5. Future Innovations in Housing Finance

In this chapter, we examine the situation of housing finance in the wake of the mortgage meltdown and global credit crisis, the structural shifts in demand that will drive housing finance innovation in the future, and current supply constraints and attempts to overcome them.

The means and methods of financial innovation for housing are similar for both developed and emerging markets:

• Diversifying sources of capital (debt and equity)

• Structuring financial products that will promote private capital investment to return to residential real estate construction, maintenance, and sustainable improvement

• Diversifying types of housing products (single/multiple family)

• Higher-density, sustainable buildings that increase housing consumers’ cash flow and ability to service long-term debt

• Pooling savings and risk-management products

• Credit enhancement

• Information technology to monitor and improve efficiency in housing finance

The cascade of foreclosures and defaults, decline of homeownership, and explosion of “underwater” mortgages overwhelmed both aspiring and existing homeowners in recent years. Home prices have fallen more than 40% since their peak in 2006, one in seven households with mortgages faces foreclosure or default, and nearly 40% of the 48.4 million homes with mortgages are “underwater,” meaning that the remaining debt exceeds the value of the property.

The tendency for property prices to fall to the level of foreclosures raises the continued threat of negative equity and a further downward spiral for neighborhoods and local and state governments that must depend on property taxes to support critical services.

Sharing this deep underwater experience that drowned the U.S. housing market are the giant government-sponsored enterprises currently under federal conservatorship, Fannie Mae and Freddie Mac. Acute challenges loom, but they also suggest the way out.

Post-Crisis Housing Markets

Effectively, most of the costs of housing finance risk have been nationalized through the recent crisis. The residential finance system is nearly completely supported by the federal government, a situation that cannot be indefinitely sustained without seriously damaging monetary stability and the prospects for a return to long-term growth. While the financial crisis management led to the recapitalization of large financial institutions, the challenges to revitalize housing finance remain unaddressed, despite green shoots of renewal covered in this chapter.

Until the recent financial crisis, the private sector played a major role in funding residential real estate. Today the way mortgages are originated and sold to the capital markets must be reformed before private capital returns. Most lending institutions held mortgages on their balance sheets, and many investors—domestic and international—bought securities backed by those mortgages. Access to housing finance had grown dramatically and steadily over the preceding decade, and homeownership reached historic highs.

Although the financing of the housing sector remains largely broken, the demographic drivers that will require the return of financial innovation continue unabated. The developed world and emerging markets continue to serve as laboratories for new financial products.

Lending institutions have curtailed credit to the real estate sector as they recapitalize their balance sheets, and investors have cut back on purchases of mortgage-backed securities. The securitization of mortgages by private firms collapsed along with private investor participation. Moreover, most of the funding goes only to the most creditworthy individuals.

This dramatic shift in funding poses a major problem that has yet to be addressed: a growing gap in the availability of credit to residential real estate markets in both mature and emerging markets.

In the U.S., the government has focused on stemming the tide of home foreclosures through loan-modification efforts while also providing its own credit to the housing sector. But this crisis management is not designed to get real estate markets functioning normally again.

Governmental resources are much smaller than those of the global capital markets that must ultimately return to channel investment into housing. Thus, sole dependence on the Federal Reserve and other public entities or GSEs (or similar housing finance agencies overseas) continues to threaten national economic growth and stability. With both major GSEs in conservatorship, the federal government acts as conservator, regulator, and prime investor through the budget (up to $200 billion annually) to keep the housing market liquid. One saying in economics is that trends that can’t go on forever won’t. This is one of them.

Structural Shifts in Housing Demand

It’s important to step back and examine what conditions are brewing to drive the next wave of financial innovation—structural shifts in the demand for capital in housing. By 2010, the ultimate global transition occurred as the majority of the world’s population came to live in cities; more than 50.5%, or 3.5 billion people, now reside in urban areas. All future global population growth will occur in urban areas.¹

By 2030, nearly 60% of the world’s population will be urban and more than half will be living in slums. In the developing world, an average five million new urban residents are absorbed in cities each month. Resulting housing shortages are accompanied by increasingly high rates of the depletion of housing stock. Historically, economic growth is always accompanied by decreases in family size, resulting in additional demand for new housing units.

In the U.S., as in many developed countries, immigration drives the majority of population growth. Currently representing 13% of the population in the U.S., immigrants will account for 70% of the population growth and future demand for housing. Their needs, their preferences in housing, and where they locate will drive much housing demand.

Meanwhile, additional age structure and household formation dynamics complicate the demand for capital in housing and need for financing a great portfolio mix of types (single family or multifamily), forms (ownership and rental), and styles (high/low density) emerging in the market.

Younger age cohorts in the population face declining income prospects, with real median household incomes in all age groups under 55 not having increased since 2000. For the youngest working cohorts (25–34), incomes are continuing to fall as they have for the past decade. This trend suppresses household formation due to high unemployment and reduces housing demand in the current period, but accelerates it later as it joins other cohorts in rising demand.²

With flat incomes, lost equity in homes, and a declining group of upwardly mobile buyers, housing finance will need to be reinvented. As job creation and economic growth return, housing demand will surge among those who deferred household formation, along with increased needs for single-family and multifamily housing. New entrants in the housing market will require a greater variety of housing options and innovations in finance, construction, and sustainability.

Financial Innovation in Housing: What Works? What Doesn’t?

Common to all the innovations we’ll examine are answers to some underlying policy questions: What is the structure or preference of tax or other subsidies? What works best, people- or place-based subsidies and incentives? What are the regulatory supply-side constraints in the provision of land and space for development and associated development rights? How can those future construction rights be transferred and ultimately financed? What is the role of information technology in bridging gaps in information about credit analysis, risk, and information concerning housing? How can technology reduce transaction costs and clear the path from savings to investment in housing?

People- Versus Place-Based Subsidies: Policy Successes and Failures in Innovating Housing Finance

Before we examine new waves of financial innovation in housing, it’s important to consider some general principles of the incentives that drive housing access and affordability. Tax subsidies, regulatory constraints on property supply through zoning and land-use planning, and technological advances that can bridge information asymmetries in assessing risk should all be considered as elements in the process.

