SHORT INTRODUCTION TO CALIFORNIA REAL ESTATE PRINCIPLES,
© 1994 by Home Study, Inc. dba American Schools
Chapter XIV: Real Estate Macroeconomics
Educational Objectives: REAL ESTATE IN THE NATIONAL ECONOMY, Impact of Government, Fiscal Policy, Equal Credit, Type of Inflations, Cost-push Inflation, Demand-pull Inflation, Monetary Inflation, Real-cost Inflation, THE MONEY MARKET, Factors Which Determine Interest Rates and Availability Of Funds, Interest Rates, PRIVATE LENDERS, Commercial Banks, Insurance Companies, Mortgage Companies, Mutual Savings Banks, Real Estate Investment Trusts (REIT), GOVERNMENT LOAN GUARANTIES, FHA, VA, FNMA, GNMA, FHLMC, FmHA, FHLBB, Mortgage Pools, R. E. TERMS GLOSSARY, INDEX.
Although real estate markets are primarily local in nature, the real estate industry is intricately interwoven into and profoundly affected by the local, regional, and national economies. The survival of a city (or town or region) will depend upon goods and services being produced for export so that residents may purchase goods and services brought into the community. The ability of a farming region to produce farm products generates income with which to buy farm machinery, gasoline, fertilizer, clothing and vacations. In turn the economy of a recreation area is kept alive with the money spent there by vacationers. Other areas may depend on mineral production such as gas, oil, and coal to survive.
The ability of a city or region to produce a commodity or service that can bring in money from outside its area is called its economic base. Industries that produce goods and services for export are called base, export or primary industries. Agriculture is the base industry of this region. Producers of goods and services that are not exported are called service, filler, or secondary industries. Included in this are local school systems, supermarkets, doctors, dentists, drugstores and real estate agents.
The existence of base industries is absolutely essential to maintaining local real estate values. Land cannot be moved to more favorable economic scenes so unless a region or city exports, it will die economically with the simultaneous loss of value of local real estate.
The extent to which regions and cities are vulnerable to changes in economic base depends on how many different kinds of base industries are present and the ability of those industries to consistently export their products. Thus, a city that relies on a single base industry is much more vulnerable than a city with a diversified group of base industries. For example, some cities have depended for decades on nearby air force bases and will suffer if these bases are cut back in size or closed down. The economies of farm communities and the prices of farm land are tied to the rise and fall of farm product prices.
These events often galvanize concerned citizens, property owners and business people into action. Many communities are busy attracting industries to smooth out the ups and downs of the local economy.
Base industry is important to the local economy. It is generally calculated that for each additional person employed in a base industry, two others will be employed in local service industries. If an electronics firm moves into a community and creates a hundred new base industry jobs, opportunities will be created for another two hundred persons in jobs such as retail store clerks, restaurant services, gas station operators, gardeners, bankers, doctors, dentists, lawyers, police, fire fighting, school teaching and local government - to name only a few.
The ultimate effect of new jobs on a local employment and housing demand will depend on what portion of the jobs can be filled from within the community and the extent of vacant housing. If a community is already operating at full employment and has no vacant housing to speak of, the addition of base jobs will result in a demand for land, building materials and labor necessary to provide new housing units. From the standpoint of local government, more people must be supplied with schools, parks, streets, libraries, water, sewage treatment, police and fire protection.
Because it takes time to develop raw land into homes, offices and stores, the supply of developed real estate cannot immediately respond to sudden changes in demand. As a result, price changes for developed real property can be rapid and dramatic over short periods of time.
For example, a new industry moves into the community and increases the demand for houses by 100. Local builders, recognizing the new demand, set to work adding 100 houses to the available housing stock. It will take time, however, to acquire land, file subdivision maps, acquire building permits, grade the land and construct the houses. The entire process may take from one to three years. In the meantime, the available supply of houses remains fixed. The result will be an increase in home prices as the newly arriving employees bid against each other for a place to live in the existing housing stock.
