Date created:13/6/03
Last modified:13/6/03
Maintained by: John Quiggin
John Quiggin

Insurance for house prices

Australian Financial Review

19 June 2003

Opinions about financial innovations seem to swing from one extreme to another. In the 1990s, patently unsound ideas like payment in stock options and the 'asset-light' corporation were received with rapt enthusiasm.

By contrast, the reaction to innovations in housing finance proposed recently by the Prime Ministerial Taskforce run by the Menzies Institute has been overwhelmingly negative. Even the Treasurer, Mr Costello, was dismissive. (Of course, the Taskforce report came out shortly after Mr Howard's announcement that he would be staying on indefinitely as Prime Minister.)

Most of the concern relates to the perception that the Taskforce proposals are designed to prolong the bubble in house prices and thereby bolster the Howard government's electoral position, which is closely tied to the housing market. Although this perception is superficially plausible, it is not supported by a close reading of the Taskforce report.

In fact, the most pressing problem in relation to innovations in housing finance today is to consider how households can protect themselves against the risk of a substantial drop in house prices. It is worth considering the Taskforce proposals, and also those of Yale economist Robert Shiller, who is currently visiting Australia.

Shiller's idea, put forward in his latest book The New Financial Order is to offer insurance against declines in the value of a house price index calibrated to match the location and quality of their own home. Having bought a home relatively recently, with the boom (or bubble) already well advanced, I would certainly be keen to purchase insurance of this kind. Moreover, the premium demanded would show whether financial institutions judged current prices to be sustainable.

The home equity proposal put forward by the Taskforce may also be seen as a kind of insurance. Instead of paying a cash premium, homebuyers would forgo part of any possible gains in return for sharing the risk of declining prices with an equity partner. Once again the willingness, or otherwise, of banks to enter such deals may be seen as a financial market judgement about the sustainability of current prices.

The insurance proposal has the advantage of being based on an index rather than on the value of a particular home, which should reduce transactions costs, and increase the attractiveness of this instrument to financial markets. On the other hand, while insurance provides protection against declining prices, it is not usually available as a put option, allowing homeowners to trade away the benefits of future appreciation. Hence, unlike the equity partnerships idea, it provides no assistance in resolving the affordability problem. Both proposals have advantages and disadvantages and it remains to be seen which, if either, will be successful in the marketplace.

Another idea arising from the Taskforce proposes a financial innovation to be undertaken by government rather than the private sector. This is the idea of a housing lifeline, put forward by Melbourne economists Joshua Gans and Stephen King. The lifeline would be a loan made to homeowners facing difficulties with their mortgages and repayable through the tax system on an income-contingent basis similar to the Higher Education Contribution Scheme.

This is an appealing idea, and immediately suggests possible extensions, ranging from modest amendments to ideas that would fundamentally transform the role of the tax system. A natural extension would be to replace the current First Homeowners Grant with a more substantial loan, including a period of several years when no repayments were required and an income-contingent repayment system which would effectively insure homebuyers against such crises as job losses.

If income-contingent loans worked as successfully for housing as they have for higher education, we might consider moving from specific-purpose loans to something more general and systematic. The idea of a cash grant, to be paid to all young adults, and available to be used for investments of any kind, has been mooted in the United States and Britain.

If such a payment were made in the form of a loan with income-contingent repayments, rather than a cash grant, it would be fiscally sustainable in the long run. It would also overcome the inequity of a situation where subsidies available to homebuyers and university students are denied to renters and blue-collar workers. Such an approach would allow the development of tax and transfer system more closely tailored to individual citizens' lifetime needs and aspirations than is possible under present rules.

Professor John Quiggin is a Federation Fellow in Economics and Political Science at the University of Queensland.

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