耶鲁大学金融市场英文文本Financial-MarketsLecture-12-Transcript.doc

Financial Markets: Lecture 12 Transcript Professor Robert Shiller: I want to start out by talking about real estate as an asset class. Its actually the biggest and most important asset class. The value of real estate in the United States today is-of real estate owned by households directly-is about twenty trillion dollars, which makes it comparable or maybe a little bit bigger than the stock market. Stocks owned directly by households are only about six trillion dollars. For a typical household, the home is the major source of wealth that theyve accumulated. Of course, other stocks are held by institutions on their behalf, but in terms of direct ownership, homes are the main thing that people own. Theres also commercial real estate, which is smaller than owner-occupied homes, but we own that indirectly too, as a people, through the stocks that we own and through the institutions we participate in. Its very important and it has some important financialthere are a lot of financial institutions built around dealing with the fundamental problems of real estate. I want to talk first about institutions and then move to what I think is, myself, more interesting, which is the real estate boom and the kind of fluctuations weve seen in real estate over the years. Im going to start out by talking about commercial real estate and the kind of vehicles that we use to invest in commercial real estate. Then I want to talk about mortgages, which is the way that we finance both commercial and owner-occupied real estate. Then finally, I want to come to the real estate boom that we are recently in. Let me start by-the way-the kind of institution that you probably know relatively little about-or commercial real estate. Commercial real estate-that means real estate owned not by individual households but by businesses. The institution I wanted to talk to you about first is called a DPP, a Direct Participation Program, which has been traditionally the single most important form of holding of commercial real estate. When you drive along and you see all these commercial buildings, you might wonder who owns them. Well, sometimes theyre owned by corporations, but I think the more important institution is the DPP, which is a financial vehicle that owns commercial real estate on behalf of investors. The most important DPP is called a limited partnership or LP. Theres a very simple reason why real estate tends to be held in limited partnerships rather than corporations and that reason is the corporate profits tax. Corporations are taxed on their profits and DPPs are not. You want, if you are setting up an organization to hold real estate, you want to do it, if you can, as a DPP because you dont want to pay those taxes. Whenever possible, an ownership vehicle for commercial real estate will have the form of a DPP. A limited partnership is one kind of DPP and it has-its not a corporation, so its a partnership. The simplest kind of partnership would be if several of you got together and formed a business. In a normal-in a simple partnership, the partnership would not be taxed because its you doing business just as partners, so you are taxed but not the partnership. The problem with partnerships, generally, has been that they dont have limited liability. A corporation is an entity that could be sued or could lose more money than its worth, but the value of a corporation can never fall below zero to the investors because the investors are not liable for the mistakes of the corporation. If you buy stock in a company the most you can lose is the money you put up, so thats called limited liability. If you take part in a partnership you are individually liable for the debts of the corporation. Thats a problem with the partnership structure because you could join a partnership and the partnership does something awful and loses more than you put into it and they can come after you for those losses. There is something, however, called a limited partnership that has two kinds of partners: a general partner and a limited partner-or usually, many limited partners. The general partner takes on the liability; the limited partners dont have liability. So typically, real estate is held in a limited partnership. Its limited becausewell, they want to put it in a limited partnership because they dont-its not easy to sell other people on joining the partnership if they could get unlimited liability for doing so. There is a general partner who takes on the liability and the limited partners, who are many, are the participants who do not share the liability. The general partner is typically the organizer of the partnership. Someone who buys a fifty-story building downtown and then, well, arranges to buy and gets partners-limited partners-to join in financing it; thats the arrangement. You have a general partner, then limited partners, and you dont hear about DPPs. Im telling you something that you probably havent heard a lot about. This is not commonly advertised or described-just like hedge funds are not commonly advertised and described-because it is thought that DPPs are suitable only for wealthy and sophisticated investors. Theyre complicated, so the general rule has been that only accredited investors should participate in them. I mentioned this before-in the U.S. and in other countries as well, theyre a similar thing. We defined an accredited investor as someone who can participate in a DPP or other sophisticated programs. The definition is in Regulation D, which defines an accredited investor. For many years now, to qualify as an accredited investor, you have to have one million dollars in wealth or income in excess of $200,000 or, if youre married, $300,000 for the couple. In 2006-I mentioned this before-in 2006, the SEC proposed raising the definition to make it harder to be an accredited investor, but they havent done that