Understanding mortgages and financing residential property purchases

Real Estate Funding Chapter

HOW TO FUND REAL ESTATE INVESTMENTS

CHAPTER ____ HOW TO FIND A MORTGAGE FOR RESIDENTIAL PROPERTY

So you want to buy a residential property and you aren't sure how to go about it. Don't worry - you are not alone. People all over the world want to own their own home and this desire has manifested itself in some interesting ways in the historical record. In Anglo-American law, for example, it was possible to claim a certain amount of land for one's family by simply erecting a simple structure that had a door and to have a fire burning in some type of fireplace by dawn just a few hundred years ago. For more than a hundred years, citizens of the United States also enjoyed the ability to claim a section of land by building a house on designated property and living there for a minimum of 5 years. Alaska was the last state to eliminate this opportunity, and people today are generally required to secure a mortgage in order to buy a piece of residential real estate.

This chapter will help you understand the basics of buying a house or commercial property today, including what a mortgage is and where to find them. First of all, we'll discuss buying residential properties. People typically don't pay cash when they buy a residential property. If this was required, it would be unlikely that anyone could afford to buy a house. Instead of paying for the whole thing at once, people make a small down payment (usually 3 to 20% of the sale price) and obtain a loan from a commercial bank or savings and loan (or savings bank) (the mortgagors) to cover the rest. This type of loan is known as a mortgage. Mortgage holders (the mortgagees) make payments on this loan every month for 15 to 30 years.

According to Black's Law Dictionary (1990), a mortgage is "an interest in land created by a written instrument providing security for the performance of a duty or the payment of a debt. At common law, an estate created by a conveyance absolute in the form of, but intended to secure the performance of some act, such as the payment of money, and the like, by the grantor or some other person, and to become void if the act is performed agreeably to the terms prescribed at the time of making such conveyance" (p. 1009). The median price for a home in 2003 was $140,000 according to the U.S. Census Bureau. The old saying in real estate, though, comes into play here: The most important thing about real estate is location, location, location. Certainly, prices vary according to the part of town, and even the state you live in. For example, homes in California cost much more than homes in rural parts of New Mexico or Oklahoma. Furthermore, if the median (middle) price is $140,000, there will clearly be houses available for much less.

HISTORY OF MORTGAGES IN COMMON LAW.

In the Anglo-American law, a mortgage refers to any of a number of related devices in which a debtor (mortgagor) conveys an interest in property to a creditor (mortgagee) as security for the payment of a money debt. The Anglo-American mortgage roughly corresponds to the hypothec in civil-law systems. The modern Anglo-American mortgage is the direct descendant of a form of transaction that emerged in England in the later Middle Ages. The mortgagor (debtor) conveyed the ownership of land to the mortgagee subject to the condition that, if the mortgagor repaid a debt he owed the mortgagee by a certain time, the mortgagee would reconvey the land to the mortgagor. If the mortgagor failed to repay the debt by the time that was specified in the mortgage, the land became the mortgagee's absolutely. This form of transaction was known, under different names, throughout the ancient world and throughout medieval Europe. It is to be distinguished from types of security devices (also known both anciently and today) in which the debtor gives the creditor possession but not ownership of the property (the pledge in civil-law systems and the gage of land in the early English common law) or in which the debtor does not even give the creditor possession of the property but simply a right to satisfy the debt out of the property if the debtor fails to pay (the lien or hypothec).

The common-law mortgage of the late Middle Ages was thus a strong form of security. The history of its development is one of progressive loosening in favour of the mortgagor. Already at the end of the Middle Ages, it had become the practice for the mortgagee to allow the mortgagor to remain in possession of the land, and this practice developed into a right in the mortgagor to remain in possession of the land so long as he was not in default on the debt.

Originally, the terms of mortgages were strictly interpreted by common-law courts; however, by the 16th and 17th centuries, English equity courts began to step in and introduced advocacy for mortgagors. At this time, equity first gave the mortgagor a right to redeem the land by paying the amount that was owing, even after he had defaulted on the debt, so long as he did so within a "reasonable time." In order to clear their title to the land after the mortgagor had defaulted, mortgagees brought actions in equity to foreclose the mortgagor's "equity of redemption." As a condition of granting the foreclosure, equity gave the mortgagor a right to the proceeds of the sale of the land to the extent that the sale realized more than the outstanding amount of the debt. In most Anglo-American jurisdictions, legislation in the 19th century extended the mortgagor's right to redeem to a fixed period after the mortgagee had foreclosed. Finally, in many Anglo-American jurisdictions, legislation required that the mortgagee sell the land at public sale after he had foreclosed, and in some of these jurisdictions the sale had to be conducted by a public official.

In the early modern period, security devices similar to mortgages of land were used with personal property, particularly by merchants, and in the 19th century use of this so-called "chattel mortgage" was common throughout the Anglo-American world. The development of the law of chattel mortgages has followed a course different from that of mortgages of land, but in most jurisdictions the end result today is similar. The creditor's rights normally do not come into play unless and until the debtor defaults. Because the chattel mortgage was typically a device used by merchants, rather than ordinary citizens, there were, until quite recently, fewer protections for the debtor in such transactions (typically, for example, there was no statutory right to redeem). Recently, however, the extensive use of chattel mortgage and similar security devices in consumer credit transactions has led to an extensive body of regulatory law protecting the consumer's interest.

Today, the mortgage is still the most widely used form of security device in transactions that involve land in these Anglo-American jurisdictions; however, there are alternative devices, such as the deed of trust (whereby a trustee holds title to the property and conveys it to the debtor if he pays the debt or sells the property and divides the proceeds if the debtor defaults) or the long-term land contract (whereby the seller of the land retains title to the land until the purchaser has paid off the amount owed), which are used in some jurisdictions, but they are increasingly subject to regulations that make them operate more like traditional mortgages.

