Default risk of wage-indexed payment mortgage in Turkey

JOURNAL OF

HOUSING ECONOMICS

Journal of Housing Economics 14 (2005) 271–293

www.elsevier.com/locate/jhe

Default risk of wage-indexed payment mortgage in Turkey q Isil Erol a, Kanak Patel b,* a b

Department of Economics, Middle East Technical University, 06531 Ankara, Turkey University of Cambridge, Department of Land Economy, Cambridge CB3 9EP, UK Received 7 July 2005 Available online 2 September 2005

Abstract This paper analyses default risk of wage-indexed payment mortgage (WIPM) in Turkey in comparison with other standard mortgage contracts originated in high inflationary economies. Emlak Bank launched WIPM linked to Civil Service employeesÕ wage (CSW) index during high inflationary period of late 1990s. Concurrently, the government introduced a policy linking CSW index to semi-annual expected rate of inflation in an attempt to facilitate housing finance for the fastest growing sector of the population. We find that WIPM protects borrowers against risk of high payment shocks whereas nominal contracts such as ARM and DIM would have resulted in high mortgage defaults.
2005 Elsevier Inc. All rights reserved. JEL Classification: C1; E3; G1; G2 Keywords: Mortgage default risk; High inflation economies; WIPM; PLAM; DIM; ARM; Mortgage markets; Default risk; Emerging economies; Turkey; Wage-indexed mortgage; Inflation risk; Credit risk

1. Introduction Index-linked mortgages have been widely used to facilitate long-term housing finance in emerging market economies. Because inflation uncertainty increases risk q *

We thank the editor and anonymous referee for helpful suggestions. Corresponding author. Fax: +44 1223 337130. E-mail addresses: [email protected] (I. Erol), [email protected] (K. Patel).

1051-1377/$ - see front matter
2005 Elsevier Inc. All rights reserved. doi:10.1016/j.jhe.2005.07.004

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associated with nominal rate mortgage contracts, and decreases lendersÕ real rate of return, in high inflation emerging economies, such as Mexico, Chile, Brazil, Argentina, and Turkey, lenders have developed different mortgage contracts that provide hedge against unexpected inflation. Price level-adjusted mortgages (PLAMs), indexed units of account mortgages (UDI), and dual-index mortgages (DIMs) have become more popular compared to the standard fixed- and adjustable-rate mortgage contracts in high inflation economies. The purpose of this study is to evaluate the performance of wage-indexed payment mortgage (WIPM), which has been originated in Turkey since the late 1990s inflationary periods. During the late 1980s, PLAM was the most preferred mortgage instrument. Emlak Bank and Vakif Bank, the two state-owned banks, originated this mortgage contract. In the early 1990s, foreign currency-denominated mortgage loans became popular. Some banks, including Is Bank, Yapi Kredi Bank, and Pamuk Bank, also originated adjustable-rate mortgages (ARM). The rapid expansion of the mortgage market in the early 1990s was followed by turbulence in mortgage lending due to devaluation of the Turkish Lira in April 1994. Emlak BanksÕ mortgage loan portfolio was severely affected by the 1994 financial crisis and, as a result, the bank was forced to drastically reduce its mortgage lending in 1995. Against the backdrop of persistent inflationary pressure, the Turkish government embarked upon a major housing finance reform in 1998. Emlak Bank, in collaboration with the government, launched a new mortgage product based on Civil ServantsÕ wage (CSW) index, which is linked to an officially announced semi-annual expected rate of inflation. The WIPM is an outstanding mortgage balance-indexed payment contract, which has no contractual mortgage rate, no periodic or lifetime cap that constrains the payment adjustments, and no pre-determined margin added to the CSW index. Emlak Bank created this mortgage design specifically for the middle-income Civil Service employees, who are the main group of borrowers of housing loans with their state-guaranteed salaries. In order to facilitate this mortgage product, the government introduced a policy to link CSW rate to the semi-annual expected rate of inflation. The aim of this policy was to provide mortgage finance to the fastest growing sector of the population, with its expanding share of both consumer demand as well as housing demand. Although the growth in financial services in both corporate and household sectors is far greater than in the public sector, foreign banks in emerging economies have mostly tended to operate in government bond markets. Consequently, innovations in housing finance have lagged behind those in developed market economies. The academic literature on the performance of mortgage products in different emerging economies is scant. Most of the existing studies have focused on the Mexican mortgage market. Lea and Bernstein (1996), Siembieda and Moreno (1997), Lipscomb and Hunt (1999), Pickering (2000), and Lipscomb et al. (2003) all examine the structure of the Mexican mortgage market and the performance of different loan contracts such as DIMs and inflation-indexed mortgages of PLAMs and UDIs. Lipscomb and Hunt (1999) study the mechanics and the behaviour of UDI mortgages, which are price level-adjusting mortgages, in comparison to the DIMs. Under the

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volatile economic conditions in MexicoÕs recent history, they simulate changes in mortgage payment-to-income and equity-to-value ratios, and respective yields. The authors report that DIMs resulted in greater incentive to default compared to UDI mortgages. Pickering (2000) examines borrowersÕ choice to default and restructure peso denominated mortgage loans to UDI mortgages. Using nationwide sample of micro-data from a commercial bank, the author estimates a multinomial logit model and tests whether it is borrowersÕ net equity or ability to pay that primarily drives them to default on peso denominated mortgages or restructure them to the UDIs. The study concludes that while borrowersÕ choice to restructure or default varies by income level, net home equity position is a more important determinant. Studies by Jaffee and Renaud (1997) discuss the main factors that hinder development of mortgage markets in economies that are in transition from a centrally planned to the market-based system. Analysing the Polish mortgage market, Chiquier (1998) compares the performance of DIMs with the standard fixed- and adjustable-rate mortgages. He shows that in unstable economic conditions, long-term fixed-rate mortgages create large interest rate risk for lenders and an affordability problem for borrowers. Variable rate mortgages result in excessive initial payments and later insignificant ones. Chiquier argues that classical mortgage instruments are more suitable for short- and medium-term loans of relatively modest amounts. Berument et al. (2001) highlight the effect of inflation uncertainty on the mortgage market in Turkey, where high and variable inflation rates over more than two decades provide a laboratory environment. After a decade of high inflation (positive unexpected inflation) between 1987 and 1997, Emlak Bank launched the WIPM. This contract provides an ideal test case for evaluating the inflation hedging performance of an index-linked mortgage contract in an environment where the real rate of interest is highly volatile. In this paper, we examine the incentives for originating WIPM and compare the default risk on this contract against alternative mortgage contracts in high inflationary environments. We estimate default risk of WIPM as measured by changes in payment-to-income and loan-to-value ratios using data from 1998 to 2004. Following Lipscomb and Hunt (1999),1 we ask the basic questions: how high WIPM payments would have to rise relative to borrowersÕ income and how high principal balances would have to become relative to house prices before borrowers defaults on the outstanding mortgages? We compare monthly payments and principal balance on WIPM against those on PLAM, DIM, and ARM under the same circumstances. Based on these comparisons, we draw some inferences about the relative advantages and disadvantages of WIPM and its importance in housing finance. Turkey, as an emerging market economy, has been experiencing the basic problem of economic instability with highly volatile inflation and fluctuating real and nominal interest rates. A detailed analysis of the performance of WIPM may provide some useful lessons to other countries experiencing similar economic instability. 1

Lipscomb and Hunt (1999) have used the same methodology to analyse the Mexican mortgage instruments. They compare the performance of newly designed UDI (indexed units of account) mortgages with DIM, the most widely used mortgage in Mexico prior to Peso collapse in 1994.

