This Selected Issues paper on the Republic of Korea reviews near-term economic prospects and risks. Korea experiences solid growth with low inflation, and vulnerabilities to potential shocks appear low. With Korea aging at an almost unprecedented rate, spending on pensions, health, and long-term care could rise by as much as 11 percent of GDP over the long term, threatening fiscal sustainability. Although risks facing financial institutions appear quite manageable, the authorities have focused on risks to the highly indebted household sector.


This Selected Issues paper on the Republic of Korea reviews near-term economic prospects and risks. Korea experiences solid growth with low inflation, and vulnerabilities to potential shocks appear low. With Korea aging at an almost unprecedented rate, spending on pensions, health, and long-term care could rise by as much as 11 percent of GDP over the long term, threatening fiscal sustainability. Although risks facing financial institutions appear quite manageable, the authorities have focused on risks to the highly indebted household sector.

IV. The Mortgage Market in Korea: Financial Risks and Development Needs1

1. Recent developments in Korean housing and mortgage markets have been a focus of regulators’ attention to emerging risks. Because of the high degree of collateralization and a reliance on relatively short-term floating rate loans, the financial risks of mortgages to lenders have been low in Korea. However, the structure of mortgages has placed a higher risk burden on borrowing households, which have a weakened financial capacity because of a high debt burden. A key developmental need, then, in the Korean mortgage market is to promote innovations—such as fixed-rate conventional mortgages and mortgage securitization—that lessen risks to households while maintaining the soundness of financial institutions. Recent trends have moved in this direction but further development is needed.

A. Mortgage Market Risks

2. Rapidly rising house prices in 2006 created concerns among the Korean authorities about a potential bubble. Housing prices rose by 11 percent nationwide for the year, but by much more in selected areas, in particular within Seoul. While the recent house price gains in Korea were within the historical range of house price volatility and fell short of a nationwide boom or the widespread surges in countries like Australia, New Zealand and the United States, the authorities were geared toward the side of caution. Korea had experienced episodes of severe financial distress following the Asian crisis and in 2003 with the collapse of the credit card boom. These experiences have sensitized Korea to the prospects of rapidly emerging financial crises.


House Price Inflation in Korea

(In percent, 3-month change annualized)

Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A004

Source: CEIC Data Company Ltd.

3. The authorities undertook a broad range of actions to suppress the rise in house prices. These included tax measures, selected price controls, and strengthened prudential regulations on the terms of mortgage financing for house purchases, specifically a tightening in late 2006 of loan-to-value (LTV) ratios and debt service-to-income (DTI) ratios for mortgages in localities experiencing price surges.

4. Both house prices and growth in new mortgages have moderated significantly in 2007. The various policy actions appear to have played a role, although the slowdown may also reflect in part the delayed effect of higher interest rates and the high prices themselves. The deceleration of mortgage lending has been concentrated in commercial banks, which were most directly impacted by the tighter prudential regulations. In contrast, insurance companies and other nonbank financial institutions have continued to lend at buoyant rates, accounting for well over half of mortgages written in the first quarter of 2007, as opposed to just over 20 percent of mortgages outstanding.


Growth in Mortgage Lending

(Annualized percentage rate)

Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A004

Source: Financial Supervisory Service.

5. Another recent development is that bank lending to small and medium enterprises (SMEs) has accelerated as household mortgages have slowed. This raises the prospect that funds raised through small business loans may have been effectively channeled into the housing market to avoid tighter mortgage restrictions, a possibility especially in the so-called SOHO (small office, home office) segment, which is extensive in Korea. An investigation by the Financial Supervisory Service (FSS) in 2007 found several hundred instances (totaling over 150 billion won) of business loans misused for purchases of houses and the authorities are sanctioning offenders. On the other hand, this leakage has not been significant enough to prevent a marked deceleration of house price inflation.

6. In general, financial institutions in Korea are not exposed directly to major risks on mortgage lending. Most of the risks on mortgages are borne by borrowers. Household mortgages in Korea have typically been 3-year floating-rate bullet loans. This short tenor without amortization is a peculiar feature of the Korean market that is absent from other Asian countries as well as advanced financial sectors (CGFS, 2006; Chiquier, 2006; Zhu, 2006). Floating rates protect the lender from interest rate risk and the short maturities pass the liquidity risk onto the borrowing household. Since mortgages typically do not amortize, they are paid off at the sale of the property or rolled over. This condition leaves the borrower exposed to the risk of failing to qualify for a rollover if either the house price falls sufficiently, leaving the loan undercapitalized, or if the borrower’s income falls enough.

Characteristics of Mortgage Products 1/

article image

Source: Veronica Warnock and Francis Warnock, “Markets and Housing Finance”, University of Virginia, April 2007.

