Mortgage finance has not kept up with the technological innovations of the last 20 years, according to Nobel Laureate, Robert Shiller.
Advancing mortgage technology yields few benefits for innovators, as competitors are quick to emulate. Innovators are also discouraged by the many regulations which guard the (born-again) sanctity of the mortgage industry.
As a result, the tendency is much more toward boilerplate mortgages rather than loans tailor made to fit the needs of individual borrowers.
The long-term amortizing mortgage — by far the standard today — wasn’t commonplace in the U.S. until after they were introduced to mitigate the financial shocks of the Great Depression. Prior to the Depression, most loans required high down payments, a short loan term and a large balloon payment. In other words, they were untenable unless the borrower had a large amount of cash on hand.
During the financially tumultuous 1970s, the price-level adjusted mortgage (PLAM) was introduced to combat the risks of extremely volatile inflation. While the interest rate remained unchanged, principal fluctuated along with changes in the Consumer Price Index (CPI). Unfortunately, according to Shiller, this innovation fizzled for many of the previously mentioned reasons.
In the 1990s shared appreciation mortgages (SAMs) were developed. SAMs allowed for investors to have an equity share in the borrower’s home. This provided buyers with greater liquidity and required less initial investment. These instruments were quickly dropped, however, once borrowers experienced the speculative downside during a market downturn and found themselves with a dramatically reduced ownership claim to their home.
Seeing the benefit to SAMs, Shiller has developed a loan product that allows borrowers to capture the upside of a shared investment while also hedging against equity loss in the event of a downturn. His solution is called the continuous workout mortgage (CWM), the principal and payments of which adjust to a local home price index. By combining the two, borrowers are more easily able to fund a home purchase while also remaining insulated against any precipitous drop in equity to market volatility.
These ideas are not new. They are essentially cribbed from the now standard operating procedure of sophisticated Wall Street investors. No one funds their own investment entirely — investments really pay when they are scaled and include multiple players, thus mitigating individual risk. All good investors know how to hedge their bets — whether it’s via government guarantees, credit default swaps (CDS) or a combination of the two — it’s only the working stiff mortgage borrowers who do not hedge their losses.
Shiller’s idea would most certainly bring balance to what is now a woefully asymmetrical investment. The problem is that the only thing lenders have to gain from such an arrangement is stability at the cost of lower and slower profits — a scenario not exactly in the wheelhouse of our great financial institutions. Lenders will only adopt these innovations if they’re forced to have more skin in the game and retain a much greater share of their loans on their books. But lenders’ perennial argument is that more skin in the game crimps the flow of funds, places crippling constraints on liquidity and ultimately makes homeownership much less attainable.
But that’s the beauty of SAMs. Borrowers are no longer as dependent on the lender for the full amount of the loan and the lender no longer takes the risk of pledging 96% of the capital, thus nullifying their argument they need to sell the mortgage to Fannie Mae and Freddie Mac in order to make more loans.
Brilliant, really. We suppose that’s why Shiller has a Nobel Prize.