This country badly needs a liquid, nation-wide derivatives market for residential real estate. I mean badly needs it. The potential social benefits of a well-designed, comprehensive, and liquid derivatives market for residential real estate are enormous. Let me explain why I feel so strongly about this. A house is both a consumer good and an investment. As a consumer good, a house must provide adequate shelter, be in good condition, have enough rooms if there's a family living in it, etc. As an investment, a house must remain attractive on the resale market. For the vast majority of homeowners in the U.S., their house is the single largest asset they own. A large percentage of homeowners also borrow heavily against their houses, so they have a very strong contemporaneous interest in the market value of their house, even if they're not going to sell their house. As a consequence, homeowners try to control as many of the factors affecting the market value of their house as they can. Some of the most important factors are events and conditions that occur beyond the physical boundaries of the property: the aesthetics of the neighborhood, the crime rate, the quality of government services (especially the quality of the local school) that the community's tax base will support, etc. How do homeowners exert control over these factors? Primarily through land use regulations -- exclusionary zoning regulations, in particular. Homeowners will use land use regulations to prevent almost any development they think will lower the market value of their house. And given homeowners' outsized influence on local governments, they're usually successful. So how does all this relate to derivatives markets for residential real estate? A derivatives market could allow homeowners to separate some of the investment components of housing -- particularly the ones that lead homeowners to adopt exclusionary zoning regulations -- from the consumption component. If homeowners were less concerned with the investment component of housing -- that is, protecting their house against a decline in market value -- then they would have less of an incentive to use land use regulations to prevent any nearby development they think might lower housing values. A derivatives market for housing is not necessarily a new idea, but there are two new and interesting proposals for such derivatives markets that I want to highlight: Chicago law professor Lee Anne Fennell's "Homeownership 2.0," and Ralph Liu's SwapRent (which I discussed previously in the context of the foreclosure crisis). 1. Homeownership 2.0 In a forthcoming law review article, professor Fennell proposes a derivatives market that would allow homeowners to reduce their exposure to fluctuations in the housing market that are attributable to "offsite factors":

Central to my approach is a distinction between parcel-specific influences on home values, which the homeowner is in a good position to personally control or insure against ("onsite factors"), and influences on home values that emanate from beyond the four corners of the parcel, such as neighborhood changes and larger housing market trends ("offsite factors"). I argue that only those value changes relating to onsite factors are essential to the homeownership bundle as it exists today.
Under Homeownership 2.0, homeowners could protect against a decline in the market value of their house by paying an investor to take on the downside risks attributable to offsite factors. As always, Fennell has a great diagram of Homeownership 2.0:
What distinguishes this from other home equity insurance proposals is that Homeownership 2.0 would allow homeowners to insure against only declines in housing values that are attributable to offsite factors, while retaining the downside risk for onsite factors. In other words, homeowners would only be buying a limited form of home equity insurance. This allays some of the moral hazard fears, because homeowners would still be on the hook for any price depreciation they cause themselves (i.e., the onsite factors). One big problem I see with Fennell's proposal is that homeowners will view the responsibility of maintaining margin accounts as unduly burdensome. Even if they have the cash to meet margin calls (many homeowners won't), they won't want to deal with frequent margin calls. The only way to sidestep this problem would be to have homeowners post high margins at the outset. I have a hard time believing that homeowners would be willing to post such high initial margins. A smaller problem I see could be worked out by contract. Homeowners would retain legal ownership of their houses, and thus would retain the ability to influence the local government, as well as the standing to challenge zoning decisions. Would homeowners be required to lobby the local government to deny a rezoning that would decrease the value of their house? Would homeowners be allowed to lobby for the rezoning? Would homeowners be required to challenge the rezoning in court? 2. SwapRent Ralph Liu is proposing a derivatives market in which investors would trade SwapRent contracts. There are many different kinds of SwapRent contracts, but the one I want to focus on is the DP (Depreciation Protection) SwapRent contract. In a DP contract, a homeowner would pay an investor a monthly premium, and in exchange the investor would be responsible for an agreed-upon percentage of the decline in the house's value. The amount of the monthly premium would depend on the percentage of the depreciation the investor is responsible for. A homeowner would have to pay higher premiums for the investor to bear responsibility for a higher percentage of the depreciation. Homeowners would still retain legal ownership of the house, and housing values would be based on a price index, such as the MSA level of the OFHEO index, or the Case-Shiller index. What I like about SwapRent is that homeowners can choose the duration of the SwapRent contract. A homeowner can protect against a decline in his house's value just for the next 3 years if he wants to. If the value of the house has declined when the contract expires, Liu explains how the contract is settled:
In the DP SwapRent (SM) contract, the investor will be responsible to the bank/homeowner for the previously agreed upon percentage of the loss in the value of the property at the time of sale, or refinancing.
Ironically, the only problem I see (from a policy perspective) also stems from the fact that homeowners can dictate the duration of the SwapRent contract. This is the problem of inside information. Say a homeowner has inside knowledge that the local government is about to approve the construction of a big, ugly, low-income apartment building in his neighborhood (he might be on the zoning board, or know someone on the zoning board), but he won't be able to move until he buys a new house, which will take about a year. In that case, the homeowner would want to buy a one-year depreciation protection contract. An investor who entered into the one-year depreciation protection contract would lose money (because he wouldn't demand a high enough premium, not knowing about the zoning decision), and would refuse to pay for failure to disclose. The availability of short-term depreciation protection contracts would encourage homeowners to use inside information in this way. Of course, this problem could be solved simply by requiring homeowners to disclose all relevant non-public information. But if the loss to the investors is high enough, you run the risk of investors deciding that it's in their interests to refuse to pay and claim failure to disclose, rather than simply accepting the loss (similar to what health insurers do). If this happens often enough, it could erode homeowners' confidence in SwapRent contracts in general; the derivatives market then might not be able to attract enough liquidity to remain viable. Technical quibbles aside, I think both Homeownership 2.0 and SwapRent are very good ideas. Land use regulations have been so fully "captured" by homeowners that no procedural safeguard will solve the problem. Decoupling some of the investment components of housing from the consumption components is the best way to roll back some of the truly pernicious land use regulations that have appeared in the last 25 years (or at least discourage their use). And a derivatives market for housing is the best way to accomplish that decoupling.

6 comments:

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Ari sh said...

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