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1. Background and Introduction of the SwapRent^SM Concept

The history of SwapRent^SM traces back to an effort to develop a consumer-oriented real estate derivatives business that included an Internet based on-line real estate index based futures and options exchange in the US back in 2001. The purpose was to bring the economic benefits of simplified financial derivatives to the consumers who are already or intend to be involved in property investment related transactions.

Bearing in mind that conventional financial derivatives in the way they had been practiced before had too many potential problems if not managed carefully and they are typically way too complicated for the average consumers, the goal was aimed at inventing something totally new from scratch and developing a fool-proof business methodology so that the new concepts and financial transactions could keep the similar economic benefits for consumers to enjoy but get to avoid all those potential pitfalls of conventional financial derivatives.

Therefore the original objectives of the inventions of SwapRent^SM and its embedded suite of consumer housing financial products were to create a totally new set of consumer financial concepts and products as well as a new system of fool-proof uses of related financial transactions so that homeowners and property investors could take advantage of the economic benefits of conventional financial derivative contracts like what the stock market investors have been doing for decades without the complexity, opaqueness and the danger of potential abuses by either the consumers or the financial institution vendors.

The best example in the past of such successful consumer banking products in housing finance is the prepayment option that was built into a conventional fixed rate long-term mortgage loan offered in the US market. The prepayment option is the choice for borrowers to re-finance for whatever reasons at will, with the usual main economic reason being a new lower borrowing rate has become available. This option is in fact a form of an interest rate derivative contract (a call option on the interest rate level).

However, banks that offered this economic benefit to homeowners have never marketed it as a derivative contract and consumers have been taking advantage of its economic benefits without any potential dangers or problems for decades. These objectives were exactly what SwapRent^SM and its embedded housing finance products such as HELM (Home Equity Locking Mortgage) and FARM (Flexible And Reversible Mortgage) were originally designed to achieve in a similar way.

The research and development breakthrough came in early 2006 and hence the birth of the new “economic owning”, “economic renting” and the “temporary own-rent switching” financial concepts. A new type of financial transactions was created to facilitate the temporary own-rent switching concept by the homeowners or commercial property owners. The name chosen for it was “a SwapRent^SM transaction”.

Therefore a SwapRent^SM transaction has become the realization of the newly created consumer financial concepts of "economic owning, renting, and temporary own-rent switching" while keeping the existing legal ownership structure for homeowners and other investment property or commercial property owners during the entire contract period.

A conventional legal ownership of a property entitles a property owner the right to occupy and use the property (a usufruct), which we could call it the “Shelter Value”, as well as the right to obtain future financial upside appreciation gains and along with it, the obligation of bearing downside depreciation loss, which we could call it the “Economic Value”. A SwapRent^SM contract aims to separate the economic value of a conventional property ownership from the shelter value in order for the owners to better manage the financial risk and return aspects of a property ownership while maintaining their shelter value at all times.

A generic SwapRent^SM transaction will allow a property owner to efficiently and effectively switch between owning and renting for a part or in full of his economic ownership in the property for a finite period of time at any time at a very low cost. It also allows the owner reversibly to switch back later on if it has become desirable at any time at the same low cost. This could all be done while the property owner keeps the legal title of his property and the right to occupy and use the property at all time. Therefore all the economic benefits of shared appreciation on the upside in exchange of a stream of present cash flow income or those of downside protection hedging objectives could be automatically realized when he simply does the reversible switch between economically owning and renting for a finite period of time.

From a commercialization perspective, by focusing on the newly created consumer financial concepts of either full or partial “economic owning, renting and temporary own-rent switching” will make the education and promotion of those inflexible conventional Shared Appreciation Mortgage (SAM) or Shared Equity Mortgage (SEM) concepts and products redundant since the new SwapRent^SM concept and its embedded mortgage product could deliver the same economic objectives as a much better alternative. It offers much more benefits due to the flexibility in that the appreciation component could be easily detached, traded in a secondary market and be re-attached to any conventional mortgage products again.