The mortgage interest rate deduction was by far the most prominent feature of tax subsidy for homeownership. From a distributional perspective, the mortgage deduction (as with all deductions) disproportionately favors the wealthy. Although the ownership subsidy has significantly risen over the past 40 years, the rate of homeownership has not varied greatly with those increases. This suggests that the deduction alone has exhausted its ability to subsidize or increase ownership on a sustainable basis.³

Although the subsidy contributed to higher demand for larger dwellings (to maximize tax deductibility), increases in total housing stock and its affordability were not maximized through the mortgage deduction. Incentives to maximize deductions through increased leverage and housing size undermined housing sustainability financially and environmentally.

On the other hand, growing evidence indicates that targeted innovations in public policy and financial innovation can increase housing stock and access. Subsidized housing for lower-income residents in many circumstances complements and does not crowd out private investment on a net basis. Government finance raises the total number of units, even with some displacement of privately generated housing. In populous markets, there is less crowding out.

In terms of innovations, the programs that have greatest effect target individual mobility rather than improvement in specific locations. Subsidizing brick-and-mortar building through tax preferences rather than consumers’ ability to exercise their own housing preferences leads to outcomes opposite the intended effect of maximizing housing quantity, quality, and choice.⁴

Project-based programs are least effective at subsidizing housing for those who need it. Tenant-based programs that provide certificates and vouchers maximizing choice are most effective in increasing housing stock.⁵

Supply-Side Housing Innovations

An increasing amount of evidence suggests that zoning and other land-use controls contribute to lack of affordability in housing.⁶ Zoning restrictions are associated with higher prices by decreasing the available land for construction and development. This suggests that these forms of government regulation contribute to high housing costs.⁷

Reducing implied land-use taxes on new construction has had a considerable impact on housing prices when included in policy innovations. In England, for example, the use of supply-side finance policy demonstrated support for housing affordability through land-use planning.⁸

One key element in nearly all programs is the use of transfer of development rights (TDR). These programs increase housing supply by enabling owners to sell development rights, while encouraging denser residential development in city centers. New development can make an important contribution to housing affordability.⁹ The creation and financing of transfer of development rights has been demonstrated in many developing and transitional markets, from India to Russia.

Technology and Financial Innovation

The nexus between information technology and financial product innovation is a pivotal factor. The increasing sophistication of risk estimates, assuming data accuracy and the absence of fraud (two heroic assumptions in the last crisis), enables innovation. The ability to evaluate credit risk and prepayment risk are examples of quantitative pricing, credit scoring, and risk-management systems that are applied to home finance. With lower information processing and communications costs, the activities of back-office mortgage servicers has decreased as service providers extend to geographically dispersed areas.

Credit analysis, with data based on debt payments relative to income, enables more precise measurement of risk. The ability to assign credit scores and automate centralization of credit information can increase access to credit and ability to monitor payments and cash flows at a consumer level. All of this enables greater standardization of documentation and financial structures, which, again, lowers costs.¹⁰

Financing Housing: Back to the Future

The long-established principles that worked in expanding capital access to the housing industry are the basis of the reinvention of home finance for the future:

• Aligning interests of private capital with policy incentives

• Creating diversified housing stock by eliminating the bias against subsidies for renters

• Pooling savings to create investment vehicles

• Using credit enhancement and guarantees to manage real estate risks

• Creating flexible capital structures for residential developments through structured finance

• Regulating land use to limit supply constraints

The restoration of the historical partnership with private investors will be central to overcoming scarcity in housing access. Because government resources are increasingly limited, bringing back private investment is vital to the return of a vibrant housing finance system.

However, several of the entrenched biases of housing finance will have to be overcome. For one, the overwhelming preference of subsidies to ownership over rental housing has led to rising homeownership accompanied by decreasing affordability. This paradox predictably proved untenable. One hundred percent LTV (loan to value) or negative amortization (interest payments less than the amount owed and added to the loan balance) mortgages were never a sustainable innovation. Along with nonrecourse mortgages and lax regulation, they inflated housing demand while unintentionally creating hidden incentives to default.

Currently, spending programs and tax expenditures (subsidies transferred to consumers or investors through tax reductions) comprise about $300 billion annually. The lion’s share of these funds supports homeownership (about $230 billion) over rental affordability (about $60 billion).¹¹ As a result, homeownership increased to 68% of all households, while the number of households spending more than 30% of their income on housing increased steadily.¹²

To restore the housing sector, the gap between shelter and affordability must be bridged. Favorable tax policies and subsidies are needed for rental housing as well as homeownership, to promote flexibility and choice in housing markets.

Closing the credit gap and moving beyond crisis management are the only ways to restore international investors’ confidence in mortgage products in residential single-family and multifamily housing. This requires public and private capital. The federal government’s dominant role in the real estate markets must be phased out, to free up its resources for other national priorities. Innovations need to focus on restoring

• The role of private investors (domestic and international) as drivers of homeownership and financing

• Confidence in securitization through mortgage-backed securities and covered bonds

Rebooting Structured Finance in Housing

Securitizations, or structured finance products aimed at dispersing risk, must return to basics. Important factors include disclosure transparency, the alignment of interests between mortgage sellers and capital market investors, improvement in collateral quality, and regulatory protections.

A number of measures are being discussed that could contribute to solutions. Financial reform after the crisis created a number of challenges to the resurgence of the mortgage securitization market, including the 5% retention of risk with originating financial institutions. A number of smaller, private-placement mortgage-backed securitizations began to appear over the past year, including one backed by the Federal Deposit Insurance Corporation that included performing loans of 12 failed banks and federal credit enhancement.¹³

More recent transactions have shown that private-sector financing can be done with rates that are within 0.5% of the rates on mortgages financed through government-sponsored enterprises.¹⁴ Nonetheless, the seemingly unlimited extension of the umbrella of Fannie Mae and Freddie Mac crowds out the private market, given the government’s access to discounted funds.

The major debate that emerges in how and when securitization can re-emerge revolves around the degree of guarantee the government provides. One proposal has suggested the creation of government-chartered issuers of mortgage-backed securities. These issuers would sell some home loans through government-guaranteed securities. The government-chartered firms would have regulated profitability and fees to cover government guarantees on affordable mortgages and rental housing. This would be an alternative to the almost complete dependency upon government-sponsored enterprises.¹⁵

Alternatively, others recommend eliminating government guarantees completely and restricting securitization only to the highest-quality mortgages.¹⁶ Issues of affordable housing could then be addressed directly through on-budget social policies rather than the overextension of off-budget guarantees (that eventually find their way back to the federal budget).

