Subtitles section Play video Print subtitles I'm going to start by talking a little bit about the history of mortgage lending. And then, I want to talk more recently about how we do commercial real estate finance, and then, residential real estate finance. And then, if I have time, I'm going to try to get into discussing -- [SIDE CONVERSATION] PROFESSOR ROBERT SHILLER: So when we talk about real estate finance, it's really about financial contracts that involve real estate, and that particularly use real estate as collateral. So, it's a very complicated history. But I'd like to put things in a long-term perspective. I want to start with the word mortgage. It actually goes back to Latin. Mortuus vadium. And that means in Latin, death pledge. And then, in the Middle Ages in France, they substituted the French word for vadium. And that's [CIRCLES GAGE ON BLACKBOARD]. I don't know how to pronounce it. That means pledge in French. And I don't know why they called them death pledges. That doesn't seem to involve death to me. But in the long history of these institutions, it became important. The Oxford English Dictionary says the word mortgage entered the English language in 1283. So, we've got a long history here. Actually, I can take it back further than 1283. I was inspired by the research of Yale historian Valerie Hansen, who has been reading old documents related to the silk trade. And her documents are based on a trove of old documents from the Tang Dynasty in China, between the 7th and 10th centuries, which reflect loans that were made to finance trade. So, you had people going back and forth from the Middle East to China with silk, and other items, and they needed financing for the trade. So, she reads these old documents in Chinese. And I was looking over her work a little bit to see whether they had mortgages. She says that in China, it didn't seem, at least if I'm getting her generalities right, they didn't seem to mortgage property, at least in these documents. But she says that among these documents are some -- they weren't all in Chinese, because they were trading between China and many other countries. So, she found some in the Sogdian language. She reads all these languages. It's an ancient language of what's modern day Iran. And it's a dead language. It died out in the ninth century. But she finds some Sogdian documents that look like mortgages. So, some people borrowed money for their silk trade, and they would mortgage their property, or their slaves. You could mortgage slaves. It's an awful thought. And then the contracts would additionally say that you were obligated to maintain the property or the slaves. I guess that meant feed your slaves. Keep them healthy. Those were mortgages from over 1,000 years ago. So, it's a very old institution. But I think it formed its modern form more recently. And it became a well-known term for the general public maybe in the late 18th century. I was trying to confirm that. I'm interested in history, just out of a passion for understanding origins of things. So, I looked up mortgage on ProQuest to find, what were they talking about. And I found an article in the Hartford Courant, dated 1778. Actually, it wasn't an article, it was an ad that someone took out. And I think it's kind of revealing of what the mortgage market looked like in 1778. We here in Connecticut, have -- did you know this? -- the oldest newspaper in America. That's the Hartford Courant. So, a man by the name of Elisha Cornwell took out an ad in the Hartford Courant in 1778. And he explains in the ad, that he sold his farm, and, instead of taking the money right up front, he'd mortgaged the farm, so that he sold it for GBP 800 to another farmer. And the farmer was promising to pay him. And if he didn't pay him, he should get back the farm. The farmer subsequently mortgaged the same farm for GBP 880. So he's made GBP 80 profit. Which would all be fine and good, except he still hadn't paid back the first mortgage. And then the guy mortgaged it again for GBP 1,000. And Mr. Cornwell is protesting: "Hey, you didn't pay me for the farm in the first place, so you don't own the farm. How are you mortgaging it multiple times? " So he said, "I thought I better put an ad in the newspaper, so that any subsequent victims of this farmer, would be warned." So, that's the end of the ad. He said, "this is my farm because he didn't pay me." But this shows how undeveloped mortgage institutions were in 1778. Because he had to put an ad in the newspaper to explain that. The problem was that nobody had any systematic way of representing title. The farmer, who supposedly bought it from Mr. Cornwell really didn't, and nobody would know that. You know, he could fool people. I think that's partly why you didn't see so many mortgages in those days. Because the law wasn't clear. The institutions were not clear about property. And so, you couldn't really do a mortgage business, if you couldn't find out whether the guy mortgaging the farm really owned it or not. And so, it wasn't until the late 19th century that government started to get rights to property sufficiently advanced that we could develop a big national or international market in mortgages. So, an important step is in Germany, in 1872, or Prussia, the government created a Grundbuch law that created a system for Prussia that established in a central book, who owns what exactly. That was in 1872. And in 1897, they made it a national German