Financial innovations and the stability of the housing market.
Allen, Franklin ; Barth, James R. ; Yago, Glenn 等
The recent crisis has underlined the importance of the interaction
of financial innovations and the housing market. We consider five major
innovations relevant to housing finance. These are (i) mortgages; (ii)
specialised housing finance institutions; (iii) government interventions
in housing finance in the US during the Great Depression; (iv) covered
bonds; and (v) securitised mortgages. The history of these innovations
and their positive and negative aspects are discussed. Future
innovations to help the stability of the housing market are also
suggested.
Keywords: mortgages; housing finance institutions; covered bonds;
securitisation
JEL Classifications: GO I, G2I, G23, G28
I. Introduction
For many years financial innovations have had a significant effect
on the housing market. Usually these have enabled an increase in the
proportion of the population that can buy houses. Sometimes, as in the
recent global financial crisis, they have had an adverse effect on the
stability of the housing market. In this paper, we consider the
financial innovations associated with the development of housing finance
and its effect on the housing market and vice versa.
Our main focus is on five important financial innovations that have
had significant positive or negative effects on the stability of the
housing market. The first is the mortgage itself. This is arguably the
most important innovation. A second key innovation was the development
of specialised housing finance institutions such as Savings and Loans in
the US and Building Societies in the UK. Initially these were very
positive developments but in subsequent years there were problems with
some of them. The Savings and Loan Crisis in the US in the 1980s was the
most prominent example. The various government entities that were
developed in the 1930s as a result of the Great Depression were a third
major financial innovation. These have had both positive and negative
effects over the years. Covered bonds where mortgages back the bonds but
also remain liabilities of the issuing banks were the fourth major
innovation. These have been widely used, particularly in continental
Europe. A related development associated with these government entities
was the introduction of securitised mortgages. This fifth innovation has
also had both positive and negative effects.
2. Some early history
The most important financial innovation associated with housing
finance is clearly the mortgage. The first evidence of the existence of
mortgages was horoi, or 'mortgage stones', in ancient Athens.
These were markers used to indicate that a property was mortgaged and to
identify the creditors. (1) By the late 12th century, mortgages had
reappeared in England in the form of common-law financial instruments to
enable the purchase and sale of property. Real estate debts that were
not paid could be recovered by lenders in property sales. The essential
characteristic of mortgages arises from the fact that the existence of
property rights allows the real estate to be pledged as collateral. Laws
must be structured to facilitate this.
In the 18th century, early land developers designed innovative
financial contracts in which real estate investors would buy not an
entire large tract, but a segment for development and resale accompanied
by an option to purchase the adjacent segment. The pioneer in this
effort was John Wood and his son, whose projects in Bath, England, used
this method to integrate individual housing units and related commercial
space to develop the city. Wood went beyond the city limits of Bath to
an area unencumbered by regulations and leased land for 99 years, with
each lease based on the performance of the development of the previous
one. By utilising options, he was able to circumvent land laws, raise
debt and equity financing, and lease and manage related properties. This
was the beginning of urban real estate development and residential
housing finance as we know it today. (2)
3. Agriculture and the promotion of homeownership
Even as urbanisation and residential development grew in the 18th
and 19th centuries throughout Europe and the United States, agriculture
remained the most important contributor to economic growth.
Homeownership accompanied reform and expansion of landownership for
farming. Focusing on land and homeownership, the Homestead Movement in
the US was geared to opening opportunities for would-be farmers in an
age when this occupation was still considered the norm. Ever since the
passage of the Land Ordinance Act of 1785 and the Land Act of 1796, the
federal government provided assistance to settlers in the form of
low-priced land. Other acts followed with regularity. In 1862, Lincoln
signed into law the Homestead Act. Under its terms, any citizen or
person intending to become a citizen who headed a family and was over
the age of 21 could receive 160 acres of land, clear title to which
would be conveyed after five years and payment of a registration fee. As
an alternative, after six months the land could be bought for $1.60 an
acre. This established housing and landownership as common American
goals. By 1890 in the United States, two-thirds of all farm housing was
owner-occupied, increasingly so throughout the 1900s. At the same time,
homeownership was less prevalent in urban areas. Over time, however, the
overall homeownership rate increased from 45 per cent at the beginning
of the 1900s to 60 to 70 per cent in 1960. As figure 1 shows, it has
remained at that level ever since.
[FIGURE 1 OMITTED]
4. Modern housing finance takes shape in the United States
The financial system in a modern economy facilitates the transfer
of resources from savers to borrowers. This allows the productive
sectors to invest in capital necessary for growth. The financial system
also allows consumers to adjust to variations in income over time so as
to smooth consumption. Homeownership, of course, requires financing
given the price of housing relative to the typical homeowner's
income. The modern financing of housing largely began with the savings
and loan industry in the United States. The development of housing
finance in Europe was similar in that it was provided initially by
specialised banks. For example, in the UK it was provided by building
societies. This development of specialised institutions to provide
housing finance was the second key financial innovation.
Origin and development of savings and loan associations
The first American savings and loan institution was organised in
1831 to enable its member shareholders to pool their savings so that a
subset of them could obtain financing to build or buy homes. Every
member was to be afforded the opportunity, over time, of borrowing funds
for this purpose, with the association terminating after the last member
was accommodated. Association membership was geographically restricted:
no loans were made for homes located more than five miles from the
institution.
This first savings and loan was organised as a mutual institution
and therefore owned by its shareholder members. Shareholders were
expected to remain with the institution throughout its life, but those
wishing to withdraw their shares were allowed to do so if they gave a
month's notice and paid a penalty of 5 per cent of their
withdrawal. The association's balance sheet consisted of mortgage
loans as assets and ownership shares as liabilities, with relatively
little net worth. These shares were the precursor of the savings
deposits held today.
After the organisation of the first savings and loans, similar
institutions spread throughout the United States for example, entering
New York in 183 6, South Carolina in 1843, and what is now Oklahoma in
1890. As these associations spread throughout the country, innovations
began to occur. For example, the self-terminating type of institution
was replaced by a more permanent type, and the borrowers were separated
from the savers. Thus, these firms began to operate with a long-term
horizon in mind, and they began to accept shareholders who were not
obliged to take out mortgage loans. Over time, competition from
commercial banks began to develop. In the early 1900s, national banks
(i.e. banks chartered by the federal government) were informed that they
were not prohibited from accepting savings deposits. Moreover, Federal
Reserve member banks were given an incentive to use this source of funds
when a lower reserve requirement was placed on savings accounts than on
demand deposits.
