Monday, September 28, 2009

Hussman: Tradeable PAR's = Solution to Mortgage Mess

If you don't read John Hussman's Weekly Commentary, you are missing out (find it at This week's commentary is especially brilliant, not just because of the market commentary (he is not optimistic), but because he continues to provide details of a system that would help to solve our nations mortgage mess (no it has not been solved and its about to get much worse) without much help from the taxpayer. I've provided an excerpt below, but you should really read the entire commentary.

The mechanics of PARs

On the mortgage side, I noted in March (On the Urgency of Restructuring Bank and Mortgage Debt, and of Abandoning Toxic Asset Purchases) “If there is any good news at present, it is that the capital infusions of late-2008 have temporarily stabilized the banking system, and that the U.S. economy is presently enjoying a brief and modest reprieve from the financial crisis. This is largely the result of an ebbing in the rate of sub-prime mortgage resets, which reached their peak in mid-2008, with corresponding mortgage losses and foreclosures a few months later. Since this crisis began, the profile of mortgage resets has been well-correlated with subsequent foreclosures. This reset profile is of great concern, because the majority of resets are still ahead. Moreover, the mortgages to which these resets will apply are primarily those originated late in the housing bubble, at the highest prices, and therefore having the largest probable loss. Undoubtedly, some Alt-A and option-ARM foreclosures have already occurred, but the likelihood is that major additional foreclosures and mortgage losses lie ahead. If we fail to address foreclosure abatement during the current window of opportunity (early to mid-2009), there may not be time for legislative efforts to contain the resulting fallout.”

We have done nothing material on this front. I continue to believe that foreclosure abatement requires debt restructuring. Short of major voluntary write-downs by lenders, which are unlikely, the best approach would be to use the Treasury as a coordination mechanism to administer what I've called “Property Appreciation Rights” or PARs (skip to the next section if you believe the credit crisis is over).

Here is some additional detail on how these might work. A homeowner with a mortgage of say $350,000 would renegotiate the debt with the lender, replacing it with, say, a $200,000 mortgage obligation plus a $100,000 PAR (and an outright reduction of $50,000). The PAR would not be payable directly from the homeowner to the mortgage lender. Instead, two things would happen. First, the homeowner would owe the PAR amount to the Treasury out of any future appreciation of the home, or if sold, appreciation on subsequent property, and ultimately out of the homeowner's estate (possibly less some exclusion based on the size of the estate). Second, the Treasury would aggregate all PAR payments received from the pool of homeowners owing them, and would distribute them proportionately to the mortgage lenders holding the PARs. In this way, the PARs would be fully tradeable and investable instruments, similar to closed-end mutual fund shares, with the Treasury acting essentially as a payment collector (through the IRS) and transfer agent. The PARs would most likely trade at a discount to their face value. More on that below.

In order to prevent advantages or disadvantages based on the date one enters the PAR pool, new revenues would be distributed to PAR holders in proportion to their remaining unpaid claims. The “Face Value” of each share would be calculated by the Treasury as the ratio of unpaid PAR claims to the number of PAR shares in existence. In practice, it would be reasonable to have several “tranches” of PAR shares, reflecting differing loan-to-value (or better yet, PAR-to-value) classes, which clearly have differing probabilities of being paid off in full.

For example, suppose the pool begins with $100,000 in PAR obligations from a homeowner, and the Treasury issues 100,000 PAR shares to the mortgage lender, for a Face Value of $1 a share. If $20,000 of payments are made, the new Face Value for a share would be reduced to the ratio of Unpaid Claims to Outstanding Shares, or $0.80.

Suppose now a new $100,000 of obligations enters the pool. In this case, the mortgage lender receives 125,000 PAR shares ($100,000 / $0.80). There are now $180,000 in unpaid obligations, and 225,000 outstanding shares, not surprisingly, representing $0.80 of unpaid claims per share. If a payment of $45,000 was now received, $20,000 would go to the mortgage lender who has 100,000 PAR shares), and $25,000 would go to the second lender (who has 125,000 PAR shares). In each case, the amount received is proportional to the outstanding amount of unpaid claims due to each holder.

Would the PAR securities trade at face value? Probably not, and that is a great advantage, because it provides a natural way for the underlying mortgage debt to be restructured while at the same time pooling the losses across all participants.

Specifically, in addition to satisfying payment of a PAR obligation by paying money to the Treasury, the homeowner could tender PAR shares (purchased on the open market) directly to the Treasury, and have the obligation canceled at the then prevailing Face Value of those PARs. I know that sounds complicated, but consider an example.

Suppose that a homeowner has a $100,000 obligation to the Treasury. Suppose also that the current Face Value of a PAR is $0.80, and PAR shares can be purchased on the open market (from mortgage lenders liquidating their questionable loans) for say, $0.60 a share. In lieu of paying $100,000 to the Treasury, the homeowner could tender 125,000 shares ($100,000 / $0.80 face value), to the Treasury, which would in turn retire the outstanding PAR shares as well as that homeowner's obligation. As a result, the Face Value of other outstanding PARs would be unchanged, so no existing holder would be helped or harmed by the transaction. Those 125,000 shares would cost the homeowner only $75,000 on the open market, even though it would cancel a $100,000 obligation.

This is important: notice that what has happened here is that some existing PAR holder has, in effect, negotiated a reduced mortgage settlement with some homeowner (in this case, a $25,000 reduction in the mortgage obligation), canceling that portion of the mortgage debt, even though the PAR holder may not have been that specific homeowner's lender in the first place.

In short, by creating a tradeable instrument, administered by the Treasury (but not requiring any public funds other than those administration costs), a market mechanism would be created to settle troubled mortgage obligations, even between unrelated participants.

Scott Dauenhauer CFP, MSFP, AIF