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RISMEDIA, December 17, 2009—With the recently released FHA actuarial review and the much earlier conservatorships of Fannie Mae and Freddie Mac, it is clearly evident that new approaches to availing capital into the housing market are both needed and necessary. The FHA and GSEs have been hemorrhaging as a result of the softened economy, with increasing levels of unemployment and underemployment, as well as the correction in housing price levels. Lending institutions that are currently originating mortgages are doing so only with further government guarantees, continuing to lay the risk upon the government and ultimately the U.S. taxpayer.

While the agencies play a critical role in supporting housing in the U.S., the Treasury Department can only buoy these entities so far, even though certain factions believe it can continue ad infinitum. We now find the U.S. taxpayer standing behind over $7 trillion of mortgage risk on highly volatile and weakened portfolios, with little return to speak of. Specifically, in financial circles, the taker of risk generally receives an appropriate return based on the level of risk assumed. Here we have, unfortunately, excessive risk being assumed (by the U.S. taxpayer) without the concomitant opportunity to yield a proper return on the exposure. The value proposition here is highly questionable.

Further, the role of the guarantors has created an environment of lack of accountability among mortgage originators. Being compensated for packaging and offloading the risk is equally as egregious as taking all the risk but without due compensation. The highly leveraged nature of lending institutions, including federal agencies, does not allow them to take significant risk of loss, thus they pass it on to taxpayers. The current system is in great need of an overhaul.

For perspective, the use of excessive levels of long term debt to facilitate home purchases dates back to the New Deal and the creation of the FHA, and subsequently the GSEs. The premise at the time (which has continued at least through 2007) was that the asset financed (i.e., the home) was not considered a volatile asset, i.e., subject to price fluctuations, and as such, lenders felt lending at high LTVs was prudent. It is now recognized that housing is a volatile asset and excessive leverage can impact borrower and lender alike, as well as those who are willing to take the ultimate risk through guarantees. Additionally, home equity represents the preponderance of a household’s net worth, and while leverage enabled the opportunity for wealth creation, it can also backfire, and recent market conditions have precipitated a significant wealth destruction which has affected U.S. and global economies. In sum, the systemic use of debt to support one of the largest components of U.S. GDP is undermining the overall financial health and stability of the U.S. economy, particularly, as the risk?return formula has been all but dismissed.

New Approaches Necessary
Prudent risk taking with the potential for a “risk?adjusted” return is a fundamental principle of finance. With higher levels of risk, like in venture capital, the return sought is considerably higher than, heretofore, purchasing a Treasury bill. Given the now identified and experienced risk in housing finance, through price volatility and the leveraging effect of high debt, we understand that the existing model need be refreshed.

The approach to debt laden financing within housing must evolve into a better risk?adjusted capital stack (read more equity), where risk is better allocated to those capable of taking it as long as there is an applicable return. Debt, generally risk averse, expects to be compensated at nominal levels, as the likelihood of recoupment is higher than equity based on its secured and/or priority claims, and current payments of cash.

Equity, the junior component of the capital stack, is willing to take the risk of investment diminution, as long as the return with success is commensurate with taking such risk. Housing finance needs to rethink the appropriate structure, given the identified risks, between the levels of debt and equity in order to create a more sound and sustainable homeownership profile.

Housing finance should subscribe to alternative risk?adjusted methods. A key method is equity sharing, a financing structure whereby third party equity is contributed to supplement down payment funds of the home buyer for a share of the ownership in the home. This results in an improved profile for the mortgage (and its guarantors’ risk) with a lower LTV and better debt serviceability. The homebuyer has a partner holding a similar objective of asset preservation and desired appreciation, while the incremental equity capital reduces the amount of overall borrowing, thereby reducing monthly payments and improving affordability.

A leading effort to enable equity sharing on a scaled basis is through PRIMARQ, a planned real estate equity exchange where accredited investors can invest alongside buyers and owners to assist in home acquisition as well as provide access to homeowner equity, without incremental borrowing. A paradigm shifting approach, the exchange will avail billions of dollars of “risk capital” to the housing market from domestic and foreign sources, reducing the demands and exposure of lending institutions and guaranteeing government agencies.

The PRIMARQ exchange will result in:
-Reduced dependency on excessive leveraging and improve the affordability gap;
-Provide private sector capital to assist home buying, refinancing and loan modification efforts;
-Create a liquid investment market for residential real estate, addressing the risk of a household’s housing?biased net worth;
-Provide for a more prudent lending environment for mortgage lenders to resume lending; and,
-Provide high quality research and data about housing values to assist in mortgage risk assessment and help facilitate housing policy.

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