1. Introduction and Objective

This article aims to propose alternatives ways of encouraging the democratization of finance, specifically in the area of real estate innovation and, that is, in risk management. Despite the increase in the complexity of both the financial markets and information technology, the owner-occupied finance industry has advanced very little in recent decades.

Real estate is an important, if not the most important, storage of wealth in the economy. On average, households in developed countries have an excessive property allocation with an exposure of between 40% and 70%. Therefore, the wealth effect of changes in house prices is much larger than in other asset prices.

As changes in real estate values impact the well-being of millions of people, there are needed strong grounds for improving property risk management and creating hedging instruments. During the financial crisis, outdated mortgage products based on the payment of monthly instalments did not help households to adapt to falling incomes; therefore, a thorough study of property finance innovations is needed, all the more so because the cyclical nature of property markets has direct consequences for the wealth of society.

The financial industry, governments, and international institutions should work to establish innovative approaches which can avoid negative future impacts on households’ wealth and can obtain positive externalities from the promotion of mortgage lending.

 

The Need for Innovation in Property Risk Management for Households

Why a New Famework is Needed to Manage Household Property Risk

The development of the finance and banking industries has contributed to economic growth. According to Patrick, there is a positive correlation between economic development, the variety of financial institutions and the number of financial assets; so, the launch of innovative products such as loan-based-crowd funding, Real Estate Investment Trusts (REITs), or hedging instruments is the way to democratize finance.

In this context, there is a clear need for innovative financial instruments that can help to soften future impacts on households’ wealth. Therefore, risk-sharing tools should be created to improve risk management and to help this most vulnerable segment of society. As in the case of savings for retirement or public health care, institutions should lead the democratization of finance by providing incentives to innovate and by helping to launch new real estate finance products that can improve the management of the risk involved.

Since homes are a primary need, the development of real estate finance on the basis of democratization and innovation is a source of economic growth. Governments should encourage innovation by providing incentives for research: for example, through fiscal incentives for financial entities brave enough to launch innovative products that provide financial advantages for households. However, some may still think that the costs of adjusting markets are higher than the costs that a free market can generate; recent events have changed the mindset of political and economic leaders.

Some eight years have passed since the financial and real estate crisis and several developed countries have received huge bailouts, but there has not been any significant development in property hedging products. A great deal of work remains to be done.

 

Lack of Real Estate Financial Innovation Post-Crisis

 

The main risks households face when financing a property are liquidity, capital value variations, and cash flow generation in order to pay down the loan. Despite the significant evolution of the financial markets during the second half of the twentieth century, mortgage contracts have hardly changed since the launch of the long-term fixed-rate self-amortizing mortgage introduced in the US in the 1930s. The main innovations have been the extension of the credit period and the introduction of fixed or variable interest payments. Mortgage providers also offer hedging products such as payment by instalments or the freezing of mortgage payments in case of job loss for a certain period of time, or a mortgage insurance in case of death of the credit holder.

A certain amount of regulation was introduced after the financial and real estate crisis, notably the Dodd-Frank Act in 2010, but financial institutions are again lending at loan-to-value ratios close to 100% [15]. The softening of credit standards is a questionable policy considering the risks undertaken both by the mortgagor and the financial institution itself—all the more so if one thinks that financial entities are not offering innovative tools for risk management [16]. Therefore, households will be highly vulnerable to future crises. Moreover, as a consequence of the lemon market, banking entities charge households and small and medium enterprises more for capital, thus damaging the financial structure of these more vulnerable segments.

 

Excessive Risk-Taking by Households and the Leverage Cycle

 

Households’ debt during the boom increased significantly and presented enormous differences between regions. These differences are difficult to explain using a purely rational approach. A behavioral approach, however, can identify several triggers that can elicit particular responses: an aggressive financial marketing campaign, limited financial knowledge, herd behavior, the fear of regret, excessive optimism, momentum investing, the gambler’s fallacy, or cognitive dissonance.

For Glick and Lansing there is a consistent leverage cycle, and during bubble periods there is a high risk that the debt will exceed the collateral. This may have dramatic negative effects, such as foreclosures or undiversified asset portfolios, as Geanakoplos suggests. Therefore, it is important that public institutions manage the leverage cycle.

From the perspective of households, it is clear that real estate finance must introduce greater innovation in order to improve risk management, diversification, and hedging.

