Speech Moderator's Opening Remarks for Panel Discussion on Mortgage Finance
Head of Financial Stability Department
Address to the Federal Reserve Bank of Atlanta 2012 Financial Markets Conference
Thank you for the invitation to participate in this event. Our topic is urgent and important, not only for the Americans directly affected by the housing meltdown, but globally. Restoring the housing market to health is essential to the recovery in this, the world's largest economy. Moreover, many observers from abroad look at the US housing meltdown and wonder whether it could happen to them. For a number of reasons, I think that would be unlikely. The United States has some unique characteristics that enabled the meltdown. In most countries, by contrast, increased mortgage distress occurs with economic downturns; it doesn't usually precipitate them.
Yet in many other ways, the US housing–finance system is not so unusual.
Americans are not obviously more enamoured of home ownership than other people. We talk about a ‘Great Australian Dream’.
Nor is the US Government unusual in encouraging home ownership. Most advanced countries do this to some extent, though often to a lesser extent and in different ways.
And there is nothing to suggest that the inherent personal qualities of American households or lenders made them borrow or lend more than is prudent. Americans are not more prone to whipping themselves into a speculative frenzy than people from other countries. Let me assure you that your counterparts elsewhere are just as susceptible to over-exuberance during a credit boom.
The boom in credit and structured finance was global. We saw it in many more places than the US mortgage market. The question we have to ask, then, is why it had such damaging consequences in that market?
I would identify four key factors as explanations.
The first is that housing supply is quite elastic here, at least in enough parts of the country to matter. The housing boom was a construction boom as well as a price boom. As a result, by 2006 there was already a substantial overhang of excess supply (Graph 1). The inherent stock-flow interaction in the housing market means that construction booms sow the seeds of their own destruction. Prices can undershoot formerly sustainable levels.
The second factor is that the system of financial regulation did not stop an even greater easing in lending standards than occurred elsewhere. And they eased in a way that exacerbated the tendency of mortgage borrowers to default in a bust. There were gaps in both prudential and consumer protection regulation. Even where those regulations applied, they did not prevent lending practices not seen elsewhere, especially around income documentation and amortisation.
This links to the third factor, which is that a range of tax and legal differences, as well as industry convention, created a system that discouraged amortisation. Interest-only loans, explicitly negative amortisation loans and cash-out refinancing, all meant that loan-to-valuation ratios that were high at origination, stayed high well into the life of the loan. American households are less likely to pay their mortgages down ahead of schedule than Australians (Graph 2). Trade-up buyers seem to have high loan-to-valuation ratios in the United States; that doesn't appear to be true in Australia. The result of all this is that the US housing stock is far more leveraged than that in Australia, even during the boom period (Graph 3).
Finally, the United States has chosen a host of institutional arrangements outside the housing–finance system that result in US households facing more idiosyncratic and collective risk than their counterparts in many other developed countries. Flexible labour markets, limited welfare systems and US-style healthcare and elder care systems are understandable policy choices. But these policy choices have implications for what can be safely managed in the housing–finance system. This fact needs to be taken into account when designing mortgage and housing policy.
With all that in mind, how can the United States restore its housing sector to health? That is the question for today's panel, and I'd like to reflect on it for a few minutes.
In my view, fixing the US housing system will require the reversal of a fifth unusual factor. During the boom, on-balance sheet mortgage lending was not seen as being a profitable or attractive business for US banking institutions. That is extraordinary to foreign eyes. I believe that a healthy mortgage market is only feasible when sound mortgage lending is an attractive business for prudentially regulated firms; ideally, it should be possible for these firms collectively to dominate that industry, even if they do not in reality.
I also think more could be done to encourage mortgage amortisation. Paying your mortgage down before the bust is the most effective way of avoiding getting into negative equity once housing prices start to fall. In the long run, this might require adjusting the tax deductibility of mortgage interest for owner-occupiers; it is not a feature of the Australian or Canadian tax systems, for example (Ellis 2010). But amortisation can also be encouraged by the design of the mortgage contract. It might be worth considering adjustable rate mortgages in a more positive light. They offer some advantages, at least if they do not have aggressive teaser rates. In particular, they allow the borrower to make prepayments that can be redrawn later if needed. Think of this as like a home equity loan where the maximum balance declines over time. Such loans are common in Australia and have proven a highly effective vehicle for precautionary savings.
Of course the transition from here to a healthy housing sector will not be straightforward. Distressed households may need help to put their finances in order. Further economic recovery will help; so will programs to restructure household debt burdens.
Our speakers today will drill into some of the possible approaches to reforming the US housing and finance systems. As with any other program of structural reform, there will be a lot of hard work ahead. It will be uncomfortable for many participants in those markets. But even with everything that is going on globally, I cannot think of a structural reform program anywhere in the developed world that will do more to improve the near-term lot of ordinary households in that country.
See Ellis L (2010), ‘The Housing Meltdown: Why did it Happen in the United States?’, International Real Estate Review, 13(3), pp 351–394 and Ellis L (2011), ‘Eight Policy Lessons from the US Housing Meltdown’, Housing Studies, 26(7–8), pp 1215–1230.