February 27, 2008
The Home Equity PartnershipBy Christopher Chantrill
Let us suppose that the mortgage meltdown has about finished melting and that some sort of recovery will shortly begin. The Federal Reserve Board has aggressively reduced interest rates from the 5.25 to 3.0 percent. And the seized-up interbank loan market appears to have eased, with the LIBOR 3-month interbank rate now close to the fed funds rate.
That means that the real-estate problem is solved, and that we can all relax, right?
Maybe that's our liberal friends, authors of the current mortgage subsidy edifice, can relax. But not conservatives.
The problem with the real-estate market is that it forces ordinary people to use far too much leverage. Americans are mostly pretty conservative about their finances. But for many Americans the only way that they can afford a home is by accepting a very risky proposition, borrowing 80 percent or more of the purchase price of their home.
It was not always thus. Before the Great Depression Americans seldom borrowed more than 50 percent of the purchase price on a home and mortgages were seldom written for a term longer than ten years. But the housing meltdown of the 1930s encouraged the federal government to introduce a range of subsidies for home ownership including the Federal Home Loan Bank and the federally insured Savings and Loan Associations with their 30 year fixed mortgages. In 1938 the Feds created the Federal National Mortgage Association, Fannie Mae. And of course mortgage interest is deductible from US income tax.
With the government underwriting home mortgages lenders could afford to offer homeowners higher and higher leverage.
This sort of high-stakes homeownership is wrong, and it is wrong for politicians to encourage it. Highly leveraged investing is all very well for hedge funds and their rich customers. But it is wrong to lure ordinary American homeowners into such a risky scheme.
As a young thirtysomething friend said to me: "I didn't know." She bought a home in the final up-leg in 2005 of the late great real-estate boom. People told her that real-estate was a good investment, and the banks and real-estate agents were happy to sell her a mortgage. But she didn't know that all booms end in tears. Now she's moved out of town and the house is under water.
High leverage is for the finance professionals, not for young professional couples with a young child and another on the way.
If highly leveraged homeownership is wrong, then what should replace it?
The answer is pretty obvious, and I'm rather disappointed that nobody has suggested it. We need less debt and more equity in the real-estate business. But how do you use get more equity when you don't have the cash to put down? You take on an equity partner to lower your risk. Let us call it "home equity partnership." Here is how it would work.
You buy a house and you get a 50 percent mortgage on a $200,000 purchase price. But, of course, you are a thirtysomething and you don't have a 50 percent down payment. So your realtor sets you up with a home equity partnership offered by retail financial institutions and on the web. You put down 20 percent of the purchase price, or $40,000 and a "partner" kicks in 30 percent.
This means that the equity in the home is shared between you and the partner. If you sell the house in five years for a $100,000 profit, then you get $40,000 and the partner gets $60,000. That's not the sort of thing you can boast about at parties.
But look at what happens on the downside. Suppose there were a mortgage meltdown and your home's value went down 20 percent. If you had taken out an 80 percent mortgage you would be out your entire $40,000 down payment. But you didn't. You only had a 50 percent mortgage, and the rest was financed with a home equity partnership. So the $40,000 loss is shared with your equity partner. You are out 40 percent of $40,000, or $16,000 and your partner is out $24,000. The house would have to lose 50 percent of its value for your investment to get wiped out.
Here's the $64,000 question. What would an equity partnership like this be worth? Would the homeowner pay a premium to the partner? Would the partner pay a premium to the homeowner for the opportunity to participate in the real-estate venture? Would it be a wash? As the homeowner pays down the balance on the mortgage would the equity shares be adjusted? On what terms could the homeowner buy out the equity partner?
Here are some more questions. Would this plan reduce the "payments" the homeowner paid on a mortgage? Would the homeowner gradually buy out the partner's share? Supposing the equity partner wanted out?
Then there are the technical questions. Would a real-estate equity partnership be practical? Would there be opportunities for fraud that would kill the whole concept? Would homeowners accept the idea of a partner getting a share of their home equity?
Nobody knows the answers to any of this.
But we do know that the current system of enticing young families into the risky scheme of highly leveraged real-estate speculation is vulnerable to cycles, and there ought to be an alternative.
And politically, what's not to like? Conservatives are desperate to encourage the American people to buy into the notion of ownership and equity and to earn themselves independence and self-respect. Our liberal friends are desperate to bury everybody in a rising tide of debt and subsidy that makes them more and more dependent on government and liberal programs when things go south.
Let the new home equity partnership be the first step towards a new Conservative Equity Society.