Housing Equity Finance: Housing Equity Finance: Creating a Stake for the PoorCreating a Stake for the Poor

Andrew Caplin, Amy Chua, Andrew Caplin, Amy Chua, Adam Gordon, and Johanna KalbAdam Gordon, and Johanna Kalb

World Bank PresentationWorld Bank PresentationMarch 2004March 2004

In almost all of the world, In almost all of the world, businesses use a mixture of debt businesses use a mixture of debt and equity to raise money, but and equity to raise money, but

households only use debt households only use debt to buy a house. to buy a house.

Why?Why?

Housing Equity FinanceHousing Equity Finance

How Does It Work?How Does It Work?

What we’ve learned from U.S., U.K., Australia What we’ve learned from U.S., U.K., Australia research and products:research and products:– Household interestHousehold interest– Investor interestInvestor interest

Developing World: Opportunities and ChallengesDeveloping World: Opportunities and Challenges

Questions and FeedbackQuestions and Feedback

How does it work?How does it work?

$200,000 house$200,000 house

Raise $50,000 (25%) with Proportional Equity Raise $50,000 (25%) with Proportional Equity Finance Mortgage (PEFM) - second to conventional Finance Mortgage (PEFM) - second to conventional first mortgagefirst mortgage

At time of sale, appreciation-sharing ratio A = 2, At time of sale, appreciation-sharing ratio A = 2, depreciation sharing D = 1depreciation sharing D = 1

– If sell for $160,000, forgiven $10,000If sell for $160,000, forgiven $10,000– If sell for $300,000, interest of $50,000If sell for $300,000, interest of $50,000

How Does It Work?How Does It Work?

Increases affordability by reducing down payment, Increases affordability by reducing down payment, monthly costs, or bothmonthly costs, or both

– Someone who could have only afforded $150,000 Someone who could have only afforded $150,000 house now can buy $200,000 househouse now can buy $200,000 house

Loss-sharing partial substitute for insuranceLoss-sharing partial substitute for insurance

– Valuable both to homeowner and lenderValuable both to homeowner and lender

Household InterestHousehold Interest Bank of Scotland zero-interest second, borrow up to 25%Bank of Scotland zero-interest second, borrow up to 25%

3% of appreciation for each 1% borrowed3% of appreciation for each 1% borrowed

Unfamiliar and expensive, yet over 15,000 issued in two Unfamiliar and expensive, yet over 15,000 issued in two yearsyears

Other small pilots in the U.S.; current private sector Other small pilots in the U.S.; current private sector efforts in Australia and U.K., public-private work in the efforts in Australia and U.K., public-private work in the U.S.U.S.

Household InterestHousehold Interest

““The SAM .. offered by the Bank of Scotland was The SAM .. offered by the Bank of Scotland was immensely popular. But … the Treasury prevented immensely popular. But … the Treasury prevented life insurers from buying the loans via life insurers from buying the loans via securitization. So the banks that offered it simply securitization. So the banks that offered it simply ran out of organizations that would finance the ran out of organizations that would finance the funds.” The Guardian, May 15 1999.funds.” The Guardian, May 15 1999.

One of many regulatory issues in U.S., U.K., and One of many regulatory issues in U.S., U.K., and Australia - rules designed for current systemAustralia - rules designed for current system

Household InterestHousehold Interest

Survey for Australian PM’s reportSurvey for Australian PM’s report

600 responses, widely representative, 600 responses, widely representative,

with 200 renterswith 200 renters

Even at highest cost (25% up front for 50% at time Even at highest cost (25% up front for 50% at time

of sale), 40% said “would increase the probability of sale), 40% said “would increase the probability of owning home” of owning home”

Investor Interest: Investor Interest: Incentive ChallengesIncentive Challenges

Incentive Problem 1: “Only use if housing is Incentive Problem 1: “Only use if housing is predicted to depreciate” predicted to depreciate”

– Why would a first-time buyer want depreciation?Why would a first-time buyer want depreciation?– Supplier of capital generally has superior informationSupplier of capital generally has superior information– Can vary price according to predicted appreciationCan vary price according to predicted appreciation– It takes two to tangoIt takes two to tango

