Martin Wolf Calls for SRM-like solution for housing finance

Martin Wolf, Chief Economic Commentator of the Financial Times argues for mortgages structured like the SRM in his September 19, 2014 article “Deeper reform of housing finance is vital for stability“:

Consideration must given to shifting away from inherently inflexible debt contracts to shared-equity contracts.  It is possible to imagine that some finance would be supplied in the form of risk-sharing contracts of the following form: the finance supplied would carry a running yield for investors but their value would be linked to some index of house prices.  This would cushion borrowers during a crash in house prices.  It would also give savers the ability to invest in the housing market other than by actually buying lumpy (and expensive) houses.

For investors, these new instruments could prove to be attractive assets.  More important, the investors would automatically share the risks in the market.  That would make the borrowers less exposed to the risks of extreme leverage and the financial system as a whole more robust.  This is one of the recommendations of House of Debt, an important book by American economists Atif Mian and Amir Sufi.

The Plight of First-time Homebuyers

Bloomberg Magazine covers the plight of first-time home buyers in its August 12th article, “First-Time Buyers Shut Out of Expanding U.S. Home Supply”.

“I definitely sacrificed in terms of location,” said Nielsen-Dembe, a 33 year old mother of two who lives with her husband and bought a house in west Denver last April for $184,500. “I had to cross streets that were not ideal in order to get a house.”

With the abundance of all-cash buyers (42% nationwide in November 2013), strong investor appetite for affordable buy-to-rent properties, and the reluctance of underwater homeowners to sell (19% of all homeowners are in negative equity, with those of inexpensive homes three times more likely), the inventory for first-time homebuyers is crunched.

The inventory of U.S. homes for sale in the bottom third of the market (those below $198,000 and most sought after by first-time homeowners) fell 17 percent in June compared with a year earlier, according to a Redfin analysis of 31 large U.S. metropolitan areas. In Denver, this number was closer to 51% and in Austin, 34%.

Depressed inventory means that first-time homebuyers, already faced with tighter lending conditions, slow wage growth and lower credit scores, are increasingly shifting their home search to less attractive but more affordable neighborhoods often with higher crime rates, more incidents of violence, less desirable school districts, higher rates of foreclosure and fewer available jobs.

Since a neighborhood’s quality directly affects a home’s value, by sacrificing neighborhood for affordability, these first-time homeowners are also at a higher risk of losing value from the purchase of their home.

At PartnerOwn, we believe that homeowners should not be punished for where or when they decide to buy a home due to macroeconomic circumstances beyond their control. That’s why the Shared Responsibility Mortgage (SRM) automatically decreases homeowners’ monthly payments when their local home values drop. This price relief is built-in to the mortgage and does not require additional paperwork, phone calls or visits to the lender. In return for this benefit, the homeowner will share a small portion of the home’s appreciation (10%) upon sale with her lender. If the home does not appreciate in value, the lender receives no compensation.

By removing the uncertainty of paying more when local home prices decrease, PartnerOwn gives homeowners the freedom and peace of mind to purchase a home in a location and at a time that works best with their personal situation. Finding the right home is stressful, but we want to make sure that paying for it isn’t.

Getting HARP’ed and the SRM

FHFA_Mel_Watt

PartnerOwn attended the Federal Housing Finance Agency’s Getting HARP’ed event in Chicago, Illinois on July 8th.  It included FHFA Director Mel Watt and representatives from The Treasury Department, Fannie Mae, Freddie Mac, Wells Fargo and Neighborhood Housing Services of Chicago.

FHFA_Panel

HARP is federal program that helps current borrowers lower their interest rates on the loans, even if their home is in negative equity.  For borrowers, their loans must meet the following criteria (note that this has changed from its initial roll-out):

  • Owned or guaranteed by Freddie Mac or Fannie
  • Originated on or before May 31, 2009
  • Have a loan to value of greater than 80%
  • Be current on your mortgage with no 30-day+ late payments in the last 6 months and no more than one late payment in the last 12 months

The event advertised the HARP program as free money.  This is because HARP takes an existing loan and lowers its interest rate.  Since programs like HARP have helped borrowers reduce their monthly payments, and we support the work of the federal government to help homeowners who can save money, we want to highlight the HARP program and are happy to see them engage with local communities as they did this week.  The FHFA says that 35,000 people alone in the Chicago metropolitan area could receive this support but still do not.  It is hard for anyone to beat the interest rates that the HARP program provides.  And we encourage people to consider HARP if they are looking to refinance their existing mortgage and want to take advantage of the historically low interest rates.