Nor will there be any need to educate the consumers and promote the complicated derivatives trading strategies such as selling a covered call option strategy or deciding when and how to buy call options and put options, … etc. since a SwapRent^SM contract automatically delivers the same economic benefits of these derivative trading strategies by simply letting property owners switch between owning and renting for a period of time.

For consumer-oriented business, sometimes the best way to introduce a new economic concept to consumers may be to introduce something new through something old that they are already very familiar with. Every consumer around the world is already familiar with the difference between owning and renting a real estate property. For example, by being an owner of a real estate property, the owner knows he will be entitled to the future financial appreciation of the property in the future. At the same time he knows he will have to bear the risk of downside depreciation. By being a renter, the tenant of a real estate property knows that he will not have any benefits of future appreciation or the risk of losing money if property value declines. Therefore similarly, by becoming an “Economic Renter” a consumer will understand that similar to being a conventional renter, by definition, he will not have the benefits of any potential future upside appreciation or the risks of potential future downside depreciation.

For example, if a person chose to reduce monthly expenses that he spent on housing every month, he sold his house and became a conventional renter for the next 5 years. He got to pay a lower monthly rental payment than the previously much higher monthly mortgage payment every month. Five year later if the house has appreciated in value by 20%, he will have no right to go back to the new owner and ask for a part of the financial gains. No matter how dumb this person may act for his failure to read the fine print, no laws or liberal politicians would be on his side.

A very important thing to note is that as a new concept and methodology a SwapRent^SM transaction will only function as a tool and add a well-defined time horizon to help property owners realize their investment views or to face up the monthly income reality when he is forced to make the temporary own-rent switch when he loses his economic monthly income capability. It will not alter the original reasons why people may want to switch or be forced to switch between owning and renting. People make own-rent switch based on normal economic reasons or personal factors such as monthly income reality, investment views, change of household economic situations, … etc.

The SwapRent^SM transaction will only facilitate it and make the transition easier since the transaction cost is drastically lower as compared to the conventional own-rent switching that involves the buying and selling of the conventional legal title ownership in a real estate property. Therefore the SwapRent^SM methodology should not have to bear the burden of the questions why do homeowners or investors want to make certain switching transactions. It is only a more efficient methodology to make the switching more flexible and reversible in a very low cost way.

When a homeowner has already decided at his own will or be forced to make an own-rent switch when he faces an imminent foreclosure and when an investor has already made the decision it is time to for him to go long on real estate, both the homeowner and the investor could save plenty of money and administrative hassles by using the SwapRent^SM alternative, as compared to the conventional own-rent switch by transferring the legal title of a real estate property in a purchase and sale contract which usually requires brokerage commissions, title search fee, property taxes, insurance cost and property management expenses to find a renter for the property, … etc.

The following sections of this paper comprise further descriptions and applications of both the transactional mechanics of a SwapRent^SM contract and its related consumer housing financial products such as HELM and FARM. Put together, they are meant to outline a generic blue print to develop an alternative housing finance system to stimulate readers’ further thinking and research on how to customize these new innovations according to local real estate market practices for a potential implementation in various countries around the world.

From the government's perspectives, tightening the credit spigot a bit and introduce non-lending based FARM type of housing finance products to homeowners could stabilize the society without sacrificing any overall homeownership level for its citizens. In fact, FARM may actually help increase it and build the homeownership on a much sounder footing.

For the first time federal government in many countries would be able to perform economic stimulus without resorting to using interest rates only. The new dimension offered by the SwapRent^SM contracts will allow the governments to increase or decrease the demand for real estate property by simply adjusting the availability of monthly cash flows used for shared economic co-ownership with property owners as provided by the free market based economic landlord investors.

As shall be fully explained below, while HELM seems to be able to offer timely helps to the current mortgage default mess through the shared appreciation concept, as a new alternative, FARM seems to be much better suited to build a stronger foundation of a new housing finance system going forward for our capitalism society.