When there is an oversupply of houses on the market, builders will react by stopping building activity until those units are sold and demand starts pushing prices upward again. Over a period of years, the supply pattern for housing will change as temporary shortages and temporary excesses alternate.
Just as a short-run increase in demand can cause a quick run up in prices, a short-run decrease in demand has the opposite effect because supply cannot be decreased as fast as demand falls. Suppose there is an overnight cutback of jobs at the local tire plant and, as a result, a hundred homeowners decide to sell and move out of the community. This would cause demand to shift downward and without a corresponding increase in the economic base of the community, only a reduction in the supply of existing homes through demolition, disasters and conversions to other uses will push prices back up.
Future demand for housing can be seen by looking at the population in terms of age distribution, and the ability of people to obtain income at various age levels. During the first ten years of life a person earns no income and is dependent on others, usually parents, for sustenance. During junior high school, high school and college (if any) a person has part-time jobs but usually is still dependent on others for financial support.
Upon leaving school and entering the labor market on a fulltime basis, a person's income rises quickly, reflecting increased productive capacity in society. As skills increase, income continues to rise rapidly. In another decade the rise stops increasing as rapidly, although it still advances. Then, somewhere between the ages of 40 and 60, depending on a person's skills and the usefulness of those skills in society, health and/or the desire to slow down, the peak earning year occurs. For those with four years of college or the equivalent, this occurs around the age fifty-five. For the nation as a whole, it occurs in the mid-forties. The peak earning year is followed at first by mild decreases in income and then by more decreases as retirement occurs.
With this earning pattern in mind, the progression of housing demand can be seen. When a person is young and setting up a household for the first time, income is low and so are accumulated assets. Thus, housing that requires no equity investment at a minimum cost is needed; that is, an inexpensive rental with no frills. During the next decade income increases and the household can increase the quality of its rental unit. At the same time savings accumulate, which, coupled with the ability to make loan payments, enable the household to meet the down payment and loan requirements for a modest housing purchase. As the family grows and income increases, it can move to larger, more expensive quarters. Typically this occurs between the ages of 35 and 45. Another upward move in house size and price usually occurs between 45 and 55 when the family reaches its maximum income.
As the children move out and income peaks and then begins to recede, the household begins to consider a smaller and less expensive dwelling unit. The need for less expensive housing becomes even more compelling upon retirement and a further reduction in income. Retirement income typically is not sufficient to support the large home bought during the peak earning years. However, the household has an equity that it can now consolidate into a smaller residence that is fully or nearly fully paid for.
The age distribution in America reflects two distinct peaks throughout this century, The smaller of the two represents persons aged 60 to 75 who were born during the decade of the 1920s, a period of economic prosperity in most parts of the nation. Fewer children were born during the economic depression that spanned the 1930s, but a major population explosion occurred following World War II with the postwar "Baby Boom. " A "Baby Bust" appears to have occurred following 1960 as the number of births per year began to decline.
As improving medical care extends life spans, households aged 65 and above are growing in numbers and will probably continue through the remainder of the century. At that time there will be a 10 year pause in growth due to persons born during the 1930s decade reaching the age of 65. As relatively few in the population ova 65 remains in the labor force, me housing demand created by these age groups will primarily be the result of their investments, pensions, social security income, public welfare and assets accumulated earlier in life such as the family home.
Of particular interest now is the huge wave of demand from the 1940-1960 Baby Boom that is working its way through the economy. The repercussions of the Baby Boom are many and varied. They will be the dominant factor in the nation's real estate industry for many years to come. They are now at the age where they have more discretionary income, and the effect can be seen in the nation's culture and marketing. They are climbing the income ladder and have more money to spend on housing. The first part of the wave has reached its prime. With top earnings, each household is requiring a housing unit suitable to it income characteristics.
Baby Boom children have now had children which will create a third wave in the age distribution of the United State population and with it, a new wave of housing demand when those children form households.
