What might be the best housing finance system?


There is no easy answer to this question. However, one point is clear: there is no “best” model if “best” model implies a one-size-fits-all solution. Rather, the specific economic circumstances of a country will largely determine which financial model fits best. Clearly, a country with a stable macroeconomic environment, advanced institutional investors, a developed banking system with high coverage and an affluent citizenry has other needs than a country with a volatile macroeconomic environment, less developed capital markets, an underdeveloped banking system and a poor populace. Yet, it seems to be advisable that decision makers look for examples of best practices in countries with comparable conditions. An UNECE study on housing finance systems might serve as a valuable primer. It elaborates on different housing finance systems and offers decision makers tools to select and implement financing schemes serving the needs of their county best.
Volatile macroeconomic conditions pose a severe challenge to housing finance systems in general. The obstacle of high inflation has been responded by some countries with varying degrees of success by resorting to mortgages fixed in real terms or double-indexed mortgages (DIM). A fixed-rate mortgage in real terms is usually created by the use of a Consumer Price Index based unit of account which serves as the exchange rate between nominal and real prices. In DIM the payments are indexed to inflation but the loan is amortized using short-term market interest rates. Both instruments are applicable for a wide variety of mortgage products.
In developing countries, formal housing finance often does not reach a substantial proportion of households, a fact which is worsened if the banking system is rudimentary and confined mainly to the major urban centres and formal housing. Countries in which such conditions prevail perhaps the most critical challenge is how best to apply the lessons of microfinance to housing. In any case, the establishment of a vibrant sector of sophisticated, commercially oriented microfinance providers which are integrated into the formal financial sector has often proven to be helpful in the course of developing a sophisticated housing finance system. In this context, low-income countries should also consider the creation of a contractual savings system for housing. Such a system creates a low-cost pool of funds (the deposits of future homebuyers) that banks make available in the form of mortgages to current-day homebuyers. As it also comprises enforced savings it helps to discipline or educate would-be homebuyers as well as it provides would-be lenders with information about the ability of potential customers to make and keep to a financial plan. Thus, contractual savings systems reduce the barriers presented by high mortgage interest costs, by maturity mismatches and by the absence of good information on the credit-worthiness of potential borrowers. And though this system inherently involves a “special circuit” of capital restricted to housing the criticism that it distorts capital market allocation applies only partially as it encourages savings otherwise not done. Furthermore, contractual savings systems continue to make up a substantial share of the market of some developed countries – like France and Germany – and have contributed to the overall stability of the housing finance sector.
For middle-income countries, it is often of interest to increase the importance of capital markets as a source of refinancing for mortgage lenders. A necessary precondition for the integration of housing finance into the broader financial markets is a well developed primary market. This aim can be achieved by the establishment of a mortgage bond system or a mortgage backed securities system. The creation of a mortgage backed securities system inherently implies the establishment of a secondary mortgage market. Though this is not necessary for a mortgage bond system, it is as well highly supported by an active and liquid secondary market. However, policymakers should reassure themselves that there is a supportive demand for the new instruments by potential investors such as pension funds and life insurance companies. A demand that is supported mainly by state institutions or international development agencies has regularly proven to be unsustainable or even harmful for housing finance systems.
Especially the establishment of a mortgage backed securities (MBS) system should be considered very critically. Its main advantage vis-à-vis a system based on mortgage bonds – the possibility of selling loans and thus freeing equity capital for new loans (off-balance-sheet-transactions) – is at the same time a significant disadvantage as the housing finance crisis in the United States has shown. The fact that the credit risk does not remain with the institution that originated the loan – as with the mortgage bond system – raises the issue of moral hazard; the originator might not adhere to strict underwriting standards and check creditworthiness thoroughly. Moreover, the opportunities for fraud and the abuse of hidden information are much higher in a MBS system. Furthermore, the inclusion of more participants in the system significantly increases the number and complexity of the necessary legal contracts. Credit rating agencies also play a critical role in the MBS system, informing investors about the credit quality of these instruments thus guiding their asset allocation. This important function of rating agencies may pose another threat to the stability and reliability of the MBS system as the rating agencies might not act in the best interest of the investors. Another weakness of the MBS system is the fact that only an institution with the necessary reputation among investors might be able to place MBSs in the capital markets. This regularly implies the commitment of government, either with implicit or explicit commitments. However, this opens the door for political influence on mortgage loan decisions so that the mortgage business will most likely not develop in a sustainable way. Yet, the mortgage bond and MBS systems do not exclude each other.
In either case, housing finance systems should be integrated only very carefully into the broader (and global) capital markets and should avoid relying too heavily on them. An increased inclusion – especially if conducted without enough foresight – means an increased exposure of housing finance systems to the down- and upswings of global capital markets. As housing property is the most significant, and supposedly most secure household asset it is of major concern that the housing (finance) market is at least partially ring-fenced from other financial operations.
Even with a well developed and efficient housing finance system it is unlikely that one country can address the housing problems of low-income households solely by the use of market mechanisms. There is, therefore, a strong social case for public subsidies that target households with limited incomes and that aim to improve access to adequate housing. The most critical issue is how to best design the subsidy programs so that they effectively achieve their social objectives without significantly distorting the (housing) market. Proven principles of good practice encompass means-testing for successful targeting, the tie of subsidies to households and the promotion of horizontal equity. As a relatively successful example of government intervention in housing (finance) markets the case of Chile is often cited. 
In any event, the “best” housing finance system should be based on reliable lending standards and should require down payments; both of these reduce the homebuyer's vulnerability. It should be market- and customer-oriented as this is the best guarantee for innovative and competitive products. And, in general, it should serve a country’s specific conditions and its populace.

Question Corner

  • What triggered the US subprime crisis? Can you compare it to past crises such as the 80s crisis? [Answer]
  • What might be the best housing finance system? [Answer]
  • Is it possible to detect housing bubbles? [Answer]

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