The New Sharing Economy Coming to Mortgages
What are the risks?
The sharing economy has taken over – from Uber to Airbnb and now your mortgage. Are you ready to be part of the new "shared" economy? There is a new product that is backed by many Silicon Valley venture funds that allows people to partner with a fund to purchase a home. The new product is termed "shared equity." The marketing folks are doing a great job … who wouldn't want to share with a Silicon Valley venture fund?
WHAT IS THE PRODUCT?
A homeowner partners with a fund to purchase a house. The fund puts half down and the borrower puts down the other half. For example, if a person only had a $50,000 down payment this would limit them to a $250,000 home assuming a 20 percent down payment. With the partnership, the fund would put up the additional $50,000 for a stake in the house so now the homeowner could buy double the house. For example, now with $100,000 to put down, the borrower could buy a $500,000 home.
WHY DOES SOMEONE NEED THIS PRODUCT?
Homeowners need this product since they don't have the additional capital to put down. This will be especially prevalent in higher cost areas where median home prices are high. For example, if someone were buying a home in Boulder, where the median price is $1 million, the borrower might only have $100,000 in cash and could partner with a fund for the additional $100,000.
HOW DOES IT WORK?
The devil is always in the details. If you partner with a fund they have an equity stake (ownership interest) in your house. How the fund makes money is on the future appreciation. For example, let's say a homeowner wanted to buy a $500,000 home, the homeowner would put down $50,000 and the fund would put down $50,000. Let's say three years later, the house sold for $600,000. For simplistic purposes assume that the loan amount was still $400,000 (the loan amount will be less but kept constant to simplify this example). The sales price is $600,000 minus $400,000 mortgage leaves $200,000 equity. The homeowner an the fund would each get back their $50,000 leaving $100,000 profit, the homeowner would get $65,000 and the fund would get $35,000.
This sounds great but what happens when the numbers aren't so rosy?
WHAT HAPPENS WHEN VALUES DECLINE?
Anyone who has been around real estate for more than 10 years has first-hand experience of what happens when prices go down. It wasn't pretty. We all know that real estate, or any asset, never moves in a straight line. There are ups and downs along the way. What happens under this scenario when prices go down.
Let's do two scenarios:
1. MINOR CORRECTION PRICES DECLINE 15 PERCENT:
Let's use the same scenario above and assume there is a minor correction and prices fall 15 percent. In this scenario, the sales price of the property would be $425,000. There would be a $75,000 loss in equity. The homeowner would share in the $75,000 loss with the company so the mortgage company would get $400,000, the fund would get $26,250 (35 percent of the $75,000 loss). The homeowner would lose her $50,000 they initially put in and be on the hook to pay the fund $1,250 ($26,250 to $25,000) (net after mortgage paid off).
1. ACTUAL CORRECTION LIKE THE LAST DOWNTURN 30 PERCENT:
In many locations, prices fell considerably more than 30 percent, but assume a 30 percent decline, which is plausible in many markets. With a 30 percent decline the sales price would be $350,000. This is where things get interesting. Assume the mortgage is still $400,000, the lender would take a $50,000 hit. Under this scenario, the total loss is $150,000, the fund likely will try to recoup their $50,000 from the homeowner. In essence, the lender would take a hit, the homeowner would lose all equity, and the fund would be left with nothing (other than possibly a claim against the homeowner for the loss which is basically worthless).
WHAT ARE THE RISKS?
The primary risk is that the risk itself is bifurcated (split) among various parties. In a traditional loan a homeowner has 20 percent at risk typically. The homeowner will be above breakeven as long as prices don't drop more than 20 percent or so. In the last crisis, many homeowners walked away when their mortgage was underwater. With putting only 10 percent down, this is a much greater probability of someone walking away, when there is a price correction since the homeowners have less skin in the game. From the last recession we found that loan to value was the number one determinant of loan performance. As long to value increases the probability of default increases. Below, I highlighted the risks to each of the five stakeholders:
1. PRIMARY LENDERS
The primary lender on the property is at heightened risk for default. Instead of having 20 percent skin in the game, the homeowner only has 10 percent. This is considered a subprime loan, but not priced/underwritten as a subprime mortgage.
The homeowner is basically using more leverage. At the end of the day, they are stretching on a property that they might not be able to afford. Furthermore, if there is a loss, they are on the hook to reimburse the fund for the loss which would wipe out their entire equity position in many cases.
3. HEDGE FUND
The funds promoting this product are going to take huge hits when the market turns. The model works great in an up market, but when the real estate market corrects, they will lose 100 percent of their principle since trying to recoup the loss from a consumer that just lost all their equity and their house will be fruitless.
4. MORTGAGE NOTE BUYERS
Just like many other financial transactions, there is no doubt that this financial arrangement will be sliced and diced. It is basically a future cash flow that can be sold in various strips. The buyers of these securities could take large hits down the road.
5. YOU THE TAXPAYER
Fannie Mae/Freddie Mac, the government insurers of mortgages announced that they will buy mortgage notes that have been originated with shared equity. This ultimately means the federal government and you the taxpayer will be on the hook for much of the losses.
THIS IS A BAD IDEA
Did we not learn anything from the last real estate crisis? Prices do not always go up. The equity sharing arrangement will be catastrophic in a down market. Not only will homeowners be impacted but taxpayers and fund owners. The equity sharing is basically a sub-prime loan in disguise; the results will be the same when the market turns. The only sharing from this program will be the huge losses shared by homeowners, lenders and taxpayers.