Other alternatives or additions to securitization include covered bonds, which are debt securities backed by the cash flows of mortgages that remain on the balance sheet of the issuing financial institutions. These have been effective in Europe and elsewhere but, to date, lack a statutory framework in the United States. Similar to securitization, the covered bond system creates tradable instruments that increase liquidity.

One feature of the Danish model of covered bonds could be helpful in other countries. The capital structure of these bonds enables borrowers to manage risks and mortgage balances as interest rates change. In this model, when a lender issues a mortgage, it is obligated to sell an equivalent bond with a maturity and cash flow that exactly match the underlying home loan. The issuer of the mortgage bond remains responsible for all payments on the bond, but the mortgage holder can buy back the bond in the market and use it to redeem the mortgage and deleverage household balance sheets when interest rates rise and home prices fall.¹⁷ This ability to manage interest-rate risk and credit risk reduced the waves of defaults and foreclosures in other countries and could do so in the U.S. as well.

From Crisis to Innovation: Working out the Foreclosure Crisis

As we’ve seen historically, innovation usually emerges from new necessities created by crisis and scarcity. A good way to see the beginnings of the next wave of financial innovation is to work through the problems created by the overhang of foreclosed properties from the mortgage meltdown.¹⁸

The U.S. averaged more than 70,000 home repossessions per month since the crisis. The crisis created a demand for ways to buy and rehabilitate properties that had entered foreclosure, failed to sell at auction, and were owned by mortgage lenders. This real-estate-owned (REO) inventory expanded in recent years from government-sponsored enterprises as well.

These properties, which remained vacant as supply outstripped demand, represented a resale inventory glut of 13.9 million homes by 2009, roughly 11% of all housing units and considerably more than housing vacancies in previous recessions. Housing markets and neighborhoods would benefit if investors were able to buy and rehabilitate these properties and turn them into long-term affordable housing or rental units.

Financing is needed to address these challenges. The structural demand for capital includes

1. Short-term capital to acquire property

2. Midterm needs to rehabilitate or demolish homes

3. Exit financing to transfer property to a buyer

At the same time, operational capacity to handle the flood of foreclosed and defaulted properties is reduced. This demands innovative pricing models that can aggregate capital sources to clear the logjam of foreclosed properties while maintaining ways to make those residences affordable. Let’s consider these various dimensions of financial innovation in turn.

Innovative Pricing Models

In markets where values are fluctuating, it is important to find ways to arrive at a fair, affordable price. Two innovative models have emerged from the crisis to deal with this problem:

• Top-down approach. The National Community Stabilization Trust (NCST) starts with a market price under normal conditions and then derives a current value. It calculates a “net realizable value” by starting with the estimated market value and subtracting holding, insurance, and other market-specific costs. Key to this approach is that the final sale price reflects local market conditions and predictions about future home prices.

• Bottom-up approach. The Community Asset Preservation Corporation (CAPC) of New Jersey buys pools of nonperforming mortgages and REO properties in low- and moderate-income communities. The CAPC then employs a variety of strategies to return these properties to productive use. Its pricing model starts with an estimate of current value and adds the costs necessary to bring the property to market. In March 2009, CAPC was the first nonprofit to complete a bulk purchase of foreclosed properties.

In both cases, the focus is on underwriting a borrower (rather than the property) into an affordable mortgage and thereby forcing a write-down of property value to the point that negative equity would be reversed. By working with private funds that bought marked-down mortgages, the ability to create realistic values emerged.

Clearing the Property Logjam

Another important innovation has been setting up intermediaries between REO servicers and local housing organizations, nonprofits, or governmental agencies seeking to stabilize neighborhoods and alleviate collapsing values. For example, in 2008, some of the country’s largest community development organizations—Enterprise Community Partners, Housing Partnership Network, Local Initiatives Support Corporation, and NeighborWorks America—came together to form NCST. Today the National Urban League is also part of the effort.

The nonprofit’s goal is to act as a bridge between state and local housing providers and the REO departments within financial institutions, which are typically not accustomed to working together. NCST facilitates the transfer of foreclosed properties to local and community development organizations.

In addition, the NCST provides flexible capital to help communities leverage their Neighborhood Stabilization Program funds and finance state and local acquisition efforts, builds local capacity through organizing and facilitating collaboration and engagement with the Trust’s partners, and acts as an industry voice for neighborhood stabilization.

Aggregating Capital

After the financial crisis, Neighborhood Stabilization Program, part of the Housing and Economic Recovery Act, provided down payment assistance and credit enhancement to leverage private capital by allocating $3.92 billion to state and local governments and nonprofits focused on housing. Obviously, this amount could address only a small portion of REO properties.

Until housing markets recover, public subsidies and philanthropic capital must leverage private capital to have a widespread impact. Creative financing is necessary at each stage, from the acquisition of the properties to disposition.

Some strategies for aggregating capital might include

• Use program-related investments (PRIs). PRIs, below-market investments, could be used more widely to subsidize returns for private capital. With public subsidies and dollars from socially motivated investors, PRIs could take the form of subordinated debt as an external credit enhancement.

• Credit-enhance housing funds. Government dollars could also be used for credit enhancement. Protecting private-sector investments from the downside would encourage investors.

• Create a publicly traded investment vehicle. A publicly traded tax-advantaged vehicle for foreclosure acquisitions would be able to raise large amounts of private capital to stabilize communities.

• Allow specialized asset managers. New mortgage and securitization paradigms are essential. By creating safe harbors for specialized asset managers, who would be allowed to make decisions on loan modification without fearing litigation from investors and have a greater authority in administrating the pool of loans, new investors could be brought in to meet stronger underwriting regulatory standards.

• Increase access to takeout financing to retire existing short- or long-term debt on more favorable terms. Access to responsible takeout financing is essential to put individuals in homes they can afford by retiring and refinancing existing mortgages on more favorable and sustainable terms. One example is the model successfully used by Neighborhood Assistance Corporation of America in low- and moderate-income communities. NACA developed and uses online software that features a user-friendly application process and stores a borrower’s documents. This greatly facilitates the underwriting of mortgages and enables NACA to offer a 30-year, fixed-rate product at a slightly below-market rate with no down payment and no closing costs. Only 0.0023% of homeowners who bought this product defaulted on their mortgages. In addition, NACA holds free events around the country to restructure unaffordable mortgages.¹⁹

Preserve Affordability

Innovative financial products can help low- to moderate-income households achieve the dream of homeownership more safely than the mortgage products that failed in recent years. Excessive leverage without equity sponsorship or equity support created capital structure and financial products that were likely to fail.

