Real Estate Research provides analysis of topical research and current issues in the fields of housing and real estate economics. Authors for the blog include the Atlanta Fed's Kristopher Gerardi, Carl Hudson, and analysts, as well as the Boston Fed's Christopher Foote and Paul Willen.

November 24, 2015

The Pass-Through of Monetary Policy

In the wake of the Great Recession, the Federal Reserve instituted three rounds of large-scale asset purchases (LSAPs) in 2008, 2010 and 2012, more commonly known as "quantitative easing 1" (QE1), "QE2" and "QE3." The objective of these interventions was to keep interest rates low in an attempt to stimulate household consumption and business investment.1

In the United States, housing is the single largest asset on the household balance sheet, accounting for 73 percent of nonfinancial assets for the average U.S. household and an even higher share for homeowners.2 Mortgage payments represent the largest class of household debt obligation.

Evidence of the effectiveness of the asset purchase programs on real economic activity has until recently been limited due to the lack of data and a credible identification strategy (by which we mean a way to separate the causal impact of the LSAPs on the economy from other government programs and market factors that were occurring at the same time). When we chart a timeline of the three LSAPs against the primary mortgage rate, we can see that the primary mortgage market rate effectively dropped below 6 percent when the Fed began buying $600 billion in mortgage-backed securities during QE1. Indeed, the rate dropped following each of the subsequent LSAPs.


Since 2009, a number of papers have been published that evaluate the effectiveness of the policy interventions through different transmission channels. One such paper (Keys, Piskorski, Seru, and Yao, 2014) reports on borrowers with adjustable-rate mortgages (ARMs) who automatically receive the benefits of lower interest rates with no frictions or transaction costs, unlike borrowers with fixed-rate mortgages (FRMs) who must refinance in order to take advantage of lower interest rates. The paper provides new evidence on the effectiveness of the LSAPs.

Our strategy is to compare the change in the household balance sheets of 7/1 ARM borrowers to those of 5/1 ARM borrowers, using credit bureau data linked to mortgages. These two ARMs are the most popular ARM products among prime borrowers with very similar credit quality and risk preferences, yet they differ only in years 6 and 7, when the 5/1 ARM is eligible for a rate reset and the 7/1 is still locked (that is, the rate is still fixed). This creates a natural experiment that allows us to isolate other factors that might affect the mortgage rate.

By controlling for borrower characteristics and economic environments, we estimate that mortgage rates in the treatment group (5/1 ARMs) dropped in the first year by 1.14 percentage points, from 5.1 percent, and that payments dropped by $150 per month, or about a 20 percent reduction on average. The average borrower had a cumulative two-year savings of $3,456.3 We also subsequently found that borrowers spent 18 percent of the money saved on paying off credit card balances and that there was an 11 percent increase in new car purchases for the group. As a result, the leverage of U.S. households' dropped considerably from its peak during the financial crisis.4

We also find significant heterogeneity for these effects across different populations. Less creditworthy and more liquidity-constrained borrowers appear to have benefited the most from LSAPs as they experienced significantly greater reductions in mortgage rates and payments and larger improvements in mortgage and credit card performance. In terms of how they spent the extra liquidity received, highly leveraged borrowers (high credit utilization) spent 40 to 50 percent of the extra liquidity received during the first year, or $814 out of $1,740, to repay their revolving debts, then spent 20 percent of the extra liquidity received during the second year. Borrowers in the top quartile of credit utilization rates allocated about 70 percent of the extra liquidity toward repaying their credit card debt. We found similar effects among borrowers in the bottom quartile of credit scores. (The low-wealth borrowers with low credit utilization experienced a much larger increase in auto debt or new car purchases.) In other words, the LSAP programs effectively stimulated household investment and consumption.

We also find, as a result of the estimated effects at the micro level, a significant impact on local (nontradable) employment growth, consumer spending, and house price recovery in regions that were more exposed to ARMs. For example, a 10 percentage point increase in the ARM share, which is associated with about a 20-basis-point average reduction in ZIP code mortgage rates, is associated with about a 0.25 percentage point increase in quarterly home price growth, or about 1 percent annual appreciation, a very meaningful increase.

By Vincent Yao, visiting scholar at the Federal Reserve Bank of Atlanta and associate professor in the Real Estate Department in the J. Mack Robinson College of Business at Georgia State University.