Impact of Government
In addition to the need of an economic base to support local land values and the effect on housing demand by population age groups and income levels, a significant influence on real estate is caused by the federal government's tax rules, laws, deficits and monetary policy.
Real estate has long been favored with special income tax treatment. For years, tax laws have allowed homeowners to deduct property taxes and mortgage loan interest when calculating state and federal taxes. Depending upon the homeowners tax bracket, these deductions amounted to a substantial lowering of the effective rate of interest paid on the mortgage.
Owners of improved investment property can deduct all costs of operating and maintaining the property plus depreciation on the improvements. For most investment properties since 1940, depreciation expense has been more of an accounting entry than a market reality. This has been a result of rising real estate prices coupled with tax rules that allowed improvements to be depreciated over accounting lives shorter than their useful lives. Moreover, tax rules have allowed depreciation to be accelerated, i. e. , taken sooner rather than later. Since depreciation is deductible at tax time and not repaid until years later when the property is sold, tax policies regarding depreciation have made real estate an attractive investment.
Although much of the special treatment has been taken away by Congress by making the periods of depreciation longer, the key point to remember here is that tax treatment of the expenses and profits from real estate greatly influence what a person can and will pay for a property. Generous tax treatment creates an upward influence on values and vice versa.
Few home buyers can afford to pay all cash for a place to live; most must borrow. As a result, the housing industry is very sensitive to the price and availability of loan money. Not only does this affect contractors and construction workers, but also appliance and furniture manufacturers, lumber mills, cement factories, real estate appraisers and real estate agents. Anyone connected with the manufacture, sale or resale of housing is directly affected by the price and availability of mortgage loan money to home buyers.
If federal, state or local governments cannot balance their budgets, they too must borrow. When they do, they complete with home buyers and businesses for available savings in the capital markets. Of these, government gets its needs filled first at whatever the interest cost. This is because if a government did not borrow it would not have enough to pay its bills and would be bankrupt.
A far-reaching law passed in 1974 was the federal Equal Credit Opportunity Act (ECOA). This law requires that all the income of a woman must be counted in full regardless of marital status or children. Prior to the ECOA, it was common for lenders to refuse to count a married woman's income if she was pregnant and discount it by 50% if she was not pregnant, but in the prime childbearing years. Coupled with prevailing lower wages from women, the size of loan a couple could get was mainly limited by the husband's income. Additionally, widows, divorcees and singles were considered high risk borrowers, divorcees and singles were considered high-risk borrowers and either did not get credit or did so only in small amounts.
The Equal Credit Opportunity Act created borrowing power that did not exist before Husband-wife families could qualify for larger loans. Mothers and daughter living together, borrowers owning together, single persons, divorced and widowed persons all suddenly found themselves with new and greater borrowing power; and with it, the ability to bid up prices. At the same time, women began to earn more money because of laws requiring equal pay for equal work and laws prohibiting sex discrimination in hiring. Furthermore, more women are going into the large force and many were choosing higher-paying career-oriented jobs.
A very important influence on real estate activity and prices in the United States has been the secondary mortgage market. Prior to the 1970 decade, home loan money came most from savings and loans, mutual savings banks, commercial banks and life insurance companies. This was a relatively limited source of money that they tended to keep a lid on real estate prices. With the advent of the Federal National Mortgage Association, the Government National mortgage association, the Federal Home Loan Mortgage Corporation and other secondary mortgage market operations, previously untapped sources of loan money where not available to real estate borrowers. Individuals and pension funds that had avoided making mortgage loans because of the work involved could not invest with ease and a guarantee of safety.
Additionally, a secondary market provides a place to sell a mortgage that a lender does not want to hold until maturity. Much of the money raised in the secondary market has been used (and will continue to be used) to fund the baby-boom children as they buy housing. However, a lot of that money also helped fuel real estate speculation and inflation in the late 1970s.
In nearly all years since World War II, prices of consumer commodities and real estate have risen. Although inflation is currently not as pressing an issue as it was a few years ago, there are four concepts with which you should be familiar: cost-push inflation, demand-pull inflation, monetary inflation and real-cost inflation.
