10. Real Estate
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10. Real Estate


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 — [SIDE CONVERSATION] 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. 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 reads 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 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’s made GBP 80 profit. Which 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. He 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 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
the mortage. 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. I will to talk now mostly
about the United States. There’s 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 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. 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
[correction: last class]– 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. They’re double-taxed. You as an individual pay
an income tax, and your corporation pays a corporate
income tax, or corporate profits tax. So, you’re taxed twice. If you incorporate yourself, or
you set up some friends to do business in a corporation,
you get taxed twice. So, you don’t like that,
and obviously you try to avoid that. The way to avoid it is not to
have a 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. 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. 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 — It is 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, 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 on the first floor of 360 State. And I bet some of you
will be over there. It would 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, 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 are 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 — [SIDE CONVERSATION] 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. 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. 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 et al. 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. There 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 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. So, that’s commercial
real estate. I want 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 want 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. 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. 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 would 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. 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. That was the deal. Banks offered that, and it was
becoming an increasingly common thing. When we say a balloon payment,
what we mean is, it’s really big. 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. 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. So, this was the way
things were done. But what happened in the
Great Depression? Two things happened. 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. Two years is up. I have got to refinance
my mortgage. I go back to the bank. 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. So, the Roosevelt Administration
decided that there was something wrong with
the old kind of 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. [SIDE CONVERSATION] 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
sometimes 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,
you’re typical family, they get married, and they’re buying
their first house, they’re 25 years old. 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 an 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 borrow, 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 all over r over 12, where r is the annual interest
rate, times 1 minus 1 all over 1 plus r over 12 to
the Mth power. That’s just the annuity
formula. 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 over 2? I meant r over 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 is 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 the 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. So, each month your
balance goes down. In 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. So, 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. 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. 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 — [SIDE CONVERSATION] 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 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 offer 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. And 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. 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 Sreet? They called it Fannie Mae. That was just an 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]. [SIDE CONVERSATION] 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, and
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 — the 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 a default, the
mortgage extra balance would be made up by Fannie
or Freddie. 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 be tied 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. 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 guys should have read the
fine print, but he didn’t. 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 down who invested
in those securities. They’re going to be mad. 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
the FHA and that 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 [addition: 2011], 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 are 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 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, 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. The textbook talks a lot about
mortgage securities. I expect you to read this
out of Fabozzi et al. 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 et al., 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. 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? This family doesn’t look
like 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, with 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? 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.

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