not be able to get it. Or it might take you 10 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 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 institutions. I said, I would start with commercial real estate and then I’ll move to single-family homes or residential real estate. And I’m going to talk now mostly about the United States. There are just too many countries to think about.
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. You kind of have to do the same sort of contract that other people are doing in your country. And I think the standardization 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.
10.2 Commercial Real Estate and Investment Partnerships
Let me talk about some of the institutions in finance in the United States. It’s natural to start with commercial real estate. So, you see a lot of buildings. My question is, how are they owned? I don’t know whether you think about this. Who owns these buildings? 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–we talked about that yesterday–you might sell shares on the stock exchange if it’s 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 sued 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, OK? They’re double-taxed. You as an individual pay an income tax, and your corporation pays a corporate income tax, or a 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 corporation, but a partnership.
The law allows you to form partnerships to own a building. So, you’re building like 360 State Street. It’s a new building that just went up in New Haven. You know this building? The biggest construction. Does anyone know who owns it? It’s probably a partnership. I haven’t investigated that. Or it’s called a Direct Participation Program.
So, 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 $1 million, 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 want to 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. 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 I 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 as the first multinational. This huge company that had all kinds of deals and alliances and business arrangements. And no one wanted that to end. The value came in the growth prospects for that. But a DPP has to end. 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 corporations all the time. You don’t hear about DPP’s. First of all, because they don’t get so big. They’re typically one building. 360 State, for example. And it only lasts for 10, 20 years, and then it’s gone. So, it doesn’t get advertised in 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 you can have a partnership that involves two classes of partners. There’s a 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 DPP is created by someone who understands and knows real estate. Let’s get 360 State Street built. You’re going to know that eventually, because once they open, they’re going to open a supermarket in the first floor of 360 State. And I bet some of you will be over there. Because it’s going to 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 managing the building, or hires a manager for the building, and has a plan and a close out 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, it’s likely what’s happened there. So, that has been the modern structure of real estate. And if they mortgage the building, the DPP would mortgage the building on behalf of the partners.
So real estate finance in the United States–I might as well write it down. 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 are not a shareholder. The DPPs became criticized in the 20th 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, all right, I guess. But how does it protect them to subject them to double-taxation? So, it became a cause that why in the United States do we have most of our investors closed out of these lucrative investment opportunities? 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 why would this be limited to them?
So, Congress in the United States, in 1960, created something new called a real–
Professor Robert Shiller: Real Estate Investment Trusts. Or abbreviated REITs. These were created in 1960 by an act of the U.S. Congress. And it was another example of the democratization of finance. And I believe it started here in the United States. Now, they’re being copied all over the world. They got off to kind of a slow start after 1960, but they have grown dramatically.
The idea is that we will allow a trust to create investments for the general public, for small investors. And they won’t be double-taxed, either, OK? So, a Real Estate Investment Trust has to follow the law, and then it can invest in buildings. So, maybe 360 State is owned by a REIT? I don’t know. But they are not subject to the corporate profits tax.
Now once again, once Congress creates a vehicle that’s not taxed, everyone is going to ask, well, I want my company to be a REIT, OK? So, they had to define it so that isn’t generally available. 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, and capital gains. This is all, I think, in your textbook Fabozzi. 95% 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 from the sale of properties held less than four years. They don’t want real estate churning companies.
So, if you define [correction: satisfy] all of that, you’ve got a REIT. So, that invention, which goes back to 1960–it’s one of those things in finance. It starts out slowly, and most people don’t hear of it, and then it starts to grow. And now they’re everywhere around the world. Well, maybe not everywhere, but in many countries we have REITs.
The U.S. 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 REITS were paying better than the savings bank, and the public flocked to them.