Di Maggio, Marco; Amir Kermani; and Rodney Ramcharan. 2014. "Monetary Pass-Through: Household Consumption and Voluntary Deleveraging," Working Paper.

Hancock, Diana and Wayne Passmore. 2014. "How the Federal Reserve's Large-Scale Asset Purchases (LSAPs) Influence Mortgage-Backed Securities (MBS) Yields and U.S. Mortgage Rates," Finance and Economics Discussion Series 2014–12. Board of Governors of the Federal Reserve System.

Keys, Benjamin J.; Tomasz Piskorski; Amit Seru; and Vincent Yao. 2014. "Mortgage Rates, Household Balance Sheets, and the Real Economy," NBER Working Paper No. 20561.


1 The LSAPs involved purchases of long-term securities issued by the U.S. Treasury, agency debts, and agency mortgage-backed securities (MBS). They ultimately affected the yields of the MBS as well as the mortgage rates offered to borrowers in the primary mortgage market through several potential transmission channels: (1) the signaling of the Fed's commitment to keeping rates low, (2) a portfolio rebalance between assets and deposits and among different durations, and (3) increasing the liquidity value of MBS (Hancock and Passmore, 2014).

2 Survey for Consumer Finance, Federal Reserve Board of Governors, 2013.

3 Di Maggio, Kermani. and Ramcharan (2014) found much bigger savings for subprime and Alt-A borrowers based on a similar approach.

4 It is notable that in the United States the majority of prime borrowers take out fixed rate mortgages while most subprime borrowers take out adjustable rate mortgages.

November 24, 2015 in Financial crisis, Mortgage crisis | Permalink


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July 01, 2015

Are Millennials Responsible for the Decline in First-Time Home Purchases? Part 2

Recall that, in our last post, we investigated the claim that millennials were to blame for the decline in first-time home purchases. Our data analysis confirmed that home purchases by first-time buyers have indeed plummeted since the crisis. We did not, however, find evidence that millennials were driving this decline. We found that, if anything, first-time homebuyers have become younger since the crisis, not older. By contrast, location appeared to be a much stronger predictor of declines in first-time buying than age.

Notwithstanding, many commentators still believe that millennials are behind sluggish sales. In this post, we take a closer look at the timing of first-time home purchases and the credit trends of first-time homebuyers with an eye towards the changing composition of homebuyers. We use the same credit bureau data set that we used in the previous post (take a look for a description of the data and our definition of first-time homebuyer). Using this data, we dig a bit deeper into two theories that are often cited for why millennial homebuyers are not buying as many homes as in the past. We first analyze whether millennials delayed the purchase of their first home in response to the crisis. Then we investigate what role, if any, credit tightening has played.

In short, we can't confirm any delay in the timing of home purchases. What we do find is that the distribution of first-time home purchases changed after the crisis. First-time home purchases by younger buyers peak earlier and persist at an elevated level over a longer period of time than before. We also find, contrary to the popular theory that credit became too tight for millennials to buy homes, that mortgage credit actually became tighter for older first-time buyers than for younger first-time buyers. Taken together, we think these data observations help to explain why the median age of the first-time buyer shifted downwards (instead of upwards) after the housing downturn.


To examine how the housing downturn affected the timing of purchases by young first-time homebuyers, we separated this group out by birth year and examined the number of home purchases from 2000 to 2014. We looked at millennial homebuyers born in 1983 and 1985 and compared them to Gen X homebuyers born in 1975 and 1977.

Chart 1 shows the number of first-time home purchases for each year, with each line representing a different birth year. The time series for the older birth years peaks between the ages of 27 and 29 while the time series for the younger birth years peaks between the ages of 24 and 25. For Gen Xers who came of age before the crash, their peak appears to be the culmination of a steep increase in purchases and an almost equally steep decline resulting in a curve that looks roughly like an inverted V. For the millennial birth years, who came of age after the real estate crash, the peak in first-time purchases occurs earlier and the decline of the curve is much more gradual. The change in the distribution of purchases after the crash suggests that the younger first-time home buyers are still purchasing homes at relatively high rates, but purchases are spread out over a wider time period.


The distribution of millennial first-time homebuyers has clearly shifted. Not only has the distribution of first-time homebuyers become younger over time (refer to previous post) but first-time home buying among the most recent birth years is peaking at an earlier age. Why might this be? We think a closer look at credit trends can shed some light on this question.

