Friday, December 30, 2011

Solution to US Housing/Foreclosure crisis

The solution to foreclosure proceedings is a voluntary arrangement between borrower and lender that is a mix between a rental agreement, rent-to-own scheme, and Natural Finance's deposit option concept.

For borrowers, strategic squatting or strategic default can offer a direct financial benefit if their mortgage is worth more than the sales proceeds of their home.  The disadvantages include credit rating damage that could prevent purchasing another home, legal hassles, possible shame from neighbours and financial industry, and uncertainty as to length of foreclosure proceedings.  Some jurisdictions also force the home owner to declare bankruptcy and pay the mortgage with any other assets they may have.

For large financial institutional lenders, the greatest disadvantage to foreclosure is that it causes an inescapable accounting loss, and diminishes their capacity to deceive their shareholders and regulators as to their solvency and size of losses.  A related issue is that foreclosure is expensive for banks as it incurs legal and selling costs, a boarded up house is worth about $50k less than a comparable home, and there may be maintenance/renovating costs and paying of property taxes.  Every foreclosed home also decreases the value of every existing foreclosed home the bank may own.  A secondary reason not to foreclose is that it perpetuates an evil PR image, and there should be some shame to foreclosure considering the industry directly, and arguably intentionally (remind me to argue in comments), caused the housing crisis.

One proposed solution to keep people in homes has been voluntary mortgage writedowns by the banks.  This would be effective in keeping people in homes, because the borrowers would feel compelled to keep paying the new lower mortgage while hoping/waiting for their home to eventually appreciate in value from the current low levels.  The reason this is a non starter for banks, is that mortgage writedowns diminish their capacity to hide losses from their shareholders and regulators, even if it might mean keeping a paying customer, and be less unprofitable than foreclosure.

Somewhat similarly, a voluntary arrangement by lender and borrower for borrower to hand ownership to the lender, and then rent the home will incur accounting markdowns by the bank.  Other issues is that the renter can then demand major maintenance work be done, and take advantage of any other renter protection regulations.  The renter can also generally leave at any time, and so the bank still bears most of the costs of foreclosure, and all of the risks of future property depreciation.  Its a good deal for the home owner turned renter only if it allows him to avoid major repair costs and/or the rent is very competitive with comparable market rates.  These factors tend to make it less attractive to the bank.

Simplest solution
One simple solution that can be extremely productive for both sides is to renegotiate and write down the future interest cost of the mortgage.  If a home worth $150K has a $200K mortgage balance, then reducing the interest rate to 2% per year, can result in yearly payments of $9k or $10k (with $4k in interest costs) compared to a 7% subprime $200k mortgage which has $20k in yearly payments including $14k in interest costs.  For the home owner, halving their monthly payments can provide a cheaper alternative than renting while still owning their home, and if the housing market rebounds, profit from that ownership.  For the bank, this avoids forcing them to write down the value of the mortgage, and only costs them the ability to inflate future profits (by pretending th 7% interest on 200k will be paid), which in many cases would not be realized.

Productive government regulation here, would be to temporarily force foreclosure actions to be accompanied with an alternative bank offer to transfer the outstanding mortgage balance to a 10 year term 2% loan.  The reason banks would fight this legislation forcefully is that it would increase the number of strategic squatters and defaults.  Banks would also make new loans only with a required 25% down payment (which is the current norm as a result of mortgage crisis), so as to avoid strategic defaults on new and recent loans where property values have not come down significantly.

Reducing bank opposition to this regulatory proposal can be done by increasing the 2% interest rate.  Matching the current best bank rates is reasonable, but will cause banks to raise their best rates.  A (1 percentage point or so) premium to the US 10 year bond (current 2%+1% = 3%) would likely be an agreeable balance between bankers lobbying power, and being attractive enough for distressed borrowers to take advantage of, and close enough to existing mortgage rates not to affect recent mortgage home buyers.

Although we live in a world where bank's opposition to legislation is very effective in preventing that legislation, the proposal is a net benefit to banks, home owners, and construction industry, and it would surprise even the most cynical that the banks could successfully block it.

