Imagine walking down the street and finding a $100 bill. Wow, you say this must be my lucky day! To take advantage of this good fortune you decide to go to the race track. After reading the Racing Sheet you place a bet in the 3rd race on the long shot 'Never Wins'. 'Never Wins' has finished last in every race that he has run. Also in the race is the favorite, 'Always Wins'. 'Always Wins' has finished in first place in every race that he has run. You still go ahead and make the bet because you strongly believe that today 'Never Wins' will win. The bet is made for $100 and the odds are 100 - 1, if he wins your payoff will be $10,000. It turns out that on this day a number of other bettors feel the same way as you and they place the same identical $100 bet that you did. The track executives while monitoring the incoming bets notice the large size of 'Never Wins' bets but they do not change the odds as they are so confident that history is on their side. After all 'Never Wins' never wins and 'Always Wins' always wins.
At race time you take your seat. The bell rings and 12 horses bounce out of the gate but 5 of them run into each other and fall to the ground. Then 4 more horses fall into a puddle and stumble onto the ground. Out of the 3 horses remaining, 1 gets disqualified as his jockey falls off. There are now 2 horses left - your horse the 100 - 1 long shot 'Never Wins' and the great champion 'Always Wins'. 'Always Wins' is about 10 lengths ahead of 'Never Wins'. As they reach the final turn, a bird flies into 'Always Win's' eyes; he becomes temporarily blinded and stops running. About 10 seconds later, the long shot 'Never Wins' runs right by 'Always Wins' and crosses the finish line in first place. You jump up with excitement and are beaming with joy! Time to collect! You say to yourself what were the chances of all of those things happening in one race?
As you approach the pay off window, you see a large crowd gathered around and they seem upset. They are yelling things and asking questions and pounding on the closed payoff window. As you get closer you find out that about 200 people placed identical $100 wagers that you had and they were looking to collect their $10,000. You quickly do the math in your head and realize that the total payoff the track has to pay is $2 million. You make your way to the window and see a sign that reads, 'No More Winning Tickets on 'Never Wins' Are Going to Be Paid.' You are angry, in shock and say to yourself what about my money? Who is going to pay off my winning bet? Why did the race track take so many long shot bets? What kind of risk controls did the track have in place? How can this happen? How can the track or the counterparty not pay up?
Something similar to this is going on in the Financial Markets today. Here is a fictitious example. If an Investment Bank has large exposure to the subprime mortgage market and the executives at that bank feel uncomfortable with it, they will hedge some of their risk. They do this by purchasing insurance. Another financial entity or counterparty will sell the Investment Bank an insurance contract or credit derivative. This contract will pay off if large numbers of subprime borrowers default on their mortgage payments. The counterparty can be another investment bank, insurance company, bank, hedge fund etc. In this example I will use the insurance company. The executives at the insurance company believe that insuring subprime mortgages is a good bet and that the likelihood of substantial payouts is small. The insurance company's analysis of the past data shows that insuring the subprime sector of the housing market has been profitable and that it likely will be so in the future. Their analysis also shows that the only way for large amounts of subprime defaults to occur is if housing prices were to decline nationally. The executives think that this is a very unlikely scenario. These stats convince the executives at the insurance company that it would be a wise decision to increase the amount of insurance they are selling and so they do. The first couple of years turn out to be very profitable for this insurance company as subprime mortgage defaults are low due to rising housing prices. However, the pendulum begins to swing the other way and more subprime mortgages go into default and then all of a sudden the unlikely happens...
The insurance company receives word that a large number of subprime mortgages are in default and that it now has to pay up and make good on its insurance contracts to the Investment Banks. The amount they have to pay out is much more than the capital it holds. The insurance company comes under siege as thousands of payoffs are due. It is able to make some payments but it does not have enough money to pay all of the claims off. So the insurance company closes its doors and stops making payments and files for bankruptcy. Many Investment Banks who thought they were hedged now receive no payments from their counterparty. The Investment Banks now have to take the subprime exposure back onto their balance sheet. It turns out their hedges were worthless because their counterparty is bankrupt. The Investment Banks are now faced with large losses.
