Housing and Financial Stability

Mortgage Lending and Macroprudential Policy in the UK and US

Alan Brener

• Publisher: Routledge
• Year: 2020
• ISBN:
  9781000030044
• Edition: 1
• Topic: Law
• Subtopic: Financial Law
• Index: Law

This book brings together politics, law, financial services regulation, economics and housing policy in the analysis of mortgage lending and macroprudential policy in the UK and US.

The book addresses the relationship between housing policy, credit and financial instability in light of the recent global financial crisis, and proposes both short and long-term solutions. Although it is not known where the next crisis will come from, history suggests that it will have credit and property at its source. Thus, it is important that the UK and other countries look more broadly at what should be done in terms of policies, institutions and tools to make the housing market and mortgage lenders more resilient against a future crisis. This book sets out a number of workable proposals. Central to this work are questions relating to the quantitative macroprudential measures, such as loan-to-value (LTV) and debt-to-income (DTI) restrictions, and whether these can be used to any significant extent in western democracies and, if employed, whether they are likely to be effective. In particular, the book questions the political legitimacy of their use and the potential consequences for the institutions, such as central banks, promulgating such policies. Preserving financial stability in very uncertain market conditions is of key importance to central bankers and other regulators, and macroprudential policy is a rapidly growing subject for both legal and economics study.

This book will therefore be of interest to financial professionals, policy-makers and academics.

1 Introduction – housing, mortgages and society

The financial crisis precipitated by the events of 2007/8 could be described as a world “undone by mortgages”.¹ It was based on an obsession with housing and the means to finance their purchase. In 1896, the architect Hermann Muthesius joined the German embassy in London as a special attaché with a brief to report on British housing. He wrote to the Grand Duke Carl Alexander of Saxe-Weimar stating, “no nation has identified itself more with the house”.² The UK, more recently, has been described as a

nation bewitched by property…home-ownership still stands its ground along with weather…as Britain’s public conversation of choice. House price surveys…command the front page; while the TV schedules are dominated by the generic pap of Location, Location, Location, Property Ladder, Trading Up or, for the more aspirational, Grand Designs.³

Ioannis Kapodistrias, the great European statesman and first president of Greece, considered that “only by owning land will they respect the property of others”.⁴ In his view, having a home of one’s own was desirable to help ensure political stability. Home ownership has been described as “a source of personal identity and status”, providing “a sense of place and belonging”.⁵ It can establish both memory and hope. Over the last hundred years, this has become central to a socio-political understanding of how a popular demand for owning a home reflects a desire for security and optimism for the future.

1 Richard Brome, ‘The English moor’ (published 1640, University of Missouri Press, Columbia, 1984), Rashley, Act 1, Scene 1.

2 Quoted by Tristram Hunt MP during the debate on the Housing and Planning Bill, 2 November 2015, Hansard, column 777.

3 Tristram Hunt, ‘How the English became obsessed with property’ (New Statesman, 2 February 2004).

4 Ioannis Kapodistrias, Letter to A. M. le Chevalier Eynard, February 1830, ‘Correspondence de Comte Capodistrias’, (1839), 3, Geneva, 472–473, Bibliothèque Université De Genève.

5 Shelley Mallett, ‘Understanding home: a critical review of the literature’, (2004) The Sociological Review, Vol. 52, No. 1, 63–89, 66.

Residential housing mortgages have provided the fuel to satisfy this desire. This has been mirrored by the involvement of banks in housing finance in, for example, the US since the 1920s and in the UK from the 1970s. This has changed the composition of bank lending and balance sheets. The rapid growth in this lending was at the heart of the recent financial crisis in the UK and in a number of other countries. The consequential financial instability threatened not just the global financial system but has spread to the “real” economy and is likely to have had a significant influence on the political system.⁶

As a consequence, international cooperation and national initiatives have developed macroprudential policymaking to improve financial stability. These steps have both measured and highlighted risks to financial stability and implemented actions to help reduce these risks. The latter policies broadly fall into two groups of instruments or “tools”: those that seek to reduce bank lending by increasing the cost to banks of rapidly increasing credit, and those that placed quantitative restrictions on such lending particularly for house purchases.

Many of these actions mirror those employed by microprudential supervisors. In addition, both macroeconomic and fiscal policies may also have macroprudential effects. This work considers these aspects in relation to residential mortgages and their respective relationships and merits. It does not cover areas such as “buy-to-let” or “equity release”, since these types of transactions have their own dynamics and operate in ways which are more akin to investment products.

Central to this work are questions relating to the quantitative measures, such as loan-to-value (LTV) and debt-to-income (DTI) restrictions, and whether these can be used to any significant extent in Western democracies and, if employed, whether they are likely to be effective. At its centre is their political legitimacy and the potential consequences for the institutions promulgating such policies.

The answer, at least in part, may exist in a different area of regulation: that regulating conduct of business. The recent financial crisis revealed serious deficiencies in the conduct of mortgages sales both in the US and UK. Superficially, both responded with similar sets of new regulations. However, the underlying regulatory concepts were different. The US focus is on standardising the structure of mortgages to make it easier for customers to understand and to compare mortgage offers. The UK’s approach is much more paternalistic evidencing a lack of trust in the consumer’s judgement with new regulations designed to protect customers from themselves.

Accepting that conduct of business regulation in the UK has its limitations and has suffered many substantial failures, this book proposes that it may still provide a more effective alternative to reliance on LTV and DTI measures to curb a mortgage lending bubble.

6 Guillermo Cordero and Pablo Simón, ‘Economic crisis and support for democracy in Europe’, (2016) West European Politics, Vol. 39, No. 2, 305–325, 317. See also Matthew Goodwin, ‘The Great Recession and the rise of populist Euroscepticism in the United Kingdom’, in Hanspeter Kriesi and Takkis Pappas (eds), European populism in the shadow of the great recession (ECPR Press, Colchester, 2015), 273–286, 281–284.