Credit scores

In Chart 2, we examine the number of first-time home purchases and median credit scores of first-time home purchasers by age bracket. The two age brackets are adults under 35 years old and adults between the ages of 35 and 48. By grouping first-time home purchases into age brackets, we are able to examine whether credit is tighter for younger borrowers than for older borrowers using the median Equifax risk score as a proxy for credit tightness.1


From 2001 to 2014, median FICO scores increased by 5.0 percent for the younger group and 5.1 percent for the older group. In general, the median credit scores of both groups appear to behave similarly, except during the years when subprime lending prevailed. The median credit scores for both younger and older buyers shifted down between 2003 and 2006, signaling that there were more purchases by higher-risk buyers. With that said, the decline in the median credit score was more pronounced for older buyers (down 4.1 percent, from 689 in 2003 to 661 in 2006) than for younger buyers (down just 1.6 percent, from 693 in 2003 to 682 in 2006). Since the crisis, the gap between the median credit scores of younger and older buyers has closed (in other words, credit has become tighter for older buyers), which may explain why first-time home purchases have fallen faster for older buyers than it has for younger buyers. Indeed, between 2001 and 2014, first-time home purchases fell by 36 percent for younger homebuyers and by 54 percent for older buyers.

The table and Charts 3 and 4, below, delve deeper into the credit trends of younger and older first-time homebuyers, showing home purchases by credit bracket, year, and age. We determined credit brackets by taking the quartiles of every individual with a credit record in the time period. As the charts show, purchases by those with the lowest credit scores, marked in blue, have plummeted steeply. Credit scores in the middle, marked in green and orange, fell sharply, too, but particularly among older buyers. Older first-time homebuyers with moderate credit scores were much less likely to buy homes after than before the crisis, falling by 50 to 60 percent. Purchases by those with stellar credit, marked in purple, were barely affected by the crisis. Perhaps a more interesting observation is that young homebuyers in the highest credit bracket were the one subgroup to increase their purchases during and after the recession. First-time purchases by this group of young buyers actually rose by 25 percent.



We believe this collection of charts demonstrates in more detail that credit became tighter for older homebuyers during the crisis—and also that an uptick in home purchases by the most creditworthy millennials has buoyed purchases for that age bracket.

The Federal Reserve Bank of New York Consumer Credit Panel/Equifax data is an unusual data set in that it allows us to compare first-time homebuyers without first conditioning by age. By comparing older and younger first-time homebuyers, we have been able to examine the claim that millennial homebuyers are behind the stagnation in home sales. In addition to our earlier findings that first-time buyers have become younger, not older, since the crisis, we find that the distribution of first-time home purchases has changed since the housing downturn. Specifically, first-time purchases by younger buyers tend to peak at an earlier age and persist at an elevated level over a longer period of time. This is in contrast to the trend before the downturn, when first-time purchases by younger buyers peaked at an older age and dropped off precipitously after peaking. Moreover, the data reveal that, while younger and older first-time buyers have similar credit trends when tracked as the median credit score, credit may have loosened more for older first-time buyers than younger first-time homebuyers during the run-up and as a consequence tightened more for older buyers than younger buyers during the recovery, resulting in a lower number of first-time purchases by this older group. Despite the fact that many believe tight mortgage credit, student loan debt burdens, and stagnating wages have made it more difficult for millennials to buy homes, it appears that credit tightness has actually weighed more heavily on older first-time homebuyers.

Photo of Carl Hudson By Elora Raymond, graduate research assistant, Center for Real Estate Analytics in the Atlanta Fed's research department, and doctoral student, School of City and Regional Planning at the Georgia Institute of Technology, and

Photo of Jessica DillJessica Dill, economic policy analysis specialist in the Atlanta Fed's research department


1 Examining credit scores over time can be misleading. Credit scores measure a person's ranking of creditworthiness at a given time. A credit score does not give an absolute measure of someone's default probability, just where they are relative to others. So, someone with a 700 credit score in one time period may have a different default probability than someone in another time period, though their rank relative to others remains the same. This becomes relevant if the creditworthiness of the American public as a whole shifts dramatically over time

July 1, 2015 in Credit conditions, Financial crisis | Permalink


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May 20, 2015

Are Millennials Responsible for the Decline in First-Time Home Purchases?

