Real Estate Economics 156 Foldvary
Chapter 16, Property financing
Do the economic characteristics of real estate make mortgage credit necessary?
No. In Islamic banking, there are no explicit interest payments.
The bank owns the real estate or is a partner.
Understanding the Mortgage Concept
A mortgage is a pledge of property to secure a debt.
Mortgages go back to ancient times.
Margin buying of stocks is also secured.
In early Roman law, those who defaulted on mortgage payments were enslaved.
Later, the sale of the property satisfied the unpaid debt.
During the Middle Ages, interest was called usury, and illegal for Christians.
Lenders owned the property under the debt was paid.
By the 1300s, interest and hypothecation were legal.
Hypothecate: to pledge property to another as security without transferring title.
Borrowers keep ownership of the property.
The great jurist Sir Edward Coke, who lived from 1552 to 1634, has explained why the term mortgage comes from the Old French words mort, “dead,” and gage, “pledge.”
It seemed to him that it had to do with the doubtfulness
of whether or not the mortgagor will pay the debt.
If the mortgagor does not,
then the land pledged to the mortgagee as security for the debt
is taken from him for ever, and so is dead to him.
And if he does pay the money, then the pledge is dead as to the mortgagee.”
The mortgage document creates a lien on the mortgaged property.
In California a deed of trust to a trustee who holds title for the lender
is a one possible security instrument.
A reverse mortgage allows the property owner to stay in the house.
California mortgage lenders provide Reverse Mortgages in three categories,
The minimum age for that is 62.
Title companies handle closings through escrow in Northern California,
whereas escrow companies and lenders handle them in Southern California.
Deeds of trust with private power of sale are the security instruments used throughout the state.
In Alameda, Calaveras, Colusa, Contra Costa, Lake, Marin, Mendocino, San Francisco, San Mateo, Solano, and Sonoma counties, buyers pay for the title insurance policy, whereas sellers pay in the other Northern California counties.
Each California county has its own transfer tax; some cities have additional charges.
A mortgage includes a promissory note, promising to pay the money owed.
Typical provisions of a promissory note
In an amortized mortgage, the mortgagor pays the interest and a portion of principal.
There are first, second, third mortgages.
The second mortgage is second in the series, not necessarily chronological.
A mortgage can have a prepayment clause;
the borrower may prepay some of the principal.
An assumable mortgage can be taken over on sale of the property.
Due-on-sale clause: the lender may require immediate payment upon a sale.
Understanding the Foreclosure Process
Seizing the collateral and selling it to satisfy the debt.
Lenders usually prefer to negotiate payments than to foreclose, which is costly.
However, when the mortgage has been sold on the secondary market, the owner may be too remote and busy to negotiate. The property can stay empty and deteriorate.
Judicial foreclosure: the mortgagee must obtain a court order.
Nonjudicial foreclosure: the lender may sell the property on default.
A nonrecourse loan bars the lender from action against the borrower if the security value falls below the amount required to repay the loan.
The borrower may have pledged collateral, but the borrower is not held personally liable.
The lender of a nonrecourse loan generally feels confident
that the property used as collateral will be adequate security for the loan.
There are two types of foreclosure in California: Trustee's Sale, and Judicial Foreclosure.
Judicial foreclosure has many disadvantages to the lender. It is not an expedited process (as is the Trustee's Sale), but involves court proceedings, orders, appraisals, and an auction.
It takes much longer and costs much more than a Trustee's Sale.
The real difficulty with Judicial Foreclosure is that it allows the Borrower a 1 year "right of redemption" in which he is allowed to buy the property back from the successful bidder. This makes purchases of such property more uncertain and tends to lower the bidding.
The advantage to the lender of Judicial Foreclosure is that a deficiency judgement against the Borrower is allowed.
The auction proceeds are used to reduce the debt (including penalties, attorneys' fees, and costs); judgement is entered against the Borrower for the balance.
