Thomas Davidoff, an assistant professor of real estate at UC Berkeley, recently chatted on KPCC’s AirTalk radio show about a new type of mortgage that he says could reduce future defaults.
It’s an innovative idea – some might say crazy – in which a borrower’s payment would fluctuate with home prices. Intrigued, I gave him a call and got him to answer a few questions on the proposal.
Q. Give me the basic outline of your plan.
A. The plan works as follows: Start with a simple, garden variety, fixed-rate mortgage. The borrower owes a constant payment up until the end of the loan term unless she moves, refinances, or defaults.
Now, make the payments and loan balance adjustable based on a home price index. When the home price index is down, payments go down, just like an adjustable rate mortgage has its payments go down when interest rates fall.
How does the bank pay for this reduction in interest due when prices fall? The loan balance increases when prices rise. This could mean rising payments, or negative amortization, just like in an adjustable-rate mortgage with a payment cap.
This loan has attractive features for both the borrower and the lender. For the lender, there is less chance of default, because people only default when their property is worth less than the cost of repaying the loan. This kind of mortgage automatically makes default less attractive. Also, because the balance rises when prices rise, there is less prepayment.
For the borrower, this is a good way to insure financial risk. Borrowers are rich when prices rise and poor when prices fall, on average. This product takes money from the states of nature in which the borrower is rich and gives them to states of nature in which the borrower is poor. It’s like the borrower’s own private Robin Hood.
Q. How are homeowners rich when prices rise, besides on paper? Are you saying they are likely to experience an increase in income?
A. Right. You owe more (in payments and/or principal) if prices rise. But prices rise because of greater demand, which is generally associated with rising incomes. Over the last few years, it was more interest rates and availability of credit driving prices.
Q. Can you give me some examples of how monthly payments could vary when home prices fall and defaults rise, and when the opposite occurs?
A. Suppose the average price of a three bedroom home is 700,000 and that there is a mortgage with payments due each month of $2,000. If the average price were to fall to $500,000, payments might fall to, say, $1,900. If the average price were to rise to $1,000,000 the loan balance might increase by 15 percent. These are rough guesses, but it wouldn’t be that hard for the bank to come up with fair adjustments so that they break even and the borrower is better off.
Q. What happens if home prices rise for an extended period like we just saw, say for seven to 10 years? Does that mean borrowers could pay a lot more on their mortgages? Will it take homeowners a lot longer to pay off their mortgages because their principal keeps increasing?
A. That depends on whether rising prices are a cost to borrowers in payments and principal or principal only. If principal only, which I think makes more sense, this would only mean that people who did refinances or sold their homes received less capital gain than they would have otherwise. If payments rise with the loan balance, then yes, borrowers would face higher payments. Again, I favor a principal rather than payment adjustment on the upside, and a payment adjustment on the downside.
Q. How could this loan program prevent, or at least limit, future foreclosure waves?
A. A borrower makes the calculation: should I pay my mortgage cost, or should I walk away from my property? Walking away only makes sense if the property is worth less than is owed, because otherwise the borrower can sell and walk away with cash, instead of the financial pain and shame of default.
If the payment is lower when prices fall, then default becomes less attractive, since paying the mortgage becomes less painful.
Q. Where did you get the idea?
A. Robert Shiller and Chip Case have long promoted the idea of getting homeowners to insure themselves against changes in prices. The recent default wave made me think of ways banks could avoid default losses, and the Case-Shiller home price index seems like a logical starting point.
Q. What’s the precedent for such a plan?
A. Adjustable-rate mortgages are very common. In the old days of inflation, people thought ARM payments would rise with housing prices. Lately, we’ve seen the opposite: underlying interest rates and home prices have moved in opposite directions, so interest rate-based ARMs may worsen the default problem.
Mortgages that adjust on overall prices are common in countries that have experienced severe inflation. The novelty of this product is to make the mortgage index based on the price of housing relative to other goods.
