REE 4204 EXAM 1

Why were the "sand states" most affected by foreclosure in the post-housing market crash period?

These were states with massive run-ups in house prices and high levels of subprime mortgage lending

debt financing -Financial Leverage

When addition taxes and financial distress costs, ______________ increases the value of the asset to a point (optimal leverage).

The tax-free nature -Municipal Bonds

_____________ of these instruments implies that investors will receive lower return on these bonds. -MY = tY(1 - t)

As prices increase -General Level of Interest Rates

______________, suppliers want to place more bonds in the market.

Higher bond prices -General Level of Interest Rates

_________________ reflect a lower yield or interest cost to the issuer.

The real rate of interest -General Level of Interest Rates

___________________________ is the equilibrium rate on riskless bonds in a noninflationary environment.

The Fisher equation

____________completes the final portion of the money-inflation-interest rate mechanism. •Inflation, especially when consistent year after year, creates expectations of future inflation. •According to the adaptations model of inflationary expectations, credit market participants adjust their expectations of near-term inflation on the basis of their most recent experience. •Borrowers who anticipate the same inflation rate expect to repay the principal with depreciated dollars and are are willing to pay a higher nominal rate.

Higher yields -Market Segmentation Theory

____________will attract investors to a maturity segment of the market.

Segmentation -Market Segmentation Theory

__________may occur when interest rates changes are expected.

"gage" -German influence

a deposit made to fulfill an agreement.

Finance

study of the process, institutions, markets, and instruments used to transfer money and credit between individuals, businesses, and governments

Most real estate financing

takes place in the capital markets.

Liquidity premiums

tend to be small and do not necessarily explain situations in which long-term rates fall below short-term rates.

What are the 4 terms of the discounted cash flow method?

the cash flows (over time), the term of the cash flows, the discount rate, and the present value of the cash flows (value of the asset).

Mortgages

long-term securities

A large and active secondary market -Secondary Mortgage Market

makes securities more liquid.

Real Property -What is Real Estate Finance?

the rights, powers, and privileges associated with the use of real estate.

Financial Instrument Institutions -The Environment of Real Estate Finance

create and purchase those instruments and the markets within which they are transferred constitute the environment of real estate finance

Prepayment or Call Option -Options in Real Estate

- gives the homeowner (borrower) the right to prepay the current balance on a mortgage at any time prior to maturity.

Options on House Prices -Options in Real Estate

CME offers futures and options on house price indices (S&P/Case-Shiller) for major metropolitan areas.

"tilt" effect -The 1970s: FRMs in an Inflationary Environment

Demand problems: Rise in long term rates →less affordable mortgages → real mortgage cost increased in the early period of the loan and decreased in later part

Explain how financial intermediaries can be exposed to interest rate risk

Financial intermediaries are exposed to interest rate risk when they borrow short (except short-- term deposits) and lend long (originate 30-year mortgages, for example). When the general level of interest rates rise, then the intermediary must refinance the short-term deposits at a higher rate. The return on the long-term assets does not rise quickly or profitably. Thus the interest expense of the intermediary rises more quickly than the interest revenue, causing a drop in income or creating a loss.

Differentiate between income and cash flows.

Income is an accounting concept that attempts to match revenues and expenses on an accrual basis. Cash flows are the actual cash inflows and outflows. It is possible to have revenue without a cash inflow, for example, when sales are made on account; and it is possible to have expenses without cash outflows, for example, with depreciation or purchases made on account

What were some of the major causes of the housing market crisis in the mid-2000s?

Increased demand for real estate relative to the fixed, shorter-term supply; relatively low mortgage rates that increased borrowing capacity; reckless lending practices; increases issuance of subprime mortgages with lower credit ratings and higher default rates.

latter

Most of real estate finance deals with the______

Maturity risk -Risks in Real Estate Finance

Other things held constant, the longer the maturity of an asset, the greater the change in value for a given change in interest rates.

Prepayment Penalty

Penalty to the borrow for repaying a mortgage before maturity -Increases the cost of the loan

Direct Financing -Financial Intermediaries

When the flow of funds takes place without the use of intermediaries -E.g. when a home seller grants a note to the home buyer

Lower prices -General Level of Interest Rates

_____________ lead to an increase in demand.

annual percentage rate (APR)

effective borrowing cost of a loan, assuming it is held to maturity.

Annual Percentage Rate (APR)

effective cost of the loan assuming that it is held to maturity.

Financial Intermediaries

financial institutions that channel funds from the surplus income units to the deficit income units.

Finance is the study of

how the flow of money and credit facilitates that production and allocation.

Commercial Banks -Financial Intermediaries

insured by the Federal Deposit Insurance Corporation (FDIC)

Hypotheca" -Roman Law

similar to "pigus;" No transfer of title or possession. Lender could take title only under actual default.

Prepayment -Options in Real Estate

penalties rare in residential real estate but common in CRE

Pension Funds -Financial Intermediaries

pool the contributions of employees and invest the funds similarly to insurance companies.

Microeconomics of the firm focuses on_______

profit maximization

Assets -After-Tax Cash Flows

provide an expected cash flow. For valuation, the relevant amount is the after-tax cash flow •Because of the tax shelter characteristics of real estate, actual cash flows are often different from income generated by the _____.

What are the major changes in the regulation of financial institutions that were brought about by the Garn-St. Germain Act of 1982?

(1) allowing thrifts to invest in commercial, agricultural, and consumer loans; (2) providing for FSLIC and FDIC assistance in shoring up the net worth of deficient financial institutions; (3) allowing bank holding companies to acquire thrifts across state lines.

The effective cost of the mortgage

(the cost of borrowing is generally measured in percentage terms) is the borrower's actual percentage cost of borrowing and can be different from the contract interest rate. The effective cost of the loan is affected by loan fees and discount points charged by the lender. •In the absence of loan fees or discount points, the effective cost of the loan is equal to the contract interest rate. •It is common for an origination fee to appear on the closing statement. •The lender may discount the mortgage—that is, charge the borrower discount points. •Truth-in-lending laws require the lender to disclose the annual percentage rate (APR) of the loan.

Put Option -Options in Real Estate

- gives the homeowner (borrower) the right to "put" the property in place of the debt or default on the debt. In this event, the lender can foreclose on the property and liquidate it to satisfy the obligation.

Municipal Bonds -Income Tax Considerations

- issued by government jurisdictions other than the federal government -interest earned from them is tax free -The tax-free nature of these instruments implies that investors will receive lower return on these bonds

Insurance Companies -Financial Intermediaries

- receive periodic or lump-sum payments from individuals or organizations in return for a promise to make future payments if certain events occur

Financial Leverage

- the concept of using debt to finance an investment project. -Two primary sources of capital: debt and equity. -Generally, the borrowing rate is less than the return on the asset (positive financial leverage). *Negative leverage when the borrowing rate > ROI, resulting in declining return on equity (ROE).

Finance emphasizes... -What is Finance?

- time value of money (TVM) and implications of interest rates on TVM and financing decisions: -Focuses on cash flows, not profits - Makes extensive use of the concept of risk

Balloon/Reset FRM

-30 year amortization but becomes payable ("balloons") over a shorter term. -Implies partial amortization over the stated term. -The remaining loan balance (balloon) must be repaid at maturity. -Typically balloons in 5 or 7 years.

Fixed-Rate Mortgages - Important Variables

-Amount Borrowed -Contract Interest Rate -Maturity (Term) -Outstanding Balance -Amortization -Payment -Financing Costs Including Discount Points -Annual Percentage Rate (APR)

Savings-Investment Cycle

-An identity, whereby the amount of savings equals the total amount invested. *Three groups of savings: by individuals, businesses, and the government *Investment considers amount invested in new plant construction, equipment and real property

Factors Affecting the Contract Interest Rate

-An increase in the loan amount -Loan term -Lock-in period -Down payment -Discount points -Credit score

The General Level of Interest Rates

-Assume that only one type of credit instrument exists (e.g. a bond) *The bond is riskless *No inflation expectation *The price of the bond is inversely related to and determined by the market-required yield *Market value of the bonds can be defined in terms of either their price or their yield.

The 1990's

-Baby boomers trading up increasing demand for up-scale housing. -Mortgage lending - national in scope. -Low mortgage interest rates - refinancing "craze". -In 1995 risk-based guidelines expanded to cover interest rate risk.

2007-2012 2000s: Period of Extremes

-Borrowers began to show willingness to walk away from speculative housing investments. -S&P downgraded large numbers of residential mortgage securities as toxic mortgage debt poisoned the global financial system. -Rebound in housing prices in the end of the 2000s decade; historically low interest rates.

The 1970s FRMs in an Inflationary Environment

-By 1979 inflation rate reached 13.3%; there was an increased volatility of the annual rate of inflation. -Demand problems: Rise in long term rates →less affordable mortgages → real mortgage cost increased in the early period of the loan and decreased in later part - "tilt" effect. -Supply problems: maturity mismatch structure of financial intermediaries.

Negative Discount Points

-Cash rebate from the loan underwriter to either the mortgage broker or the borrower. -When paid to the mortgage broker, it is referred to as the yield spread premium. -When paid to the borrower, it is used to defray settlement costs. -May be referred to as a "no-cost mortgage". -Contract interest rate would be above "par". -Borrowers with shorter expected holding periods should be more attracted to this loan.

Risk of Real Estate Assets

-Commercial project -Real estate limited partnership (RELP) -Real estate investment trusts (REIT) -Residential mortgage -Mortgage-backed securities (MBS) -Collateralized mortgage obligations (CMOs) -Commercial mortgage-backed securities (CMBSs) -Interest-Only and Principal-Only Securities (IOs and POs) -Servicing Rights

Expectations theory -Explaining the Yield Curve

-Current rates are the average of expected future rates -The current two-year rate is the average of the current one-year rate and the one-year rate a year from now.

1950's Modern Residential Finance

-Decade of savings and loan association (S&L) expansion and stability. -S&L associations enjoyed greatest growth in mortgage lending; commercial banks' share in mortgage lending declined, but recovered in the 1980s. -In 1950s over 50% of all mortgage debt was held by depository institutions.

