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					       Real Estate Finance Spring 2009
             Dean Don Weidner
• Eight sets of slides for the Spring 2009
   – Are available on my web page
   – Are also posted on the web board for this course
     under “Course Library”
       • May be amended slightly
• Course Syllabus
   – Is posted on my web page
   – Is also posted on the web board for this course under
     “Syllabus”
       • May be amended slightly
• Assignments
   – We shall proceed directly though the Syllabus


                              1                    Donald J. Weidner
         Background on Contracts and Conditions



                                    Contract of
                                       Sale                                                   Seller
            Listing                                                    Closing
Seller                  Broker                         Buyer                                  Buyer
            Agreement            “Interim Contract”                                           Lender




                             Consummation (“Closing”) of the Contract of
                             Sale is subject to certain conditions, which
                             must be satisfied within a particular period of
                                       time, usually involving:
                            a) title; b) physical condition; and c) financing.



                                            2                                    Donald J. Weidner
            Contract Conditions
• Text says conditions “are essentially
  substitutes for information.”
• Conditions may also be inserted by the buyer
  to postpone making a commitment.
• Conditions range from the extremely general
  to the extremely specific.
• Conditions may leave so much open that a
  contract fails to satisfy the requirement of a
  writing under the statute of frauds.
• Even if the statute of frauds is satisfied, the
  contract may be too indefinite to support an
  award of specific performance.

                         3                  Donald J. Weidner
                 Illusory Contracts
• “Since conditions will characteristically be
  phrased in general terms, and their fulfillment
  left to the exclusive control of one of the
  parties, there is the added question of
  illusoriness or mutuality of obligation.”

• “Generally, the problem is small, for the
  concept of good faith goes far toward
  preventing reneging parties from using a
  financing, title or other condition as an excuse
  for nonperformance.”
   – “In such cases the court will examine the motive of
     the party relying on the condition.”
      • If a written contract gives me a right, must I show that I am
        pure of heart to enforce it?
          – Not everyone thinks so. More anon.

                                   4                          Donald J. Weidner
                  Homler v. Malas,
                         (Text p. 90)

• Seller sought to specifically enforce a buyer’s
  promise to purchase a single-family residence.
• Contract, on a standard form, had a “subject to
  financing” clause conditioning Buyer’s
  performance
  – on Buyer’s “obtaining a loan” (“ability to obtain” had
    been deleted)
  – For 80% of the purchase price
  – Repayable monthly over a term of no less than 30
    years
  – However, there was no mention of
     • Interest rate (left blank)
     • The amount of monthly payment (left blank)
     • Amortization terms


                                5                   Donald J. Weidner
           Homler v. Malas (cont’d)

• Buyer said the contract “is too vague and
  indefinite” to be specifically enforced because
  the “terms of the financing contingency are
  not sufficiently identified.”
   – Georgia courts had said that a failure to specify a
     buyer’s interest rate “causes a failure of a
     condition precedent to the enforceability of the
     contract.”
• Seller said that there is no need to specify the
  interest rate in a contract that anticipates
  third-party financing.
   – Can you see what the argument might be?

                             6                     Donald J. Weidner
               Homler v. Malas (cont’d)

• Court said: it is not as if the contract had specified
  interest at the “current prevailing rate.”
• The contract assumed a search for third-party
  financing.
• Why not use the concept of good faith as a gap
  filler?
• That is, the concept of good faith would fill the
  interest rate gap by implying into the contract that
  interest would be “at the current prevailing rate”
• Stated differently, the default rule (which would
  apply unless the parties specified a different rule)
  would be that interest is at the “current prevailing
  rate”
                             7                  Donald J. Weidner
           Homler v. Malas (cont’d)
• Court concluded the contract was too “vague
  and indefinite” to be enforced against the buyer
  and ordered the buyer’s deposit to be refunded.
• Why did the court refuse to use the concept of
  good faith to fill the interest rate gap?
  – Everyone agrees the buyer is under a duty to proceed
    in good faith
• Does the strikeout suggest a different argument?
• “Mutuality of obligation” is a separate issue from
  “vague and indefinite” [and apparently, in the
  eyes of the court, an issue that was not raised]
  – Could Buyer have enforced the contract against
    Seller?
                            8                    Donald J. Weidner
            Definitions of Good Faith
• Every contracting party is under a duty of “good
  faith”
  – The question is: what does good faith require
• UCC general definition: “honesty in fact in the
  conduct or transaction concerned.”
  – Honesty to Webster: “uprightness; integrity,
    trustworthiness” also “freedom from deceit or fraud.”
• UCC definition for a merchant: “honesty in fact
  and the observance of reasonable commercial
  standards of fair dealing in the trade.”
• Many statutes use the term “good faith” without
  defining it.
• Some say good faith is an “excluder category”--
  one defined by what is deemed to be outside it
  rather than by what is in it.
                              9                     Donald J. Weidner
                 Liuzza v. Panzer
                        (Text p. 93)