Negative equity, nonrecourse loans, and declining markets combine to create an incentive for borrowers to default. The most promising counter to the problems of inadequate equity is, well, more but different equity. Financial options such as lease-purchase mortgages and shared-equity mortgages have emerged that provide a middle ground between rental and ownership. They are especially attractive for households that cannot initially qualify for standard mortgages but could be candidates for homeownership several years down the road.

• Shared-equity ownership. Models of shared equity, such as deed-restricted housing, community land trusts, and limited-equity cooperatives, are time-tested in the U.S. and Europe. A government or nonprofit invests in a property alongside the homebuyer. Shared equity enables borrowers to trade some potential upside of a purchase for financing. Hundreds of these programs now operate in the U.S.

• Lease-to-purchase mortgages. Self-Help is piloting this more experimental solution. The nonprofit buys and rehabilitates properties in Charlotte, North Carolina, and then leases the homes to “tenant purchasers,” renters likely to be able to assume Self-Help’s lease-purchase mortgages in one to five years. During the rental period, Self-Help provides credit and homeownership counseling and property-management services, to the tenant purchasers. When the tenant purchaser qualifies, he or she assumes the lease-purchase mortgage from Self-Help.

Rental Housing

Rental housing has been largely ignored as part of federal housing policy. As noted earlier, rental housing represents less than a third of the tax subsidies and expenditures provided for homeownership.²⁰ This is especially true as it relates to low-income rental housing, where the amount spent on assistance declined both as a percentage of nondefense discretionary spending and as a share of GDP. Rental vacancy rates hover at their highest levels (8%) since 1980, and multifamily starts are down two-thirds from their peak two years ago.

The demand for new rental housing is increasing, due to high levels of immigration, lower incomes, and delayed workforce and housing market entry by younger consumers.

Aside from homeless assistance, all categories of low-income housing assistance for renters have declined in recent years, including Section 8 rental assistance through public–private partnerships, housing choice vouchers that encouraged tenant mobility, and public housing. Clearly, structured finance products that address this growing demand for rental housing and developers will emerge.

Housing in Developing Countries

Housing loans comprise a very small amount of total credit in low-income countries. According to the World Bank, only 3% of outstanding credit is in housing in low-income countries, compared to 27% in high-income countries.

The developing world has among the lowest outstanding mortgage debt as a percentage of GDP—3% in Bangladesh, 7% in India, 15% in China, and 17% in Thailand, compared to 42% in the European Union.²¹ The overwhelming majority of the population in developing nations does not qualify for mortgage finance.²²

Most countries face accumulating housing shortages through increased demand driven by rapid urbanization. The formal housing sector provides only a minority of the housing stock. The urban housing backlog is 25 million units in India and 3 million units in Pakistan. High percentages of housing stock require replacement and additions in Afghanistan, Egypt, and throughout the developing world. The informal sectors provides from 60% to 80% of all housing stock.²³

Underlying all issues is the proper functioning of property markets and property rights to facilitate housing finance. As Hernando DeSoto has shown, the problem is the existence of “dead capital” that cannot be monetized in the market. He has shown that the value of savings in land is huge multiples of the amount received in foreign direct investment, yet the ability to finance those assets lags because of the absence of effective private property rights and markets.²⁴

The length of time it takes to obtain authorization or register land creates overwhelmingly high transaction costs that block the use of land and housing property as collateral to access credit for development. Poor information systems are also a hindrance. Associated with these limitations is the absence of long-term credit, meaning that property assets, which are long term, are mismatched to the assets they must finance. Short maturities, high transaction costs, ineffective legal and judicial systems, and the reluctance of the formal sector to enter poor markets limit the ability to solve housing problems in the developing world.²⁵

Common to all the emerging models of housing finance innovation are several demonstrated patterns. The attempt to build and maintain lower price points for housing access requires public–private partnerships, which have been more successful than public housing agencies that had limited term and capacity.²⁶ Leveraging funds through public–private partnerships have made programs more sustainable. Purely public programs were more open to corruption and abuse. Linkages to large-scale builders, building associations, and conventional commercial banks under conditional, performance-based terms have improved delivery of housing finance. Transparency and restrictions on sales for specific terms have prevented speculation. Encouraging ownership, joint guarantees (additional security through microfinance structures to ensure repayment), and cross-subsidy models have increased the flow of housing credit.²⁷

Savings Models

In most rapidly growing Asian economies, some of the most promising models seek to encourage and leverage consumer savings to drive housing finance. Compulsory and contractual savings schemes to provide a capital base for housing investment have proliferated. In both China and Singapore, successful housing finance models include mandatory housing provident funds. Employers and employees contribute a matching percentage of salary for housing-related expenses, including down payments, monthly payments, and building repairs.

Borrowings from the housing provident funds can be advanced for homeownership and leverage additional bank loans. Funds not used for housing are returned at retirement. China allows for a 5% contribution from employees and employers to build the housing fund.²⁸

In Singapore, the provident fund embeds lifetime earnings for retirement and channels it toward housing by allowing a household to borrow up to 20% of its retirement fund. Appreciation can accrue toward repayment of those loans on a deferred basis upon realization.²⁹

Australia also has innovative mechanisms matching access to retirement funds for households with permanent jobs to long-term housing assets. Pension funds can provide additional cash that low- and moderate-income families can apply to down payments and mortgages. The use of pension fund savings can lower carrying costs substantially and increase the capacity of homeowners to support mortgage debt.³⁰

Land Trusts

Renewable, long-term leaseholds are made available through land trusts held by nonprofit housing corporations or cooperatives for development. These land trusts or land banks enable nonprofits or governments to acquire, preserve, convert, and manage foreclosed and other vacant and abandoned properties. By permitting the relevant agency (public or nonprofit) to aggregate and obtain title to these properties, a usable asset is created to reduce blight, generate revenue, and facilitate affordable housing by lowering land acquisition costs and aggregating parcels for development.³¹

