Thursday, September 23, 2010

financing egalitarian communes where members have disparate financial means

How to you arrange temporary ownership of a commune, such as a co-housing arrangement, where each member is unable to provide equal down payments, but an eventual equal ownership status is desired?

This is as far as I know, not only an open important finance problem, but one that has been untouched.  Applications include all cooperative ventures and mutual insurance equivalents.

Marriage is a full commune.  It is a commitment to equal share from personal entitlement (70% of marriages in North America result in divorce).  A cohabitation arrangement for the purchase of co-housing involving multiple parties does not imply the same trust levels among the parties.  The main issue is that those who put nothing down are motivated to walk away from the property if the market value declines, while obtaining "free" capital appreciation if the market value goes up.  Thus they have no risk and extreme possible reward.

We will look at 4 general approaches to establishing a fair agreement between parties.  Each can have some advantages, and the choice is affected by laws of a jurisdiction (eviction laws, ability to walk away from property and mortgage).
First, If all parties agree to an equal share and cosign one large mortgage, the question becomes what is the value of cosigning to and for the members?
Second, Those parties putting up 100% for their shares can cosign a mortgage, and then reissue loans to those putting a small fraction of down payments at a profitable interest rate margin to reflect the relative (lack of) risk of each member.
Third, all investors put down equal minimum payment and then finance their share independently, or more likely collectively.  The question then becomes how to do this as efficiently as possible within the financial system, and since the answer is to finance collectively, how to minimize financing costs and the substantial risk borne by the lender.
Fourth, those investors who put up more upfront money could obtain a 1/x (1/20, in example of x=20 partners, buying a p=$100k house) share by putting down less than p/x ($5k) for their share.  Those putting less down would end up paying more than $5k for their shares + interest on the loans.  The justification is the relative risk of each owner to a drop in market value.  The question becomes how to calculate a fair discount.

All of these scenarios assume the concept of net partial ownership.  Even if there is mutual cosigning, each party is responsible for his actual share of the debt, so if 2 people buy a house, where 1 puts up all cash for his share, and the other puts down nothing, then even if they are equal owners, proceeds from selling the house are typically split in half, and then those who were responsible for debt for their share use those proceeds to pay down that debt.  In such a 2 person cosigning situation, if the 2 people buy a property for $100k that they immediately resell for a $10k loss (typical total transaction costs if resold the same day for closing price), then the first investor gets $45k back, but must pay the bank an extra $5k to cover his cosigning obligation, and thus the cash partner lost the entire $10k, while the debt partner lost nothing.  Note that an imposed fairness, as a baseline, is that all partners should be equally responsible for losses.  If the project loses $10k, then the partner who had no down payment should owe the partner who put up cash (at least) $5k.

Another concept the reader should be familiar with is the call option.  A homeowner with no down payment and no liability if he walks away effectively owns a call option on that house.  If it goes up in value, he's worth more, and if it falls he doesn't lose anything.  Call options on stocks and futures that expire 1 year from now at a price equal to the current market price are worth 2%-8% of the market price depending on the individual stock and how volatile its pricing is, and how uncertain its future.  It drops to 1%-3% when the market price is 10% above the call option strike price.

The first scenario (cosigning risk transfer privilege) is the most common approach partially because it is suited to marriages, and simplest, and partially because it satisfies banks.  A starting point in valuing the benefit of cosigning a loan is to grant the cash buyers a loan by the debt buyers in the event of a loss.  In the 2 person example, the debt buyer would owe the cash buyer $10K as an unsecured loan after liquidating the property.  If the debt buyer had invested 5K instead of 0, then no loan to either party would take place upon liquidation because both parties lost $5K.  Setting an appropriate interest for the conditional loan is a market agreement between high downpayment investors and low downpayment investors.  This can be fair to the cash investors if such a loan is likely to be repaid, and so basically only offers protection in the event the project is unattractive to the borrower since failing to pay due to hardship makes the conditional backup loan of dubious value.  Although, this arrangement transfers all of the risk (if loan is repayable) to the low downpayment investors, the arrangement can be attractive to them if cosigners reduce the interest rate of the loan sufficiently.  The appeal of this solution is relative simplicity.  An alternative is partial indemnity instead of full indemnity to the cash buyers.

The 2nd approach (relending cooperative) is similar to rent-to-own schemes.  It probably involves some right to evict and take control of a delinquent voting-rights-holder, but a delinquency option can be an "own-to-rent" right of abandonment by the borrower.  This approach can be used with many partners, and in any situation where partners must buy a share of a project (even without large secured loan).  With a large group, and bank involvement, the bank has a lending relationship with the partnership with individual investors co-signing.  The  partnership is owned in proportion to paid up capital, with senior partners (majority veto of further investment projects) having fully paid up capital.  The borrowers take out "semi-unsecured" loans from other stakeholders in the partnership (bank, partnership entity, and partnership investors), with terms that when fully paid they are granted senior partnership status, and proceeds from the sale of the partnership close out the loan.  The loans are open, such that borrowers may fully pay off the loan in order to participate in proceeds from sale of partnership, or gain voting status to stop such sale.  While interest rate charged to borrowers are set individually, a preferred model is to offer a premium over bank funding that varies according to paid up capital (and adjusts downward over time as more paid up capital is accumulated through repayments).  For normal borrowers, premium over partnership funding rate would reach 1% or less when a borrower reaches 50% paid up capital.  This approach creates a lending market for borrowers to choose from.  The open loan criteria means that borrowers can renegotiate at any time, and lenders are able to transfer the loan as well.  Transaction costs are minimized by a single standardized legal agreement where only interest rate and repayment rate are varied.