On the asset side, competition for residential mortgages was also
beginning to develop between savings and loans and banks, albeit to a
much lower degree. Without active secondary markets and with still
somewhat restrictive regulations, the two types of depository
institutions found that comparative advantages in information collection
and processing, as well as the favourable tax treatment afforded savings
and loans, still led to fairly identifiable balance sheet differences.
Thus, as the economic boom of the 1920s began, the banks and
savings and loans maintained different balance sheets, competed only
indirectly, and were regulated to a different degree and by different
levels of government. The federal regulators were most interested in
commercial banks and the payments mechanism, and the state governments
were most directly involved with savings and loans and their role in
facilitating homeownership.
Savings and loan associations and the Great Depression
There appear to have been only two periods in the first 150 years
of savings and loan history in which they have suffered large-scale
failures. The first was the Great Depression of the 1930s, and the
second was the severe economic downturn of the 1980s.
During the Depression, savings and loans did not accept demand
deposits and therefore did not suffer the runs that reportedly plagued
commercial banks. Nevertheless, their members had to draw upon their
savings to maintain consumption. Savings and loans were hard-pressed to
cope with these withdrawals because their assets were almost entirely
mortgages, and they prided themselves on maintaining low liquidity
levels. Moreover, reserves for losses were relatively low because
"many state laws ... discouraged the accumulation of reserves and
some supervisory authorities practically forced the distribution of all
earnings." (3) As withdrawals mounted and assets declined in value
due to delinquencies and defaults, savings and loans failed. These
failures severely limited the flow of funds to housing. (4)
This disruption in the housing market finally changed the role of
the federal government in the regulation of the savings and loan
industry and its intervention in the housing finance market was the
third important financial innovation.
First, on July 22, 1932, the Federal Home Loan Bank Act was signed
by President Hoover. This act set up the Federal Home Loan Bank System,
consisting of 12 regional Federal Home Loan (FHL) Banks under the
supervision of the Federal Home Loan Bank Board in Washington. The main
purpose of the system was to strengthen member savings and loan
associations financially by providing them with an alternative and
steady source of funds to promote homeownership. The system was designed
so that the FHL Banks could issue bonds in the capital markets and thus
be able to provide advances to healthy and reasonably safe institutions.
Secondly, the Home Owners' Loan Act was signed on June 13,
1933. Although the main purpose of the act was to facilitate the
refinancing of mortgages in distress cases, many borrowers seeking the
more favourable interest rate and other terms offered by the government
were also able to obtain loans. This led many borrowers deliberately to
default on their existing loans, thus exacerbating the problems of
savings and loans.5 Another purpose of the 1933 act was to allow the
Federal Home Loan Bank Board to charter federal savings and loans. The
aim was to establish savings and loans in places where the state
institutions were providing insufficient service.
Finally, the National Housing Act, enacted June 27, 1934, created
the Federal Savings and Loan Insurance Corporation (FSLIC) to provide
deposit insurance for savings deposits at savings and loans. Membership
in the FSLIC was made compulsory for federal associations and optional
for state-chartered associations. With the establishment of the FSLIC,
the savings and loans were placed on an equal footing with commercial
banks, which were insured by the Federal Deposit Insurance Corporation.
Eventually, the FDIC would become the administrator of federal deposit
insurance for savings and loans as well. On March 31,2006, the FDIC
merged the Bank Insurance Fund and the Savings Association Insurance
Fund into the Deposit Insurance Fund. The merger was mandated by the
Federal Deposit Insurance Reform Act of 2005.
Postwar growth and diversification in the savings and loan industry
Following the Great Depression and World War II, savings and loans
experienced tremendous growth for close to four decades. They surpassed
mutual savings banks in terms of total assets for the first time in 1954
and grew to half the size of the commercial banking industry by the end
of 1980. This expansion was spread throughout the entire industry, with
large and small institutions participating.
Turbulent 1980s for the savings and loan industry
As interest rates rose unexpectedly and fluctuated widely in the
late 1970s and the early 1980s, it became very clear that many savings
and loans were ill equipped to handle the new financial environment.
Their newly authorised market-rate deposits were rapidly escalating the
institutions' cost of funds, while the largely fixed-rate mortgage
portfolios were painfully slow to turn over.
The result was rapidly deteriorating profits and a significant
increase in failures. The problems persisted --even as interest rates
declined in 1982 and the maturity-mismatch problem lessened--due to a
growing deterioration in the quality of assets held by many
associations.
The turbulence of the early 1980s, however, did more than reduce
the number of institutions. It permanently affected the way savings and
loans were to do business. Instead of just savings and time deposits,
these institutions began to offer transaction accounts, large
certificates of deposit, and consumer repurchase agreements--virtually
as wide a selection as that of any commercial bank. On the asset side,
these institutions went beyond mortgages to hold consumer loans,
commercial loans, mortgage-backed securities, and a wide variety of
direct investments. As such, savings and loans were from then on to
differ from commercial banks more as a matter of degree than of kind.
The distinctions among the depository financial services firms became
forever blurred.
It is important to note that variable-rate mortgages, which existed
in the early 1970s in some states such as Wisconsin and California, were
rejected by Congress on a national basis in 1974. Although federally
chartered savings and loans were allowed to issue variable-rate
mortgages in states where state-chartered institutions were permitted to
do so, it was not until January 1, 1979, that all federally chartered
savings and loans were allowed to offer variable-rate,
graduated-payment, and reverse-annuity mortgages on a national basis.
5. Sources of funding for home purchases and homeownership rates
Sources of funding
In addition to savings and loans, non-institutional sources were
major providers of home finance before World War II. Frederiksen (1894)
reported that in the late 1800s about 55 per cent of mortgages in the
country were held by local investors who made the loans or sold the
property themselves, and about 18 per cent by non-resident investors.
