Homeowner’s Rescue and Economic Recovery Plan by Carlton Cunningham

Carlton Cunningham is a Housing Developer and a Financial Analyst in Jamaica. He is

currently pursuing the Development of Secondary Mortgages as a means of expanding Jamaica’s
housing supply.

How to give to Main Street the same treatment as Wall Street and get better returns:

The Wall Street TARP package is $700B, financed by the American taxpayer. It has been
justified by the Treasury by its intent to free Wall Street from losses on bad loans by removing
them from their balance sheets and to enable the banks to start lending again. Economic
Armageddon should have been averted. Disbursements of $335b from the approved funds have
gone directly to participating banks as increased reserves, without preconditions for their use,
while the Fed has taken non-voting cumulative preference shares in exchange, in expectation that
increased lending will follow. Interest rates have been lowered to further encourage lending.
Additionally, $600b has been committed to purchase some toxic mortgage backed securities.
Fundamentally, however, the TARP has been abandoned because of inability to value derivative
portfolios while the value of their underlying primary mortgage assets is uncertain.

Increased lending has not occurred and has demonstrated that the banks’ unwillingness to lend,
leading to systemic liquidity shortage, derives only initially from the immediate impact of
defaulted primary mortgages (whether; prime, alt-a, or sub-prime) and is fundamentally related
to banks’ fear of over exposure to liabilities such as increased margin calls arising from falling
value of leveraged products in the much larger ($53 Trillion derivatives vs $12 Trillion in
mortgages) derivatives market, or to fear of declining real product and investment demand
elsewhere. Consequently, money supply and the economy have contracted, with house prices
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spiraling downward despite successive decreases in mortgage and other lending rates.

Copyright © Carlton Cunningham & Associates January 2009

Policy should focus upon a method to create adequate primary housing demand as a means of
automatically revaluing secondary mortgage assets and thereby increase liquidity. Banks with
residual liquidity issues will be those whose lending has been skewed to high risk, excessively
leveraged products and should be allowed to fail or to surrender to state control if they are too
big to fail.

Rather than relying upon the mechanics of money creation through increased reserves, which is
the policy implemented in disbursing the first TARP tranche, uncertainty regarding the value of
mortgage assets, the main reason for bankers’ reluctance to lend, should be addressed. The
method hereby proposed is that defaulted primary mortgages must be converted to prime
mortgages or to equivalent security, with certain value. Banks, and other financial intermediaries,
will then be able to reset the value of primary mortgages and in turn revaluation of derivatives
will follow. Banks will thereafter be able to lend in response to expansionary monetary stimuli
because loan loss provisions for anticipated primary and secondary mortgage liabilities will be
reduced to normal. The balance of TARP funds should be dedicated to this end, leaving those
banks with a preponderance of other troubled assets, such as credit default swaps, the option of
nationalization or bankruptcy dependent upon the Fed’s assessment of their economic
importance.

Stabilizing the Primary Market

The laissez-faire premise that the housing market will naturally correct itself with more credit
worthy purchasers replacing less capable ones is untenable in a generally receding economy,
where three trillion dollars in distressed housing accounts exist, since the interplay between
primary and secondary markets and between those markets and the bank’s liquidity demand
simultaneous, and macro-economic rather than micro-economic solutions. Foreclosure will hurt
Main Street – the mortgagors who may be kicked onto the street. It will also hurt the banks
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which could get few returns in a fire sale, and would witness a collapse in value of their
leveraged products, if they receive possibly as little as twenty cents on the dollar. Additionally,

Copyright © Carlton Cunningham & Associates January 2009

if houses are vacated, they will rapidly deteriorate. So, how do we get Main Street to stay in the
house, while minimizing the Fed’s involvement, and give the Investor a satisfactory return?

Add Investor demand to householder primary housing demand, with the Fed taking the position
of temporary lead Investor. The proposed vehicle to achieve this objective, most efficiently, is
Shared Equity, meaning sharing the risks, responsibilities and rewards arising from the crisis of
deficient primary housing demand, between the Mortgagor, the Fed and the Financial Markets.
Unlike the housing and economic recovery act 2008, this proposal would be universally applied
to defaulted mortgages, but would not require banks to take “deep discounts” in loan balances
(which contracts money supply), cited in the published summary of the Act, as the vehicle
proposed is shared equity and shares incorporate the expected value of future returns in their
valuation, thus banks will reflect the expectation of future economic recovery in their balance
sheets.

Steps to Recovery

1. The homeowner will write a Prime Mortgage based upon the amount that his/her income can
realistically afford. Prepayments from increases in earned income, as may be revealed in annual tax
returns, should be mandatory for all participants in order to accelerate cash flows from the mortgage
pool. The homeowner will receive ordinary shares in the ownership of the house in the proportion
of the revised prime mortgage to the total value of the house or the loan whichever is greater. (Some
legislative changes to facilitate restructuring of loans are being considered by the new
Administration).

