Readers of our subscription material will see in Trends of Note an item about the plans of the Irish government to at least partially solve its economic woes by forcing banks to re-write mortgages to reflect the new realities of an over-built and cratered housing market. As we noted, the Irish can get away with such a plan while others cannot, because the Irish government nationalized Anglo Irish bank and took control of Allied Irish Bank and Bank of Ireland through recapitalizations. In the rest of Europe, national governments have much less leverage, so the combination of housing crises and bank vulnerability continue.

In the U.S., the Federal Reserve has taken to softening America’s own housing crisis while simultaneously injecting liquidity into the economy through what is known as QE3 – a third round of monetary policy that consists mainly of monthly Fed purchases of up to $40 billion in mortgage backed securities, while the housing bubble presumably works itself out. This guarantees the viability of the banks that issued the mortgages, but it does little or nothing for the millions of people whose mortgages have either been foreclosed or are in the process of foreclosure. There is little incentive for banks to refinance mortgages at lower rates, since the value of the properties they would be re-financing have depreciated an average of nearly 25% since 2007. Any bank doing these refinancing would have to take the loss in value onto its books, in addition to income lost from financing a lower rate mortgage.

The U.S. housing market is indeed beginning to work itself out, but not in a way that makes many people happy. Real estate speculators have begun buying up foreclosed homes and renting them to the very people who have been dispossessed by foreclosure, turning neighborhoods into potential slums, since the speculator have little incentive to maintain their properties and the renters have even less. But the banks profit by taking the properties off their books at some price, freeing up capital for new lending.

There needs to be a better way to work through the housing crisis, something that will benefit homeowners without penalizing banks, while at the same time getting the Fed out of the mortgage business. So, a modest proposal for a new kind of mortgage, what might be called a “participation mortgage,” in which the bank and the homeowner are partners and each participates to some degree in the risk of owning in what is now a more volatile housing market.

Here’s how it works: Someone looking for a mortgage goes into a bank and asks for a participation mortgage. After the bank verifies the potential homeowner’s income, credit status and work history, the homeowner-to-be decides how much of the upside value of the house he/she wants to pay for. At a minimum, the homeowner can take as little as 30% of the mortgage, paying only 30% of the total cost each month, while the bank carries the remainder of the mortgage on its books. The homeowner is still responsible for 100% of the upkeep costs, 100% of all local real estate and school taxes, and still receives 100% of the tax deduction. Every three to five years, depending upon the fortunes of the homeowner and the state of the economy, the homeowner can “reset” the mortgage, paying the difference between what he originally put down and the new share of ownership that he takes. Resets may be up or down, but cannot go below 30%.

Meanwhile, the bank has the option of holding the mortgage on its books or selling it into the larger market. The tools already exist to evaluate the mortgage quality and price appreciation potential of cities, neighborhoods and even individual homes, so the variety of products that such participation markets might generate is almost infinite, and can be duration-denominated to provide an income stream or packaged, rated and sold by quality, as mortgage backed securities already are. When the home is finally sold, the holder of the participation mortgage gets his percentage of the sale price – principal plus appreciation. While the bank holds it share of the mortgage, it gains a depreciation deduction on its share.

Who benefits? Who’s hurt? Well, homeowners benefit immediately by taking such a mortgage because it immediately lowers their monthly note, allowing them to either spend more or save more or both. If you have kids who are going to be heading for college someday, a participation mortgage gives you more of a savings head start. On the downside, the homeowner will lose that percentage of the accrued value that is owned by the bank, but if he or she is saving steadily, and investing carefully, that might not be a problem.

The banks? As participants, they get to take the depreciation portion of their investment off their taxes each year, so bank profits will likely rise. They could fall if the homes whose mortgages in which they are participating decline in value, but even then, they get to write off their loss, which homeowners cannot do but banks, as investors, can. In an active mortgage futures market, banks can hedge their bets, buying mortgage shares when prices are falling or selling into a rising market.

The Fed? They get out of the mortgage business, which will please fiscal conservatives to no end, and there might be some tax loss under such a plan. But a reasonable estimate is that the plan is likely to be revenue neutral at worst, and stimulative to the economy in general, allowing consumers to rebuild their savings and to resume their role as the primary engine of the economy.

Such a plan might require a bit of re-jiggering of the tax code to lock in the depreciation for the banks, but otherwise, this is a product that any bank with just a bit of courage could undertake on a test basis. If it works, there are bound to be many variants, but the principle is simple: Share the risk, share the reward. 

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