Joint Center for Housing Studies 

Harvard University 

Identifying, Managing and Mitigating Risks to Borrowers in 

Changing Mortgage and Consumer Credit Markets 

Eric S. Belsky, Karl E. Case and Susan J. Smith 

February 2008 

UCC08-14 

© by Eric S. Belsky, Karl E. Case and Susan J. Smith. All rights reserved. Short sections of text, not to exceed two 

paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. 

Any opinions expressed are those of the author and not those of the Joint Center for Housing Studies of Harvard 

University or of any of the persons or organizations providing support to the Joint Center for Housing Studies.

1

I. Introduction: The Changing Face of Debt

Household balance sheets have become increasingly leveraged over the past two decades 

and the trend has accelerated since 2000. The ratio of total household liabilities to total assets in 

the U.S. has increased 35 percent since 1987 with half the increase coming in the last five years. 

The character of household debt has changed markedly during the same period. Credit has been 

made available to a wider pool of borrowers; loan terms and underwriting standards have been 

liberalized; and credit is increasingly risk-based with less rationing. An increasing percentage of 

debts are secured and most of the added collateral is housing. These trends are common to the 

“homeownership societies” of North America, Europe, and Australia. 

This increase in secured loans has been caused by a number of factors. First and 

foremost is the large increase in the value of housing assets in recent years, which has loosened 

collateral constraints on borrowing. Second, secured loans carry a lower interest rate than 

unsecured loans, so there has been an incentive to consolidate borrowing into mortgages. Third, 

in some countries mortgage interest payments are – in whole ofr in part – tax deductible (in the 

US, for example, mortgage interest is the only form of consumer interest that is tax deductible 

since 1986). Finally, the development of a broader asset-backed securities market has increased 

the liquidity of mortgages. 

This paper concentrates on the management and mitigation of mortgage risks: the kind of 

credit risks that face the majority of indebted households. For several decades now both the US 

and UK governments have sought to extend home purchase ‘down market,’ encouraging and 

indeed requiring lenders (for example in the US via the Community Reinvestment Act (1970) 

and the Home Mortgage Disclosure Act) to extend secured credit to previously ‘under-served’ 

areas in order to build an asset-base for welfare (Case and Marynchenko 2004). At the same time, 

lenders and governments have encouraged both higher and lower income households to use 

mortgages to secure borrowing for all kinds of purchases, including those required to meet basic 

welfare needs (Smith 2005). 

There are some advantages to borrowers of these trends. Mortgages have turned housing 

into the only leveraged tax-advantaged investment that is widely available to the public, and the 

resulting wealth has become central to households’ asset accumulation. In some jurisdictions, 

such as the UK, mortgage lending is more tightly regulated than other forms of credit; and home 

price appreciation is often tax-advantaged. On the other hand, mortgages are very large loans 
2 

which provide a gateway to essential housing services as well as a lever for investment returns 

and a potential source of lower cost financing. So the costs of default can be high, putting family 

homes at risk even if missed payments relate – in practice – to secured loans that were used to 

fund health care or holidays. 

Although the landscape of risk facing both lenders and borrowers of all kinds has radically 

changed in the last quarter century, the options for protecting borrowers have been pursued much 

less vigorously than have strategies to support lenders (though, as the subprime crisis shows even 

here the solutions have been partial). This paper thus sets out the key risks for borrowers, and 

identifies some possibilities for managing and mitigating them. To this end, there are three main 

sections. Each of them flags trends or takes examples from the US and the UK – countries where 

households’ experiences of wealth accumulation and indebtedness are mediated by a style of 

owner occupation that is supported by mortgage finance. 

First, we set the scene by discussing trends in housing wealth, mortgage debt and other 

consumer credit. Second, we review the risks associated with the changing character of 

households’ debt. We divide these risks into: systemic risks, which are embedded in the wider 

economic environment, and so affect large numbers of people and areas simultaneously; and 

individual risks that mat be widespread but are the less predictable result of biographical 

disruptions including relationship breakdown, adverse health events, or accidental death or injury 

to, or disablement of, a main wage-earner. 

We then turn to a discussion of the options for mitigating risk. Here we make a 

distinction between “traditional” approaches – which include a range of state and market-style 

insurances (in which risks are pooled and premiums paid from income streams which are 

occasionally priced to reflect people’s ability to pay but are more often priced to reflect the 

likelihood of claiming) and solutions that make use of “new” financial instruments. More 

correctly, these latter solutions are about extending to ordinary households a generation of 

financial instruments which are commonly used by financial market to widen the gains, and by 

large institutions to spread the risks, of the performance of a wide range of assets and debts. It 

could be argued that these instruments (in so far as they have been used to manage housing debt) 

partly underpin the ‘credit crunch’ that has destabilized the banking sector over the past year. 

However this paper considers whether, as tools for managing the housing equity side of the 

equation, they may equally be used to protect households from some of the fallout. 
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II. Housing Wealth and Mortgage Debt

Sustained price appreciation across almost a decade has turned housing into a major store 

of wealth, particularly in the English speaking world (Belsky and Prakken 2004; Di et al. 2003; 

Muellbauer, in press; Smith 2006; Berry 2006). In the US, for example, in the second quarter of 

2007, household assets totaled $71.7 trillion, of which direct holdings of real estate accounted for 

$21.0 trillion or just under 30percent (Flow of Funds Table B100, Federal Reserve Board of 

Governors). The figure is even higher than this for the UK, where housing accounts for 43 

percent of households’ total assets today, compared with 28 percent in 1996. In both 

jurisdictions, moreover, the drift is away from that other staple of households’ wealth portfolios, 

pensions, in favor of further consolidation of wealth into home equity. In the US, in 1997, 

household holdings of real estate assets were just 16 percent higher then household pension fund 

reserves; today they are 66 percent higher. Likewise in the UK, as investment into housing is 

increasing, so savings into pensions are falling. So housing wealth is both a key component of 

retirement saving and, as we shall see, a resource that is brought increasingly into play across the 

whole of the life course. 

The increased importance of housing in these countries is the result of both appreciation 

in the value of land and a surge of capital investment. Between 2000 and 2005, a period of low 

inflation, the total value of residential real estate in the U.S. increased by $10 trillion (a 68 

percent increase), with land accounting for about half of that total (see Case, 2007). In all, 

housing values in the United States have tripled since 1987, while prices in general have only 

increased by 80 percent (see Macromarkets.com S&P Case Shiller indexes). In the UK, between 

2000 and 2004, prices rose by 60 percent; even in the long run – since 1971 – the UK has (with 

Spain) regularly topped the OECD league table for annual house price hikes (Smith 2006). 

Across this whole period, moreover, housing has performed well relative to other assets. These 

increases mean that housing is both the most widely distributed of all financial assets, and the 

major component of wealth for the majority of households. Indeed, in both countries there is 

evidence that the distribution of housing wealth to some extent evens up the distribution of all 

wealth. Smith (2005) sets out the position for the IK; data presented in Case and Marynchenko 

(2002), document the US experience, showing, for example, that among low income households, 

homeownership was an excellent vehicle for wealth accumulation in Chicago for at least two 
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decades, whereas homeowners who bought in Los Angeles in 1991 suffered losses in wealth and 

say a tendency to “negative equity” by 1995. 

Housing wealth is, nevertheless, unevenly distributed across both the US and the UK. 

The bulk of the increase in the US during the recent period of growth was, for example, 

concentrated on the West Coast and the Northeast, where seven states currently account for 47 

percent of total home value: California alone accounts for nearly a quarter of this total (Case, 

2007). In the UK, too, there is evidence that differential house price appreciation (reflecting 

differences in the desirability of locations or neighborhoods, as well as variability in the 

character, condition and quality of the stock) helps exacerbate other kinds of inequality. Thomas 

& Dorling (2004), for example, show that between 1993 and 2003, the housing wealth of the 

‘best off’ ten percent of areas in the UK rose ten times more than that in the ‘worst off’ ten per 

cent. As a result the ten per cent of children who (as a consequence of their parents’ housing 

attainment) are the most housing-asset-rich have seven times more housing wealth at their 

disposal as the least wealthy ten per cent. 

More notable still is the changing character of secured borrowing, which has turned 

housingwealth from a fixed asset into a spendable resource. With a mortgage at the interface, and 

credit constraints eased by historically low interest rates together with loan securitization, 

housing wealth is more fungible now than it has ever been before, and borrowers are taking 

advantage of this. Whether by refinancing or, increasingly commonly, by drawing routinely up to 

pre-agreed borrowing levels (Smith et al. 2002), housing ‘wealth effects’ (which are more 

marked and occur with greater speed than stock market or other financial wealth effects) are 

increasingly well documented, and have been credited with keeping the more developed 

economies afloat even through periods of recession (Benjamin et al. 2004; Case, Quigley and 

Schiller 2005; Deep and Domanski 2002; Lantz and Sarte 2001). These ‘effects’ have also, of 

course, driven the industry to adverse credit mortgages, accelerated the shift to subprime 

borrowing and encouraged the growth of predatory lending (Langley 2007; Munro et al. 2005; 

Pannell 2006), involving products which are not only aimed to extend homeownership 

‘downmarket’ but come packaged with inducements (lower overall loan repayments for 

example) to borrowers to secure all their loans against property. 

Housing is of course leveraged and that leverage has increased. In 1987, homeowners’ 

equity in the U.S. accounted for two-thirds of the total value of residential real estate. In 2007, 
5

the figure is just over half, 52 percent (see Flow of Funds Table B100). In the 2nd quarter of 

2007, households had direct mortgage liabilities of just over $10 trillion, while consumer credit 

outstanding totaled another $2.4 trillion. At the same time in the UK, there is about £3.6 trillion 

of housing assets compared with £1.2 trillion of mortgage debt. Overall, in the decade 1992-2002 

the debt required to finance owner occupation, including the non-housing debt secured against it, 

doubled for the UK (Mintel 2004) rising from 56 percent to 64 percent of GDP (Catte et al., 

2004). Though other estimates are a little lower – around 60 percent of GDP – British mortgage 

debt is one of the highest in the developed world, exceeded only by Denmark (74percent) and the 

Netherlands (79percent). Not surprisingly, mortgages account for the majority of household debt 

in the UK and owners are far more indebted than renters (May et al., 2004). Furthermore, 

aggregate levels of secured debt relative to income have tripled since 1980 (Hamilton 2003), 

rising from 95 percent to 125 percent of post-tax income in the five years to 2004 (Hancock and 

Wood, 2004). In a setting where the average house price to earnings ratio is now 5.7, exceeding 

its 1980s peak, mortgage debt has come to account for three quarters of UK households’ total 

interest-bearing liabilities (HM Treasury, 2003). 