 

A New Framework for Owner-Occupied Property Finance: Hedging Housing Value Risk

 

Despite the importance of hedging property values, the market had few hedging instruments available at the start of the recent crisis, as the former Federal Reserve Chairman, Ben Bernanke, highlighted. Capital value risk, which is correlated with macroeconomic conditions, credit market conditions, regional economy conditions and consumer behavior, affects not just households, but also lending institutions, investors in structured products backed by residential mortgage loans, and in fact the economy as a whole.

We highlight a series of proposals for hedging property value through four main themes: mortgage innovation, insurance, property derivatives, and hedging alternatives.

 

Conclusions

 

Properties represent a very large proportion of the total wealth in developed countries. Despite the potentially negative effects of financial markets, especially in the short term, the development of real estate finance on the basis of democratization and innovation is a source of economic growth.

If, in the last decade, the value of homes had been guaranteed, especially against the risk of price falls, the impact of the financial crises would have been vastly reduced. Against this background, a new framework of financial instruments that hedge property values is an unavoidable necessity for the well-being of society. Its creation may not be easy, but the recent crisis should encourage improvement and innovation.

Products, such as home equity value insurances, synthetic real estate, price level-adjusted mortgages, financial leasing for homeowners, and other hedging instruments, should be introduced in the markets in order to use finance for the benefit of society and, especially, of the most vulnerable individuals.

Given that homes are a primary need, governments should encourage innovation through policy incentives that reduce barriers to market entry and turn innovation into investment and economic value. In this regard, just as many financial entities require clients to take out life and home insurance when a new mortgage is signed, governments, international economic development organizations, labor unions, or professional organizations should help households to take optimal decisions to hedge or insure the values of the properties they own.

Summarizing, academics, governments, the financial industry, and households should all push for an improvement in the instruments available for owner-occupied property risk management to hedge asset values.

