Lecture 10: Real Estate

What this lecture covers

Shiller surveys the history and institutions of real estate finance, starting with the ancient origins of the word "mortgage" and the centuries-long struggle to establish reliable property rights, without which mortgage lending cannot function at scale. He then walks through how commercial real estate is financed through partnerships and Real Estate Investment Trusts, how residential mortgages evolved from short-term balloon loans into the modern amortizing fixed-rate mortgage after the Great Depression, and how mortgage securitization through Fannie Mae, Freddie Mac and private issuers set the stage for the 2007-2008 financial crisis.

This lecture follows the course's earlier sessions on debt, interest rates and corporate stock, and treats real estate as another major asset class with its own institutional history. After watching, you should be able to explain why secure property rights are a precondition for mortgage lending, describe the difference between a Direct Participation Program and a REIT, compute an amortizing mortgage payment, and explain how Fannie Mae and Freddie Mac's implicit government backing contributed to the 2008 crisis.

Key ideas

• Mortgage: from the Latin "mortuus vadium" (death pledge); Shiller traces documented mortgage-like loans back over 1,000 years, but argues the institution only became viable at scale once governments established clear, centrally recorded property rights, citing Prussia's 1872 Grundbuch law as a turning point.
• Property rights as a precondition for lending: without a reliable record of ownership, lenders cannot be confident a borrower actually owns the collateral, which Shiller illustrates with a 1778 newspaper ad from a defrauded Connecticut farmer and Hernando de Soto's argument that weak property rights still hold back mortgage finance in developing countries today.
• Direct Participation Program (DPP): a real estate partnership limited to wealthy "accredited investors" that avoids corporate double taxation by passing income through directly to partners, but must have a limited life and cannot be sold to the general public.
• Real Estate Investment Trust (REIT): created by Congress in 1960 to let ordinary investors access commercial real estate without double taxation, subject to rules requiring most assets, income and payouts to come from long-held real estate.
• Amortizing mortgage: a fixed-rate loan with a level monthly payment set so the present value of all payments equals the amount borrowed, using the annuity formula; introduced by the Federal Housing Administration in 1934 to replace short-term balloon-payment mortgages that had caused mass defaults during the Great Depression.
• Fannie Mae and Freddie Mac: government-created entities (1938 and 1970, later privatized) that bought mortgages from originators and repackaged them into guaranteed securities, expanding the pool of money available for mortgage lending, while remaining formally private with no explicit government guarantee, until both were placed into federal conservatorship in 2008.
• Mortgage securitization: the process of pooling mortgages into tranched securities such as Collateralized Mortgage Obligations (CMOs) and Collateralized Debt Obligations (CDOs), many rated AAA despite containing subprime loans, which spread mortgage risk worldwide and contributed to the severity of the 2008 crisis.
• Moral hazard in mortgage origination: when originators sell mortgages off quickly, they have little incentive to verify a borrower can repay, a problem post-crisis reforms addressed by requiring originators to retain 5% of the mortgage balance and by licensing mortgage brokers.

Walkthrough

The long history of mortgages and property rights (1:04)

Shiller traces the word "mortgage" to a Latin term for "death pledge" and cites Yale historian Valerie Hansen's research on Sogdian-language loan documents from the Tang Dynasty silk trade, showing mortgage-like contracts date back over a thousand years. He argues the institution could not develop into a large-scale industry until property rights were clearly and centrally recorded, illustrating the problem with a 1778 Hartford Courant ad in which a Connecticut farmer warned the public that a buyer had fraudulently mortgaged his farm multiple times without ever paying for it. He credits Prussia's 1872 Grundbuch law, which created a central registry of property ownership, as a key institutional advance, and cites economist Hernando de Soto's argument that unclear property rights still limit mortgage finance in much of the developing world.