The mortgage serves as a means of promoting the best use of society's finite resources: people and land. In this regard, mortgages provide a method that manages the transferability of land and for the improvement or working of that land by those unable to buy the property with their current resources. For example, an elderly farmer wanting to retire can sell the farm to a younger farmer; the latter can then mortgage the property in order to pay the seller full value and obtain sufficient monies to carry out personal plans for the farm. (mortgage, 2006)

Mortgages play an even more important role in maintaining the market in residential housing, since they permit individuals with relatively little personal credit to purchase a house by offering the house itself as security for the loan. In the United States, the federal government has supported this type of transaction by developing a secondary market in mortgages. Banks that have placed residential mortgages can sell them in the secondary market in order to raise capital to make further loans. The operations of the secondary market have tended to make the law and practice of the various U.S. states more uniform, since the secondary market operates more efficiently if it is dealing with a standardized product. (mortgage, 2006).

TRADITIONAL MORTGAGE FUNDING.

In response to the growing call for home ownership by average citizens, Congress created two government-sponsored enterprises (GSEs): (a) the Federal National Mortgage Association (Fannie Mae) and (b) the Federal Home Loan Mortgage Corporation (Freddie Mac), with the goal of providing banks, thrifts and other mortgage originators with a liquid secondary market that would provide an alternative to funding mortgages with deposits. A secondary mortgage market permits mortgage originators to be more responsive to dynamic mortgage demand and to lower mortgage rates for some homeowners when mortgage demand is higher. According to Koppell (2001):

Government-sponsored enterprises (GSEs) are hybrids -- part public, part private -- that affect the lives of most Americans. Anyone who has borrowed money to purchase a home, farm, or pay for college, or invested in a mutual fund has likely been touched by government-sponsored enterprises. Fannie Mae and Freddie Mac are public in several respects. Created by Congress to serve public purposes, they are exempt from state and local taxes, exempt from registration requirements of the Securities and Exchange Commission, and have a $2.25 billion line of credit with the United States Treasury. They are not, however, subject to regulations that govern the activities of federal agencies. Their staffs are not considered government employees. (p. 468)

When Congress created the GSE charters, they provided the GSEs with a variety of special benefits. Initially, many viewed these benefits as a way to enhance the GSEs' efforts in establishing a secondary mortgage market; however, with the secondary mortgage market well established and with many other well-functioning purely private secondary markets, the justification for the GSEs' benefits has shifted to the GSEs' success in lowering mortgage rates and in encouraging affordable housing (Geisst, 1990). Likewise, Koppell (2001) points out that Fannie Mae and Freddie Mac, known formally as the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, respectively, are stockholder-owned, profit-seeking corporations that were originally created by Congress to help address America's housing needs; GSEs are one type of mixed organization that combines characteristics of public- and private-sector entities.

While these funding avenues are increasingly popular at the local, state, and national levels of government, hybrids such as GSEs have received less attention. The GSEs benefit from the government-sponsored status because purchasers of their debt assume that the government will not allow the GSEs to fail, even though the government has made no explicit promise to bail out the GSEs should problems arise. This ambiguous government relationship creates an implicit government subsidy to the GSEs that is worth billions of dollars (Burgess, Passmore & Sherlund, 2005).

Congress created the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), with the goal of providing banks, thrifts and other mortgage originators with a liquid secondary market that would provide an alternative to funding mortgages with deposits. A secondary mortgage market allows mortgage originators to respond more quickly to fluctuating mortgage demand and to lower mortgage rates for some homeowners when mortgage demand is high.

When Congress created the GSE charters, they provided the GSEs with a variety of special benefits. Initially, many viewed these benefits as a way to enhance the GSEs' efforts in establishing a secondary mortgage market; with the secondary mortgage market well established and with many other well-functioning purely private secondary markets, though, the justification for the GSEs' benefits has shifted to the GSEs' success in lowering mortgage rates and in encouraging affordable housing.

The GSEs benefit from the government-sponsored status because purchasers of their debt assume that the government will not allow the GSEs to fail, even though the government has made no explicit promise to bail out the GSEs should problems arise. This ambiguous government relationship creates an implicit government subsidy to the GSEs that is worth billions of dollars (Burgess, Passmore & Sherlund, 2005).

In his chapter, "Financing the Castle: The Mortgage Agencies," Geisst (1990) reports that, "Quality, single-family housing has become the most tangible element of the American dream, symbolizing freedom and space to grow. Spurred by the crowded conditions of nineteenth-century Europe, new immigrants placed housing high on their list of priorities and considered it the epitome of what their adopted country had to offer. Over the years, many individuals have continued to place the individual castle at the top of their list of material needs. Perhaps no other single material goal has come to symbolize the American dream so succinctly. As a result, housing has become one of the United States' most vital industries and statistics related to it are closely watched signs indicating the health of the economy" (p. 83).

The story of housing is more complicated than simply building upon a dream and a hope, though. There are some important factors involved that should be taken into account by anyone wanting to locate funding for a residential mortgage today. For example, the availability of credit, the term structure of interest rates, the ability of mortgage-granting institutions to cope with economic conditions, and the individual's ability to service his or her mortgage debt all must be factored into the general discussion so that the peculiarly American method of funding mortgages since the mid-1930s can be properly understood (Geisst, 1990).

In addition, beyond these standard factors that affect mortgage markets anywhere in the United States, the mortgage industry in America also enjoys a unique level of assistance from the federal government. This assistance is offered through the vehicle known as the "agency" function, whereby a government-created agency intervenes in the marketplace in order to provide liquidity to the lenders of mortgage money. While this function may appear simple, it is in fact a complicated process that has come to be repeated many times in twentieth-century U.S. financial history. The soundness of the concept also proved itself internationally beginning in the 1950s, when it became the model for many international development agencies. The concept of agency financing is American for all intents and purposes although it was quickly recognized that the same function that provided liquidity for the mortgage market could also be redefined to help provide funds for Third and Fourth World development.

