- 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 During the financial crisis, outdated mortgage products based on the payment of monthly instalments did not help households to adapt to falling incomes; therefore, a thorough study of property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% . 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 . 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.
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.
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