The Shared-Responsibility Mortgage Could Help Bubbleproof the Housing Market
Bubbles, economist Charles Kindleberger once said, can’t exist without borrowing. His 1978 masterwork—Manias, Panics, and Crashes: A History of Financial Crises—dissected famous fiascoes. Looking at the Dutch tulip bubble of the 17th century, he showed that vendor financing pumped up tulip mania: The people who sold bulbs at inflated prices provided loans to the greater fools who bought them. We will never know what Kindleberger would have made of the 2000s housing bubble and the bust that briefly shaved $10 trillion off U.S. households’ net worth. But there is a hint in a Wall Street Journal profile published in 2002, the year before he died of a stroke at 92. “The object of his greatest fascination today is the real-estate market,” the Journal reported. “For weeks, Mr. Kindleberger has been cutting out newspaper clippings that hint at a bubble in the housing market, most notably on the West Coast.”
Kindleberger is identified as “a giant in economics” in a new book by Atif Mian and Amir Sufi called House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It From Happening Again. The lesson they draw from the long-time Massachusetts Institute of Technology economist is centuries old but almost deliberately forgotten. “Economic disasters are almost always preceded by a large increase in household debt.” To prevent the next disaster, they say, society should change the terms of debt contracts to make them more flexible and hence less harmful.
If you’ve heard of House of Debt, it’s probably because Mian and Sufi have emerged as the scourge of Timothy Geithner, the former Treasury secretary who admits to “empathy mistakes” in his own new book, Stress Test: Reflections on Financial Crises. On the Washington Post’s Wonkblog, they wrote that Geithner and the rest of the Obama administration should have pushed harder for writedowns of mortgage debt, and that their failure to do so “remains the biggest policy mistake of the Great Recession.” On their own House of Debt blog, they wrote on May 19 that Geithner holds to the “thoroughly discredited” notion that saving the banks equals saving the economy. “That Geithner still adheres to this view despite all the evidence to the contrary is truly remarkable.”
Entertaining as it is, playing the financial crisis blame game gets us nowhere. A more useful contribution from Mian and Sufi is the shared-responsibility mortgage, their prescription to make economies less vulnerable to debt-fueled bubbles. In such a mortgage, lenders take some of the hit if housing prices fall and reap some of the reward if they rise. “Had such mortgages been in place when house prices collapsed, the Great Recession in the United States would not have been ‘Great’ at all,” they argue. “It would have been a garden variety downturn with many fewer jobs lost.”
Their claim is bold, perhaps too bold, but the strategy for making debt less dangerous by putting a twist into the 30-year fixed-rate mortgage is sound. If an index of home prices in a home’s ZIP code fell, say, 30 percent, then the borrower’s monthly payment of principal and interest would also fall 30 percent. That’s not achieved by stretching out the length of the loan, which lenders sometimes will do: Despite the smaller payment, the mortgage would still get paid off over 30 years. Financially speaking, it would be equivalent to getting a reduction in principal.
If prices recover, payments go back up, but never above the original amount. Lenders would ordinarily charge a higher rate for that protection, but Mian and Sufi calculate that they would be willing to forgo a bump on the rate if they were given some upside potential: 5 percent of any capital gain the homeowner gets upon selling or refinancing the house.
Lenders in every crisis hate to take losses, so they drag their heels on writing off bad loans. The overhang of unpayable debt depresses debtors’ spending, crushing economic growth. The beauty of a shared-responsibility mortgage is that it makes those painful but essential writedowns automatic. It would, the economists say, mostly end foreclosures, which devastate poor neighborhoods. Families lose their home when the price they can get for it is lower than what it would cost to pay off the mortgage. With a shared-responsibility mortgage, when the value of the house goes down, so does the cost of paying off the mortgage. The reason: The loan’s worth becomes less to the lender. Imagine that a home’s price goes down 30 percent and the payment automatically goes down by the same amount. Then a banker who was owed $100,000 will (with gritted teeth) accept $70,000 for a loan payoff. That’s all the stream of income is worth at the new, reduced level of monthly payments. (Well, more or less, depending on whether lenders and buyers perceive values the same way.) Reducing foreclosures this way benefits the whole neighborhood, because foreclosed houses bring down surrounding property values.
Of course, a loan like this is useful only if it’s used. Borrowers would need to be steered—or forced—away from the kind of alluring subprime adjustable-rate mortgages that blew up in 2007 and 2008. So far, the shared-responsibility mortgage exists only in the minds of two ivory tower economists—Mian at Princeton University and Sufi at the University of Chicago Booth School of Business. A two-person startup called PartnerOwn plans to launch the first shared-responsibility mortgage on Chicago’s Northwest Side in cooperation with the Latin United Community Housing Association. “Our personal goal is by August,” says Dylan Hall, a former graduate student of Sufi’s who is the lead partner. So it’s off to a slow start.
If debt is dangerous, why has society balked at risk-reducing ideas such as Mian and Sufi’s? Robert Shiller, the Yale University professor who won a Nobel prize in economics last year, has had many occasions to ask himself that question, since he has been advocating alternative mortgage designs for years. He wrote an article for the May issue of the prestigious American Economic Review titled “Why Is Housing Finance Still Stuck in Such a Primitive Stage?” His long list of explanations includes inflexible regulators; the risk of lawsuits; the likelihood that any good idea will be imitated, since financial patents are hard to enforce; and suspicion. “Mistrust by the general public of the financial community encourages the use of boilerplate mortgage contracts, virtually the same for all,” he wrote. That’s not even counting the opposition of free-market austerians who worry that loan modification undermines the American character. The American Bankers Association and the Securities Industry and Financial Markets Association, namely the creditors’ lobby, declined requests for interviews about the book.
Mian and Sufi cite another obstacle: The federal government probably wouldn’t give their product the same preferential tax treatment it gives to a standard mortgage loan since it’s part equity. That’s crazy: The government should be encouraging, not discouraging, risk-reducing innovation.
Still, change is possible. Shiller notes that long-term, self-amortizing mortgages were rare before the 1930s; it took the Home Owners’ Loan Act of 1933 to launch them on a large scale. Now they’re taken for granted as if they were natural objects rather than human inventions. Progress in the 80 years since has been spotty and interrupted by excrescences such as Ninja loans (no income, no job, no assets). “Alternative forms of mortgage need to be studied on a scientific basis,” Shiller writes.
The financial system is safer now than it was before the crisis. Banks have thicker cushions of capital. Consumer protections have increased. The Federal Reserve has been put on notice to watch out for bubbles. But loans haven’t fundamentally changed. “As it currently stands, the financial system benefits very few people, and those few have a vested interest in staving off any reform,” Mian and Sufi write in their book. Charles Kindleberger couldn’t have said it better.