real estate finance business and sailing 1.ppt

WISDOM FROM RICH DAD.
From the book Rich DAD Poor DAD, by Robert Kiyosaki

1. Don’t work for money:

Rich don’t work for money. If you work for money, your mind will start thinking like an employee. If you start thinking differently like a rich man, you will see things differently. Rich works on their asset column, every dollar in their asset column is their hard-working employee.

2. Don’t be controlled by emotions:

Some people’s lives are always controlled by the two emotions of fear and greed. Fear keeps people in this trap of working hard, earning money, working hard, earning money, and hoping that it will reduce their fear. Secondly, most of us have the greed to get rich quickly. Yes, many people become rich overnight, but they have no financial education. So educate yourself and don’t be greedy or fearful.

3. Acquire assets:

Don’t buy liabilities on your way to financial freedom. People buy liabilities and think these are assets, but they are not. Many people buy luxuries first, like big cars, heavy bikes, or big houses to live in. But the rich buy assets and their assets buy luxuries. The rich buy houses and rent them, and they pay them for their Lamborghinis. The poor or middle class buy luxuries first, and the rich buy luxuries last.

4. Remember the KISS principle:

KISS stands for keeping it simple, and stupid. Don’t be too overloaded your mind when you are going to start your way to financial freedom. Things are simple and keep them simple. The simple thing to remember is assets put money in pocket and liabilities take money out of pocket. Always buy assets so they put money into your pocket.

5. Know the difference between assets and liabilities:

Assets are anything that puts money in your pocket, like stocks, bonds, real estate, mutual funds, rental properties, etc. Liabilities are anything that pulls money out of your pocket, like your house, your car, debt, etc. People think their home is their biggest asset, but it is not. A house is an asset when it generates money like when you rent a house, it generates money, and when your life in that house becomes a liability.

6. Don’t be a financial illiterate:

A person can be highly educated and become successful in their profession, but financially illiterate. Financial education is very important for any individual. Our schools and colleges did not teach us financial education. Many financial problems arise as a result of a lack of financial education. Start learning financial education and I suggest you read the book "Rich Dad, Poor Dad".

7. Increase your Wealth:

Wealth is defined as a person's ability to survive for a certain number of days in the future, or how long they could survive if they stopped working today. Consider your wealth and whether you would survive if you stopped working today for a year.

8. Mind your own business:

If you have a job, keep your job and start a part-time business and work it. Use the time that you spend on your iPhone, parties, or any other

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

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

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

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

5. Illusory Contracts (cont’d)
On the “excuse” issue, the text says:
“In such cases the court will examine the motive of the party relying on the
condition.”
If a written contract gives me a right, must I show
that I am pure of heart before I may enforce it?
Not everyone thinks so. Courts are split on their role in applying the “good
faith” requirement (or rubric).
“Good faith” can serve either as (1) a gap filler or as
(2) a mandatory rule
We shall discuss this topic further
Donald J. Weidner
5

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

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

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

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

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

11. Liuzza v. Panzer
(Text p. 94)
Contract to sell and to buy for $37,500.
Buyer’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%.”
Buyer applied to an S & L for a $30,000 loan and was
rejected because the appraisal was too low.
S & L appraisal was $32,150.
Buyer may have said “oooops!”
S & 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.
Can the Buyer walk away from the deal at this point?
That 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?
Donald J. Weidner
11

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

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

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

15. Kovarik v. Vesely (cont’d)
The 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.
Even 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.
A buyer could reasonably want:
A third-party lender to provide a “reality check” on value;
and
A standard institutional approach in the administration of the
loan
especially in the event of default.
Donald J. Weidner
15

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

17. Loan to Value Ratio
May be set in statute, regulation or internal
portfolio or other policies.
Examples of statutory language used to mandate
maximum loan to value ratios:
appraised value
estimated value
reasonable normal value
estimated replacement cost
actual cost
These terms are subject to a range of
interpretations
Donald J. Weidner
17

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

19. Length (“Term”) of Loan
The longer the length, or term, of the loan, the
lower the Debt Service
Consider, for example, an $18,000 home
improvement loan. If the interest rate is 6%, the
monthly Debt Service is
$199.98 if the term is 10 years
$116.10 if the term is 25 years
$ 99.18 if the term is 40 years
The benefit of lower debt service has a cost: the
longer the term, the more interest the borrower
pays.
Donald J. Weidner
19

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

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

22. Donald J. Weidner
22
. . .
PASSAGE OF TIME
SELF AMORTIZING LOANS
First type: Constant Payment
DEBT SERVICE COMPONENTS
Principal Interest
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.

