Across much of Europe people now have to borrow a great deal more than they did a few years ago – relative to their incomes – to buy houses. House prices in most of Europe are much higher than 10 years ago and in many countries the real cost of a typical house is more than double what it was in the mid-1990s.
In recent months interest rates in Europe have increased and they may go higher. It is therefore not surprising that governments and central banks are concerned about the affordability of mortgage debt. Higher house prices, and the more recent increases in short-term interest rates, raise big questions about the best design of mortgages.
These issues are clearly serious in the UK, where most mortgages are either variable rate contracts or with the interest rate fixed for a relatively short period. With house prices so much higher relative to incomes than even a few years ago, it is understandable that the government is focusing on the types of mortgage typically sold in the UK. But given what has happened to house prices right across Europe, the issues of risk and affordability of mortgage debt are more widely relevant.
House prices in Europe have been mostly driven by higher incomes and to a lesser extent by rising population. Low interest rates have been an important factor. But in many countries, expectations of further price rises have also played a big role. That factor is likely to be volatile and transitory, so declines in prices are clearly possible and in some countries even likely. Where interest rates will go next is uncertain.
So what types of mortgage will best suit such an environment, where house prices are higher relative to incomes, but may be volatile and cannot be assumed to carry on rising?
Across Europe today, a mortgage largely remains a nominal contract with repayments unrelated to movements in consumer or house prices.
In many countries – particularly the UK – the repayment is also very significantly affected by movements in short-term, nominal interest rates.
There are disadvantages with this type of loan: the overall real (inflation adjusted) cost of repaying it is uncertain and the initial cost of servicing the mortgage is typically higher in real terms than it later becomes – which is a strange feature given that as time passes, most people get higher incomes, not lower ones.
There are potentially big advantages in having the cost of mortgages more predictable in real terms and also having some element of the cost of repaying debt linked to changes in the value of the home. Mortgages with these features are called indexed mortgages. In a recent report, I considered in detail the characteristics of this sort of mortgage. It is of course not a new concept. For 25 years the UK government has – very successfully – been issuing index-linked debt. Other countries across the world have followed suit.
With indexed mortgages the scale of repayments can depend on consumer prices and potentially on house prices. Repayments are linked to real interest rates. Crucially, real interest rates are less variable than nominal rates.
Indexed mortgages have the twin benefit of generating a less downward-sloping real burden of repayments over time and also a less volatile one. The burden of servicing the debt is much lower in the early years of the mortgage than it is with a standard (nominal) mortgage – which is a desirable feature since that is when affordability issues are most acute.
Right now, indexed mortgages are offered hardly anywhere in Europe. Will lenders want to offer them? This depends on whether such a product would create a correspondingly attractive financial asset for investors and there is every indication that it would.
As a result of this sort of indexed mortgage lending, securities can be created that allow investors to receive streams of income that are linked to consumer price inflation and potentially also to overall house price inflation. These could come to represent a useful addition to the supply of existing index-linked bonds that create a return that is some fixed amount in excess of consumer price inflation. At the moment, these bonds are overwhelmingly issued by governments, with some limited private sector issues (often from utilities companies).
There are strong reasons to believe that innovation will come because indexed mortgages create financial assets that should suit investors – as well as creating very big benefits to borrowers.
The writer is chief UK economist at Morgan Stanley