How America Can Avoid Another Sub-Prime Mortgage Crisis

New mortgage models based on risk and profit sharing can rein in the economic incentives that led to the sub-prime crisis that hurt millions of American homeowners.

Home ownership has been seen as a vital part of the American social contract since the presidency of Franklin D. Roosevelt. Since then, it has become the passport to middle class status. The federal government has encouraged this trend through favorable tax laws and financing via the Federal National Mortgage Association (Fannie Mae). Consequently, the number of Americans who own their own home has steadily increased. However, now millions of Americans have had their homes foreclosed on and nearly half of all mortgage buyers are facing imposed poverty with obligations that leave them buried in debt.  In the past, lenders were local banks that knew their borrowers personally. Today, lending has become a complex risk-shifting exercise, where the lender bears an insignificant stake in the mortgage. The legal framework has not caught up to financial innovation. 

Analysis

A new framework is critical in order to prevent another sub-prime mortgage crisis. Lessons from alternative financial systems can enable us to build a new model that re-embeds risk, realigns the mortgage market with the social contract, and creates a deeper system of accountability. Born out of Islamic finance, innovative instruments exist to provide citizens with access to credit, including mortgages. Through a model based on a combination of profit- and risk-sharing, we can better protect our citizens and their homes from devastating financial shocks. To overcome several market failures inherent within the current lending system, we must shift away from the paradigm of caveat emptor – or “buyer beware.” This has not only shielded lenders from legal liability, but has also made assessing accountability and refinancing extremely difficult. Caveat emptor and the distributor model provided perverse incentives that drove the sub-prime market to loan on farcical standards. We can correct some crucial market failures by moving toward a mortgage business based on balanced liabilities.

To accomplish this transition, we should adopt a profit- and risk-sharing model. The difference between a traditional mortgage and one based on profit- and risk-sharing is the degree to which the lending entity, bank, or other financial institution has a stake in the continual performance of the asset over the life of the contract. 

Next Steps 

Congress should facilitate the endorsement of profit- and risk-sharing mortgages by banks and brokers. This should begin with a gradual alteration on the guidelines for approved mortgage sellers as defined by the Federal Housing Finance Agency, as well as legislation aimed at the secondary mortgage market. Also key is the alteration of the tax code to allow existing deductions for a new model founded on shared equity instead of debt. Congress may also want to take a stance on a taxpayer-favorable variation of the Danielson rule used by tax courts. The eventual objective would be converging the principles of the new model with the necessary requirements for mortgage loans and tax code purposes until a majority of newly issued mortgages conform to the requirements. The mortgage model should then be examined after a minimum of five years.

How likely are you to make Mic your go-to news source?

Andrew Terrell

An American youth studying International Economics and Political Economy.

MORE FROM

Angela Merkel sharply criticizes Donald Trump on climate change without ever mentioning his name

"Whoever thinks that the problems of this world can be solved by protectionism and isolation lives under a huge misconception," Merkel said.

Top Pope aide charged with sexual assault vows to fight his "relentless character assassination"

Pell is the highest-ranking Catholic Church official to be ensnared in the church's sexual abuse scandal.

'Hot Mic' podcast: Sterling family lawsuit, Low approval for GOP health care, Trump hotel sued

The important stories to get you caught up for Thursday.

CNN's Van Jones allegedly says the Trump Russia stories are "a big nothing burger"

He's the second CNN insider this week to apparently denounce the network's Russia coverage.

Conservative columnist Bret Stephens joins MSNBC

Stephens will remain a columnist at The New York Times.

Department of Homeland Security announces new airline security rules

The new measures could help end the electronics ban.

Angela Merkel sharply criticizes Donald Trump on climate change without ever mentioning his name

"Whoever thinks that the problems of this world can be solved by protectionism and isolation lives under a huge misconception," Merkel said.

Top Pope aide charged with sexual assault vows to fight his "relentless character assassination"

Pell is the highest-ranking Catholic Church official to be ensnared in the church's sexual abuse scandal.

'Hot Mic' podcast: Sterling family lawsuit, Low approval for GOP health care, Trump hotel sued

The important stories to get you caught up for Thursday.

CNN's Van Jones allegedly says the Trump Russia stories are "a big nothing burger"

He's the second CNN insider this week to apparently denounce the network's Russia coverage.

Conservative columnist Bret Stephens joins MSNBC

Stephens will remain a columnist at The New York Times.

Department of Homeland Security announces new airline security rules

The new measures could help end the electronics ban.