“If we were to design a housing finance system to best address the needs of the country today and in the future, what would it look like?” asks Richard A. Morris in this opinion piece.
The debate over how to reform the U.S. housing finance system has heated up recently. President Obama has endorsed bipartisan legislation proposed in the Senate that would replace Fannie Mae and Freddie Mac with a government-run insurance fund. Republicans in the House Committee on Financial Services have introduced a series of bills that would eliminate Fannie and Freddie and replace them with private companies, while some investor groups have argued to recapitalize Fannie and Freddie and return them to private ownership. But instead of merely reforming our existing framework, now is the time to reinvent the country’s housing finance system.
For millions of Americans, the largest financial obligations they will ever have will come from owning a home and making mortgage payments. Mechanisms should be created that enable homeowners to manage the risks of home ownership and of their mortgage liabilities more effectively. The following article outlines how we can reinvent our housing finance system so that risks are reduced for borrowers, lenders, investors and taxpayers, it promotes the use of private capital, and it is more efficient, dynamic and responsive to our country’s economic needs.
The Shortsighted Debate About Housing Finance Reform
The current debate about the future of the U.S. housing finance system has largely focused on two basic options. The first involves adjusting Fannie and Freddie’s business practices and governance models, then recapitalizing and re-privatizing them. The second is to eliminate Fannie and Freddie and instead have privately funded entities take over their functions.
But by centering the debate on these narrow choices – and their various hybrids – the country is missing an enormous opportunity. Rather than simply address who should perform the functions of the existing housing finance system, we should take this chance to rethink and restructure the system in innovative ways. This is best framed by posing a fundamental question: “If we were to design a housing finance system to best address the needs of the country today and in the future, would it be the one we already have?” I believe we would want a system that differs in meaningful ways.
“But by centering the debate on these narrow choices – and their various hybrids – the country is missing an enormous opportunity.” –Richard A. Morris
Our housing finance framework has spanned many generations but has centered on an inherently risky financial transaction: individuals buying homes – which are expensive and illiquid assets – by making relatively small down payments and borrowing very large amounts of money over a long time, usually 30 years. This transaction’s risk profile was tolerable years ago when job and income security were high and people stayed in their homes for many years. But unlike in prior generations, job and income security in today’s economy are much lower, and people need flexibility so they can move for work opportunities. Buying a home on such a long-term and highly-leveraged basis has become a riskier proposition. Indeed, when our economic downturn combined with a reversal in home prices, we saw how this risk can become greatly magnified systemically. In short, our current housing finance system is outdated and too risky for our modern economy.
We should work to change the system. There are straightforward ways to reinvent our housing finance system so risks are reduced, the system becomes more responsive to our economic needs, and it promotes the use of private capital as the dominant source of financing.
Reducing Homeownership Risk: ’Shared Equity’ Financing
When financing a major asset, such as a new factory or an acquisition, a company typically has a great deal of flexibility. In addition to using its own capital, it also can issue debt and/or sell stock. This allows the company to create a suitable financing structure for the asset’s risk and longevity. The key is having the ability, if desired, to share equity risk with third parties by selling shares. But this option does not exist for homeowners in the current system.
To finance their purchases, homebuyers must use 100% equity (their down payments) along with third-party debt (their mortgages). Unlike companies, homebuyers alone face the risk that their home equity declines or possibly disappears altogether, as was true for the millions who found themselves “underwater” on their mortgages during the housing crisis.
But we can create greater financing flexibility for homebuyers, and lower the risks associated with house price declines, by establishing a legal framework that easily enables institutional investors to co-invest in homes alongside occupying homeowners. I call this “shared equity” financing. This involves a transaction where less than 50% of home equity is purchased by an institutional investor. In a sense, this makes owning a home a joint-venture type of activity, with the occupying homeowner being the “majority partner” (with more than 50% of the home equity) while the institutional investor is the “minority partner”. The “partners’” interests would be aligned, and any funds due to the institutional investor would be paid upon the sale of the home when all home equity is available to both “partners”. Meanwhile, the traditional economic incentives of home ownership would be maintained for the occupying homeowner. For example, shared equity contracts would stipulate that improvements made to the home accrue to the equity account of the occupier.
