2007 Vol. 3

Real Estate

Pansy Yang, Ph.D.
Executive Director of the Fink Center for Finance & Investments

The recent credit crunch and subprime crisis has roiled capital markets, leading to record losses on Wall Street and rising foreclosures, amongst other troubles. The crisis and related contagion has spurred questions and discussion of the roles of key players, including the Fed, residential mortgage lenders, rating agencies, and Wall Street, as well as discussion of the "R" word - Recession. This issue seeks to investigate how we got to where we are today, lessons learned, and where we are headed.

Edward Leamer, Chauncey J. Medberry Chair in Management and Director of the UCLA Anderson Forecast Center provides this issue's academic perspective. Ed shares his forecasts and views on the relationship between the well-being of the housing sector, job market, and the overall economy, and his thoughts on why recession is not imminent.

Richard Syron, CEO of Freddie Mac, provides his thoughts on the liquidity crunch from an industry viewpoint. Richard discusses the multiple causes of the credit crunch, the role of GSEs in mitigating the effects on housing at crises times like these, and positive outcomes that have arisen, including widespread acknowledgement of the need for reassessing the pricing of risk. >>PLEASE SEND YOUR COMMENTS

In Theory ...
Housing and the Job Market
Why This Time is Different

Edward E. Leamer
Director, UCLA Anderson Forecast

The frequency of the media's use of the recession word has elevated dramatically following the August credit crunch. What is a recession, anyway? (Answer: a period of rising joblessness.) Is one coming soon? (We don't think so, even though the housing market is issuing a very loud alarm.) In a recession, jobs are easy to lose, but hard to find.

The period of time in which the US is officially in recession is determined after the fact by a committee of economists at the National Bureau of Research. Though these committee members all have Ph.D.'s, this work is child's play. Have your 10-year daughter look at the mountains and valleys in Figure 1 and ask her to color the ski-slopes facing East in bright yellow. Chances are excellent that she will closely approximate the work of the NBER, at a fraction of the cost.

In other words, a recession is a period of rising idleness; the idleness of labor that we call unemployment and the idleness of capital that we call excess capacity and vacancies. >>READ PAPER

In Practice ...
The Liquidity Crunch: Its Causes, Cures and
Implications for Housing Finance and the Broader Economy

Richard F. Syron
Chairman and CEO, Freddie Mac

Adapted from remarks delivered November 13, 2007 at a conference organized by the Center for Finance and Investment and the Center for Real Estate at the UCLA Anderson School of Management.

These have been tough times in the mortgage industry and volatile times in the broader financial markets. We face a situation where the market mispriced risk for a considerable period, and allowed a lot more risk to end up in a lot more places than it should have.

While some aspects of the credit crunch have eased, a lot of damage has been done and many markets are still fragile. The spread between jumbo and conforming mortgages blew out to several times its typical quarter point. And the subprime issue was the straw that broke the camel's back on credit spreads that had been too tight.

The asset-backed commercial paper market became dysfunctional. Investors remain leery of asset-backed securities. The only part of the mortgage space working relatively normally is the conventional conforming market. That's primarily the space in which Freddie Mac and Fannie Mae - both government-sponsored enterprises, or GSEs - pursue our mission of providing liquidity and stability to the markets. >>READ PAPER

Recent Events at CFI

October 28, 2007
Women in Finance Brunch
The Women's Business Connection and the Investment Finance Club at UCLA Anderson proudly hosted their annual brunch on Women in Finance on Sunday, October 28. Panelists included Christina Park (Vice President, Lehman Brothers Leveraged Finance Group), Jamie Patterson (Vice President, Merrill Lynch Investment Banking), Melanie Batiste (National Marketing Finance Manager, Toyota Motor Sales), and Renee Kuo (Vice President MBS and ABS Sales, Banc of America Securities). The event was moderated by Pansy Yang (Ph.D., Executive Director of CFI).

Discussion revolved around the work/life juggle as a female in the finance industry, the importance of continuing education, skills and qualities for success in the workplace, and the benefits of finding a mentor amongst other issues. Over 50 women were in attendance for this fun and informative event. The event was sponsored by Bank of America, Citi, Lehman Brothers, Merrill Lynch, and Toyota.

November 13, 2007
Real Estate Markets and the Macroeconomy
The recent credit crunch in the mortgage market and the related contagion has infused capital markets with great tumult. These events created a timely opportunity for CFI and the Ziman Center for Real Estate to bring together an elite group of speakers and audience members to discuss volatility in the markets and the global tightening of liquidity.

