1. Real Estate Finance © JR DeLisle, Ph. D. Lecture 2: Residential Finance Overview by James R. DeLisle, Ph.D. January 7, 2010

2. Real Estate Finance © JR DeLisle, Ph. D. Lecture Overview Risk Management –Definition of Risk –Risk Management Process Mortgages –Mortgage Process –Mortgage Risk Management –Legal Concepts in Mortgages

3. Real Estate Finance © JR DeLisle, Ph. D. Mortgage Process Borrower Lender Note & Mortgage Release Cash Repayment

4. Real Estate Finance © JR DeLisle, Ph. D. Roman/German Foundation of Mortgage Law Roman Law –Transfer of title and possession until repayment –No transfer of title or possession; lender could take: Under suspicion of default Under actual default German Law –Terminology Gage is a deposit made to fulfill an agreement Mort is French for Dead Real property (not transportable) was a dead gage –Impact In default the lender could take title Could not look further for relief

5. Real Estate Finance © JR DeLisle, Ph. D. English/US Foundation of Mortgage Law English Law –Concept of usury in that charging interest was sinful –Equitable Right Of Redemption - Allowing borrower to redeem the property after default U.S. mix of Roman, German, And English law –Early Expansion Little need for lending Building societies formed to consolidate funds for home loans –Post-civil War Increased mortgage lending to finance westward expansion Typical loan was short-term, interest-only

6. Real Estate Finance © JR DeLisle, Ph. D. Evolution of Mortgage Finance: Pre-WWII Early 1900s through 1920s –In1913 Fed ok banks to write 5yr, 50%LV, non-amort. mortgages –Building and Loan Associations expanded rapidly –Real estate prices rose rapidly –After 1929 market crash, real estate prices dropped dramatically 1930s –Market crash in 1929 ushered in the Great Depression –Banking collapse, money supply plummeted, unemployment soared –Refinancing short-term, non-amortizing loans became a problem –Solution Federal agencies created FSLIC (1934) FHA (1934) Insurance Fannie Mae (1938)

7. Real Estate Finance © JR DeLisle, Ph. D. Evolution of Mortgage Finance: Post-WWII 1940s –Preoccupied with World War Two –Veterans Administration created: Guaranty 1950s –Decade of S&L expansion and stability –30-Yr Fixed Mortgages: Maturity mismatch; interest rate risk 1960s –Creeping inflation –Disintermediation –Expansion of secondary mortgage market –1968 Government National Mortgage Association (Ginnie Mae)

8. Real Estate Finance © JR DeLisle, Ph. D. Evolution of Mortgage Finance: 70s – 80s 1970s: Inflationary Period/High Interest Rates –1970 Federal Home Loan Mortgage Corporation (Freddie Mac) –Approval of new mortgage designs: VRM, GPM, and RAM 1980s –Legislative Interventions 1981 Deregulation of Financial Institutions Act; Reg Q, S&L Dev 1981 ERTA in 1981 produced ACRS; 1986 TRA took away –Market Reactions S&L debacle 1989 Financial Institutions Reform, Recovery, and Enforcement Act Summary –FHA and VA Assumable loan advantages –Creative Financing: WRAP, PMM

9. Real Estate Finance © JR DeLisle, Ph. D. Evolution of Mortgage Finance: 1990s 1990s –Subsiding inflation resulted in lower mortgage rates –Refinancing craze –Baby boomers trading up increasing demand for up-scale housing –Internet made mortgage lending national in scope 1990s –Rapid growth of secondary market, Fannie Mae/Freddie Mac –Tax Act of 1993 eased passive loss rules and extended non- residential depreciation from 31.5 years to 39 years –Taxpayer Relief Act of 1997 set long-term capital gains tax rate at 20% and maximum depreciation recovery rate at 25%

10. Real Estate Finance © JR DeLisle, Ph. D. Revolution of Mortgage Finance: 2000s Early 2000s –Housing craze: 1-family entered spec investment market –Rapid rise in house prices through first half of decade –2006 house prices up 87% from 2000 level –Mortgage lending standards relaxed –Rapid growth of secondary market Fannie, Freddie & Wall –Massive bailouts of Fannie Mae, Freddie Mac, and Wall Street Latter 2000s –Housing bust of 2007 resulted in deluge of mortgage defaults –Sept 2008 Treasury took control of Fannie & Freddie –Changing market; prices fell, lenders tightened standards –Borrowers began to walk away from speculative housing –S&P downgrade RMS poisoned the global financial system

