How About Adjustable Principal Mortgages Instead?

As most of you know, the root cause of the credit crisis is that while asset values may fluctuate, debt obligations tend to remain fixed. This is just a basic feature of any credit crisis, and if you want to tackle a crisis, get to the root of the problem, I say. That’s why I have spent the last two weeks sending letters to the Federal Reserve, the Treasury, and to top level managers at Citibank (C), Goldman Sachs (GS) and Bank of America (BAC) suggesting a simple (and possibly very lucrative) tool for putting the banking system back on stronger footing. Thus far, I’ve gotten some positive responses to the idea, although nothing definitive. Time is not our friend, at this point, so now is the time to put the idea out into the public domain, which is the purpose for today’s article. So here’s the idea, and if readers think it sounds good, then go out and try to convince your favorite politician, or your cousin at Treasury, or friend at Citibank to take a really close look at this.

Offer borrowers adjustable principal mortgages, whether newly issued or refinanced. How would an adjustable principal mortgage be structured? It would be identical to a conventional mortgage except the principal balance on an adjustable principal mortgage would automatically adjust downward by a percentage tied to the Case-Shiller real estate index for whichever geographic area the underlying real property is located. The outstanding principal on the mortgage need not adjust upward if real estate values increased, so the product could enable the individual homeowner to retain all of the upside economic risk on his home.

And why would this product possibly diminish certain pressures that both result from, and exacerbate, the ongoing credit crisis? There are several reasons:

1. From an individual homeowner’s standpoint, such a product would protect a percentage of his (or her) equity in the home, relative to the home’s value, and would adjust his mortgage obligations for adverse changes in his wealth. Some people might even be inspired to invest a bit more in real estate, knowing their downside exposure is somewhat capped.
2. From the standpoint of an issuing bank, downside risk on the amount of mortgage principal can be directly hedged by purchasing put options written on the same Case-Shiller real estate index. The cost of these put options could be passed along to the consumer in the form of a slightly higher interest rate – hopefully providing some economies of scale in the process. And given how widely reported the real estate bubble implosion has been reported, the demand for these products among consumers could be massive. If you are a bank, here’s a great way to get customers in through that door.
3. Currently, the financial markets significantly discount the value of many mortgages. Arguably, this may be due to a perception that default risks are linked to real estate value. If so, then the capital markets may perceive a lower default risk on an adjustable principal mortgage. For instance, there may be a perception that some borrowers are less prone to default on a mortgage the structure of which guarantees that the borrower always has at least some equity in the home. If so, then the credit quality on an adjustable principal mortgage should exceed that of a comparable conventional mortgage. If the credit quality of an adjustable principal mortgage is relatively attractive compared to other mortgage products, then if borrowers refinance their existing mortgages into adjustable principal mortgages, it could significantly enhance the quality of a bank’s loan portfolio (again, assuming the bank acquires put options to hedge the risk of falling property values and falling principal balances on adjustable principal loans). If so, then adjustable principal mortgages could be one useful tool for banks to rebuild capital, which would enable them to get credit flowing again.
4. (4A marketplace in adjustable principal mortgages may limit some of the administrative costs of individually renegotiated reductions in mortgage principal for distressed American homeowners under President Obama’s recent proposals. Bankruptcy judges are a fine way to reset the terms of, and to shave principal off, existing mortgages, but it’s a one off kind of thing. A marketplace in adjustable principal provides an institutional, market-based framework that would do some of the same thing.

Why have I been pushing this idea at the Federal Reserve and Treasury? It is because it appears likely that the United States Treasury (or possibly the Federal Reserve, or a combination of both institutions) could play a crucial role in creating a marketplace for adjustable principal mortgages by selling put options on various of the Case-Shiller real estate indexes to banks. By doing so, Treasury (or the Fed) could ensure the availability of a willing counterparty in the real estate derivatives marketplace and the availability of appropriate hedging opportunities for banks that underwrite adjustable principal mortgages. An up-front options premium would immediately compensate Treasury for assuming downside risk on real estate prices, which Treasury could invest in other assets. No taxpayer dollars would be required to initiate the program. Over a very long time frame, if real estate prices resume their historic upward trajectory, many of the put options would expire worthless, limiting future cash outlays on the part of Treasury.