• Contract to sell and to buy for $37,500.
• Buyer’s obligation was conditioned “upon the
  ability of the [Buyer] to borrow $30,000.00 on the
  property at an interest rate not to exceed 9%.”
• Buyer applied to an S & L for a $30,000 loan and
  was rejected because the appraisal was too low.
• S & L appraisal was $32,150.
• S & L would only lend 80% of the appraised value
  (which was less than the $30,000 mentioned in the
  contract as a condition).
• Can the Buyer walk away from the deal at this
  point?
  – Stated differently, what more, if anything, is Buyer
    required to do to satisfy the Buyer’s obligation to
    act in good faith?
                              10                  Donald J. Weidner
                Kovarik v. Vesely
                       (Text p. 94)
• Contract provided for Buyers’ obligation to buy for
  $11,000. Buyers were to pay
  – $4,000 down, with the
  – balance to be financed through a “$7,000 purchase-
    money mortgage from the Fort Atkinson S & L.”
• Fort Atkinson S & L rejected the Buyers.
• Seller offered to provide $7,000 financing on the
  same terms that Buyers requested from Fort
  Atkinson.
• Buyers refused the alternative financing offered
  by the Seller.
• Seller sues to specifically enforce the contract.
  – Did the court correctly conclude that good faith
    required the Buyer to accept the Seller’s offer of
    financing?
                             11                  Donald J. Weidner
             Kovarik v. Vesely (cont’d)
• The majority apparently held that the obligation of
  good faith prevents the buyer from relying on the
  letter of the contract, which seems to say that the
  buyer’s obligation is contingent on the buyer’s
  ability to obtain a loan from the specified lender
• Note Judge Fairchild’s dissent.
  – A buyer could reasonably want:
     • A third-party lender to provide a “reality check” on value; and
  – A standard institutional approach in the administration
    of the loan
     • especially in the event of default.
• Reconsider the strikeout in Homler v. Malas
  – Making the buyer’s obligation contingent “on Buyer’s
    obtaining a loan”
     • Rather than Buyer’s “ability to obtain a loan”
                                   12                         Donald J. Weidner
            Kovarik v. Vesely (cont’d)
• Court also rejected the Buyer’s argument that
  the incomplete financing clause failed to satisfy
  the Statute of Fraud’s requirement of a writing.
   – What was incomplete about the financing clause?
   – Recall that it referred to “$7,000 purchase-money
     mortgage from the Fort Atkinson S & L.”
• The court’s reasoning: “the loan application . . .
  is a separate writing which is to be construed
  together with the original contract of the parties,
  and together they constitute a sufficient
  memorandum to satisfy [the Statute of Frauds].”
   – Is there one transaction or two?

                              13                   Donald J. Weidner
          Kovarik v. Vesely (cont’d)

• An alternative approach: A reasonable
  interpretation of the contract would look at
  the standard practice among savings and
  loan association with respect to this
  particular type of loan
  – That is, business practice and the rule of
    reasonableness would fill in the gaps




                          14                 Donald J. Weidner
    Note on Indefiniteness vs. Illusoriness
• Text states that indefiniteness and illusoriness are often
  hard to distinguish
• Indefiniteness
   – Can arise from a lack of specificity
   – Can allow either party to avoid a contract
       • But a buyer may avoid indefiniteness in a “subject to
         financing” clause by obtaining financing
   – Is increasingly resolved in terms of reasonableness
   – Also resolved in terms of good faith
• Illusoriness
   – Can arise out of great particularity
   – Can let the Seller off the hook.
   – Increasingly defined in terms of good faith.
                               15                    Donald J. Weidner
      Variables that Determine Debt Service

“Debt Service” is the amount of the payment
   required per unit of time (usually monthly or
   annually) to service a debt. The 4 variables
   that determine debt service are:
1) Amount of loan
  •    Usually determined by
      •   Applying a loan/value ratio to
      •   An appraisal of value
2) Length of loan
3) Rate of interest
4) Amortization terms—the terms under which
   principal is repaid
                                 16           Donald J. Weidner
            Loan to Value Ratio

• Some legislative terms used to mandate
  maximum loan to value ratios:
  – appraised value
  – estimated value
  – reasonable normal value
  – estimated replacement cost
  – actual cost




                       17                  Donald J. Weidner
          Loan to Value Ratio (cont’d)

• Many lenders do not believe that the loan/value
  ratio is a meaningful protection to their
  shareholders.
   – They believe that there is greater protection in
     exacting credit standards, increased site
     scarcity, inflation or other factors
   – Or, they are simply very eager to do a deal.
   – They might also be eager to sell the
     mortgage.
   – Therefore, they often avoid the ratio.

                           18                 Donald J. Weidner
Appraisals: Three Basic Indications of (or ways of
              approaching) Value

1. Recent Sales of Comparable
   Properties
   •   Also known as “Market Data”
       Approach
   •   The approach is less valid if there is
       an inactive market or if the property is
       unique
2. Replacement Cost
   •   Cost of replacing a building (and the
       land under it) minus depreciation
       charges on the building
                         19                Donald J. Weidner
 Appraisals: Three Basic Indications of (or
   ways of approaching) Value (cont’d)
3. Capitalized Value of Income (many methods):
   --Gross Rent Multiplier—very rough (and less
   valid if there are little or no sales of
   comparables)
   --Capitalization Rate—only slightly more
   refined
   --Discounted Cash Flow—more refined
Reconciliation relates these three factors, it does
   not simply average them. A reconciliation may
   select one factor as the most important.

                          20                 Donald J. Weidner
 GROSS MULTIPLIER  Derive value from gross rentals
                 Sales Price of Comparable Properties
                                                                    = Multiplier
                Gross Rental Revenues of Comparable
                             Properties

Assume a Recent Sale:
                        12 Million Sales Price
                                                        = 6 [Gross Multiplier]
                  2 Million Gross Rental Revenue




                 Applying this rough method, a comparable
                       property with only $600,000 of
                 Gross Rent receipts would therefore have a
               $3,600,000 value (six times gross rent receipts)
                        ($600,000 X 6 = $3,600,000)




                                                 21                                Donald J. Weidner
  CAPITALIZATION RATE  Capitalize the value of the net
                       rentals
           Basic idea:    x 8% = $1,000 per year
               is how much an investor will pay for the right to receive $1,000 per year
              if the investor will insist on an 8% return on his or her investment.

              In this example,    is $12,500
How Much Will An Investor Pay for a Building that has a $150,000 Net Cash Flow?
 A.   If I expects an 8% cash return [stated in B.             If I expects a 12% cash return [stated in
                    fractions]                                               decimals]
1)                x 8/100 return = $150,000              1)              x .12 return = $150,000
       The price                                               The price

2)    Divide each side of the equation by 8/100           2) Divide each side of the equation by .12

      ( x 8/100) x 100/8 = 150,000 x 100/8                       x .12/.12 = $150,000/.12
                   = $1,875,000                                        = $1,250,000




                                                     22                                     Donald J. Weidner
                          DISCOUNTED CASH FLOW
         Values property by a) estimating future cash flows and b) discounting
         those future cash flows to their present value. Discounting is the
         obverse of compound interest.

