We’re about to see something new in the mortgage marketplace: The government is going to insure huge numbers of shared-appreciation mortgages, a type of home financing rarely seen in the U.S. It’s a big experiment and it raises a bigger question: Is this the loan of the future?
The just-passed Housing and Economic Recovery Act includes provisions that will help some 400,000 families replace toxic loans with FHA financing. That’s the good part. The hook is this: Under the FHA reform measure borrowers and lenders who take advantage of the HOPE for Homeowners program will face stiff fees and big costs.
Usually you would look at the fees and charges associated with the HOPE program and think, well, yuck. But for those with toxic loans, a high-cost mortgage with sane terms is better than foreclosure, bankruptcy and having your stuff sitting on the curb.
During the past few months there has been a huge debate in Washington regarding how to assist those with toxic loans, assuming they should get any assistance at all. Under the FHA reform package the answer is the Hope for Homeowners program, an effort which has nothing to do with the similarly-named “Hope Now” project sponsored by the private sector.
The Black Lung Benefits Revenue Act of 1981 created a new way to own and invest in real estate: Equity sharing. Under equity sharing there can be an owner-occupant who lives on the property, a non-occupant owner such as a family member or investor and both owners can get tax breaks.
If property values go up with equity sharing both owners profit. If property values fall then the owners split the losses in accordance with their ownership percentage.
The HOPE loans also have a “sharing” provision, but it’s not equity sharing. Instead, in exchange for FHA mortgage insurance, HOPE borrowers must agree to appreciation sharing, a concept which works much differently.
Under the HOPE program borrowers share appreciation with Uncle Sam. If the property is sold in the first year of the loan then the government gets 100 percent of any value increase. In year two the percentage drops to 90 percent and if there’s a sale in year three the government gets 80 percent. In year four the government’s share drops to 60 percent and in year five and thereafter — even if “thereafter” is 20 years from now — Uncle Sam gets half of any appreciation.
The use of appreciation sharing is supposed to prevent speculators from buying property with FHA loans. However — and not incidentally — appreciation sharing could also provide the government with billions of dollars in new revenues.
So what’s the difference between equity sharing and appreciation sharing? Unlike equity sharing, with appreciation sharing if the property’s value goes down Uncle Sam or an investor is not responsible for any part of the loss.
“If we’re going to restore home values nationwide then we need to get more buyers into the marketplace,” says James J. Saccacio, chief executive officer at RealtyTrac.com, the leading online marketplace for foreclosure properties. “If we tighten mortgage standards so that only those with great credit can buy homes we won’t have enough purchasers to clear the inventory of foreclosed properties now on-hand or to stabilize home prices.”
Saccacio explains that “we have to enable purchasers with less-than-perfect credit to buy homes. Right now the subprime and the ALT-A markets are frozen. If investors are interested in mortgages at all, they’re willing to buy securities backed by prime loans and little else.
“You can understand the investor’s perspective, but the other side of the equation is this: Restoring the real estate market means restoring all of it. We need financing for entry-level borrowers, we need mortgages for those who have a 640 credit score and not just 740 and we need to assure that people who have suffered from hard times have a way back into homeownership.”
“The FHA,” says Saccacio, “re-started the housing market in the 1930s by popularizing a new concept, the long-term loan. Private-sector lenders soon introduced their own long-term products to replace the five-year ‘term’ mortgages they had been selling. In a similar sense, there’s no reason why lenders today could not once-again borrow an idea the FHA is going to promote and popularize.”
What would it take to get investors back into the mortgage marketplace? Interest, by itself, is not attractive because higher rates also mean steeper monthly payments and more risk. This is what we’ve seen with the so-called “affordability” mortgages of the past few years, loans with low monthly costs at first and then sudden and substantial increases when “start” periods end.
But interest is not the only way that investors can profit. In fact, investors don’t actually have to charge interest to benefit from a loan. In many areas of the world interest is not considered acceptable or fair, instead lenders make real estate loans and then share in the profits — and also in any losses.
What’s really happening with appreciation sharing is that risk is first being reduced and then being pushed to the end of the loan term.
Risk is reduced by requiring fully-documented loan applications, limiting payment increases when ARMs first re-set and banning prepayment penalties. With such policies delinquencies and foreclosures are reduced, meaning less risk for lenders and investors. Investors bet that they will collect big at the end of the loan term when the home is sold and there’s cash at closing.
Does the FHA approach work? In June the headline from a Mortgage Bankers Association news release said that “Delinquencies and Foreclosures Increase in Latest MBA National Delinquency Survey.” Despite the headline, the release showed that FHA foreclosure starts had actually declined.
In the U.S. and in much of the western world, charging interest is largely the norm. However it’s entirely possible to construct a mortgage which combines both interest and appreciation sharing.
The HOPE model anticipates that loans will be made to borrowers who have no choice: Their options are either foreclosure or a HOPE mortgage. Given such a strong position, the FHA can make outsized demands for appreciation.
Private-sector lenders don’t have such leverage. Instead, one can envision a system which relates credit scores and loan risk to appreciation sharing. For instance, in addition to interest a borrower with 740 credit score would not share any appreciation, at 660 a borrower might give up 10 percent while someone with a 580 credit score might give up a 35 percent.
The interest rates and appreciation percentages would be negotiable. One lender might want a 15 percent share for home buyers with a 620 credit score while another lender might want 10 percent. Both lenders might want a10-percent appreciation increase if the purchaser is an investor. A borrower might find 6 percent financing with a 15 percent appreciation kicker, or a 6.5 percent rate with a 10 percent appreciation claim. Competition — and informed borrowers — would hold down appreciation sharing percentages.
The purpose of appreciation-sharing would be to re-start the mortgage marketplace. At first one might expect high appreciation requirements, however, as housing recovers more investors would come into the marketplace thus forcing down percentages.
“Appreciation sharing is certainly not a financing model that is either cheap or risk free,” says Sacaccio. “But in an environment where mortgages for those with imperfect credit has largely closed down, the HOPE approach may be one way to re-start the marketplace.”
Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.