The increasing cost of inputs necessary to manufacture a product or offer a service results in what is called cost-push inflation. To illustrate, an automobile manufacturer increases the price of cars because labor and materials cost more. Similarly, a builder of new homes will include any increases in the prices of lumber, bricks, concrete, metal, construction labor, construction loans and government permits.
When buyers bid against each other to buy something that has been offered for sale, demand-pull inflation results. For example, three buyers for a choice lot may bid $75,000, $76. 000 and $77,000, respectfully. Demand-pull inflation is basically the result of too much money chasing too few goods. This type of inflation usually has little to do with the actual cost of producing the particular goods or services being sought. Instead, it reflects what buyers feel they would have to pay elsewhere for the same thing.
Monetary inflation results from the creation of excessive amounts of money by government. The classic example of this was Germany during the first five years after World War II. In an effort to provide money to solve all the war-torn country's problems at once, the German government created and spent money on a grand scale. However, there was no parallel increase in goods and services to be purchased with that money. The result was demand-pull inflation as millions of people with pockets, and later wheelbarrows, stuffed with newly printed currency fought to buy everything from bread and vegetables to real estate. With the space of a few short years, prices rose on the order of one million percent before the printing presses were finally shut down.
To a lesser degree monetary inflation is used today by many countries. Allowing the money supply to grow faster than the available supply of goods and services causes a temporary economic stimulus by placing more money in people's hands. But the ultimate result is a reduction in the purchasing power of that money.
Real-cost inflation is inflation caused by the increased effort necessary to produce the same quantity of good or service. For example, much easy-to-develop land has already been built upon forcing developers to utilize land that requires more effort to bulldoze into usable lots. Another example is water service to new lots. Local water districts that once could supply the town's population from a few wells or a nearby lake or river must now travel many miles to find water. The additional cost of the water system and pumping charges must be added to the user's water bill.
The knowledge of financing methods is of great importance to real estate agents. Except in the unusual case of a cash sale, the knowledge or lack of knowledge of ways in which a sale may be financed will make the difference between a successful or unsuccessful career in real estate.
Money is a commodity that commands a price for its use in the form of interest as does any other good or service. The uniqueness of real estate as an economic commodity is due in large part to the magnitude of the investment required in each real estate transaction. In most instances, the prospective purchaser does not have all the funds required by the sales contract and consequently must obtain funds through some source of credit.
Mortgage terms and interest rates are not uniform; they vary from locale to locale and from day to day. Many complex factors influence the mortgage money market, and all of them have some effect on the rates of interest charged.
The supply of land the demand for money determine the basic mortgage interest rate at lending institutions. General economic conditions and the degree of risk involved, added to the basic rate, determine the actual interest rate that will be charged for a particular mortgage loan. The supply of mortgage funds depends to a large extent on the level of savings in financial institutions, but it is influenced as well by government monetary policies.
Factors Which Determine Interest Rates and Availability Of Funds
Funds for mortgage loans become available either through the deposits on hand in savings and loan associations and banks, through the sale of securities and, in the case of insurance companies, through the accumulation of funds through the sale of insurance.
Mortgage lending institutions are forced to compete with other investment vehicles in order to have funds available for real estate loans. The laws of supply and demand have a great effect on both the availability of funds and the interest rate (price) charged for those funds.
When other investments seem more attractive to investors, there tend to be fewer dollars available for real estate loans. In the cyclical nature of the business world, there come times when investment in real estate mortgages seems more attractive than other investments. During those times, more funds tend to become available for real estate lending.
Money is much like any other commodity which responds to the laws of supply and demand. Interest is the price charged for the use of the money.
There appears to be four things that influence the interest rate which is charged on borrowed money.