Q. Why would consumers or lenders go for it?
A. Consumers get to move money from when they’re rich to when they’re poor. This is a form of insurance that consumers should be willing to pay for. The beauty is that lenders would pay consumers to do this, because it avoids default losses.
Q. Have you gotten any feedback from lenders?
A. Not yet. But the key will be whether financial institutions are willing to take an explicitly long position in housing prices. In recent history, stock market prices and housing prices have moved in opposite directions, so this should be an attractive hedge for institutions and their investors. But logically, we would expect going long housing prices to be a risky position for investors who own housing themselves and have risky income. I’m confident though, that financial institutions are in a better position to be long local housing prices than are individual investors.
Q. What’s next for your proposal? Do you plan to pitch lending groups or politicians?
A. I am working on the technical analysis of proving that under reasonable conditions, that borrowers and lenders both win from this, and that the federal government has an interest in reducing defaults. Once the technical analysis is done, I will start to pitch to the public in earnest.
Q. Honestly, what do you think is the probability of such a plan being adopted by lenders?
A. I don’t know. Economists think reverse mortgages and private annuities are the greatest things since sliced bread, yet they are not very popular products. But I think that adjusting mortgages to home prices could make everyone considerably better off. So I’m cautiously optimistic.
Here is the best way to prevent foreclosure. Rent. Then the risk is placed on the landlord. It would be really nice if you got the same tax break as an owner when you rent. That would be fair, but life is not fair. So since life is not fair and the tax code is stupid you have to invent bizarre forms of ownership that are really renting that get around the tax code. So one would be no down, iinterest only, just another form of renting but with a tax break. You can think of a thousand schemes , even stay up nights doings so. And this is just another one.
I think there should be a guaranteed income for rich people in particular ceos. Anybody who is a ceo or even has a grandfather who is a ceo would be guaranteed 10 million dollar negative income as long as they don’t work. Then these people would not argue that ceo’s are worth hundreds of millions and we could import our ceo’s from pakastan or maybe Canada. These guys under say 30 would work for under a million and have a lot of energy and companies might actually be well run.
Just a thought that was stimulated by this really “interesting” idea of a “new” form of renting (oops) mortgage.
“Here is the best way to prevent foreclosure. Rent. ”
ROTFL!!!!
What a creative idea our Professor has, have the payment go down as prices fall, but the balance only go up when prices are rising. Quite possibly the stupidest thing I’ve ever heard. Does this guy understand finance in the slightest? See, banks make money when you pay interest. When interest rates rise (and prices fall), they actually need to collect MORE interest to stay solvent, not less. Certainly they can’t afford to LOWER your interest rate in a rising rate environment as it would seem he’s suggesting
How about this for a creative mortgage. If you ever have trouble making your payments, the bank lowers your payment to $1. When you when the lottery, the bank expects to be paid in full. Perfect.
oh brother! just what the world needs…another exotic mortgage product!
How about homes values just fall to historic affordability fundamentals and everyone gets a regular 30 yr fixed mortgage with tried and tested debt/income ratios. What a concept!
Isn’t one major primary cause of the current “crisis” supposed to be that a lot of people didn’t understand the loans they were signing?
ARMs and teaser rates are both fairly simple concepts (at least to anyone who’s ever had a credit card.)
I’m a fairly smart guy, and I had to read the above article twice before I felt like I had some idea of what this guy was proposing.
So my response is, ok, go for it - - on one condition. I want a provision added that anybody who applies for one of these mortgage also has to take an essay test explaining the mortgage they’re taking and why it’s best suited for them.
Speaking of ivory towers….not only has he not consulted any real world borrowers or lenders, but he thinks a 700,000 house has a 2000 monthly payment. Idiocy.
I think this type of contract has been around for some time - it’s called RENT
Hey Padilla how much did this joker pay you to post the article?
Isn’t congress looking into possible reforms because of the abusive practices of the mortgage industry?