Organizational Innovations

Although housing has occupied a relatively small niche of microfinance, some microfinance institutions have expanded into the sector. In South Asia and Latin America, nonprofit microfinance institutions have joined government and private for-profit and nonprofit organizations as co-investors. By linking banks, housing agencies, and individual consumers, intermediaries can provide loans for housing rehabilitation, new homes, resettlement, and infrastructure.³²

Microfinance institutions (Grameen, Banco Sol, MiBanco), nongovernmental organizations (Accion, FINCA), cooperatives, mutual savings associations, municipalities, government housing programs, and commercial banks have joined together to downscale lending, create new securities and guarantees, mobilize data technology for tracking credits, and mobilize credit enhancement to reduce lending risks.³³

Housing Bonds

Mortgage banks have used long-term housing bonds to mobilize funds for housing finance. Where tax exemption has been deployed for these instruments, mortgage banks can lower their cost of capital by issuing bonds at below-market interest rates. Housing agencies have issued bonds for mortgages on apartment rentals and owner-occupied housing. Housing agencies issuing the bonds fund private-lending institutions that provide mortgages at a lower cost.³⁴

Revolving Loan Funds

Revolving loan funds operate through a variety of organizational forms (government, NGOs, and public–private partnerships in conjunction with commercial banks or nonbank lenders). The purpose of these funds is to provide long-term, self-sustainable sources of finance to build and upgrade housing based on initial capitalization of the funds (through government and nonprofit foundation funds) and driven by interest and repayment revenues. Under these funds, deficits are covered by drawdowns from accounts and interest charges. Loans can be disbursed by stages of construction and performance. In many cases, they are available for construction and home improvement and offer flexible conditions and options regarding repayment.³⁵

Credit Enhancement

Credit enhancement, the ability to cushion or protect against loan losses, has a long history and an important future in housing finance innovation. By dispersing risk of loss, either through internal measures provided by the borrower or by government, philanthropic, or other outside entities, these measures can extend credit access.

Credit enhancement provides a form of insurance that reduces the risk of loss based on detailed credit analysis. The mortgage originator provides internal credit enhancement within subordinated layers of the capital structure and the structure of loan payments. Reserve accounts to ensure against default risk are funded by excess interest rate spread payments (larger than the amount needed for debt servicing), over-collateralization (holding assets of greater value than the debt issued), and additional debt coverage. Outside parties, bank letters of credit, private or public insurance, additional guarantees or collateral pledged, or subordinated loans from other parties can provide external measures.³⁶

In all these cases, loan losses are covered by enhancement pools covering a certain portion of the outstanding debt, thereby ensuring the extension of additional credit risk. The adaptation of these measures to a variety of situations by governments, multilateral organizations, philanthropies, and financial institutions has been increasingly widespread.

Sustainable Housing, Sustainable Financial Innovation

The rising demand and costs of housing will drive innovation that is environmentally and financially sustainable. As several recent studies have demonstrated, savings in the costs of homes through suburbanization are being offset by unsustainable costs in transportation and energy.³⁷ As prices decline in the peripheral areas of major metropolitan centers, many new or displaced homeowners will continue to leave behind the communities in which they work and commute greater distances.

However, the growing costs of transportation and other services will more than offset the savings in home costs. As John McIlwain has pointed out, “[T]he outer suburbs will have the least expensive housing, but the cost in time and money of long commutes will eliminate any savings.”³⁸

The importance of financing infrastructure and housing in transportation-oriented development will increase in response to pressures to improve workforce productivity and avoid the productivity losses caused by congestion.

New modes of development favor increasing population densities and reurbanization to create market mechanisms that respond to challenges of sustainable energy and transportation costs and environmental sensitivity.³⁹ New studies show that, in more than half of the U.S. metropolitan areas, new residential building permits, density, and revitalization have dramatically increased. Infill development that uses land within built-up areas becomes more significant.

Residential and commercial buildings account for almost 40% of the greenhouse gas emissions in the U.S. With Americans spending approximately 90% of their time indoors, it is clear that green building is the direct path to a cleaner and healthier future.

Increasing energy efficiency while decreasing the catastrophic effects of the burning of fossil fuels, green building also represents an important opportunity to generate new jobs and promote economic growth. A 2008 study by the Lawrence Berkeley National Laboratory of Science estimates that a reasonable level of nationwide energy-efficiency upgrades, costing $22 billion per year, would result in nearly $170 billion in annual savings.⁴⁰ Given the political shift toward “going green,” now more than ever, there is real momentum to significantly change construction in this country.

Before the current economic crisis, the green building growth rate was about 50% to 75% per year, representing about 5% of new construction. Around the country, there are 5,000 LEED- and ENERGY STAR-certified commercial buildings, with 800,000 ENERGY STAR homes and approximately 2,000 Green-point rated homes. However, significant capital is needed to scale the retrofitting of residential, commercial, industrial, and retail properties. And although preliminary financing models have seen relative success with individual pilot projects, long-term, large-scale innovations need to be refined to create sustainable sources of funding. From the municipal bond market to green building securities, leveraging investment from the capital markets will ensure a more effective use of public and private resources.

A broad array of green building and other sustainable finance products is beginning to appear, including

• Direct mortgage, construction, and rehabilitation loans for residential properties

• Structured finance products that monetize cash flows from energy efficiency and environmental savings

• Pooled green real estate debt and equity funds and investments

• Insurance and asset-management products and services for green buildings to monitor and capitalize energy efficiencies⁴¹

The objective of these measures would be to reduce risk and create higher-valued collateral, create a cheaper cost of capital and enhanced liquidity for environmental efficiencies in homes, and provide underwriting standards for assets to be financed in this growing market.

Financing Energy and Environmental Efficiencies⁴²

We have long known that energy efficiency is the cheapest source of power. But our ability to implement solutions has been hindered by high upfront costs and uncertainty about benefits. A number of innovative financing models and program delivery have emerged in recent years that will certainly expand in the future.

Currently, there are 130 million homes in the United States—and their combined energy demand accounts for 20% of the nation’s greenhouse gas emissions. Studies have consistently found that nationwide energy-efficiency upgrades would significantly reduce emissions, create green jobs, and pay for themselves. According to “Recovery through Retrofit,” a recently released White House report that lays the groundwork for building a sustainable home-retrofit industry, existing techniques and technologies can reduce energy consumption by up to 40%, potentially saving $21 billion annually in home energy bills.⁴³

Greening older buildings has become a top priority for the U.S. Department of Energy and the White House. The availability of multibillion-dollar funding from the federal stimulus package (the American Recovery and Reinvestment Act of 2009, or ARRA) has paved the way for programs aimed at improving residential energy efficiency.

