Chapter 13 – Structural Ideas for the Economic Rescue – Fractional Homes and New Banks



Structural Ideas for the Economic Rescue – Fractional Homes and New Banks

Mom used to say, “If you don’t have something nice to say, don’t say anything at all.” I clearly ignored that advice in the previous chapter, with the “mad as hell” opening and analogies to an exploding meth lab run by the neighbors. This chapter is more polite and more positive. It is about two ideas that can help us out of the mess we are in. Both have a systems analysis flavor, and both are from MIT graduates, who have the predilection and training to think this way.

The two ideas discussed here, fractional home ownership and a new American bank initiative, each have a great systems analysis soul — removing unnecessary complexity and negative feedback loops and creating positive feedback via incentive structures to make them work. One of the best examples of a structural approach to societal problems occurred in Germany in the 1970s. Some German rivers had become so polluted with factory waste that they would catch fire. Some were paved over and declared industrial sewers. Plants were simply required to take in their water just downstream from where they pumped out their waste. The garbage became their problem instead of everyone else’s. River fires became a thing of the past, and the concrete covers were removed.

Fractional Home Ownership

John O’Brien is one of the founding fathers of the field of financial engineering. He understands the field as well as anyone, from both academic and practical experience. As a founder of Leland, O’Brien, and Rubinstein (LOR), he was one of the inventors of portfolio insurance, a dynamic hedging strategy for equity portfolios to reduce downside risk.(1) Portfolio insurance worked very well in relatively stable markets, and by October 1987, firms managing over $60 billion in assets were using the system. The basic idea was to sell futures in declining markets to protect the underlying assets, and the desired results were achieved.

However, when the stock market tanked on October 19, 1987, there was insufficient liquidity in the futures markets to absorb the selling by portfolio insurers and others, and the volume of selling drove down the futures prices and in turn the stocks themselves. Portfolio insurance was not the only or even the principal cause of the crash, but it may have contributed to the speed and size of the decline.

John has taken the lessons of portfolio insurance to heart, and perhaps more than others, considers the unintended consequences of financial ideas. In that spirit, he proposed what I believe is a particularly well thought out approach to dealing with the underlying cause of the Mess of ’08 — the collapse of home prices. His idea lets people remain in their homes, avoiding the displacement, grief, and blight that are plaguing many communities. This is possible by creating simple, transparent securities that allow the vast collection of investors to participate in solving this problem. Fed Chairman Bernanke (yet another MIT grad, Ph.D. in economics, 1979) suggested the general outline of this plan in his March 2008 speech entitled “Reducing Preventable Mortgage Foreclosures”:(2) The fact that many troubled borrowers have little or no equity suggests that greater use of principal write-downs or short payoffs, perhaps with shared appreciation features, would be in the best interests of both borrowers and lenders.

John has put meat on the bones of this suggestion. The remainder of this section is from his exposition of this idea.(3)

Sharing the Risk, Sharing the Rewards of Home Ownership

Stabilizing the housing market effectively and equitably requires more innovative approaches than just lowering mortgage interest rates and extending mortgage maturities. The two key objectives should be: (1) avoiding preventable foreclosures, and (2) increasing the affordability of the existing housing stock, thus increasing housing demand. Both of these issues can be addressed by allowing home financing to include a minority, passive equity partner. With such a partner, homeowners can right-size, i.e. adjust to an affordable level, their financial obligations by owning less than 100 percent of their homes, while maintaining all the benefits of home ownership. With a properly standardized fractional home ownership security, institutional investors could and would be that partner.

The Innovation: A Home Equity Fractional Interest Security

Currently home purchases are financed entirely with the owner’s personal capital (down payment) and debt (mortgage). There is no opportunity for the homeowner to get external equity financing, where a passive investor shares in the financial gains and losses of the home’s value.

At present, therefore, a homeowner who wants to live in a $300,000 home must bear $300,000 of exposure (and expense) to the housing market. The homeowner’s consumption of housing equals the homeowner’s investment in housing. Arguably, this makes no sense, because owning a home — rather than renting — is partly a lifestyle choice and partly an investment choice. Choosing home ownership should be possible either as a 100 percent owner with a large mortgage or a majority/controlling owner with a smaller mortgage, with the exact mix determined by the homeowner’s financial circumstances and personal preferences. There is no reason why home ownership must be all or nothing.

