WEBVTT

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I'm going to start by talking a
little bit about the history

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of mortgage lending.

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And then, I want to talk more
recently about how we do

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commercial real estate finance,
and then, residential

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real estate finance.

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And then, if I have time, I'm
going to try to get into

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discussing --

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[SIDE CONVERSATION]

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PROFESSOR ROBERT SHILLER: So
when we talk about real estate

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finance, it's really about
financial contracts that

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involve real estate, and that
particularly use real estate

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as collateral.

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So, it's a very complicated
history.

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But I'd like to put things in
a long-term perspective.

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I want to start with
the word mortgage.

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It actually goes
back to Latin.

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Mortuus vadium.

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And that means in Latin,
death pledge.

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And then, in the Middle Ages
in France, they substituted

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the French word for vadium.

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And that's
[CIRCLES GAGE ON BLACKBOARD].

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I don't know how to
pronounce it.

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That means pledge in French.

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And I don't know why they called
them death pledges.

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That doesn't seem to involve
death to me.

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But in the long history
of these

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institutions, it became important.

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The Oxford English Dictionary
says the word mortgage entered

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the English language in 1283.

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So, we've got a long
history here.

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Actually, I can take it back
further than 1283.

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I was inspired by the research
of Yale historian Valerie

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Hansen, who has been reading old
documents related to the

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silk trade.

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And her documents are based on
a trove of old documents from

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the Tang Dynasty in China,
between the 7th and 10th

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centuries, which reflect
loans that were

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made to finance trade.

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So, you had people going back
and forth from the Middle East

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to China with silk, and other
items, and they needed

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financing for the trade.

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So, she reads these old
documents in Chinese.

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And I was looking over her
work a little bit to see

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whether they had mortgages.

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She says that in China, it
didn't seem, at least if I'm

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getting her generalities right,
they didn't seem to

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mortgage property, at least
in these documents.

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But she says that among these
documents are some --

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they weren't all in Chinese,
because they were trading

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between China and many
other countries.

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So, she found some in the
Sogdian language.

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She reads all these languages.

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It's an ancient language of
what's modern day Iran.

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And it's a dead language.

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It died out in the
ninth century.

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But she finds some
Sogdian documents

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that look like mortgages.

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So, some people borrowed money
for their silk trade, and they

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would mortgage their property,
or their slaves.

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You could mortgage slaves.

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It's an awful thought.

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And then the contracts would
additionally say that you were

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obligated to maintain the
property or the slaves.

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I guess that meant
feed your slaves.

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Keep them healthy.

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Those were mortgages from
over 1,000 years ago.

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So, it's a very old
institution.

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But I think it formed its modern
form more recently.

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And it became a well-known term
for the general public

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maybe in the late
18th century.

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I was trying to confirm that.

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I'm interested in history,
just out of a passion for

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understanding origins
of things.

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So, I looked up mortgage on
ProQuest to find, what were

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they talking about.

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And I found an article in the
Hartford Courant, dated 1778.

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Actually, it wasn't an article,
it was an ad that

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someone took out.

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And I think it's kind of
revealing of what the mortgage

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market looked like in 1778.

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We here in Connecticut, have
-- did you know this? --

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the oldest newspaper
in America.

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That's the Hartford Courant.

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So, a man by the name of Elisha
Cornwell took out an ad

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in the Hartford Courant
in 1778.

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And he explains in the ad, that
he sold his farm, and,

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instead of taking the money
right up front, he'd mortgaged

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the farm, so that he sold it for
GBP 800 to another farmer.

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And the farmer was promising
to pay him.

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And if he didn't pay him, he
should get back the farm.

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The farmer subsequently
mortgaged the same

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farm for GBP 880.

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So he's made GBP 80 profit.

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Which would all be fine and
good, except he still hadn't

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paid back the first mortgage.

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And then the guy mortgaged
it again for GBP 1,000.

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And Mr. Cornwell is protesting:
"Hey, you didn't

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pay me for the farm in the
first place, so you

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don't own the farm.

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How are you mortgaging it
multiple times? " So he said,

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"I thought I better put an ad in
the newspaper, so that any

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subsequent victims of this
farmer, would be warned." So,

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that's the end of the ad.

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He said, "this is my farm
because he didn't pay me."

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But this shows how undeveloped
mortgage

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institutions were in 1778.

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Because he had to put an ad in
the newspaper to explain that.

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The problem was that nobody
had any systematic way of

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representing title.

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The farmer, who supposedly
bought it from Mr. Cornwell

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really didn't, and nobody
would know that.

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You know, he could
fool people.

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I think that's partly why you
didn't see so many mortgages

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in those days.

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Because the law wasn't clear.

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The institutions were not
clear about property.

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And so, you couldn't really do
a mortgage business, if you

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couldn't find out whether the
guy mortgaging the farm really

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owned it or not.

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And so, it wasn't until the
late 19th century that

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government started to get
rights to property

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sufficiently advanced that we
could develop a big national

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or international market
in mortgages.

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So, an important step is in
Germany, in 1872, or Prussia,

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the government created a
Grundbuch law that created a

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system for Prussia that
established in a central book,

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who owns what exactly.

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That was in 1872.

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And in 1897, they made it a
national German institution.

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Still, the United States
did not have a

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Grundbuch at the time.

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It developed throughout the
20th century in different

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countries of the world, that
property rights would be clear

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enough that one could do a
mortgage lending business.

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So that's, why I think mortgage
lending has really

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taken off in the 20th century.

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Hernando de Soto was a Peruvian
economist. He wrote a

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book a few years ago called
Mystery of Capital.

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And it's about the
developing world.

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He argued in that book that
property rights, the problems

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that we just heard about from
the Hartford Courant are still

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very big and alive around
the world today.

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That you can't easily establish
who owns what in

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many or most countries
of the world.

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So, that's a problem.

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That's why we don't
see mortgage

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finance developing there.

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You can't make a loan.

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You know, if you go to some
small town in some less

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developed country, you can ask
around, "who owns this

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property?" And they'll tell you,
"that's been in the such

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and such family for a long
time." But if you want solid

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knowledge of that, if you're
going to base financial

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transactions on it, you can't
base it just on hearsay.

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Someone else might have
a different opinion.

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So even today, in many countries
of the world, the

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laws are not developed
well enough.

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We don't have property rights
established well enough.

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And we have laws that might
inhibit mortgages.

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For example, in many countries,
if you give a

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mortgage on a property, in other
words, if you lend on a

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property, and the person doesn't
pay, you're supposed

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to be able to seize the
property, right?

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But if the court system doesn't
function well, or if

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it's kind of left leaning and
supporting the rights of the

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person living in the home, you
might not be able to get it.

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Or it might take you 10
years to get the guy

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thrown out of the house.

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Now, it seems cruel to throw
someone out of a house, who

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doesn't pay on their mortgage,
but you have to think of the

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other side of it.

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If we don't throw them out of
the house, no one's going to

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make a mortgage.

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You have to be able
to get the house.

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Right?

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That's the idea of
the mortage.

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The guy doesn't pay, the
lender gets the house.

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And so, I think there's
a general process of

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development, improving the
definition of property rights,

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and improving the ability of
lenders to get the property if

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it fails, which accounts for
the advance of mortgage

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lending in the 20th
and 21st century.

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So, that's my long history
of mortgage lending.

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But I want to get into some
specific institutions.

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I said, I would start with
commercial real estate and

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then I'll move to single-family
homes or

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residential real estate.

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I will to talk now mostly
about the United States.

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There's just too many countries
to think about.

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One thing about finance is that
it tends to develop a

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sort of tradition, and a sort
of standard contract.

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It's encouraged by laws
and regulators.

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You have to do the same sort of
contract that other people

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are doing in your country.

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And I think the standardization
is kind of a

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limitation.

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We can't be creative in
financing, because the public

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and the regulators will not be
receptive to new things.

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Let me talk about some of the
institutions in finance in the

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United States.

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It's natural to start with
commercial real estate.

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So, you see a lot
of buildings.

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My question is, how
are they owned?

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I don't know whether you
think about this.

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Who owns these buildings?

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In much of the 20th century and
still today, they tend to

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be owned as partnerships.

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Real estate partnerships, which
is different from a

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corporation.

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In a corporation --

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we talked about that yesterday
[correction: last class]--

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you might sell shares on the
stock exchange if it's public.

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And it's defined as
a legal person.

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And it has limited liability,
so that all the shareholders

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don't have to worry about
being sued as a result.

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But a partnership
is different.

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And most real estate, that's not
part of a larger business,

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is owned in a partnership,
rather than a corporation.

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And the reason is that they're
taxed more favorably.

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Corporations have to pay a
corporate profits tax.

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They're double-taxed.

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You as an individual pay
an income tax, and your

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corporation pays a corporate
income tax, or corporate

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profits tax.

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So, you're taxed twice.

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If you incorporate yourself, or
you set up some friends to

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do business in a corporation,
you get taxed twice.

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So, you don't like that,
and obviously you

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try to avoid that.

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The way to avoid it is not to
have a corporation, but a

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partnership.

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The law allows you to form

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partnerships to own a building.

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So, you're building like
360 State Street.

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It's a new building that just
went up in New Haven.

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You know this building?

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The biggest construction.

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Does anyone know who owns it?

