The Mortgage Credit Channel of Macroeconomic Transmission

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1 The Mortgage Credit Channel of Macroeconomic Transmission Daniel L. Greenwald (MIT Sloan) Macro Financial Modeling Winter 217 Meeting March 1, 217 Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

2 Introduction Mortgage markets are big. - US: nearly 7% of household credit, more than half of annual GDP. Empirical research shows strong associations between mortgage credit and macro variables. But still a lot we don t know about core mechanisms connecting mortgage credit, house prices, economic activity: - Relationship between interest rates and house prices? - Macro impact of mortgage refinancing? - Causes of recent boom-bust? Mortgage markets are complex, macro models usually abstract from the details. But do they matter for dynamics? - This paper: yes. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

3 Introduction Main question: if and how mortgage credit issuance amplifies and propagates fundamental shocks. - Mortgage credit channel. Approach: General equilibrium framework centered on two important but largely unstudied features of US mortgage markets: 1. Size of new loans limited by payment-to-income (PTI) constraint, alongside loan-to-value (LTV) constraint. Underwriting 2. Borrowers hold long-term, fixed-rate loans and can choose to prepay existing loans and replace with new ones. Prepay Data Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

4 Main Findings Main Finding #1: When calibrated to US mortgage microdata, novel features amplify transmission from interest rates into debt, house prices, economic activity. Initial source: PTI limits are highly sensitive to nominal interest rates. - Change by 8% in response to 1% change in nominal rates. Key propagation mechanism: changes in which constraint is binding for borrowers move house prices (constraint switching effect). - Price-rent ratios rise up to 4% after persistent 1% fall in nominal rates. Main Finding #2: PTI liberalization appears essential to boom-bust. Partially sufficient: 42% of observed rise in price-rent ratios, 51% of the rise in debt-household income from PTI relaxation alone. Necessary: other forces (LTV liberalization, house price expectations) dramatically dampened without loose PTI. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

5 Simple Example Consider homebuyer who wants large house, minimal down payment. Faces PTI limit of 28%, LTV limit of 8%. 1 8 Down Payment House Price Max PTI Price Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

6 Simple Example At income of $5k per year, 28% PTI limit = max monthly payment of $1, Down Payment House Price Max PTI Price Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

7 Simple Example At 6% interest rate, $1,2 payment = maximum PTI loan size $16k. Plus 2% down payment = house price of $2k. 1 8 Down Payment House Price Max PTI Price Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

8 Simple Example Kink in down payment at price $2k. Below this point size of loan limited by LTV, above by PTI. Kink likely optimum for homebuyers. 1 8 Down Payment House Price Down Payment Max PTI Price Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

9 Simple Example Interest rates fall from 6% to 5%. Borrower s max PTI now limits loan to $178k (rise of 11%). Kink price now $223k, housing demand increases. 1 8 Down Payment House Price Down Payment Max PTI Price Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

10 Simple Example Increasing the maximum PTI ratio from 28% to 31% has a similar effect to fall in rates, increases max loan size and corresponding price. 1 8 Down Payment House Price Down Payment Max PTI Price Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

11 Simple Example In contrast, increasing maximum LTV ratio from 8% to 9% means that $16k loan associated with only $178k house. Housing demand falls. 1 8 Down Payment House Price Down Payment Max PTI Price Max PTI Loan Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

12 Literature Review Heterogeneous Agent Models: Campbell, Cocco (215), Chatterjee, Eyigungor (215), Chen, Michaux, Roussanov (213), Corbae, Quintin (213), Elenev, Landvoigt, Van Nieuwerburgh (215), Gorea, Midrigan (215), Guler (214), Kaplan, Violante (214), Khandani, Lo, Merton (213), Landvoigt (215), Laufer (213), Wong (215). New: Embed into monetary DSGE, transmission through PTI. Monetary DSGE Models: Eggertsson, Krugman (212), Garriga, Kydland, Sustek (215), Ghent (212), Kiyotaki, Moore (1997), Iacoviello (25), Iacoviello, Neri (211), Liu, Wang, Zha (213), Monacelli (28), Rognlie, Shleifer, Simsek (215). New: Realistic mortgage structure, transmission through PTI. Credit Standards and the Boom-Bust: Campbell, Hercowitz (25), Favilukis, Ludvigson, Van Nieuwerburgh (215), Iacoviello, Pavan (213), Kermani (215), Justiniano, Primiceri, Tambalotti (215). New: PTI liberalization critical to boom-bust. Redistribution Channel: Auclert (215), Calza, Monacelli, Stracca (213), Rubio (211). New: Transmission through credit growth, not mortgage payments. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