2. The difference between the prime mortgage and the outstanding loan balance, or the house price, will
be converted to cumulative preference shares which will be federally guaranteed. The banks will own
these shares, hypothecated to the Fed, and will earn an income from the Fed which will pay a fixed
dividend on the shares for an agreed period. The Fed will also guarantee the future price of the shares.
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The banks will then own prime mortgages and shares with certain value which will replace assets of
uncertain value currently owned.

Copyright © Carlton Cunningham & Associates January 2009

 2.1. Correspondingly, each bank would be entitled to the share of house value net of the prime
mortgaged householders’ ordinary shares. This share would be based upon the cumulative
dividend payment plus the guaranteed future purchase price of the shares. The shares owned
by the householder and the bank determine in a dynamic way the relative share of house
price appreciation to which each is entitled (See Caplin et al, FNMA, Shared Equity
Mortgages, Housing Affordability, and Homeownership” August,2007).

2.2. A crude estimate of the Fed’s liability is as follows. Total toxic primary mortgages,
$3Trillion. Rewritten Prime loans, $2.25Trillion (assuming average 75% prime
conversion rate). Preference Shares will then be $750 billion to maintain the value of
primary portfolios. Annual percent payout on cumulative preference shares, at 4%,
(guaranteed by the Fed, so the yield can be lower than a prime mortgage but be
comparable) $30 billion. For ten years, $300 billion. Ten years is chosen as a period
in which the USA economy can be reasonably forecast to complete the
transformation proposed by the Obama administration and in which house prices will
rebound.

2.3. If the average increase in house prices, for the ten year period, is 3% p.a. then the
appreciation of the portfolio will be a little more than $1 Trillion from which the Fed
would recover $300 billion and be entitled to a share of the remaining $700 billion.
The mechanics of the calculation of profit sharing need not be of immediate concern.

2.4. The Fed will assume some risk based upon the rate of recovery of house prices
which will impact the appreciation in home equity shares and their value at “sunset”
of the guarantee. But equally, the opportunity for gains in excess of 3% cumulative
house price appreciation also will exist. The Fed may wish to Hedge its position
using appropriate econometric models and include the cost of such insurance in its
recovery formula. 1

2.5. The Fed’s intervention will serve several purposes.

Copyright © Carlton Cunningham & Associates January 2009

 2.5.1. First, by recasting homeownership interests as shares, expected future values can be
reflected as assets on the banks’ balance sheets, which would in the current situation
comprise prime mortgage shares and guaranteed cumulative preference shares. This
innovation would replace the practice of writing down the value of defaulted loans,
with uncertain prospects of recovery.

2.5.2. A stabilized primary market will have an osmotic effect upon the mortgage backed
securities market by providing a predictable basis for valuation of numerous
derivatives (eg. interest only, principal only, credit enhancers) and credit tranches.

2.5.3. Loss provisions related to mortgages will return to normal, as primary housing
demand will have been increased by an amount (the guaranteed shares) which
counterbalances the current market deficiency. Therefore, mortgage backed
derivatives will be revalued with certainty, and lending may return to normal, except
for excessively leveraged portfolios (eg. Credit default swaps) and portfolios with
excessive consumer debt (junk), which the Fed will then be able to identify and
choose to support through loans, if institutions holding them are too big to fail,
accompanied by aggressive control of shareholding and management, as is
occurring in the UK (Selective Nationalization) and several other European
countries, or simply let fail and allow winners to absorb losers (Financial
Darwinism).

2.5.4. Normal open market operations may then achieve the objective of increasing output
and employment by shifting the economists’ “LM” curve to the right while
simultaneously increasing Government Expenditure (“IS” curve shifts to the right)
through massive infrastructure works, the approach which is identified with Paul
Krugman in his work on the Japanese economy, 1992-2004, as the optimal recovery
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policy when encountering a “ liquidity trap” and which is evident in the $825
billion spending package currently before Congress.

Copyright © Carlton Cunningham & Associates January 2009

3. So, Main Street will receive comparable treatment to Wall Street – since responsibility for
bad debt will be removed from Main Street home owners’ balance sheet, just as for Wall
Street – so he/she can start working again. By contrast, simply allowing Main Street to
remain in the house, saddled with a debt he /she cannot afford, even if payments are deferred,
creates moral hazard as he/she will be motivated to abandon the debt and the house, while the
money market remains paralyzed by the expected outcome of further massive foreclosures,
and by ineffective, specious, financial support programmes (see bibliog.#5, below).