Net Cash Flow=Rent Receipts–Real Estate Taxes–Maintenance– Insurance–(Principal + Interest)
             = $1,000
Assume purchase of 10-year position 10 year leasehold

                                                    HYPO:      What is the [present]
                                                    value of the right to receive a net
         1    .833 x $1,000 = 833                   cash flow of $1,000 at the end of
         2    .694 x $1,000 = 694                   each of the next ten years?
         3    .579
                                                    Assume the investor requires a
         4    .482
         5    .402
                                                    20% rate of return. Because of
         6    .335                                  the spreading out of the $1,000
         7    .279                                  payments over the next 10 years,
         8    .233                                  their value today is only
         9    .194
         10   .162 x $1,000 = 162
                             $4,193




                                               23                             Donald J. Weidner
           Plaza Hotel Associates
              340 N.Y.S.2d 796 (N.Y.Sup. 1973)




                 PLAZA                  Operating
            OWNS THE BUILDING           Agreement
BUILDING



              ½          ½
 LAND        PLAZA                                     
                        LEASE                        HOTEL
                                                      CP

                 SUBLEASE OF  ½ FEE INTEREST



           LEASE OF  ½ FEE INTEREST


                            24                        Donald J. Weidner
               Plaza Hotel Facts
• Lease provided for rent to increase to 3% of
  the “value” of “all of the land,” exclusive of the
  building and improvements.
• It also provided that, if LL and T could not
  agree on value, appraisers would determine
  value.
• An appraisal valued the land alone at
  $28,000,000.
• Tenant sued to set appraisal aside on ground
  that it was too high because it was based on
  the assumption that the land was vacant and
  available for its highest and best use.

                          25                   Donald J. Weidner
           Plaza Hotel Highlights

• Court set aside the appraiser’s valuation
  because the appraiser “erroneously valued
  the land as available for its highest and
  best use, and not as already encumbered
  by the long term lease which restricts the
  use of the land to hotel purposes only.”
• Next, the court determined value.



                      26              Donald J. Weidner
           Plaza Hotel Highlights
• The court distinguished price from
  value:
  – “Price is determined by short term factors
    and by the caprices of the market.”
  – “Value . . . is dependent upon long term
    factors and is directly related to the intrinsic
    worth of the property that resists the impact
    of temporary and abnormal conditions.”
     • “[V]alue, even more than price, is a matter of
       judgment.”




                           27                     Donald J. Weidner
           More from Plaza Hotel

• “The concept of a fluid market such as that
  existing in regard to corporate securities,
  where one sale can indicate the value at the
  time, is just not true with respect to real
  estate.”
• The lessee’s 3 appraisals of the land alone
  ranged from $8.5 million to $11.5 million.
• The lessor’s 3 appraisals of the land alone
  ranged from $33.3 million to $34.5 million.




                        28                 Donald J. Weidner
               Plaza Hotel (cont’d)

• Plaza Hotel noted:
  – “In considering the opinions of the experts, the
    court is not unmindful that ‘the appraisal of
    rental property necessarily involves the
    discretionary application of one or more
    accepted methods of computation’ and we
    must recognize that appraisers retained in
    litigated matters, within the limits of
    professional integrity, tend to adopt those
    formulae which favor their employer’s position.”



                          29                 Donald J. Weidner
    A Different View on Free and Clear

• Compare Taylor v. Fusco Management, 593
  So.2d 1045 (Fla. 1992): “[T]he market value
  of leased property at the time a lessee
  exercises an option to purchase the property
  should be computed as if the property were
  unencumbered by the lease. Any intent to
  value the property otherwise should be
  clearly stated in the lease.”
  – The lease was a 99-year lease. The price of the
    option to purchase, in the tenant’s view, is in effect
    the present value of the rents (economically, a
    prepayment of the rent).
     • That is, the discounted cash flow.


                               30                   Donald J. Weidner
                Length of Loan

• The longer the length, or term, of the loan,
  the lower the Debt Service
• Consider, for example, an $18,000 home
  improvement loan. If the interest rate is 6%,
  the monthly Debt Service is
   – $199.98 over 10 years
   – $116.10 over 25 years
   – $ 99.18 over 40 years
• The cost for the benefit of lower debt service:
  the longer the term, the more interest is paid.

                             31             Donald J. Weidner
               Rate of Interest

• The greater the rate of interest, the greater
  the Debt Service.
• Example, a 25-year $100,000 home
  improvement loan. Monthly Debt Service
  at
  – 6% is $ 644
  – 8% is $ 770
  – 10% is $ 908
  – 17% is $ 1436

                        32               Donald J. Weidner
SELF AMORTIZING LOANS

  First type: Constant Payment

              DEBT SERVICE COMPONENTS




                                    ...
              PASSAGE OF TIME
  Principal         Interest
                               33         Donald J. Weidner
    SELF AMORTIZING
Second Type: Constant Amortization


                DEBT SERVICE COMPONENTS




                                   ...
               PASSAGE OF TIME
   Principal       Interest
                              34          Donald J. Weidner
NON SELF AMORTIZING



             DEBT SERVICE COMPONENTS




                                              BALLOON


                                   ...
             PASSAGE OF TIME
 Principal         Interest
                              35         Donald J. Weidner
       Florida Statute on Balloon Mortgages
                     (Supplement p. 22)

• Fla. Stat. sec. 697.05(2)(a)1:
   – “Every mortgage in which the final payment or the
     principal balance due and payable upon maturity is
     greater than twice the amount of the regular monthly
     or periodic payment of the mortgage shall be deemed
     a balloon mortgage.”
   – With certain exceptions, “there shall be printed or
     clearly stamped on such mortgage a legend in
     substantially the following form:
      • THIS IS A BALLOON MORTGAGE AND THE FINAL
        PRINCIPAL PAYMENT OR THE PRINCIPAL BALANCE
        DUE UPON MATURITY IS $-----, TOGETHER WITH
        ACCRUED INTEREST, IF ANY, AND ALL
        ADVANCEMENTS MADE BY THE MORTGAGEE UNDER
        THE TERMS OF THIS MORTGAGE.”