1. The Supply of Money: Banks and savings and loan associations (portfolio lenders) typically rely on their deposits for the availability of funds. Frequently, persons who save money in those accounts discover there are other investments which earn greater interest. They withdraw those funds and place them in other investments. This reduces the availability of funds through portfolio mortgage lenders. When this happens, portfolio lenders tend to participate in the secondary mortgage market and become involved in securities. This has had the effect of making a shortage of money a thing of the past.
2. Demand for Money: There are four major demands.
A. Businesses borrow money for inventory and capital needs.
B. Consumers borrow money for financing personal property purchases.
C. Government borrows money to finance its overspending habit.
D. Home buyers borrow money to purchase homes.
3. Monetary Policies of the Federal Reserve Bank: The Federal Reserve Bank has the ability to increase or decrease the supply of money in America.
4. The Fiscal Policies of the U. S. Government: The way the federal government takes care of its tax and spending policies is called fiscal policy. If the government decides to spend more than is taken in by taxation, the difference is made up by either borrowing more money or printing more money.
The demand for mortgage money must compete with all other demands for borrowed funds. The share of the credit market demanded by mortgage loans normally is between 25% to 35% of the total credit available. Mortgage debt tends to be the largest class of debt in America.
The federal government, in the form of the Federal Reserve System, exercises monetary controls regulating the ways in which the money markets operate. There are three specific policy actions available to the Federal Reserve System to regulate the money supply and, therefore, the price of money. These three are (1 ) open market operations, (2) discount rates, and (3) changes in legal reserve requirements. These policies have an impact on the member banks of the Federal Reserve System.
Open market operations are part of the main tools used by the Federal Reserve System to adjust the money supply. When Treasury-issue securities are bought in the open market by the Federal Reserve more money is available for the banking system, which will then expand the overall economy. The sale of Treasury-securities removes money from the market place, which then tends to reduce the expansion and growth of the economy. The price at which these securities are either bought or sold sets the daily or weekly interest rate quotations available.
The Federal Reserve System requires member banks to maintain a certain percentage of time and demand deposits on hand as cash or its equivalent. These reserves are primarily to provide a degree of liquidity and safety. However, the ability to get deposits and, in turn, loan these deposits to consumers who, in turn, deposit a portion of the loan means that the banking system ultimately has the ability to expand the money supply. Thus, an increase in the reserve requirements will reduce the ability of the banking system to expand the money supply. More money can be made available by reducing the reserve requirements.
When member banks need to borrow, they are able to obtain funds from the Federal Reserve System. The cost of funds to the member bank is referred to as the discount rate and is, in fact, an interest rate. From an economic point of view, as the discount rate increases, the economic incentive to borrow by the member bank system should be reduced. Thus, less money will be available to expand the money supply. Conversely, a reduction of the discount rate, making credit easier, would lead to more funds borrowed (demanded) and an increase in the money supply by the banking system.
Fiscal policy is the management of government programs, and spending for those programs allowed in the federal budget. The agency that managers the government's fiscal activities is the United States Treasury. These activities are financed by the issuance of treasury bills, treasury certificates, and treasury notes. The sale of these instruments constitutes borrowing by the federal government and must be repaid from budget surpluses or refinanced by the issuance of new debt instruments.
Mortgage markets and the lenders involved can be typified, based on two criteria. First, those lenders who are private versus government in nature, and second, those lenders who originate loans compared to secondary financing lenders who purchase existing loans in a secondary mortgage market.
The basic issues involving private lenders are the source of funds, loan specialties, and predominant geographical area of lending. Government programs typically are discussed in reference to insurance or guarantees, direct lending, or secondary market activities.
In discussing mortgage markets, one must understand that the primary mortgage market includes those lenders who loan money direct to borrowers as well as those institutions which originate loans to sell to other mortgage investors. The secondary mortgage market is the activity of buying and selling of mortgages after they have been originated.
Most real estate financing is provided by private lenders. The ability and authority to finance such activity may vary according to regulations imposed by the various governmental agencies.