13 MODEL Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

14 Model Overview Borrowing = impatient borrowers/patient savers. - Permanent types with fixed measure χ j for j {b, s}. - Preferences: V j,t = log(c j,t /χ j ) + ξ log(h j,t /χ j ) η (n j,t/χ j ) 1+ϕ + β 1 + ϕ j E t V j,t+1 Mortgage debt = durable housing. - Divisible, cannot change stock without prepaying mortgage. - Fixed housing stock, saver housing demand, no rental market. Realistic mortgages = long-term, fixed-rate, prepayable loans. - Endogenous fraction ρ t prepay each period, update balance and interest rate. Movements in long rates = Taylor rule, shock to inflation target π t. - Any shock to real rates or term premia should activate channel. Effects on real economy = labor supply, sticky prices, TFP shocks. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

15 Model Overview Borrowing = impatient borrowers/patient savers. - Permanent types with fixed measure χ j for j {b, s}. - Preferences: V j,t = log(c j,t /χ j ) + ξ log(h j,t /χ j ) η (n j,t/χ j ) 1+ϕ + β 1 + ϕ j E t V j,t+1 Mortgage debt = durable housing. - Divisible, cannot change stock without prepaying mortgage. - Fixed housing stock, saver housing demand, no rental market. Realistic mortgages = long-term, fixed-rate, prepayable loans. - Endogenous fraction ρ t prepay each period, update balance and interest rate. Movements in long rates = Taylor rule, shock to inflation target π t. - Any shock to real rates or term premia should activate channel. Effects on real economy = labor supply, sticky prices, TFP shocks. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

16 Model Overview Borrowing = impatient borrowers/patient savers. - Permanent types with fixed measure χ j for j {b, s}. - Preferences: V j,t = log(c j,t /χ j ) + ξ log(h j,t /χ j ) η (n j,t/χ j ) 1+ϕ + β 1 + ϕ j E t V j,t+1 Mortgage debt = durable housing. - Divisible, cannot change stock without prepaying mortgage. - Fixed housing stock, saver housing demand, no rental market. Realistic mortgages = long-term, fixed-rate, prepayable loans. - Endogenous fraction ρ t prepay each period, update balance and interest rate. Movements in long rates = Taylor rule, shock to inflation target π t. - Any shock to real rates or term premia should activate channel. Effects on real economy = labor supply, sticky prices, TFP shocks. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

17 Model Overview Borrowing = impatient borrowers/patient savers. - Permanent types with fixed measure χ j for j {b, s}. - Preferences: V j,t = log(c j,t /χ j ) + ξ log(h j,t /χ j ) η (n j,t/χ j ) 1+ϕ + β 1 + ϕ j E t V j,t+1 Mortgage debt = durable housing. - Divisible, cannot change stock without prepaying mortgage. - Fixed housing stock, saver housing demand, no rental market. Realistic mortgages = long-term, fixed-rate, prepayable loans. - Endogenous fraction ρ t prepay each period, update balance and interest rate. Movements in long rates = Taylor rule, shock to inflation target π t. - Any shock to real rates or term premia should activate channel. Effects on real economy = labor supply, sticky prices, TFP shocks. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

18 Model Overview Borrowing = impatient borrowers/patient savers. - Permanent types with fixed measure χ j for j {b, s}. - Preferences: V j,t = log(c j,t /χ j ) + ξ log(h j,t /χ j ) η (n j,t/χ j ) 1+ϕ + β 1 + ϕ j E t V j,t+1 Mortgage debt = durable housing. - Divisible, cannot change stock without prepaying mortgage. - Fixed housing stock, saver housing demand, no rental market. Realistic mortgages = long-term, fixed-rate, prepayable loans. - Endogenous fraction ρ t prepay each period, update balance and interest rate. Movements in long rates = Taylor rule, shock to inflation target π t. - Any shock to real rates or term premia should activate channel. Effects on real economy = labor supply, sticky prices, TFP shocks. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

