America's Home-Housing Market Stabilization

Efforts by the federal government to free up capital for lending have not been effective at reducing the growing number of homeowner defaults and the escalating number of foreclosures. Current mortgage modifications being offered, and those promised in recent announcements by the White House, do not address the root of the problem. Instead, they typically replace one high leverage situation with another one, resulting in the recurrence of the same problems for many homeowners. The logical solution, and arguably the solution fairest to everyone, is to replace a portion of the debt financing for troubled homeowners with equity financing.

The problem is that many homeowners lack the resources to provide sufficient equity on their own. EARN equity instruments solve this dilemma. These instruments require no monthly payments from the homeowner but require the homeowner to give up a percentage of the future appreciation in the home. In exchange, the homeowner benefits from a smaller mortgage with lower payments. Some versions of the instruments create a “collar” that prevents homeowners from further borrowing against the value of the home. This feature allows homeowners to pre-commit to future financial soundness. Without “deleveraging” the housing market and creating sustainable home financing, it is likely that the wave of foreclosures and the downward spiral in overall home prices will continue since homeowners will remain in or will gravitate back to the same precarious situation they are in today.

EARN instruments are an invaluable resource to help three groups: homeowners currently in default (pre-foreclosure), financially stressed homeowners with performing loans, and potential home buyers who have adequate income but lack the down payment to purchase suitable homes. In all three cases, use of these equity instruments facilitates the introduction of new standards for qualifying homeowners and underwriting home financing. Requirements such as specifying that mortgage payments do not exceed a specified percentage of monthly income are more easily implemented if equity is available beyond each homeowner’s own resources. Combining suitable standards with an equity infusion will make homeownership sustainable both for many existing homeowners and for many new ones.

EARN instruments create powerful opportunities for government solutions to the housing crisis. For instance, governments themselves can finance and temporarily hold the EARN equity instruments. This expenditure will be more effective than many other methods of assistance. Subsidizing loan rates or the underlying lenders does not address the problem of excessive leverage. In addition, EARN instruments will provide a substantial pay back and perhaps even a profit if the government holds onto them until a recovery is in progress. Financing and temporarily holding the EARN instruments is a strategy that is similar to other successful approaches in the past such as the RTC program where the government held problematic assets until markets stabilized and recovered.

At the same time, there is the possibility of creating effective coordination between the federal government, state and local governments, private investors and non-profit entities. Given its massive financial resources, the federal government is a logical entity to finance the bulk of the EARN instruments issued initially. At the same time, a federal initiative that resulted in issuance of a large number of such instruments would facilitate creation of a strong private market for the instruments. Economists and finance experts have known for many years that equity instruments for owner occupied real estate are a tremendous diversification tool for institutional investors. Home equity returns have a very low correlation with stock, bond, commercial real estate, and rental real estate returns. In addition, home equity is a $15 trillion asset class. After inducing the creation of a private market, the government could gradually sell off its own holdings.

At a more granular level, state and local governments as well as some non-profits have great expertise with respect to local housing markets. These entities are capable of ensuring a stable, efficient and fair origination process for EARN instruments and can play a key role in the process even if the federal government ends up holding most of the instruments.

Housing market stabilization through the promulgation of equity instruments represents an even handed and effective method of dealing with the current housing crisis. This approach gives homeowners deserving of help and willing to share a piece of their home price appreciation a unique opportunity not only to stay in their homes but also to do so with financing that is consistent with a new model. The new model replaces excessive debt financing with smaller loans and incremental equity financing from investors or governments. The result is affordable monthly mortgage payments, leaving room for non-housing forms of saving. While much can be learned from the current crisis, two clear lessons for homeowners are to avoid excessive leverage and to diversify savings beyond the four walls of one’s home.

David Shapiro, President and CEO of the EARN Group
Jeff Strnad, Charles A. Beardsley Professor of Law, Stanford University and Advisor to the EARN Group

Delinquencies Grow, Home Equity Shrinks

I don't know if it was the left jab or the right hook, but I do know that the resulting blows would have felled Mickey Rourke on a TKO.

According to the Mortgage Bankers Association, quarterly delinquencies for all loans rose to 7.88%, up 2.00% over the previous year. That does not include the number of homes in foreclosure which rose to 3.3% of all loans. Taken in tandem, over 11% of American homeowners were either in default or in foreclosure as of the end of 2008.

As if we needed to punctuate that message, one must remember that these are numbers AFTER the GSE’s put a temporary moratorium on foreclosures.

It becomes increasing apparent with each passing day that we must convert debt to equity or run the risk of this disease spreading to the point where the mediation could kill the patient.