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UK N.I.E.R. A Better Housing Finance System - Feb 2013


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UK National Institute of Economic and Social Research: A Better Housing Finance System Review - Feb 2013

UK National Institute of Economic and Social Research: A Better Housing Finance System Review - Feb 2013

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  • 1. National Institute Economic Review A Better Housing Finance System Angus Armstrong National Institute Economic Review 2013 223: F4 DOI: 10.1177/002795011322300109 The online version of this article can be found at: Published by: On behalf of: National Institute of Economic and Social Research Additional services and information for National Institute Economic Review can be found at: Email Alerts: Subscriptions: Reprints: Permissions: >> Version of Record - Feb 4, 2013 What is This? Downloaded from by guest on March 2, 2013
  • 2. F4 National Institute Economic Review No. 223 February 2013a better housing finance systemAngus Armstrong*Housing finance has long been recognised as a particular must ensure that the infrastructure for capital marketsweakness of the UK economy, associated with demand supports an efficient allocation of capital from a macro-and house price booms and busts for decades. The lack financial perspective. This matters for financial stabililtyof regulatory response to innovations in housing finance and competition and therefore falls squarely within theover the past two decades has allowed the system to remit of the Financial Policy Committee.become even worse. There remains a particular shortageof affordable long-term fixed rate mortgages, the supply Financial infrastructureof mortgages is influenced by the animal spirits of high Two revolutions occurred in finance in the 1980s. Theyield investors and wholesale funding vehicles directly first, emphasised by Morrison and Wilhelm (2010),contributed to the fragility of banks’ balance sheets. was in information technology where batch processing meant that the loans of retail banks could be codedIn a well-functioning financial system real economic and traded. This shifted the craft of banking from old-transactions are matched, as far as possible, by funding fashioned qualitative credit assessments through localwith similar characteristics. So, for example, long term branches to assessments based on what can be measured,utility investment projects are often funded by long aggregated and benchmarked. The emergence of globalterm debt contracts. In most advanced economies the capital markets for syndicated loans and early forms ofsame is also true of mortgages; the preferences of young asset-backed securities were dominated by banks withborrowers are matched by those of older savers through large capital bases and expertise in loan origination andlong term contracts, often on fixed interest rate terms. evaluation. The second was an intellectual revolutionThe UK stands out as an exception. Prior to the crisis where efficient markets and rational expectations cameour long term savings funds, such as pension funds and to dominate finance theory. It followed that privatelife assurance products, together worth around £1.8 capital markets would allocate resources efficientlytrillion, invested in only 5 per cent of all our mortgage and therefore that there was less justification for statebacked securities. And with over 10,000 retail mortgage intervention. This provided the rationale for deregulation,products on offer, there was negligible take-up of long- in particular the removal of barriers between differentterm fixed rate mortgages. types of financial firms.Putting the needs of households, as both borrowers and The combination of these two events triggered a wavelenders, at the centre of our financial system requires of mergers, as banks sought to build operations thatreform of the retail and wholesale mortgage markets. straddled retail funding and wholesale capital markets.The Miles Review (2004) looked at some of the market Investment banks secured the large capital bases theyfailures in the retail market. This commentary looks needed to increase transaction volumes, and retailat the market failures in the mortgage securitisation banks and building societies secured the know-how tomarket and presents the case for reform. This requires a deploy their existing loan books to create new financialchange in the mindset of our regulators. The distinction products. The new global banks created waves of newbetween bank and capital market based finance is now assets through financial engineering using existingredundant. They are fully integrated and therefore collateral from the loan books of traditional banks.regulation cannot be targetted only at banks. Regulators These securities are mostly incomplete contracts, in the* National Institute of Economic and Social Research. e-mail: Downloaded from by guest on March 2, 2013
