Financial Post on the Canadian Five-Year Mortgage Maturity Wall

In a February 17, 2011 Financial Post article (“Why do mortgage rates rise fast, fall slowly?”) John Greenwood made a bit of a mess trying to summarize my view on Canada’s five-year mortgage maturity wall:

According to Mr. Kiff, the main reason 10- and 20-year mortgages aren’t more common in Canada is because financial service providers consider them uneconomical.Whenever banks make home loans they generally protect themselves from the risk that the customer may pay the money back early by including strict repayment penalties. But current regulations put strict limits on such penalties. “So the banks have this wall at five years,” Mr. Kiff said in an interview.

Bottom line: Lenders can’t charge what they feel they need to charge so they don’t offer longer term mortgages at an affordable price.

Mr. Kiff, who previously worked at the Bank of Canada, said Canadians would be better served if there was more choice of longer term mortgages. The IMF recently recommended that the federal government change the rules around mortgages so that lenders are able to provide broader product choice without unnecessary limits on how they charge for products.

What needs to happen is “at least, let the market determine where the rates should be,” he said. “What [mortgage] works best depends on the borrower, on the borrower’s own personal situation.”

He’s got the gist of it right. The five-year “wall” is caused by a five-year maturity cap on CDIC deposit insurance, and a prepayment penalty limit on residential mortgage loans in the Interest Act. The deposit insurance cap makes it difficult for banks to cost effectively match lending and borrowing beyond five years. Section 10 of the Interest Act effectively gives homeowners the right to prepay mortgages with a term to maturity greater than five years after five years of payments for a fixed prepayment penalty equal to three months of interest.

In my (“Boring but Effective“) research paper that Mr. Greenwood cites, I speculate that it is possible that, the government is reluctant to remove these restrictions because it prefers to keep mortgage terms short, to reinforce the counter-cyclical impact of short-term interest rate swings. However, it could be merely an unintended consequence of meeting some other well-meaning policy objective…

Recourse and Residential Mortgage Default: Theory and Evidence from U.S. States

The lender recourse/non-recourse issue didn’t come up at the FDIC-FRB housing finance symposium (see here for the agenda) but a recent paper by Andra Ghent and Marianna Kudlyak has some interesting things to say about it:

The recent surge in defaults on residential mortgages has renewed interest in under- standing borrowers’decisions of whether to default and what factors in‡uence that decision. One factor of interest is the recourse permitted to lenders. In some U.S. states, recourse in residential mortgages is limited to the value of the collateral securing the loan. In other U.S. states, the lender may be able to collect on debt not covered by the proceedings from a foreclosure sale by obtaining a de…ciency judgment. Large increases in defaults in states that severely restrict lender recourse, such as California and Arizona, raise the question of whether allowing lenders more recourse substantially deter default.,,

We analyze the impact of lender recourse on mortgage defaults theoretically and empirically across U.S. states. We study the effect of state laws regarding deficiency judgments in a model where lenders can use the threat of a deficiency judgment to deter default or to shorten the default process. Empirically, we find that recourse decreases the probability of default when there is a substantial likelihood that a borrower has negative home equity. We also find that, in states that allow deficiency judgments, defaults are more likely to occur through a lender-friendly procedure, such as a deed in lieu of foreclosure.

 

FDIC and FRB Symposium on Mortgages and the Future of Housing Finance – Part 3

Recently I attended a two-day symposium on mortgages and the future of housing finance  on on October 25 and 26, 2010, hosted by the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve System. (Here’s the link to the agenda: www.fdic.gov/bank/analytical/cfr/oct2010-conf.html.)

There were three sessions that I personally found particularly interesting that I’ll be summarize over the next few days; (1) loss mitigation and loan modification practices and performance, (2) adverse selection in mortgage securitization, and (3) mortgage default decisions including strategic default. In this second post, I’ll focus on strategic defaults.

This session started out with an intriguing paper which I can’t provide a link to, that was written by Kenneth Brevoort (Fed Board of Governors) and Cheryl Cooper (Urban Institute). It ran through the post-foreclosure experiences of individual borrowers in great detail. Here are some of the interesting factoids:

• The higher the FICO credit score prior to foreclosure, the bigger the drop in post-foreclosure FICOs. This kind of makes sense, because after foreclosure, the FICO has to at least drop through the 680 threshold. So for example, they find that homeowners who start out at 780 drop an average of 160 points (to 620), whereas those who start out at 680 drop only 85 points (595). Of course, there’s also a lower bound to FICO scores (300).
• It takes seven years for a foreclosure to be removed from a borrower’s credit record, but scores can bounce back quite dramatically right after the foreclosure event. They find that the recovery trajectory for prime borrowers is slower than for subprime borrowers, and recent recovery rates have been slower than historical rates.
• Few get all of the way back to pre-foreclosure scores even over many years, and they tend to remain delinquent in some way for years (e.g., credit cards or auto loans).