There was a second boom, after the tax reform of 1986 eliminated some tax advantages of DPPs, partnerships. It used to be that the government allowed generous depreciation allowances for partnerships. And people would invest in buildings just as tax dodges. Because if you’re allowed to depreciate the building very effectively, you can kind of cook your profits so that it’s not taxable. And so people we’re investing in buildings too much. The government created a distortion that encouraged too much investment in DPPs. So in 1986, the government 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 suddenly lots of new kinds of REITs appeared. And REITs that involved specialized properties, and the like. Now they’re big, and everyone talks about them. But it’s interesting to me that it took 50 years to get as big as they are now.
And the recurring theme here–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 invention of REITs for example, more and more people are getting involved, OK? So, that’s commercial real estate.
10.3 Residential Real Estate Financing before the Great Depression
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. So this is bigger. In the United States, about 2/3 of households own their own home. It varies across countries, but there are many other countries with similarly high home ownership rates. And this home ownership 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. I already took you back to the silk trade in the Tang Dynasty, but I’m going to be less so far back. I’m 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 called the Homeowners Loan Corporations to bail people out, and they ended up bailing out 20% of American homeowners [correction: with mortgages]. It was a terrible crisis, and so, what was happening?
I am pointing this out because it’s important in the history of real estate finance. Before the Great Depression, mortgages were growing. 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 $10,000, they would typically lend you half the money. They would lend you $5,000. And the loan would say, you pay interest every month until two years has ended, and then you’d repay the $5,000, OK? And then, you can try to get another mortgage. You come back to us and we’ll do it again, if we feel like it, OK? 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, all right? Balloons are big. So you’re paying monthly interest, but then in two years you have got to come up with the whole $5,000, all right? But people thought, it’s all right, I’ll just go back to the bank, or maybe I’ll go to another bank. You know I can go wherever I want and I can borrow $5,000, OK? So, this was the way things were done.
But what happened in the Great Depression? Two things happened. The unemployment rate went up to 25%; A. B, home prices fell in many cases by more than 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, OK? Two years is up. I got to refinance my mortgage. I go back to the bank, and I show up and I say, A, I’m unemployed and my house is worth $4,000. The bank says no dice; you’re not going to get renewed. So what happens? You’re forced to dump your house on the market. You declare bankruptcy. You’ve lost everything. You’ve lost your $5,000 down payment. If you buy a $10,000 house, and you borrow $5,000, then the other sum is called your down payment. So that’s what happened. It was happening to millions of Americans.
10.4 Residential Real Estate Financing after the Great Depression
So, the Roosevelt Administration decided that the old kind of mortgage didn’t–there was something wrong that mortgage. So, in 1934, a year after Franklin Roosevelt became President, they set up the Federal Housing Administration. And it was trying to get lenders back in to lend to homeowners, because it was a catastrophe in the country.
Professor Robert Shiller: So, in order to get lenders back in, the FHA started insuring mortgages. And that meant that if you’re a mortgage lender, and the person you lent the money to doesn’t repay you, and the house isn’t worth enough–you can get the house, but 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 U.S. government imposed the long-term mortgage on the mortgage industry. And they said, this is better. And secondly, it cannot be a balloon payment mortgage. The government said, 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 required that the mortgages be 15-year amortizing.
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 never caught on. To amortize means to pay down the balance. So, an amortizing mortgage has no balloon payment at the end. A 15-year amortizing mortgage has a fixed monthly payment. You make it every single month. And at the end, you’re done. You take your spouse out to dinner and you say, we 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 amortizing mortgages is a little confusing to some people, and in 1934, it took some education. But I want to just describe the amortizing mortgage system. So, we’re going to have a mortgage of maturity. The maturity of the mortgage is in M, and that’s in months. So, in 1934, they started out with 15-year mortgages, which I thought was pretty aggressive, but by the early 1950s, the FHA was emphasizing 30-year mortgages. That’s a long time to pay off on 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, all right? So let’s give them a full 30 years to pay off the mortgage. They’ll be 55. Kids will be going off to college. 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.
