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THE FUTURE OF HOUSING FINANCE
E Philip Davis
NIESR and Brunel University
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 12th
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 account of. 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 are 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 underidentified 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.
Larry 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%. 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 cionsideed 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 lending, 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 reduces 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.