Moreover, as well as having loans secured against their home, owners have the 

possibility (because home ownership comes with such a high credit weighting in the United 

Kingdom) to engage in a wider range of unsecured borrowings than renters (and some mortgages 

come with an unsecured top up taking borrowers over the 100percent loan-to-value maximum). 

In the UK, owners are twice as likely as renters to have a credit or charge card, for example, and 

more likely to have borrowings against any cards they do have (Bridges et al., 2004). They are 

also more likely to have unsecured personal loans of other kinds. Home ownership thus enhances 

the possibility for households to acquire unsecured debt, and one of the risks this brings is ‘debt 

overhang’ – where total borrowings exceed the value of all assets, including those in housing. 

 

III. Round Up of Risks 

In economies driven more by credit than cash, both lenders and borrowers have become 

vulnerable to the risks of default. Lenders have, in theory, been well-protected. They may make 

credit contingent on borrowers themselves “insuring” the lender (either by charging more for 

risky or – in the case of mortgages, high loan-to-value – loans, or by packaging a mandatory 

insurance into the loan). They may reduce their exposure to risk by selling off parts of their loan 
6 

book in the form of mortgage-backed securities. Or they may hedge their exposures by using 

credit derivatives (though these do not seem to have worked effectively for those drawn into the 

current sub-prime crisis). Borrowers, however, are also vulnerable to a range of risks which may 

either raise the cost of their loan (payment reset risks), depress the income stream they are 

relying on to service repayments (income shocks), place additional demands on their earnings 

and savings (budget shocks) or eat into the assets (or investment vehicles) they may depend on to 

clear the loan in the medium or long term (investment or equity risks). There are a number of 

ways of organizing discussions around these risks, but we have chosen one which differentiates 

those risks which are systemic (both a product of, and an influence on, the dynamics of the 

economy as a whole) and those which arise from a range of biographical disruptions which 

interact with, but occur irrespective of, wider economic trends. Of course, there is no hard line 

between these micro- and macro- effects, but one reason for making this distinction is that it is 

helpful when considering methods of, and options for, risk mitigation. 

Systemic Risks 

A first key systemic risk for borrowers is the payment reset risk posed by rising interest 

rates. The affordability of any loan is linked to the rate of interest attached to repayments. Most 

unsecured loans charge fixed interest over a specified (short) period. Part of the drift from 

unsecured to secured borrowing is prompted simply by the fact that even the most expensive 

secured loans tend to have lower interest rates than their unsecured counterparts. Many 

mortgages however charge interest at a variable rate from the start, or are fixed for a short period 

(often, as an inducement to borrow) below base rates, and then opened to the market rate 

(sometimes with a lock-in period for borrowers who took advantage of the introductory deal). So 

the more loans consolidate against housing, the more vulnerable borrowers are to interest rate 

fluctuations. This true in the UK, where a widespread preference for variable rate loans (an 

average of 65 percent of mortgages held between 2000 and 2002 were of this type) makes 

borrowers there uniquely vulnerable to short-term fluctuations in interest rates (Miles, 2004). It 

is also true in the US, where the ‘down-market’ extension of home ownership was built almost 

entirely on the low entry costs enabled by the presumption of long term low interest rate, and 

where, paradoxically there has also been a push towards variable rate loans (prompted, not least. 

by the point Alan Greenspan argued in 2004 when he observed that ‘many homeowners might 
7

have saved tens of thousands of dollars had they held adjustable-rate mortgages, rather than 

fixed-rate mortgages, in the last decade’. 

Low interest rates have been a hallmark of the mortgage market for almost a decade. In 

the UK for example, interest rates averaged 5 percent between 2000 and 2004, in contrast to 7 

percent in the 1990s and 11 percent in the 1970s and 1980s. In the US, rates plummeted from a 

high of almost 23 percent in 1981 to a low of closer to 5 percent in 2003 (and conventional 

mortgage rates have fallen from a millennial peak of 8.6% in May 2000 to a low of 5.2% in June 

2003).1

 Where high levels of borrowing have adjusted to these rates (assisted in the US by a 

process of securitization which extended funds to a wider range of ‘subprime’ borrowers), the 

sustainability of repayments depends on their stability. However, this is increasingly in question. 

Between June 2003 and September 2007 in the US, interest rates rose, new borrowing dropped, 

and refinancing began to mean much higher monthly outlays for borrowers. This is the root of 

the recent subprime panic, which has itself generated a wave of systemic consequences.2

Likewise a number of studies suggest that even small interest rate hikes could trigger substantial 

repayment difficulties in the UK, a point underlined in the modeling exercises reported in Miles 

(2004), which show the sensitivity of mortgage arrears and repossessions to rising interest rate. 

A second systemic risk relates to income shocks. The economies of the more developed 

world have been adjusting for some years to high rates of employment. This generates the steady 

streams of income that mortgage borrowing, in particular, depends on for its sustainability. There 

is currently less concern about employment risks than about interest rates and in the UK, and 

much of the USA, the outlook seems robust. Employment, like incomes, is nevertheless 

polarized, and lower income groups have least job security. Given the oft-quoted truism that 

owner occupation in the ‘home ownership’ societies accommodates half the poor as well as all 

 

1

 A major reason for such low interest rates is that the world has been “awash” in liquidity, having generated a 

massive volume of saving during the last 10-15 years. Much of that saving found its way to American securities 

markets simply because of the sheer volume of trade and perception of safety. Countries with large foreign trade 

surpluses must do something to balance their payments in foreign exchange markets (see Richard Cooper: Living 

with Global Imbalances), so many countries have substantial accumulations of dollars and dollar denominated assets, 

and a substantial volume of non-US money is now used to purchase Treasury’s and even into Agency securities. 

China owns about $350 billion of U.S. sovereign debt and Japan owns about $650 billion, In short, massive liquidity 

from abroad, domestic pension funds, insurance companies, college and university endowments and foundation 

portfolios all held down rates and reduced spreads as the world competed for every last basis point. 2

 A subprime ripple (whose direct costs add up to a fraction of the size of the bond market, for example) made waves 

across the world’s banking and finance markets for a complex set of reasons linked to the growing complexity of 

mortgages instruments, the increasingly complex risk-sharing arrangements that have never been tested in a volatile 

market-place, and possible mis-pricing in the MBS market. 
8 

the rich, any contraction of the job market is risky for the sustainability of mortgage repayments 

on the (rather large) margins of the sector. 

Income shocks can, however, themselves be triggered by the changing fortunes of the 

housing economy. When existing home sales decline or prices fall, the economy experiences a 

decline in aggregate expenditure and ultimately a reduction in employment. This occurs 

through several distinct channels. 

First, there is the risk of a change in the effect of housing wealth on consumption. When 

households accumulate assets, they tend to spend more than they otherwise would have, either by 

withdrawing equity from those assets or by saving less in other forms. While there is some 

evidence that spending patterns does not immiediately respond to declines in home value – that 

the effect is asymmetric – this may only be true until a particular threshold is exceeded (see Case 

Shiller and Quigley, 2006; Smith and Searle 2008). So when household asset values generally, 

and house prices in particular, fall, this may, sooner or later, lead to a contraction in consumer 

spending, prompting a fall in profits and a loss of employment in the affected sectors. 

Second, fewer sales of existing homes means that brokers, building inspectors, appraisers, 

mortgage lenders, home appliance firms, and others in the real estate industry face a decline in 

demand and experience a direct loss of income. While the sale of an existing dwelling unit is 

simply a transfer or exchange of assets (and thus is not a component of National Income), the 

transactions costs associated with the exchange are high; the transfer typically induces spending 

on furniture, appliances, decorating, and so forth, but also fees generated by brokers, lenders, 

appraisers, and others. 

But without doubt, the third and biggest direct effect is likely to result from the decline in 

new housing construction. The US construction industry alone employs 7.5 million workers, and 

in the beginning of 2006 new investment in residential structures was at an annual rate of over 

$800 billion, or about 5.6 percent of GDP (U.S. Department of Commerce, Bureau of Economic 

Analysis, NIPA Accounts.) By September 2007, housing starts had fallen to an annual rate of 

1,190,000 from a peak of 2,265,000 in February 2006 (U.S. Census Bureau, Construction 

Reports). This decline of over a million suggests a substantial direct impact. 

Furthermore, even (perhaps especially) in a benign economic climate – even if 

unemployment and interest rates both stay relatively low – highly indebted borrowers remain 

vulnerable to the financial consequences of biographical disruptions of all kind (as documented 
9

below). These include family relationship breakdowns, ill-health and premature death of a 

mortgagor, against which, so far, neither state nor private safety nets offer a comprehensive 

protection package (Easterlow and Smith, 2004; Ford et al., 2003). In these events in the short 

term, and in many other cases in the long run, borrowers may be vulnerable to a third systemic 

risk: to factors affecting the value of (housing) assets which they might otherwise wish to tap 

into to clear their debts or tide them over repayment difficulties. 

A third systematic risk for borrowers thus effectively relates to house prices – or at least 

to the investment risk embedded in house price volatility. Property values are key to the 

sustainability of current levels of consumer debt, not just because the loans they secure are 

related to the value they hold, but because they represent the major portion of most households’ 

wealth portfolio, Moreover, while housing has historically shared this role with pensions, recent 

years have seen a marked shift in the balance towards housing, especially among the younger age 

cohorts. And of course, housing is the only one of these resources which can be cashed in early, 

by selling up or trading down. A recent study in the UK has underlined the importance of 

property values for households wealth and wider wellbeing, showing the extent to which 

borrowers now look to the wealth in their homes as a financial buffer and a welfare resource 

(Smith et al. 2007). So it is perhaps not surprising that, in recent years, price volatility has 

become as much of a buzzword as sustainability where housing debt is concerned not least 

because of its consequences for consumer protection in the mortgage market (Hilbers et al., 

2001; Laslett et al., 2001). If house prices stagnate or decline, as they tend to when rising interest 

rates rule out cost-effective refinance and propel a wave of sales and repossession (see Case and 

Shiller 1996), then the one resource home buyers look to for financial security – their home – is 

at risk: they stand to lose both the asset and the housing service it contains. 