Commercial real estate: partnerships and REITs (13:33)

Shiller explains that commercial buildings are typically owned through partnerships rather than corporations to avoid the double taxation corporations face, describing Direct Participation Programs (DPPs) as real estate partnerships restricted to wealthy "accredited investors" with a required limited lifespan. He describes how this restriction excluded ordinary investors from commercial real estate, prompting Congress to create Real Estate Investment Trusts (REITs) in 1960, which let small investors participate without double taxation, subject to rules on the share of assets and income that must come from long-held real estate. He notes REITs grew in booms tied to interest rate regulation changes in the 1960s, the 1986 tax reform, and the 1990s real estate boom.

From balloon mortgages to the amortizing mortgage (28:06)

Shiller describes pre-Depression mortgages as short-term (two to five years) balloon-payment loans, where borrowers paid only interest and then owed the full principal at maturity, expecting to refinance. When the Great Depression combined 25% unemployment with home prices falling by half, many borrowers could not refinance and lost their homes, prompting the government to bail out 20% of American homeowners through the Homeowners Loan Corporation. In response, the 1934 Federal Housing Administration required insured mortgages to be long-term (eventually 30 years) and fully amortizing, with a fixed monthly payment computed from the annuity present-value formula so the loan is paid off exactly at maturity. Shiller walks through a historical mortgage table showing how the split between interest and principal in each payment shifts over the life of the loan, and notes the fixed-rate amortizing mortgage remains common in only two countries, the United States and Denmark, in part because of the higher rates lenders must charge to guarantee a rate for decades and the risk it poses to bank balance sheets.

Fannie Mae, Freddie Mac, and the illusion of the implicit guarantee (48:02)

Shiller explains how the government created the Federal National Mortgage Association (Fannie Mae) in 1938 to buy mortgages from banks and free up capital for further lending, privatizing it in 1968, and created the Federal Home Loan Mortgage Corporation (Freddie Mac) in 1970 to buy mortgages and repackage them into guaranteed securities. Although both were officially private with no government guarantee, investors worldwide, including major Chinese buyers, treated their securities as effectively government-backed, partly because outlets like the Wall Street Journal listed them under "Government Securities." When both entities went bankrupt in the 2008 housing crash, the government placed them into conservatorship and honored their obligations rather than let global investors lose money, illustrating how a repeatedly denied guarantee can become real once the stakes are high enough. Shiller briefly contrasts this with Canada's smaller, government-owned mortgage insurer, which avoided a comparable housing bubble.

Securitization, the 2008 crisis, and post-crisis reform (1:01:14)

Shiller describes how mortgages were pooled into Collateralized Mortgage Obligations (CMOs), divided into tranches by prepayment risk, and Collateralized Debt Obligations (CDOs) holding subprime mortgages, many rated AAA by agencies despite the underlying credit risk, and sold to investors worldwide. He describes the long chain of mortgage origination, sale, and servicing that separated the person who wrote the loan from the ultimate risk-bearer, creating a moral hazard problem where originators had little incentive to verify borrowers' ability to repay, sometimes coaching applicants to overstate their income. He closes by describing post-crisis reforms in Europe and the United States, including the Dodd-Frank Act requirement that mortgage originators retain 5% of the mortgage balance and new licensing requirements for mortgage brokers, aimed at realigning incentives while preserving the basic securitization system.

Before you watch

• Familiarity with the earlier lecture on present value, discount bonds and annuities is useful, since the amortizing mortgage formula is a direct application of the annuity present-value formula.
• The prior lecture's discussion of corporations and their double taxation helps explain why real estate is often held through partnerships instead.

Check your understanding

1. Why does Shiller argue that clear, centrally recorded property rights are a necessary precondition for a large-scale mortgage market?
2. What is the difference between a Direct Participation Program and a REIT, and why did Congress create REITs in 1960?
3. Why did balloon-payment mortgages contribute to the housing crisis of the Great Depression, and what specific features did the 1934 amortizing mortgage introduce to address that problem?
4. Why did investors around the world treat Fannie Mae and Freddie Mac securities as effectively government-guaranteed even though the U.S. government officially denied backing them, and what happened when both entities went bankrupt in 2008?
5. How did the separation of mortgage origination from mortgage risk-bearing create a moral hazard problem, and what reform did the Dodd-Frank Act introduce to address it?