Banks, Financial Services, Real Estate, Round Table

The article was prepared for the International roundtable-seminar “Latvian banks: what lies ahead?” held in the Baltic International Academy on 18 May 2016. Its organizers: Baltic International Academy (BIA), Employers’ Confederation of Latvia (LDDK), Diplomatic Economic Club (DEC) and online magazine baltic-course.com.

Mortgage lending has several definitions that differ depending on the study purposes, legislation of the country concerned, and the branch of knowledge is being analyzed. In terms of the economic substance, a mortgage is a mechanism for securing an obligation by means of a pledge of real property, the purpose of which is to increase funds under a long-term loan. This means that the creditor, under the existing laws, can dispose of real estate served as a pledge to pay off the borrower's arrears in the event of bankruptcy or other factors thwart his debt service obligations [1].

Civil Law of the Republic of Latvia defines a mortgage as a pledge of real estate with no transfer of ownership [2].

Mortgage lending is critical for both the household welfare and level of development of the national economy, as a whole. Real estate (house or apartment) is often the most valuable assets for most households, and a mortgage, in turn, is their main source of additional borrowed funds, so presence of the mortgage and its conditions have a huge impact on household finances [3]. Recent studies have shown that presence of mortgages in households can about-turn its marginal propensity to consume, as it reduces liquidity of real estate [4].

Empirical evidence suggests that lower interest rates ensure an increase at the housing market, especially in purchase and sale sector. Increase at the mortgage market in the early XXI century led to expansion of demand and consumption, which, in turn, resulted in incurrence of heavy debts on mortgage loans. The subsequent penalties in a form of alienation of real estate in favor of banks caused serious damage to the household economics, as well as to the housing market [5].

Thus, the relationship between the mortgage market and the housing market can increase the impact of housing price shocks, increase the impact of changes in mortgage interest rates on economic activity, and sometimes can put the household wealth at risk (with potential consequences for the national financial system).

Therefore, initial drop in mortgage rates can have an impact on rising housing prices, and, hence, the households welfare and quality of life. An increase in the collateral value of its assets can provide households access to more loans on preferential terms (via the so-called “credit channel” - a mechanism for transferring monetary policy into the real economy). This, in turn, can contribute to increased demand for housing, and to additional increase in housing prices [6]. Thus, a condition of simultaneous increase in household debt and the market value of housing assets occurs. Resolution of such situation can be made in two directions. On the one hand, households may use an additional liquidity of their property to increase spending on consumer goods or to invest in various financial assets. However, a further increase in mortgage rates will expend household liabilities for accumulated debt, which will exert negative influence on the market value of housing assets [7].

In the mid-1980s, such situation was observed in the Nordic countries, where liberalization and deregulation of financial markets were carried out, which caused expansion of crediting and led to excesses on the real estate markets; stock prices rose, and asset price bubbles were occurred [8].

Yet another example of the mortgage market and the housing market impact is the Great Recession of 2008. Therefore, when in 2003 the traditional mortgage market became saturated, the finance industry began to combine low-rated mortgage loans – often subprime mortgages - to maintain and increase financial flows. By 2006, more than half of the country's largest financial companies were involved in the MBS (mortgage-backed securities at risk) market [9]. As a result, such actions led to a downturn in the housing and mortgage markets, which had an impact both on the US economics and on the global economic system.

According to the research conducted in Russian regions, mortgage rates has a significant impact on prices in the primary housing market, however, degree of such impact depends on the housing market segment. This impact is most strongly felt in the more favorable typical regional housing markets located in regions with a high employment level and well-developed infrastructure. In less favorable regions, such impact is observed to a lesser extent [10]. It should be noted that only a decrease in mortgage rates can not have a marked impact on prices for new housing constructions. Only a general decrease in the price of borrowed capital can have a significant impact on lowering prices at the primary housing market. At the same time, an increase in mortgage rates makes significant corrections to existing prices, and, perhaps, makes existing residential real estate more attractive in terms of investment activity, but herewith less accessible to the most of buyers.

This empirical evidence suggests that, given the cyclical nature of interest rates, government control over the mortgage market, as well as timely indexation of mortgage payments can improve efficiency of the housing market based on improving household welfare. According to the author, main role of the mortgage market is to stimulate the housing market, which will lead to an inflow of additional investments into the country, growth in employment and, as a result, a welfare gain and solution of the most important social problem of provision of housing.

1. Chukanov, A. and Guchek, N. (2017). MORTGAGE LENDING: A MODERN APPROACH. Journal of Tula State University. Economic and legal sciences, 5(1).
2. Pravo.lv. (2017). Civil Law of the Republic of Latvia. [online] Available at: http://www.pravo.lv/likumi/05_3_gz.html [Accessed 13 Sep. 2019].
3. Campbell, J. and Cocco, J. (2015). A Model of Mortgage Default. The Journal of Finance, 70(4), pp.1495-1554.
4. Kaplan, G. and G. L. Violante (2014). A Model of the Consumption Response to Fiscal Stimulus Payments. Econometrica 82 (4), 1199–1239.
5. Mian, A., A. Sufi, and F. Trebbi (2015). Foreclosures, House Prices, and the Real Economy. Journal of Finance 70 (6), 2587–2634
6. Gao, Zhenyu, Michael Sockin, and Wei Xiong. 2017. “Economic Consequences of Housing Speculation.” Working Paper
7. Ganong, Peter, and Pascal Noel. 2017. “The effect of debt on default and consumption: Evidence from housing policy in the great recession.” Unpublished Working Paper
8. Fellman, S. (2019). Economic development in the Nordic countries. [online] Nordics.info. Available at: http://nordics.info/show/artikel/economic-development-in-the-nordic-countries/ [Accessed 13 Sep. 2019].
9. Coghlan, E., McCorkell, L., Hinkley, S., McCorkell, L., Hinkley, S., Hinkley, S., McCorkell, L. and Hinkley, S. (2018). What Really Caused the Great Recession?. [online] Irle.berkeley.edu. Available at: https://irle.berkeley.edu/what-really-caused-the-great-recession/ [Accessed 13 Sep. 2019].
10. Kornilov, N. (2015). IMPACT OF MORTGAGE RATES ON PRICING IN THE PRIMARY HOUSING MARKET. Statistics and economics, 2.