As of Friday October 12th, 2007, given the current negative sentiment for the near term outlook on US residential real estate, a SwapRent (SM) market rate levels (mid-point between bid and offer rates) for MSA (Metropolitan Statistical Area) of Los Angeles could look like the following as one of the arbitrarily suggested example scenarios for illustration purpose only:
1Y 2Y 3Y 4Y 5Y ….. 10Y 15Y 20Y
15% 10% 5% 3% 2% ….. 1% 0% -2%
If the Mortgage Funding Cost (MFC) stays the same at 5% for all maturities, it means the annual subsidies from the synthetic “economic landlord” investors to the synthetic “economic tenant” homeowners (i.e. the MFC minus the Generic SwapRent (SM)) are as follows:
-10% -5% 0% 2% 3% ….. 4% 5% 7%
The break-even points for the investors of cumulative general US residential real estate market appreciation (negative sign means depreciation) represented by the MSA level property index are when these indices will have to go up by this amount (without considering compounding and the time value of money for illustration simplicity):
-10% -10% 0% 8% 15% ….. 40% 75% 140%
Since SwapRent (SM) rates capture more than the information of the current physical rental rates in a given neighborhood or city in the real world and it also reflects the market expectation of the expected return from the price changes during the holding period, the very high Generic SwapRent (SM) rates for the shorter maturities indicate the extreme bearishness in the US residential real estate market at the moment. As long as the drop in prices at the end of the contract period as represented by the local MSA index does not go below 10% for a 1-year contract the investors will come out ahead. The same is true for the cumulated returns for a 2-year contract. The flat annual subsidy and expected return for a 3-year contract simply indicates that people may think the market could recover to where we are at today in 3 years’ time. Starting from a 4-year contract there will be positive annual subsidies for the homeowners, ditto for the even longer term maturity contracts.
As could be seen by these examples, the supply and demand as well as the general market expectation will drive where the Generic SwapRent (SM) rates could be traded in a given local market although they will also be bound by any risk-less arbitrage opportunities that might exist.
It also illustrates that in the current environment if the homeowners want annual subsidies such as in the case of the defaulting subprime borrowers whose ARM rates had been reset higher may need to commit to longer terms contracts, say 4 or 5 years and longer in order to attract investors’ interests. The homeowners could always unwind their SwapRent (SM) positions that were built in their SwapRent (SM) embedded mortgages after one or two years for the remaining maturities whereas the market levels and the general real estate market sentiments may have already changed by then.
These examples only serve as an illustration of how the trading mechanics of the Generic SwapRent (SM) rates could be like under the current bearish market outlook for the US residential real estate market. It could change drastically when the market sentiments change, just like how market rates behave in any other financial markets. The point is that if the SwapRent (SM) markets have been implemented and made a wide spread reality soon enough, a general US real estate market recession or even depression could well be avoided. It could easily be understood since if the existing lending banks start offering these 5-year SwapRent (SM) contracts soon enough to the defaulting homeowners, the borrowers would not have to default now (nor ever later on, as explained below … ). Massive imminent foreclosures could be avoided or at least be postponed for another 5 years or longer. So there would not be some massive selling pressure in the current market and of course the market will be able to hang on without a major collapse. It almost sounds like a self fulfilling prophecy ….. but it is so true.