I. The Attractivenessof U.S. Financial Markets: The Exampleof Mortgage Securitization1
1. Despite projections that its current account deficit is likely to remain high, the United States has been an attractive destination for foreign capital in recent years. Foreigners held an estimated $3.3 trillion in net U.S. assets (25 percent of GDP) at the end of 2005, and another $800–900 billion (6–7 percent of GDP) are likely to be added by the end of 2006. Besides strong economic fundamentals and sound monetary policy, the ability of U.S. financial markets to intermediate domestic demand with foreign supply of funds at attractive risk-adjusted returns has helped sustain foreign inflows and support the dollar exchange rate.
2. As an example, this paper discusses how financial innovation turned U.S. mortgages into an asset class with world-wide investor appeal. Mortgage securitization enabled households to tap foreign savings while satisfying foreign investors’ demand for higher returns on safe investments. The paper also asks whether a bubble in the housing market has developed as easy global financing conditions helped bring U.S. mortgage rates to historic lows. The answer is “probably not,” but regulatory vigilance remains essential to limit the potential fallout from a downturn—especially among smaller banks that have built up exposures to mortgage and construction loans.
A. Securitization and Recent Trends in Mortgage Markets
3. The securitization, or pooling, of home loans into mortgage-backed securities (MBS) has made the nationwide mortgage market significantly more efficient and less volatile over the past 20 years:
The U.S. housing market was historically composed of many local markets, and lending volumes depended on funding conditions of depositories in the region. Developers tended to build up housing inventories in anticipation of stronger demand when mortgage conditions would improve, contributing to regional boom and bust cycles (Schnure, 2005).
With securitization, banks and other mortgage originators have been able to shift significant amounts of credit and market risks to MBS holders (Figure 1), decoupling mortgage funding conditions from local deposit growth rates. Funding conditions are now determined in the national and international markets, and are therefore less volatile than before.
Figure 1.Mortgage Securitization in the U.S. Market
Source: Haver Analytics.
Figure 2.Residential Investment and Mortgage Growth
Source: Haver Analytics.
4. Securitization benefited from the fact that standard U.S. mortgages carry fixed interest rates for up to 30 years, much longer than in most other countries. Their long maturity makes them relatively easy to bundle, notwithstanding the fact that mortgages can also be easily refinanced or prepaid. Initially, the MBS’ success also owed much to the role of government-sponsored housing enterprises (GSEs), such as Fannie Mae and Freddie Mac:
Most of the pooling was historically done by the GSEs, who also guarantee cash flows on the underlying debt. These companies promoted greater uniformity in lending standards and lowered transaction costs, which contributed to improved market access for lower and middle-income households.
The GSEs provided liquidity and market-making in the early stages of the market, as well as during periods of market turmoil in the 1990s. Given their favorable rating and low funding costs, the GSEs also gained from issuing commercial bonds and investing the proceeds in their own MBS issues and other securities.
More recently, supervisors have become concerned that the GSEs’ large MBS portfolios could pose systemic risks, given that their significant interest rate exposures are being hedged with other financial institutions. As of end-2005, the GSEs still held a combined 25 percent of MBS issued with their backing, down from the peak of 37 percent in 2003.
5. The bulk of securitization has lately been done by private mortgage institutions (Figure 3). Among other factors, this reflects both an increase in “jumbo” mortgages and a rising share of loans to non-prime borrowers, both of which cannot be included in a security with a GSE-backed default guarantee. This niche has been filled by private institutions, including banks and mortgage brokers, which also securitize mortgages and home equity loans with still riskier characteristics. For example, the declining affordability of housing has boosted demand for mortgages with strongly discounted initial rates and negative amortization options, allowing more expensive purchases for a given monthly payment.
Figure 3.Mortgage Issuance by Institution
Source: Haver Analytics.
6. These “exotic” mortgage products have begun to play a well-publicized role in recent years, especially in the condominium market. Their strong take-up during 2004/05 has prompted U.S. regulators to emphasize the need for banks to improve risk management procedures and maintain prudential exposure limits. Moreover, smaller banks appear to have become more revenue-dependent on private and commercial construction activity. This may not be as much of an issue in the “hottest” markets—where price increases are driven by the limited availability of land—but more in peripheral markets with significant construction of new housing.