Investor Interest: Investor Interest: Incentive ChallengesIncentive Challenges

Incentive Problem 2: “Few improvements, Incentive Problem 2: “Few improvements, poor maintenance, little sales effort” poor maintenance, little sales effort”

– Credit for value-enhancing improvementsCredit for value-enhancing improvements– As-is clause enforcedAs-is clause enforced– Appropriate use of indices for ex ante Appropriate use of indices for ex ante

incentives, ex post verificationincentives, ex post verification

Investor InterestInvestor Interest

PEFM-backed securities with ten-year PEFM-backed securities with ten-year horizon, full liquidity, idiosyncratic risk horizon, full liquidity, idiosyncratic risk diversifieddiversified

Table 1 provides data on returns and Table 1 provides data on returns and correlations among equities, bonds, bills, correlations among equities, bonds, bills, residential real estate, 1975-2002residential real estate, 1975-2002

Summary Statistics March 1975 to December 2002

Domestic Equities

10-year Bond

Cash Real

Estate

Real Geometric Return 5.46% 4.87% 1.67% 2.00%

Real Std Deviation 16.19% 11.57% 3.23% 1.47%

Sharpe Ratio 0.34 0.42 0.52 1.36

Kurtosis 0.66 3.55 1.01 0.38

Skewness -0.49 1.07 0.96 0.42

Correlation:

Domestic Equities 1.000 0.188 -0.074 -0.032

10-year Bond 0.188 1.000 -0.202 -0.083

Cash -0.074 -0.202 1.000 0.066

Real Estate -0.032 -0.083 0.066 1.000

Source: Global Financial Data and authors’ analysis

Investor InterestInvestor Interest

Investor InterestInvestor Interest

Decent expected returnsDecent expected returns

Wonderful correlation propertiesWonderful correlation properties

Recent years shows importance of Recent years shows importance of correlationcorrelation

Investor InterestInvestor Interest

Below, vary appreciation-sharing ratio Below, vary appreciation-sharing ratio AA in in PEFM, fix depreciation-sharing at 1.PEFM, fix depreciation-sharing at 1.

““Mean-variance” analysis Mean-variance” analysis – Bootstrap technique off monthly joint returnsBootstrap technique off monthly joint returns– No short salesNo short sales

Crude continuous 30% taxation assumptionCrude continuous 30% taxation assumption

Multi Asset-Class Efficient Frontier Using the Mean-Variance Approach

PEFM (various appreciation-sharing ratios), March 1975 to December 2002

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0%

Standard Deviation

Expected Real Return

Par Price A=1.50 A=1.75 A=2.00 A=2.25 A=2.50

Large Risk Reduction

Investor InterestInvestor Interest

Investor InterestInvestor Interest

Renters saving to purchase a home have a Renters saving to purchase a home have a special interest in keeping pace with special interest in keeping pace with housing markethousing market

Australian survey scenario: Tax free saving Australian survey scenario: Tax free saving for home in one of three funds: savings for home in one of three funds: savings account, local housing market account, or account, local housing market account, or stocks and bondsstocks and bonds

Investor InterestInvestor Interest And the winner is …. real estateAnd the winner is …. real estate

– Nearly 40% of total funds if allowed to divideNearly 40% of total funds if allowed to divideNon-Owning Survey SampleHow would you allocate your money across the three investment alternatives?

31.4%

39.3%

29.6%

0.0%

10.0%

20.0%

30.0%

40.0%

Savings accountBalanced fundProperty accountInvestment Account

Percentage Allocated

Investor InterestInvestor Interest

New market: renters helping renters become New market: renters helping renters become owners in a virtuous circleowners in a virtuous circle

Not 0-1, but gentle graduation to ownershipNot 0-1, but gentle graduation to ownership

Could be used by parents on behalf of Could be used by parents on behalf of childrenchildren

Housing Equity Finance in the Housing Equity Finance in the Developing WorldDeveloping World

Opportunities and ChallengesOpportunities and Challenges

OpportunitiesOpportunities

Key Features of Housing Equity:Key Features of Housing Equity:

– Reduces monthly payments for homeownersReduces monthly payments for homeowners– Reduces financial risk for homeownersReduces financial risk for homeowners– Attracts new capital to finance homeownershipAttracts new capital to finance homeownership– Helps renters saving for a home to gain same financial returns Helps renters saving for a home to gain same financial returns

as homeownersas homeowners

Question: What pressing development problems do Question: What pressing development problems do you think that housing equity finance could help you think that housing equity finance could help address? address?