1980s Deregulation, Growth in AMIs and Thrifts Crises

-Depository Institutions Deregulations and Monetary Control Act (MCA) passed in 1980. -Removed rate ceiling on some deposits -The Garn-St. Germain Act (1982) introduced competition and incentives for risk-taking.

The 1960s

-Disintermediation in 1966 (during the "credit crunch") and 1969 -Thrifts' rate significantly lower than the yield on short-term Treasuries. -In 1968 the Truth in Lending Act passed to assure a meaningful disclosure of credit terms and costs allowing borrowers to avoid abuse lending practices and shop for mortgages. -Development of secondary mortgage market - securities and bought and sold after their origination

Markets tend to be less efficient when: -Market Efficiency

-Dominated by few large investors -Involve illiquid assets -Have large transaction and information costs

1990's The Dominance of the Secondary Mortgage Market

-Domination of government-sponsored enterprises (GNMA, FNMA and FHLMC) and secondary mortgage market. -Increased share of mortgage bankers in mortgage originations. -Increased standardization of loan documents and evaluation processes.

The Role of Risk in Valuation

-Earn risk-free return for postponed consumption -Earn risk premium based on risk exposure -Optimal level based on degree of risk aversion -Discount rate associated with the equity portion of the real estate investment should be higher that the rate associated with the debt of the project

The 1980's

-FSLIC forbearance allowed troubled institutions to continue to undertake risky investments. -Financial Institution Reform, Recovery and Enforcement Act (FIRREA) passed in 1989. -Widespread S&Ls failures due to deregulation and maturity mismatch issue.

Early 1900s through 1920s -American Residential Finance - Early American History

-Federal Reserve in 1913 allowed banks to write 5-year, 50% loan-to-value ratio, non-amortizing mortgages. -During early 1920s building and loan associations expanded rapidly. -During early 1920s real estate prices rose rapidly. -After 1929 market crash real estate prices dropped dramatically.

NOI (or accounting profits) vs. after-tax cash flows -Issues in Real Estate

-Focus on after-tax cash flows -Added cash flows from minimizing taxes allow for greater accumulation of wealth, since cash flows can be reinvested in other corporate investments.

Price anticipation effect

-Future expected inflation -Decrease in supply of credit

English Developments

-Gage system introduced in 1066 -Dead gage in French - mort gage -Concept of usury in that charging interest was sinful -Equitable right of redemption - allowing borrower to redeem the property after default •Equitable right of redemption used today in all states •Some states, by statute, grant an additional period of time during which the mortgagor can redeem the property - statutory right of redemption

German Influence

-German law recognized the concept of "gage" - a deposit made to fulfill an agreement. -Borrower could physically deliver portable property as a gage - "live gage." -Real property (not transportable) - a "dead gage." -In case of default when collateral was dead gage the lender could take possession, but could not look beyond the gage for relief.

Introduction of alternative mortgage instruments (AMIs) -The 1970's

-Graduated-payment mortgage (GPM) - lower initial payment; initial negative amortization -Shared appreciation mortgage (SAM) -Adjustable rate mortgage (ARM) -Price level adjusted mortgage (PLAM) - initial rate = real rate

2000s Period of Extremes

-Housing market craze in the 2000s - Single-family homes entered the speculative investment market. -Mortgage lending standards relaxed. -By 2006, housing prices had risen >80% from their 2000 level. -Rapid growth of secondary mortgage market through mortgage purchasing by Fannie Mae, Freddie Mac, and Wall Street. -Aggressive buying of subprime and Alt-A mortgages and MBS by Fannie Mae and Freddie Mac.

2000s Period of Extremes

-In 2007 sharp drop in prices across the U.S. due to weakening economy and high inventories of unsold homes. -Rising delinquencies due to negative equity and large subprime market. -Collapse in 2008 of several Wall Street investment firms and take over of Fannie Mae and Freddie Mac by the government. -Changing market as house prices fell and lenders tightened standards.

Income effect

-Income goes up -Demand for credit goes up -Interest rates go up

Post-Civil War -American Residential Finance - Early American History

-Increased mortgage lending to finance westward expansion -Typical loan was short-term, interest-only (called non-amortizing) and covered 40 - 50% of the value of the property

Fisher equation

-Inflationary expectations are incorporated in nominal interest rates. The _____________ expresses this relationship as follows: I = r + p where: I = the equilibrium nominal rate of interest observed in the credit market, r = the real rate of interest, and p = the expected inflation over the maturity of the bond. -When the money-inflation-interest rate mechanism is viewed from start to end, the line of causation runs from money to the economy to inflation to inflationary expectations to credit markets to interest rates

"fudicia" -Roman Law

-Initially the instrument used in RE loans, provided that title and possession of the property be held by the lender until repayment.

General Level of Interest Rates

-Interest rate on an instrument reflects general market rates and the risk of the specific instrument. -Transition mechanism of money and interest rates: *Money supply → economy → inflation → inflationary expectations → credit markets → interest rates

Financial Intermediation

-Intermediary stands between the supplier and user of credit. -Performs economic functions by assuming: *Liquidity risk (think savings account versus mortgage) *Credit evaluation on borrower and property and risk management *Interest rate risk - exposure through fixed rate mortgages (FRM) and prepayment

Secondary Mortgage Market

-Issue mortgage-related securities (MRSs) using mortgage pools as collateral

1950's Modern Residential Finance

-Large difference between the maturity of the institution's assets and liabilities due to wide acceptance on the 30-year fixed-rate mortgage -maturity mismatch. -Increased interest rate risk because of fixed-rate mortgages. -Problem exacerbated by the lack of prepayment penalties on mortgages. -Due to stable inflation and interest rate environment, maturity mismatch was not a serious problem.

Early expansion -American Residential Finance - Early American History

-Little need for lending -Some building societies formed to consolidate funds for home buying

1930's American Residential Finance - Early American History

-Many states passed legislation enacting moratoriums on foreclosures. -A number of federal agencies created including Reconstruction Finance Corporation (RFC in 1933); Federal Home Loan Bank System (FHLBS, 1932),Home Owners Loan Corporation (HOLC, 1933), Federal Savings and Loan Insurance Corporation (FSLIC, 1934), Federal Housing Administration (FHA, 1934), and Federal National Mortgage Association (FNMA or Fannie Mae, 1938).

1930's American Residential Finance - Early American History

-Market crash in 1929 ushered in the Great Depression. -Property values fell to about half of the 1928 level. -Banking system collapsed, money supply plummeted, unemployment soared. -Refinancing short-term, non-amortizing loans became a problem.

Valuation -Issues in Real Estate

-Market value versus book value -Appraised value -Depends on expected amount, timing, and risk associated with the asset's cash flows

Liquidity effect (short-run)

-Money supply goes up -Demand for bonds goes up -Interest rates go down

Agency costs types: -Agency Theory

-Monitoring costs -Bonding costs -Structuring costs

Income Tax Considerations

-Municipal bonds - issued by government jurisdictions other than the federal government. -Interest earned from municipal bonds is tax free. -The tax-free nature of these instruments implies that investors will receive lower return on these bonds. -MY = tY(1 - t) where MY is the yield on a municipal bond, tY is the taxable yield on a comparable non-municipal bond, t is the investor's marginal tax rate.

Biweekly Mortgage

-Paying biweekly effectively reduces the payment period for the mortgage, holding the amount and the interest rate constant. -Alternatively holding the maturity constant the total monthly payment is lower than with monthly payment mortgage.

Financial Intermediation

-Performs economic functions by assuming: *Liquidity risk (think savings account versus mortgage) *Credit evaluation on borrower and property and risk management *Interest rate risk - exposure through fixed rate mortgages (FRM) and prepayment

1960s: Inflation, Disintermediation and Rise of the Secondary Mortgage Market

-Period of rising inflation up to 6.1 % in 1969.-Treasury Securities - attractive investment alternative due to high Treasury yields.

Prepayment Protection Mortgage

-Popular in 1940s and again in late 1980s and 1990s -The borrower gives up the right to prepay the mortgage without penalty in exchange for a lower interest rate. -Does not preclude prepayment, but rather imposes prepayment penalty. -Different cost structures *Freddie Mac PPM structures: *Initial restricted prepayment for the first 3 years followed by a penalty of 2% of the outstanding balance after year 3. *5-year restriction and penalty of 6 months' interest on the remaining balance if prepaid after year 5.

1940's Modern Residential Finance

-Preoccupied with World War Two. -Veterans Administration created. -The Veteran's Administration was given authority to develop a mortgage insurance program, similar to that of the FHA.

Real Estate Finance Includes the study of: -What is Real Estate Finance?

-Residential and commercial properties -Terms of residential and property leases -Appraisal of residential and commercial properties -Financing of residential and commercial real estate -Valuation of mortgages -Real estate taxation issues -Primary and secondary mortgage markets -Securitization of mortgages

Interest Rate Risk -Risks in Real Estate Finance

-Risk of loss due to changes in market interest rates -Fixed-income assets are most susceptible

Marketability risk -Risks in Real Estate Finance

-Risk that the asset doesn't trade in a large, organized market -I = r + p + k, where k is risk premium associated with noninflationary risks

Mechanics of the Fixed-Rate Mortgage

-The 30-year, fixed-rate mortgage (FRM) has dominated the mortgage market in the US since 1930s. Characteristics: -Fixed-rate -Fully amortizing -Level payment

The Fisher Equation

-The inflation rate plays an important role in the determination of market rates. -Fisher equation: I = r + p I - the equilibrium nominal rate of interest observed in the credit market r - the real interest rate P - the expected inflation over the maturity of the instrument

Expectations Theory -The Yield Curve

-The long-term rate for some period is the average of the short-term rates over that period -Upward-sloping (downward-sloping) curves indicate that market participants expect rates to rise (fall) in the future.

Primary Mortgage Market

-The market where mortgages are originated. -Originators either hold mortgages in portfolio or sell them into the secondary mortgage market.