Frederiksen's study indicates that the mortgages averaged less
than one-half of the value of the mortgaged property, and that less than
one-half of the property in America was under mortgage. (6)
Interestingly enough, when local investors were replaced increasingly by
more formal and more regulated sources after World War II, two major
real estate crises occurred, one in the 1980s and the other in the late
2000s, with the most recent one more widespread and costly than the
earlier crisis. It is interesting to note that most prior instances of
bubbles in the US had been purely local in nature. Certainly regulation
played a role in the recent crisis, but national markets that are to
some extent facilitated by the rise of standardisation and more
regulated sources of funding should help buffer local supply and demand
shocks. This suggests that the management of monetary policy was an
important cause of a national bubble rather than regulation per se.
As may be seen in table 1, savings and loans were a major provider
of funding for housing until 1980. Afterwards, commercial banks became
more important than savings and loans. But in recent decades,
government-sponsored enterprises (GSEs) have dominated the field. With
the collapse in the private securitisation of mortgages in recent years,
their share has in fact increased. It is interesting that life insurers
increased their share of the market in the 1940s and then reduced it
again from 1950. One possible explanation is that in the 1930s and 1940s
mortgage terms were significantly liberalised. By 1947 the term to
maturity was nearly 20 years and the loan-to-value ratio was roughly 70
per cent. Life insurance companies prefer longer-term assets (their
mortgages had the longest maturities as compared to banks and savings
and loans) and the lengthened maturity was attractive to them. During
this period they decreased their holdings of Treasury securities at the
same time as they increased their holdings of home mortgages, while
their total assets increased substantially. The savings and loans and
the GSEs' shares then grew after 1950 as the life insurance
companies' share declined. Also, the share of the other category
(mainly households) was declining as the life insurance share was
increasing. Lastly, as a result of the depression and war there were
lots of governmental changes in the housing sector that favoured savings
and loans and GSEs.
As shown in figure 2, financing of homeownership differs
substantially across countries. In the US, securitisation has clearly
become very important, while in Denmark covered bonds dominate. In other
countries like Australia, Japan, Austria, Finland, France, Germany, and
Greece, homeownership has been financed largely through the use of
deposits at financial institutions.
[FIGURE 2 OMITTED]
It should be noted that, in 1769, Frederick the Great of Prussia
structured the first covered bonds in the aftermath of the Seven
Years' War to ease the credit shortage in agriculture. This was the
fourth important innovation. These bonds were later extended to provide
funding for residential and commercial real estate. Issued by banks and
secured by a pool of mortgages, covered bonds resemble mortgage-backed
securities, with the exception that bondholders have recourse to the
underlying collateral of those bonds because the mortgages stay on the
balance sheets of issuing banks. (7) The holders of covered bonds also
have recourse to the bank that issued the covered bonds if the value of
the pool of mortgages should prove insufficient.
The use of covered bonds has been largely restricted to European
countries, with the spread to Canada and the United States being a
recent development. These bonds are the primary source of mortgage
funding for European banks. As compared to the securitisation used by
banks in the United States, covered bonds have a cost disadvantage due
to greater capital requirements. (8) In addition, the FDIC is unhappy
about the use of covered bonds in the United States as they create a
class of claimants that stand in front of the FDIC in a liquidation.
Figure 3 shows the extent to which the mortgage-backed covered bonds
played a role in financing homeownership in 2010. Denmark is notable,
with covered bonds accounting for 100 per cent of residential loans
outstanding. In the United States, covered bonds are a new development
and thus still relatively unimportant in financing homeownership. In
Europe, banks shifted to greater covered bond issuance after the banking
crisis.
Homeownership rates
How do countries compare in terms of homeownership? The answer to
that question has varied over time. In 1890, the US homeownership rate
was at 17.9 per cent compared to 6.7 per cent for Europeans. By the
middle of the 20th century, that rate had risen above 61 per cent in the
United States, but European countries were gaining as well. Their rates
were 50 per cent for Belgium, 33 per cent for France, 13 per cent for
Germany, 26 per cent for Sweden, and 43 per cent for the United Kingdom.
(9)
Figure 4 shows more recent data, with homeownership rates varying
from a low of 38 per cent in Switzerland to a high of 98 per cent in
Romania. Of the 47 countries in the figure, only Switzerland and Germany
(43 per cent) fall below 50 per cent. These low rates have been
attributed to cultural factors, very low rents, and conservative
mortgage lending. (10) Another important factor is tenant/landlord
rights. For example, in Germany tenants have very strong rights and
cannot be evicted easily. Italy, Greece, and Spain have much higher
rates of homeownership, reflecting cultural values, discriminatory
policies toward private rental housing, and weaker support of
'social' rental housing (low-cost public housing owned and
managed by government or nonprofit organisations). (11) Fisher and Jaffe
have found that, even though there are several partial factors
associated with high or low rates of homeownership, no single
explanation can account for all global patterns. In their words,
"any explanation of worldwide homeownership rates must be limited
from a generalisable proposition to an anecdotal explanation with
limited empirical content." (12)
Figure 5 provides information on the ratio of home mortgage debt to
GDP to accompany the homeownership rates just discussed. As may be seen,
Switzerland has the highest ratio at 130 per cent in 2009, even though
it has the lowest homeownership rate among the countries in the figure.
This reflects a high cost of housing due to substantial increases in
housing prices over the past decade and a sizeable group of wealthy
domestic and foreign-born (often transient) individuals who can afford
more expensive homes. Germany has a mortgage-debt-to-GDP ratio that was
relatively low at 47 per cent in 2010, reflecting its low rate of
homeownership. Overall, the ratio for the 27 European Union countries
was 52.4 per cent in 2010 as compared to a US ratio of 76.5 per cent in
the same year.
6. Federal government involvement in mortgage markets
Since the 1930s, the federal government has played an increasingly
important role in the allocation of mortgage credit. This involvement
consisted of several innovations. Instruments of federal policy to
increase mortgage credit include or have included loans insured and
guaranteed by the Federal Housing Administration and Veterans
Administration; secondary mortgage transactions by the Federal National
Mortgage Association (Fannie Mae), Federal Home Loan Mortgage
Corporation (Freddie Mac), and the Government National Mortgage
Association (Ginnie Mae); interest rate subsidies; tax expenditures; and
direct loans. The Federal Home Loan Bank Act set up the Federal Home
Loan Bank System in 1932, consisting of twelve regional Federal Home
Loan Banks (FHLBs), to strengthen savings and loans by providing them
with an alternative and steady source of funds to promote homeownership.