Opportunities: Our ListOpportunities: Our List

Turn the housing crisis in the developing world Turn the housing crisis in the developing world into an economic opportunity.into an economic opportunity.

Create a broader base of asset ownership, giving Create a broader base of asset ownership, giving more people a larger stake in economic growth. more people a larger stake in economic growth.

Provide a new, potentially lower-risk investment Provide a new, potentially lower-risk investment opportunity for domestic and international opportunity for domestic and international investors. investors.

Opportunities: Opportunities: Links to Links to World on FireWorld on Fire

Create a stake in economic system for poor Create a stake in economic system for poor majorities – first through investment, then through majorities – first through investment, then through homeownershiphomeownership

Align incentives for poor majorities and rich Align incentives for poor majorities and rich minoritiesminorities

Build consensus for economic reformsBuild consensus for economic reforms Create domestic investment opportunities for Create domestic investment opportunities for

wealthy minorities wealthy minorities

ChallengesChallenges

Our ListOur List

- Distortions in the Housing MarketDistortions in the Housing Market- Lack of Financial InfrastructureLack of Financial Infrastructure- Weakness in Legal InstitutionsWeakness in Legal Institutions- Weakness in Financial MarketsWeakness in Financial Markets- Getting the Incentives RightGetting the Incentives Right- Cultural BarriersCultural Barriers- Negative PerceptionsNegative Perceptions

Question: What do you see as the key challenges that Question: What do you see as the key challenges that implementing housing equity finance will face?implementing housing equity finance will face?

What Countries Are Best What Countries Are Best Candidates to Pilot HEF?Candidates to Pilot HEF?

Minimize challenges and maximize opportunities Minimize challenges and maximize opportunities

- Expected growth in housing marketExpected growth in housing market

- Political stabilityPolitical stability

- Developed financial and legal institutionsDeveloped financial and legal institutions

- Existing reform and development effortsExisting reform and development efforts

Thinking Creatively: BeijingThinking Creatively: Beijing

Challenge Challenge – Economic success creates pressure on urban housing Economic success creates pressure on urban housing

pricesprices

OpportunitiesOpportunities- Leverage the existing housing fund into a more Leverage the existing housing fund into a more

effective investment mechanism for low and middle effective investment mechanism for low and middle income home-buyersincome home-buyers

- Create a virtuous cycle: low-income homeowners Create a virtuous cycle: low-income homeowners helping each otherhelping each other

Thinking Creatively: EgyptThinking Creatively: Egypt

Challenge: Significant Market DistortionChallenge: Significant Market Distortion- 2 million units empty2 million units empty- Thousands of families priced out of the real estate marketThousands of families priced out of the real estate market- Explosive population growthExplosive population growth

OpportunitiesOpportunities- Help to correct market distortion by turning residents Help to correct market distortion by turning residents

into buyers into buyers - Maximize the assets of the new real estate finance Maximize the assets of the new real estate finance

companiescompanies

Why Housing Equity Finance?Why Housing Equity Finance?

Can be tried on a local level with a limited Can be tried on a local level with a limited pool of participantspool of participants

Can be integrated into existing housing Can be integrated into existing housing finance development and reform programsfinance development and reform programs

May mesh well with certain cultural valuesMay mesh well with certain cultural values

ConclusionConclusion

Starting a dialogueStarting a dialogue

– Opportunities/Challenges?Opportunities/Challenges?– Pilot Locations?Pilot Locations?

For more information: For more information: Adam Gordon, Adam Gordon, adam.gordon@yale.eduadam.gordon@yale.edu

Special thanks to Yunlong Gao, Christopher Joye, Special thanks to Yunlong Gao, Christopher Joye, Martin Mayerchak, Russell Pittman, Nicholas Robinson, John Martin Mayerchak, Russell Pittman, Nicholas Robinson, John

Weiser, and the Yale Law SchoolWeiser, and the Yale Law School