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The other day, my buddy and I were talking about the housing crisis and "the great unwind." Everyone from Jim Cramer to Bill Gross believes markets cannot turn around until we find the bottom in housing. We are all so nervous about asset deflation that nobody wants to own anything. The housing market, in particular, is in paralysis. Policymakers have the seemingly competing aims of "protecting the homeowner" and "getting the securitization market functioning again."
There are several issues associated with the securitization market and problems the "bad bank" will have that I will address in a subsequent piece -- so let's look more directly at the root of the problem: stemming further home price declines and keeping people in their homes. On this topic, my buddy remarked, "What I don't get is who exactly are these homeowners we're trying to save? Most of the problem loans over the past three or four years are from people that never really 'owned' anything."
What he meant was that many of these home purchasers took out an 80% first loan and maybe a 10%, 15% or even a 20% second -- they had very little equity in these homes to begin with given the frothy credit market. (For what it's worth, it would be really interesting to see how much equity has been in/was ever in all these foreclosed homes.) And once the real estate broker commission is figured in, marking on the "bid side," virtually any equity is wiped out. And I am not even talking about the folks who took out "liar loans."
Before I get into the solution, I have to say that everyone seems to be looking for someone to blame in this crisis. But nearly everyone involved in the process has culpability, so let's stop for a minute with the blame assessment and focus on solving this conundrum that we have dragged the entire world into.
OK, so the issue is, how do we stop home prices from going down? How do we stem all of these foreclosures? My friend asked the key question: "What's so big about homeownership, anyway?" He's got a point -- other than those in the industry, who made money on real estate the last five years? And it will be a while before we recoup those lofty levels achieved earlier this decade ... longer if we don't find a bottom soon. Many who bought in recent years would probably like to just walk away. So, why don't they? Simple -- because they have to live somewhere.
Which comes to the rather elegant solution: Why don't they just live in their own house ... as a renter? Seriously -- sign away the title in exchange for a favorable five-year lease from the bank, maybe with a renewal option. They get to stay in their home, which keeps that home off the market (and in reality, no bank really wants to sit on vacant foreclosed real estate), the bank draws income and keeps the home, which it can sell later. There is no stigma for the homeowner because nobody will know the difference. They get to stay in the house, reduce their cash outflow, keep their kids in the same schools, and communities can be held together. More importantly, the Sword of Damocles is removed from above their heads -- no more wondering how they are going to make ends meet.
As it is, these owners have no equity -- so they are not giving up anything (other than an out-of-the-money option on the comeback in real estate). We could index the rent to the local area, or just a straight percentage of the existing mortgage payment (say 50%). Even give them the option to buy the home back at the end of their lease for some premium to the loan amount at the time of conversion (say 110% to 125% of loan amount). If a further sweetener is needed, allow the owners to take a write-off on their capital loss if they enter this "pre-pack" program. Make the owner/renter responsible for maintenance, just as if he were the owner. And if they fulfill the five-year lease term, do something to help their credit scores, such as not making this a default event.
Sounds pretty good for the homeowner, but what about for the lender? Right now, the lender is facing the hassle, expense and uncertainty of foreclosing on the home, maintaining the vacant property, and selling into a miserable market. So the prospects of speeding through and/or avoiding that process and still having an income-producing asset (with a known tenant) may be attractive. Instead of selling the asset to a "bad bank," they could deposit the home and the rental contract into a real estate investment trust (REIT). They could then sell the REIT via an IPO to raise money and free up capital.
The bank may have to take a haircut in order to get a market-clearing dividend -- but given that the equities market tends to value REITs based on current yield, it is probably not as bad as selling the homes or the loans in today's distressed market (and presumably they don't have an about-to-be-foreclosed-upon loan on the books at par). They could also add a percentage of performing traditional mortgage assets to boost the yield (or maybe even some corporate bonds, to help that market get back on its feet).