2. How Does A SwapRent^SM Contract Work

In the past few years the fictitious housing affordability in the US was created based on transient short term variable interest rates. When the rates were already trending higher the low-income borrowers were still lured into owning real estate properties by the “teaser rates”. Those subprime borrowers were originally not qualified as owners. They could at most rent to have a shelter to sleep in. They should have been renters to begin with given there was no other alternative true housing affordability offered through any effective conventional shared equity or shared appreciation finance products in the US.

The answer to the perennial question of to own or to rent varies as time evolves. Sometimes the rental rate is higher (say at 2% of house value per annum) and more expensive than buying (say at a temporary teaser rate of 1%). Other times the reverse is true (say at a 5% mortgage rate when teaser rates expire). It would be nice if property owners can have a choice to separate the legal ownership from the economic interests and hence the financial risks and rewards of owning a property, a way to continue the legal ownership and synthetically switch back and forth between owning and renting only economically and temporarily according to the market conditions and their monthly income reality at the time.

That goal is what the SwapRent^SM market was designed to achieve. Homeowners could use them in a SwapRent^SM embedded mortgages HELM (Home Equity Locking Mortgage) either with their existing lenders through a loan mod conversion or with any other new lenders that offer them through a refinancing arrangement. Alternatively they could be offered through FARM (Flexible And Reversible Mortgage), which is a new way to let renters flexibly and reversibly enjoy partial or full future appreciation of the real estate property that they occupy.

If the generic SwapRent^SM rate is trading at 2% of the current house value and the current cost of owning as expressed in the mortgage funding cost is at 5% of the current house value in a 5-year SwapRent^SM contract example, there will be an annual 3% cost differential between the SwapRent^SM payments and the mortgage payments. That means renting is cheaper than owning at this point in time in this example.

So if the defaulting subprime borrowers decide to switch back to the more affordable renting only economically for a period of time they will be able to receive 3% annual saving subsidy in monthly payments from the economic landlord investors so that the borrowers could afford to continue to keep legally and stay in their homes.

If they agree to become economic renters (of their own houses) for a period of time they will not have any future appreciation benefits or downside depreciation risk during that time period, just like a conventional renter. The investors who act as the “economic landlords” by receiving the SwapRent^SM payments and paying out the mortgage funding cost will.

The homeowner or mortgage borrower could switch back to the full economic ownership until SwapRent^SM contract expires or whenever they want to unwind the contract without restrictions before the contract terminates automatically at maturity. This may become desirable for them because they may have more monthly income to acquire more economic ownership later on, because they may decide to move and sell the house or simply because their views on the real estate markets have turned more positive.

The SwapRent^SM enabled economic renting could easily be done for only part of the house value, say 25%, 50% or 75% of the current house value instead of the entire 100%. That means the homeowners could decide to be only partial economic renters for a period of time so that they could get just enough monthly subsidy to afford a home while still enjoy the remaining partial appreciation benefit.

The low-income working family, first time homebuyers and the senior citizen community could all benefit further from the flexibility on both the notional amount and the duration of the economic renting period offered by a liquid SwapRent^SM trading market for their specific property, neighborhoods or cities.

Conceptually, SwapRent^SM is a new invention of an alternative way between the buying/selling and the renting of a real estate property for property owners. The idea is to provide a very simple way in the mind of the property owners to let them protect the gains in their home or commercial property equity value. As long as a property owner has the mental capability to sign a contract to purchase a house or to sign a lease to rent an apartment he or she should have the ability to sign a SwapRent^SM contract in order to stay out of the price fluctuation of his/her home or a commercial building that he/she owns for either a short or a prolonged period of time.

The core principle and goal of these new user-friendly consumer financial product innovations is that homeowners or commercial property owners do not need to have advanced knowledge or education in financial derivatives or any other sophisticated institutional capital markets instruments in order to make the SwapRent^SM transactions.

The business idea is to design and create a very simple concept and method for property owners to simply “rent” (“SwapRent^SM“) (to pay a “rent” or to pay a “SwapRent^SM“ to stay in) their own house for a certain period of time and therefore to achieve the objective of not having a potential future loss or gain in their home equity value during that same time period, while continuing the existing legal title ownership of the property.

