Mortgage Markets

Mortgage Markets: Regulation and Intervention M Flanagan, Manchester Metropolitan University Business School, Manchester, UK ª 2012 Elsevier Ltd. All rights reserved.

Glossary Adverse selection Refers to a process by which negative outcomes occur when borrowers and investors have asymmetric information (i.e., access to different information), and, in this case, is concerned with negative outcomes that are more likely to be selected because of regulatory intervention or policies. Agency dilemma Also called as the principal–agent problem. It is another special case that can arise when interests diverge and asymmetric information allows the agent some discretion to pursue his/her own interests at the expense of those of the principal. Equal outcomes A policy objective that seeks to reduce inequalities in material condition between individuals or households in a society. This usually means (re)distributing income or wealth. Equitable procedures A policy objective that tries to ensure the fair, even-handed, and dispassionate implementation of government regulations and policies. Externality An effect on a party not directly involved in the transaction responsible for the externality. As a result, prices do not reflect the full costs or benefits of a product or service. Housing externalities can include impacts on fire hazards and health conditions, while specific housing finance externalities could be informational, positional, or systemic (institutional) risk. Moral hazard Characteristic of principal (e.g., lender, employer) and agent (borrower, worker) relationships

Why Intervene? Governments intervene in housing markets because of negative externalities caused by a fundamental conflict between the objectives of borrowers (citizens) and investors. The main housing objective in developed countries can be simplified to Every citizen should have the opportunity of a decent, wellbuilt home at a price they can afford, in environmentally sustainable communities where they want to live and work.

The complementary objective for investors can be sim­ plified to All mortgage investors should expect to earn a predict­ able and sustainable return over the term of the mortgage with all risks equitably and fairly divided.

POLICY

where the differing objectives of the parties and the costs of policing and enforcing contracts motivate selfinterested behaviour that conflicts with the objectives of the other party. Principles of good regulation A set of guidelines concerning efficiency, management roles, proportionality, innovation, and competition used by regulatory authorities to guide and inform the design and implementation of regulations. Retributive justice A morally acceptable, proportionate, and necessary punishment in response to failure by institutions or individuals to comply with mandated regulations or legislation. S&Ls A savings and loan association is a financial institution that accepts savings deposits and makes mortgage, car, and other personal loans to individual members – a cooperative venture known in the United Kingdom as a building society. Social efficiency A policy objective that directs the use of resources by government to meet social goals (e.g., access to homeownership), which may be contradictory to market, or financial efficiency considerations. Unintended regulatory effects An idea that every regulation, no matter how well intended or supported by all interested parties, may be followed by unforeseen and unintended negative consequences that can negate the positive effects of the original regulation.

Housing is simultaneously a consumption good, as well as investment collateral, whereby governments who aspire to housing ‘every citizen in decent homes’ intervene, whatever their political and market outlook, to ensure sufficient funding to achieve equitable outcomes in hous­ ing provision. This requirement to ensure a steady stream of afford­ able funds from investors to all types of borrowers ranging from creditworthy to non-creditworthy, no matter their social grouping, has informed most government interven­ tions in developed countries over the last three centuries. As the housing finance market has grown in size and sophistication, governments have institutionalised and widened the scope of the type and variety of interventions to achieve particular outcomes. The type and method of intervention will vary depending on whether the focus of regulators is on the private or public housing sector.

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The article proceeds by demonstrating that regulation has a long lead time shaped by economic crises, wartime conflicts, and factors specific to a country. To do this effectively over a long time line, historical interventions are sketched in the US, Western European, and Japanese housing finance systems to highlight how the objectives described above influence regulators. These objectives, as well as the different types of intervention summarised later, are generally applicable to all developed mortgage markets in a global financial market. While regulation and intervention is an ongoing evol­ ving process in all developed countries, the worldwide historical perspective will emphasise that heightened and fundamental intervention, which involves the reshaping of housing finance institutions and the introduction of new legislation and regulations, tends to occur after sig­ nificant economic recessions or destructive military conflicts. The postcrisis institutional and regulatory regime gen­ erally provides new and innovative mortgage products which can meet the increased quantitative and qualitative demands from all types of consumer groups for decent, affordable housing and from investors for a stable and guaranteed return on their investments. However, these postcrisis interventions and innovations usually take place over decades, reflecting the long-term nature of the hous­ ing market and the interests of the different institutions and lobby groups. Finally, many of the major worldwide capital market innovations of the last 30 years have developed as a result of specific legislation and regulations enacted by the US Federal government to achieve its primary objectives of decent housing for borrowers, and guaranteed stability for investors.

An Historical Perspective on Housing Regulation and Intervention United States The US housing finance market has been of significant influence on other housing finance markets over the last half-century because of the primary position of the United States in world affairs. Terminating building societies were the first widely used US housing finance institutions around the 1780s. These institutions were arrangements whereby a small local community funded its members until the last member was housed at which point the arrangement was terminated. Products were nonamortising with semiannual payments, while loan terms were typically up to 10 years with a maximum loan-to-value (LTV) ratio of 60%. The societies evolved, during the 1870s, into mortgage banks lending funds, raised by selling mortgage-backed bonds, from the established East Coast states to the expanding Western

