To Save Mortgages, Should We Share Them?

It’s been almost five years since the housing bubble burst. And still the long sought-after recovery is nowhere in sight. Nearly 11 million households owe more on their mortgages than their houses are worth.

Lenders foreclosed on more than 680,000 homes in the first three months of 2011, according to RealtyTrac. Yet banks remain so overwhelmed by the tide of failed loans that three of the largest ones recently failed out of the federal loan modification program (which itself has helped only a small fraction of needy families avoid foreclosure).

In this environment, it’s understandable that frustrated homeowners and lenders might ask: Isn’t there some way out of this? And isn’t there some way to make sure a crisis like this never happens again?

“The crisis has been dealt with very badly,” says Andrew Caplin, an economics professor at New York University. “Every single policy has pushed people further away from re-entering the U.S. lending market.”

Caplin thinks he has an answer. In fact, he’s been talking about it since 1995. It’s called the “shared appreciation mortgage.” The idea is to encourage banks to lower homeowners’ monthly payments by letting them share in the home’s rising value over time. In exchange for lowering the homeowners’ interest rates and/or principal, lenders get more assurance that the loan will eventually be repaid plus an equity stake in the home, which they can redeem when the home is eventually sold. (Credit.com’s Adam Levin wrote about shared appreciation mortgages in a recent column, Play It Again, SAM.)

Caplin thinks the shared appreciation mortgage is the perfect tool to lead us out of the current mess. He also thinks it could eventually replace the 30-year mortgage as America’s loan of choice.

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Sounds simple right? Well, not exactly. While technically legal, shared appreciation mortgages have never caught on, due partly to an arcane IRS ruling from 1983 that, for all practical purposes, bans them.

“Get rid of the tax barrier and you could actually implement this today,” Caplin says.

Others think that’s not such a great idea. They see shared appreciation mortgages as potentially helpful in helping current homeowners make their loans more affordable. But as a replacement for 30-year, fixed-rate mortgages, which over the last 75 years have played a huge role in building the wealth of the American middle class?

Skeptics say that’s taking a good idea and pushing it too far.

“I do think it has some potential merit,” Barry Zigas, director of housing policy at the Consumer Federation of America, says of shared appreciation mortgages. “But to say these things should replace the 30-year fixed-rate mortgage? I think it’s a big leap.”

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One Loan, Two Uses

Depending on how one sees the current mortgage crisis, the shared appreciation mortgage can be seen as either a short-term fix for a short-term problem, or as a long-term fix for a system that is fundamentally broken.

In the short term, most analysts agree: Americans own millions of mortgages that no longer make any sense. Nearly 11 million households are paying more for their mortgages than their houses are actually worth. Some of those home valuations may rebound before the owners eventually sell; millions more are so deeply underwater that they may never recover. For these people, the incentive to walk away from the home is high, despite all the damage that doing so would cause to their future ability to get credit, not to mention the impact that more empty houses would have on the neighborhoods that homeowners leave behind.

To address this problem, the Obama administration created the Home Affordable Modification Program (HAMP), which offers incentives to lenders and loan servicers to encourage them to alter underwater home loans, either by reducing the interest or the principal.

Unfortunately, the program has been an unmitigated failure. The administration initially said the program would help up to 5 million people, but only a small portion of that number has found any kind of relief. Why? The government’s incentives are not high enough to overcome the costs of processing modifications, plus the lost income lenders and servicers will experience once the changes become final, according to research by a Congressional Oversight Panel.

In the short term, shared appreciation mortgages can fill this gap, supporters—and many skeptics—agree. Such a tool could create what the federal program has not: A real incentive for banks to modify mortgages.

“The banker who makes the loan would be interested in that property because he’s buying a piece of the upside,” says Noël B. Cunningham, a law professor at New York University. “All sorts of market drivers seem to indicate that this would be a marketable mortgage.”

How It Could Work

Despite their disagreement over the sustainability of 30-year mortgages, some consumer advocates agree with Caplin that the shared appreciation mortgage could be a useful tool for digging the American housing market, and the larger economy, out of the hole. Currently, banks have little incentive to modify loans, except the abstract threat that an unknown number of loans will end in foreclosure and never be repaid.

SAMs could change that, some economists and consumer experts believe. By converting a traditional loan into a SAM, the lender would agree to lower its monthly income now by writing a new loan with lower interest rate and principal. In return, the bank would be entitled to some amount of money when the home is later sold.

