April 5, 2009

Loan-Shedding, Own-to-Lease: Financial Stability while Unlocking Demand

First Published February 11, 2009 @ nolanchart.com

We know all too well about the speculative swell of asset prices in recent time, and low income people getting trapped in malinvestment when the rise could sustain no more. The housing downturn has left them with negative home equity, especially those that were consuming on it, snidely referred to as "eating the house". So obviously these people have had to execute a big cut-down in their consumption Or let go of the house they had "bought" on ARM financing. They have little option but to execute one of the two (consumption cutdown or foreclosure) in order to make their monthly household cash flow work. There is no more the madness of "home equity" loans around for them, and credit card limits are being rightly cut down.

The foreclosures are killing the banks, whereas the cutbacks are sending the economy into an iterative contraction-layoff spiral; not to speak of the fear of ghost neighborhoods coming into existence, and possible heating up of the rental market due to the mass movement of people from "owned" homes into apartment rentals.

However, switching to renting has its advantages for the economy. It will free up the people's household budgets as rentals are way cheaper than full mortgage payments that unfold post ARM reset. Supplemented by tax cuts to the lower income brackets, renting can actually reverse the demand destruction to a decent extent and, thereby, churn a stable job scenario. Further combined with the Economic Recovery & Reinvestment work from the Government, this switch can really strengthen the Real Economy.
But there would still remain the problem of banks going down under - with more ARM resets, more foreclosures properties will flood the market and depress it further. Few buyers exist than can cough up a 30% down payment that banks are demanding. The quandary of ghost neighborhoods also does not get solved by this exodus to renting. The problem with the Government first giving these banks money, and then forcing them to lend for housing with low down payments, is that all foreclosures that occur in future on these new "fiat loans" will become Government's liability/mistake. At best, Government can ensure, by "savior's directive", that the receiver banks continue to make working capital and payroll loans to companies.

The Obama Administration just announced a trillion dollar fund to help banks with their problems. With continued foreclosures, the property valuations will depress further, and it's estimated that the combined losses of the major US banks will not be less than $3 trillion. It is unlikely that the US Government will be able to save all the troubled banks.
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Perhaps, a policy direction that can be taken is that help is provided to a bank proportionate to the number of abandoned houses that it prevents, by switching an "owner" that is delinquent on his mortgage payments into a willing renter of the same property. If a new category of private entities can come up to buy the wobbly mortgage assets from banks at good discounts to face values, and convert them into rentals, they can be provided with appropriate tax breaks funded from the trillion dollar fund as encouragement. These entities will also be able to benefit from the massive bargains in liquidation auctions if any banks go under, and some probably will. The Government can even consider itself entering this market. The profits from the venture can part pay the tab for the Economic Recovery & Reinvestment and the Financial Stability Trust over the years. The rental arrangement can be say, of 5 years duration, through which the erstwhile "owner" will have the first right to buy the property afresh at mutually acceptable terms. The erstwhile owner could be encouraged towards the conversion by allowing him to write off any housing loan Principal that he repaid up to his "switch-point" as loss over the next 5-8 years in his tax returns. This approach will control the flood of houses into the market for resale, and contain the valuation losses for the people that are, and intend to stay, current on their mortgage payments. It will take the troubled assets off the Banks' balance sheets, and help prevent empty neighborhoods.
The biggest, and really the most intended, gain in the above approach to Financial System Rescue will be the resurrection of plummeted demand for goods and services in America. That would help arrest the hemorrhage of jobs in the economy. And THIS demand resurrection will not be via more loan-loading onto the low income households, rather through the much needed loan-shedding. In current economic circumstances, pursuing Economic Recovery and trying to help a delinquent owner stay in ownership of his asset will only work cross purpose.

The key to unlocking demand is to assist and support a struggling homeowner's switch into renting.

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