If you're a keen follower of those endless hearings that are conducted in the vast oak-paneled rooms of the United States Senate, you might have heard mention of a September 14, 2011 session held by the Housing, Transportation, and Community Development Subcommittee on Banking, Housing, and Urban Affairs. It was chaired by US Senator Robert Menendez (D, NJ) along with Ranking Member Jim DeMint (R, SC), and the topic was "New Ideas for Restructuring and Refinancing Mortgage Loans."
Among the witnesses was Marcia J. Griffin, President and Founder of HomeFree-USA, a non-profit homeowners' advocacy group. Among other things, she stated that the US ought to prioritize the development of the Shared Appreciation Mortgage (SAM) as a way to achieve equitable and broad-based refinancing of troubled home loans.
So what is a SAM? They are not currently offered by any major US loan originator, but should they be?
The Basics of SAM
The name of the product is self-explanatory. The SAM was first introduced in the early 1980s during a period of high interest rates that made qualifying for a mortgage a challenge for many prospective homebuyers. The concept was a simple tradeoff: the lender would offer the borrower a fixed rate, fixed term loan that was one or two points lower than what the borrower would normally qualify for. The short-term loss to the lender would be repaid from a share of the property's appreciated value when the owner refinanced, moved (paying off the loan in the process), or otherwise terminated the loan.
The amount of appreciation due the lender could vary from 20% to as high as 50%. The bigger the share, the lower the rate offered to the borrower. For example, if a current 30-year standard fixed rate mortgage were 5%, a SAM with 25% appreciation assigned to the lender might carry a 4% rate. For a SAM with 50% appreciation assigned to the lender, the rate might be three percent.
Here's an example. Say the borrower takes out a discounted SAM on a house valued at $200,000. After five years, the home has appreciated by $10,000 and the owner decides to sell. In a 50% revenue-sharing arrangement, the borrower would owe the lender half that ($5,000) plus the remaining unpaid balance of the loan.
If the house depreciated in value over the five-year period, when the house is sold the lender gets only the unpaid balance remaining on the loan, and nothing more. The lender has in effect given the borrower a regular mortgage at a discounted rate.
The trick with SAMs is that you've got multiple variables that can affect the profitability of the deal. They include changes in interest rates, changes in the overall real estate market, and changes to the property itself. You're banking on the accuracy of real estate forecasts many years into the future. You don't need to be a rocket scientist to see that in hindsight, just about any lender agreeing to a 30-year SAM on a residential property in 2007 would have quickly regretted the decision as housing prices plummeted.
When SAMs were introduced in the 1980s, in the United States the concept never caught on because adjustable rate mortgages (ARMs), with both a lower initial rate and the potential for the rate to go even lower, proved more attractive to consumers than any fixed rate mortgage. The SAM, like other specialty products, faded from view. Today, some are suggesting that it's time to consider the SAM again.
Crunching the Numbers
Let's look at how the SAM compares with a traditional fixed rate mortgage.
SAM:$100,000, 30-year fixed discounted rate at 3%Monthly payment = $421 Interest paid after 48 payments = $11,496Balance remaining = $91,260
Traditional:$100,000, 30-year fixed standard rate at 5%Monthly payment = $536Interest paid after 48 months = $19,397Balance remaining = $93,630
After 48 months, the savings to the borrower (and loss to the lender) in interest payments and added equity is $10,271. Let's say the deal called for 50% appreciation sharing. If the property value declined over four years, then the deal is bad for the lender. If the property appreciated by $10,271 (a bit over ten percent in four years), then it's a break-even for both parties. But if the property appreciated by $20,000 (twenty percent in four years), then it's the homeowner who is the big loser.
SAMs in the UK
How have SAMs worked in real life? We have to go overseas for a significant case study. In the UK in 1997-1998, The Bank of Scotland and Barclays Bank sold thousands of shared appreciation mortgages. They were offered primarily to pensioners (retirees), during a time just before the boom in the real estate market. Many of the deals were structured so that the borrower got 25% of shared appreciation and the lenders got 75%.
Then property values soared, and over the next ten years prices increased by three or four hundred percent. Borrowers found themselves locked into SAMs that were extremely costly to them.
For example, a property valued at $150,000 in 1997 might easily have been worth $450,000 ten years later. A typical borrower took out a SAM of $37,500, or 25% of the 1997 value. The agreement stated that, upon death or sale, the lender was entitled to 75% of the amount of appreciation plus the original loan. This is a terrific deal for the bank, which stood to receive something like $260,000 while the borrower got $190,000.
But if the borrower wanted to buy another home, in a rising market a bankroll of $190,000 wasn't going to be enough for a comparable home. And just about any intelligent borrower would realize that had they not chosen to save one or two points and instead had opted for a traditional mortgage, they'd be pocketing the entire amount of the appreciation instead of handing it over to the bank.
As the real estate market heated up in the early 2000s in the UK, disgruntled SAM borrowers got together and formed the Shared Appreciation Mortgage Action Group (SAMAG). They hoped to find a legal settlement for what they called the "victims" of shared appreciation mortgages, and the group explored legal remedies. Today, if you go to the SAMAG website, you're directed to the website of Struggle Against Financial Exploitation Ltd. (SAFE). It's unclear as to what, if any, legal action is being contemplated against Barclay's and the Bank of Scotland.
The Fine Points of SAM
Because of their dependence on a set of variables, SAMs have evolved with various features that are designed to inhibit profit taking and deception, primarily on the part of the borrower.
An opportunistic borrower might be tempted to take a SAM for a while and then refinance to avoid sharing the appreciation, but SAMs often have a prepayment penalty or anti-refinancing clause to keep consumers from doing that. Often, during the first three years of the loan if the borrower prepays more than 20% of the outstanding balance, there's a penalty assessed based on either the amount of the prepayment or a chunk of interest. These provisions are not triggered by a sale of the property.
One key issue, of course, is the definition of "appreciation." Appreciation comes from two sources: improvements in the real estate market, and physical improvements made to the property. Market shifts cannot be helped. But from the homeowner's point of view, the cost of making home improvements may be a problem. If you spend $20,000 on a new bathroom, that new bath will increase the value of your home, which is normally a good thing because when you sell your home, you'll get it all back. But what if you had signed a contract with your lender promising to fork over 50% of your home's appreciation? Suddenly your new bathroom is now going to cost you $30,000.In such cases, neither lender nor borrower wants there to be any impediment to improvements that would enhance the value of the property. Consequently, SAM loan documents state that a "Qualified Major Home Improvement" (QMHI) is excluded from the calculation of appreciation. A QMHI is any "substantial" kitchen or bath m odernization; a project that increases the living area of the home; new decks, porches, patios, or garages; and paving a previously unpaved driveway. In addition, the project must be completed within six months after you've started it, and the total cost of the project needs to exceed either $10,000 or 6% of the original value (or adjusted value) of the home.
How can the homeowner ensure that the property is valued correctly? A QMHI needs to be clearly defined and then the "basis value" of the house adjusted upwards. To do this, the homeowner has the property appraised. Then the homeowner builds the new garage or installs the bathroom. The cost is $20,000. As soon as the work is complete the property is appraised again, and the new appraisal should match the cost of the upgrade. This should make it a QMHI, triggering an adjustment of the basis value.
Are SAMs the answer for today's struggling mortgage market? Lenders might jump on board if there were a widespread belief that prices will sharply rebound. If the market stays in the doldrums, SAMs will not be attractive to lenders. Lenders are watching the marketplace and Washington to see if the SAM is on the way back.
David Reinholtz
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