Welcome to Safe as Houses, a series delving into a topic close to the heart of many Australians – property. This is not a series on where the market might be heading. Instead we aim to explore how we view property and float some alternative ideas.
Today, University of Cambridge Professor of Geography Susan Smith explains how the property market carries unnecessary risk for home buyers – risk that could be avoided through the use of prudent financial innovation.
The idea of financial innovation around housing is generally viewed with disdain these days. After all, it sparked a major economic crisis, and is seen as a cause of, rather than a solution for, the problems of the world economy.
But the truth is that housing markets are financially quite conservative. There is nothing very innovative about the way that homes are traded, for example. And that in itself is problematic.
Even now, we do not understand the beliefs and behaviours that drive home prices. Indeed, there is a lot we do know about the equity side of the housing equation. As a result, ordinary home buyers have far too much resting on the investment return on their property. They tend to hold all nearly of their wealth in a single and unusual investment vehicle, which is neither sensible nor useful, and can be extremely risky.
Mortgage markets have attracted more attention. But even mortgages, at root, have changed rather little over the years, despite all the bells and whistles attached to modern products. To be sure, there have been myriad novel features built into mortgage contracts – including an array of options for people to borrow more as home prices rise. But these are just embellishments on the basic self-amortising loan, linked to nominal interest rates.
One consequence of this underlying inertia is that there is far too little risk-sharing built into mortgages. There are all kinds of future uncertainties whose risks are not shared in these instruments, and this is especially problematic, in my view, in relation to home price volatility. Some people say such volatility doesn’t matter when people move home so infrequently and usually go on to buy somewhere else. But it does matter if housing wealth is your asset-base for welfare, and it matters even more if that wealth could do better in a different investment vehicle.
In short, financial innovation is limited in some key elements of the housing economy. The really big 21st century innovation occurred instead in financial markets, and even here key initiatives centred on massively increasing the supply of credit, rather than on managing the housing economy as a whole. Mortgaged-backed securities and mortgage-heavy collateralised debt obligations, for example, were used to raise money from investors and this in turn created a wave of credit that was channeled back to a growing pool of ever more marginalised borrowers. The rest as they say is history – and a sorry tale it turned out to be.
The very odd thing here is that financial markets proved so disinterested in instruments designed to spread the the risks and share the gains of housing assets – even though mortgage debt is, of course, anchored on them. This neglect compounded the problems that the oversupply of credit helped create and it makes me wonder whether, despite the problems caused by innovations in financial markets in the past (by over-complex, unjustly opaque and poorly regulated financial engineering) a fairer housing future may in the end depend on having more innovation, not less.
For example, I would be interested to see banks take seriously the idea of mortgages that not only share interest rate risks between lenders and borrowers, but also share price, or investment risks. I would also be keen to give people the option to reduce their housing costs by not buying the whole of the investment vehicle linked to their property.
After all, when you pay $400,000 for a home, the housing services component (the cost of enjoying the accommodation it confers) might only be worth, say, $350,000. The remainder – say $50,000 – is something that, as an owner occupier you are forced to put into an investment vehicle whose performance depends on the fortunes one little plot in the corner of a single neighbourhood. That’s risky, and I think it is unnecessary.
To change things for the better, I would like to see a housing system where owner occupation as we know it is broken apart. That is, instead of having to tie my bundle of housing services to the lumpy idiosyncratic savings vehicle attached to it, I would like to keep my choice of accommodation separate from decisions about my wealth portfolio. I can’t do this, and neither can anyone else, without another round of financial engineering. Whether we dare go there – whether markets can be reformed and regulated sufficiently for us even to consider it – is more a matter for governments and policy makers than for financial engineers and investors.
This is the fifth article in the Safe as Houses series. Read the other instalments here:
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Comments (10)
Colin MacGillivray
Retired architect (logged in via email @gmail.com)
"ordinary home buyers have far too much resting on the investment return on their property....(which).... can be extremely risky."
If a house buyer buys a house with a deposit of say, 20% of its value and can fairly comfortably afford the mortgage payments, there is almost no risk. (An emergency like job loss or illness can be insured against.)
This is what our parents did. The risk comes with financial overcommitment driven by wanting a more expensive house than you can afford.