yet; so, it remains at one million dollars to do it. Nonetheless, DPPs dont advertise. You see mutual fund advertisements everywhere. You dont see advertisements for participation in commercial real estate like this because the government would be on their backs if they did it. Since its available only to accredited investors, you cant be advertising because everyone would see it; thats why the financing of a lot of this real estate is something of a mystery, because they cant talk openly about it. These DPPs go back a long time but there began to be complaints about them because people said, well why is it, because Im not an accredited investor, I cant get into real estate like these other people do? Why isnt there something offered to me thats like a DPP thats available to everyone? Another way of putting it, the government is effectively saying that unaccredited investors are free to invest in corporations that invest in real estate and theyre subject to the corporate profits tax. Wealthy people have the choice of getting around the corporate profits tax. So, in a sense, the tax structure was regressive. It was saying, were going to have lower taxes on rich people than on ordinary people; that didnt seem fair at all, so there was a complaint aired about DPPs in the late 1950s. People said, lets change it, lets make it so that everybody can have something like a DPP. Congress finally acted and it was in the year 1960 that Congress defined a new investment vehicle called a Real Estate Investment Trust; this is for everyone. A Real Estate Investment Trust is for small investors, although wealthy, big investors can invest in it also. So, they had to make a distinction. These are called REITs, Real Estate Investment Trusts. Congress had to make a distinction between these and corporations and its kind of a subtle distinction because there are lots of corporations that own real estate. Like, for example, Wal-Mart might want to-they pay corporate profits tax. After 19-I dont know if Wal-Mart-was it around in 1960? I dont know. Lets say it was. Wal-Mart, after the 1960 Act of Congress, would say, hey were a real estate investment trust, we own real estate-all these stores-but thats not what the intent of this bill was. They wanted REITs to be companies that just owned real estate and Wal-Mart is primarily a retailer. They specified that 75% of assets must be real estate and 75% of income must be real estate income-so that would be ruling out Wal-Mart. And 95% of income must be paid out-they cant retain earnings. That limits it further. Theyre supposed to be like a pass through vehicle-theyre owning real estate on your behalf, so they shouldnt be retaining earnings. Also, they had to be long-term holders; it had to be less than 30% of income from sales of properties less than four years-less thanno more than 30% of their income from sale of properties had to be from properties held less than four years. They didnt want flippers; they didnt want the company thats speculating in real estate, they want it to be a holder of real estate. Real Estate Investment Trusts became very important in three waves. One-the first wave of REIT growth occurred right after Congress passed the 1960 bill. The first wave was in the 1960s and, at that time, Congress had limits-state governments had limits on the interest that savings banks could pay people on their accounts. So, a lot of people switched from savings accounts to REITs-thats called disintermediation. An intermediary is a bank, so when they pull out of banks they were disintermediating and going from banks into REITs. Although, in some sense, it wasnt really disintermediation because you could say a REIT is a different kind of intermediary between the individual and the investment. The second boom in REITs occurred after 1986. The Tax Reform Act of 1986 made DPPs much less valuable to investors, and so a lot of wealthy people switched from DPPs to REITs. Before 1986, the tax law allowed use of DPPs as a tax loss device. People would invest in buildings solely for tax purposes because you could write off the depreciation on the building, so people were cynically setting up DPPs as tax shelters only. Congress said, finally-I think wisely-in 1986, that we dont want to create rules that encourage people to do a different sort of business just to evade taxes. So, they made a-they said that losses that-depreciation that-In 1986, the Tax Reform Act of 1986 said that depreciation on structures in DPPs is called a passive loss and can be used to offset only passive income, which comes from something like another DPP. So it eliminated the tax advantage. If they didnt have a particular tax advantage to DPPs, they went into REITs. The third REIT boom was in the 1990s and I think this third REIT boom is different from the others because it didnt arise from any government regulation change. It arose from the beginnings of the housing bubble-the real estate bubble that were now in. There just became a lot of enthusiasm for REITs. Its not just a bubble; its also that REITs began to be more diversified. They have many different kinds of REITs for different kinds of real estate. It became a more interesting and diverse asset class. Thats what I wanted to say about commercial real estate. The two principle ways that commercialwell, there are three ways. One is commercial real estate is held by corporations in the line of business, but after that it would be DPPs and REITs. We have democratized-Now, REITs are a rapidly growing force in investing and now we have substantially democratized real estate holdings so its not exclusively DPPs that are holding-not primarily-we have a lot of REITs now. Next topic, I want to talk about mortgages. Mortgages are debts secured by property as collateral. When you mortgage a property that means that you offer the property as collateral for a loan. That means that if you fail to pay