Counter Party risk, or the risk that an institution does not pay out on a derivative, insurance contract, bet or trade when it is supposed to, is a real risk. It is occurring more frequently than before. The US financial system is based on market participants paying off their bad bets. What if the counter party can't pay off? What if a financial entity that assumes it is hedged, is not? How does one ensure that a counterparty is strong enough to make a payout? If an insurance company decides to stop payments because it has no reserves left, what does that do to the financial system? These are the issues facing financial institutions today. As bets go wrong and payouts missed, counterparty risk will become a larger problem in our financial system. A number of the Investment Bankers have mentioned this potential problem during their earnings conference calls. I have recently become aware of the acuteness of this problem and will be writing more about it in the future.
1/2/2008 Update: This article was also published by Seeking Alpha, a popular financial web site. Seeking Alpha added a couple of words to the title, I guess to jazz it up a little.
The link is:
http://seekingalpha.com/article/58780-counterparty-risk-and-the-subprime-fiasco?ref=patrick.net
Sunday, December 30, 2007
Thursday, December 27, 2007
Fasten Your Seat Belts
The news out of Pakistan has made the markets a bit edgy. As the events in Pakistan unfold over the next few days, the markets will react to signs of stabilization in Pakistan or signs of deterioration in Pakistan. Let's hope for the former but prepare for the latter.
Wednesday, December 26, 2007
Market Thoughts
As of today's close, (From the Yahoo Finance Site):
Dow = 13,551.69
S & P = 1,497.66
NASDAQ = 2,724.41
From my calculations:
Dow 50 DMA = 13,411.37
Dow 200 DMA = 13,338.84
S and P 50 DMA = 1,484.52
S and P 200 DMA = 1,489.37
NASDAQ 50 DMA = 2,692.07
NASDAQ 200 DMA = 2,608.05
All of the indexes have retaken their moving averages but will they hold onto these levels? If you look at the indexes over the past 6 months, the 50 DMA has been a level that has been repeatedly crossed but the 200 DMA has been one that has held firm. The repeated crossing of the '50' reveals the skittishness of market participants. It also shows that market participants have much less conviction in their trades and are ready to swing the other way if conditions warrant. The 50 DMA on the S and P stand out as it is below the 200 DMA and is a sign of weakness. This makes sense since the financials have been weak and the S and P has large exposure to the financials. The 200 DMA lines on each of the 3 indexes have acted as support and therefor a breach in these moving averages will have higher significance. Although the 200 DMA does tend to be a lagging indicator, it should be closely observed.
How is the economy doing? The macro picture of the economy seems cloudier. For example on Christmas Eve I went shopping on 5th Ave in midtown Manhattan. It was in the early afternoon and the weather was perfect! While in one store I noticed that it was fairly empty, so I asked the floor manager how business was. His response went something like this "Business has been spotty at best, definitely worse than last year... I am not sure where these economic reports are coming from - the ones that state that all is well in the economy, because that is not what we are seeing here." Now I do not want to get this nice floor manager in trouble so I will not mention the name of the store. But if a hi - end retailer's business is spotty, what is the condition of the rest of retail?
The weakening housing market may be taking its toll on the consumer especially as credit conditions tighten on everything from credit cards to HELOCS. What are the HELOCS you ask? Well they are not like the Warlocks - those nasty characters at the end of H G Wells' classic "The Time Machine" - but rather they are lines of credit that a home owner could tap into when needed. The HELOCS were a sign of the easy money that flooded our economy, but the tap has now gone to a trickle and that makes me wonder about the state of the US consumer. The US consumer is about 70% or about $9 trillion of the US's $13 trillion behemoth GDP. Figure out the consumer, you figure out the economy and equities too.
Dow = 13,551.69
S & P = 1,497.66
NASDAQ = 2,724.41
From my calculations:
Dow 50 DMA = 13,411.37
Dow 200 DMA = 13,338.84
S and P 50 DMA = 1,484.52
S and P 200 DMA = 1,489.37
NASDAQ 50 DMA = 2,692.07
NASDAQ 200 DMA = 2,608.05
All of the indexes have retaken their moving averages but will they hold onto these levels? If you look at the indexes over the past 6 months, the 50 DMA has been a level that has been repeatedly crossed but the 200 DMA has been one that has held firm. The repeated crossing of the '50' reveals the skittishness of market participants. It also shows that market participants have much less conviction in their trades and are ready to swing the other way if conditions warrant. The 50 DMA on the S and P stand out as it is below the 200 DMA and is a sign of weakness. This makes sense since the financials have been weak and the S and P has large exposure to the financials. The 200 DMA lines on each of the 3 indexes have acted as support and therefor a breach in these moving averages will have higher significance. Although the 200 DMA does tend to be a lagging indicator, it should be closely observed.