Explicit Option -Options in Real Estate

-The right to purchase property at a specified price within a specified time. *Often in relation to the purchase of raw (undeveloped) land

Timing of cash flows -Issues in Real Estate

-The sooner a cash flow is received, all else equal, the great its present value (PV)

Market Segmentation Theory -The Yield Curve

-There are two (or more) markets for securities of different maturities -Assumes that investors will not change their preferences as a result of yield discrepancies

Market Efficiency -Efficient Market Theory

-Weak form efficient -Semi-strong efficient -Strong form efficient

Risk of cash flows -Issues in Real Estate

-When a possibility exists that the actual cash flow may be different from the expected and probabilities can be assigned to these possibilities.

Portfolio Theory

-When assets are combined to form a portfolio , the expected return on the portfolio will be equal to the weighted average (based on the relative value of each asset in the portfolio) of the expected returns on the individual assets.

risk of the portfolio -Portfolio Theory

-____________ will depend on the correlation of the portfolio's assets returns. §e.g. if the returns of two assets are perfectly negatively correlated it is possible to construct a riskless portfolio(certain returns) §Benefits of diversification through portfolio construction

Secondary Mortgage Market

-agencies and firms purchase mortgages from other intermediaries or brokers that deal with surplus income units, using funds raised though sales of securities they create. -Issue mortgage-related securities (MRSs) using mortgage pools as collateral

Efficient Market -Efficient Market Theory

-an asset trades in a market where its value reflects all available information about that asset *An investor cannot earn excess return over the normal return by employing information that is available to everyone

List 3 "services provided by financial intermediaries.

-liquidity: Deposits at financial intermediaries are very liquid. Some (checks or demand deposits, for example) are considered part of the nation's money supply. -credit evaluation: Intermediaries often have a greater expertise in judging the credit of debtors. They know the local economy well and can judge property values (collateral) with a high level of expertise. Those with funds to lend but without the ability to judge default risk will place their funds with an intermediary. -insulation from interest rate risk: Intermediaries take on interest rate risk by borrowing short and lending long term. Those who have funds to lend but who do not wish to take on interest rate risk will place those funds on a short-term basis with intermediaries.

Give several examples of options in real estate.

-mortgages: The mortgagor has a call option. If interest rates fall and the value of the mortgage (to the lender) rises, then the mortgagor can refinance the loan by paying its balance. That is, the mortgagor can pay off a high-valued mortgage for a lesser amount (balance). The mortgagor also has a put option. Should the value of the property fall below the balance on the loan, then the mortgagor can put the house to the lender. That is, the mortgagor can pay off a mortgage with a given value for an amount that is less (the value of the property). -explicit options: The option to buy raw land at a given price up to a certain date. Here a developer may want to tie up land for future development but may lack the funds for an outright purchase. The option serves this function. The developer will exercise the option on or before the exercise date if the value of the land equals or exceeds the exercise price. -leases: Leases often include options to renew at stated rents or rents adjusted by the Consumer Price Index (CPI). If market rents are substantially above the renewal rent as called for in the renewal option, the lessee will exercise the option and renew the lease. If market rents fall, the lessee will renegotiate the rent down or seek another property to lease.

Investment Companies -Financial Intermediaries

-pool the funds of savers and invest the funds in a portfolio of assets

discount points

1 point = 1% of the loan amount and it is a cash charge paid by the borrower to the lender at time of origination

What provisions of the FIRREA addressed the causes of the savings and loan failures.

1. The Act required higher capital for thrifts and instituted risk-based capital requirements. Risk-based capital requirements mandate a certain amount of capital for a thrift based on the riskiness of its assets. 2. The amount of funds that a thrift could loan to any one borrower was limited. 3. Appraisers were required to become state-licensed or certified. 4. The insurance agency (FSLIC) was separated from the regulatory agency (FHLBB). 5. Thrifts were required to follow Generally Accepted Accounting Principles. 6. The types of assets that thrifts could invest in (qualified thrift investments) were defined

Indicate 3 benefits of a well-organized secondary market for mortgages

1. Three benefits of a well-organized, secondary market for mortgages include the following: increased liquidity for mortgages (The increase in liquidity for mortgages will, in turn, reduce the market rate of interest on mortgages.) 2. elimination of maturity mismatch (Secondary mortgage market agencies can issue long-term debt to obtain the funds necessary to purchase the long-term mortgages, thus matching the maturity of assets and liabilities, something many financial institutions are unable to do.) 3. elimination of regional mismatch of supply and demand for funds. (With a secondary mortgage market, depository institutions with a surplus of savings over investment needs can purchase mortgages in the secondary market, thereby providing funds to the sellers of the mortgages in other regions of the country that may have an excess demand to originate mortgages over their deposit inflows.)

Liquidity Premium Theory -The Yield Curve

A premium must be paid to investors who are reluctant to tie up their funds for long periods of time

Efficient Market Theory

According to efficient market theory, an asset trades in a market where its value reflects all available information about that asset. •No one individual is able to trade on the basis of information available to all other market participants and, in the process, make excess returns. •An investor cannot make returns in excess of normal returns by employing information that is available to everyone. Market efficiency applies to the type of information that is available about assets: •Weak form market efficiency exists when the price of the asset completely reflects its historical prices. •Semi-strong form market efficiency exists when the price of the asset reflects not only past price behavior but also any other public information. •Strong form market efficiency exists when the current price reflects all information, whether public or private.

effective cost of the mortgage (EBC)

Affected by the loan fees charged by the lender -Loan fees include - origination fee; lender inspection fee, assumption fee, underwriting fee, VA funding fee FHA MIP, tax service fee, document preparation fee, flood certification fee, prepaid interest, MIP (first year).

Define agency costs.

Agency costs are costs to ensure that an agent operates in the interest of the principal.

Agency Theory

Agency theory and agency problems deal with the relationship between principals and agents. Agency problems exist in many real estate activities and transactions. Agency costs are costs borne by the principal to reduce or prevent agency problems: •Monitoring costs are outlays for audits and other control procedures. •Bonding costs are payments made to third parties to ensure the honest behavior of agents. •Structuring costs involve compensation to agents to ensure performance consistent with the interests of the principal.

Role of Risk in Valuation

Although convenient formulas generally are not available to real estate analysts, some general guidelines can be followed: •The discount rate associated with the equity portion of a real estate investment should be higher than the rate associated with the debt on the project. •Debt holders presumably estimate their risk when calculating their required rate on debt—an upward adjustment is justified for the risk of equity cash flows. •The greater the perceived risk, the greater the appropriate discount rate should be.

Define an "efficient market".

An efficient market is one in which the value of traded assets reflects all currently available information. Assets are said to be priced efficiently in the sense that no excess profits can be consistently made by trading on any type of publicly available information, including the past price behavior of the assets that are traded. Efficient markets are characterized by large numbers of buyers and sellers trading assets about which there is an abundance of publicly available information.

Define an equitable right of redemption.

An equitable right of redemption is the right given to the borrower to bring a delinquent loan current. Under this right the lender is not allowed to accelerate the loan or take title to the property until a formal foreclosure procedure process takes place.

The Gibson Paradox

An increase in the money supply increases the demand for bonds and goods and services, resulting in upward pressure on bond prices, forcing interest rates down

Liquidity, Income, and Price Anticipation

An increase in the supply of money can have three effects on credit markets:

Define Options

An option is the right to buy (sell) an asset at a given price on or before a certain date.

Asset Valuation Equation

Because each asset can be valued in terms of the amount, timing, and risk of the cash flows, there are four elements in the equation: •the (present) value, •the amount of the cash flows, •the time period in which or over which the cash flows occur, and •the discount rate. Given any three of the four elements in this basic valuation equation, the fourth can be computed.

"live gage." -German influence

Borrower could physically deliver portable property as a gage

Callability risk -Risks in Real Estate Finance

Borrower may repay the debt before maturity

Explain how the borrowers attempted to circumvent then enforcement of the due-on-sale clause

Borrowers attempted to circumvent the due-on-sale clause in their mortgages in several ways. One was to rent the property at a low lease payment, giving the borrower an option to purchase the property at a low or nominal amount some time in the future. Another way was the use of a land contract. The buyer would contract with the seller to make payments on a contract to buy the property at a future point in time with the buyer occupying the property in the interim.

Indicate the major reasons for widespread failure of savings and loans in the 1980's. Include a discussion of RAP verses GAAP accounting?

By allowing thrifts to follow accounting practices established by the regulators instead of the more conservative Generally Accepted Accounting Practices (GAAP) established by the accounting profession, the "profits" and "net worth" of many thrifts appeared better than they really were. Many Regulatory Accounting Principles (RAP) guidelines allowed for more generous reporting of revenue and less stringent reporting of expense than would be allowed under GAAP. For example, RAP allowed the annual appreciation in the value of an asset purchased at a discount to be included in income over a shorter period of time than did GAAP. This meant that more of the appreciation would be reported as profits each year. While RAP often allowed all of a commitment fee to be included in income GAAP allowed only an amount equal to the expenses related to the commitment. RAP also allowed a greater portion of origination fees to be included in income while GAAP allowed only those fees to be included that represented the cost of originating a loan. Finally, none of the regulatory additions to net worth discussed above met criteria established by Generally Accepted Accounting Principles

Fixed-rate mortgage (FRM)

Characteristics: -Fixed-rate -Fully amortizing -Level payment

Provide several examples of real estate assets that involve risk. Explain the source of the risk.

Commercial property itself (such as hotels, warehouses, office buildings, etc.) involves risk because, although the future after-tax cash flows can be estimated, they are uncertain due to unknown events such as the state of the economy, tax laws, and so forth. Thus, securities that are backed by real property can have greater (in some cases, less) risk than the underlying, property. This is due to the risk of mismanagement by the security issuers. An example would be as follows: A real estate limited partnership that invests in commercial properties has the risk not only of the underlying property but also the risk resulting from mismanagement or agency costs of the general partner. Mortgage-backed securities also are risky. If the homeowners default on their mortgage and the value of the property is less than the balance on the mortgage, then the mortgages will be worth less and, therefore, some or all of the securities backed by the mortgages will be exposed to losses.

