Aurora Borealis
1 May 2013 CFA Institute Journal Review

Mortgage Market Design (Digest Summary)

  1. Marc L. Ross, CFA

A well-functioning mortgage system is critical to a nation’s economic well-being, and an understanding of and experimentation with mortgage design could have positive long-term benefits. The author discusses mortgage market design using a multidisciplinary approach.

What’s Inside?

Residential mortgages are the largest liability in the finances of a typical household and a major portion of bank assets. Understanding design features of these contracts and how the United States can learn from other countries’ mortgage systems is the focus of the author’s research and analysis. Such a wide-ranging approach results in a more robust treatment and understanding of the seminal issues.

How Is This Research Useful to Practitioners?

The author argues in favor of a cross-disciplinary approach to gain better insight into the structure of mortgage markets.

Urban economics studies the impact of household decisions regarding location, ownership, and financing of a residence on other households in the same community. Financial distress and possible foreclosure can lead to neglect and declining house prices in a community. From the perspective of asset pricing, mortgages are risk-sharing contracts between the lender and borrower. The author reviews fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs)—the former are unaffected by interest rate changes and the latter are very much affected by them. Default risk is present with both contracts and can be accelerated by borrowing constraints and negative home equity, although default carries costs to the borrower (e.g., having to move and a blighted credit score). Unlike those in many other countries, U.S. lenders carry the risk of low house prices because borrowers have a put option on their house; they can walk away if they can’t pay their loan.

Behavioral finance studies borrowers’ financial decision-making processes in relation to personal circumstances. The author considers the effects of moving, degree of financial sophistication, and preferences for present consumption. He finds that FRMs create idiosyncratic risks, uncertainty over moving propensity affects prepayment risk, and information asymmetry can influence mortgage market structure, which all contribute to illiquidity in mortgage-backed securities. The degree of financial sophistication affects mortgage selection and the refinancing decision. Finally, home equity may lead borrowers to succumb to present temptation for consumption at the expense of long-term well-being.

Financial intermediation discusses how intermediaries fund mortgage loans. The author reviews deposit-finance lending, the securitized mortgage system, and covered bonds. Although deposit-finance lending encourages prudent lending by having lenders keep “skin in the game,” it suffers from the risks of liquidity and maturity transformation and potential incentive misalignment during the threat of a negative economic shock. His review of securitization includes an emphasis on the risks revealed in the 2007–09 financial crisis. The author includes a brief discussion of covered bonds and highlights their potential benefits and risks relative to the first two systems.

The macroeconomics of a country can influence its mortgage system. The author cites the Federal Reserve’s reluctance to raise interest rates, lest it create distress among mortgage lenders. Indeed, interest rate changes can affect both ARM and FRM borrowers differently.

Finally, the author briefly evaluates the causes of the recent credit debacle. Critical components were misaligned incentives and loose underwriting. The merits of mortgage modification are still unclear in the wake of so many foreclosures. He presents some potential alternatives to the standard FRMs and ARMs along with policy recommendations for greater transparency, but he does note that too much regulation could stifle innovation. He concludes with a review of the attributes of the current U.S. mortgage funding model and highlights the merits of the Danish covered-bond system as a possible alternative.

How Did the Author Conduct This Research?

The author draws on established literature from several different fields, arguing that insights from different areas of study are critical to a better understanding of mortgage systems and how they can be improved. He applies his conclusions to the U.S. mortgage market, particularly in light of its dysfunction during the 2007–09 financial crisis. Better regulation is needed in the form of consumer protection to facilitate transparency and ease of evaluating various mortgage types. Additionally, the author reviews current mortgage design and touches on suggested alternatives to the standard offerings of FRMs and ARMs. These alternatives are possible solutions to asymmetry and conflicts of interest that are inherent in the current system. He concludes with a discussion of the Danish mortgage system.

Abstractor’s Viewpoint

The topic of mortgages needs to include discussion of both the people who design them and those who use them. Any study of the topic that limits itself to a niche approach misses several critical components. The author draws a similar conclusion and takes a far-reaching look at essential disciplines that underpin the functioning of mortgages. Events of the past five years have made it an opportune time to revisit mortgage market design in the quest for a more efficient housing system.

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