First-time homebuyers play a critical role in the housing market because they allow existing homebuyers to sell their homes and trade up, triggering a cascade of home sales. While their share of all purchases has remained fairly flat over time (see our previous post on this topic), the number of first-time homebuyers has declined precipitously since the real estate crash. Many think of first-time homebuyers as younger households, and believe millennials are largely behind the decline in first-time homebuying. There are a variety of theories about why millennials have been slow to enter homeownership. One theory says that millennials would rather rent in dense urban areas where land is scarce than buy homes in the suburbs. Another theory blames steep increases in student debt for crowding out mortgage debt and reducing the homeownership opportunities of younger generations. Yet another theory argues that because the recession lowered incomes, younger people can't afford to buy. Finally, underwriting standards tightened after the recession, causing mortgage lenders to require larger down payments and higher credit scores in order to buy a home. Some worry that this more stringent lending environment has raised the bar too high for millennial homebuyers in particular.

We can't examine all these theories in a blog post, but we can examine the validity of the assumption that millennials are driving the decline in first-time homebuyers. We approached this from two angles. We first looked at whether the age distribution of first-time homebuyers has changed, and then we tried to discern patterns in first-time home buying across states. In general, we find that the age distribution of first-time homebuyers has become younger, not older, since the crisis. We also found that the dramatic fall in purchases varies much more strongly across states than by age. The preliminary figures suggest that housing market and local economic conditions may explain as much or more of the decline in first-time homebuyers than a generational divide.

Searching the data for first mortgages
Our analysis is based on the Federal Reserve Bank of New York Consumer Credit Panel/Equifax data. This data set provides longitudinal, individual data, using a 5 percent sample of all persons with a credit record and social security number in the United States.i We examined the age, location, and credit scores of people who bought homes for the first time and looked at how these characteristics changed after the crisis.ii

To identify first-time homebuyers, we flagged the first year of the oldest mortgage for each individual in the credit panel. This reveals the first instance of someone obtaining a mortgage, even if they subsequently buy another home or even transition back to renting. The trade-off is we were able to observe only those who use debt finance, and thereby excluded all cash purchases. While many homeowners do own their homes outright, we expect most first-time buyers and certainly most young buyers to have a mortgage.iii

Having isolated first-time homebuyers in this data set, we looked at their purchasing trends and demographic attributes from 2000 to 2014. In this data set, we found that roughly 1 percent to 2 percent of the population purchased a mortgage-financed home for the first time in a given year. Forty-nine percent to 53 percent had no mortgage (this category combines renters and those who own their homes outright), and 45 percent to 50 percent were paying down an existing mortgage.


Buyers aren't getting older
We found that the number of first-time home buyers fell precipitously after the crash, from 3.3 million a year to around 1.5 million to 1.8 million. However, the age distribution of these first-time homebuyers does not change dramatically, though the median age of actually went down slightly since the peak. If we were to believe that the decline in first-time buyers was driven primarily by younger workers requiring more time to amass a down payment or pay off student debts, then we would expect to see first-time buyers getting older.


We did not see a strong explanation for dramatic declines in first-time homebuyers when we compared younger and older adults. It doesn't appear that millennials are driving the decline. By comparison, when we reviewed the number of first-time home purchases by state, we found very dramatic differences that population alone cannot explain. Unsurprisingly, first-time homebuying fell further in places where the housing crisis hit the hardest.

The chart shows the number and percent change in first-time homebuyers from 2001 to 2011 by state. There is a wide variety in the percent change in first-time homebuyers, with declines as strong as 65 percent in some states and as low as 10 percent in others. North Dakota was the only state to have increases in first-time homebuyers, likely due to the oil industry growth there.


This analysis does have some weaknesses. For one, as we mentioned, it omits cash buyers, who are an increasingly important segment of the housing market, especially in hard-hit states like Georgia and Florida. Also, other research has shown that the transition from renter to owner and back can happen many times in a person's lifetime, and this data set does not control for homeownership "spells" older than one year (see Boehn and Schlottman 2008). Notwithstanding, this analysis suggests that the decline in first-time homebuying is driven not by swiftly changing preferences nor the economic constraints of the younger generation but by regional and local economic conditions. Stay tuned for more, as we plan to look further into how the real estate crisis altered the home purchase decisions of young first-time homebuyers relative to older generations.