In spite of HARP’s benefits, HARP also provides an opportunity for us to reflect on the benefits of our product, the Shared Responsibility Mortgage.  Effectively, PartnerOwn believes that reduced monthly payments should be built into the mortgage contract from the beginning to protect homeowners in market downturns.  HARP is a federal program that came about after the crisis.  It required federal approval and has had changing standards as it has tried to impact more and more homeowners.  The need for a program like HARP speaks to the problems of the original mortgage contract itself, and that is why we want to make the SRM a standard so that one-off programs like HARP will not be needed in the future.

HARP does have its limitations.  It can provide borrowers with a lower interest rate, but there is no possibility of principal modification.  Basically, if you and your family bought at the height of the bubble, and the market subsequently went down through no fault of your own, you are still on the hook for all of that debt, albeit at a lower interest rate.  The Shared Responsibility Mortgage lowers a borrower’s monthly payment according to changing market conditions, however.  Our monthly form of principal modification has been cited to be  more effective in providing assistance to homeowners than interest rate reductions.  Further, we believe that the intervention used to help homeowners keep current on their mortgages should be the most effective, and investors should expect those modifications as well to keep their borrowers able to pay their obligations.

For more about the efficacy of principal modification, you can check out this article from the Woodstock Institute about its relevance for the Chicagoland area.

PartnerOwn in Bloomberg Magazine

PartnerOwn in Bloomberg

PartnerOwn’s work is covered in Bloomberg Magazine’s May 26th Opening Remarks column, “The Shared Responsibility Mortgage Could Help Bubbleproof the Housing Market.”  There was a typo since PartnerOwn is a joint venture for Shima Rayej and Dylan Hall.

So far, the shared-responsibility mortgage exists only in the minds of two ivory tower economists—Mian at Princeton University and Sufi at the University of Chicago Booth School of Business. A two-person startup called PartnerOwn plans to launch the first shared-responsibility mortgage on Chicago’s Northwest Side in cooperation with the Latin United Community Housing Association. “Our personal goal is by August,” says Dylan Hall, a former graduate student of Sufi’s…

 

Shared Responsibility Mortgage

Shared Responsibility MortgagePartnerOwn’s work to improve mortgage finance is based on the research of economists Amir Sufi and Atif Mian, who propose the Shared Responsibility Mortgage (SRM) in their new book, House of Debt.  Their research into the Great Recession has made them the experts on its underlying causes, and their down-to-earth approach makes their book (and blog) a great read.  With this post, we want to introduce a few key concepts that draw on their work and explain the basic need for their proposal, the SRM.

Buying a home is more than buying rooms, a roof, a garage and a backyard.  It is buying into a neighborhood, a school district, and a commute to work.  A homeowner may control the house but not the neighborhood, the local businesses, or the school district.  Things change.  And these changes can hurt or help the value of the home.  If a nearby employer leaves the neighborhood for example, the home and its neighborhood may be less desirable since there are fewer jobs.

In addition to neighborhood risk, homeowners face market risk.  To buy homes, people use a lot of debt (90% of the value of the home for the typical buyer).  This is dependent on someone or some institution being able to make those loans.  So, starting in 2007, when the housing market began to go through a major correction and banks needed to be bailed out by the government, lending became less common which hurt home values.  People who were using the value of their home to get by started to consume less because they lost wealth.  This in turn hurt businesses and caused layoffs.  More people defaulted on their debt.  And overall, nationwide home values dropped over 30% in the course of a single year.

Because most homeowners use debt to purchase their homes, they are not protected if the neighborhood or the housing market changes.  The debt is constant.  These risks would make any investor cringe, especially since most mortgages are thirty years in length, ample time for the risk to be realized.  However, as mortgages have grown in length and require lower down payments, our government and banks still encourage borrowers to take on this greater risk and hope things work out.

This is why PartnerOwn is working to implement Sufi and Mian’s SRM.  Its most fundamental innovation is to tie the homeowner’s debt to the local housing market.  If home prices go down because of the neighborhood and market risk, the homeowner’s monthly payment will go down as well.  So, if the neighborhood decreases by 10% in value, a homeowner’s monthly payments will also decrease by 10%.  Effectively, the risk is shared with the lender, who can better handle the risk through modern diversification strategies.  This will protect the homeowner who has a significant portion of her wealth tied up in her home and provide relief in case the local neighborhood or housing market experiences a downturn.  Additionally, the homeowner never has to make up those decreased payments. It is simply part of the original agreement between the homeowner and the lender.