By the same token, if real estate prices continue to deteriorate over the very long term, then Treasury would potentially face significant future cash outlays as the put options it has written expire in the money. Treasury could defray a portion of any such future outlays with the options premiums it has earned, and the reinvested returns thereupon. And ideally, if private participants enter the real estate derivatives marketplace and provide sufficient volume and liquidity, then it may be possible for Treasury to exit that marketplace entirely over time.

The real promise of this scheme is that a marketplace for adjustable principal mortgages as above described could, arguably, align risk more efficiently than the financial marketplace currently does. The current credit crisis demonstrates that individual homeowners are not, in all cases, optimally suited to bear macroeconomic risk in real estate value. Moreover, banks are likely to be in a far better position to hedge macroeconomic real estate risk more cheaply than individual homeowners could. Finally, both the United States Treasury and Federal Reserve are ideally suited to bear certain long-term macroeconomic real estate risks given those institutions’ uniquely long-term investment horizons, so writing long term put options on the Case-Shiller indexes could be a possibly lucrative business for these institutions.

The question is whether adjustable principal mortgages simply postpone a day of final reckoning, or whether they could be a useful tool among others to alleviate current stresses on individuals and banks alike. I have no answer to this question, but what I aim to do is to get people to ask the question in the first place. The basic building blocks of the capital markets as they exist seem like they are coming apart, which isn’t fun for those of us who happen to own liquid assets like stocks and bonds, but it also creates an opportunity to take a very radical look at how to structure the next capital market that will replace the one we all grew up with. Those institutions that get in on the ground floor with some radical ideas will stand to make fortunes, and those which fail to adapt. Well…..

Disclosures: The author owns shares of GS, C and BAC.

Comments

[wobatus:]

dave and reveigel, actually, as proposed it would not be more risky. So long as the initial underwriting standard is prudent (more so than it was) and the banks could hedge and charge a rate premium, it is a viable product. At least this guy is thinking outside the box.

Mar 08 08:38 AM

[Lee Bush:]

More monkey business. Much better solution would be to let the effected parties suffer their 'just desserts', then apply an old government program, "The Homestead Act". ----

Mar 08 08:47 AM

[Jon Smirl:]

"The cost of these put options could be passed along to the consumer in the form of a slightly higher interest rate"

Yes you could build this. It's not going to be a slightly higher rate. Either you buy a 30 year put (expensive) or multiple short term ones. The price of multiple short term ones is going to spike during a recession. Passing the cost of this on as a variable payment means that your payment will also spike upward in a recession.

You can't make the risk go away, somebody (lender, government, home owner) is paying a premium for it whether they know they are or not.

The perfect form of this is to put your down payment in a savings bond and rent. Now you don't have any capital risk.

Mar 08 10:33 AM

[prudentinve...:]

Your idea appears to be an extension of the the cramdown laws just passed by congress, except that you would dispense with the formalities of a bankruptcy court ordering the principal write-down.

The same vexing question comes up, who is supposed to pay for the loss? By custom, in orderly civilised society, profits are retained (after tax) by those who generate them, and losses are borne by those who incur them.

These notions lead one to wonder whether civilised society, based on a sound and fair legal foundation of contract law, may be getting closer to its end. This would be too high a price to pay for temporary expediency.

Mar 08 10:39 AM

[Summer Sea:]

At least you're trying to think of something, and the article appears to be on the right track. Probably start by adjusting each principle to 33% of the mortgage holder's annual income x 30 years. Once the new priciple is established and a fixed monthly payment is calculated, banks rewrite each loan. An additional 5 years on the front of the loan (same calculated payment) goes to the bank for loses.
The gov. needs to fix this thing and be done with it.

Mar 08 11:22 AM

[User 366653:]

I still like my idea better. Here it is again.

Like the author, I have sent this idea to everyone I can think of. Unlike the author, I have gotten no response.

