The Investment Strategy Group of Contango Capital Advisors provides regular updates on economic and financial conditions. In this commentary, we examine the likelihood – and the impact – of a wholesale writedown of mortgages.


The drumbeat for a wholesale write-down of mortgage principal is getting louder. Somewhere between 20 percent and 30 percent of US mortgage holders are underwater. Many will default, leaving their homes to be dumped on the market in foreclosure sales. Others can’t qualify to refinance into a lower rate loan, even though rates are now at historic lows, because of negative equity and higher credit standards. Those trapped in high rate loans are scrimping by and, in many cases, prevented from moving to job opportunities elsewhere. The swelling supply of defaulted homes drives all home prices lower. As one’s house is the principal component of personal net worth, many people feel – and indeed are – poorer, and so spend less. Hence the economy is weighed down by a giant anchor that, if left untended, will take several more years to loosen.

In earlier cycles, government demand via increased deficits offset lower consumer demand. However, that well has run dry, at least for the foreseeable future. There seems virtually no prospect of greatly increasing federal government spending while state and local expenditures, and so employment, are declining. There is more and more talk about mortgage principal reduction as the only feasible way to kickstart the economy. We take it seriously.

One Man’s Liability Is Another Man’s Asset


It’s Accounting 101: Balance sheets have two sides. The homeowner’s mountain of debt is the saver’s mountain of assets – safe bond assets, what is more. So, when the great write-off comes, there will be a dollar-for-dollar amount of investor losses. Much of the mortgage debt now resides with our government, via Fannie Mae and Freddie Mac guarantees as well as in the mortgage-backed bonds the Fed purchased in huge amounts to drive down interest rates. The rest is held by insurance companies, pension funds and mutual funds in the US and in Europe.

So we, as taxpayers, will bear probably the bulk of the loss while we, as holders of life insurance policies and pensions, ought to look very carefully at the assets of our insurance carriers and pension funds. The investment implications of this are clear. There isn’t much you can do about a life insurance policy but you certainly can look deeply into the portfolios of all the other investment funds that you own. In particular, high-coupon mortgage-backed bonds are likely to be relatively old, and the most likely to be written down. Not only will principal be lost, but because rates have fallen so much, the odds are that you or your fund purchased such bonds at premiums, meaning that resulting losses will be even greater than the face amount of the write-down.

The Silver Lining


There’s no way to recoup the entire write-down on the mortgages. But there may be a way to recover in part. The most palatable means of performing the mortgage balance evisceration is via the shared appreciation concept. To illustrate, a mortgage is written down from 120 percent to 80 percent of a house’s current appraised value. Initially, the investor loses one-third of the value of his asset. But, the investor would be entitled to half of the appreciation of the house above the new mortgage value. So, even if the house sold only for its appraised value, the investor would get back another 10 percent of the original loan. And if home prices rose once these changes were in place …

Playing out this scenario will likely entail bruised feelings and uncertainty for the first year or so, but then something very interesting is likely to happen. Institutions will want to sell some or all of their shared appreciation rights. It would be possible to assemble a geographically (and otherwise) diversified portfolio composed of these rights, and thereby create a new security. So far, it has been possible to buy into apartments, via real estate investment trusts (REITs), but otherwise it has been impossible to invest in a diversified way in the core of the housing market – owner-occupied houses. Over the long term, such housing has been a very effective inflation hedge. We look forward to this opportunity.

A Real Innovation for Retirement


Even more interesting, the establishment of a market for shared appreciation rights based on reset mortgages would only be the beginning of what would be possible. Once such a market is established, consider the opportunity open to an existing homeowner, especially one close to retirement. To date, getting equity out of your house has required either selling it or taking out a reverse mortgage. The first option puts you out on the street, or at least away from your neighborhood and friends. The second is a loan that accumulates interest, even if you can’t be evicted.

Suppose that you could sell shared appreciation rights in your house, while you continue to live in it? That possibility already exists in Australia. The Australian product is designed for retirement, and the buyer of shared appreciation rights is paid when the property is sold or the owner dies, whichever comes first. In this way, actuarial analysis of the pool underlying the security can provide a reasonably predictable timing of cash flow (subject, of course, to average rates of home appreciation).

If the concept of shared appreciation rights is indeed introduced in the US in response to the mortgage crisis, we believe that a new class of investment and retirement funding opportunities will be created, constituting some balm for those write-off wounds – as well as some intriguing possibilities for investors.

The opinions expressed above are solely those of Contango Capital Advisors and do not necessarily reflect the views of Zions Bancorporation, its affiliates or its management.

IMPORTANT NOTE: Wealth management services are offered through Contango Capital Advisors, Inc. (Contango), a registered investment adviser and a nonbank subsidiary of Zions Bancorporation. Investments are not insured by the FDIC or any federal or state governmental agency, are not deposits or other obligations of, or guaranteed by, Zions Bancorporation or its affiliates, and may be subject to investment risks, including the possible loss of principal value of the amount invested. Some representatives of Contango are also registered representatives of Zions Direct, which is a member of FINRA/SIPC and a nonbank subsidiary of Zions Bank. Employees of Contango are shared employees of Western National Trust Company (WNTC), a subsidiary of Zions Bank and an affiliate of Contango.