Savings and Loan Associations
The largest lenders in single family residential markets are savings and loan associations. The main function of savings and loan associations is to attract savings from a local area for investment back into that area in the form of mortgages. Savings and loans attract money from local savers and have an advantage over local banks in that they are able to pay slightly higher interest rates on deposits.
Savings and loan associations are either formed as stock companies or mutual companies, chartered either by the state in which they are located or by the federal government. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 provided for the dismantling of the Federal Home Loan Bank Board. The legislation also abolished the Federal Savings and Loan Insurance Corporation.
In place of the FSLIC, the new law set up the Federal Deposit Insurance Corporation as the primary federal agency responsible for insuring the deposits of savings association as well as banks.
The Office of Thrift Supervision has been created to replace the Federal Home Loan Bank Board. The OTS is under the supervision of the Treasury Department.
The type of loans in which the savings and loan associations specialize are primarily one to four units in size of properties located within one hundred miles of the main office for persons relying on non-governmental or conventional loans. The normal loan to value ratio is approximately 80%. . However, higher percentage loans may be made if the borrower will purchase private mortgage insurance (PMI). The associations can make loans on other types of property as well as construction loans. However, the operation and activities, as well as regulations, governing associations may differ from area to area.
Commercial banks are depository institutions which are able to make loans for many reasons for many different activities. The majority of the funds under the control of or available for investment by commercial banks are demand deposits, short-term in nature. Therefore, the predominant type of loan desired by commercial banks will be short-term. This is evidenced by loans such as consumer installment debt and short-term debt for commercial loans although some long-term debt loans may be available to preferred customers.
The predominant lending activity of commercial banks for real estate is construction loans or interim loans for development purposes, providing a scheduled, periodic and partial advance of funds to a builder as progress payments as each construction stage is completed. The lending area tends to be local in nature. Interest rates for construction loans are normally higher than long-term rates available on permanent loans.
Commercial banks are chartered by the state in which they are located or by the federal government. Federally chartered banks come under the control of the Comptroller of the Currency and the Federal Reserve System which set requirements for reserves, loan ratios, etc. State chartered banks come under the control of the state banking authorities. Federally chartered banks are also audited by the Federal Deposit Insurance Corporation (FDIC) which provides, in the event of bank failure, insurance up to $100,000 per account.
Life insurance companies generate large insurance reserves which are in fact savings, and are held for policy holders. The source of these funds is regional or national in nature and the sums of money are quite large. The investment of these funds is limited to some degree by the states in which companies are incorporated or licensed. Since the policy reserves are long-term in nature, insurance companies desire to invest in long-term assets that require a minimum of administration.
The placement of large sums of money with minimum administrative cost requires that insurance companies specialize in one or two types of lending activities. The minimum amount of loans with the maximum of dollars involved would be for large commercial projects such as shopping centers, apartment complexes, etc. The lending activities for these types of loans is also on a wide geographic basis. A second type of lending activity would be for the purchase in the secondary market of large blocks of existing mortgages from other lending agencies. The purchases would come from wide geographic areas, and thus, the insurance company would like to purchase loans which have either governmental insurance or governmental guarantees attached to them, or seasoned conventional loans where the down payments are substantial and/or private mortgage insurance exists for a part of the loan. The major objective of insurance companies is to deal with as few borrowers as possible, thus collections will be from large borrowers or from other lenders who service (collect the payments) the mortgages purchased in the secondary market.
Local lending activities are enhanced by mortgage banking companies which are in effect money brokers. The mortgage banker represents other institutional investors such as pension funds, insurance companies, savings banks, and the like. The company originates mortgages in the primary market for sale to these other institutional lenders in the secondary market, thus the control on the mortgage banking firm comes from the lenders to whom they are trying to sell loans.
The characteristics of the loans are determined by the type of purchaser in the secondary market. The mortgage banking firm does not lend its own money, but uses interim financing, typically from a commercial bank. As loans are originated, they are pledged as collateral for the interim financing and then the interim financing is paid off when the entire portfolio of loans is sold. This process is known as warehousing loans.