Here is my plan to help solve the bank crisis. It would apply to the nineteen largest banks, and would work as follows:
The government would insure each bank's entire existing portfolio at the current value, subject to all applicable regulations and FASB valuation methodologies in force prior to adoption of FASB 157. New loans and investments would be subject to the same regulations, but wouldn't be insured by the government.
As a down payment for this insurance, the bank would issue non voting common shares to the government representing twenty-five percent of the bank's common equity. For each year that the insurance remains in force, the bank would issue preferred stock representing an additional three percent of base level equity value to the government, for up to ten years.
The bank would have the right to cancel the insurance at any time after three years.
The advantages of this strategy are:
Virtually no up-front costs to the taxpayer. In fact, the taxpayer would immediately receive tens of billions in equity.
Public confidence in the bank(s) would be fully restored immediately. The fear of government interference, as a result of "nationalization", would disappear because the government's equity stakes would be non voting. Confidence in the entire financial sector would most likely improve dramatically and immediately.
The value of the bank's common stock would probably appreciate immediately, resulting in a profit to the government/taxpayer. While this plan would dilute the existing common, it is very clear that the prices of most bank stocks reflect the risk of armageddon. Fifty percent dilution is not a problem if your stock has gone from 50 to 1 or 2 or 3. If you assume that profits could return to half of "normal" over the next five years, the newly diluted stock has plenty of upside from here.
The value of the bank's preferred stock, trust preferreds, and debt would immediately increase dramatically. Credit ratings would be restored to legitimate investment grade. This means the bank(s) would now be able to raise new PUBLIC and PRIVATE capital, and would not need additional Government funds. In fact, the bank(s) would be able to use the proceeds of new preferred stock to repay TARP ahead of schedule.
Furthermore, as compared to the plans already in place, and those being considered, the advantage of my idea is that virtually all the costs are POTENTIAL, and DEFERRED, rather than DEFINITE, and IMMEDIATE.
Additionally, it is likely that gains in the bank's share prices would offset a significant portion of any losses that may accrue from the insured portfolio(s). Since implementation of this plan would certainly hasten the recovery of our national economy, the assests insured by the government would be more likely to improve in value than to decline any further. In any event, the government will be in a better position to absorb losses, since the TARP money will have been returned, and no additional TARP funds would have been dispursed.
To summarize, my plan would "nationalize" the current loans of the banks, while leaving the banks intact, with no additional up front costs to the taxpayer. The "moral hazard" issue - helping the "shareholder" at the expense of the "taxpayer", is handled by making the taxpayer a shareholder. Confidence in the security of our financial system would be restored, and we could get on with trying to solve some of our other problems.

Mar 08 11:32 AM

[ain't no fo...:]

Right on wobatus - this is a fascinating approach, and if nothing else it would buy us some TIME to work through the current situation... thinking outside the box indeed. I like it!

Dragon

P.S. Of course, the cynic in me wonders whether it will be initiated the day after the housing market bottoms!


On Mar 08 08:38 AM wobatus wrote:

> dave and reveigel, actually, as proposed it would not be more risky.
> So long as the initial underwriting standard is prudent (more so
> than it was) and the banks could hedge and charge a rate premium,
> it is a viable product. At least this guy is thinking outside the
> box.

Mar 08 11:59 AM

[Dave Wrixon:]

America is obviously trying to find a way through this impenetrable financial maze.

Let me give you a couple of clues.

Fiscal Restraint
Hard Work

I guess that is going to prove way too complicated for most. Much easier to come up with yet another piece of financial engineering magic.

Mar 08 12:20 PM

[GDK:]

Right on Dave.

Individual responsibility can hurt and still set you free. Any form of the cramdown will result in lenders either not leding, or making upfront costs so high the little guy will never experience the American Dream. This Nanny state mentality will destroy the wealth of America.

