Transatlantic Mortgage Credit Crisis – the Role of Financial Structure and Regulation

SUERF / Nykredit Conference

“Property prices and real estate financing in a turbulent world”

Copenhagen, November 15, 2012

Hans-Joachim DübelFinpolconsult.de, Berlin

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Research QuestionsSession 3: “Is Mortgage Lending Stabilizing or Destabilizing?”

1. How do macroeconomic imbalances and mortgage lending interact?

2. What causes of mortgage credit boom / busts were inherent to mortgage lending structures or regulations?

Four candidatesMortgage finance system designIntermediary (banking / insurance) competition and regulationBorrower (consumer protection) regulationAlternatives to retail lending (mortgage / housing policy)

3. What can governments do and what has been agreed on?

Empirical basis of analysis are mortgage crises countries on both sides of the Atlantic

2011 research funded by the Korean Development Institute

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Macro-Structural InteractionSavings / Investment, Capital Account and Structural Factors

Source: IMF data & analysis

Decades of excess capital inflows may cause Dutch Disease: •Cheap capital, expensive wages (REER),•Economy biased towards non-tradeable sectors (real estate, finance),Eurozone periphery 15 years (de-facto Eurobonds late 90s - 2010),USA 30 years (global borrowing privilege).

Gross savings and investment as a % of GDP, 1980 – 2010

Capital Inflows and Structural Factors in Credit Booms in 47 Economies, 1960 - 2010

Credit boom = interaction of capital inflow, financial

innovation and deregulationMortgage credit boom / bust

analysis historically often disregards capital flows.

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Macro-Structural Feedback EffectHousing Credit Has Become Correlated to Capital Accounts

Housing Loans and Current Account Deficit (% of GDP)

Source: IMF, Finpolconsult.

2000 - 2010

Colombia, 1991 - 2002

Causality goes both ways Mortgage lending historically driven by ‘active’ capital imports (emerging economies, commercial RE). Housing is just the latest asset class deemed ‘safe’ & easy to originate, trade. Dutch disease economies (U.S., periphery) overdevelop real estate and finance and create ‘passive’ capital imports (deep securities markets) to avoid collapse.

Mexico, 1991 - 2002

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Structural Causes, Instruments Mortgage-related Securities Clearly Helped to Create Credit Booms

Source: Finpolconsult, central banks., SIFMA

Housing finance system design = credit intermediary design + funding exit design•Insurance/structured finance: U.S.: GSE + MBS, Finco’s + structured finance, commercial banks + ABS (+ deposits)•Banking: Spain: commercial banks + MBS + covered bonds (+ deposits)Conclusion: on the macro level, European commercial banks did not materially act differently from U.S. GSE/Finco/Bank mix. Main carrier of credit boom in both cases were debt securities.

Spain 2003 – 2010(bank-based system)

United States 2004 – 2010(capital mkts & insurance-based system)

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Structural Causes, Instruments (2)Unsecured Cross-border Bank Debt / FX Swaps may Cause Credit Booms, Too!

Source: Central Banks, Finpolconsult.

Ireland: foreign bank entrants bidding up deposit rates + interbank depositsHungary: foreign bank entrants bidding up deposit rates + interbank deposits plus FX swapsSimilar constellations:•Turkey: bank syndications and IB X-currency swaps,•Mexico, Colombia 1990s cross-border bank deposits.

Ireland 2003 – 2010 Hungary 2003 - 2010

Conclusion:Type of funding exit hardly matters, as long as debt is liquid and tradeable. Debt securities & interbank allow lending beyond an exhausted local deposit base.Regulatory strategies: limit loan-to-deposit ratio (Ireland IMF / Hungary Austrian reg); or rather capital account controls?

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Structural CausesSystem Design and Regulation Principles

Agents Facing Similar Risks Require Similar Solutions

3 Essential Control Items

BorrowersLeverageMismatch Real asset (house price) valuation

IntermediariesLeverage MismatchFinancial asset valuation

PPT will focus on borrowers, overlooked regulation dimensions.

Theoretical Foundations Capital risk formula:

Capital risk = mismatch risk + net asset value risk

Mismatch risk = (duration of assets – duration of liabilities*liability value / asset value) *change in interest rates.(leveraged duration gap)

Net asset value risk = change in asset value – change in liability value

Real asset valuation formula: House price = imputed rent stream /

interest rate (consol)Full sector models: Di Pasquale/Wheaton,

Renaud include space markets, i.e. models imputed rent cycles.

Source: Finpolconsult.

