"The more I find out, the less I know."

Tuesday - June 28, 2005 at 12:49 PM in

Housing and Financial Risk

On the Volokh Conspiracy today, Todd Zywicki argues that some of the more exotic flavors of mortgage today (such as interest-only loans where you are not required to pay off the principal of the mortgage) are not a problem because they can be part of a financial diversification strategy.

I had a similar debate with one of my cousins recently, after I mentioned my surprise at learning how much our home had appreciated since we bought it--and how much net worth was consequently tied into it.

In fact, a common response from many people with a background in economics and finance is "how can you diversify into assets other than your home?"
If you look at a home purely as a financial asset, then it might be useful to look for strategies to lock in today's values (or at least cushion the downside). But that doesn't work for your home: you have to look at asset value, cash flow, and functional value all at the same time.

In my case (and probably almost everyone's case, unless you're specifically buying a house for the appreciation and not to live in), the functional value of the house outweighs the asset value. Since my house is paid for, I can get full use of it at the cost of very little cash flow (just real estate taxes and utilities). Even if our income and liquid assets were to almost completely dry up, we would still have the house.

Any strategy to lock in the current asset value will create new risks that we might lose the house if the strategy backfires or we suffer an adverse life event--risks which basically don't exist for us today. Just taking out a mortgage dramatically increases the cash flow required to keep the house, making it much more likely that an adverse event could cost us our home. Because we value the use of the home more than the asset value, the fact that it is worth more than we paid for it is an interesting curiosity but has little immediate impact on us financially.

If you want to look at risk in the very narrow sense of deviation of expected return, then it may make sense to diversify away from personal real estate. But in the broader sense, I define risk as the chance that some future event might force my family to make significant lifestyle changes. And in that sense, this is an instance where broader financial diversification can only lead to more risk.

The financial community often defines "risk" as "deviation of expected return." This is a very different meaning than what the layperson thinks of in terms of risk, which I think leads to a lot of confusion when trying to help people understand important finance concepts (i.e. the importance of diversification). It isn't even a very intuitive definition in finance, since most people aren't too concerned about the "risk" of making more money than expected. But it does have the advantage of being preprogrammed in most statistical calculators, so I guess we're stuck with it.

But all this argument assumes that the person taking out the exotic mortgage is doing it as part of a well-disciplined asset allocation strategy. I don't know of any specific data on this point, but everything I've seen (and my gut instinct) tells me that this is not the case.

Rather, people are taking out exotic mortgages as a way to buy more house(s) than they can realistically afford, usually because they want to ride what they hope will be a continued wave of appreciation. In other words, exotic mortgages are being used as a tool to increase the concentration of assets in real estate, not decrease it. This is classic bubble behavior.

One possible outcome (one which I happen to think is at least reasonably likely) is that a decline in housing prices will leave some people in the overextended position of having negative equity (they can't pay off the mortgage by selling the house) and also unable to make payments (insufficient cash flow). This leads to a forced-sale situation just like a slow-motion margin call, where the owner can't make payments so the bank is forced to sell the house at a loss, which can drive down other local real-estate prices and lead to a spiral of unwinding debt and forced sales. This downward spiral is also known as a market crash.

Exotic mortgages do not cause these kinds of situations, but they do make them more likely by decreasing the equity of the homeowner. Margin rules on the stock market and the traditional down-payment requirements on houses are designed to keep enough of an equity cushion in the market so that a few forced sales don't lead to a cascade effect. Unfortunately, in the pursuit of more business, mortgage underwriters have been eroding this safety net in recent years.

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