A trustee's sale is the easy method of foreclosure.
It's fast and inexpensive.
However, no deficiency judgement is allowed.
In a Deed of Trust the borrower (Trustor) gives the Trustee (typically a title company) the right to sell the property if the Buyer defaults.
The first step is a Notice of Default. It states the amount in default. 90 days is given to cure the default by catching up on all late payments, penalties, and costs.
After the 90 days expires, the lender files a 21 day Notice of Trustee's Sale, at which time an auction is held, usually at Court, with limited publicity resulting in a greatly depressed price. After it is over, the former owner must be evicted if he refuses to leave.
The Borrower can still catch up on all late payments until 5 business days prior to the sale. Within the last 5 days, the only way to stop a sale is by payment in full of the entire balance.
Most lenders prefer NOT to foreclose. Banks are in the money business, not the real estate business. They try to avoid foreclosure, because it is bad for their books if their ratios of REO (real estate owned) and bad debts climb.
By State law there is never a personal liability
for a purchase mortgage for a personal residence.
The owner can "walk away" from the property
with immunity from personal liability regardless of the method of foreclosure.
Deed in Lieu of Foreclosure
This is a short-cut, when the owner gives the property back to the Bank.
However, many lenders now refuse to take a Deed in Lieu of Foreclosure.
They get "cleaner" title if they foreclose, effectively wiping out all other claims to the property.
Bankruptcy
Many borrowers stall until the last minute and then file bankruptcy to stop the sale.
If there is no equity in the property,
the lender eventually will make a
"Motion for Relief from the Automatic Stay"
to allow the foreclosure to proceed.
This takes time and costs the lender more money.
If the debt is greater than the property's value,
in order to sell it and turn the lender's interest into cash,
the lender must agree to accept less than full payment as satisfaction of the debt.
Many lenders realize that some money soon is better than less money
(since foreclosure auctions usually bring low prices) later,
especially if the debt continues to increase during the pendency of the foreclosure.
Tax consequences
Most people are shocked that they can lose their property and still owe taxes on the profit.
We often hear people say that they prefer to be foreclosed since they will not owe any tax,
but if they sell (and have no net sales proceeds) they will owe substantial tax.
That’s incorrect.
The tax results of a foreclosure, deed in lieu of foreclosure, or short sale
depend on the nature of the loan:
whether it is recourse or non-recourse.
Recourse means that the borrower has personal liability for the loan,
in addition to the risk of losing his real property.
Tax Consequences of non-recourse loans
Non-recourse loans include typical California purchase loans
used to buy an owner occupied residence of up to 4 units.
State Law protects borrowers from personal liability on a purchase mortgage for a home which they occupy at purchase.
(If the borrower later converts the home to rental, he is still protected.)
The State has put the risk on the lender; the most a lender can do is take back the house.
This law applies to properties of up to 4 units,
and applies only to loans used to purchase the property.
The tax consequences of foreclosure, deed in lieu of foreclosure, or short sale on a non-recourse loan are simple:
the property is taxed as if it were sold for the total outstanding amount of the loan
(or sales price, if higher).
Taxability of the gain and deductibility of the loss depend on the nature of the property.
Alternate security instruments
In a land contract, or contract for deed, title is transferred after a series of payments.
The buyer has equitable ownership, the lender legal ownership.
If the buyer defaults, no foreclosure is needed.
It would often be better for the owner to sell rather than have a foreclosure.
The buyer can assume the loan.
The lender could buy the property with a deed in lieu of foreclosure.
Structure of the U.S. housing finance system p. 270vc
Loan origination: creating a new loan. This is the primary mortgage market.
The originators can sell the mortgages in the secondary mortgage market.
The current system of housing finance originated in the Great Depression.
There were many loan defaults as real estate prices collapsed and unemployment soared.
Many banks failed. Construction ground to a halt.
The government stepped in to revive real estate.
