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					   Real Estate Finance

       Holger Sieg
University of Pennsylvania
   The Moral Hazard of Renting
• Renting a house creates a serious moral hazard problem
  for the owner since the renter has little incentives to
  maintain the house.
• Renting also creates a monitoring and screening
  problem since it is difficult and costly to evict a renter
  that has defaulted on rental payments.
• Owner occupied housing solves both problems, but
  creates a financing problem.
• Most owners cannot afford to buy a house without
  receiving a loan or some sort of financing from a bank.
• Home financing creates additional complications.
•   A mortgage is a secured, nonrecourse loan.
•   A secured loan is a loan in which the borrower pledges some asset (the
    house) as collateral for the loan, which then becomes a secured debt owed
    to the creditor who gives the loan.
•   The debt is thus secured against the collateral.
•   In the event that the borrower defaults, the creditor takes possession of the
    house used as collateral.
•   The creditor may sell it to regain some or all of the amount originally lent to
    the borrower (foreclosure of a home.)
•   A nonrecourse loan is a secured loan where the collateral is the only
    security or claim the creditor has against the borrower.
•   The creditor has no further recourse against the borrower for any deficiency
    remaining after foreclosure against the property.
•   If you default on a mortgage you do not have to declare personal
                          Call Options
•   The buyer of the call option has the right, but not the obligation to buy an
    agreed quantity of a particular commodity from the seller of the option at a
    certain time (the expiration date) for a certain price (the strike price).
•   The price of a call option is difficult to compute since it depends on the
    expectations about the future price of the asset.
•   Even if the call is out of the money, i.e. if the current price of the asset is
    below the strike price, the call option still has a positive value, since it is
    possible that the price of the asset will rise over the strike price before the
    expiration date of the option.
•   Pricing call options is difficult since we need to make assumptions about the
    law of motion of the price of the underlying asset.
•   In finance we use continuous time stochastic processes to model asset
    prices and then use stochastic calculus to price derivatives such as options.
Buying a House is Buying a Call
• To understand a transaction in which an individual buys a home
  using a large mortgage, it is useful to think about it in terms of
  buying a call option.
• The bank “owns” the house and rents the house to the “owner.”
• The owner can buy the house back from the bank at any time by
  paying off the mortgage. (purchase option)
• Effectively, the owner does not own the house until he has paid off
  the mortgage, but owns a call option.
• The initial down-payment is the price of the call option.
• The monthly interest payments are the rental payments.
• The strike price is the remaining principal.
• Each monthly payments reduces the strike price of the call.
                    An Example
• Suppose you buy a house worth $500,000 putting 10 percent down.
• The bank provides a 30 year mortgage with a 5 percent interest rate.
  Your monthly payment is $2,415.70.
• Property taxes can easily add another $500-1,000 to your monthly
  payment. Home owners insurance will add another $100.
• But the good news is that you can deduct local taxes and mortgage
  interest payment from your income when you compute federal income
  tax payments.
• Over the course of the 30 years, you will pay $419,651 in interest
  payments and $450,000 in principal payments.
• The price of the call option is $50,000.
• As a rule of thumb, the home value-to-income ratio should be
  approximately 3. You need to make $167,000 in household income.
• After-tax income is approximately $10,000. You monthly payments
  are $3,000 which means you spend 30 percent of your income on
  your home.
      Primary Mortgage Market
• In a traditional loan, a bank lends money to an individual
  to buy a home using funds deposited with that bank.
• The credit or default risk is entirely born by the local
• The main advantage of this arrangement is that there is
  little moral hazard since local banks have strong
  incentives not to make bad loans.
• This arrangement has three disadvantages:
  (1) small or growing markets may not have enough liquidity;
  (2) borrowing may shut down if local banks are in trouble;
  (3) local banks hold an undiversified portfolio and are thus exposed
  to risk that could be diversified.
             Secondary Market
• The secondary mortgage market is the market for the
  sale of securities or bonds collateralized by the value of
  mortgage loans.
• Intermediaries buy loans from local banks and
  repackage loans for resale via mortgage-backed
  securities (MBS).
• Investors can buy and hold a diversified portfolio of
  mortgage backed securities.
• The local banks can also pass the mortgage risks to the
  investors in the secondary market.
• The main players in the secondary market are
  government sponsored enterprises.
    Fannie Mae and Freddie Mac