19 Credit Limits Borrowers face two credit limits at origination only. Loan-to-value constraint: m i,t θltv p h t h i,t. - Widely studied in the literature. - Key property: moves with house prices. - m ltv i,t θ ltv p h t h i,t. Payment-to-income constraint: (q t + α)m i,t (θpti ω) income i,t. - Real constraint affecting all US borrowers, but largely unstudied in macro. - Key property: moves with interest rates (elasticity 8). - m pti i,t (θ pti ω) income i,t /(qt + α). ( ) Overall limit: mi,t min m ltv i,t, mpti i,t. Underwriting Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

20 LTV and PTI in the Data LTV limits show up as large single-bin spikes at various institutional limits (a) CLTV Histogram: 214 Q (b) PTI Histogram: 214 Q3 More Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

21 LTV and PTI in the Data PTI ratios instead look like truncated distribution. Are borrowers constrained? (a) CLTV Histogram: 214 Q (b) PTI Histogram: 214 Q3 More Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

22 LTV and PTI in the Data Interpretation: some borrowers search for a house that exactly satisfies both limits, but may end up with one a little smaller. Then max out LTV (a) CLTV Histogram: 214 Q (b) PTI Histogram: 214 Q3 More Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

23 LTV and PTI in the Data Support for theory: PTI bunching larger in cash-out refinances, where no housing search occurs (even though LTVs lower) (a) CLTV Histogram: 214 Q (b) PTI Histogram: 214 Q3 More Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

24 Representative Borrower s Problem State variables: average principal balance m t 1, mortgage payment x t 1, housing stock h b,t 1. Control variables: nondurable consumption c b,t, labor supply n b,t, prepayment rate ρ t, size of new houses h b,t, size of new loans m t. Budget constraint: ( c b,t ρ t m t (1 ν)πt 1 ) m t 1 πt 1 x t 1 + τπt 1 (x t 1 νm t 1 ) }{{} new issuance + (1 τ)w t n b,t δp h t h b,t 1 ρ t p h ( ) t h b,t h b,t 1 (Cost(ρ t ) Rebate t ) m t + T b,t Credit constraint: mt ( ) min m ltv i,t, mpti i,t dγ e (e i ). Agg. LOM Borr. Optimality Saver s Problem Eqm. Defn. Monetary Policy Prod. Tech. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

25 Representative Borrower s Housing Decision Housing optimality condition (unconstrained or no LTV): u h p h b,t /uc b,t + E t t = { [ Λ b,t+1 p h t+1 1 δ Λ b,t+1 is borrower stochastic discount factor, µ t is multiplier on credit constraint. C t ( collateral value ) is marginal value of relaxing constraint via extra $1 of house value: where F ltv t 1 C t µ t F ltv t θ ltv is fraction constrained by LTV. Note: p h t is the price of housing that can be used to collateralize a new loan. ]} Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

26 Representative Borrower s Housing Decision Housing optimality condition (ρ t+1 = 1, LTV only): u h p h b,t /uc b,t + E t t = { [ Λ b,t+1 p h t+1 1 δ 1 µ t θ ltv Λ b,t+1 is borrower stochastic discount factor, µ t is multiplier on credit constraint. C t ( collateral value ) is marginal value of relaxing constraint via extra $1 of house value: where F ltv t C t µ t F ltv t θ ltv is fraction constrained by LTV. Note: p h t is the price of housing that can be used to collateralize a new loan. ]} Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

27 Representative Borrower s Housing Decision Housing optimality condition (ρ t+1 = 1, LTV and PTI): u h p h b,t /uc b,t + E t t = { [ Λ b,t+1 p h t+1 1 δ 1 C t Λ b,t+1 is borrower stochastic discount factor, µ t is multiplier on credit constraint. C t ( collateral value ) is marginal value of relaxing constraint via extra $1 of house value: where F ltv t C t µ t F ltv t θ ltv is fraction constrained by LTV. Note: p h t is the price of housing that can be used to collateralize a new loan. ]} Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