Federal regulations have been enacted to affect the behaviour of
mortgage lenders in the pursuit of social objectives. These regulations
include the Fair Housing Act (Title VIII), the Equal Credit Opportunity
Act, the Home Mortgage Disclosure Act, and the Community Reinvestment
Act.
Table 2 shows that the United States is one of relatively few
countries among those listed in which the government provides support to
residential mortgage markets. (13) However, most European governments
have very close ties to their large banks and support them in times of
crisis.
New mortgage products and mortgage insurance
During the 1920s, the US mortgage market relied heavily on mutual
savings banks, savings and loan associations, insurance companies, and
commercial banks. These four types of institutions accounted for 74.4
per cent of the total new mortgage loans made on one- to four-family
housing from 1925 to 1930. The typical mortgage terms on loans made by
these institutions during this period were quite different from those
prevailing in subsequent periods, including the present. During the
1920s, mortgages were written with term to maturities not exceeding
twelve years and with loan-to-value ratios close to 50 per cent. In the
1930s and 1940s, however, these mortgage terms were significantly
loosened. By 1947, the term to maturity approached twenty years and the
loan-to-value ratio was roughly 70 per cent. In more recent years, both
of these factors were further liberalised.
During the 1930s, the housing and banking industries virtually
collapsed. Between 1930 and 1933, more than 8,800 banks failed. In 1933
alone, 3,891 banks suspended operations. Total housing starts fell 70
per cent, from 2,383,000 in 1926-30 to 728,000 in 1931-5. It is
estimated that only 150,000 persons were employed in on-site
construction in 1933. At the same time, approximately half of all home
mortgages were in default, and foreclosures were occurring at the
phenomenal rate of over 1,000 per day. Nonfarm real estate foreclosures
reached a maximum of 252,000 in 1933.
Government-sponsored enterprises (GSEs)
The United States established three government-sponsored
institutions to support the housing sector. First, as noted earlier, the
Federal Home Loan Bank Act set up the Federal Home Loan Bank System in
1932, consisting of twelve regional Federal Home Loan Banks, to
strengthen savings and loans by providing them with an alternative and
steady source of funds to promote homeownership. It now provides such
funding to all depository institutions. Second, the Federal National
Mortgage Association (FNMA, also known as Fannie Mae) was established in
1938 to buy home mortgages and thereby created a secondary market for
such mortgages. In 1968 Fannie was privatised and traded as a publicly
listed company. Third, the Federal Home Loan Mortgage Corporation
(FHLMC, also known as Freddie Mac) was established in 1970 to provide
competition to Fannie Mae and increase the availability of residential
mortgage credit by contributing to the development and maintenance of
the secondary market for residential mortgages. This securitisation of
mortgages is the fifth major financial innovation.
Figure 6a shows the ratio of total mortgages outstanding to GDP
over the past century, while Figure 6b shows the growing importance of
financial institutions like FHLMC and FNMA in financing homeownership
over the past three decades.
[FIGURE 6a OMITTED]
The securitisation of residential mortgages has clearly spread
beyond the United States during the past 30 years, as shown in table 3.
Other developments have also facilitated the financing of homeownership,
such as covered bonds in Denmark and Pfandbrief in Germany. Clearly,
however, the use of securitisation and covered bonds to fund home
purchases is found in more mature economies due to their more complex
legal and financial issues.
[FIGURE 6b OMITTED]
[FIGURE 7 OMITTED]
To show the limited role of securitisation in housing markets in
countries around the world, we rely upon data in the World Bank Survey
IV released in September 2012. Figure 7 shows the percentage of bank
assets in residential real estate loans in various mature and emerging
market economies for 2010, while figure 8 shows the percentage of the
loans that have been securitised. Comparing these two figures, it is
clear that almost all the banks in the countries do indeed hold
residential real estate loans on their balance sheets. However, in only
a relatively few countries are such loans securitised. The vast majority
of the countries in which no real estate loans are securitised are
developing countries.
[FIGURE 8 OMITTED]
7. Turmoil in global housing markets: implications for the future
of housing finance
In the wake of the global financial crisis of 2007 to 2009, it is
important to understand the implications of this economic tsunami for
the future of housing finance. We begin with the collapse of the housing
and mortgage markets in the United States.
The US housing crisis
The residential mortgage market in the United States has worked
extremely well over the past two centuries, enabling millions to achieve
the dream of homeownership. The homeownership rate reached a record high
of 69.2 per cent in the second quarter of 2004 before declining to 65.5
per cent at the end of the second quarter in 2012 (see figure 1), with
all segments of society participating during the rate-increasing period.
To be sure, housing markets have experienced previous periods of
turmoil. After the Great Depression, the first major episode was the
collapse of the savings and loan industry in the early 1980s. This led
to significant changes in mortgage markets.
When the Federal Reserve changed its policy to combat inflationary
pressures in the late 1970s, short-term interest rates rose rapidly, and
the yield curve inverted, with short-term rates exceeding longer-term
rates. At the time, savings and loans were heavily involved in the
mortgage market, holding about half of all mortgage loans in portfolio.
The vast majority of these loans were traditional fixed-rate, 30-year
mortgages. The inverted yield curve meant nearly all savings and loans
were insolvent if their mortgage portfolios had been marked to market
because the interest rates on their outstanding mortgage loans were
lower than the rates on Treasury securities of comparable maturity as
well as newly issued mortgage loans. The nearly 4,000 savings and loans
in existence at the time were estimated to be insolvent on this basis by
roughly $150 billion (or $417 billion in 2011 dollars).
The reason for this dire situation was that the savings and loan
institutions were largely prohibited from offering adjustable-rate
mortgages or hedging their interest-rate risk through the use of
derivatives. Congress responded to the crisis by broadening the powers
of savings and loans so they could operate more like commercial banks,
which largely avoided the same plight. Furthermore, savings and loans
were also allowed to offer adjustable-rate mortgages.
This financial innovation enabled savings and loans to shift some
of the interest-rate risk to borrowers. While adjustable-rate mortgages
accounted for less than 5 per cent of originations in 1980, that share
had increased to 64 per cent in 2006, before declining to 37 per cent in
2010 as a result of the financial crisis. (14)
The second episode of disruption emerged in the summer of 2007,
triggered by the 'subprime mortgage market meltdown'. The
1980s savings and loan crisis was more regional in nature, while the
subprime damage was truly national in scope. Millions of households with
subprime loans (loans made to less creditworthy individuals) became
delinquent on their mortgages, and many lost their homes to foreclosure.
