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Theoretical modelling of the demand for mortgage finance : a heuristic framework

Theoretical modelling of the demand for mortgage finance : a heuristic framework. Vítor Neves Faculty of Economics University of Coimbra , Portugal. Summary. Demand for mortgage finance vs. demand for mortgage debt The ‘closed relationship’ approach

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Theoretical modelling of the demand for mortgage finance : a heuristic framework

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  1. Theoretical modelling of the demand for mortgage finance: a heuristic framework Vítor Neves Faculty of Economics University of Coimbra, Portugal Glasgow, 20 September 2001

  2. Summary • Demand for mortgage finance vs. demand for mortgage debt • The ‘closed relationship’ approach • A heuristic ‘multiple-exit’ framework for the analysis of the demand for mortgage finance

  3. Background What is the real importance of mortgage market imperfections (namely, maximum institutional loan-to-valueand payment-to-income ratios) in the explanation of mortgage demand? What are the issues? Topics to be discussed lifting institutional mortgage market constraints might have no impact on the demand for mortgage finance desired payment-to-income ratios and expectations might be crucial factors in the explanation of mortgage LTV decisions What are the conditions under which mortgage liberalisation leads to a mortgage market expansion?

  4. Demand for mortgage finance vs. demand for mortgage debt • demand for mortgage finance (or credit)as mortgage originations (primacy to decisions at the time of the house purchase) • demand for mortgage debtas the amount of outstanding debt secured by the owner’s principal residence (analysis of mortgage debt decisions all over the household lifecycle)

  5. The ‘close relationship’ approach • A close relationship between mortgage and owner-occupied housing demand usually presumed. • Demand for mortgage finance as a derived demand, “a multiple of housing demand, a multiple that receives little attention.” (as the demand for housing increases so does the demand for mortgage credit)

  6. A more sophisticated view: mortgage demand within an optimizing framework • The quantity of borrowed funds demanded is determined both by the optimal housing expenditure and the optimal ratio of equity to borrowed funds at that level of expenditure. • An unconstrained homebuyer seeksa combination of own and borrowed funds such that the marginal cost per money unit is the same for any source of funds – the minimal marginal cost of capital to the borrower. • Any equity-mortgage desired mix is possible depending on the relative opportunity costs.

  7. mortgage maximization or minimization? • The demand for mortgages as a corner solution. • the importance of the magnitude of the after-tax cost of mortgage debt relative to both the cost of other forms of debt financing and the after-tax returns on nonhousing investments. • A mortgage cost lower than the cost of other debt financing and/or the interest on savings would lead to mortgage debt maximization (e.g. the US case) while the opposite would result in mortgage debt minimization (e.g. the Canadian case).

  8. When a stochastic rs is considered any value for the mortgage between zero and the maximal allowable amount is an admissible optimal outcome for some set of household preferences, even in the case where the expected returns on nonhousing assets are greater than the cost of mortgage finance. • It is no longer true that the largest allowable mortgage is the only rational outcome in a U.S.-like case. In addition, the comparative-static effects developed for the certainty model become ambiguous in sign.

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

  10. Opposing views and observations • demand for mortgage finance is not a perfect proxy for housing demand (Goodman, 1992) • ‘excess mortgage’ debt (Jones, 1993) • the puzzling experience of Southern European countries • the Canadian experience of residential mortgage finance in the first half of the XX century (Harris, 1998) • the Dutch case: new mortgages applied in the purchase of investment products and expensive consumption goods • borrowers may substitute one type of credit for anotherand choose to finance asset purchases by means of different forms of finance(Meltzer, 1974)

  11. taking stock • the close relationship presumption has contributed to inhibit research on mortgage demand • In its debt maximization hypothesis formulation in particular, it has contributed to bias the researchers’ attention towards the study of the impact of borrowing constraints – and mortgage market imperfections in general – on access to homeownership. • The mainstream approach has concealed the importance of looking into the demand for mortgage credit and the equity-mortgage mix as an outcome of deliberate, at least partially autonomous, household genuine choices.

  12. 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.

  13. the decision on how much to save and for how long, as well as on how much to borrow, is part of a savings-homeownership plan, that is, a global project aiming at becoming owner in the best feasible conditions. • consumers’ housing finance decisions are complex.

  14. Looking for an alternative: an encompassing heuristic ‘multiple-exit’ framework • Why give priority to the heuristic properties of the model – its capability to highlight households’ options – rather than to formal rigour? - important goals: • fully grasp household’s genuine mortgage choices • To take full account of complexity (the decisionon how much to borrow is part of a set of complex and interrelated consumer decisions) and uncertainty(agents are endowed with only a partial capacity to grasp their current and future circumstances and hence are unable to calculate the optimal decision)

  15. Assumptions • I assume that households make a joint decision on the house value and the loan-to-value ratio compatible with that value. • households are ‘risk’ averse in a more or less degree and aspire to reach a desired level of housing consumption and/or a satisfactory rate of return of housing investment with the minimum lifetime mortgage costs compatible with nonhousing consumption smoothness and a minimal disturbance to their portfolio of nonhousing assets.

  16. households are forward-lookingacting subjects in an uncertain environment • ‘agents maximize utility’ is no more than a proposition about motivation (an intention or ambition agents pursue), not realization, as does modern mainstream economics

  17. PTI ratios and house values compatible with those ratios

  18. LTV ratios and house value compatible with those ratios

  19. The LTV decision at the time of the house purchase

  20. The LTV decision with binding borrowing constraints

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