  • 3. Armstrong A better housing finance system  F5sense that many of the embedded features are difficult infrastructure is updated and can be introduced hedge and cannot be valued across all possible states. Financial regulators failed to upgrade the financialThey therefore straddle the traditional domains of infrastructure to take account of the integration of banksinvestment and retail banking.1 These innovations ended and capital markets.the earlier neat distinction between bank-based financeand market-based finance. Shin (2010) points out that RMBS and economic imbalancesthis is the first post securitisation crisis in which banking Issuance of UK Residential Mortgage Backed Securitiesand capital markets are closely intertwined.2 (RMBS) began in the early 1990s. The market was small and most securitisations were issued by non-bankRegulators abrogated their responsibility and allowed financial institutions which competed with the largemarket participants to develop the infrastructure for the bank franchises. The securities were in the form of ‘pass-new securities. Financial infrastructure includes, inter through’ securities where the cash flows of payments fromalia, disclosure requirements, legal status of contracts, the mortgage pass straight through to the investor. This isaccounting treatment and the structure of market making often characterised as the ‘originate-to-distribute’ modelfor securities. These rather technical issues have long of securitisation.been recognised as profoundly important to how marketsevolve and economic efficiency. Douglass North (1994) From 2000 RMBS issuance became a very significanthas suggested that the creation of an appropriate financial source of mortgage finance in the UK. In 2007 RMBSinfrastructure was central to economic development in funded almost half of all net new mortgages with the totalthe West.3 Responsibility for setting benchmarks was stock of outstanding securities reaching around £400bn.accepted by industry organisations such as the British However, the structure of the RMBS issued changed inBankers Association and European Bankers Federation, very important ways. They were no longer pass-throughand for creating appropriate contractual frameworks by securities but issued using master trust technologythe International Swaps and Derivatives Association.4 imported from the securitisation of credit card receivables in the US. The trusts are connected to the issuing bankAs a consequence of the laissez faire approach to the and are very economical in that they allow many issues offinancial infrastructure, new global banks are able to securities from a single vehicle.create new securities, make markets in them and eventake proprietary positions in the same securities. Prices The role of RMBS in UK economic imbalances is alludedare disclosed on a party-to-party basis and for those to in Barwell and Burrows (2011), who compare twosecurities which cannot be valued by a third party (level 3 periods of rapid financial expansion. The first wasassets) the bank can set its own valuation. Only haircuts associated with the run-up in equity prices in the dot-limited the number of times the same security could be com boom. As most of the funds were channelled fromre-used in collateral backed intermediation (e.g. repo outside the banking system e.g., from equity investments,and some derivative markets).5 The new market place when asset prices fell there was only a secondary impactallowed bankers to extract rents through the control on banks. The second period, 2001–7, was associatedof information and greater leverage from extending the with rapid household borrowing, rising house priceschain of intermediation. The result was an egregious and current account deficits. The authors show that themisallocation of credit and vulnerability in financial household sector had a net lending (dis-saving) deficit ofinstitutions. £175bn over this period. However, households borrowed £782bn from the banking sector while only contributingThe importance of infrastructure is illustrated by Robert £370bn in deposits. The shortfall of £412bn wasMerton’s old analogy to innovation and train networks. covered by funding from the wholesale markets. FigureWhen a faster train is invented this is a beneficial 1 shows the rapid rise in the share of bank lending to theinnovation. But if the rail track infrastructure is unable household sector funded by handle the faster trains this becomes a vulnerability tothe system. If the new train crashes this is a problem for The converse of the reliance on wholesale fundingthe company and passengers who, perhaps unknowingly, became known as banks’ customer funding gap. This istook the risk. If the track is also damaged, then there the total customer loans less their deposits, which mustis an externality on all others users of the network. be funded from the wholesale markets. This reliance onThe best solution is neither to ban the faster train nor wholesale funding is widely recognised as one of theallow them to use the outdated track. The faster train main vulnerabilities in the banking sector in the run-upmust be introduced when – but only when – the track to the crisis (especially in the case of Northern Rock). Downloaded from by guest on March 2, 2013