There is significant US economic benefits from adopting this plan.  First, reducing foreclosures is the first step in finding a bottom in housing prices.  Helping both stop the deflationary spiral harming the economy, and helping homeowners and banks with a healthy housing market.  For instance, homeowners with a low interest mortgage can get a premium selling price on their home if the buyer takes over the mortgage.  For instance, a property that was worth 150k (but with 0 in equity to homeowner), could be sold for $220k with an assumed 200k mortgage at 2 or 3%, and 20k in proceeds for the owner (less commissions and lawyer fees which probably leaves under 10k to owner).  Such sales prices though would allow homeowners to benefit a little, but help banks and the real estate industry quite a bit because such sales allow the industry to pretend there is a healthy rebound in housing prices, and so influence home buyers to be more interested, and shareholders to place a higher value on banks.

A government solution is not necessary, though helpful to force the solution.  A partial legislation or voluntary solution could apply to corporations formed to hold MBS securities.  In their case, since they are not involved in creating new mortgages, offering the optional alternative to foreclosure could transform subprime securities worth 10cents on the dollar with 7% nominal coupons into securities worth closer to 1 dollar with 2% nominal coupon.

More Complex Solution
The only significant problem with adjusting the interest rate of mortgages to help reduce the incentive or chance of strategic default is that it continues to give the home owner the option of defaulting if home prices don't come back up to the mortgage values.  Even if the home owner is provided with significantly lower financial carrying costs for staying in his home, he still has the option of reducing those carrying costs to 0 by defaulting and squatting in his home.  The bank is then left with traditional expensive foreclosure remedies, and so the only one who benefits from the arrangement might be the home owner who gets to delay strategic default (at a discount while waiting) until he is more sure it is his most favourable choice.  The unfavourable-to-bank home owner choice is less likely at a 2% adjusted mortgage rate, than it is at a 3% or higher interest rate.

The overwhelming attractiveness of the simple interest-adjustment solution above for the bankers is it allows them the opportunity to realize a 2% or 3% yearly return on their distressed housing loan portfolio, which is an option they would jump at today (facing 30% or so loss, currently).  The above paragraph outlined loopholes that might cause the banks to fail to meet such targets.  The proposition of allowing the banks to lock in a moderately profitable outcome is the key to an ideal solution for them.

The complex multipart solution that provides an improvement over simple interest rate adjustments is as follows.  Although the term "rent" is used initially, it actually refers principally to an option premium paid by the borrower:

First, calculate an attractive low market rental value for the property as a starting point, then reduce it by say $50/month further.  The purpose is to make renting the property attractive for a home owner as an alternative to foreclosing on him.

Next, reduce monthly "rental" further by an additional $100-$400 meant to cover expected maintenance and repair costs.  The reason for this additional decrease is that maintenance and repairs can be done at the home occupant's discretion either as DIY labour, or through an additional bank loan to cover the costs of approved third party craftsmen.

Next, comes adjusting the mortgage interest rate (I).  Yearly Interest Payments (YIP) = Annual rental payments (above) - Property taxes - Fire insurance premiums.  The latter 2 items are (ideally) paid by the bank.  The Interest rate I is thus = YIP / Mortgage balance.  The result is roughly equivalent to an interest only mortgage.  As an example, a $200k mortgage, with $2k in property taxes and $120 of fire insurance premiums, and $1010/month ($12,120/year) as the agreed "rental" payment, then YIP are $10k, and the adjusted mortgage interest rate is 5%.  For a 200k mortgage this adjusted interest rate may actually be higher than the original contracted mortgage interest rate (justification for home owner soon).  For a 300k mortgage, YIP are still $10k, and the adjusted  mortgage interest rate is 3.33%.  The term of the mortgage is reset to 30 years.

The rights of the home owner/occupier, are to continue occupying the property as long as he continuously pays the agreed "rental" fee.  The owner/occupier can transfer the right to occupy the property (for continued "rental"/support payments) to anyone he chooses, and may profit from that transfer.  The owner/occupier may sell the property at any time with the bank having first rights to proceeds (after 3rd party realtor/legal fees) up to the static mortgage balance.  The owner may abandon the property at anytime.  The owner/occupier has the right to pay down the mortgage balance at any time, which makes part of his future monthly payments pay down part of the mortgage principal instead of just the interest.