The development of mortgage agencies originally occurred, and has remained, at the wholesale level of mortgage funding. The agencies that have been created since the mid-1930s have operated between mortgage grantor, or "originator" in financial parlance, and the capital markets. On the retail, or individual, level mortgage borrowing has remained a private transaction between the individual and the banking institution. How and why banking institutions involve the agencies in the mortgage process involves both the fulfillment of a commitment as well as a response to monetary conditions, which sometimes can prove pernicious to the market as a whole (Geisst, 1990).

Despite the growing presence of agencies through the middle part of this century, housing finance has remained in the private sector. Individuals have sought mortgages from the traditional sources of funds: commercial banks and especially savings and loan associations or savings banks. Thrift institutions have been integrally involved in mortgage lending since the nineteenth century and have in recent years suffered most because of their limited nature as depository/lending institutions dedicated almost solely to redirecting savers' funds into the housing market. Their plight over the years helped prompt the banking legislation of the early 1980s designed to help them cope with the interest rate effects of restrictive monetary policies and the subsequent damage caused to the expansion of the housing market as a whole (Geisst, 1990).

In the nineteenth century, depository institutions that were dedicated to granting mortgage loans only were called building associations. The first was established in Philadelphia in 1831 and was called the Oxford Provident Building Association. The nomenclature used was English in origin, and U.S. building associations were modeled after the English building societies developed about 50 years earlier. The English institutions and their U.S. counterparts were organized as mutual societies; that is, the institutions were owned by depositors. They were not capitalized by the sale of stock and thus there were no public shareholders as such. The current capital structure of U.S. savings and loan associations still reflects this original model. In the mid1980s, about 80% of all S & Ls were still operating as mutual societies (Geisst, 1990).

The ownership of thrifts is not as important as are the organizational problems they pose for the housing market as a whole. Being mutual means that thrifts were, and still for the most part are, local institutions whose influence does not extend beyond the geographical area in which they operate. On the negative side, this means that mortgage lending is primarily local in nature, subject to a lack of standardization in lending rates. On the positive side, it suggests that credit analysis of potential homebuyers should be left to indigenous institutions that know the local market best. (Geisst, 1990, p. 84).

During the period that ultimately resulted in the stock market crash of 1929 and the major depression that followed, thrift institutions and banks became the primary sources of mortgage money. Loans made were booked as assets by the lending institution and remained on the books until final payment was made. But out of the financial turmoil of the 1930s rose myriad new financial institutions designed to provide a safety net against future unforeseen events. Essentially, these new institutions would leave the traditional mechanism of mortgage granting in place while providing another layer of previously unexplored governmental assistance in an attempt to ensure an orderly, growing market. (Geisst, 1990).

FEDERAL HOUSING ADMINISTRATION.

When the Federal Housing Administration (FHA) was first created under Title I of the National Housing Act, it was the first venture by the federal government into the area of consumer financing. Along with the Electric Home and Farm Authority, the FHA was an attempt by the federal government to stimulate the flagging economy by assisting the consumer. Originally, the FHA provided insurance to banks or other depository institutions for home modernization loans made to homeowners. By the term "home modernization" was meant loans made to install indoor plumbing or lavatories. The purpose of this program was as much geared to upgrading health as it was to improving housing standards and providing economic stimuli. If the borrower subsequently defaulted under this program, the agency would reimburse the lender for a certain percentage of the loan's value. Given the depository institutions' new emphasis on retail lending, this assistance slowly began to introduce banks to retail lending on an even greater scale, as would another small agency created by similar legislation. (Geisst, 1990).

According to its organizational Web site at http://www.hud.gov/offices/hsg/fhahistory.cfm, the Federal Housing Administration, generally known as "FHA," provides mortgage insurance on loans made by FHA-approved lenders throughout the United States and its territories. FHA insures mortgages on single family and multifamily homes including manufactured homes and hospitals; the organization is the largest insurer of mortgages in the world, insuring nearly 33 million properties since its inception in 1934. FHA mortgage insurance provides lenders with protection against losses as the result of homeowners defaulting on their mortgage loans. The lenders bear less risk because FHA will pay a claim to the lender in the event of a homeowner's default. Loans must meet certain requirements established by FHA to qualify for insurance.

In contrast to conventional loans that adhere to strict underwriting guidelines, FHA-insured loans require very little cash investment to close a loan. There is more flexibility in calculating household income and payment ratios. The cost of the mortgage insurance is passed along to the homeowner and typically is included in the monthly payment. In most cases, the insurance cost to the homeowner will drop off after five years or when the remaining balance on the loan is 78% of the value of the property -whichever is longer.

FHA is the only government agency that operates entirely from its self-generated income and costs the taxpayers nothing. The proceeds from the mortgage insurance paid by the homeowners are captured in an account that is used to operate the program entirely. FHA provides a huge economic stimulation to the country in the form of home and community development, which trickles down to local communities in the form of jobs, building suppliers, tax bases, schools, and other forms of revenue.

Congress created the Federal Housing Administration (FHA) in 1934. The FHA became a part of the Department of Housing and Urban Development's (HUD) Office of Housing in 1965. When the FHA was created, the housing industry was flat on its back:

Two million construction workers had lost their jobs.

Terms were difficult to meet for homebuyers seeking mortgages.

Mortgage loan terms were limited to 50% of the property's market value, with a repayment schedule spread over three to five years and ending with a balloon payment.

America was primarily a nation of renters. Only four in 10 households owned homes.

