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One aspect of the mortgage crisis in the
US right now is that so many people are
finding themselves with an upside down
mortgage, which is where the amount of
the principle that they still owe is greater
than the value of the property. This
represents a big risk for the lending
institutions,
because the borrower has a
very strong incentive to walk away from
the
mortgage at that point, and the best the
bank can do is foreclose and then sell the
property at auction and take a big hit.
My proposal is to rethink that whole
relationship and devise a totally different
structure for financing home ownership.
Let's
say Jon Smith wants to by a house in
Fooville and so he goes to the First Bank
of Fooville for financing. Jon and the First
Bank form a LLC which buys the house
with funds provided by the bank and
whatever Jon can afford for a down
payment.
The LLC issues ownership shares to the
bank and to Jon in proportion to how
much they each put in, and Jon pays rent
to
the LLC for the right to live in the house.
The LLC pays a dividend to its
shareholders from the rental income, and
Jon holds
options to purchase the remaining shares
that the bank owns based on the value of
the house. Now here's the key: Jon's
options expire in one year, at which time
the home is reassessed, and he is issued
new options based on the new assessed
value. The amount of the rent would also
be adjusted each year based on an index
of the rental market in the region.
I think there are a number of advantages.
First, Jon can never face foreclosure.
While he could face eviction if he can't
pay
the rent, even if that occurs he would
still maintain the ownership shares that
he has (he would even keep his options)
and
when a new tenant moves in he would
start earning dividends from their rental
payments. An advantage for the bank is
that
if the value of the property increases, so
does the value of their investment, but of
course both parties are exposed to the
risk that the value might decline.
Now let's consider a simple scenario:
Several years into the deal, the economy
goes south and Jon loses his job. The
only
job he can find pays much less, and he
can no longer afford the rent. Since he
does own a significant stake in the
LLC by this point, he would have a strong
incentive to find a cheaper place to live
as quickly as possible, freeing up home
for
a new tenant. This would be a soft
landing for Jon, because by moving into a
smaller place his rent would be less, and
he
would still be earning dividends from the
new tenant. It would make little
difference to the bank (as long as a new
tenant is
found quickly) which means there would
be a giant upside from their point of view
because the chance of default would be
much lower than with a traditional loan.
Some downsides do occur to me. If the
value of the property drops too fast, Jon
could end up being able to buy up the
remaining shares easily once the options
re-adjust, which would not be a good
outcome for the bank. Maybe there could
be some built in inertia to how quickly
the price of the options can change year
to year to prevent this scenario. On the
other hand, if the value shoots up, Jon
could find himself wishing he had gone
with a traditional thirty year loan. Jon
would
also be subject to the volatility of the
rental market.
An option: Maybe the annual share price
adjustment could be based on an
average of the historical assessments
from each
of the previous five years so the parties
are less likely to be exposed to volatility.
Thoughts?
Already in common use
http://en.wikipedia...iki/Islamic_banking
Common practivce in many parts of the world. [WcW, Aug 07 2008]
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Setting up an LLC for every individual single-family-residence property seems like an expensive way to go, just because of the initial corporation filing and ongoing annual paperwork fees, if nothing else. Wouldn't it make more sense to re-jigger this idea as a form of REIT (Real Estate Investment Trust) with multiple properties held in the portfolio and wherein Jon may both be a shareholder and a renter? This isn't meant to suggest a huge departure from the stated idea, just a shift into viable products which are already currently available in the market. |
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Rather than shifting the emphasis towards REIT status (as jurist suggests) perhaps the key is to commoditise the approach and to make it less tailored: from my perspective the most expensive parts of the idea s written are
(a) negotiating the articles of association/shareholders agreement which would regulate the behaviour of the LLC/limited company and
(b) agreeing and administering the revaluation of the options annually. |
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While standardising terms means that they are going to be less appropriate for the individual purchasing the property, it would save costs. Also, purchasing property (and lending on the basis of the property) is pretty much always a bit of a punt, so the key thing is apportionment of risk (no easy task, particularly if the aim is to divide risk more fairly between purchaser and institution). |
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A further simplification (and cost saving measure) would be rather than going for a yearly "rent-review" style revaluation of the investment, simply specify at the start the proportion of the shares to be purchased each year (or other interval). |
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There's also the issue of the second owner. Why would Sally choose to move into Jon's house when she could buy a new home and be vested in it? |
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What happens if Jon can't handle the payments and then you can't find a renter/potential owner to replace him? What happens if the crime rate goes up in that neighborhood and then nobody wants to live there? What if Jon does not want to move to a cheaper home because he does not like the neighborhood or the schools surrounding it? What if Jon or any other renter decides to destroy the property? Who is responsible for the repairs? If the bank spends $4000 repairing the property, will Jon ever get any dividends again? |
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[jurist], You are probably right about
LLCs being too expensive to set up, in
reality I think that there would probably
have to be some new type of legal entity
designed for this specific purpose and
tailored for its needs, especially with
respect for how taxes would come into
play. I don't think this is necessarily
unrealistic, the concept of the
condominium required legislative action
to be possible when it was first thought
of. |
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[phoenix], If Jon moves out because he
can't afford the rent, then the property
would go on the rental market just like
any other property on the rental market.
