Mortgage Design in an Equilibrium Model of the Housing Market

Trustees Of Boston University, Boston

Investigators

Abstract

In the wake of the Great Recession, there has been substantial discussion about how the design of various mortgage products contributed to falling house prices, rising default, and contractions in consumption, output, and employment. In particular, many observers have suggested simple modifications to standard fixed-rate and adjustable-rate mortgages might have helped to cushion the blow of a sharp housing downturn. Analyzing the costs and benefits of various mortgage designs is complicated, because in response to changes in mortgage contracts, households will change their prepayment, refinancing, default, and consumption behavior, lenders will change their lending standards and interest rates, and all of these actions will feed back into house prices, further affecting lender and household actions. There is no existing research that analyzes mortgage design in light of these complicated feedbacks. This project will fill the gap with a theoretical economic model that is fit to data, which will allow the researchers to simulate the housing market and boarder economy under different mortgage contracts and monetary policies. Because mortgages are the largest debt obligations of the vast majority of households, improving the mortgage system to stabilize the housing market and consumption has the potential to have large benefits for society. This project will also help inform the ongoing policy debate on how to reform the housing finance system. Because household behavior, lender behavior, and house prices all depend on one another, an analysis of mortgage design requires a general equilibrium analysis of housing and mortgage markets that incorporates substantial heterogeneity across households and aggregate shocks. The investigators will use tools from heterogeneous agent macroeconomics to create a quantitative general equilibrium life cycle model with aggregate shocks in which households have realistic long-term mortgages and a rich set of choices as to whether to prepay, refinance, move, or default, lenders set interest rates for different mortgage contracts in response to prepayment and default risk, and household and lender decisions aggregate up to determine house prices. The model will be calibrated to the U.S. housing market, with a focus on matching recent empirical evidence on how mortgage payment size and loan-to-value ratios affect default and consumption. The model will then be used to simulate how different mortgage contracts affect housing market volatility and particularly in busts like the Great Recession, allowing the researchers to understand the tradeoffs involved in mortgage design qualitatively and quantitatively. This project will also shed light on how these different mortgage contracts affect the transmission of monetary policy and how monetary policy affects the performance of various mortgage contracts by varying the extent to which the central bank adjusts interest rates in response to developments in the housing market and the real economy.