                              36                  Donald J. Weidner
    Florida Statute on Balloon Mortgages
                      (Cont’d)


• There are also special provisions concerning
  “the case of any balloon mortgage securing the
  payment of an obligation the rate of interest on
  which is variable or is to be adjusted or
  renegotiated periodically, where the principal
  balance due on maturity cannot be calculated
  with any certainty.”
• Failure of a mortgagee to comply with these
  provisions “shall automatically extend the
  maturity date of such mortgage.”

                          37                 Donald J. Weidner
    Pre-Depression Residential Financing
• Amount. At least theoretically, very low loan/value
  ratios, typically 50-60% of appraised value.
  – Lenders stretched their appraisals.
  – Borrowers took out second, third, mortgage loans.
• Length. Seldom for more than 10 to 15 years. In
  1925, the average length for mortgages issued
  – by life insurance companies was 6 years;
  – by S &Ls was 11 years.
• Rate of Interest: Junior mortgages were at higher
  rates of interest.
• Amortization Terms: Balloons were common.
In the Great Depression: 1 million American families
  lost their homes to foreclosure between 1930-
  1935.                      38                   Donald J. Weidner
    Post-Depression Mortgage Insurance
• Amount. Government undertook to insure loans with
  much higher Loan/Value Ratios (consumers were
  unable to pay big downpayments coming out of the
  depression)
• Length. To decrease debt service, the government
  insured longer loans. Terms increased up to 40 yrs.
  for certain projects.
• Rate of Interest. The government would not insure
  loans above a certain interest rate. “Points” became
  important.
• Amortization Terms. Government would insure only
  fully self-amortizing loans.
  Fundamental Lesson of Great Depression seemed to
  be: never require a consumer to pay Debt Service
  that escalates.
       --We subsequently forgot or rejected that lesson.

                            39                   Donald J. Weidner
                    Points
• “Point” is one percent of the face amount of
  a contract debt.
• Points can be characterized differently, ex.,
  as interest, for services, etc.
• Basic way points can work:
  – Buyer executes note to Seller for $40,000 (more
    terms specified).
  – Lender purchases note from Seller charging 6
    points [$40,000 X 6% = $2,400]).
  – That is, Lender pays only $37,600 for the $40,000
    note [$40,000 minus the $2,400].
  – Buyer still pays “interest” on full $40,000 face
    amount.
                         40                   Donald J. Weidner
  The American Dream of Home Ownership


Americans Living in
  their Own Homes
• 1940     41%
• 1950     53%
• 1981     65%
• 2006     69%*
*By 2008, many suggest that federal housing officials trying to get the
homeownership rate as high as possible helped cause the “subprime”
         crisis by encouraging loans to high-risk borrowers
 Many also fault Alan Greenspan’s Federal Reserve Board for keeping
                   interest rates too low for too long
                                      41                         Donald J. Weidner
 “NEW” TYPES OF CONSUMER MORTGAGES
                  (Text p. 380)



1) Adjustable Rate Mortgage (ARM) (a.k.a.
   “Variable Rate Mortgage”)
2) Graduated Payment Mortgage (GPM)
3) Renegotiable Rate Mortgage (RRM)
4) Shared Appreciation Mortgage (SAM)
5) Price Level Adjusted Mortgage (PLAM)
6) Reverse Annuity Mortgage (RAM)


                         42         Donald J. Weidner
  1) ADJUSTABLE RATE MORTGAGE
• Interest rate rises and falls according to some
  predetermined standard.
• An interest rate increase must mean at least
  one of the following three things:
  --1. Debt service payments will increase; or
  --2. The length of the loan will increase; or
  --3. The amortization terms will change
  (create or increase a balloon)




                         43                 Donald J. Weidner
  Adjustable Rate Mortgages (cont’d)
Protections provided for consumers:
     Limit the frequency of interest rate increases
     Limit the magnitude of each interest rate increase
     Limit the total amount of interest rate increases
     Require downward adjustments if the standard declines.
     Offer borrowers the right to prepay without penalty upon
      interest rate increase
        Note: you may not be able to refinance, even if rates have
         dropped, if the value of the property has dropped.
• “Balloon” disclosure rules may define a
  balloon more narrowly than simply as
  any payment larger than one before
  – Ex., as any payment more than twice the
    size of a preceding payment (as in Florida).

                                   44                           Donald J. Weidner
 2) GRADUATED PAYMENT MORTGAGE

• Monthly payments gradually rise, while the
  interest rate and the term of the loan are
  fixed.
• Initial concept: Help the young family that
  reasonably expects its income to grow
  substantially over the years following the
  loan closing.



                       45              Donald J. Weidner
 3) RENEGOTIABLE RATE MORTGAGE
      (a.k.a. “Rollover Mortgage”)
• Series of renewable short-term notes, secured
  by a long-term mortgage with principal fully
  amortized over the longer term.

• As initially approved, the interest rate could be
  adjusted up or down every 3 to 5 years and
  could rise or fall as much as 5 percentage points
  over the entire 30-year life of the mortgage.



                          46                 Donald J. Weidner
            Goebel v. First Federal
                      (Text p. 374)

     The note provided:
1.    Interest shall be paid monthly.
2.    Initial interest rate was 6% per annum.
3.    The initial interest rate may be changed
      from time to time at the S & L’s option.
4.    There will be no interest rate change during
      first 3 years.
5.    There will be no interest rate change
      without 4 months written notice.
6.    The Promisor has 4 months from notice of a
      change to prepay without penalty.

                             47              Donald J. Weidner
                 Goebel (cont’d)
• Nine years later, Lender said the interest rate
  was being increased and that Borrower had
  the option to
   – Make increased monthly payments of Debt
     Service, or
   – Increase the length of the loan.
   – [No mention was made of balloons.].
• Court’s approach to construing the note:
  construe the ambiguous contract language
  against the drafter, especially
   – when the drafter has much greater bargaining
     power, and
   – when the drafter supplied its “standard form.”

                            48                    Donald J. Weidner
                      Goebel (cont’d)
•     As to increasing monthly Debt Service, court
      said expressio unius controlled: There were
      provisions for increasing Debt Service in some
      situations but not to defray an interest increase.
1.    Note stated that monthly Debt Service could be
      increased to accommodate future advances; and
2.    Note stated that Lender had a right to payment for
      taxes, insurance and repairs “on demand”
     1.   Lower court said this included the right to increase
          monthly Debt Service.
3.    Yet the note “fails to make similar provisions” for an
      increase in interest
     1.   Therefore, the promisor could not be required to increase
          monthly debt service to pay for an increase in interest.