Explain why a stock market, such as the New York Stock Exchange, is more efficient than some real estate markets

Compare the stock market to, for example, the market for office buildings in Toledo, Ohio. The number of market participants, buyer and sellers, is much larger in the New York stock market than in the market for office buildings in Toledo. While there are thousands, perhaps even millions, of participants in the stock market, the number of participants in the office market in a particular city may be only a few dozen. Also the quality of information must be considered. Knowledge of the financial statements of all publicly traded corporations is abundant and available to all at little cost. Information relevant to valuing an office building in Toledo may be less well known. Information about supply and demand, absorption rates, the city's policy toward development, and so forth, may be known to only a few well-informed market participants. Finally, the number of transactions in the office building market will be few and infrequent. Trades in the New York Stock Exchange, on the other hand, occur daily and in the hundreds of millions.

List and explain the type of risks associated with specific securities?

Default risk is the risk that the debt issuer will fail to meet the interest and/or principal payments on the obligation. Maturity risk is the risk that interest rates will change subsequent to the issue of the bond and therefore that the value of the bond will change. Liquidity risk is the risk that the bond will not be able to be sold in a large and efficient market. If sold in a "thin" market a discount may be applicable. Callable risk is the risk that the bond issuer will call (repurchase the bond at or near its face value) the bond prior to maturity in the event that market interest rates drop.

What are some of the weaknesses of FIRREA?

Despite the intentions of FIRREA there are still some weaknesses including: (1) failure to institute deposit insurance based on the riskiness of the assets of the thrift, (2) continuation of insurance on very high levels of deposits ($100,000), (3) risk-based capital requirements encouraged thrifts to invest more in long-term residential loans exposing them to additional interest rate risk, (4) failure to mandate a minimum level of capital than would mandate closure of a thrift.

Define disintermediation and explain why it caused severe disruptions in the housing market?

Disintermediation is the withdrawal of funds from depository institutions (thrifts) by depositors. It is really a net outflow of funds whereby more funds are removed from the institutions than newly deposited. Regulation Q disintermediation caused many depository institutions to curtail lending.

Discuss the major changes in the residential finance market from 1950 to the 1990s with regard to the role of the federal government?

During this period of time the role of the federal government in the financing of residential properties increased dramatically. Federal legislation: (1) addressed discrimination in selling and lending (HMDA, CRA); (2) subsidized homes through grants and low-income housing programs; (3) made the market for mortgages more efficient by creating and supporting the secondary mortgage market; (4) provided subsidized insurance and short-term lending for financial intermediaries, particularly the thrifts (FDIC, FSLIC, FHLB); (5) subsidized insurance for mortgages (FHA, VA); and (6) required lenders and others to disclose information (Reg. Z, ILSFA, RESPA, ECOA).

Applies Economics

Economics is the study of the allocation of resources for the purpose of producing goods and services for various members of society.

How did FIRREA change the regulatory structure of the mortgage market in terms of regulators and regulations?

FIRREA: (1) eliminated the Federal Home Loan Bank Board and transferred its duties and powers to the Office of Thrift Supervision, (2) eliminated the Federal Asset Disposition Association, (3) eliminated the Federal Savings and Loan Insurance Corporation and established the Savings Association Insurance Fund under the guarantee of the Federal Deposit Insurance Corporation, (4) established the Federal Housing Finance Board to oversee the twelve Federal Home Loan Banks, and (5) established an independent board of directors for FBLMC and gave some supervision of this agency to HUD

Continued growth of the secondary market -The 1970's

Fannie Mae and Freddie Mac continued to grow and by 1980 held or guaranteed >1/5 of all mortgage debt outstanding.

How did federal programs support the mortgage and housing market in the 1930's Depression?

Federal programs either channeled funds into the mortgage market or subsidized mortgage insurance against default. The biggest government effort was the Federal Housing Administration established by the National Housing Act. This legislation set up a system of subsidizing mortgage default insurance for long-term amortizing loans. The federal government also established the Federal National Mortgage Association to establish a secondary market for the FHA insured loans.

risk

Finance is more concerned with______ than is the traditional field of economics

How is the focus of finance different from the field of traditional economincs?

First, finance focuses on the valuation of assets and the maximization of the value of assets, whereas economics often focuses on profit maximization. Second, finance focuses on the intertemporal transfer of money and credit between lenders and borrowers and is thus concerned with such things as the time value of money. Third, finance makes a clear distinction between profits and cash flows. Economics—particularly microeconomics— develops models based on profit maximization. Finally, finance makes extensive use of the concept of risk and risk minimization. Microeconomic models have traditionally deemphasized the role of risk in theories of how a firm operates.

Discuss the major changes in the residential finance market from 1950 to the 1990s with regard to the types of mortgage loans?

From 1950 through the early 1980s the predominant type of mortgage was the longterm fixed-rate, fixed-payment loan. In the 1980s several alternative mortgage instruments were introduced. Two popular AMIs were the adjustable-rate mortgage (ARM) and the graduated-payment mortgage (GPM). Today the ARM survives as the only significant AMI to the fixed-rate, fixed-payment mortgage.

If you were a large homebuilder in a metropolitan area, how might you hedge your risk that the market for the houses might crash?

If you were a large homebuilder, you could hedge you risk by selling futures in the Case-Shiller index at a specified price. If the index declines, you would be able to purchase the index in the future at a lower price and sell it for the predetermined (greater) price.

Fisher equation:

I = r + p I - the equilibrium nominal rate of interest observed in the credit market r - the real interest rate P - the expected inflation over the maturity of the instrument

How can the equation of exchange be used to explain the monetary theory of inflation?

In the equation, velocity, V, and the amount of real transactions, T, are held to be constant or sluggish, meaning that the price level, P, changes in direct proportion to the money supply, M. Further, the direction of causality runs from changes in the money supply to changes in prices, not the reverse

Outline the critical issues on each side of the "battle" for enforcement of the due-sale clause in the late 1970's and early 1980's

In the late 1970s and early 1980s interest rates rose to historically high levels. The value of the low rate loans issued several years prior to this time fell for the lender (and rose for the borrower). Thus, borrowers who desired to sell their residences found they could obtain a higher price if the buyer could assume the existing low-rate loan. If the low-rate loan could be assumed, it would remain on the books of the lender. The lender would then face higher costs on deposits (interest paid out) but would not receive higher income (interest paid in) if many of the loans on the books had low rates. Thus, an assumption of a low-rate loan is a wealth transfer from the lender to the borrower. Through the assumption the lender sacrifices some profitability (or solvency) and the mortgagor receives a higher price for the property

Explain why increased interest rate volatility increases interest rate risk of the thrift asset-liability maturity mismatch?

Increased interest rate volatility means that interest rates will move up and down more frequently and by wider margins. Therefore, when rates rise, the maturity mismatch problem becomes evident. When rates fall, mortgagors refinance their loans at the lower rate. Because the lender loses if rates rise but does not gain if they fall, any change in interest rates is injurious to the lender's profits. Thus high interest rate volatility causes the maturity mismatch problem of the thrifts to worsen.

Define leverage.

Leverage is the use of debt to finance a portion of the acquisition of an asset (real property).

Real Estate Limited Partnerships (RELPs) -Risk of Real Estate Assets

Limited partnerships are partnerships that provide limited liability to the partner-investors, like corporate stock. •In addition to the risk of the cash flows, __________ investors incur other risks. •Risk may be associated with the actual cash flow taken by the general partner for operating the partnership as well as the value of the partnership interest on resale. •Because there is no organized, liquid marketplace for___________, substantial liquidity or marketability risk may exist for these investments.

Give 3 explanations why long-term and short-term Treasuries would have different yields on the same date?

Liquidity preference theory indicates that investors prefer the short-term instruments because of their liquidity and the insulation from interest rate risk. For this reason investors are willing to pay a greater price or, what is the same, accept a lower yield for short-term securities. Market segmentation theory indicates that there are different markets for short-term and long-term debt instruments. Some investors (demand side) prefer one type of debt instrument over the other and thus are players in two or more different markets. The expectations theory indicates that interest rates on longer-term securities reflect the market's expectations about future interest rates. An upward sloping curve indicates that interest rates are expected to rise in the future and a downward sloping, curve indicates that rates are expected to fall.

Liquidity Premium Theory -The Yield Curve

Long-term rates tend to be higher that short-term rates

Basic Valuation Equation -Issues in Real Estate

Look at equation on slide -Where CF stands for periodic cash flows, r is the appropriate discount rate, and n is the number of cash flows

Equation of Exchange -General Level of Interest Rates

MV = PT - M = money supply - V = velocity of circulation (the average number of time $1 turns over in 1 year) - P = general price level - T = the volume of trade

Secondary Mortgage Market

Major participants are the Federal National Mortgage Association (FNMA, or Fannie Mae), the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac), the Government National Mortgage Association (GNMA, or Ginnie Mae), the Federal Home Loan Bank Board, and private firms

Segmented markets -Explaining the Yield Curve

Market divided into distinct segments

inversely -Fixed-Rate Mortgages and Interest Rate Risk

Market values of fixed-rate mortgages change__________with market rate changes.

Explain how agency costs contributed to the subprime meltdown from 2006 to 2009

Mortgage bankers originated to be sold off to the secondary mortgage market. Once sold, the risk of default losses went with the mortgages (for the most part). Since the mortgage banker was compensated for the origination in the form of origination fees, yield-spread-premiums, and other fees, it would be in the interest of the mortgage banker to originate as many loans as possible regardless of the riskiness of the loans in terms of the credit worthiness of the borrower. Thus, the risk was passed along to the secondary mortgage market.

Explain why mortgage bankers were popular in the post-Civil War era?

Mortgage bankers were popular in this era because there were few depository financial intermediaries in the developing West. In order to buy property in this expanding part of the country, buyers would have to obtain credit from lenders that were located in the large metropolitan areas on the East Coast. Mortgage bankers supplied the necessary connection, originating loans in the developing West and selling these to large financial institutions in the East.

What were the characteristics of mortgages in the latter half of the 19th century. Explain why they minimized interest rate risk for the lender.

