Working Paper: NBER ID: w24446
Authors: Adam M. Guren; Arvind Krishnamurthy; Timothy J. McQuade
Abstract: How can mortgages be redesigned to reduce housing market volatility, consumption volatility, and default? How does mortgage design interact with monetary policy? We answer these questions using a quantitative equilibrium life cycle model with aggregate shocks, long-term mortgages, and an equilibrium housing market, focusing on designs that index payments to monetary policy. Designs that raise mortgage payments in booms and lower them in recessions do better than designs with fixed mortgage payments. The benefits are quantitatively substantial: In a simulated crisis under a monetary regime in which the central bank lowers real interest rates in a bust, house prices fall 2.24 percentage points less, 23 percent fewer households default, and consumption falls by 0.79 percentage points less with ARMs relative to FRMs. Among designs that reduce payments in a bust, we show that those that front-load the payment reductions and concentrate them in recessions outperform designs that spread payment reductions over the life of the mortgage. Front-loading alleviates household liquidity constraints in states where they are most binding, reducing default and stimulating housing demand by new homeowners. To isolate this channel, we compare an FRM with a built-in option to be converted to an ARM with an FRM with an option to be refinanced at the prevailing FRM rate. Under these two contracts, the present value of a lender's loan falls by roughly an equal amount, but the FRM that can be converted to an ARM, which front loads payment reductions, reduces the declines in prices and consumption six times as much, and reduces default three times as much.
Keywords: mortgages; housing market; monetary policy; default; consumption volatility
JEL Codes: E4; G01; G2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Mortgage design indexed to monetary policy (E52) | Housing market volatility (R31) |
| Mortgage design indexed to monetary policy (E52) | Household default rates (G59) |
| Frontloading payment reductions during recessions (E62) | Household default rates (G59) |
| Frontloading payment reductions during recessions (E62) | Housing demand (R21) |
| Design with option to convert to ARM (L63) | Price declines and consumption (D12) |
| Design with option to convert to ARM (L63) | Household default rates (G59) |