Derivatives traders fueled the overlending of the housing boom by demanding huge volumes of mortgage-backed securities and their offshoots, few questions asked. But that doesn’t mean derivatives are all bad. In fact, a leading designer of derivatives has come up with a plan that he says would actually protect homeowners from the market’s crazy swings. And he may even be right.
The inventor is Ralph Y. Liu, a Taiwanese-born American entrepreneur in Corona, Calif. Liu worked on Wall Street for years, and most recently pioneered the first yuan-denominated interest-rate swap for domestic Chinese banks, which is a big deal. (Here’s a link to a Wall Street Journal story about that exploit.) The point is, Liu is the real thing.
Liu’s idea is to create derivatives that would let people continue to live in their houses, and keep legal ownership to them, without being exposed to fluctuations in the home’s value. He sees two sets of customers:
--Poor people who are in danger of losing their homes because they can't pay the mortgage could offer to surrender the upside potential in the home's price. An investor who wanted to gamble that the house will rise in value would pay a certain monthly amount to the homeowner, who would then be able to afford the mortgage.
--Rich people who want to be protected against the risk that the value of their homes will fall. These people, who presumably have the spare cash to buy a kind of price insurance, would pay a certain monthly amount to an investor (aka speculator), who would take on the risk of a decline in the house's value.
You could also buy a product that would work both ways--taking away your upside potential while simultaneously taking away your downside risk. The beauty? You'd still have legal title to the house, and when the contract expires after one, two, five years or more, everything would go back to the status quo ante.
I spent more than two hours on the phone with Mr. Liu to figure this one out, so I'm just scratching the surface here. For more, check out SwapRent.com.
The closest thing to Liu's SwapRent is a sale-leaseback arrangement. That's where you sell your house and then lease it back from your new landlord, with an option to repurchase it later. But in a sale-leaseback you actually lose title to the property. Sale-leasebacks have been used fraudulently in "foreclosure rescue" scams where the scammers boot out the previous owners and resell the house, grabbing whatever equity they can. That's not an issue with Liu's SwapRent.
Another cousin of SwapRent is the shared-appreciation mortgage, which has run into bad publicity in Britain. There, the homeowner gets a lower rate on a mortgage loan in return for giving the lender a portion of the appreciation on the home when it's sold. Trouble is, if you give up too much of the appreciation, and housing prices have shot up, you don't have enough cash left after the sale to buy another house.
Liu hasn't completely solved that sticky problem. Let's say you agree to give up the entire upside on your house. Under Liu's system, if the value goes up by $200,000 by the end of the contract, then your bank will pay $200,000 to the investor and simultaneously increase your indebtedness by the same amount. That means your monthly payments go up. If you can't afford them, you could end up losing the house. Then again, if you did this deal in the first place, it's because you feared losing the house earlier anyway.
You might be wondering who decides how much value the house has gained or lost when it comes time to settle the contract. Liu wants to base the house's change in value on the movement of a price index, such as those developed by S&P Case-Shiller, or Radar Logic, or Dataquick. Advantages: No bickering over appraisals. And no "moral hazard"--i.e., the risk that someone who was fully protected against a decline in appraised value would let the property go to hell or do bizarre paint jobs and renovations that would repel potential buyers. Disadvantage of an index-based approach: If your property falls in value more than that of the city index, and you bought downside protection, you're out of luck.
Liu has tirelessly sought support from lawmakers, regulators, and investment bankers for his concept. He says several bankers have told him they're interested but don't want to be the first to move. Says Liu: "Nobody wants to stick their necks out." On the positive side, lawmakers and regulators are eager for new ideas to cope with the coming deluge of delinquencies and foreclosures. In August, Federal Reserve Chairman Ben Bernanke wrote to New York Sen. Charles Schumer endorsing new ideas for mortgages, including shared-appreciation loans, of which SwapRent is a new variant.