Tomasz Piskorski presented a paper he co-wrote with Christopher Mayer, Edward Morrison and Arpit Gupta, that sought out evidence of strategic defaults using information from a legal settlement involving Countrywide Financial Corporation. As part of the settlement, Countrywide had to implement a streamlined modification program that offered expedited, unsolicited modifications to all borrowers who were at least 60 days delinquent. The authors found abundant evidence of strategic defaults, in this case defined as borrowers who stopped making payments to exploit the new modification program.

The Piskorski et. al. paper is still in the “preliminary and incomplete” stage, so it’s not yet available for wider distribution. However, in the discussion that followed, one cautionary note was expressed, in that coincidentally, what looked like strategic default behavior was driven by reset dates on the predominantly 2/28 hybrid adjustable-rate mortgages (ARMs) that were offered by Countrywide.

The paper presented by Jane Dokko focused on the potential influence of negative equity on strategic default:

We study borrowers from Arizona, California, Florida, and Nevada who purchased homes in 2006 using non-prime mortgages with 100 percent financing. Almost 80 percent of these borrowers default by the end of the observation period in September 2009. After distinguishing between defaults induced by job losses and other income shocks from those induced purely by negative equity, we find that the median borrower does not strategically default until equity falls to -62 percent of their home’s value. This result suggests that borrowers face high default and transaction costs. Our estimates show that about 80 percent of defaults in our sample are the result of income shocks combined with negative equity. However, when equity falls below -50 percent, half of the defaults are driven purely by negative equity. Therefore, our findings lend support to both the “double-trigger” theory of default and the view that mortgage borrowers exercise the implicit put option when it is in their interest.

In the discussion that followed, it was mentioned that expected home price dynamics (expected changes and volatilities) could usefully be incorporated into the analysis.

And that’s all for my coverage of the FDIC-FRB Symposium!

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* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management.

FDIC and FRB Symposium on Mortgages and the Future of Housing Finance – Part 2

Recently I attended a two-day symposium on mortgages and the future of housing finance  on on October 25 and 26, 2010, hosted by the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve System. (Here’s the link to the agenda: www.fdic.gov/bank/analytical/cfr/oct2010-conf.html.)

There were three sessions that I personally found particularly interesting that I’ll be summarize over the next few days; (1) loss mitigation and loan modification practices and performance, (2) adverse selection in mortgage securitization, and (3) mortgage default decisions including strategic default. In this second post, I’ll focus on securitization adverse selection problems.

And actually, to be more accurate, the papers presented at this conference actually bring into question the idea that there is a residential mortgage securitization adverse selection problem. The first paper (that can be downloaded here) was presented by Ashlyn Nelson, concluded that:

While the paper supports that the bank applies lower screening efforts on loans that have higher ex ante probability of being securitized, it further shows that loans remaining on the bank’s balance sheet are, ex post, of worse quality than sold loans. Most of the differences can be explained away by secondary market investors’ information advantage over the originating bank due to the time lag between loan origination and loan sale. While many blame the presence of the secondary market for the emergence of “liars’ loans,” we find that ironically these loans hurt the originating bank more than it did the secondary market.

Yan Chang also presented a paper (available here) that came to a somewhat similar conclusion:

We find that banks sold low-default risk loans into the secondary market while keeping higher-default risk loans in their portfolios. This result holds for both subprime and prime loans. We do find strong support for adverse selection with respect to prepayment risk; securitized loans had higher prepayment risk than portfolio loans. It appears that in return for selling loans with lower default risk, lenders retain loans with lower prepayment risk. Small lenders place more emphasis than large lenders on default risk versus prepayment risk of the loans they retain. Securitization strategies of lenders changed during the sample period as they became less willing to retain higher-default loans after the housing market reached its peak.

In the discussion that followed, Laurie Goodman (of Amherst Securities) was rather critical of the Chang paper. First off, it used a dataset supplied by LPS Applied Analytics that under-represents subprime loans. She also thought that some of the more bizarre results could be because originators just couldn’t sell their higher-risk loans.

