You may have heard in the last few weeks about a proposal to establish a European mortgage funding organisation of the kind found in most developed economies outside Europe.
The European Mortgage Finance Agency (Emfa) will fulfil a very specific function. It will be a public/private partnership in which lenders provide the equity capital and the EU provides an umbrella of support to create the confidence amongst debt investors required to provide a stable funding source for mortgages across Europe.
Emfa is designed to create a unified secondary mortgage market across the EU and accession countries by providing a guarantee of payment to investors in mortgage-backed securities (MBS). Emfa would be open to all mortgage lenders on the same transparent terms.
Although Emfa will provide its guarantee on MBS backed by all kinds of residential mortgage loans, it could facilitate the development of standardised mortgage products to sit alongside existing products. It would also facilitate standardisation of the mortgage process, creating a more efficient industry.
Emfa could bring a number of benefits, such as integrating European mortgage markets, reducing imbalances of monetary policy impact across the eurozone, developing EU capital markets and providing banks with a new balance sheet, capital and risk management tool.
But one aspect of the proposal seems to have caught the popular imagination – long-term fixed-rate loans without redemption penalties. To understand why Emfa is required to establish a market in these loans we need first to understand why such a product exists in some countries and not others.
In the UK the system developed by building societies in the Victorian era saw retail deposits used to fund mortgages. Because deposits are short-term, they necessitated the use of variable rate mortgages.
Today, the basic funding instrument remains the same. Some 75 per cent of UK mortgage funding comes from deposits. Banks have been offering fixes since the 1980s, funded mainly from uncollateralised bonds. But beyond five-year terms these bonds become relatively uneconomic as investors demand higher risk premiums.
This contrasts with the state of affairs in most other developed countries. For example, some 200 years ago the mortgage bond market was established in Germany. Instead of placing their savings in deposits, savers bought bonds with interest rates fixed for long periods, funding fixed-rate mortgages.
With the uncertainty investors faced in those days, it was necessary to design a system that protected the saver from the two main risks – that the borrower defaulted or that interest rates declined and the borrower switched to a cheaper loan. To protect investors, the maximum loan-to-value ratio permitted was 60 per cent and borrowers were prevented from repaying their loan early.
But what does this mean in Britain today? We have a competitive mortgage market but a product gap in long-term fixed-rate loans without lock-ins. Lenders would love to fill this gap but a new mechanism for funding such loans is needed.
UK borrowers still have no choice but to face one of the twin mortgage risks – interest rate rises or being locked into an uncompetitive rate. Critics say that removing these risks creates volatility for lenders. But today it is quite unnecessary to force these risks onto the borrower when, with the right institutional framework, they can be absorbed by the industry and professional investors in the secondary mortgage market.
Emfa is designed merely to augment mortgage funding arrangements already in place. It will have no business if lenders do not come to it and therefore has to provide a securitisation platform which would be attractive to lenders. It need not offer long-term fixed-rate prepayable funding – whether it did would be a policy issue – but at least it creates the opportunity for such a market.