Mortgages in the latter half of the nineteenth century were primarily five-year nonamortizing loans. This was true for both residential loans and farm loans. At the end of the five-year period the principal of the loan was simply refinanced at the then prevailing rate of interest. Because these loans rolled over every five years and were refinanced at the new market rate of interest, they minimized interest rate risk for the lender. If rates rose one or two years after origination, there were only a couple of years remaining before they would be refinanced at the higher rate.

The Gibson Paradox

Not all economists agree that increases in the growth rate of money will necessarily result in higher nominal interest rates. •An increase in the money supply could lead to an increase in the demand for bonds, goods, and services. This results in upward pressure on bond prices, forcing interest rates down (the liquidity effect). •Those who believed that increases in the supply of money should depress interest rates concentrate only on one element of the entire mechanism. •The impact of money on the demand for goods and services (inflation) and on the demand for bonds may ignore additional effects of inflation and inflationary expectations on credit markets.

Discuss the concept of optimal capital structure as it pertains to real estate investments.

Optimal capital structure refers to that combination of debt and equity which maximizes the value of the equity position. Starting with an all equity-financed property, the addition of debt increases the value of the equity. This is so because for a small amount of debt, the cost of debt is lower than the return on the asset, thus providing the benefits of leverage. At some point, however, additional debt decreases the value of the equity. Too much debt raises its cost, reducing or eliminating the benefits of leverage. At the same time it increases the variance of the returns to the equity position. This increase in variance of returns causes the capitalization rate for equity to increase, thereby having an additional depressing effect on the value of the equity position.

Liquidity premium -Explaining the Yield Curve

Premium paid for liquidity

Distinguish between primary and secondary markets and give an example of each?

Primary markets handle the exchange of newly issued securities from the originator to investors. Secondary markets handle the exchange of existing securities between parties. An example of a primary market is the origination of mortgages by savings and loan associations to homeowners. An example of a secondary market is the New York Stock Exchange.

"dead gage.\" -German influence

Real property (not transportable)

Identify the problems created by Regulation Q during the 1960's and 1970's?

Regulation Q was established and implemented by the Federal Reserve Board in the 1930s. This regulation established the maximum rate of interest that commercial banks could pay to their checking and savings deposits. Savings and loan associations were made subject to Regulation Q in the 1960s and allowed to pay one-quarter of 1% over the rate allowed for commercial banks. The maximum rate on checking accounts was usually set at zero. The Regulation caused severe disintermediation when market rates rose significantly above the maximum Regulation Q rate.

Indicate the major reasons for widespread failure of savings and loans in the 1980's. Include a discussion of regulatory additions to net worth?

Regulatory authorities encouraged additions to net worth such as income capital certificates, net worth certificates, and appraised equity capital, all of which were intended to produce accounting entries, which raised the level of the net worth of the thrifts on the books. Generally, the accounting entries consisted of additions to assets and to net worth without any cash inflow from profitable operations. This "window dressing" failed to alleviate the problem of thrift failures

The Yield Curve

Relates maturity and yield at the same point in time

weak form efficient -Market efficiency

Research shows that real estate markets are _____________

Inflation Risk -Risks in Real Estate Finance

Risk in loss of purchasing power

Define risk. Which term in the DCF model reflects risk?

Risk is the possibility combined with the probability that the actual result (return on an asset) will differ from the expected result (return on an asset). Risk is usually reflected in the size of the discount rate used to value the future cash flows.

Default Risk -Risks in Real Estate Finance

Risk that the borrower will not repay the mortgage per the contract.

What are the risk-based capital guidelines? Give and example of the current risk-based capital guidelines for thrifts?

Risk-based capital guidelines are requirements that establish a minimum amount of capital (net worth) for a financial institution based on the riskiness of its assets. Any of the examples from table 5-10

List the 5 types of financial intermediaries and give a brief description of each.

Savings and loan associations accept short-term deposits from the public and loan funds primarily in the residential real estate market but some also participate in the commercial real estate market. Life insurance companies obtain funds from premiums collected for life insurance and invest those funds in long-term investments such as corporate bonds and real estate. Credit unions accept deposits from their members and make generally short-term, consumer-type loans with some lending for residential mortgages. Mutual savings banks are very similar to savings and loans except in their form of organization—they are mutuals and not corporations. Otherwise they are virtually identical. Commercial banks accept short-term deposits and issue commercial paper to make commercial, agricultural, and personal loans. They originate both commercial and residential mortgages.

Discuss the major changes in the residential finance market from 1950 to the 1990s with regard to the types of mortgage lenders?

Savings and loan associations grew in importance from originating 19% of the mortgages in 1950 to 27% in 1990. Savings banks declined in number and percentage of mortgages fell while the share represented by federal and related agencies increased dramatically from 1950 to 1990.

Investment Companies -Financial Intermediaries

Some___________________ (e.g., real estate investment trusts) specialize in real estate properties and mortgages; others invest in mortgage-type securities

Explain the "zombie theory of savings and loan failure as outlined by Professor Kane?

The "Zombie" theory of thrift failure as outlined by Ed Kane is that insolvent thrifts endeavored to undertake risky investments in an attempt to restore solvency. To do so, many of these thrifts competed aggressively for deposits by offering high interest rates to depositors. The result was that other thrifts had to raise their deposit interest rates to remain competitive. This competition caused the profit of solvent thrifts to fall and many of them became insolvent.

What was the purpose of the FHA?

The FHA was established to provide subsidized mortgage insurance for long-term fixed-rate, fixed-payment, amortizing mortgages.

Indicate the major reasons for widespread failure of savings and loans in the 1980's. Include a discussion of FSLIC forbearance?

The FSLIC was slow to close many failed thrifts. Rather, they hoped that during the crisis interest rates would fall and lower the cost of thrifts' sources of funds. They also hoped that many thrifts would gain profitability through undertaking high return investments allowed by the Garn-St. Germain Act of 1982.

Interest rate -General Level of Interest Rates

___________ on an instrument reflects general market rates and the risk of the specific instrument.

What was the purpose of the FNMA?

The Federal National Mortgage Association was established to create a secondary market (buy and sell) for FHA loans.

What was the purpose of the FSLIC?

The Federal Savings and Loan Insurance Corporation (FSLIC) was established to insure the deposits of savings and loan associations against default. The insured thrifts would pay a premium based on the dollar amount of deposits insured. The FSLIC was a sister organization the Federal Deposit Insurance Corporation (FDIC) that insured the deposits of commercial banks.

What is the relationship between the Gibson Paradox and the Fisher Equation?

The Fisher equation explains the Gibson paradox once it is realized that changes in the money supply create inflation and, thus, inflationary expectations in the future.

What is the Fisher equation?

The Fisher equation indicates that the nominal rate of interest includes a component for expected or anticipated inflation. Specifically, the nominal rate equals the real estate plus expected inflation. Expected inflation is, in part, dependent on the most recent inflationary experience.

What is the Gibson paradox?

The Gibson paradox is the observation that there is a positive and direct correlation between changes in the money supply and interest rates. This is contrary to the liquidity theory that predicts an inverse relationship. The explanation is found in the Fisher equation discussed next.

Give two reasons why the actual yield on a corporate bond would be greater than the real rate of interest?

The actual yield on a corporate bond may be greater than the risk-free rate because of default risk, the existence of inflation, callability risk, maturity risk, or, if the firm is small, liquidity risk.

Monetary theory of inflation -General Level of Interest Rates

The greater the rate of growth in money, the greater the rate of inflation. •The limit on growth in the real volume of trade is determined by the growth in real resources. •The velocity of money is stable. Because it depends on the demand for real money, which is determined by slowly changing institutional factors, money supply and prices are linked. •The direction of causation runs from money to prices. Increases in the supply of money lead to changes in the level of prices. •Inflation results from an increase in the money supply in excess of the increase in goods and services.

Why does the DCF model focus on cash flows and not income?

The discounted cash flow model focuses on cash flows because these are available for the owner to reinvest in other assets or to reduce liabilities that have a cost associated with them.

What is the equation of exchange?

The equation of exchange, MV = PT, is an identity that indicates that the money supply times its velocity is equal to the amount of real transactions times the price level; or the amount of money spent in a given period is equal to the amount of money received.

What was the major difference between the fiducia, the pignus, and the hypotheca in Roman Law?

The fiducia gave legal title to the lender until such time that the loan was repaid. With a pignus the title remained in the hands of the borrower, the property was pledged as collateral, and the lender could take title to the property in the event a default was likely. The hypotheca was identical to the pignus except that the lender could take title only upon an actual default by the borrower.

inflation

The fixed-rate, fixed-payment mortgage was an ideal instrument for a noninflationary environment. Once inflation and inflationary expectations accelerated, interest rates rose and created severe problems for the fixed-rate loan. The tilt effect created an affordability problem for borrowers. The volatility in interest rates created the maturity mismatch problem for lenders. This in turn created the need to develop alternative mortgage instruments (AMIs) such as the graduated-payment mortgage (GPM), the adjustable-rate mortgage (ARM), the shared-appreciation mortgage (SAM), and the price-level adjusted mortgage (PLAM)

Monetary theory of inflation -General Level of Interest Rates

The greater the rate of growth in money, the greater the rate of inflation

What is the real rate of interest?

The real, risk-free rate is that rate that would exist on default-free (and free of other risks) obligations in an inflation-free environment. Most economists believe that the real rate of interest is approximately 1-3%.

interest rate volatility

The increase in interest rate volatility had a dramatic affect on the value of the call option of a typical residential mortgage. Without prepayment penalties, a drop in interest rates made it profitable for borrowers to refinance. With a rise in rates, properties with existing, assumable mortgages rose in value. Thus, the volatile interest rates caused both the call option and the right to assume existing mortgages to become very valuable. With increasing interest rate volatility in the 1970s, lenders added a premium to the rate they charged to cover the increased value of the call option. Since the value of an assumable loan also became greater during this time, a battleground developed between the right of a buyer to assume an existing loan on the one hand, and the right of the lender to enforce the due-on-sale clause on the other. And because the profitability of lenders was directly affected by the ability to enforce the due-on-sale clause, lenders put their efforts into firmly establishing that right. Regulators of financial institutions were concerned with their profitability (solvency) as well and, thus, lined up on the side of enforcement. Both court decisions and legislation (Garn- St.Germain Act, 1982) eventually favored the enforcement of the due-on-sale clause.

