Financial Fragility with SAM?

• Author: DANIEL L. GREENWALD,TIM LANDVOIGT,STIJN VAN NIEUWERBURGH
• DOI: http://doi.org/10.1111/jofi.12992
• Date: 01 April 2021
• Published date: 01 April 2021

THE JOURNAL OF FINANCE •VOL. LXXVI, NO. 2 •APRIL 2021

Financial Fragility with SAM?

DANIEL L. GREENWALD, TIM LANDVOIGT, and STIJN VAN NIEUWERBURGH*,†

ABSTRACT

Shared appreciation mortgages (SAMs) feature mortgage payments that adjust with

house prices. They are designed to stave off borrower default by providing payment

relief when house prices fall. Some argue that SAMs may help prevent the next

foreclosure crisis. However, home owners’ gains from payment relief are mortgage

lenders’ losses. A general equilibrium model in which f‌inancial intermediaries chan-

nel savings from saver to borrower households shows that indexation of mortgage

payments to aggregate house prices increases f‌inancial fragility,reduces risk-sharing,

and leads to expensive f‌inancial sector bailouts. In contrast, indexation to local house

prices reduces f‌inancial fragility and improves risk-sharing.

THE $10 TRILLION MARKET IN U.S. mortgage debt is the world’s largest con-

sumer debt market and second largest f‌ixed-income market. Mortgages are

not only the largest liability for U.S. households, but also the largest asset of

the U.S. f‌inancial sector. 1Given the heavy exposure of the f‌inancial sector to

*Daniel L. Greenwald is at the Massachusetts Institute of Technology Sloan School of Manage-

ment. Tim Landvoigt is at the University of Pennsylvania Wharton School. Stijn Van Nieuwer-

burgh is at the Columbia University Graduate School of Business. We are grateful for comments

from Adam Guren and Erik Hurst, from conference discussants Nina Boyarchenko, Zhiguo He,

Yunzhi Hu, Tim McQuade, Kurt Mitman, Vincent Sterk, Fang Yang, and Jiro Yoshida, and from

conference and seminar participants at the SED in Edinburgh, Philadelphia Fed, St. Louis Fed,

Columbia GSB, Princeton, HEC Montreal, Wharton, the Bank of Canada Annual Conference, the

FRB Atlanta/GSU Real Estate Conference, the UNC Junior Roundtable, NYU Stern, HULM, Uni-

versity of Melbourne, UNSW in Sydney,University of Colorado at Boulder, MIT Sloan f‌inance, MIT

economics, the Sveriges Riksbank, the Federal Reserve Board of Governors, ITAM, University of

Chicago, University of Michigan, the NYC real estate conference at Baruch, MIT economics, the

AREUEA National Conference, the BI-SHoF conference in Stockholm, the pre-WFA real estate

conference in San Diego, the NBER SI Real Estate meeting in Cambridge, the CEPR conference

in Gerzensee, the EFA meeting in Warsaw, Columbia University junior conference, the Ameri-

can Finance Association, the Banking Conference at University of Columbia Graduate School of

Business, and the pre-SED Conference in St Louis.

†We hav e rea d The Journal of Finance’s disclosure policy and have no conf‌licts of interest to

disclose.

Correspondence: Stijn Van Nieuwerburgh, Graduate School of Business, Columbia University,

New York; e-mail: svnieuwe@gsb.columbia.edu

1Banks and credit unions hold $3 trillion in mortgage loans directly on their balance sheets in

the form of whole loans and an additional $2.2 trillion in the form of MBSs. Including insurance

companies, money market mutual funds, broker-dealers, and mortgage REITs in the def‌inition of

the f‌inancial sector add another $1.5 trillion to the f‌inancial sector’s agency MBS holdings. Adding

DOI: 10.1111/jof‌i.12992

© 2020 the American Finance Association

651

652 The Journal of Finance®

mortgages, large house price declines and the default waves that accompany

them can severely hurt the solvency of the U.S. f‌inancial system. This became

painfully clear during the f‌inancial crisis of 2008 to 2011, as U.S. house prices

fell by 30% nationwide, and by much more in some regions, pushing roughly

25% of U.S. home owners underwater by 2010 and leading to seven million fore-

closures. Large losses on real estate loans caused several U.S. banks to collapse

during the crisis, while the stress to surviving banks’ balance sheets led them

to dramatically tighten mortgage lending standards, precluding many home-

owners from ref‌inancing into lower interest rates.2Homeowners’ reduced abil-

ity to tap into their housing wealth short-circuited the stimulative consump-

tion response from lower mortgage rates that policy makers had hoped for.

