We’ve referred to the Debt Hangover speech by Andrew Haldane, the Bank of England’s financial stability wizard, once already on Thursday. But it’s worth revisiting to highlight his views on mortgage structuring.
It’s a curious idea drawing on the the recent rise of contingent capital bonds — also known as CoCos — as a much championed solution to the banks’ own capital needs.
As Haldane opines:
A better-designed debt contract would automatically adjust repayment terms when the borrower found the going getting tough. Debt would become, in the language of economics, state-contingent – contingent on the borrower’s state of financial health.
By cushioning fluctuations, these instruments have the potential to stabilise automatically debt dynamics. And by averting costly default, they potentially benefit both creditors and debtors.
There has been recent interest among banks in issuing state-contingent instruments – so-called contingent capital. These instruments convert into equity in the event of a pre-defined stress trigger being breached. So these instruments offer repayment insurance to banks at the point it is most valued. They are, in effect, a contractually pre-committed form of debt-equity swap.
Which leads him to suggest that the CoCo framework might be just as sensible for solving the retail mortgage market’s problems too. He explains as follows:
As several academics have argued, the same basic principles could be applied to the debt contracts issued by households, companies and even sovereigns.
Take a typical mortgage contract. A rise in the value of a property relative to the loan gives the borrower equity against which they can borrow. This provides an incentive to tradeup, raising house prices and generating further equity. This amplifier operates symmetrically, as falling collateral values reduce refinancing options and drive down prices. Economists call this effect the financial accelerator. It adds to cyclicality in credit provision and asset prices.
So, while a traditional mortgage incentivises cash-machine like use, either through equity withdrawal or ‘trading up’ when assets are appreciating — hence accelerating the house price rise effect — it happens also to amplify the exact opposite behaviour when asset prices depreciate.
A CoCo mortgage, on the other hand, would slow or even reverse the so-called ‘financial accelerator’ — hence easing the potential for extreme asset price fluctuations on either side. As Haldane explains, that could be a benefit to everyone:
Instead of being fixed in money terms, imagine a mortgage whose value rose with house prices. So the repayment burden would rise automatically with asset prices to slow a credit boom and fall in a recession to reduce the chances of mortgage default. Mortgages would operate like a contractually pre-committed debt-equity swap between households and banks. They would automatically stabilise household loan-to-value ratios. By reducing the amplitude of the credit cycle, they ought to benefit both borrower and lender.
Although, presumably, the legions watching property speculation shows on TV would not agree.
Nevertheless, it’s definitely the sort of mortgage-related reform investors would be wise not to rule out. As the Times reports, Mervyn King is increasingly listening to more unconventional economic thinking. Who’s to know what’s coming next?
Related links:
I should not have CoCo-ed? – FT Alphaville
The sweet fix of CoCos? – Gillian Tett, FT