Glasgow, 20 September 2001

Theoretical modelling of the demand for mortgage finance:

a heuristic framework

Vítor NevesVítor NevesFaculty of EconomicsFaculty of Economics

University of CoimbraUniversity of Coimbra, , PortugalPortugal

Summary

Demand for mortgage finance Demand for mortgage finance vs. vs. demand for mortgage debtdemand for mortgage debt

The ‘closed relationship’ approachThe ‘closed relationship’ approach A heuristic ‘multiple-exit’ framework A heuristic ‘multiple-exit’ framework

for the analysis of the demand for for the analysis of the demand for mortgage financemortgage finance

BackgroundBackground What is the real importance of What is the real importance of mortgage market mortgage market

imperfections (namely, maximum institutional imperfections (namely, maximum institutional loan-to-valueloan-to-value and payment-to-income ratios) and payment-to-income ratios) in in the explanation ofthe explanation of mortgage demand mortgage demand??

What are the issues? Topics to be discussedWhat are the issues? Topics to be discussed lifting institutional mortgage market constraints lifting institutional mortgage market constraints

might have no impact on the demand for might have no impact on the demand for mortgage finance mortgage finance

desireddesired payment-to-income ratios and payment-to-income ratios and expectations might be crucial factors in the expectations might be crucial factors in the explanation of mortgage LTV decisionsexplanation of mortgage LTV decisions

What are theWhat are the conditions under which mortgage conditions under which mortgage liberalisation leads to a mortgage market liberalisation leads to a mortgage market expansionexpansion??

Demand for mortgage finance vs. demand for mortgage debt

demand for mortgagedemand for mortgage finance ( finance (oror credit) credit) as as mortgage originationsmortgage originations

(primacy to decisions (primacy to decisions at the time of the at the time of the house purchasehouse purchase))

demand demand for for mortgage mortgage debtdebt as the amount as the amount of outstanding debt secured by the of outstanding debt secured by the owner’s principal residenceowner’s principal residence

((analysis of mortgage debt decisions all analysis of mortgage debt decisions all over the household lifecycleover the household lifecycle))

The ‘close relationship’ approachThe ‘close relationship’ approach

AA close relationship between mortgage and close relationship between mortgage and owner-occupied housing demandowner-occupied housing demand usually usually presumpresumeded..

DDemand for mortgage finance asemand for mortgage finance as a derived a derived demand, demand, “a multiple of housing demand, a “a multiple of housing demand, a multiple that receives little attention.”multiple that receives little attention.”

((as the demand for housing increases so as the demand for housing increases so does the demand for mortgage creditdoes the demand for mortgage credit))

A more sophisticated view: mortgage demand within an optimizing framework

TThe quantity of borrowed funds demanded he quantity of borrowed funds demanded is is determined determined bothboth by the optimal housing by the optimal housing expenditure and the optimal ratio of equity to expenditure and the optimal ratio of equity to borrowed funds at that level of expenditureborrowed funds at that level of expenditure..

AAn unconstrained homebuyer seekn unconstrained homebuyer seekss a a combination of own and borrowed funds such combination of own and borrowed funds such that the marginal cost per money unit that the marginal cost per money unit iis the s the same for any source of funds – the minimal same for any source of funds – the minimal marginal cost of capital to the borrowermarginal cost of capital to the borrower..

Any equity-mortgage desired mix Any equity-mortgage desired mix is is possible possible depending on the relative opportunity costsdepending on the relative opportunity costs..

mortgage maximization or minimization?mortgage maximization or minimization? The demand for mortgages as a The demand for mortgages as a corner corner

solution.solution. the the importance of the importance of the magnitude of the after-tax magnitude of the after-tax

cost of mortgage debt relative to both the cost cost of mortgage debt relative to both the cost of other forms of debt financing and the after-of other forms of debt financing and the after-tax returns on nonhousing investmentstax returns on nonhousing investments..

A mortgage cost lower than the cost of other debt A mortgage cost lower than the cost of other debt financing and/or the interest on savings would financing and/or the interest on savings would lead to mortgage debt maximization lead to mortgage debt maximization (e.g. the US (e.g. the US case) case) while the opposite would result in mortgage while the opposite would result in mortgage debt minimizationdebt minimization (e.g. the Canadian case) (e.g. the Canadian case)..

WWhen a stochastic hen a stochastic rrss is is consideredconsidered any value any value for the mortgage between zero and the for the mortgage between zero and the maximal allowable amount is an admissible maximal allowable amount is an admissible optimal outcome for some set of household optimal outcome for some set of household preferences, preferences, even in the case where the even in the case where the expected returns on nonhousing assets are expected returns on nonhousing assets are greater than the cost of mortgage financegreater than the cost of mortgage finance ..

IIt is no longer true that the largest allowable t is no longer true that the largest allowable mortgage is the only rational outcome in a mortgage is the only rational outcome in a U.S.-like case. In addition, U.S.-like case. In addition, the the comparative-comparative-static effects developed for the certainty static effects developed for the certainty model become ambiguous in signmodel become ambiguous in sign..