The question now is, how do we decide on the monthly payment? The idea of amortizing mortgage is that you have a fixed payment every month. You have an interest rate. And you want to make sure that the present value of the monthly payments equals the mortgage balance at the beginning. So, the initial mortgage balance, that’s the amount you borrowed, has to equal present discounted value of all the monthly payments. So what will I call the monthly payment? Let’s call the monthly payment x, it’s the monthly payment in dollars. So, the mortgage balance is equal to x/(r/12)[1-1/(1+r/12)M], where r is the annual interest rate. That’s just the annuity formula, OK? So that’s the formula that’s used to compute. I’ve shown you that formula before. It’s the present value of a stream of payments equal to x. Did I write r/2? I meant r/12.
So what you have to do if you are calculating an amortizing mortgage, if the person is borrowing the 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 x 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. I found this in the Yale Library. Can you read that? This is from a 50-year-old book. This is before they had computers. And so it was too hard to do this calculation. Can you read it in back? Sort of. This is for a 10-year mortgage. I just picked 10 years. That was uncommon, that’s rather short. Some people would get shorter mortgages, especially older people. You know, if you’re 60 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 the page from a mortgage book for 10 years, and this is for a 5% mortgage.
So, it shows the monthly payment for $1,000. If someone’s borrowing $5,000, you’d multiply this by five. They show it for around $1,000. And the monthly payment per $1,000 is $10.61. So what they’ve done is they’ve found out $10.61 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 payments schedule. The payment every month is $10.61. But what this table shows, is the break down between amortization and interest. So, it shows the principal for each month. So, at the beginning you borrow $1,000 on this mortgage, and you’re paying $10.61 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 $10.61 per month, but part of that is interest. What part of that is interest? Well it’s 5% divided by 12 of the $1,000 balance at the beginning. Your initial interest is $4.17, so your principle is the $10.61 minus the interest. So then, that reduces your balance. The initial interest is $4.17, the principal is $6.44, then the balance is $993.56 after one month.
The next month, they figure what fraction of your payment is interest by multiplying 5% over 12 times the balance, $993.56, and then that comes out to be $4.14 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 $4.17 interest, the next month is $4.14 interest. Offsetting that is in the first month, the $6.44 being used to pay off your mortgage. The second month it’s more, $6.47, OK? I couldn’t show the whole page here, but here after six years, six months your interest is down to $1.74, because your balance is down to $407.61. And so your payment of principal is much higher. 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 six years six months, what do they still owe? Well, they now owe, instead of $1,000, they owe $407.61.
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. 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. United States and Denmark. And this is a strange thing. This invention has not caught on around the world. It’s unique to only two countries, although you can get it in other countries. It’s not available in Canada in any number, I guess you could find it, but it’s not common elsewhere. Every time I go to a foreign country, I ask the people there, why don’t you have fixed rate mortgages? I don’t necessarily get good answers. I’ve been trying to understand why it hasn’t caught on.
Then I recently saw that Alistair Darling, who was under the Labour government–
Professor Robert Shiller: Alistair Darling was Chancellor of the Exchequer in the United Kingdom until the Conservative government took over. He issued a statement saying that U.K. should finally adopt the long-term mortgage. The problem is, is that any country that doesn’t have a long-term fixed rate mortgage, runs the risk of falling 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 in great numbers. So, he said he’d like to see the U.K. get people borrowing at 10, 20, or even 25 years for their mortgages. But instead what happened was, the Conservative government took over. But you can, in the U.K., get long-term mortgages. I think it’s true in most countries of the world. They’re just not common there.
It’s a bit of a puzzle. Why is it that only two countries do this generally? I have a couple of reasons to 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 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 to them. 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 tie their money up for 30 years, and then they have depositors who can withdraw their money at anytime, 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 regulators accept these concepts. It puts some risk on the public of the possible bailout of the banking system. And then, you have to get past public resistance. You have to make the public understand that, when you get a fixed rate mortgage, it’s a clean contract. We have no worries for 30 years. As opposed to problems that have sometimes occurred.
