FARJHO (SM) – A New Type of Housing Finance Products without the Possibility of Foreclosure or Property Repossession
(This historical article was previously published at SwapRent.com in May, 2009. An earlier name FARM was used interchangeably in the text. It was meant to explain what a generic FARM structure, the predecessor of FARJHO (SM), is when the bank is the partner with the aspiring home owner. A trust structure was also used as an example for illustration purposes rather than the recommended LLC structure in the US.)
A home seeking person could start out as a regular renter for a residential property in a location of his choice. The bank or an investor will purchase the property into a trust or simply in a co-ownership legal structure for him. In the trust, the person could buy into a portion of the legal ownership of say, between 0% to 100%. Either 5%, 10% or 20% could be a good starting point depending on the issuing bank’s credit standard. He could buy into more of the legal ownership vehicle now or later at the then prevalent market price.
Meanwhile through these new “economic owning” or “economic renting” concepts, this new home occupier could make proper arrangements with the bank to become an “economical owner or renter” for whatever proportion of the total value of the property any time in a totally flexible and reversible manner (either buying or selling) for whatever length of time through making SwapRent (SM) transactions at REIDeX.com.
Being a renter gives a person the rights to occupy and use of a property, i.e. the “Shelter Value”. Being an owner will give him the right for the financial gains or “Economic Value”, if there is future appreciation by the time he decides to sell, in addition to the same rights to occupy and use that a typical renter would have during his ownership. Of course he will also have to bear the risk of depreciation if he has to give up ownership at any given time pre-maturely as a part of the same “Economic Value”.
To put it in a very simplified way, the cost differential between the cost to rent and the cost to own for a specified period of time will determine the “Economic Value” or whether a person will be entitled to the future financial gains of the appreciation and the responsibility of bearing the risk of loss due to depreciation, meanwhile he could continue to occupy and use the property regardless what the financial value of the property may be now and in the future.
For simplicity reasons, let’s use the same numerical example for the $800,000 house as illustrated in the SwapRentSM transaction example above. Since the real physical rental rates may be higher or lower than the SwapRentSM rates (especially the short term rates) depending on the market conditions in each country, let’s assume a real rental rate of the property is 1.5% per annum ($1,200 per month). It could certainly be lower or higher, say 2.5% at other times as the market supply and demand forces dictate. The corresponding SwapRentSM for a 5-year contract may be 2% ($1,600 per month) and cost of ownership (e.g. MFC or Mortgage Funding Cost, as in the Western financial system) may be 5% per annum ($4,000 per month). The cost difference between economically renting and owning in this 5-year SwapRentSM contract example is $2,400 a month.
Therefore upon agreeing to pay $1,200 a month real rental payment the person could occupy and use the property for the next 5 years say in this 5-year contract example. He could decide to reversibly buy into the economic ownership units of between 0% to 100% of the home value with a price tag of between $0 to $2,400 more a month in additional monthly payments, on top of the rental payments ($1,200) he is already paying in his legal rental agreement, through Generic SwapRentSM contracts traded at REIDeX.
He could also sell freely the number of units of economic ownership for the remaining maturity of the contracts that he already bought before for whatever reasons he may have at any time during the 5-year period before maturity. Furthermore, if he is only interested in obtaining future appreciation potential, he may pay a bit more in monthly payments to acquire that appreciation potential only with AG SwapRentSM contracts instead, so that he would not have to bear the downside risk if the property value goes lower in the future. It should be easily understandable that an AG SwapRentSM contract will be more expensive than a corresponding Generic SwapRentSM contract since it will only gives the acquirer the right of future appreciation without the responsibility of the risk of downside losses.
It would be very interesting to note that in a non-recourse mortgage loan, as currently uniquely practiced as an anti-deficiency rule in some states (e.g. California) the US, the same financial profile could be simulated by conventional renting plus owning AG (Appreciation Give-up) SwapRentSM contracts, i. e. appreciation only, by the home occupier.
Whereas for the rest of the world, where recourse mortgage loans are usually practiced, the financial profile is equivalent to conventional renting plus Generic SwapRentSM contracts, i.e. the ownership units (either conventional legal or the new economic) always come automatically with the responsibility of downside depreciation risks for the owners.