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

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

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

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

27. Goebel (cont’d)
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.
Donald J. Weidner
27

28. Goebel (cont’d)
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.
And, therefore, Borrower could not be forced to
continue to pay debt service for a longer term
Enforcing the parties’ intent?
Donald J. Weidner
28

29. Goebel (cont’d)
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)?
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
“Due on sale” clause was enforceable
How does this fit with what the court said about a
balloon (“this method was not used”)?
Donald J. Weidner
29

30. Note to Goebel v. First Federal
No argument was made that an interest increase was
unconscionable or otherwise illegal.
See 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.”
Recall, “good faith” can be a “gap filler” to salvage an otherwise
indefinite contract, particularly by importing the general business
practice.
Recall, too, that the borrower in Goebel had the option to prepay
without penalty upon an interest rate increase.
Indicating that market forces would limit the lender from
exacting an increase.
Donald J. Weidner
30

31. Pre-”Great” Depression Residential Financing
Amount. At least theoretically, loan/value ratios were very low,
typically 50-60% of appraised value.
Lenders stretched their appraisals.
Borrowers took out second, third (“junior”) mortgage loans.
Length. Seldom for more than 10 to 15 years. In 1925, the average
length for mortgages issued
 by life insurance companies was 6 years;
 by S &Ls was 11 years.
Rate of Interest: Junior mortgages were at higher rates of interest
than first mortgages.
Amortization 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.
Donald J. Weidner
31

32. Post-”Great” Depression Mortgage Insurance
Transformed Mortgage Terms
Amount. Government undertook to insure loans with much
higher Loan/Value Ratios (consumers were unable to pay big
down payments coming out of the depression)
Length. To decrease the debt service on the larger loan
amounts, the government insured longer loans. Terms
increased up to 40 yrs. for certain projects.
Rate of Interest. The government would not insure loans
above a certain interest rate. “Points” became important.
Amortization 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.
Donald J. Weidner
32

33. The American Dream of Home Ownership
Americans Living in their Own
Homes (text 352)
1940 41%
1950 53%
1960 62%
1981 65%
2006 69%*
2017 64%
Donald J. Weidner
33
*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
been on the Federal Reserve Bank’s Board of Governors.

34. “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)
2)Graduated Payment Mortgage (GPM)
 And its variant the Growing Equity Mortgage (GEM)
3)Renegotiable Rate Mortgage (RRM)
4)Shared Appreciation Mortgage (SAM)
5)Price Level Adjusted Mortgage (PLAM)
6)Reverse Annuity Mortgage (RAM)
Donald J. Weidner
34

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

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

37. Adjustable Rate Mortgages (cont’d)
Mechanisms 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
Ex., Florida statute defines it as any payment more
than twice the size of a preceding payment.
Donald J. Weidner
37

38. 2) GRADUATED PAYMENT MORTGAGE
Monthly 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.
Initial concept (back in the Nixon administration):
Help the young family that reasonably expects its
income to grow substantially over the years following
the loan closing.
Initial, 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.
Donald J. Weidner
38

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

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

41. 4) SHARED APPRECIATION MORTGAGE (p.
375)
Lender 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:
If the home is sold before the end of x years, the lender will
receive a percentage of the increase in value;
If 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.
Donald J. Weidner
41

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

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

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

45. Growth of Securitization of Mortgage Debt (See p.
352-355)
In 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.
In 1938, the Federal National Mortgage Association (Fannie Mae) was
created to buy and to sell federally insured mortgages.
(“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.”)
In 1968, the Government National Mortgage Association (Ginnie Mae)
was created as a second, secondary market agency to take over the low-
income housing programs previously run by Fannie Mae. It was
responsible for promoting the MBS.
According 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 . . . .”
Donald J. Weidner
45

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

47. Growth of Securitization in Mortgage Debt
(cont’d)
In short, Fannie Mae and Freddie Mac buy and sell
mortgages, both federally insured and
conventional, and issue Mortgage Backed Securities
Whereas 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
Donald J. Weidner
47

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

49. Growth of Securitization of Real Estate Debt
(2002 Eggert article at 355-61)
The history of mortgaged-backed bonds stretches back to
the 19
th
century.
Private title and mortgage insurance companies sold
certificates secured by mortgage pools in the 1920s.
The 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.
Donald J. Weidner
49

50. Growth of Securitization of Real Estate Debt
(2002 Eggert article at 355-61)(cont’d)
Various definitions of securitization.
His: “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.”
Think, selling interests in a package of receivables.
Through securitization, the source of mortgage funding has
shifted from depositary institutions to the capital markets.
broker sells to lender, lender sells to bundler, bundler
transfers to seller, seller transfers to SPE (trust), which
issues the securities the seller sells.
Donald J. Weidner
50