states. These building societies grew strongly but then defaulted in large numbers during the 1890s recession due to poor underwriting control by agents on behalf of investors. The next major restructuring of the US housing finance market occurred after the Great Depression fol­ lowing the tremendous growth in the US economy of the 1920s. Very large levels of unemployment caused signifi­ cant numbers of foreclosures and payment delinquencies with deflation halving house prices. The US (Hoover) administration responded by bailing out insolvent lending institutions via the Home Owners’ Loan Corporation (HOLC) and the Reconstruction Finance Corporation (RFC). Both corporations purchased defaulted mortgages, which was successful in avoiding systemic institutional failure, but was also an early example of the moral hazard issue in that some homeowners defaulted to take advan­ tage of the subsidies. Roosevelt’s administration, legislating via the 1934 National Housing Act, made a very significant nation­ wide institutional intervention by creating the Federal Housing Administration (FHA) to provide insurance against mortgage default. The Federal National Mortgage Association (Fannie Mae) was then created as a government-owned agency to provide a secondary mortgage market for FHA-insured mortgages (see article Mortgage Market Functioning). Two deposit insurance companies, the Federal Deposit Insurance Corporation (for commercial banks) and the Federal Savings and Loan Insurance Corporation (for S&Ls), were established. These institutions significantly expanded the lending capacity of the US housing finance system by developing the insured 80% LTV, 20-year long-term, and fixed-rate amortizing mortgage. Fannie Mae was later privatised in 1968 and allowed to place conventional instead of gov­ ernment-insured mortgages, while Ginnie Mae was established to take over Fannie Mae’s governmentinsured loans. The next major restructuring of the US housing finance system came in the 1970s and 1980s as a result of rising inflation caused by the two oil shocks, the effects of the Vietnam War, and changes in monetary policy which adopted money supply instead of interest rate targets. S&Ls were particularly hard hit as they had relied on short-term deposits to fund long-term fixed-rate mort­ gages, while housing demand was also hit by the increase in interest rates. This situation was magnified by unin­ tended regulatory effects: a federal regulation known as Regulation Q which limited the rates banks and thrifts could pay on time deposits and resulted in investors placing money in the unregulated money market mutual funds (see article Mortgage Interest Rate Regulation). Freddie Mac was established in 1970 to provide liquidity to the struggling S&Ls. Both Freddie Mac and Ginnie

Mortgage Markets: Regulation and Intervention

Mae created the market in mortgage-backed securities (MBSs) in the early 1970s. Further innovations rapidly followed such as multiplepass MBSs or collateralized mortgage obligations (CMOs) and real estate mortgage investment conduits (REMICs), which brought more investors into the housing finance market such as mutual funds, life insurance companies, pension funds, and foreign investors. Finally, Basel I in 1989 lowered the capital adequacy risk weights for Fannie Mae and Freddie Mac MBSs to 20%, while allowing leverage to increase from 2 to 5 times, making mortgages a very profitable and stable long-term investment. At this stage, due to the simultaneous introduction and explosion in the use of hedging derivative instruments, many new mortgage products appeared on the US market (see arti­ cle Mortgage Innovation). While significant new products were being developed on the funding supply side, major legislation was enacted to stimulate housing demand, such as the 1974 Housing and Community Development Act or the Community Reinvestment Act (CRA) of 1977 which aimed at increas­ ing the ability of US society to deliver affordable housing to all social groupings. Increased housing demand, driven by many social, economic, and demographic factors, com­ bined with the increased availability of flexibly funded and affordable mortgages. It was further facilitated by the introduction of automated underwriting systems resulting in a massive reduction in underwriting costs and through­ put times and the commoditisation of mortgage products on a scale similar to other innovations such as the Ford Model T and the personal computer. Western Europe Despite their close proximity, well-established economic and trading history, and many societal similarities, Western European countries, including the United Kingdom, have different housing finance systems – a mixture of retail deposits, mortgage bonds, and contract savings systems. Terminating building societies, prevalent in the United States around the 1780s, were institutions imported from the United Kingdom. In the United Kingdom, however, these institutions grew into perma­ nent building societies and operated primarily at a local or regional level, drawing their funds from retail deposits and, in contrast to the United States, with reduced reli­ ance on capital markets. In the United Kingdom, these institutions had mutated very little since the 1800s, reflecting the relative prosperity and stability of the United Kingdom. Furthermore, in the United Kingdom, variable-rate mortgages have tended to dominate, which ensure that borrowers tend to absorb the interest rate risk and prevented UK financial institutions from running into the difficulties experienced by the S&Ls in the United

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States. Although building societies adapted to the disrup­ tion caused by the First World War and Second World War, significant changes did result from funding pressures arising as a result of the 1970s and 1980s recessions and government policy changes that encouraged private homeownership at the expense of public housing. As a result, banking institutions or demutualised building societies began to dominate in the provision of housing finance drawing their funding from a wider variety of sources, including MBSs and mortgage bonds. The reg­ ulation and control of mortgage lending institutions has been long established in the United Kingdom and is currently the responsibility of the Financial Service Authority (FSA). The United Kingdom legislated the use of covered mortgage bonds in 2003 based on the 2003 EU UCITS Directive and followed up with more comprehensive legislation in 2008. This would seem to have caused many UK institutions to increasingly use covered mortgage bonds instead of securitised mortgage bonds as an additional funding source to their retail deposits (see article Covered Bonds). In contrast with the United Kingdom’s reliance on retail deposits and the United States’ reliance on mort­ gage securitisation, most continental European countries have finance systems based on a mixture of retail deposits, the more recent contract savings systems, and the longerestablished mortgage bond, dating from the end of the eighteenth century. Unfortunately, no European-wide definition exists for a mortgage bond and significant differences exist between the structure and legal standing of mortgage bonds issued in different countries. It is generally accepted to be an instrument backed by a pool of mortgages secured against housing or real estate assets. Furthermore, ultimate liabi­ lity for the performance of the bond is held by the originating institution and not securitised and thereby removed from the originator’s balance sheet, as in the case of an MBS. Prussia and more specifically the Silesien Landschaft, now part of modern Germany, issued one of the first mortgage bonds (Pfandbriefe) in 1770. This approach spread initially eastwards to Estonia (1802) and Livonia (1803) and finally to Poland in 1825 with the Warsaw Landschaft. In 1830, Ludwik Wolowski became profes­ sor of Industrial Economy in Paris and was instrumental in establishing the Cre´dit Foncier de France in 1852 which became one of the first large mortgage banks. At and around the same time, national legislation to set up mortgage banks funded by mortgage bonds began to appear in many other European countries, most notably Denmark, where the need for housing finance soared as a result of the Great Copenhagen Fire of 1795. Switzerland established the Caisse Hypothe´caire du Canton de Gene`ve in 1857. In 1870, the Preußische Centralboden-Credit-Actiengesellschaft, regarded as

