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A Proposed Solution to the Foreclosure Crisis

Posted by Larry Doyle on August 17, 2010 12:12 PM |

With the Conference on The Future of Housing Finance being held in Washington today, do we really expect the government to propose anything that may help support or fix our system of housing finance? I am not optimistic and I am an optimist by nature. I am a big believer in unleashing the power and strength of entrepreneurial minds to address our problems. Why haven’t these minds developed solutions? Do you think that these minds are stifled by the overwhelming presence of Uncle Sam? I do. Back to housing and entrepreneurial spirits.  

I love when Sense on Cents can provide fertile ground for the free and open exchange of ideas, opinions, thoughts, and analysis on critically important issues of the day. I am deeply grateful when people not only comment here at Sense on Cents but I encourage people to provide written commentary. I can not promise that I will run every commentary that is submitted but I will seriously review and consider running those that I believe are deserving of greater exposure. I appreciate your allowing me to make those judgments. Plus ….it is my blog.

I have always maintained that jobs and housing are the two great linchpins upon which our economy rests. The government has thrown hundreds of billions of dollars at our housing crisis with no meaningful success….all reports aside. What can be done to solve the foreclosure crisis weighing on our housing market, our economy, and ultimately our nation? 

A friend of Sense on Cents presented a very interesting proposal to me this morning. I am happy to run this commentary and strongly encourage readers to review, critique, question, and share this commentary. I had a question which the writer quickly answered. I am sure there are many more questions on this proposal. I am happy to provide the forum for truly engaging dialogue and analysis at Sense on Cents.  The fact that ‘people who care’ can communicate in this format is truly awesome. Please engage!! On that note, I humbly submit, 

No cost housing stimulus:
Solution to the foreclosure crisis

Because of negative equity most underwater homeowners can’t sell their homes and they can’t refinance. Bankruptcy and/or default is not an option for most homeowners. Especially for homeowners that feel a moral obligation to meet their financial commitments. The unjustness of this predicament extends to all homeowners because about 15 million potential homebuyers are locked-out of a housing market that desperately needs more buyers.

From the mortgage/banking industry perspective; their survival is hinged on the hope that the underwater homeowners will continue to embrace their moral, social, and ethical values in spite of the financial hopelessness of their long term situation.

Until this quagmire is resolved our housing market will continue to suffer because the seller/buyer ratio is drastically unbalanced. Additionally, the number of bank owned properties are increasing which is also forcing serious downward pressure on home values.

Here’s the solution: “Equity Warrants”. 

The underwater homeowner could issue an Equity Warrant to cover their negative equity thereby allowing the homeowner to sell their home even though the proceeds may not be sufficient to completely pay-off the mortgage.

This Equity Warrant would grant rights to the borrower’s future equity in any home they own. When, and if, the borrower’s future equity equals the amount of the warrant, the lender would have the right to convert the warrant to a note secured by the home owner’s real equity.

The downside to the borrower is that someday the warrant will be converted to a note that will require interest and payments. The downside to the mortgage holder is that they will not receive full payoffs for existing loans. The upside to the mortgage/banking industry–and our economy–would be a substantial reduction in the number of foreclosures.

However, to soften the impact to the mortgage holder, the warrants could be sold by the mortgage holders. As an ironic twist, instead of trading Credit Default Swaps, Wall Street could trade Equity Warrants.

This system would create millions of potential homebuyers, thereby improving our housing market and home values. Additionally, the underwater homeowners would have a respectable alternative to short-sells and defaults.

What would it take to make this happen? This system would need an act of congress to enact laws requiring mortgage holders to accept Equity Warrants from underwater homeowners.

Example #1:
Suppose homeowner in Florida owes $250K, he sells his home for $210K. He is $40K short so a warrant is issued to the mortgage holder with a face value of $40K. The warrant accrues interest at the 5 year Treasury bond rate of 1.40%.

