Friday, June 19, 2009

Equity not Interest

My two proposals for financial reform are: Shared Equity Financing and adding a loan component to medical savings accounts ... making a Medical Savings and Loan.

The common thread for these two reforms is that they focus on building equity while finding alternatives to interest.

Western history is full of economic collapses caused by loans falling out of sync with the equities backing the loans.

For example, a mortgage is a margin play against real estate. We saw in our current economic crisis that a drop in housing prices put a large number of home owners "underwater." Their home is worth less than the loan against the home.

The primary goal of a regulatory regime is to keep loans in sync with equities. The alternative is to find alternatives to interest bearing loans.

The interest on a loan is simply a premium that a lender pays to access money. Interest bearing loans add the premium to the payments.

The medical loans that I outlined in previous post approach the premium from a different angle. Rather than backloading the premium, it frontloads the premium. People owning a medical savings account will pay a premium to have access to a guaranteed medical loan that would cover a gap between their savings and high deductible insurance.

As the premium was paid in advance, there is no reason that this loan should bear interest.

Shared Equity Financing is an alternative to traditional interest bearing mortgages. Rather than borrowing a fixed amount of money against the house, the property owner takes out a percent based lien against the property. This lien would track local property values. The liens would be purchased by entities wishing to invest in real estate.

Both reforms are designed to help individuals build and maintain equity. The MSL program encourages individuals to build equity in their medical savings account. Shared Equity Financing helps people regulate their exposure to the local realty market. A traditional mortgage is a margin play. You have a loan of a fixed amount tagged to a property of a variable amount. In such a scenario, one never really knows how much equity they have. A shared equity lien is percentage based; So, the homeowner would know with certainty the percentage of the home that they own.

Our financial system collapsed as it was based on extremely complex formulas that tried to shield investors from risk.

I believe that the real quality of a financial instrument lies in its ability to reflex the equity behind the instrument. Before imposing a new regulatory regime, I think we would be wise to develop financial tools that better reflect the equity in our economy.


Scott Hinrichs said...

While interest is a premium for using someone else's money, it is important to recognize that like every other commodity, the time value of money fluctuates. Any system of lending must recognize and implement this fact. Any attempt to create a fixed value for using others' money will only drive the actual value of such usage underground.

You say that paying a premium up front would eliminate the need for interest later on. The only way this can work is for lenders to require a large enough premium to cover the risk of fluctuations in the time value of that money over the lifetime of the loan.

The flip side of this kind of transaction is represented in instruments like passbook savings and certificates of deposit with guaranteed returns. These instruments generally pay out very low (but guaranteed) returns because they must take into account the risk of opportunity loss and the risk of changing money values during the time involved.

Perhaps this would be proper when it comes to mortgage lending, since it would match those that are willing to make a long term investment that has low level gains with home buyers that intend to hold the asset for the long term and want to make a level payment during that term.

y-intercept said...

The upfront premium point was about medical loans. I suspect that people would be willing to pay a high upfront premium based on the fact that they are currently paying a high upfront premium for health insurance.

I suspect that the premium for guaranteed medical loans would be substantially lower than the premium for insurance. The cost of care is likely to be the same (or possibly less) when people negotiate directly with their doctor. Because most people will be paying back medical loans, one would expect the premium for medical loans to be substantially lower than the premium for pure insurance.

The premiums for real estate would probably work as follows: Let's say you wanted to sell a 50% lien on a $100k house. That lien would probably go for something like $40k (not $50k). This is a 20% upfront premium on the value of the loan.

Lets say you wanted to buy back the lien 10 years from now when the market value for the house was $200k. Assuming that the market was still taking a 20% premium on shared equity liens, you would find that you could buy a 50% mortgage on a $200k property for $80k.

Essentially, you just made a loan that tracks the local real estate. you only lose the premium if you lose the house in a foreclosure or if the housing market tanks.

In both cases, we find that by tying the premium directly to the equity, we dramatically reduce the amount taken by the bank or insurance firm.