 

Individual Risks 

Debtors face a number of risks that can strike them individually and compromise their 

ability to repay their debts, and which have little to do with systemic risks that involuntarily and 

simultaneously hit large numbers of people (such as regional or national recessions, regional or 

national house price declines, or national increases in interest rates). Individual risks include 

events that disrupt incomes, such as the death or disability of an earner, divorce, and job loss or 

curtailment of hours. They also include unforeseen events that shock budgets such as large and 
10

uninsured (or not fully insured) medical expenses, large home repairs, and debt payment shocks. 

Furthermore, the influence of more systemic risks on individuals depends importantly and 

predictably on their individual attributes. For example, whether or not an increase in interest 

rates has any impact on an individual, as well as the magnitude of any impact, is governed by 

how much debt that individual holds, how much of that debt is adjustable, how large a teaser rate 

was initially offered on how large a portion of the debt, and whether the debt has any other 

features that can trigger a repayment shock, such as a fixed interest-only period. Similarly, 

younger and minority workers have higher unemployment rates and greater rates of job 

separation so are at higher risk of an income shock. They also are less likely to have health 

insurance and so are more vulnerable to budget shocks. 

Individuals are also exposed to investment risk when they use debt to secure an asset 

such as a home. In this case, while individuals are exposed to systemic risks like the end of a 

speculative bubble, they are also exposed to the risk that the balance between supply and demand 

for homes of the types they purchased in the locations they purchased them shifts in a way that 

erodes the value of their home. This occurs when the home becomes functionally obsolete or a 

neighborhood falls into decline. Households are also exposed to risks that their neighbors will 

default or disinvest in nearby homes, thereby reducing the value of their own home. Borrowers 

are almost never now themselves insured against this risk of loss of value, although the lender 

demands the borrower pay insurance that indemnifies the lenders. An additional investment risk 

is that home will be damaged by accident or natural disaster. This risk is typically insured by 

property insurance policies, although these increasingly come with exclusions. 

Modelers of mortgage loan terminations (both mortgage prepayments and defaults) have 

long been interested in these individual risks and considered how to take them into account in 

risk-based pricing and underwriting. These risks are often referred to as trigger events (Vandell 

1995; Elmer and Seelig 1998). To the extent that these events are predictable and correlated with 

individual borrower attributes, it is possible not only to price and make underwriting decisions 

based on them, but also to take more borrower attributes into account in making these decisions. 

Insuring against certain risks is exceptionally difficult because the insured can engage in 

risk-seeking behavior, game the insurer, or because only the riskiest apply (adverse selection). 

An example of risk-seeking behavior is the impact of offering unemployment insurance. This can, 

on the one hand, protect those on the periphery of the labor market from mortgage default 
11

‘between jobs’; on the other hand it might encourage people to risk changing jobs too frequently 

perhaps putting themselves at risk of ‘last in, first out’ penalties which – because they are beyond 

individuals’ control – might have to be picked up by the insurer. An example of taking advantage 

of the insurer is divorce. If insured for divorce, individuals can file for a divorce in order to get 

out of their debt obligations. An example of adverse selection is that only those in occupations 

most apt to result in disability will purchase disability insurance, making it impossible to price 

the insurance for less than the principal amount. Thus, in cases with a high degree of moral 

hazard risk, insurance products simply are not offered. However, Shiller (2003) has argued that 

the range of these circumstances are defined more narrowly than they need to be – a point we 

return to later. 

IV. Risk Mitigation

Risk mitigation for indebted consumers in societies where so much borrowing is stacked 

against property – that is, against people’s homes – generally depends on some kind of 

partnership between states, markets and borrowers. However, over the last two decades, 

countries have retreated from direct mitigation (for example the rules for using taxation to meet 

interest payments for unemployed mortgagors in the United Kingdom are now very narrowly 

drawn), encouraging market based insurance providers to take their place. Old partnerships have 

thus dissolved and the principle of solidarity has been replaced by one of mutuality, as well as by 

other kinds of private safety net (such as debt cancellation and suspension contracts, third-party 

guarantees, and overcollaterlization of loan pools). The question we address here is whether the 

existing suite of safety nets is, or could be sufficient; or whether an alternative style of 

partnership might be more effective. 

Traditional Methods: Consumer Credit Insurance, Loan Payment Protection 

Insurance, and Debt Cancellation Products 

Most risks associated with lending are managed by lenders, not consumers. Furthermore, 

the methods used to manage these risks protect lenders, not borrowers, against credit risk, 

interest risk, liquidity risk, and prepayment risk.3

 Borrowers pay for this protection through the 

 

3

 It is notable, for example, that unlike in the United States, in the United Kingdom the term ‘credit insurance’ refers 

almost exclusively to a trade service – to schemes designed to protect business interests against customer default and 

non-payment of debts incurred against a range of goods and services. 
12

interest rates and fees they are charged and by the way these are adjusted based on the 

characteristics of the borrower and the loan product. In some cases, as for example with 

mortgage lending, lenders are also protected against loss in market value of the collateral through 

mandatory insurance charged to the borrower. While consumers can protect themselves against 

some risks through options embedded in their product terms (such as fixed rate loans that 

insulate them from interest rate risk), with few exceptions the only products that explicitly 

protect the consumer instead of the lender in the United States are credit insurance and debt 

cancellation contracts or debt suspension products.4

 In the United Kingdom there is a complex 

array of loan payment protection insurances for borrowers to cover mortgages, unsecured loans 

and credit card debts, as well as a range of insurances to cover loss of income through accident, 

sickness and unemployment. This suite of “loan payment protection insurances” spans the kinds 

of products that in the United States are referred to as credit insurance, debt cancellation, and 

debt suspension. While the focus here is on the United States, some parallels to the United 

Kingdom are drawn below. This is worthwhile, not least because, despite the very different 

regulatory regimes in each country, the shortcomings of credit insurance and loan payment 

protection insurance are quite similar, and stand in puzzling contrast to generally highly levels of 

satisfaction with the products among those who purchase them. 

In the United States, credit insurance is offered by insurance companies and marketed (as 

is the majority of loan payment protection in the UK) through lenders that act as brokers at the 

point of sale. Often, the lender itself uses a broker that both takes the application for the loan and 

sells the consumer durable (automobile, home, furniture, etc.) being financed. Debt cancellation 

and debt suspension is offered by banks at the point of sale of credit for consumer durable 

purchase or credit card debt. 

Credit insurance, loan payment protection insurance, and debt cancellation/suspension 

are of potential real value to consumers because failure to repay debts results in higher future 

borrowing costs and future restricted access to credit. By indemnifying lenders on behalf of 

consumers, events that would otherwise have triggered a default are averted. Moral hazard 

 

4

 There are, of course, some exceptions that prove the rule. Fannie Mae has offered products that protect mortgagors 

from large home repairs or the kinds of events, like layoffs or disability, that are covered by credit insurers and 

lenders offering debt cancellation products. But the penetration of these products is very low. Robert Shiller (2003) 

lists several small scale efforts to insure consumers, including against loss of home equity through “home equity 

assurance” in Chicago in the late 1970s and a program in Syracuse in the late 1990s. Another product he discusses 

is Yale’s Tuition Postponement Option of 1971-1978 which calculated payments based on a fixed percentage of 

future annual income. As a result, higher income students would pay more than lower income students. 
13

concerns restrict the range of events covered by these products mostly to those over which the 

consumer has limited or no direct control.5 In addition, events whose occurrences are 

independently verifiable are favored so that insurers can avoid consumer fraud. The most 

common events covered are death, disability, and involuntary unemployment as a result of a 

layoff. Events that also compromise the capacity of an individual or household to repay its debts 

permanently or for some period of time that are more voluntary in nature, such as separation or 

divorce, are seldom covered for the reasons described above, even though these are some of the 

main causes of financial difficulty feeding into payment default. Even so, insurers are vulnerable 

to adverse selection and must price their products to cover that risk. For example, some argue 

that those who anticipate a health problem or work in an occupation more prone to injury are 

more apt to purchase credit insurance or debt cancellation than others. As noted above, carrying 

such insurance can also lead consumers to engage in risk-seeking behavior since one of the 

consequences of a reduction in income is neutralized. The most recent work on mortgage 

payment protection insurances in the UK found no evidence of either adverse selection of risk 

taking (Ford et al. 2003), and few believe that people will intentionally take an action that will 

result in death or disability just to avoid paying off bills. Nevertheless insurers concern 

themselves with such possibilities, and this is reflected in pricing practices. 

Surprisingly little information exists about insurance and cancellation products that 

protect consumers, and few analyses of these products exist in the public domain. There is more 

information on credit insurance largely because past concerns with the product, and—more to the 

point—questions relating to how it was priced and marketed, led to statutorily required 

disclosures as well as federal data collection on the use of credit insurance. Indeed, by the time 

the Truth in Lending Act became law in 1968, a long and controversial enough history had 

developed with the product that a special carve out was made for credit insurance.6

 Debt 

cancellation is a newer product made possible by an Office of the Comptroller Currency ruling 

that national banks could offer it and that it did not constitute an insurance product. Apart from 

the OCC which regulates debt cancellation products, the banks that offer them, the lawyers that 

 

5

 The most noteworthy of these are coverage of family leave by all tradition products and the use of debt suspension 

agreements in the case of childbirth or child’s education over which individuals most certainly have control. 

6

 For a history of credit insurance see Fagg (2004). It can be dated back the Morris Plan in 1910 which developed 

into several Morris Plan Banks and culminated with the opening of the Springfield Morris Plan Company in 1926. 
14

work for these banks, and some consumer advocacy organizations that have looked into the issue, 

not much attention has been paid to these products. 

Credit insurance and Loan Payment Protection 

First, we explore credit insurance and loan payment protection approaches to mitigating 

the risks of consumers. 

Nature of credit insurance: Credit insurance in the United States covers a range of 

credit products, including credit cards, installment loans, mortgages, second mortgages, home 

equity lines of credit, and credit cards. A variety of different events are covered including 

death (through credit life), accident and health (through credit disability), unemployment 

(through credit involuntary unemployment), and repair or replacement of personal property 

(though credit property insurance).7 The products are often bundled together to cover a variety 

of unfortunate events. The lender, not the consumer, determines the bundle of features offered 

and the choice of carrier. 