How is the economy doing? The macro picture of the economy seems cloudier. For example on Christmas Eve I went shopping on 5th Ave in midtown Manhattan. It was in the early afternoon and the weather was perfect! While in one store I noticed that it was fairly empty, so I asked the floor manager how business was. His response went something like this "Business has been spotty at best, definitely worse than last year... I am not sure where these economic reports are coming from - the ones that state that all is well in the economy, because that is not what we are seeing here." Now I do not want to get this nice floor manager in trouble so I will not mention the name of the store. But if a hi - end retailer's business is spotty, what is the condition of the rest of retail?
The weakening housing market may be taking its toll on the consumer especially as credit conditions tighten on everything from credit cards to HELOCS. What are the HELOCS you ask? Well they are not like the Warlocks - those nasty characters at the end of H G Wells' classic "The Time Machine" - but rather they are lines of credit that a home owner could tap into when needed. The HELOCS were a sign of the easy money that flooded our economy, but the tap has now gone to a trickle and that makes me wonder about the state of the US consumer. The US consumer is about 70% or about $9 trillion of the US's $13 trillion behemoth GDP. Figure out the consumer, you figure out the economy and equities too.
Tuesday, December 18, 2007
A Solution to the US Housing Problem
The first topic for "Mostly Stocks" will be the U.S. housing market. Before I begin I would like to note that this can be the best time of the year for some people in our communities and possibly a more difficult time of the year for others. Perhaps remember that as we all go about the frenetic paces of our lives. I heard a stat the other day that floored me - the number of people who attend the daily meal service at a mid - town NYC church has doubled from a year ago. It seems hard to believe but it was true. Hopefully the New Year will bring better times for those in difficult circumstances.
The housing market is of critical importance to the US economy and therefor to the US stock market as well. Among those who have noted its importance to the US economy include the bond market giant Bill Gross of PIMCO at http://www.pimco.com/TopNav/Home/Default.htm and the respected economist Nouriel Roubini of the RGE Monitor at http://www.rgemonitor.com/ . Commenting on a subject in which both of these great minds are experts in may not be the easiest of tasks for me but this forum will at least allow the discussion on this important problem to be continued. Thanks for reading.
I - The Problem
The US is facing large economic problems caused by the deteriorating housing market. To recap, some home owners have missed mortgage payments and some have lost their homes due to those missed payments. As mortgage payments were missed, the value of many mortgage backed securities has fallen. Missed mortgage payments and lower mortgage security values have caused large write - offs for financial institutions. These write - offs have caused lenders to rein in their lending. This is the cycle that the American financial system is in at the moment. In a worst case scenario the cycle could force millions of Americans out of their homes and create financial problems that become so large that the financial system could come to a grinding halt.
In this essay I have outlined a possible solution that may help stop this cycle and repair the system. First I give a very quick overview of my solution. Then I give details as to what each party will have to give up and what each will receive in return. A large part of the problem is driven by Adjustable Rate Mortgages that are adjusting to higher interest rates. The peak cycle for mortgage resets will be in 2008. This solution directly addresses this mortgage resetting problem. Since the three major players in this arena - the home owners, the lenders, and the government – all have different objectives, finding a solution that satisfies all three players is critical. In my view, this solution has merit since it provides this.
Since there are likely to be large problems and disagreements with this radical solution that I propose here I encourage and welcome feedback for I look to accomplish two things with this essay. The first is to offer a unique solution to a very tough problem, and the second is to push others to continue the discussion on this important topic. The more that solutions are discussed, the more likely the most appropriate one is found.
II - The Solution
1) The Highlights
I propose creating a new Federal Program called The Opt in Program or (TOP). This program would negotiate with both the home owner and the lender and would offer an incentive to each of the participants. It would offer the home owner a way to keep his home and would also offer the lender a cash bonus incentive to participate. It is important to note that this would strictly be a voluntary program and that the participants willingly enter it.