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the direct precursor to the modern German mortgage bank, was established, while the Austro-Hungarian Empire legislated, in 1874 and 1876, bills ‘‘concerning the safeguarding of rights of the holders of mortgage bonds’’. Finally in 1900, the German Mortgage Bank Act (HBG) came into force. In all cases, mortgage bonds, which safeguard investors’ interests based on a pool of mortgages instead of a single mortgage, are backed up by extremely strong legal frameworks and close supervision of the mortgage banks. A widespread and popular type of mortgage funding system developed in some parts of Europe after the First World War with the generic name of contract savings systems (see article Contract Saving Schemes). A parti­ cular version developed in Germany and Austria is known as the Bausparkassen system. People in this system agree to save an amount of money over a period of time in return for a commitment on the part of the lender to provide a mortgage loan. Generally, the savings enjoy some tax relief and the mortgage is also below money market rates. These systems are closed systems in that mortgages are funded completely by contract savings deposits. Besides Germany, the Bauspar system is an important part of the national housing finance system in Austria, the Czech Republic, Croatia, Romania, Slovakia, and Hungary. Outside Europe, India and China have also adopted Bauspar systems. From today’s vantage point, we can see how most European countries have developed along different paths. France, Italy, Belgium, Ireland, Finland, Norway, and Austria have a higher proportion of retail deposits in their funding (although not as high as the United Kingdom), with France, in particular, having a welldeveloped contract savings system (plans d’e´pargne loge­ ment). On the other hand, Germany, Denmark, and Sweden have higher levels of mortgage bond and contract savings funding. Significant differences also exist in the type and number of mortgage products offered, with the first group offering shorter-term (10–15 years) and lowerLTV loans. While both groups offer a mixture of fixedand variable-rate mortgages, the shorter-term group tend towards fixed-term mortgages while the longer-term group tends towards mortgages with a greater variable or periodic review element. Although membership of the European Union requires compliance with a superstructure of regulations and laws covering most aspects of trade and social interaction, housing finance and its regulation still remain outside its remit. Housing finance regulation and intervention remains very much under national control with various degrees of regulation and risk control ranging from lighthanded (e.g., United Kingdom) to intensive (e.g., Denmark). EU-wide harmonisation efforts in this area are mainly directed at ensuring a consistent way of

communicating information on the terms and conditions of mortgage products to European consumers. Some effort has gone into setting minimum European-wide standards for a ‘safe’ mortgage bond known as the 22 IV UCITS Directive.

Japan In Japan, housing market finance evolved as a result of the devastation and destruction caused to the housing stock by the Second World War and the need to rehouse large numbers of the population. Some of the initial postwar institutional developments bore some resemblance to the then current US institutional arrangements, an outcome likely influenced by US policy advisers. However, no secondary mortgage markets were developed and housing finance was largely funded by national or local govern­ ment. Although the first and second 1970s oil shocks impacted the United States and other major housing markets, the significant exception was the Japanese hous­ ing market, whose housing markets and institutions were only affected after the property bubble collapse that occurred in the ‘lost decade’ of the 1990s. In 1950, the Government Housing Loan Corporation (GHLC) was established to provide long-term (35 years), low-interest, high-LTV (80%), fixed rate mortgage (FRM) and adjustable rate mortgage (ARM) finance to private individuals and public sector, operating through other financial institutions such as banks. These institu­ tions would for a fee check the creditworthiness of the mortgage applicant as well as collecting term repayments. This situation persisted up to the early 1970s from which time private sector institutions started to become a major force in providing mortgage finance. Private sector insti­ tutions are regulated by the Bank of Japan, while the GHLC is regulated by the Ministry of Infrastructure, Land, and Transportation. The GHLC was mainly funded by government-backed bonds and credit guaran­ tees (Fiscal Investment and Loan Programme), while private sector institutions are funded by retail deposits from household savings. GHLC government bondbacked and subsidised (up to 200 basis points) lending rates were lower than private sector rates which were driven more by lending and deposit rates prevalent on the money markets. In 2001, the Japanese government initiated a major institutional reform requiring the GHLC (since renamed as the Japanese Housing Finance Agency or JHF) to reduce its dependence on government FILP funds over a 6-year period. It also transformed its funding and operating model into a form very similar to the (nonpri­ vatised) US Fannie Mae, creating a secondary mortgage market and obtaining funding via MBSs.

