GLOBAL FINANCIAL STABILITY REPORT
Reform and Strengthen Housing Finance, Says IMF
IMF Survey online
April 6, 2011
- Government's role in housing finance linked to price swings
- Lenders should improve risk management, underwriting standards
- Simple products and better legal structures should help countries
The severity of housing market booms and busts depends in part on the role played by government in mortgage lending, according to the latest research from the IMF.
The biggest crisis to rock the global economy in over 80 years was related to a crash in subprime mortgage lending in the United States, and the new IMF research sheds light on how housing finance can roil financial markets and hurt a country’s economy.
In the years before the crisis, lax lending standards and an overabundance of money led to an increase in mortgage credit growth, which in turn spurred the house price boom and bust of the 2000s.
“No matter which way housing is financed—covered bonds, securitized products, or just old-fashioned on-balance sheet bank loans - the depth of the bust is related to the underlying quality of the loans,” said Laura Kodres, chief of global stability analysis in the IMF’s Monetary and Capital Markets Department, in a press conference to launch the study.
The research looked at housing finance systems in some advanced countries, including the United States, Spain, Ireland, and the United Kingdom, and how they contributed to financial instability in the recent crisis.
The IMF found that government intervention in housing finance, such as subsidies to first-time homebuyers and capital gains tax deductibility, exacerbated house price swings, and amplified mortgage credit growth in the years before the recent crisis in advanced economies. The study also concluded that countries with more government involvement experienced deeper house price declines in the bust.
A common way to limit the destructive leverage associated with mortgage loans is a limit on the loan-to-value ratio. For advanced economies, limits on these ratios do seem to play a role in attenuating housing price booms and busts, but when emerging economies are added to the sample, the effectiveness is not apparent. This may be because some mortgages are not in the data as they are originated outside the official sector or that more people make large down payments, making a tightening of the ratio irrelevant.
Best practices for all countries
The IMF study uses its cross-country analysis to form basic best practices to strengthen a country’s housing finance system, including
• Stricter underwriting and supervision to limit risks
• Better calibrated government participation in housing finance, including less direct government provision of mortgage credit, and targeted policies to achieve social objectives like affordable housing for the poor
• Improved alignment of incentives between loan originators and eventual investors when any type of capital-market funding, such as securitization, is used.
It is important for emerging economies to first develop solid regulation, supervision, and legal structures to underpin mortgage financing, according to the IMF.
Governments can help maintain stable financial systems through better regulation, by setting up credit bureaus to help lenders accurately evaluate borrowers, and consumer protection schemes to educate consumers about the nature and risks of the different mortgages. According to the IMF, these steps are more helpful than directly providing mortgage credit or distorting housing prices through subsidies and tax exemptions.
Risky and complex mortgage products, such as foreign currency mortgages, or foreign-currency indexed mortgage rates, which were prevalent in some Eastern European countries in the lead up to the crisis, should be avoided in markets that do not provide hedging, which would allow a borrower to offset the foreign currency risk of an appreciation with another instrument. Such instruments are usually not accessible to households.
Reduced role for Fannie Mae and Freddie Mac
The IMF examined recent U.S. housing policies, and the report agrees with recent government proposals to slowly wind down mortgage lending giants Fannie Mae and Freddie Mac, together with better defined and more transparent government participation in the housing market.
Government guarantees for securitized mortgages will need to continue for now given the still fragile state of the U.S. housing market and until the private sector securitization market is reformed and starts functioning normally.
These reforms would have a positive impact on the U.S. financial system and would help strengthen global financial stability, according to the IMF.