Explaining Taleb – home equity for debt
July 15, 2009
Interesting article by Taleb. While I am not sure who gets credit for the idea, I have heard Andrew Caplin make this proposal. Caplin has made the argument that banks can swap interest for equity, thereby not so much making them landlords, but partners in the “business” of homeowning; that is to say, similar to when a corporate restructuring occurs: rather than pay bondholders 100 cents on the dollar, corporations will offer bondholders some form of equity ownership (typically senior to common equity, as in warrants or preferred stock) and new bonds, with lower interest rates and different maturities. So, if that framework is translated, homeowners (the corporation) would putatively offer the bank a deal to take an ownership share (say, 20%) and reduce the interest rate and/or term of the mortgage. The logic is that if enough homeowners are able to effect this restructuring (or banks are mandated to adopt this), an ostensible recovery will occur in home prices, thereby raising the value of the equity where both bank and homeowner gain value.
Of course, there are other fine details that would have to be clarified — such as triggers (e.g. corporate debt restructurings offer have a trigger to swap back to new debt securities if the company’s equity reaches a set target — so, in order for banks to monetize their ownership of the equity in these homes, they would have to offer some form of refinancing in toto, taking out their equity and reverting back to traditional mortgages; this seems to me to be both the problem and potential of the idea — that is, it solves the short-term problem of foreclosures, while setting up an apparatus that will produce new forms of securitization, default insurance, refinancing packages, and so on that will not so much disrupt the form of home ownership, but refashion it in newer forms of capital distributions).
Here is an excerpt from Caplin’s proposal and here is the link to several other pieces by Caplin addressing the issue.
The form of the renegotiation of under water mortgages that we propose involves debt for equity swaps. Such swaps are common in the corporate sector: for example the recent recapitalization of GMAC and many other lending institutions is based on debt holders agreeing to swap debt for equity in the newly re-organized firm. The rationalization of such a swap is that it replaces the fixed obligation of the debt contract with the more flexible obligation of the equity contract, in which the amount of the ultimate repayment depends on how well the business does. Economic logic dictates that similar forms of debt for equity swap be made available for households that find themselves thrust into problems by forces largely beyond their control. Unfortunately, the institutional realities have hitherto prevented such swaps from being undertaken.
We present a five part plan of action to overcome barriers to rational equity-based renegotiation of existing mortgage contracts. The first stage involves regulators and legislators specifying terms of debt for equity swaps. The second involves their creating an appropriate fiscal and accounting framework. The third involves their setting up projects to demonstrate the economic viability of debt for equity swaps. The fourth involves addressing legal obstacles posed by securitization. The fifth involves the simplification of secondary default for borrowers who swap debt for equity.
Some critical advantages of the plan are:
* It aligns the interests of lenders and borrowers, in that they share costs associated with the fall in house prices, and potential gains associated with their recovery.
* It avoids creating incentives for default or delinquency.
* It respects borrowers’ ability to pay in the short run and the long run to avoid secondary default.
* It bridges the contractual divide that separate borrowers from investors in securitized mortgages. This cannot be left to the household.
* It provides a contractual form that is useful in the long run.
* It encourages owners of mortgages and mortgage backed securities to renegotiate at an earlier stage in the default cycle than they do at present.
* It relies to the maximum extent possible on creative use of regulations to provide incentives for restructuring, greatly reducing costs to taxpayer.
Overall, our plan would greatly speed market normalization, reduce default and foreclosure, increase asset values of holders of mortgage backed securities, all the while costing taxpayers far less now than they will be due later. Moreover it works simultaneously to resolve short run problems and to rectify longer term structural problems of mortgage markets.