Initial Questions on Alex Perriello’s Shared Equity Idea

Alex Perriello, the CEO of Realogy Franchise Group (the parent company of Coldwell Banker, Century 21, ERA, Sotheby’s, and Better Homes & Gardens), who used to be my boss’s boss, has an op/ed in yesterday’s New York Times. In it, he proposes a novel solution to the foreclosure crisis:

Fortunately, there is a solution. Rather than be at odds, homeowners and investors should partner in long-term equity-sharing arrangements.

Here’s how it would work. Let’s say a homeowner purchased a house in 2004 for $300,000 with no money down, and the property is now worth $150,000 — a 50 percent drop in value.

In an equity-sharing arrangement, the lender would write a new loan for $150,000, retire the original $300,000 loan and, to make up for that loss, take a 50 percent deeded ownership interest in the property. The homeowner would also agree to split 50 percent of the net proceeds of any future sale of the property with the lender. The new arrangement would also include a buyout provision, so that if the homeowner ever wanted to take over the lender’s share, he would simply pay the lender a predetermined amount of cash.

Read the whole thing. It’s worth considering, given both Alex’s position in the industry, as well as his decades of experience in this crazy industry. I may not agree with everything Alex always says and does, but he’s seriously one of the wise men of our business and a leader worth paying attention to.

Let’s think this through briefly, because there’s a lot to like here, but ultimately a couple of reasons why it will be much, much harder to implement than Alex believes.

Share the Pain, Share the Upside

The essence of the proposal is that lenders and homeowners should share the pain of the downturn in the housing market, and share in the upside if things should turn around. It attempts to get around the moral hazard problem of simply writing down the mortgages of homeowners whose equity in their homes have been wiped out. You see, if someone owes $300,000 on a home now worth $150,000, simply reducing his principal owed to $150,000 means that if he later sells the house for $200,000, he ends up with a personal gain of $50,000. If his original down payment was 10%, or $30,000, that means this homeowner just ended up with a $20,000 windfall. That’s moral hazard of the first order.

With Alex’s proposal, that $50,000 gain would be split between the homeowner and the lender 50/50. There is still some moral hazard there, IMHO, since the homeowner is getting $25,000 of his original $30,000 equity back, but it’s not as severe.

Securitization and Tranche Warfare

The first problem is that most lenders today do not hold the loans. Rather, they are sold and resold until they ultimately end up in a securitization pool with 5,000 other mortgages, to be sliced and diced into various tranches and reissued as mortgage-backed securities. Alex mentions this in his piece:

In most cases, however, lenders immediately sold their loans to investors and merely performed loan-servicing duties like collecting monthly payments and sending statements.

In those instances, the lender would have already made its money when the loan was originated, the proceeds from the new loan and the 50 percent deeded interest in the property would go to the investor, not the lender. The investor would also benefit from any future sale or when the homeowner exercised the buyout provision.

One problem is that the term “investor” is far too general. With securitization, there is rarely a single class of investor. Here’s a typical RMBS securitization pool:

The key concept for Alex’s proposal is “Last Loss and First Loss”. The senior tranches, the ones with the highest ratings, are the first to get paid by the proceeds of the pool. Taking a 50% writedown on the principal balance would surely wipe out the bottom tranches, and those investors might not be so keen on such a thing. In fact, there is a bit of a conflict of interest between the senior and junior tranches as it comes to foreclosure. Without knowing the specific terms of a particular trust, it isn’t clear whether the trustee — who is ostensibly the legal owner of these mortgages — can do what Alex is asking for. In some cases, where foreclosure results in the maximum value for all classes, the trustee should move to foreclose. In others, if the writedown-plus-equity results in maximum value, the trustee should do that. But it isn’t as simple as substituting “investor” for “lender”.

Subordinate Creditors & Subsequent Default

Whether bank-owned mortgage, or securitized mortgage, what do we do about subordinated creditors (i.e., second mortgages, home equity lenders)? Are their interests totally extinguished, even in the event of a resale at later date for more than the full value?

The homeowner owes $300K on a house worth $150K. In addition, he’s taken out $50K in a home equity loan. The first mortgage lender agrees to the restructuring. Does the HELOC lender also need to agree? If so, what does he write the loan principal down to? What percentage of equity share does he receive?  Three years later, the home is sold for $300K. The first lienholder recovers the full $150k loan; let’s say the second lienholder now recovers $25K (half of the HELOC amount). Does the remaining $100K get divvied up somehow?

For that matter, in the event of subsequent default by the same restructured homeowner, what happens? As an equity holder (perhaps with 50%), is the first bank legally responsible for the HELOC debt to the second bank?

There are some fun scenarios and hypotheticals that need to be explored here.

Systemic Risk: CDO and CDS

Finally, although I’m sure I can think of some other interesting angles on the idea, we do not know what the unforeseen consequences to the financial systems would be of such a move. Because restructuring the mortgage in this manner would probably qualify as a default event under virtually every CDS (credit default swap) written on the RMBS pool, on a particular tranche of the pool, or on any CDO (synthetic or otherwise) created on the RMBS pool and its CDS. The actual size of the liability is unknown, but the notional amounts on the CDS are in the trillions of dollars.

What seems like an innocent restructuring of a homeowner’s mortgage to help him stay in the house could create massive payoff liabilities for a number of banks, hedge funds, insurance companies, and others who bet on the mortgage market via CDS. After all, CDS exposure is what brought AIG down.

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None of this is to meant to discount Alex’s idea out of hand. There is something really interesting embedded in the idea of sharing the loss today in exchange for sharing in the upside. I rather wish the Federal government had thought about this when they were busy bailing out the big banks and General Motors and such.

But if the idea is going to become practical to push as policy, some or all of these (and other) questions will need to be addressed. Plus, I’m sure I’m missing some angles, since this is but a blog post on an interesting topic, rather than a considered study or paper.

So… what say you? Good idea? Bad idea? What other issues would need to be addressed to make this reality? What other barriers stand in the way?

Enquiring minds want to know.

-rsh