The Miraculous Continuous Workout Mortgage

Professor Robert Shiller

Nobel Prize winner Robert Shiller et al. have posted Continuous Workout Mortgages: Efficient Pricing and Systemic Implications to SSRN. The paper opens,

The ad hoc measures taken to resolve the subprime crisis involved expending financial resources to bail out banks without addressing the wave of foreclosures. These short-term amendments negate parts of mortgage contracts and question the disciplining mechanism of finance. Moreover, the increase in volatility of house prices in recent years exacerbated the crisis. In contrast to ad hoc approaches, we propose a mortgage contract, the Continuous Workout Mortgage (CWM), which is robust to downturns. We demonstrate how CWMs can be offered to homeowners as an ex ante solution to non-anticipated real estate price declines.

The Continuous Workout Mortgage (CWM, Shiller (2008b)) is a two-in-one product: a fixed rate home loan coupled with negative equity insurance. More importantly its payments are linked to home prices and adjusted downward when necessary to prevent negative equity. CWMs eliminate the expensive workout of defaulting on a plain vanilla mortgage. This subsequently reduces the risk exposure of financial institutions and thus the government to bailouts. CWMs share the price risk of a home with the lender and thus provide automatic adjustments for changes in home prices. This feature eliminates the rational incentive to exercise the costly option to default which is embedded in the loan contract. Despite sharing the underlying risk, the lender continues to receive an uninterrupted stream of monthly payments. Moreover, this can occur without multiple and costly negotiations. (1, references omitted)

If it is not obvious, this is a radical idea.  It was not even contemplated before the financial crisis. That being said, it is pretty brilliant financial innovation, one that should not just be discussed by academics. The paper provides a lot more detail about the proposal for those who are interested. And if you want to avoid taxpayer bailouts of the housing market in the future, you should be interested.