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It's probably a partnership.

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I haven't investigated that.

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Or it's called a Direct
Participation Program.

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So, the partnership is an
investment that is offered

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only to accredited investors.

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It's not generally available
to the general public.

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And what is an accredited
investor?

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The Securities and Exchange
Commission takes it upon

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itself to define, who are
accredited investors that

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don't need the protections
of the SEC.

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Basically, accredited investors
are wealthy people.

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And it's defined in the SEC
laws who is accredited.

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You have to have at least $1
million, or minimum income.

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And so, if you are an accredited
investor, you can

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invest in a DPP.

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And then, the income of the
property flows through to you

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as your personal income.

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It's not corporate income,
so it's taxed only once.

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Think about that.

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Well, why would anyone want
to form a corporation?

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Because I don't want
to be taxed twice.

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So, why don't we do all business
as a DPP, as a

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partnership?

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The problem is that the
government doesn't want you to

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do that, and so they have rules
about what can form a

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partnership.

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One of the rules is that they
have to have a limited life.

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So, a corporation
goes on forever.

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And it derives a lot of its
value from the fact that it

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lives forever.

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There's no end date.

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So, we talked about that when I
when I brought up the first

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real corporation, the Dutch
East India Company.

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The reason it got so valuable
is, people could see that this

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was growing as the first
multinational --

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It is this huge company that
had all kinds of deals and

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alliances and business
arrangements.

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And no one wanted that to end.

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The value came in the growth
prospects for that.

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But a DPP has to end.

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It's well-designed
for a building.

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You buy the building, and you
depreciate it over the life of

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the contract.

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And then there's an end date,
and at the end date you sell

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the building to someone
else, and then you

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close down the DPP.

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You don't hear about these
partnerships as much.

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You hear about corporations
all the time.

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You don't hear about DPP's.

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First of all, because they
don't get so big.

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They're typically
one building.

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360 State, for example.

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And it only lasts for 10, 20
years, then it's gone.

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So, it doesn't get advertised
in the public, because it's

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not available to the public.

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They can't go around trying to
bring you in as an investor,

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because they have to
verify that you're

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an accredited investor.

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So, it tends to be a project
for wealthy people.

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Now, I mentioned that
corporations

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have limited liability.

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Partnerships do not,
in general.

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But you can have a partnership
that involves

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two classes of partners.

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There's a general partner that
runs the business and does not

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have limited liability.

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In other words, if the business
goes bad and loses

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money, the general partner
can get sued.

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But there are other partners,
called limited partners, and

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they have to be passive
investors.

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And they have limited
liability.

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So what often happens, is a DPP
is created by someone who

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understands and knows
real estate.

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Let's get 360 State
Street built.

19:53.050 --> 19:55.010
You're going to know that
eventually, because once they

19:55.010 --> 19:58.070
open, they're going to open a
supermarket on the first floor

19:58.070 --> 19:59.510
of 360 State.

19:59.510 --> 20:02.280
And I bet some of you
will be over there.

20:02.280 --> 20:04.580
It would be the closest
supermarket to Yale

20:04.580 --> 20:06.690
University.

20:06.690 --> 20:08.420
But it's all part of
somebody's plan.

20:08.420 --> 20:12.550
There was some general partner
who thought up this structure,

20:12.550 --> 20:21.630
and got limited partners in, and
is managing the building,

20:21.630 --> 20:25.100
or hires a manager for the
building, and has a plan and a

20:25.100 --> 20:26.440
close out plan.

20:26.440 --> 20:28.290
The building won't disappear,
but they'll sell

20:28.290 --> 20:29.710
it to someone else.

20:29.710 --> 20:31.830
I really don't know
the financing

20:31.830 --> 20:33.350
structure of 360 State.

20:33.350 --> 20:35.110
But I'm just pointing
out, it's likely

20:35.110 --> 20:37.390
what's happened there.

20:37.390 --> 20:42.710
So, that has been the modern
structure of real estate.

20:42.710 --> 20:48.250
And if they mortgage the
building, the DPP would

20:48.250 --> 20:51.290
mortgage the building on
behalf of the partners.

20:54.310 --> 21:05.210
So, real estate finance in
the United States --

21:05.210 --> 21:07.560
I might as well write it down.

21:07.560 --> 21:19.360
DPP is a Direct Participation
Program.

21:22.950 --> 21:28.230
And it's direct, in the sense
that you as an investor are

21:28.230 --> 21:31.520
participating directly
in the profits of it.

21:31.520 --> 21:33.840
You are a partner, you are
not a shareholder.

21:37.280 --> 21:45.560
The DPPs became criticized in
the 20th century, because

21:45.560 --> 21:49.340
small investors couldn't
access these.

21:49.340 --> 21:52.540
Small investors were confined,
because they weren't

21:52.540 --> 21:55.640
accredited, they weren't big
enough or important enough.

21:55.640 --> 21:58.250
They were not allowed
to invest in these.

21:58.250 --> 22:02.330
It was supposed to be to
protect them, I guess.

22:02.330 --> 22:05.270
But how does it protect them
to subject them to

22:05.270 --> 22:06.840
double-taxation?

22:06.840 --> 22:11.710
So, it became a cause that why
in the United States do we

22:11.710 --> 22:15.950
have most of our investors
closed out of these lucrative

22:15.950 --> 22:18.820
investment opportunities?

22:18.820 --> 22:22.010
Basically, individuals couldn't
invest in commercial

22:22.010 --> 22:22.600
real estate.

22:22.600 --> 22:25.490
And people said, well people
are supposed to diversify,

22:25.490 --> 22:27.020
they are supposed to hold
different kinds of

22:27.020 --> 22:29.250
investments.

22:29.250 --> 22:35.330
So, why would this be
limited to them?

22:35.330 --> 22:40.660
So, Congress in the United
States, in 1960, created

22:40.660 --> 22:43.910
something new called a real --

22:43.910 --> 23:00.970
[SIDE CONVERSATION]

23:00.970 --> 23:09.460
PROFESSOR ROBERT SHILLER: Real
Estate Investment Trusts.

23:13.170 --> 23:17.330
Or abbreviated REITs.

23:17.330 --> 23:23.710
These were created in 1960 by
an act of the U.S. Congress.

23:23.710 --> 23:27.110
And it was another
example of the

23:27.110 --> 23:30.030
democratization of finance.

23:30.030 --> 23:33.000
And I believe it started here
in the United States.

23:33.000 --> 23:37.590
Now, they're being copied
all over the world.

23:37.590 --> 23:40.630
They got off to kind of a slow
start after 1960, but they

23:40.630 --> 23:42.340
have grown dramatically.

23:48.450 --> 23:58.690
The idea is that we will allow
a trust to create investments

23:58.690 --> 24:02.360
for the general public,
for small investors.

24:02.360 --> 24:06.410
And they won't be double-taxed,
either.

24:06.410 --> 24:10.920
So, a Real Estate Investment
Trust has to follow the law,

24:10.920 --> 24:12.770
and then it can invest
in buildings.

24:12.770 --> 24:15.650
So, maybe 360 State is
owned by a REIT.

24:15.650 --> 24:16.900
I don't know.

24:23.190 --> 24:26.530
But they are not subject to
the corporate profits tax.

24:26.530 --> 24:31.220
Now once again, once Congress
creates a vehicle that's not

24:31.220 --> 24:34.370
taxed, everyone is going to ask,
well, I want my company

24:34.370 --> 24:36.150
to be a REIT.

24:36.150 --> 24:38.570
So, they had to define
it so that

24:38.570 --> 24:41.710
isn't generally available.

24:41.710 --> 24:43.190
It's limited to real estate.

24:43.190 --> 24:48.040
So the law says, 75% of the
assets of the company have to

24:48.040 --> 24:51.230
be in real estate or cash.

24:51.230 --> 24:56.860
75% of the income has to
be from real estate.

24:56.860 --> 24:59.990
90% of their income must be
from real estate dividend,

24:59.990 --> 25:03.390
interest, and capital gains.

25:03.390 --> 25:06.080
This is all, I think, in your
textbook Fabozzi et al.

25:06.080 --> 25:11.710
95% of the income must
be paid out.

25:11.710 --> 25:14.230
And there has to be a
long-term holder.

25:14.230 --> 25:18.680
No more than 30% of the income
can be from the sale of

25:18.680 --> 25:21.910
properties held less
than four years.

25:21.910 --> 25:26.350
They don't want real estate
churning companies.

25:26.350 --> 25:27.310
So, if you define
[correction: satisfy]

25:27.310 --> 25:30.860
all of that, you've
got a REIT.

25:30.860 --> 25:36.000
So, that invention, which
goes back to 1960 --

25:36.000 --> 25:37.120
It's one of those things
in finance.

25:37.120 --> 25:41.250
It starts out slowly, and most
people don't hear of it, and

25:41.250 --> 25:44.010
then it starts to grow.

25:44.010 --> 25:47.550
And now they're everywhere
around the world.

25:47.550 --> 25:49.050
Well, maybe not everywhere,
but in many

25:49.050 --> 25:50.960
countries we have REITs.

25:50.960 --> 25:55.100
The U.S. REITs grew in a
succession of booms. The first

25:55.100 --> 26:00.760
boom was in the late 1960s, when
the interest rates in the

26:00.760 --> 26:03.120
United States rose above
deposit ceilings.

