Academic journal article National Institute Economic Review

Financial Innovations and the Stability of the Housing Market

Academic journal article National Institute Economic Review

Financial Innovations and the Stability of the Housing Market

Article excerpt

The recent crisis has underlined the importance of the interaction of financial innovations and the housing market. We consider five major innovations relevant to housing finance. These are (i) mortgages; (ii) specialised housing finance institutions; (iii) government interventions in housing finance in the US during the Great Depression; (iv) covered bonds; and (v) securitised mortgages. The history of these innovations and their positive and negative aspects are discussed. Future innovations to help the stability of the housing market are also suggested.

Keywords: mortgages; housing finance institutions; covered bonds; securitisation

JEL Classifications: GO I, G2I, G23, G28

I. Introduction

For many years financial innovations have had a significant effect on the housing market. Usually these have enabled an increase in the proportion of the population that can buy houses. Sometimes, as in the recent global financial crisis, they have had an adverse effect on the stability of the housing market. In this paper, we consider the financial innovations associated with the development of housing finance and its effect on the housing market and vice versa.

Our main focus is on five important financial innovations that have had significant positive or negative effects on the stability of the housing market. The first is the mortgage itself. This is arguably the most important innovation. A second key innovation was the development of specialised housing finance institutions such as Savings and Loans in the US and Building Societies in the UK. Initially these were very positive developments but in subsequent years there were problems with some of them. The Savings and Loan Crisis in the US in the 1980s was the most prominent example. The various government entities that were developed in the 1930s as a result of the Great Depression were a third major financial innovation. These have had both positive and negative effects over the years. Covered bonds where mortgages back the bonds but also remain liabilities of the issuing banks were the fourth major innovation. These have been widely used, particularly in continental Europe. A related development associated with these government entities was the introduction of securitised mortgages. This fifth innovation has also had both positive and negative effects.

2. Some early history

The most important financial innovation associated with housing finance is clearly the mortgage. The first evidence of the existence of mortgages was horoi, or 'mortgage stones', in ancient Athens. These were markers used to indicate that a property was mortgaged and to identify the creditors. (1) By the late 12th century, mortgages had reappeared in England in the form of common-law financial instruments to enable the purchase and sale of property. Real estate debts that were not paid could be recovered by lenders in property sales. The essential characteristic of mortgages arises from the fact that the existence of property rights allows the real estate to be pledged as collateral. Laws must be structured to facilitate this.

In the 18th century, early land developers designed innovative financial contracts in which real estate investors would buy not an entire large tract, but a segment for development and resale accompanied by an option to purchase the adjacent segment. The pioneer in this effort was John Wood and his son, whose projects in Bath, England, used this method to integrate individual housing units and related commercial space to develop the city. Wood went beyond the city limits of Bath to an area unencumbered by regulations and leased land for 99 years, with each lease based on the performance of the development of the previous one. By utilising options, he was able to circumvent land laws, raise debt and equity financing, and lease and manage related properties. This was the beginning of urban real estate development and residential housing finance as we know it today. …

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