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Oxford Review of Economic Policy 2008 24(1):145-175; doi:10.1093/oxrep/grn005
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© The Authors 2008. Published by Oxford University Press. For permissions please e-mail: journals.permissions@oxfordjournals.org

This article appears in the following Oxford Review of Economic Policy issue: HOUSING MARKETS AND THE ECONOMY [View the issue table of contents]

Financial innovation and European housing and mortgage markets

David Miles*
Vladimir Pillonca**
* Morgan Stanley, e-mail: david.miles{at}morganstanley.com
** Morgan Stanley, e-mail: vladimir.pillonca{at}morganstanley.com


  Abstract

In this paper we assess the recent history of house prices and of mortgage lending across Europe. We develop a simple economic framework to estimate the likely contributions of fundamental factors, such as changes in real incomes and population growth, to house price appreciation. We also try to quantify how much of price rises might have been driven by rising expectations of future capital gains. We estimate that this might have played a significant role in several countries, including Spain, Sweden, Belgium, and the UK. We then consider what different types of mortgage arrangement might become attractive in a world of higher house prices, analysing types of indexed mortgage that have advantages where prices are higher relative to incomes and where house prices may be volatile and cannot be assumed to carry on rising.

Key Words: mortgages • house prices • indexation • bubbles

1 If there are no credit restrictions and households can control the rate at which they repay debt, then it is likely that the real (inflation-adjusted) mortgage rate is the relevant measure of the cost of debt. But when households have less control over the timing of debt repayments, the nominal rate can be more important. This is particularly true with repayment mortgages with a flat repayment profile, where the front-end loading problem can be acute if inflation and nominal interest rates are high.

2 With a fixed real interest rate so that real repayments are fixed and nominal payments only vary as the consumer price index changes.


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