on the loan, the property is taken by the lender to satisfy your debts. It makes it possible for people to borrow who otherwise couldnt borrow. If you put a property up as collateral, then the lender knows that they can get the money back from you. The critical thing is the loan-to-value ratio, or LTV. A mortgage lender doesnt want to lend more than the property is worth because that would mean a loan-to-value ratio overone. Then if you fail to pay on the mortgage-pay off the debt-the lender can seize the property and sell it. But if the loan to value ratio is greater than one, they wont be able to get all the money back. Moreover, whenever they seize a property and try to sell it, it usually loses value anyway in the process. For example, if theres a homeowner who youve lent money to and the homeowner is defaulting on the mortgage, the homeowner might wreck the house-that happens all the time-or they might steal things from it. Who knows, theyre angry and theyre living in this house. They can stall you for a year; youre trying to sell the house, they hire lawyers and sue you and youve got to hire lawyers. There are lots of costs, so you want to have a loan-to-value ratio, which is sufficiently low, that the collateral will cover the value of the loan. The history of mortgages is that they have generally over time gotten more easy on loan-to-value ratio and also on maturity. The maturity of a mortgage is the date when its paid off. If we go back to the 1920s-and Ill compare that with now-the typical mortgage had a loan-to-value ratio of 60% and a maturity of five years, often even less than that. They also had-they were-back then, in the 1920s, they were called balloon payment. What that means is that you would borrow $5,000 to buy a house and in five years and every year along the way youd be paying interest on your mortgage. Then, in five years you had to come up with $5,000. It was interest, interest, interest until the end and then it was the $5,000. Of course, five years is too short because most people live in a house for more than five years. But, the assumption was, well, when five years comes up you refinance the mortgage; you get a new one. The banks werent willing to lend more than five years because they didnt trust you; they thought things would change and whatever. After 1929, real estate prices fell dramatically and people became unemployed. The unemployment rate in the United States rose to 25%. Lots of people could not refinance their mortgages because they were unemployed. You go to a bank and say, I want to borrow to refinance my mortgage, which is due now. Theyre asking me to pay $5,000; I dont have $5,000. But the bank would say, hey youre unemployed; we cant give you a mortgage. Anyway, your loan-to-value ratio is getting pretty precarious because your house is now down 30% in value; your loan-to-value ratio, if we were to give you $5,000, would be something like 90%. They would say, no way are we going to do that; our rule says we cant lend on a LTV of higher than 60%. So, people would be turned down for the refinancing of their mortgage. What happened? They would lose the house. That happened in huge numbers in the 1930s. The 1930s was the biggest housing crisis in U.S. history. You see what the problem was: the mortgages were too short. The loan-to-value ratio-well its not so much the loan-the maturity was short and the balloon payment at the end that they changed. In 1933, under the Roosevelt Administration, Congress created something called the Home Owners-I mention this-its actually relevant to right now-Home Owners Loan Corporation, or HOLC, that was financed by the U.S. Congress. It started offering, indirectly, but started offering mortgages to all these people who couldnt refinance. It did it through banks; they gave the money to banks to make loans to people who were in trouble. They created a very important change. They said five years is too short-its got to be longer-they said fifteen years. And get rid of this balloon payment thing at the end-that was a dumb idea. People cant pay that, if theyre in any trouble, they cant come up with the whole value of the loan all at once. They demanded that the mortgages be self-amortizing-this is what came in in 1933. It was a very important change in mortgage finance. Self-amortizing means that youre not just paying the interest every year-or every month-youre paying interest plus principal. So, when the mortgage ends, youre just clear and free; you dont have to pay anything-nothing comes at the end. The HOLC said, thats a lot more sensible; so they demanded that that be done. Of course, banks would be reluctant to do it by themselves, but the governments coming with a checkbook to write the money, so they can make the mortgage, and guarantees it. The HOLC said, dont worry if they dont pay, well pay. So, the banks said, of course well do that; that created a major change in mortgage lending. This is especially relevant because-I dont know if you saw-maybe you did-in The New York Times yesterday, AlanBlinder, who is a Former Vice Chairman of the Federal Reserve Board under Greenspan and is now a Professor at Princeton, had an article saying, we need to bring back the HOLC now. In fact, our own SenatorChristopher Dodd has a bill in Congress right now to bring back the HOLC, basically. He has a new name for it-I think its called Home Equity Protection Corporation-but almost the same idea. Ideas that were common-that were new-in the 1930s are being brought back. We dont have to make the change. Well in a sense, the other thing that happened was, in 1934, Congress set up the Federal Housing Administration-FHA. The FHA is specifically aimed at guaranteeing mortgages for low-income people and it was a vision that Roosevelt had to bring more and more people into owning homes in this country. The FHA went further than the HOLC; they demanded that mortgages be twenty ye