In Canada, in 1980, the interest rates shot way up, and we had a duplicate of the problem that we saw in the U.S. People couldn’t afford to refinance their mortgages, and a lot of people lost their homes. And so, it was a big problem. But they somehow got through that, and they’re not really thinking about fixed rate mortgages in Canada even now, today.
10.5 Mortgage Securitization & Government Support of Mortgage Markets
I wanted to go on talking about innovation in finance. Another very important innovation is securitization of mortgages, and government support of mortgage markets. In the United States, in 1938, the federal government, this is also the Roosevelt Administration, set up the Federal National Mortgage Administration, which was a government agency that would buy mortgages to support the mortgage market. On Wall Street they couldn’t pronounce Federal National Mortgage–or is it Association? I’m sorry; it’s Association not Administration. You know what they called it on Wall Street? They called it Fannie Mae. That was just irreverent short name for the Association. It was run by the government. However, in the year 1968, the U.S. government privatized Fannie Mae, and it 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’re done. They can’t loan any more money unless they raise more deposits. Well, Fannie Mae would buy the mortgage from them, and they’d have money again to lend again. They did this in ‘38, because we were still in the Depression, and the housing market was still depressed. They weren’t building homes. There were lots of unemployed construction workers. And so, Roosevelt was just thinking how can we stimulate the economy? And this was one of their ideas. So, Fannie Mae was the mortgage finance giant that was created in 1968 [correction: created in 1938, privatized in 1968].
Professor Robert Shiller: In 1970, the government created another Fannie-Mae-like institution. Its official name was Federal Home Loan Mortgage Corporation. Wall Street had to invent a name for it. So, they called it Freddie Mac. 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.
Both of these organizations are private companies now, created by the government, they both use these names officially now. So that’s their name now. Fannie Mae and Freddie Mac.
Freddie Mac was initially different. Because what the government asked Freddie Mac to do, was buy mortgages, and then repackage them as mortgage securities, and sell them off with a Freddie Mac guarantee. 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 why did the government even do that? Anyone can create–remember we have a corporate law. I can start my own Freddie Mac. My own Fannie Mae. But the government did create them 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 would 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, if there were default, the mortgage extra balance would be made up by Fannie or Freddie, OK? Well, they did then get other companies, called mortgage insurers, to insure at least part of the balance.
It’s a complicated financial agreement. But what we had was private companies created by the U.S. government, that created securities for investors that were guaranteed against default, and based on mortgages. So, the government then also stated that these are private companies and the U.S. government does not stand behind them.
People started to say the government created these two corporations, and now they’re securitizing and guaranteeing trillions of dollars of mortgages. 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 to anyone who bought their securities, because their guarantee is not backed up by the federal government.
So people complained, though. They said, you’re saying that it’s not backed up by the federal government, but do you really mean that? If Fannie or Freddie goes bankrupt, will the U.S. government just let them go under? Well, the official statement was, yes; the government will let them go under. Guess what happened? 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, OK? And now, what do we do? We’re in the Bush Administration. Republican. They don’t particularly like bailouts. So you think, of course, George W. Bush would just–it’s the law, right? The federal government’s 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 Fannie Mae was created by the U.S. government. In particular a lot of Chinese, those poor innocent Chinese, are trusting the Americans, and they put many billions of dollars into Fannie Mae. Are you going to go and tell the Chinese, “Sorry, we won’t back it”? Well, someone can 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 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 that’s the Wall Street Journal; that’s not the government talking. But, the U.S. government should have come in and told them, no, those are not government. So we poor, innocent, Chinese investors, we’ve read your paper and it said Government Securities.
Now George Bush could’ve said, tough luck, you know? You guys should have read the fine print, but he didn’t, all right? Why not? Because it jeopardizes too much. If the U.S. 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? 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 U.S. government took them both under conservatorship, and is paying their debts, so those do 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 eventually you end up guaranteeing it.
