Mortgage credit risk in EU countries: Constraints on exploiting the single currency market

The adoption of a single EU currency market raises questions about how individual country mortgage policies are likely to affect the gains that can be realized from this larger market. We use an option pricing model to provide some perspective on this issue. We address questions such as how does the risk exposure of a mortgage guarantee program in one country compare with those in other countries? What kind of effects do any such differences or varying legal restrictions on lender recourse have? Do the programs help complete financial markets? That is, are the programs structured as unsubsidized financial intermediaries which help allocate risks? Or, are the programs essentially wards of the state which encourage risk taking? In short, we aim to provide a simple, tractable way to think about how individual country policies affect the ability to exploit the potential offered by the larger market. Our conclusions are three. First, when correctly structured, mortgage default insurance can be expected to reduce non-price rationing at an actuarially fair price. It follows that to the extent that such programs lead to more complete markets without subsidies they are also more efficient than are the many schemes now used which rely on subsidies to address mortgage market incompleteness. Second, considerable care must be exercised in the development of such instruments. In a number of countries the pricing policies do not appear to be prudent. The program terms imply either that regulators often expect a much safer economic environment than seems likely, or, alternatively, the programs have been conveying either unbudgeted subsidies or incurring contingent liabilities. Such liabilities have already been realized in Sweden, and the current exposure in the Netherlands as well as with the restructured program in Sweden, appear to be large. Finally, we find that the potential geographical risk diversification provided by the single currency market can be expected to reduce mortgage rates and improve risk allocation. However, legal, fiscal, and regulatory issues with respect to credit risk limit the ability to exploit this larger market.