Many of these homebuyers took out 'hybrid' mortgage loans,
which featured low introductory interest rates for two or three years
but a higher rate thereafter. This financial innovation was fine as long
as home prices continued to rise. With increases in home prices,
borrowers could refinance their mortgages at lower interest rates as
equity was being built up. Such individuals had the opportunity to
improve their credit ratings at the same time. Another contributory
factor was increases in loan-to-value ratios that were occurring at more
or less the same time. This also contributed to the overall
deterioration in lending standards.
Unfortunately, home prices fell--and fell dramatically. This led to
a surge in foreclosures and a tightening of credit standards by lenders
that triggered the housing market meltdown, and contributed to a more
general financial crisis and deep recession.
Changes in U8 mortgage markets over the past three decades
contributed to the most recent crisis. Before 1980, as already noted,
the vast majority of mortgage loans were made by savings and loans.
These institutions originated, serviced, and held these loans in their
portfolios. But as early as 1970, the combining of these three functions
by a single institution began to change the funding of home purchases,
as mortgage loans were increasingly securitised.
In subsequent years, Ginnie Mae, Fannie Mae, and Freddie Mac became
the primary securitisers of home mortgages. These three entities
securitised only 5.2 per cent of all outstanding mortgages in 1970, but
their share rose to a high of 49.5 per cent in 2000 before declining to
40.7 per cent in 2005, and then subsequently increasing to 59.1 per cent
in the second quarter of 2012 (see table 1).
Furthermore, financial institutions themselves began to securitise
mortgages, which are referred to as private-label-backed mortgage pools,
which was an innovation.
[FIGURE 9 OMITTED]
Their share of home mortgages was less than 1 per cent in 1984 and
then increased to a high of 21 per cent in 2006, before declining to 14
per cent in 2009. The private-label-backed mortgage pools increased
significantly before the financial crisis and then declined abruptly
during and after the crisis. Another factor was that, beginning in the
second half of the 1990s, subprime mortgage loans grew rapidly in
importance. The subprime share of total originations was less than 5 per
cent in 1994, increased to 13 per cent in 2000, and then grew to more
than 20 per cent in 2005 and 2006, before declining to 0.3 per cent in
2010. Lending institutions and investors seeking higher yields in the
earlier years of the decade found the subprime market attractive but
apparently underestimated the risks. At the same time, the prospect of
subprime loans coupled with rising home prices undoubtedly enticed
borrowers in many parts of the country. Home prices jumped nationally at
an average annual rate of nearly 9 per cent from 2000 to 2006 based on
the S&P/Case-Shiller Home-Price Index 10-Metro Composite, after
rising an average of slightly less than 3 per cent per year in the 1990s
(see figure 9).
Housing problems in other countries
The United States was not the only country to endure problems in
its housing sector in recent years. As table 4 shows, ten of the
nineteen countries experienced significant increases in housing prices
during the past decade before prices declined. The three countries that
experienced the biggest declines in prices were Ireland (-25.3 per
cent), the United States (-22.6 per cent) and Spain (-20.8 per cent).
The experiences of seven of the countries, moreover, were similar to
that of the United States.
The question now becomes, 'Why, despite the fact that some
countries experienced bigger increases in home prices than the United
States, did the US housing market suffer far worse than the markets in
these other countries?'
For one thing, riskier borrowers were granted an increasingly
larger share of mortgage loans, and lending standards were far more
lenient in the United States. According to Lea (2010b), "First
subprime lending was rare or nonexistent outside of the United States.
The only country with a significant subprime share was the UK (a peak of
8 per cent of mortgages in 2006). Subprime accounted for 5 per cent of
mortgages in Canada, less than 2 per cent in Australia and negligible
proportions elsewhere."
In the United States, borrowers with little or no documentation
regarding their income or net worth were able to obtain mortgage loans.
In retrospect, this was a damaging financial innovation that affected
the stability of the housing market in a negative way. Interest-only and
negative amortisation loans were also made available to many borrowers.
Lastly, loan-to-value ratios in some cases exceeded 100 per cent.
Although some of these practices existed in other countries such as the
UK, they were less prevalent than in the United States.15 In Germany,
moreover, the maximum loan-to-value ratio was 80 per cent.
One might think that the country with the highest level of mortgage
debt relative to GDP would also be the country with the worst-performing
mortgage market. Figure 5 would indicate that this country is the
Netherlands. However, as table 4 shows, home prices in the Netherlands
rose higher than those in the United States before the crisis, but the
corresponding decline was far lower during the period of bust. The fact
that Dutch home prices did not collapse as they did in the United States
spared the Netherlands problems in its housing market.
In addition, although the Netherlands did extend high loan-to-value
mortgages to borrowers, they remained a small minority of total
mortgages. The tax subsidy extended to borrowers, moreover, was less in
the Netherlands as compared to the United States. (16)
In contrast to the Netherlands, Ireland had the biggest increase in
home prices before the crisis and the biggest collapse in home prices
during the bust, as shown in table 4. Figure 5 also shows that Ireland
had the third-highest mortgage-debt-to-GDP ratio at 87 per cent in the
European Union. Its housing market also suffered severely in recent
years.
Lastly, it might be noted that, in Denmark, covered bonds are the
dominant source of housing finance. This form of financing is an
alternative to securitisation of mortgages, which has been so important
in the United States. The advantage of covered bonds is that the bonds
remain on the balance sheets of financial institutions and are
collateralised with home mortgages that also remain on the balance
sheets. Other European countries use covered bonds, though to a far
lesser degree. During the past decade, Denmark saw greater fluctuations
in housing prices than the United States, yet avoided the housing
problems that afflicted the United States. Covered bonds may therefore
be a good complement, if not substitute, for securitisation.
8. Future innovations in housing finance
So far we have focused on five major financial innovations in
housing finance and a few developments and variations on these. We turn
next to innovations that are likely to be important going forward, some
of which have been tried in various parts of the world.
Equity and other forms of security to preserve affordability
Innovative financial products can help low- to moderate-income
households achieve the dream of homeownership more safely than the
mortgage products that failed in recent years. Excessive leverage
without equity sponsorship or equity support created capital structures
and financial products that were likely to fail.