During the 1940s, FHA programs helped finance military housing and homes for returning veterans and their families after the war. In the 1950s, 1960s and 1970s, the FHA helped to spark the production of millions of units of privately-owned apartments for elderly, handicapped and lower income Americans. When soaring inflation and energy costs threatened the survival of thousands of private apartment buildings in the 1970s, FHA's emergency financing kept cash-strapped properties afloat. The FHA moved in to steady falling home prices and made it possible for potential homebuyers to get the financing they needed when recession prompted private mortgage insurers to pull out of oil producing states in the 1980s. By 2001, the nation's homeownership rate had soared to an all time high of 68.1% as of the third quarter that year. To date, FHA reports that it, together with HUD, have insured almost 33 million home mortgages and 47,205 multifamily project mortgages since 1934. FHA currently has 4.8 million insured single family mortgages and 13, 000 insured multifamily projects in its portfolio. "In the more than 60 years since the FHA was created, much has changed and Americans are now arguably the best housed people in the world. HUD has helped greatly with that success" (The FHA, 2006, p. 3).

While the FHA especially would become better known for providing mortgage insurance, the early agency functions nevertheless proved to be harbingers of financial practices yet to come. In 1936, the chief executive officer of the FHA remarked that the principal achievement of the agency seemed to be "the big thing," that is, familiarizing commercial bankers with small consumer loans amortized on a monthly basis. Until the Depression era, consumer loans were provided mainly by private finance companies, and not commercial banks per se. Now with government assistance they had gotten a taste of small retail business and as Administrator George McDonald of the FHA put it, I think the local banks which went into this business will never get out of it... And they will be enough to furnish competition to the finance companies." (Geisst, 1990, p. 81).

The next development in the early history of the housing agencies came in 1934, when Congress passed the National Housing Act specifically to provide federally guaranteed mortgage insurance. Administration of the provisions of the legislation was placed in the hands of the FHA. Rather than create a new administrative body, the FHA was designated because the legislation was actually opposed by the thrift industry. The building associations opposed it because they felt that the insurance provided would also apply to mortgages originated by commercial banks and insurance companies, allowing them to further encroach on traditional thrift industry profits (Geisst, 1990). The act, though, also included provisions that the thrifts did support and this helped secure the passage of the legislation. To this end, the Federal Savings and Loan Insurance Corporation (FSLIC) was created to provide insurance for savers' deposits at S & Ls for $5,000 per account. The FSLIC set a premium to be paid by the participating institutions. By becoming members of the insurance corporation, thrifts were able to extend their credibility to the public and profit in a marketing sense as well. This was especially important to the industry as a whole because the Banking Act of 1933 had made deposit insurance available to commercial banking customers as of July 1, 1934.

From its inception in 1934 to year end 1944, the FHA made insured or direct mortgage loans of slightly over $7 billion. 7 In 1944, and again in 1948, new developments were occurring in the mortgage market that further shaped the market and brought it closer to its present form. While the 1930s certainly witnessed the origin of federal assistance in the mortgage market in the form of providing guarantees to mortgage originators, it was the 1940s that ushered in the idea of making a market in federally underwritten mortgages.

Prior to the 1940s, the newly developed agencies had made considerable headway in providing assistance to the housing market. In addition to the mortgages insured or guaranteed, their influence was also felt in the interest rates for new mortgages granted by lending institutions. Prior to the establishment of agencies, the rates attached to new mortgages depended on the lending institution. As a result, different rates were being charged in different parts of the country. For instance, the average contract rate charged on a first mortgage for an owner-occupied residential property granted by an S & L. In Worcester, Massachusetts, in January 1934 was 5.65%. In Austin, Texas, the rate was 7.45%, while in San Diego, it was 7.19%. The same sort of differentials could be found in mortgages granted by commercial banks and savings banks as well; the rate, though, was the same (5%) for all geographical areas on mortgages granted by the Home Owners Loan Corporation. This arrangement caused one commentator to remark in 1937 that "a leveling tendency among interest rates charged in different parts of the country appears to be in prospect, partly as a result of the extension of the activities of Federal agencies which have uniform rates for all their loans" (Geisst, 1990).

As a result of the founding of the Home Loan Bank Board and the specific agencies themselves, the process of interest rate standardization of home mortgages became embedded in the U.S. housing market. This was true, however, only of those lending institutions that availed themselves of agency support. But in commercial terms many lending institutions would have to follow suit in order to maintain their lending policies in face of this competition. 10 Ten years earlier, the Farm Credit System had undergone a similar rationalization of interest rates. Agency intermediation had begun to have an effect in both the consumer and housing loan markets. (Geisst, 1990).

VETERANS' ASSISTANCE AND FANNIE MAE

The government's only attempt to provide mortgage assistance to a special group within society occurred with the establishment of the Servicemen's Readjustment Act of 1944. This legislation originally allowed veterans to purchase homes at prewar prices upon their return but was soon afterward expanded so that servicemen could obtain mortgages at lower interest rates than nonveterans. The agency entrusted with this function was the Veterans Administration (VA) established in 1930 (now the Department of Veterans Affairs, but still the "VA"), which combined all federal agencies that up until that time provided services for former servicemen. The VA Web site for its Home Loan Guaranty Services at http://www.homeloans.va.gov/mission.htm states: "The VA Loan Guaranty Service is the organization within the Veterans Benefits Administration, charged with the responsibility of administering the home loan program" (p. 1).

The VA also reports the following military service requirements being required for eligibility for these services:

Wartime - Service During: WWII 9/16/1940 to 7/25/1947

Korean 6/27/1950 to 1/31/1955

Vietnam 8/5/1964 to 5/7/1975

Veterans must have at least 90 days on active duty and been discharged under other than dishonorable conditions. If a veteran served less than 90 days, he or she may be eligible if discharged for a service connected disability.

Peacetime - Service during periods: 7/26/1947 to 6/26/1950

2/1/1955 to 8/4/1964

5/8/1975 to 9/7/1980 (enlisted)

5/8/1975 to 10/16/1981 (officer)

Veterans must have served at least 181 days of continuous active duty and been discharged under other than dishonorable conditions. If a veteran served less than 181 days, he or she may be eligible if discharged for a service connected disability.