Photo of Carl Hudson By Elora Raymond, graduate research assistant, Center for Real Estate Analytics in the Atlanta Fed's research department, and doctoral student, School of City and Regional Planning at the Georgia Institute of Technology, and

Photo of Jessica DillJessica Dill, economic policy analysis specialist in the Atlanta Fed's research department


i The data is a 2.5 percent sample of all individuals with a credit history in the United States. So, for example, this sample resulted in 636,638 records in 2014, which would correspond to an estimated 254,655,200 individuals with credit records and social security numbers in 2014.

ii We excluded anyone who had an older mortgage in a prior year. Doing so resulted in only a very small percentage of records being excluded.

iii Our approach and results are similar to those cited in Agarwal, Hu, and Huang (2014), who find that the homeownership rate between 1999 and 2012 varies between 44 percent and 47 percent for individuals aged 25—60 using a different time frame and age distribution of the same data set. Because our definition—and that of Agarwal, Hu, and Huang—is unique, it differs from the widely cited homeownership rate published by the U.S. Census Bureau. The rate published by the Census Bureau ranges between 65 and 68 percent for individuals over 25 years old and is calculated by dividing the number of owner-occupied households by the total number of occupied households. Homeownership rates have also been derived using other data. Gicheva and Thompson (2014) derive a homeownership rate using the Survey of Consumer Finance and find the mean homeownership rate to be 61 percent between 1995 and 2010. Gerardi, Rosen, and Willen (2007) used the Panel Survey of Income Dynamics (PSID), which tracks households over time and captures changes in tenure status, to identify home purchasers. They reported a range of 5.6 percent (in 1983) to 9.6 percent (in 1978) of households buying homes in the 1969—99 timeframe.

May 20, 2015 in Financial crisis, Homeownership, Housing boom, Housing crisis | Permalink


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January 14, 2015

The Effectiveness of Restrictions of Mortgage Equity Withdrawal in Curtailing Default: The Case of Texas

As an economist who has studied the causes of the recent mortgage default and foreclosure crisis, I am often asked how to design policies that will minimize the likelihood of another crisis. My typical response to such a question is that one of the most effective ways of lowering mortgage defaults would be to limit borrower leverage by either increasing down payment requirements at the time of purchase or limiting home equity withdrawal subsequent to purchase.

The reason behind my belief is twofold. First, economic theory tells us that being in a situation of negative equity (where the remaining balance of the mortgage is greater than the market value of the property) is a necessary condition for default and foreclosure. Homeowners with positive equity will almost always have a financial incentive to sell their homes instead of suffering through the foreclosure process, while borrowers who are “under water” have a difficult time refinancing or selling (since they would need to have enough cash at closing to cover the difference between the outstanding balance of the mortgage and the sale price/appraisal of the house) and have less of a financial incentive to continue paying the mortgage. Second, numerous empirical studies in the literature have confirmed the theory by documenting a strong positive correlation between the extent of negative equity and the propensity to default on one’s mortgage.

New evidence on preventing defaults

An important new paper by Anil Kumar, an economist at the Federal Reserve Bank of Dallas, provides new evidence that shows just how effective restricting leverage can be in preventing mortgage defaults. His paper confirms many of the findings in previous studies that have shown a positive relationship between negative equity and default. However, it goes a step further by using plausibly random variation in home equity positions created by a government policy that placed explicit restrictions on home equity withdrawal.

Kumar's paper is a significant contribution to the literature because it seems to overcome a serious identification issue that has plagued most empirical studies on the topic. The major challenge is that a homeowner can partially control his or her equity position through decisions about initial down payments on purchase mortgages and decisions about cash-out refinancing and home equity loans or lines of credit subsequent to purchase. As a result, it's unclear whether homeowners with more negative equity are more likely to default because of their worse equity positions or because of other reasons (unobserved by the researcher) that happen to be correlated with the decision to put less money down at purchase or to extract more equity over time.

Both theory and empirical evidence tell us that more impatient individuals tend to borrow more and are more likely to default on their debts. Thus, it might simply be the case that more impatient borrowers who are less likely to repay any type of debt choose to put less money down and extract more equity over time, creating the observed correlation between negative equity and the propensity to default. To put it in the language of econometrics, there are both selection and treatment effects that could be driving the correlation that we see in the data, and the policy implications of restricting borrower leverage are likely very different depending on which cause is more important.

Do home equity restrictions cause lower default rate?