References

  1. Case, K.E.; Quigley, J.M.; Shiller, R.J. Wealth Effects Revisited 1978–2009. Cowles Foundation. Yale University 2011, Discussion Paper 1784.
  2. Case, K.E.; Quigley, J.M. How housing booms unwind: Income effects, wealth effects, and feedbacks through financial markets. J. Hous. Policy 20088, 161–180.
  3. Patel, K. Lessons from the FOX residential property futures and mortgage interest rate futures market. Policy Debate 19945, 343–360.
  4. McCulloch, J.H. Risk characteristics and underwriting standards for price level adjusted mortgages versus other mortgage instruments. Financ. Rev. 19865, 65–97.
  5. Caplin, A.; Chan, S.; Freeman, C.; Tracy, J. Housing Partnerships: A New Approach to a Market at a Crossroads; MIT Press: Boston, USA, 1997. Available online: http://goo.gl/jYN7tK (accessed on 10 of September of 2015).
  6. Seiler, M.; Webb, J.; Myer, N. Diversification issues in real estate investment. Real Estate Lit. 19997, 163–179.
  7. Weiss, A.N.; Shiller, R.J. Home equity insurance. Real Estate Financ. Econ. 199919, 21–47.
  8. Bakke, E. Income-Linked Loan Contracts in a Norwegian Perspective. Case: Norwegian State Education Loan Fund. Norges Handelshoyskole, 2006. Available online: http://goo.gl/bQjUQ1 (accessed on 20 of September of 2015).
  9. Shiller, R.J. The New Financial Order: Risk in the 21st Century; Princeton University Press: Princeton, USA, 2009.
  10. Pierson, M.W. REO to Rental: The Creation of a New Asset Class and the Transformation of the American Single Family Landscape. Doctoral dissertation, Massachusetts Institute of Technology, Cambridge, MA, USA, 2014. Available online: http://goo.gl/dpNBvl (accessed on 02 of October of 2015).
  11. Gaytan, A.; Ranciere, R. Wealth, Financial Intermediation and Growth, 2004. Working Papers Universitat Pompeu Fabra. Available online: https://goo.gl/gc388b (accessed on 02 of October of 2015
  12. Patrick, H.T. Financial development and economic growth in underdeveloped countries. Dev. Cult. Chang. 196614, 174–189.
  13. Roig, J.; Soriano, J.M. Liquidez y cotización respecto al valor neto de los activos de los REIT españoles (las SOCIMI). Eur. Dir. Econ. Empres. 201524, 92–107.
  14. Green, R.K.; Wachter, S.M. The American mortgage in historical and international context. Econ. Perspect. 200519, 93–114.
  15. Calavia, M. La Banca Vuelve a Dar Hipotecas por Hasta el 100% del Valor de Tasación. CincoDías, 14 April 2015. Available online: http://goo.gl/D88xQx (accessed on 04 of October of 2015).
  16. Shiller, R.J. Why is Housing Finance Still Stuck in Such a Primitive Stage? Econ. Rev. 2014104, 73–76.
  17. Roig, J. Análisis e Inversión en el Mercado Inmobiliario Desde Una Perspectiva Conductual. Tesis Doctoral, Universitat Politècnica de Catalunya, Barcelona, 2015. Available online: http://goo.gl/ostk8X (accessed on 02 of September of 2015).
  18. Glick, R.; Lansing, K.J. Global Household Leverage, House Prices, and Consumption. FRBSF Economic Letter, 11 January 2010. Available online: http://goo.gl/v6JLAc (accessed on 04 of October of 2015).
  19. Geanakoplos, J. Leverage, default, and forgiveness: Lessons from the American and European crises. Macroecon. 201439, 313–333.
  20. Bernanke, B. Home Equity Insurance. Equity. Lock Financial, 2008. Available online: https://goo.gl/T3VKlE (accessed on 10 of october of 2015).
  21. Gras, R.; Roig, J.; Soriano, J.M. Análisis y pronóstico del precio de la vivienda en España: Modelo econométrico desde una perspectiva conductual. Estud. Empres. 20151, 145–166.
  22. Sinai, T.M.; Souleles, N.S. Can Owning a Home Hedge the Risk of Moving? Working paper 15462; National Bureau of Economic Research: Cambridge, MA, USA, October 2009. Available online: http://goo.gl/o2lhcd (accessed on 10 of October of 2015).
  23. O’Brien, J. A Revolutionary Help for Homeowners, The Christian Science Monitor, 26 November 2008. Available online: http://goo.gl/nZsCta (accessed on 20 of October of 2015).
  24. Shiller, R.J. Derivatives Markets for Home Prices; Working paper w13962; National Bureau of Economic Research: Cambridge, MA, USA, April 2008. Available online: http://goo.gl/nh1n1R (accessed on 20 of October of 2015).
  25. Fernandez, J.; Llovera, F.J.; Roig, J. Los REITs españoles como vehículo de inversión y financiación de la actividad inmobiliaria: Las SOCIMI. Cap. 20128, 308–363.
  26. Fabozzi, F.J.; Shiller, R.J.; Tunaru, R.S. Property derivatives for managing European real estate risk.
    Financ. Manag. 201016, 8–26.
  27. Baum, A. Real Estate Investment, 3rd ed.; Routledge, Taylor & Francis Group: Oxford, UK, 2015.
  28. Shiller, R.J. An Interview with Robert Shiller. The Politic, April 3 2010. Available online: http://goo.gl/xfjaG7 (accessed on 02 of September of 2015).
  29. Sánchez, A. C.; Andrews, D. To Move or Not to Move: What Drives Residential Mobility Rates in 630 the OECD? Working paper 846; Organization for Economic Co-operation and Development: Paris, France, February, 2011. Available at: 631 http://goo.gl/qXVkkt (accessed on 07 of September of 2015).
  30. Housing Market, Financial and Social Stability in Europe. 2014. Available online: http://goo.gl/rTTB3D (accessed on 20 of August of 2015).
  31. Kroszner, R.S.; Shiller, R.J. Reforming US Financial Markets; MIT Press: Boston, USA, 2011.
  32. Hellebrandt, T. The Economics and Estimation of Negative Equity. Quarterly Bulletin, Q2, 2009. Available online: http://goo.gl/ZtjSEP (accessed on 20 of October of 2015).
  33. Duffy, D.; O’Hanlon, N. Negative equity in Ireland: Estimates using loan-level data. Eur. Real Estate Res. 20147, 327–344
  34. An, X.; Deng, Y.; Gabriel, S.A. Asymmetric information, adverse selection, and the pricing of CMBS.
    Financ. Econ. 2011100, 304–325.
  35. Patoine, B. Desperately Seeking Sensation: Fear, Reward, and the Human Need for Novelty: Neuroscience Begins to Shine Light on the Neural Basis of Sensation‒Seeking; Dana Foundation: New York, USA, 2011.
  36. La Porta, R.; Lopez-de-Silanes, F.; Shleifer, A.; Vishny, R.W. Legal determinants of external finance.
    Financ. 199752, 1131–1150.
  37. Roig Hernando, J. «Humanizing finance by hedging property values.» Journal of Risk and Financial Management 9.2 (2016): 5.

Deja una respuesta

Cerrar menú