  • 4. F6 National Institute Economic Review No. 223 February 2013Figure 1. Securitised lending as a share of bank lending to Figure 2. Major banks’ customer funding gaphouseholds and corporations 700 30 600 25 500 20 400 Share in per cent Billions, £ 300 15 200 10 100 5 0 1997 1999 2001 2003 2005 2007 -100 0 1997 1999 2001 2003 2005 2007 Customer funding gap Customer funding gap adjusted for securitisation (a) Households Non-financial corporationsSource: Bank of England. Source: Bank of England, Financial Stability Report, 2008. Note: (a) Customer funding gap less securitised debt.Figure 2 shows the customer funding gap both in total inter alia on the actual maturity of the mortgages, whichand excluding securitisations. The difference between the becomes the duration of the security. Estimating thetwo measures shows the extent to which the customer actual maturity of mortgages accurately is complicatedfunding gap was covered by securitisations. because the tendency to pre-pay differs by households and economic conditions, in particular interest rates.7If the securities issued were the old pass-through In the UK the task is complicated even further by thesecurities then this gap would not have appeared. The predominance of floating rate (or short-term fixed rate)mortgages would no longer be on bank balance sheets mortgages and the sheer diversity of products available.and no longer need on-going funding. The risk would Prior to the crisis over 10,000 different mortgagehave entirely passed to the investor. However, with products were available.8the new securities the banks were exposed throughtheir obligations to the master trust vehicles and their The cash-flows associated with pools of heterogeneousholdings of RMBS assets. Many securities were bought mortgages are unpredictable and not well suited toor funded by UK banks seeking to improve the returns investors who prefer predictable cash-flows. Theon their treasury book. Shin makes this point clear: master trust technology is an ingenious partial solution“the reason for the severity of the crisis lies precisely to this problem as it creates bullet-style securities (anin the fact that the bad loans were not all passed on anticipated 1–5 year maturity with a coupon and singleto final investors. Instead the ‘hot potato’ was sitting final payment) from a large pool of constantly changinginside the financial system, on the balance sheets of the mortgages. Note that while the securities are anticipatedmost sophisticated financial institutions.”6 to be 1–5 year maturity, the legal term to maturity of the underlying mortgages is still 25–30 years. TheRMBS and bank vulnerability trust is a financial structure which delivers all stagesMortgages are usually long-term contracts where the of a credit intermediation process, including credit,borrower has an option to pre-pay at any time, perhaps liquidity, currency and maturity transformation. This isdue to a home move or decision to re-finance the a complex process and requires the sponsoring bank tomortgage. When mortgages are securitised in traditional provide ongoing liquidity support and credit recourse ifpass-through securities the value of the security depends the mortgages underperform. Downloaded from by guest on March 2, 2013
  • 5. Armstrong A better housing finance system  F7The investor base is largely limited to those seeking short- ‘fire-sales’ and no-trading, which contributed to theduration assets, who understand complex structured vulnerability of the sponsoring bank. There are twoproducts and have an ongoing relationship with the information based market failures for this outcome:sponsor. Approximately 60 per cent of buyers wereleveraged accounts such as banks, hedge funds and • Information asymmetries in the wholesaleconduits and the same proportion was sold to foreign market,currency investors. This has important implications. • Information asymmetries in the retail market.First, the maturity mismatch between the mortgages and the issued notes resides in the trust (as does the Long term investors need to convince their trusteesrisk inherent in a