A home equity fractional interest (HEFI) security would separate the consumption and investment decisions. For example, a homeowner might own 80 percent of a $300,000 home (with $240,000 financed by a down payment and mortgage) and an outside, passive equity investor would own the other 20 percent. The homeowner consumes housing at the $300,000 level, but has only $240,000 of exposure (and expense) to the housing market.

This innovation would have major short-term benefits for foreclosure mitigation and long-term benefits for stabilizing home prices. And it is possible now.

Mitigating the Mortgage Foreclosure Crisis — Avoiding Preventable Home Mortgage Foreclosures

The majority of preventable home mortgage foreclosures consist of an owner-occupied home where the owner wishes to remain in the home, but only has the financial capacity to maintain a mortgage of, say, 80 percent of the home’s current market value. A foreclosure could be prevented if the lender restructured the current mortgage to 80 percent of the current market value plus an HEFI security.

The homeowner pays for the mortgage reduction with the HEFI. Because the homeowner now has equity in the home (previously, the mortgage likely exceeded the home’s current market value) and a sustainable mortgage expense, foreclosure is unlikely. This restructuring is not a bailout, doesn’t risk taxpayer money, and is not unfair to responsible homeowners or renters.

Stabilizing Home Prices — Balancing Housing Supply and Demand

Traditionally, a home seller must find a buyer who both wants to consume the shelter and amenities provided by the home and has the means and desire to purchase it. This double-match problem makes it harder to match buyers and sellers, thus reducing effective housing demand and putting added pressure on home prices. The HEFI solves this problem — if the buyer wants to own a large house without taking large exposure to the market (and the resulting added cost), passive equity investors can make up the difference. This increases effective housing demand, which would help absorb the nation’s excess housing supply, thereby stabilizing prices at a higher equilibrium price than would otherwise be possible.

A Capital Market for Home Equity Fractional Interest Securities

The HEFI security represents a passive investor interest in a home — just as a share of stock represents a passive investment in a company. Institutional investors such as pension and endowment funds would be interested in HEFIs to achieve diversification beyond stocks and bonds. The single-family, owner-occupied (SFOO) equity asset class is as large as the entire U.S. stock market, around $10 trillion. To be properly diversified, institutional investors should …

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All notes for this chapter about Economic Rescue from Global Economic Collapse, Fractional Home Equity Ownership and New Banks

1. Andrew Kupfer, “Leland, O’Brien, and Rubinstein: The Guys Who Gave Us Portfolio Insurance,” Fortune , January 4, 1988, http://money.cnn.com/magazines/fortune/fortune_archive/1988/01/04/70047/index.htm

2. Ben S. Bernanke, speaking at the Independent Community Bankers of America Annual Convention, Orlando, Florida, March 4, 2008, www.federalreserve.gov/newsevents/speech/bernanke20080304a.htm

3. John O’Brien, “Stabilizing the Housing Market,” working paper, November 11, 2008. A similar article appeared in the Christian Science Monitor , November 26, 2008, www.csmonitor.com/2008/1126/p09s02-coop.html . Links to further discussion of this topic are found at CIFT Berkeley, http://cift.haas.berkeley.edu/systemsview.html and at Home Equity Securities LLC , www.homeequitysecurities.com/

4. It’s ahead of the Home Shopping channel, but way behind CNBC and Bloomberg, and, on most days, ESPN.

5. You can watch those 15 minutes here: www.youtube.com/watch?v=_ZAlj2gu0eM , or search YouTube for “CNN: Understanding the Crisis.” A variation of this idea was first suggested to Sal Khan by Todd Plutsky, his friend and classmate from Harvard Business School.

6. All 650 videos can be seen at www.youtube.com/user/kahnacademy

7. http://cift.haas.berkeley.edu/nabi-intro.html . This will doubtlessly evolve further past the date of this writing; the current version will be kept at the CIFT page.

8. http://paul.kedrosky.com

9. Barry Ritholtz, Bailout Nation: How Easy Money Corrupted Wall Street and Shook the World Economy (New York: McGraw-Hill, 2009), excerpted here: www.boingboing.net/2008/11/25/bailout-costs-more-t.html

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