Private sector loan payment protection in the UK is available for mortgages, unsecured 

loans, credit card and store card debt. These are usually sold at the same time as the debt is 

incurred, and are designed to cover failure to repay due to accident, sickness or unemployment. 

There is also government income support for mortgage interest, which is available only to 

mortgage holders, comes into play nine months after the loss of all income from earnings, 

covers a limited loan size, and has other tightly drawn eligibility rules. In addition, there are a 

suite of ‘stand-alone’ income replacement (or lump sum pay-out) insurances that can be used 

either (or both) to repay debts or for other things. These latter are most actively sold to 

mortgagors (usually when they take out their loan) and take the form of life and critical illness 

insurances (policies which are increasingly packaged as one), permanent health insurance, and 

unemployment insurance. 

Credit insurers in the United States sell a credit insurance group policy to lenders. Thus, 

the lender not the consumer is the customer. The lender then sells the insurance to the borrower 

and issues a certificate of insurance to the borrower. Banks, credit unions, finance companies, 

auto dealership and retailers make the presentation of the insurance to the consumer. Credit 

 

7

 Other less common events are also covered, such as leaves of absence for childbirth or adoption or gaps in 

insurance coverage between the amount insured and the amount owed (such as in the event of a car accident on an 

auto loan). 
15

insurers compete for the business of these “producers” not only through their product offerings 

and pricing, but also through incentives offered to the producers. 

How much business is conducted through the different types of producers is unknown, 

but Fagg (2004) shows that from 1993-1995 in Ohio, nearly a third of policies were produced by 

auto dealers, a quarter by banks, a fifth by finance companies, an seventh by credit unions and 

the rest by others. Note this does not include credit insurance sold in conjunction with mortgages 

because the Ohio statistics are for unsecured consumer credit only. Also, many national retailers 

own captive credit-insurance companies and offer credit insurance to their customers through 

these affiliated companies. Insurance companies sign up producers using their own sales staff or 

general agents that represent more than one insurance company to sign up producers. 

In the case of product purchases, the offer is usually made by a sales person or finance 

department at the time of loan application or approval in conjunction with the purchase of a good. 

In the case of credit cards, which are often marketed through mail solicitations, the offer is made 

by including a flyer in the initial offer and following up even after a credit card has been 

approved. Consumers in the US, like those in the UK, thus do not shop for credit insurance in 

the traditional sense. Instead they are offered it by a lender in conjunction with a credit 

transaction. In large part, this is a reflection of the small size of the credit transactions involved. 

It is only practical to originate the insurance at the time of loan or line origination. Fagg (2004) 

reports that the bundle offered to credit card borrowers usually includes life, disability, 

involuntary unemployment, and family leave. Retailers usually include all these plus property 

insurance. Personal lines of credit and home equity lines of credit usually offer life only. In the 

mortgage world, credit life was roundly criticized in the early 2000s and is now less often 

offered. 

The maximum rates for credit life and disability insurance are established by state 

regulators or legislatures. Carriers usually charge the highest rate in part because the rate 

becomes the presumptive market price and in part because insurers must charge the highest rate 

so they can pass along the largest possible commission to producers, or else risk losing market 

share. Credit unemployment and property insurance rates are set by carriers and rate filings are 

submitted. In some states, these rates must be approved. A single upfront premium is the 
16

standard product for closed end loans (often rolled into the loan amount) and a premium rate is 

applied monthly to outstanding balances in the case of open-ended credit.8

In closed-end credit, the individual types of credit insurance are often sold separately. 

Life and disability insurance are available to anyone under a maximum age set by the state. 

Although a borrower typically signs an underwriting statement stating that they are free of 

specific conditions, no fact checking is performed unless a claim is later filed. A single premium 

is charged to everyone below the cutoff age that purchases the insurance regardless of 

circumstances. This means that risk-based pricing of insurance is not permitted. All comers get 

the same price, leaving the insurer vulnerable to adverse selection and an average risk pool that 

benefits the more risky of the insured owing to their health condition, occupation, etc. In openended credit, because of the even smaller balances typically involved, it is more common for a 

variety of types of insurance to get bundled together for a single premium so that it is large 

enough to cover the risks and the costs of originating and administering the policy. In the case of 

closed-end credit, a premium refund is issued if the loan is repaid before the end of its term. 

Use of credit insurance: The Federal Reserve Board has tracked the use of credit 

insurance since 1977 by periodically asking a random sample of households if they carry credit 

insurance on each of several different debt products. The most recent survey to ask about credit 

insurance was conducted in 2001. It showed sharp decline in the use of credit insurance for a 

purpose it is most commonly used for and the only product about which consumers have been 

asked about in each survey – to insure installment loans. The penetration rate held steady at 

about 64 percent of borrowers in 1977 and 1985 but fell to 23 percent by 2001. In terms of other 

products, fully 32 percent of households with a first mortgage, 23 percent of second mortgage 

and home equity line of credit (HELOC) holders, and 20 percent of credit cards said they had 

credit insurance. 

The staff of the Federal Reserve Board is confident that those who have credit insurance 

know that they do so, and thus believes that these estimates of market penetration are sound. It 

remains to be seen, however, how many of those who report having credit insurance may have 

debt cancellation because a separate question about it is not asked. However, it is likely that at 

least some portion of debt cancellation or suspension agreements in force is over and above the 

 

8

 For more information on how premiums are set and the costs of originating and administering credit insurance see 

Fagg (2004) and Consumer Credit Union and the Center for Economic Justice (1998). 
17

reported credit insurance use figures. It is also probable that the decline in the use of credit 

insurance reflects at least in part an increase in the use of debt cancellation. However, most 

industry sources believe debt cancellation only started to get offered widely by 2001. 

While it is unclear precisely how many loans or lines of credit carry credit insurance, the 

2002 Fact Book on Credit-Related Insurance issued by the Consumer Credit Insurance 

Association (CCIA) provides additional information collected through a very different method. 

The report does states that the information is derived based on analysis developed by A.M. Best 

from statutory annual statements of insurance providers. This gives a number for premiums 

collected over the course of the year for several categories of lending. From 1995 to 2000, net 

written premiums were in the $6.3 to 7.2 billion range. Credit life and disability each accounted 

for about $2.3-$2.5 billion of this total. Unemployment credit insurance reached 1.2 billion in 

2—and credit property and casualty has hovered around $1 billion over the entire period. 

However, about one-fifth of credit-related insurance, by CCIA estimates, is not reported to the 

CCIA. Thus, the total net premiums are higher than reported totals. 

The use of loan payment protection insurance (which spans products similar to credit 

insurance, debt cancellation, and debt suspension) may be more widespread in the United 

Kingdom than in the United States. As in the US it is hard to generate figures for UK borrowers 

concerning the extent of payment protection in place across all styles of loan. The most recent 

estimates are contained in the GFK-NOP consumer survey commissioned as part of the Office of 

Fair Trading investigation of payment protection insurance (OFT 2006). The comprehensive 

Financial Resources Survey of 60,000 consumers which this company runs each year seems to 

show low rates of take up for all kinds of PPI in the last twelve months: half those with new 

mortgages, one in three or four of those with new unsecured loans, and less than one in five with 

new credit and store cards also purchase insurance. However, charting behavior over a longer 

time period using a follow-up sample of just over 1000 (1131) borrowers, the indication is that 

as many as two in three (62% of all borrowers) had either taken out PPI in the past or currently 

held such a policy. Furthermore, looking specifically at mortgagors, and documenting only 

those protection and insurance policies designed to protect mortgage repayments, Ford et al. 

(2003), using a sample from the Survey of English Housing, estimate that (excluding life 

insurance, which has exceptionally high market penetration in the United Kingdom), three in five 

mortgage holders has some kind of protection: 40 percent hold critical illness coverage, 37 
18

percent have mortgage payment protection insurance, 20 percent have permanent health 

insurance, and 12 percent are insured against unemployment. Nevertheless, the survey of 

mortgagors in this study showed that coverage is often partial (covering a limited range of 

eventualities), and is limited to one earner in the majority (two out of three) of households. 

Consumer attitudes towards credit insurance: Surveys sponsored by the Federal Reserve 

Board provide some insight into consumer attitudes towards credit insurance in the United States. 

A major reason for fielding these surveys was to test whether consumers understood the product, 

to see how many felt pressured to purchase it, and to ask whether those who purchased it were 

satisfied. While in 1977, about 39 percent of purchasers of credit insurance on installment loans 

felt a lender had “strongly recommended or required” it, by 2001 17 percent did so. The share 

that felt the lender required them to get the insurance dropped from 26 percent to 5 percent.9 

Thus, it appears that while progress has been made in alerting consumers to the fact that credit 

insurance is not required, and the practice of strong marketing pitches has eased, neither has been 

eliminated. Furthermore, only a few percent of those who did not insure their installment loans in 

each of the years felt the product had been strongly pitched to them. In addition, a much higher 

proportion of those who did not take out insurance in each year – compared with those who did 

– said that the question of insurance was not raised during their application. Hence, the intensity 

of the pitch and people’s understandings of whether or not insurance is a requirement of the loan, 

probably continues to play a nontrivial role in a fraction of decisions. 

Nonetheless, of those that purchased insurance on installment loans, the share that after 

the fact had a good opinion of it has held steady at about 87-89 percent. As in 1985, fully 19 out 

of 20 installment loan borrowers who took out insurance in 2001 said they would do it again. 

Among those opting out, however, the share with a good opinion of it fell from 60 percent in 

1985 to 32 percent by 2001. The share of purchasers thinking it was bad went from 2.2 percent in 

1997 to about 5 percent in both 1985 and 2001, and from 9 percent of non-purchasers to 26 

percent in 1985 and 46 percent in 2001. By these measures, the proportion of borrowers with an 

unfavorable impression of credit insurance had increased and may have played a material role in 

the decline in the use of credit insurance as a wrap around for installment loans. 

 

9

 Conversely, the share of purchasers that thought the decision to get credit insurance was irrelevant to creditor’s 

decision to grant credit increased from 80 percent in 1977 to 86 percent in 2001 and of non-purchasers from 91 to 97 

percent. 
19

Among other products, the share of insurance purchasers (non-purchasers) in 2001 rating 

credit insurance as good ranged from 91 (35) percent of second mortgage/HELOC borrowers, to 

75 (36) percent of primary mortgage holders to 57 (35) percent of credit card holders. Those 

rating it as bad ranged from 30 (47) percent of credit card holders to 10 (46) percent of primary 

mortgage holders, to less than half a percent (45 percent) of second mortgage/HELOC holders. 

