Housing finance in an inflationary environment: A simulation of the hybrid price-level adjusted mortgage in the case of Mexico

The demand for new housing in Mexico currently far exceeds the supply. A major factor in this imbalance is the lack of a viable secondary mortgage market, causing a scarcity of loanable funds. Borrowers desire mortgages that are affordable, not only initially but over time as well, even during uncertain inflationary environments. Lenders and potential secondary market investors desire mortgage instruments that minimize the risk of borrower default. Therefore, selection of the correct mortgage instrument is extremely important for the success of a functional Mexican secondary market.; This research explores the performance of three mortgage models under 24 sets of simulated data. The simulations were designed to reflect Mexico's future, long-term inflation and interest rate environment under most likely, worst case, and best case economic conditions. The models include: (1) a dual-index mortgage or DIM, (2) a mortgage based on the UDI, an inflation-indexed, peso-denominated unit of account used only in domestic financial transactions, and (3)an experimental model known as the Hybrid price-level adjusted mortgage or Hybrid PLAM.; Two default criteria were established to determine the incidence of default under the simulated conditions. The criteria were based on the attainment of specified maximum payment-to-income ratios and minimum equity-to-home value ratios. Non-defaulting models were further compared based on a set of performance criteria to determine superiority.; The findings reveal that the DIM model produced the highest number of loan defaults. Furthermore, full amortization under the DIM, based on 20-year and 30-year maximum loan terms, was not assured. The Hybrid PLAM model produced the second-highest number of defaults. These defaults occurred when borrowers originated loans during periods of high expected inflation that sought to minimize their exposure to inflation risk. Finally, the UDI mortgage model produced no defaulting loans based on the two default criteria. Further examination based on other performance criteria revealed that the UDI model was the superior model in this study. Therefore, mortgage loans based on the UDI model would appear to be a viable contender for use in a Mexican secondary mortgage market.