March 2004
Does the United States Really Have the Best Housing-Finance System in the World?

It has been said that the United States has the highest homeownership rates among developed nations.  At a March 23 AEI conference, Hans-Joachim Duebel, an international financial services and policy consultant, presented an analysis of the European Union mortgage-finance systems.  Bert Ely of Ely & Co., and Alex Pollock, Chicago Federal Home Loan Bank, compared the U.S. and EU systems and provided commentary.

Hans-Joachim Duebel
International Financial Services and Policy Consultant

I would like to discuss the similarities and differences between the European and U.S. mortgage markets.  It is important to first provide some background.  The size of the mortgage market relative to GDP in the European Union is 42.6 percent, whereas in the United States the ratio is 79.6 percent.  However, growth rates in this sector are comparable: the EU averages 8.2 percent and the United States 8 percent.  Income levels, urbanization trends, and financial market conditions contribute to these figures.  The United States has a national market with increasing consolidation, allowing lenders to achieve significant economies of scale.  Consolidation is farther advanced on the wholesale side then on retail.  Europe is fifteen regional markets, each of which is substantially consolidated.  The distribution of mortgages in the United States is unbundled; Europe is only recently beginning to offer unbundled products. Fifteen - thirty year, fixed rate, pre-payable instruments comprise the vast majority of U.S. mortgages.  European mortgages are variable rate or fixed for five years or less with pre-payment limits.  The funding and risk management also differ.  A majority of U.S. mortgages are sold into the secondary mortgage market while most European mortgages remain on the balance sheet, funded by deposits.

I found a number of correlations that help explain the differences in the European and U.S. markets.  First, product range and homeownership rates are related, especially among emerging markets-Spain and Italy-which display a limited range of products.  In addition, the degree of interest rate risk protection varies widely in Europe due to historical reasons.  Inflation risk history has led to vastly different market shares of fixed-rate products.  The European mortgage market is now focusing on potential benefits for consumers.  Market strategies, such as improved access to distribution and information, can further develop the market.  In addition, implementing policy strategies-limiting government intervention and transferring mortgage loans-are also possible solutions the EU is considering.  The European capital markets are trying to catch up to the level of the United States, but structural differences remain. 

Alex Pollock
Chicago Federal Home Loan Bank

Mortgage finance systems have different patterns of risk distribution.  What we have seen is a long-term financial regime shift.  The post-war structure used savings and loans, interest rate ceilings, international trade, and housing finance credit crunches.  The current structure is comprised of capital markets and government-sponsored enterprises with floating exchange rates, advanced globalization, a robust housing finance system, and no interest rate ceilings.  There are two mortgage funding structures: deposit financed and bond market financed.  The deposit finance structure resembles a banking and contract savings model, where the bond market reflects a mortgage bond and mortgage-backed security model.  The bond-based models (EU mortgage market and the GSEs) are specialized institutions viewed as having lower risk.  They focus on pure mortgage finance and have the ability to tap capital market funding for longer-term fixed-rate funds.  American GSEs efficiently link long-term residential mortgages with the bond markets.  We can learn from comparing both systems since neither is perfect. 

Bert Ely
Ely & Co.

I suggest to you that credit risk is not the issue in the U.S. residential mortgage market, at least much less so than in other parts of the developed world.  Interest rate risk is a very manageable risk through maturity matching, but it is a low margin business.  The real risk lies in pre-payment risk, due to its unpredictable nature.  Interest rate risk matches cash inflows and outflows-not so with pre-payment.  Prepayment risk and its beneficiaries tend to be higher-income borrowers, and what we have is a cross-subsidy that flows from the less well-off to the high-income class.  The U.S. housing subsidy is significant.  I suggest that the need for government involvement in housing distorts costs and results in a housing finance system where resources are spent to avoid artificial costs and high bank capital standards.  This raises the question of how we define a mortgage interest rate.  We tend to use the "stated" rate, which does not include initial costs incurred.  I suggest that we must amortize the borrower's upfront costs. Another issue concerning the efficiency of the housing market is the difference between the "originate to hold" versus the "originate to sell" housing models.  The European model is an "originate to hold", which means the originator keeps ownership of the mortgage and finances it in the capital markets.  "Originate to sell" is the secondary mortgage market, which dominates the U.S. system.  It is important to realize that both systems can and do fund thirty-year fixed mortgages, and both pass on interest and pre-payment risk to funders.  On these issues both systems are equal.  The key aspect of the U.S. market is that we have a higher capital requirement than the European model.  The criteria for evaluating the merits of various housing models are: efficiency of producing housing finance, minimizing cross-subsidies, no tax-payer risk, minimal distortion in capital allocation process.  Using these criteria, we can achieve the most efficient and comprehensive housing finance model.   

AEI research assistant Jessica Browning prepared this summary.