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.

Shiller on Primitive Housing Finance

Robert Shiller has posted Why Is Housing Finance Still Stuck in Such a Primitive Stage? The abstract for this brief discussion paper reads:

The institutions for financing owner-occupied housing have not progressed as they should, and the financial innovation that has followed the financial crisis of 2007-9 has not been focused on improving the risk management of individual homeowners. This paper lists a number of barriers to housing finance innovation, and in light of these barriers, the problems of some major innovations of the past and future: self-amortizing mortgages, price-level adjusted mortgages (PLAMs), shared appreciation mortgages (SAMs), housing partnerships, and continuous workout mortgages (CWMs). (1)

The paper is more of an outline than a fleshed out argument, but it has some interesting points (and not just because the author recently won a Nobel Memorial Prize in Economics).  They include

  • Shared appreciation mortgages (SAMs), which offered some risk management of home price appreciation, were offered by the Bank of Scotland and Bear Stearns in the 1990s, but acquired a damaged reputation with the boom in home prices. U.K. homeowners who took such mortgages, and lost out on the speculative gains, were so angered that they filed a class-action lawsuit against the issuers. The suit was dropped, but the reputation loss was permanent. (5)

  • There has been some questioning of the assumption that insuring homeowners against a decline in home value is a good thing. Sinai and Soulelis (2014) have written that the existing  mortgage institutions may be close to optimal given that people want to live in their house forever, or move to a similar house whose price is correlated with the present house, and so are perfectly hedged. But their paper cannot be exactly right, given the sense of distress that homeowners are experiencing who are underwater. They are more certainly not right about all homeowners, many of whom actually plan to sell their home when they retire. (5-6)

  • The difficulties in making improvements in mortgage institutions have to do with the complexity of the risk management problem, coupled with mistrust of institutional players. The Consumer Financial Protection Bureau, created by the Dodd-Frank Act and having authority over mortgages, among other things, seems oriented towards addressing complaints from the public, and has focused its attention so far on such things as unfair collection practices, bias against minorities, and excessive complexity of financial products being used to confuse customers. These are laudable concerns, but complaints that economists might register about the fundamental success of mortgage products to serve risk management well have not yet taken center stage. (6)

  • New Development economics, Karlan and Appel (2011), Bannerjee and Duflo (2012) has shown how carefully controlled experiments can reveal solid steps to take regarding new financial institutions for poverty reduction. The same methods could be used to improve mortgage institutions, as well as rental, leasing, partnership and cooperative institutions, in advanced countries. (7)

These are just brief thoughts. It will be interesting to see how Shiller develops them further.