cross-currency swap). Second, the that RMBS is an established and well understoodbuyers are already ‘within the financial system’ rather asset class. Yet the complexity, heterogeneity andthan an additional source of funds. Third, leveraged opacity of the issuing vehicles and securities creates ainvestors are measured on a marked-to-market basis fundamental difference in information between issuers,and therefore may respond to falling prices by selling market makers and traders or short-term investorsassets to maintain their capital. This lack of diversity (‘insiders’) and the natural long-term domestic investorof buyers means that the assets are vulnerable to ‘fire base (‘outsiders’). Despite the introduction of the EUsales’ (too few potential new buyers even at very low Prospectus Directive in 2005, the offer documentsprices). Allen and Gale (2009) refer to markets with differ for each issuer (reflecting the different trusta lack of diversity investors as ‘limited participation’ mechanisms) and the numerous supporting documentsmarkets.9 for interest rate, funding and currency swaps etc. mean that there is a very high information barrier for non-The master trust structure can also contribute to specialists.11 While this is inevitable given the design ofthe vulnerability of the sponsor bank. The maturity the securities, it was often taken to extremes.12 Theremismatch between the underlying mortgages and is even a lack of agreed basic definitions across issuersissued securities is managed by the sponsoring bank for standard concepts such as ‘arrears’ or even whathaving the option to call or repay the notes at set dates constitutes a ‘prime’ mortgage. Loan level data wasbetween 1–5 years. Sponsoring banks fund these calls only provided to the credit rating agencies and not toby issuing new securities prior to the call date or by the market, preventing independent verification of theextending liquidity to the trust. However, if investors characteristics of the mortgage pool. Market makersperceive that the securities may not be called – which post securities prices which are ‘indicative’ rather thanwould crystallise a mark-to-market loss from the ‘last traded prices’ thus leading to uncertainty whensudden extension in maturity – this can bring about the prices are volatile.13very event that they fear. In distressed circumstances,investors’ fear of extension will lower RMBS prices, In each instance the lack of infrastructure leaves anmaking securitisation a less economical funding vehicle. asymmetry of information between the ‘insiders’ andThis in turn can prevent refinancing and therefore the ‘outsiders’ who are the more natural counter-precipitate the very extension risk they feared. parties. This is merely a new application of Gresham’s Law which has been central to financial markets sinceInformation asymmetries the sixteenth century. Akerlof (1970) famously showedThe main weakness of the RMBS market is that the how asymmetries of information in the used car marketsecurities are issued to meet the demand from mostly can lead to socially sub-optimal outcomes and evenshort-term, leveraged and often overseas investors who closing markets. Pagano and Volpin (2010) show howthey frequently engage with. This creates a ‘limited conventions in securitisation markets are in the interestsparticipation’ market and a maturity mismatch between of issuers and primary market makers while liquidlegal maturity of the mortgages and the securities. The secondary markets are a public good and hence under-lack of robust market infrastructure meant information provided by the market.14 Real and perceived imbalancesproblems prevented a wider investor base from of information undermine markets, especially in timesdeveloping, even as securities prices fell way below of stress leading to illiquidity. This also explains why,reasonable asset values. The maturity mismatch is worse after numerous attempts, market participants are unablethan mortgages being funded by bank deposits because to establish a ‘market-based’ solution. It is difficult forwhen prices fall leveraged investors are constrained to issuers to overcome investors’ suspicions and crediblysell further to protect their capital.10 Bank depositors demonstrate that structures have not been created in lineare unconstrained and insured. The outcome was with issuers’ private incentives. Downloaded from by guest on March 2, 2013