26:03.120 --> 26:05.830
There used to be ceilings that
the government imposed on

26:05.830 --> 26:08.690
savings banks deposit rates.

26:08.690 --> 26:10.780
And so suddenly, the REITS were
paying better than the

26:10.780 --> 26:13.570
savings bank, and the public
flocked to them.

26:13.570 --> 26:18.550
There was a second boom, after
the tax reform of 1986

26:18.550 --> 26:25.130
eliminated some tax advantages
of DPPs, partnerships.

26:25.130 --> 26:28.060
It used to be that the
government allowed generous

26:28.060 --> 26:30.840
depreciation allowances
for partnerships.

26:30.840 --> 26:34.490
And people would invest in
buildings just as tax dodges.

26:34.490 --> 26:37.340
Because if you're allowed to
depreciate the building very

26:37.340 --> 26:40.930
effectively, you can kind of
cook your profits, so that

26:40.930 --> 26:42.630
it's not taxable.

26:42.630 --> 26:46.990
And so, people we're investing
in buildings too much.

26:46.990 --> 26:50.910
The government created a
distortion that encouraged too

26:50.910 --> 26:53.700
much investment in DPPs.

26:53.700 --> 27:02.260
So in 1986, the government
eliminated a lot of the

27:02.260 --> 27:04.170
advantages of partnerships.

27:04.170 --> 27:08.070
And that caused the
second REIT boom.

27:08.070 --> 27:11.290
And then, it was starting in the
1990s with the real estate

27:11.290 --> 27:18.790
boom that suddenly lots of new
kinds of REITs appeared.

27:18.790 --> 27:20.790
And REITs that involved
specialized

27:20.790 --> 27:22.040
properties, and the like.

27:23.630 --> 27:28.120
Now they're big, and everyone
talks about them.

27:28.120 --> 27:30.870
But it's interesting to me that
it took 50 years to get

27:30.870 --> 27:34.020
as big as they are now.

27:34.020 --> 27:39.740
And the recurring theme here
-- a couple of them --

27:39.740 --> 27:43.310
One is that the finance industry
finds it difficult to

27:43.310 --> 27:47.030
innovate, and innovations take
many years to happen.

27:47.030 --> 27:51.020
And secondly, that there there's
a trend toward the

27:51.020 --> 27:53.380
democratization of finance.

27:53.380 --> 27:55.550
That if you go back in history,
you'll find these

27:55.550 --> 27:59.220
same mortgages and partnerships
and the like, but

27:59.220 --> 28:02.420
they were limited to a small
number of wealthy people.

28:02.420 --> 28:03.780
And we're moving.

28:03.780 --> 28:06.190
With the invention of REITs
for example, more and more

28:06.190 --> 28:07.440
people are getting involved.

28:10.630 --> 28:12.070
So, that's commercial
real estate.

28:12.070 --> 28:16.650
I want to talk now about
residential real estate, which

28:16.650 --> 28:18.330
is actually bigger.

28:18.330 --> 28:21.830
There are more houses than there
are office buildings in

28:21.830 --> 28:23.640
this country.

28:23.640 --> 28:25.350
Or there's more value
in houses.

28:25.350 --> 28:28.350
So this is bigger.

28:28.350 --> 28:32.500
In the United States, about
2/3 of households

28:32.500 --> 28:35.280
own their own home.

28:35.280 --> 28:37.710
It varies across countries,
but there are many other

28:37.710 --> 28:41.670
countries with similarly high
home ownership rates.

28:41.670 --> 28:45.330
And this home ownership is a
product of government policy

28:45.330 --> 28:49.790
that encourages mortgage
lending.

28:49.790 --> 28:53.090
So, I want to talk a little
bit about the history of

28:53.090 --> 28:56.880
mortgage lending, and the
history of problems in

28:56.880 --> 28:57.710
mortgage lending.

28:57.710 --> 29:01.330
I already took you back to the
silk trade in the Tang

29:01.330 --> 29:04.100
Dynasty, but I'm going to
be less so far back.

29:04.100 --> 29:08.900
I'm going to talk about the
United States and the Great

29:08.900 --> 29:10.340
Depression.

29:10.340 --> 29:11.330
So, the Great Depression.

29:11.330 --> 29:18.780
The United States in the 1930s
after the 1929 Stock Market

29:18.780 --> 29:23.440
Crash was faced with a severe
housing crisis.

29:23.440 --> 29:27.800
Home prices were falling, and
people were defaulting on

29:27.800 --> 29:31.980
their mortgages in
great numbers.

29:31.980 --> 29:35.090
In fact, the government had to
create what they called the

29:35.090 --> 29:38.230
Homeowners Loan Corporations to
bail people out, and they

29:38.230 --> 29:42.070
ended up bailing out 20%
of American homeowners.

29:42.070 --> 29:46.050
It was a terrible crisis, and
so, what was happening?

29:46.050 --> 29:48.100
I am pointing this out, because
it's important in the

29:48.100 --> 29:52.810
history of real estate
finance.

29:52.810 --> 29:58.300
Before the Great Depression,
mortgages were growing.

29:58.300 --> 30:02.270
Before the Great Depression,
they tended to be two to five

30:02.270 --> 30:08.770
years, and they were
balloon payment.

30:08.770 --> 30:10.410
What do I mean by that?

30:10.410 --> 30:14.650
When you bought a house in 1920,
you would go to a bank

30:14.650 --> 30:18.080
and they would give you a loan
for two to five years.

30:18.080 --> 30:22.300
So, if you bought a house for
$10,000, they would typically

30:22.300 --> 30:23.380
lend you half the money.

30:23.380 --> 30:25.390
They would lend you $5,000.

30:25.390 --> 30:29.970
And the loan would say, you pay
interest every month until

30:29.970 --> 30:37.640
two years has ended, and then
you'd repay the $5,000.

30:37.640 --> 30:40.040
And then, you can try to
get another mortgage.

30:40.040 --> 30:42.250
You come back to us and
we'll do it again, if

30:42.250 --> 30:43.370
we feel like it.

30:43.370 --> 30:44.700
That was the deal.

30:44.700 --> 30:47.610
Banks offered that, and it was
becoming an increasingly

30:47.610 --> 30:48.350
common thing.

30:48.350 --> 30:51.540
When we say a balloon payment,
what we mean

30:51.540 --> 30:53.570
is, it's really big.

30:53.570 --> 30:55.230
Balloons are big.

30:55.230 --> 30:57.860
So, you're paying monthly
interest, but then in two

30:57.860 --> 31:02.740
years you have got to come
up with the whole $5,000.

31:02.740 --> 31:05.300
But people thought, it's all
right, I'll just go back to

31:05.300 --> 31:07.130
the bank, or maybe I'll
go to another bank.

31:07.130 --> 31:13.010
You know I can go wherever I
want and I can borrow $5,000.

31:13.010 --> 31:15.900
So, this was the way
things were done.

31:15.900 --> 31:18.250
But what happened in the
Great Depression?

31:18.250 --> 31:19.610
Two things happened.

31:19.610 --> 31:25.910
Unemployment rate went up to
25%, A. B, home prices fell in

31:25.910 --> 31:28.010
many cases by more than half.

31:28.010 --> 31:33.040
So, if you borrowed $5,000
against a $10,000 home, your

31:33.040 --> 31:36.450
home might be worth
only $4,000 now.

31:36.450 --> 31:37.990
So, what do you do now?

31:37.990 --> 31:40.360
You go to a bank.

31:40.360 --> 31:41.870
Two years is up.

31:41.870 --> 31:43.540
I have got to refinance
my mortgage.

31:43.540 --> 31:46.110
I go back to the bank.

31:46.110 --> 31:49.000
I show up and I say, A, I'm
unemployed and my house is

31:49.000 --> 31:50.790
worth $4,000.

31:50.790 --> 31:54.310
The bank says no dice, you're
not going to get renewed.

31:54.310 --> 31:56.050
So, what happens?

31:56.050 --> 31:58.830
You're forced to dump your
house on the market.

31:58.830 --> 32:00.180
You declare bankruptcy.

32:00.180 --> 32:01.270
You've lost everything.

32:01.270 --> 32:05.840
You've lost your $5,000
down payment.

32:05.840 --> 32:10.380
If you buy a $10,000 house, and
you borrow $5,000, then

32:10.380 --> 32:12.810
the other sum is called
your down payment.

32:12.810 --> 32:13.900
So, that's what happened.

32:13.900 --> 32:15.490
It was happening to millions
of Americans.

32:19.030 --> 32:22.810
So, the Roosevelt Administration
decided that

32:22.810 --> 32:24.060
there was something wrong with
the old kind of mortgage.

32:28.390 --> 32:37.270
So, in 1934, a year after
Franklin Roosevelt became

32:37.270 --> 32:46.460
President, they set up
the Federal Housing

32:46.460 --> 32:47.710
Administration.

32:50.040 --> 33:00.050
And it was trying to get lenders
back in to lend to

33:00.050 --> 33:03.130
homeowners, because it was a
catastrophe in the country.