The paper focuses on a policy enacted in the state of Texas that placed severe restrictions on the extent of home equity withdrawal. The Texas constitution, enacted in 1876, actually prohibited home equity withdrawal. The prohibition was eventually lifted in 1997 and the restrictions were further relaxed in 2003, but even in the post-2003 period, Texas law placed serious limits on equity withdrawal, which remain in effect today.1 Subsequent to purchase, a borrower cannot take out more than 50 percent of the appraised value of the home, nor exceed 80 percent of total loan-to-value (LTV). For example, if a borrower owned a home worth $200,000 and had an outstanding mortgage balance of $140,000, the borrower would be allowed to take out only $20,000 in a cash-out refinance. It is important to note that this LTV restriction does not bind at the time of purchase, so a homebuyer in Texas could take out a zero-down-payment loan, and thus begin the homeownership tenure with an LTV ratio of 100 percent (we will come back to this issue later).

Here's a nice quote in the April 4, 2010, issue of the Washington Post crediting the cash-out restriction for Texas weathering the foreclosure crisis better than many areas of the country.

But there is a broader secret to Texas's success, and Washington reformers ought to be paying very close attention. If there's one thing that Congress can do to help protect borrowers from the worst lending excesses that fueled the mortgage and financial crises, it's to follow the Lone Star State's lead and put the brakes on "cash-out" refinancing and home-equity lending.

At first glance, the data suggest that such a sentiment may be correct. In the figure below, we display subprime mortgage serious delinquency rates (defined as loans that are at least 90 days delinquent) for Texas and its neighbors (Arkansas, Louisiana, New Mexico, and Oklahoma). We focus on the subprime segment of the market because these are the borrowers who are more likely to be credit-constrained and thus more likely to extract home equity at any given time. It is apparent from the figure that Texas had the lowest subprime mortgage delinquency rates over most of the sample period. While the paper uses a slightly different data set, a similar pattern holds (see Figure 1 in the paper). The figure is certainly compelling and suggests that the home equity withdrawal restrictions in Texas had an important effect on default behavior, but a simple comparison of aggregate default rates across states really doesn’t tell us whether the policy had a causal impact on behavior. There could be other differences between Texas and its neighboring states that are driving the differences in default rates. For example, house price volatility over the course of the boom and bust was significantly lower in Texas compared to the rest of the country, which could also explain the differences in default rates that we see in the figure.

The paper uses a relatively sophisticated econometric technique called "regression discontinuity" to try to isolate the causal impact of the Texas policy on mortgage default rates. We won't get into the gory details of the methodology in this post, so for anyone who wants more details, this paper provides a nice general overview of the technique. Essentially, the regression discontinuity approach implemented in the paper compares default rates over the 1999–2011 period in Texas counties and non-Texas counties close to the Texas borders with Louisiana, New Mexico, Arkansas, and Oklahoma while controlling for potential (nonlinear) trends in default rates that occur as a function of distance on each side of the Texas border. The paper also controls for other differences across counties that are likely correlated with mortgage default rates (such as average house price appreciation, average credit score, and more). The idea is to precisely identify a discontinuity in default rates at the Texas border caused by the restrictions on home equity withdrawal in Texas. This strikes us as a pretty convincing identification strategy, especially in light of the fact that information on actual home equity withdrawal is not available in the data set used in the paper.


The estimation results of the regression discontinuity specification show that the equity restriction policy in Texas lowered overall mortgage default rates over the 13-year period by 0.4 to 1.8 percentage points depending on assumptions about sample restrictions (including counties within 25, 50, 75, or 100 miles of the border) and functional form assumptions for the “control function” (that is, whether distance to the border is assumed to be a linear, quadratic, or cubic polynomial). At first glance, this may not seem like a large effect, but keep in mind that the average mortgage default rate over the entire sample period was only slightly above 3 percentage points in Texas and 4 percentage points in the neighboring states. The paper also restricts the sample to subprime mortgages only and finds significantly larger effects (2 to 4 percentage points), which makes sense. We expect subprime mortgage borrowers to be affected more by the equity restriction since they are more likely to withdraw home equity.2 The paper implements a battery of robustness checks to make sure that the results aren’t overly sensitive to functional form assumptions and adds controls for other types of state-level policy differences. Based on the results of those tests, the findings appear to be quite stable.

But is it a good policy?