Five years later the warrant is callable since the homeowner was able to purchase an existing home for $300K. (Which was a really good deal at the time since new construction for a similar home would have been $400K.) In the five years since the warrant was issued the homeowners equity has grown to $150K.

The warrants are only callable after 5 years or 10 years.

The home owner’s note to settle the warrant is $54K ($50K plus interest). The note is serviced by Citibank and is considered a HELOC. It’s a 10 year interest only note at the Treasury bond rate plus 1%.

The original warrant was sold by the mortgage company on the Equity Warrant market for 90% of the face value.

Winner and Losers- The homeowner wins because if he would have been forced to stay in the original home his equity would not have increased as much as the new home increased. Plus he was able to improve his living standard by being able to move into a better home.
The warrant holder wins.
The original mortgage holder wins because a possible foreclosure was adverted.
The housing market and all homeowner’s win because this homeowner and a few million others were able to enter the housing market which helped to push home values up.

Example #2:
Suppose a homeowner in Atlanta sold his home for $300K but owed $500K. A warrant was issued to the mortgage holder for $200K.

Ten years later the home that he purchased for $175K is still only worth $175K. The owner dies. The warrant is expired and worthless.

Example #3: 
A homeowner in Indianapolis was $25K short at the closing on his home. Ten years later the homeowner was only able to accrue home equity in the amount of $20K. The warrant is called but only $20K could be recovered. The remainder is forgiven.

Example #4:
A homeowner in Nevada was $60K short at the closing on his home. Two years later the homeowner wants to re-locate to New York. The homeowner was able to accrue $30K in new equity so he converts his original warrant face value to from $60K to $30K after he pays the warrant holder $30K. Eight years later the homeowner is still renting an apartment in NY. However the warrant is called and the remaining $30K (plus interest) is collectable since the homeowner did not fulfill his obligation to become a homeowner during the warrant term.

Please do not be bashful in asking questions and making comments. My initial question was where the equity warrant would fall in terms of credit position. The writer indicated it would by necessity be a second lien. I would have imagined as much.

I commend this writer for laying out this proposal. I think it is certainly worthy of further consideration and analysis. In light of our current situation, what do we have to lose. Can our housing and foreclosure crisis get much worse? 

Comments, questions, constructive criticisms always encouraged and appreciated.  Thank you to the writer for sharing his proposal. 

Larry Doyle

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  • Pat J

    I love this idea and any other idea that presents solutions to the deficient amount that makes it impossible for homeowners to make a dignified exit to more affordable housing.

  • fred

    LD,

    Hate to be a buzz kill, but this idea sounds like more Wall Street financial engineering to generate fees and kick the can down the road to keep the game going.

    What’s so wrong with a short sale with a promissory note attachment for the negative equity to the mortgagor; if “dignity” is an issue just don’t tell anyone.

    If the short seller then qualifies for another mortgage based upon conservative underwriting standards great, otherwise renting is always an option. Isn’t this the only way real estate prices can drop to a level of “true affordability”.

    Most cases of negative equity exist for home purchases made after 2003. Prudence should have dictated a real estate holding committment of at least the historical averaqe of 7-10 years, a down payment of 20% and a maximum mortgage of 3-4 X salary.

    I support those willing to honor their committments but doesn’t that include living with the consequences of bad decisions?

    • Steve

      Fred-
      Just my 2 cents on some of your comments… It’s not easy to do a short sell. The buyer has to know you are short selling which is makes the buyer want to low ball the offer. Next, the lien holder(s) has to agree and that is usually a long process. Then if the transaction does get completed the seller’s credit report indicates that loan was not paid as agreed. A short sell is basically a default.
      Also- don’t assume that the average underwater homeowner is in that predicament because of bad judgement or is otherwise sub-prime quality. Most of the sub-primes have already defaulted.
      Most of today’s underwater homeowners got into their mortgages with solid credit and good down payments.And the vast majority of today’s underwater homeowners are current on their payments. So they don’t need a modification. (Unless it’s a principle write-down which would likely cause a complete collapse of the mortgage industry.)
      What is needed is exactly what is outlined in the Equity Warrant suggestion. Of course it needs tweaked but don’t throw the baby out with the bathwater.