  • 6. F8 National Institute Economic Review No. 223 February 2013The second hurdle in attracting long term domestic The good news is that it is also achievable. Prior to theinvestors is that they prefer longer duration assets. crisis, plain vanilla pass-through securitisation marketsLong-term fixed rate mortgages (with minimal early had operated in other countries for over three decades.repayment charges) would benefit investors by creating Other countries with similar institutional frameworksmore duration and, importantly for households, by have also succeeded. Australia has a well functioningminimising the interest rate risk they cannot otherwise mortgage securitisation markets with simple pass-hedge (which contributes to the volatility of consumer through securities where the risk is passed to investorsspending).15 Surveys by the Council of Mortgage with no residual risk in the banking system. CanadaLenders have suggested that households would, in has a more elaborate state-owned securitisation vehiclefact, prefer these mortgages.16 Yet the UK is unique in which accepts RMBS containing insured and conforminghaving a negligible market share of long-term fixed rate mortgages and transforms them into state-backedmortgages, in contrast to North America, Continental homogeneous bonds. This removes all informationEurope and Asia. The Miles Review (2004) suggests that asymmetries, lowers the cost of mortgages and increasesbanks cross-subsidise from existing to new customers and competition in the lending market.17 There is aare biased towards repeat transactions, which distorts contingent liability to the state, but the insured mortgagesthe price of longer-term products. It is also possible that have such little risk that the state has this contingentthere is an infant industry argument – until there are liability through the banks anyway. As the flip-side offixed rate mortgages there can be no information on pre- the securitisation method is the bank funding model, itpayment patterns to assist investors with hedging the comes as no surprise that Australia and Canadian banksduration risk. have proven more robust.Policy options What would be an appropriate model for the UK? ThisThis commentary argues for a macro-financial goes back to Merton’s analogy with the train track. Toapproach to financial stability. The objective is to have reduce asymmetric information a regulated standardiseddomestic long-term investors participate in mortgage RMBS pass-through vehicle would be outlined with clearsecuritisations. This would match the underlying conditions and limits on the types of mortgages whichpreferences of borrowers and lenders for long term and could be included. The terms of the vehicle could only befixed rate contracts (index linked would be even better). changed by the regulator, presumably after learning fromAt the peak of the market our long term domestic savings the experience from non-regulated RMBS. To be surebase of pension funds and life assurance companies that the securities would qualify as an investable assetmanaged around £1.8trn but accounted for only 5 per class, the regulator would set disclosure requirementscent of the RMBS investor base. In the past, this scarcity depending on the needs of the intended investor base.of suitable long term sterling fixed rate securities has They achieve this in Holland and Australia and evenmeant that such investors have typically held much Northern Rock’s Granite bonds now trade as pass-higher foreign equity allocations than their overseas through securities perfectly well.18 Detailed loan levelcounterparts. data on the mortgages within the securities would be available in a public data repository as a public goodThere would be three benefits from this better matching to allow long term domestic investors to manageof borrowers and investors. First, the better matching prepayment risk.of maturity would mean that there is less systemicrisk from old-fashioned bank runs, slower capital Mortgage lenders in the retail market of course seek tomarket runs or encumbering assets through covered differentiate their products. However, we need to gobond issuance. Second, the supply of housing finance beyond caveat emptor; we know enough about biaseswould be less subject to the animal spirits of high yield and imperfect decision making to understand that someinvestors as long-term investors are not subject to the products are more predatory than welfare enhancing.same accounting or capital constraints. Third, this will For most households this is by far the most importantallow challenger banks to have access to a new investor financial transaction in their life and the aim of regulationbase and so allow more competition against incumbent should be better decision making. This is not always thebanks. Moreover, if reform is not introduced, past same as profit maximising. Just as in other markets, suchmethods of securitisation cannot be un-invented – so as for food products, clear and transparent labelling ofthese markets are likely to re-emerge with the same the risk characteristics is possible. It would be necessaryvulnerabilities. Reform is therefore both necessary and to introduce a ‘conforming mortgage contract’ whichdesirable. sets out conditions (such as loan to value etc.) and to Downloaded from by guest on March 2, 2013