I think a loan that would take the equity generated from rising prices would qualify as abusive.
As a “mortgage insider” you would understand that a 30 year fixed loan becomes cheaper the longer you hold it. Let me clarify it for you . Inflation guarantees a fixed rate loan will be repaid with dollars worth less than the ones that were borrowed. a $2000 payment in 30 years is less than a $2000 payment now. Still can’t grasp the concept? Think of what things cost 30 years ago and compare it to the price of things today.
Do you also think stock brokerages should take the extra equity in a trade if you use margin?
How about banks increasing loan amounts because a business is sucessful?
Matt and the good professor:
This proposal doesn’t pass the teenager test. That is when considering presenting a concept to the public if a teenager can’t comprehend it, neither will the audience.
This one falls under the UC’s mission. basic research, probably not practical, or in a more perjorative term, a science project.
Now the mortgage guys are really getting desperate. Just like Lanser asked - you expect homeowners to caugh up more money in a rising price environment when they are only richer on paper, not in reality?
PLEASE!
You guys that still have jobs doing loans should be going back to school and learning a profession quick because you are never going to replace those incomes again.
Oops! I meant ‘Mat’ asked, NOT Lanser.
Hey Bob, that’s pretty funny. I’m still laughing. You’re absolutely right - it’s called RENT.
Aparently the fools who bought homes with interest only payment option arms are now realizing that those loans too are nothing more than RENT. The only problem with renting from the bank on an interest only loan is that when things turn south, you lose everything.
Kinda better to be a renter these days.
[...] that adjusts to pricing indexes? Mathew Padilla at the OC Register’s Mortgage Insider blog interviews an assistant professor from UC Berkeley who is proposing a mortgage that sees payments adjust relative to a national price index (such as [...]
You small-minded naysayers crack me up. I want to discuss solutions to this mortgage mess that don’t involve dumb new government rules.
I know some of the folks on this blog argue that the basic problem was imprudence by homebuyers, and I tend to agree, with a little lender nuttiness tossed in. We will always have cycles that include irrational emotional behavior. However, I think we can reasonably limit the wild swings of such cycles.
The beauty of this proposal is that it’s an equity sharing relationship. If prices rise, the lender shares in the equity gain. And if prices fall, the lender shares in the loss.
This could be good for both parties. It would lead to fewer foreclosures.
However, I don’t expect it to be adopted by anyone. It would take considerable effort and patience to explain this to consumers, and I don’t see that happening.
-Matt
Hey Matt, what are you talking about? You seriously expect people to let lenders share in the gains during boom times? Who’s going to fall for that nonsense?
How about you get a loan you can afford based on your income and ability to pay that money back? AND, you pay it down over time just like everything else?
What a friggn’ concept! Geez!
Since when did it become the collective accepted idea that homes were no longer to either pay off or pay down?
Oh, I forgot - about 5 years ago. Problem is, now you’re seeing what happens to those who fell for that concept.
how about if UC tuition goes up, then all the professors get a paycut.
All this small minded naysayer can say is the solution to the mortgage mess is the market. Home prices will adjust, opportunity will be created, hardships will be experienced, and at the end of the day, the maket will return to equilibrium. Because this looks to be the widest swing in recent history does not mandate panic or new creative financing schemes.The world is not ending, and we don’t need the political pandering of all of the 2008 presidential want to be’s, all claiming to represent the victimized homeowners in default ,to solve the problem. For the record, ” because people only default when the property is less than the cost of repaying the loan” is absurd, and a little lender nuttiness” is grossly understated.
I am hard pressed to see the need to limit the “wild swings” of any real estate cycle, especially this one. If there is a role of government in stabalizing these cycles, it would be in investigating the mortgage and securities fraud perpetrated by lenders, Wall Street investment firms, brokers, all affiated support services, as well as the borrowers, and imposing penalties so severe that MAYBE we will learn from this mess and not repeat it over and over and over again.