Question: IQuestion: If any value between zero and the f any value between zero and the maximal allowable amount for the maximal allowable amount for the mortgage is consistent with a maximising mortgage is consistent with a maximising rational behaviour, aren’t we “lost in the sea rational behaviour, aren’t we “lost in the sea of universal possibilities” where “the of universal possibilities” where “the important relationships and connections in important relationships and connections in particular circumstances” are left particular circumstances” are left unaddressed? unaddressed?

Opposing views and observations demand for mortgage finance is not a perfect proxy demand for mortgage finance is not a perfect proxy

for housing demandfor housing demand (Goodman, 1992 (Goodman, 1992)) ‘‘excess mortgage’ debt (Jones, 1993)excess mortgage’ debt (Jones, 1993) the puzzling experience of Southern European the puzzling experience of Southern European

countriescountries the Canadian experience of residential mortgage the Canadian experience of residential mortgage

finance in the first half of the XX centuryfinance in the first half of the XX century (Harris, (Harris, 1998)1998)

the Dutch case: the Dutch case: new mortgages applied in the new mortgages applied in the purchase of investment products and expensive purchase of investment products and expensive consumption goodsconsumption goods

borrowers may substitute one type of credit for borrowers may substitute one type of credit for anotheranother and choose to finance asset purchases by and choose to finance asset purchases by means of different forms of financemeans of different forms of finance (Meltzer, (Meltzer, 1974)1974)

taking stock the close relationship presumption has contributed the close relationship presumption has contributed

to inhibit research on mortgage demandto inhibit research on mortgage demand In its debt maximization hypothesis formulation in In its debt maximization hypothesis formulation in

particular, it has contributed to bias the particular, it has contributed to bias the researchers’ attention towards the study of the researchers’ attention towards the study of the impact of borrowing constraints – and mortgage impact of borrowing constraints – and mortgage market imperfections in general – on access to market imperfections in general – on access to homeownership.homeownership.

The mainstream approach The mainstream approach has concealed the has concealed the importance of looking into the demand for importance of looking into the demand for mortgage credit and the equity-mortgage mix as mortgage credit and the equity-mortgage mix as an outcome of deliberate, at least partially an outcome of deliberate, at least partially autonomous, household genuine choices.autonomous, household genuine choices.

But certainly some authors working within

this approach have provided important

insights: the demand for mortgage finance and the

optimal date of switching to ownership are simultaneously determined. Households are assumed to desire some housing debt position and start saving towards the down payment some time before the switching to ownership really takes place.

the decision on how much to save and for the decision on how much to save and for how long, as well as on how much to how long, as well as on how much to borrow, is part of a borrow, is part of a savings-savings-homeownership planhomeownership plan, that is, a , that is, a global global projectproject aiming at becoming owner in the aiming at becoming owner in the best feasible conditions. best feasible conditions.

consumers’ housing finance decisions are consumers’ housing finance decisions are complex.complex.

Looking for an alternative: an encompassing heuristic ‘multiple-exit’ framework

Why give priority to the heuristic properties of the Why give priority to the heuristic properties of the model – model – its capability to highlight households’ its capability to highlight households’ options options – rather than to formal rigour?– rather than to formal rigour?- important goals:- important goals: fully grasp household’s genuine mortgage fully grasp household’s genuine mortgage

choiceschoices To take full account of To take full account of complexity complexity (t(the decisionhe decision

on how much to borrow is part of a set of on how much to borrow is part of a set of complex and interrelated consumer decisionscomplex and interrelated consumer decisions) ) and and uncertaintyuncertainty (agents are (agents are endowed with only a endowed with only a partial capacity to grasp their current and future partial capacity to grasp their current and future circumstances and hence circumstances and hence are are unable to calculate unable to calculate the optimal decisionthe optimal decision))

Assumptions I assume that households make a joint I assume that households make a joint

decision on the house value and the loan-to-decision on the house value and the loan-to-value ratio compatible with that value. value ratio compatible with that value.

households are ‘risk’ averse in a more or households are ‘risk’ averse in a more or less degree and less degree and aspireaspire to reach a desired to reach a desired level of housing consumption and/or a level of housing consumption and/or a satisfactorysatisfactory rate of return of housing rate of return of housing investment with the minimum lifetime investment with the minimum lifetime mortgage costs compatible with nonhousing mortgage costs compatible with nonhousing consumption smoothness and a minimal consumption smoothness and a minimal disturbance to their portfolio of nonhousing disturbance to their portfolio of nonhousing assets.assets.

households are households are forward-lookingforward-looking acting acting subjects in an uncertain environmentsubjects in an uncertain environment

‘‘agents maximize utility’ is agents maximize utility’ is no more than ano more than a proposition about motivation (an intention proposition about motivation (an intention or ambition agents pursue), not realization, or ambition agents pursue), not realization, as does modern mainstream economicsas does modern mainstream economics

Y

HPSbMrf hm ...,,,

.,,, SbMrf

YV

m

Y

PTI ratios and house values compatible with those ratios

LTV ratios and house value compatible with those ratios

WV 1

1

WV W

The LTV decision at the time of the house purchaseThe LTV decision at the time of the house purchase

The LTV decision with binding borrowing constraintsThe LTV decision with binding borrowing constraints