Fully explain the concept of interest rate risk as it relates to thrift asset-liability maturity mismatch?

The maturity mismatch problem arises when the assets (usually mortgages) held by a thrift have an average maturity (actually, duration) significantly longer than that of its liabilities. This means that the liabilities turn over more frequently and are thus funded at different rates of interest more frequently than that of the assets. This is particularly a problem when market rates rise. The rate that the thrift must pay on liabilities (and expense) rises more quickly than the return on the slow turnover assets (income) producing lower profits or even losses. The long-term assets suffer a large reduction in market value when rates rise because of their lengthy maturity and the reluctance of mortgagors to prepay loans.

Distinguish between money and capital markets. In which of these markets does most real estate financing take place and why?

The money market is the market for credit obligations with maturity of one year or less. The capital market is the market for credit obligations with maturities longer than one year. b. Most real estate financing is long-term because of the nature of the product being financed. Real property has a long life and generates cash flows over a long period of time.

Explain how the mortgage market of the 1940's differed from that of the 1920's?

The mortgage market of the 1940s was characterized by long-term, fixed-rate, fixed-payment amortizing loans. There were virtually no adjustable-rate loans and no interest-only loans. In the 1920s there were many five-year, interest-only loans. In the 1940s the major residential mortgage lenders were the savings and loan associations, mutual savings banks, and commercial banks. In the 1920s the major lenders were commercial banks and life insurance companies.

Presently, a one-year Treasury yields 7.8% and a two-year Treasury yields 9%. What does this say about market expectations of the one-year Treasury rate that will be observed one year from now? Will it be higher or lower than the present one-year rate? Give and estimate of its value.

The one-year yield one year from today will be higher. The estimate of that rate is 10.2%

What is the origin of the equitable right of redemption?

The origin of this right resides in English common law of the Middle Ages. Prior to this right, a lender could foreclose on a loan and take possession of the property, which may have greater value than the remaining debt. Because this seemed unfair, borrowers petitioned what was called the "Court of Equity" to reinstate their loan if they could eventually make the loan payments. This was granted and became known as the equitable rights of redemption.

market-required yield -The General Level of Interest Rates

The price of the bond is inversely related to and determined by the _______________.

Purchasing Power Risk -Maturity Risk

The risk that inflation will erode the value of the principal amount of the bond. Long-term bonds will be priced lower to yield more than short-term bonds.

yield curve

The shape of the ___________ may be different from what we might expect from maturity risk alone.

Real Estate Finance

The study of the institutions, markets, and instruments used to transfer money and credit for the purpose of developing or acquiring real property

Identify the supply problems of a standard fixed rate mortgage in an inflationary environment

The supply problems of a standard fixed-rate mortgage in an inflationary environment stem from the maturity mismatch problem. When inflation creates an increase in market rates of interest the cost of funds for financial institutions (rate on deposits) rise more quickly than the revenue from their long-term fixed-rate mortgages. The result is a decline in profits and, if the decline is significant, insolvency for the institution

Explain how leverage can be used to increase the value of equity in a real estate investment.

The traditional explanation of value creation through leverage lies in the difference between the rate of return on the asset being acquired and the cost of debt. If the cost of debt is less than the return on the asset, then that portion of the asset being financed will throw off a yield greater than the cost to finance that portion. This difference accrues to the equity owner of the asset.

Summarize the historical use of property as collateral for a loan to finance its purchase.

The use of property as collateral for a loan has its roots in ancient times. The fiducia gave the lender legal title to the property used as collateral until the loan was paid. Under German law the concept of a "gage" or pledge was developed whereby the property, if possible, was physically delivered to the lender. Since this was impossible for land, the concept of a dead pledge or mortgage was developed and later introduced into English common law. There, the lender could foreclose on the loan if the payments were not made and obtain title to the property. Today this tradition continues. With a mortgage, the lender is able to foreclose and request the court to provide title to the property if the borrower fails to make the loan payments. With a deed of trust the lender can request the trustee sell the property and apply the proceeds to the payment of the debt.

Interest Rate Risk -Maturity Risk

The values of bonds with longer maturities change more than those with shorter maturities when interest rates change. Long-term bonds have more interest rate risk because they have longer lives over which it is possible for market rates to change

What is the yield curve?

The yield curve is a locus of points that indicate the yield on securities of various maturities as of a point in time.

What does it mean when we say that mortgages (or pass-through securities backed by mortgages) are callable?

This means that the borrower (mortgagor) has the right to repay the loan without a prepayment penalty in the event that the market rate of interest drop

yield curve

Three principal theories are responsible for the shape of the __________: •liquidity premium theory •market segmentation theory •expectations theory

Outline the causes of the high default rate on mortgages during the 1930's Depression

Up to the 1930s most real estate loans were non-amortizing, which meant that none of the principal was paid down. During periods of property price appreciation (such as what occurred in the 1920s) property owners would have taken out second, third, and other loans, also non-amortizing. When the Great Depression hit in the early 1930s, two things occurred. First, property values fell dramatically, many well below the outstanding balances on the loans. Second, at the same time, the high rate of unemployment meant that many homeowners were unable to make their mortgage payments. The combination of these two factors led to the large numbers of mortgage defaults.

inventory -After-Tax Cash Flows

When accounting for ____________, first-in-first-out will maximize reported earnings, whereas last-in-first-out will reduce earnings and, thus, taxes

Portfolio Theory

When assets are combined to form a portfolio, the expected return will be equal to an average of the expected returns on the individual assets, weighted by the relative amount of each asset included in the portfolio. •The risk of the portfolio is not equal to a weighted average of the risk of those individual assets. •Risk refers to the random component of returns over time. Portfolio construction exploits the random element in the returns of individual assets by combining several assets whose returns are less than perfectly positively correlated with each other. •Portfolio construction reduces the risk of the portfolio over that present in individual assets, without sacrificing expected returns.

Identify the demand problems of a standard fixed rate mortgage in an inflationary environment

When inflation leads to an increase in interest rates, the payment on the standard fixed-rate mortgage increases because the lender demands to be compensated for expected future inflation over the life of the loan. Since the borrower's income will not rise immediately, the real payment of this type of loan is large in the early years of the loan and small in the later years. This increase in the real payment in the early years and reduction in the real payment in the later years is called the tilt effect because the real payments are tilted forward in time toward the first period of the loan

Added -After-Tax Cash Flows

__________ cash flow from reduced taxes allows for a greater accumulation of wealth—cash flows can be reinvested in other corporate investments.

Market value -The General Level of Interest Rates

___________ of the bonds can be defined in terms of either their price or their yield.

Commercial Banks -Financial Intermediaries

accept demand and time deposits; borrow funds from other sources; and advance funds to individuals, businesses, and the government.

Equitable right of redemption -English Developments

allowing borrower to redeem the property after default

Three groups of saving: -Savings-Investment Cycle

by individuals, businesses, and the government

Balloon/Reset FRMs

appeal to those who want a lower beginning contract rate. •This type of loan provides a 30-year amortization but becomes due and payable over a shorter term. •Typically these loans are written to balloon in five or seven years. Some loans offer an option to reset the rate and extend the mortgage for the full 30 years.

Savings and loan associations -Financial Intermediaries

are insured by the FDIC, and credit unions are supervised by the National Credit Union Administration.

Mortgage Payments -The Mortgage Constant

are structured as an ordinary annuity, which means that the payments fall at the end of each period.

Pension funds -Financial Intermediaries

build reserves to meet retirement needs of their contributors. They invest modestly in commercial properties.

Both Money markets and Capital markets

channel the flow of funds between users and suppliers of credits

income effect

comes into play when the higher level of income causes an increase in the demand for credit (supply of bonds).

Capital markets

deal in long-term securities (over 1 year in maturity).

Money Markets

deal in short-term securities (maturities of 1 year or less).

Agency Theory

deals with the relationship between principals and agents

Expectations Theory -The Yield Curve

explains a wide range of yield curves with varying slopes. •If two rates have observed equilibrium yields, the supply and demand for these two securities would be equal. Investors won't want to shift from one to the other and cause the equilibrium rates to shift. •To be indifferent, investors must expect the one-year rate to be established in the market. Forecasting errors get larger the further out computations are made. •When long-term yields are below short-term yields, investors may expect that rates will fall. •Upward-sloping curves indicate that market participants expect rates to increase; downward-sloping curves indicate expectations of falling rates.

What does the flow of funds cycle show?

how the savings from the surplus income units (individuals, businesses, and governments) flow through to the deficit income units (individuals, businesses, and governments) in a period of time, usually one year. The cycle also shows how the funds flow either directly from the surplus income unit to the deficit income unit or through intermediaries.

Give several examples of agency costs in real estate.

i. Federal regulators spend many millions of dollars auditing the books of financial intermediaries to make sure they are not operating in a fashion that would endanger the insurance funds. ii. Homesellers pay real estate brokers a commission based on a percentage of the sale price of the property to ensure that the broker will attempt to obtain the highest price possible for the property. iii. Commercial real estate lenders hire voucher control agents to make sure that the proceeds from Acquisition, Development, and Construction (ADC) loans are paid to the contractors who are building the structure and not diverted to another project. iv. A lessee in a mall may agree to pay a rent based in part on a percentage of sales so as to encourage the mall owner to expend funds to attract more customers to the mall. v. A mortgagee requires that property taxes and hazard insurance be paid by the mortgagor into an escrow fund so that the value of the collateral is preserved.

Modigliani and Miller proposition -Financial Leverage

in perfect markets (no taxes, no distress costs) capital structure is irrelevant (does not create or destroy value).

Municipal Bonds -Income Tax Considerations

include bonds issued by various states, counties, municipalities, and other nonfederal government organizations. •The interest from these bonds is tax-free at the federal level (but not at the state level for investors in other states). •The tax-free nature of the interest payments means that investors accept a lower return on these bonds. This relationship is expressed as follows: MY = TY(1 - T) where: MY = the yield on a municipal bond, TY = the taxable yield on a comparable nonmunicipal bond, and T = the investor's tax rate.