That the product is not often asked for initially by borrowers is also made abundantly 

clear by the 2001 survey. Only 1 percent of mortgage holders, and even fewer of others, said 

they initiated the request for insurance—in most cases it was offered before it was inquired about. 

Except in the case of mortgages, in which the use of telemarketing may have led to offers being 

made after loan documents were signed, the overwhelming majority of purchasers for all credit 

products were solicited at the time of application or approval. 

Unfortunately, the Federal Reserve did not cross-tabulate responses with borrower 

attributes such as income, race, ethnicity, or age. Thus, it is impossible to know whether there are 

systematic differences among these groups in their take-up rates for credit insurance for each 

credit product, the aggressiveness with which the products were sold, their reasons for taking 

them or not taking them, their attitudes towards them, and their understanding that credit 

insurance is optional. Small sample sizes restricted the subdividing of the data that could take 

place with any degree of statistical relevance. 

In the United Kingdom, the Office of Fair Trading surveyed consumers of loan 

payment protection products in 2006. Like in the United States, the survey showed relatively 

high levels of satisfaction with and understanding of these products by those who bought them. 

And, like in the United States, the survey found these product are ‘sold not bought’ so there is 

little shopping around. 

Regulation of credit insurance: In the United States, credit insurance and credit insurers 

are regulated by the states. Maximum permitted “prima facie” loss rates for credit life and 

disability are set by the states. In some cases rates on credit property and unemployment 

insurance have to be state approved, but at a minimum a filing justifying the rate must be made. 

Setting the “prima facie” rate involves balancing the goals of protecting the solvency of 

companies against providing a benefit to consumers at a reasonable cost. States also regulate 

other activities of insurance companies and, in all states but Louisiana, hold insurers to the 
20

standards of the Uniform Commercial Code. States also require insurance companies to disclose 

their activities in annual statements that are made public. 

But the federal government does regulate credit insurance through special TILA 

requirements. These requirements allow netting out the cost of insurance from APR calculations 

if the lender provides written disclosure of the cost of the insurance and that the purchase of the 

insurance it is voluntary. TILA also requires that consumers affirm the purchase in writing. In 

addition, credit insurers are required to comply with more general consumer protection laws, 

including those against unfair and deceptive business practices enforced by the Federal Trade 

Commission. Issues of regulation for the UK are discussed by Elaine Kempson in her paper for 

this symposium. 

Problems with credit insurance: Several complaints have been leveled against credit 

insurance in the United States. The industry has been faulted for charging unnecessarily high 

fees, offering a product the protects lenders as much as consumers, using aggressive sales 

methods, competing for lenders not consumers, and coercing or duping consumers into 

purchasing the product (Durkin 2002). The practice of compensating brokers through 

commissions that are a fraction of the premium collected has also been criticized. The Consumer 

Union and the Center for Economic Justice (1998) lay out these arguments in some detail and 

also make several recommendations about how to address these alleged problems.10

A principal charge is that the insurance companies profit too much because the loss ratio 

(what is returned to insured in benefits as a percent of insurance premium paid) is unusually low 

relative to other products.11 The Consumer Union and the Center for Economic Justice (1998) 

points out that the National Association for Insurance Commissioners (NAIC) model regulation 

for credit life and disability suggests a minimum ratio of only 60 percent, while actual ratios for 

group life insurance, group accident and health, and automobile insurance are 90 percent, 75 

percent, and 70 percent respectively. Yet despite this, according to NAIC, in 1997 the actual 

nationwide credit insurance loss ratios ranged from only 12 percent to 49 percent depending on 

the product. Furthermore, state approved loss ratios varied considerably with the lowest in 

 

10 Among their recommendations include: establishing minimum loss ratios, ban gross indebtedness premium 

calculations, better consumer disclosure than provided for by TILA, prohibit certain practices and stiffen penalties 

for unfair and coercive sales practices, ban post-claims underwriting, and demanding that insurers and lenders offer 

each individual coverage separately rather than bundled in ways selected by the lenders and insurers. 11 Yet another complaint is that premium is sometimes charged in closed-end loans on gross indebtedness, including 

not just the principal balance but all interest payments over the life of the loan. 
21

Louisiana and the highest in New York. However, the study does not examine reasons why 

nationwide loss ratios or state-approved ratios may be so low. One explanation is the uncertainty 

or volatility around claims, although the long history of credit insurance would argue against the 

former possibility. Another is political influence and pressure brought to bear with some success 

in some states and little or none in others. 

Another common charge relates to the potential for consumers to be pressured or coerced 

into taking out credit insurance. Lenders have both the motivation and the opportunity to push 

the product. The motive comes from the fact that agents have an incentive to push the product to 

earn a premium and protect the lender from certain events that might otherwise cause a borrower 

to default. The opportunity comes from the fact that consumers are primarily interested in the 

approval of their loan application and may not fully understand the insurance and its role in the 

approval process.12 Critics contend this leaves consumers vulnerable to coercion and being 

misled (Barron and Staten 1995). The high penetration rates of costly products are touted as 

evidence of a problem, though of course these rates could be also be viewed as evidence of the 

need for, and the acceptance of, the product. The fact that the shares of people with insurance 

who feel it was strongly recommended or required by their lender relative to those that opted not 

to purchase the insurance is further circumstantial evidence that some of those who bought it 

may have done so under pressure or a misapprehension. Only one study to our knowledge, 

however, has attempted to undertake a more thorough investigation of the subject, controlling 

such factors as whether the borrower already had life insurance (Barron and Staten 1995). The 

study, while based on 1993 data, a sample that was not likely representative due to low response 

rates, and a methodology that some might argue with, found that at most 1 percent of surveyed 

credit life insurance purchasers believed insurance was required, 1.6 percent because they 

thought it improved their chances of success, and 0.6 percent because of sales pressure. Inclusion 

of direct measures of coercion did not affect the model fit much.13 This is much lower than the 

raw shares suggested by simple responses to the Federal Reserve surveys and to the survey used 

to fit the Barron and Staten model. Also, the incidence of misunderstanding and of consumers 

feeling pressured by strong sales tactics, at least, is on the wane as measured by Federal Reserve 

Board funded surveys. 

 

12 For an interesting piece on the marketing of credit insurance from the producer’s perspective, See Elsea (1988). 13 It is worth noting, however, that the decision to purchase credit life was positively associated with race and 

ethnicity and negatively associated with education, often even after controlling for direct coercion measures. 
22

The credit insurance industry has also been criticized for engaging in “reverse 

competition” (Credit Union and Center for Economic Justice 1998). This is the process of 

competing for the business of lenders by offering them the highest possible compensation rather 

than for consumers by providing them the lowest possible price. Consumers do not shop for 

credit insurance in the traditional sense. Rather, they are offered it as part of a credit transaction 

by the lender. Thus, while lenders should take into account the pricing of the product and its 

features since more competitive terms should result in higher take up rates by consumers, they 

can also be swayed by insurers who offer them higher sales commissions even if the price of the 

product is greater than that of competitors. As further evidence of the ill effects of reverse 

competition, the two groups cites the testimony of an industry consultant that stated the reason 

credit unemployment coverage was added to the bundle offered consumers on credit cards was 

the lower balances on open than closed-end debt and the need to boost premiums to defray the 

fixed expenses of originating and administering policies. This was done, they argue, for the 

insurer’s not the consumer’s benefit. Part of the reverse competition entails, they also argue, 

handing over significant shares of the premium to compensate brokers. Nationwide 

compensation of this sort was more than 30 percent for credit life and disability in 1997. Of 

course, premiums are small, so even modest large shares can equate to modest sums. In addition, 

the low loss rates in part reflect high costs of origination. Agents have also been criticized for 

aggressive sale tactics that in some cases has resulted in legal actions and large settlements 

(Credit Union and Center for Economic Justice 1998). 

Lastly, the value of insurance is also as good as the insurer’s willingness to make good on 

its claims. If insurers drag their feet on paying claims or deny legitimate claims, the insurance is 

worthless. Keest (1995) faults the industry for only checking eligibility factors after a claim is 

filed, taking the underwriting statement signed by the insured as true until the industry decides it 

may want to challenge it. 

While these criticisms have been leveled against credit insurance, all of them, except 

perhaps the state-permitted loss rate, could be leveled against all insurance products. Indeed, as 

long as consumers take out credit insurance at the point of a retail sale, agents that both sell the 

consumer product and the credit insurance are likely to play a significant role. And as long as 

lenders and insurance carriers remain largely distinct, credit insurers will have to compete for 

lenders, and consumers will likely get offered only the credit insurance product offered by the 
23

lender they have elected. Of course, if consumers shopped around for credit insurance rather 

than taking the product offered by the lender or the lender’s agent, an informed consumer could 

select the best available product rather than the product most available to them. 

In the United Kingdom, the loan payment protection industry came under criticism 

recently following a ‘super complaint’ submitted in 2005 by the Citizens’ Advice Bureau to the 

Office of Fair Trading. The complaint argued that Payment Protection Insurance is harming the 

interests of consumers. The consumer survey and market study launched by the Office of Fair 

Trading (2006) in response found multiple faults with the industry that echo faults found in the 

United States. 

The report highlights, first, a cluster of issues around information and sales tactics. As 

noted above, these products were faulted for being ‘sold not bought.’ In addition, the study 

found that what consumer shopping does take place is complicated by complex pricing and 

variable information (for example, more detail tends to be provided on what is covered, than on 

what is excluded). Terms are often confusing, there is little standardization among products, and 

it is hard to compare prices. Unlike in the United States, however, the price of unsecured loans in 

the United Kingdom tends automatically to include the costs of insurance, and over one in four 

respondents to the Office of Fair Trading consumer survey had the impression that their 

application for credit would be more likely to succeed if they agreed to insure their loans. On the 

whole, it appears that while consumers may not shop for these products rationally, suppliers 

appear to be making few attempts to remedy this. 

Second, the report contains a cluster of indicators pointing to the poor value for money 

represented in Payment Protection Insurance products. Like in the United States, these include 

low claims ratios compared to other insurances, high commission rates (from 50 percent for 

mortgage payment protection insurance, to 61 percent for credit card payment protection and 70 

percent for retail credit), and excessive price variability which is not linked to differences in the 

quality of products. 

