Obama's last hope

Make no mistake: President Obama’s recently announced $US75 billion housing plan is a long-term policy disaster insofar as it merely treats the symptoms of the calamity in an extremely costly manner via crude short-term interest rate relief - read good taxpayers bailing out bad - and remarkably does nothing at all to prevent the next generation of US borrowers experiencing exactly the same problems in the future. In fact, it can be argued that it only creates a higher tax burden for tomorrow’s taxpayers.

Disturbingly, the Administration’s response also exacerbates the underlying dysfunctionality that is the root cause of the US’s housing market woes by, for example, offering defaulting borrowers scope to wriggle out of their home loan contracts through the judicial system (or, in the words of the Administration, “allow judicial modifications of home mortgages during bankruptcy for borrowers who have run out of options”).

This will only undermine the enforceability of US mortgages and embed a new risk premium that will inevitably lead to higher future interest rates and likely funding uncertainty - why finance US mortgages when they can be overturned by the courts?

And by reinvigorating the two GSEs, Fannie Mae and Freddie Mac, to, ironically, “ensure the strength and security of the mortgage market”, without any genuine reforms or discussion of their future, the Administration has demonstrated that it does not understand the fundamental flaws inherent in the US banking and finance system, which, as I have previously outlined, precipitated this crisis in the first place.

The Administration’s asinine approach to dealing with the greatest economic challenge since the depression has, to be frank, left me despondent and thinking that the more gloomy prognoses - including those predicting a Japanese-style “lost decade”- could well come to pass. This conclusion was certainly echoed in private discussions I had with respected academics during my recent visit to the US.

All is not lost

There remains, however, “hope” that the more thoughtful decision-makers in the Administration, such as Housing Secretary Shaun Donovan, and President Obama’s key economic advisor, Austin Goolsbee, will search out the superior long-term reforms that they so desperately need.

In this context, I was fortunate enough to be able to present several solutions to the Transforming America’s Housing Policy summit for Obama Administration officials in New York which both Donovan and Goolsbee attended.

The summit’s preamble was entitled, “A crisis would be a terrible thing to waste”, which could not have better captured the awkward cross-roads at which US policymakers find themselves. The difference between the US experiencing an interminable decline and recovering in the medium term to reclaim its place as one of the global economy’s drivers of entrepreneurship and innovation, will arguably hinge on it response to this catastrophe.

The good news is that I believe there is a way forward, albeit one that will require courage, foresight and conviction on the part of the Administration’s decision-makers. Given the life-defining stakes, it is never too late to recalibrate one’s trajectory.

At the summit I presented a specific policy solution to the US’s housing market problems, which appeared to be very well received and featured prominently in our panel’s discussion on reclaiming the promise of home ownership. (This panel included the leading US academic economists, Robert Shiller and Raphael Bostic.)

The proposal also appeared to attract considerable interest from powerful US stakeholders, such as the influential Democratic Senator for New York, Charles E Schumer, whose advisors contacted me after the summit to convey their support.

As I outline below, this plan directly cauterises the US’s underlying housing market dysfunctions, delivers far greater and more permanent interest rate relief for distressed borrowers, allows banks to immediately recapitalise their balance-sheets with a $77 billion cash injection, and will ultimately cost taxpayers much less than the initiative the Administration has announced.

On all objective counts I find it hard to see how it does not unambiguously dominate the Administration’s alternative. And based on consultations with US experts, I believe that it would be easier to implement since borrowers, lenders, investors and taxpayers would all be clearly better off than they are under the Administration’s scheme.

As I’ve noted before, one of the most critical lessons from the global financial crisis has been that many households have far too much leverage - particularly in the US where the average borrower’s mortgage is now worth an astonishing 95 per cent (PDF 1.71MB) of their home (ie, 30 to 40 per cent are “underwater”). And the only genuine policy solution to the resultant desire to deleverage is the development of external markets in housing equity - or “shared equity” - which borrowers can use synergistically in combination with traditional debt finance.

Let me demonstrate how the application of a government-managed “debt for equity swap” program would allow distressed US borrowers to radically deleverage their balance-sheets and, in turn, permanently reduce their mortgage repayments by 35 per cent or more in exchange for sharing some of the economic benefits of home ownership with taxpayers:

- Assume that the average “distressed” borrower’s loan-to-value (LTV) ratio (ie. their mortgage as a percentage of their home’s value) is, say, 115 per cent (this is likely to be a fair approximation given the average LTV across the whole market is 95 per cent). Under this debt-for-equity swap proposal, the traditional lender would only write off 15 per cent of the value of their loan to bring the borrower’s LTV back to 100 per cent of the property’s value (as opposed to the lender writing off most of the loan’s value, as would ordinarily be the case with a borrower in extreme default). A similar write-down is anticipated in the Administration’s scheme.