Negative equity, non-recourse loans and declining markets combine
to create an incentive for borrowers to default. The most promising
remedy to the problems of inadequate equity is not more but different
equity. Financial options have emerged such as lease-purchase mortgages
and shared-equity mortgages that provide a middle ground between rental
and ownership. They are especially attractive for households that cannot
initially qualify for standard mortgages, but could be candidates for
homeownership several years down the road. Some different options are as
follows.
* Shared-equity ownership. Models of shared equity, such as
deed-restricted housing, community land trusts, and limited-equity
cooperatives, are time-tested in the US and Europe. A government or
nonprofit invests in a property alongside the homebuyer. Shared equity
enables borrowers to trade some potential upside of a purchase for
financing. Hundreds of these programmes now operate in the United
States.
* Lease-to-purchase mortgages. Self-Help is piloting this more
experimental solution. The nonprofit buys and rehabilitates properties
in Charlotte, N.C., then leases the homes to 'tenant
purchasers'--renters likely to be able to assume Self-Help's
lease-purchase mortgages in one to five years. During the rental period,
Self-Help provides credit and homeownership counselling, as well as
property management services, to the tenant purchasers. When the tenant
qualifies, he or she assumes the lease-purchase mortgage from Self-Help.
Rebooting structured finance in housing
Securitisations or structured finance products aimed at spreading
risk must return to basics. Important factors in this regard are
disclosure transparency, the alignment of interests between mortgage
sellers and capital market investors, improvement in collateral quality,
and regulatory protections.
One feature of the Danish model of covered bonds could be helpful
in other countries. The capital structure of these bonds enables
borrowers to manage risks and mortgage balances as interest rates
change. In this model, when a lender issues a mortgage, it is obligated
to sell an equivalent bond with a maturity and cash flow that exactly
match the underlying home loan. The issuer of the mortgage bond remains
responsible for all payments on the bond, but the mortgage holder can
buy back the bond in the market and use it to redeem their mortgage and
deleverage household balance sheets when interest rates rise and home
prices fall. (17) This ability to manage interest-rate and credit risks
reduced defaults and foreclosures in other countries and could help do
so in the United States as well.
From crisis to innovation: working out the foreclosure crisis
Usually, as has been the case historically, innovation emerges from
new necessities created by crises and scarcity. A good way to see the
beginnings of the next wave of financial innovation is to consider the
problems created by the overhang of foreclosed properties arising from
the mortgage meltdown. (18)
Financing will be needed to address the challenges. The structural
demand for capital includes: 1) short-term capital to acquire property;
2) mid-term needs to rehabilitate or demolish homes; and 3) exit
financing to transfer property to a buyer.
At the same time, operational capacity to handle any surge in
foreclosed and defaulted properties is reduced. This demands innovative
pricing models that can aggregate capital sources to clear the logjam of
foreclosed properties while maintaining ways to make these residences
affordable.
Innovative pricing models
In markets where house values are fluctuating, it is important to
find ways to arrive at a fair, affordable price. Two innovative models
have emerged from the crisis:
* Top-down approach. The National Community Stabilisation Trust
(NCST) starts with a market price under normal conditions and then
derives a current value. It calculates a 'net realisable
value' by taking the estimated market value and subtracting
holding, insurance, and other market-specific costs. Key to this
approach is that the final sale price reflects local market conditions
and predictions about future home prices.
* Bottom-up approach. The Community Asset Preservation Corporation
(CAPC) of New Jersey buys pools of non-performing mortgages and REO (19)
properties in low- and moderate-income communities. CAPC then employs a
variety of strategies to return these properties to productive use. Its
pricing model starts with an estimate of current value and adds the
costs necessary to bring the property to market. In March 2009, CAPC was
the first nonprofit to complete a bulk purchase of foreclosed
properties.
In both of these cases, the focus is on underwriting a borrower
(rather than the property) into an affordable mortgage and thereby
forcing a write-down of property value to the point where negative
equity would be eliminated. By working with private funds that buy
marked-down mortgages, the ability to create realistic values emerges.
Technology and financial innovation
The nexus between information technology and financial product
innovation is a pivotal factor in any housing finance system. The
increasing sophistication of risk estimates, assuming data accuracy and
the absence of fraud, enables innovation. The ability to evaluate
creditworthiness and prepayment risk are examples of quantitative
pricing, credit scoring, and risk-management systems that are applied to
home finance. With lower information processing and communications
costs, the activities of back-office mortgage servicers have decreased
as service providers extend their geographic scope.
Credit analysis, with data based on debt payments relative to
income, enables more precise measurement in pricing of risk. The ability
to assign credit scores and automate centralisation of credit
information can increase the access to credit and ability to monitor
payments and cash flows at a consumer level. All of this enables greater
standardisation of documentation and financial structures, which again
lowers housing costs. (20)
Savings models
In most rapidly growing Asian economies, some of the most promising
models seek to encourage and leverage consumer savings to sustain
housing finance. Compulsory and contractual savings schemes to provide a
capital base for housing investment have proliferated. In China and
Singapore, successful housing finance models included mandatory
'housing provident' funds. Employers and employees contribute
a matching percentage of salary for housing-related expenses, including
down payments, monthly payments, and building repairs. Borrowings from
the housing provident funds can be advanced for homeownership and
leverage additional bank loans. Funds not used for housing are returned
at retirement. China allows for a 5 per cent contribution from employees
and employers to build the housing fund. (21) In Singapore, the
provident fund embeds lifetime earnings for retirement and channels
money towards housing by allowing a household to borrow up to 20 per
cent of their retirement fund. Appreciation can accrue towards repayment
of those loans on a deferred basis upon realisation. (22)
Supply-side housing innovations
An increasing amount of evidence suggests that zoning and other
land-use controls work against affordability in housing. Zoning
restrictions, which decrease the amount of land available for
development, are associated with higher prices. This suggests that such
forms of regulation contribute to higher housing costs.
Reducing implied land-use taxes on new construction has had
considerable impact on housing prices when included in policy
innovations. In the UK, for example, the use of supply-side finance
policy demonstrated support for housing affordability through land-use
planning.
