To Prevent Another Housing Crash, Spread the Risk

The Earle W. Kazis and Benjamin Schore Professor of Real Estate argues for a schema in which mortgages decline in sync with any potential fall in housing value — effectively preventing homeowners from going underwater.

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Based on research by Daniel Greenwald, Tim Landvoigt, and Stijn Van Nieuwerburgh
Photo by Tom Rumble on Unsplash

The 2008 housing crash imposed an enormous financial burden on US households. As house prices fell by 30 percent nationwide, roughly 1 in 4 homeowners was pushed underwater, eventually leading to 7 million foreclosures.

It didn’t have to be that way. A decade after the crash, my research colleagues and I have found significant evidence supporting a mortgage scheme that would prevent another wave of foreclosures in the event of a crisis. It’s called the shared appreciation mortgage, or SAM.

Already being piloted by the fintech industry, SAM would index mortgage debt to house prices so that a borrower’s mortgage payments, principal balance, or both, would fall as house values decline. It would reduce the borrower’s debt burden in bad times, reducing the likelihood of default and foreclosure.

“SAMs can eliminate most mortgage defaults,” as I write with Daniel L. Greenwald of the Massachusetts Institute of Technology and Tim Landvoigt of the University of Pennsylvania in our working paper, which sheds new light on the equilibrium implications of introducing such home equity products. We conclude that, “in sum, indexation to local house price shocks is highly effective at reducing the risk of foreclosures and financial fragility.”

SAMs are far from hypothetical. First pioneered in the 1980s and then popularized in the academic world by Andrew Caplin of New York University in the late 1990s, SAMs have attracted increasing attention since the crisis. The fintech companies Unison, Patch, and Point, among others, have begun offering home equity products where they offer cash today for a share in the future home value appreciation — if the home value depreciates in the event of a crash, then the borrower’s payback is also less, essentially preventing the borrower from ever going underwater.

There is a flipside. Lenders would have to endure losses from debt forgiveness when house prices fall. These new losses may come at times when the financial sector is already weak. But we argue that, overall, fragility is reduced under SAM — and as was made painfully clear in the 2008-2011 episode, financial fragility (the likelihood of financial crisis) should be a primary concern for policymakers.

Boston vs Vegas

Our paper uses a quantitative model of the US mortgage market, including the financial sector, to examine the performance of SAM contracts. We find that the typical SAM proposal, which indexes mortgages to house prices at the local (i.e., city or ZIP) level, combines two distinct mechanisms — indexation to overall US house prices, and indexation to local house prices relative to the national average — which have dramatically different effects on financial fragility.

Indexing mortgages to the performance of local house prices relative to the national average is effective at limiting foreclosures and lenders’ exposure to risk. Under such a contract, mortgage payments would fall in the hardest-hit areas (e.g., Las Vegas) during a crash, while payments would actually rise in the least affected areas (e.g., Boston). The key to this scheme is that these risks are diversifiable for national lenders. At the same time, the flow of debt relief to the most affected areas reduces the overall foreclosure rate substantially. Hence, indexation actually strengthens banks during crises by diminishing a major source of their existing mortgage risk.

In sharp contrast, indexation to national house prices raises lenders’ exposure to undiversifiable house price risk, leading to large financial sector losses when these prices fall. Facing declines in net worth and the potential of failure, banks contract lending, causing a credit crunch that actually worsens the decline in house prices. At the same time, the untargeted nature of this debt relief, with borrowers in virtually unscathed Boston receiving the same forgiveness as those in hugely affected Las Vegas, implies only a moderate reduction in foreclosures.

We believe that understanding these two forces is important for the appropriate design of indexed mortgages, even if real-world proposals combine both types of indexation. Our main takeaway is that designing novel mortgage contracts requires careful consideration of their impact on financial fragility.

Lastly, we identify a potential obstacle to indexed mortgage contracts: the distribution of gains to different economic actors. Banks in our model often prefer contracts that increase financial fragility, as these schemes allow them to earn high profits in good times, but use government assistance (e.g., the Federal Deposit Insurance Corporation, or FDIC) to limit their downside risk in crises. Our work implies that improving financial stability under SAMs could likely require a change in how bank regulators measure and manage financial sector risk.

“Redesigning the mortgage market through product innovation may allow an economy to avoid a severe foreclosure crisis like the one that hit the US economy in 2008-2010,” we write. “Indexation of cross-sectional local house price risk is highly effective at reducing mortgage defaults and financial fragility.”

About the researcher

Stijn Van Nieuwerburgh

Stijn Van Nieuwerburgh is the Earle W. Kazis and Benjamin Schore Professor of Real Estate and Professor of Finance at Columbia University’s...

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