April 03, 2008
The Mortgage Meltdown and Negative Equity Certificates
Posted by Fred Tung

Ice_cube_jarno_vasamaa_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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