Mar 08 01:54 PM

[beautyseer:]

The greedy CEOs and their self-serving management cabals have destroyed capitalism as surely as greedy elite bureaucrats destroyed communism. While proclaiming "free" enterprise, these pirates used the false rallying cry of "decontrol" to put government in the pocket of special, big-money interests and create a national Ponzi scheme in which we are still trying to help AIG pay off on soap bubbles blown in a tornado. The job of government -- the reason that it is instituted -- is to protect ALL the people, not just the elites that want every country to become a third world country for the purposes of holding down production (while padding their own inconscionable bonuses, decorator offices, resort vacations, and corporate air forces. Stop trying to save big ANYTHING. Government is US, trying to rebalance the inherent imbalances that make for poverty and injustice, choas and illness for all unless we take so collective responsibility against them. But this asset crisis is larger than any institution can solve by throwing money at it. What is needed now is an international day of debt forgiveness. Wipe the books clean. Nobody owes anybody anything. Begin again. With due caution and concern for the well being of ALL this time. Despite what you may have heard on talk radio, it is NOT all about the money. When the smoke clears, we stand in the ruins -- economically, environmentally, politically -- and must imagine a better way of life and begin to build it from the ground up in local, sustainable communities. After the empire, in the supershambles of lost "superpower" we will need to cooperate, and think small. In a drug-free America!

Mar 08 02:41 PM

[Repsonsible...:]

You MUST work in The OBAMA Administration , a insider probbaly what a Ridiculous Plan , I make You a MTG , if the economy gets bad YOU OWE Me LESS,, I LOSE , If the econommy does better and the price goes UP I get NOTHING !
So I assume ALL the RISK and get none of the Upside , Ya You Gotta be in a Obama shill !
NO Busniess man in there right mind would ever make a Deal like that ,,'
You people confuse Business with NOT for Profit sounds alot like Communnism to me !

Mar 08 03:09 PM

[Econ 101:]

The author identifies this idea himself, as a "Scheme". A scheme to defraud the American people of still more money. This idea is just a variation on the CDOs that put us here.

As for 366653's idea, it is a complicated bit of tripe that rehashes another way to prop up the thieves in charge at AIG, Citi and BAC.

Here's my idea: Liquidate AIG, CITI and BAC. Throw the bums out on their ears without any money for losing billions. Then publish their pictures and addresses on the web. Let them deal with all the people they screwed.

Mar 08 03:34 PM

[Buckoux:]

beautyseer: "When the smoke clears, we stand in the ruins -- economically, environmentally, politically -- and must imagine a better way of life and begin to build it from the ground up"......"In a drug-free America!".

And with you, and people just like you, in charge!

What are you smokin', "dude"?

Mar 08 03:40 PM

[Augustus:]

". . . As long as the banks could hedge and charge a rate premium . . . "

+++++

Who the heck will they hedge with? AIG offered that deal and is now gone. Some institution is going to assume the losses of the entire US real estate market declining? Rots of Ruck with that.

Mar 08 03:44 PM

[Blackeyebart:]

The problem with adjusting the housing loan principle is the flow on effect on the bank's balance sheets.

In years gone by the Government controlled (some)housing interest rates. This is a better bet. It reduces the cost of the mortgage without destroying it, and it is capable of delicate control as circumstances change.

An important advantage is that reducing the interest rate reduces the home-owners desire to sell which can be expected to help the housing market recover.

Finally we have to plan for recovery, which will require dramatic action to suppress a carnival of asset bubbles. Pushing up interest rates can have a cooling effect.

Mar 08 06:42 PM

[ain't no fo...:]

Blackeyebart, that will be a wonderful problem to have

"Finally we have to plan for recovery, which will require dramatic action to suppress a carnival of asset bubbles. Pushing up interest rates can have a cooling effect."

Mar 08 08:21 PM

[richpee:]

I'm confused? Alex Trais seems to be talking about personal adjustable Principal home mortgages??But User 366653 seems to be talking about the entire bailout program on sub-prime mortgages...where's the match here?
Am I missing something?

I've also written number of letters..no answers of course..who cares what I think...it seems.

