There have been six major banking crises in developing countries since the mid-1970s, all were associated with housing booms followed by busts according to an International Monetary Fund (IMF) Global Financial Stability Report to be issued next week. 

The degree to which these cycles have been associated with financial instability differs among countries due in part to important differences in countries' housing finance systems, including the role of government.  However, where recessions are linked to housing booms and busts, those recessions are on average more severe and last longer than those that are not.   

IMF released two chapters in its report titled Durable Financial Stability: Getting There from Here.  One chapter is devoted to the role of a country's housing sector on the stability of its economy as a whole. The IMF study looks at characteristics of the housing markets in dozens of countries, both "advanced" and "emerging" to determine what characteristics correlated with instability in the housing market and found that boom/bust cycles were caused or at least magnified by several factors:

• Excessive competition and aggressive lending often associated with deregulation;
• Capital inflows that sustain the supply of credit to households while leading to vulnerable funding for lenders and borrowers;
• An extended period of low monetary policy rates

The relationship between rising house prices and mortgage credit growth, particularly in advanced economies, was amplified by government participation in housing finance.  Subsidies to first-time home buyers, tax deductibility of capital gains on housing, and government provision of mortgage guarantees or credit tend to amplify house price swings by exacerbating both the boom and the subsequent bust.  There are indications that certain tax breaks to homeowners are particularly likely to distort demand and lead to volatility in house prices.  The report chides the Obama Administration for failing to recommend elimination or modification of tax deductions for home mortgage payments in its recent plan to reform the housing finance system, calling that policy "both expensive and regressive."   

The study specifically faults the U.S. for the role private label securitization played in the housing crisis because of its association with deterioration in underwriting standards and incentive problems.  Once the crisis began, it also led to a situation in which servicers have had little incentive to renegotiate loans because of the compensation model in their contracts.  The report suggests that the US might do well to adopt the covered bond model which has contributed to safer mortgages in Europe and could complement securitization as capital market mortgage financing.

Going forward, the report suggests that both advanced and emerging economies would do well to return to basics; solid underwriting standards consistent across various types of lenders; prudential limits on loan-to-value ratios and debt-to-income ratios, and "better-calibrated" government participation.

The report says that the later means that government participation should have less focus on direct provision of credit and more concern about system effects and externalities.  It would also rely on more targeted measures to achieve social objectives such as affordable housing for low-income households.  Some countries, the report says, might want to reconsider their focus on homeownership; good-quality rental housing could be a better option for low-income households.  This could be accompanied by more level tax treatment across owner-occupied and rental housing and reassessment of tools such as mortgage interest deductibility "which should be capped and apply only to first mortgages on primary residences"

IMF makes some additional suggestions for housing finance reform specific to the U.S including enhanced internal risk management at financial institutions and improved underwriting standards and supervision.  Housing related tax expenditures should be reviewed and the role of the government sponsored enterprises (GSEs) reassessed so as to create a more level playing field in the mortgage markets.  It applauds most of the administration's recent recommendations including winding down the GSEs by gradually raising their insurance guarantee fees, reducing their investment portfolios, and lowering the conforming loan ceiling.  The report also comes down solidly in favor of one of the three options for government involvement in housing finance suggested by the Administration - a privatized system plus public catastrophic reinsurance with first-loss insurance coverage from private sources  "The option is likely to provide the lowest-cost access to mortgage credit and would make government participation (and taxpayer exposure) explicit.  However, pricing the catastrophic insurance will be challenging given the need to avoid overinvestment in housing that would exacerbate distortions and contingent liabilities.

Government guarantees for securitized mortgages need to be continued for the near term given the Resignificant remaining uncertainty in the mortgage markets and substantial swings in the cost of financing could be particularly damaging  However, government guarantees should be explicit and fully accounted for on the government's balance sheets.  Over the medium term the GSEs should be wound down to make way for private-label securitization to reemerge as a viable option.