In any case, there’s some food for thought here, keeping in mind that previous searches for the “smoking gun” of adverse selection, and slack screening of securitized loans has been hard to come by. For every study that has seemingly found adverse selection evidence, there’s another that disputes in some way or another.

That’s all for the securitization sessions, and in the next post I’ll cover the strategic default-focused sessions.

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* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management.

FDIC and FRB Symposium on Mortgages and the Future of Housing Finance – Part 1

Recently I attended a two-day symposium on mortgages and the future of housing finance  on on October 25 and 26, 2010, hosted by the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve System. (Here’s the link to the agenda: www.fdic.gov/bank/analytical/cfr/oct2010-conf.html.)

There were three sessions that I personally found particularly interesting that I’ll be summarize over the next few days; (1) loss mitigation and loan modification practices and performance, (2) adverse selection in mortgage securitization, and (3) mortgage default decisions including strategic default. In this first post, I’ll focus on loss mitigation.

The sessions on loss mitigation and loan modification highlighted several papers that tried to determine why we are not seeing more loan modifications (as opposed to foreclosures). Gene Amromin gave us the lay of the land based on a paper he wrote with Sumit Agarwal, Itzhak Ben-David, Souphala Chomsisengphet and Douglas Evanoff that can be downloaded here.

Basically, they document that foreclosure is the dominant form of loss mitigation, and that securitized loans are less likely to receive modifications. Borrowers with the highest ex-ante likelihood of getting back on track (“self-curing”) are less likely to be offered modifications (e.g., high credit scores and low loan-to-values). They also find that affordability, as opposed to negative equity,  is the primary driver of redefaults.

Paul Willen discussed the challenges in determining which borrowers are “deserving” of concessional modifications. Servicers don’t want to offer modifications to delinquent borrowers who will self cure, or who will redefault. This assessment is very difficult, making foreclosure the path of least resistance. On the other hand, Sanjiv Das presented a theoretical loan modification model that accounted for these unknowns to show that smart modifications improve the lender’s loan value (the paper can be downloaded here). The optimal modification involves a principal writedown coupled with shared-appreciation going forward.

However, as we all know, principal writedowns are seldom being employed, and the rest of the session’s discussion focused on the why-nots. A popular scapegoat in this regard is securitization. However, Andra Ghent presented a paper that showed that concessionary residential mortgage modifications were rare even during the Great Depression (download here). Furthermore, there were no instances of principal forgiveness in her dataset (loan level data from the New York City metropolitan area). Interestingly, she posits that the Home Owners’ Loan Corporation (HOLC) may have reduced renegotiation incentives:

Our results also suggest a possible downside to government programs such as the HOLC. To the extent that lenders benefi…t from government programs that remove non-performing mortgages from their balance sheets, such programs may adversely a¤ect lenders incentives to preserve the values of their mortgages through private renegotiation.

Adam Levitin brought us back to the present with a discussion of the role of servicers in loss mitigation. (He didn’t present a paper, but has written extensively around this topic, as you will see if you visit his website.) He said the the paucity of loan modifications isn’t the fault of securitization per se, although the unbundling of servicing from lending seems to me to be a symptom of securitization.

Anyways, Adam ran through the factors that distort servicer incentives. For example:

• Servicing and trust fees are fixed creating strong incentives just to minimize costs, and not maximize value. For example, there is no incentive to maintain costly loss mitigation systems through the cycle.
• Servicing fees are based on outstanding principal, which reduces any incentives to offer principal reductions.
• The big servicers are affiliated with banks that own 2nd liens on the properties that underlie the 1st lien mortgages they service. These 2nds would have to be written off in a typical principal writedown.
• Servicers often hold “residual” interests in the transactions that they service, so they’re incentivized just to keep the cash flows coming.

Adam presented a couple of potential policy prescriptions, including intervening in trust operations (e.g., impose an ombudsman funded by servicer) and allowing residential mortgage cramdowns in bankruptcy. However, during one of the Q&A sessions, he admitted that that ultimately it will be a political decision as to who will bear the cost of principal writedowns. Also, there is the problem of what to do about 2nd lien writeoffs that push some big banks to the cliff edge?

That’s all for the loss mitigation sessions, and in the next post I’ll cover the securitization sessions.

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* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management.

End the Credit Rating Addiction

One of the earliest takeaways from the global financial crisis was the importance of access to information for effectively functioning financial markets. And, in that regard, credit ratings can serve an incredibly useful role in global and domestic financial markets—in theory.

