Submitted by Leo Kolivakis, publisher of Pension Pulse.
On Wednesday, The Sceptical Market Observer, Luc Vallée, posted a piece on his blog, a simple bailout plan for housing and US economy.
Luc cites Martin Feldstein’s article, “How to Save an ‘Underwater’ Mortgage“, published in the Wall Street Journal last Friday:
“Here is an alternative: Make an attractive offer to all homeowners but tweak the incentives so as to attract only those needing help. Specifically, offer to all existing homeowners (of owner-occupied homes), mortgage relief up to 33% of the value of their mortgage in exchange for the same percentage of equity in their home. As a virtue of being offered to everyone, all individual decisions to accept or refuse the government’s offer would provide much needed information about the quality of individual loans. This information would represent the Holly Grail for the financial sector as it would allow banks and investors to finally put a fair value on mortgage pools.
“The opportunity for each individual homeowners to “sell” a portion of their home to the government (in a debt-equity swap fashion) also offers the following: truly significant mortgage payment reductions for borrowers, some breathing room to support consumption and a huge quality improvement in banks’ balance sheets. If designed as a simple mortgage pre-payment program, such a plan could be implemented by motivated banking loan officers within six months.
“Consider a homeowner who bought a house in 2006 for $250,000 with a $240,000 mortgage ($10,000 down payment). This homeowner may now be contemplating foreclosure as the value of his home is likely closer to $200,000 today and/or his monthly mortgage payments too high. Under the proposed plan, the homeowner could choose to accept mortgage relief for $60,000 (25% of the original $240,000 mortgage) in exchange for a 25% equity stake in his home. By selling the property for $300,000 in 7 years (assuming a reasonable 6% annual nominal appreciation), the homeowner’s share of the house would then be $225,000; $35,000 above the $180,000 modified mortgage. Not bad for a $10,000 initial investment, largely under water today! The government would get back $75,000; enough to recoup its capital and protect against inflation.
“A simple example would also convince the reader that the offer would be rejected by homeowners with enough home equity. This means that each individual decision to reject the government’s offer would also send a strong signal to the market as to who would repay their mortgages in full without government help.
“In the previous example, if the house were to be sold early for $220,000, the outstanding bank mortgage ($180,000) would be repaid first to the bank and the balance of the proceeds from the sale ($40,000+) would go directly to the restructuring government entity. The balance of government equity ($20,000-) would then be converted into a fully recourse loan yielding 3%. The conversion of the equity into a full recourse loan would provide a disincentive for the owner to sell his/her house early or to enter foreclosure. This would help stabilize the housing market by keeping more homes off the market until prices have appreciated enough. Moreover, the full recourse conversion would also deter borrowers with no prospect of ever repaying their loans from entering the swap agreement; providing much needed information about which loans which should be definitely written off. Moreover, the relief effort would focus on making sure that only troubled, but salvageable, borrowers are turned into viable homeowners.
“Assuming an average mortgage relief of $60,000 for the 12 million homeowners with little or marginally negative equity today, the total cost of the plan would be $720 billion. However, as we saw, most of this money could be recovered, once the homes are sold. Moreover, if banks were forced to first write down each mortgage by 5% before being entitled to the debt-equity swap money, the initial funding for the scheme and the ultimate cost to taxpayers could be substantially reduced.
“Allocating the bail-out money directly to American homeowners would be a politically superior strategy than buying up banks or let hedge funds and private equity investors buy the toxic waste; not least because it would allow many families to stay in their home. Banks, on the other hand, would be much closer to assessing their loan portfolios at values that might actually reflect their true worth under more favourable market conditions. This prospect alone would promote the strong support of banks which in turn would speed up implementation and thus could help avert bank nationalization.
“By taking an equity position in homes, the government insures a certain fairness as it extracts something (i.e. equity) from over-leveraged homeowners, without passing moral judgment, rather than trying to determine administratively who should get it. Finally, as the leverage is transferred from over-leveraged owners to the government most able to support it, the risk to the economy is also considerably reduced.”
Isn’t this simple enough? As I said above, please let me know what you think!
This past week, I received an email from Ralph Liu, Chairman & CEO of Advanced e-Financial Technologies, Inc. (AeFT).
Ralph sees problems with Feldstein’s proposal and he wrote me the following comment on how he is working on innovative solutions to tackle the US housing crisis:
There have been many proposals on how to fix the mortgage crisis. It does not seem that the politicians have not been presented what the better ways may be to fix the foreclosure problems but rather the politicians lack of political will to adopt those good ideas. Looking back in history, most of the time people do not get what they deserve that makes most economic sense. They get what the politicians tell them to get. This time around it seems not much different from before.