Data represent annual averages or maximums for the period 2001-2005.

7. To guard against this outcome, lenders have required relatively stringent LTV ratios even apart from the government’s recent tightening of prudential terms. On average, the LTV ratio in Korea is slightly over 50 percent, significantly below comparable markets. This high collateralization protects lenders against credit risk on the loans but requires borrowers to provide a large amount of their own funds for down payments. The stringency of the LTV requirements also creates the incentive to utilize funds borrowed from other channels to qualify for bank mortgages. This incentive intensifies the need for closing any remaining gaps in the credit information system regarding the full extent of borrowers’ indebtedness so that lenders can make appropriate credit decisions about borrowers’ debt servicing capacity.

8. Mortgage structures have changed dramatically in the last several years. Loan maturities have lengthened in response to government encouragement and tax incentives that allow deductibility of interest on longer term mortgages. Between 2004 and 2006, the share of outstanding mortgages of maturity 3 years or less fell from 60 percent to 30 percent, while the share of over 10 years maturity rose from 21 percent to 51 percent. Over the same period, the share of amortizing mortgages rose from less than one quarter to more than one half. Some borrowers shifted to an amortizing loan with a 3–5 year grace period and may face debt-servicing difficulties when payments jump with the inclusion of amortization.


Shares of Housing Loans, By Maturity

(In percent)

Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A004

Source: Financial Supervisory Service.

B. Mortgage Market Development

9. The mortgage market in Korea has a number of development needs. In terms of overall size relative to the economy, mortgage markets in Korea lag advanced financial centers and other prominent Asian emerging markets. Beyond overall market depth, there is also a need for greater development of fixed-rate conventional loans and mortgage-backed securities (MBS). Korea is well poised to catch up, however, since its macroeconomic environment and financial infrastructure are generally strong.

Market Depth

10. The mortgage market in Korea is relatively undeveloped compared to other advanced and emerging market economies. The depth of the market, measured by the ratio of outstanding mortgages to GDP, is below other Asian centers such as Hong Kong SAR, Singapore and Malaysia, as well as most other OECD countries. This relative lack of development seems to be less rooted in the broad features of financial infrastructure in Korea than in the specific features of the mortgage market, including the relatively recent introduction of securitization features.


Mortgage Market Depth

(Mortgage debt outstanding/GDP; average, 2001-05; in percent)

Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A004

Source: Warnock and Warnock (2007).

11. Korea has the financial infrastructure to support mortgage market development. A recent cross-country empirical study of determinants of mortgage market depth (Warnock and Warnock, 2007) highlights three broad features that are significant in market development: credit information, creditor rights, and macroeconomic stability. Credit information relates to features such as the existence of a comprehensive credit bureau and privacy laws that are not overly restrictive. Creditor rights encompass features such as a general rather than specific description of assets and liabilities in contracts; a unified property registry; priority of claims for secured creditors and the ability to seize collateral outside of court. Macroeconomic stability is measured by low inflation volatility, which has been a feature of Korea’s economy in recent years. The country is relatively strong in terms of credit bureau coverage compared to the OECD as well as other Asian centers. It is similarly strong on credit information quality but lags other advanced and emerging financial centers somewhat in terms of creditor rights scores. Overall, these features bode well for the future development of Korea’s mortgage market.


Credit Bureau Coverage

(Percent of population)

Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A004

Source: World Bank, Doing Business database.

Credit Information and Creditor Rights Scores

Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A004

Source: World Bank, Doing Business database.

Benefits of Market Development

12. The development of the mortgage market in the direction of generating long-term fixed-rate conventional mortgages and MBS has a number of potential beneficial effects. It eases qualification for financing for home purchases and promotes home ownership and develops the capital market through providing a steady stream of long-term debt instruments for institutional investors with a long maturity horizon. Beyond that, however, mortgage market development would work to improve overall financial stability in the Korean context by shifting more of the risk bearing in housing finance onto banks and the capital markets in general and away from households. Korean households have built up relatively high levels of debt relative to income, reaching levels comparable to countries such as Japan and the United States. Korean banks, however, have improved their financial condition in recent years, raising their capital adequacy, asset quality and profitability. The developing trends to lengthen maturities and shift from bullet to conventional loans redistribute the balance of risk taking in a stabilizing fashion.


Korea: Household Financial Debt to Disposable Income


Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A004

Source: CEIC Data Company Ltd.

Capital Adequacy and Asset Quality of Korean Banks

(In percent)

Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A004

Source: Financial Supervisory Service.

