How a new spin on mortgages might ease the next housing bust

The Great Recession was a disaster for many U.S. homeowners. House prices fell by an average of 30 percent nationwide. Roughly 25 percent of homeowners found themselves underwater — meaning the value of their house dipped below the amount they owed on the mortgage. There were some 7 million foreclosures.

Now some financial technology lenders are promoting shared-appreciation mortgages, which feature mortgage payments that adjust to house prices. SAMs could help stave off borrower default by providing payment relief when house prices fall. But will they also introduce more risk into the financial system?

That’s a question MIT Sloan assistant professor Daniel L. Greenwald explores in “Financial Fragility with SAM?”

Co-authored with Tim Landvoigt of University of Pennsylvania’s Wharton school and Stijn Van Nieuwerburgh of NYU’s Stern school, the paper explains how indexing payments to housing prices means homeowners would have lower monthly payments during housing shocks, potentially avoiding a wave of defaults that could impact the solvency of the financial system.

There are many possible designs of SAMs, but in one typical scenario, the lender offers the borrower a below-market interest rate in exchange for a share of the appreciation of the property when it’s sold — providing the market is rising. If the property is sold at a loss, the borrower must still pay back the principal balance on the loan, but the lender forgoes any contingent interest.

SAMs were briefly used in the U.K. in the mid-1990s, but earned a bad reputation when the contracts took a hefty share of homeowner equity gains — in some cases up to 75 percent — during an era of dramatic appreciation in home prices.

In the United States, SAMs are currently a tiny fraction of the total $10 trillion mortgage debt market. If they become more popular, however, policymakers will need to understand how they work and the impact they could have on the economy more broadly, said Greenwald.

Indexing matters

In particular, Greenwald and his colleagues wanted to know if the way mortgage debt was indexed — either to aggregate national house prices or to the relative local market only — affected financial stability. When indexed to national housing prices, the researchers’ model showed, SAMs destabilize the financial system. That’s because national house prices represent a large and undiversifiable source of risk for the banks.

While banks are already exposed to this risk through borrower default, the risk is mitigated under the current system because the vast majority of borrowers continue to repay their loans, even when house prices fall, Greenwald explained.

But under national indexation, banks would automatically take write-downs on their entire loan portfolio as house prices fall, leading to massive losses — up to 30 percent in the 2000s housing crash, according to the researchers’ model. Those losses are many times larger than what banks endured under traditional mortgage contracts, Greenwald said.

“Indexing to national house prices causes a huge financial crisis. In our model, an enormous number of banks fail,” said Greenwald. “With a high number of bank failures, the government is likely to bail them out. This means government spends lots of money, which produces a large burden on taxpayers.”

In contrast, when SAMs are indexed to relative local values, they help stabilize the system, the model showed. If values in Las Vegas dropped much lower than the national average, those homeowners would get the most relief in the form of lower payments, while Boston homeowners might have higher payments because their homes retained more value compared to the national average. This maintains banks’ ability to hedge their risk. It means lower losses for banks and fewer defaults for homeowners.

Avoiding financial fragility

The paper’s findings are intended to help policymakers better understand how indexes might be adapted to ensure relief for homeowners while keeping the financial system stable.

“Our main takeaway,” says Greenwald, “is that designing novel mortgage contracts requires careful consideration of their impact on financial fragility.”