      • fred

        Steve,

        “I ain’t buyin what your sellin”. If the short sale process has to be modified or expedited let’s get moving on that rather than going in a totally different direction.

        I don’t disagree that the idea of the “short sale” warrant is innovative or might prove useful for those that otherwise feel “trapped” in homes, but how can a citizenry who needs a Consumer Protection Czar or who didn’t understand how a mortgage reset might increase their monthly mortgage payment really come to grips with all the nuances of derivatives theory and option pricing models?

        • Steve

          Fred-
          1. For the bank it’s a matter of trading uncollateralized mortgages for uncollateralized notes. A major plus would be the elimination of a potential default and/or foreclosure which would likely cost substantially more than accepting the warrant, even if it expires worthless.

          2. For the for homeowner it’s an escape, trading a bad situation for a potentially better situation.

          3. For the housing market it’s a new client for the real estate agent.

          4. No taxpayer dollars needed!

          What’s wrong with this picture?

          • fred

            Steve,

            There is nothing wrong with the idea, I just don’t believe it is the solution to this countries problems. If a “warrants” market were to develop, it would certainly address the illiquidity issue inherent in direct real estate investment.

            My mother once told me, “before you go and change things take the time to understand the way things are being done and why they are being done that way. You will gain both respect and allies. Politically, it’s always easiest to work within the status quo”.

            Steve, if you agree that some user friendly modifications to the short sale mechanism, already in existence, might be provide some desired relief, I’ll throw my support behind your warrants idea as a potentially workable alternative to the illiquidity issue. The times demand change, let the markets decide, debt or equity.

            Interestingly, the time it would take for these warrants to achieve par is probably the amount of time this country needs to work through it’s real estate overvaluation problem. An overvalued market can correct down near term or sideways overtime. Both types of corrections have positive and negative consequences.

  • phil trupp

    I have to agree with Fred. The ideas are deceptively complex, and complexity has a way of compounding. Too many “what ifs.” Those who purchased homes after 2003 need relief, or perhaps forbearance is the right word. The possible solutions listed here portend the built-in danger inherent to virtually all future projections. What happens if the market worsens five years or 10 years from now? What happens in the case of bankruptcy? Could these ideas, while very clever, add to future uncertainty?

  • Pat J

    All fair points but I still like the idea if it were tweeked a bit. Treat the difficiency like a student loan which can’t be included in a bankruptcy…limits on the warrant amounts{example # 2 should probably foreclose}
    Don’t allow warrant amounts to be forgiven at all.

    • fred

      Pat J,

      Don’t confuse the primary mortgage market with the mortgage securities market. The mortgage securities market isn’t stalled because of a lack of primary mortgage transactions, it is stalled because of government involvement, government backstops, mark to model valuations and mortgagee inability or unwillingness to pay according to the terms and conditions of the mortgage agreement. Probably the most damaging issue of all is the banking industries, (Fed included), failure to recognize delinquency or default thus preventing workouts from occurring.

      Would warrants or transferrable rights to future real appreciation help the mtg securities market to become fully functional? Only to the extent that “problem mortgages” are considered prepaid by banks and written off the books at par.

      Is this a viable workout option to a negative equity transaction? Only if the mtgee and mtgor agree. Will a “derivatives” mortgage securities market develop and provide liquidity to the “current mgt securities market”, I would argue the opposite, we need a fully functioning mtg securities market for accurate valuation of the derivatives, ie. the Black-Scholes Option Model inputs. Without the ability to accurately value these warrants you have the same problem we have now another disfunctional market.

  • Pat J

    Hey Fred,
    Your points are well taken . I don’t know that a perfect solution exists but we have to start somewhere and there are some positives to be taken away from some of the points stated above.

