Franklin Allen is a professor of finance and economics at The Wharton School, University of Pennsylvania, and co-director of the Wharton Financial Institutions Center. James R. Barth is a Scholar in Finance at Auburn University and a Senior Finance Fellow at the Milken Institute (the non-profit think tank that published this book, in collaboration with FT Press.) Glenn Yago is Senior Fellow/Senior Director at the Milken Institute and founder of its Financial Innovations Labs. These distinguished authors have together written Fixing the Housing Market: Financial Innovations for the Future.
As these authors remind us, there were 48.4 million mortgaged homes in the U.S. as of 2005. Estimates are that nearly 40 percent of these are now “underwater;” that is, they represent negative equity. The prices of homes have fallen more than 40 percent since a 2006 peak, and more than 14 percent of households now face foreclosure or default.
All this poses “the continued threat of … a further downward spiral for neighborhoods and local and state governments that must depend on property taxes to support critical services.”
Back to the Future
In this situation, one factor working against recovery is that the residential finance system is almost entirely a ward of the federal government, “a situation that cannot be indefinitely sustained without seriously damaging monetary stability and the prospects for a return to long-term growth.” It is imperative, these authors believe, that the United States get its private investors involved again in the financing of housing.
In that process, they say, U.S. might have to change some of the spending programs and tax expenditures that entrench various biases in the world of housing finance. At this point I have to pause and note that though the very idea of “tax expenditure,” a phrase they casually use in this context, is in some respects a controversial one, it is indisputable that taxing certain activities and leaving untaxed (or taxing at a lesser rate) other related or alternative activities distorts the movement of capital. The deductibility of home mortgage interest, in particular, favors both ownership over the leasing of a home, and mortgage borrowing over cash-on-the-barrelhead payment. Some reconsideration of this and related policies is surely in order.
By the start of the 21st century the idea had taken hold that a house was a “giant savings account, with the added benefit of appreciation.” This led to the rush to build, or to own and flip, ‘McMansions.’
To the (Danish) Manor Born
So, aside from removing tax and subsidy-based distortions, what do Allen et al suggest ought to be done to draw private money back into the housing market? They are enthusiasts of a Danish model for covered bonds. In Denmark, when a lender issues a mortgage, it must sell an equivalent bond with a matching cash flow and maturity. Both the bonds on the one side and the mortgages they mirror on the other side remain on the balance sheets of the banks.
One of the advantages of the arrangement is that when interest rates rise, and housing prices fall, a homeowner can protect himself, hedging the household’s finances, by buying the corresponding bond. The authors suggest that it is because of these sensible instruments that “Denmark avoided the housing problems the U.S. experienced” over the last decade, even though Denmark was “subjected to greater fluctuations in housing prices.”
The authors don’t believe that the U.S. ought to give up on the goal of helping low-to-moderate income people own their own homes. They believe, though, that there are innovative ways of working toward this end that don’t require “excessive leverage without equity sponsorship.”
One improved approach, they say, is the creation of lease-to-purchase mortgages. The tenancy period of a such a contract could be anywhere from one to five years, and during that period the sponsor could provide credit counseling and property management assistance to the tenant/purchasers. The tenant would then step into the place of the sponsor, assuming a mortgage, when he graduated, so to speak, to homeowner.
The book is, on the whole, well-informed and illuminating. My impression is that the authors do get a bit starry-eyed about some of the ideas they endorse, and that the Denmark model in particular could have used further inquiry. They don’t come down clearly on the question of whether such covered bonds should be considered a substitute for the sort of securitization to which we are accustomed, or merely a complement.