28 Representative Borrower s Housing Decision Housing optimality condition (Benchmark model): u h p h b,t /uc b,t + E t t = { ]} Λ b,t+1 p h t+1 [1 δ (1 ρ t+1 )C t+1 1 C t Λ b,t+1 is borrower stochastic discount factor, µ t is multiplier on credit constraint. C t ( collateral value ) is marginal value of relaxing constraint via extra $1 of house value: where F ltv t C t µ t F ltv t θ ltv is fraction constrained by LTV. Note: p h t is the price of housing that can be used to collateralize a new loan. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

29 Constraint Switching Effect When rates fall, PTI limits loosen. Borrowers switch from PTI- to LTV-constrained, increasing F ltv t. House prices rise, also loosening LTV limits. Interest Rates PTI Limits F ltv LTV Limits House Prices Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

30 Comparison of Models Main Result #1: Strong transmission from interest rates into debt, house prices, economic activity. Experiment: consider economies that differ by credit limit and compare propagation of shocks: 1. LTV Economy: LTV constraint only. 2. PTI Economy: PTI constraint only. 3. Benchmark Economy: Both constraints, applied borrower by borrower. Computation: Linearize model to obtain impulse responses. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

31 Constraint Switching Effect (Monetary Policy Shock) IRF to near-permanent -1% (annualized) fall in nominal rates. Debt 1 5 IRF to Infl. Target Price-Rent Ratio 4 2 IRF to Infl. Target F ltv IRF to Infl. Target LTV PTI Benchmark More Series Exog. Prepay Version TFP IRFs Credit Standards IRFs 43% PTI Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

32 Constraint Switching Effect (Monetary Policy Shock) Debt response of Benchmark Economy closer to PTI Economy even though most borrowers constrained by LTV (75% in steady state). Debt 1 5 IRF to Infl. Target Price-Rent Ratio 4 2 IRF to Infl. Target F ltv IRF to Infl. Target LTV PTI Benchmark More Series Exog. Prepay Version TFP IRFs Credit Standards IRFs 43% PTI Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

33 Credit Standards and the Boom-Bust Main Result #2: PTI liberalization essential to the boom-bust. - So far, have been treating maximum ratios θ ltv, θ pti as fixed, but credit standards can change. - Fannie/Freddie origination data: substantial increase in PTI ratios in boom. Time Series Fannie Mae Docs News Article Experiment: unexpectedly change parameters, unexpectedly return to baseline 32Q later. 1. PTI Liberalization: θ pti from LTV Liberalization: θ ltv from Computation: nonlinear transition paths. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

34 Credit Standards and the Boom-Bust Fannie Mae data: PTI constraints appear to bind after bust but not during boom (a) PTI Histogram: 26 Q (b) PTI Histogram: 214 Q3 Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

35 Credit Standards and the Boom-Bust Cash-out refi plots even more striking (a) PTI Histogram: 26 Q (b) PTI Histogram: 214 Q3 Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

36 Credit Standards and the Boom-Bust Main Result #2: PTI liberalization essential to the boom-bust. - So far, have been treating maximum ratios θ ltv, θ pti as fixed, but credit standards can change. - Fannie/Freddie origination data: substantial increase in PTI ratios in boom. Time Series Fannie Mae Docs News Article Experiment: unexpectedly change parameters, unexpectedly return to baseline 32Q later. 1. PTI Liberalization: θ pti from LTV Liberalization: θ ltv from Computation: nonlinear transition paths. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

37 Credit Liberalization Experiment LTV liberalization generates small rise in debt-to-household income (2%). Price-rent ratios fall (-3%). Price-Rent Ratio Debt F ltv LTV Liberalized PTI Liberalized Data More Series LTV Intuition PTI Intuition Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

38 Credit Liberalization Experiment PTI liberalization generates large boom in house prices, price-rent ratios (42%), debt-household income (51%). Price-Rent Ratio Debt F ltv LTV Liberalized PTI Liberalized Data More Series LTV Intuition PTI Intuition Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

39 Credit Liberalization Experiment Liberalized PTI amplifies contribution of other factors (e.g., LTV liberalization) to boom. Price-Rent Ratio Debt F ltv Both Liberalized LTV Liberalized PTI Liberalized Data More Series Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

40 House Price Expectations Experiment Loose/absent PTI limits likely necessary condition for alternative sources of boom Price-Rent Ratio 4 2 Debt 4 2 F ltv 7 6 LTV Economy Benchmark Economy Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