This moran assumes that everyone will have the same job, same location, and will never want to move again.
Seems to be another smoke screen bandaid for a bigger problem.
First, I think the economists, lenders, politicians, etc. should stand back and identify root cause before they attempt to put a band aid or prescribe tylenol for this ailing patient (the RE market)
It all starts with the market’s ability to buy. Therefore, are prices too high for the market to sustain itself? Compared to traditional affordability metrics, I wonder how these economists would answer that. If affordability is not teh issue and prices are not too high, then why even bother attempt to devise new loan products that essentially do just that?
Or, is the ability for a buyer to take on higher-than-traditional DTI’s the problem?
Or, should the credit markets allow buyers’ to be able to buy homes that are over 5 times their annual income? What should be the safe multiple? Seems to be a disagreemnt between the buyers, creditors, realtors and the politicians. They should probably step back and crunch the numbers to get a better bearing of what is going on and come up with a realistic plan that will solve the problem in the long term.
My opinion as to the problem at hand - root cause: The FED lowered rates to avoid after 9/11 and encourage growth in credit driven markets. They then failed to monitor the growth of all markets (or if they were, they were not looking at the correct metrics or didn’t have the correct metrics). Regardless, FED reaction was non-existent until the problem was fully bloomed. We then ended up seeing a huge acceleration in growth of several markets, namely RE. This is a market that is much safer when growth is slow, and consistent over the long term. Instead we had accelerated short term growth that “sucked up” the sustainable long term growth for the next decade.
Now let’s see how they skin this cat, seeing that now inflation is a problem. They really backed themselves into a corner on this one.
These exotic loans only encourage more growth within a market that has already grown beyond its sustainable limit. Suck it up and deal with it is probably the most sensible, realistic fix - it will also get us to the bottom of this correction faster and then the growth of this market will resume on its normal merry way.
Doing anything else will just prolong the pain. It seems they want to do the opposite - sustain the current RE market - so it doesn’t grow, but just stagnates, until the affordability levels return to sustainable levels and the market itself returns to a normal growth rate. Is this even possible?
Housing in Orange County has hundred of Entrance but very few Exits. Housing is a place to live, never a good investment.
Brokers and Realtors made a fortune on your purchases, so be careful.
Rent and Live within your mean. Be Happy.
Well said Carlos…………….
Hey, this concept could work. And let’s not stop at housing. How about the same thing with fuel prices, toys from China, candy from Mexico, cars from the USA, etc. When the quality of those products goes down, so does the price. If the quality improves, then the prices go up. Everyone takes a risk: the bank, the borrower, the investor. RSM…risk sharing management. How do you think this will fly with the shareholders of Countrywide, Wells, WAMU, Bank of America, etc.? Oh, and I’m sure Wall Street will jump on it like flies on sh-t, because they’re just waiting for the next best mortgage idea to come along.
There is no solution gentlemen. The market is screwed. Face it. Sure Congress will come up with a solution –in 10 YEARS!!! The wheels of bureaucracy turn slow. The market is moving down with robust momentum–too fast for congress. Meanwhile, fools will lose their home. By the time a solution comes around, it’s too late.
Matt- It is an interesting idea, but id does not seem equitable from the borrowers viewpoint. The sharing is really only one-way. If value goes up, the debt goes up so the lender is sharing in the gain; but if value goes down, the payment lowers but the debt does not. As another commenter pointed out, this makes it very difficult for the borrower to sell. For this to truly be an equity sharing arrangement, the actual debt would have to drop when values go down, sharing both the gain and the loss. This would put the lender in the position of a real estate owner, which I think we would find most lenders do not want.
“rex agreements” are similar to this strategy…..
still boils down to income and ability to pay……..
home price appreciation doesnt necessarily equate to personal wage inflation.
we cant have any new products create artificial gains/losses due payment fluctuations
otherwise this debacle continues.
enough is enough