51. Growth of Securitization of Real Estate Debt
(2002 Eggert article at 355-61)(cont’d)
Most simple tranches (strips): interest-only tranche and
principal-only tranche.
If 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.
Quaint: 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.”
Qualified later by concerns about complexity, inability to predict,
frequent downgrades as defaults occur.
Other “credit enhancements” are also involved.
Donald J. Weidner
51

52. Growth of Securitization of Real Estate Debt
(2002 Eggert article at 355-61)(cont’d)
“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.”
But 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.”
For example, an originator selling a mortgage may agree to
buy the mortgage back if it goes into default with 6 months of
the sale.
Donald J. Weidner
52

53. Growth of Securitization of Real Estate Debt
(2002 Eggert article at 355-61)
“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.”
to make the assets “bankruptcy remote.”
That 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)
companies 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.
The collection and distribution of payments of principal and interest are made
by servicers employed by the SPV.
Originally by the originators or packagers of the loans, often by specialized
servicing firms.
On default, the servicer may begin foreclosure proceedings.
In general, early prepayment and foreclosure are the two biggest risks to
investors.
Donald J. Weidner
53

54. Federal Reserve Policy
When 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”
Thus, there was cheap money to help drive up prices
When Treasury obligations were not paying investors very
much, they turned to mortgaged-backed securities for higher
yields at, they thought, relatively little risk
At the same time, Chairman Greenspan believed that the
discipline of the markets, rather than regulation, would prevent
excessive risk taking in mortgage-backed securities.
He later acknowledged that he had overestimated the
discipline of the markets.
Donald J. Weidner
54

55. “Crisis Looms in Market for Mortgages”
(Supplement p. 1)
Gretchen Morgenson, “Crisis Looms in Market for Mortgages,” New York Times,
March 11, 2007.
As of March, 2007, the nation’s $6.5 trillion mortgage securities
market was even larger than the United States treasury market.
As 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.”
Yet some financial institutions were still making rosy projections
based on the assumption that home prices would not fall.
35% of all mortgage securities issued in 2006 were in the
subprime category.
Donald J. Weidner
55

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

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

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

59. 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
British bank HSBC leads the early 2007 charge to enforce repurchase
agreements.
“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.”
Billions in mortgages are covered by repurchase agreements.
However, many originators say that they cannot afford to buy back
the loans or they are seeking bankruptcy protection.
“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.”
Donald J. Weidner
59

60. Rating Agencies
Credit rating agencies are supposed to assess risk of
investment securities—however, the agencies are paid
by the issuer of the security.
Homeowners selling their houses, by contrast, do not hire
the person who appraises them for the benefit of the buyer.
The rating agencies gave the mortgaged-backed
securities a AAA rating, which suggested they were as
safe as Treasury Obligations.
The projections they made about loan performance
assumed a low foreclosure rate
That data focused only on recent history and thus suggested a
foreclosure rate of perhaps only 2%
They didn’t include the newer, more risky mortgages
Nor did they anticipate falling real estate prices
Donald J. Weidner
60

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

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

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

64. The Rating Agencies (cont’d)
The SEC began investigating the rating agencies to
see if their ratings complied with their own published
standards.
Neither one of two plausible scenarios, knaves or
fools, is pretty:
“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.)”
Donald J. Weidner
64

65. The Rating Agencies (cont’d)
By November 2007, the securitization market had collapsed
but the stock market had not yet collapsed.
Investors in the more transparent stock market “want to
believe that the Federal Reserve can cure all problems by
cutting the overnight bank lending rate.”
However, the collapse of securitization made credit hard to
obtain for many, “and a change in the Fed funds rate will not
offset that.”
“[I]t has become very difficult to get a home mortgage
without some kind of government-backed guarantee.”
Ironically, 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.
Donald J. Weidner
65

66. The Rating Agencies—2015 Update
In 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 mortgage-
backed securities that were at the heart of the
financial crisis.
Separately, S & P agreed to pay CALPERS (the
California Public Employee’s Retirement System) $125
million.
Donald J. Weidner
66

67. Collateralized Debt Obligations
Securitization 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).
A collateralized debt obligation is a pool of different tranches (or
slices) of mortgages
Or a pool of mortgages mixed with other receivables, such as
credit card receivables
Lower-rated tranches were called “toxic waste”
That is, they are so high-risk, they are “toxic”
But the tranches were being pooled to make them appear to be
less risky
And made to appear even less risky with credit default swaps
(contracts allegedly to insure investors against defaults)
Donald J. Weidner
67