33:03.130 --> 33:06.540
[SIDE CONVERSATION]

33:06.540 --> 33:08.080
PROFESSOR ROBERT SHILLER: So,
in order to get lenders back

33:08.080 --> 33:12.280
in, the FHA started insuring
mortgages.

33:12.280 --> 33:17.220
And that meant that if you're
a mortgage lender, and the

33:17.220 --> 33:20.630
person you lent the money to
doesn't repay you, and the

33:20.630 --> 33:21.910
house isn't worth enough --

33:21.909 --> 33:23.749
you can get the house, but
sometimes you might lose

33:23.750 --> 33:26.080
money, because the house
has lost value --

33:26.080 --> 33:28.060
the government will
make it up.

33:28.060 --> 33:31.000
So, the government came
in with what's

33:31.000 --> 33:33.710
called mortgage insurance.

33:37.719 --> 33:41.329
And at the same time, the
government said all mortgages

33:41.330 --> 33:48.430
that are insured by the FHA must
be 15 years or longer.

33:48.429 --> 33:53.219
And so, the U.S. government
imposed the long-term mortgage

33:53.219 --> 33:56.079
on the mortgage industry.

33:56.080 --> 33:57.430
And they said, this is better.

34:00.790 --> 34:04.800
And secondly, it cannot be a
balloon payment mortgage.

34:04.800 --> 34:08.580
The government said, this is
really imposing too much on

34:08.580 --> 34:12.240
ordinary people that they have
to come up with a huge sum of

34:12.240 --> 34:14.930
money at the end of
the mortgage.

34:14.930 --> 34:18.690
So, they required that the
mortgages be 15-year

34:18.690 --> 34:19.940
amortizing.

34:25.150 --> 34:28.910
Such mortgages had been offered
already by some banks

34:28.910 --> 34:32.700
in the United States in the
1920s, but it was innovative

34:32.700 --> 34:35.740
finance, and too complicated
for most people.

34:35.740 --> 34:39.480
They never caught on.

34:39.480 --> 34:44.290
To amortize means to pay
down the balance.

34:44.290 --> 34:49.460
So, an amortizing mortgage has
no balloon payment at the end.

34:49.460 --> 34:54.910
A 15-year amortizing mortgage
has a fixed monthly payment.

34:54.910 --> 34:57.110
You make it every
single month.

34:57.110 --> 34:59.360
And at the end, you're done.

34:59.360 --> 35:03.550
You take your spouse out to
dinner and you say, we paid

35:03.550 --> 35:05.560
off our mortgage, we're done.

35:05.560 --> 35:08.470
So, there's no family
crisis at the end.

35:08.470 --> 35:11.350
It's a fixed monthly payment.

35:11.350 --> 35:14.310
Now the arithmetic of amortizing
mortgages is a

35:14.310 --> 35:19.580
little confusing to some people,
and in 1934, it took

35:19.580 --> 35:21.170
some education.

35:21.170 --> 35:25.020
But I want to just describe the

35:25.020 --> 35:28.660
amortizing mortgage system.

35:32.230 --> 35:40.120
So, we're going to have a
mortgage of maturity --

35:40.120 --> 35:48.560
The maturity of the mortgage is
in M, and that's in months.

35:48.560 --> 35:53.010
So, in 1934, they started out
with 15-year mortgages, which

35:53.010 --> 35:55.700
I thought was pretty aggressive,
but by the early

35:55.700 --> 36:01.240
1950s, the FHA was emphasizing
30-year mortgages.

36:01.240 --> 36:03.610
That's a long time to pay
off on your house.

36:03.610 --> 36:07.850
But the idea is, you know,
you're typical family, they

36:07.850 --> 36:10.440
get married, and they're buying
their first house,

36:10.440 --> 36:12.420
they're 25 years old.

36:12.420 --> 36:15.840
So, let's give them a full 30
years to pay off the mortgage.

36:15.840 --> 36:17.420
They'll be 55.

36:17.420 --> 36:20.540
Kids will be going
off to college.

36:20.540 --> 36:21.670
They'll still be working.

36:21.670 --> 36:23.200
That's a comfortable
length of time.

36:23.200 --> 36:26.420
Why not give them 30 years?

36:26.420 --> 36:28.980
And we guarantee the interest
rate for 30 years.

36:28.980 --> 36:30.320
No surprises.

36:30.320 --> 36:34.580
You just know you have
this monthly payment.

36:34.580 --> 36:37.810
The question now is, how do we
decide on the monthly payment?

36:41.130 --> 36:46.380
The idea of an amortizing
mortgage is that you have a

36:46.380 --> 36:49.010
fixed payment every month.

36:49.010 --> 36:50.720
You have an interest rate.

36:50.720 --> 36:55.940
And you want to make sure that
the present value of the

36:55.940 --> 36:58.500
monthly payments equals
the mortgage

36:58.500 --> 37:00.180
balance at the beginning.

37:00.180 --> 37:07.620
So, the initial mortgage
balance, that's the amount you

37:07.620 --> 37:15.080
borrow, has to equal present
discounted value of all the

37:15.080 --> 37:15.960
monthly payments.

37:15.960 --> 37:19.340
So, what will I call the
monthly payment?

37:19.340 --> 37:22.690
Let's call the monthly
payment x, it's the

37:22.694 --> 37:23.964
monthly payment in dollars.

37:27.140 --> 37:35.040
So, the mortgage balance is
equal to x all over r over 12,

37:35.040 --> 37:47.400
where r is the annual interest
rate, times 1 minus 1 all over

37:47.400 --> 37:55.310
1 plus r over 12 to
the Mth power.

37:55.310 --> 37:58.370
That's just the annuity
formula.

37:58.370 --> 38:00.730
So, that's the formula that's
used to compute --

38:07.160 --> 38:08.410
I've shown you that
formula before.

38:12.290 --> 38:18.730
It's the present value of a
stream of payments equal to x.

38:18.730 --> 38:19.790
Did I write r over 2?

38:19.790 --> 38:25.970
I meant r over 12.

38:25.970 --> 38:29.520
So, what you have to do if you
are calculating an amortizing

38:29.520 --> 38:35.290
mortgage, if the person is
borrowing the mortgage

38:35.290 --> 38:42.190
balance, and I quote a rate r
per year, I have to plug that

38:42.190 --> 38:45.840
into the present value formula,
and find out what

38:45.840 --> 38:49.610
monthly payment x makes the
present value equal to the

38:49.610 --> 38:51.350
amount loaned.

38:51.350 --> 38:53.880
Now, that is a little bit of
arithmetic that mortgage

38:53.880 --> 38:56.050
lenders would have had
trouble doing.

38:56.050 --> 38:58.340
It is not that hard
to do, right?

38:58.340 --> 39:03.550
But I have here a page from
a mortgage table.

39:03.550 --> 39:06.800
I found this in the
Yale Library.

39:06.800 --> 39:09.340
Can you read that?

39:09.340 --> 39:11.700
This is from a 50-year-old
book.

39:11.700 --> 39:15.080
This is before they
had computers.

39:15.080 --> 39:17.490
And so, it was too hard to
do this calculation.

39:20.310 --> 39:21.880
Can you read it in the back?

39:21.880 --> 39:23.720
Sort of.

39:23.720 --> 39:26.220
This is for a 10-year
mortgage.

39:26.220 --> 39:28.060
I just picked 10 years.

39:28.060 --> 39:30.040
That was uncommon, that's
rather short.

39:30.040 --> 39:32.080
Some people would get
shorter mortgages,

39:32.080 --> 39:33.210
especially older people.

39:33.210 --> 39:35.130
You know if you're 60
years old, you don't

39:35.130 --> 39:37.790
want a 30-year mortgage.

39:37.790 --> 39:39.550
You probably won't
live that long.

39:39.550 --> 39:41.430
So, they did give out shorter
mortgages as well.

39:41.430 --> 39:47.110
So, this is the page from a
mortgage book for 10 years,

39:47.110 --> 39:49.580
and this is for a 5% mortgage.

39:49.580 --> 39:59.050
So, it shows the monthly
payment for $1,000.

39:59.050 --> 40:03.290
If someone's borrowing $5,000,
you'd multiply this by five.

40:03.290 --> 40:08.150
They show it for
around $1,000.

40:08.150 --> 40:15.830
And the monthly payment
per $1,000 is $10.61.

40:15.830 --> 40:21.420
So, what they've done is they've
found out $10.61 is

40:21.420 --> 40:24.930
the x that makes this
present value for r

40:24.930 --> 40:28.070
equal 5% equal to $1,000.

40:28.070 --> 40:31.640
They've done exactly
this calculation.

40:31.640 --> 40:36.360
Now, they show the payments
schedule.

40:36.360 --> 40:40.420
The payment every
month is $10.61.

40:40.420 --> 40:44.260
But what this table shows,
is the break down between

40:44.260 --> 40:50.340
amortization and interest. So,
it shows the principal for

40:50.340 --> 40:51.320
each month.

40:51.320 --> 40:55.440
So, at the beginning you
borrow $1,000 on this

40:55.440 --> 41:03.640
mortgage, and you're paying
$10.61 per month.

41:03.640 --> 41:06.090
So, each month your
balance goes down.

41:06.090 --> 41:09.080
In this balance column,
they subtract --

41:09.080 --> 41:11.970
well, the question is, how
do you figure it out?

