Insuring Against Dropping Prices

Want to Entice Home Buyers?
Insure Them Against Losses

Stock market investors who believe prices are low, but not certain they have bottomed, can hedge their bets by doing what is called "dollar cost averaging." By committing fixed amounts of capital at regular intervals, they are guaranteed to accumulate relatively more stock when prices are cheapest.

No doubt one of the problems exacerbating the drop in real estate prices nationally is that there's no equivalent strategy for prospective homeowners: you either buy, or you don't buy.

If prices are falling nationally at an accelerating rate, as the latest Case-Shiller numbers indicate, it seems safer to wait until it's clear that they aren't. Of course, when all Buyers simultaneously do this, a "buyers' strike" results. That causes demand to vaporize, and a further drop in prices becomes self-fulfilling.

Interrupting this cycle should be a high priority for the Obama administration. Once buyers return to the housing market, price equilibrium will eventually follow. And once the housing market stabilizes, it's at least possible for the U.S. (and global) economy to begin to recover, as well.

Fortunately, there is a relatively cheap, innovative way to make buying a house in today's harrowing economic environment less like a leap of faith, and more like dollar cost averaging: government-sponsored home insurance.

Although severely tarnished by its association with AIG, the concept of insurance and risk dispersion has great social utility. People now insure against any number of events -- death, illness, unemployment, fire, etc. -- where the odds of occurrence are low, but the consequences if it does are financially catastrophic.

Surely the prospect of one's home losing tens (or hundreds) of thousands in value would qualify as a financial disaster, at least for most of us.

"Sauce for the Gander"

The solution is to allow (require?) new homeowners to pay a recurring premium on an insurance policy, written by the government, that would defray a significant percentage of any realized loss on their home. (Does the government guaranteeing against loss sound familiar? It's essentially the same tack that the FDIC uses to entice strong banks to buy the assets of failed banks -- or the Treasury and Fed used to get JP Morgan Chase to buy Bearn Stearns.)

To ensure the proper financial incentives and deter speculators, such government-underwritten insurance should have three features:

One. Ten percent deductible. Buyers who face no risk of loss have no reason to behave responsibly. Indeed, it would be rational to buy as much house as you could, because the gain would be yours, while any loss would be made up by the government (apparently, only Wall Street gets to play that game). If instead the first 10% of any loss was borne by the homeowner, that incentive goes away.

Two. Profit-sharing. To further deter home buyers looking for a quick score, the home price insurance policy should contain a reciprocal quid pro quo: the government is your partner, 50-50, on any gain. In fact, Stanford University has long used a variant of this policy to extend cheap financing to faculty buying (very expensive) Bay area homes. Stanford's gains on the "back end" defray much of the program's expense.

Three. One policy per household, non-assignable.

One of the reasons credit derivatives became the world's biggest game of fantasy football (Michael Lewis' characterization) is because investors didn't have to have an insurable interest to play. As Lewis puts it, "[credit defaults swaps] are like buying fire insurance on your neighbor’s house, possibly for many times the value of that house — from a company that probably doesn’t have any real ability to pay you if someone sets fire to the whole neighborhood." ("How to Repair a Broken Financial World," The NYT; 1/3/09)

The legal profession has long recognized the perils of such untethered speculation, and developed a concept, champerty, that prohibits uninterested third parties from buying stakes in other people's lawsuits.

The home insurance program needs a comparable policy: one person, one homestead, one home price insurance policy.

By its terms, government-sponsored home insurance would be self-sunsetting. That is, as risk-aversion in the housing market subsided, fewer people would feel the need for loss protection (and be willing to pay the associated premiums). In the meantime, many prospective home buyers clearly would be willing to trade a floor under their potential home losses for a ceiling (or at least a brake) on their prospective gains.

Critics will no doubt characterize such an insurance program as tantamount to fixing home prices, or at least setting a floor under them. In normal market conditions, that might be true.

However, the current housing market, characterized by paralysis and, at least in some markets, freefalling prices, is anything but normal. Under the circumstances, it is incumbent upon government to interrupt a particularly dangerous vicious cycle -- home price deflation -- before its momentum becomes even more difficult to break.