•   To create additional demand in the secondary market, the federal
    government created two agencies which were later converted into publically
    traded companies. These are also known as government-sponsored
    enterprises (GSEs).
•   Federal National Mortgage Association (FNMA), commonly known as
    Fannie Mae, was founded as a government agency in 1938 as part of
    Franklin Delano Roosevelt's New Deal to provide liquidity to the mortgage
•   The Federal Home Loan Mortgage Corporation (FHLMC) , commonly
    known as Freddie Mac, was created in 1970 to expand the secondary
    market for mortgages and create competition to Fannie Mae.
•   Fannie Mae and Freddie Mac are the leading buyer in the U.S. secondary
    mortgage market. Currently, Fannie and Freddie hold or guarantee about
    50% of the nation’s outstanding home mortgages.
     Private Mortgage Insurance
• Lenders sometimes want to insure themselves of the default risk
  and require borrowers to pay for this insurance.
• Private Mortgage Insurance is insurance payable to a lender for a
  security that may be required when taking out a mortgage loan.
• Historically all home purchasers that bought a house with a down-
  payment less than 20 percent were required to buy PMI.
• PMI is expensive: typical rates are $55/month per $100,000
• In our example, suppose you buy the $500,000 without a down-
  payment, you will have to pay an additional $275 to your monthly
• Of course, there is no guarantee that you will be approved by the
  insurance company to qualify for PMI. In that case, you will not
  obtain the mortgage and you will not be able to buy the house.
     Public Mortgage Insurance
• Since PMI is expensive and hard to get for low income
  households, the federal, the federal government also
  offers public mortgage insurance.
• To obtain public mortgage insurance from the Federal
  Housing Administration in the United States, you must
  pay a mortgage insurance premium (MIP) equal to 1
  percent of the loan amount at closing.
• Fannie Mae then essentially makes up any missed
  payments to the bondholder that the borrower misses.
• It also makes up for any loss for the loan not being fully
  repaid either by the borrower or from the sale of the
• The risk of a downturn in housing markets is shifted to
  the taxpayers that guarantee the GSEs.
            Potential Problems
• GSE’s hold a large fraction of the undiversified risk in the
  housing market. The other fraction is held by
  international investors.
• Local banks have few incentives to screen mortgage
  applicants since they no longer bear the risk, they just
  make commissions from selling mortgages.
• Investors of MBS have often little knowledge about the
  exact type of mortgages that they are holding.
• As a consequence they have a hard time evaluating the
  risk associated with the investments,
• Credit Rating Agencies may not be of much help and
  may provide bad incentives if they misclassify
• As long as housing prices keep on rising, none of this
        Measuring Housing Prices
•   It is difficult to compute housing price indexes since only a small fraction of
    all houses is sold each period.
•   We thus do not have transaction prices for the vast majority of houses at
    each point of time.
•   The indices are calculated from data on repeat sales of single-family
    homes, an approach developed by economists Karl Case, Robert Shiller
    and Allan Weiss.
•   To construct a repeat sales index you need to observe housing two
•   Of course, housing transactions are not random events and this
    methodology is especially problematic during a housing market crisis in
    which the sample of houses that are transacted are clearly not a random
    sample of the underlying housing stock.
•   Of course, the main competitor of the repeat sales index that is based on
    the median housing price is even worse!
          Some Personal Advice
• If you want to gamble or speculate in real estate, don’t do it with your
  own house.
• Instead you should invest into real estate investment trusts (REIT).
  These are mutual funds that are offered by many different
  companies. Leave the investment decisions to professional real
  estate managers.
• If you still want to gamble in real estate, get an MBA in Real Estate
  Finance from Wharton or any other decent Business School. Then
  try to make a career out of it.
• Follow the 3 to 1 rule to determine whether you can afford to buy a
• Whatever house you buy, remember that there will come a day when
  you will have to sell again.

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