  • NRG

    just got through watching ‘chairman’ Frank on Cavuto and then Kudlow…I wonder what the deal was allowing him to creep away from the mess he helped create with a modest, equivocated mea culpa….and about 50 references to Hank Paulson as if he were a deity….%$&*er should be in jail.

    don’t agree with Oreilly on things economic…he’s an economic baboon, but he’s got Frank down….have to wait for Rush tmw, I guess…but disppointed with Larry and Neal….unless they wouldn’t have got him on if they played any video archives as part of his interview…

    Equity warrants? the govt is in business of stifling creativity….unless they find a way it benefits them, it won’t go anywhere…

    as these guys were talking I was visualizing a world without govt interference…that means that the local savings bank would accumulate a portfolio of mortgages….then bundle them and sell them….to their own clients who knew not only the credits, but the neighborhood, the bankers and their families etc. etc….hey, they could even buy them indirectly by making deposits at an unregulated rate in accounts that didn’t have govt regulations attached to them…maybe they could give me 5% on a savings account if a friggin passbook so I could see what I got…and if they screwed up I could take my money out of the bank and thye’d have instruments backed by mortgages in their portfolio that another local savings bank, which was more prudent can then come in an scoop up at a great rate so they could actually pay me 6% on my passbook…..etc etc. etc.

    • fred

      NRG keep visualizing, I like your ideas. Part of the problem though is the institutional investor’s unsatiable appetite for yield to meet their unreasonably high target return objectives; it wouldn’t be long before they would crowd us little guys right out of the market.

      Ps. The Kyle Bass interview on CNBC yesterday is a must see. I’m sure you can find it somewhere on the web.

  • Larry,

    Your arguments that lead to the suggestion of a solution are sound in my opinion. What I offer to you is a suggestion not to reinvent the wheel. You see, there is already a security instrument in place today that can accomplish this in a much simpler and reasonable fashion. It is called HEFI; Home Equity Fractional Interest. Instead of using debt it uses an Equity Instrument as a modality. Essentially it is a Call Option on a Tenant in Common Interest. It allows for the Note Holder to reduce the Principal Balance in exchange for a share in current equity and future appreciation without putting the homeowner into a future debt position. HEFI was authored in 2003 and the first Patent representing 27 patent claims was awarded last year April with another 30 pending. This instrument was reviewed with Frank, Pelosi, Allison, Barr and Bair in March of this year and is been highly received. A short power point can be found at http://www.slideshare.net/equidebt/h-option .

    It is simply a much easier way to accomplish the same thing but with greater results.

    • Steve

      I read about HEFI but I don’t see how this would help me sell my house so that I could by buy another house. I need to relocate closer to my work but my house is only worth $200K, I owe $250K.

      • fred

        Steve,

        “me thinks he doth protest to much”; you wouldn’t happen to know whose idea this “equity warrants” concept was, would you?

        A short sale shouldn’t mark you with a scarlet D (defaulter), it should be an available option for responsible borrowers with negative equity in their homes.

        Your credit rating should only suffer to the extent that the “negative equity” debt created, reduces your capacity to borrow. Why shouldn’t it, the timing of the transaction dictates it!

        Steve, 1) all equity investments have one thing in common, RISK of LOSS, 2)some equity investments are less liquid than others. You made a bad investment given your desired holding period. You have two option 1) hide the loss by staying put (the strategy being employed by banks and the fed), or 2) do a short sale, take the hit and move on.

        Your arguing for a third option, that would, after the fact, allow you to essentially “emerge whole”, because you think you are a responsible person who had some bad luck. To convert debt into equity through the magic of time.

        Frame the trade: to exchange future positive equity potential for current negative equity realized. I’d only take the other side with a gov’t guarantee and gold as collateral. The necessary assumptions for this trade to work are that real estate resumes it’s uptrend, rates stay artificially low and the warrant doesn’t expire worthless or less than par.