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The organisation of the rest of the paper is as follows. Section 2 outlines the macroeconomic environment in Turkey and examines the evolution of residential mortgage market within its monopolistic market structure. This section also provides a brief description of Emlak BankÕ mortgage lending business, which acts as a lender and developer in residential property market. Section 3 provides details of WIPM and explains its monthly repayment schedule. The Turkish governmentÕs housing policy for financing public sector housing is also outlined in this section. Section 4 analyses the performance of WIPM in relation to PLAM, DIM, and ARM. The repayment schedules of these mortgage contracts are estimated from 1998, when the WIPM was originated, until 2004. The default incentives of both the public sector and the private sector employees are analysed through simulated changes in mortgage payment-to-income and outstanding loan-to-value ratios. The final section presents some concluding remarks.

2. Macroeconomic environment and mortgage market The state of development of a countryÕs mortgage market basically depends upon the degree of macroeconomic stability. Macroeconomic instability has a major effect on demand for mortgages. High rates of inflation and nominal interest rates are typical features of volatile economies that reduce affordability of traditional mortgages issued in more mature market economies. Experience in emerging market economies has highlighted the problems with traditional fixed rate mortgages (FRMs). Over time, the real value of loan payment, which is constant in nominal terms, is eroded by persistently high inflation. This decline in real value of payments over the term of the loan is known as the tilt problem. Since the tilt effect increases with inflation, it is clear that higher levels of inflation make it more difficult for households to be qualified for loans based on their current income. The standard adjustable-rate mortgages (ARMs) reduce tilt effect and enable mortgage lenders to manage moderate inflation risk. However, ARM does not perform well in periods of high inflation because it creates major payment shocks for borrowers who suddenly find their monthly payments increase more than their incomes. From early 1960s to early 1990s, three institutions supported the housing finance system: Social Security Fund (SSF), Governmental Housing Development Administration (HDA) and Ministry of Resettlement and Construction, and commercial banks. During this period, SSF financed purchases of over 230,000 housing units. In order to accommodate the rising demand for housing and to develop the housing construction industry, the government established Housing Development Administration (HDA) in 1984. The HDA, working through its loan originator banks of Emlak Bank, Pamuk Bank, and Vakif Bank, has funded over 500,000 housing construction loans and issued over 250,000 long-term housing loans since its formation. Emlak Bank and Vakif Bank have facilitated affordable long-term housing loans to low- and middle-income households and have dominated the housing finance market with 87–97% of the total mortgage loans in their portfolios. Mortgages

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offered by these main lenders were all fully amortizing loans with loan-to-value (LTV) ratios that ranged from 20 to 80% at maximum. Although some HDA mortgages had terms of up to 15 years, commercial banks were unwilling to lend for longer than 5 years. Vakif Bank mainly originated dual index mortgages (DIM) and price level-adjusted mortgages (PLAM). Emlak Bank originated foreign currency, especially Deutsche Mark, denominated housing loans in the early 1990s. However, the bank was severely affected by the 1994 financial crisis when the Turkish Lira collapsed against the Deutsche Mark. With mounting mortgage defaults, the bank was forced to virtually freeze its mortgage lending activity by 1995. In 1998, Emlak Bank launched the new WIPM, specifically designed for the high inflationary environment. The structure of the housing finance market has been basically monopolistic with few lenders dominating the market. During the period from mid-1980s to mid-1990s, Social Security Fund was replaced by HDA with its three loan originator banks. Commercial banks held a very small percentage of mortgage loans in their asset portfolios. HDA lost its monopoly as a housing finance institution due to diminishing value of its fund under the weight of interest rate subsidies and its mortgage products with very low loan-to-value ratios. Commercial banks entered into housing finance business in the late 1980s as part of their expansion from consumer lending activity (see Fannie Mae, 1992). In the early 2000s, the mortgage market began to expand rapidly as a result of the change in investment policies of commercial banks. Until the late 1990s, the government was borrowing at high rates and banks were able to earn high income by investing in government bonds. As supply of high-income government bonds dried up, banks moved into housing finance business. The value of the mortgage loans jumped from 40 billion TL (US$195 million) in 1997 to 673.2 billion TL in 2000 and reached to approximately 2.7 trillion TL (US$2.03 billion) by the end of 2004.2 Fig. 1 shows the relative share of housing loans and other consumer loans over the past 8 years. Only recently, in the past 3 years from 2000 to 2004, the share of the mortgage market went up to 13%. As stated by Turel (2000), for the most moderate-to-middle income households, home ownership in the authorised market was achieved through self-provision, either purchasing from builders or estate agents or acquisition through cooperatives. Over the past decade, the Turkish economy has experienced two financial shocks, in 1994 and 2001, which sharply increased nominal interest rates over the expected inflation rate (see Fig. 2). Under these circumstances, fixing the mortgage rate to nominal interest rate, as in the case of the FRM and ARM, would have resulted in extremely high mortgage payments for borrowers, leading to high rates of mortgage defaults. Naturally, banks have not been willing to lend for long-term housing loans because of lack of confidence in economic stability, concerns over creditworthiness of borrowers, and their desire for liquidity. A volatile economy also affects the supply of funds and types of mortgages offered by lenders. In a volatile

2 The figures are real market values calculated as nominal mortgage loan values denominated in consumer price index (inflation) number of the corresponding month (December) of each year.

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12000000 10000000

Billion TL

8000000 6000000 4000000 2000000 0

1997

1998

1999

2000

Other

219935

640905

755403 2674577 812810 1860233 4988906 10174546

Automobile

340318

469628

447154 2339508 286010 1198317 4688961 8456515

Housing Loans

39998

68972

46508

673204

2001

48092

2002

258019

2003

2004

800558 2712631

Fig. 1. Housing loans in total consumer credits (1997–2004). Source: The web site of Banks Association of Turkey.