On November 13, the centers hosted an executive briefing on real estate markets and the macroeconomy. The event featured a discussion with three distinguished members of the business community: Robert Parry, Former President and CEO, Federal Reserve Bank of San Francisco, Michael Perry, Chairman and CEO, Indymac Bancorp, and Richard Syron, Chairman and CEO, Freddie Mac. Professor Richard Roll, Director of CFI and Professor Stuart Gabriel, Director of the Ziman Center, chaired and moderated the briefing.

Panelists engaged in a candid discussion of factors that brought us to where we are today, that include worldwide liquidity, historically low interest rates, public policy in favor of single family home ownership, innovation in mortgage lending, and all around fear and greed. Going forward, solutions offered included rent-to-own, rescuing a portion of sinking loans, greater transparency although not Sarbanes-Oxley restrictive, and greater attention to pricing risk.

CFI Working Paper

"Catastrophic Risk and Credit Markets"
Mark Garmaise (UCLA Anderson) and Tobias Moskowitz (University of Chicago)

Financial markets can play a key role in mitigating catastrophe risk by efficiently spreading the risks, as well as supplying capital. Catastrophes, such as Hurricane Andrew in Florida and the Northridge earthquake in California, have given rise to innovations in the market for catastrophe risk. Firms have developed complex statistical models to assess risk; they invest in buildings and structures that have lower expected losses from natural disasters, and they utilize the catastrophe risk securitization market.

How efficient and competitive the catastrophe insurance markets are is another question. A new working paper by Mark Garmaise and Tobias Moskowitz takes a fresh look at the catastrophe insurance market, its inefficiencies and spillover effect to credit markets. The authors develop a model of the pricing and financing of properties in the presence of catastrophe risk and test their theory using unique data on catastrophic earthquake risk and commercial property loan contracts and prices in the U.S. from 1992-99.

The empirical results support the model's predictions. Inefficiencies in the supply of catastrophe insurance lead to inefficiencies in bank credit markets. Banks are inefficient in financing properties facing catastrophic risk because they do not specialize in monitoring whether property owners are taking measures and making investments to ensure maximal safety. Insurers, on the other hand, are properly equipped to evaluate safety-enhancing investments, but due to insufficient capital and a relatively small number of providers, the catastrophe insurance market is also inefficient.

Garmaise and Moskowitz analyze the impact of earthquake risk specifically, and find that in Los Angeles county, the median quake risk reduces the probability of bank financing by over 20%. They examine a specific event, the Northridge earthquake, and find that in the immediate months after, properties with high earthquake risk were especially unlikely to be financed with bank loans, and bank-financed transactions were concentrated in lower risk properties while the relationship between cash-financed transactions and the catastrophic risk of a property remained unchanged. However, this effect lasted only for about three months and had no significant longer-term effects.

The paper presents a general framework for analyzing a broad set of catastrophic risks including hurricane, terrorism, and political perils. The main result, that inefficiencies in the supply of catastrophe insurance lead to distortions in credit markets, supports the contention that catastrophe risk, and in particular earthquake risk, may neither be optimally priced nor optimally allocated among market participants. In particular, inefficiencies in the supply of catastrophe insurance leads to less bank financing of catastrophe-susceptible properties, limited market participation by less wealthy investors and incomplete insurance coverage. - P. Yang >>READ PAPER, "Catastrophic Risk and Credit Markets" (PDF)

CFI Research Note

Real Interest Rates, Expected Inflation and Real Estate Returns: A Comparison of the U.S. and Canada
Richard Roll (UCLA Anderson) and Kuntara Pukthaunthong-Le (San Diego State University)

Belief in a negative relation between mortgage rates and real estate values is virtually ubiquitous among journalists, homeowners, and real estate brokers. It appears to be based on compelling logic: an increase in mortgage rates implies a higher monthly payment for new borrowers, who should thereafter be less able to afford a home. But empirical support for the above belief has not been overwhelming; house prices have often boomed in periods of high inflation and high nominal interest rates. Is there some reason why increases in mortgage rates should not bring lower housing values? The answer is yes.

The mortgage interest deduction in the United States effectively implies that homeowners in high inflation environments can deduct part of the real value of the principal of their mortgage loans over time. Nominal mortgage rates rise with inflation and are fully deductible for most homeowners while the real value of the outstanding principal declines over time. This suggests that increases in nominal interest rates could actually have a positive impact on house prices if those increases are induced by higher expected inflation.