11. Real Estate Finance © JR DeLisle, Ph. D. 2010s: A Return to Mortgage Fundamentals Definitions –Mortgage: Pledge of real estate as collateral –Note: Promise to pay and honor covenants Direct Parties –Mortgagee: lender –Mortgagor: borrower Motivations –Mortgagee: receive attractive risk-adjusted returns through origination, operation and disposition –Mortgagor: capture capital to acquire real estate

12. Real Estate Finance © JR DeLisle, Ph. D. Traditional Mortgage Amortization Patterns

13. Real Estate Finance © JR DeLisle, Ph. D. Types of Residential Loans Conventional Loan –Does not carry government guarantee –May have private insurance PMI if over 80% Insures excess only;; if 85% LV, 5% coverage Government Insured –FHA Loan Government insurance; 100% coverage Loan limits set by city and cost of housing Borrower pays insurance premium –VA Loan Max loan limits; no downpayment Government guarantee to lenders Limits: generally 25% of loan amount

14. Real Estate Finance © JR DeLisle, Ph. D. Other types of Mortgages/Financing Supplemental funding for mortgaged properties –Second Mortgage –Line of Credit Seller Financing –Purchase Money Mortgage –Use of Subordination Clause Land Contract –Seller retains title –Purchaser has equitable title –Seller conveys title when purchaser completes the performance obligations

15. Real Estate Finance © JR DeLisle, Ph. D. Risk Management and Residential Mortgages Risk Defined –Definition: variation between expectations and realizations –Nature: unavoidable due to temporal nature of real estate Sources –Lack of understanding of market and individual behavior –Inadequate information –Inaccurate data –Invalid predictive model –Unforeseen change in environment –Other externalities

16. Real Estate Finance © JR DeLisle, Ph. D. Real Estate Risk Management Approaches Avoidance Geographic or Product Entity types/individuals Improve decision-making & Price Information Models Control Via contingency plans: foreclosure Transfer: insurance, contract, sale Limit Hold harmless clauses Form of entity, pool, co-endorsement Hedge: Take opposite positions; Buy-sell contracts, futures

17. Real Estate Finance © JR DeLisle, Ph. D. Mortgage Risk Management: The Pleasure, Pain and Bailout Principle Overview –Voluntary relationships need controls –Goal: alignment of interest –Mortgage is a “Put” Option Pleasure, Pain and Bailout Concepts –Pleasure: some form of economic or qualitative satisfaction –Pain: compromises or payments to compensate –Bailout: ability to exit, terminate Mortgage Application of PPB –Pleasure: exchange of capital for promise to pay –Pain: loan servicing, delinquency, inspection and management –Bailout: in essence, mortgage is a “put” to the lender, foreclosure

18. Real Estate Finance © JR DeLisle, Ph. D. Application of PPB: Mortgagee & Mortgagor Concept Pleasure Pain Bailout MortgageeMortgagor Income: stable with positive spread for arbitrage Fees: origination, servicing Capital: access to debt to purchase real estate beyond own sources Risk transfer: cap potential loss Tax: Interest deduction Give up cash Commitment Risks Sell mortgage Securitize mortgages Liability: obligation to pay Credit line: reduces capacity Risks: ownership, maintenance Sell and repay Assumption: transfer debt Walk away

19. Real Estate Finance © JR DeLisle, Ph. D. Major Risks in Residential Mortgage Lending Temporal Risks –Long term Loan: interest rate/disintermediation risk –Periodic Payments: Timing and receipt of payments –Repayment: Early Termination, either voluntary or involuntary Default Risks –Causes: inability or unwillingness –Economic Event: failure to make payments –Contractual Event: Violations of covenants Collateral Risks –Loss/erosion of value –Lack/loss of access to claim collateral

20. Real Estate Finance © JR DeLisle, Ph. D. Options Embedded in Mortgages Put Option: Option to Default –Borrower can “put” the property to the lender –When If the property value is less than the loan balance If the loan is non-recourse Call Option: Option to Prepay –Borrower can “call” the loan from the lender by paying off loan balance –When If sell the property If refinance early when market rate below contract interest rate

21. Real Estate Finance © JR DeLisle, Ph. D. Lecture Review Risk Management –Definition of Risk –Risk Management Process Mortgages –Mortgage Process –Mortgage Risk Management –Mortgage Concepts –Mortgage Transfer, Foreclosure & Bankruptcy