Friday, October 24, 2008

Perpetual Mortgage: A Better Way Out

Unless and until the housing market stabilizes, which is a less stringent test than bottoming out, pressure on economy and especially financial market will not subside. This seems a fairly broad consensus now. So there're many answers offered. Presidential candidates and Congress are busy in a race to the bottom, dreaming up all kinds of economically nonsensical, legally borderline or even outright unconstitutional, socialist and/or totalitarianistic ways of "helping homeowners".

As far as I'm concerned, we're selling our collective soul to the devil by embracing government bailout and intervention in panic, without questioning or thinking it through.

I have a better idea than forcing/coercing banks to "modify" mortgages: offer homeowners the option of converting existing mortgage into perpetual mortgage.

Here's how it works.

Say you bought a house on $200K mortgage and are now in danger of default and the house is worth only $150K. You can convert into a perpetual mortgage with a principal of the original amount, $200K. You're still the homeowner, enjoying the tax deduction and all. The lender is still the lien holder. The differences with traditional mortgage are

1. You pay only interest. Assuming the same interest rate , your monthly payment drops by about 15% depending on the rate.
2. Your equity on the property remains 0 as long as you don't sell it.
3. If you sell it at a profit, you don't get an immediate windfall. Instead, you get a reverse mortgage from your original lender on the profit. This reverse mortgage can be sold in case you want to cash out.
4. If you sell it at a loss, you don't take an immediate hit. Instead, you carry a loan on the difference.

The idea is to soften the blow to homeowners when the market goes down, and to give people the option of forfeiting wealth accumulation for maximum lifestyle. The choice is yours to make.

Allow me to remind you of three simple facts about traditional mortgage model:

1. Many people are not ready to deal with the 50%, 100% leverage from housing price on their down payment. As a result, when housing goes up, people make unrealistic assumptions about their networth and financial future; when housing goes down, people go panic and/or desperate. Forcing such huge leverage on unsuspecting, unprepared public ultimately forces the risk on the society as a whole -- it becomes a political/social problem, exactly as we're witnessing now.

2. Such leverage is inherently destablizing at the macroscopic level. When economy runs into headwind, the housing market is likely to go down. But homeowners are also likely to lose their jobs. Positive feedback, exactly as we're witnessing now. Perpetual mortgage spreads out the profit/loss on the house so that both homeowners and lenders have more buffer to cope with it.

3. Most mortgages are never paid off. They either get prepaid (sold or refinanced) or foreclosed. Both are among the biggest risks to lenders, thus adding to the interest rate. Perpetual mortage largely eliminates the delusional assumption that it will be paid off on schedule. It also reduces both by A) discouraging flipping, and B) easing foreclosure danger.

It's not a cure-all. But it should make it less painful for many homeowners and lenders while limiting governmental intrusion on capitalism.

Note that this is very different from renting from the bank. You own the house, participate in its appreciation as well as depreciation, enjoy the tax benefit etc. Banks can also impose the same down-payment requirement, although this is impossible when converting existing mortgages. It also differs from "interest-only" mortgages in that, in case of a downturn, homeowner pays the depreciation over a period of, say, 10 years. The original lender is obliged to offer this loan.

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