Homeowner Rescue Plan

Homeowner’s Rescue and Economic Recovery Plan by Carlton Cunningham Carlton Cunningham is a Housing Developer and a Financial Analyst in Jamaica. He is currently pursuing the Development of Secondary Mortgages as a means of expanding Jamaica’s housing supply. How to give to Main Street the same treatment as Wall Street and get better returns: The Wall Street TARP package is $700B, financed by the American taxpayer. It has been justified by the Treasury by its intent to free Wall Street from losses on bad loans by removing them from their balance sheets and to enable the banks to start lending again. Economic Armageddon should have been averted. Disbursements of $335b from the approved funds have gone directly to participating banks as increased reserves, without preconditions for their use, while the Fed has taken non-voting cumulative preference shares in exchange, in expectation that increased lending will follow. Interest rates have been lowered to further encourage lending. Additionally, $600b has been committed to purchase some toxic mortgage backed securities. Fundamentally, however, the TARP has been abandoned because of inability to value derivative portfolios while the value of their underlying primary mortgage assets is uncertain.

Increased lending has not occurred and has demonstrated that the banks’ unwillingness to lend, leading to systemic liquidity shortage, derives only initially from the immediate impact of defaulted primary mortgages (whether; prime, alt-a, or sub-prime) and is fundamentally related to banks’ fear of over exposure to liabilities such as increased margin calls arising from falling value of leveraged products in the much larger ($53 Trillion derivatives vs $12 Trillion in mortgages) derivatives market, or to fear of declining real product and investment demand elsewhere. Consequently, money supply and the economy have contracted, with house prices 1

spiraling downward despite successive decreases in mortgage and other lending rates.

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January 2009

Policy should focus upon a method to create adequate primary housing demand as a means of automatically revaluing secondary mortgage assets and thereby increase liquidity. Banks with residual liquidity issues will be those whose lending has been skewed to high risk, excessively leveraged products and should be allowed to fail or to surrender to state control if they are too big to fail. Rather than relying upon the mechanics of money creation through increased reserves, which is the policy implemented in disbursing the first TARP tranche, uncertainty regarding the value of mortgage assets, the main reason for bankers’ reluctance to lend, should be addressed. The method hereby proposed is that defaulted primary mortgages must be converted to prime mortgages or to equivalent security, with certain value. Banks, and other financial intermediaries, will then be able to reset the value of primary mortgages and in turn revaluation of derivatives will follow. Banks will thereafter be able to lend in response to expansionary monetary stimuli because loan loss provisions for anticipated primary and secondary mortgage liabilities will be reduced to normal. The balance of TARP funds should be dedicated to this end, leaving those banks with a preponderance of other troubled assets, such as credit default swaps, the option of nationalization or bankruptcy dependent upon the Fed’s assessment of their economic importance. Stabilizing the Primary Market The laissez-faire premise that the housing market will naturally correct itself with more credit worthy purchasers replacing less capable ones is untenable in a generally receding economy, where three trillion dollars in distressed housing accounts exist, since the interplay between primary and secondary markets and between those markets and the bank’s liquidity demand simultaneous, and macro-economic rather than micro-economic solutions. Foreclosure will hurt Main Street – the mortgagors who may be kicked onto the street. It will also hurt the banks which could get few returns in a fire sale, and would witness a collapse in value of their leveraged products, if they receive possibly as little as twenty cents on the dollar. Additionally,

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January 2009

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if houses are vacated, they will rapidly deteriorate. So, how do we get Main Street to stay in the house, while minimizing the Fed’s involvement, and give the Investor a satisfactory return? Add Investor demand to householder primary housing demand, with the Fed taking the position of temporary lead Investor. The proposed vehicle to achieve this objective, most efficiently, is Shared Equity, meaning sharing the risks, responsibilities and rewards arising from the crisis of deficient primary housing demand, between the Mortgagor, the Fed and the Financial Markets. Unlike the housing and economic recovery act 2008, this proposal would be universally applied to defaulted mortgages, but would not require banks to take “deep discounts” in loan balances (which contracts money supply), cited in the published summary of the Act, as the vehicle proposed

is shared equity and shares incorporate the expected value of future returns in their

valuation, thus banks will reflect the expectation of future economic recovery in their balance sheets. Steps to Recovery 1.

The homeowner will write a Prime Mortgage based upon the amount that his/her income can realistically afford. Prepayments from increases in earned income, as may be revealed in annual tax returns, should be mandatory for all participants in order to accelerate cash flows from the mortgage pool.