Mortgage Markets: Regulation and Intervention

What Shapes Regulation and Intervention? It is possible to divide housing finance systems into two general categories, namely those systems that have with­ stood or adapted well to economic and social crises and those housing finance systems in transition to a model based on one of four systems. The four well-established generic types of systems, as discussed in the historical perspective, are the (1) retail deposit system (e.g., UK building societies); (2) mortgage securitisation system (e.g., US governmentsponsored enterprises (GSEs)); (3) contract savings system (e.g., German Bausparkassen banks); and (4) mortgage bond system (e.g., Danish mortgage banks). Regulation and intervention closely reflects the category a country’s housing finance system is classified under. Within the first category, regulation is aimed at scaling and optimising the system for the benefit of lenders and borrowers, while regulation in the second category is primarily about (re)establishing legal and institutional frameworks. However, even then, no two types of governmental housing finance intervention will be the same. Each gov­ ernment will have a different blend of institutional and mortgage guarantees, tax incentives, housing and mort­ gage regulations, specific support for weaker members of society, and mortgage educational programmes. Each society will reach a dynamic equilibrium based on its own particular housing and mortgage finance objectives, ruling government philosophy, lobby groups pressure, and crisis events. Finally, the degree and amount of mort­ gage regulation and intervention within these systems is no predictor of stability and performance due to the (in)ability of regulators to police and enforce large hous­ ing and capital finance markets that are often outside their span of control. This subsection continues by briefly reviewing regula­ tion practice within each of the four generic housing finance systems and concludes discussing some of the regulation issues faced by countries in transition.

Retail Deposit System: United Kingdom In the United Kingdom, responsibility for regulating both consumers and investors lies mainly with the FSA set up under the Financial Services and Market Act, 2000. The FSA was (until recently) characterised as light-handed with regard to regulation of internationally operating banking institutions and somewhat more heavy-handed with regard to the regulation of its local building societies. A major proportion of UK housing finance intervention is

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therefore achieved through specific regulations aimed at building societies. The embodiment of the UK regulatory objectives, including housing finance, is found in the FSA’s Conduct of Business Sourcebook (COBS). This is inci­ dentally a more concise and light-handed ‘best practices’ manual compared to the multitude of ‘heavy-handed’ manuals and computer systems found within the many different US regulatory and GSEs. It distinguishes three broad objectives by which the FSA shapes housing reg­ ulation policy. 1. promoting efficient, orderly, and fair markets; 2. helping retail consumers achieve a fair deal; and 3. improving our business capability and effectiveness. They achieve a balance of regulation by applying five ‘principles of good regulation’: (1) using resources in the most efficient and economic way; (2) emphasising the role of senior management in ensur­ ing regulatory compliance; (3) imposing restrictions on industry in proportion to the expected benefits; (4) facilitating innovation in connection with regulated activities; and (5) minimising adverse effects on competition as well as promoting competition. Government subsidisation of housing has been greatly reduced over the years as some favourable tax regulations have been removed. The security of retail deposits still benefit from both explicit and implicit governmentbacked guarantees, while additional housing benefits are also paid directly to particular social groups. UK regula­ tors permit a wide range of fixed- and variable-rate type mortgage products with high LTVs. Mortgage Securitisation System: United States In the United States, factors shaping regulatory policy are opaque as regulatory responsibility for achieving the effi­ cient and effective functioning of the housing finance market is spread across many agencies at both a federal and state level. Lobby groups, challenging legislation or regulation in the US Federal and State Court system, also significantly shape US intervention. The United States was traditionally regarded as a heavy-handed regulator in terms of numbers of federal and state agencies, GSE organisations, housing finance institutions, and tonnage of handbooks. On the other hand, enforcement of the regulations became increasingly light-handed over the last 15 years due to an ‘unholy’ alliance between borrowers and investors in the housing finance system; that is, insatiable borrowers demand for more affordable and higher-quality housing as well as

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investors demand for high, predictable, and governmentguaranteed yields on their abundant and leveraged funds. A moral hazard problem arose in that both groupings felt that the US government would always implicitly guaran­ tee the privatised GSEs (i.e., Fannie Mae and Freddie Mac) debt obligations. Policy objectives and interventions are shaped by one or more of the following four principles: (1) achieving social and/or economic efficiency; (2) ensuring equitable procedures for all groups of borrowers; (3) achieving equal outcomes by redistributing income to less-advantaged members of the society; and (4) ensuring retributive justice for those repeatedly flout­ ing or ignoring regulations. In the case of the first policy objective, some US agency regulators may focus more on economically efficient out­ comes (e.g., the Federal Reserve), while others on socially efficient outcomes (e.g., the HUD). The second and third policy objectives in the United States have been charac­ terised by well-documented areas of conflict between federal and state agencies, intrafederal agencies, as well as consumer lobby groups and federal agencies. The fourth policy objective, that is, that wrongdoers will be caught and suitably punished, has been much in discus­ sion recently on a variety of levels but notably with reference to apparent abuses in the certification of subprime mortgages. Some observers, including the Congress of Oversight Panel (COP) as well as the Federal Reserve, claim that these types of abuses demonstrate how agency dilemma, adverse selection, and moral hazard issues introduced by regulatory intervention can have major and significant unintended consequences. A major proportion of US housing finance intervention is achieved through tax policy, institutional regulation, and targeted government programmes. Guarantees have tended to be implicit rather than explicit. Recent federal foreclosure prevention programmes have tended to oper­ ate by providing interest rate subsidisation rather than principal reduction.