Advantages of credit insurance: Credit insurance and loan payment protection insurance 

are appealing because they hold consumers harmless if a limited range of events occurs. They are 

the insured party or hold certificates of insurance. As a result, events over which the debtor has 

little control do not end up ruining their credit records and forcing them to pay sharply higher 

subprime rates in the future. Other benefits are more psychological, such as reduced concerns 
24

that future events may drive a person to default and/or bankruptcy. Indeed, in 2001 4 percent of 

those with closed-end credit insurance in the United States that thought insurance good stated it 

provided them with a sense of security. But 74 percent cited the protection it affords them as the 

reason for purchasing. A surprisingly small 4.5 percent stated it the protection it affords their 

credit rating (though awareness of the importance of credit rating at that time may have been 

more limited than today). 

Many buy insurance because they are underinsured and want it, not because of aggressive 

sales tactics. In fact, the evidence suggests that the overwhelmingly majority are satisfied with 

the product after the fact even if it may have been the strong recommendation of the lender that 

motivated them to purchase it. Hence, while aggressive tactics persist and some borrowers are 

under the mistaken impression that the insurance is required the majority who purchase the 

insurance are under no misapprehension. Apart from whether they may overpay the insurance, 

have been targeted because of their predisposition to influence, or have been persuaded of its 

value by clever methods, even after time has passed, the product is popular with those who use it. 

Fagg (2004) lists three reasons why credit insurance is purchased by consumers in the 

United States: 1) they have a need; 2) the product is available; and 3) the cost of the product is 

reasonable. As evidence of the first reason, he points to the significant fraction of borrowers who 

take out insurance and the need it fills for those who are uninsured or underinsured. As evidence 

of the second reason, he points to the less obtrusive and more convenient process of applying for 

credit insurance than for similar basic insurances, such as life insurance which may require a 

medical examination, a lengthy underwriting process, and uncertainty about the premium that 

will ultimately be charged. It is easy to understand and meets a need a consumer may have when 

they borrow. As evidence of the third reason, Fagg points to the fact that it adds only a small 

absolute dollar amount to monthly payments that consumers feel they can swing and for which 

they get back a real benefit. He acknowledges that it is more expensive than basic insurance 

(credit life v. term life for example) but explains that it is justified by its convenience and the 

smaller amounts it can be issued in. This is akin, he states, to the higher price that people pay in 

a convenience store for goods. To that might be added the higher cost of a slice of pizza than a 

pie because it is available in the smaller amount the consumer wants. 

From the producer perspective, credit insurance and payment protection insurance 

indemnifies them, provides them with fee income, and allows them to avoid collecting on a debt 
25

at a time of personal or family crisis. Indeed, an important reason that credit insurance and loan 

payment protection insurance evolved is that when lending was local in nature, it was very 

difficult for lenders to approach known grieving neighbors to get repaid after the death or 

disability of a family member. 

Overall conclusions about credit and loan payment protection insurance: Credit and 

loan payment protection insurance is not for everyone and not everyone uses it. Furthermore, its 

use has been waning. The profile of the consumer that opts for credit insurance in the United 

States is also distinct. A higher proportion of low-income debtors purchase it, as might be 

expected given their lesser other insurance coverage and smaller average savings. Within the 

low-income population, the higher proportion of minorities than whites that use the product is 

cause for concern though may reflect their even lower other insurance coverage rates than whites. 

Consumers that elect to purchase the insurance are generally content with it, but some express 

dissatisfaction and are more favorably disposed than those who elect not to purchase it. Many 

concerns have been raised about the agency risk in the system, the impact of competition for 

agents on pricing and the uniformity of pricing to consumers, sales tactics, and state-regulated 

prices. This, together with the emergence of debt cancellation products, likely explains the 

declining use of credit insurance. 

Charges that credit and loan payment protection insurance protect creditors as much as 

consumers are beside the point – creditors underwrite the policy and price it to manage the risk 

plus earn a competitive return on capital. The advantage of credit and loan payment protection 

insurance is that they fully relieve consumers of their debt or makes payments for a period of 

time on their debt under certain circumstances. The problem with the products come from how 

they are actually priced and offered with some of the factors, like the small size of loans involved, 

make lowering the costs more difficult. Credit and loan payment protection insurance fairly 

offered and priced can provide significant benefits to consumers who lack certain other more 

expensive and broad insurances, such as health or disability insurance. They also help protects 

consumers that have little or no savings to fall back on in the event of a significant disruption to 

income or a sudden unexpected necessary expense that force them to default on their debt, in 

turn restricting future access to credit and driving up future borrowing costs. Especially if the 

coverage results in some concession on the interest rates and fees charged by the lender with 

respect to comparably situated borrowers to reflect the credit enhancement, credit insurance is a 
26

desirable way to protect debtors. In an ideal world, the price of the credit and loan payment 

protection insurance and the loan would reflect the value of indemnifying the lender, which the 

lender would subtract from the interest rate, plus the value to borrower of protection against a 

reduction in their credit score and lost access to credit. 

Debt cancellation contracts and debt suspension agreements 

Here we examine market-based approaches to allowing consumers to cancel or suspend 

their debt. Of course, bankruptcy law provides a government-sponsored approach to discharging 

debts. Like debt cancellation and suspension agreements, bankruptcy has its costs but it is 

beyond the scope of this paper to examine real, notional, and personal costs of filing for 

bankruptcy and having debts restructured in bankruptcy. 

Nature of debt cancellation: Debt cancellation and debt suspension are similar in design 

to credit insurance but are offered directly by banks and are regulated differently than credit 

insurance. Debt cancellation relieves a borrower of making payments for a period of time (or 

permanently in the case of death) while debt suspension allows borrowers to defer payments for 

a period of time without interest accruing. Some of these facilities are now built into the structure 

of mortgage finance – payment option mortgages and interest only loans give one kind of 

flexibility, and in the UK and Australia mortgages are flexible enough to allow borrowers to 

build up overpayments and use them to service under-payments or payment gaps in future. Debt 

cancellation and suspension products sensu stricto have their origins in the efforts of national 

banks to protect themselves from losses arising from the death of debtors and later to assert the 

right to offer products with these features even though they have insurance-like characteristics.14 

 

14 In 1963, the National Banking Review of the Office of the Comptroller of the Currency (OCC) found that it was a 

legitimate exercise of banking powers to enter into debt cancellation contracts with borrowers for the purposes of 

setting up reserves for losses from the death of borrowers. In 1977, the OCC codified an earlier ruling that 

expanded debt cancellation contracts to cover loss, theft, or destruction of collateral. Of course, this perceived 

incursion of banks into an area so similar to credit insurance was resisted by credit insurance companies. In 1987 a 

bank in Arkansas announced its intention to write debt cancellation contracts. After first stating it did object to this, 

the state insurance regulator reversed itself after pressure was applied by credit insurers. The bank sued, won, won 

on appeal, and the Supreme Court refused to hear the case. This opened the doors for banks to offer debt 

cancellation products without fear of legal challenge. The OCC continued to expand permissible powers of banks in 

this area by an interpretive letter in 1994 that extended these powers to include offering products that cancel debts in 

the event of disability and unemployment of the borrower. In 1995 and 1996, bank powers were expanded further to 

offer vehicle service contracts on auto loans or leases financed by banks. These marked the final steps in allowing 

national banks to offer debt cancellation products that were fully competitive with credit insurance. Nevertheless, 

additional clarifications of the powers and obligations of national banks to offer debt cancellation have been ongoing 

since then. For more details on the law and regulations governing debt cancellation products, see CreditRe (2003). 
27

Technically, a debt cancellation contract or suspension agreement involves a loan term or a 

contractual arrangement that modifies a loan term in which a bank agrees to cancel or suspend all 

or part of a customer’s obligation to repay the loan upon the occurrence of a specified event. 

These events now include involuntary termination of employment, death, disability, and family 

leave, and covered instruments include loans, lines of credit, and vehicle leases. While the OCC 

established the precedent for national banks, virtually all state banks are also authorized to offer 

the product because states have parity provisions to avoid state banks being at a disadvantage 

relative to national banks. While once the authority of banks to offer the product was questioned 

and the coverage available limited, by 2000 these doubts were gone. Banks can now, in fact, 

cover even more events than even credit insurers, such as debt suspension in the event of 

childbirth and debt protection in the event of a hospital stay. 

Debt cancellation and suspension involve charging borrowers a percentage of their loan 

balances on credit cards for the benefit of debt cancellation coverage. Banks also offer them 

closed end loans. Because the lenders offer the debt protection directly to consumers, there is no 

separate “producer” involved like there is with credit insurance. In the case of credit cards, the 

solicitation by the bank is done mostly via mail. In the case of auto and other closed-end loans, 

unless the customer comes to a branch to apply for the loan, a third-party originator such as a 

retailer may still be involved (check with CCIA). 

Many banks that offer these products contract with a credit insurer either to administer the 

products. Banks also frequently take out contingent liability insurance policies with credit 

insurance companies. These so-called “CLIPs” are intended to transfer some of the risk to a credit 

insurer. This allows banks to manage safety and soundness requirements in an efficient way. 

Use of debt cancellation and suspension: Unfortunately, there is no public information 

on how widespread is the use of debt cancellation and suspension agreements. Industry contacts 

suggest that take up rates on credit cards and installment loans are about the same, or slightly 

higher, than the take up rates had been when banks offered credit insurance instead. Because 

these banks products are more a substitute for than an addition to credit insurance, the figures 

reported for 2001 from the Survey of Consumer Finance for how widespread the use of debt 

cancellation, debt suspension, and credit insurance combined are probably about right in order of 

magnitude. But the balance since 2000 has tipped decidedly towards debt cancellation and 

suspension. In part this is because of the timing of OCC rulings and in part, according to 
28

industry experts, because loan officers at banks prefer to offer debt cancellation and suspension, 

which enjoy good reputations, rather than credit insurance which is less well regarded. 

Importantly, debt cancellation and suspension can be offered to mortgage borrowers also, but its 

penetration in this market is likely lower simply because banks originate only a fraction of 

mortgage loans. 

Consumer attitudes towards debt cancellation and suspension: There is no publicly 

available information on consumer attitudes toward debt cancellation either, but its reputation 

has not been sullied to the degree of credit insurance, so it is likely that it is viewed at least 

favorably by those who opt for it as those who opt for credit insurance. 