So irrespective of what route we may take to get out of this current crisis. Even no measure is taken there will still be an end to it when the last house gets foreclosed. At that time what alternative housing finance system should we adopt for the future? Are we going to tread on the same old path or should we look for something that will give us a paradigm shift in the way people own homes going forward?
FARM (Flexible And Reversible Musharakh or Mortgage) is one of such paradigm shifting new methodologies that many governments could consider. We been working on developing consumer financial products that could offer the same economic benefits of the conventional complicated financial derivatives without its opaqueness and potential shortcomings for the past 8 years. It has been a long way to get to this fine-tuned and come up with a mature design of a new consumer housing financial product.
First we developed a quantitative methodology based on the cost differentials between owning and renting a real estate property in order to put a value of the two major benefits of owning a real estate property. The first is the right to occupy and use a property similar to a conventional renting. Second is the right to future financial gains from appreciation and the obligation of bearing the risk of financial losses due to depreciation. We created a new financial instrument called a SwapRent contract to represent this financial profile of a property ownership. We then took one more step and split the SwapRent contract into two more sub-contracts to separately represent each of the future upside appreciation and the downside depreciation risk.
The secondary marketplace for people to trade these new SwapRent contracts is called REIDeX and currently hosted at http://www.REIDeX.com . For those interested in more details please visit our research web site at http://www.SwapRent.com .
Those quantitative methodologies are the hard part. Once a new way to quantify and trade these future appreciation units of owning a property is done then things could get a lot more interesting when you start applying these new methods. For example, FARM is a new consumer property financing product where would-be homeowners could start out as a renter and buying these appreciation units along the way based on his economic monthly income capability. His down payment will entitle him as a co-owner with the bank in a trust account that he rents from. This co-ownership legal trust structure is already a common practice in many conventional Islamic mortgages that FARM is also based on.
Here are two original product design white papers, FARM – A new type of housing finance products without foreclosure possibility ( http://www.scribd.com/doc/
18306698/FARM-A-new-type-of-) and FARM vs HELM – The Two Opposite Entry Points to Adjust Economic Ownership in Real Estate Property ( http://www.scribd.com/doc/ housing-finance-products- without-foreclosure- possibility 18596828/FARM-vs-HELM).
The homeowner could purchase the entire property from the bank any time if he has the money. If he doesn’t, then the monthly payment will first go to the rent so that he will have the right to occupy and use the property. Whatever additional monthly income capability will then go to purchase these appreciation units to mimic a conventional property ownernership. Two immediate benefits are first, he could purchase the appreciation potential of the property for only part of the entire house value if he does not have enough income to own entirely. This opens up opportunity for a lot more people to own homes who normally may not become homeowners without such a new product, hence the increased portable housing affordability. In the past, the way for these low income families to own homes was to be offered a subprime mortgage. That was the root cause of our current financial crisis. SwapRent and FARM allow them to occupy and use the property and still get to own part of the future appreciation without the risk of being foreclosed.
That leads to the second advantage which is when the homeowner loses his monthly income capability due to loss of job or disability in the future, he will only lose part of these future appreciation units. As long as he has the monthly income to rent he could continue to own, occupy and use the property for whatever length of time he wishes. Nobody will be able to foreclose and evict him as in addition to being a renter of the house he himself is still a part owner of the house in the co-ownership trust he set up with the bank before. That is why we call this new invention FARM a new housing finance product without foreclosure possibility.
From the institutional investors’ perspective, pension funds for the first time could have a liquid way with very low transaction cost to establish a position in pure residential real estate market exposures through these SwapRent contracts that either the homeowners or the co-owning banks would like to pass on to other investors. They could therefore easily further diversify their investment portfolios with many residential properties located in different parts of the country or even different parts of the world. The residential real estate could finally be treated as a separate investable asset class in the institutional investment world.
There are more details to the execution part of the methodology then could be covered here. If you have any questions, contact Ralph Liu directly at firstname.lastname@example.org and he will be pleased to answer them.
[Important disclaimer: I have no affiliation to Ralph Liu or his firm.]
Would Martin Feldstein's proposal due away with PMI?
And if house prices do not appreciate? This assumption that the whole thing is a temporary downturn and house prices will soon resume a 'reasonable' 6% nominal appreciation is suspect. Housing has very long secular cycles and after this housing bust, it may be years before we see any kind of appreciation, reasonable or not.
