By Bambo Bamgbose, Executive Vice President & Chief Financial Officer for eManagement

At last, we arrive at the much awaited solution promised in the first installment of this series.

Here’s a series recap:

Part 1:   We reflected on the notion that it hardly seems logical that in a world that has changed so dramatically [since the 1950s & 60s] the original concept of the 30-year mortgage has remained largely singularly static. For an economic landscape that has transformed dramatically, it seemed to rapidly become obvious that a number of traditional mainstays will need to be re-examined.

Part 2:  We asked the questions, how many of us are doing today exactly what we thought we would be doing 10 years ago? Have our families grown in the last 5 or 10 years? Have our needs changed? In light of these realities, doesn’t it make sense for homeowners to rethink the concept of home ownership in a manner that is more aligned with the needs and realities of how they live today?

Part 3:  We debated the issue of ownership and probed whether or not individuals and families who were forced out of their homes when they could not meet the obligations to repay the debt concluded that the home they lived in was never really theirs, no matter how long they had made regular, timely payments until every last cent was paid on the obligation. Was renting to own perhaps a better way to think of home ownership in this context?

Continuing our discussion…

Now imagine this. The new administration announces a news conference to unveil a new 21st century approach to home ownership that will be offered as a public/private partnership initiative.  Today’s announcement provides prospective home buyers with an alternative route to home ownership in a new approach to home buying. As the details are rolled out, a new paradigm begins to emerge…

A New Approach to Home Ownership ~ Re-defining the lending relationship

The First Paradigm Shift…   

As I discussed in my last blog entry, the current framework for home ownership using a 30 year mortgage is a very highly leveraged transaction.  The average “homeowner” actually owns a very tiny percentage of the home.  The first shift involves reducing the leverage home buyers enter into by redefining the roles of the parties in the home purchase transaction to more appropriately reflect the responsibility and risk of each party.

Reassessing the Risk to Value Proposition…

Within the old paradigm, the home buyer was represented as an entity that had purchased an asset (at least on paper) and in turn pledged that asset to a lender in return for a loan (refer to the 3rd installment of this series for the discussion of ownership from the home buyer’s perspective).  The home buyer perceived their property as an asset against which they could borrow.  In reality, though this was not the case, maintaining that illusion was critical in order to justify the leverage that was occurring.

Dealing with Reality…

Isn’t the reality the fact that for the vast majority of  home buyers, they are co-purchasers with the mortgage lender being the majority owner of the property and the home buyer as the minority owner?  Under current standards, the real risk to value proposition is not reflected in how the transaction is recorded.  By re-assessing the risk to value proposition, the party with the majority of equity (and the greatest investment at risk) should be required to reflect some measure of the investment risk on their books.  The minority owner in turn would no longer be required to reflect this huge financial obligation on their credit report.  And the buyer (minority owner) also would be stripped of the ability to re-leverage the associated asset as was the case with much of the debt assumed by consumers over the past 10 years). Think re-financing craze…

Requiring the lender to acknowledge their participation as co-purchaser would force the tough questions to be asked up front in order for institutions to be able to justify their portfolios to regulators and to their shareholders.  Admittedly, this might result in some purchasing decisions not going forward but in the long run would likely save some ill-advised transactions from occurring.  In practical terms, this shift creates a purchase transaction that is primarily accomplished through collateralization versus leverage.

The Second Paradigm Shift…

The second paradigm shift would require a change in the relationship between lending institutions and home buyers.  In this new framework, upon completing the purchase transaction of the property, the minority owner (the home buyer) would enter into a long term capital type lease with multiple options to terminate or renew with the majority owner (the institution that holds the mortgage on the property) ranging anywhere from five (5) to fifteen (15) years.  I use the term capital type lease purposefully because this idea would require some revisions to the accounting standards currently used to classify a lease as operating versus capital.