Mortgage bankers make their profits from two sources. First, loan origination fees are charged along with normal closing costs which generate income; and secondly, the function of servicing loans is performed by the local firm. Service consists of collecting monthly payments and arranging for their proper distribution; i. e. , a portion is allocated to escrow or to an impound account for the payment of taxes and insurance, with the principal and interest passed on to the institutional lender. For making the collections on the mortgage package, and forwarding only one payment to the owner of the package of mortgages, the mortgage banking firm collects a service fee. Mortgage banking companies serve as correspondent or intermediary position between the borrower and the final lender in the marketplace.
Mutual savings banks are hybrid institutions which have characteristics of both commercial banks and savings and loan associations. They are located primarily in the northeast section of the United States and are mutual companies (each depositor owns a proportional share). Even though they are located in one region of the United States, they are typically unable to invest the large amounts of savings they attract, and thus tend to loan on a national level. Making loans as an absentee lender, mutual savings banks tend to prefer to purchase existing FHA insured or VA guaranteed loans where the risks to the lender are extremely low.
Real Estate Investment Trusts (REIT)
Real estate investment trusts are stock companies which were created with tax advantages to stimulate investment in real estate. The real estate investment trust gets funds by the sale of securities in the capital markets as well as it own ability to borrow. The investment of these funds, according to its prospectus, can be as either a lender, typically on a construction or interim (short-term) basis, or an equity investor. The lending or investing area for a trust tends to be quite large, either regional or national, in scope and is typically on large scale development projects such as subdivision development, apartment complexes, or resort development. Since the RElTs are traded securities, they are controlled by the Securities and Exchange Commission.
Credit unions may be an excellent source of mortgage money for their members. Usually, credit unions offer mortgage loans to their membership at an interest rate below the commercial rate at any given time. To be financially able to make long-term mortgage loans, the credit union must be of substantial size.
There are also individuals who invest in mortgages. These investors are usually an excellent source for second mortgage loans. The seller of real property should not be overlooked as an individual investor. The sellers may finance the sale of their property by taking a regular second mortgage, taking a second mortgage in the form of a wrap-around, taking a purchase money first mortgage, or financing through means of a contract for deed. In times of extremely high interest rates, a sale often cannot be made without the seller providing a substantial part of the financing for the buyer.
A final choice for a lender which generates a large source of long-term funds available for mortgage purposes would be pension funds from various companies, unions, etc. These funds operate primarily in the secondary market through correspondents and purchase blocks of existing mortgages for the long-term portfolio for the beneficiary members of the various funds. The lending policies and regulations of these funds vary substantially.
The governmental role in mortgage lending has been very prevalent over the past several decades with the most prominent activity being that of guaranteeing or insuring single family residential mortgage loans. Along with the guarantee and insurance programs are many important functions not particularly visible to the public in general.
One of the purposes of the National Housing Act of 1934, which established the Federal Housing Administration, was to provide long-term loans with higher loan to value ratio. The FHA operates and administers many lending programs for which it will underwrite mortgage insurance. The FHA programs are not direct lending programs, but only provide insurance on qualified properties and individuals. The list of various FHA lending programs is long and changes from time to time. A further discussion of FHA mortgages follow later.
The four major functions of FHA are to:
1. Provide insurance for mortgages;
2. Provide stability in the buying and selling of mortgages in the secondary market;
3. Raise building standards; and
4. Facilitate and encourage home ownership.
Another prominent government agency involved in the mortgage market is the Veteran's Administration. While not a direct lender, the VA guarantees loans made to eligible veterans. The definition of eligibility varies from time to time. The current definition may be obtained from the Veteran's Administration. Eligible veterans may secure certificates of eligibility from the Veteran's Administration which outlines their benefits. They may then apply to any designated VA lender for a loan under the program.