                                    49                           Donald J. Weidner
                        Goebel (cont’d)
•  As to increasing the term (the length of the loan), the
   court focused on the language that all Principal and
   Interest “shall be paid in full within 25 years.”
1. Lender argued this clause was intended for its benefit
   and that it, therefore, could set it aside.
2. The court appears to have begged the conclusion when
   it said that this clause was for the Borrower’s benefit.
• The court said it was not nullifying the provisions
   increasing the interest rate because an interest increase
   would still be collectible:
    1. if interest rates first drop before they rise
    2. In the event of a prepayment of the mortgage
       •   “Due on sale” clause is enforceable
       •   How does this fit with what the court said about a balloon (“this
           method was not used”)?



                                       50                             Donald J. Weidner
        Note to Goebel v. First Federal
• No argument was made that an interest increase was
  either unconscionable or illegal.
• See also Constitution Bank (Text p. 385): “If the lender may
  arbitrarily adjust the interest rate without any standard
  whatever, with regard to this borrower alone, then the
  note is too indefinite as to interest. If however the power
  to vary the interest rate is limited by the marketplace and
  requires periodic determination, in good faith and in the
  ordinary course of business, of the price to be charged to
  all of the bank’s customers similarly situated, then the
  note is not too indefinite.”
• Recall, “good faith” can solve the problem of an
  indefinite contract
• Recall, too, that the borrower had the option to
  prepay without penalty upon an interest rate
  increase.
       • Indicating that market forces would limit the lender.
                                    51                           Donald J. Weidner
             4) SHARED APPRECIATION
                    MORTGAGE
• Lender agrees to lend at a flat rate below the current
  market rate in return for borrower’s agreement that:
    If the home is sold before the end of x years, the lender will
      receive a percentage of the increase in value;
    If the home is not sold within x years, an appraisal will
      establish the value at that time and the borrower will pay a
      lump sum “contingent interest” equal to the lender’s share of
      the appreciation.
              BUT::::if the borrower requests, the lender must
  refinance an amount equal to the unpaid loan balance plus the
  contingent interest.


                                  52                    Donald J. Weidner
5) PRICE LEVEL ADJUSTED MORTGAGE

• It is the loan principal, NOT the interest
  rate, that varies over the term of the
  mortgage.
• The principal is adjusted up or down
  according to a prescribed inflation index.




                       53               Donald J. Weidner
      6) Reverse Annuity Mortgage
• Designed to enable seniors to draw cash out
  of the equity in their homes.
• The typical RAM gives the borrower monthly
  payments over the borrower’s lifetime or over
  a predetermined period.
• With each monthly payment by the lender, the
  debt increases.
• Typically, the debt is to be repaid at the
  earlier of death of the borrower, or x years
  from the loan origination, money to come
  from sale of the property or the borrower’s
  estate.

                        54                Donald J. Weidner
Growth of Debt Securitization in Real Estate
                     (Text p. 363)

• In 1934, Congress created the Federal Housing
  Administration (FHA) to induce thrift institutions
  to originate long-term loans with relatively low
  down payments by insuring lenders against the
  risk of default.
• In 1938, the Federal National Mortgage
  Association (Fannie Mae) was created to buy
  and to sell federally insured mortgages.
   – In 1968, the Government National Mortgage
     Association (Ginnie Mae) was created as a second,
     secondary market agency to take over the low-
     income housing programs previously run by Fannie
     Mae.

                            55                 Donald J. Weidner
Growth of Debt Securitization in Real Estate
                 (cont’d)
• Fannie Mae “was then restructured as a private
  corporation with ties to the federal government”
   – And “given the authority to buy and sell
     conventional (non-federally insured) home
     mortgage loans.”
• In 1970, Congress established the third major
  secondary mortgage market agency, the Federal
  Home Loan Mortgage Corporation (Freddie
  Mac),
   – which is also empowered to buy and to sell
     conventional mortgages.


                         56                Donald J. Weidner
Growth of Debt Securitization in Real Estate
• “In the 1970s, the secondary market agencies became
  critical in promoting the growth of securitization.”
   – “Issuers of mortgage-backed securities pool hundreds of loans
     together, obtain credit enhancement, usually in the form of
     guarantees, from a secondary market agency, and sell their
     interests in a pool of mortgages to investors.”
1. “The first generation of mortgage-backed securities
   were pass-through certificates that entitled the
   holders to a proportionate share of interest and
   principal as these amounts were paid by mortgagors.”
2. Issuers of mortgage-backed securities “subsequently
   divided the flow of mortgage interest and principal
   from the pool to create debt instruments of varying
   maturities and levels of risk.”
   – These different slices are known as “tranches”
                                   57                       Donald J. Weidner
              Federal Reserve Policy

• When the Fed Funds Rate was only 1%, Federal
  Reserve Chairman Alan Greenspan announced
  that the FOMC would maintain an “highly
  accommodative stance” for as long as needed to
  promote “satisfactory economic performance”
  – Thus, there was cheap money to help drive up prices
  – Treasury obligations were not paying investors very
    much
  – Investors turned to mortgaged-backed securities for
    higher yields than Treasury bills at, they thought,
    relatively little risk
• At the same time, Chairman Greenspan believed
  that the discipline of the markets would protect
  against excessive risk taking.

                            58                   Donald J. Weidner
   “Crisis Looms in Market for Mortgages”
                      (Supplement p. 1)


Gretchen Morgenson, “Crisis Looms in Market for
  Mortgages,” New York Times, March 11, 2007.
• As of March, 2007, the nation’s $6.5 trillion mortgage
  securities market was even larger than the United
  States treasury market.
• “Already, more than two dozen mortgage lenders have
  failed or closed their doors, and shares of big companies
  in the mortgage industry have declined significantly.
  Delinquencies on loans made to less creditworthy
  borrowers—known as subprime mortgages — recently
  reached 12.6 percent.”
• 35% of all mortgage securities issued in 2006 were in
  the subprime category.


