One way of presenting the issues involved in mortgage market economics is to consider certain phenomena as puzzles. The benchmark for such puzzles is typically the outcomes of a perfectly competitive economy with complete markets. For example, why do countries have such different systems of housing finance, together with their domination by different mortgage contracts: Germany with its bond-funded long-term fixed rate debt, and variable rate mortgages in the UK? History, the evolution of institutional features and public policy all have a role in the emergence and development of such diverse markets. Chapter 1 noted some reasons why we might observe very different mortgage instruments in different economies, for example the long-term fixed rate contract prevalent in the US. This then raises the question of how we might expect mortgage markets to develop and what research issues might emerge or persist?
Lea (2000) considers the global trends in housing finance systems. Some of these trends have been noted earlier in the book, such as increased integration of the global economy. The adoption of a common currency by the European Union in 1999 is an example of this integration. The prevalence of variable rate debt in the UK is an example of where the dominance of a particular form of mortgage contract results in a barrier to integration. Securitisation encouraged the flow of housing finance across national boundaries. Lea notes the vulnerability of national housing finance systems to economic and financial crises occurring in other parts of the world. For example, the South East Asian real estate crises. The processes of integration and globalisation are far from complete and there remains a significant variety of market structures and contract designs.
The future evolution of actual housing finance systems is likely to be complex and difficult to predict. For example, flexible mortgages have optimal properties but have spread unevenly on an international scale. They are prevalent in Australia but they have not become widespread in the US. The mortgage market is ever shifting and complex. Van Order (2000) points to the dangers of forecasting its future shape. He notes that it would have been difficult from the viewpoint of the 1970s to predict the rise of the US secondary market in the 1980s, and then to forecast the competitive reaction of savings and loans institutions in the 1990s. However, it may not be unreasonable to forecast that competition, technological advance and improved information will render markets more complete.
One spreading feature in mortgage markets is the unbundling of origination, servicing, investment and risk management of mortgage debt via securitisation. The trend towards unbundling mortgage products provides an interesting example of the different ways that housing finance systems can evolve. Van Order (2000) adopts a contrary view for the US in suggesting that the trend towards unbundling might actually be reversed. Unbundling has created information problems for secondary market institutions. Primary lenders have superior knowledge of the performance of the loans that they sell on to the secondary market. Thus we have classic cases of adverse selection and moral hazard. However, improved access to, and processing of, information to remove this problem reduces the need for specialisation in origination, servicing and investment, thus rebundling might occur. Van Order notes that the extent of any rebundling will depend upon the secondary market charter and regulations.
There are some interesting implications of improved information for the study of household behaviour in the mortgage market, the major focus of this book. Chapter 7 discussed the possibility that mortgage instruments and consumers might be mis-matched ('mis-selling'). At least for some transitional period, such agency problems might be endogenous to the evolution of a complex housing finance system. However, such mismatching is most likely when credit risk is not individually priced. Customised contracts will be optimal. Thus the ultimate degree of heterogeneity in a system of more complete markets would make such mis-matching less likely. The spread of automatic underwriting in the US offers the possibility of individually priced products. Technological advances might then facilitate the efficient repackaging of this heterogeneous debt for investors. So the evolving mortgage market may match borrowers' preferences in different ways, compatible with more complete markets.
Each housing finance system has its own developmental issues. In the UK the debate is in terms of obtaining the benefits of the US model with its prevalence of long-term fixed rate debt, leading to a less volatile housing market. There is an existing basis for securitisation in the UK, which might facilitate the supply and adoption of long-term fixed rate instruments. The adoption of the FRM might also be encouraged by some implicit or explicit FRM subsidy, as in the US. One suggestion has been changes in the funding arrangements of lenders, to achieve a better matching of assets and liabilities. This could be assisted by making fixed rate mortgage-backed bonds of interest to pension funds (Maclennan et al. 1998). Discussion in this book has noted reasons why we might observe a variety of mortgage contracts, so that long-term fixed rate debt might not suit all. Defining the issue in terms of encouraging borrowers to adopt a long-term perspective on financial planning might lead to different ideas.
Modifying inflationary and interest rate expectations to reflect a low inflation environment, thus encouraging borrowers to take a long-term view is another possibility. The paradox here is that a flat yield curve, with stable expectations, might render the choice between fixed and variable rate debt irrelevant. Competition between UK lenders that has resulted in a proliferation of often heavily discounted deals may have also encouraged a short-term perspective on the choice of mortgage instrument. The spread of more flexible mortgage repayment vehicles could assist in overcoming capital market imperfections and liquidity constraints that might shift the borrowers' focus to the long term, though for this to work borrowers might need to be protected against possible default. Securitisation and the increased integration of mortgage markets with international capital markets might ultimately dictate the borrowers' menu of mortgage contracts.
Securitisation of mortgage debt will become an increasingly important phenomenon in many housing finance systems. Securitisation requires a number of preconditions to develop into a sustainable market. Legal underpinnings, macroeconomic stability and competitive mortgage markets are all necessary. A standardised mortgage product must be available, so that similar mortgages can be pooled. This ensures that cash flows are more predictable and investment companies can more readily apply due diligence. Origination must be based upon clear and known underwriting standards with the ability to ascertain the credit risk of borrowers. There is the problem here that securitisation can facilitate standardisation of mortgage products, and favourable primary market developments, but that a self-sustaining market requires these features as a precondition. The discussion in Chapter 1 warned against relying upon securitisation as a universal panacea, and transition and developing economies in particular may require the careful nurturing of their primary markets, and a regard to the critical sequencing of development towards more integrated capital markets.
Previous chapters have discussed the emergence of new market segments, in particular sub-prime lending. From the securitisors' point of view the division between sub-prime and prime lending might become less distinct, with an erosion of the segmented basis of mortgage lending to these markets. Improved information and the general evolution of the housing finance system might offer a central place to flexible amortisation, even for borrowers who are a high credit risk. Ultimately, even the distinction between mortgage borrowing and other debt components might become completely irrelevant. There is even an argument for the demise of securitisation, if markets become more complete. Securitisation need not fade away if it continues to afford benefits of increased liquidity or overcomes information problems, and even in a world of individually priced fully flexible mortgage instruments there may be identifiable stable pools of interest and debt repayments for packaging. These ideas are speculative but invite a consideration of trends in mortgage market developments.
There are at least two cautions to any forecast of more complete markets, and the demise of the mortgage product as we know it. The first is that there are enough existing capital market imperfections and information problems to keep interested academics and practitioners busy for some time. This is especially so in evolving housing finance systems. The second is that teleological predictions are fraught with danger, for example consumer behaviour, lenders' preferences and a continuing need to identify collateral might all sustain clearly distinguished mortgage products. An emerging research issue that reflects upon the factors underpinning the existence of different mortgage contracts is the interaction of housing/ mortgage decisions with consumers' portfolio choices, particularly when those portfolios are not fully diversified. This is already evident in the work of Brueckner (1997) and Fratantoni (1997, 1998). These issues will be of interest and of practical importance for some time.
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