Under the lease, the minority owner would also receive a renovation allowance that would enable them to configure and/or upgrade the home as they would like.  The size of this allowance would vary directly with the length of time of occupancy – – the longer the occupancy, the larger the allowance.  The title for the home would be placed jointly in the names of the majority owner and the minority owner with their respective positions clearly outlined. Lease payments would be calculated on the present value of the total rents for the period of occupancy instead of the value of the property and would be derived using a formula that was based on a number of factors including:

1) Market price/sq. ft.
2) Length of expected occupancy
3) Home buyer’s income
4) Home buyer’s credit history
5) Other factors

Since payments would be calculated on the present value of total rents for the period of occupancy versus the value of the property (one example of a deviation from current accounting standards), the monthly payments would be lower and much more affordable for the home buyer.  Interest on the capital type lease would be tax deductible similar to the tax deductions currently taken by businesses for capital leases—an application that would continue the long-standing public partnership to promote home ownership using the tax code.

 The Third Paradigm Shift…

The third paradigm shift involves creating a new investment relationship between the minority owner (home buyer) and majority owner (lender) supported by a public/private initiative. To reinforce mutual accountability, the home buyer would receive shares in the financial institution from which they obtained the loan.  These shares would be purchased at no cost to the home buyer for a slight discount below market price and would be held in trust until the end of each lease period where the home buyer had the option to purchase the property or renew or terminate their lease.

Where would the money to purchase the shares come from you ask?  The public/private initiative referred to earlier would be the source.  Currently, there are a variety of tax credits available to homebuyers.  A portion or perhaps all of these credits would be eliminated for the home buyer and in turn would be re-allocated to be used to purchase the shares discussed earlier. 

If the minority owner (home buyer) chose to exercise the option to purchase the property from the majority owner (lender), the shares they (home buyer) received when they entered the lease agreement would be cashed in and counted as a down payment against the outstanding cost of the property.  If the home buyer opted not to exercise the purchase option, they could renew the lease and remain shareholders of the financial institution by keeping their shares. 

Potential Benefits…

A home buyer who renewed their lease would receive the following benefits:

1) The payments they made to date would be credited to them as equity in the property and the property title would be updated to reflect that
2) They would receive a new renovation allowance  at each lease renewal to update the property
3) After completing three (3) successive lease renewals, they would be granted majority owner status and would have their shares released from trust to them to use as they saw fit.

For the home buyer who opted not to renew their lease, the investment feature would allow them to build a nest egg with the appreciation of their shares in the institution with which they executed the lease and at some future point re-enter the housing market.  If the shares failed to appreciate as expected, they would have still benefited from the tax deduction they received during the lease term and would not be burdened with the debt of a mortgage when the lease ended. 

A home buyer who was unhappy with their lease or with the majority owner lender, could choose to find other lenders whose stock prices were doing better when their lease ended and seek to execute a transaction with them instead.  This in turn would serve to promote competition among lending institutions seeking to be perceived as well-managed firms in order to attract new business. It could also potentially open up new secondary markets for unhappy or displaced majority and minority owners seeking new partners.

The most important benefit, however, would be a shift in the approach to home ownership that

a) more accurately reflects the risk to value relationship of the parties, and
b) promotes collateralized ownership based on the incremental transfer of equity

What about the lender? 

Wouldn’t they be left holding the bag, so to speak?  Not at all. The lending institution, as the majority owner of the property would be able to re-lease the property to a new minority owner or sell the property outright to an interested investor if the option to purchase was not executed.  In addition, the new public/private initiative used to purchase shares would represent a new source of capital for financial institutions.  Finally, they would also have benefited from the income stream received during the term of the lease.

In this new framework, the role of lending institutions would change from being merely financial arbiters to becoming asset managers of real assets rather than just managing the values of those assets.  As is the case today for non-payment of rent, failure by the home buyer to fulfill their financial obligations would result in the possibility of eviction.  They might also face the forfeiture of some pro rata portion of their shares based on how long they had maintained their lease in good standing.

Join the conversation . . .

So now that you have read about my idea for a 21st century mortgage framework, what are your thoughts?  What do you see as the advantages and disadvantages within the three paradigms presented?  Are there major pitfalls to this approach?  Perhaps, some of the ideas presented here can be part of a broader solution for a 21st century mortgage strategy.  I invite you to build on it and let the discussion flow…