One key element in nearly all programmes is the use of transfer of
development rights. These programmes increase housing supply by enabling
owners to sell development rights, while encouraging denser residential
development in city centers. New development can make an important
contribution to housing affordability. The creation and financing of
transfer of development rights has been demonstrated in many developing
and transitional markets such as India and Russia.
9. Concluding remarks
Financial innovation is an imperative for promoting
well-functioning housing markets. Changes in the increasing structural
demand for capital in housing are demographically driven and shape
market structure and performance. Urbanisation and household formation
have fuelled financial innovation in housing markets throughout
history--from the very first mortgages to covered bonds, guarantees,
insurance, tax credits and subsidies, and secondary market development.
Regardless of geography, using cash alone to buy or build housing has
long proven unfeasible for the vast majority of people. In earlier
historical periods, specialised lenders charged relatively high interest
rates that limited capital access and impeded entry of new participants,
such as developers, consumers, and financial intermediaries. Financial
innovations, however, enabled private investors to enter the market,
fund development, and create long-term, low-cost sources of capital.
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NOTES
(1) Fine (1951).
(2) Rabinowitz (2002).
(3) Bodfish (1931, p. 7).
(4) According to Bodfish (1935, p. 22), "One-half of the
counties in the United States as a result of the Great Depression now
had no mortgage loan institutions or facilities."
(5) Bodfish (1935, p. 21).
(6) Frederiksen (1894).
(7) Allen and Yago (2010) and Paulson (2008).
(8) For further discussion, see Bernanke (2009).
(9) Haines and Goodman (1991).
(10) Economist (2011).
(11) Lea (2010a).
(12) Fisher and Jaffe (2003).
(13) According to Ergungor (201 I), the fiscal year 2010 budget
indicates that" ... the U.S. government will spend $780 billion in
tax expenditures over the next five years to subsidize housing through
mortgage interest and property tax deduction...."
(14) Office of Thrift Supervision (2011).
(15) See Lea (2010b) and Ellis (2008).
(16) See Ellis (2008).
(17) Allen and Yago (2010).
(18) This discussion is largely based on a financial innovations
lab conducted for the Ford Foundation in 2009. REO Financial Innovations
Lab, Milken Institute, February 2009.
(19) REO properties stands for Real Estate Owned properties. This
term is used in the US to describe a class of property owned by a
lender, typically a bank, government agency or government loan insurer
after an unsuccessful sale at a foreclosure auction.
(20) Committee on the Global Financial System (2006).
(21) Li and Yi (2007).
(22) Chiquier and Lea (2009).
Franklin Allen *, James R. Barth ** and Glenn Yago ***
* Brevan Howard Centre, Imperial College Business School and
Wharton School of the University of Pennsylvania. E-mail:
allenf@wharton.upenn.edu.
** Auburn University and Milken Institute. *** Milken Institute,
Israel Center. The authors gratefully acknowledge the excellent
assistance provided by Nan (Annie) Zhang, a research assistant at the
Milken Institute. We also thank an anonymous referee for very helpful
comments.
This paper is based on our book, Fixing the Housing Market, Wharton
School Publishing-Milken Institute, 2012, and our paper Allen, Barth and
Yago (2013).
Table 1. Nonfarm residential mortgage holdings by type of
institution, (a) 1900-2012Q2
Percentage of total holdings
Year Total holdings
(US$ billions) CBs S&LsW LICs GSEsM Other
1900 2.92 5.42 34.38 6.27 0.00 53.93
1905 3.52 8.32 36.08 7.22 0.00 48.38
1910 4.43 10.05 40.69 9.11 0.00 40.15
1915 6.01 9.41 41.82 8.68 0.00 40.09
1920 9.12 8.77 39.93 6.12 0.00 45.18
1925 17.23 10.78 40.80 8.17 0.00 40.24
1930 27.65 10.29 38.11 10.41 0.00 41.19
1935 22.21 10.02 32.80 9.91 0.00 47.28
1940 23.81 12.59 33.54 12.13 0.75 41.00
1945 24.64 13.78 34.69 14.74 0.03 36.77
1950 54.36 19.19 37.08 20.30 2.44 20.99
1960 162.11 12.56 49.77 17.73 1.79 18.14
1970 352.25 12.96 52.71 12.12 5.24 16.97
1975 574.64 14.43 53.62 6.48 11.11 14.35
1980 1,100.40 15.61 48.41 3.40 16.14 16.44
1985 1,732.10 13.60 37.58 1.94 28.15 18.74
1990 2,893.73 16.19 23.91 1.52 39.83 18.55
1995 3,719.23 18.63 14.64 1.05 48.35 17.34
2000 5,508.59 19.02 11.90 0.75 49.49 18.85
2005 10,049.21 19.21 10.47 0.50 40.74 29.08
2010 11,386.53 21.11 4.32 0.46 53.77 20.33
2011 10,034.36 21.22 4.09 0.06 58.16 16.47
2012 Q2 9,844.03 21.93 3.52 0.07 59.14 15.34
Sources: US Federal Reserve Flow of Funds and Bureau of the Census
(Statistical Abstract Supplement, Historical Statistics of the United
States, 1961). Notes: (a) Commercial banks (CBs), savings and loans
(S&Ls), life insurance companies (LICs), government-sponsored
enterprises (GSEs), and 'other,' which includes state and local
government employee retirement funds, private issuers of asset-backed
securities, finance companies, real estate investment trusts, and
credit unions, (b) Include mutual savings banks (MSBs). (c) This
number includes all government-sponsored institutions participating in
the mortgage market (government-sponsored enterprises and agency-and
GSE-backed mortgage pools) both on-balance sheet holdings and
securitised mortgages.
Table 2. Government support for mortgage markets
Country Government mortgage Government security
insurance guarantees
Denmark No No
Germany No No
Ireland No No
Netherlands NHGa No
Spain No No
United Kingdom No No
Australia No No
Canada Canada Mortgage Canada Mortgage
Housing Corporation Housing Corporation
Japan No Japan Housing
Finance Agency
South Korea No No
Switzerland No No
United States FHAa GNMA (a)
Country Government sponsored
enterprises
Denmark No
Germany No
Ireland No
Netherlands No
Spain No
United Kingdom No
Australia No
Canada No
Japan Possible
South Korea Korean Housing
Finance Corporation
Switzerland No
United States Fannie Mae, Freddie
Source: Lea (2010a).