Fannie Mae, the popular name for FNMA, was created to provide liquidity in the mortgage market through the purchase or sale of FHA or VA loans. Until 1968 Fannie Mae was a federal agency, but became a privately owned corporation which is now traded on the New York Stock Exchange and deals in the purchase and sale of conventional, FHA, and VA loans. FNMA can raise funds by going to the capital market and bidding for funds successfully against other borrowers, or by selling mortgages which it currently holds in its portfolio.
Ginnie Mae, the popular name for Government National Mortgage Association (GNMA), was created to replace FNMA when it became a private corporation. Ginnie Mae is a corporation under the control of the Department of Housing and Urban Development. The direct charges of GNMA are to administer special assistance programs, usually aimed at low income housing, and to work with FNMA in secondary market activities.
Freddie Mac, the common name for FHLMC, is the secondary market mechanism for the savings and loan associations, similar to FNMA and GNMA, and comes under the control of the Federal Home Loan Bank Board. Freddie Mac can purchase pools of conventional mortgages as well as FHA and VA mortgage loans. FHLMC has forced a degree of standardization on the savings and loan associations mortgage lending practices since they will only purchase loans which are prepared using a standardized loan application, credit report, and appraisal form as published by Freddie Mac. The function of the agency is to buy mortgages in the secondary market when money is tight, thus providing more funds to the member associations for lending in the local areas; and absorbing excess funds from member associations when money is less tight by the sale of mortgages to those member institutions.
The Farmer's Home Administration is a sister agency to the Federal Housing Administration with the express charge of facilitating real estate activity in rural areas. This agency has the ability of either making loans directly or underwriting through other financial intermediaries. It typically will be active in rural areas where little or no other real estate credit is available.
The Federal Reserve Board and the Federal Home Loan Bank Board are two government agencies which oversee either the commercial banks or savings and loan associations. As such, they have an indirect effect on activities in the mortgage market. As discussed earlier, the Federal Reserve Board has control over such policies as reserve requirements and discount rates, which affect not only how commercial banks will be controlled, but also the United States economy as a whole. The Federal Home Loan Board oversees the actions and activities of savings and loan associations. It operates Freddie Mac, which was discussed above. In effect, the Federal Home Loan Bank Board is the "central banker" of the savings and loan industry.
Mortgage pools are collections of loans packaged together for the purpose of providing security for investment. For example, ABC Mortgage Company puts together several million dollars worth of VA guaranteed mortgage loans. This "package" of mortgage securities (pool) is sold to a group of investors who each put up a minimum amount of dollars. Each investor purchases a part of the package/pool. The pool is secured by the mortgages. These pools generally have a lower rate of interest with a lower risk due to the backing of the real property. They, therefore, tend to be more marketable than some other securities which lack such backing.
The Government National Mortgage Association (GNMA) is an agency of the Department of Housing and Urban Development. It is a mortgage securities pool and is involved in special government programs. It tends to specialize in urban renewal projects, housing for the elderly, and other high-risk mortgages.
GNMA also purchases high-risk, low yield mortgages at market yield rates and, frequently, sells them to the FNMA. The difference in the cost and the yield is absorbed by the agency as a subsidy for the housing industry. This program is called the TANDEM PLAN.
GNMA is the largest of the mortgage-backed, pass-through securities pools. "Ginnie Maes" are issued through FHA-approved mortgagees. These are usually mortgage bankers. GNMA guarantees the monthly interest and principal amortization will "pass through" to the investor.
Pension funds, mutual funds, foreign and domestic investors purchase "Ginnie Maes. "
The second largest of the mortgage-backed securities pools is under the Federal Home Loan Mortgage Corporation (FHLMC). FHLMC issues "Participation Certificates. "
The third largest of the mortgage-backed securities pools is under the Federal National Mortgage Association.
The major disadvantage of mortgage-backed securities for investors lies in the fact that many borrowers of money for the purchase of homes pay off early. Most mortgages are for thirty year terms. These loans are often paid off early. It is impossible for the investor to know in advance if the mortgage will be paid off early, go into foreclosure or be refinanced at a lower interest rate.