                               59                  Donald J. Weidner
     Crisis in Mortgage Market (cont’d)

• Subprime Lenders created “affordability
  products,” mortgages that
  – Require little or no down payment
  – Require little or no documentation of a
    borrower’s income
  – Extend terms to 40 or 50 years
  – Begin with low “teaser” rates that rise later in
    the life of the loan.
• Mortgages that require little or no
  documentation are known as “liar loans.”

                           60                  Donald J. Weidner
      Crisis in Mortgage Market (cont’d)
• “Securities backed by home mortgages have
  been traded since the 1970s, but it has been
  only since 2002 or so that investors,
  including pension funds, insurance
  companies, hedge funds and other
  institutions, have shown such an appetite for
  them.”
• Wall Street was happy to help refashion
  mortgages into ubiquitous and frequently
  traded ones, and now dominates the market.
  By 2006 Wall Street had 60 percent of the
  mortgage financing market.
                        61              Donald J. Weidner
      Crisis in Mortgage Market (cont’d)
• The big firms “buy mortgages from
  issuers, put thousands of them into pools
  to spread out the risks and then divide
  them into slices, known as tranches,
  based on quality. Then they sell them.”
• Some of the big firms even acquired
  companies that originate mortgages.
  – Investors demands for mortgage-backed
    securities was insatiable
  – The greater the demand, the less the
    investment banks insisted on quality loans.

                         62                 Donald J. Weidner
          Banks Sue Originators on Repurchase
                     Agreements
                               (Supplement p. 7)
Carrick Mollenkamp, James R. Hagerty, Randall Smith, “Banks Go on Subprime
   Offensive,” The Wall Street Journal, March 13, 2007
• “Although the specifics vary from deal to deal, repurchase
  agreements obligate the mortgage originator, under
  some circumstances, to buy back a troubled loan sold
  to a bank or investor. That obligation sometimes kicks in if
  the borrower fails to make payments on the loan within the
  first few months or if there was fraud involved in obtaining
  the original mortgage.”
• Billions in mortgages are covered by repurchase
  agreements.
• However, many originators say that they cannot afford to
  buy back the loans or they are seeking bankruptcy
  protection.
• Many loans went to “straw borrowers,” people who obtain
  the loan for another home buyer.
    – In some cases, brokers wrote contracts through straw men
                                       63                        Donald J. Weidner
                 Rating Agencies
• Credit rating agencies are supposed to assess
  risk for investors
• The rating agencies gave the mortgaged-backed
  securities a AAA rating, which suggested they
  were as safe as Treasury Obligations.
• Data on loan performance focused on a low
  foreclosure rate
  – But that data, focusing on recent history, suggested a
    foreclosure rate of perhaps 2%
  – It didn’t include the newer, more risky mortgages
  – Nor did it anticipate falling real estate prices


                             64                    Donald J. Weidner
                    The Rating Agencies
                           (Supplement p. 10)


• Floyd Norris, “Being Kept in the Dark on Wall Street.” The New York
  Times, November 2, 2007.
   – Securitization was extremely profitable for
     investment banks, and only they seemed to
     understand what was going on.
   – The products they sold (labeled CDO
     [collateralized debt obligation] or otherwise)
     “could be valued according to models, which
     made for nice, consistent profit reports” for the
     people who bought them.

                                    65                       Donald J. Weidner
         The Rating Agencies (cont’d)
• “No one seemed to be bothered by the
  lack of public information on just what was
  in some of these products. If Moody’s,
  Standard & Poor’s or Fitch said a weird
  security deserved an AAA, that was
  enough.”
• “And then they blew up.”
• “Now we are learning that the investment
  banks did not know what was going on
  either, and they ended up with huge
  pools of securities whose values are, at
  best, uncertain.”
                       66               Donald J. Weidner
       The Rating Agencies (cont’d)
• “Rating agency downgrades do not destroy
  markets for corporate bonds, simply
  because enough information is
  disseminated that other analysts can reach
  their own conclusions.”
• “But the securitization markets collapsed
  when it became clear the rating agencies
  had been overly optimistic.”
  – Some suggest that information shared with
    rating agencies should be shared with the
    entire market.
                        67                Donald J. Weidner
           The Rating Agencies (cont’d)
• The SEC is investigating the rating agencies to
  see if their ratings complied with their own
  published standards.
• Neither one of two plausible scenarios, knaves
  or fools, is pretty:
• “It is hard to know which conclusion would be
  worse. [1] If the agencies violated their own
  policies, they will be vilified for the conflicts of
  interest inherent in their being paid by the
  issuers of the securities. [2] If they did not, they
  will be derided as fools who could not see how
  risky the securities clearly were. (In hindsight, of
  course.)”
                           68                  Donald J. Weidner
         The Rating Agencies (cont’d)

• The collapse of securitization has made
  credit hard to obtain for many, “and a
  change in the Fed funds rate will not offset
  that.”
• “[I]t has become very difficult to get a
  home mortgage without some kind of
  government-backed guarantee.”



                       69               Donald J. Weidner
       Collateralized Debt Obligations
• A collateralized debt obligation is a pool of
  different tranches (or slices) of mortgages
  – Or a pool of mortgages with other receivable,
    such as credit card receivables
• Lower-rated tranches were called “toxic
  waste”
  – They are so high-risk, they are “toxic”
• But the tranches were being pooled to
  make them appear to be lower risk
  – And made to appear less risky with credit
    default swaps (insurance against defaults)
                          70                  Donald J. Weidner
           The Housing Bubble

• From 2000-2003, there was a speculative
  bubble in housing.
• Prices kept going up, mortgage financing
  was available.
• People were seeing residences as
  investments, and non-real estate
  professionals were buying multiple
  residences to “flip”
• However, from 2000-2007, the median
  household income was flat.
                      71             Donald J. Weidner
               The Housing Bubble

• Therefore, the more prices rose, the more
  unsustainable the rise and its financing.
• By late 2006, the average home cost nearly 4
  times what the average family made
  – As opposed to an historic multiple of only 2 or 3
• People began to default on their mortgages
  soon after taking them out.
• By late 2006, housing prices started going down.
• As defaults started, more houses came on the
  market, prices went further down.