Initially, TOP will need to be funded but over time it will pay for itself. Initial funding will be provided by the selling of bonds. Below I go into further detail about funding TOP. Here is a big picture view of TOP: The home owner and the lender voluntarily 'opt in'. Once the home owner and the lender have 'opted in, ' TOP negotiates a settlement with the lender that includes the cancellation of the old mortgage. In exchange, the lender receives a cash bonus, and a new TOP issued Treasury security similar to a fixed rate bond that matures in 15 or 30 Years. This bond would be guaranteed by the Federal Government. TOP will also negotiate with the borrower. The borrower is offered a way to keep his house with a more affordable standard new 30 year mortgage. In exchange when the home owner sells the home a percentage of the profits will go to TOP. This percentage will decrease as the mortgage amortizes. TOP's percentage of the profits will pay for the TOP issued bonds and likely all of the costs of the program.
This proposal is a win for all three major parties. The government keeps the banking system solvent, helps home owners to stay in their homes, and receives revenues to cover the program. The home owner keeps the home at an affordable monthly payment. The lender receives a cash bonus incentive for participating and over time all of his money back with interest.
2) The Details:
a) The Home Owner
By opting in, the home owner would keep his house, his credit rating, and receive a new conventional 30 Year fixed rate TOP issued mortgage. This mortgage will be based on a newly calculated discounted home value he could afford and will be calculated by a TOP financial expert who will analyze the home owner's financial condition. In exchange, the home owner would give up much of his financial independence, be under strict TOP over site, and agree to give up a percentage of the profits when the home was finally sold. The home owner's old mortgage would get cancelled and TOP will issue the home owner a new mortgage. This new mortgage will have a value that is not less than 75% of the old home value. The percentage of profits the home owner gives up when the home is sold will be based on how much the home owner's mortgage was discounted and on how long he paid the TOP issued mortgage.
After the home owner opts in he will be under strict financial over site. For example if the roof needed repair and the home owner needed a bank loan to fix it, that would need to be approved by TOP. The home owner would also be required to take insurance to insure against missed mortgage payments due to sickness or a death. The home owner would not be allowed to miss any payments. If a payment were not received within 31 days of the due date, the home owner loses the home. Upon sale of the home the home owner would receive a percentage of the profits based on a linear formula. The other portion of the profits would go to TOP. For a percentage break down of profits see the table below. A time based profit sharing formula is necessary since home prices tend to increase over time, so the longer the home owner stays in the home the greater the chances for the home value to increase. This increased home value would benefit TOP. The details of the plan would be explained in a required meeting that the home owner would have with a TOP financial expert.
b) The Lender
By 'opting in' the lender would cancel the mortgage and in exchange would receive an up front cash bonus payment and a new TOP issued Treasury - like bond. The lender can chose either a 15 Year agreement or a 30 Year agreement. For a 15 Year bond agreement, the lender receives 4% of the face value of the loan as a bonus. For a 30 Year bond agreement, the lender receives 10% of the face value of the loan as a bonus. The larger bonus is to encourage the lender to chose the 30 Year bond agreement over the 15 Year Bond agreement since home prices are likely to increase more over a 30 Year period. The new bond will be issued to the lender by TOP and will mature in 15, or 30 Years. The bond will have the same face value as the original mortgage. It will be a fixed rate bond and it will be guaranteed by the Federal government.
The cash bonus is necessary as an incentive to entice the lender to opt into this program. The lender participation is crucial but it is also as crucial for his participation to be voluntary. A cash bonus is a good way to entice the lender to cancel the old mortgage and agree to accept a TOP issued treasury like bond. With a cash based incentive, a lender may be more inclined to participate.
c) The Government
TOP serves the government’s interests as well. It will provide the means to the government to help millions of Americans keep their homes and allow the government to avoid the negative side effects that often plague neighborhoods hit by large numbers of foreclosures. This program will also help keep the banking system solvent as fewer homes go into foreclosure. TOP duties will include but not be limited to issuing bonds, making payments and receiving payments. When the home is sold, TOP will receive a percentage of the profits. The percentage of the profits that TOP receives will vary according to the table below. TOP will also make a bonus incentive payment up front to the lender for his participation.