500 Interbank Money Market Rate

Percentage Changes

400

Consumer Price Index Real Interest Rates

300 200 100

19 90 / 19 1 90 / 19 9 91 / 19 5 92 / 19 1 92 / 19 9 93 / 19 5 94 / 19 1 94 / 19 9 95 / 19 5 96 / 19 1 96 / 19 9 97 / 19 5 98 / 19 1 98 / 19 9 99 / 20 5 00 / 20 1 00 / 20 9 01 /5

0

-100 Fig. 2. Annual market interest rate and inflation (Consumer Price Index) movements in Turkey between 1990 and 2002. Source: Consumer Price Index (CPI) from State Institute of Statistics and Inter-bank Money Market Rate from International Financial Statistics (IFS) prepared by the International Monetary Fund (IMF).

environment, lenders are not only reluctant to offer long-term mortgages, but offer short-term loans that are less affordable for borrowers. The scarcity of funding sources due to unpredictable inflation rate is obviously a major impediment to an efficient mortgage lending system.

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Sale of Houses Turkish Lira Turkish Lira Savings Institutional Investors Depositors

LENDER & DEVELOPER State-Owned Bank

Households Securities

Securities (Bonds)

Promissory Notes (evidences debt) Mortgage Loans (money advanced)

Fig. 3. Emlak BankÕs mortgage lending system.

2.1. Emlak Bank and its alternative index-linked mortgages Emlak Bank,3 is a leading mortgage lender in the country with large investments and interests in expanding its mortgage products. It deploys the traditional mortgage lending system in which the institution performs the major functions of mortgage origination, servicing, funding, and portfolio risk management. The bank does not utilize services of third party vendors such as mortgage insurers, real estate appraisers, and accomplishes all the primary functions of mortgage lending. In addition to housing finance, the bank has two other functions, namely, residential construction and retail banking. The Turkish Banking Act stipulates that only Emlak Bank has the legal authority to participate in joint venture of residential construction business (Fannie Mae, 1992). Being involved in residential construction sector directly, it operates as a lender/developer institution in the market. Fig. 3 shows that the bankÕs mortgage lending comprises both the retail and wholesale sectors. It also raises funds from sale of its own built houses. Its wholesale business is on the fund raising side only, where funds are obtained primarily from institutional sources through the capital market rather than directly from the public sector. In other words, the mortgage bank originates mortgage loans, which are funded by the issuing securities. Emlak Bank offers mortgages for purchases of three types of housing units: those constructed by the bank, those constructed in joint-partnership business in which the bank participates with builders or developers, and those constructed by other builders in the market. Among these three types of units, dwellings constructed by individual builders in the market are the biggest part, 56%, of the housing stock of the bankÕs mortgage portfolio. The bankÕs own housing construction projects share is about 40% of the total number of mortgages originated and these projects, 18 in total, are developments in four main cities of Istanbul, Ankara, Izmir, and Adana. Emlak Bank has originated basically two types of mortgage contracts since the late 1990s: fixed rate mortgages (FRMs) and index-linked payment mortgages (ILPMs) linked to wage rate and to consumer price. Whilst FRMs are offered as short-term loans for all three types of housing units mentioned above, the IL-PMs 3

‘‘Emlak’’ means real estate in Turkish language.

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Number of Mortgages

A 16000 14000 12000 10000 8000 6000 4000 2000 0 Number of Fixed Rate Mortgages (68.7%)

Number of Index-Linked Payment Mortgages (31.3%)

Billion Turkish Lira

B 100000 80000 60000 40000 20000 0 Market Value of FRMs (56%)

Market Value of IL-PMs (44%)

Fig. 4. (A) The number of fixed rate mortgages (FRMs) and index-linked payment mortgages (IL-PMs) issued by Emlak Bank at as 06.07.2001. (B) The market value of Emlak BankÕs fixed rate mortgages (FRMs) and index-linked payment mortgages (IL-PMs) as at 06.07.2001. Source: Emlak Bank, Istanbul.

are created as new mortgage instruments, especially for the purchase of the bankÕs own housing units with 10- to 15-year maturity mortgages. As can be seen in Fig. 4A, the share of IL-PMs in the overall mortgage lending is 31% with the market value of outstanding mortgage balance of 44% (see Fig. 4B). It is important to note that among the IL-PMs, WIPMs are about 82% compared to 18% PIPMs.

3. Wage-indexed payment mortgage (WIPM) As mentioned earlier, Emlak Bank launched the new WIPM in 1998, which is based on a specifically designed Civil ServantsÕ Wage Index. The WIPM has 10-year mortgage term with an initial maximum loan-to-value ratio of 75%. Its mortgage repayments are indexed to civil service employees wage income in order to maintain the affordability of the mortgage for this group of borrowers. Because mortgage repayments are variable, the mortgage term is also variable to accommodate shortfalls in repayments as wage rates change over time. The contract details are summarized in Table 1. In a typical WIPM, the monthly mortgage repayment for the first 6-month period is a fixed amount and is calculated by dividing the total loan amount by the mort-

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Table 1 The specification of the wage-indexed payment mortgage Contract maturity Arrangement fee Prepayment penalty LTV ratio at origination Index Insurance Margin Periodic cap Lifetime caps Reset frequency Initial coupon payment

120 months — No penalty payment 75% Civil servantÕs wage index Property insurance (no mortgage default insurance policy) — — — Semi-annually (every 6 months) Total loan/contract maturity

gage term. There is no contracted or pre-determined coupon rate to amortize the loan balance. At the beginning of the second 6-month period, and all subsequent semi-annual periods, the repayment is calculated by amortizing the outstanding mortgage balance at CSWR over the remaining term. At the beginning of every January and July, the government announces the expected semi-annual inflation and the Ministry of Finance concurrently sets the semi-annual CSWR in line with the expected inflation. That is, CSWRtþ1 ¼ t petþ1 .

ð1Þ

The actual inflation at semi-annual date at time t + 1, patþ1 , may be higher or lower than the governmentÕs announced expected inflation at time t, t petþ1 , that is patþ1 ¼ t petþ1 þ etþ1 ;

ð2Þ

where et+1 is the unexpected inflation. If etþ1 > 0 If etþ1 < 0

CSWRtþ1 < patþ1 . CSWRtþ1 > patþ1 .

ð3aÞ ð3bÞ

If the actual semi-annual inflation for period t + 1 is higher than the officially announced expected inflation at time t, the Ministry of Finance compensates employees in the following semi-annual period by an amount et+1 plus an additional fixed markup of 2%, known as a welfare share. It is important to note that, although the Ministry of Finance compensates employees for the difference between the actual and expected inflation, the value of mortgage repayment, MP, is calculated using the expected semi-annual inflation only and no adjustment is made for any shortfall between the expected and the actual semi-annual inflation. That is, MP tþ1 ¼ f ðCSWRtþ1 Þ

or

MP tþ1 ¼ f ðt petþ1 Þ.