For example, Caplin wrote in a paper for the Brookings Institute, imagine a home with a mortgage of $200,000. Immediately after the loan is written, the economy tanks, and the house value falls to $180,000. The homeowner is now underwater by $20,000. The lender could substitute $40,000 of the original mortgage with a SAM, cutting the borrower’s interest payments by 20% each month and enabling her to stay in the home.

When the borrower eventually sells the house, the bank would reap 40% of any increase in the home’s value. If the value jumps to $300,000, the bank gets $48,000, while the homeowner keeps the rest. (The exact numbers for the loan amount, interest rate and shared equity would vary, Caplin says.)

If the home’s value stays the same or goes down, the bank would get nothing.

“This can be a shared risk proposition for the lender, who is likely to lose significant amounts of principal no matter what happens,” Zigas says. “And then both sides can share in any upsides, so this doesn’t result in any bonanza for the borrower, and both sides have something to gain if things turn around.”

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Wait. Didn’t We Already Try This?

It’s easy to miss, but the federal government already has a program that uses shared appreciation mortgages to help struggling consumers. It’s called Hope for Homeowners, and it was created in 2008 by the Bush Administration with $300 billion in available funding and the stated goal of helping 400,000 people avoid foreclosure.

In return for government insurance, lenders must agree to reduce the mortgage to no more than 90% of the home’s value. Homeowners must agree that if they sell the house more than five years after the new mortgage is finalized, they will share 50% of the appreciation with the government.

So how many people have received help from Hope for Homeowners so far? 375. That’s all. When the program ends on Sept. 30, it will go down as a complete failure.

The big question is why. Banking industry representatives say that the complete lack of interest in Hope for Homeowners is a clear demonstration that consumers just don’t like the idea of sharing the value of their home appreciation. In addition, lenders don’t like the idea of giving homeowners a break on mortgages now, with no idea of when they might get their money back. What happens if the homeowner stays in the house for 50 years?

“It is a reasonable idea in theory, and it’s easy to write an academic paper about,” says Bob Davis, executive vice president of government relations for the American Banking Association. “But in practice neither the lenders or borrowers were too interested.”

Others say that Hope for Homeowners failed because it was low on lenders’ lists of priorities. Most lenders and loan servicers concentrated their modification efforts on complying with HAMP, created months after Hope for Homeowners started. HAMP has had its own implementation problems, helping just a fraction of the 4 million people for whom the program was originally intended.

Even so, HAMP is somewhat more popular than Hope for Homeowners primarily because it entails simple changes to interest rates and loan terms, rather than anything as exotic as sharing proceeds with the government, says Paul Leonard, lobbyist for the Financial Services Roundtable’s Housing Policy Council, a trade group for large lenders and servicers.

“They’re just more complicated factors that everyone has to agree to,” including the borrower, lender, servicer and investor, Leonard says. “That’s the greatest challenge.”

For its part, the department of Housing and Urban Development says that Hope for Homeowners failed partially because of rules specific to the program when it was created, including the requirement that homeowners pay abnormally high insurance premiums.

More fundamental to the concept of shared appreciation mortgages, many homeowners didn’t like the fact that the program might cost them more than it was worth. For example, suppose a homeowner obtains a new mortgage that is $20,000 cheaper than the original, Meg Burns, a HUD staff member, told Congress in 2009. But then say the house value jumps by $70,000 over the next 20 years, which means paying the government half the increase, or $35,000.

That means the homeowner loses out on $15,000.

“(W)e have heard an outcry from many, many counselors and consumer advocates that they cannot, in good conscience, recommend the program to struggling homeowners because the immediate and future cost to consumers is simply too high,” Burns said in her testimony.

All of these problems could be easily overcome, Caplin counters, if Congress and regulators got serious about making shared appreciation mortgages as an option for consumers.

“Name one competently run program of loan modification,” Caplin says. “The federal government has been clueless.”

Are We Insane?

Supporters take the argument for shared appreciation mortgages one step further. Instead of a short-term tool to kickstart the housing markets, Caplin and others believe SAMs could be a long-term solution to what they see as the fundamental craziness in America’s dominant mortgage system.

“It’s insane,” he says. “You can’t lend 97% of the value of an asset that you don’t understand. No other country does that.”

At the heart of the insanity, as Caplin sees it, is the 30-year fixed-rate mortgage, usually with downpayments of less than 20%. Such loans became the norm in the U.S. after the Great Depression, helped by government policies that subsidize home buying, such as the mortgage interest tax deduction, and by government-created companies like Fannie Mae and Freddie Mac, which popularized the sale of mortgages to investors, freeing up capital to be immediately reinvested in the form of new loans.

