Friday, 30 July 2010

Ending the land cycle - or the mortgage cycle

Martin Wolf has an intriguing proposal to "end the land cycle" - by which he means: make sure that any future rise in the value of land goes to society rather than the individual landowner.

This argument has three parts. First, he makes a moral case that increases in land value are largely a function of external effects - increasing population density and infrastructure investments - and therefore why should the current occupier of the land capture all the benefits? Second, a practical case that the current system has stymied productive new development - because it's easier and cheaper for landowners to get a return by reducing the competitive supply of new housing (through the planning system) than by investing in new infrastructure which benefits everyone.

Third, the current system of land ownership through debt is one big casino: buyers borrow money in order to put a bet on the Ponzi game continuing. When it does not, the losses are shoved onto two groups of people who were unprepared for it: recent buyers, many of whom were seduced into buying by the self-serving anecdotes of previous buyers, and now lose all their equity; and taxpayers, who may have known about it but have no choice but to bail out the speculators. Caught in the crossfire is the rest of the economy - productive businesses and consumers - who may want to borrow money for non-speculative purposes, but with the system temporarily broken, can't. Thus, while the economy adjusts: a major recession.

It's a very striking article but I am not sure how he would implement the proposal. Only a massive political change could allow this to happen. However, a more modest version of the proposal might have a chance - and would provide much more macroeconomic stability.

Imagine that, instead of borrowing a fixed nominal amount of debt to buy a house, you co-invested with the bank in the house's equity. The bank would provide money and receive an equity share in the value of the house, and you would receive the balance.

Over time you'd pay rent to the bank on their share (instead of interest), and buy out their equity stake (instead of capital repayments).

This would make the bank a genuine partner with a stake in the success of your housing "enterprise". Banks would gain when property prices rise and lose when they fall - as they do now - but without all the discontinuous disruptions of debt-related bankruptcy and default.

The risks faced by banks would not be eliminated, but they would change. Banks would not see the same sudden reversals in the values of leveraged assets - the assets would become less volatile but would rise and fall with the state of the economy.

The risks faced by householders would change too. As your house becomes more valuable it would become more expensive to buy pieces of it from the bank - so perhaps you would slow your equity purchases to keep your monthly expenditure constant. Probably householders would have some options over how quickly or slowly they acquire equity from the bank.

In order to value the equity each month when it is purchased, banks and householders would agree a way to estimate the value of a house without selling it. This could simply involve uprating the purchase price by the increment in a general house price index (like Case-Shiller), or could involve revaluing it occasionally. In some places with very illiquid markets, where frequent revaluation is impractical, you might stick with the old-fashioned nominal debt mortgage.

One of the benefits of debt over equity is that it puts the valuation risk in the hands of the asset owner - who is presumably in a better position to value it accurately than the bank. This is also why banks don't typically make equity investments in companies. So it may be that a mixed model is best, with some debt and some equity - smoothing out the risks for both homeowners and banks, but still putting responsibility on the homeowner to pay a fair price for the property.

The capital structure of banks and mortgage debt would change too. Instead of highly leveraged fixed-income bonds, mortgages would become more like equity instruments. The backing of these instruments by real property assets would substitute for the role of bank capital and reserves, so - if appropriate regulatory adjustments were made - banks would not suddenly need to hold much more capital. In a sense, the homeowner might become a co-investor in the bank. Indeed, this indicates that the model might be more suitable for building societies and mutually owned credit unions than banks.

It's not clear exactly how this would work out in the long term - so why not try a pilot? A bank who's
interested in exploring this could offer it a a product (perhaps slightly subsidised) to a hundred new housebuyers at random across the UK. After five years we'd have a good idea of how it works and if it's workable, the idea would spread further.

Trials of innovative financial products have positive externalities - a theme I have been exploring in my posts about asset diversity and correlations - so maybe someone nice in the Bank of England might like to sponsor an experiment like this. Or the FSA. I know I have at least one or two occasional readers from there, so over to you guys.

2 comments:

Min said...

Henry George?

PunditusMaximus said...

Your proposal has nothing to do with your problem. How would it affect the usage of planning boards to create artificial land scarcity?