Currently the only business method available to a property owner to lock in the gains or loss in the home equity value is to do a “sale and lease back” transaction. This includes a real property sale transaction and the renting from the new owner of a property that the original property owner had already been occupying. The high transactional cost associated with it as well as the tax and legal considerations are usually the deterrents for property owners to widely adopt the “sales and lease back” transaction as a temporary tool for the purpose of simply locking in the financial gains or loss for a specified period of time.

Using exchange traded futures and options could be another way to lock in the home equity value but the index-based contracts do not offer a sufficient close relevance to the real fluctuation of the house value of a homeowner. The method involved is also way too complicated for most normal homeowners without advanced derivatives or market trading knowledge and experience.

From the consumers' perspectives, a SwapRent^SM transaction could therefore be viewed as a synthetic version of “sale and lease back” that only captures the economic benefits of a “sale and leaseback” without the legal title transfers, triggering of a tax event or the associated high transactional brokerage cost.

As a derivatives instrument, SwapRent^SM could be used with any kind of property price indices or no index at all. For example, the contract could be valued and settled by using property appraisals or the real transaction prices of the property.

As could be easily understood, the trading liquidity for a specific property will be very small. When the use of a house price index is selected in a SwapRent^SM contract, the trading liquidity will increase with the size the geographical area or number of households that are covered in the particular index.

The transaction services between the homeowners and investors could be done directly through a peer-to-peer (P2P) format or they could be done with a financial intermediary. Either banks or local governments could be engaged to be the financial intermediaries in between the property owners and investors.

As illustrated on slide #4, there are three ways to bring the monthly subsidy from investors to homeowners in return for a part of the future appreciation, P2P (peer-to-peer), B2C (through financial intermediaries such as credit unions, banks, mortgage lenders, etc. or local governments using FARM or HELM to offer services to homeowners) and B2B (trading SwapRent^SM contracts between financial institutions or local government housing agencies). The interests and participation from institutional financial intermediaries could greatly help create the critical mass of transaction liquidity necessary to provide the best pricing for end users that are either homeowners or investors.

3. The Benefits of SwapRent^SM Transactions for Homeowners and Property Investors

The new ability of SwapRent^SM to separate the economic ownership from legal ownership has many advantages. For example, the moral hazard and the home improvement issues of the conventional renting could be alleviated through the economic renting concept of a SwapRent^SM transaction. To put into an investment professional lingo, having the legal ownership will give you the alpha of holding an asset, switching to economically renting will let you hedge away the beta (the market risks) of owning a specific property.

Therefore a public housing project with SwapRent^SM based economic renting would become a much better neighborhood than the one with a conventional renting only because people will invest in home improvements freely since they will be the legal owners of the apartment that they live in but by being an “economic renter”, they will be insulated from the potential fluctuation of the financial value of the real estate markets in general. They will be shielded from the neighborhood appreciation/depreciation potential represented by a neighborhood or city property price index in exchange for receiving the monthly subsidy that represents the own-rent cost saving by being an “economic renter”.

Whatever home improvement investment they have already made to the properties they will be able to get to recoup those investments when they actually sell the properties on legal terms later on. The development of this new economic concept will have great implications for urban planning and public housing policy for city and county local governments in the future.

As a perhaps a bit of an extreme example, domestic servants for the first time may even live in the same building or neighboring buildings located in the same tony neighborhood as their wealthy employers do due to this newly created “portable housing affordability”.

The upscale neighborhoods may not have a conventional affordable housing complex or even the conventional apartment rental units. So the employers may enjoy the full ownership (both full legal title ownership and full economic ownership, i.e. with the entire upside financial appreciation potential) of the houses because of the employer's high monthly income earning power.

The domestic servants may get to enjoy similarly the full legal title ownership of a smaller house and perhaps only a much smaller economic ownership that entitles them to the financial value of only a small fraction of future appreciation potential because of their much lower monthly income level. They can of course buy into more fractional units of future appreciation potential of either their own home or the city level property value represent by an index through SwapRent^SM contracts at their free wills at any time when they start to have higher earning power in the future. Meanwhile they may get to enjoy a nicer living neighborhood and their children may get to attend the same high quality school districts as their employers' children do. Doesn’t that sound like a good step closer toward a true democracy?