B. U.S. Housing Finance and Global Investors2
7. Mortgage-related financial products have been highly sought after by foreign investors. Such investors held close to $1 trillion in GSE bonds and GSE-backed MBS by March 2006, an amount equivalent to about a third of the increase in U.S. net foreign debt since the 1980s (Figure 4). In other words, once holdings of equities and other investment instruments are netted out, a major part of the rising indebtedness of the United States reflects foreign investment inflows into the U.S. housing sector. To understand the strong foreign interest in these securities, it is instructive to first look at the attractiveness of the U.S. financial market for foreign investors in general.
Figure 4.U.S. Net Foreign Asset Position and Foreign Holdings of Agency and GSE Securities
Sources: Haver Analytics; International Financial Statistics; and Fund staff calculations.
8. Reflecting its size, market-based structure, and favorable economic conditions, the United States has the deepest and most liquid financial market in the world (e.g., Burger and Warnock, 2004). The amount of bonds denominated in U.S. dollars was $22.5 trillion in March 2004, equal to more than 40 percent of outstanding global bond issues (Figure 5). Next to the large U.S. Treasury market, the U.S. private debt securities market is also the dominant corporate debt market in the world. As of 2003, the amount of outstanding corporate bonds issued in the United States amounted to $6.5 trillion, or half the global market. The U.S. equity market enjoys a similarly dominant position, in part because of the high degree of protection afforded to financial investors by the U.S. legal system (Kho and others, 2006).
Figure 5.U.S. Share of Global Debt Securities Outstanding
Source: BIS; International Financial Statistics; and Fund staff calculations.
9. Besides their size, U.S. securities markets have a number of structural advantages over other markets. For example, the U.S. market offers ample liquidity in benchmark issues covering the full range of maturities along the yield curve. This ranges from the very short-term—T-bills and the repo market—to the long-term, recently underpinned by the reintroduction of 30-year bonds. Many other countries have concentrated benchmark issuance on specific segments of the yield curve—largely 5–year or 10-year maturities—and short-term markets are not always as fully developed as the United States. The United States also has the largest stock of inflation-indexed bonds on issue. In addition, a large network of primary dealers and specialized financial institutions have created liquid markets in repos, futures, options, and, more recently, credit derivatives. By facilitating ways of splicing and combining risks associated with different securities, the market provides for efficient risk pricing mechanisms and allows investors to structure exposures closely in line with their desired risk-return tradeoffs.3
10. Moreover, the U.S. Treasury market has historically been highly internationalized, given the U.S. dollar’s role as global reserve currency. Treasuries have been sought as instruments for hedging and collateral, and as the currency of choice for official foreign exchange reserves. As of mid-2004, the U.S. dollar has been involved in about 90 percent of the $1.9 trillion worth of daily global foreign exchange transaction (Figure 6), and an estimated $1.8 trillion of U.S. dollar holdings constitute two thirds of official foreign exchange reserves reported to the IMF. U.S. markets have also been an important source of funds for firms from other countries—the US$-Eurobond market is of similar size as the U.S. corporate bond market, both in outstandings and relative magnitude.
Figure 6.Currency Denomination of Financial Products, 2004
Source: McKinsey Global Institute, 2005.
1/ Because there are two currencies in a single foreign exchange transaction, the potential total is 200%; the share of other currencies comprise the remaining 37%.
11. The attractiveness of U.S. markets for foreign investors is borne out by a comparative analysis with other large financial markets (Figure 7, previous page). Between 2000 and 2004, the amount of U.S. debt securities held by foreigners increased by close to 20 percent per year, compared to growth rates of around 8 percent or less of either domestic or international securities holdings of European and Japanese securities. Although the euro area had seen increases in foreign holdings in similar magnitude in the late 1990s, foreigners now account for 36 percent of GDP in holdings of U.S. debt securities, compared to only about 27 percent of GDP in the euro area. The larger size of the U.S. market explains why the overall market share held by foreigners is about equal, however.4 On the equity side, growth in foreign investments in the United States has also been stronger in recent years, although on a much smaller scale than in the debt market.
Figure 7.Foreign Participation in Major Financial Markets
Sources: Bis; International Financial Statistics; and Fund staff calculations.