Service after 9/7/1980 (enlisted) or 10/16/1981 (officer)

If a veteran was separated from service which began after these dates, he or she must have:

Completed 24 months of continuous active duty or the full period (at least 181 days) for which you were ordered or called to active duty and been discharged under conditions other than dishonorable, or Completed at least 181 days of active duty and been discharged under the specific authority of 10 USC 1173 (Hardship), or 10 USC 1171 (Early Out), or have been determined to have a compensable service-connected disability;

Been discharged with less than 181 days of service for a service-connected disability. Individuals may also be eligible if they were released from active duty due to an involuntary reduction in force, certain medical conditions, or, in some instances for the convenience of the Government.

Gulf War - Service during period 8/2/1990 to date yet to be determined

If a veteran served on active duty during the Gulf War, he or she must have:

Completed 24 months of continuous active duty or the full period (at least 90 days) for which you were called or ordered to active duty, and been discharged under conditions other than dishonorable, or Completed at least 90 days of active duty and been discharged under the specific authority of 10 USC 1173 (Hardship), or 10 USC 1173 (Early Out), or have been determined to have a compensable service-connected disability, or Been discharged with less than 90 days of service for a service-connected disability. Individuals may also be eligible if they were released from active duty due to an involuntary reduction in force, certain medical conditions, or, in some instances, for the convenience of the Government.

Active Duty Service Personnel

If an individual is currently on regular duty (not active duty for training), he or she will become eligible after having served 181 days (90 days during the Gulf War) unless discharged or separated from a previous qualifying period of active duty service.

THE DEVELOPMENT OF MORTGAGE-BACKED SECURITIES

The pressure that developed over the years to spin Fannie Mae off to the private sector reached its peak in 1968 with the founding of the Government National Mortgage Association, better known as Ginnie Mae. The purpose of this agency was to assume the special assistance and liquidation functions that, up until that date, had been carried out by Fannie Mae. In addition, Ginnie Mae also guaranteed mortgages originally insured or guaranteed by the government through other agencies. since the original agencies became operative 30 years before. The Housing Act of 1968, unlike its legislative predecessors, had a quantitative objective; it called for the construction or rehabilitation of 26 million new housing units within a ten-year period. The "decent home" goal of 1949 had been given specific form. As Lyndon Johnson was to note later in his memoirs, "We had high hopes for the new law but the experts had warned us... without the proper mixture [of responsible fiscal and monetary policies] the realization of a goal of 26 million housing units was doubtful." (Geisst, 1990).

Based on the legislation authorizing Fannie Mae, the trends then concentrated its efforts on its secondary market functions while Ginnie Mae continued to purchase mortgages backed by FHA or the VA. Additionally, Ginnie Mae was able to provide assistance to low- and middle-income housing by acting in concert with Fannie Mae. While the procedure used in this respect was somewhat convoluted, it does highlight the federal government's commitment to provide housing to potential homebuyers at all income levels (Geisst, 1990).

The tandem program provided direct government assistance in the purchase of mortgages to provide housing for lower-income families. Ginnie Mae would issue a commitment to purchase the mortgages at par, or face value. Fannie Mae would then make the actual purchase at the market rate for the mortgages. These rates usually were below par, given that the interest rates attached to them were lower than those attached to traditional commercial mortgages. When the time arrived for the actual financing to be carried out, Fannie Mae would retain the mortgages if their market prices had risen to par. If they had not, Ginnie Mae would purchase them at par from Fannie Mae, thereby providing assistance using government money. The cost to the federal government would be the difference between the two prices.

Since Fannie Mae was no longer operating within governmental budget restraints, it now had freer rein to expand its activities in the market. Within two years of operating under this new system it had expanded its mortgage portfolio twofold, from about $6.5 billion in 1968 to slightly over $14 billion in 1970. But for the most part, the assistance provided was confined to FHA and VA mortgages. The specially assisted mortgages continued to form the bulk of its asset portfolio. Despite the fact that Fannie Mae had been privatized, it still had to keep its activities within the confines of its original legislative objectives.

Ginnie Mae also acquired an important market function that would be expanded several years later. The Housing Act authorized it to guarantee interest and principal repayments as securities issued by private mortgage institutions that were backed by pools of FHA or VA mortgages. This was the origin of what became known as the mortgage-backed security. A large market developed around these securities within the decade as the demand grew for fixed-income securities in general, especially for those with specific asset backing (Geisst, 1990).

According to their organizational Web site at www.ginniemae.gov/,"At Ginnie Mae, we help make affordable housing a reality for millions of low- and moderate-income households across America by channeling global capital into the nation's housing markets. Specifically, the Ginnie Mae guaranty allows mortgage lenders to obtain a better price for their mortgage loans in the secondary market. The lenders can then use the proceeds to make new mortgage loans available" (About Ginnie Mae, 2006, p. 3).

Ginnie Mae does not buy or sell loans or issue mortgage-backed securities (MBS). Therefore, Ginnie Mae's balance sheet doesn't use derivatives to hedge or carry long-term debt. What Ginnie Mae does is guarantee investors the timely payment of principal and interest on MBS backed by federally insured or guaranteed loans -- " mainly loans insured by the Federal Housing Administration (FHA) or guaranteed by the Department of Veterans Affairs (VA). Other guarantors or issuers of loans eligible as collateral for Ginnie Mae MBS include the Department of Agriculture's Rural Housing Service (RHS) and the Department of Housing and Urban Development's Office of Public and Indian Housing (PIH). (About Ginnie Mae, 2006, p. 3).

Ginnie Mae securities are the only MBS to carry the full faith and credit guaranty of the United States government, which means that even in difficult times an investment in Ginnie Mae MBS is one of the safest an investor can make. (About Ginnie Mae, 2006, p. 1).