13. The effect of mortgage securitization on financial system risk is complicated. Where competition leads banks to seek to expand market share, credit risks on property loans may be underpriced and may lead to an asset price bubble. In such circumstances, securitization can improve financial stability by prompting originators to price risk more realistically in order to maintain the marketability of the MBS that is generated (Green and others, 2007). On the other hand, as recent developments in the U.S. sub-prime market have shown, when securitization is highly liquid and credit assessment is effectively delegated by interested parties (say, to rating agencies), MBS can contribute to a weakening of risk assessment. In the Korean situation, since the undeveloped state of MBS suggests that the liquidity benefits of market development are high, it is important for supervisors to make sure through the examination process that both mortgage originators and regulated MBS buyers adhere to good standards of risk assessment in order to preserve the benefits.

Fixed-rate Mortgages

14. Long-term conventional mortgages have been slow to develop. At present, fixed rate and mixed loans are about 6 percent of the market. Borrowers have been reluctant to take fixed-rate mortgages. Rates faced by household borrowers have been in a significant long-run decline, creating weak expectations of significant rate increases. Against this background, the prevailing rate differential favoring variable-rate loans has been the dominant consideration. Conditions for fixed rate loans may, however, be turning more favorable. Since mid-2005, consumer rates have been in a modest uptrend and in 2007 the rate differential on fixed-rate mortgages has fallen on average to 20 basis points from 55-60 in late 2006. Recent increases in the 91-day CD rate, to which variable mortgage rates are tied, have squeezed the profit margin on floating-rate mortgages and started to push rates up, closing the gap versus conventional mortgage loans.

Mortgage-Backed Securities (MBS)

15. There is considerable scope for MBS to develop in Korea. Although Korea has a relatively large bond market among Asian countries and a well-developed asset-backed securities market (Lee, 2002; Chiquier and others, 2004; You, 2005; Chan and others, 2006), MBS is a relatively small share. The share of MBS among debt securities has increased only marginally, even in the face of the government’s tightened prudential regulations that promote the use of longer maturities, which would favor securitizable mortgages. The share of MBS among Korean debt securities rose from 1.37 percent at end-2005 to 1.55 percent in March 2007. At end-March 2007, MBS represented only 3.4 percent of outstanding mortgage loans. Growth has thus far been inhibited by the rate advantage for floating-rate mortgages and the consumer’s reluctance to make the higher monthly cash payments on conventional mortgages.

Size of Bond and MBS Markets 1/

(Amounts outstanding, in billions of US dollars)

article image
Sources: Citigroup; government housing agencies; and BIS.

Excluding money market instruments.

Excluding housing agency bonds and MBSs as well as private MBSs.

As a percentage of total bonds and MBSs.

The Role of the Korea Housing Finance Corporation

16. In 2004, the government established the Korea Housing Finance Corporation (KHFC) to promote the development of long-term conventional fixed-rate mortgages and MBS in Korea. The KHFC sets terms and conditions of mortgages that it will purchase from cooperating originating institutions. Generally, these are fixed-rate conventional mortgages up to 20 years maturity and 70 percent LTV with prepayment penalties. KHFC, in turn, packages these loans into mortgage pools that support the issuance of MBS of various maturities that are sold to investors. The principal investors are commercial banks, insurance companies and investment trusts, with the longer term investors taking a relatively large share compared to their shares of debt securities in general.

17. KHFC takes on several risks to effectively subsidize mortgage market development. At present, the KHFC assumes important residual risks related to conventional mortgage generation and securitization. It guarantees the payment of interest and principal on the senior tranches of securitized MBS. In addition, it holds on its own account the subordinate MBS tranche, which carries the greatest credit and prepayment (liquidity) risk, which KHFC manages chiefly thorough the use of a graduated schedule of prepayment penalties on the underlying mortgages. It also guarantees mortgages to low-income borrowers and guarantees no loss to lenders on reverse mortgages (a new, but potentially significant, product given Korea’s aging population) even if the residual equity value on the underlying property is exhausted before the borrower dies. Fundamentally, these risks are covered by the Korean government, which supports the KHFC.

18. Given the potential benefits from development of the conventional mortgage market and mortgage securitization and the existing small scale of such activity, it is reasonable for KHFC to play this supporting role. But as the market for conventional and reverse mortgages grows, the relative volume of contingent liabilities will likely increase significantly. The continued growth of the market will depend a good deal on maintaining the financial credibility of the KHFC. This will require a plan for phasing down the extent of subsidization through guarantees. This is a longer term problem, however, and the current small scale and growth of risks does not make such planning a priority. More useful would be to focus near-term efforts on the development of new derivatives products that would be useful in managing market and prepayment risks, such as over-the-counter interest rate options.

C. Policy Implications

19. While mortgages do not pose an imminent threat to financial sector stability, there are areas where risk management can be improved and development enhanced.