In Canada, mortgage interest is not tax deductible, so increases in nominal interest rates caused by increased inflation brings no corresponding tax benefit to homeowners.

Higher interest rates induced by inflation should, however, also reduce the real returns for mortgage lenders in both countries, so nominal mortgage yields might rise by more than the expected inflation increase to compensate lenders for the added tax burden. But this supply consideration is the same in the two countries, so whatever the overall impact of inflation on house prices might be, it should be less in the United States than in Canada.We find empirical evidence that the effect of inflation on real house prices is indeed less in the U.S. We study real monthly returns on real estate investment trusts (REITs), which should be strongly correlated with real house prices because all types of real estate are substitutes. We impute real interest rates and expected inflation rates from nominal and indexed bonds in Canada and the U.S. and study the relation between REIT real returns and changes in these rates while controlling for broad equity movements.

Real interest rate changes have strongly negative and quite similar effects on REIT returns in both countries. In contrast, changes in expected inflation have very dissimilar effects; in Canada, increased inflation reduces REIT values significantly while the impact is not significantly different from zero in the U.S. Other empirical characteristics of REIT returns, such as the response to broad equity movements and explanatory power, are remarkably similar in the two countries, so we feel safe in concluding that some underlying genuine cause, possibly mortgage interest deductibility, is responsible for the striking dissimilarity in the impact of inflation. >>READ PAPER, "Real Interest Rates, Expected Inflation and Real Estate Returns: A Comparison of the U.S. and Canada" by Kuntara Pukthuanthong & Richard Roll

October 17
Matthew Barrett
Managing Director, Barclays Capital
Matthew BarrettMatthew Barrett is a managing director and head of distressed debt and Special Situations Investing at Barclays Capital. Based in Los Angeles, Mr. Barrett is portfolio manager and is responsible for a team of professionals that invest proprietary capital in a wide range of assets, including distressed debt investments and other special situations. Prior to joining Barclays Capital in 2006, Mr. Barrett was at Oaktree Capital Management for 10 years as a Managing Director, Head of Analysis, and a leader of its Opportunities Funds -- one of the largest global distressed debt and special situations platforms. He received his MBA from the Anderson School in 1986.

October 17
Stephen Greene

Managing Director, Eureka Capital Markets, LLC
Stephan GreeneStephen Greene is a senior managing director at Eureka. He has over 20 years of experience in mergers and acquisitions, financial restructuring and capital raising. Steve has played a meaningful role in closing over 70 transactions with an aggregate value in excess of $15 billion. Prior to Eureka, he established and led Andersen's Healthcare Corporate Finance practice in New York and was the co-founder and leader of Andersen's Western Region Corporate Finance practice. Before joining Andersen, he was a managing director with Houlihan, Lokey, Howard & Zukin, Inc. in charge of Houlihan's San Francisco office.

He received his M.B.A. in Finance from the Anderson School, U.C.L.A. He also holds an M.A. History (Fulbright/Hays fellowship) and a B.A. (Phi Beta Kappa and Honors in History), both from Stanford University. Steve is a Registered Securities Principal (Series 24) and a Registered Securities Representative (Series 7 and 63) through the NASD.

November 1
Hans Hufschmid

CEO, GlobeOp
Hans Hufschmid is chief executive officer of GlobeOp and is based at the company's London office. Prior to becoming a founding partner in GlobeOp in 2000, Hufschmid was a principal at Long-Term Capital Management (LTCM) and co-head of its London office for five years, supervising traders, researchers, programmers and administration personnel.

He also served on the company's risk management and management committees. He previously spent 10 years with Salomon Brothers in London and New York, the last four as global head of foreign exchange sales and trading. A managing director, he was also a member of Salomon Brothers' credit committee. Hufschmid holds a B.S. in business administration from the University of Southern California and an MBA from the University of California, both in Los Angeles.

Number One in Finance Publications

UCLA Anderson Ranked #1 in Publications Per Tenure-Track Finance Faculty in Top Four Finance Journals Over Past Five Years
(Figures from W.P. Carey School of Business at A.S.U.)

  1. UCLA Anderson - 3.27
  2. Duke - 2.53
  3. Purdue - 2.50
  4. University of Chicago - 2.36
  5. Emory - 2.20
  6. Ohio State - 2.15
  7. Stanford - 2.13
  8. Harvard - 2.08
  9. M.I.T. - 1.95
  10. Utah - 1.92

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