Did the free market fail?
What caused the Great Depression?
The Federal Home Loan Bank Act of 1932 created savings and loans associations for home financing, regulated by the Federal Home Loan Bank Board.
Federal Housing Administration
Congress created the Federal Housing Administration in 1934 to prop up real estate.
The FHA provided governmental mortgage insurance for lenders.
Borrowers purchase the mortgage insurance from the FHA on behalf of the lender.
The initial fee is 2.25 percent of the loan, and the annual fee is ½ percent of the loan.
If the borrower defaults, insurance covers any losses from foreclosure.
Anyone may apply for an FHA loan, but there are maximum limits.
Bankers made FHA-insured loans and then sold them to insurance companies,
greatly expanding the secondary mortgage market.
Private mortgage insurance existed prior to the Great Depression.
The huge amount of defaults caused the PMI firms to fail.
MPIs became common again after 1957
with the establishment of the privately owned Mortgage Guarantee Insurance Corporation.
Private Mortgage Insurance
MGIC Investment Corporation (NYSE: MTG) is the parent of
Mortgage Guaranty Insurance Corporation (MGIC).
Based in Milwaukee, Wisconsin, MGIC serves more than 5,000 lenders across the U.S.
It is the nation's leading provider of private mortgage insurance.
MGIC protects mortgage investors from credit losses.
Private MI also benefits consumers by helping them achieve home ownership sooner
with low-down-payment loans.
Why would a borrow use a PMI rather than the FHA?
For loans larger than the FHA limit.
When the loan falls bellow 80 percent of the property value,
the borrower may cancel the PMI insurance.
This often happens via appreciation.
Department of Veterans Affairs Loan Guarantee Program
The Department of Veterans Affairs began to guarantee mortgage loans after WWII.
It guarantees the payment of a private loan if the veteran defaults.
No down payment is required.
This can be considered part of the military compensation.
The applicant must have served on active duty.
About 10 percent of new loans are VA guaranteed.
The Federal National Mortgage Association - Fannie Mae
Created in 1938 as a government agency to buy mortgages from lenders.
Fannie Mae created a secondary market for FHA-insured loans.
It became nominally private in 1968.
Measured by assets, Fannie Mae is the 3rd largest US corporation.
But it is still tied to the government.
One third of the board is appointed by the US president.
The US Treasury is authorized to lend Fannie Mae money if needed for its operations.
Government National Mortgage Association (Ginnie Mae)
After 1968, Fannie Mae no longer provided loans directly to homeowners.
The federal government created the Government National Mortgage Association,
GNMA, Ginnie Mae, to provide subsidized loans.
A bank can originate a below-market loan to a low-income borrower,
and then sell it to GinnieMae at full market value.
The difference is paid from the budget of the Dept. of Housing and Urban Development.
In 1970, Ginnie Mae introduced a payment guarantee program backed by the US government.
Ginnie Mae guarantees the payments on mortgages insured by other agencies such as FHA.
The creation of mortgage-backed securities in the 1970s led to a huge increase in mortgages and combined with high inflation to fuel the speculative rise of real estate prices that ended in the recession of 1980.
Federal Home Loan Mortgage Corporation (Freddie Mac)
There was no secondary market for uninsured conventional loans.
The Federal Home Loan Mortgage Corporation (FHLMC), Freddie Mac, was created in 1970.
Freddie Mac operates a secondary market for conventional real estate loans.
Mortgage Market Participants
In 2003 the total mortgage debt was $9.3 trillion.
There are several types of originators.
Mortgage bankers do not have demand deposits or checking accounts.
They borrow money from commercial banks and originate new loans.
They sell the loans in the secondary market, but may service the original loans.
Mortgage brokers are intermediaries between borrowers and lenders.
Commercial banks hold about a quarter of the mortgage debt.
Savings institutions hold about 9 percent of the mortgage debt.
Some credit unions as cooperatives also originate mortgages, for their members.