WHAT ARE MORTGAGE-BASED SECURITIES?

Mortgage-backed securities (MBS) are pools of mortgages used as collateral for the issuance of securities in the secondary market. MBS are commonly referred to as "pass-through" certificates because the principal and interest of the underlying loans is "passed through" to investors. The interest rate of the security is lower than the interest rate of the underlying loan to allow for payment of servicing and guaranty fees. Ginnie Mae MBS are fully modified pass-through securities guaranteed by the full faith and credit of the United States government. Regardless of whether the mortgage payment is made, investors in Ginnie Mae MBS will receive full and timely payment of principal as well as interest. (About Ginnie Mae, 2006, p. 1).

Ginnie Mae MBS are created when eligible mortgage loans (those insured or guaranteed by FHA, the VA, RHS or PIH) are pooled by approved issuers and securitized. Ginnie Mae MBS investors receive a pro rata share of the resulting cash flows (again, net of servicing and guaranty fees). Ginnie Mae I MBS requires all mortgages in a pool to be the same type (e.g. single-family). Each mortgage must be, and must remain, insured or guaranteed by FHA, VA, RHS or PIH. In addition, the mortgage interest rates must all be the same and the mortgages must be issued by the same issuer. The minimum pool size is $1 million; payments on Ginnie Mae I MBS have a stated 14-day delay (payment is made on the 15th day of each month). (About Ginnie Mae, 2006, p. 2).

Ginnie Mae II MBS allows multiple-issuer pools to be assembled, which in turn allows for larger and more geographically dispersed pools as well as the securitization of smaller portfolios. A wider range of coupons is permitted in a Ginnie Mae II MBS pool, and issuers are permitted to take greater servicing fees -- " ranging from 25 to 75 basis points. The minimum pool size is $250,000 for multi-lender pools and $1 million for single-lender pools. Ginnie Mae II MBS have an additional five-day payment delay because issuer payments are consolidated by a central paying agent (payment is made on the 20th day of each month). (About Ginnie Mae, 2006, p. 2).

Real Estate Mortgage Investment Conduits (REMICs) direct principal and interest payments from underlying mortgage-backed securities to classes with different principal balances, interest rates, average lives, prepayment characteristics and final maturities. Unlike traditional pass-throughs, the principal and interest payments in REMICs are not passed through to investors pro-rata; instead, they are divided into varying payment streams to create classes with different expected maturities, different levels of seniority or subordination or other differing characteristics. The assets underlying REMIC securities can be either other MBS or whole mortgage loans. (About Ginnie Mae, 2006, p. 3).

REMICs allow issuers to create securities with short, intermediate and long-term maturities -- " flexibility that allows issuers to expand the MBS market to fit the needs of a variety of investors. Ginnie Mae Platinum Securities provide investors with greater operating efficiency, allowing holders of multiple MBS to combine them into a single platinum certificate. Ginnie Mae Platinum Securities can be used in structured finance transactions, repurchased transactions as well as general trading. (About Ginnie Mae, 2006, p. 3).

How much will my monthly payments be?

Monthly payments for a typical home in the United States will probably be 0.75% to 1.15% of the purchase price. On a $150,000 home that's $1,125 to $1,725/mo. This includes taxes and insurance. Generally speaking, though:

The bigger your down payment, the lower the monthly payments.

The lower the interest rate, the lower the monthly payments.

The longer the loan, the lower your monthly payments. But it's better to get a shorter loan so you pay it off quicker and save on interest, if you can afford the higher payments.

You can make a home more affordable by buying a duplex and renting out the other side, or renting out a room in a single-family house, at least until you can afford not to. You might not be able to afford $1,500/mo. For a $150,000 house. But if you get a $200,000 duplex with payments of $2,000 a month and rent one side out for $800/mo., your burden is only $1,200/mo. Plus you'll get big tax deductions by having rental property. To afford a house you'll need the up-front money as well as money for the monthly payments

CHAPTER SUMMARY: OBTAINING A MORTGAGE

You generally need four things to qualify for a mortgage:

Money to make the down payment.

Income that's 2 to 3 times higher than your mortgage payment. (more on figuring mortgage payments in a minute)

Two years of solid employment history (same job or field).

Decent (not perfect) credit.

There are sometimes ways around this if you lack one or two of those, but usually not if you lack three or four.

All the costs involved in buying a home

150,000 avg.

3-20% Cash down

80-97% Mortgage

1-8% of sale price

Paid in cash at closing, or rolled into mortgage

For app. fee, credit report, inspection, appraisal.

Paid in cash

Closing costs are fees charged by the companies and government offices which process the loan and the sale of the property. They're generally 1 to 8% of the sale price. You might be able to have the closing costs added to the mortgage so you don't have to pay them up front. http://michaelbluejay.com/house/basics.html

STEP-BY-STEP GUIDE.

Owning your own home doesn't have to be a dream anymore. Today, with an array of programs available for first-time buyers and a wealth of information online, becoming a homeowner is no longer reserved for the wealthy, but for those who are armed with the right information. So, if you're ready to make the long-awaited dream a reality, follow these 10 easy steps to your home sweet home:

PULL YOUR CREDIT REPORT AND CORRECT ANY ERRORS. By law, under the Fair Credit Report Act, you have the right, free of charge, to dispute any entry on your credit report. Because your credit score and corresponding credit grade will play a significant role in your options when it comes to shopping for interest rates and mortgage programs, it is essential that you review your report. You can request a copy of your credit from TransUnion, Equifax or Experian by mail or online, or you may order a copy of your "merged" report, which lists data from all three credit bureaus, at creditreport.com.

TAKE A FIRST-TIME HOME BUYERS CLASS. Accessing information on home ownership is easier than ever before. A good place to start is FannieMae.com, which offers useful tips on applying, qualifying, and purchasing for first-timers and re-financers. Your local bank may offer seminars or classes where agents, brokers, attorneys and loan officers are onsite to answer any questions. Learn about loan types, sizes, interest rates, low-income programs and down payment assistance.

