Last Sunday's NYT reported on an idea that regulators and legislators have been kicking around to keep
people in their homes and save the housing markets--negative equity certificates. (Also see an earlier WaPo story). These certificates would be available to existing mortgage lenders willing to refinance upside-down mortgages--loans whose outstanding balance exceeds the current value of the home. Under the plan, a government-insured refinancing would reduce the outstanding mortgage balance to the current home value. The original lender, in addition to getting paid the current value of its collateral from the refinancing, would receive a negative equity certificate. This certificate would entitle the holder to any appreciation in home value realized when the the owner sells--up to the amount of the original loan. In effect, the old lender gets any prospective upside in exchange for stripping its loan down to the current market value of the home. Proponents anticipate that a trading market would develop for these certificates.
According to NYT, Treasury Secretary Henry Paulson's latest pronouncement would limit the plan to homeowners who are paying on their mortgages pre-reset, but who may be otherwise be tempted to abandon their homes once their interest rates jump.
At first blush, it seems like an interesting idea. The borrower gets to stay in her house without taking the credit hit of foreclosure. The original lender gets potential upside--which might be tradeable--without having to incur the costs of foreclosure, resale, and interim maintenance. And it's better than getting stripped down in bankruptcy--a prospective modification to the Bankruptcy Code that was (until recently) working its way through Congress--where the lender gets no upside. But several problems come to mind:
1. Valuation. How do we decide the market value of the home at refinance time? I know, we can get an appraisal! Just like the last time we got a mortgage on this house . . . .
2. Loan servicers. I thought one of the original precipitators of the mortgage meltdown was that for mortgages sold and bundled into pools for purposes of securitization, the servicers did not have clear authority to commit to workouts. So foreclosure was the only readily available option. If this is still true, then it's unclear how this latest proposal will help.
3. Homeowner incentives. With all the potential home appreciation captured in the negative equity certificate, the homeowner is basically a renter, with all that that implies. The homeowner has no more incentive to invest in maintenance than renter. In fact, the homeowner is worse off than a renter, since she can't call the landlord to fix the plumbing. Perhaps the terms of the certificate could be modified to give the homeowner some piece of the upside to counter this problem. Law scholars (e.g., Lee Fennell) have suggested the possibility of separating home-specific risk from market risk, leaving home-specific risk to the owner and selling market risk to investors. But the mechanics for implementing this idea seem pretty complicated. In any event, it's hard to figure how a simple split of the upside could be large enough to incentivize the homeowner and still small enough to be acceptable to the lender, who could own all the upside (net of attendant costs) through foreclosure.
4. Screening for sham sale. Presumably, the negative equity certificate covers only the first sale post-refinance. This would give homeowners some incentive to engage in sham sales to shed the overhang of the negative equity certificate in order to own the upside. Lenders will balk without some mechanism to police for this.
5. Tax and accounting consequences. I hesitate to offer any opinion on tax and accounting issues, except to raise the possibility that lenders may have to take a write down either when they do the refinance or sell the negative equity certificate (which might not be different from the foreclosure scenario either).
6. Irony. Let's solve a (somewhat) derivatives-driven crisis with . . . another derivative! We could bundle them, get an investment-grade rating from one of the big rating agencies, and sell NECBSs (Negative-Equity-Certificate-Backed Securities) to institutional investors!
For a thorough vetting of the proposal, check out Calculated Risk, especially the comments.
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1. Posted by Brett McDonnell on April 3, 2008 @ 13:21 | Permalink
Fred,
Fascinating. On point 3, homeowner incentives, it seems the problem is a bit less severe than you say. Homeowners do have a claim to the residual gain on selling if the selling price is above the level of the original loan. As I understand the proposal, the homeowner would still get the difference between the final sale price and the level of the initial loan. The certificate holder only gets the difference between the initial loan and the new loan. Right?
2. Posted by Fred Tung on April 3, 2008 @ 13:31 | Permalink
You're right, Brett. The payout on the certificate is capped, such that in effect, the original loan can't get overpaid. My sense, though, is that in many markets, it could take a long time for values to appreciate to the point where the original homeowner has a shot at any upside.
3. Posted by Jake on April 3, 2008 @ 20:08 | Permalink
The proposal is a variation on reverse mortgages.
Point 3 is scarcely self-evident. The possessor of a life estate has ample incentive to preserve the property -- unless, that is, the possessor is indifferent about living in a dump versus a palace, in which event it's hard to comprehend how any sort of public policy (short of the threat of imprisonment) will alter the possessor's indifference about the matter. Human nature, folks.
4. Posted by Fred Tung on April 3, 2008 @ 20:29 | Permalink
Jake, Point 3 likens the homeowner to a renter, so while she of course will have some incentive to preserve the property, her incentives won't be those of an owner. So for example, she might paint the interior but might be less willing to spring for a new roof or remodel the kitchen. Her incentives, moreover, seem much weaker than your hypothetical holder of a life estate, who captures all the appreciation in her ownership interest when she sells.
5. Posted by Jake on April 4, 2008 @ 22:04 | Permalink
Fred --
We seem to agree that renters have different incentives than owners, or life tenants for that matter, in terms of caring for the property they inhabit.
My point is that a negative equity certificate appears to resemble a reverse mortgage, an arrangement that effectively converts the homeowner to a life tenant.
For the "renter" analogy to ring true, a negative equity certificate would have to function like a sale-leaseback. This does not appear to be the case.
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