Shared responsibility mortgages

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The mortgages that are predominantly used in U.S. housing finance, and explicitly promoted by the federal government, place an undue amount of risk on families who own their homes. Our main policy recommendation is to encourage the Federal Housing Finance Agency to declare more “equity-like” mortgages as mortgages conforming to the federal government’s securitization guidelines. This would enable these mortgages to be securitized by the federal housing finance giants Fannie Mae and Freddie Mac, which would promote their growth in the home mortgage marketplace.

The widespread use of such mortgages will protect families from unforeseen downturns in the housing market, and will reduce the painful boom-and-bust episodes that have characterized housing markets in recent years. The economic benefits are large. We believe that the Federal Housing Finance Agency must play a critical role in overseeing and enforcing the use of such equity mortgages.

Why debt mortgages are problematic

A home mortgage that currently satisfies the conforming mortgage definition is a standard debt contract, which places a great deal of risk on the homeowner. Suppose a homeowner buys a home for $100,000, using an $80,000 debt mortgage. The homeowner has $20,000 of equity in the home. If house prices drop by 20 percent then the home is worth only $80,000. But the interest payments on the mortgage and the mortgage balance remain the same. House prices fall during economic downturns, which make homeowners less able to pay the mortgage payments. Further, if the homeowner sells the home for the new price of $80,000 then the homeowner must pay the $80,000 mortgage and is left with nothing. The homeowner loses 100 percent of her equity even though house prices dropped only 20 percent.

This is the effect of debt. Debt contracts force losses on the homeowner before the lender bears any loss. This makes no economic sense. The average homeowner in the United States is far less able to bear house-price risk than the investors putting money into the financial system. The use of debt contracts means homeowners are bearing this risk when it would be far better for investors to bear that risk.

In our 2014 book, “House of Debt: How They (and You) Caused the Great Recession and How We Can Prevent It from Happening Again,”¹ we show that the use of debt contracts in housing finance amplifies housing price booms, and makes housing price busts painful for the entire economy. Research shows that severe economic downturns are preceded by mortgage debt-financed housing booms. When house prices fall, the losses are born disproportionately by middle- and low-income homeowners. Further, foreclosures skyrocket, which depresses house prices even for those that continue to pay their mortgage. Homeowners reduce spending dramatically in response to the decline in housing wealth. The sharp drop in consumer spending sends the economy into a tailspin. This cycle explains the Great Depression in the 1930s and the Great Recession of 2007-2009 in the United States as well as the severe economic downturns seen in Ireland and Spain during the previous decade.

The financial system must overcome its addiction to mortgage debt. By uniquely allowing straight debt mortgages to be securitized by Fannie Mae and Freddie Mac, the federal government encourages the exact type of mortgages that we know are bad for homeowners and the overall economy. The government should instead push for more equity-based mortgages, which would provide relief to the homeowners that most need it in case of a downturn in the housing market.

What is an “equity-like” mortgage
and why would it help?

How does a more “equity-like” mortgage work? The mortgage contract we promote in our book is the Shared Responsibility Mortgage. In this mortgage, the principal balance of the mortgage and the interest payments are linked to a local house price index that measures the average value of houses in the zip code of the purchased home. If house prices in the neighborhood fall, the principal balance and interest payments automatically adjust downward. This provides relief to the homeowner exactly when it is most needed: when difficult economic circumstances arise in the neighborhood.

In our book, we use the example of a mortgage in which the principal balance and interest payments adjust downward by the same percentage point as the fall in house prices. So if a homeowner has a monthly payment of $1,000 and house prices in the zip code fall by 20 percent then the monthly payment automatically adjusts downward to $800. If house prices rise once again, the monthly payment will increase up to $1,000, but the payment can never be higher than the original amount of $1,000 paid when the home was purchased, no matter how high house prices go in the neighborhood.

In return for the protection against house price declines, the lender who provides the mortgage is given an extra payment in case house prices rise and the homeowner sells the home. So, for example, if the home increases in value from $100,000 to $120,000 and the owner sells the home, then a part of the capital gain of $20,000 would be paid to the lender. We calculate that only 5 percent to 10 percent of the capital gain would need to be paid to ensure the lender is properly compensated for the downside protection. In this example, this implies a payment of $1,000 to $2,000 out of the $20,000 capital gain.

An interesting related idea is the ratchet mortgage by housing finance specialists Bert Ely and Andrew Kalotay. It is essentially a one-way adjustable rate mortgage where the interest rate paid by the borrower is tied to a long-term government bond rate such as the 10-year Treasury bond. The key characteristic is that interest rates only adjust downward: if the reset formula yields a higher interest rate than the current rate paid by the borrower then the current rate prevails. Interest rates tend to fall in recessions, which would provide automatic savings to homeowners exactly when they need it. Further, homeowners would not bear the risk that interest rates rise in the future. Of course, the initial interest rate on a ratchet mortgage would be higher than a fixed-rate mortgage, but the protection offered would be advantageous to the homeowner and to the broader economy.

Both of these types of mortgages more equitably share house price risk than traditional mortgages. This has large benefits for the economy. When house prices fall, middle- and low-income homeowners using an equity-like mortgage would not bear the lion’s share of the burden. Their interest payment would automatically decline, and their housing wealth would be preserved. As a result, they would not cut spending so dramatically. Equity-like mortgages provide exactly the type of automatic stabilizer the economy needs to avoid severe recessions.