ð4Þ

This process of determination of the value of mortgage repayment takes place at the beginning of each semi-annual period until the loan is fully amortized. Thus, WIPM, by being balance-indexed mortgages, differ significantly from ARM in the USA in that there is no contracted mortgage rate. This mortgage instrument also has no periodic or lifetime caps that constrain the repayment adjustments, and no pre-specified

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Percentage (%) Changes

60 50 40 30 20 Consumer Price Index

10

House Price Index

20

04

/1 03

/1 20

20

02

/1 01

/1 20

00

/1 20

19

99

/1 98

/1 19

97

/1 19

19

96

/1 95

/1 19

94 19

/1

0

Fig. 5. Semi-annual changes in house price index (HPI) and consumer price index (CPI) between 1994 and 2004. Source: House price index (HPI) and the consumer price index (CPI) data are obtained from State Institution of Statistics.

margin to be added to the current value of the CSW index. Also, there is no arrangement fee that is charged to borrowers at the loan origination date. During the period 1994 and 2004, the House Price Index (HPI) and the Consumer Price Index (CPI) were highly correlated, with the correlation coefficient of 87.65%. Therefore, changes in house price index track the movements in actual inflation fairly closely (see Fig. 5). That is, % HI ¼ HI tþ1
HI t ffi patþ1 . If etþ1 > 0 H tþ1 ffi patþ1 > t petþ1 . If etþ1 < 0 H tþ1 ffi patþ1 < t petþ1 .

ð5Þ ð6aÞ ð6bÞ

In the event that actual inflation exceeds the expected inflation, and therefore also the CSWR (see Eq. (6a)), there is no incentive for borrowers to default on their mortgages. This is because, first, their outstanding debt amount is adjusted to t petþ1 (=CSWRt+1), which would be lower than actual inflation rate, patþ1 , and second, and the increase in HPI would be greater than CSWRt+1. However, for the lender the real return is negative when patþ1 > t petþ1 . This is precisely what happened in the first half of 2001 when the expected inflation rate 00=2 pe01=1 and CSWR01/1 15.9% while the actual inflation rate pa01=1 was 32.32% (see Fig. 2). Conversely, if actual inflation is lower than expected inflation rate (see Eq. (6b)), the lender realises an unexpected gain. However, a lower value of pa increases borrowersÕ incentive to default on their mortgages because they bear the burden of a considerably higher value of mortgage repayment at a time when the house price index has declined sharply. This was actually the case in the first half of 2002, when expected inflation rate 01=2 pe02=1 and CSWR02/1 was 27.68% while actual inflation rate pa02=1 was 12.09% (see Fig. 6).

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Percentage (%) Changes

60 50 40 30 20 10

CSW Index Consumer Price Index

20

04

/1

/1 03

/1 02 20

20

/1 20

01

/1 00

/1 20

19

99

/1 98

/1 19

97

/1 19

96 19

/1 95 19

19

94

/1

0

Fig. 6. Semi-annual changes in CSW index and consumer price index (CPI) between 1994 and 2004. Source: Consumer price index (CPI) data are obtained from State Institution of Statistics and the CSW index from the Ministry of Finance.

It is important to note that WIPM borrowers are not compelled to take out mortgage default insurance against risks such as critical illness, unemployment or even death. However, fire insurance and cover for other hazards are obligatory. In September 2000, after the 1999 Marmara earthquake, it became also obligatory to have earthquake insurance. Emlak Bank has recourse lending policy, which includes assets other than the house such as cash, bank savings, government bonds, guarantee from persons or legal entities or other securities.4 If borrower fails to meet the contractual mortgage repayments due to temporary liquidity problem, the bank normally consents to reschedule the accumulated unpaid amount subject to a new redemption plan. In the event of default, if the proceeds from sale of the property are insufficient to cover the outstanding loan balance plus costs, the Banking Regulation and Supervision Agency rules permit the bank to take possession of other assets. From information obtained from Emlak Bank, we gather that the bank has rarely resorted to legal action on mortgage defaults in the past. 3.1. Monthly payments To describe the process of semi-annually adjusted mortgage repayments, we introduce the following notation:

4

According to the law of Banking Regulation and Supervision Agency (BRSA), there are three main groups of collateral securities. The first group consist of cash and deposits, bills, and bonds issued by the Treasury. The second group contains gold and other precious metals, share certificates quoted at stock exchange, guarantees of banks operating in the OECD countries and the third group consists of guarantee from persons or legal entities with high credibility.

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L = Total loan amount. n = WIPM contract maturity in months. i = ith adjustment period for mortgage repayment, the total number of adjustment periods = n/reset frequency. Thus, i = 1,2, . . . , I where I = 120/6 = 20. j = The jth monthly repayment date in the ith adjustment period, where 0 6 j 6 6. OB(i, j) = The outstanding mortgage balance after the repayment at (i, j). w (i, 0) = semi-annual increase in CSW index (expected inflation) for the ith adjustment period. MPi = The value of monthly repayment at the ith semi-annual adjustment period. gi = Number of remaining months from adjustment periodÕs beginning to the contract maturity for i = 1 gi = n, and for i = 2–20 gi = gi
1
6. The value of each monthly mortgage repayment, MP, is computed in order to allow the principal to be paid in full by the end of the contract term. As mentioned earlier, the first semi-annual repayment on a WIPM contact is fixed amount and is calculated by dividing the total loan amount by the mortgage term. Thereafter, at each monthly payment date, the outstanding balance decreases by the fixed amount of MP. MP i ¼

L gi

where gi ¼ n;

OBði; jÞ ¼ ½L
ðMP i  jÞ

ð7Þ for i ¼ 1; j ¼ 0; . . . ; 6.

ð8Þ

At the beginning of the second period, the mortgage repayment schedule behaves as an adjusted payment mortgage, and the outstanding balance is adjusted semi-annually in line with changes in CSW rate. The monthly repayments are calculated as follows:
 ð1 þ wði; 0ÞÞ MP i ¼ OBði; 0Þ for i ¼ 2; 3; . . . ; I. ð9Þ gi Thus, OB (i, 0) * (1 + w (i, 0)) is the CSWR-adjusted outstanding balance that determines the value of monthly payment and the time to maturity. OB (i, 0) = OB (i
1, 6) implies that the remaining OB at the end of the sixth month adjustment period i
1 equals the outstanding balance at the beginning of period i. The outstanding debt amount after the repayment date t (i, j) is OBði; jÞ ¼ ½OBði; 0Þð1 þ wði; 0ÞÞ
ðMP i  jÞ

ð10Þ

note that for i = 2, OB (2, 0) = L
(MP1 * 6). In standard mortgage contracts such as fixed- and adjustable-rate mortgages, the periodical coupon payments are based on the risk-free interest rate. The fair value of the mortgage loan is defined as that value which makes the present value of expected future income on the property, discounted at the mortgage coupon rate, equal to the

