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Three Proposals for Regulating the Distribution of Home Equity

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The Consumer Financial Protection Bureau’s recently-released “qualified mortgage” rules effectively discourage predatory lending but miss an equally important source of systemic risk: low-equity clustering. Specific “volatility-inducing” mortgage terms, when present in a substantial cluster of mortgage contracts, exacerbate macroeconomic risk by increasing the chance that the housing and lending markets will have to absorb a wave of simultaneous defaults after a downturn in housing prices. This Article shows that these terms became prevalent in a substantial proportion of residential mortgages in the years leading up to the home mortgage crisis. In contrast, during the earlier “amortization era” (when mortgagors were more likely to borrow at different times, with more substantial down payments, and more continual rates of amortization, without a need to refinance), an equally-sized negative shock to housing prices would likely produce less negative equity and confine it to a smaller set of borrowers. Instead of prohibiting the volatility-inducing terms, this Article proposes three policies to better assure a greater diversification in the distribution of equity: (a) a modified home-mortgage interest deduction; (b) a modified “qualified residential mortgages” standard; and most importantly, (c) direct macroprudential regulation through a “cap-and-trade” system of leverage licenses and through instituting varying degrees of “conforming mortgages” for Fannie Mae and Freddie Mac. Limiting the simultaneous clustering of negative equity mortgages could reproduce the structural advantages of the amortization era, when inevitable downturns disparately impacted homeowners with different levels of equity and could more easily be absorbed by the market.