A mortgage fix for lenders and homeowners: Shared equitySeptember 1, 2011: 11:18 AM ET
Lenders could write down mortgages in exchange for claims on future appreciation – potentially making it a win not only for homeowners but also for lenders and investors.
FORTUNE -- Next week President Obama is slated to make a highly anticipated speech about jobs. Given that falling home prices have continued to strain consumers and the overall economy, many hope his speech will include an aggressive plan to strengthen the housing market. After all, the health of real estate is closely tied to households' willingness to spend and drive growth of the broader economy.
This comes as the administration considers a range of options, the New York Times reported earlier this week. They include everything from allowing millions of homeowners with government-backed mortgages to refinance them at today's lowest interest rate of about 4% to tweaking existing refinancing programs so that more homeowners take part.
Amid all these talks, however, one idea that seems to have been overlooked is a concept supported by a few economists, including Harvard University's Kenneth Rogoff and Massachusetts Institute of Technology's Bill Wheaton. They think the government should facilitate mortgage write-downs in exchange for claims on a percentage of future appreciation – potentially making it a win not only for homeowners who owe more on their homes than their properties are worth, but also a win for lenders and investors who would eventually be repaid for giving borrowers a break.
Here's how it could work, Wheaton explains. Say an owner bought his house for $100,000 a few years ago. Today the house is only worth $60,000, which means the loan is 40% underwater. Rather than risk foreclosure, the loan could be restructured in a way that would give both the borrower and lender a stake in the deal. A smaller mortgage of $60,000 would be issued. In exchange for the lower monthly home loan payments, the lender would have a claim of, for instance, 50% of the future appreciation – capped at $40,000. Later when the owner moves and sells the home for, say, $90,000, he would give up $15,000 of the sales proceeds.
Wheaton says if the owner holds onto the $60,000 property longer, giving it more time to appreciate (say it sells for $140,000), the lender would recover all its money. But this is a big if. And the lender could put a clause into the loan that keeps the owner in the home until the value of the property recovers a designated amount, but that could make the deal more complicated and potentially less attractive for the homeowner.
Admittedly, the plan isn't perfect. Home prices have to actually appreciate in order for it to work, and it's anyone's guess when that will happen. And the lender might still see some losses, but not necessarily as much as it would see in foreclosure.
Nevertheless, the idea of shared equity between lender and borrower is worth a serious look, given previous programs that have only had mixed results in stemming foreclosures. In the wake of the bust of the housing market and subsequent financial crisis, for instance, Congress enacted Hope for Homeowners in 2008, followed by the Making Home Affordable Plan in 2009 and so on. So far, nothing has been a home run.
"The issue with loan modifications and why you haven't seen more is that banks don't really know who to give them to," says Manuel Adelino, real estate finance professor at Dartmouth University. In 2009, Adelino helped author a study by the US Federal Reserve Bank of Boston that found lenders rarely renegotiate since the foreclosure crisis started in 2007. "They run the risk of giving modifications to people who might not need it. You can say you'll only give modifications to people who are delinquent on their mortgage payments but then you give them and others the incentive to be delinquent."
There's also the risk that even if borrowers are able to modify the terms of the loan for lower monthly payments, they may eventually default. This would merely delay the foreclosure process by several months and prolong the pains of the housing recovery. Although the pace of decline of home prices slowed in June and has been the case in recent months, the housing market remains in excess, Gluskin Sheff economist David Rosenberg wrote earlier this week. There's currently about nine months worth of supply of properties to work off -- no better than where the market was during the depths of despair in 2008. And with about 4.1 million more mortgages that are at least 90 days delinquent or in foreclosure, another 10.5 months of supply is expected to seep into the market and send prices further down.
This isn't to say that a plan centered on the concept of shared equity doesn't have a place in the housing market. It could still be a sweet deal for borrowers and lenders, given what they could potentially lose by foreclosing.
Plus it's a plan that clearly doesn't exactly let borrowers off the hook, at least not easily. What's more, if Wall Street got its bailout, even if unwillingly, shouldn't Main Street get a chance?