A Market Based Solution To The Real Estate Crisis
Richard A Graff

The current residential mortgage crisis and looming commercial mortgage crisis demonstrate that many of our real estate capital formation practices have become inappropriate.  This should prompt us to re-examine current practices, discard innovations that have proven counterproductive, give consideration to alternatives that may not be so easily abused, and revitalize a regulatory system that has been substantially marginalized or circumvented over the last two decades.  With these objectives in mind, it is instructive to see what the current residential crisis reveals about widely misperceived risk dimensions of mortgage finance in today's markets.

Financial observers have widely noted that the dominant feature distinguishing real estate financial products today from their analogues of a quarter century ago is liquidity.  Less noted but of equal significance is the feature that most distinguishes the real estate financial industry today from its counterpart of a quarter century ago - absence of accountability.  These changes can be traced to the same source - mortgage securitization.

Prior to mortgage securitization, lending institutions retained the loans they originated, which meant that a lender lost equity when a borrower failed to repay a loan.  Accordingly, job performance metrics for management and loan officers focused on long-term performance of the loan portfolios they generated rather than on short-term fees.  With the emergence of securitization, the focus of the metrics shifted to the fees and long-term concerns were left to investors who bought the securitized loans.

With financial industry attention focused on a new source of income - short-term fees associated with generation of mortgage-backed securities - the stage was set for a debt-driven real estate bubble.  Increased home construction meant more residential mortgages to be securitized; so construction was enabled with little concern for risk.  Below-prime home buyers and home-buying speculators meant an enlarged buyer pool to absorb the increased construction; so new loan products were introduced to enable these buyers without concern for risk to mortgage investors.

Among the loan products introduced to enable below-prime and speculating buyers and increase the buying power of prime credit buyers: interest-only mortgages, variable-interest mortgages, negative amortization mortgages, mortgages with balloons, mortgages that create too much leverage.  Their common denominator: they generated up-front mortgage origination and securitization fees and postponed the inevitable day of reckoning.  Of little concern was the fact that the Roosevelt administration’s New Deal had determined these products to be unsuitable during the home finance reformation that followed the last systemic real estate debacle.

These changes effectively ended credit constraints in the residential market.  The only remaining ingredient needed for a residential bubble was a robust economic environment with low interest rates to galvanize buyers, and the Federal Reserve supplied that.

Economics and history lessons are important to the design of regulatory reform and allocation of financial accountability.  However, the questions that urgently need answers but have not been addressed adequately are the following: how to stabilize prices in the market for securitized residential finance, how to restore at least some of the homebuyer interest rate savings from mortgage securitization, how to accelerate evolution of the real estate market to a state of stable equity prices, and how to minimize the market value declines needed to reach the stable prices.

In responding to these questions, it is important to note that the residential real estate market has evolved too much for a return to the residential finance system created by the New Deal without avoidable economic pain.  An imbalance between the supply of residential property and the demand of potential home buyers already exists due to the elimination of speculators from the demand side of the supply-demand equation.  Banishment of below-prime-credit home buyers from the residential market would worsen the imbalance and lengthen the time required for the market to dispose of the surplus supply of product.  It would also deepen residential value declines required for the market to attain a new pricing equilibrium, which would amount to an unnecessary deletion of enormous real estate-based wealth from the domestic economy.

In order to mitigate additional economy-wide losses of homeowner real estate-based wealth, future home buyers need access to interest rate savings from securitized residential finance.  This necessitates a restoration of confidence in the securitized finance market.  In this case, the New Deal residential finance system provides a model designed to protect both buyers and lenders: an end to pay-less-now pay-more-later loans and a return to financings that have unvarying interest rates and monthly payments and are totally amortizing.

New Deal finance is a partial blueprint for a solution to the residential real estate crisis.  It is not the whole solution because New Deal finance is interwoven with checks and balances in the form of legal and financial constraints designed to reduce investment risk for both lender and home buyer but not designed for compatibility with mortgage securitization.

In the New Deal system, sizable buyer down payments create an equity cushion to protect lenders against real estate wastage during legal recourse in the event that foreclosure becomes unavoidable.  At the same time, foreclosures are designed to be costly and time-consuming to discourage lenders from shifting their focus of attention from loan repayment to the value of the collateral.

New Deal finance encourages buyer and lender to explore the possibility of finding a mutually acceptable Plan B version of the loan agreement if default becomes unavoidable under the original agreement.  However, this sort of flexibility assumes that there is only one lender and one buyer.  It also assumes that negotiations between the parties are simple and inexpensive to arrange and that legal approval of renegotiated provisions is simple and inexpensive to obtain. These assumptions are valid in a world of unsecuritized residential finance but not in today's world of securitized finance.

Securitization eliminates lender flexibility in response to buyer default because it replaces a single investment interest in each loan with multiple investment interest classes (e.g., tranches) and creates a loan manager/servicer who has fiduciary responsibilities to all investment interest holders.  Inflexibility results because any prospective substitute for the original loan agreement cannot burden all tranches equally, thus creating a basis for legal action by loan investors against the loan manager.  The only way the loan manager can avoid legal exposure is by responding inflexibly towards defaulting borrowers and foreclosing. 

Lender inflexibility is not unfair to borrowers under these circumstances.  It is the cost associated with the financial equivalent of an otherwise free lunch.  Loan securitization entails a borrower trade-off of incremental benefits and risk in which the incremental benefits are certain but the incremental risk is only contingent.  Every home buyer who uses securitized finance benefits throughout home ownership from lower interest costs and lower monthly payments, whereas only defaulting buyers can experience any impact from incremental foreclosure risk.

One might expect that the inflexible foreclosure posture of the loan manager transfers value from home buyer to lender.  However, this is where the incompatibility of securitization with mortgage checks and balances introduces a structural inefficiency, because lender inflexibility doesn't reduce the time and expense required for the lender to foreclose.  In other words, securitization doesn't transfer any lost value from defaulting home buyer to lender, it simply dissipates the value as a frictional transaction cost.

Economic impact of the inefficiency on securitized loan value could be minor so long as prospective loan default rates remain low.  This may protect the long-term viability of many securitized interests in prime mortgages.  However, the prospect of realistic economic scenarios with 40+ percent default rates in below-prime mortgages should signal the end of the secondary market for most securitized interests in these loans.  It follows that liquidity cannot be restored to the residential real estate market without the likelihood of additional market value declines so long as mortgages are the only source of leverage available to below-prime-credit buyers.

The key to the long running success of the American home ownership system has been widespread availability of low-cost residential finance.  Until recently, the basis for that low-cost finance was a mortgage securitization system that enabled fixed-income investors to finance prospective homeowners at low perceived investor risk, a perception that clearly has changed in the case of below-prime mortgages.  This suggests that a market-based solution to the real estate crisis should include a new generation of residential financial products that provides financiers with enhanced protection against loss risk in the presence of significant buyer default risk.

Electrum Partners has developed a family of financial products for residential and commercial real estate with this investment characteristic.  The products divide real estate ownership rights between buyer and financier instead of assigning all ownership rights to one of the parties.  This enables the financier to take possession of the real estate in default resolution without any need to secure additional ownership rights, which reduces the complexity of default resolution and the frictional cost that results from the action.

The preceding analysis suggests that the residential mortgage crisis resulted from a problem that was in part technological: an incorporation of old financial technology into newer financial technology with which it was not completely compatible.  Accordingly, any market-based solution to the crisis should include the introduction of a financing instrument that reduces or eliminates the incompatibility between mortgage finance and securitization when there is significant buyer default risk.  The Electrum Partners family of products includes financing instruments designed to achieve precisely this objective.