A Better Housing Finance System
Armstrong, Angus, National Institute Economic Review
Housing finance has long been recognised as a particular weakness of the UK economy, associated with demand and house price booms and busts for decades. The lack of regulatory response to innovations in housing finance over the past two decades has allowed the system to become even worse. There remains a particular shortage of affordable long-term fixed rate mortgages, the supply of mortgages is influenced by the animal spirits of high yield investors and wholesale funding vehicles directly contributed to the fragility of banks' balance sheets.
In a well-functioning financial system real economic transactions are matched, as far as possible, by funding with similar characteristics. So, for example, long term utility investment projects are often funded by long term debt contracts. In most advanced economies the same is also true of mortgages; the preferences of young borrowers are matched by those of older savers through long term contracts, often on fixed interest rate terms. The UK stands out as an exception. Prior to the crisis our long term savings funds, such as pension funds and life assurance products, together worth around 1.8 trillion [pounds sterling], invested in only 5 per cent of all our mortgage backed securities. And with over 10,000 retail mortgage products on offer, there was negligible take-up of long-term fixed rate mortgages.
Putting the needs of households, as both borrowers and lenders, at the centre of our financial system requires reform of the retail and wholesale mortgage markets. The Miles Review (2004) looked at some of the market failures in the retail market. This commentary looks at the market failures in the mortgage securitisation market and presents the case for reform. This requires a change in the mindset of our regulators. The distinction between bank and capital market based finance is now redundant. They are fully integrated and therefore regulation cannot be targetted only at banks. Regulators must ensure that the infrastructure for capital markets supports an efficient allocation of capital from a macrofinancial perspective. This matters for financial stabililty and competition and therefore falls squarely within the remit of the Financial Policy Committee.
Two revolutions occurred in finance in the 1980s. The first, emphasised by Morrison and Wilhelm (2010), was in information technology where batch processing meant that the loans of retail banks could be coded and traded. This shifted the craft of banking from old-fashioned qualitative credit assessments through local branches to assessments based on what can be measured, aggregated and benchmarked. The emergence of global capital markets for syndicated loans and early forms of asset-backed securities were dominated by banks with large capital bases and expertise in loan origination and evaluation. The second was an intellectual revolution where efficient markets and rational expectations came to dominate finance theory. It followed that private capital markets would allocate resources efficiently and therefore that there was less justification for state intervention. This provided the rationale for deregulation, in particular the removal of barriers between different types of financial firms.
The combination of these two events triggered a wave of mergers, as banks sought to build operations that straddled retail funding and wholesale capital markets. Investment banks secured the large capital bases they needed to increase transaction volumes, and retail banks and building societies secured the know-how to deploy their existing loan books to create new financial products. The new global banks created waves of new assets through financial engineering using existing collateral from the loan books of traditional banks. These securities are mostly incomplete contracts, in the sense that many of the embedded features are difficult to hedge and cannot be valued across all possible states. …