Initially TOP will run a deficit since its payments to the lender will be greater than the payments it receives from the home owner. TOP will therefore have to raise cash. A way to do this is for TOP to issue Treasury like bonds. These bonds will pay for the bonuses to the lender and for the monthly shortfall mentioned above. So TOP will have 2 sets of payments streams - one to the original lender and the second to the bond holders from TOP’s initial funding. TOP will initially have one revenue stream - the monthly payments received from the home owner. Over time, TOP will have a second larger revenue stream. This revenue stream will occur as home owners who have opted into TOP sell their homes and TOP receives its portion of the profits. Please see the table below for the breakdown. By the end of thirty years, the revenue TOP receives will likely offset all of the deficits and debts that TOP accrued.
TOP will also need to provide up front counseling to the home owners, hire real estate experts, and employ financial experts. Some of these services can be provided on a contract basis with outside firms wile others may have to be done by TOP itself. So there will be a large over head cost for TOP that must be accounted for as well. I have only used a very rough estimate for this number.
Since there will be large sums of money entering and leaving the program there will need to be in depth scrutiny of all transactions, costs and funding. An independent body that has full control of TOP’s financial transactions may be the best route. Since integrity in a program like this will be of the highest importance, checks and balances will have to be carried out.
d) The Costs and the Revenues – I used what I believe to be fairly conservative numbers.
Costs:
- The number of home owners ‘opting in’ = 2 million
- The average amount of the original mortgage = $400,000
- The average new mortgage issued (Revenues) = $340,000
- The average discount from the original loan = $60,000
- The average mortgage discount to home owner = 15%
- Cost of each bonus if 1/2 of lenders opt for the 15 Year Plan and the other half of the lenders opt for the 30 Year Plan = $30,000
- The total shortfall due to home discount = $120 billion ($60,000 x 2 million)
- The total bonuses to be paid to lender = $60 billion ($30,000 x 2 million)
- The costs of running this entity over 30 years. This is a rough estimate for I am not sure of these costs = $40 billion (or $20,000 x 2 mill)
- Total costs of program = $220 billion * (Present Value)
* This was a rough present value since all costs are not up front.
Revenues
Note that the revenue TOP receives from the monthly mortgage payments is included above in the Costs section.
- Average new loan = $340,000
- Average length before home owner resells = 15 years
- Average annual home appreciation per year = 5%
- Average value of home after compounding for 15 years = $706,836
- Average profit of home = $366,836 ($706,836 - $340,000)
- Average Percentage of profit to TOP (see table at an average 15% discount = 45%
- Average profit to TOP = $165,077 (0.45 x $366,836)
- Total profit from home owner to TOP = $330 Billion ($165,000 x 2 million)
- Present Value of TOP portion of the home sale using an average of 15 years and a 3% interest rate = $212 Billion
- Present Value of TOP portion of the home sale using an average of 15 years and a 2% interest rate = $245 Billion
- Surplus generated or deficit ran = + $25 Billion to - $8 Billion
III - Comments on the Program
Using a discount rate of 2% the approximate gain from the program would be around $25 billion. Using a discount rate of 3% the approximate loss from the program would be around $8 billion. There are quite a number of variables that may swing this program one way or the other and quite a number of questions may arise about my assumptions or about the program.
Some Assumptions that might be questioned:
- The annual rates of return of the home.
- How long the home owner stays in the home.
- The interest rate for the present value calculation or the inflation rate.
- The cost of running TOP.
- The discount home price given to home owner.
Questions that might arise:
- Will these terms entice the home owner to participate?
- Will these terms entice the original lender to participate?
- Will the tax payer go for it?
- Will the markets like it?
- Will elected officials like it?
- How many home owners drop out of the program, and then lose their homes?
IV - Final thoughts
If a program like this were enacted it would likely be extremely controversial. I tried to make the plan as fair as possible and gave this quite a bit of thought. Also, during the process I tried to put myself in the shoes of all of the people who could be affected by my program. I thought about home owners losing their homes, what would entice the lender, the sanctity of contracts, costs and surpluses. I even tried to come up with a different acronym than ‘TOP’ but did not want to waste time on this, figuring I could change that later. I also ran it by a few people and then made some changes. I am sure after more feedback that I will make changes to this plan. So we will see what happens. Thanks again for reading.
Table for Percentage of Profits from house sale to owner and to TOP. **
A is % Discount to the Home Owner
B is % of the Profit from house sale to Home Owner if house is sold at Year 1.
C is % of the Profit from house sale to Home Owner if house is sold at Year 30.
D is % of the Profit from house sale to TOP if house is sold at Year 1.