In practice, credit ratings have inadvertently contributed to financial instability—in financial markets during the recent global crisis and more recently with regard to sovereign debt. To be fair, the problem does not lie entirely with the ratings themselves, but with overreliance on ratings by both borrowers and creditors.

In one of the background papers for the Fall 2010 Global Financial Stability Report that I prepared with IMF colleagues, we recommend that regulators should reduce their reliance on credit ratings. Markets need to end their addiction to credit ratings.

Credit ratings should be seen as one of several tools to measure credit risk, and not as the sole and dominant one. Instead, credit ratings, which measure the relative risk that an entity such as a government or a company will fail to meet its financial commitments, have become hardwired into various rules, regulations and triggers. Central banks often use ratings in their collateral acceptability rules. The Basel II standardized approach to determining bank capital requirements relies heavily on ratings. And, many institutional investors—pension funds, insurance companies, retirement funds, and the like—have rules that trigger the sale of securities when they are downgraded below certain levels.

Yet, when investors, regulators and borrowers rely on credit ratings too mechanically, changes in ratings, particularly abrupt downgrades, can lead to deleterious selloffs of securities. Not only does this create the potential for broader spillovers, but the resulting declines in the prices of securities trigger further sell-offs. In other words, those notorious domino effects!

Actions by ratings agencies to “smooth out” or make changes in ratings less abrupt—for example, through a warnings ahead of a possible downgrade—may be intended to minimize disruptions. However, they we find that much of the market reaction occurs when these warnings are released rather than when the actual rating changes.

And, as events of the past year or so have highlighted, sovereign ratings could have taken better account of debt composition and contingent liabilities. However, in some cases—Greece for example—the rating agencies did not have access to all the information they needed. In that regard, the IMF encourages countries to prepare and make publicly available a fiscal risk statement.

Still, the real solution lies in reducing the reliance on credit ratings as much as possible. This should start with removing the mechanistic use of ratings in rules and regulations, which some countries are already beginning to do. Investors must be weaned off credit ratings too. Policymakers should persuade the larger ones, at least, to perform their own risk assessments as part of deciding what to buy or sell.

Realistically, of course, not all investors have the same ‘in house’ capacity for risk assessment. Smaller and less sophisticated institutions will have to continue to rely heavily on third-party ratings. So, the process of reducing reliance on ratings should differentiate according to the size and sophistication of institutions, and the instruments being rated. Also, agencies—the main ones being Standard & Poor’s, Moody’s, and Fitch—whose ratings continue to play key regulatory roles (as in the Basel II standardized approach) should be subjected to increased oversight. (Both of these approaches were included in the recently signed U.S. financial sector reform legislation.)

Beyond this, our paper recommends that policymakers should also continue to push rating agencies to improve their procedures, including those related to transparency and governance. This will provide more assurance to those that use ratings that they are fairly constructed. Credit rating agencies aggregate information about the credit quality of various types of borrowers and their financial obligations. The ratings they issue allow many of those borrowers to access global and domestic markets they would not otherwise have, enabling them to attract investment funds. As a result, ratings add liquidity to markets that would otherwise be highly illiquid.

Wringing out the volatility, without drying up the liquidity, is the goal of any effort to reform the credit ratings agencies that issue them.

Credit Derivatives: Systemic Risks and Policy Options

Credit derivative markets are largely unregulated, but calls are increasingly being made for changes to this “hands off” stance, amidst concerns that they helped to fuel the current financial crisis, or that they could be a cause of the next one. The purpose of this working paper I co-wrote with Jennifer Elliott, Elias Kazarian, Jodi Scarlata, and Carolyne Spackman is to address two basic questions: (i) do credit derivative markets increase systemic risk; and (ii) should they be regulated more closely, and if so, how and to what extent? The paper begins with a basic description of credit derivative markets and recent events, followed by an assessment of their recent association with systemic risk. It then reviews and evaluates some of the authorities’ proposed initiatives, and discusses some alternative directions that could be taken. You can download the whole paper here, but below I’ve copied and pasted the conclusions:

Although important strides have recently been made in reducing operational risks, counterparty risk remains a significant problem in credit default swap (CDS) and other over-the-counter (OTC) derivatives markets. The recent CDS central clearing counterparty (CCP) launches in Europe and the United States are promising developments. However, a single global CCP would accomplish the largest reduction in systemic  counterparty risk, benefit from the largest network and scale economies and a larger pool of  counterparties and resource base, and limit opportunities for regulatory arbitrage and  competitive distortions. There is a risk of a “race to the bottom” as each CCP has an  incentive to fight for market share by economizing on risk management, and lowering  margining requirements and contributions to a guarantee fund. Evidence of this can be seen,  in part, as competition for market share has resulted in the fallout of two of the four initial CCP proposals. International cooperation is needed to avoid national regulators contributing to such a race to the bottom.

