Obama's last hope

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.