E is % of the profit from house sale to TOP if house is sold at Year 30.
A B C D E
5% 70% 90% 30% 10%
6% 67% 88% 33% 12%
7% 64% 86% 36% 14%
8% 61% 84% 39% 16%
9% 58% 82% 42% 18%
10% 55% 80% 45% 20%
11% 52% 78% 48% 22%
12% 49% 76% 51% 24%
13% 46% 74% 54% 26%
14% 43% 72% 57% 28%
15% 40% 70% 60% 30%
16% 37% 68% 63% 32%
17% 34% 66% 66% 34%
18% 31% 64% 69% 36%
19% 28% 62% 72% 38%
20% 25% 60% 75% 40%
21% 22% 58% 78% 42%
22% 19% 56% 81% 44%
23% 16% 54% 84% 46%
24% 13% 52% 87% 48%
25% 10% 50% 90% 50%
** I only placed the starting and the ending values. Other values can easily be calculated using a straight line formula.
The housing market is of critical importance to the US economy and therefor to the US stock market as well. Among those who have noted its importance to the US economy include the bond market giant Bill Gross of PIMCO at http://www.pimco.com/TopNav/Home/Default.htm and the respected economist Nouriel Roubini of the RGE Monitor at http://www.rgemonitor.com/ . Commenting on a subject in which both of these great minds are experts in may not be the easiest of tasks for me but this forum will at least allow the discussion on this important problem to be continued. Thanks for reading.
I - The Problem
The US is facing large economic problems caused by the deteriorating housing market. To recap, some home owners have missed mortgage payments and some have lost their homes due to those missed payments. As mortgage payments were missed, the value of many mortgage backed securities has fallen. Missed mortgage payments and lower mortgage security values have caused large write - offs for financial institutions. These write - offs have caused lenders to rein in their lending. This is the cycle that the American financial system is in at the moment. In a worst case scenario the cycle could force millions of Americans out of their homes and create financial problems that become so large that the financial system could come to a grinding halt.
In this essay I have outlined a possible solution that may help stop this cycle and repair the system. First I give a very quick overview of my solution. Then I give details as to what each party will have to give up and what each will receive in return. A large part of the problem is driven by Adjustable Rate Mortgages that are adjusting to higher interest rates. The peak cycle for mortgage resets will be in 2008. This solution directly addresses this mortgage resetting problem. Since the three major players in this arena - the home owners, the lenders, and the government – all have different objectives, finding a solution that satisfies all three players is critical. In my view, this solution has merit since it provides this.
Since there are likely to be large problems and disagreements with this radical solution that I propose here I encourage and welcome feedback for I look to accomplish two things with this essay. The first is to offer a unique solution to a very tough problem, and the second is to push others to continue the discussion on this important topic. The more that solutions are discussed, the more likely the most appropriate one is found.
II - The Solution
1) The Highlights
I propose creating a new Federal Program called The Opt in Program or (TOP). This program would negotiate with both the home owner and the lender and would offer an incentive to each of the participants. It would offer the home owner a way to keep his home and would also offer the lender a cash bonus incentive to participate. It is important to note that this would strictly be a voluntary program and that the participants willingly enter it.
Initially, TOP will need to be funded but over time it will pay for itself. Initial funding will be provided by the selling of bonds. Below I go into further detail about funding TOP. Here is a big picture view of TOP: The home owner and the lender voluntarily 'opt in'. Once the home owner and the lender have 'opted in, ' TOP negotiates a settlement with the lender that includes the cancellation of the old mortgage. In exchange, the lender receives a cash bonus, and a new TOP issued Treasury security similar to a fixed rate bond that matures in 15 or 30 Years. This bond would be guaranteed by the Federal Government. TOP will also negotiate with the borrower. The borrower is offered a way to keep his house with a more affordable standard new 30 year mortgage. In exchange when the home owner sells the home a percentage of the profits will go to TOP. This percentage will decrease as the mortgage amortizes. TOP's percentage of the profits will pay for the TOP issued bonds and likely all of the costs of the program.
This proposal is a win for all three major parties. The government keeps the banking system solvent, helps home owners to stay in their homes, and receives revenues to cover the program. The home owner keeps the home at an affordable monthly payment. The lender receives a cash bonus incentive for participating and over time all of his money back with interest.