This kind of financing is distinctly different from other “equity-like” home financing techniques, such as the shared-appreciation mortgage, which allows for sharing in house price appreciation but remains a debt obligation for the homeowner. In a shared equity structure, the institutional investor only get its share of home equity — if there is no home equity (as would be the case for “underwater” homes), the investor gets nothing with the occupying homeowner having no further obligation to the investor.
Homebuyers could use shared equity financing to reduce equity risk and also potentially to lower mortgage amounts. Many underwater homeowners probably wish they had this option when they bought their homes. The technique, however, also could be used by homeowners with a great deal of equity in their homes who want to diversify their wealth by selling a portion of their home equity to invest in other assets. From a macro standpoint, this type of financing would distribute home price risk more broadly and enable institutional investors to get exposure to residential home prices and to use it to create diversification benefits.
A New Kind of Insurance: House Price Risk
A private market should be developed which provides homeowners with insurance against severe declines in home prices. There are a number of potential frameworks for providing this kind of insurance. The most straightforward would involve basing the insurance on changes in home price indices, which would be developed for a range of different regions. House price insurance then would be a matter of measuring changes in a given index’s value from the date an insurance policy goes into effect to the date of an insurable event, such as the sale of a home.
“This shared equity financing plan could be used to lower the equity risk for buyers and also reduce borrowing, an option that many underwater homeowners probably wish they had when they first bought their homes.” –Richard A. Morris
Although premiums for such insurance may be high initially, they should become more reasonable as the housing market normalizes and insurers develop increasingly effective ways to hedge house price risk. (Shared equity financing could help in this regard by providing liquidity for institutions to trade house price risk exposures systematically.) Again, by shifting risk away from individual homeowners to institutions, home price insurance would help make the overall housing finance system less risky, more flexible and dynamic, and better suited to meeting the challenges posed by our modern economy.
A Better Way to Manage Mortgage Debt: Refinancing at Less than Par Value
Another way to reinvent the housing finance system would be to introduce a mechanism that allows mortgages to be refinanced for less than par value (i.e., 100 cents per dollar of debt).
Our current system allows 30-year fixed-rate mortgages to be paid off early without penalty, enabling homeowners to refinance their mortgages at par value when interest rates fall. This has allowed millions to lower their home mortgage payments – and, consequently, their financial risk – as the Federal Reserve has eased monetary policy. A mechanism allowing borrowers to manage their mortgage balances when interest rates rise also should be developed. Doing so will reduce risk in the housing finance system.
An example is Denmark’s system, in which a standardized type of mortgage-backed bond (a “covered bond”) is created whenever a fixed-rate mortgage is issued. These covered bonds are widely traded and their prices are broadly publicized. As with all fixed-rate debt securities, the traded prices of these bonds rise above par value when mortgage interest rates decline and fall below par value when rates rise.
As in the U.S., the Danish system allows borrowers to refinance their mortgage principal balances at par value without penalty when interest rates decline, and thereby lower their monthly mortgage payments. Importantly, however, and unlike in the U.S., the Danish system also enables borrowers to maintain their monthly payments, but to reduce their mortgage principal balances when rates rise. This involves having a borrower buy a covered bond in the open market at a price below par when interest rates rise and then relinquish it to extinguish their outstanding mortgage debt at par value.