The bank has the right to increase annual "rental" payments according to local rent control board guidelines.  Any increases in rental/support payments reduce the mortgage balance as they are paid.  The bank should also have the rights to simplified eviction procedures, if the home owner fails to make payments.  The home owner should have the right to legal recourse, if the bank acts improperly in repossessing the home, but the recourse is for financial (including punitive) damages, rather than preventing eviction.  If any supplemental home improvement/maintenance loans are made by the home owner against the property, then if the owner transfers the payment obligations, the bank should have the right to either approve the transfer of supplemental loans or demand repayment of supplemental loans upon transfer.  Essentially the owner has the right to demand that essential repairs (roof, heating, plumbing, appliances if included in original mortgage) be paid for by the bank, but the costs of those repairs become a loan to the homeowner.  Non essential improvements/renovations have no obligation by the bank, but can have negotiated assistance, or can be freely undertaken by homeowner if he believes they will enhance the property's market value.

Taking a moment to explain this structure, a traditional mortgage is already very similar to a call option, and more specifically a deposit call option.  The owner feels like he is merely renting his home from the bank, though he has voting (director) control over the property.  The call option strike price is the current mortgage principal balance, and the characteristics that make it like a deposit option are that principal payments adjust the strike price down, and regular maintenance (mortgage) payments are required to keep the option in good standing.  The home owner, with a traditional mortgage, also owns a put option (giving him the right to limit his risk) with a strike price that is also the mortgage balance.  The put option is the choice of strategic default.  The major difference between a traditional mortgage and these call and put options are the legal hurdles that make exercising the put option right are slow or not completely free (for instance credit rating damage). to the homeowner, and makes cancelling the call option slow from the banks perspective through foreclosure proceedings.

The proposed solution to foreclosure has 3 major differences with a traditional mortgage.  First, all legal obstacles to exercising either the put option of abandoning the property, and the cancelling of the call option by the lender are reduced to the legal processes of month to month leases.  "Renter or landlord" can terminate with 2 months notice, but the "landlord" only has the right if the home owner refuses to pay "rent".  The home owner has the right to demand the privilege of essential repairs from the lender, even though he is responsible for their costs (through market rate loans).  Third, the option premium equivalents of traditional mortgages are significantly adjusted.  The home owner's put option is replaced with the renter's right to abandon a property. The traditional mortgage's deep-in-the-money call option (when substantial down payment is made, and/o there is homeowner equity) has its premium adjusted (as reflected in the interest rate) to reflect the fact that it is a long term out of the money option.  The above YIP formula  appropriately discounts the interest rate based on how far out of the money the option is.

The benefits to this structure are substantial.  First for the home owner, in the context of facing foreclosure proceedings or strategic default, the obvious likely eventuality is renting his next residence.  This provides the home owner with below market living accommodations if compared to rent.  The home owner receives an option that is valuable if the property value will approach market values that existed in 2007 (height of housing bubble) in the next 30 years.  If there is any reasonable hope for that outcome, then the home owner receives all of the profit resulting from a sale price exceeding the mortgage balance, despite only having the effective responsibilities of a renter.  Furthermore, because he can transfer his option (for cash) to anyone that does have the hope that the property value will exceed the mortgage principal within the next 30 years, or someone that appreciates the below-market rental obligations, there is additional significant opportunity for profit by the home owner.  If at any point the home owner feels confident that the market value will appreciate sufficiently, he can pay down the mortgage balance, and thus save on relatively high interest costs, or freely make home improvements that will either enhance his enjoyment or profit.

Benefits for the bank are also substantial.  They avoid recording losses on original loans.  In the above example of a property worth $150k with an original $200k mortgage, the resulting 5% interest rate is above current market rates.  So, not only do they avoid recording losses on bad original loans, they stand to make better than market returns on the original (higher than current market) loan value.  Even if the original mortgage was $300k, resulting in a mere market return of 3.3% on that original balance, the bank saves an additional $100k in writedowns.  In fact from a real cash flow perspective, both the above original mortgage (200k and 300k) interest results are identical to a 6.66% interest return on a new 150k interest mortgage without incurring the legal costs of foreclosure, or the transaction costs of finding a new home-owner borrower.  From the bank's perspective, even though the real market cashflows are identical between an original 200k and 300k mortgage, an original 300k mortgage as the call option strike price is much more valuable, because if the market price of the home goes up substantially over the next 30 years, the bank will be repaid 300k in principal rather than 200k or 150k.

