Monday, September 06, 2010

SEF-Lien in Practice

President Obama is correct in condemning financial tools that create huge paper profits without creating value. To solve this problem, we should create financial tools with stronger ties between profits and the value of real equities.

The federally backed mortgage industry happens to be a great example of a system that generates huge paper profits by separating profits from the value of the underlying equity.

A mortgage is a fixed interest loan placed against a property. A mortgage is essentially a huge margin play against the real estate market. Such a margin play has two faults: First it encourages people to buy more house than they need in boom times. In times of bust, mortgages go underwater and increase the depth of the collapse.

This post introduces an alternative to Mortgages that I call Shared Equity Financing. Please note, Shared-Equity-Financing can exist in conjunction with mortgages. The two systems would enhance each other by encouraging financial diversity.

A mortgage is a margin play. With a mortgage, one might take out a $50,000 loan against a $100,000 property. This is a good deal when the value of the property increases. A bad deal when it drops.

As the name implies, a Shared-Equity Lien is a direct investment. With a SEF-lien, a homeowner sells shares in a property. Instead of taking out a $50,000 loan against the property, the homeowner would sell a half share in the house.

The value of the SEF-Lien would track the local real estate market. If the market goes up, the value of the SEF-lien rises. If it drops, the value of the SEF-Lien falls.

It is likely that the SEF-Liens would be bundled up and resold on the market as is done with mortgage backed securities. For that matter, one of the best ways to price SEF-liens would be to create regional pools of SEF-liens. A homeowner could sell a portion of a house into a regional pool and repurchase it at a later time.

SEF-Liens would actually be a good deal for investors seeking security in the real estate market. Unlike mortgage backed securities which are backed by paper, the liens would be directly backed by real equity. Buying a $10,000 SEF-Lien would be a lot like buying $10k in land.

A system of shared equity financing would enhance the mortgage system by giving people greater control over their exposure to the volatile real estate market.

In practice, it is likely that people would use SEF-liens in conjunction with mortgages. If a family had a job with a fixed salary, they might have a mortgage with a five year time horizon. The rest of the house would be financed with a SEF-lien. Every couple of the family would take out a new mortgage to buy the next chunk of the home.

The SEF-Lien gives a home buyer the ability to control exposure to a volatile real estate market, while creating an interesting investment for the financial community. An investor would be happy buy shares in a property knowing that the family will be wanting to buy back that share at market prices five years down the road.

I believe that banks would favor a mix of mortgages and SEF-Liens. A 30 year mortgage is a risky investment for a bank. No-one can rationally guess what will happen thirty years from now. Financing with a mix of SEF-Liens and shared equity creates a more dynamic investment tool.

The current mortgage system clearly contributes to a boom/bust cycles. A system of shared equity financing would create a system that corrected overvaluations in the market. If people felt the housing market was overpriced, they would sell SEF-liens. If they felt the market was oversold, they would buy up the securities.

I put the SEF-Lien idea on the back burner because creating such a system would entail a great deal of work writing up contracts and coordination between banks, government regulators, realtors and home buyers.

The general concept is worth pursuing. Our current financial system creates systemic risk by encouraging people to place large margin plays against real estate. This system produces huge paper profits without increasing value. A system of shared equity financing would do a better job tying our financial tools to the underlying value of equities.

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