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original loan amount.5 The time value of expected mortgage cash flows is calculated using the appropriate market interest rate. This measure reflects the market price of the mortgage loan rather than lenderÕs personal preferences. However, the individual lender may of course disagree with these market prices and view some loans to be under-or-overvalued in the market (Tuckman, 1995). Emlak Bank uses CSWR, which is linked to the expected inflation rather than the market interest rate to determine periodical repayments on WIPMs. Thus, the basic rule in determining the monthly payments on a WIPM is totally different from the standard contracts in that it does not take into consideration the present value of the expected cash flows and equate them to the loan balance in order to achieve a fair mortgage pricing. Instead, the amount of monthly payment is determined at the beginning of the semi-annual adjustment period based on CSWR, which then remains fixed for the next 6 months. This amount is calculated such that the outstanding loan balance would be paid in full over the remaining contract term. 4. Comparative analyses of default risk of WIPM and other mortgage contracts in high inflation economies PLAMs and DIMs have played an important role in facilitating long-term mortgage lending and borrowing in emerging economies such as Chile, Brazil, Mexico, Ghana, and Colombia. PLAM is designed to keep the real mortgage payments constant over the life of the mortgage. The initial payment is calculated based on the current prevailing real interest rate in the market. The subsequent nominal payments over the life of the mortgage are then calculated each year in line with the rate of inflation. DIM is designed to make the mortgage both affordable for borrower and profitable for lender. It amortizes the loan with respect to two independent indices: an index reflecting the change in borrowerÕs wage and a financial index that reflects the cost of funds. Another form of indexation is the Ôindexed unit of account,Õ which was created in Chile in 1967. 5

The basic rule for determining a fixed amount of monthly payment MP for a 10-year FRM is: MP

TX ¼120 t¼1

1 ¼ OBð0Þ; ð1 þ 12c Þt

where OB (0) represents the amount of debt at the origination of the loan, c is the fixed coupon rate, and T represents the 10-year mortgage maturity in terms of the total number of months. The equation states that if the yield-to-maturity of the mortgage, or the coupon rate, is flat at c, then the present value of all mortgage cash flows is equal to the original loan amount. In the case of ARM, instead of discounting the expected mortgage payments for the whole loan term of 10 years, a different value of monthly payment is calculated for each adjustment period depending upon the basic rule that ÔThe present value of all monthly payments in a particular adjustment period should be equal to the remaining loan balance at the beginning of that adjustment period.Õ The basic rule in determining the monthly payments on a WIPM is totally different from the standard contracts by not taking into consideration the present value of the expected cash flows and equating them to the loan balance in order to achieve a fair mortgage pricing. The amount of each monthly payment is determined at the beginning of every semi-annual adjustment period, which then remains fixed for the next 6 months. This amount is calculated such that the outstanding loan balance would be paid in full over the remaining contract term.

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In 1995, Mexico introduced a price level-adjusting unit of account called the Unidad de Inversion (UDI). UDI is an amount of currency that is indexed to the inflation and is converted to pesos at the time of payment. UDI mortgages are a fixed real rate loan. The loan is repaid inline with the current value of the UDI index and an initial real interest rate, which is fixed over the mortgage maturity. Therefore, the indexation is achieved by quoting prices in a money-like unit rather than relying on an indexation formula as in the case of PLAM and DIM (see Shiller, 1997). WIPM design is similar to that of PLAM and DIM, which is based on an indexation formula that amortizes the loan balance. However, the WIPM does not have either a nominal or real amortization rate. This design has evolved specifically because the interest rate has been highly volatile over the last 15 years. In particular, there were two major financial crises in 1994 and 2001, when the monthly inter-bank money market rate reached 350 and 400%, respectively. The actual inflation rate peaked at 119% in 1994 and 73% in 2001, which resulted in extremely high real interest rate in these periods. Under these volatile economic conditions, the payment rate or amortization rate (as in the case of ARM and DIM) on the mortgage would have resulted in extremely high mortgage defaults. In Mexico between 1986 and 1995 almost all mortgages were dual indexed mortgages, which were indexed to either the average cost of funds for all Mexican banks or 28-day Mexican Treasury notes. When the interest rate soared during this period, the mortgage defaults reached a record number in 1995 (Lea, 1996; Lipscomb and Hunt, 1999). A recent study by Berument and Malatyali (1999) analysed the behaviour of the Turkish Treasury interest rates based on the Fisher hypothesis. This study uses the sample period from November 1988 to June 1998. In their regression of interest rate on expected and unexpected inflation, it is found that both coefficients of expected inflation and inflation risk are statistically significant. The empirical findings reveal that while the interest rate is positively related to expected and unexpected inflation, the interest rate increases less than expected inflation.6

6

Berument and Malatyali (1999) specify that the inflation rate follows an autoregressive process in order q. That is, q X pat ¼ i0 þ ij pat
j þ et . j¼1

The conditional expectation of the inflation rate at time t with the given information set at time t
1 is q X ij pt
j . Eðpt =Xt
1 Þ ¼ i0 þ j¼1

The authors use ARCH model in order to forecast the inflation risk or conditional variance of unanticipated inflation at given time t as p X c1j e2t
j . h2t ¼ c0 þ j¼1

To capture the effect of positive unexpected inflation on interest rate, the Fisher equation is modified to include inflation risk, conditional standard deviation of unexpected inflation, ht in Quasi Maximum Likelihood regression analysis. The estimates of the modified Fisher equation are the following, where t statistics are reported in parentheses: rt ¼ 0.032ð4.18Þ þ 0.55pet ð2.26Þ þ 0.94ht ð2.46Þ;

R2 ¼ 0.89.

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285

This empirical evidence supports TobinÕs (1965) hypothesis that, during periods of high inflation (due to positive unexpected inflation) the real interest rate declines. The real interest rate has been observed to be even negative at times.7 The nominal mortgage contracts such as DIM and ARM would have resulted in payment shocks for borrowers leading to high default risk, and would have produced negative real return for lenders, leading to real interest rate risk. Mortgages indexed to the expected inflation provide protection against high mortgage defaults. Lenders also benefit from originating mortgages indexed to the expected inflation, rather than highly volatile nominal market interest rate, as long as the real interest rate declines and remains negative in high inflationary conditions. PLAM and UDI mortgage contracts, which are fixed real rate loans, also insulate both the borrower and lender in real terms from volatile interest rates. However, these mortgage designs suffer from major payment shocks in that if the inflation rate rises faster than wage rates for any period of time, the payment burdens on borrowers can become unsustainable, resulting in a high level of defaults. We now illustrate the costs and benefits of WIPM with reference to PLAM, ARM, and DIM from civil service employeesÕ standpoint. For each of the mortgage design starting from 1998, when WIPM was originated, we calculate the amortization schedule for the first 7 years of a 10-year mortgage term with loan balance of 15 billion Turkish Lira (TL). We exclude UDI from our analysis because it is not widely used and its indexation is quoted in money-like unit, which differs considerably from the WIPM structure. Table 2 presents the repayment schedule for each of the four mortgage designs. It can be seen that the outstanding mortgage balance of WIPM and DIM rises over time. The WIPM borrower owes approximately 3.1 times the initial loan amount after 7 years while the DIM borrower owes 14.3 times the initial loan amount. In contrast, the remaining balance for the ARM declines systematically. The remaining balance for PLAM declines sharply over the same period. As noted above, the PLAM design uses the inflation rate, normally CPI, to revalue the mortgage balance at the end of each adjustment term. Since inflation declined rapidly from 99% in 1997 to 9.3% in 2004, the outstanding balance for the PLAM plummets. The spike in this outstanding balance scheme in 2002 is due to the jump in inflation from 39 to 68.5%. Over the 7-year period, nominal annual payments for WIPM and DIM increased, at an increasing rate, every year. By the seventh year of WIPM, the annual payment is 7.2 times greater than the initial payment in 1998. For the DIM, the annual payments begin at 1.55 billion TL and soar to 14.325 billion TL, which is nine times 7