12. With their 20-100 basis points spread over Treasury bonds in recent years, MBS issues have been one the key instruments purchased by foreign investors (Figure 8). Payment flows relating to the underlying mortgage portfolios are regarded as highly secure. Indeed, as the supply of U.S. Treasury bonds declined in the late 1990s, MBS were considered as a possible alternative for long-term benchmark bonds. Although MBS are subject to duration risk—for example, a drop in interest rates tends to cause a surge in refinancing and prepayments—this can be hedged in interest rate derivatives markets. It is therefore not surprising that a large part of funds flowing into global fixed-income markets have found their way into the U.S. mortgage market. Indeed, reflecting their low risk rating, about one third of GSE-backed MBS held abroad are included in official foreign exchange reserves, while asset-liability management concerns have prompted global pension funds to invest in MBSs, fulfilling both a need for longer-term securities and stepped-up income flows.5
Figure 8.Mortgage-Backed Securities Spread
Source: Bloomberg, LP.
13. All this suggests that the U.S. financial system, and the mortgage market in particular, have evolved in a way conducive for tapping the increasing supply of funds provided by foreign investors. U.S. markets had the infrastructure in place to intermediate large foreign inflows at a time when demographic and other factors created significant demand for housing loans, and U.S. financial institutions have also proved adept at creating instruments that catered to investors’ different risk appetites. To some extent this has been matched by European covered bonds (“Pfandbriefe”)—which have MBS features, except that the underlying loans remain on banks’ balance sheets—that have also been high in demand. However, the market for covered bonds, measured by outstanding amounts, is only an estimated one tenth the size of the U.S. MBS market, and issuance has been sluggish owing to depressed conditions in the German housing sector.
C. Has It Gone Too Far?
14. Many observers are wondering whether foreign capital inflows into the U.S. housing market have kept interest rates artificially low, contributing to a housing bubble. There is some evidence that long-term interest rates in the United States might have been higher in the absence of bond purchases by foreign investors (e.g., Warnock and Warnock, 2005). However, long-term interest rates, and by implication mortgage rates, were low throughout the industrialized world, and recent issues of the IMF’s World Economic Outlook have identified a number of structural reasons for this phenomenon, including high corporate saving, low inflation expectations, and reduced financial market volatility. Nevertheless, the question needs to be asked whether risk and credit allocation mechanisms in the U.S. housing market have remained efficient in the face of abundant capital availability. This requires an examination of the current level of house prices.
15. Are U.S. house prices overvalued? Going through the third major cycle in 30 years, national house prices have on average risen by 7 percent per year since 1995—10 percent since 2000—accompanied by a strong surge in sales volumes (Figure 9). There is ample anecdotal evidence of overvalued property and speculative activities in some of the hottest local housing markets, including along the Pacific and Atlantic coast lines. Trends in other regions have been considerably less dynamic, however, and a number of factors indeed supported an increase in prices in recent years (Mühleisen and Kaufman, 2003):
Reflecting demographic and immigration trends, the home ownership rate has increased strongly and remains close to the record 69.4 percent reached in 2004 (Figure 10, previous page).
The combination of strong disposable income growth, low interest rates, and large capital gains has provided a powerful boost to the financial situation of households. The housing affordability index has recently declined but remains near its longterm average.
Price increases appear to reflect a growing demand for higher-quality housing in terms of size, features, and appliances. Moreover, house price inflation has been concentrated at the higher end of the real estate market.
Figure 9.House Price Inflation
Source: Haver Analytics.
Figure 10.Housing Activity and Home Ownership
Source: Haver Analytics.
16. Long-run price trends are most closely associated with household income, whereas the level of mortgage rates and the unemployment rate seem to affect mostly the short-term dynamics (Box 1). This result is consistent with earlier findings, although the model has only been run only on a nation-wide basis for the purpose of this paper. The equation is relatively sensitive to sample periods and the type of house price index used, but the most robust specification indicates that national house prices were around 15-20 percent above a range consistent with fundamentals in 2005 (Figure 11).
Box 1.U.S. House Price Estimates
A simplified version of the approach by Mühleisen and Kaufman (2003) is used to gauge the level of house prices relative to fundamentals. The key variable is disposable income (per household), whereas the 30-year mortgage rate and the unemployment rate have no significance over the long term. The dependent variable is the OFHEO repeat price index. All variables are in logs.
|Disposable income per household||0.963217||0.0000|
|Adjusted R-squared||0.98162|Figure 11.Model Estimation of House Price Index
Source: Fund staff calculations.
