Housing Equity Finance: Creating a Stake for the Poor Andrew Caplin, Amy Chua, Adam Gordon, and Johanna Kalb World Ban

1. Housing Equity Finance: Creating a Stake for the PoorAndrew Caplin, Amy Chua, Adam Gordon, and Johanna KalbWorld Bank PresentationMarch 2004

2. In almost all of the world, businesses use a mixture of debt and equity to raise money, but households only use debt to buy a house. Why?

3. Housing Equity Finance • How Does It Work? • What we’ve learned from U.S., U.K., Australia research and products: • Household interest • Investor interest • Developing World: Opportunities and Challenges • Questions and Feedback

4. How does it work? • $200,000 house • Raise $50,000 (25%) with Proportional Equity Finance Mortgage (PEFM) - second to conventional first mortgage • At time of sale, appreciation-sharing ratio A = 2, depreciation sharing D = 1 • If sell for $160,000, forgiven $10,000 • If sell for $300,000, interest of $50,000

5. How Does It Work? • Increases affordability by reducing down payment, monthly costs, or both • Someone who could have only afforded $150,000 house now can buy $200,000 house • Loss-sharing partial substitute for insurance • Valuable both to homeowner and lender

6. Household Interest • Bank of Scotland zero-interest second, borrow up to 25% • 3% of appreciation for each 1% borrowed • Unfamiliar and expensive, yet over 15,000 issued in two years • Other small pilots in the U.S.; current private sector efforts in Australia and U.K., public-private work in the U.S.

7. Household Interest • “The SAM .. offered by the Bank of Scotland was immensely popular. But … the Treasury prevented life insurers from buying the loans via securitization. So the banks that offered it simply ran out of organizations that would finance the funds.” The Guardian, May 15 1999. • One of many regulatory issues in U.S., U.K., and Australia - rules designed for current system

8. Household Interest • Survey for Australian PM’s report • 600 responses, widely representative, with 200 renters • Even at highest cost (25% up front for 50% at time of sale), 40% said “would increase the probability of owning home”

9. Investor Interest: Incentive Challenges • Incentive Problem 1: “Only use if housing is predicted to depreciate” • Why would a first-time buyer want depreciation? • Supplier of capital generally has superior information • Can vary price according to predicted appreciation • It takes two to tango

10. Investor Interest: Incentive Challenges • Incentive Problem 2: “Few improvements, poor maintenance, little sales effort” • Credit for value-enhancing improvements • As-is clause enforced • Appropriate use of indices for ex ante incentives, ex post verification

11. Investor Interest • PEFM-backed securities with ten-year horizon, full liquidity, idiosyncratic risk diversified • Table 1 provides data on returns and correlations among equities, bonds, bills, residential real estate, 1975-2002

12. Investor Interest

13. Investor Interest • Decent expected returns • Wonderful correlation properties • Recent years shows importance of correlation

14. Investor Interest • Below, vary appreciation-sharing ratio A in PEFM, fix depreciation-sharing at 1. • “Mean-variance” analysis • Bootstrap technique off monthly joint returns • No short sales • Crude continuous 30% taxation assumption

15. Investor Interest

16. Investor Interest • Renters saving to purchase a home have a special interest in keeping pace with housing market • Australian survey scenario: Tax free saving for home in one of three funds: savings account, local housing market account, or stocks and bonds

17. Investor Interest • And the winner is …. real estate • Nearly 40% of total funds if allowed to divide

18. Investor Interest • New market: renters helping renters become owners in a virtuous circle • Not 0-1, but gentle graduation to ownership • Could be used by parents on behalf of children

19. Housing Equity Finance in the Developing World Opportunities and Challenges

20. Opportunities • Key Features of Housing Equity: • Reduces monthly payments for homeowners • Reduces financial risk for homeowners • Attracts new capital to finance homeownership • Helps renters saving for a home to gain same financial returns as homeowners • Question: What pressing development problems do you think that housing equity finance could help address?

21. Opportunities: Our List • Turn the housing crisis in the developing world into an economic opportunity. • Create a broader base of asset ownership, giving more people a larger stake in economic growth. • Provide a new, potentially lower-risk investment opportunity for domestic and international investors.

22. Opportunities: Links to World on Fire • Create a stake in economic system for poor majorities – first through investment, then through homeownership • Align incentives for poor majorities and rich minorities • Build consensus for economic reforms • Create domestic investment opportunities for wealthy minorities

23. Challenges • Our List • Distortions in the Housing Market • Lack of Financial Infrastructure • Weakness in Legal Institutions • Weakness in Financial Markets • Getting the Incentives Right • Cultural Barriers • Negative Perceptions • Question: What do you see as the key challenges that implementing housing equity finance will face?

24. What Countries Are Best Candidates to Pilot HEF? • Minimize challenges and maximize opportunities • Expected growth in housing market • Political stability • Developed financial and legal institutions • Existing reform and development efforts

25. Thinking Creatively: Beijing • Challenge • Economic success creates pressure on urban housing prices • Opportunities • Leverage the existing housing fund into a more effective investment mechanism for low and middle income home-buyers • Create a virtuous cycle: low-income homeowners helping each other

26. Thinking Creatively: Egypt • Challenge: Significant Market Distortion • 2 million units empty • Thousands of families priced out of the real estate market • Explosive population growth • Opportunities • Help to correct market distortion by turning residents into buyers • Maximize the assets of the new real estate finance companies

27. Why Housing Equity Finance? • Can be tried on a local level with a limited pool of participants • Can be integrated into existing housing finance development and reform programs • May mesh well with certain cultural values

28. Conclusion • Starting a dialogue • Opportunities/Challenges? • Pilot Locations? For more information: Adam Gordon, adam.gordon@yale.edu Special thanks to Yunlong Gao, Christopher Joye, Martin Mayerchak, Russell Pittman, Nicholas Robinson, John Weiser, and the Yale Law School