Involving government (taxpayers' debt) to ease the mortgage lender's and holder's pain delineates class warfare.
Either you can afford markets rates or you can't. Economy not growing then walk away, go rent. Foreclosure, make them produce the paperwork (deed), they don't have it, sold it to some guy in a mud hut overseas as a derivative investment.
Allow the free markets to work even if it involves liquidation. Kicking the can down the road will cause decades of stagnation.
SwapRent and its embedded FARM are only tools for different people to effectively express their different investment views on the future direction of the real estate markets or to obtain monthly subsidy assistance under a fair, equitable and precise quantitative methodology. REIDeX is the marketplace for them to do so efficiently in a very low cost way. The main economic function is quite similar to trading shares of companies on a stock exchange. Few people would agree on the future directions of the stock market and hence there are always buyers and sellers. When stock is cheap enough no matter how bearish the sentiment is there will be buyers. Similarly the monthly subsidy to homeowners (i.e. cost differential between owning and renting a property) will adjust itself for contracts of different maturity to reflect the supply and demand based on people's sentiments. When it is cheap and attractive enough buyers will automatically come in. The difference of SwapRent to a stock is that a SwapRent contract could lock in long term outcomes of appreciation or depreciation if necessary (e.g. 2, 3, 5, 10, 20 or even 30-year contract to match a 30-year underlying fixed rate mortgage, etc.). More technical info is at the SwapRent home page and the following prior blog post may also be of further interest to you on this point. Thanks. http://swaprent.com/blog/2009/08/06/08062009-what-does-switching-between-owning-and-renting-a-real-estate-property-really-mean/
The SwapRent methodology and its embedded new housing finance products HELM and FARM were all created based on pure free market principles. As a suggested way of government participation, the two prior blog posts below also talked about how using a free market incentive program that is open to every citizens rather than a preferential bailout concept for only selected distressed homeowners would produce much better result to curb foreclosures and restore our property market back to prosperity.
My brain disengaged the clutch as soon as I saw the bit about "reasonable 6% appreciation".
Boys and girls, this whole hare-brained line of thinking has gotten us into all this trouble. So at least please stop NOW.
In the long run, there is NO sane reason to expect real estate prices to rise faster than the general level of prices and wages, i.e. according to average inflation rates. Why not? Because if they rose faster over extended periods of time, hardly anyone could still afford housing after some time.
The problem with all this is of course that at the end of the day, everyone still needs a roof over their heads, so imbalances are going to correct themselves. Eventually. With all this entails. Which is a major part of what we are witnessing now. And that the Powers that Be are going through major contortions to prevent real estate prices from falling to sane levels again is most certainly NOT helping.
Could I just sell a 99 percent stake in the house to the federal government? I could live essentially rent free. And the government would even have to pay local property taxes? Looks like win/win* to me.
Oh, and why again would the government want to protect itself from inflation? Makes zero sense.
Sounds like something created by a Realtor doesn't it? 6% rate appreciation from a depreciating asset (houses wear out and only constant promotion of home ownership to those that can't afford them make it go up)would actually imply a 6% inflation rate, meaning 9% mortgage rates. Pay option ARM's might make sense then. The idea has some plausibility though in the sense that we are in a situation where people are going to need to take a hair cut. The FDIC can't pay and all the others out there get their money and only a few intermediaries take hair cuts. The first thing that needs to be done is the government need to let operations like GS have their equity wiped out next time and bring in new private capital and new owners. Too big to fail need to be broken up. The only cash is in pockets of people and represented by bank accounts, so they have the only money available to pay losses of the FDIC. The mistakes were made when they set up the Fed and put this exponential compound interest model into operation in a mathematically impossible solution.
Sounds like a perpetual motion machine – many of the schemes almost appear plausible. But that damn friction always fouls them up.
If housing has gone up historically at about 3%, why should it now be 6% with a declining home owning demographic as baby boomers downsize?
On Yves Smith post re debt repudiation I tried to make the argument that the number of underwater homes is near 20% of the total. That estimate results in $2.5 Trillion of mortgages that are in question.
That would imply that banks would have to take $800 billion of phony equity in houses to "fix" the problem in the proposed solution.
As Jesse point out in his piece on the 150 banks in trouble this additional $800b would just sink the banks into oblivion.
A restructuring plan that assumes that RE will magically revert to annual appreciation of 6% is wrong. It will not work.
We need massive inflation to get out of this debt hole. That is not going to happen. So the only alternative is to restructure the mortgages and other debts to smaller numbers. That is how the courts would settle this on an individual basis. But we do not have the time to let that process flow through.