Contract Savings System: Germany The German Bauspar contract savings system is subject to relatively heavy-handed regulation under banking legis­ lation enacted by both federal and state government within Germany. The main act called the Bausparkassengesatz sets out the main principles that govern the Bauspar contract. Institutions must conduct their business under the General Business Principles (GBP) and Standard Terms and Conditions for Bauspar Contracts (STCB) which cover the contract amount, sav­ ings rate, repayment rate, and interest rates for the savings

and the loan. Institutions can only allocate saved and previously collected savings as loans. German Bausparkassens are supervised by the German Federal Financial Supervisory Agency (BaFIN) and the German Central Bank. BaFIN issue the licences allowing a Bausparkasse to operate and also approve its mortgage contract rates. The German Central Bank, on the other hand, monitors the liquidity position of every Bausparkasse in accordance with legislation on banking monitoring and supervision in Germany mainly enshrined in the Act on Contractual Savings Banks (CSBs). Because of the closed nature of the system, loan amounts are smaller than those from other generic hous­ ing finance systems and hence usually complement other sources of finance. Credit risk to the lender is low because the borrower has already demonstrated a good savings record. Their popularity is also due to the fact that both their savings and loan interest rates are effectively sub­ sidised and cheaper, by up to 600 to 800 basis points, than consumer general loans. In Germany, this subsidy is paid in the form of a savings bonus which is subject to income thresholds and is regulated by another act called the savings premium dedicated to housing (Wohnungsbaupra¨miengesetz).

Mortgage Bond System: Denmark The housing finance system in Denmark has come through the recent worldwide credit and economic crisis in good shape, further improving its well-earned reputation as a heavy-handed but effective regulator. Danish mortgage bonds (realkreditobligationer) are supported by a strong legal framework (the Danish Mortgage Credit Act (updated 2003)) and close super­ vision of mortgage banks by the Danish Financial Supervisory Authority to ensure low risk for investors. Loan sizes are also limited in the same act to a max­ imum LTV of 80%. However, even though risk is very low for lenders, borrowers still enjoy a wide range of different and flexible, fixed- and variable-type mort­ gage products. The low or ‘balanced’ risk is achieved by a variety of means, but principally by ensuring that mortgage bonds are of a ‘pass-through’ type whereby principal and interest rate payments from the pool of borrowers closely match those paid to the pool of lenders. The Danish mortgage system is primarily market-based and without public subsidies with exceptions for special groups, living in social housing who are often allowed a higher LTV combined with a govern­ ment guarantee. Housing finance repayments are subject to normal tax regulations and enjoy no advan­ tageous regulations.

Mortgage Markets: Regulation and Intervention

Systems in Transition Some countries do not have well-established systems or are in transition from one system to another due to political, economic, or social reasons (see article Policies to Promote Housing Choice in Transition Countries). This is currently true of many countries with examples in the former Soviet bloc, China, South Africa, and so on. These countries do not generally reinvent the (housing finance) wheel, but will tend to adapt one of the four generic types of housing finance systems identified above as being particularly stable or beneficial to coun­ tries over a long period of time. A recent example is that of Japan which has moved towards the greater use of securitised mortgage bonds. For these countries, regula­ tion and intervention is about the degree or type of regulation, as well as the adoption, establishment, and implementation of different housing finance systems, institutions, and legal frameworks. Evaluation of the advantages and disadvantages of the four basic systems and the eventual choice between them is a long and complex task. Establishment and implemen­ tation can be even longer as demonstrated by the 6-year transition period in Japan of the GHLC to the JHF mortgage securitisation system. Generally, governments will decide bearing in mind the interests and objectives of the two main stakeholders in the housing finance system, namely lenders and borrowers. A particular system will tend to promote specific types of mortgage products over others. The mortgage bond system (Denmark), for exam­ ple, results in longer term periods and higher loan amounts than the contract savings system (German Bausparkassen). The mortgage securitisation system (United States) generally has a higher return on equity and lower operating costs than the other three systems. Once a housing finance system is decided upon and adapted, based on one of the four generic types, then, more often than not, the initial degree and type of legal framework, regulation, and intervention will be similar to that observed and studied in a reference country of which several will exist. To do otherwise would be to run needless and often unquantifiable operating and imple­ mentation risks for both lenders and borrowers as all four systems have been well measured, tested, and documen­ ted over decades, if not centuries.

Types of Intervention The following taxonomy can be used to characterise most of the common types of housing finance interventions: (1) guarantees of mortgage loans and deposits of housing finance institutions; (2) regulation of mortgage product specifications and availability;

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(3) regulation of housing finance institutions; (4) regulation of the tax treatment of mortgage loans and funding; (5) regulation of mortgage and deposit interest rates; and (6) educational or informational programmes.

Guarantees of Mortgage Loans and Deposits of Housing Finance Institutions Government deposit guarantees, by their nature, are pri­ marily aimed at reassuring investors that their deposits are secure (see article Housing Finance: Deposit Guarantees), while mortgage insurance programmes ensure that lending institutions continue to lend to bor­ rowers with more risky credit ratings (see article Mortgage Payment Protection Insurance). The massive growth in the US financing system (and all other stable generic housing finance systems), since the Second World War, has come mainly as a result of the perception that investors and lending institutions run very little risk in terms of expected long-term returns. Discussions on the efficiency or effectiveness of this type of intervention often are difficult to quantify as, in practice, it is abun­ dantly clear that where governments do not offer explicit guarantees or insurance, investors still assume that impli­ cit guarantees exist, leading to significant moral hazard issues. The best-known and longest-running loan guarantee programme is the US FHA mortgage insurance for sin­ gle-family homes (see article Access and Affordability: Mortgage Guarantees). However, the Federal Department of Housing and Urban Development alone administers at least another 20 programmes, while pri­ vate mortgage insurance (PMI) institutions also provide insurance for the more creditworthy and least risky mortgage loans. Insurance is an area where adverse selection means that public-guaranteed loan pro­ grammes may always be needed to ensure a sufficient supply of affordable funds to poorer sections of society, first-time buyers, or single-family households with small deposits. US mortgage insurance is available for almost all borrowers, housing, and locality, with no restrictions on loan type. Within the other types of finance systems in developed housing markets, countries such as Germany often attempt to limit mortgage insurance by borrower, mort­ gage product, or housing construction. In the United Kingdom, retail deposit insurance was also limited to a set amount per investor per institution. However, guar­ antees of mortgage lending institutions or deposits, where not stated or legislated explicitly, are often implicit as demonstrated by the recent US bailout of the privatised GSEs Fannie Mae and Freddie Mac, the UK Northern Rock and Bradford and Bingley Building Societies, the