Berument and Malatyali (1999) use the treasury interest rate in their regression analysis. However, the Turkish government does not continuously issue Treasury Bills. The International Financial Statistics (IFS) data on T-Bill rates are from February 1994 to January 1996 and from January 1999 to December 2002. Therefore, we use interest rates on the bills traded in the secondary market and assume that these bills are held for 1 month and the real interest rates are realised at the end of that period. Using the IFS data on money market interest rates and inflation (CPI) data, reported by the State Institute of Statistics, we estimate the real interest rate both on annual and monthly basis. On average, the observed real interest rate has been negative between 1987 and 1997, which supports Berument and MalatyaliÕs research that high inflation results in declining, and even negative, real interest rate.

286

Table 2 Amortization schemes for alternative mortgage designs

Year

20 Billion Turkish Lira (TL) LTV = 75% 15 Billion TL 4.9% @ 5%

Outstanding balance (Billion TL)

CSW rate First half

Second half

Wage-indexed payment mortgage (WIPM) 1998 15.000 1999 18.206 2000 27.770 2001 33.912 2002 40.818 2003 48.945 2004 46.655

0.000 0.300 0.200 0.159 0.277 0.100 0.060

0.349 0.320 0.163 0.212 0.127 0.083 0.060

Year

CPIt/CPIt
1

Outstanding balance (Billion TL)

Price level-adjusted mortgage (PLAM) 1998 15.000 1999 10.576 2000 9.492 2001 4.817 2002 7.422 2003 2.750 2004 1.396

— 0.697/0.991 0.688/0.697 0.390/0.688 0.685/0.390 0.297/0.685 0.184/0.297

Annual payment (Billion TL)

P/I ratio civil servants

P/I ratio public sector workers

P/I ratio private sector workers

LTV ratio

1.761 3.050 4.505 6.209 9.239 11.216 12.734

0.371 0.375 0.396 0.389 0.402 0.412 0.421

0.470 0.466 0.440 0.439 0.533 0.470 0.493

0.704 0.851 0.871 0.908 0.997 0.880 0.929

0.75 0.55 0.49 0.41 0.31 0.29 0.23

Annual payment (Billion TL)

P/I ratio civil servants

P/I ratio public sector workers

P/I ratio private sector workers

LTV ratio

0.410 0.183 0.130 0.052 0.064 0.024 0.013

0.522 0.227 0.144 0.059 0.084 0.027 0.015

0.776 0.415 0.284 0.122 0.158 0.050 0.029

0.75 0.32 0.17 0.06 0.056 0.02 0.007

1.943 1.488 1.469 0.832 1.462 0.635 0.394

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House price at origination Loan-to-value ratio Loan amount Real interest rate at origination

Annual payment (Billion TL)

P/I ratio civil servants

P/I ratio public sector workers

P/I ratio private sector workers

LTV ratio

Adjustable-rate mortgage (ARM), margin = 0% 1998 15.000 1999 14.988 2000 14.963 2001 14.830 2002 14.787 2003 14.412 2004 13.091

0.746 0.735 0.567 0.919 0.590 0.340 0.231

11.198 11.035 8.586 13.656 9.009 6.027 5.044

2.343 1.356 0.759 0.856 0.392 0.224 0.167

2.987 1.687 0.843 0.966 0.520 0.256 0.195

4.442 3.080 1.667 1.998 0.973 0.478 0.368

0.75 0.45 0.27 0.18 0.11 0.09 0.07

Year

r

Annual payment (Billion TL)

Payment-toincome civil servants

P/I ratio public sector workers

P/I ratio private sector workers

LTV ratio

1.549 2.587 4.219 6.257 9.623 12.446 14.325

0.327 0.318 0.371 0.392 0.419 0.463 0.474

0.416 0.395 0.412 0.442 0.555 0.528 0.554

0.619 0.722 0.816 0.915 1.039 0.988 1.045

0.75 0.78 0.87 0.79 0.81 1.01 1.07

Outstanding balance (Billion TL)

Outstanding balance

Dual index mortgage (DIM) 1998 15.000 1999 26.074 2000 49.269 2001 66.081 2002 106.387 2003 170.837 2004 214.922

0.746 0.735 0.567 0.919 0.590 0.340 0.231

CPIt First

Second

0.2953 0.2554 0.1785 0.3232 0.1209 0.1200 0.0310

0.3120 0.3450 0.1801 0.2731 0.1583 0.0570 0.0573

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Nominal r

Year

The payment-to-income ratios for both the public and private sector workers are calculated by using the annual average earnings of workers published by the State Institute of Statistics in Ankara. The data are collected for the production and mining industries and also electric, gas, and water industries (service sector). 287

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greater than the initial payment. The initial nominal payment for the ARM is six to seven times higher than the other contracts. In 2001, ARM payment becomes two times greater than the annual WIPM and DIM payments. The standard ARM uses the same rate for both the coupon payment and amortization. This rate is normally pegged to the inter-bank deposit rate. The annual interest rate soared to 92% in 2001 financial crisis. Interest rate was also very high in 1998 and 1999, 74.6 and 73.53%, respectively, which results in significantly higher initial payments on the ARM. For the PLAM, nominal annual payment begins at 1.94 billion TL and declines to 394 million TL in 2004. Its outstanding balance declines sharply, which makes the annual payment on PLAM almost negligible over this period. We follow Cohn and Fischer (1975) in order to highlight the costs and benefits of WIPM from borrowerÕs perspective. In their article, Cohn and Fischer define the main desirable characteristics of the mortgage instrument from borrowerÕs standpoint. First, borrower is able to choose a particular payment-to-income ratio that can vary as desired over the life of the mortgage. Second, borrower has the ability to budget the mortgage payments in the foreseeable future; therefore, it is desirable if the mortgage payment does not deviate widely from the trend ratio of payments to income. Finally, there is a low level of uncertainty about the real cost of the mortgage or the real rate of interest. Cohn and Fischer argue that the principal criterion to judge alternative mortgage designs is the stability of payment-to-income (P/I) ratio. Table 2 presents P/I ratios for each of the mortgage design over the period 1998– 2004. In order to examine default risk of WIPM and other mortgage contracts for various borrower groups, we also calculate the annual payment-to-income ratios both for the public sector and private sector workers. For the ARM, high nominal interest rate results in extremely high initial P/I ratios. For the first 4 years of the contract maturity, P/I ratio ranges from 0.76 to 2.3 for the civil servant employees. ARM P/I ratios are notably higher for workers examined as alternative group of borrowers. This implies that in high inflation economies the initial payment on ARM is simply unaffordable for the borrower. Moreover, P/I ratio for ARM design creates a disparity in payments over the life of the contract, with excessive initial payments and insignificant payments nearer the end. The initial PLAM P/I ratio for civil servant employees is 0.41. However, due to continuous decline in inflation (except 2001 financial crisis) P/I ratio is very low, it ranges between 0.01 and 0.18. Although PLAM seems to be a very safe mortgage instrument for civil servant employees, there is no incentive for the lender to originate these mortgages because they have negligible repayments. In contrast, the PLAM would have systematically increasing annual payments over the sample period 1998–2004 when was inflation persistently high. Since PLAM has fixed real rate of interest, it is still beneficial for borrower as stated by Kim (1987) and Cohn and Fischer (1975). However, when the initial real rate of interest is very high, the PLAM and ARM become unaffordable. Moreover, during periods when wages lag behind increases in prices, as in 1994 and 2001 financial crises, the adverse effect of the PLAM would have been even greater for those borrowers whose income lagged behind inflation.