Understanding the Mortgage Loan Origination Process
Fannie Mae and Freddie Mac have jointly created an application form to be used in loans that end up in the secondary markets.
Borrowers are required to disclose employment history and financial information,
including copies of tax documents.
The originator has to comply with several governmental requirements.
The equal credit opportunity act of 1974 prohibits lenders from discriminating on the basis of race, sex, religion, marital status, age, and being in public assistance programs.
Under the consumer credit protection act (RESPA) or truth in lending, the lender is required to disclose the full details of a loan, including the full cost as an annual percentage rate (APR).
The APR is the effective annual interest rate including all fees and finance charges.
The Real Estate Settlement Procedures Act requires that lenders provide a good faith estimate of the settlement costs. The applicant has the right to obtain a copy of any appraisal report.
Lenders have to say whether they expect the loan to be sold in the secondary market, and to let the borrower know when it has been so sold.
The Flood Disaster Protection Act requires that lenders disclose to borrowers whether the property lies within a flood hazard area.
If so, the lender must require that the borrower obtain flood insurance, if available.
It is usually only available from the FEMA, the Federal Emergency Management Administration’s National Flood Insurance Program.
The Fair Credit Reporting Act requires that lenders obtain permission before investigating an applicant’s credit history.
If the loan request is denied because of his credit history, then the lender must notify the applicant.
Mortgage Underwriting p. 379
What is “underwriting”?
The process of evaluating the risk of an applicant and a property
to make a decision on the loan application is called underwriting.
The lender has to qualify the applicant and the property.
Lenders typically require title insurance.
Properties without the insurance can’t be sold in the secondary market.
The lender often requires an appraisal to verify the market value.
Loan-to-value Ratio Guidelines
The loan-to-value ratio: divide the loan amount by the lesser of the sales price or the appraised value. A higher LTV ratio implies a greater risk.
To be accepted in the secondary market, loans with a LTV ratio of 80 percent or higher must carry PMI, FHA, or VA insurance.
Down payment source guidelines by Fannie and Freddie require that funds used for down payments be provided primarily by the borrower.
His own investment has to be at least 5 percent; the rest can be a gift.
If the LTV ratio is less than 80, then the entire down payment can be a gift.
Income ratio guidelines
The mortgage debt ratio MDR is the percentage of the borrower’s gross monthly income required to meet monthly housing expenses.
Monthly housing expenses include the principal and interest payments, insurance, taxes, and any residential association fees.
Under the guidelines, the MDR must not exceed 28 percent, or 29 for FHA loans.
The total debt ratio is the percentage of the borrower’s gross monthly income required to meet monthly contractual expenses.
These include expenses for housing and other loans, including credit cards, alimony, and child support.
Total payments should not exceed 36 percent of a borrower’s gross income, or 41 for FHA loans.
Sources of capital in commercial property markets
Loans for commercial property comes from investors such as individuals, insurance companies, banks, and real estate investment firms.
Real estate investment trusts (REITs) sell shares of stock and buy real estate properties or debt.
This enables investors to place relatively small amounts of money into real estate,
or to invest without having to manage property.
REITs do not have to pay corporate income taxes if 95 percent or more of their profits is distributed to the shareholders as dividends.
Thus, REITS cannot use retained earnings for expansion, but sell additional shares.
Another way to invest in real estate is with a partnership.
Limited partnerships have two types of partners: general and limited.
The general partners run the operation and have unlimited liability.
The limited partners buy shares and cannot lose more than their investment.
A benefit of partnerships is that profits, deductions, and tax credits flow through to the partners, so there can be tax advantages.
But limited partners get passive losses, which can only offset passive income.
The underwriting criteria for commercial property involve the income of the property.
Lenders typically require that the net operating income be 15 to 20 percent higher than the payments required to service the debt.
Commercial properties don’t generally get insurance or guarantees,
and have larger down payments.