Some CDS market systemic risk concerns could be alleviated if policymakers and market participants had access to more detailed transaction and position information. Better information would also enable authorities to detect market abuse. More effective CDS market surveillance will require clearer regulatory and supervisory mandates. However, even with the right mandates, enforcement resources are stretched, and there are many pressing issues that regulators must balance.

The recent U.S. Treasury proposal for a comprehensive regulatory framework that would cover all OTC derivatives is a step in the right direction. Not only does it call for the centralized clearing of all standardized OTC derivatives, but also for the imposition of comprehensive reporting requirements, even on trades that do not clear through CCPs.  Aggregate data on all trades will have to be reported to the public, and individual trade  details to federal regulators. The International Organization of Securities Commissions (IOSCO) has made a similar proposal, although it covers only standardized credit derivatives.

In addition, accounting statements generally reveal very little CDS risk exposure information beyond notional amounts and market values. While there has been general agreement that more disclosure is needed, discussions have tended to get bogged down in questions of how much disclosure and to whom. Although accounting standard setting bodies are moving toward requiring enhanced reporting and transparency of bank’s exposures, important gaps should be filled. For example, the maximum degree of concentration exposure to single  counterparties should be presented. Also, valuation changes affecting credit quality and their impact on the financial statements, based on different market scenarios, such as a mild or deep recession, would be useful.

Finally, regulators and other standard setters in the major jurisdictions need to work closely with their counterparts to share transaction and position information relevant to assessing systemically important linkages through these markets. Furthermore, as noted above, they need to work to ensure coordination in implementation and enforcement, in order to prevent regulatory arbitrage.

Some important topics were not covered in this paper. These include legal issues surrounding takeover directives, and the impact of CDS contracts on the competing rights of shareholders, creditors and other investors. In addition, concerns have been raised about “empty creditor”  issues, whereby creditors who have bought protection in the CDS market are unmotivated to participate in restructuring negotiations (in the extreme, such creditors may be highly
motivated to actually push for bankruptcy). This was seemingly only an academic problem (see the Hu and Black paper), but it appears to have become relevant in the wake of recent bankruptcy activity.

It should be noted that the paper did not address more fundamental questions about whether CDS trades add positive value to the economic system. For many years, credit derivatives have been justified as an efficient way to distribute risk and promote financial stability. However, recent events make it difficult to argue that the markets for these instruments have materially limited the negative outcomes of this crisis, and there is a widespread view that they may have exacerbated systemic instability.

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* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management.

Revive Securitization to Speed Exit from Crisis

Restarting securitization markets, particularly in the United States, is critical to limiting the fallout from the economic crisis, and to eventually withdrawing central bank and government support. In this post I summarize the content of an article that I wrote with several of my colleagues (Andy Jobst, Michael Kisser and Jodi Scarlata) for the IMF’s Global Financial Stability Report.

Since the crisis began, investors have shunned securitization products, such as mortgage-backed securities, and central banks and governments have taken up the slack with various programs to support securitization markets.

While many question whether it would be worthwhile to restart the market for securitized assets, although with reforms to guard against the excess that caused the markets to implode. If private investors return to the business of securitizing loans again, central banks and governments can withdraw from their role as “buyers of last resort,” which makes restarting these markets important to exit strategies.

Securitization allows less liquid, income-generating assets, such as home mortgages, to be packaged into securities and sold to investors. The latest round of reforms are focused on securitized instruments that are “tranched,” which means they are divided into portions, making payments first to the “senior” tranche holders, then to “mezzanine” tranche holders, with “equity” tranche holders getting whatever is left over. They allow risks to be split up and distributed to a more diversified set of holders. In Europe, covered bonds, a form of securitization in which the originator retains an economic interest in the loans, also play a key role in financing mortgage lending (see below).

Restarting the market

In the Global Financial Stability Report we put forward a number of specific policy recommendations, to address the shortcomings of securitization, which include:

• Reduce incentives to rely excessively on credit rating agencies and rating-related regulatory requirement gaming. Rating agencies should disclose their methodologies and publish their rating performance data. Regulators and other rulemakers should reduce reliance on ratings.

• Improve securitization disclosure and transparency standards—at the product level to facilitate more investor do-it-yourself risk and return analysis, and at the issuer level to produce financial statements that more accurately reflect their securitization-related exposures.

