Treasury Finally Recognizes Residential Equity Sharing

On October 15, in a little noticed Federal directive, the US Treasury Department approved the mechanism which could finally solve the mortgage crisis.  Finally the government is recognizing what borrowers have been saying for more than two years, to fix the housing market -- the "underwater" portion of loans needs to become equity.

Currently more than 2 million housing units are on the market with no offsetting demand.  We need to remember that most people facing short sales and foreclosure do not want to move.  They would stay and make payments if their loan could be restructured so as to allow them to stay.  Restructured does not have to mean “forgiven,” now it can mean a conversion of some of that debt into equity.

There are immediate benefits.  Liquidity is created because not only can the equity participations be pooled and sold as securities, but once the 80% loans have been current for 12 months they too can be pooled and sold as securities.  Perhaps as many as 2,000,000 homes would exit the marketplace.  Getting these homes off of the market would increase property values and re-ignite the economy.

Long term benefits also exist.  Under Fannie and Freddie when homeowners do sell short or are foreclosed upon they are precluded from buying for 2-5 years based on current underwriting guidelines.  These owners are now kept in the active marketplace.  Debt for equity restructurings, such as proposed above, depend on market value appraisals and not on the borrower’s financials (or lies told about those same financials).  This fact alone will reduce uncertainty and allow for the securitization of these products.

What needs to happen?

Lenders should get every loan re-appraised upon the request of and at the cost of the borrower.  Where the LTV ratio exceeds 111% (so the property is now worth 90% of the loan) the loan should be restructured according to the example above.

If a Property is sold within 12 months of the modification the lender gets 100% of the appreciation. Thereafter the percentage of the appreciation sharing declines by 10% every year so that at approximately year 6 the percentage is set equal to 50% and it stays at that percentage throughout the remaining life of the equity sharing arrangement.  If the property is not a primary residence, the minimum percentage might be 65% rather than 50%.  

The instrument utilized to secure the equity/appreciation interest in the home is called a HEFI (Home Equity Fractional Interest).  The HEFI offers a patented (US Patent #7,516,099 issued in 2009) methodology and a standardized security instrument for implementing these equity sharing agreements and making them liquid. 

If a property is transferred on a less than arms-length basis the HEFI agreement must also transfer unless the new buyer and the lender reach a buyout agreement.  In order to protect against fraud the lender will have approval rights over all sales which are below market value.

Where properties have multiple liens a sharing arrangement will be required.  Perhaps, the first lien holder should be treated as primary debt up to 80% of the current appraised value.  All liens in excess of 80% of current appraised value should be treated equally dollar for dollar.

Moral Hazard concerns are dealt with by the simple fact that the lender(s) get all the upside for the first 12 months and the majority for the first 5 years.  There is no incentive for a borrower to try and "play" the system.  Similarly if a "not-underwater" borrower wants to use a HEFI to sell a participation in the future appreciation of their house, once the above plan is in place, that option will exist.  Further, once there is a liquid market for HEFIs, new home builders and developers can offer buyers of new homes the opportunity to opt for a HEFI, in conjunction with a 1st lien at 80%, to reduce the borrowers debt burden or down payment.

The net effect would be to remove 80% of the short sales or threatened foreclosures from the market and bring back a healthy real estate market in those areas which have been most heavily hit by the downturn. It will create a true housing market equity option which can be traded on the open market, opening up a new asset class that is currently not available to divest into.  It will allow banks to value loans at current market value without balance sheet disasters.

This is a business solution to a business problem.  Now is the time to act utilizing a real solution instead of putting another band aid on the problem.