The DOE has issued a request for proposals for a new Retrofit Ramp-Up initiative, specifically seeking “game-changing” programs. It has encouraged state and local governments to create financing mechanisms that can leverage public money to drive the broader adoption of retrofits. President Obama has also proposed the HOMESTAR program, which would help households pay for retrofit projects, reducing their high initial costs.⁴⁴

Stimulus funding represents the largest injection of federal dollars for energy efficiency in U.S. history. But given the enormous cost of comprehensively retrofitting millions of homes, even these record sums are insufficient. It is therefore crucial to use these public funds in such a way that private investors are given an incentive to deploy their capital as well.

Residential energy-efficiency financing programs have existed for years in states and municipalities—but so far, none has caught on widely enough to attract private capital. Taking a retrofitting program to scale requires improvement in several areas: marketing of products and services to likely customers; a trained workforce capable of extensive, quality field implementation; financing offers that are replicable; and the ability to sell loan pools into a national secondary market, allowing for a more rapid and systematic recycling of funding back into loan programs.

Furthermore, there is an inherent tension in the need to tailor programs to local conditions and preferences—thus yielding multiple, relatively small loan programs—and the need for large, homogenous pools of securities that can capture the transaction efficiencies of modern financial markets. State and local governments, the administrators of most of the energy-efficiency financing programs, design programs to meet their region’s needs but look to access to broader pools of private capital.

Market growth depends on successfully integrating program design and financial product design. Program rules shape the risk/return tradeoff that drives the financial products. Consumers respond to program features such as ease of billing or attractive payment terms, but these details vary considerably across smaller, locally focused programs. Broad standardization is needed for national loan pools and securitization (which would lower costs).

Energy-Efficiency Mortgages

The financial logic of these “green mortgages” is clear: Potential borrowers add the cost of the energy-efficient home improvements to the new mortgage, and the energy savings boosts their disposable income, creating higher borrowing capacity. Energy-efficient mortgages (EEMs) are based on the principle that energy savings create disposable income—and, thus, the ability for a homeowner to carry a larger mortgage to finance these capital improvements. Because the homeowner is presumed to have higher credit quality than otherwise, in theory, the mortgage carries a lower default risk and can be issued at a lower interest rate. EEMs allow homeowners to pay for the cost of energy-efficiency upgrades with tax-advantaged mortgage interest rates, while avoiding large upfront out-of-pocket costs and aligning payments with the long periods it may take for some of the energy-efficiency upgrades to pay off.

Only 1,066 FHA-insured EEMs were originated in the United States in 2007. The numbers in previous years were even lower. Three challenges have emerged. First, the link between energy savings and lower default rates has not been proven, so it is unclear whether the energy savings are sufficient to make it worthwhile for lenders to reprice the loans. Second, the loans are more difficult to sell into the secondary markets, increasing lender risk. Finally, because EEMs are more complicated loans, they are more difficult to make, but lenders have little incentive to offer EEMs because they get no additional compensation for the extra work.

The marketing of EEMs should be easy because homeowners know how to obtain a mortgage and refinance, so the lender can simply introduce energy efficiency into the transaction. Furthermore, the mortgage market infrastructure is huge and efficient, with very low transaction costs. The EEM has been available in all 50 states for more than a decade. Currently, EEMs are sponsored by the FHA, Fannie Mae, the Department of Veterans Affairs, the Agriculture Department, and state housing finance agencies.

Several solutions to the product’s design flaws are based on lessons learned. Key provisions include creating an inexpensive, nationally available audit tool to reduce customer costs; qualifying borrowers based on credit risk rather than projected savings; and reducing the cost to the customer and to the lender by using federal and state programs to drive down the interest rate.

Given the potential energy savings, a federal, state, or Fannie Mae/Freddie Mac subsidy to reduce costs in the early years while performance data is gathered would make sense. Pilot programs offering ENERGY STAR–branded mortgages are currently underway. If EEMs reach sufficient volume, performance will be demonstrated and loans can be priced for the secondary market.

Any lender can use the ENERGY STAR mortgage as long as the product meets two conditions. First, it must produce at least a 20% improvement in the whole home’s energy use. Second, because the ENERGY STAR brand helps lenders with marketing, lenders must provide consumers with some additional benefit, such as covering the cost of the audit or the appraisal or reducing the interest rate. The pilot programs will demonstrate whether these features increase consumer adoption.

Unsecured Home Improvement Loans

When heating and cooling systems fail and must be replaced, homeowners can often obtain unsecured home improvement loans through the contractor to pay for the replacement. If contractors could refer them to loans offered by different financial institutions (with more choices and made cheaper through subsidies), the consumers’ replacement decisions would more likely tip toward energy-efficient systems. Capital to support unsecured home improvement loans for greater energy efficiency comes from public and private sources (including Fannie Mae, state and local budgets, and banks). Several examples include

• Public loan programs. Widely available through partnerships with utilities and local banks, the Fannie Mae Energy Loan is the largest public source of unsecured loans. After originating a loan, the Fannie Mae–approved lender transfers loan obligations to Fannie Mae but continues to service the loan. It is the one of the few loan programs with a functioning secondary market at this time. However, it will be challenging to expand, as the interest rate is high (currently between 12% and 15%).

• Pennsylvania’s Keystone Home Energy Loan Program (HELP). Homeowners receive loans for energy-efficient home improvements at attractive terms in a program provided and subsidized by the state. The state administers the program and acts as a secondary market, buying loans from lenders through its pension funds. By acting as a ready buyer, the state secures the availability of residential home improvement lending and lowers the interest rate offered to consumers.

Although it might be expected that delinquencies and defaults would be a key challenge for these programs, loan loss rates have been very low and have risen only slightly during the recession. The reason? Self-selection by borrowers, who are largely homeowners with no plans to move, great credit scores, and high home equity values. EnerBank reports a ten-year loss rate of only 0.8%, with a small but manageable rise in 2008 and 2009. There is little need for a secondary market partner because so many loans are paid off in the first year.

