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We need home equity insurance now
Barry Nalebuff
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Kai Ryssdal: For all the promise the banks seem to be showing, housing is still playing catch up. The company that watches foreclosure numbers -- RealtyTrac -- reported this morning filings last month were up 46 percent over March a year ago. Today the Obama administration named the first six lenders that are going to participate in a $75 billion foreclosure-relief program. But commentator and economist Barry Nalebuff says there is a cheaper way to turn things around.
BARRY NALEBUFF: The housing market is in a vicious cycle of scared buyers, foreclosures and falling prices. In a normal world, falling prices increases demand and reduces supply. But today's housing market is far from normal. As prices fall, demand falls with it. People are afraid prices will far further, so they hold back. No one wants to catch a falling knife. Paradoxically, falling prices also lead to increased supply, due to defaults, distressed sales, and foreclosures.
One way to break this downward cycle is to offer home buyers protection against losing money on their homes. People buy insurance to protect against floods and fire. But they can't protect themselves from losing all their home equity in a declining market. With such insurance in place, many more people would be willing to buy in this declining market and thereby turn the market around.
That's why we need this type of insurance now and on a big scale. What we need is a federal home equity insurance program. How would it work? If prices fall, you're covered. The insurance would be linked to the overall house price index at a local level, not the price your home. That way, you can't sell at a loss just because you didn't maintain the house. Lenders would also be protected, with first claim on any payment from the policy. Protecting lenders should make them more willing to provide loans and help bring some leverage back into the mortgage market.
Unlike other bailout programs, providing home equity insurance won't cost taxpayers billions. Here's why. Having insurance available changes the whole market psychology. The very existence of the insurance increases demand which reduces the risk that prices will fall. This makes the insurance cheap to provide. Indeed, if the increased demand just stabilizes prices, there won't be any claims and the cost of providing the insurance will be free.
Can it be done? Yes. Six years ago, my colleagues and I worked with HUD and Neighborhood Works to develop just such a product for Syracuse. After nearly a decade of declining prices, this product helped turn the market around.
What works for Syracuse is good, even essential, for America.
Barry Nalebuff is a professor of business strategy at the Yale School of Management.
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Did I miss something in Larry's proposal? While listening to Barry talk about developing government house-value insurance, I couldn't help but wonder if he owned a few houses that have lost their value lately, and wanted the government to step in and save him.
If, as he assumes, the value of the houses in an area are just in the middle of a temporary slump, in an area that is economically diverse, and will soon recover, that is one thing. But for many areas of the country, the jobs have left the building, and won't be coming back, and neither will the values of the homes. I used to live in Flint, Michigan. It will never recover from the auto industry's problems. Buick is no longer headquartered there. The downtown Buick manufacturing plants that date back to the time Billy Durant was personally designing them have been torn down, and they aren't ever coming back. Should the government have guaranteed the value of the homes that are vacant because ex-GM workers have left?
Also, for many years I have driven around, seeing the palatial homes in burgeoning subdivisions that were going up throughout Michigan's suburbs and wondering how people could afford them. According to my taxes, my wife and I earned enough to place us in the top 5 percent income range in the United States. Yet with that, we were barely scraping by with an elderly, modest 3 bedroom home in a modest neighborhood in inner city Flint. We have three daughters, but its a good thing they are capable of bringing in lots of scholarships, or we wouldn't have been able to afford college for them. Well, of course, now we know that many of the people that bought those houses COULDN'T really afford them. I am really upset that you would now have the audacity to ask me to guarantee the value of those houses that were built to sell to people who couldn't actually afford them. Much like taxpayers guaranteeing the insurance of palatial homes that people build on beautiful beachfront property, it is asking the majority of poor people to pay for the lavish housing of a few who want to live beyond their means. It is a non sustainable concept.
This insurance scam sounds like it would produce the same echo chamber of skyrocketing home prices that caused the housing bubble. At least this time some honesty would accompany the fact that the government is on the hook. The more short sighted government programs and solutions that get foisted upon the people, the more corruption and fraud gets piled on the national debt. This is evidenced by AIG bonuses and other abuses by insolvent megabanks.
As a future home buyer who was saving up for a solid 20 down house payment when everything fell apart, I'm glad that home prices are dropping to more realistic values. The tax credit incentive gives me a certain comfort level for a small short term loss. People can look at historical home value trends before 2000, and should feel safe buying quality properties in those ranges. They will be in good shape because the impending inflation from all of the money we are currently printing will help keep the dollar value of their mortgages constant. I think renewing a new home buyer tax credit in the fall will be a necessary step for propping up home prices, and can be done without all the risk of even more poorly designed insurance.