But to me there's something about granting a reduction in a delinquent home mortgage to someone who's failed to properly pay in the first place and not get into delinquent situation on their mortgage seems like playing Russian Roulette with 6 bullets filling all the open cylinders of the gun..no chance for survival and not shooting yourself!!!

Guys what about something so simple....

If our government is set to reward delinquent home owners ready to go into foreclosure..

Then let the banking/mortgager company who is holding the loan..not give the homeowner any reductions on their mortgages..

"WHY DO THEY DESERVE ONE?" but to lower the mortgage rate of interest to 2.5 to 3% extend the loan over a 40 year period which would lower the house payment substantially..the


1.home owner gets to stay in the house
2. The mortgage company is not forced into losing more money and interest
3. The government isn't having to"come up with " piles of money for the bail out..we keep our nations debt down!
4. American citizen don't feel raped by dead beats as they are thinking now...na d if it's a real person who's gotten into harms way by lsoing their job-being fired etc..then they have an aditonal optin to stay in their homes..

We have a win win for everyone..the owner gets a 2nd chance to prove their mettle....the loan gets extended..
The house if it was going "under or is under water" the owner will have time to come back with the return of house values. If they fail to keep up their payments the loan company can then justifiably take -reposes the home and resale it for the adjusted market value and then take the loss justifiably.

Mar 08 09:00 PM

[User 372441:]

Using this type of mortgage what will happen happen to principle portion of the scheduled payments? will it be reduced therefore reducing the overall income to the sercuritized pool? In our current situation, it is conceivable that this reduction in priciple payment would exceed the the reduction in payment amounts represented by outright default. what about loans with lower durations? i.e. loans closer to maturity that have a higher principle component to to the payment.

Mar 09 09:16 AM

[Alex Trias:]

Thanks, Prudentinvestor. There is much more to your comment than appears on the surface. I take from it two deep questions. First, who pays for the loss? I am assuming (and this is a HUGE assumption on my part) that if the Treasury were to sell 30 year (or 20 year, or some other long time frame) put options on a Case Shiller Index, there would be no loss. My assumption is either (1) real estate prices increase over the 30 year period; (2) even if real estate prices fell over 30 years, the premiums paid to Treasury would adequately compensate for this risk, and Treasury could reinvest those premiums in sufficiently high-yeilding assets to pay for the losses on the put options once they expire. And yes, I am assuming European style options, which I did not make explicit in my article. So the short answer to your excellent point is "I am assuming no losses".
We all know where it ends, when someone says "I am assuming no losses". But that is the big assumption behind this short article, and you do an excellent job pointing it out.
If I had more space to write, I would have expanded the article to address your second point: who pays for the loss IF there is one (and when is there never a loss?)
The answer is: the US taxpayer. The basic concept here is to subsidize downside risk at the expense of society. This runs exactly COUNTER to how an efficient capital market is supposed to work (punish and reward risk takers), because what I am suggesting is to give the risk taker the upside, and give the US taxpayer the downside. Doesn't this lead to a risk of over-investment (ie., another even larger asset bubble?)
Answer: yes.
Question: Why is Alex suggesting we even consider this proposal?
Answer: to get people to take risk again.
See, the real issue that I am seeing is that nobody will take risk at the moment. The capital markets cannot function unless people are willing to buy risk, and right now, that willingness is falling apart. What I am suggesting is to really offer an "unfair" good deal for homeowners and banks, give them all this upside and give the downside to the US taxpayer, as a means to get risk appetite up again. And once banks are back into the business of taking risk, and people are willing to put some capital into real estate (or other risky assets) again, you pull the plug on my "adjustable principal" program. Get the US Treasury completely out of the business.
My reasoning boils down to just this. I was walking to my office this morning, and went past a Starbucks. They were handing out free coffee on the street. So, I took a free cup, drank it, and went in later this morning to buy another cup. I'm suggesting Treasury basically offer the markets a free cup of coffee to get investors back in.
End of society? Maybe. We're already down that path. We'll get real close to the edge by the time this is all done.



