6. Lessons Learned—Back to the Future

Financial innovation is imperative for promoting well-functioning housing markets. Changes in the increasing structural demand for capital in housing are demographically driven and shape market structure and performance.

As documented throughout this book, urbanization and household formation have driven financial innovation in housing markets throughout history—from the very first mortgages to covered bonds, guarantees, insurance, tax credits and subsidies, and secondary market development.

Regardless of geography, using cash alone to buy or build housing has long proven overly restrictive and prohibitively expensive. In earlier historical periods, specialized lenders charged interest rates that limited capital access and hindered entry of new participants, such as developers, consumers, and financial intermediaries. Financial innovations then enabled private investors to enter the market, fund development, and create long-term, low-cost sources of capital. All these innovations required reporting, regulation, and oversight.

Securitization contributed to the housing bubble as originators ignored credit risk and underwriting standards disintegrated. However, both directly and through covered bonds and other structured products, securitization lowered funding costs, created sources of capital for borrowers, and expanded opportunities for institutional investors around the world.

Innovative loan products can reduce costs to creditworthy borrowers (either homeowners or rental housing developers), while other products will enable financial institutions to manage risk and free up capital that can be used to meet housing needs.¹

From the Homestead Act and other nineteenth-century land reforms, to the emergence of secondary mortgage markets and securitization, innovation has been a vital element of housing finance. Market-based finance emerged over the past century and became important throughout the world. It has varied widely in form, mix of instruments, government support, market structure, and types of housing. There is no “one size fits all” version.

Highly regulated and noncompetitive financial systems have been curtailed as the importance of property rights became more widely recognized through land reform, land registries, and collateralization. With greater access to capital, the cost of financing has fallen, making homeownership and rental housing more affordable over the past century. The increased availability and range of mortgage products for homebuyers and developers, combined with structured finance, created greater liquidity in real estate markets and drove trillions of dollars of investment into this sector. Moreover, mortgage-equity withdrawals have contributed greatly to credit availability and, hence, aggregate consumption.²

During the recent housing bubble, however, home prices went far above what average families could afford. Public and business policies that eased lending requirements and led to more lax and less transparent underwriting standards seriously slanted debt-to-equity ratios. As more mortgage defaults and foreclosures ensued, liquidity constraints in markets collapsed the housing price bubble. As credit markets froze and contagion spread throughout the financial sector, the macroeconomic conditions that had encouraged growth and shelter-access disappeared.

Housing markets, structured finance, and mortgage-backed securities functioned properly when transparent information, independent analysis, and standardized reporting were available. But as conformity and opaque reporting replaced transparency—and as mortgage originators became detached from the consequences of erratic lending due to perverse incentives—undesirable outcomes spread. Housing markets and prices collapsed. The wisdom of crowds was replaced by the madness of mobs in the mortgage marketplace. As investors fled, market deterioration compounded further.

As government oversight weakened, excessive leverage (Securities and Exchange Commission [SEC] deregulation of investment banks in 2005 allowed leverage to more than double) and overly complex financial products enabled some banks to evade capital requirements. New mortgage-collateralized debt obligations created problems for rating agencies, and investors swept the market.³

New waves of housing demand have broken into the markets, and recent crises raise new questions: What is the appropriate role for government in the housing market? How can housing markets operate more efficiently? What can be learned from mistakes of the past?

In all the banking and financial crises we have studied, periods of initial financial liberalization and prosperity in real estate markets drove demand to peaks that led to regulatory failures, overpricing, and shoddy risk analysis.⁴ Our review of the long sweep of housing finance history yields the following lessons, which are consistent across time in developed and emerging markets alike.

Lesson 1: Don’t Compromise on Credit Analysis

As demand for mortgage-backed securities outstripped supply and inflated home values, guidelines designed to ease credit failed. Fundamental analysis was neglected, increasing information asymmetries among all parties in the housing market (largely through principal-agent conflicts that drive moral hazard and adverse selection).

Nearly $20 trillion in mortgages originated during the period of easy credit from 2003 to 2008. Before 2007, when housing prices began to decline, residential real estate was estimated at $60 trillion; by 2011, it had declined to $50 trillion. Much wealth was destroyed in Spain, Ireland, and numerous other European countries, as well as the United States.

Whether attempting to fund new housing in emerging countries or trying to understand the complexities of collateralized debt obligations (CDOs), clear and unambiguous information is essential. Investors need to know about titles, financial accounts, deeds, and contracts. This information makes it possible to determine value, assess risks, and track performance. As Hernando de Soto states, “[W]ithout standardization, the values of assets and relationships are so variable that they can’t be used to guarantee credit, to generate mortgages and bundle them into securities, to represent them in shares to raise capital.”⁵

Clear property rights are vital to expand access to affordable housing—whether owned or rented—in emerging or developed markets. Property rights facilitate housing credit by establishing clear collateral and legal claims. Transparent real estate laws are also critical for effective credit analysis and allocation.