So the paper appears to confirm what previous research on the relationship between equity and mortgage default has found, although it uses methods that aren’t quite as clean as the regression discontinuity approach employed in this analysis. However, it doesn’t mean that such a law change is necessarily good policy. While it seems to be effective in reducing defaults, it may also have some real costs. The most obvious one is the decrease in the volume of low-cost secured credit that many borrowers used to improve their circumstances during the housing boom. An unintended consequence of the policy might have been to push financially distressed households into higher-cost credit markets like credit cards or payday loans. A second drawback of the policy may have been that it increased homeowner leverage at the time of purchase. As there were no restrictions on LTV ratios at the time of purchase, many homebuyers may have decided to make lower down payments, knowing that their access to equity would be restricted in the future. It’s also possible that this may have resulted in a larger volume of subprime mortgage lending in Texas. Households with relatively high credit scores who could have obtained a prime mortgage with significant down payments (say, 20 percent), may have turned to the subprime segment of the market, where they could obtain loans with low down payments but with much more onerous contract terms.

While it’s not clear whether the actual Texas policy of restricting home equity extraction is welfare-improving, it might seem from the research that restricting borrower leverage is an effective way to reduce mortgage default rates. But limiting borrower leverage is very unpopular. In fact, it probably isn’t too much of an exaggeration to say that the vast majority of market participants are adamantly opposed to such policies. After all, it is perhaps the only policy upon which both the Center for Responsible Lending (CRL) and the Mortgage Bankers Association (MBA) share the same negative view.3 Thus, while such policies have been adopted in other countries, don’t expect to see them adopted in the United States any time soon.4 To the contrary, policy is more likely to go in the opposite direction as evidenced by the Federal Housing Finance Agency’s announcement to relax down payment requirements for Fannie Mae and Freddie Mac.

Photo of Kris GerardiBy Kris Gerardi, financial economist and associate policy adviser at the Federal Reserve Bank of Atlanta


1 Before 1998, both home equity lending (loans and lines of credit) and cash-out refinancing were explicitly prohibited in Texas. A 1997 constitutional amendment relaxed this ban by allowing for closed-end home equity loans and cash-out refinancing as long as the combined LTV ratio did not exceed 80 percent of the appraised value (among a few other limitations that are discussed in the paper). In 2003, another constitutional amendment passed that further allowed home equity lines of credit for up to 50 percent of the property’s appraised value, although still subject to a cap on the combined LTV ratio of 80 percent.

2 The effects are actually smaller for the subprime sample when compared to the average default rate over the entire sample period, since the average rate is significantly higher in the subprime segment of the market (10 percent subprime default rate compared to the 3 percent overall default rate in Texas).

3 See the CRL's view of increased down payment requirements and the MBA's perspective.

4 In the post-crisis period, Canada, Finland, Israel, New Zealand, and Norway have all placed restrictions on borrower leverage. For an overview, see Rogers (2014).

January 14, 2015 in Financial crisis, Housing crisis, Mortgage crisis, Mortgage default | Permalink


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February 19, 2014

Asymmetric Information and the Financial Crisis

In describing the $13 billion settlement reached between JPMorgan and the Department of Justice last November, Attorney General Eric Holder said,

Without a doubt, the conduct uncovered in this investigation helped sow the seeds of the mortgage meltdown. JPMorgan was not the only financial institution during this period to knowingly bundle toxic loans and sell them to unsuspecting investors, but that is no excuse for the firm's behavior.

What Holder describes sounds like a textbook example of what economists call asymmetric information: JPMorgan knew something about the loans it was selling (that they were toxic) that they didn't reveal to investors. Specifically, the government alleged that JPMorgan reported facts to the investors that turned out to be wrong. For example, JPMorgan may have said that it made only 10 percent of the loans in a pool to investors (as opposed to owner-occupants) when the actual percentage was 20 percent. So it would seem as if economic theory, which has a lot to say about asymmetric information, should help us understand the crisis. Indeed, to many, asymmetric information and "bad incentives" are the leading explanations of the financial crisis. For example, a Reuters article that described the settlement made the following claim:

The behavior that the largest U.S. bank admitted to, authorities said, is at the heart of what inflated the housing bubble: lenders making bad mortgages and selling them to investors who thought they were relatively safe. When the loans started turning bad, investors lost faith in the banking system, and a housing crisis turned into a financial crisis.

In future posts, we will consider this seemingly intuitive idea, and argue that the economic theory of asymmetric information, in fact, provides very little aid in understanding the central questions of the crisis.

Let's focus on Holder's quote. The standard theory of asymmetric information implies that JPMorgan's misrepresentations could not cause significant losses to investors. That may seem surprising. Many may think that either we don't understand the economics of asymmetric information or it's just another example of the naïveté of economists regarding how the real world actually works. While there is certainly no shortage of examples of economists holding naïve opinions about the real world, in this case, we will argue that we are correctly characterizing the economist's view and that it is based on a common-sense argument.

