The property rights problem

Bailing-out banks won’t fix the US economy. We need to stabilise home prices and standardise the way we value property.

Have we analysed the roots of the current economic crisis or started at the middle? Is it really just the unregulated financial markets and over-liquidity, or have these factors compounded an already broken system? How can we say our securities are “secure” when they are valued incorrectly, are now priced negatively and the bottoming-out point is unknown?

America got into the crisis initially because real estate – and thus the mortgages on it – was valued incorrectly. No one knows the true worth of property in the US. In fact, there is often uncertainty about the actual physical boundaries, as well as other characteristics, of many properties – hence the entire antiquated industry of title insurance.

Think about when you buy a new or used car: no lender requires title insurance. Why not? Because there’s no doubt about the car’s provenance and ownership. US homeowners, though, are required to purchase this insurance to indemnify themselves against loss if the title is defective. Every time a house changes hands, there again are the surveyors out to check the property lines for the umpteenth time so title insurance can be written.

How, then, did today’s crisis unfold? Incorrectly valued mortgages became speculative financial instruments for trading, which makes it possible to drive prices up or down seemingly without limit. And, as they traded downwards, they of course took the price of real estate down with them. Meanwhile, lending banks went over, the precipice of insolvency because the liquidity on which they depend dried up, all because their asset-backed securities have little or no value or even negative value.

Remember, a mortgage is called a “security” because it is secured with a tangible asset. But if its value isn’t real, it can’t really be secure. That’s the starting point for a toxic mix. Throw in excess liquidity (from 2000 to 2006) and housing demand, misvaluations and subprime mortgages to an already overstretched housing and real estate market, and it begins to be deadly unstabilising. Price becomes dependent on speculation, rather than on the actual value of the home and land.

Giving money to the banks is not going to fix this problem. Home values will still be driven by speculation. What we need are deep regulatory changes to the current system that can help establish a secure and true market value of land and real estate and will help stabilise prices for today and the future. That can happen only when the rights on property are recorded in a standardised, transparent and trustworthy manner. Anything short of this is an invitation for more speculation.

The antiquated US system is ridiculously wasteful and does little to provide the full protection of property rights, and title insurance is a poor substitute for the property rights system American property owners need and deserve. The title insurance process is, of course a moneymaking proposition, but that doesn’t change the fact that it is a major culprit in the incorrect valuation of real estate that has brought America and the world to the current crisis. It also slows the transfer of deeds, adds to the expense and thus makes the property market less liquid.

It’s no accident that the root of the crisis is in America. Other countries with sophisticated economies have reliable property rights systems that establish correct mortgage valuation. For example, there is rarely a question about the value of the underlying assets in Canada and Australia, two other countries where mortgages are traded as financial instruments. And the rest of the world hardly knows title insurance. In most countries, public registries keep records of property transfers over time and whether there have been other parties with interest (eg, laying claim to ownership) in a transparent and standardised manner. These registries have the final word, and if they make a genuine error there is a system of remediation.

One key to how things work beyond the US is the public nature of information about property. At the registry, part of that public information includes characteristics of real estate (legal, financial, boundaries, etc) that makes transparent the establishment of a price – that is, the property’s value. There is very little room for speculators to drive the valuation process into the toilet.

As the US government shells out additional hundreds of billions in bank bail-out money, and whatever other hundreds of billions are to come, it needs to make sure some of it is spent on providing citizen property owners and markets with real security over their property – their full money’s worth. It’s time to stop America’s wasteful and risky process. The first step: use some of the bail-out money to establish a regulatory infrastructure for real estate valuation in the form of a nationwide property registry system where titles are well established and transparent to everyone.

If your sinks started to overflow and your pipes were bursting, you’d call a plumber. What if he showed up with towels, threw them on the floor to sop up the water and handed you a bill for $700bn? You’d be flabbergasted.

America needs to fix the plumbing, not just throw towels on the floor. That will take replacing some of the old pipes, like the non-transparent property rights registration process, with ones that will protect property rights at much lower costs today. The US government owes this to its citizens and to the rest of the world who are suffering downstream from the American crisis. Surely it makes sense to invest some of that bailout money to address one of the root problems that has brought all of us to the brink?

It’s time for a structural reform of the system that secures rights on property and real estate – even in the least-secure neighbourhoods – and hence leads to correct valuation. Now is a great opportunity for the new president to make the “ownership society” into something more than a hollow phrase.

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.”