It is estimated that Obama's plan could benefit 8 to 9 million homeowners from the new modification procedures. So how do you know you qualify for the Mortgage Modification? Check the website <a href="http://obamamortgage2009.blogspot.com/">http://obamamortgage2009.blogspo... to see if you qualify. I was also in trouble and I am glad I did check it before I talk to my mortgage company and it helped - John Mayer, California
Frankly, my first reaction was negative, for reasons which some of the other comments have noted.
But I'm impressed that Prof. Nalebuff actually submitted his ideas to a real-world test; empirical trials are far too rare in economics.
Insuring against investment loss is not always as exotic as modern derivatives and hedges; crop insurance and commodities futures contracts have long been an accepted part of the business of agriculture. Note, though, that widespread crop failures (due to drought, for example) generally require the Federal Government to step in as the insurer of last resort.
That is the major concern that I have here -- a national downturn in the real estate market like the present one results in losses so widespread that no private insurer could survive them. The second concern is -- we don't seem to be very good at correctly pricing rare but large-scale catastrophe. Many credit-default swaps appear to have been far too cheap, while private insurance against flood or earthquake is prohibitively expensive. Third, six years of data in one market is better than no data at all, but hardly enough to justify a national roll-out.
How about continuing field trials of equity insurance, with an eye to eventually substituting it for the mortgage-interest deduction on Federal income taxes? Given what we know about loss aversion, I think many people would prefer the smaller, recurring loss of the deduction, which could pay the premium for the insurance against the large potential loss of equity.
It is estimated that Obama's plan could benefit 8 to 9 million homeowners from the new modification procedures. So how do you know you qualify for the Mortgage Modification? Check the website <a href="http://obamamortgage2009.blogspot.com/">http://obamamortgage2009.blogspo...
to see if you qualify. I was also in trouble and I am glad I did check it before I talk to my mortgage company and it helped - John Mayer, California
It is estimated that Obama's plan could benefit 8 to 9 million homeowners from the new modification procedures. So how do you know you qualify for the Mortgage Modification? Check the website <a href="http://obamamortgage2009.blogspot.com/">http://obamamortgage2009.blogspo...
to see if you qualify. I was also in trouble and I am glad I did check it before I talk to my mortgage company and it helped - John Mayer, California
I have high respect for Nalebuff. The lessons of his first book have made me a lot of money out on the street in the real world.
With that said, he needs a reality check for his ivory tower. His proposal is not politically feasible now. Simply replace every reference to "insurance" with "derivative", and you get the idea. Why? because insurance IS a derivative. A contract on an asset (house) for the other party to perform if an event happens (it burns down).
There is already a way to protect your equity. You can short futures contracts of the S&P Case Schiller index. It does not behave exactly like insurance, but if you keep up with renewing the contracts, it locks in your price for the house. The cost is the broker fees you pay for renewing the contract, and you can choose when to be value fixed, and when not to.
Also, I think Nalebuff, in this case, is wearing the same beer goggles that the AIG mathematicians were wearing. Or, he is suffering from selective storytelling. I believe this because the Syracuse program stared around 2001. Was it his program, or did the market bubble attract buyers to Syracuse? I imagine the high sales volume of 2006 and 2007 cancelled out a lot of insurance contracts, saving him from a 2008 disaster.
Insuring debt works, and on both small and huge scales. But insuring equity sets the put-strike price at the market on the first day. And with an illiquid underlying asset, this means the insurer takes the place of the house owner, where the insurer "borrowed" the down payment from the "real owner" and the "real owner" pays "rent" to the mortgage company. This tells you what the cost of the insurance needs to be - and I guarantee you 1.5% of value is too low. The real owner is the owner in name only, and the government essentially owns the house on day one, but without the up-side. Huh, what? That’s right, it’s insurance, so without the up-side.
The nation’s housing needs a dose of honesty and simplicity. We need owners financially invested in their homes with a decent down payment, and appraisers chosen through a blind system. Should it be against the law to borrow more than 85% of the value of your home? I can't believe I just typed that!
See how far we have fallen? next we will be eating our young.
I can't believe that Marketplace even let this run. We're in the condition we're in now *because* insurance companies were insuring the housing bubble without fully understanding their complexities (well, one of many reasons). Marketplace has been - for months - constantly reiterating this fact over and over again to its listeners. I don't understand how this same program can, in good conscious, have allowed this to even air. How Mr. Nalebuff thinks that his proposal is somehow more secure and can withstand a "burst" of another kind, when for an unknown reason houses throughout the country lose value overnight, is beyond me. This is just another AIG waiting to happen. This should have been easily filtered by the Marketplace staff and shoved in a drawer somewhere. And Mr. Nalebuff needs not only his head examined, but needs to return his MIT diploma (or how about giving it "honorarily" to President Obama?).
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