Analyzing the cost of a tenancy workout for the credit crisis.

September 25, 2008 at 5:35 am | Posted in credit, Housing, regulations | 3 Comments
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Maybe we can have an agency or a fund that buys off foreclosed properties from banks, and allows the erstwhile owner to continue to occupy the place as a tenant (I’ve written about this here) . This would take the toxic mortgage off the bank’s balance sheet, and, by buying the mortgage at face value, or at a slight discount to face value, it would basically rescue the bank’s capital by overpaying for the debt. This, in turn, may support the mortgage market and the derivatives on these mortgages.

Knowing that the bad mortgages – those approaching foreclosure- can be sold at near-par (I suggest a 3-5% discount) would support prices of all mortgages.

In the meantime, the agency could convert the foreclosure process into a tenancy process – Ownership transfers to the agency, the previous owner now pays rent (at a rate somewhat lower than the mortgage payment, but one which covers the capital cost of the money the agency used to acquire the place), and, if s/he makes the rent payment regularly for a certain period of time (say two years – after all, plenty of renters lock themselves into a two year lease), they can then exit without a foreclosure on their credit record.

How much will this cost?

Lets try some round numbers to estimate this.

Two-thirds of about 110 million households own their homes, while the historical rate has been about 64%. The difference is about 3 million households, or about 4% of current homeowners. While the cycle could take homeownership even lower, I think rescuing homeowners would support the market to the point that perhaps prices and, more importantly, home ownership does not dip too far below this level.

The median home price in August 2008 was $203100, down from $224,400 in August 2007. However, we can assume that the median foreclosure may be above this amount for a couple of reasons – 1. Foreclosures are more likely in higher priced areas, and urban / suburban areas, and 2. The slowdown is worse in higher priced areas such as Southern California. Foreclosures started off in below-median-income households, but I think they are moving up the income ladder.

So lets assume the average mortgage on a foreclosed home is $300,000. This translates into about $850 billion in capital to purchase these foreclosed homes, at a 5% discount. Putting this money to work may help support pricing and keep other homeowners in their homes despite a decline in house prices.

I have previously estimated that the fall in home values could leave aggregate mortgage debt about $1.8 trillion above home values, so a real estate (RE) fund that buys up to $850 billion in property and converts them into rentals could make a serious dent in the problem. I wouldn’t worry too much about the derivatives market if we can bring some stability to the underlying real estate market – the derivative losses may be limited somewhat by the underlying stabilization, and anyway, I would rather use taxpayer money to support both Wall Street and Main Street, not just Wall Street.

Assuming a 4% cost of capital for the RE fund, and a $4000 median property tax, the median rental on these properties would be ~$1350 per month. We would have some people falling behind on the rent as well, so there would be losses on that as well, but I’m guessing that by stabilizing the market, and by charging rent that is probably considerably below what the tenant was previously paying in monthly installments, we might make it easier for the tenant to make these reduced payments.

So this fund would need $850B in capital, hopefully be able to largely produce returns that meet its cost of capital, and have assets that would eventually be sold to recover a fair amount of the principal, with a holding period of 2-5 years. Administratively, this would be a tough challenge to manage, but one could contract with property management agents to take care of some of these issues.

The ultimate cost to the tax payer may be a relatively small portion of the real estate fund. If we assume that about 20% of tenants fall behind on their payments (a conservatively high figure) during the two-year lease period (at a median of 1 year into the lease), that is just a $10 billion shortfall in lease collections. Lets say these 20% of properties are then sold (instead of being rented out to someone else) at a 20% loss. That is a 4% loss to the fund = $35 billion. Finally, assume the rest of the properties are eventually sold at a 10% loss. That would be $70 billion.

By my estimates, the total cost of a tenancy workout would be $115 billion, spread over several years. This is assuming the taxpayer-funded RE fund would actually purchase 3 million homes. But why not bring in private players who would get government backstop funding, based on these assumptions? Let them buy the properties at a 4% cost of capital, manage the process and the landlord -tenant relationship, and participate in the gain / loss relative to these back of the envelope calculations?

I would love to see a plan built around some such framework, and I would support the use of taxpayer money for this purpose.

$700B real estate fund!

September 21, 2008 at 6:02 pm | Posted in credit, Housing | Leave a comment
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In round numbers, total residential mortgages outstanding are about $11 trillion (See the time series on OFHEO’s website here).

Roughly, 65% of Americans live in owned housing, of which a third own the property free and clear. About 45% of about 108 million households have mortgage debt. Thanks to easy credit and the record low interest rates in 2003-2004, a majority of properties were recently refinanced, so the average age of mortgages are 3-5 years, with relatively few loans of pre-2001 vintage.

So basically, the government wants the authority to buy up about 6.3% of all outstanding mortgages, by initial value.

The government won’t buy a sample of mortgages – they will buy the worst of the lot, so we can expect that a very large number of the mortgages in the taxpayer’s portfolio will go delinquent at some point – in fact, many may already be delinquent by the time the government acquires them. With home prices sinking and very little equity to start with, in these toxic mortgages, the homeowners (I use the word loosely, its more like occupants) are basically upside down – They owe more in the mortgage than the house is worth, so many of them will walk away and go through foreclosure, unless the government also works out some kind of foreclosure avoidance package.

Otherwise, the US government is about to become the world’s largest residential real estate owner.

Own-to-rent?

September 21, 2008 at 5:30 pm | Posted in credit, Housing, regulations | 2 Comments
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Here’s an idea. How about, the government acquire toxic mortgages and modify the foreclosure process. Maybe the title transfers over to the government. The government then transfers it over into what is, essentially, an apartment REIT, and appoints a property manager to manage its rental portfolio.

The erstwhile homeowner is now a tenant of the property. They’ve lost equity – if they ever had any- but not the roof over their head. They now owe rent instead of the monthly mortgage payment, and perhaps the rent can be modified to the interest payment on the outstanding balance at a reasonable interest rate (Perhaps the current average 30-year fixed rate), rather than either a low teaser rate or a too-high post-reset ARM rate.

The tenant is basically locked in to a 2-year lease, so they have to pay rent for two years. If they fail to do so, they have a foreclosure on their credit report; if they do make the payments, they walk away with no equity, but also no dings to their credit. The foreclosed home stays occupied, so there isn’t a flood of bank-owned real estate boosting supply and depressing prices. The neighborhood doesn’t start emptying out, and foreclosed homes don’t drag down values – or boost crime in vacant homes.

Perhaps the government could in turn sell these rental REITs to investors – They buy into the rental cash flows + the value of the property. We know that the government will lose on this – The REIT cannot be valued at what the government paid for the assets in the REIT, but at least this will provide liquidity to both the financial markets as well as support the real estate market, helping borrowers in trouble.

I think this might be a workable idea, although it needs developing further.

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