Wednesday, March 11, 2009

A Different Way to Fund Housing

I have said before that buying a house is a little bit crazy.  If I went to the bank and said "I want to borrow four times as much money as I have, so that I can put it all in stock", the bank would laugh before they threw me out.

So...why will the bank let me leverage up 5:1 to speculate in real estate?  I am not a professional real-estate developer.  All my risk is concentrated in one property.  And owing that much on one property is terrible diversification.

We've seen two things happen at the same time which have changed the nature of home ownership in the US in a bad way.
  • At least over the last 5 years, home owners were allowed to put a lot less money down - that is, they had higher leverage in buying houses.
  • Home prices have become volatile.
Let's look at those two things in slightly more detail: when you write a loan that is backed by an asset, you want the owner (the person with the equity stake) to put enough money up that even if the asset goes down in value, its new value is less than the loan amount.  If you don't do this, the owner is "under water" and the loan isn't secured.  By making home owners pay a 20% down-payment, banks would protect themselves from a 20% decrease in house prices.  

That was a very wide margin back in the day, but the price swing we've seen of late is larger than that in some states.  Furthermore banks have been allowing down payments to get smaller, via piggy-back loans, seller-pays-closing costs, and all sorts of other weirdness.

I think these two trends may be related: the more houses are financed, the more housing prices are influenced by interest rates (because without cheap financing, the demand for housing goes down).  And the more houses are financed, the less housing prices have to change to put people under water.

it occurred to me that we don't have to use debt to finance housing.  I'd like to suggest a different model: equity mortgages.  (I realize that the logistics of this virtually impossible, but I still think it is interesting as a thought experiment.)

Under a "debt" mortgage (i.e. what we have now) the home owner owns the house, the house is collateral on the loan, and the home owner gains or loses all fluctuations in the price of the house.

Under an "equity" mortgage (i.e. what I am proposing) the hmoe owner owns part of the house, and the bank owns part of the house.  The home owner and the bank split gains or losses due to changes in the houses price.

How does this change things?
  • A home owner can't be underwater; as a home decreases in value, the mortgage shrinks proportionally.  If you own 1/5th of your house, that is true no matter how the market fluctuates.
  • A home owner has a smaller exposure to house prices.  If you put down a 20% down payment, you are exposed to house price changes only on that money.  Since the down-payment is put up in cash, you can think of this as speculating in house prices with some of your own money, but not the banks.
  • Banks are exposed to both the upside and down side of house price changes.
  • Banks are no longer exposed to default risk due to house price changes.  Because the owner can't be underwater, the home owner always has motivation to make payments.
These bullet points reveal a question: how does the mortgage get paid off?  In practice co-ownership of the house becomes very tricky.  Does the bank get to say whether you can renovate the bathroom?  Do you have to buy out the bank's share?  If so, do you have to do it on a schedule?  Can the bank sell its share to someone else?

I don' think equity mortgages are something we'll see any time soon, but I think they do illustrate some implications of debt-based housing finance that deserve closer inspection.

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