An Ownership Rights-Based Alternative To Mortgage Finance
Richard A Graff
The financial industry has driven economic growth in the United States for more than two centuries, and real estate finance has been a major contributor to that growth since the New Deal reforms of the 1930s. However, the current residential mortgage crisis and looming commercial mortgage crisis demonstrate that many of our real estate capital formation practices are inappropriate and our regulatory structures inadequate to discourage abuse. These crises should prompt us to re-examine current practices, discard innovations that have proven counterproductive, and give consideration to alternatives that may not be so easily abused.
It is illuminating for these purposes to regard real estate as simply a bundle of ownership rights. Then mortgage finance can be regarded as a way to (1) create two packages of property rights that together reduce to the bundle of ownership rights and (2) arrange for a financier to invest in one package in order to enable a real estate buyer to acquire the other package for less up-front cost.
Because of the nature of debt, the two property rights packages in mortgage finance are not subbundles of the bundle of ownership rights. However, alternative methodologies exist to create property rights packages that do separate the bundle of ownership rights into subbundles. These alternative financial structures can enable real estate buyers to acquire the buyer property rights package at lower financing cost than mortgage finance because the financing package in these structures exposes potential lenders to lower loss risk than mortgage finance.
Alternative financial structures of this type provide a viable way to restructure financings of defaulted properties that otherwise involve excessive loss risk. Such financings could form a large piece of a market-based solution to both real estate crises.
Before describing the alternative structures, it is instructive to examine what the current residential crisis reveals about mortgage investor risk in today's market. The fundamental insight to be gained is that incompatibility exists between securitization and mortgage finance that can force prolonged gridlock in both real estate equity and debt markets. The incompatibility is due to the fact that mortgage finance is interwoven with checks and balances in the form of legal and financial constraints designed during the New Deal to reduce investment risk for both lender and buyer but not designed for compatibility with mortgage securitization or today's flexible loan structures.
In the New Deal system, sizable buyer down payments constitute a constraint that creates an equity cushion to protect the lender 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 and include rights of redemption in order to discourage lenders from shifting their focus of attention from loan repayment to the value of the collateral. Because of the equity cushion, loss risk is borne by both buyer and lender.
The loss risk encourages buyer and lender to explore the possibility of finding a mutually acceptable revised loan agreement in the event that default becomes unavoidable under the original agreement. However, this sort of flexibility assumes that there is an equity cushion. It also assumes that there is only one lender and one buyer.
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 revision of the loan agreement cannot burden all tranches equally, thus creating a potential 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 real estate buyer who uses securitized finance benefits throughout the real estate ownership from lower interest costs and lower monthly payments, whereas only defaulting buyers experience any potential impact from incremental foreclosure risk.
One might expect that the inflexible foreclosure posture of the loan manager transfers value from the real estate buyer to the lender. However, this is where the incompatibility of securitization with mortgage checks and balances introduces an inefficiency, because an inflexible foreclosure position doesn't enable the lender to reduce the time and expense required to foreclose. In other words, securitization doesn't transfer any lost value from the defaulting buyer to the lender, it simply dissipates the value as a frictional transaction cost and delays productive asset redeployment.
An alternative financing methodology can remove the structural inefficiency. U.S. property law allows conventional real estate ownership to be split into bundles of ownership rights of distinct types, each of which can be separately deeded to a different investor. The simplest case involves two ownership rights bundles - one conveying possessory ownership prior to a specified date, the other conveying possessory ownership after that date. In this case, the rights bundles are known as a term ownership interest and a remainder ownership interest.
The two ownership interests can be used as the basis for an ownership structure with securitizable finance for the prospective real estate buyer that corresponds closely to a conventional mortgage. In lieu of a mortgage, a financier essentially purchases a term ownership interest in the property that expires at the same time as the mortgage that the term interest is designed to replace. The buyer purchases the corresponding remainder ownership interest. Instead of receiving a loan from the lender, the buyer leases the term interest with rental payments that correspond closely to the mortgage payments that the rents are designed to replace.
In short, this financing structure replaces the traditional relationship between lender and buyer with a corresponding relationship between landlord and tenant. There is no debt in this structure. Nonetheless, the financing can be structured so that tax implications are the same as conventional debt finance. Accordingly, from the perspectives of financier and buyer there is no difference between this all-equity financial structure and the mortgage structure it replaces so long as there is no lease default. In this case, the lease and the term interest disappear together when the lease ends and the buyer owns the property free and clear.
Prior to lease expiration, the property has two owners instead of the conventional one. The financier is the sole owner in possession by virtue of holding the only current ownership interest in the property. However, the possession of the financier is constructive rather than actual because the term interest is leased to the buyer. The buyer has actual possession of the property by virtue of the lease, but the buyer is not an owner in possession because the buyer's equity interest is a future ownership interest.
Differences between the all-equity financial structure and the corresponding mortgage structure become apparent if the buyer defaults on the financing. In this case, no costly and time-consuming foreclosure process is required to repossess the property since the financier already is the owner in possession. It is only necessary for the financier/landlord to pursue an eviction to remove the nonpaying tenant.
Termination of the buyer's remainder ownership interest is a separate legal issue that depends on which contingent rights to the remainder interest the financing structure assigns to the financier (several alternatives exist). However, lessee eviction is the only property rights termination that the financier needs to conclude in a timely manner, since the financier only needs to reestablish actual possession in order to redeploy the property as a cash generating asset.
The replacement of mortgage finance with all-equity finance eliminates value dissipation in default due to the incompatibility between securitization and mortgage debt. It also reduces value dissipation in unsecuritized re-financings of defaulted properties that involve significant re-default risk. Intuitively, the all-equity financial structure achieves this result by assigning a large enough bundle of ownership rights to the financier when the finance is created to reduce the complexity of legal issues involved in asset repossession. No court is needed to transfer possessory ownership rights from buyer to financier because the financier already owns them.
The financial structure described here was developed recently. However, at the core of the structure is the concept of separating real estate ownership into separately owned bundles of ownership rights. The body of law governing this concept is as old as the body of law governing mortgage finance, both having evolved out of pre-industrial Common Law.
The success of our political economic system is based on the productive deployment of capital. When capital becomes unproductive, our system cleans up the problem and redeploys the remaining capital more productively. It would be ideal if a leveraged financial structure could be found that would make every risky real estate financing turn out well and eliminate any need to clean up bad deals. Unfortunately, there doesn't appear to be any such structure. However, a leveraged financial structure that allows promising but risky purchases to be financed and cleans up the situation with minimal capital loss to the parties involved if the financing turns bad is an attainable alternative.
Electrum Partners developed the all-equity leveraged financial structure to deal with the problem of capital loss in default resolution. This all-equity financial structure deserves attention because it is superior to traditional mortgage finance in allocating financial accountability in circumstances that are inherently riskier for the financier. It could also be the innovation that enables risky buyers to maintain access to at least some of the interest cost advantages of securitized finance, to their immediate advantage and the long-term benefit of the national economy.