Although funds for unsecured loans are constrained by the current credit crisis, a large and efficient infrastructure for processing and securitization already exists. Contractors sell the loans as part of their offerings, banks originate the loans, and the secondary markets securitize them as part of ABS financings. Infrastructure for origination and distribution of these loans and a strong base of expertise are already in place. A tiered interest rate to attract proactive buyers, with the best rates reserved for comprehensive home performance loans, appears to have a good track record. With access to a broader secondary market, these programs could grow.

Property Tax–Based Financing

Municipalities have long used property assessments and taxes to finance public projects. Property tax–based financings could also provide homeowners with funding for energy-efficient improvements and solar installations. The homeowner repays the loan through a voluntary increase in the property tax bill. Funds are provided by a local bond mechanism (similar to a municipal bond issued for a specific purpose but are taxable at the federal level). Repayment terms are long (10–20 years), and because repayment is tied to the tax bill and carries the same seniority over the mortgage, default rates should be generally low. Any property assessments in arrears have a senior lien to mortgage payment in the event of default, which led to a Federal Housing Finance Agency directive not to underwrite mortgages for properties with an energy-related assessment. Current litigation and proposed legislation seek to overcome these concerns through Department of Energy and other certifications to ensure that savings could be supported and would serve the interests of building owners, municipalities, and mortgage lenders.

Because basic efficiency measures can cut energy costs by up to 35% annually, energy savings are believed to exceed the cost of related tax assessment, thereby overcoming the upfront cost barrier by financing over a longer term and improving cash flow for owners.⁴⁵ When regulatory and legal issues are addressed, similar options will most certainly materialize to address the needs of this financing and overcome the objections of federal regulators.

The loan obligation moves to the next owner if the home is sold. In theory, the energy savings would be greater than the increase in property tax, generating a positive cash flow to the homeowner.

The pool of loans is not tax exempt at the federal level, so it cannot be sold into the tax-free municipal bond market. This decreases liquidity significantly because the tax-free segment of the overall market totals $600 billion per year, while the taxable segment is $6 billion per year. Additionally, the lack of an active securitization market limits liquidity. When the secondary markets do open, government agencies and philanthropic funds could provide credit enhancement to pools of loans, enabling purchase at lower risk.

As a voluntary property tax increase, this type of financing is designed to take seniority over an existing mortgage. New mortgages can be issued with this seniority clearly spelled out, but seniority status for existing mortgages has been challenged. It is not a matter of simply getting the mortgage lender to agree to a change in status. Most mortgages are not held by the original lender, but have been placed in securitized loan pools held by a large number of investors. Financial institutions holding large mortgage pools are very concerned about losing their senior position. Legal opinions vary on this, and the issue has not been resolved.

Sixteen states have passed legislation for these property tax–based programs, allowing municipalities to create financing districts. Pilots have been launched in California (Sonoma County, Berkeley, and Palm Desert); Babylon, New York; and Boulder, Colorado. In these programs, home loans have been financed out of general obligation funds, so the market’s acceptance of these new financial products has not been tested. Homeowner acceptance has been good, but project scale to date has been small in each locale. The White House included property-based finance as a major component of the Recovery Through Retrofit plan. The California Energy Commission has funded expansion of PACE throughout California with its allocation of the ARRA funds for energy efficiency.

Whether administered by local government or by an outsourced administrative partner (such as the startup company Renewable Funding), the key bottleneck is transfer of loans from the originator to the secondary markets. An early aggregator and buyer of bonds would resolve a key risk. The use of credit enhancement by the federal government, or possibly state and local government, is needed for property-backed bonds to be placed in the secondary market. Private markets are not currently in a position to provide this insurance, but such bonds may have strong appeal to new lenders because they are secured by tax liens and have seniority to mortgage debt, pending expected legislative resolution of the issues surrounding these innovations. In any case, the ongoing attempt to link long-term asset development to improve energy/environmental efficiency will continue in the future.

One large investment required by the Oregon program was a unified software platform for loan origination and processing. This platform works for three utilities. It is hoped that access to loan payment history, the best predictor of default risk, will help with underwriting and servicing. The platform is intended to become a regional demonstration project.

Conclusion

With national, state, and local governments facing budget crises in the U.S. and Europe, and the overwhelming challenges of growth in the developing world, several common patterns emerge in the range and rate of financial innovation in housing. Governments seek leverage and homeowners seek to manage debt loads to obtain shelter and improve it. Environmental and energy demands link housing to other aspects of physical infrastructure (transportation and communication), social capital (education and community stability), and growing structural demands for capital. The successes outlined here are up and running through long-term financing mechanisms, structured finance, home equity and improvement loans, payment systems, and risk-management software and platforms that help improve credit analysis. Identifying and replicating the best models will work. Different financing programs share many commonalities—credit enhancement and loan loss reserves, diffusion of risk, and program and financial product design that align incentives for the long-term goal of attracting private capital. Tax-advantaged financial innovations promote and enable public–private collaboration by property owners, renters, financial institutions, and growing capital markets that will support expanded access to shelter. Active investment utilizing this financial toolkit will restore shelter access and affordability.

Endnotes

1 “2009 Revision of World Urbanization Prospects,” United Nations, March 2010.

2 “2009 State of Nation’s Housing,” Joint Center for Housing Studies, Harvard University, 2010.

3 Edward L. Glaeser and Jesse M. Shapiro, “The Benefits of Home Mortgage Interest Deduction,” NBER Working Paper 9284, October 2002; James Poterba and Todd Sinai, “Tax Expenditures for Owner-Occupied Housing: Deductions for Property Taxes and Mortgage Interest and the Exclusion of Imputed Rental Income,” Zell-Lurie Real Estate Center, Wharton School Working Paper, January 2008.

4 Witold Rybczynski, “How Affordable Is Affordable Housing?” Zell-Lurie Real Estate Center, Working Paper 497, December 2010.

5 Todd Sinai and Joel Waldfogel, “Do Low Income Housing Subsidies Increase Housing Consumption?” NBER Working Paper No. 8709, January 2002; Ellen Seidman and Jennifer Tescher, “From Unbanked to Homeowner: Improving the Supply of Financial Services for Low-Income, Low-Asset Customers,” Joint Center for Housing, Working Paper Series, February 2004.

6 For example, see William K. Jaeger, “The Effects of Land-Use Regulations on Property Values,” Environmental Law 36, no. 105 (2006): 105–130.

7 Edward L. Glaeser and Joseph Gyourko, “The Impact of Building Restrictions on Housing Affordability,” Federal Reserve Bank of New York, Economic Policy Review, June 2003.