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Irish Anglo Irish Bank, and the German Hypo Real Estate and BayernLB banks. Currently, some governments, such as the German Federal government, are either discussing or introducing legislation to persuade the financial markets that these types of interventions, which could be exploited through moral hazard arbitrage, are the exception and not the rule. In this case, it remains to be seen whether investors will continue to fund these countries’ housing markets with the same enthusiasm and at the same spreads. Regulation of Mortgage Product Specifications and Availability Regulation of mortgage specifications is an intervention type used by all regulators. This arises because each type of generic system has its own intrinsic operating charac­ teristics with weaknesses and strengths which can be exploited by investors and/or lenders. Unregulated inno­ vation resulting in the large-scale adoption of popular mortgage products by either investors or borrowers could result in medium- to long-term damage to a coun­ try’s housing finance system. Conversely, arguments also exist that unregulated innovation, in a Darwinian model of evolution, allows more stable mortgage products to prosper and survive. It is not always clear whether the latter argument considers the existence of implicit gov­ ernment guarantees. In any case, because of the very long durations involved with mortgage products but the shortterm consequences to investors and borrowers when cat­ astrophic loss threatens, all governments prefer not to take unnecessary risks and impose a degree of regulation on product specifications and to a lesser extent on availability. Lighter-handed regulators such as the United Kingdom and United States tend to allow a greater vari­ ety of mortgage products and specifications compared to heavier-handed regulators such as Canada, France, and Germany. Since the recent US subprime crisis, the avail­ ability of different mortgage products in all countries has been significantly reduced with the more light-handed regulated countries such as the United Kingdom being particularly affected. This is undoubtedly a sensible reac­ tion aimed at reducing investors’ risk within a country’s finance system due to the complexity of the product offerings but with knock-on effects to the ability of bor­ rowers to access housing finance with suitable terms and conditions. Regulation of Housing Finance Institutions All housing finance institutions in every country are regulated under one or more pieces of national legislation. Institutions operating in different countries either for the purpose of lending or raising funds may be subject to

other countries’ regulations or, as in Europe, to EU direc­ tives. In many cases, institutions may also be subject to regulations set by different regulatory bodies in the same country, for example, one agency who may regulate on behalf of borrowers’ interests and another on behalf of investors’ interests. Regulation within the same country may be differentially applied to different institutions involved in the housing finance market depending on a range of factors. The rationale for regulation is straight­ forward in that it is in the interest of all stakeholders that the rules of the game are agreed upfront, expectations do not change significantly over the duration of the loan or investment, and that risks are minimised as much as possible. In the United Kingdom, regulations will differ signifi­ cantly for (mutual) building societies such as the Nationwide Building Society compared to other (limited) institutions such as HBOS or the Newcastle Building Society. These regulations impose different capital ade­ quacy rules or restrictions on the amount of wholesale funds in comparison to retail funds. In the current global financial market, many institutions have avoided these regulations by ‘shopping around’ for more friendly reg­ ulatory regimes. One such example is the case of (German) Hypo Real Estate who were fatally weakened and bailed out by the German Federal government as a result of trading by its subsidiary Depfa Bank plc, who were based in Dublin and initially profited from lax Irish regulatory oversight. Some of the problems that have befallen UK building societies arose because they found it increasingly difficult to attract sufficient funds for expansion – a similar problem to the US S&Ls in the 1980s. As a result, many larger UK building societies demu­ tualised in the last two decades moving from one type of regulatory regime to another. Capital adequacy is regulated by transnational institutions such as Basel I and II. Institutions operating in European countries are subject to various directives such as Solvency II for capital adequacy or Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) for insur­ ance supervisors. Often, these different regulatory regimes are complementary and do not impose too oner­ ous a burden in terms of extra transaction costs or reduction in trading. Interventions are agreed and nego­ tiated by all parties who then have some years to implement the reporting systems. Regulation of the Tax Treatment of Mortgage Loans and Funding The rationale for the favourable tax treatment of mort­ gage loans and funding is generally to reduce perceived (financial) entry or exit barriers and to encourage bor­ rowers or investors to make decisions which benefit society or particular social groups within a society. Tax