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

69. Securitisation, When it goes wrong . . . .
(cont’d)
Benefits 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.”
Donald J. Weidner
69

70. 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.
Donald J. Weidner
70

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

72. 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”)
Donald J. Weidner
72

73. Securitisation, When it goes wrong . . . .
(cont’d)
“This creates what economists call a principal-agent problem.”
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.
“The loan originator has little incentive to vet borrowers
carefully because it knows the risk will soon be off its
books.”
“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.”
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)
Donald J. Weidner
73

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

75. Securitisation, When it goes wrong . . . .
(cont’d)
Looking forward:
“Investors need to know who is holding what and how it should be valued.”
Regulators may call for consistent evaluation of assets across firms.
There will be calls for greater standardization of “structured products.”
Regulators 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.”
[The 2015 settlements with the Justice Department and with CALPERS
more closely align the interests of the rating agencies and investors].
“[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.”
Donald J. Weidner
75

76. Fannie Mae and Freddie Mac: End of Illusions
(Supp. P. 22)
Fannie Mae and Freddie Mac: End of Illusions, The Economist, July 19, 2008, p. 79.
In August, 2007, Lehman Brothers closed its subprime mortgage lender, BNC Mortgage.
According 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.”
By July 2008, it was clear that “the rescuers themselves have needed
rescuing.”
The stock in both Fannie and Freddie had crashed.
On 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.
Separately, 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.
On October 3, 2008, Congress [4] passed the TARP rescue package (see a
subsequent slide).
Donald J. Weidner
76

77. 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]
“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.
Donald J. Weidner
77

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

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

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

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

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

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

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

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

86. Credit Default Swap (CDS)
A 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.
Simply, 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.
However, anyone could buy a CDS. You did not have to own
the MBS or have an insurable interest. These were “naked”
CDSs, or bets.
By the end of 2007, there were an estimated $62 trillion in
outstanding CDSs.
Compared to the $18 trillion 2015 U.S.A. GDP
Donald J. Weidner
86

87. 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.
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.
Starting at $600 billion and increasing to $1.8
trillion
Donald J. Weidner
87

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

89. The Federal Reserve Response (cont’d)
On 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.
The 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.
At the same time indicating it would continue to hold
the federal funds interest rate at close to zero.
Critics expressed concerns about inflation and about
asset bubbles.
Donald J. Weidner
89

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

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

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

93. Federal Reserve Response (cont’d)
Also 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%).
This is the first time Fed has publically pegged interest rate
policy to the unemployment rate
U.S. unemployment as of October 2015 was 5 percent.
With still no increase in interest rates.
And none of the inflation that critics predicted.
Donald J. Weidner
93

94. The “Taper”
In December 2013, the Fed announced that it would
begin to reduce (“taper”) its monthly purchases by
$10 billion a month
$5 billion less a month for mortgage-backed securities and
$5 billion less a month for treasury obligations
At the same time it said that it would continue to
hold short-term interest rates near zero for the
foreseeable future.
In January 2014, it said it would do so “well past” a 6.5% unemployment rate
The “taper” was concluded in October 2014.
Donald J. Weidner
94

95. Where to Next?
In December 2015, the Fed raised the key rate for the
first time since 2006, by .25%.
Unemployment rate at 5%. Intermediate term objective of at
least 2% inflation.
They said they will watch to make sure that
unemployment remains low and that inflation stays high
enough.
While central banks around the world are still keeping
rates extremely low.
“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.
Donald J. Weidner
95

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

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

98. The Return of Securitization (cont’d)
“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.’”
See also Section 941 of Dodd Frank, the “credit risk
retention rule,” which requires mortgage securitzers to
keep certain “skin in the game.”
Or, 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.”
There is an exception for “qualified residential
mortgages”
“Another tightening of the rules makes ‘re-securitizations’,
where income from securitised products was itself
securitised, more difficult.”
Dodd Frank also addressed this problem.
Donald J. Weidner
98

99. Post Mortgage Meltdown (Text p. 382)
In 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!
Compliance is presumed if certain underwriting practices
followed.
Donald J. Weidner
99

100. Dodd Frank
In 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 ability to repay the loan
according to its terms.”
With a presumption of compliance for “qualified
mortgages.”
Creditors encouraged to refinance “non-standard
mortgages.”
Donald J. Weidner
100

101. Dodd-Frank (cont’d)
Dodd-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.
“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.
Donald J. Weidner
101