The fixed-rate model. (Cover Report: Secondary Market).

Housing finance systems around the world are built around preferences for different mortgage types. An important reason for the success of the U.S. system is the long-tem, fixed-rate mortgage.

THERE ARE MANY FACTORS UNDERLYING THE SUCCESS OF HOUSING FINANCE SYSTEMS. They include a strong legal and regulatory framework, competition and diverse funding options for lenders. However, a somewhat overlooked factor is the mortgage instrument itself. A mortgage is a legal document defining the terms and conditions of the loan and pledge of the property. More important, the terms of the mortgage determine the affordability of the mortgage for the borrower and the sharing of interest-rate risk between the borrower and lender. The choice of mortgage instrument also has implications for the efficiency and stability of the housing finance system. Around the world, various factors have led to the prevalence of long-term, prepayable, fixed-rate mortgages (FRMs) in some countries such as the United States and Denmark, while in other nations, shorter-term fixed-rate instruments with restrictive prepayment penalties and/or adjustable-rate mortgages (ARMs) have emerged. Moving forward, lenders and governments would b e wise to give serious attention to developing markets that support long-term, prepayable fixed-rate mortgages.

The U.S. model

An important reason for the success of the U.S. housing finance system is the long-term, fully prepayable fixed-rate mortgage. ERMs insulate borrowers from interest-rate risk. A long-term, fully pre-payable FRM is in fact a "downwardly adjustable" loan in that the maximum rate is capped for the life of the loan, but the borrower can refinance (in many cases today with no out-of-pocket expense) into a lower-rate loan.

Fixed-rate mortgages contribute to macroeconomic stability, insulating borrowers from payment shock during periods of rising interest rates and providing for ongoing or additional consumer spending during low or falling interest rate periods. The use of the FRM is a major contributing factor to today's strong housing market, which has been sustaining the U.S. economy during the current slowdown.

Lenders in many countries around the world mainly offer ARMs. These instruments are well-suited for depository institutions, as they facilitate interest-rate risk management through matching assets and liabilities. But if the interest-rate risk is not borne by the lender, who bears it? The answer, of course, is the borrower.

This result may be acceptable if interest rates are stable. But if interest rates are volatile, use of ARMs can lead to borrower payment difficulties, high default rates and undermined financial system stability. This was the case, for example, in the United Kingdom during the late 1980s. All mortgages at that time were ARMs with rates determined by lenders. In response to sharply contractionary monetary policy, mortgage rates increased from approximately 10 percent to 14 percent over a six-month period in 1989. Default rates subsequently rose to record-high levels.

The FRM presents challenges as well. As was discovered during the savings-and-loan crisis in the United States, it is an instrument that is exceedingly difficult to manage for depository institutions.

A strong secondary mortgage market is a key factor in sustaining the dominant role of the FRM for the following reasons:

* It redistributes the interest-rate risk of mortgage lending away from borrowers and mismatched depositories to capital market investors that have the ability to price and hedge it effectively.

* It improves the liquidity of FRMs, making them more attractive to lenders and more accessible to borrowers.

* It stimulates competition, improving the efficiency of the primary market.

Affordability and homeownership implications

FRMs and ARMs have different implications for affordability and homeownership. In a typical interest-rate environment characterized by an upward-sloping yield curve, ARMs with rates based on the short end of the yield curve will have lower initial rates than FRMs, enhancing affordability.

This affordability benefit is somewhat illusory, however, as the payment-to-income ratio based on the initial ARM rate is not a good measure of the longterm affordability of the mortgage. Prudent underwriting should take into account the potential payment shock of rising mortgage rates--this is why qualifying borrowers on discounted initial ARM rates is a risky practice. Recognition of this feature of ARMs may lead lenders to use more conservative underwriting guidelines, offsetting some of the affordability benefit.

Lenders offering fixed-rate mortgages can be somewhat more aggressive in underwriting, because the borrowers are shielded from future payment change. In this way, the fixed-rate mortgage may facilitate the development of the sub-prime market.

FRMs are increasingly being priced off the intermediate portion of the yield curve, reflecting borrower mobility and increasing prepayment sensitivity. This improves their initial affordability. In higher interest-rate environments, graduated-payment options may also improve affordability.

Global comparisons

A form of fixed-rate mortgage is the dominant instrument in four of the top five and seven of the top 10 mortgage markets by size in the world (see Figure 1). All of these markets have outstanding track records of macroeconomic stability, and most have well-developed mortgage-backed security (MBS) or mortgage bond markets. In all cases, consumers have a choice between FRMs and ARMs.