                             72                     Donald J. Weidner
               The Housing Bubble

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



                               73                Donald J. Weidner
  Securitisation, When it goes wrong . . . .
                     (Supplement p. 13)

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

                              74                  Donald J. Weidner
  Securitisation, When it goes wrong . . . .
                      (cont’d)

• Benefits of securitization:
  1. “Global lenders use it to manage their balance
    sheets, since selling loans frees up capital for
    new businesses or for return to shareholders.”
  2. Small regional banks no longer need to place
    all their bests on local housing markets—”they
    can offload credits to far-away investors such
    as insurers or hedge funds.”
  3. Reduced borrowing costs for consumers
         and businesses.

                          75                Donald J. Weidner
Securitisation, When it goes wrong . . . .
                    (cont’d)


4. One “systemic” gain: “Subjecting bank
     loans to valuation by capital markets
     encourages the efficient use of capital.
5. Broadens the distribution of credit risk.
         *      *      *
Three cracks in the new model:
   1. A high level of complexity and confusion.
   2. Fragmentation of responsibility warped
   incentives.
   3. Regulations came to be gamed.
                        76               Donald J. Weidner
  Securitisation, When it goes wrong . . . .
                          (cont’d)

1. On Problem # 1: complexity: “financiers did
  not fully understand what they were trading.”
   – Schwarcz says some contracts “are so convoluted
     that it would be impractical for investors to try to
     understand them”
   – Skel and Partnoy concluded that CDOs “are being
     used to transform existing debt instruments that are
     accurately priced into new ones that are overvalued.”
• “Securitisations are generally structured as ‘true
  sales’: the seller wipes its hands of the risks.”
   – Recall the practical problem with the repurchase
     agreement.
                              77                   Donald J. Weidner
           Securitisation, When it goes wrong . . . .
                                 (cont’d)

2.       “The second lesson of the past few weeks is that
         securitisation has warped financiers’ incentives.”
     •     One middleman has been replaced with several.
In mortgage securitisation, the lender is supplanted by
    --the broker
    --the loan originator
    --the servicer (who collects payments)
    --the investor
    --the arranger
    --the rating agencies
    --the mortgage-bond insurers
    Note: By January of 2008, there was widespread
    concern over the stability of the bond insurers.

                                      78                   Donald J. Weidner
  Securitisation, When it goes wrong . . . .
                         (cont’d)

• “This creates what economists call a
  principal-agent problem.”
  – “The loan originator has little incentive to vet
    borrowers carefully because it knows the risk
    will soon be off its books.”
  – “The ultimate holder of the risk, the investor,
    has more reason to care but owns a complex
    product and is too far down the chain for
    monitoring to work.”
     • Most investors were sophisticated institutions too
       taken with alluring yields to push for tougher
       monitoring
                             79                   Donald J. Weidner
  Securitisation, When it goes wrong . . . .
                        (cont’d)


3. The Gaming of regulations.
  • Only now are the politicians looking at the
    rating agencies.
  • “Regulatory dependence on ratings has
    grown across the board.”
     • Banks can reduce the amount of capital they have
       to set aside if they hold highly rated paper
     • Some investors, such as money-market funds,
       must stick to AAA-rated securities.



                            80                  Donald J. Weidner
  Securitisation, When it goes wrong . . . .
                           (cont’d)


• “Investors need to know who is holding what and
  how it should be valued.”
• There will be calls for greater standardization of
  “structured products.”
• Regulators will want to see the interests of rating
  agencies “aligned more closely with investors,
  and to ensure that they are quicker and more
  thorough in reviewing past ratings.”
   – “theirs is one of the few businesses where the
     appraiser is paid by the seller, not the buyer.”

                               81                       Donald J. Weidner
    Fannie Mae and Freddie Mac: End of Illusions
                        (Supp. P. 19)

•    Fannie Mae and Freddie Mac: End of Illusions, The
     Economist, July 19, 2008, p. 79.
•    Fannie and Freddie “were set up to
     provide liquidity for the housing market
     by buying mortgages from the banks.
     They repackaged these loans and used
     them as collateral for bonds called
     mortgage-backed securities; they
     guaranteed buyers of those securities
     against default.”
                               82                 Donald J. Weidner
  Fannie Mae and Freddie Mac: End of Illusions
                          (Cont’d)

• The belief in the implicit government guarantee of
  the obligations of Fannie and Freddie:
   1. Permitted them to borrow cheaply.
        1.They engaged in a “carry trade”—they earned
          more on the mortgages they bought than they paid
          for the money they raised.
   2. Allowed them to operate with tiny amounts of
      capital and they became extremely leveraged
      (“geared”): 65 to 1!
        1.$5 trillion of debt and guarantees!
• Their core portfolio was fine, with an average Loan/Value
  ratio was 68% at the end of 2007: “in other words, they
  could survive a 30% fall in house prices.”
                              83                   Donald J. Weidner
 Fannie Mae and Freddie Mac: End of Illusions
                        (Cont’d)


• However, in the late 1990s, they moved
  into another area: buying the mortgage-
  backed securities that others had issued.
  – Fannie and Freddie were operating as hedge
    funds
  – “Again, this was a version of the carry trade;
    they used their cheap debt financing to buy
    higher-yielding assets.”
  – Fannie’s outside portfolio grew to $127 billion
    by the end of 2007.
     • Leaving them exposed to the subprime assets they
       were supposed to avoid.
                            84                  Donald J. Weidner
  TARP: “Troubled Asset Relief Program”
• $700 billion rescue package approved by
  Congress October 3, 2008.
• The original idea was to free banks and
  other financial institutions of the most toxic
  loans and securities on their books by
  purchasing them in auctions.
• The thought was that the government
  would pay more than the nominal amount
  that they could be sold for but at an
  amount that might even result in a profit if
  held to term.
                        85                Donald J. Weidner
                TARP (cont’d)
• After much criticism, the announced
  government shifted from its core mission
  of buying distressed mortgage assets and
  instead began purchasing ownership
  stakes in banks.
• England led the way with this solution,
  suggesting that the federal government
  may put $250 billion in banks in return for
  shares.
  – With some restraints on executive
    compensation.
                        86              Donald J. Weidner
Potential Foreclosure Relief Through TARP

• Lawmakers are currently discussing how
  to allocate funds between institutional
  relief and relief to individual homeowners.
• Some in Congress are pressing to give
  consumers more of the rights that
  businesses have in bankruptcy
  – For example, to give bankruptcy judges new
    “cram down” powers to force lenders to
    accept revised home loans.