Weakly underwritten instruments and private securitizations (which government agencies later absorbed during the crisis) increased borrowers’ incentives to default, due to their limited equity and lenders’ lack of adequate recourse. The proliferation of new and flexible mortgage products alone was not the primary cause of the market failure. Instead, the abbreviated loan process and abandonment of long-proven underwriting standards destined many of those products to fail.

Underwriting ignored transaction costs (escrow taxes, insurance, and so on) enabled loan-to-value ratios above historically proven safe limits and resulted in automated and unverified valuation models. The resulting layering of risk—based on deceptive credit terms, financial illiteracy, or fraud by borrowers—led to a flood of credit on unreasonable terms.

These failings led to the explosion of moral hazard, which ultimately pushed the costs of excessive risk onto taxpayers. Foreclosures, delinquencies, and negative equity left an unprecedented number of vacant homes, increasing downward pressure on values in struggling neighborhoods.

Lesson 2: Flexible Capital Structure Matters

Financially sustainable capital structures for the housing market require a balance of debt and equity. Early innovations in savings for housing, such as the building societies discussed in Chapter 2, “Building Blocks of Modern Housing Finance,” developed a method for collectively accumulating equity to support long-term lending. These pioneering principles were later embedded in government entities, nonprofit organizations, formal financial institutions, and home-savings products. Lessons from those earliest models of peer-to-peer lending can be applied to today’s crisis in developed economies and growing demand in emerging and frontier markets. New investment vehicles can arise from old innovations.⁶

Since the Great Depression, long-term (20–30 years), fixed-rate mortgages have financed homeownership and enabled developers to provide affordable rental housing. This innovation sprang from the failure of earlier capital structures in housing and the absence of long-term, low-cost loans.

After the saturation of the housing market in the U.S. in 1925, lending standards were loosened as property values rose. Homes were bought with short-term loans (three to five years) requiring 50% equity payments. Many buyers took out secondary loans to pay for the primary loan and purchase price. The classic mistake of financing long-term housing assets with short-term credit, coupled with inadequate equity, led to massive defaults and delinquencies as values declined.

When the market collapsed in the Great Depression, the federal government intervened by offering refinancing through the creation of the Home Owners Loan Corporation. Later the Federal Housing Administration provided broader mortgage insurance, which enabled the absorption of excess inventory and restored the flow of credit. Extended loan maturities became the new standard in real estate markets in the U.S. and abroad.

With proper underwriting, the 30-year, fixed-rate mortgage increased the supply of sustainable credit. The alignment of interests among homebuyers, developers, and lenders continued under conditions that enabled liquidity, standardization, and transparency.

As we’ve shown, rebooting securitization with retained-interest transactions by originators, introducing covered bonds, and dealing with other gaps in the market’s capital structure are vital to reinventing housing finance. Loan-modification programs, debt-for-equity swaps that allow rent-to-own as an alternative to foreclosure, and encouragement of investor finance could also be helpful.⁷ All these measures could improve liquidity over the longer term.

New policies and programs that enable shared equity, flexibility in mortgage refinancing, and lower transaction costs in finance for homeownership and rental housing can overcome the frictions that have hampered monetary policy, inflated foreclosures, and slowed economic recovery.⁸

Lesson 3: Size Matters

Supersized mortgages and houses led to much of the overleveraging and sprawling developments that made housing unaffordable. According to the Census Bureau, the average new home sold in the U.S. ballooned in size over the last three decades, from 1,700 square feet to 2,422. That’s a 42% increase, with the trend intensifying since the late 1990s.

“McMansions” had nothing to do with making room for more kids. (The average size of the American household fell from 2.76 people in 1980 to 2.57 in 2009.) Instead, rising home prices lured some consumers into an over-reliance on housing as an investment; they built homes that were larger than needed and harder to maintain, with the anticipation that they could serve as a giant savings account, with the added benefit of appreciation.⁹ Taste may also have been a factor in the shift to larger homes.

What if houses returned to the size expected by the typical U.S. homebuyer 30 years ago? The average new home would have been 722 square feet smaller in 2009. If you consider the average cost per square foot, returning to the expectations of our parents’ generation would have produced a savings of $80,000 per home in 2009 alone. America’s total expenditures on all new homes sold over the past 30 years would have been $1.2 trillion less in today’s dollars, and that savings would continue to accrue in the future. That’s before taking into account the cost of furnishing, heating, cooling, and cleaning all that extra space.

Today Americans devote 34% of their household expenditures to their homes. But if Americans are willing to rethink their assumptions about what their houses should be, they could radically improve the lives of those who live in those homes.

The relationships among housing size, suburbanization, and exurbanization, and the demand of increased energy inputs have created costs that should be factored into twenty-first-century credit analysis.

Factors such as neighborhood compactness, access to public transit, and rates of vehicle ownership affect mortgage performance. There is a direct, statistically significant link between longer, costlier commuting and a higher risk of default.¹⁰ Transportation and energy costs take a growing toll on disposable income as urban settlement patterns are increasingly dispersed. Roughly 17% of an average U.S. household income goes to transportation costs, so mortgage underwriting procedures should consider this factor as it relates to financial risk.