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Structural CausesLeverage: Lender Self-Insurance May Reduce Systemic Risk

UK median loan-to-value and –to-income ratios 1974 - 2010

Source: LHS E. Pinto, RHS – Council of Mortgage Lenders

- Third-party insurance followed by lender self-insurance- Hump-shaped LTV curve

- Increase with liberalization of the 1980s- Some learning effect after early 1990 bubble- Collapse after 2007; re-regulation?

U.S. very high-LTV lending incidence by FHA, Fannie 1981 - 2008

- Third-party insurance (agencies, private MI)- Monotonously increasing LTV (until crash)

- S&L LTV liberalization 1971 (mortgage insurance 80%95%)), coinciding with Freddie creation.

- FHA very high-LTV since the mid-1980s, Fannie since late 1990s

• Note: you don’t need increasing LTV to fuel a bubble with public insurance (Canada CHMC).

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Structural CausesLeverage: ...but Third-party Insurance may Help to Avoid Sudden Stop

UK high LTV market conditions 2002 - 2009

Source: LHS - Fannie Mae, RHS – Council of Mortgage Lenders, Bank of England, Finpolconsult

US Fannie Loan Purchase Agreement Haircuts, June 2008 vs. April 2011

Third-party insurance -Procyclical:

- LLPA for higher LTV/lower scores and GSE guarantee fees rise after 2008

-Anticyclical: - Forbearance: private MI kept alive by GSE,

i.e. formally 95% market remained intact- Streamlined refinancing iniatitive to

temporarily increase LTVs (reduce LLPAs, guarantee fees).

Lender self-insurance -High-LTV market disappears.-Policy intervention (equity loan program) discouraged by austerity pressure.-Strong reduction of homeownership rate de-facto acceptedConclusion: Combine both worlds, self insurance in normal times and third-party catastrophic protection(US GSE reform concept)

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Structural CausesLeverage: Capital Gains or Cash Savings as Sources of Equity

Americans, Despite The High Homeownership Ratio, Do Not Save Ex-ante for Housing

Source: Federal Reserve, NIPA, Infratest, Finpolconsult

In a high inflation / leveraging world, it does make no economic sense to save ex-ante for housing.

In a low inflation / deleveraging world, it makes economic sense to save ex-ante.

The Qualified Residential Mortgage concept (e.g. 80% LTV) is ultimately a function of available equity generation options:-U.K. proposal for ‘equity loans’, no fiscal savings support-U.S. no specific proposal, no fiscal savings support-Germany fiscal contract savings for housing support integrated into general old age retirement tax support

U.S. Household Savings & Capital Gains are Inversely Correlated

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Structural Causes Mismatch: ARM and FX Credit Pricing, Growth Dynamics

Source: MBAA, ECB, Finpolconsult.

U.S. Germany

SpainBelgium

Europe: ARM share north of 70%•Index trackers in Western & Southern Europe•Foreign currency ARM in CEEU.S. ‘option ARM’ and initial teaser rates with rising trend since 1990Result of financial liberalization 1980s, rate decompression 1990sBIS/IMF analyses confirm linkage to market and house price booms.

ARM / FX Share, Market Growth in the EU

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150%

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250%

300%

350%

400%

0% 20% 40% 60% 80% 100% 120%Mortgage to GDP ratio 2007

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ARM Forex FRM

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Structural CausesMismatch: Aggressive ARM Pricing Implicitly Speculating on Perma-Bailout, Limited Ex-ante Protection

Source: ECB, Bank of England, Finpolconsult.

Eurozone – Use of ARM Rate Caps and ARM Share

UK Index Tracker vs. Reviewable Rate Product Pricing

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ARM and FX introduced by commercial banks where it best matches their funding conditions; crowding-out of traditional mortgage banks (also U.S. conflict GSE vs. private label)Clearest sign of comm bank-dominance: interbank indicesCaps basically only where FRM existsLimited evidence of consumers driving the processConsumer protection introduces additional bias (e.g. prepayment indemnities Spain vs. Germany); usually against FRMGenerally non-risk-adjusted pricing Relative default risk of products manipulated by central bank bail-outs.ARM destroy returns for individual savers, institutions.

And Here Comes the Bailout, Courtesy of SaversKey Mortgage Portfolio Interest Rates 2003-2011

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Structural CausesCollateral Valuation: Passively Tracking House Price Inflation Rather than Protecting Consumers

U.S. House Price and Rental Trends, 1987 - 2011 Europe vs. U.S. House Price to Income Ratios, 2005 = 100

Source: Richard Koo, ECRI, Finpolconsult.