2) The Details:
a) The Home Owner
By opting in, the home owner would keep his house, his credit rating, and receive a new conventional 30 Year fixed rate TOP issued mortgage. This mortgage will be based on a newly calculated discounted home value he could afford and will be calculated by a TOP financial expert who will analyze the home owner's financial condition. In exchange, the home owner would give up much of his financial independence, be under strict TOP over site, and agree to give up a percentage of the profits when the home was finally sold. The home owner's old mortgage would get cancelled and TOP will issue the home owner a new mortgage. This new mortgage will have a value that is not less than 75% of the old home value. The percentage of profits the home owner gives up when the home is sold will be based on how much the home owner's mortgage was discounted and on how long he paid the TOP issued mortgage.
After the home owner opts in he will be under strict financial over site. For example if the roof needed repair and the home owner needed a bank loan to fix it, that would need to be approved by TOP. The home owner would also be required to take insurance to insure against missed mortgage payments due to sickness or a death. The home owner would not be allowed to miss any payments. If a payment were not received within 31 days of the due date, the home owner loses the home. Upon sale of the home the home owner would receive a percentage of the profits based on a linear formula. The other portion of the profits would go to TOP. For a percentage break down of profits see the table below. A time based profit sharing formula is necessary since home prices tend to increase over time, so the longer the home owner stays in the home the greater the chances for the home value to increase. This increased home value would benefit TOP. The details of the plan would be explained in a required meeting that the home owner would have with a TOP financial expert.
b) The Lender
By 'opting in' the lender would cancel the mortgage and in exchange would receive an up front cash bonus payment and a new TOP issued Treasury - like bond. The lender can chose either a 15 Year agreement or a 30 Year agreement. For a 15 Year bond agreement, the lender receives 4% of the face value of the loan as a bonus. For a 30 Year bond agreement, the lender receives 10% of the face value of the loan as a bonus. The larger bonus is to encourage the lender to chose the 30 Year bond agreement over the 15 Year Bond agreement since home prices are likely to increase more over a 30 Year period. The new bond will be issued to the lender by TOP and will mature in 15, or 30 Years. The bond will have the same face value as the original mortgage. It will be a fixed rate bond and it will be guaranteed by the Federal government.
The cash bonus is necessary as an incentive to entice the lender to opt into this program. The lender participation is crucial but it is also as crucial for his participation to be voluntary. A cash bonus is a good way to entice the lender to cancel the old mortgage and agree to accept a TOP issued treasury like bond. With a cash based incentive, a lender may be more inclined to participate.
c) The Government
TOP serves the government’s interests as well. It will provide the means to the government to help millions of Americans keep their homes and allow the government to avoid the negative side effects that often plague neighborhoods hit by large numbers of foreclosures. This program will also help keep the banking system solvent as fewer homes go into foreclosure. TOP duties will include but not be limited to issuing bonds, making payments and receiving payments. When the home is sold, TOP will receive a percentage of the profits. The percentage of the profits that TOP receives will vary according to the table below. TOP will also make a bonus incentive payment up front to the lender for his participation.
Initially TOP will run a deficit since its payments to the lender will be greater than the payments it receives from the home owner. TOP will therefore have to raise cash. A way to do this is for TOP to issue Treasury like bonds. These bonds will pay for the bonuses to the lender and for the monthly shortfall mentioned above. So TOP will have 2 sets of payments streams - one to the original lender and the second to the bond holders from TOP’s initial funding. TOP will initially have one revenue stream - the monthly payments received from the home owner. Over time, TOP will have a second larger revenue stream. This revenue stream will occur as home owners who have opted into TOP sell their homes and TOP receives its portion of the profits. Please see the table below for the breakdown. By the end of thirty years, the revenue TOP receives will likely offset all of the deficits and debts that TOP accrued.
TOP will also need to provide up front counseling to the home owners, hire real estate experts, and employ financial experts. Some of these services can be provided on a contract basis with outside firms wile others may have to be done by TOP itself. So there will be a large over head cost for TOP that must be accounted for as well. I have only used a very rough estimate for this number.
Since there will be large sums of money entering and leaving the program there will need to be in depth scrutiny of all transactions, costs and funding. An independent body that has full control of TOP’s financial transactions may be the best route. Since integrity in a program like this will be of the highest importance, checks and balances will have to be carried out.
d) The Costs and the Revenues – I used what I believe to be fairly conservative numbers.