• Provide incentives for securitizers to retain some exposure to the performance of their products to better align their interests with those of investors, including basing securitizer compensation on the longer-term product performance.

• Simplify and standardize securitization products to improve liquidity, and reduce valuation and risk management challenges

Also, not only is it important to reform accounting standards and prudential regulations, but it is equally important to evaluate how they might interact before any are implemented. Impact studies should be conducted to ensure that, in combination, they promote sustainable securitization. If not, there is a risk that they could further impede, not help restart securitization, by inadvertently making the process too costly.

End of “high octane” markets

Prior to the crisis, securitization market growth was fueled increasingly by “high octane” products that made little economic sense except to those collecting fees. These included resecuritizations, such as collateralized debt obligations of collateralized debt obligations, known as CDO-squared, as well as collateralized debt obligations of mortgage-backed securities backed by subprime mortgages. Some of these products were effectively disposing of tranches for which there were no buyers, and designed to exploit holes in credit rating agency methodologies. Had investors been able to see the flaws in the rating methodologies with more information about the underlying risk exposures, they could have insisted on additional credit enhancement, but the complexity of many of these products made it difficult to detect how credit ratings were assigned.

The impact of this over-reliance on credit ratings was exacerbated in many cases by a paucity of information regarding the underlying risk exposures. Moreover since the need to maintain high credit ratings was well entrenched in various regulations, when downgrades did occur, they spread quickly through the financial system with devastating effects.

Securitization encouraged additional financial players, interested in the fee-making opportunities, to participate in the process. In the old, bank-dominated mortgage lending business model, borrowers dealt directly with lenders. But the new “originate-to-distribute” model inserted numerous fee collecting firms between the borrower and the ultimate creditor. For example, credit rating agencies that earned the bulk of their revenue from securities issuers were not properly motivated to look out for the final investors, who had come to rely on their ratings. The compensation of investment banks and dealers was based on sales volumes, with little regard for the longer-term performance of the securities.

Furthermore, accounting rules and regulatory standards allowed financial institutions to play “shell games” with various securitization-related operations. As a result, market participants and even the authorities were shocked at the domino effects that followed the breakdown in the U.S. subprime mortgage markets.

In contrast, the market for covered bonds has weathered the storm fairly well (see below).

Covered Bonds (by Andy Jobst)

A covered bond is a secured debt obligation collateralized by a dedicated portfolio of assets (the cover pool) that is kept by the issuer on its balance sheet. Because issuers of covered bonds are fully liable up to their registered capital, there is a double layer of protection for investors—the assets and the issuer. Most covered bonds are issued under special laws that set prudential standards for product structures and the credit quality of the cover pool, to limit incentives for excessive risk-taking and slippage in underwriting and monitoring standards. In Europe, covered bonds have long been the preferred method of capital market-based mortgage funding. But covered bonds do have a downside: They do not provide the balance sheet leverage and regulatory capital relief commonly associated with securitization in which the pool of assets backing a bond is moved off the issuer’s balance sheet.

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* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management.

IMF’s Global Financial Stability Report on Restarting Securitization Markets

I was the “team leader” of Chapter 2, which tracks the rise and fall of securitization markets, and evaluates the various initiatives aimed at restarting them on a sounder footing, focusing on the markets for securities not backed by governments or government-sponsored enterprises. The analysis attempts to discern how securitization can positively contribute to financial stability and sustainable economic growth.

While most of the current proposals are unambiguously positive for securitization markets and financial stability, some proposals—such as those designed to improve the alignment of securitizer and investor interests and accounting changes that will result in more securitized assets remaining on balance sheets—may be combined in ways that could halt, not restart, securitization, by inadvertently making it too costly for securitizers. While recent regulatory proposals are aimed in the right direction, a careful look at their interactions is warranted before they are finalized.

The chapter can be downloaded here.

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* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management.

Canadian Residential Mortgage Markets: Boring But Effective?

The IMF just published my paper on Canadian mortgage markets. A 2008 paper by Vladimir Klyuev, my colleague and sometimes collaborator, concluded that the Canadian market for housing finance is highly advanced and sophisticated, but financing options were somewhat limited, particularly at terms longer than five years.

This paper argues that the paucity of longer-term loans is caused by a five-year maturity cap on government-guaranteed deposit insurance, and a prepayment penalty limit on residential mortgage loans in the Interest Act. That said, the availability and cost of residential loans for prime borrowers are comparable to those in the United States.

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* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management.