However, there are significant differences in the characteristics of FRMs offered in these countries, based on consumer and investor preferences and historical development.

The following are the main differences:

* Length of fixed-rate period: Denmark, France and the United States are the only countries offering loans with rates fixed over the life of the mortgage. Other countries offer loans with rates fixed for five to 10 years (medium-term FRMs) or short initial fixed-rate periods on adjustable-rate loans. Although borrowers still benefit from payment protection during the fixed-rate period, they are exposed to potentially unlimited payment change when the fixed-rate period ends.

* Prepayment option: Danish and U.S. lenders offer borrowers a free prepayment option (the cost is in the rate). In other countries, lenders impose substantial penalties for early repayment during the fixed-rate period. The use of prepayment penalties allows lenders to better match their assets and liabilities, which are typically simple bullet bonds or deposits combined with interest-rate swaps. The effect of prepayment penalties is to pass some of the interest-rate risk back to borrowers, because they cannot take advantage of declining interest rates. Countries that restrict prepayment also have lower ratio of new to existing loans, as the refinance component of new lending is much smaller (e.g., Germany).

Why are fixed-rate mortgages more common in some countries than in others? There are several factors that contribute to the prevalence of one type of instrument over another. A major factor is the type of lender.

If the dominant lenders are depository institutions, they will use instruments that allow them to most effectively manage interest-rate risk. This is the case in the United Kingdom and most of its former colonies (the exceptions being Canada and the United States), where the dominant lenders until recently have been building societies. These lenders offer discretionary ARMs-loans in which the rate is set by the lender without reference to an external index.

In Denmark, Germany and the United States, mortgage banks have been significant or dominant mortgage lenders. These lenders have used fixed-rate mortgages in large part because their funding has come from the capital markets, and investors preferred fixed-rate instruments.

Another factor in instrument selection is historical and cultural. If markets have a long history of using a particular type of instrument, it may be difficult for lenders to get borrowers to try a different instrument design. U.K. borrowers have a long history with and understanding of ARMs, and have generally been reluctant to accept FRMs. On the other hand, U.S. borrowers have a long history with FRMs and prefer them to ARMs.

Countries with a history of inflation and interest-rate volatility are more likely to use ARMs than FRMs. In the post-World War II period, the United Kingdom has seen substantially more interest-rate volatility than the United States. However, the impact of this volatility is ameliorated to some degree through the loan pricing. The U.K. discretionary ARM is priced as a spread to the average retail cost of funds--an implicit index that is not as volatile as short-term money-market rates.

The relative pricing of ARMs and FRMs is another factor related to instrument choice. Borrowers tend to focus on the size of the mortgage payment in selecting a mortgage loan. In most interest-rate environments, the initial rate on the ARM is lower than that on the FRM and thus many borrowers will select ARMs to reduce the initial payment burden of the loan.

The relative cost of funding for lenders also plays a role. Deposit rates are typically lower than money-market rates (before consideration of branch operating costs), and therefore instruments whose pricing is based on deposits will look more attractive to borrowers than those funded in the capital markets.

Secondary mortgage markets have been slow to develop in most countries because lenders funded through the capital markets have been unable to provide competitively priced loans relative to depository-funded institutions. Australia is the only other country with a deep secondary market-Germany and the Scandinavian countries have deep mortgage bond markets as well.

A fourth factor, related to the third, is the degree of development of the country's capital markets. The more developed the capital markets, the more likely it will be there are investors that can manage or prefer longer-term securities with the cash-flow uncertainty associated with prepayment.

The two countries offering a long-term, fully prepayable FRM--Denmark and the United States--have had deep and well-developed capital markets for a long time. They are the only countries that fund more than 50 percent of their mortgages via the capital markets. In addition, strict interest-rate risk guidelines for lenders providing FRMs in both countries contribute to the vast majority of new FRMs being financed in the capital markets.

Monetary policy considerations also may affect the use of different types of mortgage instrument, One of the issues impacting the United Kingdom's decision on whether to adopt the euro is the potential impact of interest-rate policy decisions made by the European Central Bank. The effect of interest-rate changes will be much greater in the United Kingdom, where nearly all borrowers have ARMs, than in countries where most borrowers have fixed-rate mortgages (e.g., France, Germany). The U.K. government is concerned that interest-rate policy will have a disparate impact because of the interest-rate sensitivity of its population.