What is worse, broad based debt repudiation or broad based debt relief?? The answer is easy. Repudiation is a path to chaos, debt relief will be very painful but not chaos.
@Bruce said…debt relief will be very painful but not chaos.
skippy…If they can keep the gollum glued together long enough. They may have won a reprive, for now, but RE/CRE has yet to show its true mass eh?
The presumption of a 6% appreciation rate is absurd. Also, the lender's equity position would be a no gain proposition for the lender. He gets full settlement only when the asset sells. There's the risk, what will the asset sell for? Moreover, in the instance of a subprime home loan there is a very high probability that loan should not have been made!
If memory serves, Feldstein sat on the Board of AIG in the period leading up to its failure. He may have sat on its Board when it ran afoul of FASB guidelines and Hank Greenberg was forced out. The bonifides are a bit tainted.
The earlier comment that it the proposal reeks of Realtor input is really very much on point.
There is reason to believe bottoms are finally forming in single family house markets in some areas.
Here in SW Florida at Ground Zero many houses are now selling below square foot replacement cost, even after counting the underlying lot as valueless.
Obviously this pricing is driven by the waves of foreclosures. Equally obviously this pricing has terminated virtually all new construction except for custom homes.
iow "Supply" on the construction side is coming into balance with "demand". Meanwhile the "supply" of foreclosures is not infinite either. Nor is the projected supply of foreclosures alone large enough to supply the r.e. market for even one year in nearly all years.
Nor is there a large remaining inventory of new spec-built houses. Developers and builders started working these inventories off back in 2006. And not building new ones. Nor do existing houses have infinite lifespans.
An initial snap-back in pricing(a/k/a dead-cat bounce in beat-up stocks) is a reasonable projection over the next 12-24 months.
As the supply of foreclosures dwindles existing home prices will recover to about 90-95% of replacement cost, plus a separate realistic value for the lot. A lot of areas are seriously oversold right now.
This will take many people by surprise since the rise will be 15% or more from the bottom in one year.
I do not however believe in a return of routine 6% annual returns on r.e.
swaprent said: "..were all created based on pure free market principles."
Erm…. It's seems to me Americans have clung long and hard (1980's?) to the notion of "pure free market principles" and look what that's gotten us.
It's not a direct criticism of the idea, but wrapping the scheme in phrases like that set off my B.S. detector.
You'll just need an intellectual mind to understand a bit more details to be able to tell the good ones from the bad. As I mentioned in one of my prior blog posts – An Amish man may tell you “I told you so.” when he sees a car wreck on the road. That shouldn’t stop us from building better cars and designing better traffic rules. It would be quite stupid to go back to ride horse-drawn buggies again simply because this Amish man got a confirmation of his belief for himself.
Here is the link to the original post.
Rube Goldberg idea and will be gamed and changed to suit powerful constituencies like all govt giveaways.
I talked to a Washington insider about the "Brady Plan" for underwater homeowners in june last year. His reply: there's a committe working on it since the beginning of 2008. But it raises huge problem of "moral hazard". I assumed he wasn't talking of Moral Hazard in megabanking.
Here comes the Amish lady. She goes to NYC and everybody looks just like Rube Goldberg to her. The most unpleasant folks in my case study groups back when I was in business school were those who did not read the case but somehow opined the most. Many other small time econ blog sites are full of anonymous hitters taking jab at everybody else's ideas with nothing to contribute. Will the real intellectuals here please stand up?
As I mention before that the SwapRent methodology is a 100% pure free market based system. Part of its function is as simple as establishing a transparent and efficient marketplace where an investor may agree to provide a fairly priced monthly subsidy to any property owner who may want to receive it for whatever reasons as long as he agrees to share a part of the future appreciation of the property with this monthly subsidy provider. No government's involvement or taxpayer's money will ever be necessary for this to function other than a regulatory role as it usually plays on any other business transactions in our capitalism society.
This SwapRent quantitative methodology also has nothing to do with forecasting or assuming future returns on the real estate markets but rather simply let those people with different views on that (6%, 10%, -20% or whatever) buy and sell against each other so that at least one of them will be right and happy at the end of the contract. It only makes sure that the pricing of the exchange contracts is based on an agreed upon scientific and repeatable methodology that allows anyone at any time to swap a part of future appreciation of a real estate property vs. receiving a current monthly cash flow and vice versa.
Will somebody please read the case before coming to the case study meeting so that we may have a meaningful discussion? Thanks.
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I recently came accross your blog and have been reading along. I thought I would leave my first comment. I dont know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.
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