Thrift Institutions -Financial Intermediaries

include savings and loan (S&L) associations, mutual savings banks, and credits unions and compete with commercial banks

Real Estate Finance and Investment -What is Real Estate Finance?

includes a broad range of residential and commercial property issues as well as taxation, law, and lending issues.

Financial Intermediaries... -Financial Intermediaries and Markets

including brokers, mortgage bankers, and government entities manage the flow of funds, by channeling surplus income units to deficit income units.

Discount points -Annual Percentage Rate (APR)

increase the borrower's cost of the loan by reducing the amount of funds actually acquired by the borrower

Insurance Companies -Financial Intermediaries

invest funds to build reserves and invest in many commercial properties.

The amortization of the mortgage

is a form of forced saving—the debt is replaced with equity. With each payment, the borrower contributes additional equity.

Net operating income -After-Tax Cash Flows

is determined by subtracting the out-of-pocket expenses of operating the real estate asset from the revenues.

effective cost of the mortgage (EBC)

is the borrower's actual percentage cost of borrowing

Real Estate -What is Real Estate Finance?

land and all fixed and immovable improvements on it

Interest rate risk -Fixed-Rate Mortgages and Interest Rate Risk

risk of loss due to changes in market interest rates.

Finance focuses on______

maximizing asset values

Put options on commercial properties

may differ in the exercise of the option

U.S. law -American Residential Finance - Early American History

mix of Roman, German, and English law

Financial markets can be divided into two categories:

money markets and capital markets.

Transition mechanism of money and interest rates: -General Level of Interest Rates

money supply → economy → inflation → inflationary expectations → credit markets → interest rates

Direct Financing -Financial Intermediaries

occurs when an individual purchases bonds directly from the government or grants notes directly to a home buyer.

Interest-Only FRMs

offer an initial period in which the monthly payment is interest-only and contains no amortization of the loan principal. •This type of loan appeals to borrowers with high opportunity costs or other investment opportunities. •These FRMs generally offer (1) a 30-year loan with an initial 10-year interest-only period followed by a 20-year fully amortizing period; or (2) a 30-year loan with an initial 15-year interest-only period followed by a 15-year fully amortizing period.

The contract interest rate in a mortgage -Outstanding Balance of the Mortgage

rate that is stated in the contract and is the rate on which the payment, amortization of the loan, and outstanding balance are based: •An increase in the loan amount, loan term, or lock-in period can increase the contract rate. •Making a higher down payment, paying more discount points, or having higher quality credit generally reduces the contract rate

liquidity effect

refers to the initial short-run effect of an increase in the money supply on interest rates

Maturity risk -Risks in Real Estate Finance

refers to the risk associated with bonds with longer maturities. There are two related risks: •Interest rate risk. The values of bonds with longer maturities change more than those with shorter maturities when interest rates change. Long-term bonds have more interest rate risk because they have longer lives over which it is possible for market rates to change. •Purchasing power risk. The risk that inflation will erode the value of the principal amount of the bond. Long-term bonds will be priced lower to yield more than short-term bonds.

Marketability risk -Marketability or Liquidity Risk

refers to the risk that the bond may not trade in a large, organized (liquid) market. •The inability to sell the security quickly for cash for its intrinsic value will cause investors to require a yield premium. •The following equation describes the return on a particular security: LI = r + p + k where: I = the nominal rate, r = the real rate, p = the expected inflation rate, and k = other risk factors specific to the security.

price-anticipation effect

reflects the decrease in the supply of credit (at current rates) as a result of future expected inflation.

Surplus Income units - The Financial Marketplace

represent the funds to lend

Deficit Income units -The Financial Marketplace

represent the need to borrow credit.

Default Risk -Risks in Real Estate Finance

risk that the bond issuer will be unable to pay the interest and principal on the obligation. •Rating agencies investigate the financial strength of corporations and municipalities that issue bonds. •A lower rating reflects a greater possibility of default. •The yield on lower-rated bonds will be greater than that on higher-rated bonds

Intermediary -Financial Intermediation

stands between the supplier and user of credit

What real estate-related topics explain how the focus are of concern to real estate finance?

single-family residential property; multifamily residential property; appraisal of properties; management of real estate properties; sales and exchange of residential and commercial properties; origination and sale of residential mortgages; origination of commercial mortgages; sale-leaseback arrangements; equity participation loans; the economics of brokerage, taxation of commercial real estate investments—the law and real estate lending; and real estate in a portfolio context.

Callability risk -Risks in Real Estate Finance

the possibility that an issuer of a bond may call it (demand to buy it back) before maturity for an amount equal to or near its face value. •Noncallable bonds cannot be called before maturity. The investor in a noncallable bond benefits if market interest rates fall below the rate offered on these bonds. •An equivalent bond that is callable will have a lower value, or higher yield, because of the likelihood that the issuer will take advantage of its right to call the bond when it approaches face value.

Risk -What is Finance?

the possibility that the actual result will differ from the expected outcome.

The Outstanding Balance of the Mortgage

the present value of the remaining stream of payments, discounted at the contract rate

The Financial Marketplace -Savings-Investment Cycle

the system whereby savings are transferred from what are termed surplus income units to what are termed deficit income units

"Pigus" -Roman Law

title and possession remain with the borrower; no transfer of title. Lender could take title and possession under "a suspicion of the probability of default."

Financial Instruments - The Environment of Real Estate Finance

used to transfer money and credit for the purpose of developing and acquiring real property.

Investment -Savings-Investment Cycle

§considers amount invested in new plant construction, equipment and real property

The Mortgage Constant

•calculates the amount of payment required to amortize $1 at a certain interest rate and a given number of payments; and •is multiplied by the amount borrowed to yield the payment.

Real Estate Investments Trusts (REIT) -Risk of Real Estate Assets

• consist of purchasing stock in a corporation that in turn purchases real estate properties (equity _______), mortgages on real estate properties (mortgage ______, or a combination (hybrid _______). The stockholder in a ______ incurs the same risk as the underlying real estate asset, as well as the operating risk of the _________ and liquidity risks associated with the resale of the ______ stock

Asset valuation

• is concerned with those principles that maximize the wealth of the investor. •An asset provides cash flows over time to its owner. The valuation of the asset depends on the expected amount, timing, and risk associated with the cash flows. •These elements are all included in the discounted cash flow (DCF) model of valuation. •The formula applies to any asset capable of providing cash flows to its owner.

Savings-Investment Cycle - The Financial Marketplace

•A simple flow of funds in the _____________________ illustrates the environment of real estate finance and investment.

Secondary -Secondary Mortgage Market

•Any subsequent sale of the security takes place in the ______________ market.

Market Segmentation Theory -The Yield Curve

•Different markets exist because some institutional investors may have different needs for short- versus long-term bonds. •If a change in interest rates is not anticipated, investors won't segment themselves in one end of the maturity spectrum. •Segmentation may occur when interest rates changes are expected. •Higher yields will attract investors to a maturity segment of the market.

Theory of Financial Leverage and Optimal Capital Structure

•Financial leverage is the concept of using debt to finance an investment project. •The two primary sources of capital for financing any project are debt and equity. Real estate projects are most often financed with a mix of these two. •The amount of debt used and the cost of that debt determine the extent to which the equity yield is increased. •The process of incurring debt at a cost less than the return on the investment is positive (favorable) financial leverage. Negative (unfavorable) financial leverage occurs when the cost of borrowing exceeds the return on the investment. •Financial leverage creates financial risk if there is some chance that the cost of the debt may exceed the return to the investment.

Interest-Only and Principal-Only Securities -Risk of Real Estate Assets

•From a pool of mortgages, it is possible to sell rights to receive principal payments only or rights to receive interest payments only. •These two cash flows will behave differently when market interest rates change. •Owners of principal-only securities (POS) receive the same total payments as they otherwise would, but payments will be stretched over a longer period of time. This factor lowers the value of the POS. •Because interest is paid on any outstanding principal, owners of interest-only securities (IOS) will receive a larger stream of payments they otherwise would. This factor increases the value of the IOS.

Functions of Financial Intermediaries

•Liquidity Risk. When a deposit is made in a financial intermediary, the depositor receives a liquid asset. •Credit Evaluation and Risk Management. Intermediaries have superior knowledge of the credit risks associated with the mortgagor or the property being mortgaged and are aware of measures to reduce risk. •Interest Rate Risk. By issuing short-term deposits and investing in long-term, fixed-rate mortgages, intermediaries transfer interest rate risk to their stockholders, noteholders, or deposit insurer.

Options

•Options are rights. The owner of an option has a right, but not an obligation, to purchase or sell an asset at a predetermined price from or to another individual on or before a given date. •Options have intrinsic value and market value (the latter generally is greater than the former). The intrinsic value is the excess of the current price of the asset over the strike price for a call or the excess of the strike price over the current market price for a put. •The value of all call options (without dividends) and some put options is greater unexercised at any time before the expiration date. The value of the option will be greater than its intrinsic value. •Options with no intrinsic value will have some positive market value because of their nature as a right and not an obligation.

statutory right of redemption -English Developments

•Some states, by statute, grant an additional period of time during which the mortgagor can redeem the property

Options

•Stock prices follow a pattern that has a large random component. The longer the time period over which prices can move, the greater the cumulative effect of the random components. •The greater the volatility of price movements, the wider the probability distribution of prices will be on any given date. •Options are traded on debt instruments such as Treasury securities or MBSs. •The value of debt securities fluctuates because of change in market interest rates. The value of debt securities moves inversely to changes in interest rates. •An option on a debt security will have a greater value the longer the duration of the security and the more volatile interest rates are expected to be. As volatility in interest rates increases and is extrapolated, the value of options pertaining to real estate-related debt increases.

Options on House Prices

•The Chicago Mercantile Exchange offers futures and options on house price indices for 20 major metropolitan areas. •Each index is calculated on what is called the repeat sales pricing technique. This technique compares the price of a sample of homes sold in the latest month to their prices when sold at an earlier time. •The indices are designed to allow those with an investment interest in housing to hedge their risks. •Investors can hedge their risk of a market decline by buying puts or selling futures on the index.