Note: (a) NHG stands for National Hypothek Garantie meaning National
Mortgage Guarantee, FHA for Federal Housing Administration, and GNMA
for Government National Mortgage Association.
Table 3. Date of first mortgage-backed securitisation
Year Country
1970 United States
1984 Australia and Canada
1985 United Kingdom
1988 France
1989 South Africa
1991 Spain
1995 Germany and Ireland
1996 Argentina
1999 Brazil, Japan, Italy and South Korea
2000 India
2003 Mexico
2004 Malaysia
2005 China
2006 Russia and Saudi Arabia
Source: Milken Institute, Capital Access Index 2005.
Table 4. Average house price changes in selected countries (rankings
of countries in parentheses)
Country Boom (1998: Bust (2006:
Q1-2006-Q2) Q2-2011:Q3)
United States 49.9 (15) -22.6 (2)
Australia 78.5 (7) 17.7 (17)
Belgium 55.2 (11) 12.4 (14)
Canada 53.3 (13) 28.5 (19)
Denmark 79.5 (6) -19.5 (4)
Finland 68.4 (8) 2.7 (11)
France 102.2 (4) 5.1 (12)
Germany -11.4 (18) -5.7 (9)
Ireland 131.4 (1) -25.3 (1)
Italy 53.4 (12) -7.9 (6)
Japan -25.6 (19) -8.3 (5)
Netherlands 61.0 (10) -6.9 (8)
New Zealand 64.2 (9) -1.7 (10)
Norway 53.0 (14) 24.3 (18)
South Korea 4.4 (17) 6.5 (13)
Spain 108.6 (3) -20.8 (3)
Sweden 83.4 (5) 16.0 (16)
Switzerland 10.7 (16) 14.2 (15)
United Kingdom 112.2 (2) -7.3 (7)
Country Overall (1998: Similar to the
Q1-2011:Q3) United States?
United States 16.0 (16) --
Australia 110.1 (3) No
Belgium 74.4 (7) No
Canada 96.9 (4) No
Denmark 44.6 (13) Yes
Finland 72.9 (8) No
France 112.6 (2) No
Germany -16.5 (18) No
Ireland 72.9 (9) Yes
Italy 41.2 (14) Yes
Japan -31.8 (19) No
Netherlands 49.8 (12) Yes
New Zealand 61.4 (11) Yes
Norway 90.2 (6) No
South Korea 11.1 (17) No
Spain 65.3 (10) Yes
Sweden 112.9 (1) No
Switzerland 26.4 (15) No
United Kingdom 96.6 (5) Yes
Source: Cohen, Coughlin, and Lopez (2012).
Figure 3. Covered bonds in selected countries, 2010
Mortgage-backed covered bonds outstanding
Latvia 0
Poland 1
Slovakia 5
Hungary 8
Czech R. 11
Austria 13
Finland 14
US 15
Greece 27
Italy 36
Portugal 37
Ireland 39
Netherlands 55
Norway 94
Sweden 253
France 269
UK 275
Germany 295
Denmark 446
Spain 457
Note: Table made from bar graph.
Mortgage-backed covered bonds as per cent of residential
loans outstanding
US 0
Poland 1
Luxembourg 1
Latvia 2
Netherlands 6
Italy 8
Austria 12
Finland 13
UK 14
Germany 19
Ireland 21
Portugal 24
Greece 25
Hungary 25
France 25
Slovakia 31
Norway 32
Czech Republic 44
Spain 50
Sweden 67
Denmark 100
Source: Hypostat (2010).
Note: Table made from bar graph.
Figure 4. Foreclosure by market segment
Selected countries, 2009
Switzerland 38
Japan 61
Argentina 62
Russia 64
Canada 66
US 67
Australia 67
Turkey 68
New Zealand 68
Israel 71
Brazil 74
South Korea 75
Norway 77
South Africa 77
India 82
China * 82
Iceland 83
Mexico 84
Singapore 89
European Union and other selected countries, 2010
Germany 43
Denmark 54
Netherlands 56
Austria 58
France 58
Finland 59
Sweden 66
UK 66
US 67
Poland 69
Luxembourg 70
Cyprus 74
Ireland 75
Portugal 75
Czech Republic 77
Iceland 77
Belgium 78
Malta 79
Italy 80
Greece 80
Russia 81
Turkey 81
Slovenia 81
Spain 85
Norway 85
Slovakia 86
Bulgaria 87
Latvia 87
Estonia 87
Lithuania 91
Hungary 93
Romania 98
Source: Allen, Barth and Yago (2012).
Notes: * Homeownership rate only for households that have hukou.
(Hukou are people with official registration at cities of
residence.) Based on the latest available data. In countries like
Brazil where there are favelas it is not clear exactly how these
are treated in terms of the homeownership rate that is provided.
Also, it is not clear in another country like South Africa what is
included or excluded in the homeownership rate. The sources listed
do not always provide sufficient detail to elaborate on these
issues.
Note: Table made from bar graph.
Figure 5. Home mortgage debt to GDP in various countries around
the world
Selected countries, 2009
Saudi Arabia 1
Argentina 1.7
Indonesia 2.1
Russia 2.1
Brazil 2.6
Turkey 4.6
India 7
Mexico 9.8
China 15
Korea, South 20.8
South Africa 22
Japan 35.7
Singapore 60.2
Australia 61.9
Norway 70.8
New Zealand 78.2
US 81.4
Switzerland 130
European Union countries, 2010
Romania 6
Bulgaria 12
Czech 13
Slovenia 14
Slovakia 17
Poland 19
Lithuania 22
Italy 23
Hungary 25
Austria 28
Greece 35
Latvia 36
France 41
Estonia 42
Finland 42
Malta 44
Luxembourg 45
Belgium 46
Germany 47
Spain 64
Portugal 66
Cyprus 69
Sweden 82
UK 85
Ireland 87
Denmark 101
Netherlands 107
Sources: EMF Hypostat (2010) for EU countries and Iceland, Russia,
Norway, Turkey and the United States: Warnock and Warnock (2008) for
the other countries.
Note: Based on the latest available data. EMF Hypostat (2009)
provides the latest data as of 2009, and Warnock and Warnock (2008)
for the average data from 2001-5.
Note: Table made from bar graph.