  • 7. Armstrong A better housing finance system  F9introduce better stress testing on the ability to pay based 11 Murphy (2012).on total household credit exposures which must be met 12 There was often very little time between posting the offer documents and subscription deadline.for inclusion as regulated pass-through securities. 13 This is the same as past practice in the US corporate bond market. In 2002 a system of reporting consistent prices basedOnce these securities are permitted, given the low credit on last trades called TRACE was introduced. While this wasrisk and contribution to financial stability, they could heavily resisted by market makers, the outcome appears tobe favourably treated with respect to access to the Bank have been a success in terms of improving market liquidity. 14 See Pagano and Volpin (2010).of England’s liquidity facilities. The regulated RMBS 15 See Campbell and Cocco (2003).would need to be treated the same as covered bonds in 16 See Housing Finance Review (HM Treasury 2008), p. 41.discussions on eligibility in banks’ liquidity buffers. It 17 The state conduit does not hold securities unlike Fannie Maemay be necessary to begin with a buying programme, and Freddie Mac in the US which held large inventories of sub-such as the Australian Office of Financial Management prime securities. 18 After the non-asset trigger event in November 2008 theRMBS investment programme or quantitative easing extension risk was crystallised and Granite bonds transferredthough buying credit securities as in the US. A more from bullet style to pass-through securities.radical alternative would be to introduce a Canadianstyle agency. Interventions on this scale to addressspecific market failures are not therefore subsidies. referencesFinally, since this form of securitisation transfers risk to Akerlof, G.A. (1970), ‘The market for ‘lemons’: quality uncertaintythe investor, ring-fenced banks ought to be encouraged to and the market mechanism’, Quarterly Journal of Economics, 84 (3), pp. 488–500.use only this method of securitisation. This would allow Allen, F. and Gale, D. (2009), Understanding Financial Crises, Oxford,households to benefit from financial innovation without Oxford University Press.jeopardising the stability of a ring-fenced bank. Armstrong, A. (2012), ‘Restoring trust in banking’, National Institute Economic Review, 221, July, pp. R4–R10.notes Barwell, R. and Burrows, O. (2011), ‘Growing fragilities? Balance1 See Armstrong (2012) for further information. sheets in the Great Moderation’, Bank of England Financial2 Shin (2010) p152. Stability Paper, No. 10.3 See North (1994). Campbell, J.Y. and Cocco, J. (2003), ‘Household risk management4 ISDA is a trade body which oversees collateral intermediation and optimal mortgage choice’, Quarterly Journal of Economics, and derivatives. According to Katerina Pistor they successfully 118(4), pp. 1449–94. campaigned national governments so that net counterparty Claessens, S., Pozsar, Z., Ratnovski, L. and Singh, M. (2012), ‘Shadow balances prevail over other creditors which no doubt banking: economics and policy’, IMF Discussion Note 12/12. contributed to the growth of a $60tn market. Financial Services Authority (2011), Mortgage Market Review Data5 Claessens et al. (2012) estimate that on average one unit Pack. of collateral supported three times more collateral based HM Treasury (2008), Housing Finance Review, London, HMSO. intermediation (e.g. repo, swaps and CDO contracts). Miles, D. (2004), The UK Mortgage Market: Taking a Longer-Term6 Shin (2010) p.157. View, London, HMSO.7 In the US there is a sizeable cottage industry estimating and Morrison, A. and Wilhem, W. (2010), ‘Investment banking: past, hedging prepayment risk. present and future’, Journal of Applied Corporate Finance, 19(1).8 See FSA (2011). Comparing re-payment profiles of two Murphy, G. (2012), Speech to Euromoney EU Prospectus Directive mortgages in the context of life cycle income model is highly (PD) Conference, London. complex, see Campbell and Cocco (2003). This suggests that the North, D.C. (1994), ‘The evolution of efficient markets in number of products was more to do with exploiting information history’, Economic History EconWPA 9411005, available at problems than efficiency. Allen and Gale (2009) refer to this condition as a limited Pagano, M. and Volpin, P.0. (2012), ‘Securitization, transparency, and participation market. liquidity’, Review of Financial Studies, 25(8), pp. 2417–53.10 See Shin (2010). Shin H.S, (2010), Risk and Liquidity, Oxford, Oxford University Press. Downloaded from by guest on March 2, 2013