41:11.970 --> 41:15.370
You're paying $10.61 per month,
but part of that is

41:15.370 --> 41:17.580
interest. What part of
that is interest?

41:17.580 --> 41:24.760
Well it's 5% divided
by 12 of the $1,000

41:24.760 --> 41:26.140
balance at the beginning.

41:26.140 --> 41:32.390
Your initial interest is $4.17,
so your principle is

41:32.390 --> 41:37.320
the $10.61 minus the interest.
So then, that

41:37.320 --> 41:39.190
reduces your balance.

41:39.190 --> 41:43.820
So, the initial interest is
$4.17, the principal is $6.44,

41:43.820 --> 41:49.960
then the balance is $993.56
after one month.

41:49.960 --> 41:53.150
The next month, they figure what
fraction of your payment

41:53.150 --> 41:58.160
is interest by multiplying 5%
over 12 times the balance,

41:58.160 --> 42:07.960
$993.56, and then that comes out
to be $4.14 interest. You

42:07.960 --> 42:10.310
see the interest is going to be
going down, because you're

42:10.310 --> 42:11.630
paying off the loan.

42:11.630 --> 42:15.720
But your payment is fixed, so
the payment against principal

42:15.720 --> 42:16.810
is going up.

42:16.810 --> 42:21.630
So, the first month was $4.17
interest, the next month is

42:21.630 --> 42:23.880
$4.14 interest.

42:23.880 --> 42:29.350
Offsetting that is in the first
month, the $6.44 being

42:29.350 --> 42:30.890
used to pay off your mortgage.

42:30.890 --> 42:35.940
The second month it's
more, $6.47.

42:35.940 --> 42:40.730
I couldn't show the whole page
here, but here after six years

42:40.730 --> 42:45.900
six months your interest is down
to $1.74, because your

42:45.900 --> 42:50.190
balance is down to $407.61.

42:50.190 --> 42:53.790
And so, your payment of
principal is much higher.

42:53.790 --> 42:57.220
The reason this table is
important is that people move

42:57.220 --> 42:58.930
and they sell their
house early.

42:58.930 --> 43:01.190
They don't hold it for
the full 10 years.

43:01.190 --> 43:04.560
So, you have to figure out when
someone sells his house

43:04.560 --> 43:08.220
after six years six months,
what do they still owe?

43:08.220 --> 43:14.400
Well, they now owe, instead of
$1,000, they owe $407.61.

43:14.400 --> 43:17.080
So, that's the idea of
a long-term mortgage.

43:17.080 --> 43:20.100
Your interest payments are
changing all the time, your

43:20.100 --> 43:22.520
principal payments are changing
all the time, but

43:22.520 --> 43:25.440
your total payment is fixed.

43:25.440 --> 43:34.290
That was an invention, a
financial innovation in 1934.

43:34.290 --> 43:37.690
This is called a conventional
fixed rate mortgage, and it's

43:37.690 --> 43:41.010
now offered in many countries
of the world.

43:41.010 --> 43:46.490
However, there's only two
countries where it's the major

43:46.490 --> 43:47.960
kind of mortgage.

43:47.960 --> 43:50.370
United States and Denmark.

43:50.370 --> 43:53.980
This is a strange thing.

43:53.980 --> 43:58.550
This invention has not caught
on around the world.

43:58.550 --> 44:01.890
It's unique to only two
countries, although you can

44:01.890 --> 44:04.970
get it in other countries.

44:04.970 --> 44:07.800
It's not available in Canada
in any number, I guess you

44:07.800 --> 44:14.550
could find it, but it's
not common elsewhere.

44:14.550 --> 44:17.160
Every time I go to a foreign
country, I ask the people

44:17.160 --> 44:22.530
there, why don't you have
fixed rate mortgages?

44:26.040 --> 44:27.500
I don't necessarily
get good answers.

44:27.500 --> 44:30.410
I've been trying to understand
why it hasn't caught on.

44:30.410 --> 44:37.380
Then I recently saw that
Alistair Darling, who was

44:37.380 --> 44:38.630
under the Labour government --

44:45.642 --> 44:49.122
[SIDE CONVERSATION]

44:49.120 --> 44:50.790
PROFESSOR ROBERT SHILLER:
Alistair Darling was

44:50.790 --> 44:54.950
Chancellor of the Exchequer in
the United Kingdom until the

44:54.950 --> 44:57.310
Conservative government
took over.

44:57.310 --> 45:02.260
He issued a statement saying
that U.K. should finally adopt

45:02.255 --> 45:03.505
the long-term mortgage.

45:08.690 --> 45:13.020
The problem is that any country,
that doesn't have a

45:13.020 --> 45:16.620
long-term fixed rate mortgage,
runs the risk of falling into

45:16.620 --> 45:19.210
the same problem that the United
States did in the Great

45:19.210 --> 45:20.230
Depression.

45:20.230 --> 45:22.760
Some kind of crisis like that
could mean that people would

45:22.760 --> 45:25.940
lose their homes in
great numbers.

45:25.940 --> 45:30.730
So, he said he'd like to see the
U.K. get people borrowing

45:30.730 --> 45:35.150
at 10, 20, or even 25 years
for their mortgages.

45:35.150 --> 45:37.430
But instead what happened
was, the Conservative

45:37.430 --> 45:39.440
government took over.

45:39.440 --> 45:42.920
But you can, in the U.K.,
get long-term mortgages.

45:42.920 --> 45:45.900
I think it's true in most
countries of the world.

45:45.900 --> 45:47.940
They're just not common there.

45:47.940 --> 45:49.480
It's a bit of a puzzle.

45:49.480 --> 45:53.660
Why is it that only two
countries do this generally?

45:53.660 --> 45:58.320
I have a couple of reasons
to offer why it is.

45:58.320 --> 46:02.360
One of them is that the general
public is resistant to

46:02.360 --> 46:05.640
long-term mortgages, because
they charge a higher interest.

46:05.640 --> 46:13.580
If the lender is going to
guarantee it for 30 years,

46:13.580 --> 46:15.320
they're going to have to charge
you a higher rate,

46:15.320 --> 46:18.180
because that guarantee costs
something to them.

46:18.180 --> 46:24.500
And consumers are resistant
to paying the higher rate.

46:24.500 --> 46:26.140
And that's part of
the problem.

46:26.140 --> 46:28.890
The other part of the problem is
that bank regulators might

46:28.890 --> 46:32.920
not encourage banks to make
these loans, because it's

46:32.920 --> 46:34.550
risky for banks.

46:34.550 --> 46:38.590
If banks tie their money up for
30 years, and then they

46:38.590 --> 46:40.690
have depositors who can withdraw
their money at

46:40.690 --> 46:44.310
anytime, the banks could go
under, if there was ever a run

46:44.310 --> 46:44.780
on the banks.

46:44.780 --> 46:48.500
They can't liquidate these
mortgages fast at all.

46:48.500 --> 46:51.250
So, you need a coordinated
effort of a government to

46:51.250 --> 46:57.720
first make sure the regulators
accept these concepts.

46:57.720 --> 47:01.270
And it puts some risk on the
public of the possible bailout

47:01.270 --> 47:02.520
of the banking system.

47:08.540 --> 47:11.120
And then, you have to get
past public resistance.

47:11.120 --> 47:14.070
You have to make the public
understand that, when you get

47:14.070 --> 47:17.390
a fixed rate mortgage, it's
a clean contract.

47:17.390 --> 47:21.080
We have no worries
for 30 years.

47:21.080 --> 47:24.780
As opposed to problems that
have sometimes occurred.

47:24.780 --> 47:33.730
In Canada, in 1980, the interest
rates shot way up,

47:33.730 --> 47:37.630
and we had a duplicate of the
problem that we saw in the

47:37.630 --> 47:41.530
U.S. People couldn't afford to
refinance their mortgages, and

47:41.530 --> 47:44.570
a lot of people lost
their homes.

47:44.570 --> 47:47.910
And so, it was a big problem.

47:47.910 --> 47:51.020
But they somehow got through
that, and they're not really

47:51.020 --> 47:53.290
thinking about fixed
rate mortgages in

47:53.290 --> 47:55.270
Canada even now, today.

48:00.825 --> 48:05.945
I wanted to go on talking about
innovation in finance.

48:05.950 --> 48:11.190
Another very important
innovation is securitization

48:11.190 --> 48:18.410
of mortgages, and government
support of mortgage markets.

48:18.410 --> 48:25.770
In the United States, in 1938,
the federal government, this

48:25.765 --> 48:30.735
is also the Roosevelt
Administration, set up the

48:30.740 --> 48:43.760
Federal National Mortgage
Administration, which was a

48:43.760 --> 48:49.000
government agency that would buy
mortgages to support the

48:49.000 --> 48:51.480
mortgage market.

48:51.480 --> 48:57.120
On Wall Street they couldn't
pronounce Federal National

48:57.120 --> 48:58.570
Mortgage --

48:58.570 --> 49:00.010
or is it Association?

49:00.010 --> 49:06.580
I'm sorry, it's Association
not Administration.

49:10.730 --> 49:12.480
You know what they called
it on Wall Sreet?

49:16.140 --> 49:17.410
They called it Fannie Mae.

49:22.490 --> 49:26.900
That was just an irreverent
short name for the

49:26.900 --> 49:28.280
Association.