Let's start with the economics. Let's assume that JPMorgan is selling a pool of loans, about which it knows the true quality, to a group of buyers who can't observe the true quality. What does economic theory say will happen?

A. Investors will overpay for the assets and lose money.
B. Investors will underpay for the assets and make money.
C. Investors will infer the true quality of the loans and pay accordingly.

The answer is C. To many, that may sound shocking, but the basic logic is simple: investors know that they cannot observe the true quality of the loans and they know that JPMorgan has an incentive to dump bad loans in the pool. Thus, they correctly infer that JPMorgan will dump bad loans in the pool. In other words, investors form correct beliefs about the quality of a loan,1 despite not being able to observe quality directly.2

"Knowingly bundl[ing] toxic loans" may be unethical or even illegal, but according to the economic theory of asymmetric information, it shouldn't cause unexpected financial losses to investors. The key to understanding the gap between Holder and economics is the word "unsuspecting." Economists assume that all market participants are inherently suspicious. Market participants understand that the people with whom they are doing business have an incentive to cheat them if those people know more about the products that they are selling.

Are economists naïve to think that market participants can figure out the incentives of their adversaries? We would argue that common sense says people are pretty suspicious. Take, for example, real estate agents. A cursory search on the internet yields the following table of "translations" of real estate listings:

Loaded with Potential: means loaded with problems the seller didn't want to tackle.
Cute: means they couldn't think of any other possible way to describe it.
Great Bones: means you're going to have to gut it and rebuild.
Wooded/Shaded Lot: means surrounded by trees and leaves on the ground.
Charming: means they couldn't think of a more appropriate word.
Needs a Little TLC: means it needs about $45,000 dollars or more in renovations and repairs.
Won't Last Long at This Price: means the price is so low it will compel you to see it but it will take a miracle for you to want to buy it.
No Disclosures: means you're going to have to find out all the problems with the home on your own.

Most people read this and chuckle, but no one is surprised that real estate agents stretch the truth. After all, it's their job to convince you to buy. And, in general, people view salespeople as among the least ethical of all occupations, only slightly above members of Congress. Perhaps the most egregious example of this, and in fact the example that motivated the seminal paper on the economics of asymmetric information, is used-car salespeople. Do used-car salespeople try to misrepresent the quality of the cars that they are trying to sell? Most people would likely answer this question with a resounding "Yes, of course." Does this cause injury to most used-car buyers? Not so much. Since the general public recognizes that "used-car salesman" is basically American slang for a fraudster, nobody really believes what they say.

In subsequent posts, we will answer questions about the crisis that turn on asymmetric information problems:

  1. Theory says investors should have guessed the quality of the loans. Did they?
  2. If investors knew the quality of the loans they were buying, why did JPMorgan pay $13 billion to settle accusations that it misrepresented the quality of the loans it was selling?
  3. Can't policymakers fix some of these incentive problems? Doesn't forcing issuers such as JPMorgan to retain a portion of the securities they issue align incentives and mitigate the asymmetric information problem?
  4. If asymmetric information didn't cause investor losses, does that mean it doesn't affect economic outcomes? (Spoiler: The answer is an emphatic no.)
  5. What about rating agencies? Didn't they know that deals were bad but lie to investors and say they were good?

Photo of Paul WillenBy Paul Willen, senior economist and policy adviser at the Federal Reserve Bank of Boston, and


Photo of Kris GerardiKris Gerardi, associate economist and policy adviser at the Federal Reserve Bank of Atlanta.

1 In some situations, investors will hold beliefs that may be wrong on an individual asset-by-asset basis, but that are right on average. For example, they might not know which loans are the most likely to default, but their beliefs about the performance of the pool of loans will be, on average, right.

2 More generally, the revelation principle says that in any equilibrium of an asymmetric information game, we can confine our attention to equilibria in which all private information is fully revealed. For example, in Akerlof's (1970) example of equilibrium in the used car market, the seller knows whether the car is a peach or a lemon but only the lemons trade. Everyone knows which car is good (the one that the dealer doesn't sell), but the buyer doesn't buy it because he knows that the dealer would have an incentive to substitute a bad car.

February 19, 2014 in Financial crisis, Mortgage crisis, Subprime MBS, Subprime mortgages | Permalink


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