http://www.finreg21.com/homeTHE U.S. PROPERTY RIGHTS SYSTEM IS SEVERELY BROKEN: We need to treat this crisis as an opportunity not only to install a more rigorous regulatory regime for the financial sector…we need to overhaul the way property rights and property values are established in this country. We need a structural reform that establishes standards for how property is evaluated and how it is offered to the market.
Elena Panaritis, author, Prosperity Unbound: Building Property Markets with Trust

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.

First 100 days:  A fix for the housing crisis

In his speech to Congress, President Obama spoke of how the proper response to the economic crisis is not just a matter of immediate fixes, but also an opportunity to make investments that will serve the nation’s long-term interests. The same idea should govern the housing recovery plan. Otherwise, we get nothing more than a crutch when we need a cure.

As much as short-term help is needed to keep more people from foreclosure, there is a big opportunity to get to the end of the crisis by starting at the beginning of the problem. The conventional wisdom is that subprime mortgages represent the beginning. In fact, the beginning goes back much further. The current crisis stems from the absence of a system that provides stability to the value of properties in the United States.

Instead, real estate “value” in the United States continues to be set through speculation, and that undermines the security – that is, the underlying asset – when mortgages are traded as part of complex financial instruments. We cannot ignore a simple truth of economics: if we are going to treat mortgages as securities, then they must be secured by the tangible asset: namely, land and buildings. To do otherwise has proven to be a recipe for disaster.

The opportunity before the U.S. government with a housing recovery plan is to set up a new system that will keep us from ever getting to this crisis point again. How? The devil is in the details.

It’s no accident that other countries, even those that trade mortgages as financial instruments (such as Australia and Canada) have avoided the levels of off-the-cuff valuation of property we’ve seen in the United States. The reason is that other countries have standardized the information needed to determine the genuine value of real estate and hence mortgage valuation.

This information – actual boundaries, property transfers, claims, liens, and so on – is made available to everyone. The system is sound and transparent. And where do they keep this information? In national property registries, which maintain all the data, in a standardized format, that buyers and sellers need to undertake transactions related to real property.

The United States has a broken registry system, and instead of ever fixing it allowed a title insurance industry to arise as a substitute. Title insurance is non-transparent and (at best) inconsistently regulated, yet it is the main system through which information about property valuation flows. Plus, you have to pay for the information. This leads to all sorts of problems, and fuels speculation.

The Obama Administration’s housing recovery plan ought to look forward. Help people facing foreclosure today, yes, but also establish a national, standardized property registry responsible for the collection of all titles and all information about characteristics of property. Even statewide registries would be a tremendous improvement.

The first step is to mandate an agency to gather whatever exists in state and local registries and title insurance companies around the country, no matter how inadequate, and centralize and standardize that information. Then, establish a mechanism for making this information available to all. Further, figure out how to fill in the missing information. Finally, create a system for the registry to provide remediation in the case of errors.

It is critical that we correct how the value of real estate is established. By finally securing the asset, we can guarantee long-term price stability and rid the system of the speculation that has put us in this crisis. Let’s look at the current housing crisis as an opportunity to make this long-term fix.

This isn’t about setting property prices now and letting them remain static. Rather, it’s about letting a dynamic property market flourish in a way that protects Americans from having to bail out banks or themselves in the future.

Bailouts; fragile confidence; falling stock markets; talking heads; criticism; applause; more criticism; Republicans; Democrats; Latvia’s economy collapsed; Citibank stock down to less than $3; fear; nationalizations; hope; speeches; uncertainty; and more bailouts. What is going on? How can we get out of this mess?

What is going on is exactly what everyone is trying to figure out. There is so much uncertainty out there that I would not be surprised if people started asking astrologists what will happen to their pensions and savings. So much effort is being put into reversing this crisis, yet things still look gloomy.

As I was writing my book and comparing the robustness of property markets and property rights systems in the United States and other countries I realized early on that the United States has a rather weak system for defining and stabilizing property rights. In such a context speculation is almost certain and of course can lead to destabilizing prices and push the entire market beyond its limits.

I strongly believe that the key challenge in our current crisis is to stabilize home and real estate prices. But no one seems to be attacking it head on.

Unfortunately, the weak U.S. property rights system is complemented with some private-sector risk management tools that seem only to increase the uncertainty as they muddle the supply. I talked about this topic 2 days ago on Radio http://www.archive.org/details/RadioInterviewFebruary242009

What needs to happen to stabilize home prices now and for the future? The first step is to reverse the trend toward property being a speculative entity. That will require consolidating in a standardized manner all information about the asset in a single property registry system. We can get the information to begin from the existing (less than ineffective) public registries and from title insurance companies.
This would be a better approach than one that concentrates only on the effects of the crisis, rather than the impacts. Instead of a focus on nationalizing the banking sector, let’s take the more effective – and less expensive – route of undertaking a deep reform of the public registry system and fix the valuation method of every home out there.

You may be interested in reading the following articles:

Nationalizing America’s Banks  (The Economist February 26)

The risks of a bust-up in Europe (The Economist February 26)

No “magic bullet” in Obama housing relief plan.  ( February 18)

Last December, I presented my book at the World Bank sponsored by the World Bank Institute. That talk was special not only because Francis Fukuyama was on the panel and presented a historic development of property rights in economies around the world, and not only because the auditorium was filled to standing room only, but also because Deborah Thomas was there. I wrote about Deborah in my book (chapter 5)
She is a woman from the old segregated and distressed neighborhoods of DC whose financial worth equaled a welfare check … back in the day. She lived with her five children in a housing project, and her mother lived in similar conditions (rent-controlled housing). This living arrangement was all that was offered in the market for people like Deborah: social housing; never owning her own home or apartment, but instead a government- controlled subsidized rental.
One night, Deborah’s home caught fire. She was seriously injured as she tried to rescue her children, one of whom was blinded that same night. After her house was burned she was then officially declared homeless. She had no choice but to move into her mother’s apartment at 14th and W Streets, NW, in DC (across from today’s well-known bookstore/café “Bus Boys and Poets”) – the same apartment she had been raised in as a child, in a building that had been rent-controlled since the 1970s.
But her mother’s building was “Condemned.” A notice glued on the front door of the building declared that it was unsatisfactory for living purposes and that the 150 units had to be vacated in 30 days, with families bussed to shelters.
Deborah and her family were victims of what I call “Unreal Estate” – property so burdened with regulations and unclear rights about usage and responsibilities that it render the asset illiquid.
Unlike so many people who feel powerless to do anything but accept this fate, Deborah researched the regulations, looking for ways the law might allow the tenants to have a choice to purchase and become proud owners of their apartments. She learned that the tenants had the right of first refusal. With her leading the way, the tenants exercised that right. Today, their building and each apartment are valued so much higher, now that they have been pulled out from under public housing regulation and have renovated.
Deborah is no longer on welfare. Instead, she is a proud Middle Class lady in a community that she cares about and to which she belongs. Ownership of her apartment provides a reason to strive, work, save, and invest, and offers a better future for her and her kids.
Deborah’s story is one of HOPE that became REAL CHOICE and has led to a new PROSPERITY.