Two plans out there today to restructure US mortgages involving apparent negative equity whereby the home value is now less than outstanding debt. One of these is by Eric Posner and Luigi Zingales and involves offering mortgage holders in zip codes that have experienced 20 percent or greater house price declines to restructure their mortgage to current house values – i.e., zero equity. The catch would be that, if home values appreciated by the time they were sold, then their bank would get 50 percent of the upside. Of course, this the upside of a house price index and not the house itself so as to avoid moral hazard.
Sound familiar? [DDET Read more]
It is not dissimilar to Rismark’s equity finance mortgage except that is based on an equity holding of the house’s actual value. This has not been lost on Rismark’s Chris Joye who two weeks ago proposed a mortgage restructuring plan directly to the Obama Administration. Here is an account. His plan is to start with banks setting back mortgages to the zero equity position (like Posner and Zingales) but in return the government agrees to take a 25 percent equity finance mortgage on the adjusted principal so as to insure against this continuing on with further house declines or stagnation (something that Posner and Zingales don’t appear to allow for which is a bit of a worry). That mortgage means that should house prices appreciate above the readjusted level, the government gets 50 percent of the upside. But this is all distinct from Posner and Zingales as it is based on actual market transactions for homes rather than an index. You are trading off a risk of moral hazard with basis risk on the entire portfolio. Experience in Australia suggests that the moral hazard risk is low and so commercial products that could have been based on house price index have been marketed based on real transaction values.
Either way, we may come out of all this with some radical changes in home financing practices.
[Update: Chris’ post is now on ft.com]
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Core Economics 
Here are some issues off the top of my head that I see with the alternative Zingales plan based on a very cursory review:
1) This plan is not tied to mortgage stress or defaults but rather just house price changes;
2) Any package must be targeted explicitly to borrowers in extreme default (as mine does);
3) The economics of this product are unclear: “where house prices have dropped more than 20 percent the option to have their mortgage reduced to the current market value of the house. In exchange, these homeowners would yield to their lenders 50 percent of the future appreciation of the house.”
4) So if my house has fallen 30% in value, or 50% in value, taxpayers still only get the same 50% claim of the upside (ie, irrespective of the price fall?);
5) In contrast, under my plan the ratios are constant: if you take a 20% (or 25%) government provided shared equity loan, the taxpayer gets 40% (or 50%) of the upside;
6) Banks get no cash at all under this plan—there is no recapitalization; no shared equity refinancing; they just suffer big losses;
7) Borrowers get a much lower reduction in their repayments: with a 115% LTV the borrower gets nothing; with a 120% LTV the borrower gets only 20%;
8) Under my solution, all defaulting borrowers get a minimum 25% reduction in their 30 year mortgage repayments;
9) Under my solution, a borrower with a 115% LTV, would get a 35% reduction in their 30 year mortgage repayments;
10) The plan has an inherent problem because it uses house price indices: the individual home has significant return volatility of around 15-20% pa (proven empirically);
11) You will therefore have many situations where the local area index is rising, and the borrower’s property has not risen, or fallen; that is the borrower may have to pay a large cost to the taxpayer that exceeds the value of their home;
12) This is a recipe for disaster;
13) This plan offers NO long term housing “equity” finance reform opportunities to reduce reliance on debt—that is, they are not creating a new equity finance market as a result (which could be used to permanently restructure household balance-sheets);
14) This plan does not create a recyclable fund that could be used in perpetuity to minimize foreclosure risk.
Chris
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In his 2008 Letter to Shareholders, released last week, Warren Buffett said that, based on the experience of Berkshire’s subsidiary, Clayton Homes, it seemed that very few mortgage-holders walked so long as they could afford to keep up the payments, as even Clayton’s sub-prime borrowers (35% of the total) nearly all still can.
The equity restructure plans don’t address negative equity as such. They address the many cases where, whether by home buyers’ aspirational stupidity or by mortgage brokers’ persuasiveness and greed, families ended up with the wrong home and the wrong mortgage product.
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