However, UK regulation in this area could benefit from incorporating some aspects of the US’s approach. The regulation of mortgage selling in the UK has followed a path set in the 1980s, largely designed to protect wealthy customers from abuse by their trusted investment advisers. There are limitations to this approach, and US financial services’ policymaking could provide innovative examples for use in the UK. This work highlights three particular aspects.

First, the US “qualified mortgage” is a largely unknown concept in the UK. This provides a mechanism for policymakers, including politicians, to set limits to the public “risk appetite”, balancing consumer protection, ensuring financial stability and meeting societal expectations and aspirations. Second, there does not appear to have been any assessment of the role of sound conduct of business policies employed by, for example, the Veterans Administration (VA), a significant Government Sponsored Enterprise (GSE), during the financial crisis. While other GSEs, such as Fannie Mae and Freddie Mac, failed and were rescued by the Federal government, the VA was unaffected and prospered, as did those borrowers it served. It is possible that the VA’s support for mortgages was successful for reasons other than good conduct of business policies, but this is an aspect which merits further research. Additionally, there is scope for much greater, and possibly more effective, innovative regulatory policy in this area by making use of the extensive data available on potential borrowers rather than the current reliance on long customer interviews examining sources of income and the customers’ assessment of their expenditure and future intentions.

Conduct of business policy in this area may be hampered by the structure of regulation in the UK. Macroprudential policymaking is undertaken within the Bank of England while conduct of business policy is the responsibility of the Financial Conduct Authority. Moreover, it is not entirely clear that the macroprudential policymakers fully understand the difference between credit and affordability risk and the importance of this distinction for both conduct of business and macroprudential policy. This issue and the results of interviewing senior current and former regulators indicate a possible disjunct between the two sets of policymakers and how conduct of business policy, in relation to mortgages, may provide important support for macroprudential policies.

As mentioned, the rapid expansion of credit to support house purchases has been central to almost all financial crises particularly in the latter part of the 20th and early years of 21st centuries. This may be due to a variety of reasons including increasing household formation, ready access to credit and cultural norms.⁷ For example, Germany has one of the lowest homeownership rates in Europe.⁸ This appears largely due to a well-developed private rental sector and high levels of tenant protection with modest rent rises, many of which are subject to statutory controls. In the UK, however, since the financial crisis the option of owning a home of ones’ own has faded for those who currently do not have sufficient funds to put down a large deposit and cannot prove that they can afford a mortgage.⁹

7 Germany provides an interesting comparison. Germans continue to save rather than consume. However, equity investments are seen as too volatile and bank and savings deposits, the traditional place for German savings, continue to have very poor rates of return. However, based on anecdotal information, Germans continue to rent since rent increases are controlled and tenancies are long term and heavily protected. However, moving to a new tenancy can be very expensive so most Germans simply do not move. Instead, many are using their savings to buy new properties which they let out in turn, which provides a much higher and stable rate of return. German households own 75% of all housing but only 43% live in their own homes. The balance is rented out by one household to another, European Central Bank, ‘Housing finance in the Euro area’, (March 2009) Occasional Paper Series, No. 101, 34.

8 Eurostat, Housing statistics, Eurostat (June 2019).

9 Daily Telegraph, ‘Is the British dream of home ownership dead?’ (3 January 2015).

Macroprudential policy may have the unequal task of attempting to suppress house price booms as it seeks to maintain a lid on the pressure cooker of an asset bubble. Moreover, macroprudential policy is predicated on its ability to identify sufficiently early potential risks to financial instability and root causes and to deploy the necessary macroprudential tools in time and to effect. The evidence that this would happen is not robust. Further, in the UK a major reason for such a high demand for housing, house price inflation and rapid credit creation is the significant deficit in the supply of housing. Government policy in this area has, at the very least, failed to support macroprudential policy and may be running counter to its objectives. This highlights the constraints on macroprudential policy since there are significant limits on its ability to influence fiscal and socio-economic policy.

In summary, although discussions on macroprudential policy go back to at least the early 2000s, the difficulties inherent in this form of regulation, coupled with a reluctance to interfere when asset prices rose rapidly, meant that it took the recent financial crisis for its importance to be fully recognised. Macroprudential policy is at a very early stage. Nevertheless, there is a danger that it may become too narrowly focused. To avoid this happening it needs to address, both conceptually and operationally, a range of issues. These include the following: the political and institutional legitimacy of macroprudential policy; how it relates to microprudential and conduct of business regulation; the need to manage excessive expectations; and recognition that any belief that macroprudential policy can be “fine-tuned” is a chimera. At the same time, macroprudential policy has a tendency to expand its scope as risks are perceived to migrate from one area to the next.

Further, macroprudential authorities need to consider the wider economic and societal issues and the effectiveness of some of the macroprudential tools and their potential for unintended consequences. Finally, it is possible that LTV and DTI limits may simply not work in the face of market forces, political interference and the lack of any willing constituency reinforcing such measures. It is possible that too many expectations are balanced on the columns of macroprudential policy while the countervailing forces of monetary policy and political expediency may help to create instability in the structure.

Consequently, macroprudential policy needs to be subject to realistic expectations with limited “role responsibility creep”, and policymakers need to reinforce the public and political legitimacy of their role. Moreover, macroprudential policy needs to be coordinated with monetary and fiscal policy. Finally, it should not neglect the importance of conduct of business affordability assessment regulations in helping to contain the growth of credit in the economy.

Chapter 2 examines the importance of financial stability and the geopolitical concept of the “turbulent frontier” applied to macroprudential policy. It is likely that the latter will be extended to encompass one aspect of the economy af...