Mortgage Market Design: Lessons from the Great Recession

Rigidity of mortgage contracts and a variety of frictions in design of the market and the intermediation sector hindered efforts to restructure or refinance household debt in the aftermath of the crisis. Using a simple framework that builds on mortgage design literature, we illustrate that automatically indexed mortgage contracts or debt relief policies can reduce borrower’s debt burden during economic downturns, thereby leading to significant welfare gains. We show that benefits of such solutions are substantially reduced if there are errors in understanding the underlying structure of income and housing risk and their relation to the indices on which such contracts or policies are based. Empirical evidence reveals significant spatial heterogeneity and time-varying nature of the distribution of economic conditions. This, ex-ante, poses challenges to effective design of automatically indexed mortgage contracts and debt relief policies. We also discuss significant spatial heterogeneity of frictions that can differentially impact pass through of ex-post debt relief policies implemented by financial intermediaries. We conclude by discussing potential gains from indexing mortgage contract terms or debt relief policies to local economic conditions as well as other mechanisms that minimize adverse effects of various implementation frictions.