The apparent free gift of profitability hope given to the "renter" is also of significant benefit to the bank.  Home owner's hope will remain marketable for the first 10 or 15 years no matter how poorly the housing sale or rental market performs in that time, because hope for the following 15-20 years should remain.  In fact, it will take 25 years before a clear opinion that the hope for a property reaching a specific value is deemed worthless.  Until then, in most likely valuation scenarios, someone will be willing to provide the bank with 6.66% annual return on the starting 150k market value because the hope for profit from the option is deemed not to be worthless yet.  After 25 years of continuous payments, the return to the bank would be 165% cumulative non-compounded, and if the property were still valued at 150k, it would be 165% cumulative profit.  After 30 years, if the property is still valued 150k, the bank returns are 200% ($300k in profit) from the property, if all payments are made.  If the property goes up in value, the bank profits up to the original mortgage balance.

Property management costs and benefits of the arrangement are a benefit to both sides.  Unlike a tenant, the home owner is incentivized to save on maintenance and repair costs because he is liable for their costs even if he is promised that the repairs will be made.  Unlike tenants, he has no incentive to ever break anything intentionally.  The vested interest in saving maintenance costs by the owner makes property management cheaper.  Both sides are relatively protected from a property in poor state of repair, even if the state of repair is misjudged.  The home owner's right to improve the property is a substantial benefit compared to a tenant, and such projects usually are a benefit to the lender.

Tax advantages to US home owners are substantial.  Almost the entire monthly payment by the home owner is treated like mortgage interest.  That is fully tax deductible in the US.  A 20%-50% government rebate on housing costs.  An equivalent rent payment would not be tax deductible.  A traditional mortgage would include at least $6000 in non-tax deductible principal repayments.  For the banks, there may also be a significant tax advantage.  I'm not a US tax law expert, but using Canadian tax principles for options, if the bank can argue that what is conceptually an interest only mortgage is in fact a call option, and its cash flow from the security is not interest revenue, but instead option premiums, then it can argue that it is not receiving taxable revenue.   Option premiums are considered part of the capital account, but rather than option premium cash inflows being considered capital gains when they are received, they are cost base adjustments, which have no immediate tax obligations.  This means that the taxes due on option premiums received by the banks would be payable 30 years from now when the option is exercised, and would be paid at the reduced capital gains rate, rather than the general income rate.

New Home Sales and non-bank home financing
The core aspect of the included distressed housing solution is to turn under-water mortgages into rental-like arrangements with an option to lock in a portion of far off future profits from the sale of the property.  The arrangement also involves a no-money-down/zero-equity-position home owner.  This section will show how the substantial benefits discussed above for home owners facing foreclosures from banks, can be applied to general home sellers and buyers.  Because there is no down payment necessary, banks or other external lenders aren't a necessary recourse.  The only complexity with private sales  involves ensuring that maintenance and repairs will be done.

First, let's name the 2 parties of this transaction.  The Occupant Director Owner is the person "buying" the home.  He has full ownership rights, and mostly rental obligations.  He is not necessarily on deed/title.  The Option-encumbered Owner is the person "selling" the home.  He is the one with ultimate capital at risk.  Has the obligation to take the property if abandoned, and power to evict only if due payments are not made.  Next, lets assume that a home with a current market value of $150k has a market value rent of $1200/month, and has an expected market value 30 years from now of $270k.  The exercise is to estimate the total value of the rights given to the Occupant director owner.

The right to occupy the property indefinitely ($1200/month = market value of rent), including the right to abandon all interests and rights in the property.
+ The right to all sales proceeds of the property above a specified strike price.
+ The right to sell the property if the Option-encumbered Owner is provided proceeds in the amount of the strike price.
+ The option to lower the strike price by paying down the "principal" (making supplementary payments) at any time.
+ The right to transfer his option and rights in the property to anyone.
+ The right to decide improvements to and use of the property including sublets.
+ The right to not be evicted just because the Option-encumbered Owner prefers to sell the property.
+ value of tax benefits
- The liability for the costs of repairs and maintenance if required from the Option-encumbered Owner.
- The liability and compliance duty of laws and regulations normally imposed on a property owner.

