The future of housing finance.

Davis, E. Philip

Housing finance was at the epicentre of the global financial crisis. It raises a variety of risks which change over time and are notoriously difficult to manage, including credit, interest rate and market risk and mortgage pre-payment risks. The welfare consequences of these risks are particularly important because house buying is usually the largest financial transaction households make, and the cost of housing means that they cannot usually hedge their exposures to these risks. As recent events have shown, housing finance is also central to financial intermediation and stability. Innovation may have increased the supply of housing finance but it may also have heightened the concentration of risks. There is an extraordinarily diverse set of national models of housing finance. It is natural to ask which one is best, whether they can be transferred across national boundaries and how to undertake reform. Many regulatory issues at both micro-prudential and macro-prudential level are wide open.

Accordingly, NIESR, supported financially by the ESRC, Money Macro and Finance Group, and the Centre for Macroeconomics, held a conference at the Bank of England on 12 September to discuss these issues from the point of view of leading experts from around the world. This edition of the National Institute Economic Review incorporates articles based on five of the presentations at the conference.

Angus Armstrong and Philip Davis challenge the widespread supposition that the house price and lending boom of the 2000s was the unique and key cause of the financial crisis that began in 2007, in the light of the fact that there was a similar boom in the late 1980s which did not lead directly to a global systemic banking crisis. They contend that the strong parallels between the cycles found both statistically and econometrically suggest that the received wisdom is incorrect and other factors than the housing boom caused the crisis, while macroprudential policy is overly targeted at the control of house prices and lending per se.

Accordingly, there is a need for further research to capture distinctive structural and conjunctural factors underlying the recent crisis which differ from the earlier boom, which macroprudential policy needs to take into account. Key distinguishing factors may include the initial level of debt/income and the related impact of inflation, the impact of lower interest rates in the recent boom and global contagion via liquidity in the recent episode; and the ready availability of credit from mortgage bond issuance which was much less important in the 1980s. Also changing owner occupation rates and patterns of population densities may have had a markedly different effect across the booms. And of course the behaviour of banks and financial markets differed.

Mortgage bonds and bank behaviour are at the forefront of most of the other papers. For Franklin Allen, James Barth and Glen Yago, the recent financial crisis has underlined the importance of the interaction of such financial innovations and the housing market. They consider five major innovations relevant to housing finance, including not only securitised mortgages but also mortgages per se, specialised housing finance institutions; government interventions in housing finance in the US during the Great Depression; and covered bonds. The history of these innovations and their positive and negative aspects are discussed. Notably, a flawed innovation in the US in the 2000s was the private securitisation giving rise to lax underwriting that can in turn be traced to perverse incentives. It is evident that there is a great deal of 'path dependence' in housing finance and therefore radical innovations from elsewhere are not always easily adopted. The scope of government involvement in the US for example was mainly developed during the Great Depression and is firmly rooted in practice. Covered bonds that are widely employed elsewhere are at a disadvantage in the US due to higher capital requirements and caution of the FDIC over their senior status.

International comparison shows that outcomes of housing finance systems vary markedly, and with rich countries such as Germany and Switzerland at the bottom of the scale it is by no means clear that a high owner occupation rate is optimal. Future innovations to help the stability of the housing market are also suggested, notably more equity financing to enhance affordability, better management of risks in securitisations, appropriate pricing of housing and better credit analysis. Interestingly, they do not cite the need for recourse that was an Achilles heel of much of the US system, giving rise to 'strategic default'.

Focusing more closely on topics covered by Allen et al., Susan Wachter contends that housing finance and, specifically, the subprime private label securitisation market in the US, was the core of the global financial crisis. Excessive debt expansion in respect of leverage and credit quality in the run-up to the crisis resulted in credit risk, which was under-identified and mispriced ex ante, and in systemic risk. Much of the problem can be traced to the loss of monopoly on behalf of the government sponsored enterprises (GSEs) that had previously effectively enforced a cautiously leveraged 30-year fixed rate mortgage as standard. Breach of the monopoly in the 1990s and 2000s via the growth of private securitisers allowed a proliferation of riskier and poorly underwritten loans whose default risk was massively underpriced. Competitive firms failed to internalise three forms of foreclosure externality, linked to fire sales, bank loss and borrower losses which meant their lending decisions boosted aggregate risk. The author contends that some progress has been made in US regulation, for example in stress testing, better infrastructure of monitoring aggregate risk, and preclusion under Dodd-Frank of some risky forms of mortgage lending. But the necessary fundamental reform of the US securitisation system has yet to be brought about.

Lawrence Schembri shows that the Canadian system of housing finance proved to be resilient and efficient during the global financial crisis and its aftermath, in contrast to that of the US described in the previous two papers. The Canadian system's effectiveness is the result of a rigorous and mostly Federally-based prudential regulatory and supervisory regime (implementing principal- rather than rule-based approaches) coupled with targeted government guarantees of mortgage insurance and securitisation products with for example mandatory insurance of loans with LTVs of over 80 per cent. Compared with the US, the small number of large and diversified banks is probably also key for stability in Canada. Shorter maturity of typical mortgages than in the US helps asset and liability matching and ensures borrowers share interest rate risk; there are lesser tax subsidies, and there is also better scrutiny of risk management practices in securitisations. Full legal recourse in the case of default is mandatory, reducing incentives to default markedly.

In the post-crisis period, household debt levels and house prices have risen in Canada, owing, in part, to accommodative monetary conditions. These vulnerabilities were mitigated by tightening macroprudential policy, including mortgage insurance rules, and strengthening mortgage underwriting standards. But the outcome shows that with the macroprudential tools currently in operation, improving credit standards on individual loans is easier than affecting macroeconomic trends in credit growth. The Canadian housing finance framework needs to be adjusted and strengthened by rebalancing the risk exposures away from the government towards the private sector participants in the housing finance market. Although some measures have already been taken for this purpose, more adjustments may be needed to create the right incentives and achieve a sustainable rebalancing in risk exposures. Measures should also be considered to open a liquid private label securitisation market in Canada; whereas this could help sustain the activity of smaller lenders, the history of such a market in the US lends grounds for caution.

Finally, the paper by Jesper Berg and Christian Bentzen describes the Danish mortgage system by comparing it with that of the UK. The Danish system has attracted a great deal of attention as a type of narrow banking model where mortgage loans are financed by specialised institutions that issue bonds with cash flows that match that of the mortgage loans. Thereby, the Danish system outsources many of the risks that are usually kept on the balance sheet of banks to bond investors, inter alia improving financial stability. Measured in terms of four criteria (affordability, robustness to house price falls, resilience to a crisis in terms of ability to lend, and absence of government subsidies), the Danish system performed better during the financial crisis than the UK one. For example mortgage spreads remained markedly lower and there was no credit crunch for mortgages in the wake of 2008. A strength of the Danish system and an example to other countries is rapid foreclosure procedures which reduce loss-given-default as well as reducing default incentives. The authors also highlight transfer of the more transparent risks to investors and the safety valves in relation to credit risks that are opaque and therefore more difficult to transfer. But again, the Danish system is deeply rooted in law and tradition and would be hard to transplant wholesale to other countries.

E. Philip Davis *

* NIESR and Brunel University. E-mail: e_philip_davis:msn.com.