institution. Still, the United States did not have a Grundbuch at the time. It developed throughout the 20th century in different countries of the world, that property rights would be clear enough that one could do a mortgage lending business. So that's, why I think mortgage lending has really taken off in the 20th century. Hernando de Soto was a Peruvian economist. He wrote a book a few years ago called Mystery of Capital. And it's about the developing world. He argued in that book that property rights, the problems that we just heard about from the Hartford Courant are still very big and alive around the world today. That you can't easily establish who owns what in many or most countries of the world. So, that's a problem. That's why we don't see mortgage finance developing there. You can't make a loan. You know, if you go to some small town in some less developed country, you can ask around, "who owns this property?" And they'll tell you, "that's been in the such and such family for a long time." But if you want solid knowledge of that, if you're going to base financial transactions on it, you can't base it just on hearsay. Someone else might have a different opinion. So even today, in many countries of the world, the laws are not developed well enough. We don't have property rights established well enough. And we have laws that might inhibit mortgages. For example, in many countries, if you give a mortgage on a property, in other words, if you lend on a property, and the person doesn't pay, you're supposed to be able to seize the property, right? But if the court system doesn't function well, or if it's kind of left leaning and supporting the rights of the person living in the home, you might not be able to get it. Or it might take you 10 years to get the guy thrown out of the house. Now, it seems cruel to throw someone out of a house, who doesn't pay on their mortgage, but you have to think of the other side of it. If we don't throw them out of the house, no one's going to make a mortgage. You have to be able to get the house. Right? That's the idea of the mortage. The guy doesn't pay, the lender gets the house. And so, I think there's a general process of development, improving the definition of property rights, and improving the ability of lenders to get the property if it fails, which accounts for the advance of mortgage lending in the 20th and 21st century. So, that's my long history of mortgage lending. But I want to get into some specific institutions. I said, I would start with commercial real estate and then I'll move to single-family homes or residential real estate. I will to talk now mostly about the United States. There's just too many countries to think about. One thing about finance is that it tends to develop a sort of tradition, and a sort of standard contract. It's encouraged by laws and regulators. You have to do the same sort of contract that other people are doing in your country. And I think the standardization is kind of a limitation. We can't be creative in financing, because the public and the regulators will not be receptive to new things. Let me talk about some of the institutions in finance in the United States. It's natural to start with commercial real estate. So, you see a lot of buildings. My question is, how are they owned? I don't know whether you think about this. Who owns these buildings? In much of the 20th century and still today, they tend to be owned as partnerships. Real estate partnerships, which is different from a corporation. In a corporation -- we talked about that yesterday [correction: last class]-- you might sell shares on the stock exchange if it's public. And it's defined as a legal person. And it has limited liability, so that all the shareholders don't have to worry about being sued as a result. But a partnership is different. And most real estate, that's not part of a larger business, is owned in a partnership, rather than a corporation. And the reason is that they're taxed more favorably. Corporations have to pay a corporate profits tax. They're double-taxed. You as an individual pay an income tax, and your corporation pays a corporate income tax, or corporate profits tax. So, you're taxed twice. If you incorporate yourself, or you set up some friends to do business in a corporation, you get taxed twice. So, you don't like that, and obviously you try to avoid that. The way to avoid it is not to have a corporation, but a partnership. The law allows you to form partnerships to own a building. So, you're building like 360 State Street. It's a new building that just went up in New Haven. You know this building? The biggest construction. Does anyone know who owns it? It's probably a partnership. I haven't investigated that. Or it's called a Direct Participation Program. So, the partnership is an investment that is offered only to accredited investors. It's not generally available to the general public. And what is an accredited investor? The Securities and Exchange Commission takes it upon itself to define, who are accredited investors that don't need the protections of the SEC. Basically, accredited investors are wealthy people. And it's defined in the SEC laws who is accredited. You have to have at least $1 million, or minimum income. And so, if you are an accredited investor, you can invest in a DPP. And then, the income of the property flows through to you as your personal income. It's not corporate income, so it's taxed only once.