4. The measures proposed to deal with the specific situation leads to some more general
observations.
4.1. The Great Depression led to the introduction (New Deal) in the USA of the 20 – 30
year Fixed Rate Mortgage (FRM) which greatly improved access to housing, by
substituting long-term low interest loans, supported by the Federal Housing Authority,
for short term (5-7 years), annually negotiated Adjustable Rate Mortgages (ARM). This
innovation, coupled with the subsequent development of a secondary mortgage market
(viz. FNMA 1954+ and other Government Sponsored Enterprises) again sponsored by
the Federal Government, has underpinned the extraordinary statistic whereby mortgage
loans outstanding represent 80% GDP compared with Europe 42%. (see bibliog.# 7,
Wachter & Green, Illus. from European Mortgage Federation, Federal Reserve System,
Dubel). Similar results have been achieved in emerging markets which have liberalized
and employed some form of securitization or mortgage liquidity facility (World Bank, 30
Years of Shelter Lending, Ch.4). Consequently, the housing market and the mortgage
liquidity facilitated by securitization has been pivotal to US growth and development,
especially over the last 30 years, in face of weakened international competitiveness of all
but its hi-tech products, a fact which may be easily forgotten in the current debacle.
Housing is an industry with domestic competitive advantage.
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Copyright © Carlton Cunningham & Associates January 2009

 4.2. In addressing the Great Recession, which now confronts the US and the rest of the
world, while improved regulation is required, further financial innovation is needed to
correct the anachronism, rooted in pre - New Deal short term (5-7year) ARMs. These
required balloon payments at their expiry just when banks may have become illiquid,
thereby ensuring that defaulted home loans had to be written down on the banks’ balance
sheets, the assets foreclosed and “marked to market” under adverse conditions. This
practice gave rise then to liquidity contracting loan loss provisions and continues to do
so now, even when the FRM has superseded the short term ARM, at precisely the time
when expanded money supplies are required. The idea of mortgaged ordinary shares,
linked to purchasers’ incomes and with repayment spread over a 30 year FRM, coupled
with cumulative preference shares directly owned by the market, whether Wall St. or a
pool of more affluent friends and neighbours, provides a shock absorber by adding
investor’s to householder’s demand, using instruments which include expected future
income.

4.3. The structure of the investment in housing should therefore be altered. The deed of
homeownership that should be promoted is equity shares, and it is the equity shares that
should become collateral for loans, in the same way that pass through securities permit
investors to acquire shares in a pool of mortgages. The homeowner and lender should
have similar flexibility in acquiring or disposing of their interests in property at the
primary level as occurs in the secondary market.

4.4. In the event of default it is the shares, in whole or in part, that should be acquired subject
to clear rules of acquisition and valuation. To illustrate – when John Public, engineer,
loses his hi-tech job and takes a 30% pay cut, his mortgaged ,shares can be reduced by
30% to create a lower prime mortgage amount, with the requirement to repurchase the
percentage of shares conceded when his situation improves and over a mutually agreed
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period. If he/she has no job prospects then all of his/her shares will regrettably be
conceded and sold, possibly acquired by a Homeowners Trust or other special purpose

Copyright © Carlton Cunningham & Associates January 2009

 vehicle (SPV) to maintain mortgage payments. He/she may rent from the SPV which
would function as the social safety net for the large number of unemployed persons
temporarily displaced as the economy restructures.

4.5. Meanwhile, upon acquisition of a portion of John Public’s shares, the bank will be able
to book them at par or at an appropriate discount and may hold or resell them. The
systemic shock will be restricted to the possible % reduction in the value of the prime
mortgaged shares acquired, in order to liquidate them. This reduction in share value will
be less than will occur under foreclosure since the value of shares includes their
expected future earnings, as opposed to “marking to current market value” of a
distressed asset. Also, the necessity to auction the house, with its attendant costs and
trauma, will be avoided.

4.6. The valuation of the bank’s shares will be subject to regulation to prevent accounting
abuse.

4.7. Interests in the house will become liquid and may better serve John Public for purposes
of residence or investment and will improve the operation of financial markets.

5. In respect of volatility of house prices it should be recalled that it is sustained attention to

demand side initiatives, some legitimate, some fraudulent, and the consequence of poor
oversight– over thirty years – that has driven the real estate bubble. Insufficient attention
was paid to supply side initiatives to release new lands for development or to increase
densities, and it is this which has created Economic Rents which are now being corrected.
Post-2008 housing policies should be developed to maintain real estate prices more or less in
line with replacement costs by sustaining supply in line with demographic and income trends.
In this way sustainable housing expansion will become normal, be real rather than primarily 1
the result of inflation, and “housing bubbles” less likely.

Copyright © Carlton Cunningham & Associates January 2009

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Copyright © Carlton Cunningham & Associates January 2009

Selected Bibliography

1. Bernanke – Housing and Economic Recovery Act 2008

2. Caplin et al, FNMA – Shared Equity Mortgages, Housing Affordability and

Homeownership

3. Fabozzi – Mortgage Backed Securities

4. Figlewski – A Silver Bullet for Toxic Mortgage-Backed Securities

5. Hugh’s List # 87, Sub-prime mortgage bubble

6. Hull – Futures, Options and Other Derivatives

7. Wachter and Green – Housing Finance Revolution

8. World Bank “Thirty Years of Shelter Lending”

Copyright © Carlton Cunningham & Associates January 2009