The homeowner will receive ordinary shares in the ownership of the house in the proportion

of the revised prime mortgage to the total value of the house or the loan whichever is greater. (Some legislative changes to facilitate restructuring of loans are being considered by the new Administration). 2. The difference between the prime mortgage and the outstanding loan balance, or the house price, will be converted to cumulative preference shares which will be federally guaranteed. The banks will own these shares, hypothecated to the Fed, and will earn an income from the Fed which will pay a fixed dividend on the shares for an agreed period. The Fed will also guarantee the future price of the shares. The banks will then own prime mortgages and shares with certain value which will replace assets of uncertain value currently owned.

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2.1. Correspondingly, each bank would be entitled to the share of house value net of the prime mortgaged householders’ ordinary shares. This share would be based upon the cumulative dividend payment plus the guaranteed future purchase price of the shares. The shares owned by the householder and the bank determine in a dynamic way the relative share of house price appreciation to which each is entitled (See Caplin et al, FNMA, Shared Equity Mortgages, Housing Affordability, and Homeownership” August,2007).

2.2. A crude estimate of the Fed’s liability is as follows. Total toxic primary mortgages,

$3Trillion. Rewritten Prime loans, $2.25Trillion (assuming average 75% prime conversion rate). Preference Shares will then be $750 billion to maintain the value of primary portfolios. Annual percent payout on cumulative preference shares, at 4%, (guaranteed by the Fed, so the yield can be lower than a prime mortgage but be comparable) $30 billion. For ten years, $300 billion. Ten years is chosen as a period in which the USA economy can be reasonably forecast to complete the transformation proposed by the Obama administration and in which house prices will rebound. 2.3. If the average increase in house prices, for the ten year period, is 3% p.a. then the

appreciation of the portfolio will be a little more than $1 Trillion from which the Fed would recover $300 billion and be entitled to a share of the remaining $700 billion. The mechanics of the calculation of profit sharing need not be of immediate concern. 2.4. The Fed will assume some risk based upon the rate of recovery of house prices

which will impact the appreciation in home equity shares and their value at “sunset” of the guarantee. But equally, the opportunity for gains in excess of 3% cumulative house price appreciation also will exist. The Fed may wish to Hedge its position using appropriate econometric models and include the cost of such insurance in its recovery formula.

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2.5. The Fed’s intervention will serve several purposes.

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January 2009

2.5.1. First, by recasting homeownership interests as shares, expected future values can be

reflected as assets on the banks’ balance sheets, which would in the current situation comprise prime mortgage shares and guaranteed cumulative preference shares. This innovation would replace the practice of writing down the value of defaulted loans, with uncertain prospects of recovery. 2.5.2. A stabilized primary market will have an osmotic effect upon the mortgage backed

securities market by providing a predictable basis for valuation of numerous derivatives (eg. interest only, principal only, credit enhancers) and credit tranches. 2.5.3. Loss provisions related to mortgages will return to normal, as primary housing

demand will have been increased by an amount (the guaranteed shares) which counterbalances the current market deficiency.

Therefore, mortgage backed

derivatives will be revalued with certainty, and lending may return to normal, except for excessively leveraged portfolios (eg. Credit default swaps) and portfolios with excessive consumer debt (junk), which the Fed will then be able to identify and choose to support through loans, if institutions holding them are too big to fail, accompanied by aggressive control of shareholding and management, as is occurring in the UK (Selective Nationalization) and several other European countries, or simply let fail and allow winners to absorb losers (Financial Darwinism).

2.5.4. Normal open market operations may then achieve the objective of increasing output

and employment by shifting the economists’ “LM” curve to the right while simultaneously increasing Government Expenditure (“IS” curve shifts to the right) through massive infrastructure works, the approach which is identified with Paul Krugman in his work on the Japanese economy, 1992-2004, as the optimal recovery policy when encountering a “ liquidity trap” and which is evident in the $825 billion spending package currently before Congress.

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3. So, Main Street will receive comparable treatment to Wall Street – since responsibility for

bad debt will be removed from Main Street home owners’ balance sheet, just as for Wall Street – so he/she can start working again. By contrast, simply allowing Main Street to remain in the house, saddled with a debt he /she cannot afford, even if payments are deferred, creates moral hazard as he/she will be motivated to abandon the debt and the house, while the money market remains paralyzed by the expected outcome of further massive foreclosures, and by ineffective, specious, financial support programmes (see bibliog.#5, below). 4. The measures proposed to deal with the specific situation leads to some more general

observations. 4.1. The Great Depression led to the introduction (New Deal) in the USA of the 20 – 30

