Time for New Innovation in the Fractured Housing Finance System
Risk Reduction Mortgages – Delivering Affordability and Diversification to Today’s Homeowner
The adage, “There ain’t [sic] no such thing as a free lunch,” has long been held sacrosanct amongst economists and market participants. Within the world’s largest market – residential real estate – where all sorts of risk exists, the idea of a free lunch simply doesn’t equate.
Fact is, many would argue that far from providing a free lunch, let alone real benefit, the current housing finance system is once again in disrepair and at serious risk of precipitating yet another destabilizing market crash.
While the system does still work, it is fraught with problems and far from optimal for today’s homeowner. Tens of millions of existing homeowners, and those seeking to purchase, face huge challenges – diminished affordability, the prospect of paying thousands annually in exorbitant fees, the inability to diversify and protect their most valuable asset, and the potential for total investment loss through foreclosure.
Fortunately, there is a solution. One that stands set to make affordability a reality for tens of millions of homeowners and those seeking to purchase. Able to provide a diversification benefit – termed “the only free lunch in Economics” – addressing home-price risk for what is typically a homeowner’s largest investment.
Fractured Housing Finance Industry
Affordability
Today’s homebuyer is faced with challenges that can make a home purchase very difficult. Affordability and credit qualification remain major issues in the current environment. Chief obstacles include the following:
- Rising prices that have well-surpassed pre-2008 crisis levels throughout many regions of the country
- A rising rate environment that stands poised to go higher
- Still elevated credit standards and strict documentation requirements
- Stagnant wages that have substantially lagged traditional wage-growth levels
Exacerbating the problem is the fact an estimated 70-percent of homebuyers simply can’t afford a standard 20-percent down-payment. Unable to do so and relying on high-LTV mortgage products, a large proportion of buyers find themselves forced to take on expensive PMI, FHA or piggy-back second mortgages, which can easily cost thousands of dollars annually. And they generally end up strapped with high interest rates.
Not surprisingly, the increased costs due to higher rates and mortgage insurance place many homeowners at a heightened risk of foreclosure.
Lack of Diversification
Beyond the home purchase challenges, homeowners must deal with the risk of price volatility in their local market. Most people understand the notion of diversification and the fact you need to avoid having all eggs in one basket. Unfortunately, there has been no means or mechanism enabling an individual homeowner to diversify their home investment in the past.
This presents a real problem, given that a home represents the largest, most concentrated asset for the typical person. Lack of diversification exposes homeowners to the potential for substantial depreciation in their most valuable asset, and increases their risk of catastrophic investment loss through foreclosure.
Unsustainable System
Despite legislation, regulation and myriad industry changes (post-2008) meant to address the underlying issues that led to the meltdown, the housing finance system remains fraught with risk. Many consider this an unsustainable path.
No less expert than U.S. Rep. Jeb Hensarling (R-TX), chairman of the House Financial Services Committee, recently penned a commentary piece for the Wall Street Journal (Fannie and Freddie, Make Way for Ginnie Mae – Sept. 5, 2018) addressing this very issue.
He notes that this is the 10-year anniversary of the infamous federal government takeover of Freddie Mac and Fannie Mae, agencies widely considered to be major contributors to the 2008 housing market meltdown.
According to Hensarling, both entities have returned to prominence in the market and remain responsible for securitizing half of all new mortgages.
“Fannie and Freddie’s quiet return to much of their pre-crisis market dominance has created a state of systemic risk. That’s bad news for competition, innovation and taxpayers,” he says. “With about $190 billion in taxpayer bailouts to date and some $5 trillion in obligations effectively guaranteed by the federal government, Congress must rein them in before they help create another housing crisis.”
Hensarling goes on to state, “The new system we envision would be based on private capital, competition, innovation, consumer choice and market discipline. Yet prospects for such reform remain dim.”
The Solution
Chairman Hensarling’s warning regarding another pending housing crisis should give pause to stakeholders throughout the entire residential real estate ecosystem.
Fortunately, there is an innovative product now available to the market that addresses many of the key problems and the major risks inherent in the current housing-finance system.
The Risk Reduction Mortgage, created and offered by Home Diversification Corp, a Manchester, NH-based fintech startup founded in 2016, was created to address affordability and local market risk due to price volatility.
The mortgage product, underpinned by “Diversification Agreements” (swap arrangements where the borrower sells a local home price index and buys a national price index) enables homeowners to nationally diversify the value risk on their home. In essence, the approach allows underperforming areas to be subsidized by outperforming neighborhoods and regions.
Validated scientific analysis demonstrates the fact that Risk Reduction Mortgage products are capable of substantially reducing risk to the overall housing finance system. In fact, there is evidence they would have helped avert the 2008 meltdown had they been adopted in place of the toxic mortgage products widely utilized at that time.
The Benefits
Given the size of the housing market – $30 trillion U.S. and $160 trillion globally, with $1.4 trillion in annual mortgage originations – it’s fair to say these products will provide substantial benefit to key stakeholders.
The product will:
- Eliminate the need for PMI, HFA or piggy-back second mortgages for those unable to afford the standard 20-percent down payment. This equates to savings of thousands of dollars each year for the tens of millions of homeowners in this category – an estimated 70-percent of the $1.1 trillion annual purchase mortgage market. They will significantly enhance housing affordability for those within that group, especially first-time homebuyers.
- Allow homeowners to fully diversify their local home-price risk nationally. Typically their largest, most concentrated investment, homeowners will see their home equity value risk reduced substantially. They will also enjoy a similar reduction in foreclosure risk and benefit from a lower interest rate due to their reduced-risk profile. The diversification benefit will also provide a value-add that is estimated at more than 1-percent of the home value annually. This equates to more than $3,000 annually in economic benefit for a typical $300,000 home.
- Provide creditors (e.g.- GSEs) up to a 70-percent reduction in systemic credit losses.
- Substantially reduce risk and provide stability to the current housing finance system. Massive Government bailouts and other extraordinary measures, such as those instituted in the wake of the 2008 meltdown, could be altogether averted with prudent home diversification provided by RRMC’s Risk Reduction Mortgages.
Free Lunch? Or Not
No doubt, there may be debate as to whether the diversification benefit delivered by a Risk Reduction Mortgage does in fact constitute an economic, “free lunch.”
What is not debatable is the fact that once Risk Reduction Mortgages become widely adopted, they stand to deliver substantial annual savings to homeowners and creditors, alike. They will measurably reduce risk, offer enhanced affordability, and provide stability to a housing finance system that is in serious need of change.