The third approach (equal minimal risk) guarantees that the ownership situation is fair and equal to all investors at all times.  The cost is likely much higher financing costs for those that would be capable to pay cash for their share.  Project organizers and investors agree to a minimum down payment and payment schedule from investors.  Those potential investors who are unable to meet the payment terms, can pool together and split 1 share.  In its simplest version, 1 lender (bank-like) lends the necessary proceeds above accumulated down payments to the partnership at a unified interest rate and terms.  In order to minimize the interest rate, the bank is offered terms of full forfeiture of individual shares and partnership assets after 6 months delinquency.  After 3 month's delinquency of one member/partner, the other members are offered the opportunity to take over the delinquent member's share obligations, and all of those that agree get an equal fractional share of that share.  No compensation is owed to the delinquent shareholder.  After 4 month's delinquency, the partnership can offer the membership share to outsiders with any proceeds for purchase of the share obligations going to the partnership.  Prior to "bank" repossession of the share, the partnership may vote to socialize ownership of the share by a majority to eliminate the share and distribute its obligations among all other shareholders.  The advantage of this structure is that all investors can walk away and abandon their share of the project, or resell their rights/obligations.  Investors with substantial capital can syndicate with the primary "bank" lender to form a lending partnership that acts as one, and where individual investors break even on the high interest rate charged to the partnership.  This is suited to high risk projects.  An interest rate premium that decreases over time, as the project matures and more paid up capital is accumulated, can make sense.  An example of 12% for first year with a 1% reduction each year for the first 5 years might be typical (improvements below), depending on loan syndication participation and overall project quality.  The ability to over-ride eviction laws in a jurisdiction can be important in permitting this type of risk taking by the lending syndicate.

The fourth solution (share discounts) is appropriate when partners with low capital are confident of the project's success.  This option involves cosigning loans by all partners.  Allowing full paying shareholder to underpay for their share, is direct compensation for their cosigning benefit and project participation.  It differs from the cosigning-risk-transfer-privilege (first solution) in that it involves a less speculative risk transfer to the capital-rich partners (if the borrowing partner must abandon due to health reasons or inability to pay, then an unsecured loan from them is worth little).  As a base-line for pricing, transaction costs of reselling the project at the same nominal price on same day of closing should be fully reflected.  So if those transaction costs are estimated at 10% of the project value, then all those who pay less than 10% down for their share "price" be increased by up to 10% while those who fully pay for their share should have their share cost reduced by 10%.  Note that we should not adjust for market risk (project value increasing or decreasing) because that is theoretically fully reflected in the purchase price.  While market price of assets reflect the cost of insurance and maintenance, the inequality of loss between those that fully pay their share versus those who fully borrow for their share, means that either the highest cash investors have full unilateral/veto control over insurance coverage and maintenance programs, or they must be compensated for democratic control of these issues by all sharemembers.   The first option is easier.  Spelling out insurance carriers and coverage together with maintenance policies (less important than insurance for most assets) is an alternative to succumbing to total insurance decision tyranny.  The one other factor that should be adjusted among sharemembers is the value of the call option held by low to no cash down members.  Its value(s) should be split evenly betweens sharemembers.  Estimating the 1 year call option premium for each sharemember can be done using the Black-Sholes formula where the strike price of each option is the project cost less the member's down payment.  Those members who hold a higher than average call option premium (low cash investors) as part of their share would pay the difference from the average to those who hold a lower than average call option premium (high cash investors).

The dynamics of the third solution are the most interesting.  If the project is abandoned by nearly all, then any person willing to take over project obligations can satisfy the lending syndicate, and the syndicate members have sunk costs motivating them to do so.  Project members with good credit ratings and borrowing power, can join the lending syndicate by borrowing at lower costs than they are lending, and securing the loan partially with their syndicate share.  This effectively makes the 3rd option an improved 2nd option, because it simplifies the loan into a single agreement.  In a large member project, the risks tend to be limited to market risks, because the network effects of a large group means relative certainty that one member's hardship causing loss of his share is assumed by another member or member's contacts if the project remains viably marketable.  While the project commits to a fixed payment schedule with no prepayment option, it can purchase a syndicate position from any syndicate member through market agreement (if it purchased the entire syndicate, it would have the same effect as repaying the loan in full since it would be paying itself).

In my next article, I will show how natural finance secured queued soft loans can help both fairly set interest rates in a manner continuously adjusting to market conditions, and meet flexible operational needs of a project.  Natural finance can basically help a large group of poor communalist nitwits fund an expensive project.


  1. Note that while this is framed as a financing solutions for egalitarian communes, they are appropriate for any desired share percentages among members.

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