If Sally moves in, she'd just be paying
rent, she wouldn't hold options to buy
shares. As for why she would do that, I
guess that would be for the same set of
reasons that anybody else would rent
instead of buy a house. That the
landlord is a LLC owned by Jon and
some bank should make no difference
to her. |
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[Jscotty], The scenarios that you
describe are definitely real risks, but
part of the problem we currently have is
that the banks have not taken into
account these types of risks in their
traditional lending policies because the
risks are hidden. As a result, banks are
failing as people are motivated to
abandon their upside down mortgages.
As far as the issue of destruction of the
property, the structure of the
corporation would have to take that risk
into account, maybe some small
percentage of the rent would be set
aside to pay for insurance and pay for
repairs. Also, while it is difficult to get a
tenant to pay for damage that they do
to a rental property, the contract could
hold Jon to a higher degree of liability
for his own actions, especially if the
legal structure of the deal defines him
as different from an ordinary tenant
(tenants have lots of protections from
liability or eviction from rental units in
most parts of the US.) |
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"bad" mortgages of the sort that are
causing havoc right now are biased on
allowing marginal buyers to make very
marginal payments on homes valued
(apparently inaccurately) outside their
means. A buyer who can make both a
rental and a quasi-mortgage payment
are not the sorts that are now
defaulting en masse. This is also a
baked idea and as a tool is used
frequently by Islamic banks that refuse
to charge interest. |
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The increasing number of mortgage failures are a result of certain people's expectations of a government bailout. Bailing such people out will perpetuate the cycle. |
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If lenders have a guarantee that, whether or not borrowers repay their debt, they'll get repaid regardless, there will be little reason for them to be picky about who they lend to. Indeed, it's possible that a loan - purchase - default - foreclosure - bailout sequence may work to the benefit of everyone but the taxpayer who foots the bill for the bailout. |
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As for the basic idea: one of the great features of a 30-year-fixed mortgage is that the homeowner doesn't have to worry about changes in interest rates, property values, etc. As long as the homeowner can make the same dollar-denominated monthly payment, he keeps the house. |
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I'm sorry but anyone who foreclosed on a home and lost it didn't get "bailed out". The reason why banks stepped up the repayment rates was as a response to the falling value of the property. By trying to keep their buyers "right side up" on wacky home loans they effectively ate their tail. Don't blame the short sightedness of the buyers (there was plenty) blame the fools that bought the brokered loans (bank highers up). They should suffer for their irresponsible behavior. |
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The individual borrowers don't get bailed out, but it looks like many of the entities that bought mortgages will. |
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As for short-sightedness of buyers, if someone with bad credit is allowed to live in a home for three years, paying less on the mortgage than he would have paid in rent, and then simply walks out on the loan (with credit that's functionally no worse than it was to begin with) what has that person lost? An unethical person would not have to be in the least "short-sighted" to accept such an opportunity. |
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market forces dictated the terms of the loans. the buyers were just bystanders in a confidence game pulled by lenders. The buyers thought they were buying a home. The lenders knew that they were scamming anyone who bought the loan packages. I personally blame the lenders and the people who bought the loans without doing due diligence. Furthermore the markets are now telling us that the homes were overvalued and the buyers would have gotten less than what they paid for. Hardly a "sweet" deal. |
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