I wanted to say something about other countries a little bit. Canada has something like Fannie Mae and Freddie Mac called the Canada Housing and Mortgage Corporation. And so, I’ll just talk about other countries. The Canada Housing and Mortgage Corporation. 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. So it isn’t heard as much from.
I was a keynote speaker at a conference on 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 was looking at Canada, and the Canada banking system. And I said to the group, Canada and America are just so similar I can’t see much of a difference. Canada didn’t have Fannie and Freddie. It didn’t have these housing problems. But the worldwide recession hit Canada pretty hard. And so I said, Canada and U.S. are kind of like two peas in a pod. They’re so similar. People like to make much of differences, but the Canadian economy just moves up and down in lockstep. And I also said, Canada was saved by the oil crisis, being an oil exporter. In 2008, remember when the oil prices shot up?
But little to my knowledge, there was a reporter for the Financial Post in Canada in the audience. And my talk got reported in the Financial Post. And then I went on their website and there was angry blogs from Canadians. I don’t think it’s so insulting to Canada to say that we’re just basically similar. And I’ll have 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 U.S. did. Part of the reason the U.S. had a housing bubble as big as it did is that these guys really weren’t independent; they were taking orders from the government. The government was telling them to increase their lending to low-income or to underserved communities. 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.
10.6 Mortgage Securities & the Financial Crisis from 2007-2008
The textbook talks a lot about mortgage securities. I expect you to read this out of Fabozzi. I actually got complaints in past years. Students found this the least enjoyable part of the readings for this course. But you should know about these things. We have securities called Collateralized Mortgage Obligations. These are mortgage securities that are sold off to investors. And they hold mortgages, but, as is explained in Fabozzi, they will divide them into 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 interests. So, they would divide up the risks into different classes of securities. And some of them were rated AAA by the rating agencies, because they thought there was almost no risk to those securities. And others were rated differently. And 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. 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. A lot of these securities that were rated very highly by the rating agencies, rated AAA, 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 companies in the United States, not just Fannie and Freddie, but lots of companies, were issuing mortgage securities that had AAA ratings, which meant that Moody’s and Standard and Poor’s and the other rating agencies were telling you basically there’s 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.
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? This is what happened. It’s gotten to be a complicated set of steps. Somebody originates the mortgage, OK? That means I talk to the homeowner. I have the homeowner fill out the papers. Then, after they’ve originated the mortgage, they sell it to an investor, 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. What does it mean to service the mortgage? It means to call you on the phone if you’ve 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. That’s a separate entity. And then we have the CMO 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. I think that we are making progress.
But I want to just conclude with just a little reference to one important change that was made in both Europe and the United States. The European Parliament passed a new directive that requires, or incentivizes, mortgage originators to keep 5% of the mortgage balance in their own portfolio. That means, if you originate mortgages, you can sell off 95% of the mortgages to investors, but you have to keep 5%. So, this 5% limit was then later incorporated into the Dodd-Frank Act 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 idea is this–and I know, I heard people tell me. Mortgage originators sometimes got cynical. They thought, OK, I’m helping this family fill out a mortgage. What do I care, you know? This family doesn’t look–they’re not going to pay this back. 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. A family would come wanting to buy a house, and the mortgage broker would say, what is your income anyway? And they would tell him the income. And he’d say, you’re trying to buy a $300,000 house on that income? I don’t know if I can do this. But then he’d 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 thought you had some other–why don’t we say 50,000 thousand a year. Or say 60,000 a year. And the couple would look at him in disbelief and say, “No, we only have 40,000.” He would say, “Well, think about it. You have other sources, don’t you? Everybody does this, you know.” So, “OK, we have $60,000.” He says fine. And they thought, well, the mortgage broker 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 could take up a business as mortgage broker. You can’t anymore.
So, what’s happening all over the world is that we’ve learned from this experience, but we’re retaining this basic system of mortgage securitization. Mortgage lenders that are professional. 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.
Fabozzi, Foundations of Financial Markets, Ch. 22–25
Shiller, Finance and the Good Society, Ch. 9