In the process, the 30-year mortgage became a keystone of the American economy. It created demand not just for home builders, appliance manufacturers and carmakers, but also for armies of Wall Street traders angling for ways to slice and sell different combinations of mortgage-related products.

The only problem, Caplin says: It’s all hogwash. There’s no way a bank can possibly guarantee in 2011 that a homeowner will be able to pay her mortgage through 2041. And unlike commercial property loans, which have clauses for unforeseen events like bankruptcy and industry downturns, residential mortgages assume the homeowners will pay no matter what financial disasters arise.

“Think about how ridiculous the 30-year mortgage contract is. I promise unconditionally to pay, regardless of what happens,” Caplin says. “Well of course I’m not going to pay regardless of what happens! What about recessions and job losses?”

What’s more, downpayments below 20% of the house value are crazy, too, Caplin believes. Given the risk of default over the 30-year life of modern mortgages, even a loan with a 20% downpayment “is inherently risky,” says Joe Mason, a professor of banking at Louisiana State University.

Some consumer advocates disagree. When structured properly, loans with low downpayments perform just as well as high-downpayment loans, according to research by the Center for Responsible Lending. The mortgage crisis wasn’t caused by loans to low-income people with low downpayments and 30-year fixed-rate mortgages, says Kathleen Day, the center’s spokeswoman.

“It’s simply not true” that 30-year mortgages hurt homeowners and caused the meltdown, says Barry Zigas, director of housing policy at the Consumer Federation of America. “The mortgages that were the leading edge of this crisis were subprime, pick-a-pay, ARMs, reverse ARMs, all sorts of features that contribute to terrible performance.”

Given years of horrible mortgages that drove the U.S. economy over a cliff, consumers may be ready for a change. According to a survey of consumers featured in a study published by Fannie Mae in 2007, 84% of renters said they would be “highly” or “somewhat” likely to consider a shared appreciation mortgage. Among people who already own homes, 65% said they would consider such a loan.

The Word “Kafka-esque” Seems to Apply

It all seems so elegant, so…obvious. So why haven’t banks embraced the shared appreciation mortgage? Enter IRS Ruling 83-31. The problem for the tax agency is that a SAM presents a tricky tax question because it involves debt and equity simultaneously, Caplin says. Rather than tease out the different tax burdens that might befall borrowers, lenders and investors in a SAM, the IRS decided to table the issue permanently by placing SAMs on its “no-rulings” list, thereby barring future generations of tax bureaucrats from even considering how SAMs should be taxed.

“They refuse to issue tax opinions on SAMs, so if your bank launches one, you have to tell your investors, ‘I have no idea what I’m selling to you,'” Caplin says.

We called the IRS numerous times to ask for an explanation of why shared appreciation mortgages are being held in regulatory limbo, and whether they may escape it anytime soon. Anthony Burke, an agency spokesman, said he woud get back to us. He never did.

The Obama administration has the power to change the rule immediately, moving SAMs off the IRS no-rulings list and forcing the agency to answer the question of how SAMs would be taxed. We called and emailed the White House Council of Economic Advisors multiple times to ask whether this might be possible, but never received a response. Both Mason and Caplin doubt it will happen.

“That’s nothing the administration can’t do with a pretty simple change to the tax code,” Mason says. Nevertheless, “I don’t see the discussion of how to help existing homeowners changing anytime soon.”

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Agreement on a Limited Role

Caplin has ambitious goals for shared appreciation mortgages. He believes they could someday replace the 30-year, fixed-rate mortgage as America’s favorite type of home loan. By giving both lenders and borrowers a stake in the outcome of the mortgage, SAMs could reduce risky bets by both sides, stopping the next cycle of real estate boom-and-bust before it even starts.

“We’re this far into the crisis and it’s still okay to lend 96.5% in pure debt? No questions asked?” Caplin says. “Anybody who understands economics knows that housing shouldn’t be all debt.”

Some consumer advocates aren’t willing to go quite so far. To argue that SAMs could take the place of traditional mortgages, “frankly the history of the mortgage market in the last 75 years simply does not bear that out,” Zigas says.

But both sides agree: the mortgage market remains stuck in recession. Shared Appreciation Mortgages could be one effective tool for getting it moving again.

“The fantasy that these mortgages are going to recover is wrong,” Caplin says. “You’ve got to do rather large write-downs of principal. It’s the perfect way to start this market back.”