This experience led economists and policy makers to ask whether a differ-

ent mortgage f‌inance system would result in a better risk-sharing arrange-

ment between borrowers and lenders.3While contracts offering alternative al-

locations of interest rate risk are already widely available—most notably, the

adjustable rate mortgage (ARM), which offers nearly perfect pass-through of

interest rates—contracts offering alternative divisions of house price risk are

still rare. Recently, however, some f‌intech lenders have begun to offer such

contracts, most prominently the shared appreciation mortgage (SAM), which

indexes mortgage payments to house price changes.4

An SAM contract ensures that a borrower receives payment relief in bad

states of the world, potentially reducing mortgage defaults and the associ-

ated deadweight losses to society. However, SAMs impose losses on mort-

gage lenders in these adverse aggregate states, which may increase f‌inancial

fragility at inopportune times. Our paper is the f‌irst to study how SAM con-

tracts affect the allocation of house price risk between mortgage borrowers,

f‌inancial intermediaries, and savers in a general equilibrium framework, and

to propose a shift in the mortgage design literature from a focus on household

risk management to one on system-wide risk management. The main goal of

this paper is to quantitatively assess whether SAMs present a better arrange-

ment to the overall economy than standard f‌ixed-rate mortgages (FRMs).

We begin with a rich baseline model in which mortgage borrowers obtain

long-term, defaultable, prepayable, nominal mortgages from f‌inancial inter-

mediaries. These intermediaries are f‌inanced with short-term deposits raised

from savers and equity raised from their shareholders, subject to realistic cap-

ital requirements, and are bailed out by the government in the event of insol-

vency. Borrowers face idiosyncratic house valuation shocks, while banks face

the Federal Reserve Bank and government-sponsored enterprise (GSE) portfolios adds a further

$2 trillion and increases the share of the f‌inancial sector’s holdings of agency MBS to nearly 80%.

2Charge-off rates of residential real estate loans at U.S. banks went from 0.1% in mid-2006 to

2.8% in mid-2009, returning to their initial value only in mid-2016.

3The New YorkFederal Reserve Bank organized a two-day conference on this topic in May 2015.

4Examples of start-ups in this space are Unison Home Ownership Investors, Point Digital Fi-

nance, Own Home Finance, and Patch Homes. In addition, similar contracts have been offered to

faculty at Stanford University for leasehold purchases over the past 15 years Landvoigt, Piazzesi,

and Schneider (2014).

Financial Fragility with SAM? 653

idiosyncratic prof‌it shocks, which inf‌luence their respective optimal default de-

cisions. We solve the model using a state-of-the-art global nonlinear solution

technique that allows for occasionally binding constraints.

To evaluate the mortgage system’s resilience to adverse scenarios, our model

economy transits between a normal state and a housing-crash state featuring

high house price uncertainty and a decrease in aggregate home values, in ad-

dition to aggregate business-cycle income risk. With FRMs, the arrival of a

housing-crash state leads to higher rates of borrower defaults, bank losses, and

failures, along with large decreases in borrower consumption as the f‌inancial

sector contracts.5

To study the impact of alternative mortgage contracts, we consider SAM

economies in which mortgage payments are indexed to either aggregate house

prices or local house prices. We contrast the effects of alternative schemes on

the model’s key externalities: the deadweight losses and risk-sharing conse-

quences of borrower and bank default. Our main result is that indexation

to aggregate (national) house prices reduces borrower welfare even though

it slightly reduces mortgage defaults, due to a severe increase in f‌inancial

fragility. These contracts lead mortgage lenders to absorb aggregate house

price declines, which causes a wave of bank failures and triggers bailouts ulti-

mately funded by taxpayers, including the borrowers. Equilibrium house prices

are lower and decrease more in crises due to higher mortgage spreads as credit

supply contracts. Ironically, while overall welfare declines, intermediary wel-

fare increases as banks enjoy large gains from increased mortgage payments

in housing expansions and can charge higher mortgage spreads in a riskier

f‌inancial system.

In sharp contrast, indexation of mortgage payments to the local component

of house price risk only can eliminate up to half of mortgage defaults while

reducing systemic risk. Banks’ geographically diversif‌ied portfolios of SAMs

allow them to offset the cost of debt forgiveness in areas where house prices

fall by collecting higher mortgage payments in areas where house prices rise.

Lower mortgage defaults substantially reduce bank failures and dampen f‌luc-

tuations in intermediary net worth, stabilizing the f‌inancial system and re-

ducing deadweight losses. Banking becomes safer, but also less prof‌itable, due

to a fall in mortgage spreads and in the value of the bailout option. As a re-

sult, the welfare of borrowers and savers rises, at the expense of bank own-

ers. Overall welfare increases. The empirically relevant case, which we label

regional indexation, combines aggregate and local indexation and generates

modest welfare benef‌its for the economy.

Last, we examine the consequences of several alternative SAM implemen-

tations. Indexing interest payments only—which are f‌ixed only until the next

borrower mortgage transaction—has much weaker effects than indexing prin-

cipal. Asymmetric indexation, which allows payments to fall but never to

rise, dramatically decreases mortgage default rates, but does so by shrinking

5Throughout the paper, we use “default” to refer to permanent nonpayment or foreclosure,

rather than late payment or delinquency.