                        87                Donald J. Weidner
    Opposition to “Cram Down” Authority
• Treasury Secretary Paulson and others in
  the Bush administration are opposed to
  the proposal, saying it would frighten even
  more investors away from the mortgage
  market.
• Lenders also argue that write-downs of
  mortgages by bankruptcy judges will
  increase the risk of mortgage lending at a
  time when the market is already
  struggling, and this could harm
  consumers.
                       88               Donald J. Weidner
              Other TARP Issues

• Policymakers are also considering
  standardized loan modification practices to
  be used by firms that service mortgages.
  – Loans modified under these principles would
    qualify for at least a partial federal guarantee.
  – It is unclear who would be required to pay
    premiums for that protection.




                           89                  Donald J. Weidner
            Note and Mortgage

• The typical “mortgage” transaction
  involves two separate documents:
  – 1. A note
  – 2. A mortgage.
• We have been considering some of the
  variables in notes.
• We now turn to take an even longer look
  at the variables among and within
  mortgages and mortgage substitutes.

                      90               Donald J. Weidner
    DRAGNET CLAUSE IN MORTGAGE
                   (Text p. 387)




• A dragnet clause in a mortgage uses a
  single property to secure the original
  debt and any other debt owed, or to be
  owed, by the mortgagor to the
  mortgagee.
  – The clause “drags” other debts into the
    mortgage



                          91              Donald J. Weidner
    DRAGNET CLAUSE IN MORTGAGE
              (Cont’d)
• Courts vary in approach to dragnet clauses
  – Some “interpret” dragnet clauses narrowly, holding,
    ex., that dragnet clauses will only secure subsequent
    debts directly related to the property.
  – Or, a court may “presume” that a future advances
    clause only covers advances of the same quality or
    relating to the same transaction,
     • perhaps unless the documentation concerning the
       subsequent advance refers to the original
       mortgage as providing security.



                             92                   Donald J. Weidner
       State Bank of Albany v.Fioravanti
                      (Text p. 387)
• 1966: Fee Owner executed $2,500 Note #1 and
  Mortgage #1 on Lot 1.
   – Mortgage #1 had a dragnet clause providing that
     additional subsequent debt would be secured by
     the mortgage, but no more than $2,500.
   – Lender recorded Mortgage #1.
• 1973: Fee Owner executed $6,800 Note #2 &
  Mortgage #2 on Lot 2 to same Lender.
   – No reference was made to Lot 1.
• Fee Owner conveyed Lot 1 to Grantee who
  assumed “the payment” of Mortgage #1 on Lot 1.

                             93              Donald J. Weidner
                Fioravanti (cont’d)
• Fee Owner paid in full the 1966 Lot 1 Note#1 in
  connection with which Mortgage #1 (with the dragnet
  clause) was issued and recorded on Lot 1.
• Fee Owner defaulted on the 1973 Note#2, causing
  Lender to foreclose Mortgage #2 on Lot 2.
   – Lender got a $3000 deficiency judgment in the
     foreclosure of Mortgage #2.
• L sued Grantee of Lot 1 to foreclose Mortgage #1 on
  Lot 1 to recover $2,500 of the $3,000 deficiency from
  the foreclosure of Mortgage #2 on Lot 2.
   – Recall, the dragnet clause in Mortgage #1 had a
     $2,500 limit on the additional debt that could be
     dragged in.


                            94                  Donald J. Weidner
                 Fioravanti (cont’d)

• HELD: “payment of the 1966 note [secured by
  Mortgage #1 on Lot 1] could not terminate the
  bank’s right to foreclose the mortgage.”
  – To decide otherwise would defeat intent.
• TO EMPHASIZE: The note and mortgage are two
  separate instruments. One can survive the other.
• Dissent: Lender’s document did not specify that
  the Lot 1 Mortgage would survive the payment of
  the Lot 1 Note
  – Construe a document that is at best ambiguous against
    the person that drafted it.

                             95                  Donald J. Weidner
              Fioravanti (cont’d)

• In Florida, dragnet clauses are construed
  against the drafter.
• Wrinkle: pre-existing debt.
  – United Nat’l Bank v. Tellam, 644 So.2d 97 (FL
    3d DCA 1994)(invalidating attempt to drag in
    pre-existing debt rather than future debt).
    Court forces existing debts to be specified
    and prevents dragging in future debts that
    were never anticipated at making of the
    Mortgage.

                        96                 Donald J. Weidner
 AFTER ACQUIRED PROPERTY CLAUSE
                 (Text p. 388)


• Secures a single debt with a mortgage
  that purports to encumber both the
  property originally mortgaged and all
  future property the borrower will acquire.
• Attempts to bring future property under
  the mortgage rather than future debt.
• However, real estate lenders only get
  limited benefit from after acquired
  property clauses in mortgages.
                        97            Donald J. Weidner
  AFTER ACQUIRED PROPERTY CLAUSE
              (Cont’d)
• A mortgage with an After Acquired Property clause
  will be outside the chain of title of the property that is
  acquired later.
• Subsequent purchasers or mortgagees of a second
  parcel will not find the After Acquired Property clause
  in the recorded chain of title of the second parcel.
   – Hence they will not be bound by that clause.
      • The purpose of the recording acts is to allow buyers and lenders
        to rely on the instruments properly recorded in a particular
        parcel’s chain of title.
• In sum: a subsequent purchaser or mortgagee of the
  second parcel will defeat the lender-mortgagee of the
  first parcel who is trying to rely on the After Acquired
  Property clause in the mortgage on the first parcel.
   – This is true whether a tract or a grantor-grantee
      index is used.                98                         Donald J. Weidner

				
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