17. With long-term interest rates rising, the housing market has entered into an adjustment phase. The 30-year mortgage rate is back at a five-year high, mortgage applications have slowed, sales have dropped, and price increases appear to have retreated from last year’s peaks. However, past experience suggests that aggregate house prices are much more likely to trade sideways than go through a prolonged decline unless economic conditions deteriorate, causing sharp increases in unemployment. It is not clear to what extent such precedents provide guidance in a market that has seen considerable structural changes in recent years (see Chapter 5 of this volume). In particular, the rapid expansion of “exotic” mortgage products that may have increased the exposure of both borrowers and lenders to an economic downswing. On the other hand, some of these potentially negative effects could be offset by structural changes in favor of lower volatility that have been mentioned earlier in this chapter.
18. The MBS market has shown few signs of concern about the slowing housing sector. Given the rise in exotic mortgage products, many analysts have been concerned that a correction in the housing market could entail some financial losses on the part of real estate lenders and MBS holders. However, others have pointed out that the risks from exotic mortgages still appear limited, given their relatively recent appearance, relatively diversified ownership, and some signs of a return to more conservative lending practices in 2006 (Cagan, 2006).6 Indeed, risk spreads on securities backed by home equity loans, including those with higher risk tranches, do not indicate that financial markets are anticipating a significant increase in defaults on mortgage payments (Figure 12), even as spreads on other assets with higher risk characteristics have increased.
Figure 12.Home Equity Loan Asset-Backed Securities Spread to LIBOR
Source: J.P. Morgan Chase and Co.
19. This paper suggests that U.S. financial markets have been skilful in developing tools that have helped households exploit favorable global financing conditions to boost homeownership and acquire housing wealth. This is likely to have contributed to a rising current account deficit, but indications are that credit and risk allocation mechanisms in the U.S. housing market have remained relatively efficient. This should provide comfort as the real estate market has entered what so far appears to be a cyclical downswing.
BalakrishnanR. and V.Tulinforthcoming“U.S. Dollar Risk Premiums and Capital Flows,”IMF Working Paper (Washington: International Monetary Fund).
BurgerJ. and F.Warnock2004“Foreign Participation in Local Currency Bond Markets,”International Finance Discussion Paper No. 794 (Washington: Board of Governors of the Federal Reserve System).
CaganC.L.2006“Mortgage Payment Reset: The Rumor and the Reality” First America Real Estate Solutions.Available on the web at http://www.loanperformance.com/infocenter/whitepaper/FARES_resets_whitepaper_021406.pdf.
MühleisenM. and M.Kaufman2003“Are U.S. House Prices Overvalued?,” in United States: Selected IssuesIMF Country Report No. 03/245 (Washington: International Monetary Fund).
KhoB.C.R.M.Stulz and F.E.Warnock2006“Financial Globalization Governance and the Evolution of the Home Bias”unpublished manuscript.
McKinsey Global Institute2005$118 Trillion and Counting: Taking Stock of the World’s Capital Markets. Available on the web at http://www.mckinsey.com/mgi/publications/gcm/index.asp.
PeekJ. and J.A.Wilcox2006“Housing, Credit Constraints, and Macro Stability: The Secondary Mortgage Market and Reduced Cyclicality of Residential Investment,”American Economic ReviewVol. 96 pp. 135–40.
SchinasiG.C.Kramer and T.Smith2001Financial Implications of the Shrinking Supply of U.S. Treasury Securities (Washington: International Monetary Fund).
SchnureC.2005“Boom-Bust Cycles in Housing: The Changing Role of Financial Structure,”IMF Working Paper 05/200 (Washington: International Monetary Fund).
SwistonA.2005“A Global View of the U.S. Investment Position,”IMF Working Paper 05/181 (Washington: International Monetary Fund).
Prepared by Martin Mühleisen.
This section partly draws on Schinasi and others (2001).
For example, the tranching of MBS backed by sub-prime mortgages and home equity loans allows risk-averse investors to pick up yield at limited exposure, while some of the substantive credit risk is borne by investors with a stronger risk appetite (e.g., hedge funds and speculative bond funds).
Data on portfolio allocations suggest that foreign investors are not overweight U.S. assets, although the size of U.S. net foreign liabilities has become large compared to other countries even when factors such as the size and openness of the U.S. economy are taken account of (Swiston, 2005).
Balakrishnan and Tulin (forthcoming) point out that foreign investors have not demanded a risk premium to invest in U.S. assets, as expectations of dollar depreciation were only partly being offset by growing interest differentials in favor of the United States.
Exotic mortgages have only begun to spread as better data and more refined financial tools have become available to lenders, including complex behavioral models and sophisticated financial innovations that allow the tailoring of attendant risks to dedicated investor classes.