Mortgage instruments for dealing with the tilt

There are a number of mortgage instruments that can assist in overcoming capital market imperfections and replace mortgage contract designs that suffer from the tilt. Mortgage contracts vary in the manner and extent to which risk is shared between the borrower and the lender. For example, the variable rate mortgage places the adverse effects of unanticipated inflation with the borrower. The borrower takes the full burden of the tilting of mortgage payments. In contrast the fixed rate mortgage potentially places the risk of a fall in interest rates on the lender, though this is typically priced into the mortgage in the form of a correction for expected inflation, and a premium to cover the risk of unexpected inflation. Thus mortgage design is essentially about risk sharing, a topic to be developed further in chapter eight. However, who takes the burden in sharing interest rate risk cannot be separated from susceptibility to the tilt, a factor that we will see in the mortgage contract designs discussed here.

One candidate for overcoming the tilt problem is the price level adjusted mortgage (PLAM). In this design the real payments on the mortgage are indexed to a price, or other suitable index (Friedman 1980; McCulloch 1982; Houston 1988, Buckley et al. 1993). The main design feature is that the real mortgage payments are evenly spread up to maturity, and the front-loaded burden (the tilt) is removed. Of course, unexpected increases in the rate of inflation will cause a real increase in mortgage payments for prospective mortgage holders and those facing a variable rate of interest, but these rises are significantly less than the disproportionate changes in real payments resulting from the tilt.

Not surprisingly, the use of price indexed mortgage designs has predominated in developing economies where inflation rates can be very high. However, this system is not without its problems; for example Chile abandoned indexed mortgages in 1982, while some countries such as the Philippines and Ecuador had to halt mortgage lending or obtain government funding (Buckley et al. 1993). The problem here for households is one of affordability if real wages decline. This is evident from the important role of income growth in equation (4.1), which places the payment burden in the wider macroeconomic setting.

One argued solution to the indexing problem is to index mortgage payments to the average wage. This would suit households because it is now possible to ensure that nominal mortgage payments always form a constant proportion of income.8 However, if the general rate of inflation is in excess of the rate of increase in wages, problems now emerge for the lender. The lender would be facing reductions in real mortgage payments and this can cause problems of sustainable funding. One possible solution is the use of a duel index (Buckley et al. 1993). Payments are indexed to the average wage and the mortgage balance is indexed to the general level of prices. Payments are a constant proportion of income, and the lender retrieves the real mortgage balance. Shortfalls in real payments are added to the mortgage balance outstanding. Extending the mortgage term further accommodates this.9 Lea & Bernstein (1996) argue that the duel index mortgage (DIM) was effective in Mexico during the 1980s, but had its efficacy blunted by government policies and bank reactions during the 1990s.

The tilt creates problems of affordability. One way of overcoming this is to offer lower nominal payments to the borrower in the early years of the mortgage. This might take the form of a graduated payment mortgage where later payments are higher to compensate for initially lower payments. Alternatively, temporary discounts or teaser rates can be offered to borrowers, which lower their initial payments (Phillips & Vanderhoff 1992). In some countries these approaches may also create funding problems for lenders (Buckley et al. 1993). A further problem is the increased risk of default if lower initial payments are amortised (Brueckner 1984). GPMs are not widespread in the US, comprising only 9.3% of households' primary mortgages reported in the 1999 American Housing Survey. This is also true of the UK where, like the US, teaser rates are more popular. However, GPMs might be expected to become more prevalent during periods with high rates of inflation (Brueckner 1984).

One further means of overcoming the tilt and achieving an optimum mortgage design is to allow borrowers to have autonomous control over their payment scheduling. That is to have a fully flexible mortgage that facilitates the smoothing of lifetime consumption. Brueckner (1984) noted that flexible scheduling can create the conditions characteristic of a perfect capital market, achieved through the ability to borrow and lend by varying the amortisation rate. Households who have a discount rate higher than the mortgage rate, and who expect increased incomes, can vary mortgage payments to bring non-housing consumption forward in time. This is not possible with level payment scheduling.

Brueckner pointed out that even with flexible amortisation the exact conditions for optimal spending and saving over time may not be achieved due to a default constraint. This is the condition that the total debt does not exceed the value of the property, that is there should be no negative equity. With sufficient build up of deferred payments the lender could face the risk of ruthless default. However, if the major cause of default originates with affordability and fluctuations in income, then flexible amortisation scheduling might minimise this risk. Brueckner's analysis offers some important results, including the possibility that the introduction of flexible amortisation might lower rather than increase housing demand.10 More generally, the impacts of flexible amortisation are best considered in a portfolio context with uncertainty, a perspective to be explored more fully below.

In the UK borrowers may be more wary of fully flexible amortisation because default on negative equity does not relinquish obligations to pay off the mortgage. Payment flexibility that allows an increase in the rate of amortisation, generating savings in interest cost over the life of a mortgage, might be more favoured, and competition in the UK market has made this option generally available. One outcome might be that lenders place constraints on flexibility that favour over-rather than underpayment. In fact, Brueckner's model suggests the asymmetric treatment of faster and slower rates of amortisation. The optimum payment profile in the Brueckner model is flat while the default constraint binds (that is, too low payments build up too much future debt and risk default), followed by a gradually increasing size of payment to reflect rising incomes.

There is some casual but suggestive empirical evidence from the United Kingdom for the presence of asymmetry in payment flexibility.11 Most so called flexible mortgages emphasise the facility to increase the rate of debt amortisation rather than reduce it, though payment holidays are often provided. First Active Financial PLC, in the United Kingdom, conducted a survey of flexible mortgages and their characteristics. First Active established a benchmark of characteristics to determine what can correctly be described as a flexible mortgage product. The required features include full flexibility for under- and over-payment, with daily calculation of interest and no redemption fees for early repayment. Only four products achieved all of these characteristics by October 2000.12 United Kingdom mortgage providers place a clear marketing emphasis upon potential cost savings over the life of a mortgage.

The time profile of real mortgage payments is an important consideration of optimum mortgage design. A second linked design focus is the sharing of inflation risk between borrowers and lenders. The conventional FRM imposes the tilt on the borrower and inflation risk on the lender. The fully indexed mortgage imposes the tilt on the lender and inflation risk on the borrower. Thus these two mortgage instruments represent extremes in the sharing of different risks. Scott et al. (1993) introduced the idea of the partially indexed affordable mortgage. The design is based on a trade-off between the lender and borrower with respect to risk sharing and affordability (that is the tilt). This suggests that the borrower and the lender might wish to compromise on the extent to which they adopt these varying risk positions. Put another way, the consumer's demand for indexed debt may be less than 100%.

Scott et al. argued that it would be optimal for borrowers to have a hybrid price level adjusted mortgage (PLAM) that consists of a mix of FRM and PLAM.13 Though this mortgage instrument is not evident in the major economies there is a tendency towards hybrid debt; for example 'pick and mix' mortgages in the UK, and combinations of fixed and adjustable rate debt in the US.14 With this framework in place a more inflationary environment might well lead to the emergence of the partially indexed affordable mortgage. The tendency towards facilitating consumer choice is most apparent with the flexible mortgage which can help overcome many of the problems emerging from capital market imperfections and less than optimal mortgage designs. The discussion which follows considers the theoretical and empirical importance of flexible payment scheduling.

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  • elizabeth garland
    What is the mortgage tilt problem?
    8 years ago

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