A house is…
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Alex Malone
(logged in via Facebook)
I don't know if the author reads below the line, but I'd like some clarification on how modification, renovation etc works under her model. When the owner-occupier does up a home, they do so for their own comfort and for added resale value. It seems you would have to be forever teasing out which is which and renegotiating with the bank at every stage.
The bank would need dedicated staff evaluating the value of every little modification. They would need to become experts in everything from kitchen fittings to pool gates. Worse, at the initial negotiation they'd have to be making psychological judgments about the occupant: How often is this person going to repaint my weatherboards? Are they gonna use coasters on my mantlepiece?
I just don't see banks being interested in that kind of business.
Colin MacGillivray
Retired architect (logged in via email @gmail.com)
This is worth a read regarding investing in a home. Although it's a US example where owners can deduct mortgage payments from income tax liability:
http://www.getrichslowly.org/blog/2007/07/16/renting-vs-buying-the-realities-of-home-buying/
Derek Bolton
Retired s/w engineer (logged in via email @gmail.com)
Deductibility of mortgage interest from tax (I assume it's only the interest that can be deducted) is consistent with having to pay tax on the increased value. It makes it the same as rental property.
It's not clear what effect that should have on house prices. In principle it could be made neutral by yearly declaring an increased value of the house and paying tax on that - the same as the tax saved on the interest payments. In practice, people would have to be disciplined about saving more so that they can afford the tax bill when moving home.
Kevin Cox
(Adjunct Associate Professor at University of Canberra)
Professor Smith is correct when she says we need innovation in the way we finance the purchase of a house. Fortunately we can innovate without changes in financial regulations. This will happen because the current system is costly and there are less expensive ways to buy a house than a traditional mortgage using existing financial regulations.
Within five years we will see competition to the finance model of a bank lending money to purchase a house, the borrower purchasing the house and then…
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Derek Bolton
Retired s/w engineer (logged in via email @gmail.com)
The mechanism for sharing the risk exists - it's the rental market. The freehold could be part of a portfolio of investments with many shareholders, while the renter invests his or her own capital wherever he pleases. If that's not happening, one has to ask why not. In Australia, it is a consequence of the tax arrangements.
Also, as Colin points out, the banks do take some risk. In the US, part of the problem was that they take even more of the risk than in most countries: while they could foreclose and sell the property, they could not pursue the borrower for any remaining loss. So it was a bit like insurance - the buyer takes the first so many dollars of the loss and the bank takes the rest. As a result, when prices dropped so much that buyers no longer had any equity left in the property they just walked away.
Tim Paton
Automotive Engineer (logged in via email @timpaton.net)
I agree that the rental market is an important aspect that's not being considered.
However, one needs to question the reason why people are so eager - desperate - to make the enormous investment necessary to get into the home ownership "market". Of course, part of it is that we need somewhere to invest our equity, but another big part is that renting is a deeply unattractive option for many people, and ownership is the only other option available.
To address this, we need to identify and fix some of the aspects of renting that are so unattractive. Tenants need more rights. Security of tenure is one factor that needs to be seriously looked at. Choosing to rent is choosing a life of uncertainty, subject to being force to move house at the investment whim of a landlord. Very few people choose to live like this if they can afford to buy their way out of the rental market.
Judith Olney
Ms (logged in via email @bigpond.com)
This is true Tim, not only is it a life of uncertainty to rent, it is also extremely expensive. With average weekly rents in my town being between $300-$400 per week, it is very difficult for people to save enough for a mortgage deposit to buy a property of their own.
People still need a roof over their heads while they are saving, (if they have enough income left over to save), so must pay rent, unless they are lucky enough to be able to live with parents while saving. It becomes a viscous circle…
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Chris O'Neill
Telecommunications Engineer (logged in via email @optusnet.com.au)
"In Australia, it is a consequence of the tax arrangements."
Indeed, if you rent to someone else, you pay tax on the income received. If you "rent" to yourself, you pay zero tax on any rental value. People who own there own home are far better off than someone earning the same income and paying the same tax. Tax doesn't have much to do with how well off you are.
Greg Surname
(logged in via Facebook)
Why is buying so much more attractive than renting? Unless you own a house outright the you are making a payment of some form towards accommodation, either rent or mortgage repayments. Mortgage repayments are higher than rent, but it is only the difference between the two that can be considered as contributing to the investment portion of the payment. If repayments are only a little more than rent then this represents a good, fairly risk-free investment.