Yet Another Way to Fund Housing

In a previous post I suggested that housing could be funded via equity instead of debt, an idea inspired from other economists and twisted slightly.  It's a somewhat impractical idea - at best the equity stake in a house owned by those other than the occupant would be split into tiny pieces and combined to make a "housing equity index"-style investment.  (The goal of slice and dice here is to emulate stock index funds and insulate passive investors from the occasional idiot home owner who destroys his own equity.  The goal is not to create tranches to change the risk curve like a CDO.)

The problem with this scheme is that the equity holders of the house would either have a say in how the house is managed (an annoying intrusion on home owners) or have no say (which means their capital is at risk).  This new scheme tries to work around this by keeping ownership with the occupant.

Derivatives As Insurance

Derivatives are like the force - they can be used for good or evil.  A legitimate use of derivatives is to offset one risk with the exact opposite risk.  For example, an airline (which is hurt by rising fuel prices) can use derivatives to cheaply set up an investment that goes up when fuel prices rise.  The result is that the airline's net exposure to fuel prices is smaller, which means the airline isn't as at risk to fuel price changes.  This use is a "hedge".

By comparison, derivatives can also be used to speculate - I can buy those same derivatives without being an airline - if fuel prices go up, I win my speculative bet - if they go down, I lose my money.

Derivatives that are used as a hedge are sort of like "insurance" - they provide compensation to the buyer when bad things happen.  If I buy a put option on the S&P, I have bought insurance against the stock market falling.  If the market falls (and I lose money from my stocks) the party who wrote the put will pay me - my insurance payout.  The cost of buying that put option was like a premium.

It should be noted that a derivative contract can be insurance to both parties!  If an oil company writes insurance on fuel prices going up and sells it to an airline, this is good for both parties. If fuel prices go up and the oil company has to pay out on the insurance, that's okay, they're printing money because fuel is expensive.  If fuel prices go down, they get to keep the premiums just when they need it.

(I mention this because A.I.G. has just cost us tons of money by writing insurance policies that came due using derivatives.  A.I.G.'s mistake was not writing the insurance - it was writing insurance that they didn't have the money to pay out.  What they did is equivalent to me starting to write insurance on an earthquake in California.  If it happens, I don't have the millions of dollars to pay out claims.  Maybe I could get a bailout and $165 million in bonus money...)

A New Kind of Home Insurance

So here's my scheme: home depreciation insurance.  The home owner agrees with a third party to:

• Pay the third party if the home price goes up and
• Receive money if the home price goes down.

This effectively lowers the market swings.  If I have a $400,000 house and buy a $200,000 depreciation policy, then if my house price falls by 25% I am only out $50,000, not the full $100,000.  (The other $50,000 "lost" is a loss for the third party.)  If the house goes up by 25%, I only gain $50,000, not $100,000.

In other words, I have given up some of the up-side of owning a home to avoid some of the down-side.  Given that a home is a single asset that is more expensive than most Americans savings, this improves the balance of the home-owners portfolio (which is normally over-weighted in non-diversified real-estate).

Homes are bought with leverage (e.g. I buy a $400,000 home with only $80,000 of my own money), to use the financial lingo.  Leverage (borrowing money to buy more of something that changes in price) amplifies the change in value of whatever you buy.  So our use of mortgage financing is making us all more susceptible to housing market price swings, relative to our personal income, savings, etc.  Depreciation insurance is an attempt to counter-act this problem, by letting the home owner "sell" some of the risk to a third party.

Who would be on the other side of the equation?  I can think of a few possible parties:

• Real estate investors who want exposure to house price appreciation but don't want to have to manage a rental property.*
• Pension fund managers who want to balance a series of asset classes that are unrelated (e.g. stocks vs. bonds vs. houses) to optimize return on volatility.
• Home owners who would consider buying a second home as an investment but don't want to buy less than a whole house worth of exposure.

* Buying a rental property to speculate in real-estate is a little bit tricky - the tenant and land lord have opposite incentives financially.  By comparison, in an owner-occupied house the owner and occupant are one in the same, so there is no conflict.  In other words, if you buy part of the appreciation of someone else's owner-occupied home, you don't have to be as worried that they'll scratch the hell out of the new wood floors.