Costs:
- The number of home owners ‘opting in’ = 2 million
- The average amount of the original mortgage = $400,000
- The average new mortgage issued (Revenues) = $340,000
- The average discount from the original loan = $60,000
- The average mortgage discount to home owner = 15%
- Cost of each bonus if 1/2 of lenders opt for the 15 Year Plan and the other half of the lenders opt for the 30 Year Plan = $30,000
- The total shortfall due to home discount = $120 billion ($60,000 x 2 million)
- The total bonuses to be paid to lender = $60 billion ($30,000 x 2 million)
- The costs of running this entity over 30 years. This is a rough estimate for I am not sure of these costs = $40 billion (or $20,000 x 2 mill)
- Total costs of program = $220 billion * (Present Value)
* This was a rough present value since all costs are not up front.
Revenues
Note that the revenue TOP receives from the monthly mortgage payments is included above in the Costs section.
- Average new loan = $340,000
- Average length before home owner resells = 15 years
- Average annual home appreciation per year = 5%
- Average value of home after compounding for 15 years = $706,836
- Average profit of home = $366,836 ($706,836 - $340,000)
- Average Percentage of profit to TOP (see table at an average 15% discount = 45%
- Average profit to TOP = $165,077 (0.45 x $366,836)
- Total profit from home owner to TOP = $330 Billion ($165,000 x 2 million)
- Present Value of TOP portion of the home sale using an average of 15 years and a 3% interest rate = $212 Billion
- Present Value of TOP portion of the home sale using an average of 15 years and a 2% interest rate = $245 Billion
- Surplus generated or deficit ran = + $25 Billion to - $8 Billion
III - Comments on the Program
Using a discount rate of 2% the approximate gain from the program would be around $25 billion. Using a discount rate of 3% the approximate loss from the program would be around $8 billion. There are quite a number of variables that may swing this program one way or the other and quite a number of questions may arise about my assumptions or about the program.
Some Assumptions that might be questioned:
- The annual rates of return of the home.
- How long the home owner stays in the home.
- The interest rate for the present value calculation or the inflation rate.
- The cost of running TOP.
- The discount home price given to home owner.
Questions that might arise:
- Will these terms entice the home owner to participate?
- Will these terms entice the original lender to participate?
- Will the tax payer go for it?
- Will the markets like it?
- Will elected officials like it?
- How many home owners drop out of the program, and then lose their homes?
IV - Final thoughts
If a program like this were enacted it would likely be extremely controversial. I tried to make the plan as fair as possible and gave this quite a bit of thought. Also, during the process I tried to put myself in the shoes of all of the people who could be affected by my program. I thought about home owners losing their homes, what would entice the lender, the sanctity of contracts, costs and surpluses. I even tried to come up with a different acronym than ‘TOP’ but did not want to waste time on this, figuring I could change that later. I also ran it by a few people and then made some changes. I am sure after more feedback that I will make changes to this plan. So we will see what happens. Thanks again for reading.
Table for Percentage of Profits from house sale to owner and to TOP. **
A is % Discount to the Home Owner
B is % of the Profit from house sale to Home Owner if house is sold at Year 1.
C is % of the Profit from house sale to Home Owner if house is sold at Year 30.
D is % of the Profit from house sale to TOP if house is sold at Year 1.
E is % of the profit from house sale to TOP if house is sold at Year 30.
A B C D E
5% 70% 90% 30% 10%
6% 67% 88% 33% 12%
7% 64% 86% 36% 14%
8% 61% 84% 39% 16%
9% 58% 82% 42% 18%
10% 55% 80% 45% 20%
11% 52% 78% 48% 22%
12% 49% 76% 51% 24%
13% 46% 74% 54% 26%
14% 43% 72% 57% 28%
15% 40% 70% 60% 30%
16% 37% 68% 63% 32%
17% 34% 66% 66% 34%
18% 31% 64% 69% 36%
19% 28% 62% 72% 38%
20% 25% 60% 75% 40%
21% 22% 58% 78% 42%
22% 19% 56% 81% 44%
23% 16% 54% 84% 46%
24% 13% 52% 87% 48%
25% 10% 50% 90% 50%
** I only placed the starting and the ending values. Other values can easily be calculated using a straight line formula.
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