The most important variability in any premiums paid over the fair rental value is the strike price offered to the buyer.  The strike price offered is mostly based on the sellers optimism or concerns and his preference for either a more certain sale of the property or his willingness to operate a long term rental income property.  The best guess for what a property will be worth 30 years from today is the expected core inflation rate.  The 30 year future value of a 150k home is calculated as 270k by using a compound 2% growth rate, which results in 81% total growth.  Though, historical analysis of median home prices shows a 300% average price increase for median home sales over any 30 year period, these do not reflect the expected growth in value of an existing home, because homes have gotten larger and nicer over the years, and more homes are built and sold in growing and popular areas.

Using a 270k strike price option, that is giving the buyer the right to "fully purchase" the property any time within the next 30 years for $270k, we need to value this benefit to the buyer.  Although there are benefits to both buyer and seller of permitting the seller to increase required monthly payments each year by an inflation-based amount (justified later), the easiest way to value the option is to keep the monthly payments fixed for the entire 30 years.  Because the buyer can transfer his option and ownership rights freely, with locked in monthly payments, he gains at least the rental savings from the lack of a 2% annual increase in rent.  A simplified portrayal of a 2% annual "rent" increase would be a $300 annual increase in yearly payments.  So the 2nd year annual payments would be $300 higher, the 3rd year, $600 higher... and the 30th year, $8700 higher.  The average over 30 years is $4350.  That is a $130500 total benefit to the buyer over the 30 years. Since the buyer wants a fixed monthly payment, then a fair price to pay for the option to "fully buy" the property for $270k is an extra $4350/yr or $362.50/month.  Even though this front loads payments for the total benefits to the buyer in the first few years, its still fair to the buyer.  After 15 years, he may have overpaid the fair value rent by an average of $2175/yr, but the last 15 years are expected to be underpaid by $2175/yr, and that is a benefit that can be sold for that amount to a new Director-Occupant owner.  Importantly, the buyer can abandon all rights and responsibilities to the property if he is disappointed with the property's market value potential.  Finally, an option at the end of its life cannot be worth less than 0.  If the property 30 years from is worth less than $270k, then the terminal value of the option will be 0.  Even if the expected value is 270k, there is still a chance it will be worth more.  The option buyer gains all profit from the property's value in excess of 270k.  Option holders have a coin flip analogy of heads they win, tails they don't lose.

Just because the expected future value is 270k doesn't mean that is the only choice for an option strike price.  150k, the current market value, is also a natural choice.  Valuation issues aside, a seller may be more attracted to a 150k strike price because it makes it much more certain that the option holder or a transferee will end up buying the property in 30 years, and so much more likely that he will be committed to the property's upkeep and maintenance, and more likely to find a new buyer if he wishes to live somewhere else.  A low strike price eliminates most continued property management work the seller is likely to be responsible for.  More importantly, are the valuation issues.  A 150k strike price for a property expected to be worth 270k is a benefit valued about $120k higher than an option with 270k strike price (another $333/month in premiums).   Because this seems to transfer almost all of the risk onto the buyer, and likely with resistance from the buyer, a useful compromise is to halve the risk between buyer and seller.  A 210k strike price is worth $60k to the buyer, and so worth $166.66 in higher monthly payments to the seller.  A 210k strike price is low enough to keep the buyer, and his possible transferees, confident of realizing value from the property and committed to maintain it and continue sustaining the contract.

Lets look at the transaction  from the perspective of a seller and his alternative of selling the property for $150k.  Often, the decision to sell rather than rent out, is based on avoiding the hassles and risk of property management, which this arrangement is likely successful in achieving.  Instead of selling, he is able to generate $1200 + 362.50 + 166.66 in monthly revenue. $20750 per year or 13.83% annual return.  At the end of 30 years, he will either get $210k, or his property back if it is worth less than $210k.  So, up to an additional $60k in profit.  If he has good credit, he could likely qualify for a $120k 30 year mortgage at a 4% interest rate.  That results in $6840 annual payments of which $4800 is initial interest.  Net income (after interest) on the property is $15950, and net cashflow $13910 per year.  On the 30k invested/tied-up in the property, those are 53% annual yield, and 46.36% cashflow annual yield without including the potential 60k in profit at the end of 30 years.

