An article in Financial Times led me to a good research paper by Luci Ellis, an economist at Bank for International Settlements (BIS). BIS is the “bank for central banks” based in Basel, Switzerland.
The paper confirmed what I suspected when I wrote Mortgage Loans Around the World. Basically the home loan borrowers in the U.S. had it too good. When the system is too good to the borrowers, it’s not so good to the lenders. The lenders are made more vulnerable to credit losses.
The paper compared the United States with other developed countries which also have an advanced financial system for housing and home loans. It revealed several structural factors which made the United States stand out in the world. These factors made it more likely that the U.S. lenders will run into trouble. From the abstract:
“Some of these outcomes seem to have been driven by tax, legal and regulatory systems that encouraged households to increase their leverage and permitted lenders to enable that development. Given the institutional background, it may have been that the US housing boom was always more likely to end badly than the booms elsewhere.”
According to the research paper, the unique institutional drivers for the United States are:
1. Supply of new housing is relatively flexible. More land is available in the U.S. It’s easier to create over-supply of housing in the U.S.
2. Tax system encourages higher leverage and flipping. Mortgage interest is tax deductible. Borrowers tend to maintain high loan-to-value (LTV) ratios.
3. Legal system is swift but generous to defaulters. Home loans are non-recourse, either legally or practically.
4. Lenders could rely on external credit scores. Lenders in other countries must determine the borrower’s credit worthiness on their own. As a result, they are forced to be more careful.
5. Financial regulation did not prevent riskier lending. Regulations were too permissive.
6. Cash-out refinancing is inexpensive in the United States. Having a long-term fixed rate loan that is also refinancable is quite unique in the world.
7. Structured finance enabled subprime and other non-conforming lending. Securitization is more prevalent for U.S. mortgages.
Here’s the link to the full paper if you are interested.
Ellis, Luci (2008): “The housing meltdown: Why did it happen in the United States?“, BIS Working Papers No 529.