Further, tying mortgages explicitly to house prices would lessen the likelihood of unsustainable bubbles emerging in the first place. Research shows that debt fuels bubbles by engendering false security among lenders. Lenders feel they are immune to the bubble when providing debt financing because homeowners bear almost all of the risk. Explicitly tying house prices to mortgage payments would force lenders to think twice about lending into an unsustainable housing boom.

Are “equity-like mortgages” feasible
in today’s mortgage market?

Yes.

PartnerOwn, a firm based in Chicago, is commercializing a version of the Shared Responsibility Mortgage. Their work has given context to the theoretical benefits for mortgage borrowers, lenders, and investors while also highlighting some of the remaining obstacles.

PartnerOwn’s surveys show that mortgage borrowers prefer the Shared Responsibility Mortgage relative to current mortgage product offerings. In a sample of 40 borrowers at Chicago Housing and Urban Development Homebuyer Workshops, 80 percent preferred it to a 30-year fixed rate mortgage after watching a 15-minute in-person presentation. Sixty percent of online respondents similarly preferred the Shared Responsibility Mortgage after watching a 3 minute-video about the product. Perhaps most encouraging, 80 percent of respondents were able to correctly articulate the payoff structures in multiple scenarios of the product. Millennials, a demographic that is often priced out of more “price stable” neighborhoods, have been among the most interested groups.

Regional banks have been receptive to the Shared Responsibility Mortgage for ensuring the stability of the local market that they serve, and PartnerOwn has begun work on a fund that sources capital from multiple regional banks to provide liquidity for the new home mortgage product. The Federal Reserve Bank of Chicago recently highlighted it in its publication ProfitWise as a tool for Community Reinvestment Act: Shared Responsibility Mortgages, it said, “would also provide benefits to the bank or institution that holds the mortgage, such as helping expand lending to new potential borrowers who are concerned about house price volatility, and potentially helping lenders earn CRA credit for serving LMI [low-to-moderate income] communities.”

Institutional investors are encouraged by the new mortgage’s incorporation of frictionless modifications for mortgage borrowers and the reduction in defaults at a portfolio level. The Great Recession revealed that various government programs, such as the Home Affordable Modification Program and Home Affordable Refinance Program, showed the strains that take place when developing modification rules and applying these on behalf of investors in mortgage-backed securities amid an economic downturn. The Shared Responsibility Mortgage provides modifications when they are needed in a local economy to help keep mortgages performing, and the resultant effects from fewer defaults and streamlined modifications ultimately trickle up to institutional investors.

PartnerOwn’s biggest task is now in ensuring compliance with the various regulatory agencies for residential mortgages, consumer finance, and banking to provide mortgage lenders with regulatory assurance should they become Shared Responsibility Mortgage lenders.

Why does the federal government
need to be involved?

The federal government has been incredibly influential in the U.S. mortgage market since the Great Depression by serving as a provider of liquidity to mortgage lenders and by lowering the cost of funding mortgages. This consideration is even truer today since 94 percent of residential mortgage-backed securities are issued by Fannie Mae and Freddie Mac.²

The two housing giants also have historically defined what mortgages are available to market participants. In the 1970s, their standardized mortgage contracts, such as the 30-year fixed rate mortgage, became available for resale to institutional investors. More recently, the Consumer Financial Protection Bureau has defined a “qualified mortgage” to provide clarity to mortgage-market participants about the rules governing various mortgage products to prevent the more outrageous terms and practices that contributed to the debt buildup that led to the Great Recession.

The government should be involved in promoting the use of mortgage contracts that have better economic properties. We give three specific reasons for government involvement below.

First, by securitizing debt mortgages and not securitizing Shared Responsibility Mortgages, the federal government through Fannie Mae and Freddie Mac provide a huge cost advantage to debt mortgages that meet the definition of a conforming mortgage. The government currently tilts the game toward the mortgages that have bad economic properties. The Federal Housing Finance Authority should even the playing field by declaring the Shared Responsibility Mortgage a conforming mortgage.

Second, the economic benefits of Shared Responsibility Mortgages may not be reflected in private market pricing because of externalities. More specifically, research shows that debt contracts have large negative externalities on the economy that are not properly priced among private parties. The most obvious example is foreclosures. Foreclosures are the direct result of mortgage debt contracts that force the homeowner to bear the losses when house prices decline; a foreclosure has negative effects on house prices throughout the neighborhood. The entire neighborhood is made better off if the lender and any given homeowner agree on an Shared Responsibility Mortgage instead of a debt mortgage. Because such externalities are present, the government should play an important role in promoting this new home mortgage product.

Third, the Federal Housing Finance Authority, and potentially the Consumer Financial Protection Bureau, should play an important role in setting the terms for Shared Responsibility Mortgage contracts, which are more complex than the 30-year fixed rate mortgage contract—and more complexity often comes with manipulation and misleading practices by financial intermediaries. We show in our book that a Shared Responsibility Mortgage with an equivalent interest rate as a 30-year fixed rate mortgage should only require the homeowner to pay the lender 5 percent to 10 percent of the capital gain at sale. One worry would be that a financial intermediary would take advantage of the complexity of the new mortgage product by offering contracts that take much more of the capital gain than is fair. We believe the Shared Responsibility Mortgage has large economic benefits, but the complexity comes with the need of oversight.

A more stable housing market

Housing is crucial to sustaining a strong middle class, but the current mortgage finance system encourages volatility and excessive risk-bearing by homeowners. More equity-like mortgages such as the Shared Responsibility Mortgage would stabilize the housing market and protect homeowners against economic downturns. The benefits would accrue to the entire economy.