In addition to economic owning and renting, the home occupier could of course also decide to buy into the underlying legal ownership in the trust in a lump sum fashion (money obtained from savings, work related bonus compensations, a sale of other financial assets or even winning a trophy prize from a game show competition, etc.) any time he wishes at the then future price level with the bank which has been his co-owner in the trust.
If there is enough money at hand the home occupier could buy into the entire remaining legal ownership at the then current price in order to gain complete property ownership at any time he/she wishes. However, since the legal ownership comes with very high transactional cost and many other legal and tax complications, it does not offer the same liquidity, flexibility and reversibility that making SwapRentSM transactions at REIDeX could easily provide.
For example, to sell back portions of the legal ownership would be quite difficult and expensive under both the current Western financial system and Islamic mortgage practices. With the innovative economic owning/renting concepts, when the home occupier does not have enough monthly income to sustain these economic ownership (job loss, disability, etc.), he/she will simply lose part of the future appreciation potential that is represented by these economic ownership units that he/she owns.
There will no longer be a reason for foreclosing and eviction, unless he/she cannot even pay for the normal real rental payments. The social safety net of providing rental payment assistance to unemployed people is a totally separate issue and it is usually provided in each developed country.
Most likely those safety net would kick in at that time for the home occupiers to continue to stay in their homes to look for another job and obtain income again. This is exactly how the newly created flexible economic ownership concept as facilitated by the SwapRentSM methodology could help avoid defaults and foreclosures and enhance social stability in a new alternative housing finance system.
To summarize, the two major benefits of FARM are first, the homeowner could purchase the appreciation potential of the property for only part of the entire house value if he does not have enough income to own entirely. This opens up opportunity for a lot more people to own homes who normally may not become homeowners without such a new product, hence the increased portable housing affordability. In the past, the way for these low-income families to own homes was to be offered a subprime mortgage. That was the root cause of our current financial crisis. SwapRentSM and FARM allow them to occupy and use the property and still get to own part of the future appreciation without the risk of being foreclosed.
That leads to the second advantage that is when the homeowner loses his monthly income capability due to loss of job or disability in the future, he will only lose part of these future appreciation units. As long as he has the monthly income to rent he could continue to own, occupy and use the property for whatever length of time he wishes. Nobody will be able to foreclose and evict him as in addition to being a renter of the house he himself is still a part owner of the house in the co-ownership trust he set up with the bank.
The provider banks of this new type of SwapRentSM based co-ownership mortgages could similarly use the very same SwapRentSM contracts traded at REIDeX with other free market based investors around the world to hedge off their own financial and property risks from being a temporary co-owner in the co-ownership trusts with the local homeowners. The provider bank could therefore act solely as a middleman without having to hold any market risks of these real estate properties. As illustrated on slide #11 below, the intermediary banks, local governments or housing agencies could charge a fee or a spread for the services provided either as a for-profit business or as a fully self-funded not-for-profit entity.
None of these new transactions or mortgage products described above involve the Riba concept, or the charging interests on the use money, that Sharia, the Islamic laws forbid. Therefore, ideologically, these type of new housing finance product could be much more easily acceptable to the Muslim consumers since not only this new arrangement is more religiously advantageous but also the consumers are already very familiar with the Diminishing Musharakah type of Islamic mortgages which also uses a similar co-ownership trust structure.
If the Western societies could also learn the lesson and adopt this new innovative housing finance system made possible by the new “economic owning, renting and temporary own-rent switching” concepts as facilitated by SwapRentSM contracts, then homeowners will benefit from the flexibility and affordability, provider banks and mortgage lenders will benefit from the better risk management and governments will also enjoy higher tax revenue from enhanced property value and stronger economy. The entire society could subsequently enjoy a peaceful growth and prosperity.
All these could be accomplished without the use of the concept of borrowing or lending, hence the potential abuse of it for housing people. When that nirvana time comes, words such as “mortgage foreclosures”, “property repossession”, “securitizations”, “credit default swaps”, … etc. may not be necessary in our banking glossary any more.
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