Is Equity Sharing the New Way Forward in Housing Finance?
Equity sharing is when a homeowner finds a partner to help pony up cash for a down payment. The homeowner retains the obligation to make the mortgage payments, but gives up a chunk of the home's equity.
We don't need just need to figure out what to do with Fannie and Freddie. Rather, we need a sustainable system for financing residential real estate that is not so heavily reliant on debt. Equity sharing, the process by which a third-party investor injects risk capital to the housing transaction in exchange for a partial equity stake in the property, is one such possible solution.
Fannie and Freddie, with their implicit (turned explicit) government backing, drove down the cost of mortgage debt, expanded the availability of credit, and helped fuel home price appreciation. This worked great, until it didn't. The system became highly unstable and ultimately crashed, largely due to the excessively high levels of debt Americans had used to purchase homes.
As any seasoned investor will tell you, asset depreciation can be tolerated and absorbed if risk is managed correctly. A key component of that risk management is smart use of leverage. Without leverage, losses take on a 1-1 ratio with the investment. That is, bet $100 to lose $100. But with leverage, the scales tip, and can do so dramatically if investors (or borrowers) are only required to post a fraction of the purchase price in equity. Even a "safe" mortgage where a borrower puts down 20% is akin to betting $20 to lose $100. Add some zeroes and potential losses pile up quickly.
According to Freddie Mac, as of December 2010, the total value of US housing stock was $16.5 trillion, down a cool $7 trillion from the peak in 2006. Underpinning this dizzying large number is $10.1 trillion in debt, for a total current loan to value (or "LTV") of 61.2%. Taken at face value, that actually doesn't sound too bad. But dig into the data and it's easy to see why most experts agree the housing market in this country cannot truly heal without some sort of material change to the way homes are financed.
At last tally, around 11 million US homeowners are underwater on their mortgage, meaning they owe more than their home is worth. With the median home price hovering around $180,000, that means about $2 trillion in housing stock is stuck, trapped in a negative equity situation that will either be resolved by default and eventually foreclosure, a modification or workout scenario, or simply through waiting and hoping appreciation comes back. Put another way, a full one-third of our excess housing value is immobile, paralyzed.
See Is it Better to Rent or Buy a Home?
What the system needs is a structural process for injecting equity and paying back debt. Homeowners need to recapitalize their balance sheets at more sustainable levels, which would not only allow underwater borrowers to sell, but greatly reduce the portion of individual discretionary income that goes toward debt service. Pay less interest, buy more stuff, stimulate the economy, create jobs. Wash, rinse, repeat.
The challenge of course is where to find this admittedly sizable chunk of cash. Why, the free market, of course.
In a rare show of legislative foresight, Congressman Gary Miller, Republican representing California, introduced a bill last September that would launch a pilot program through the Federal Housing Administration for "equity sharing" as a way to reduce our dependence on debt to finance the purchase of homes.
Equity sharing, while containing certain complexities, is relatively straightforward. A homeowner finds an equity partner to help pony up cash for a down payment. The homeowner retains the obligation to make the monthly mortgage payments, but in exchange for the down payment assistance gives up a chunk of home's equity. The equity partner is silent(ish) in that he or she doesn't get to pick carpet or paint colors, but the homeowner is obligated to maintain certain levels of responsible home maintenance.
Far from just another way to make it easier for individuals without much money to buy houses, equity sharing programs inject risk capital into the housing finance system rather than debt. That is, equity investors stand side by side with homeowners and take the first loss if housing prices fall, providing lenders more cushion and ultimately less risk on their loans. More equity (and consequently less debt) creates a more stable, less risky housing market.
Equity Sharing has applications in distressed housing situations as well. Third-party equity investors can inject capital into underwater mortgages, enabling borrowers to lower LTVs to acceptable levels for a refinance.
And while far from a silver bullet to solve our country's housing woes, equity sharing is a start. Already firms are popping up looking to set up equity sharing transactions. Steve Cinelli, CEO of Primarq, an equity sharing facilitator headquartered in the Silicon Valley, is optimistic about the industry's potential: "[Equity sharing] sets forth a direction for more affordable and sustainable homeownership, more prudent lending practices, and a reduction of the role of government in supporting a most critical element of the US economy."
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