year Fixed Rate Mortgage (FRM) which greatly improved access to housing, by substituting long-term low interest loans, supported by the Federal Housing Authority, for short term (5-7 years), annually negotiated Adjustable Rate Mortgages (ARM). This innovation, coupled with the subsequent development of a secondary mortgage market (viz. FNMA 1954+ and other Government Sponsored Enterprises) again sponsored by the Federal Government, has underpinned the extraordinary statistic whereby mortgage loans outstanding represent 80% GDP compared with Europe 42%. (see bibliog.# 7, Wachter & Green, Illus. from European Mortgage Federation, Federal Reserve System, Dubel). Similar results have been achieved in emerging markets which have liberalized and employed some form of securitization or mortgage liquidity facility (World Bank, 30 Years of Shelter Lending, Ch.4). Consequently, the housing market and the mortgage liquidity facilitated by securitization has been pivotal to US growth and development, especially over the last 30 years, in face of weakened international competitiveness of all but its hi-tech products, a fact which may be easily forgotten in the current debacle. Housing is an industry with domestic competitive advantage. 1

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January 2009

4.2. In addressing the Great Recession, which now confronts the US and the rest of the

world, while improved regulation is required, further financial innovation is needed to correct the anachronism, rooted in pre - New Deal short term (5-7year) ARMs. These required balloon payments at their expiry just when banks may have become illiquid, thereby ensuring that defaulted home loans had to be written down on the banks’ balance sheets, the assets foreclosed and “marked to market” under adverse conditions. This practice gave rise then to liquidity contracting loan loss provisions and continues to do so now, even when the FRM has superseded the short term ARM, at precisely the time when expanded money supplies are required. The idea of mortgaged ordinary shares, linked to purchasers’ incomes and with repayment spread over a 30 year FRM, coupled with cumulative preference shares directly owned by the market, whether Wall St. or a pool of more affluent friends and neighbours, provides a shock absorber by adding investor’s to householder’s demand, using instruments which include expected future income. 4.3. The structure of the investment in housing should therefore be altered. The deed of

homeownership that should be promoted is equity shares, and it is the equity shares that should become collateral for loans, in the same way that pass through securities permit investors to acquire shares in a pool of mortgages. The homeowner and lender should have similar flexibility in acquiring or disposing of their interests in property at the primary level as occurs in the secondary market. 4.4. In the event of default it is the shares, in whole or in part, that should be acquired subject

to clear rules of acquisition and valuation. To illustrate – when John Public, engineer, loses his hi-tech job and takes a 30% pay cut, his mortgaged ,shares can be reduced by 30% to create a lower prime mortgage amount, with the requirement to repurchase the percentage of shares conceded when his situation improves and over a mutually agreed period. If he/she has no job prospects then all of his/her shares will regrettably be conceded and sold, possibly acquired by a Homeowners Trust or other special purpose

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vehicle (SPV) to maintain mortgage payments. He/she may rent from the SPV which would function as the social safety net for the large number of unemployed persons temporarily displaced as the economy restructures. 4.5. Meanwhile, upon acquisition of a portion of John Public’s shares, the bank will be able

to book them at par or at an appropriate discount and may hold or resell them. The systemic shock will be restricted to the possible % reduction in the value of the prime mortgaged shares acquired, in order to liquidate them. This reduction in share value will be less than will occur under foreclosure since the value of shares includes their expected future earnings, as opposed to “marking to current market value” of a distressed asset. Also, the necessity to auction the house, with its attendant costs and trauma, will be avoided.

4.6. The valuation of the bank’s shares will be subject to regulation to prevent accounting

abuse. 4.7. Interests in the house will become liquid and may better serve John Public for purposes

of residence or investment and will improve the operation of financial markets. 5. In respect of volatility of house prices it should be recalled that it is sustained attention to

demand side initiatives, some legitimate, some fraudulent, and the consequence of poor oversight– over thirty years – that has driven the real estate bubble. Insufficient attention was paid to supply side initiatives to release new lands for development or to increase densities, and it is this which has created Economic Rents which are now being corrected. Post-2008 housing policies should be developed to maintain real estate prices more or less in line with replacement costs by sustaining supply in line with demographic and income trends. In this way sustainable housing expansion will become normal, be real rather than primarily the result of inflation, and “housing bubbles” less likely.

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Selected Bibliography 1. Bernanke – Housing and Economic Recovery Act 2008 2. Caplin et al, FNMA – Shared Equity Mortgages, Housing Affordability and

Homeownership 3. Fabozzi – Mortgage Backed Securities 4. Figlewski – A Silver Bullet for Toxic Mortgage-Backed Securities 5. Hugh’s List # 87, Sub-prime mortgage bubble

6. Hull – Futures, Options and Other Derivatives 7. Wachter and Green – Housing Finance Revolution 8. World Bank “Thirty Years of Shelter Lending”

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January 2009