DECIDE HOW MUCH YOU CAN AFFORD. According to Jesse Brown, author of Investing in the Dream, the first step in determining how much house you can afford is to look at how much you have as a down payment. "Generally, a bank or mortgage lender will not give you a loan if the monthly costs of your proposed mortgage amount [payment plus property tax and homeowners insurance] and other monthly debt payments add up to more than 28% of your gross monthly income," he says. The lower your debt-income ratio, the more house you can afford.

DECIDE WHERE YOU'D LIKE TO LIVE. The location of your home, including school districts, business districts, economic growth areas and proximity to state and local highways will contribute to your home's property value. A good rule of thumb when evaluating the value of a prospective home is to consider what would make your future home attractive to purchasers when you are ready to sell.

FIND A REAL ESTATE AGENT. When you are deciding on a new location or neighborhood to buy a new home, a Realtor can help you determine the pros and cons based on your family's needs and preferences. "This is the biggest purchase of your lifetime, and you've got to make sure that you're working with someone you can trust," says Javier Perez, loan officer for Washington Mutual in Chicago. "This is a client-driven market, so I advise prospective homeowners to interview several Realtors, loan officers and attorneys to determine the best fit."

GET PRE-QUALIFIED. The process of pre-qualification is an essential step. "Realtors require a commitment letter that lets them know you've been pre-approved for a specified loan amount based on your current credit and income," says Craig Hodges, mortgage loan officer and real estate broker at Vision Mortgage in Belvidere, Ill. "If your credit is good, the pre-qualification may last for up to 120 days, but if it's lower than average, it may have to be renewed every 30 days."

INSPECT YOUR HOME AND NEIGHBORHOOD. During your first walk-through of a home, be sure to check out the condition of the roof, the plumbing, walls, floors, carpet, furnace and any interior or exterior damage. Drive through the area during different times of the day to observe traffic patterns and neighborhood routines. In addition to speaking with the sellers, talk to others who live in the neighborhood about their experiences in that location.

MAKE AN OFFER. When you have found the home of your dreams, you are ready to make an offer through a purchase agreement that includes your offer, prospective closing date, down payment, any seller assistance monies and other applicable terms. If you include an earnest money deposit in your purchase contract, be sure that the offer allows you to get your money back if a professional inspection reveals problems with the house or if you are unable to get approved for a mortgage.

APPLY FOR A MORTGAGE. Your broker can help select the mortgage that's right for you, including interest rates (fixed or adjustable), length of loan (15, 20 or 30 years), size of loan, type of loan (conventional, FHA, VA) and other fees. Once you've applied, your loan will be submitted for processing, underwriting, all inspections ordered and a closing date set.

CLOSING. At the end of the process, the buyer and seller sign all legal documentation and effectively transfer ownership. The buyer pays remaining costs and down payment while the lawyers, Realtor, closer, agent and loan officers finalize the transaction. Once all paperwork is completed, you will receive the keys.

As a new homeowner, housing experts suggest that you maintain a good payment history in case you want to refinance in the future. "The process doesn't end at closing," says Perez. "It's an ongoing benefit to your family and your future. It's an asset that will continue to grow for years to come." (10 Steps to Home Ownership, 2004, p. 39).

Here's a summary of what you've learned -- to buy a house you make a down payment in cash, get a bank loan for the rest, and pay the closing costs in cash. Remember that you might be able to have the closing costs added to your loan instead of paying them in cash. Remember also that the amount of money you have to put down varies depending on the type of loan you get and what the bank requires, and the closing costs vary too.

FUNDING FOR COMMERCIAL REAL ESTATE.

A number of studies to date have emphasized the growing sophistication of commercial property market financing and funding (Ball, Lizieri & Macgregor, 1998). Indirect property vehicles are paper assets which are backed in some way by commercial property. The investment returns on these assets, or the risks associated with those returns, are linked to the underlying real property market. Indirect property investments encompass equity vehicles, debt vehicles, hybrid debt-equity vehicles and derivatives. The relationship between indirect and direct market behavior varies according to the type of vehicle. Indirect property vehicles reduce many of the disadvantages of direct ownership: large lot size; illiquidity; high transaction and management costs; and lack of public information; these vehicles also have their own disadvantages as well though (Ball et al., 1998). These constraints typically include generally higher levels of volatility and closer correlations with other asset markets, reducing the degree of risk diversification.

In the UK, property company shares are the best known indirect investment. Property companies may be property investment companies or trader-developers. These two forms are valued differently: the former in relation to the net asset value of the property owned, the latter in terms of earnings growth. Property company shares possess greater liquidity but are subject to greater volatility than direct holdings of property. By contrast, the United States has witnessed the rapid expansion of so-called Real Estate Investment Trusts, or REITs. These are (generally) publicly traded collective forms of property investment which offer tax advantages to investors. Collective investment vehicles in the UK, such as Property Unit Trusts, are yet to offer similar tax benefits and are valuation-based with no secondary market (Ball et al., 1998). According to Ratcliffe, Shepherd and Stubbs (2003), the category of trusts and bonds can be included in the same category as real estate investment trusts, investment unit trusts, property unit trusts and property bonds. The structure and purposes of these different media for investment is not explained in detail, because from the standpoint of the developer their policies and practices are much the same and largely resemble those of the insurance companies and pension funds; their performance to date, though, has been extremely variable, and their role in the development field is as yet not great (Ratcliffe et al., 2003).

Empirical evidence as to whether indirect property assets are property investments is mixed. Indirect equity vehicles experience higher volatility than the direct market and have higher correlations with stock market prices. More recent research examining long-run relationships or correcting for the smoothing in property indices and the effect of gearing on property company and REIT performance suggest a closer link between indirect and direct markets. Debt vehicles such as mortgages, mortgage debentures, bonds and mortgage-backed securities may not seem to exhibit returns that are related to the underlying property market; the risk associated with those returns (and hence the risk-adjusted returns), though, is inextricably related to property market conditions (Ball et al., 1998).

