Thursday, March 22, 2012


In Philadelphia, Baltimore, and their respective suburbs, some homeowners still pay "ground rents." The term, which dates from the eighteenth century, is a misnomer as the payments represent interest on renewable 99-year or perpetual mortgages. Although the creation of new ground rents fell out of favor before World War II, ground rents and other types of long-term, interest-only mortgages have much to recommend them and are widely credited with making Philadelphia the "city of homes" and Baltimore the "city of home owners."

In the eighteenth and nineteenth centuries, lenders found in ground rents a secure, readily salable (liquid) long-term asset that generally yielded between five and six percent. Defaults were rare because loan to value ratios (LTV) were conservative, typically in the neighborhood of 50 percent, and the interest due any given quarter or year was negligible compared to the value of the real estate, providing borrowers with strong incentives to make payments. Moreover, in case of default, lenders could lawfully enter the home and seize and sell any personal property found at the address. Rarely was it necessary to repossess the real estate to keep an account current.

Homeowners liked ground rents because the contracts kept their housing payments relatively low and eliminated the refinancing risks that periodically crushed those whose mortgages fell due when interest rates were high, mortgage renewals were unavailable, or housing prices were plummeting, as during the Great Depression. Ground rents were extinguished when a homeowner bought his contract from the investor holding it. When market interest rates were relatively high, the contracts could be purchased cheaply. When they were relatively low, the contracts were dear. The key was that homeowners could decide if and when to purchase the contract, allowing them to ride out financial storms rather than be sunk by them. "It is worthwhile noting," wrote legal scholar Frank Kaufman in 1940, "that relatively few ground rent defaults occurred during the recent depression. In fact," he continued, "Baltimore has seen less of the foreclosure evil than have other large cities in which only ordinary mortgages are used."

That raises the question of whether widespread use of ground rents could have mitigated the crisis of 2007-8. They might have, even if the average ground rent LTV had increased to 100 percent and the contracts were securitized as mortgages were. Ground rents would have decreased borrower opportunism (moral hazard) by making it easier for lenders to force homeowners who continued to reside in their houses to keep their accounts current and, in the case of walkaways, to foreclose on the property. In addition, as interest rates fell following the crisis, the value of ground rents would have increased, offsetting to some degree losses realized on the sale of foreclosed properties. The vicious cycle witnessed since 2007 -- decreased home prices and liquidity leading to defaults that decrease home prices and housing market liquidity yet further, triggering yet more defaults -- may have been stopped sooner or even prevented in the first place. We will never know for sure, of course, but regulators should consider allowing some modern experimentation with these hoary instruments of home finance.

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