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For the WIPM, the initial P/I ratio for civil servants is 0.37, which is noticeably lower than ARM and PLAM designs. Since the WIPM repayments are indexed to the civil servantsÕ wage rate, P/I ratio remains almost unchanged around its initial value. Therefore, WIPM enables the borrower to maintain a stable P/I ratio. Although the initial P/I ratio for WIPM is considerably higher than the generally accepted ceiling of 20–28%,8 Emlak Bank has continued to underwrite these mortgages for two main reasons. First, during the inflationary periods, house price appreciates more than the rate of inflation. Second, the WIPM is specifically designed for upper-middle income borrowers who can draw on other assets in the event of a short fall in mortgage repayment. The public sector workers have a considerably higher initial P/I, ratio of 0.47, compared to civil servants. Since the wages of public sector workers are not adjusted to the expected inflation, or the repayment index of WIPM, the default risk for public sector employees is higher. Although the WIPM design results in relatively volatile P/I ratios (0.44–0.53) for the public sector workers, the contract generates affordable payments for this group of workers. However, WIPM is not a suitable contract for the private sector workers, who have considerably lower wages compared to the public sector employees. The DIM has the lowest initial P/I ratio, which is approximately 0.33 for the civil servants. Over the 7-year period, P/I ratio increases to 0.47, which indicates that DIM has a fairly volatile P/I ratio compared to WIPM. The first payment on DIM is usually set as the percentage of the loan amount (see Chiquier, 1998). Lipscomb and Hunt (1999) state that, in Mexico, lenders typically originated DIMs with an initial monthly payment of 0.75% of the loan amount. We examine the inflationindexed DIM design, in which the repayments are indexed to inflation and adjusted every 6 months. As can be seen in Table 2, the annual payments are insufficient to amortize the principal in the long run. In fact, the short fall in payments becomes very large that the loan can never be repaid over its term. A very high level of interest rate, that is 74.6–92%, causes severe underpayment on DIM. By the end of the seventh year, DIM balance is more than 210 billion TL and the annual payment becomes more than 14 billion TL; since this amortization is practically impossible, borrower would automatically default. DIMs with payments indexed to the wage would maintain payment affordability but it can become tremendously costly in terms of the accumulated debt burden. Our comparative analysis of alternative mortgage designs demonstrates that for each group of borrowers examined, the standard ARM does not perform well in a high inflationary environment. Table 3 presents a summary of mortgage design evaluation from borrowerÕs standpoint. It can be seen that ARM design is particularly risky with high interest rate risk and unaffordable initial payments. The DIM has relatively lower or affordable initial P/I ratio for civil servant employees, which is more volatile than WIPM P/I ratios over the life of the mortgage. However, DIM P/I 8 McCulloch (1986) stated that for the PLAM, the lenders generally imposed a ceiling of 20% on the initial ratio of the loan payment to the borrowerÕs income. As inflation appeared to become more reliable, lenders increased this limit to 25% than to 28% and sometimes even higher. For the ARMs, commonly used ceiling on the initial P/I ratio is 28%.

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Table 3 Evaluation of alternative mortgage designs from borrowerÕs perspective Criteria

WIPM contract

PLAM contract

ARM contract

DIM contract

Interest rate risk Initial payment-to-income ratio Volatility of payment-to-income

Insulated High Almost stable

Insulated High Volatile

Risky Extremely high Extremely volatile

Risky Lowest Fairly volatile

ratios are significantly higher. This contract generates unaffordable payments especially for the private sector employees. The DIM exposes borrowers to interest rate risk, as in the case of ARM design. Due to high nominal interest rate, both the inflation- and wage-indexed DIM design result in mortgage repayment shortfall, which may lead to high mortgage defaults.9 Both PLAM and WIPM have a clear advantage in that they insulate borrower from adverse effect of high interest rate. The WIPM has almost stable P/I ratio, whilst PLAM P/I ratio varies considerably over the mortgage term. Having examined payment-to-income ratio, we analyse loan-to-value (LTV) ratio of these alternative mortgage contracts, which is another basic ratio that measures credit risk (risk of default) on a mortgage loan. For borrower to exercise his default option the market value of house must be less than the market value of mortgage debt. Analysing the Mexican mortgage market, Lipscomb and Hunt (1999) argue that because house prices often lag behind inflation, homeownerÕs equity erodes while the real value of the principal amount remains constant for indexed mortgages. Thus, when analysing index-linked mortgages, the important question is whether property values move sufficiently in line with repayment index so as to prevent erosion of borrowerÕs equity. There is only limited publicly available information on the expected trends and volatility of property values, especially at the individual sub-market level. The Housing Price Index (HPI), compiled by the State Institute of Statistics, is the only index that incorporates current prices for building materials, labour costs, and land prices and so reflects price changes in the primary market for owner-occupied housing. As seen in Fig. 7, cumulative percentage changes in HPI have considerably outpaced changes in inflation between 1995 and 2004. Since house price index appreciated faster than inflation, the loan-to-value ratio for WIPM is expected to decline continuously even though unpaid principal increased systematically over the mortgage term. As seen from Table 2, the outstanding loan balance for PLAM and ARM is significantly lower than for other designs. Since the market value of homeownerÕs mortgage debt would always be less than the market value of the house, there is no risk of negative equity. In contrast, the LTV ratio for DIM is significantly high 9 Over the period that we examine these alternative mortgage designs the real rate of interest has been considerably high. During the periods when real interest rate is low, the ARM is still very risky for the borrower because the interest rate ranges from 40 to 76% and would result unaffordable initial payments. For the DIM, there is still a risk of accumulated debt burden due to high enough interest rates. On the other hand, extremely high inflation rates, which result in negative real rate of interest, lead to unaffordable payments for the inflation-indexed DIM borrower.