To pay for this protection, the homeowner would pay a small portion of the increase in the home’s value at sale.  So, if a homeowner bought a home for $100,000 and sold it for $110,000, the homeowner would pay 5% of the $10,000 made, which is $500.  The homeowner essentially borrows from the future increase in the home’s value to receive protection.  If the home does not increase in value, no payment is made.  Sufi and Mian argue that this simple innovation would have helped limit the severity of the most recent crisis.

PartnerOwn is currently working to implement a version of Sufi and Mian’s SRM.  We have identified a first investor, a local housing agency in Chicago, to help us originate SRMs for its clients.  They believe the SRM to be a more responsible form of lending for their clients and a way to invest in their local neighborhood.  We look forward to keeping you updated about our progress.  And if you have any questions about the SRM, please do not hesitate to contact us along the way.

Team PartnerOwn
team@partnerown.com

LUCHA’s Homebuyer Seminar

Recently, PartnerOwn had the pleasure of taking part in a six-hour housing counseling seminar on a Saturday with twenty future home buyers.  The program was provided by LUCHA.  LUCHA is a nonprofit neighborhood housing agency serving the Humboldt Park, West Town and Logan Square neighborhoods in Chicago.  PartnerOwn wanted a glimpse at programs like these that have improved a borrower’s ability to stay current on her mortgage and are a great service to the local communities they support.

LUCHA home buyer seminar

LUCHA home buyer seminar

LUCHA’s seminar covered a wide array of homeownership: from financing the home purchase to monitoring energy usage.  We learned a great deal, and we also saw the need for better financing opportunities for borrowers since participants talked through issues of credit scores and down payment needs . We recognize that any new financing arrangement should be flexible enough to provide options for borrowers with different down payment thresholds or credit scores that do not reflect their financial situation.

The day began by enumerating the positive and negative aspects of homeownership.  The participants listed many “consumption” based benefits of homeownership, and the instructor suggested that purchasing the home is also an investment towards the end of the brainstorming session.

To acquire financing for their home purchase, all participants were interested in obtaining a mortgage.  The instructor provided tips for obtaining and maintaining a good credit score.  One participant was surprised that after paying off all of his credit card accounts and closing them, his score could be hurt because it lessened his credit history.  It made PartnerOwn wonder if there are better ways to determine a borrower’s ability to pay a mortgage, outside of using a credit score alone?  Research has demonstrated how the dependence on credit scores led to lax screening in the most recent housing crisis.

A mortgage lender spoke next about financing options that banks provided to borrowers.  It was a great opportunity for participants to learn more.  Many banks currently offer down payment assistance programs.  The banker also stressed that they did not want to “put borrowers in a position to fail” when making a loan given what has happened in these past five years.  Unfortunately, the banker did not discuss the risks that borrowers face, such as house prices decreasing in value or the possibility of being in negative equity.  This is surprising given that Zillow estimates that 30% of Chicago homes are still in negative equity.

Juan Linares, LUCHA’s Executive Director and a commercial real estate lawyer spoke next about legal considerations when going through the home purchase process.  He emphasized asking for more than the standard five day inspection period to make a decision because it can often be difficult to book an inspector and get the results in the contracted timeframe.  His insight was invaluable for all involved.

Juan Linares, Executive Director, LUCHA

Juan Linares, Executive Director, LUCHA

Next on the docket was a real estate agent.  The real estate agent spoke about the commitment one must sign and the small things agents can do to make sure that the purchase goes smoothly.  One anecdote was to specify the models of the appliances that would stay in the house since he once had a client end up with a rusty refrigerator that was switched into the home because the contract only specified a refrigerator.

A real estate appraiser and an electrical provider dug into the details of keeping up a home and ensuring that the home you buy is the right one.  LUCHA’s team then closed with advice for down payment grant opportunities available through state and federal agencies.  Most of the programs took the form of a loan at a higher interest rate than the mortgage itself.  While it is enviable to help borrowers overcome the down payment obstacle, it seems doing by encouraging more debt may not be ideal in the long run.

It was a great day for homeownership.  And we thank LUCHA for the opportunity to participate.  Stay tuned for more updates.  PartnerOwn is busy at work creating our financing solution for residential real estate and acquiring the resources to make it a reality.

The PartnerOwn Team