Today, University of Cambridge Professor of Geography Susan Smith explains how the property market carries unnecessary risk for home buyers – risk that could be avoided through the use of prudent financial innovation.
The idea of financial innovation around housing is generally viewed with disdain these days. After all, it sparked a major economic crisis, and is seen as a cause of, rather than a solution for, the problems of the world economy.
But the truth is that housing markets are financially quite conservative. There is nothing very innovative about the way that homes are traded, for example. And that in itself is problematic.
Even now, we do not understand the beliefs and behaviours that drive home prices. Indeed, there is a lot we do know about the equity side of the housing equation. As a result, ordinary home buyers have far too much resting on the investment return on their property. They tend to hold all nearly of their wealth in a single and unusual investment vehicle, which is neither sensible nor useful, and can be extremely risky.
Mortgage markets have attracted more attention. But even mortgages, at root, have changed rather little over the years, despite all the bells and whistles attached to modern products. To be sure, there have been myriad novel features built into mortgage contracts – including an array of options for people to borrow more as home prices rise. But these are just embellishments on the basic self-amortising loan, linked to nominal interest rates.
One consequence of this underlying inertia is that there is far too little risk-sharing built into mortgages. There are all kinds of future uncertainties whose risks are not shared in these instruments, and this is especially problematic, in my view, in relation to home price volatility. Some people say such volatility doesn’t matter when people move home so infrequently and usually go on to buy somewhere else. But it does matter if housing wealth is your asset-base for welfare, and it matters even more if that wealth could do better in a different investment vehicle.
In short, financial innovation is limited in some key elements of the housing economy. The really big 21st century innovation occurred instead in financial markets, and even here key initiatives centred on massively increasing the supply of credit, rather than on managing the housing economy as a whole. Mortgaged-backed securities and mortgage-heavy collateralised debt obligations, for example, were used to raise money from investors and this in turn created a wave of credit that was channelled back to a growing pool of ever more marginalised borrowers. The rest as they say is history – and a sorry tale it turned out to be.
The very odd thing here is that financial markets proved so disinterested in instruments designed to spread the risks and share the gains of housing assets – even though mortgage debt is, of course, anchored on them. This neglect compounded the problems that the oversupply of credit helped create and it makes me wonder whether, despite the problems caused by innovations in financial markets in the past (by over-complex, unjustly opaque and poorly regulated financial engineering) a fairer housing future may in the end depend on having more innovation, not less.
For example, I would be interested to see banks take seriously the idea of mortgages that not only share interest rate risks between lenders and borrowers, but also share price, or investment risks. I would also be keen to give people the option to reduce their housing costs by not buying the whole of the investment vehicle linked to their property.
After all, when you pay $400,000 for a home, the housing services component (the cost of enjoying the accommodation it confers) might only be worth, say, $350,000. The remainder – say $50,000 – is something that, as an owner occupier you are forced to put into an investment vehicle whose performance depends on the fortunes one little plot in the corner of a single neighbourhood. That’s risky, and I think it is unnecessary.
To change things for the better, I would like to see a housing system where owner occupation as we know it is broken apart. That is, instead of having to tie my bundle of housing services to the lumpy idiosyncratic savings vehicle attached to it, I would like to keep my choice of accommodation separate from decisions about my wealth portfolio. I can’t do this, and neither can anyone else, without another round of financial engineering. Whether we dare go there – whether markets can be reformed and regulated sufficiently for us even to consider it – is more a matter for governments and policy makers than for financial engineers and investors.
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