So far, we haven't asked the government to do a thing with this process, so we'll ask them to help by really providing tax incentives for investment in the REIT. Call it the "Keep Americans in Their Homes" act ("KATH"), and make all "KATH" REIT dividends (and potentially capital gains for original purchasers) tax-free for the life of the REIT. This does create a lost revenue opportunity in the future, but that may be more palatable than a capital outlay right now. And don't keep this offer out there forever -- give lenders 12 to 18 months to convert their assets into a REIT; beyond that, no "KATH" dividend exemption. This may incentivize banks, lenders and homeowners to get rolling.
With a tax-free dividend, backed by geographically diverse real estate (that could eventually appreciate as the demographic trends catch up with supply) and five-year rental contracts so there is clarity on dividends, these "KATH" REITS may make attractive investments. Back them with a 30-year Treasury SLUG zero (that extinguishes if the homes themselves provide the terminal value), and maybe they become NAIC-eligible bonds for insurance companies to buy. Slap a rolling interest guarantee on them, a la Brady Bonds. Let's be creative rather than trot out the haggard "bad bank" idea again.
Make "KATH" REITs eligible for the TALF facility. Have the homeowner/renter allocate a percentage of their payment as a pseudo-DRIP (dividend reinvestment plan) into the REIT to which they belong, so they also have an investment in the process. Make them patriotic, like War Bonds -- let people "Invest in America."
What is also nice about this idea is that we don't have to do this with every property near foreclosure. We just need to do this with some of them -- just do one or two REITs to prove it can be done -- and that may provide an alternative valuation process that could put a floor under existing bank assets that is different from "the model" currently being used. People may feel comfortable that this is a viable exit strategy, and thus not be held hostage by the distressed asset bid, where buyers will negotiate every assumption to their advantage.
Ultimately, there is no reason a securitization trustee couldn't use this as a more attractive way to dispose of nonperforming assets -- the servicer/trustee's role is to maximize the value of the assets in the securitization, so they need options. The REIT cash flows could flow through the securitization, or the IPO of the REIT could be deemed the recovery event instead of a foreclosure or restructuring, with the proceeds applied according to the Trust Indenture.
But we can start small, start simple.
( FNM) and
( FRE) both have whole loans on their books -- they could be the guinea pigs for such a strategy. Have them each REIT some loans near foreclosure. Once they do it, if successful, the markets will take care of the rest.
This isn't meant to be the only takeout strategy, but it's one arrow in the quiver to target housing. Right now, we have two options: foreclosure and loan restructuring. The rental/REIT idea can be a third. Compared with the other two, I can see a couple of advantages. First, I think this has speed and is scalable -- we do not have to re-underwrite new loans, nor do we have to rely on the vagaries of the foreclosure market. But second, this is de-levering -- de-levering for the banks, and de-levering for the homeowner. We move from financed assets to owned assets. We are finding permanent capital via the REIT; it truly will be a cathartic experience for many involved. It may not be for everyone (and let's be realistic -- I don't expect us to issue $1 trillion of these things, unless we find a way to "Brady" them), but every lender could pursue all three options ... at least they will
I realize there are a lot of details to be ironed out, but think about it: If we moved some of the foreclosure housing stock out of the sale pool and into the rental pool, we may provide enough support/confidence for the rest of the real estate market to stabilize. We'll keep people in their homes. We'll keep communities together. We'll de-lever. And we'll invest in America.
"KATH" REITs -- let's think about it. It may be out of left field, but is it really more absurd that anything else we are thinking of?
Know what you own: Examples of existing residential REITs include Equity Residential (EQR) - Get Report, Avalonbay (AVB) - Get Report, Senior Housing Properties Trust (SNH) - Get Report, Essex Property Trust (ESS) - Get Report and UDR (UDR) - Get Report.
At the time of publication, Oberg had no positions in the stocks mentioned.
Eric Oberg worked in fixed income, currencies and commodities for Goldman Sachs for 17 years before retiring as a managing director.