Global Housing Price Boom and its Aftermath, The

Housing Finance International, Dec 2007 by Renaud, Bertrand, Kim, Kyung-Hwan

Financial globalization measured by gross external assets and liabilities relative to a country's GDP has about tripled since the mid-1970s (IMF, 2007). The depth of the global financial system measured as the ratio of total global financial assets to nominal world GDP has risen from 108% in 1980 to 316% in 2005 (McKinsey Global Institute, 2007). High income countries account for most of this increase in financial globalization. The Bank of England (October 2007, Figure A) estimates the size of the global financial markets at the end of 2006 at 149.1 trillion dollars. Meanwhile the global nominal GDP itself has grown from USD 10 trillion in 1980 to USD 48.2 trillion in 2006, with high income countries as defined by the World Bank representing $36.6 trillion.

Three major structural changes have been especially favorable to the global development of long-term finance and the deepening of mortgage markets. The development of securitization has added a new channel of funding to traditional forms of deposit-based funding by lenders. A new era of very low and stable inflation has drastically reduced the inflation risk premium in long-term lending. The volatility of advanced economies has been reduced by half, which has led to more stable employment and therefore more stable housing demand and improved efficiency in the sector.

First and foremost is the major innovation of mortgage securitization in the late 1970s.6 Securitization creates a new funding channel for housing in addition to traditional forms of deposit-based funding that were prone to stop-go lending in the US, especially prior to financial liberalization in the 1980s. Over time, funding with residential mortgage backed securities (RMBS) expanded from domestic to international capital markets. Because securitization is a major way to contain capital costs for banks, the development of asset-backed securities (ABS) for non-housing loans like credit cards or car loans developed quickly. Securitization is now a major pillar of the structured debt finance revolution in modern finance.

By expanding sources of funding, securitization can make new types of loans possible because no innovative mortgage product can be brought to market as a line of business without a sustainable way to fund it. The growth of the US subprime market is currently the most visible outcome of the securitization innovation with much debate about the strengths and "agency" problems of the "originate and distribute model".

The steadily declining market share of 'portfolio lending' in the US and other markets is a good illustration of the impact of financial liberalization. It has been a significant part of the broader transition from government-led financial systems relying on 'special circuits' to finance housing prior to the 1980s to market-led financial systems. This transition was essentially complete in advanced economies by the mid-1990s when the global housing boom started.

Facing the prospects of rapid integration and growth of European capital markets, "covered bond" instruments have also been modernized and standardized. The covered bond market has been growing rapidly as it offers another attractive low-cost and transparent funding channel to chief financial officers (CFO) who must constantly secure alternative sources of funding - as the failed business plan of Northern Rock in the UK has just illustrated. It is also generally agreed that the implementation of the Basel II Accord should stimulate the use of covered bonds by modifying the relative capital cost of issuing covered bonds compared to RMBS securitization.