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Percentage Changes

14000 12000 10000 8000 6000 4000 2000

D ec

.1 99 4 D ec .1 99 5 D ec .1 99 6 D ec .1 99 7 D ec .1 99 8 D ec .1 99 9 D ec .2 00 0 D ec .2 00 1 D ec .2 00 2 D ec .2 00 3 D ec .2 00 4

0

Housing Price Index

Consumer Price Index

Fig. 7. Cumulative percentage changes in housing price index and consumer price index between 1995 and 2004. Source: State Institute of Statistics, Ankara.

and it becomes even greater than unity towards the contract maturity. Therefore, the DIM clearly results in negative equity for borrower and consequently high default risk for lender. Hence, for lender, WIPM seems to be a better mortgage instrument in high inflationary environment. The lender benefits from the balloon payment structure of the WIPM, which results in relatively higher loan-to-value ratios than the standard ARM and PLAM. Since repayments on WIPM are indexed to borrowerÕs income, default risk is also low due to lower payment burden problem for borrower, especially in the early years of contract maturity. In addition, WIPM does not have a negative amortization risk, as in the case of DIM, which may result in high mortgage defaults. Although the WIPM is a suitable housing finance, and meets the demands of middle-income public sector employees, it does not meet requirements of the private sector employees. Under the stable economic environment of the last few years, where the real interest rate is moderately positive, we believe that the WIPM may no longer continue to be a desirable mortgage design for the lender. If the stable economic condition of the recent years continues in the future, it would certainly be better for the lender to adopt the standard mortgage instruments, such as FRMs and ARMs, as used in economies with moderate inflation.

5. Conclusion This paper analyses default risk of WIPM, which is widely originated in four big cities (Istanbul, Ankara, Izmir, and Adana), in comparison with default risk of the standard PLAM, DIM, and ARM. By linking the civil service employeesÕ wage index

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to the expected inflation, the Turkish government in collaboration with a stateowned bank created the new inflation-indexed mortgage contract in order to facilitate long-term housing finance. The money market interest rate has been highly volatile in real terms over the last decade. During the periods of financial crises in 1994 and 2001 the real interest rate soared to extremely high levels while the average annual real interest rate was been predominantly negative between 1990 and 1997 (excluding 1994 financial crisis). Analysing the Turkish treasury interest rate behaviour, recent empirical evidence indicates that the nominal interest rate increases less than the expected inflation, resulting in declining real rate of interest when unexpected inflation is positive. During periods of major positive inflation shocks, the real rate of interest declines and becomes even negative. Under these circumstances, the lender benefits from originating mortgages linked to expected inflation rather than to the real interest rate. In a volatile inflation environment, a nominal mortgage loan can be an extremely risky asset for the lender with its real capital value highly sensitive to inflation. Using historical data between 1998 and 2004, we simulate the repayment schedules for WIPM and other standard mortgage contracts. We calculate the annual mortgage payment-to-borrowerÕs income and loan balance-to-house value ratios as basic indicators of mortgage default risk. Our simulation results show that the WIPM protects both the lender and borrowers in real terms from volatile interest rates. We find that this specific contract design is suitable for civil service employees, who can maintain stable payment-to-income ratios over the mortgage term. Since the WIPM repayments are indexed to civil service employeesÕ wage index, default risk is lower for this group of borrowers due to lower payment burden problem, especially in the early years of the contract term. We conclude that the WIPM is an appropriate mortgage design in high inflation environment. The success and usefulness of this mortgage instrument depends not only on the contract design itself, but also on the correct set of supporting actions and policies by the government and financial institutions. The WIPM is an innovative mortgage instrument. Given that this contract combines two economic policy targets, namely facilitating housing finance for an expanding population and creating mortgage market under highly volatile inflationary environment, policy makers in other emerging economies may also adopt this mortgage instrument. References Berument, H., Malatyali, K., 1999. Determinants of interest rates in Turkey. Discussion Paper: 9902, The Central Bank of the Republic of Turkey. Berument, H., Ozcan, K., Neyapti, B., 2001. Modelling inflation uncertainty using EGARCH: an application to Turkey. Working Paper, Bilkent University, Ankara. Chiquier, L., 1998. Dual index mortgages (DIMs): conditions of sustainable development in Poland. East European Regional Urban Sector Assistance Project, The Urban Institute. Cohn, R.A., Fischer, S., 1975. Alternative mortgage designs. In: Modigliani, F., Lessard, R.D. (Eds.), New Mortgage Designs for Stable Housing in an Inflationary Environment. Federal Reserve Bank of Boston Conference Series.

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Fannie Mae, 1992. Creating a market oriented housing finance system in Turkey. Fannie Mae International Housing Finance Team, Washington, United States. Jaffee, D M., Renaud, B., 1997. Strategies to develop mortgage markets in transition economies. In: Doukas, J., Murinde V., Wihlborg, C. (Eds.), Financial Sector Reform and Privatisation in Transition Economies. Kim, T., 1987. A contingent claims analysis of price level-adjusted mortgages. AREUEA J. 15 (3), 117–131. Lea, M.J., 1996. Restarting housing finance in Mexico. Unpublished Paper presented at the US/Mexico Global Forum. Lea, M.J., Bernstein, S.A., 1996. Housing finance in an inflationary economy: the experience of Mexico. J. Housing Econ. 5 (1), 87–104. Lipscomb, J.B., Hunt, H., 1999. Mexican mortgages: structure and default incentives. historical simulation 1982 to 1998. J. Housing Res. 10 (2), 235–265. Lipscomb, J.B., Harvey, J.T., Hunt, H., 2003. Exchange-rate risk mitigation with price-level-adjusting mortgages: the case of the Mexican UDI. J. Real Estate Res. 25 (1), 23–41. McCulloch, J.H., 1986. Risk characteristics and underwriting standards for price level adjusted mortgages versus other mortgage instruments. Housing Finance Rev. 5, 65–97. Pickering, N., 2000. The SOFOLES: niche lending or new leaders in the Mexican mortgage market? Working Paper, Joint Center for Housing Studies, Harvard University. Shiller, R.J., 1997. Indexed units of account: theory and assessment of historical experience. Unpublished Paper presented at the International Conference of the Central Bank of Chile. Siembieda, W.J., Moreno, E.L., 1997. Expanding housing choices for the sector popular: strategies for Mexico. Housing Pol. Debate 8 (3), 651–677. Tobin, J., 1965. Money and economic growth. Econometrica 33, 671–684. Tuckman, B., 1995. Fixed Income Securities: Tools for TodayÕs Markets. Wiley, Canada. Turel, A., 2000. Limits of home ownership in Turkey. Paper presented at the ENHR conference in Gavle.