Real Estate Economics

Economics allows one to spot market failures, and to propose new and superior mechanisms to replace outmoded ones. In real estate finance, the big idea that I have been developing concerns markets in housing equity. One day, these markets will exist worldwide, and I will get to participate in the transition from a debt only structure to a debt and equity structure in the market for residential real estate finance. The material below details how I became involved with these issues, which are bearing practical fruit in Australia. Moreover there are many reasons for optimism that a U.S. launch will occur within the next few years. Among the reasons for optimism are that many problems in mortgage design have been ironed out over the past few years, and that leaders in the business, academic, and policy community have begun to focus on how essential an innovation these mortgages represent if there are to be any further advances in homeownership. The following paper co-authored with James Carr and Zhong Yi Tong of the Fannie Mae Foundation and Fred Pollock is representative in this regard (Trivikraman Thampy and Kheng Mei Tan provided invaluable research assistance, as acknowledged).

Shared Equity Mortgages, Housing Affordability, and Homeownership

There is another, and far less happy, reason for optimism that these mortgages will at some point be launched in the U.S. Lack of availability of equity options not only played a role in triggering the current wave of defaults, but also blocks renegotiation of terms. When a business has borrowed more than it can afford to pay off, it commonly enters a renegotation phase with lenders. Provided the business has continuing value, a lender may be willing to convert some of the debt into equity, lightening the immediate burden and allowing the business to regain stability. Such options might be of great value to distressed borrowers in the current market, and asset markets may look favorably on the opportunity thereby to prevent distress sales at rock bottom prices. Unfortunately, the U.S. regulatory framework is archaic in insisting that ownership of housing equity is an all-or-nothing affair. It is in part for this reason that many will soon have nothing. One can only hope that those in positions of power will put in the hard work necessary to open such options to those who are currently in distress. If not now, when?

The history of my involvement with this idea is roughly as follows. In 1993, Charlie Freeman, Joe Tracy, and I were working together on a project that produced data on refinancing of mortgages. We soon uncovered a disturbing fact: those who lived in areas in which house prices had fallen were unable to refinance their mortgages when interest rates fell. This struck us as both damaging, and absurd. Why should those most in need of a cost reduction be denied the right to a lower interest rate merely because they lived in poorly performing real estate markets? We proposed that the mortgage contract be amended to allow even those in such markets to refinance if rates fell significantly. We wrote up our findings and our proposal in an article entitled "Collateral Damage: How Refinancing Constraints Exacerbate Regional Recessions". We then submitted the paper for publication in the Journal of Political Economy. It received a contemptuous review, based on the simple proposition that "if such a simple contract amendment was such a good idea, it would already be here." Fortunately, we were able to publish in the Journal of Money, Credit, and Banking.

Why did our JPE reviewer make such a superficial comment, and why does our profession allow it to pass unchallenged? Because it relates to a very profound question that does not as yet have a good answer. The question is why many simple ideas with wide social benefit do not get put into practice. So challenging is this question that economists grasp at straws in trying to answer it. One of these straws is the claim that the question itself is poorly posed. If there were indeed such ideas, so this argument goes, they would already be in practice. After all, people will pay for things they like, so that the profit motive will ensure that good ideas are indeed put into practice. So any reformer claiming to have some simple new formula for social improvement is likely delusional. Hence the review.

By background and by temperament, I do not like the imposition of arbitrary authority. I also have a strong nose for BS. My coauthors were similar in this regard, and so we decided to propose a far bigger idea that we believed would provide massive social benefit, and yet was equally absent from the economic scene. Many economists buying their first house are surprised at the primitive capital structure. Why all debt, why no equity? Rather than simply having this thought and passing on, we settled down to writing a conference paper proposing an entirely new capital structure for the housing finance market. We presented this paper at a conference on Kiawah Island in 1995, full of impish joy at making so bold a proposal in front of many top housing economists. Our joy was short-lived. The paper was brushed aside by discussants, and was rejected from the conference volume. We were sent a note by the conference organizers "wishing us luck in finding an outlet for our ideas".

Another day, another challenge. We decided to up the ante, and to write a book showing that our idea for equity markets had profound economic logic, and that it was institutionally viable. Sewin Chan joined us in writing this book, of which I am extremely proud. It provides a broad tour of the relevant economic ideas, as well as getting to grips with many contractual and institutional details. Here is a link to the book itself, as well as to the review in the New York Times. The first link also connects you to the MIT Press, where the book can be ordered.

Housing Partnerships: A New Approach to a Market at a Crossroads with Sewin Chan, Charles Freeman and Joseph Tracy. Cambridge and London: MIT Press, 1997, pages xiv, 265.
Read the first chapter
Household Asset Portfolios and the Reform of the Housing Finance Market with Sewin Chan, Charles Freeman and Joseph Tracy. TIAA-CREF Research Dialogues 59, February 1999, pages 1-12.

They say that overconfidence is universal, and of possible evolutionary value. If so, survival of my line is assured. Ed Glaeser and Bob Shiller both wrote very supportive reviews. More generally, I expected there to be a rapid and strong reaction to these ideas, whose force is overwhelming to those of a rational bent. Instead, the book received a tepid response from economic researchers, who apparently wondered why I, an established economic theorist, would take time off from "real" research (i.e. proving theorems) to dabble in worldly ideas way beyond my ability to understand or to influence. Certainly, my professional stock fell as I revealed a taste for reality. And while the ideas were enjoyed by some policy types and practitioners, none of those who initially contacted us were able to move the ideas forward.

The lukewarm initial response led to a period of idling. During this time I continued to pursue the abstract question that had initially motivated my urge to interact with the living laboratory of economic ideas that reality provides. Why do so many good ideas come to nought in markets for housing finance? And what does this say about the broader sources of institutional inertia? With respect to the former, I wrote a brief paper on the painfully slow growth of the reverse mortgage market. With respect to the latter, I put down some ideas that constitute a "proto-theory" of institutional inertia. In essence, there appears to be an inertial equilibrium in which governments, firms, and consumers all play an intimate role.

The Reverse Mortgage Market: Problems and Prospects forthcoming in Pension Research Council Volume on Innovations in Housing Finance for the Elderly, edited by Olivia Mitchell, 2001

Inertia in the U.S. Housing Finance Market: Cases and Causes, mimeo

At the end of 2001, I was unsure about next steps. What wonderful changes have taken place since that time! At that time, the (then) Prime Minister, John Howard, became aware of these ideas, and commissioned several authors to write a report on housing finance reform in which they played a prominent role. There is every reason to believe that within 3 years, markets in shared equity mortgages will be under-way in at least three countries: Australia, the U.S., and the U.K. While I fully intend to take a significant role in shaping the development of these markets, many others have made, and will continue to make, key contributions. Watch this space for additional postings on developments in these markets world-wide. Please feel free also to email me if you know of any developments that are worth sharing.