Selling equity in your house

Robert Waldmann

was working on a post about how financial innovation is profitable and pernicious. The ideas are that profitable new financial instruments are used to evade prudential regulations and to make financial markets more confusing so unsophisticated investors can be fleeced.

Then I thought of a kind of financial innovation which might be profitable and useful.

One financial innovation which would have been useful if it had taken off is the Shiller local home price bond. This is an instrument indexed to home prices in a locality (that is to say I won’t be able to explain it any more clearly. I’m sure shiller can. Use google scholar). This is something local governments should sell as their property tax revenues depend on local real estate values. That risk can be delocalized, that is, diversified, with benefits both the the local citizens and investors who hold a diversified portfolio of real estate indexed bonds. Good idea. Not profitable.

One financial innovation which caused trouble is the home equity loan. This enabled people to risk foreclosure. It contributed to the current crisis (less than sub-prime first mortgages but some). Atrios has a theory. He thinks that the problem is that people thought they were selling part of their home to the bank, not using part of their home as collateral on a loan. They didn’t understand that the bank bore risk only in the case of foreclosure.

OK so how could people sell part of their home to a bank ? It sure wouldn’t work to say the bank owns 10% of this home and gets some interest rate times the assessed value of the home. First home assessors would make out like bandits. Second the adverse selection and moral hazard problems would be huge.

OK ex Prof Black meet Prof Shiller — the Shiller bond is the instrument which enables home owners to shift the risk to someone else without creating huge state verification costs and agency problems.

The deal is as follows.
Bank give Ms and Mr J. Doe some cash $Z.
Ms and Mr J. Doe owe the bank a constant alpha times the Shiller price index for their locality. Ms and Mr Doe must pay an interest rate of x% (should be indexed but hey let’s not be too innovative make it a fixed nominal interest rate) times their debt plus y% of the outstanding debt each year. So debt in dollars changes with this payment then with the change in the index. y% of the house is collateral.

This way if the local economy tanks and house prices fall, the bank bears the burden (which they can pass on to MBS buying suckers of course). If there is a housing bubble without an increase in wages, the Does have a cash flow problem. They also have equity in their home again so they can sell another bit to another bank to meet their payments.

I think, in this way, it is possible for homeowners to hedge that part of their house price risk that they don’t personally control (doesn’t depend on whether they maintain their house) or have private information on (doesn’t depend on whatever the hell is happening with our plumbing which I don’t know exactly what it is but it will cost the owner(s) of the house where I am typing quite a bit).

That way they can borrow without leveraging up and increasing the risk of foreclosures.

Also works for the thrifty as the bank can agree to pay a constant amount of cash to the Does each year in exchange for the house price indexed flow (which is naturally hedged by new equity generated by changes in local housing prices).

update: I still don’t have a post dumping on financial innovation, but I do have a title “Structured by Cows ?”.