Regulation of debt cancellation and suspension: Regulation of debt cancellation 

contracts and debt suspension agreements for national banks is entirely under the purview of the 

Office of the Comptroller of the Currency for purposes of safety and soundness, ruling on 

permissible powers, and examining compliance with fair lending laws. However, through state 

parity in banking power laws, state banks have the same powers and are governed by the same 

regulations as national banks offering these products but are examined for compliance by state 

rather than federal regulators. The regulation of debt cancellation hence involves a single federal 

regulator and features regular examinations. While the Federal Trade Commission is charged 

with enforcing the law with respect to marketing practices in offering debt cancellation as is the 

case with credit insurers, the OCC can refer cases it may uncover in its examinations. 

In 1996, the Federal Reserve amended Regulation Z implementing the Truth in Lending 

Act to require inclusion of debt cancellation fees in the Annual Percentage Rate disclosure, 

unless certain disclosures are made and certain requirements similar to those demanded in the 

case of credit insurance are met. The amendment was upheld in court. The OCC, however, has 

since issued far more stringent disclosure rules and constraints on marketing practices that may 

constitute unfair or deceptive. In 2002, the OCC issued an involved consumer protection rule. 

Importantly, it prohibited national banks from offering lump sum, single premium debt 

cancellation contracts on residential mortgages. It also provided for standardized consumer 

disclosures of key information that are suited both to mail and telephone solicitations (via a 

short-form disclosure), and a lengthier disclosure that must eventually follow it. Important 

features of the new rule intended to protect consumers include the following: prohibiting banks 

from tying approval of terms of a loan to the customer’s purchase of the product; engaging is 
29

misleading advertisement and practices, retaining the unilateral right to modify product terms 

unless it benefits the consumer or the consumer has the right to cancel without a penalty; offering 

a bona fide option of a product that has a refund feature; offering a bona fide option to pay the 

premium monthly rather than as lump sum (except for mortgages were a lump sum payment is 

no longer allowed); disclosing that the decision to purchase the product is optional and does not 

affect the application, a refund option is available, a monthly payment option is available; 

disclosing that additional information will be provided in a long-form disclosure form when only 

a short-form disclosure is first presented. The rule also requires the customer in most cases to 

provide written acknowledgment of receipt of disclosures, and provide an affirmative election to 

take the product. Banks are also under obligation to make all these disclosures simple, direct, and 

readily understandable.15 

Advantages of debt cancellation and debt suspension: These bank products have the 

same advantages as credit insurance discussed above, but have some additional features that are 

more appealing than credit insurance from both the consumer’s and the lender’s point of view. 

First, the customer works directly with the lender. The compensation of the loan officer is 

therefore established by the bank and not according to an arrangement with a third-party 

insurer’s policy. Thus, consumers do not necessarily receive a price as high as the maximum 

prima facie credit insurance rate in a state because a third-party has competed for business by 

offering the highest commission possible to the lender. Second, it means that a lender, if it 

works with a credit insurer at all, likely bargains for the lowest price for the administration of the 

product or risk sharing that the bank can get from the insurer. In a competitive market, this 

should help reduce prices to consumers. Third, banks may be able to deliver the product more 

cheaply because marketing costs of credit insurers are removed from the equation. As for the 

lender, it allows it to price and underwrite the product to its own standards and guarantees the 

same regulations will apply regardless of the state it is operating in. 

Problems with debt cancellation and suspension: Debt cancellation may have some of 

the same problems as credit insurance but it clearly avoids others. Reverse competition is less of 

an issue, for example, and the price of the product is set by the market rather than insurance 

regulators so often faulted for providing too generous loss ratios to credit insurers. Comments 

 

15 For more information of the rule and how regulators responded to comments on the proposed rule, see the final 

rule: Department of the Treasury, Office of the Comptroller of the Currency, 12 CFR Parts 7-37, [Docket No. 2-14] 

RIN 1557-AB75. 
30

received on the OCC rule ultimately issued in 2002, though, provide insights into lingering 

concerns with these products and how they are priced and offered. Advocates are still concerned 

that despite the heightened disclosures, there is a risk of reverse competition and a risk that 

lenders can pressure customers into purchasing debt cancellation or suspension products. The 

choice of offered coverage and the bundle offered is still in control of the lender. Consumers, 

though they certainly could, still may not shop for a lower combined interest rate and debt 

cancellation contract cost elsewhere because of search costs and a more overriding focus on loan 

approval. Advocates also are troubled by allowing banks the authority to offer a no-refund 

product at all or to unilaterally modify a contact or agreement under any circumstances. 

Overall conclusions about debt cancellation and suspension: Like credit insurance and 

loan payment protection, debt cancellation and suspension have the distinct advantage of 

insuring the borrower as well as the lender against risks over which they have little or no control. 

Like credit insurance, they give borrowers a convenient way to insure against certain risks 

without going through lengthy underwriting and having to pay for larger blanket policies. There 

is little question that relative to credit insurance the risks of reverse competition increasing rather 

than decreasing prices for consumer is much lower if not eliminated. The regulations governing 

the offering of these bank debt protection products are both stringent and uniform across states. 

Examination for compliance is regularly scheduled as part of broader bank examinations (though 

how central a concern of these exams they are remains to be seen and likely depends on external 

pressures that ebb and flow). Not enough is known about actual pricing or practices to judge 

whether they are materially better than under credit insurance, but the disclosures are more 

rigorous and restrictions on practices greater. Thus, on balance debt cancellation and suspension 

have greater appeal than credit insurance provided it is not offered at a higher cost and does not 

involve more elements bundled together. 

There are perhaps three broad conclusions regarding the use of insurances and related 

market resources for risk mitigation among borrowers. First, they are declining in popularity, 

cover a limited range of events, and even then tend to be too expensive for those that need them 

most.16 Second, they have recently been open to criticism by those most concerned with 

consumer protection, and may be implicated in insurance aversion among some borrowers. And 

 

16 Ford et al. (2003) found the main reasons that mortgagors in the United Kingdom failed to buy coverage was 

overall cost (unaffordabilty) or the judgment that such insurances represent low value for money. 
31

finally, their effectiveness depends almost entirely on the resources and behaviors of individuals, 

who may or may not be in a position to make the best use of what is on offer. 

Hence it is generally agreed that a return to some broader risk sharing is necessary to 

stabilize credit markets and protect their participants, particularly where borrowing is packaged 

into mortgages. An alliance of home buyers, lenders and government is, for example, at the heart 

of SHOP – the safe home ownership partnership proposed by Ford and Wilcox (2005) to manage 

the (credit) risks of mortgage arrears and repossession in the United Kingdom. But so far the 

options for sharing risks in this way have been limited in scope, uneven in coverage and 

relatively costly. They are also based on relatively unsophisticated financial instruments, which 

(alongside tighter regulation) is why they are less cost-effective, less appealing and less safe than 

they could be. What are the alternatives? 

“Modern Methods”: Derivatives 

When large organizations face the kinds of risks today’s householders routinely live with, 

they make use of a suite of financial instruments invented precisely to manage such uncertainties. 

These are known as ‘derivatives’: they are contracts (usually in the form of futures, options and 

swaps) which, thanks to innovations in financial engineering, effectively separate the investment 

returns on commodities, assets and securities from their ownership and use. So although the value 

of a derivative does ‘derive’ from the price of an underlying asset (such as housing) or, more 

properly from a ‘basket of assets’ (in the case of housing, usually a price index), the contracts 

themselves can be traded independently. As we shall see, this means that derivatives can be used to 

help spread the risks of holding certain kinds of stock or investments (including mortgage debt and 

housing equity). 

It is probably the case that the awkward (and partial) integration of mortgage and 

financial markets – including the complex world of credit derivatives and the fragmentary 

market for MBS derivatives – that underpins the ‘credit crunch’ currently destabilizing parts of 

the Anglo-American banking system. So it may seem naïve – perhaps dangerous – to suggest 

that there is anything in the way financial markets work that could protect homebuyers, or could 

cushion borrowers more generally, from the fallout of this. However, at a time when mortgages 

no longer look like assets, and borrowing ceases to offer the means by which individuals and 

institutions “spend their way” out of problems, it is worth remembering that home equity – even 
32

in its highly mortgaged state – still has financial worth. Even borrowers with negative equity 

hold the title deed to a relatively large financial asset. Until recently, however, there has not been 

much they could do with this. This is because, even though the value of derivatives markets 

exceeds ten time the world’s entire GDP, nearly none of this is anchored on the single largest 

class of assets in existence: housing. Until last year there was limited engagement of housing 

with financial markets: there were no exchange-traded housing derivatives at all, and the only 

country with a tiny amount of over-the-counter activity was the UK. This, however, looks 

increasingly set to change: in 2006 the Chicago Mercantile Exchange began selling US housing 

options and futures on the Case-Shiller S+P house price index; last year, Radar Logic began 

licensing its own daily residential property index (RPX); there is a continuing surge of activity in 

the UK on the Halifax house price index, and an embryonic market is developing in Australia. 

Although derivatives are generally used by large institutions to diversify their 

investments and hedge their exposures, there is no reason in principle why they should not be 

packaged into products or initiatives designed to protect consumers – except that these markets 

are least well developed in areas that could be most useful to the majority of borrowers. So it is 

at least worth considering whether and how housing derivatives could be harnessed to help 

manage or mitigate the credit, income and investment risks to which mortgagors are exposed.17 

 The following overview of the options for developing derivatives-based risk mitigation 

therefore concentrates on housing (equity) rather than debt (credit) derivatives. Whereas 

conventional risk-mitigation strategies concentrate on how to manage debt directly (credit 

insurance, income support, loan cancellation, bankruptcy and so on), some of the most 

interesting modern methods focus on equity-orientated solutions to protecting homeowners in 

debt. These solutions recognize that just as mortgages are households’ major source of debt, so 

home ownership accounts for the majority of people’s wealth. It makes sense, therefore, to 

consider innovative ways to enable people to use home equity to manage mortgage debt, 

particularly where this helps avoid bankruptcy and prevent homelessness. 

 There are already a number of schemes which adopt this principle without the help of 

derivatives. In the UK, for example, the Joseph Rowntree Foundation has argued in favor of a 

 

17 Some people regard mortgage backed securities as derivatives, but these are mainly investment vehicles, like 

bond: they only work as derivatives when they are made into this style of instrument – for example packaged into a 

special purpose vehicle in the credit derivatives markets, or as part of the tiny market in MBS derivatives. 