On Mar 08 10:39 AM prudentinvestor wrote:

> Your idea appears to be an extension of the the cramdown laws just
> passed by congress, except that you would dispense with the formalities
> of a bankruptcy court ordering the principal write-down.
>
> The same vexing question comes up, who is supposed to pay for the
> loss? By custom, in orderly civilised society, profits are retained
> (after tax) by those who generate them, and losses are borne by those
> who incur them.
>
> These notions lead one to wonder whether civilised society, based
> on a sound and fair legal foundation of contract law, may be getting
> closer to its end. This would be too high a price to pay for temporary
> expediency.

Mar 10 09:09 AM

[Alex Trias:]

You are onto something. I like this idea. Actually, you are onto something huge.

So, what are you doing to push this? Are you publishing? Sending proposals out? Whatever you are doing, you have a great idea, very simple, and expedient in terms of both moral hazard and in terms of shoring up asset quality as a means to get capital flowing again. With an idea this good, you really have to push it. If I can help you, send me an e-mail.


On Mar 08 11:32 AM User 366653 wrote:

> I still like my idea better. Here it is again.
>
> Like the author, I have sent this idea to everyone I can think of.
> Unlike the author, I have gotten no response.
>
> Here is my plan to help solve the bank crisis. It would apply to
> the nineteen largest banks, and would work as follows:
> The government would insure each bank's entire existing portfolio
> at the current value, subject to all applicable regulations and FASB
> valuation methodologies in force prior to adoption of FASB 157. New
> loans and investments would be subject to the same regulations, but
> wouldn't be insured by the government.
> As a down payment for this insurance, the bank would issue non voting
> common shares to the government representing twenty-five percent
> of the bank's common equity. For each year that the insurance remains
> in force, the bank would issue preferred stock representing an additional
> three percent of base level equity value to the government, for up
> to ten years.
> The bank would have the right to cancel the insurance at any time
> after three years.
> The advantages of this strategy are:
> Virtually no up-front costs to the taxpayer. In fact, the taxpayer
> would immediately receive tens of billions in equity.
> Public confidence in the bank(s) would be fully restored immediately.
> The fear of government interference, as a result of "nationalization",
> would disappear because the government's equity stakes would be non
> voting. Confidence in the entire financial sector would most likely
> improve dramatically and immediately.
> The value of the bank's common stock would probably appreciate immediately,
> resulting in a profit to the government/taxpayer. While this plan
> would dilute the existing common, it is very clear that the prices
> of most bank stocks reflect the risk of armageddon. Fifty percent
> dilution is not a problem if your stock has gone from 50 to 1 or
> 2 or 3. If you assume that profits could return to half of "normal"
> over the next five years, the newly diluted stock has plenty of upside
> from here.
> The value of the bank's preferred stock, trust preferreds, and debt
> would immediately increase dramatically. Credit ratings would be
> restored to legitimate investment grade. This means the bank(s) would
> now be able to raise new PUBLIC and PRIVATE capital, and would not
> need additional Government funds. In fact, the bank(s) would be able
> to use the proceeds of new preferred stock to repay TARP ahead of
> schedule.
> Furthermore, as compared to the plans already in place, and those
> being considered, the advantage of my idea is that virtually all
> the costs are POTENTIAL, and DEFERRED, rather than DEFINITE, and
> IMMEDIATE.
> Additionally, it is likely that gains in the bank's share prices
> would offset a significant portion of any losses that may accrue
> from the insured portfolio(s). Since implementation of this plan
> would certainly hasten the recovery of our national economy, the
> assests insured by the government would be more likely to improve
> in value than to decline any further. In any event, the government
> will be in a better position to absorb losses, since the TARP money
> will have been returned, and no additional TARP funds would have
> been dispursed.
> To summarize, my plan would "nationalize" the current loans of the
> banks, while leaving the banks intact, with no additional up front
> costs to the taxpayer. The "moral hazard" issue - helping the "shareholder"
> at the expense of the "taxpayer", is handled by making the taxpayer
> a shareholder. Confidence in the security of our financial system
> would be restored, and we could get on with trying to solve some
> of our other problems.
>
>
>

Mar 10 09:14 AM