Prosperity Unbound

Last week I gave a presentation to the IMF on how property rights issues have contributed to the current housing market crisis right here in the US.  Below I share with you a review by the IMF of the presentation and some of my thoughts on the subject:

“Elena Panaritis gave us a different perspective today, by analyzing institutional aspects of property markets. Her seminar covered a wide range of institutional problems in property rights, including often hard to anticipate property disputes that could turn real estate into what she called “unreal” or illiquid estate, and reforms to address them based on a recently published book (Prosperity Unbound: How To Transform Unreal Estate and Build Property Markets with Trust). Elena used examples from Latin America and Emerging Europe and discussed the reform program that she led with her team in Peru, as well as reforms currently in progress in Bulgaria.

Elena argued about the presence of problems with property rights even in developed countries, including in the US and in Europe. In the case of the US, some of these problems have come to the forefront during the current crisis, primarily in the so called “up and coming neighborhoods,” where many of the subprime mortgages were given.

She described in detail what she called “reality check analysis,” which is the first step of the reform process to create reliable property markets and includes: understanding the origins of the problem at hand and the institutions and organizations involved, analyzing the distortions at each break of the property rights system going as far back in history as needed, determining the players involved and their incentives, and finding out who are the winners and losers of the reform.

Elena, could you help us better understand the implications of your analysis for the current housing market crisis and its origins?”

Elena: “In brief, I believe this crisis thus far has been analyzed from the middle, leaving out the needed scrutiny of its origins. This leads to misunderstandings that make the crisis worse.

We have repeatedly heard about problems from over-leveraging and loose banking and lending regulation, all justified; we ought, however, to look at the original assets (property – real estate) and try to understand the characteristics of property markets and why we had faulty valuations that have led to negative real estate prices (banks demolishing foreclosed homes), as well as to have over 7 million US real estate owners whose mortgage values are higher than the actual values of their houses.

My analysis focuses precisely on defining “why” we got to such a miss-valuation.

Doing a review of the property market behavior throughout recent history, I have observed that the US has a rather weak institutional infrastructure when it comes to securing the tradability risk of real estate. Property rights in the US are not always as solid as many of us think they are, which distorts incentives and relative prices. There can always be considerable risk regarding boundaries, usage, eminent domain etc. Not all information is registered in the county registries, and so one has to do a long search and also purchase title insurance to accompany the final transaction. The end result is that some of the characteristics of real estate assets allow speculative bubbles. Property (being a tangible and finite asset, with the basic parameters transparent to the market players) usually functions as a catalytic asset in the financial markets, because of its relative stability and thus its valuation.

In the case of the US though, the valuation of property is very much based on the information provided by the private title insurance and not by the public registry. This is because the public registry is not able to provide such information, because its data is not complete enough to produce relative price analysis – plus the registry operates mainly as an archive. Multiple transactions on the same property and neighborhoods (in a highly mobile economy as the US) help the title insurance to operate as a proxy to a very weak registry system. Working in new areas with no previous transactions (undervalued neighborhoods because of housing project regulations etc) makes valuation relatively arbitrary. The liquidity surge of the early part of the 2000’s produced a speculative rise of prices in such neighborhoods, as there was no basis for objective valuations and relative prices were very much distorted (and continue to be).

Title insurance is not an ideal solution for a problematic property rights system, as it does not really secure property rights. A well functioning property rights system, such as the ones in Canada, New Zeland, and Australia, would do a better job.”