Mixed use and diversification that accompany location efficiency are also key factors in stabilizing housing markets. Diversification by income levels, use (retail and residential), and tenure (rental and ownership) attract different elements of demand that result in more sustainable communities. Reduced isolation, labor market access, and other elements that strengthen social capital in communities appear to bolster financial and environmental sustainability as well.¹¹

Lesson 4: Structured Products and Secondary Markets Work

If lenders and investors monitor credit quality and if timely, adequate information is provided, securitization works well. Beyond the product, market, and regulatory failures previously noted, the ability to securitize (with proper risk retention by originators to align interests) is central to housing finance. The link between risk management and capital access for housing has been historically demonstrated.

Secondary markets expand liquidity and help to balance the broader costs and risks of housing finance. They provide access to capital across market segments (including low- and moderate-income borrowers), types (owner-occupied and rental housing), geographies (urban and rural), and originators (including credit unions, micro lenders in developing countries, and community-based lenders). Providing a wide range of product choices to borrowers can achieve the link between housing finance and macroeconomic growth policy.

As information technology, data reporting, and regulatory transparency become more widespread, the transitions to recovering secondary markets and securitization will succeed without sacrificing stability.

For housing to be affordable and sustainable, securitization, covered bonds, and other hybrid products are required. Long-term, fixed-rate mortgages require liquidity in real estate financing. Capital markets have proven fundamental to this process, insofar as they enable the diversification of risk for investors while avoiding its reconcentration on financial institution balance sheets, as occurred in the most recent crisis.

When successful, regulatory measures ensure benefits to renters, owners, and developers in single-family and multifamily housing. Government guarantees and subsidies could enable sustainable financial innovation by private, nonprofit, and public investors. New products and delivery modes for housing construction, access, and retrofitting are discussed in Chapter 4, “Housing Finance in the Emerging Economies,” and Chapter 5, “Future Innovations in Housing Finance.”

Final Remarks

Beyond the economic characteristics of housing as a physical structure providing shelter and investment value to consumers lays the broader meaning of homes and the hopes and dreams tied to them. Our hope in this book is to provide a guide to the workings of the troubled global housing markets and an inventory of the financial toolkit necessary to fix them. As the housing crisis in the developing world and the major disruptions in developed markets prove, no quick fixes or applications can be cut and pasted into vastly different demographics, economic environments, and capital markets. Nonetheless, the principles of housing finance remain consistent, achievable, and available to guide the creation of affordable homes and sustainable communities to better serve society’s interests.

Endnotes

1 Edmund S. Phelps and Leo M. Tilman, “Wanted: A First National Bank of Innovation,” Harvard Business Review (January/February 2010): 102–103.

2 John V. Ducka, et. al., “How Financial Innovations and Accelerators Drive Booms and Busts in U.S. Consumption,” Federal Reserve Bank of Dallas Working Paper, May 2011.

3 For more detail see, Franklin Allen and Glenn Yago, Financing the Future, New York: Pearson, 2010; James R. Barth, Tong Li, Wenling Lu, Triphon Phumiwasana, and Glenn Yago, The Rise and Fall of the U.S. Mortgage and Credit Markets: A Comprehensive Analysis of the Meltdown (New York: John Wiley & Sons, 2009).

4 James R. Barth, Daniel E. Nolle, Triphon Phumiwasana, and Glenn Yago, “A Cross-Country Analysis of the Bank Supervisory Framework and Bank Performance,” Financial Markets, Institutions & Instruments 12, no. 2 (2003):.67–120.

5 Hernando de Soto, “The Destruction of Economic Facts,” Bloomberg Businessweek, April 28, 2011.

6 Peter Tufano and Daniel Schneider, “Using Financial Innovation to Support Savers: From Coercion to Excitement,” in Insufficient Funds: Savings, Assets, Credit and Banking Among Low-Income Households, ed. Rebecca Blank and Michael Barr (New York: Russell Sage, 2008); Peter Tufano and Daniel Schneider, “New Savings from Old Innovations: Asset Building for the Less Affluent,” in Financing Low-Income Communities, ed. Julia S. Rubin (New York: Russell Sage, 2007).

7 Lewis S. Ranieri, Kenneth T. Rosen, Andrea Lepcio, and Buck Collins, “Plan B: A Comprehensive Approach to Moving Housing, Households and the Economy Forward,” Ranieri Partners Management and Rosen Consulting, April 4, 2011.

8 David Milkes and Vladimir Pillonca, “Financial Innovation and European Housing and Mortgage Markets,” Oxford Review of Economic Policy 24, no. 1 (2008): 176–179.

9 James Barth, Tong Li, and Rick Palacios, “McMansion Economics,” Los Angeles Times, November 21, 2010.

10 Stephanie Yatos Rauterkus, Grant Thall, and Eric Hangen, “Location Efficiency and Mortgage Default,” Journal of Sustainable Real Estate, in press.

11 Loretta Lees, “Gentrification and Social Mixing: Towards an Inclusive Urban Renaissance,” Urban Studies 45, no. 12 (2008): 2,449–2,476.