  • Prudential regulation of mortgage lending should strive to be functionally based and not applied differentially across classes of institutions or geographic areas. Standardizing prudential regulations has the benefit of reducing loopholes and promoting the securitization of the underlying mortgages, which contributes to capital market development. Applying differential prudential rules governing mortgage loans to different types of institutions creates incentives for borrowers to exploit regulatory arbitrage. Institutionally differential regulatory treatment should, therefore, be limited and, where necessary, applied at the broadest practical levels, such as minimum required capital ratios. The application of more restrictive prudential requirements to speculative zones risks fragmenting the underlying mortgage market. The lack of standardization on LTV and DTI complicates the pooling and securitization of the mortgages. In this regard, the authorities’ recent steps to extend standard credit screening rules, including DTI rules, to nonbank mortgage originators is welcome.

  • Efforts to promote credit information sharing among lenders should be broadened. Credit bureaus should coordinate and integrate consumer and small business credit information sources to generate a truer picture of the debt exposures of underlying individuals.2

  • Market initiatives to promote fixed-rate mortgages can be taken.

    • A broader range of over-the-counter derivatives hedges should be developed in terms of interest rate options to cover pre-payment risk on fixed-rate loans. The authorities’ relatively restricted approach to granting OTC derivatives licenses, especially for foreign firms, limits the degree of product innovation.

    • A liquid long-term government bond benchmark should be developed to facilitate the pricing of conventional mortgages.

  • The KHFC can take specific actions to develop further fixed-rate mortgages and MBS.

    • The KHFC should widen its list of participating institutions through which fixed-rate loans are originated. At present, several participating banks appear to be reluctant to promote the use of the KHFC fixed-rate mortgage because they see it as a competitive product to their own variable-rate loans, which are an attractive asset that they want to hold on their balance sheets. Broadening the list of participating institutions would heighten competition in originations to promote the spread of fixed-rate loans.

    • As risk management capabilities within the financial sector improve, the KHFC should lessen the prepayment penalties it imposes on its fixed-rate loans to make them more attractive to borrowers.

    • The KHFC may consider offering credit enhancement for the senior tranche on private sector residential MBS. An increased role for the KHFC as a third-party guarantor can allow it to pare down its risk by reducing its holdings of subordinated tranches on its own direct securitizations.

    • Finally, the KHFC could consider purchasing adjustable-rate capped mortgages from originating institutions, as opposed to buying only conventional loans on KHFC-specified terms. This would accelerate the MBS process, since most existing mortgages are floating rate. However, experience in other countries with securitizing floating rate loans is relatively limited and managing the interest rate risk is more complicated. Also, this activity works against the promotion of fixed-rate loans by making variable-rate mortgages more liquid to originators. The KHFC would therefore need to balance its dual objectives of promoting the fixed-rate instrument and the growth of MBS.


  • Chan, E., M. Davies, and J. Gyntelberg, 2006, “The Role of Government-Supported Housing Finance Agencies in Asia,BIS Quarterly Review (December).

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  • Chiquier, L., 2006, Housing Finance in East Asia, (Washington: World Bank).

  • Chiquier, L., O. Hassler, and M. Lea, 2004, “Mortgage Securities in Emerging Markets,World Bank Policy Research Paper No. 3370 (Washington: World Bank).

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  • Committee on the Global Financial System, 2006, “Housing Finance in the Global Financial Market,CGFS Paper No. 26 (Basle: Bank for International Settlements).

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  • Green, R., R. Mariano, A. Pavlov, and S. Wachter, 2007, “Mortgage Securitization in Asia: Gains and Barriers,prepared for NBER 18th Annual East Asian Seminar on Economics (June).

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  • Lee, J.H., 2002, “Mortgage Securitization in Korea,AsRES-AREUEA Joint International Conference, Seoul, Korea (July).

  • Warnock, V., and F. E. Warnock, 2007, Markets and Housing Finance, NBER Working Paper No. 13081 (Cambridge, MA: National Bureau of Economic Research).

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  • You, S. D., 2005, “Korean Mortgage Markets: Transition to Securitizations,Housing Finance International (March).

  • Zhu, H., 2006, “The Structure of Housing Finance Markets and House Prices in Asia,BIS Quarterly Review (December).


Prepared by Edward Frydl.


An example of existing gaps is the following. Presently, Korea Credit Bureau (KCB), the consumer credit bureau, and Korea Enterprise Data (KED), the SME credit bureau, operate under a limited information-sharing arrangement. If a lender wants to check for a SOHO credit, KED will check with KCB to provide the personal credit review. However, no automatic review of business credit is generated by a personal loan check.

Republic of Korea: Selected Issues
Author: International Monetary Fund