During periods of adverse market conditions, borrowers are more likely to default on their obligations; when capital values fall sharply, lenders may not be able to recover their capital by selling the property held as security. In addition bank lending has a significant impact on property markets; in fact, the boom-slump conditions of the 1980s and early 1990s illustrate the close relationship between property and financial markets. In turn, property has an impact on banking and financial service performance (Ball et al., 1998).

An old adage suggests that the first rule of the commercial real estate developer is 'never use your own money', quite commonly property development agencies either deploy their own surpluses and reserves to support current projects or seek an expansion of their capital base. Almost by definition, virtually all development undertaken by the major financial institutions, directly or by way of joint venture, can be categorized as internally financed. Likewise, a number of construction firms acting as developers use their own financial resources to fund projects, as do certain leading business and retail organizations. Funding by prospective owner-occupiers in all sectors of the commercial property market is quite popular. For as long as the capital is available, the risk acceptable and the opportunity cost satisfactory, internal finance has the great attraction of ensuring full recoupment of future rental growth (Ratcliffe et al., 2003).

A property development company can extend its capital base by increasing its share capital or its loan capital. In simple terms, the holders of the share capital (equity) own the company itself, and the holders of loan capital are creditors of the company. Thus, the holders of share capital are not creditors and have no security, and the holders of loan capital have no rights in the company beyond the receipt of interest and the repayment of the loan in accordance with the terms on which they were issued. The amount a company may borrow by way of loan capital is laid down in the articles of association of the company (Ratcliffe et al., 2003).

Generally speaking, there are two principal types of loan capital: debenture and loan stocks. Debentures and debenture stocks are roughly similar to mortgages and are secured either on certain specific assets of the company or as a floating charge over all the company's assets. Secured debts of this kind rank for repayment before unsecured debt in the event of the company being wound up. Unsecured loan stocks, the other form of loan capital, are debts, as their name implies, which are not charged on the company's assets. If the company falls into liquidation, they rank after secured loans along with other general creditors but before the holders of share capital. One kind of unsecured loan stock carries with it the right to convert into share capital on pre-arranged terms and within a limited period: this is known as convertible unsecured loan stock and it comes with a variety of conversion rights. A final form of fixed income company finance is preference shares, which do not form part of the loan capital, and on a winding-up do not rank for repayment until all creditors have been paid in full. Again, there are various types of preference shares, such as 'cumulative', where the right to a dividend can be carried forward from one year to another; 'non-cumulative', where once a dividend is passed for one year the right to receive it is lost; and 'participating' preference shares, where there are rights to share in profits above the fixed dividend (Ratcliffe et al., 2003).

The share capital held as ordinary shares is usually referred to as the equity. Equity in this sense means that which remains after rights of creditors and mortgagees are cleared and, although different forms of share capital exist, most public property companies do not have very complex share capital structures. The risk-bearing nature of equities is reflected in the 'gearing' of a company, in other words, the ratio of loan or fixed income capital to share or equity capital. During periods of growth and profitability, in a highly geared company, where loan capital is proportionately greater than share capital, holders of ordinary shares gain commensurately; not surprisingly, though, during slack periods, the reverse is also true, and profits can easily be wiped out (Ratcliffe et al., 2003).

A careful review of how capital can be raised on the stock market is beyond the scope of this chapter; however, it is important to note that there are two types of new issue by which this can be achieved. First, the bringing to the market of companies that have not previously been quoted. Second, the raising of additional capital by companies already quoted. The former will normally be effected by an 'offer for sale', whereby an institution such as a merchant bank buys a block of shares from the existing shareholders and offers them to the general public at a fixed price; by a 'placing', where an institution may buy the stock or shares and arrange for the placing of the issue with various funds or companies known to be interested; an 'introduction' when a company already has many individual shareholdings and Stock Exchange quotation simply provides a public market for shares that previously could only be dealt in privately; or a 'tender', which is exactly the same as an offer for sale except that the price of the shares is not fixed in advance. One way in which companies already quoted can raise additional internal funds without increasing their debt charge is the issue of further equity capital. This is normally done by way of a 'rights issue', that is, the issue of shares to existing shareholders at a concession (Ratcliffe et al., 2003).

The performance of the stock market in the early years of the twenty-first century has prompted some property companies to 'de-list', i.e. buy back their shares and withdraw from the stock market, because their view is that the value of their property assets is not effectively reflected in the value of the company's shares. As with most financial matters, the question of timing is important, not merely in respect of the general climate for borrowing but also the class of capital to be selected. In times of depressed equity prices, a rights issue is normally to be avoided and, if interest rates are at a reasonable level, a prior charge to increase loan capital is usually preferable. Conversely, when equity prices are high, leading property companies might be best advised to make a rights issue rather than increase their loan capital; however, it must be kept in mind that, while significant amounts of funding can be raised from the market, the costs involved in such initiatives may be considerable, comprising not only the legal and valuation fees but also the costs of underwriting the issue, producing a prospectus, advertising and stockbrokers' charges (Ratcliffe et al., 2003).

It is in the field of internal or corporate finance that most innovation has been shown by property development companies over recent years. The range of devices, instruments and techniques has appeared endless, with many American mainstream corporate financing practices being adapted and adopted in global financial markets. The amount of 'commercial paper' issued by property development companies since the late 1980s has been enormous, largely because of its low cost, high flexibility and simplicity to the borrower, and its competitive yield, liquidity and range of maturities to the lender; the inherent dangers of such promissory activity, though, became readily apparent during a period of worldwide recession during the first half of the 1990s (Ratcliffe et al., 2003).