While upon first thought, acquiring the future appreciation potential of properties could be a desirable thing to have, it does come with a cost and the cost of this investment could be totally wasted as we have seen in recent years if the value of real estate property declines instead, let alone the risk of bearing further financial losses that usually comes with economic ownership when the property market actually collapses.

Houses may appreciate in value slowly through time under most usually competent governments but we cannot always count on governments to do the right things to foster a gradually growth of property market. Therefore the inability of the low-income people to participate in the boom and bust cycles of the property investment games may not necessarily be a bad thing after all.

Through SwapRent^SM contracts these low-income families could simply continuously enjoy the comfort and the security of their homes by having the legal title ownership and becoming the “economic renters” of their own homes irrespective what may happen to the financial value of the property markets in the future. An investment in a home ownership could finally become a true long-term shelter and be removed from the financial ups and downs similar to that of a casino game.

The main implications of this are that first, cities may not need to waste taxpayer's money to build that many low-income housing complexes with substandard building materials anymore, which often end up slums and they foster class distinctions and prejudice in our human societies. Second, low-income people will no longer be forced, duped, coerced or at some other occasions, be allowed to willfully intend to go into borrowing and owning something they could not afford (i.e. the combined cost of both legal title ownership and future appreciation potential as expressed in economic ownership) based on their current and foreseeable future monthly earning power.

After this new housing finance methodology has been adopted, the abuse of irresponsible borrowing/lending and over-leveraging with a hope to get rich quick that had caused our current default-led global financial crisis will have much less chance to get to be repeated on a massive scale again.

People will learn that success in life may have to be earned in an old fashion way through hard work instead of keeping hoping to gamble with borrowed money. The practice of the simple economic concept of shared appreciation or shared ownership will indeed automatically discourage the abuse of over-stretched borrowing in our economic societies. SwapRent^SM and REIDeX could be the right solutions as the newly invented business method and marketplace to make that simple economic concept a reality in the most effective and efficient way.

To summarize, among many other applications, the five key economic advantages of the SwapRent^SM contract and its related consumer housing finance products are:

1. For those informed and educated homeowners to hedge the financial value of the properties that they own by switching between owning and renting economically only based on their views on what the overall real estate market will do in the near future while keeping the legal title ownership of all their properties at all time.
2. Considering the relative cost of owning and renting, the less affluent homeowners could decide to be economic renters or owners solely based on their monthly income reality and how much monthly subsidy they could receive to afford legally owning the properties while being partial or entire economic renters for a period of time. This will increase the housing affordability for young first-time would-be homeowners, low-income working families and retired senior citizens. For senior citizens, it also offers a much better alternative to the ineffective, inefficient and expensive reverse mortgage product for the seniors.
3. Due to the alleviation of moral hazard associated with conventional renting, SwapRent^SM will improve the neighborhood quality of both the public housing projects and the conventional apartment rental complexes. It could thus reduce crimes and improve the overall well being of the urban environments at anywhere in the world where it has been implemented. In addition, with this newly created portable housing affordability, municipalities will no longer have to waste taxpayers' money to build low quality affordable housing complexes that often turn into slums.
4. For both institutional and individual investors to become synthetic “economic landlords” by simply receiving SwapRent^SM payments and paying out mortgage funding cost for a particular neighborhood or city for a period of time. They could establish such cross border reversible long property exposures easily all over the world without having to worry about the management of these properties and incurring the normally high transactional cost and taxes.
5. For current apartment or house renters to establish an “anticipatory hedge” position through receiving SwapRent^SM payments based on a particular city level property price index so that they can lock in today's real estate price levels for intended purchases of real estate properties in that city in the future. They would not be priced out of the market if indeed real estate prices rise sharply in the future since they would have locked in the cost level through the SwapRent^SM contract.