Solving the Subprime Mess with "Negative Equity Certificates"

The Office of Thrift Supervision (part of the U.S. Department of Treasury) is considering a proposed solution to the subprime mortgage mess using so-called "negative equity certificates." It's a plan that would aid homeowners who owe more on their mortgages than their homes are currently worth - 10 percent of all U.S. homeowners, according to the Financial Times - while at the same time helping lenders that underwrote those same mortgages.

"We want to avoid having people walk away from their homes," Kevin Petrasic, an OTS spokesman, told the Washington Post.

Let me illustrate how this proposal would work. Let's say someone bought a home for US$250,000 and took out a loan for US$240,000 from Bank ABC (paying the rest in cash), but has since seen the value of the home drop to U$200,000. The homeowner now has US$40,000 in "negative equity."

Under the plan, the homeowner would be able to refinance the mortgage with the U.S. Federal Housing Administration, based on the current value of the home. So instead of a US$240,000 mortgage, he would now have a US$198,000 mortgage (we're assuming US$2,000 was paid in cash).

The FHA would buy the US$240,000 loan from Bank ABC, giving it US$200,000 and a "negative equity certificate" for the remaining US$40,000. Were the homeowner to eventually sell the home, the FHA loan would be paid off first, then the original lender, up to the value of the certificate. Any money left over would go to the homeowner.

The homeowner wins because he is now paying down a smaller debt and - if interest rates are the same or lower than when he first bought the home - he also has lower monthly payments.

Bank ABC wins because it gets most of the money back from the original loan and may still recover the rest. This is far better than the borrower walking away from the now-onerous original mortgage, as a growing number of homeowners are currently doing.

"It beats foreclosure," Jaret Seiberg, an analyst at Stanford Policy Research, told the Washington Post.

This will help lenders limit their losses and avoid an "avalanche of borrowers who choose to walk away from the mortgage," Scott Polakoff, the OTS senior deputy director, told Bloomberg News.

The "negative equity certificates" would be tradable, and creators of the proposal anticipate there would be a market for them. Initially the certificates would be worth pennies on the dollar, but as the housing market recovers and home values rise, so too would the value of these certificates.

How does this help solve the subprime mess? It affixes a known value to mortgages that are in the greatest danger of going into default.

Huge investment vehicles have been built around such risky mortgages, and because no one knows what they're really worth (their value will keep declining as long as home values fall), financial institutions around the world are facing hundreds of billions of U.S. dollars in potential losses.

Even if these mortgages end up being worth 83 percent of their face value (as in the example above), it at least has a known value. And with "negative equity certificates," there's also a chance the mortgages could end up being worth more.

The White House and members Congress have yet to comment on the proposal.

"We have got some good initial indications of interest and we are just hoping for this to be part of the solution," an OTS spokesman told the Financial Times.