The Wrong Medicine

According to Sinai, the belief that housing markets are uncorrelated and that prices are highly volatile led to the development of products to protect against wide variations, including derivatives based on the Case-Shiller Home Price Indices and home equity insurance products that allowed households to pay a fee to guarantee that their house values would not fall below a certain point. Those financial products never took off, he says, perhaps in part because -- as the research reveals -- buying a home serves as natural protection against swings in housing prices.

Sinai adds that owners get the advantage of living in the house, which is similar to an added dividend. People also tend to build savings in the form of home equity. "Homeownership seems to induce saving on the part of households because they will pay down the mortgage, and by the time they are in their 70s they have no housing debt anymore. People are willing to put equity into a house, but wouldn't be disciplined to put it into the stock markets."

People tend to invest in homeownership because they have the ability to use debt to finance homes they might otherwise be unable to afford at times when it seems home prices are on the rise, Sinai notes. However, he adds, that the use of borrowed funds to increase purchasing power cuts both ways, and the role of debt in home buying is an important caveat to the research. "Owning a house with a lot of leverage is really, really risky and there are no two ways about that." When a home's price falls below the value of an existing mortgage, the homeowner cannot afford to move because there is no equity left to form a down payment on another home. "The real cost of house price declines come from leverage. That's the real risk of owning a house."

The use of innovative mortgage products with features such as teaser or adjustable rates, which helped spur the recent housing boom and bust, should not be abandoned but should be used with care, Sinai says. Improved regulations and more education could help homebuyers avoid the problems now weighing on residential markets. "Giving credit to people who can't afford it is not innovative -- it's just a mistake. We don't let people use any regulated medicine that they want. We make them get a prescription. Yet we let them use any financial medicine they want, whether it is good for them or not."

On March 26, the Obama administration announced plans to help homeowners who are underwater with their mortgages. Lenders will be asked to reduce by 15% or more the principal owed on a loan that exceeds the current value of the home. The reduced amount would be forgiven by the lender over three years if the borrower continues to make monthly payments.

Sinai says that while he has not seen how the plan would work in detail, it is an attempt to stem the risk placed on the entire economy when housing markets contract. "It is abundantly clear that when people owe more on their houses than they are worth, it creates severe dislocation for households, the community and the banking sector," he notes. "We're in a situation where we have to adopt some very expensive policies to compensate for the fact that there was systemic easy credit. If we want to try and make housing a less risky sector, one would consider encouraging households to use less leverage. That would reduce the risk of a downturn like we have just seen and enhance the risk-management benefits of owning a house."