David Miles’s wants more equity funding of house purchases.

Introduction and summary.

A few days ago, David Miles (external member of the Bank of England Monetary Policy Committee) advocated a system under which a proportion of those providing funds to mortgagors take a stake in the relevant house. That is, a proportion of creditors or “fund providers” share capital profit or loss made when a house is sold. His objective is to reduce house price volatility.

That system amounts to a move in the direction of the system advocated by Positive Money, Laurence Kotlikoff and others for the banking system AS A WHOLE. I’ll argue below that the latter system kills several birds with one stone, whereas Miles’s system, at best, kills just one bird.

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One problem with Miles’s system is that having lenders take an equity stake in the mortgagors’ houses means there is then less incentive for house owners to look after or improve their houses: why spend money on your house if someone else walks off with a proportion of the money you’ve spent?

Of course the latter problem could be solved by having house owners keep records of what they’ve spent on their house. But that’s a bureaucratic nightmare. Plus how does one value the person hours expanded by someone on their house when they do house improvements themselves?

Second, Miles claims that his system would lower house price volatility. As he puts it “But a world in which people could rely less upon standard debt contracts to finance house purchases would probably be one in which both individual household risk and aggregate housing market volatility was lower.”

A problem with that argument is that given a housing boom, “fund providers” will probably stampede into the housing market because there seems to be profit to be made. I.e. given a general house price frenzy, lenders or “equity providers” will probably be as much caught up in the frenzy as everyone else.

A better system.

In the case of house finance, there is a way of making “fund providers” share in profits and losses which has been around for a few years now. It’s the system advocated by Positive Money, Laurence Kotlikoff and others.

Under the latters’ system, bank depositors who want their money to be loaned on (so that they can earn interest) have to take a stake in the underlying loans. And that applies not just to loans to mortgagors, but to ANY TYPE OF borrower.

Now that “Kotlikoff” system does what David Miles wants to achieve. And for the following reasons.

Under a Kotlikoff / Positive Money system, depositors CHOOSE what is done with their money. E.g. they can opt for conservative mortgages: mortgages where the owner-occupier has a relative high equity stake. But that sort of house owner, as Miles rightly points out, is not the problem.

Alternatively, depositors can fund riskier mortgages. But unlike the existing system where banks and depositors are backed by taxpayers, there is no such backing under a K/PM system. That is, anyone who funds risky mortgages takes a hair cut if those mortgages do badly.

Think about it: if you can do something that looks profitable but a bit risky and the taxpayer stands behind you, you’ve got nothing to lose, have you? In contrast, if you stand to take a hit when the risk doesn’t pay off, you’ll think twice.

Thus the K/PM system ought to reduce house price volatility.

Next, Miles’s system REDUCES THE CHANCES of a bank going bust, but it doesn’t wholly rule it out. Thus his system does not do away with taxpayer backing for private banks (the TBTF subsidy, etc). In contrast, Kotlikoff’s system does totally do away with bank subsidies. Reason is that however large a loss made by a bank, depositors who have chosen to act in a commercial manner, i.e. have their money loaned on, carry the costs and risks.

Finally, please note that for the sake of brevity, I’ve given an over-simple description of Kotlikoff and Positive Money’s systems, and I’ve glossed over the differences between their two systems. 

Conclusion.

Looks like game set and match to Kotlikoff and Positive Money.