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?-- JakePatterson, Aug 06 2008 Already in common use http://en.wikipedia...iki/Islamic_bankingCommon practivce in many parts of the world. [WcW, Aug 07 2008] 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.-- jurist, Aug 06 2008 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.
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).
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).-- calum, Aug 06 2008 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?-- phoenix, Aug 06 2008 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?-- Jscotty, Aug 06 2008 [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.
[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.
[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.)-- JakePatterson, Aug 06 2008 "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.-- WcW, Aug 07 2008 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.
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.
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.-- supercat, Aug 07 2008 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.-- WcW, Aug 08 2008 The individual borrowers don't get bailed out, but it looks like many of the entities that bought mortgages will.
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.-- supercat, Aug 08 2008 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.-- WcW, Aug 08 2008 random, halfbakery