Furthermore, since derivatives on the debt side of housing are not as obviously useful to consumers as derivatives on 

the equity side, our discussion focuses only on the later innovation. 
33

flexible approach to housing tenure for at least 20 years. Initiatives are in place to allow renters 

to “staircase up” into ownership when and if their incomes allow, and to draw back on these 

funds by “staircasing down” if they get into repayment difficulties. This “reverse staircasing” is a 

way to avoid mortgage arrears and possession following financial hardship. But although similar 

ideas around fractional ownership and equity share have also been encouraged by governments 

as well as the UKs Council of Mortgage lenders, these special schemes and arrangements tend to 

be limited in scope and coverage, not least because it is hard to make them attractive to 

institutional investors. 

 The only other option available to home owners to use housing equity to offset mortgage 

debt is to borrow up. Flexible mortgages, for example, were initially encouraged by 

governments precisely because they allow people to overpay when incomes are robust, and 

underpay or take payment holidays should earnings dip or other expenditures increase. And this 

has, to an extent worked, in the robust economic climate of the last decade. Drawing from a 

survey of flexible mortgagors, for example, Smith and Ford (2002) show that while just 17 per 

cent have some form of mortgage credit insurance (accident, sickness or unemployment 

insurance) fully 35 per cent – more than twice as many – have enough savings stored in their 

mortgages to cover repayments for the same period. Looking more generally, both Benito 

(2007) (using the British Household Panel Survey) and Smith et al. (2007) (using qualitative 

interviews with a cross-section of English mortgagors) show how mortgage equity withdrawal 

may one way to draw from housing wealth for form a financial buffer. 

However, Case and Shiller (1996) showed over a decade ago that there is a tight link 

between price stagnation or decline in housing markets, and the risk of mortgage default. Some 

of the reasons for this, and evidence of its continuation into the current housing and mortgage 

market cycles are set out earlier in this paper. Falling prices (and even house prices which do not 

appreciate in line with inflation, or as fast as other assets) can prevent people using home equity 

to mitigate the other (credit and income) risks to which they are vulnerable and which cannot 

easily (or cost-effectively) be managed in other ways. And this is where housing derivatives 

might be useful. 

Housing derivatives are based on house price indices (HPIs) whose future values can be 

traded in the form of contracts settled in cash. Not only does this mean that individuals and 

organizations that own no physical housing at all can buy into the ups and downs of property; 
34

crucially it means that those (primarily home owners and buyers) who have too much wealth 

concentrated into housing (or whose only financial resource is in the form of housing) can, for 

the first time, ‘sell off’ some of that risk to protect themselves against stagnant or declining 

prices, and to manage unsustainable debt. 

A case for managing the risks of over-exposure to housing by hedging with an HPI 

(which is effectively a basket of properties) is introduced by Case et al. (1993) for the USA, and 

elaborated for the UK by Iacoviello and Ortalo-Magné (2002). The economics are spelled out by 

Englund et al. (2002), who use a rich Swedish dataset to show that although real estate stocks 

can offer some protection for the risky portfolios of highly affluent investors, if the aim is to 

minimize risk overall ‘housing should be financed, almost exclusively, by going short on the 

housing index’ (p. 187). The social argument is sketched by Smith et al. (2009) who use 

qualitative data from the UK to show both the extent to which borrowers depend on the 

magnitude and liquidity of the wealth in their home as a financial safety net, and the extent to 

which they are willing to engage with derivatives-inspired solutions. The wider picture for 

Europe is filled in by Quigley (2006) who uses data from a panel of countries to show the 

potential financial gains and likely reduction of risk for households exposed to different levels of 

price volatility. In an earlier discussion, Quigley (2005) cited derivatives as the answer to his 

rhetorical question of ‘How to improve the welfare of European housing consumers at practically 

no cost’. His recent more detailed analysis, concludes with the observation that ‘The benefits to 

consumers of hedging in European housing markets are on the order of several percentage point, 

not several basis points’ (2006, p. 17). In short, the potential advantage to home buyers of being 

able to hedge their housing risks effectively is high. 

The advantages are higher still if their net result is to maintain a property market liquid 

enough to allow borrowers who are in difficulty to trade down. One vehicle for this is home 

equity insurance, as discussed in Shiller and Weiss (1994). This (together with some kind of 

‘down payment’ insurance) is the only widely-discussed retail application of housing derivatives 

to date, and it has already been applied in the USA, in the much-discussed pilot scheme in 

Syracuse (Caplin et al. 2003). More important here, however, is that possibility that housing 

derivatives can be drawn into solutions to credit risks that avoid the need for trading down or 

refinancing, and that avert the threat of possession. 
35

Less is written about the use of housing derivatives to manage credit risk directly (though 

see Case et al. 2003). However various scenarios can be envisaged by thinking of real estate 

derivatives simply as a means of splitting out the two components of housing (Hsi) which are 

currently indivisible: the cost of the homes (or housing services) that people own, occupy and 

use (Hs); and the cost of the investment vehicle (Hi) – the ups and downs of price – which home 

buyers must always purchase as well. There is already a market for Hs and Hi combined (Hsi): 

this is currently the only way people can buy into home ownership; they must buy both the 

property and the investment vehicle. But if markets could be developed for Hs and Hi separately 

(if the investment returns could be detached from the ownership and use of the property), then 

the scope for using equity solutions to handle credit crises is radically enlarged. The possibilities 

this opens up are summarized below (drawing from a fuller account contained in Smith, 2007). 

First, with a market in Hi – with the option to buy into the performance of a basket of 

house prices – the need to buy into home ownership itself simply for investment returns is 

removed. So price-linked savings vehicles (savings accounts and bonds), of which there are 

now several in the UK, can potentially protect savings from house price inflation and so 

remove the impulse to ‘buy early and pay high’. This tendency to enter home ownership (too) 

early as an insurance against being locked out of the market later is common in the UK. It 

occurs to a lesser extent in the US (Banks et al. 2002) but it is one of the factors which 

currently propels younger households into unsustainable debt. In fact, if the tax treatment of 

house-price linked savings and bonds were brought into line with that on home equity, the 

possibility to buy house price performance in small chunks, without the added costs of the 

physical property, could significantly reduce the borrowing commitments of households who 

are currently on the margins of ownership. 

Second a market for Hs without Hi (or without some proportion – perhaps up to 40 

percent of Hi) potentially reduces the costs of entry to home ownership. Even with current 

market uncertainties this might improve affordability – possibly by as much as 25 percent. In 

effect, then, buyers can sell tomorrow’s price appreciation in return for today’s more sustainable 

levels of debt. There are currently examples of this on the market in Australia. 

Third, perhaps most critically, derivatives-based solutions may be appropriate for people 

who are conventional home buyers (ie they have the package Hsi), but who can no longer service 

their loan. For example, Syz et al. (2008) working at the Zurich Cantonal Bank, have developed 
36

a house price-linked mortgage to protect borrowers who, like many in today’s US subprime 

sector are in danger of default as house prices fall and refinance proves costly. This is a secured 

loan whose repayments vary with a local housing index, so that as prices fall, so do loan 

repayments (alternatively this reduction can be rolled up and subtracted from the principal at the 

end of the repayment period). The aim here is to manage both price and credit risk in a variety 

of ways that are elaborated in Syz (forthcoming). A similarly radical concept, which has a wide 

variety of possible applications, has been developed by Liu (2006) under the umbrella of 

SwapRent (SM). This is presented as a method of separating out the legal and economic 

ownership of housing, and it formalizes the way home buyers can sell a slice of their future price 

appreciation (some proportion of their investment return over a certain number of years), in 

return for a capital sum, or an income stream sufficient to reduce the extent of their default and 

limit the risk of foreclosure. This product (via the mortgages that embed it) potentially allows 

home buyers to rent when it is economical to rent and own when it is advantageous to own (or to 

change the proportion of their property that they are renting or owning), without moving or 

giving up the title to their property. Obviously this has a variety of applications other than that of 

managing credit risk, but currently it is appealing as a means of handling the combination of 

rising interest rates and uncertain house prices that are destabilizing so many of those whose loan 

portfolio is mainly rolled up against their home. 

V. Conclusions

In societies like the US and the UK, where consumption is fuelled by credit rather than 

cash, the prospect of developing new partnerships between governments, markets and individuals 

to ensure consumers against unsustainable debt, is appealing. As well as lenders being protected 

against events they do not control, borrowers could be too: they could avoid default, keep their 

credit score intact, and – in a world where so much borrowing is now secured against housing – 

avoid homelessness. Much of the discussion in this paper has focused on mortgagors, partly 

because of the growing use of mortgages to anchor all kinds of debt, but also because, unlike the 

credit card market which is dominated by national banks that can offer debt cancellation contracts, 

the mortgage market is dominated by other players that cannot. Thus, traditional products—and 

arguably more efficient ones like debt cancellation, enabled because banks self-insure and avoid a 

third party—are also less available to mortgage borrowers, and are less regulated. 
37

There are merits in both the conventional insurances and the derivatives-based solutions 

discussed here, though neither is problem-free. Products incorporating derivatives should be 

cheaper at the point of sale, and may offer a one-off solution to a one-off problem (caused by 

stacking borrowing against homes in a period of uniquely low interest rates). But there is no reason 

to think that – even when the product range is bigger – these solutions will automatically be priced 

more fairly, regulated more effectively, delivered more efficiently, or be more successful in 

avoiding the charge of sharp practice, than the more traditional solutions whose mixed merits are 

detailed in this paper. The first priority of most actors in financial markets actors is probably not to 

meet the needs of ordinary households: in fact the deterrent of ‘reputational risk’ is very strong; 

almost as problematic as growing insurance aversion among consumers. 

Nevertheless, it might be in the interests of some policy makers, some market segments 

and a broad sweep of consumers, to build partnerships to deliver derivatives-based retail 

products. There is no reason, in principle, why these should not be fairly-priced, efficient, and 

cost-effective risk-management tools for all parties. There may, indeed, be an argument for using 

housing derivatives to win back the partnership approach to sustainable finance that was lost in a 

previous wave of enthusiasm for traditional market-based insurance. To the extent that properly 

regulated, wisely-used financial markets can effectively protect large institutions from risk, there 

is no reason why they should not – with a little more political imagination – be used to deliver a 

range of social goals that are currently priced off the agenda. 
38

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