Mortgage Design in an Equilibrium Model of the Housing Market

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, realistic and priced long-term mortgages, and a housing market that clears in equilibrium. We begin by comparing ARMs and FRMs to elucidate the core economic tradeoffs. ARMs provide hedging benefits in a crisis by reducing payments when income falls if the central bank lowers interest rates. This stimulates purchases by new homeowners, reduces default, and short circuits a price-default spiral, reducing price declines. The welfare benefits of ARMs in a crisis are large – equivalent to 15 percent of a year of consumption over an eight year crisis – because ARMs particularly help young, high LTV households who face severe liquidity constraints. The overall benefits of ARMs also depend on the extent to which agents anticipate these hedging benefits and take on more risky debt positions in response. We evaluate several proposed mortgage designs that add state contingency to standard mortgages and find that an FRM that can costlessly be converted to an ARM has the best combination of insurance and macro-prudential benefits.