For example, a covered bond with $100,000 of principal paying a 6.0% coupon rate of interest will have a market value of about $90,000 if mortgage interest rates rise to 7.0%. Therefore, a borrower with a $100,000 6.0% mortgage can borrow $90,000 at a rate of 7.0%, buy a 6.0% covered bond in the market, and then immediately relinquish it to extinguish the 6.0% mortgage obligation. The result: The borrower has replaced the $100,000, 6.0% mortgage with a new $90,000, 7.0% mortgage. The lowered principal balance combines with the higher interest rate to leave the borrower’s monthly mortgage payments unchanged at $600, but $10,000 of principal has been permanently extinguished via this mechanism. Then, this lowered principal amount can be refinanced again without penalty when interest rates fall, thereby permanently lowering the borrower’s monthly mortgage payment.
This framework has enabled Danish homeowners to dynamically manage their mortgage debts and minimize their financial risks in a manner that otherwise is available only to large companies. This model could be applied in the U.S. with relative ease, since the country is dominated by fixed-rate mortgages that are securitized by Fannie, Freddie and Ginnie Mae. This would lower the overall risks in our housing finance system and improve the responsiveness of the housing finance sector to changes in monetary policy. It would create a stimulative effect by decreasing mortgage payments when the economy is soft and interest rates fall, and it would also lower financial leverage when rates rise as the Fed tightens monetary policy in order to rein in an overheating economy.
Removing Complexity from the System
The U.S. housing finance system is very complex. As such, it is ripe for streamlining, taking out both costs and “complexity risk” – the risk that things fail because they are too complex to handle in times of stress. An overhaul will require great political skill and leadership because our complex system has many varied economic interests. Reinventing the system, however, will pay enormous dividends by lowering costs, enhancing flexibility and minimizing operational risk.
“The U.S. housing finance system is rife with complexity. As such, it is ripe for streamlining, taking out both costs and “complexity risk” – the risk that things fail because they are too complex to handle in times of stress.” –Richard A. Morris
There are many things policymakers could do to streamline the housing finance system. For example, the country should consider establishing a “uniform commercial code” for housing finance and, in the process, set national standards and practices as opposed to continuing with the patchwork of state and local laws and regulations, which hinders efficiency. A holistic electronic mortgage finance system could be developed, providing more efficient forms for clearing property titles, as well as for underwriting, settling, securitizing and trading mortgages. Mortgage servicing policies, protocols and compensation are being rethought, but appropriate standardized frameworks should be established for relevant real estate asset classes, such as performing mortgage loans, non-performing loans, and modified loans. These should be re-examined on a regular basis. There are many more areas that should be reviewed, and I invite others to suggest how to reinvent key operational aspects of the country’s housing finance system.
Our current housing finance system is governed by a complex web of federal, state and local laws and regulations. Individual aspects of my proposal likely could be implemented under existing rules, but certainly not all. A fundamental reinvention of the housing finance system requires legislation that allows for new products, services and operational functions to be developed seamlessly while also clearing away legal and regulatory complexity. This can be done by expanding current legislative proposals to include the legal frameworks needed to establish the desired transformational changes. We should seize the opportunity to adjust the country’s legal and regulatory framework for housing finance, ensuring complexity is reduced and flexibility is increased.
The debate on reforming the U.S. housing finance system is too narrowly focused. Rather than simply deciding the futures of Fannie and Freddie and outlining the role of the federal government, we should reinvent how housing is financed and its risks are distributed. The goal should be to establish a system that is less risky for all – homeowners, financial institutions and U.S. taxpayers – and that is more dynamic, flexible and suitable for our present-day economy. There are clear routes to accomplish this objective, and policymakers in the Administration and Congress should make it a priority to find ways to move responsibly beyond the outdated framework that contributed to the country’s devastating housing crisis.
Richard Morris has been an officer in corporate strategy for two large corporations, including vice president of strategic initiatives with Fannie Mae from July 2006 through May 2011. He currently advises financial services companies on opportunities for growth through business and market innovation driven by insights emerging from the fields of behavioral economics and behavioral psychology. He is also a senior advisor to the Boston Consulting Group for two practice areas: financial institutions and regulatory institutions.