49:28.280 --> 49:29.530
It was run by the government.

49:33.220 --> 49:40.790
However, in the year 1968, the
U.S. government privatized

49:40.790 --> 49:46.270
Fannie Mae, and it became
a private corporation.

49:49.270 --> 49:50.830
So what did Fannie Mae do?

49:50.830 --> 49:53.490
It would buy mortgages
from banks.

49:53.490 --> 49:55.890
They were trying to encourage
the mortgage market.

49:55.890 --> 49:59.720
So, a bank would lend money to
someone to buy a house, and

49:59.720 --> 50:00.380
then they're done.

50:00.380 --> 50:01.820
They can't loan any
more money unless

50:01.820 --> 50:03.440
they raise more deposits.

50:03.440 --> 50:07.260
Well, Fannie Mae would buy the
mortgage from them, and they'd

50:07.260 --> 50:08.890
have money again
to lend again.

50:12.600 --> 50:14.900
They did this in '38, because
we were still in the

50:14.900 --> 50:19.340
Depression, and the housing
market was still depressed.

50:19.340 --> 50:20.450
They weren't building homes.

50:20.450 --> 50:22.690
There were lots of unemployed
construction workers.

50:22.690 --> 50:25.750
And so, Roosevelt was just
thinking how can we stimulate

50:25.750 --> 50:26.970
the economy?

50:26.970 --> 50:29.900
And this was one
of their ideas.

50:29.900 --> 50:34.990
So, Fannie Mae was the mortgage
finance giant that

50:34.990 --> 50:36.900
was created in 1968 [correction:
created in 1938,

50:36.895 --> 50:39.955
privatized in 1968].

50:39.960 --> 50:46.160
[SIDE CONVERSATION]

50:46.160 --> 50:51.800
PROFESSOR ROBERT SHILLER: In
1970, the government created

50:51.800 --> 50:54.130
another Fannie-Mae-like
institution.

50:57.350 --> 51:01.240
Its official name was Federal
Home Loan Mortgage

51:01.240 --> 51:03.580
Corporation.

51:03.576 --> 51:06.886
Wall Street had to invent
a name for it.

51:06.890 --> 51:12.760
So, they called it
Freddie Mac.

51:12.760 --> 51:15.180
They thought, well, we gave a
girl's name to Fannie Mae,

51:15.180 --> 51:16.410
let's give a boy's name.

51:16.410 --> 51:19.610
I guess that's a boy's name.

51:19.610 --> 51:25.150
Both of these organizations
are private companies now,

51:25.150 --> 51:30.100
created by the government, and
they both use these names

51:30.100 --> 51:30.930
officially now.

51:30.930 --> 51:32.560
So, that's their name now.

51:32.560 --> 51:34.850
Fannie Mae and Freddie Mac.

51:34.850 --> 51:37.120
Freddie Mac was initially
different.

51:37.120 --> 51:40.590
Because what the government
asked Freddie Mac to do, was

51:40.590 --> 51:45.590
buy mortgages, and then
repackage them as mortgage

51:45.590 --> 51:50.510
securities, and sell them off
with a Freddie Mac guarantee.

51:53.040 --> 51:55.720
So, once Freddie Mac started
doing this, Fannie Mae said,

51:55.720 --> 51:58.080
well, can't we do that too?

51:58.080 --> 51:59.910
So, they both do it.

51:59.910 --> 52:03.540
So, what the government had
done is create two private

52:03.540 --> 52:04.870
corporations.

52:04.870 --> 52:10.320
You kind of wonder why did the
government even do that?

52:10.320 --> 52:11.310
Anyone can create --

52:11.310 --> 52:12.850
Remember we have a
corporate law.

52:12.850 --> 52:15.020
I can start my own
Freddie Mac.

52:15.020 --> 52:16.610
My own Fannie Mae.

52:16.610 --> 52:19.870
But the government did create
them by privatizing Fannie Mae

52:19.870 --> 52:23.880
and by creating Freddie Mac.

52:23.880 --> 52:25.870
And they are both
in the mortgage

52:25.870 --> 52:28.210
securitization business.

52:28.210 --> 52:31.170
So, they would buy from mortgage
originators --

52:31.165 --> 52:32.875
the people who lend the money.

52:32.880 --> 52:34.800
They'd buy the mortgages.

52:34.800 --> 52:37.280
In other words, they would take
the IOU from someone.

52:37.280 --> 52:42.040
They'd repackage them into
securities, and sell them off

52:42.040 --> 52:47.810
to the public with a guarantee
from Fannie or Freddie, that,

52:47.810 --> 52:52.140
if there were a default, the
mortgage extra balance would

52:52.140 --> 52:56.170
be made up by Fannie
or Freddie.

52:56.170 --> 53:00.860
Well, they did then get other
companies, called mortgage

53:00.860 --> 53:04.540
insurers, to insure at least
part of the balance.

53:04.540 --> 53:06.560
It's a complicated financial
agreement.

53:06.560 --> 53:09.890
But what we had was private
companies created by the U.S.

53:09.890 --> 53:13.700
government, that created
securities for investors that

53:13.700 --> 53:15.970
were guaranteed against
default,

53:15.970 --> 53:20.250
and based on mortgages.

53:23.370 --> 53:30.530
So, the government then also
stated that these are private

53:30.530 --> 53:33.770
companies and the U.S.
government does not stand

53:33.770 --> 53:35.030
behind them.

53:35.030 --> 53:37.700
People started to say the
government created these two

53:37.700 --> 53:42.350
corporations, and now they're
securitizing and guaranteeing

53:42.350 --> 53:45.860
trillions of dollars
of mortgages.

53:45.860 --> 53:47.870
Is this going to come back
and end up being

53:47.870 --> 53:51.220
paid for by the taxpayer?

53:51.220 --> 53:55.050
So, the government stated
clearly, these are now private

53:55.050 --> 53:55.710
corporations.

53:55.710 --> 53:57.250
Fannie Mae started out
as part of the

53:57.250 --> 53:59.250
government, but no longer.

53:59.250 --> 54:01.100
Now, it's a private
corporation.

54:01.100 --> 54:04.270
And if Fannie Mae goes bankrupt,
woe be tied to

54:04.265 --> 54:07.035
anyone who bought their
securities, because their

54:07.040 --> 54:10.670
guarantee is not backed up by
the federal government.

54:10.670 --> 54:13.200
So people complained, though.

54:13.200 --> 54:17.320
They said, you're saying that
it's not backed up by the

54:17.320 --> 54:20.600
federal government, but do
you really mean that?

54:20.600 --> 54:23.700
If Fannie or Freddie goes
bankrupt, will the U.S.

54:23.700 --> 54:26.940
government just let
them go under?

54:26.940 --> 54:29.430
Well, the official statement
was, yes, the government will

54:29.430 --> 54:31.010
let them go under.

54:31.010 --> 54:34.140
Guess what happened?

54:34.140 --> 54:38.810
In 2008, the real estate market
crashed and we had our

54:38.810 --> 54:42.410
first housing crisis that
was similar to the Great

54:42.410 --> 54:43.670
Depression.

54:43.670 --> 54:47.820
And in that housing crisis,
both Fannie and

54:47.820 --> 54:50.700
Freddie went bankrupt.

54:50.700 --> 54:52.330
And now, what do we do?

54:52.330 --> 54:53.890
We're in the Bush
Administration.

54:53.890 --> 54:54.800
Republican.

54:54.800 --> 54:58.090
They don't particularly
like bailouts.

54:58.090 --> 55:01.880
So you think, of course, George
W. Bush would just --

55:01.880 --> 55:03.100
it's the law, right?

55:03.100 --> 55:06.050
The federal government's not
going to bail them out.

55:06.050 --> 55:10.160
But then some people said, wait
a minute, you know all

55:10.160 --> 55:12.980
over the world people are
investing in these, thinking

55:12.980 --> 55:16.530
that Fannie Mae was created
by the U.S. government.

55:16.530 --> 55:19.370
In particular a lot of Chinese,
those poor innocent

55:19.370 --> 55:23.790
Chinese, are trusting the
Americans, and they put many

55:23.790 --> 55:26.870
billions of dollars
into Fannie Mae.

55:26.870 --> 55:29.120
Are you going to go and
tell the Chinese?

55:29.120 --> 55:32.010
Sorry, we won't back it.

55:32.010 --> 55:34.920
Well, someone can say, sure,
go tell them that.

55:34.920 --> 55:37.270
It's what we've been
saying all along.

55:37.270 --> 55:40.140
But then the Chinese could
come back and say, well,

55:40.140 --> 55:42.050
you've been saying that, but
nobody believed you.

55:42.050 --> 55:44.230
Everyone knew that that
wasn't right.

55:44.230 --> 55:47.970
And the federal government
didn't take all the right

55:47.970 --> 55:50.020
steps to make it really clear.

55:50.020 --> 55:54.420
For example, the Wall Street
Journal used to list Fannie

55:54.420 --> 55:57.710
Mae bonds and Freddie Mac bonds
in a section of the

55:57.710 --> 56:02.740
newspaper entitled ''Government
Securities.'' And

56:02.740 --> 56:03.940
that's the Wall Street
Journal.

56:03.940 --> 56:05.680
That's not the government
talking.