      • Steve,

        HEFI is a vehicle that allows for Equity Sharing to occur. It creates an equity security instrument. How you use it depends on situation. I believe the point of the original article was about how to sell the home and exchange the negative equity for its future appreciation. HEFI would substitute no differently than a warrant. In the affordable housing space an equity sharing arrangement allows for that home to be sold forward with a lower debt structure. The HEFI becomes an equity investment by the lender who took the principal reduction. See http://slidesha.re/bQ9gUR for a graphical on how that might work.

  • ted

    I don’t see many homeowners doing this nor many banks actually believing they’d actually get paid on a warrant.

    The only benefit to a bank is that it’s another “asset” on the books that can be marked to market at the full amount of the warrant, extending and pretending that it’s a performing asset, even if it won’t mature for 10 years. This idea buys more time for banks to clean up their books without additional government support.

    This idea would only kick the can down the road 5-10 years?

    A smart homeowner would never pay on the warrant. They’d simply file Chapter 7 and move on with life. Most who’ve lost a home recently, or been severly underwater, aren’t too anxious to jump back into homeownership.

    I like the idea in theory, but it will never happen.

    The only cure for housing is time and more government support for banks, as much as I don’t like to see taxpayer money given to banks, it’s the only thing that’s going to turn the ship around (within 10-15 years).

  • lisa

    Its a clever idea but why would the lenders go for it? Doesnt it extend a shaky loan and de-collateralize it? As each year passes we all approach death and the warrant expires. I just dont see the upside for the lenders.

  • Joanna

    WOW! So simple and logical. A “self bailout” that would not be forced upon people that didn’t want to participate. The mortgage holder is off the hook from a problem loan. The homeowner can go on with life. The housing market would benefit from the influx of new buyers. The tax payers are not burdened with another bail out. And in the end the homeowner may will repay the IOU (warrant) with money that would not have been available if they stayed in their underwater position. However it is not likely that a Wallstreet will trade the warrants… but the bank could sell the paper like a lot of companies do with their receivables.

  • Paul

    You have to be kidding. This is great fodder for discussion around the keg at the block party but outside that it’s utter crap. First off this whole charade makes sweeping assumptions about the future of the housing market and what motivates buyers. A transfer of debt that follows you around in hopes of being eliminated by future appreciation in a new home? Whatever. And if this isn’t ripe for sucking fees, corruption and fraud. This wouldn’t fly in a million years. The country will literally be smoldering ashes before this happens. Was a nice mental excercise though. Oh and PS, like every other focus on the sell side person, you are assuming 2006 creditworthiness on the buyside even with this debt shell game you call warrants. Basically this turns all the underwater equity into off balance sheet transactions. That will end well. Ask Enron.

  • Greg

    This could work if the warrant came with a clause that states that the home-owner may not put a lien on any new equity. Otherwise–the homeowner might get equity in a new home, take out a 2nd loan (HELOC) to cash out of the new equity, and then still fail to have the cash to pay off the warrant. So the warrant from the old home should some-how be “recorded” (like mortgage liens are) against the title of the new home, right?

    And I think Wall Street would trade these–Wall Street will trade just about anything. It would create another regulatory oversight issue however if they are tradable.

    Major issue: how to prevent scammers from weasling their way in. But that’s always an issue.

  • joanna

    This would work if the concept could go through a bit of refinement. It does provide banks and homeowners with an escape. If nothing is done the negative equity situation will continue to go south. Creating more red ink for everyone. Also, the lien holders have very little to loose since their loans are not fully collateralized by the value of the homes due to the falling home values. NO bank wants to hold loans that are not fully collateralized, so, why wouldn’t they go for this plan.
    The warrants are basically IOUs and would have to be treated like HELOCs so anyone that would elect to get into the “equity warrant” would not be able to take out a second mortgage until the warrant is settled.
    And why would anyone do a chapter 7 to get out of the Warrant? They could do that now…and just walk away from the present situation.
    The housing market needs some hope and if this plan would allow a substantial number of the underwater homeowners to re-enter the market, positive things could happen.






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