Discounted cash-flow valuation (‘income’) method is superior to ‘open market’ valuation (Koo, Shiller). Currently either contract prices or ‘open market values’ are the norm in retail. In commercial mortgage finance, DCF is the norm, so why do we impose ‘open market values’ on

consumers? Conservative bias should be introduced

Bank / debt investor is in an asymmetric risk position.

Regulators cannot agree on a standard (Financial Stability Board)

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Structural Causes Realized House Price Risk is More Often Causal to Poor Underwriting Than Vice Versa

Source: Federal Reserve, Bank of Spain, Finpolconsult.

Many issues on the agenda of regulators (e.g. Financial Stability Board) are the result of price risk:-Cyclical increase in loan-to-value ratios (as opposed to structural) ; constant LTV rule?-Extension of loan maturities and negative amortization features-Higher frequency of interest-only periods and initial teaser rates-Lower spreads for both prime and non-prime lending-Low-documentation lendingThese cyclical features can be traced for both crisis, and non-crisis, countries!Can follow-on effects of inflation be credibly regulated away?

United States, 2002 - 2010 Spain , 2002 - 2010

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Structural CausesLeverage (Expanded): Housing (Fiscal) Policy Issues

Public subsidy budgets and social housing construction in selected European countries, ca 2005

Rental sector share and incidence of mortgage lending to vulnerable households, ca. 2005

Source: European Housing Ministers, Finpolconsult for EBRD Transition Report.

High-leverage mortgage markets can remain stable, if social rental is present (Netherlands, Denmark, Austria), i.e. leverage is targeted to older households and/or middle class.Chronic lack of rental housing adds to vulnerability:

U.S.: governments have actively discriminated against multi-family housing now since the 1930s. Unintended New Deal consequence.Spain: legacy of rent controls led to de-facto discrimination in a large multi-family building stock. Subprime market during the 2000s tied to extremely low ARM rates.Ireland: complete neglect of social housing led directly to large subprime market during 2000s.

Good practice UK: rental housing has been revived in the 1990s. Housing associations replaced council housing. Buy-to-let market. Mortgage market relatively resilient.

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Government InterventionIdeal: Reduction of System Vulnerability to Global Liquidity Shocks

Increase in Leverage and Mismatch of Housing Finance Systems to be Unwound

1. Vulnerability of systems featuring high borrower leverage, mismatch, dubious valuations, small rental sector to a given liquidity shock is maximal. 2. Such risk layering increases the impact of a given liquidity shock on prices, credit growth (pass-through).

3. Liquidity shocks themselves are maximized by financial innovation, autonomous (portfolio) capital flows, aggressive cross-border entry. Interaction between flows and innovation central.

4. Once house price and credit inflation is produced, this dominates all other commonly cited credit risk factors..

Source: Finpolconsult.

Implication: ‘Volcker Rules’ for the mortgage markets•Discourage leveraged interest rate risk speculation by borrowers with their most important financial asset, equity in housing•Discourage (leveraged) interest risk speculation by mortgage lenders and force interest rate risk to be taken by institutions.

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Government InterventionReality: We Can’t even Agree on the BasicsRegulation reality•No agreement on leverage

- US introduced ‘Qualified Res Mortgage’ with 80% LTV, but has no concept on equity generation,- Europe can’t agree on 100% (!) LTV threshold due to opposition from high tax subsidy countries (NL),- In banking some progress (leverage ratio), but also lots of opposition. Mortgage CR unchanged.

•No agreement on mismatch- 80% of European market uses ARMs, including Denmark. US with limited progress only.- Basel III fails again to impose a penalty on mismatch. Central bks keep pump-priming instruments.- Solvency II forces institutions to reduce long-term asset exposure.

•No agreement on collateral valuation- Appraisal, broker, lender, securitization industry adamantly opposed to long-term mortgage lending

value concept.- FSB / EU produce laundry lists rather than guidance.• No agreement on housing policy:- Almost zero chance of repetition of the UK post-1990 rental housing reform program due to austerity.- ‘The (fiscal) money is not lost, it is just with somebody else’ – landowners, bankers, developers,

brokersSummary: 1.We regulate mostly those, who don’t have a seat at the negotiation table

• E.g. credit intermediaries, foreign currency lending in Europe.2.We create lots of useless regulations while leaving the important issues as above unsolved

• E.g. regulating follow-on effects of house price inflation vs above, reluctance to address capital flow.3.We create expensive new financial regulators instead of investing into housing reform