- Yet instead of taxpayers making a cash gift to lenders to temporarily cut borrowers’ repayments, the government would effectively “buy-out” or refinance 25 per cent of the reset traditional loan by swapping that portion of the debt with a taxpayer-funded “shared equity” loan (this could be achieved by simply having the borrower pay down 25 per cent of the reset traditional loan with the funds they receive from the government).

- Importantly, the shared equity loan carries no monthly repayments whatsoever during its maximum 30-year life. In exchange for the shared equity finance, taxpayers would receive half of the property’s future capital growth in lieu of interest when the home owner elects to repay the loan either on refinancing or sale of the property (this contrasts starkly with the Administration’s program where taxpayers currently get nothing in return for their $75 billion bailout). However, the shared equity lender (viz, taxpayers) formally own no legal interest in the home since the instrument is structured using a traditional mortgage contract; the owner therefore retains control over what they do with the property in the future as they would under any other loan.

- The traditional lender is now left with a dramatically lower (and hence less risky) 75 per cent LTV. They are also directly paid 25 per cent of the face value of their reset loan by the government and hence get the benefit of a significant cash injection - which, as I show below, is worth about $77 billion - onto their balance-sheets (this constitutes a much needed recapitalisation for the banks).

- The borrower is now only paying a full rate of interest on a home loan that is just 65 per cent of its original value. Thus they benefit from a permanent 35 per cent reduction in their interest and principal repayments over the 30-year life of the loan package. In contrast, the reduction in repayments realised by borrowers under the Administration’s current proposal only lasts five years - after which rates are ratcheted back up, thereby once again raising the risk of “redefault”.

- Assuming that overall house prices increase at a rate no greater than nominal GDP during the next 30 years, which given the recent 25 per cent correction seems like a defendable expectation, taxpayers could expect to earn an 5-10 per cent annualised, ungeared rate of return on their equity investments, which is dramatically superior to the 100 per cent losses that they will realise on their $75 billion “gift” to distressed borrowers under the Administration’s current plan.

- How much would this cost? According to the Mortgage Bankers’ Association, 6.6 per cent of the circa $11 trillion of US home loans are currently estimated to be in 60 days or more arrears. Assume that half of these borrowers will go into foreclosure and need to access this new debt for equity swap program. That gives $363 billion worth of loans in extreme distress. If the average LTV is 115 per cent and the lender wears a 15 per cent write-down then the total value of the reset debt would be about $309 billion.

- A 25 per cent debt for equity swap program would therefore cost taxpayers roughly $77 billion, which, coincidentally, is almost exactly the same amount of money that the President has set aside for his housing package.

- The unique benefits of the plan include the fact that once the properties are sold and the shared equity loans repaid, the government can recycle the capital to assist new households in distress.

- That is, the $77 billion housing equity fund could be used by the government on a recycled basis to reduce the risk of families facing foreclosure in perpetuity (as opposed to the current once-off “cash splash”). And since traditional lenders are avoiding foreclosure and the associated losses, there is an argument for them to contribute to the plan in the longer-term.

- The performance of this first generation equity portfolio would help build the foundations for the development of a wider market in private equity finance that could reduce the risk of excessive household leverage in the future. In particular, the returns realised on these loans and the timing of the cash-flows would resolve many questions that have prevented these markets from emerging previously. And definitive resolution of the tax and legal treatment of these instruments as part of the plan would remove one of their key impediments in the US.

Private and publicly-funded markets in housing equity now exist in Australia, NZ, and the UK. Indeed, Australian research and practical experience have been explicitly used as a guide for several billion dollars worth of government investment in public-sector shared equity initiatives in the UK and NZ, which are helping thousands of families deleverage.

Combined with the fact that leading US academics, including Ian Ayers and Barry Nalebuff at Yale, Luigi Zingales at the University of Chicago, Edward Glaeser at Harvard, and Andrew Caplin at NYU, have all recently made similar calls for the US government to help borrowers swap a portion of their housing debt for equity, it is hard not to acknowledge that there is immense merit to this plan.

Nobody has a monopoly on good ideas. And nobody would begrudge the Administration for seeking to refine their solutions to this calamity. I just hope Larry Summers, Shaun Donovan, Timothy Geithner and Austin Goosblee have the humility and foresight to listen. Because guys, what you are currently proposing to implement will almost certainly set the US economy on a long-term course towards permanent irrelevance.

If truth be known, I feel helpless because I doubt very much whether they will listen. I have been told by influential US stakeholders that it is all too late. And it distresses me deeply to see the much-vaunted Obama Administration make precisely the same ill-conceived and vested missteps as its predecessors.

But let me be clear - the debt for equity swap program outlined above is the only hope US policymakers currently have of marrying long-term relief for distressed families with much more fundamental reform.