56:05.680 --> 56:09.080
But, the U.S. government should
have come in and told

56:09.080 --> 56:11.200
them, no, those are
not government.

56:11.200 --> 56:14.710
So, we poor, innocent, Chinese
investors, we've read your

56:14.710 --> 56:18.110
paper and it said Government
Securities.

56:18.110 --> 56:21.060
Now George Bush could've
said, tough luck.

56:21.060 --> 56:25.820
You guys should have read the
fine print, but he didn't.

56:25.820 --> 56:26.420
Why not?

56:26.420 --> 56:29.020
Because it jeopardizes
too much.

56:29.020 --> 56:32.170
If the U.S. government lets
these agencies that it created

56:32.170 --> 56:35.810
go bankrupt, and it lets all
those people all over the

56:35.810 --> 56:38.620
world down who invested
in those securities.

56:38.620 --> 56:39.870
They're going to be mad.

56:42.150 --> 56:43.790
We have a reputation.

56:43.786 --> 56:47.696
The United States is able to
raise so much money from all

56:47.700 --> 56:51.880
over the world, because they
think that it's safe here, and

56:51.880 --> 56:55.500
if we just let these fail it's
not going to look right.

56:55.500 --> 56:57.840
So, the U.S. government
took them both under

56:57.840 --> 57:01.890
conservatorship, and is
paying their debts, so

57:01.890 --> 57:03.620
those do not default.

57:03.620 --> 57:07.560
What we've learned from this
lesson is that you can say a

57:07.560 --> 57:10.730
million times that you're not
going to guarantee something,

57:10.730 --> 57:14.150
but eventually you end
up guaranteeing it.

57:17.930 --> 57:19.380
I wanted to say something
about other

57:19.380 --> 57:20.890
countries a little bit.

57:20.890 --> 57:26.580
Canada has something like Fannie
Mae and Freddie Mac

57:26.580 --> 57:29.520
called the Canada Housing and
Mortgage Corporation.

57:32.260 --> 57:37.420
And so, I'll just talk about
other countries.

57:37.420 --> 57:45.060
The Canada Housing and
Mortgage Corporation.

57:57.390 --> 57:59.360
It was created by the government
of Canada, and it

57:59.360 --> 58:02.780
does work that resembles
the FHA and that

58:02.780 --> 58:05.530
resembles Fannie Mae.

58:05.530 --> 58:07.280
But it's owned by the
Canadian government.

58:07.280 --> 58:10.060
It's not privatized.

58:10.060 --> 58:14.410
And so, you might say, well,
it's the same in Canada.

58:14.410 --> 58:17.420
But the big difference
is, it's smaller.

58:17.420 --> 58:19.960
They didn't let it get as big
as Fannie and Freddie.

58:19.960 --> 58:24.480
So, it isn't heard
as much from.

58:24.480 --> 58:29.330
I was a keynote speaker at a
conference on February 3

58:29.325 --> 58:30.355
[addition: 2011],

58:30.360 --> 58:33.760
that the Financial Times
organized in New York called

58:33.760 --> 58:36.030
Focus on Canada.

58:36.030 --> 58:40.230
And I had to give a talk about
Canada to New York investors.

58:40.230 --> 58:43.250
They told me there were hardly
any Canadians in the audience.

58:43.250 --> 58:46.240
What are we doing here in New
York talking about Canada?

58:46.240 --> 58:47.670
Well, it's because
the Americans

58:47.670 --> 58:49.600
invest heavily in Canada.

58:49.600 --> 58:53.280
So, I was up talking to all
these American people, and I

58:53.280 --> 58:56.700
was looking at Canada, and the
Canada banking system.

58:56.700 --> 59:02.690
And I said to the group, Canada
and America are just so

59:02.690 --> 59:04.540
similar I can't see much
of a difference.

59:08.470 --> 59:10.900
Canada didn't have Fannie
and Freddie.

59:10.900 --> 59:13.920
It didn't have these housing
problems. But the worldwide

59:13.920 --> 59:16.990
recession hit Canada
pretty hard.

59:16.990 --> 59:20.290
And so I said, Canada and
U.S. are kind of like

59:20.290 --> 59:23.550
two peas in a pod.

59:23.550 --> 59:25.410
They are so similar.

59:25.410 --> 59:28.160
People like to make much of
differences, but the Canadian

59:28.160 --> 59:31.950
economy just moves up and
down in lockstep.

59:31.950 --> 59:36.200
And I also said, Canada was
saved by the oil crisis, being

59:36.200 --> 59:38.500
an oil exporter.

59:38.500 --> 59:42.210
In 2008, remember when the
oil prices shot up?

59:42.210 --> 59:45.150
But little to my knowledge,
there was a reporter for the

59:45.145 --> 59:47.725
Financial Post in Canada
in the audience.

59:47.730 --> 59:55.070
And my talk got reported in the
Financial Post. And then I

59:55.070 --> 59:57.100
went on their website
and there was

59:57.100 --> 59:59.960
angry blogs from Canadians.

59:59.960 --> 1:00:02.300
I don't think it's so insulting
to Canada to say

1:00:02.300 --> 1:00:03.600
that we're just basically
similar.

1:00:10.930 --> 1:00:14.920
And I have say this for Canada,
they did not get so

1:00:14.920 --> 1:00:18.520
gung-ho on supporting mortgages
as the United States

1:00:18.520 --> 1:00:22.030
did, so they didn't have such
a big housing bubble

1:00:22.030 --> 1:00:24.400
that the U.S. did.

1:00:24.400 --> 1:00:27.110
Part of the reason the U.S. had
a housing bubble as big as

1:00:27.110 --> 1:00:31.750
it did is that these guys really
weren't independent.

1:00:31.750 --> 1:00:33.530
They were taking orders
from the government.

1:00:33.530 --> 1:00:36.920
The government was telling them
to increase their lending

1:00:36.920 --> 1:00:41.250
to low-income, underserved
communities.

1:00:41.250 --> 1:00:42.730
They were promoting
the bubble.

1:00:42.730 --> 1:00:46.900
And so, Fannie and Freddie were
told to promote lending

1:00:46.900 --> 1:00:49.940
to houses during the real estate
bubble that preceded

1:00:49.940 --> 1:00:51.250
the crisis.

1:00:51.250 --> 1:00:54.230
That didn't happen, at least
not so much, in Canada.

1:00:54.230 --> 1:00:57.380
So, they've had less
of a bubble.

1:00:57.380 --> 1:01:02.140
But still the two countries are
basically very similar.

1:01:05.960 --> 1:01:09.140
The textbook talks a lot about
mortgage securities.

1:01:14.030 --> 1:01:17.560
I expect you to read this
out of Fabozzi et al.

1:01:17.560 --> 1:01:21.900
I actually got complaints
in past years.

1:01:21.900 --> 1:01:25.470
Students found this the least
enjoyable part of the readings

1:01:25.470 --> 1:01:27.200
for this course.

1:01:27.195 --> 1:01:30.785
But you should know about
these things.

1:01:30.790 --> 1:01:34.530
We have securities called
Collateralized Mortgage

1:01:34.530 --> 1:01:36.740
Obligations.

1:01:36.740 --> 1:01:42.270
These are mortgage
securities that

1:01:42.270 --> 1:01:44.850
are sold off to investors.

1:01:44.850 --> 1:01:50.300
And they hold mortgages, but, as
is explained in Fabozzi et

1:01:50.302 --> 1:01:55.722
al., they will divide them into
separate tranches, or

1:01:55.720 --> 1:02:02.020
separate securities, in terms
of prepayment risk.

1:02:02.020 --> 1:02:04.530
That is that there's a risk
that the mortgages will be

1:02:04.530 --> 1:02:07.810
paid off early in times
when it's adverse to

1:02:07.810 --> 1:02:09.510
the investor interests.

1:02:09.510 --> 1:02:13.210
So, they would divide up the
risks into different classes

1:02:13.210 --> 1:02:14.370
of securities.

1:02:14.370 --> 1:02:18.340
And some of them were rated AAA
by the rating agencies,

1:02:18.340 --> 1:02:20.510
because they thought there was
almost no risk to those

1:02:20.510 --> 1:02:22.440
securities.

1:02:22.440 --> 1:02:25.830
And others were rated
differently.

1:02:25.830 --> 1:02:33.770
And these CMOs were sold to
investors all over the world.

1:02:33.770 --> 1:02:36.810
Another kind of security,
which the textbook talks

1:02:36.810 --> 1:02:41.910
about, is a CDO, which is
a Collateralized Debt

1:02:41.910 --> 1:02:43.110
Obligation.

1:02:43.110 --> 1:02:47.000
These are issued to investors,
and they typically hold

1:02:47.000 --> 1:02:50.360
mortgage securities
as their assets.

1:02:50.360 --> 1:02:53.800
Many of them held subprime
mortgages in recent years,

1:02:53.800 --> 1:02:57.750
mortgages that were issued
against subprime borrowers.

1:03:01.850 --> 1:03:05.290
A lot of these securities that
were rated very highly by the

1:03:05.290 --> 1:03:10.960
rating agencies, rated AAA,
ended up defaulting and losing

1:03:10.960 --> 1:03:12.780
money for their investors.

1:03:12.780 --> 1:03:14.980
And the investors were
all over the world.