8 C. M. E. Whitehead, “Planning Policies and Affordable Housing,” Housing Studies 22, no. 1 (2007): 25–44; A. W. Evans, Economics and Land-Use Planning (Oxford: Blackwell, 2004).

9 Urban Land Institute–Seattle, “Total Affordability: Meeting the Housing Challenge-Case Studies” August 20, 2009; Margaret Walls and Virginia McConnell, Transfer of Development Rights in U.S. Communities, Resources for the Future, Washington, DC, September 2007.

10 Committee on the Global Financial System, “Housing Finance in the Global Financial Market,” Bank for International Settlements, Working Paper No. 26, January 2006.

11 Congressional Budget Office, “An Overview of Federal Support for Housing,” November 3, 2009.

12 John McIlwain, “Housing in America: The Next Decade,” The Urban Land Institute Trustees Meeting, January 26, 2010; James Barth, et al, The Mortgage Meltdown and Global Credit Crisis (New York: John Wiley & Sons, 2009).

13 “Rebooting the Private MBS Market,” Mortgage Banking, October 1, 2010.

14 “IFR–Sequoia Deal Bolsters Case for RMBS Revival,” Reuters, March 1, 2011.

15 “A Responsible Market for Housing Finance: A Progressive Plan to Reform the U.S. Secondary Market for Residential Mortgages,” Mortgage Finance Study Group, Center for American Progress, Washington, DC, January 2011.

16 Peter J. Wallison, Alex J. Pollock, and Edward J. Pinton, “Taking the Government Out of Housing Finance: Principles for Reforming the Housing Finance Market,” American Enterprise Institute, Washington, DC, March 24, 2011.

17 Franklin Allen and Glenn Yago, Financing the Future (New York: Pearson, 2010).

18 This discussion is largely based on a financial innovations lab conducted for the Ford Foundation in 2009.

19 For other interesting financing models, see Alan Boyce, Glenn Hubbard, and Chris Mayer, “Streamlined Refinancings for up to 30 Million Borrowers,” Draft 11, September 1, 2011; and Robert J. Shiller, Rafal M. Wojakowski, M. Shahid Ebrahim, and Mark B. Shackleton, “Continuous Workout Mortgages,” Yale University, Cowles Foundation for Research in Economics, Discussion Paper No.1,794, April 2011.

20 Douglas Rice and Barbara Sard, “Decade of Neglect Has Weakened Federal Low-Income Housing Programs,” Center for Budget and Policy Priorities, Washington, DC, February 24, 2009.

21 Michael Davies, et al. “Housing Finance Agencies in Asia,” Housing Finance International (March 2009): 38–40.

22 UN-Habitat, “Community-Based Housing Credit Arrangements in Low Income Housing: Assessment of Potentials and Impacts,” Nairobi: UN-Habitat, 2004.

23 G. Landaeta, “Strategies for Low-income Housing, Lund University,” Sweden, 2004.

24 Hernando de Soto, The Mystery of Capital (New York: Basic Books, 2000).

25 “Housing for All: The Challenges of Affordability, Accessibility and Sustainability: A Synthesis Report,” UN Human Settlements Programme, Nairobi, 2008.

26 Davies, et al. (2009).

27 Zaigham Mahmood Rizvi, “Pro-Poor Housing,” Housing Finance International (Spring 2010): 15–18.

28 S. M. Li and Z. Yi, “Financing Home Purchase in China,” Housing Studies 22, no. 3 (2007): 409–425

29 L. Chiquier and M. Lea (ed.), Housing Finance Policy in Emerging Markets (Washington, DC: World Bank, 2009): 265–277.

30 Janet Xin Ge, “An Alternative Financing Method for Affordable Housing,” Housing Finance International, December 2009.

31 “Financial Innovations for Housing: After the Meltdown,” Milken Institute, November 2009.

32 “Housing for All” (2008).

33 A. Escobar and S. R. Merrill, “Housing Microfinance: The State of Practice,” in eds. F. Daphnis and B. Ferguson, Housing Microfinance (Bloomfield, CT: Kumarian Press, 2004).

34 J. Gyntelberg and E. Remolona, “Securitization in Asia and the Pacific: Implications for Liquidity and Credit Risks,” Bank of International Settlements Review, June 2006.

35 National Development Council, Revolving Loan Fund Handbook, State of California, Department of Housing and Community Development, 2008.

36 A full discussion of all these measures can be found in F. J. Fabozzi and M. Choudhry (eds.), The Handbook of European Structure Financial Products (Hoboken, N.J.: John Wiley & Sons, 2004).

37 “Beltway Burden: The Combined Cost of Housing and Transportation in the Washington, D.C. Metropolitan Area,” Urban Land Institute Terwilliger Center for Workforce Housing, 2009; “Priced Out: Persistence of Workforce Housing Gaps in the Boston Metropolitan Area,” Urban Land Institute Terwilliger Center for Workforce Housing, 2010.

38 McIlwain (2010).

39 John V. Thomas, “Residential Construction Trends in America’s Metropolitan Regions,” U.S. Environmental Protection Agency, 2009.

40 R. Brown, S. Borgeson, J. Koomey, and P. Biermayer: “U.S. Building-Sector Energy Efficiency Potential,” Environmental Energy Technologies Division, Ernest Orlando Lawrence Berkeley National Laboratory, University of California Berkeley, September 2008.

41 “Business Case for Commercializing Sustainable Investment,” Capital Markets Briefing Paper, Capital Markets Partnership, Washington, DC, 2009.

42 Much of this discussion is summarized from our “Financing the Residential Retrofit Revolution,” Milken Institute Financial Innovations Lab Report (April 2010).

43 “Recovery Through Retrofit,” White House Report/Middle Class Task Force, Council on Environmental Quality, October 2009. See www.whitehouse.gov/assets/documents/Recovery_Through_Retrofit_Final_Report.pdf (accessed March 16, 2010).

44 “Financial Assistance Funding Opportunity Announcement,” U.S. Department of Energy, October 2009. See www.eecbg.energy.gov/Downloads/EECBGCompetitiveFOA148MON.pdf (accessed March 16, 2010). The Retrofit Ramp-Up application deadline was December 2009; award recipients were notified in March 2010, with awards distributed in May 2010.

45 Property Assessed Clean Energy Policy Brief, 2010.