The only complex part of the arrangement is how to handle maintenance and necessary repairs.  The core problem is that a private seller may not be able to adequately guarantee all necessary repairs.  Insurance companies could be more helpful here, but a solution that doesn't rely on them is necessary.  The basics of the maintenance/repair agreement is that any repairs/maintenance paid by the seller increase the option's strike price, and interest accrued by the cost of the repairs are added to the monthly premiums, while those costs paid by the buyer do not affect the strike price.  This is not balanced towards the buyer.  Compensation for the imbalance to the buyer can be in the form of  lower monthly payments (as mentioned in the above complex bank solution), but can also be in the form of a lower option strike price.  For instance, the 2% annual growth rate that was used to calculated the expected value of the property 30 years from now ($270k), may be considered conservative.  3% growth including expected maintenance and cosmetic improvements necessary to make it comparable to the "median future home sale" in quality is also reasonable. So using a conservative expected future value (2%) is fair partial compensation to the buyer for taking on the cost liability of maintenance and repairs.  All of the other intangible rights of ownership are also compensation for the buyer.  The biggest buyer compensation of all though, is the privilege to abandon the property, and the privilege to demand repairs.  The buyer gets the benefit of reacting to actual events.  If the home is a lemon, with many undisclosed defects by the seller, the buyer may choose to leave at the cost of a couple of months rent.  Its also easier to resolve a conflict with the seller (compared to traditional sales) because they have an ongoing relationship.

Dealing with the complexity of a seller being responsible for repairs, but preferring to avoid them, results in a 3rd negotiated amount (in addition to monthly payment and option strike price) between buyer and seller:  The interest rate to be charged for maintenance/repairs paid for by the seller.  A very high interest rate discourages the buyer from seeking repairs by the seller, but it may make the overall deal unappealing to the buyer, and if there are costly needed repairs early in the contract is likely to result in the buyer abandoning the property.  One solution is to have an interest range that increases over time.  For instance 4% in the first year growing to 34% in 30th year (or 8% first year, to 23% in 30th year).  Another point of negotiation between buyer and seller is the seller can admit that roof, heating system and appliances will require one replacement over the 30 year period, and so set aside special low interest funding provisions for those eventual events.

Transformation of home ownership society
This new home ownership model (lets call it Director Occupant Purchase Option) lessens the need for capital accumulation structures such as banks.  Though banks may not be inherently evil, they do make a "too-essential-to-fail" argument that allows them to extort benefits from society.  The Director Occupant Purchase Option is not a loan/credit transaction, so credit ratings don't matter any more than they do for rental contracts.  I see a potential for less litigation between home sellers and buyers (or long term lease renters) because the parties have more reason to compromise, and the buyer can simply abandon the property if disappointed.  It still allows people to upgrade to new homes.  Buyers can sell/transfer their ownership rights and option.  Sellers can transfer their income streams.

Home ownership is viewed as positive for a society, because it causes a vested interest in the society.  A healthy, growing, attractive society is good for property values, and both the buyer and seller in a Director Occupant Purchase Option (DOPO) benefit from a more attractive society (through the favourable impact on property values).  The model will increase "home ownership" rates because some people will find DOPOs more attractive than renting.  Its ironic that in cosmopolitan  urban centers such as Toronto,  most people in favour of community programs tend to be renters, and most opposed, property owners.  Its ironic because a sustainably attractive and livable city will drive up rents and property prices with more financial impact on home owners than its corresponding pressure on property taxes.

The link to Natural Finance
Natural Finance also separates the control (directorship and occupancy) of the organization from financial investment.  Investors are entitled to be repaid.  Not to interfere in the operations of the organization.  Investors only have the additional right that accounting controls exist to channel funds back to investors as promised, and ensure they aren't squandered or pilfered.