Mortgage Markets: Regulation and Intervention

treatment can affect both principal and interest cash flows via either income or capital gains tax. Tax treatment of mortgages and funding therefore differs from government to government depending on a wide range of factors – social, political, and economic. The favourable treatment of housing and mortgage costs within a tax system can introduce considerable distortions into countries overall tax systems and considerably influence property prices. The United States is particularly active in using its tax code to engineer particular results often influenced by the focused efforts of lobby groups. The deferral of capital gains on home sales, added to the US tax code in 1951, was adopted to shield homeowners from tax liability when unforeseen circumstances such as job changes required them to sell one house and buy another. Significant reductions in tax capital gains on home sales for people aged 55 and older were instituted largely to reduce tax liabilities for older persons who decide to become renters or to purchase smaller homes. The United States also allows its citizens to deduct mortgage interest on their primary residence from their income tax. The Congressional Budget Office (CBO) suggested that up to one-third of owner-occupied housing would not have been built if tax benefits had not lowered the after­ tax cost of buying a house far below the cost of other investment assets. Further research also indicated that households would buy less expensive houses in the absence of tax subsidies and that housing prices might be lower. However, these benefits come at a considerable price as the CBO also suggested that marginal tax rates could be at least 10% lower if the deductions for mort­ gage interest and property taxes, the deferral and exclusion of capital gains for home sales, and the use of tax-exempt bonds for owner-occupied housing were eliminated. The United Kingdom withdrew its residential mort­ gage relief regime Mortgage Income Relief At Source (MIRAS) in 2000 but still allows capital gains tax relief exemptions on primary residences. At the time of with­ drawal, around 11 million households made use of the income tax relief at a cost of £1.5 billion a year to all UK taxpayers. The UK treasury estimated that the main ben­ eficiaries from the withdrawal of tax relief were, apart from taxpayers, lenders who were estimated to have saved at least £50 million in reduced tax administration. Germany allows private individuals to deduct mort­ gage interest, while capital gains tax is not applicable except for a residential property sold within 10 years of its purchase. Similar tax regimes exist in Denmark, France, Italy, and most other European countries. VAT or value-added tax is levied on new housing in some European countries such as France, Italy, and Belgium but exempted in most others such as Germany, the United Kingdom, and Denmark.

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Income tax relief on mortgage payments is there­ fore a particularly significant (and costly) intervention in its magnitude and effect on consumer and lender behaviour and is discussed in more detail elsewhere (see article Access and Affordability: Homeowner Taxation). Regulation of Mortgage and Deposit Interest Rates Interest rate subsidies, guarantees, or control of mortgage and deposit interest rates is a type of housing finance intervention used by every country (see article Mortgage Interest Rate Regulation). The rationale, how­ ever, can be twofold and much debate rages over the longterm benefits of such regulation and intervention. First, the motivation can be to encourage both inves­ tors and borrowers to participate in the housing market as discussed in the previous subsection, with central banks and governments exercising volume and price control through interest rates. Effectively, central banks control mortgage deposit interest rates by setting general market rates at which they will lend to its institutions. The interested reader is referred to the 2010 discussion by B. S. Bernanke of the US Federal Reserve on the topic of monetary policy and the housing bubble. Bernanke’s conclusion is that the US subprime crisis was a result of the failure of regulation and intervention that was too lax. Second, and perhaps more prevalent in the current economic times, subsidising mortgage interest instead of forgiving or reducing mortgage principle is seen as a ‘less’ (moral hazard) dangerous way of helping distressed bor­ rowers continue to live in their properties and avoid foreclosure. The current US$43 billion Home Affordable Mortgage Program (HAMP) is an example of the latter approach, subsidising the interest payments of up to 5 million US homeowners. It aims for a mortgage payment which sustains an affordable 31% debt-to­ income (DTI) ratio. This is achieved by a reduction in interest rates (on average, from 7.58 to 2.92%) but no modification of loan principle. The interested reader is again referred to the excellent reports from the COP on this topic and the intensive arguments both for and against any type of mortgage interest subsidisation. As mentioned earlier, the contract savings-type sys­ tems such as the Bauspar subsidise and regulate both mortgage and deposit interest rates. Part of the demise of the US S&Ls was due to unintended regulatory effects of Regulation Q which limited the rates thrifts could pay on their deposits. Educational or Informational Programmes Intervention by governments in the form of education or information programmes has been identified as a very

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Mortgage Markets: Regulation and Intervention

specific and cost-effective method of intervention in mortgage markets (see article Education Programmes for Home Buyers and Tenants). UK commentators have identified mortgage product knowledge (or lack of) as a critical factor in the reason why consumers might choose suboptimal mortgage products. Similar conclusions have also been drawn in the United States by the COP prompted by the significant numbers of expensive subprime mortgages that were sold to consumers who would have easily qualified for cheaper prime mortgages. Many current US mortgage intervention programmes, espe­ cially directed at minorities, stress the importance of information and education in helping people decide the level of mortgage, down payment, and ongoing affordability. Good education and information may help mitigate problems caused by opportunistic agents or intermediaries in large and sophisticated mortgage markets. Targeted financial or social support to specific social groups threatened by mortgage foreclosure is a well-used and practised intervention type which is addressed in much more detail elsewhere in the encyclopaedia (see article Foreclosure Prevention Measures).

Future Intervention Trends The amount and mix of intervention in all housing sys­ tems will change as a result of the current worldwide recession caused by the US subprime crisis. Existing national lending and regulatory housing institutions will, if ‘history repeats itself’, fundamentally change. New transnational institutions may well be set up and existing institutions such as Basel, IMF, or the World Bank Group strengthened. These changes will be gradual, involving lengthy study and negotiation between national govern­ ments and lobby groups that could take decades before reaching a conclusion. However, no fundamental changes should be expected in how regulation is shaped or the broad intervention approaches that regulators may take. In the United States, both the COP and the Federal Reserve have already suggested that more and better enforced regulation is required. Other (banking and pen­ sion) lobby groups suggest that a market-efficient focus should be adopted. Yet more groups suggest that a socially efficient focus with better outcomes for poorer members of US society should be adopted. The debate will be long and the outcome unpredictable. The US government is in the unique position of being one of the few national governments with the resources to provide almost unlim­ ited housing finance guarantees. EU regulators (e.g., EU Government Expert Group on Mortgage Credit) and institutions will, due to Europe’s large 600 million population, widespread currency union, and strict competition directives, almost certainly have a