1:03:14.975 --> 1:03:19.535
The United States is a leader
in mortgage finance.

1:03:19.540 --> 1:03:26.260
And companies in the United
States, not just Fannie and

1:03:26.260 --> 1:03:28.760
Freddie, but lots of companies
were issuing mortgage

1:03:28.760 --> 1:03:33.840
securities that had AAA ratings,
which meant that

1:03:33.840 --> 1:03:36.240
Moody's and Standard and Poor's
and the other rating

1:03:36.240 --> 1:03:38.350
agencies were telling
you basically

1:03:38.350 --> 1:03:40.320
there's no risk to them.

1:03:40.320 --> 1:03:45.000
And so, people in Europe, in
Asia, were investing in these,

1:03:45.000 --> 1:03:47.750
and they thought they were
perfectly safe, and then they

1:03:47.750 --> 1:03:49.000
went under.

1:03:51.790 --> 1:03:54.120
Part of it was bad
faith dealings

1:03:54.120 --> 1:03:55.470
by some of the issuers.

1:03:55.470 --> 1:03:59.900
Some of the issuers themselves
doubted that these mortgages

1:03:59.900 --> 1:04:01.800
were so safe.

1:04:01.800 --> 1:04:04.090
But what do I care?

1:04:04.090 --> 1:04:06.320
This is what happened.

1:04:06.320 --> 1:04:11.490
It's gotten to be a complicated
set of steps.

1:04:11.490 --> 1:04:13.730
Somebody originates
the mortgage.

1:04:13.730 --> 1:04:15.680
That means I talk to
the homeowner.

1:04:15.680 --> 1:04:18.110
I have the homeowner fill
out the papers.

1:04:18.110 --> 1:04:21.810
Then, after they've originated
the mortgage, they sell it to

1:04:21.810 --> 1:04:26.090
an investor, like Fannie or
Freddie or some private

1:04:26.090 --> 1:04:29.220
mortgage securitizer.

1:04:29.220 --> 1:04:32.460
And the private mortgage
securitizer finds a mortgage

1:04:32.460 --> 1:04:35.890
servicer, it may be the
originator, who will then

1:04:35.890 --> 1:04:37.250
service the mortgage.

1:04:37.250 --> 1:04:39.530
What does it mean to service
the mortgage?

1:04:39.530 --> 1:04:41.640
It means to call you on the
phone if you've missed your

1:04:41.640 --> 1:04:43.360
payment, for example.

1:04:43.360 --> 1:04:45.720
Or if you have questions about
the mortgage, there should be

1:04:45.720 --> 1:04:47.110
someone you call.

1:04:47.110 --> 1:04:49.120
So, the mortgage servicer
does that.

1:04:49.120 --> 1:04:50.670
That's a separate entity.

1:04:50.670 --> 1:04:55.430
And then we have the CMO
originator, then we have the

1:04:55.430 --> 1:04:57.150
CDO originator.

1:04:57.150 --> 1:05:00.190
It's gotten to be a very
complicated financial system.

1:05:00.190 --> 1:05:03.320
And then the whole
thing collapsed.

1:05:03.320 --> 1:05:07.950
So, there's been a lot of reform
to try to see, what can

1:05:07.950 --> 1:05:10.510
we do to prevent this
kind of collapse?

1:05:10.510 --> 1:05:12.840
Some people would say, let's
end the whole thing.

1:05:12.840 --> 1:05:14.610
Let's go back to 1778.

1:05:14.610 --> 1:05:17.400
Let's not have mortgage
securitizers.

1:05:17.400 --> 1:05:21.150
But that's not the steps
that have been taken.

1:05:21.150 --> 1:05:24.230
I think that we are
making progress.

1:05:24.230 --> 1:05:27.920
But I want to just conclude with
just a little reference

1:05:27.920 --> 1:05:32.850
to one important change that
was made in both Europe and

1:05:32.850 --> 1:05:35.460
the United States.

1:05:35.460 --> 1:05:44.930
The European Parliament passed a
new directive that requires,

1:05:44.930 --> 1:05:52.040
or incentivizes, mortgage
originators to keep 5% of the

1:05:52.040 --> 1:05:54.750
mortgage balance in their
own portfolio.

1:05:54.750 --> 1:06:01.060
That means, if you originate
mortgages, you can sell off

1:06:01.060 --> 1:06:04.390
95% of the mortgages to
investors, but you

1:06:04.390 --> 1:06:06.990
have to keep 5%.

1:06:06.990 --> 1:06:11.400
So, this 5% limit was then later
incorporated into the

1:06:11.400 --> 1:06:14.830
Dodd-Frank Act in the
United States.

1:06:14.830 --> 1:06:17.980
So, we again have the
same requirement.

1:06:17.980 --> 1:06:23.350
And this is supposed to reduce
the moral hazard problem that

1:06:23.350 --> 1:06:26.760
created the crisis, and
retain the mortgage

1:06:26.760 --> 1:06:29.680
securitization process.

1:06:29.680 --> 1:06:34.320
So, the idea is this --

1:06:34.320 --> 1:06:36.330
And I know, I heard
people tell me.

1:06:36.330 --> 1:06:39.290
Mortgage originators sometimes
got cynical.

1:06:39.290 --> 1:06:41.260
They thought, OK,
I'm helping this

1:06:41.260 --> 1:06:43.690
family fill out a mortgage.

1:06:43.690 --> 1:06:45.790
What do I care?

1:06:45.790 --> 1:06:48.010
This family doesn't look
like they're not

1:06:48.010 --> 1:06:49.260
going to pay this back.

1:06:52.056 --> 1:06:53.346
But what do I care?

1:06:53.350 --> 1:06:54.460
I'll fill it out.

1:06:54.460 --> 1:06:55.970
I'll sell the mortgage
to someone else,

1:06:55.970 --> 1:06:58.260
and I'm out of here.

1:06:58.260 --> 1:07:00.170
In fact, it got bad in
some cases, with

1:07:00.166 --> 1:07:02.056
some mortgage brokers.

1:07:02.055 --> 1:07:06.395
A family would come wanting to
buy a house, and the mortgage

1:07:06.400 --> 1:07:10.940
broker would say, what is
your income anyway?

1:07:10.940 --> 1:07:13.240
And they would tell
him the income.

1:07:13.240 --> 1:07:16.140
And he'd say, you're trying
to buy a $300,000

1:07:16.140 --> 1:07:17.920
house on that income?

1:07:17.920 --> 1:07:20.390
I don't know if I can do this.

1:07:20.390 --> 1:07:22.410
But then he'd say.

1:07:22.410 --> 1:07:22.970
Wait a minute.

1:07:22.970 --> 1:07:23.790
Think about this again.

1:07:23.790 --> 1:07:25.900
Is that really your income?

1:07:25.900 --> 1:07:28.960
You told me your income
is $40,000 a year.

1:07:28.960 --> 1:07:30.960
Are you sure?

1:07:30.960 --> 1:07:33.270
Why don't we say $50,000
thousand a year.

1:07:33.270 --> 1:07:35.110
Or say $60,000 a year.

1:07:35.109 --> 1:07:39.069
And the couple would look at him
in disbelief and say, no,

1:07:39.069 --> 1:07:40.949
we only have $40,000.

1:07:40.950 --> 1:07:42.360
He would say, well,
think about it.

1:07:42.359 --> 1:07:46.339
You have other sources,
don't you?

1:07:46.340 --> 1:07:48.490
Everybody does this, you know.

1:07:48.490 --> 1:07:50.650
So, OK, we have $60,000.

1:07:50.649 --> 1:07:51.899
He says fine.

1:07:54.180 --> 1:07:56.300
And they thought, well, the
mortgage broker gave me

1:07:56.300 --> 1:07:58.670
permission to do this.

1:07:58.670 --> 1:08:00.430
And he doesn't care,
because he's not

1:08:00.430 --> 1:08:02.840
going to take the loss.

1:08:02.840 --> 1:08:05.800
So, the new law is supposed to
discourage that kind of thing.

1:08:05.800 --> 1:08:08.190
And there's lots of new laws
that are trying to tighten up.

1:08:08.189 --> 1:08:10.959
For example, mortgage brokers in
the United States now have

1:08:10.960 --> 1:08:12.090
to be licensed.

1:08:12.090 --> 1:08:15.030
It used to be just five years
ago, you could be an ex-con,

1:08:15.029 --> 1:08:17.939
fresh out of jail, and you could
take up a business as

1:08:17.939 --> 1:08:19.299
mortgage broker.

1:08:19.300 --> 1:08:20.740
You can't anymore.

1:08:20.740 --> 1:08:22.870
So, what's happening all over
the world is that we've

1:08:22.870 --> 1:08:26.400
learned from this experience,
but we're retaining this basic

1:08:26.399 --> 1:08:29.249
system of mortgage
securitization.

1:08:29.250 --> 1:08:31.690
Mortgage lenders that
are professional.

1:08:31.689 --> 1:08:34.429
The basic industry has
been retained.

1:08:34.430 --> 1:08:36.800
And we're hoping and thinking
that maybe we

1:08:36.800 --> 1:08:38.750
have a better system.

1:08:38.750 --> 1:08:43.210
So I will stop there, and
I'll see you on Monday.