Residential Mortgage -Risk of Real Estate Assets

•The amount and timing of a _________________payment are spelled out in the note as part of the contract between the lender and the mortgagor. •The amount and timing of the cash flows may differ from what is outlined in the note or expected by the lender. The precise value at liquidation is unknown and subject to risk. •When a property has positive equity and there is no delinquency, the mortgagor may prepay the loan to sell the property or refinance the loan at a lower interest rate. •State laws may affect the amount of recovery that the lender may obtain in a foreclosure action

Commercial Project -Risk of Real Estate Assets

•The cash flow of a ____________________ depends on several factors, all subject to risk. •These factors include actual revenues and expenses. Revenues, in turn, depend on many other risk factors. •The terminal cash flow, the amount received by the investor when the asset is sold or disposed of, is also subject to risk. •The value of a real estate asset will be more sensitive to some of these variables than to others. All represent elements of risk because actual amounts may differ from expected amounts. •If the _______________ is financed, then the equity position may be exposed to greater risk.

Risk of cash flows

•The concept of risk involves the recognition that probabilities can be assigned to possible future cash flows. •When probabilities cannot be assigned to these possibilities, uncertainty is said to exist. Risk exists when it is possible that the actual cash flows will differ from those expected (for any reason) and probabilities can be assigned to those possibilities

Role of Risk in Valuation

•The importance of considering risk in a real estate investment lies in the determination of the discount rate to employ in the DCF model. •The greater the perceived risk, the greater the required rate of return of an investment. •No formulas translate a given level of risk of a real estate investment into a proper discount rate. The returns on an individual real estate project cannot be related easily to the marketplace to determine systematic risk. •In the stock market, the capital asset pricing model (CAPM) is used to suggest a discount rate for equity. With the CAPM, the risk-free rate, the return on the market, and the stock's systematic risk are used to suggest a proper equity discount rate.

Theory of Financial Intermediation

•The most common financial intermediaries are commercial banks, savings and loan associations, mutual savings banks, and life insurance companies. •An intermediary, such as a depository institution, receives credit from suppliers when it issues a liability (deposit). It lends the credit, creating an asset for itself, at a higher rate of interest than it provides. •Intermediaries must provide an economic service. •Suppliers and users of credit could deal with each other directly and eliminate (i.e., share) the margin charged by the intermediary.

Callability risk -Risks in Real Estate Finance

•The premium for __________________ can be seen in the yields of the Government National Mortgage Association (GNMA) securities, which are backed by a pool of mortgages. •If a homeowner decides to prepay his or her mortgage before maturity, the entire principal is passed through to the GNMA bondholder and no further interest payments on this amount will be paid. •The homeowner has issued a callable bond (mortgage) and likely will exercise the call option if market rates fall below that on the mortgage. •Homeowners will refinance (call) their mortgage at the lower interest rate. Because GNMA bondholders do not benefit from an increase in value when rates fall, they are exposed to __________________.

Options on Commercial Properties

•The same default option pertains to commercial properties financed in part by debt. If the development does not work out and the market value of the property falls below the indebtedness, the owner will sell the property to the lender. •If the property is suffering a net operating loss, the owner will be quicker to sell the property to the lender rather than hold the put option. •The lender may require contractual provisions that reduce the value of such a put option, such as a personal note that allows the lender to attach assets other than the property used to secure the debt. •The lender may require a larger down payment to reduce the probability that the value of the property will fall below the loan balance. to real estate-related debt increases.

Mortgage-Backed Securities (MBS) -Risk of Real Estate Assets

•The same risk associated with individual mortgages applies to securities backed by pools of mortgages, especially pass-through securities. •An investor who purchases a __________________ will own a prorated portion of several hundred mortgages. The investor faces the same prepayment risk as the originator of a loan who would holds it in a portfolio. •Because ___________ represent large pools of mortgages, the portfolio effect may reduce the risk associated with individual mortgages. Systematic risks, such as a substantial decline in market rates that could lead to accelerated prepayments, would not be diversified. •Investors want ___________that may have greater or lesser prepayment rates than average. If they can identify these _______, and purchase the security at the average value for all such securities, they may reap excess returns.

Servicing Rights -Risk of Real Estate Assets

•The value of ______________ to mortgages depends on expected cash flows, which are subject to risk. • arise when an originator of a portfolio of mortgages sells that portfolio to an investor but continues to service the loans for a fee. •The originator collects the monthly payment, sends out delinquency notices, and collects delinquent penalty payments. •Many originators also sell the _______________. The value is determined based on the size and timing of the cash flows in relation to risk. •The major risk comes through accelerate prepayments that would eliminate the remaining servicing fees associated with the prepaid loans. •A decline in market rates will cause the value of ______________to decline.

Leverage and Value

•The value of the equity position of the investor increases with the use of leverage. The basic principle that drives the process is that the investor can borrow at a rate less than the return on the asset. •Debt financing may carry a smaller cost for reasonable levels of loan-to-value ratios. •Lenders are given preference before equity holders to receive cash flows in the form of interest payments because of their legal position. •With the exception of default, the amount of the payments is not subject to risk, as is the case with equity that represents a claim on residual cash flows.

What are the major changes in the regulation of financial institutions that were brought about by the Depository Institutions and Monetary Control Act of 1980?

•Thrifts were allowed to offer demand deposits (checking accounts) whereas prior to the Act they could only offer savings accounts. • Regulation Q (established maximum limits on the interest rate financial institutions could offer on demand and savings deposits) was gradually phased out in the few years following the Act. • Commercial banks and thrifts were allowed to offer virtually any type of deposit account they wished.

Determination of Interest Rates

•U.S. Treasury bonds are considered to be free of default risk and short-term Treasuries are free of maturity risk. •The only consideration by investors is the expected rate of inflation. •The long-run relationship between inflation and short-term Treasuries is approximately accurate. •The Fisher equation is relevant when establishing yields on Treasury obligations. •The difference in these yields reflects different risk characteristics of the securities (e.g., default, callability, maturity, and marketability, and tax effects).

General Level of Interest Rates

•Various forces interact to determine the level of interest rates in the economy. •Different credit instruments have their own interest rates. •As prices increase, suppliers want to place more bonds in the market. •Higher bond prices reflect a lower yield or interest cost to the issuer. •Lower prices lead to an increase in demand. •The real rate of interest is the equilibrium rate on riskless bonds in a noninflationary environment. •Once consideration is made for risk, inflation, and other factors, supply and demand will shift and, thus, the rate of interest on specific securities.

Primary -Secondary Mortgage Market

•When a security is created and sold for the first time by a deficit income unit, or when a mortgage is originated by a lender to a household, the transaction takes place in the_______________market

Options on Residential Mortgage

•When homeowners obtain a mortgage with a lien on a residence, they have contracted for some options. •A prepayment or call option gives homeowners the right to prepay the current balance on the mortgage at any time before its maturity. •Because prepayment penalties are rare in residential mortgages, they are viewed by lenders as a provision that places them at a competitive disadvantage in that the mortgagor has issued a callable bond. The mortgagor has another option as well—the put option. The mortgage is secured by a lien on the residence. In the event of default, the lender can foreclose on the property and liquidate to satisfy the obligation

Examples of Options in Real Estate Finance

•With the exception of options on MBSs, there are no standardized option contracts that are traded on an organized exchange. •This does not mean that options in real estate are limited to those on MBSs. •Various real estate contracts grant valuable options to one or both parties to the transaction.

Irrelevance of Capital Structure

•Without taxes, rearranging the cash flows of a corporation due to different proportions of debt and equity cannot create value. •An equity holder can borrow personally to purchase stock in an all-equity firm. After paying interest on the personal indebtedness, residual cash flows are identical to those that would have occurred if the firm had issued the debt. •Because the replication of the cash flows does not depend on the firm issuing the debt, the capital structure of the firm itself does not create or enhance value. •Although value may be created by dividing cash flows of a firm into debt and equity returns, this division does not have to be done at the firm level. It can be done at the personal level. •Because leverage cannot be created as cheaply anywhere else, leverage can add value. For a cash-constrained investor, leverage will free up funds for additional real estate investments that will provide the benefits of diversification.

Commercial Mortgage-Backed Securities (CMBS) -Risk of Real Estate Assets

•________________ are similar to residential MBSs, but these bonds are backed by mortgages on commercial properties, such as office buildings and shopping centers. •A bond backed by a commercial mortgage inherits some risk associated with the mortgage. In turn, the commercial mortgage inherits risk from the property financed with the mortgage. •The risk of a _____________ is related to the risk of the property ultimately backing it up.

Collateralized Mortgage Obligations (CMO) -Risk of Real Estate Assets

•__________________ are similar to MBSs, but the timing of the cash flows associated with the underlying mortgages have been arranged to serve the needs of different investors. •Financial institutions created ____________ to address the risks associated with MBSs. •A tranche promises bond-like payments on certain dates. The originator of the ______________ estimates the payment and prepayment behavior of the underlying mortgages and constructs the tranches accordingly. •Although this arrangement makes the payments of the first tranches more certain, it also increases the risk associated with the subsequent tranches.

Timing of cash flows

•assumes that the sooner a cash flow is received, the greater its present value. •This principle is recognized in the DCF model. The later in the life of the asset that a cash flow is received, the larger the discount factor that is applied: (1 + r)^n where: r = the appropriate discount rate and n = the number of cash flows

Explicit Options

•contracts are entered into often in relation to the purchase of undeveloped land. •A developer may secure the right to purchase land while completing a development package, including financing the project. •The value of the option to the developer may well be worth its price. •If land values escalate over the period of exercise, the option will be valuable. If prices fall significantly, the option holder can buy the property in the market at a lower price, losing the option premium.to real estate-related debt increases.

Financial Intermediaries: -Financial Intermediaries and Markets

•provide liquidity to savers, •borrow short and lend long, and •evaluate borrowers' credit risk.

Finance focuses on.. -What is Finance?

•the maximum value of equity interest of owners, •the transfer of funds between individuals, •cash flows, not profits, and •the concept of risk.