greater input into the coming debate than previously permitted. Until now, as already noted, EU regulators have tended to intervene by issuing directives on minimal consumer informational specifications for mortgage pro­ ducts. However, it is now intervening using competition directives to ensure that national financial guarantees for failing housing institutions do not give unfair competitive advantages to other national or EU lending institutions. Several examples already exist in the immediate after­ math of the crisis, whereby some Irish, Dutch, Belgian, German, and English lending institutions must divest and meet stringent capital adequacy criteria. Because of the massive and relatively unimpeded flow of capital, transnational institutions such as the G20 or BIS may well, via its working groups or yet to be formed operating arms, be better placed to oversee and regulate certain aspects of housing finance markets. Both the G20 working group – Enhancing Sound Regulation and Strengthening Transparency – and the BIS group have already indicated their intentions to concentrate more on consumer demand factors rather than investor supply factors and have suggested a greater focus on LTV ratios and loan loss provisioning standards. The working groups’ statements that many national institutions and products were either unregulated or lightly regulated (e.g., Icelandic, Greek, and Irish banks) may be indicative of future heavy-handed intervention. Current governmental efforts to agree a worldwide banking tax may well be a precursor to the more difficult issue of harmonising worldwide housing markets. Although this role and direc­ tion will meet with scepticism from many quarters, what is unarguable is that these transnational institutions may be the only ones with sufficient capital adequacy, to offer investors sufficiently credible guarantees that will allow all borrowers to finance their future homes. See also: Central Government Institutions; Contract Saving Schemes; Covered Bonds; Education Programmes for Home Buyers and Tenants; Financial Deregulation; Financial Regulation; Foreclosure Prevention Measures; Government Sponsored Enterprises in the United States; Housing Finance: Deposit Guarantees; Housing Market Institutions; Housing Policy: Agents and Regulators; Mortgage Innovation; Mortgage Insurance; Mortgage Interest Rate Regulation; Mortgage Market Functioning; Mortgage Market Regulation: Europe; Mortgage Market Regulation: North America; Mortgage Market, Character and Trends: Africa; Mortgage Market, Character and Trends: Brazil; Mortgage Market, Character and Trends: China; Mortgage Market, Character and Trends: France; Mortgage Market, Character and Trends: Germany; Mortgage Market, Character and Trends: India; Mortgage Market, Character and Trends: Italy; Mortgage Market, Character and Trends: Japan; Mortgage Market, Character and Trends: Korea; Mortgage Market,

Mortgage Markets: Regulation and Intervention Character and Trends: Mexico; Mortgage Market, Character and Trends: United Kingdom; Mortgage Market, Character and Trends: United States; Mortgage Payment Protection Insurance; Policies to Address Spatial Mismatch; Policies to Promote Housing Choice in Transition Countries; Subprime Mortgages.

Further Reading Basel Committee on Banking Supervision – The Joint Forum (2010) Review of the Differentiated Nature and Scope of Financial Regulation: Key Issues and Recommendations. ISBN: 92-9197­ 566-4. Bernanke BS (2010) Monetary policy and the housing bubble. Speech at the Annual Meeting of the American Economic Association. Atlanta, GA, USA, January 3. Blankart CB (1990) Strategies of regulatory reform. In: Majone G (ed.) Deregulation or Re-regulation? Regulatory Reform in Europe and the United States, pp. 211–222. London: Pinter. Calomiris CW, Kahn CM, and Longhofer SD (1994) Housing finance intervention and private incentives: Helping minorities and the poor. Journal of Money, Credit and Banking 26(3): 634–674. Congressional Oversight Panel (COP) (2009) Foreclosure crisis: Working toward a solution. Congressional Oversight Panel. Publication No. 110-343. Washington, DC: Government Printing Office. Diamond BD and Lea MJ (1992) The decline of special circuits in developed country housing finance. Housing Policy Debate 3(3): 747–777.

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Foster CD (1992) The dangers of mixing social with economic regulation. In: Privatisation, Public Ownership and the Regulation of Natural Monopoly, ch. 51, p. 291. Oxford: Blackwell. G20 Working Group 1 (2009) Enhancing sound regulation and strengthening transparency. Final Report. Department of Finance Canada 035. Ottawa: Canadian Ministry of Finance. Government Expert Group Mortgage Credit (GEGMC) (2008) White paper on the integration of EU mortgage credit markets. COM (2007) 807. Brussels: Commission of the European Communities. Immergluck D (2009) Foreclosed: High Risk Lending, Deregulation and the Undermining of America’s Mortgage Market. New York: Cornell University Press. Kay J and Vickers J (1990) Regulatory reform: An appraisal. In: Majone G (ed.) Deregulation or Re-regulation? Regulatory Reform in Europe and the United States. London: Pinter. Turner A (2009) The Turner Review: A Regulatory Response to the Global Banking Crisis. Financial Services Authority. London: FSA. UNECE (2005) Housing Finance Systems for Countries in Transition: Principles and Examples. United Nations Publications. ISBN: 92-1­ 116923-2. US Department of Housing and Urban Development (2006) Evolution of the US Housing Finance System. Washington, DC: US HUD.

Relevant Websites www.fsa.gov.uk – UK FSA (Financial Services Authority). www.hud.gov – US Department of Housing and Urban Development (HUD) www.fanniemae.com – US Fannie Mae.