Final thoughts

There is no ideal mortgage instrument. All instruments represent a tradeoff between lender and borrower needs. A critical factor in mortgage design is providing an instrument that is suitable for the prevailing macroeconomic conditions. In stable, low-inflationary economies, an important indicator of the robustness of a housing finance system is an existence of a wide variety of mortgage instruments. In volatile, high-inflationary economies, only a narrow range of instruments may be appropriate-if any at all. But with this caveat, a compelling case can be made for the prepayable fixed-rate mortgage. This instrument is good for the consumer. Borrowers have much more limited capability of managing interest-rate risk than lenders and institutional investors. For most borrowers, the mortgage payment represents 25 percent to 40 percent of gross income. Large increases in the mortgage payment are almost guaran teed to cause difficulty for a majority of borrowers. A fixed-rate mortgage removes most, if ot all, of this risk for the borrower.

The FRM can be good for the economy and a country's financial system as well. Borrowers are protected from rising mortgage payments and lenders will be shielded from rising default rates during periods of increasing interest rates. Borrowers will benefit from falling interest rates if they have the opportunity to refinance. Lenders will benefit through increased loan production volume. The economy will also benefit as consumers reduce their debt payment burdens.

But there is a catch. The provision of mortgages that insulate borrowers from interest-rate risk and are profitable and safe for lenders depends critically on the development of long-term mortgage capital markets. The secondary mortgage market in the United States and the European mortgage bond markets both have been successful in providing funding options for lenders offering FRMs.

As markets develop and mature, borrowers are likely to demand FRMs, and lenders will have o provide them. For example, two building societies in the United Kingdom have recently introduced long-term FRMs. In traditionally variable-rate markets such as Korea and Thailand, lenders have begun offering five-year FRMs. In such markets, it will be critical to develop securitization and/or collateralized-bond financing to support the continued use of these instruments. The main challenges in introducing FRMs are educating consumers about the benefits of payment stability, even if this means taking a loan with a higher initial interest rate; and educating investors about the risks and returns of ERMbacked securities. A major obstacle in developing a prepayable FRM product is persuading investors to buy long-maturity securities with options risk. Lenders in Denmark and the United States have been very successful in doing this, and thus represent effective role models for other countries.

Mortgage interest rates in many parts of the world now stand at or near historic lows. Inevitably, rates will rise and present challenges for borrowers and lenders using ARMs. Now is the time for lenders and policy-makers in other countries to consider the benefits of the long-term, prepayable FRM and take steps to develop it in their markets.

Figure 1

Characteristics of Worldwide Loan Offerings

                Mortgage Debt Outstanding,
Country             2001 ($ billions)

United States             $5,757
Japan                     $1,525
Germany **                $1,026
United Kingdom             $795
Canada                     $294
France                     $288
Netherlands                $261
Australia                  $197
Spain                      $177
Denmark                    $110

                    Mortgage Originations       Dominant Mortgage
Country         (Gross Advances) ($ billions)*     Instrument

United States               $2,030                   LT FRM
Japan                        $204                   ST/MT FRM
Germany **                   $47                     MT FRM
United Kingdom               $234                      ARM
Canada                       $46 ***                ST/MT PRM
France                       $42                     LT FRM
Netherlands                  $77                     MT FRM
Australia                    $27                       ARM
Spain                        $45                       ARM
Denmark                      $18                     LT FRM

                Percentage of Loans Funded
Country          by MBS or Mortgage Bonds

United States              53%
Japan                      <1%
Germany **                 20%
United Kingdom              5%
Canada                      6%
France                     12%
Netherlands                <2%
Australia                  19%
Spain                      13%
Denmark                    90%

* With the exception of te United States and United Kingdom, origination
data is estimated based on 2000 data

** Data from EMF members only; does not include loans from Bausparkasse

*** Data available as of 3Q2001

Key: LT FRM: Long-term fixed (> 10 years)

MT FRM: Medium-term fixed (5-10 years)

ST FRM: Short-term fixed (1-4 years)

Michael J. Lea is president of Countrywide International Consulting Services LLC (CICS) and executive vice president of Global Markets for Countrywide Financial Corporation, Calabasas, California CICS specializes in the analysis of and provision of technical assistance to primary and secondary mortgage market institutions worldwide. Lea has more than 15 years of international experience in 30 countries spanning six continents.