41 House Price Expectations Experiment Expected (but not realized) increase in housing prefs explains entire rise in price-rent (11%) and debt-income (93%) ratios in LTV Economy Price-Rent Ratio 4 2 Debt 4 2 F ltv 7 6 LTV Economy Benchmark Economy Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

42 House Price Expectations Experiment Much smaller impact in Benchmark Economy (41% of price-rent rise, 22% of debt-income rise) Price-Rent Ratio 4 2 Debt 4 2 F ltv 7 6 LTV Economy Benchmark Economy Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

43 House Price Expectations Experiment Macroprudential policy: cap on PTI ratios more effective at limiting boom-bust cycles Price-Rent Ratio 4 2 Debt 4 2 F ltv 7 6 LTV Economy Benchmark Economy Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

44 Conclusion Macro model with two novel features: - Payment-to-income constraint. - Endogenous prepayment of long-term debt. Novel transmission channel from interest rates into credit, house prices, economic activity. - Credit, house prices through constraint switching effect. - Output through frontloading effect (see paper). - Monetary policy more effective, but may pose tradeoff (see paper). PTI liberalization appears essential to boom-bust. - Cap on PTI ratios, not LTV ratios more effective macroprudential policy. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 28

45 APPENDIX Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

46 Boom-Bust Paths (Data) Percent deviations from price-rent trough (1997Q4). Log Price-Rent (%) (a) Log Price-Rent Log Debt-Household Income (%) (b) Log Debt-Household Income LTV/PTI Both Dodd-Frank Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

47 Macroprudential Policy: Dodd-Frank Limit Counterfactual with Dodd-Frank cap, (θ ltv, θ pti ) (.99,.43) substantially dampens cycle, cuts price-rent ratio rise by 61% Price-Rent Ratio Debt F ltv Both Liberalized Dodd-Frank 2 4 Data More Series Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

48 Demographics and Preferences Two types of infinitely lived agents: Family of borrowers (b) with measure χ b. Family of savers (s) with measure χ s = 1 χ b. Both types provide labor: n t = n b,t + n s,t, taxed at rate τ. Complete set of contracts over consumption and housing services traded within each family, but not across families. Separable, expected utility preferences over consumption, housing services, and labor supply (for j {b, s}): V j,t = log(c j,t /χ j ) + ξ log(h j,t /χ j ) η (n j,t/χ j ) 1+ϕ + β 1 + ϕ j E t V j,t+1 Borrowers are more impatient than savers: β b < β s. - Motivation to borrow. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

49 Asset Technology Housing: Divisible, owned by both types, requires maintenance cost. Cannot change housing stock without prepaying mortgage. Fixed housing stock H, saver demand H s. - Total collateral value, not price, crucial to constraints. - Price effects are upper bound. One-Period Bonds Nominal risk-free bond in zero net supply with rate R t. No short positions/borrowing in one-period bond = traded by savers only in equilibrium. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

50 Asset Technology Mortgages: Only source of borrowing in the economy. Long-term nominal bonds with fixed interest rates. - See paper for adjustable-rate version. Originated with principal balance mt, borrower repays fraction ν of principal each period. Contract specifies fixed coupon rate qt (interest + principal), saver receives $(1 ν) k qt mt at all t + k until prepayment. Interest payments are tax deductible. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

51 Idiosyncratic Heterogeneity 1. Income shocks: An endogenous fraction of borrowers (those with low enough income draws) are constrained by PTI, the rest by LTV. - Equivalent to any shock that creates dispersion in house value-to-income ratio. Details PTI by Income - Effect: smooth out constraint, dampen mechanism. 2. Prepayment cost shocks: An endogenous fraction of borrowers (those with low enough costs) prepay their loans. - Simplifying assumption: borrower must choose whether to prepay based only on aggregate state. Details Redistribution Effects - Can still respond to: average existing rate vs. new rate, total extractable equity, forward looking expectations. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

52 Income Shocks Want heterogeneity so that endogenous fraction are constrained by PTI. Idiosyncratic labor efficiency shocks e i,t iid Γ e, so individual borrower s income is income i,t = w t n b,t e i,t. Shocks affect only credit limits, not consumption or labor supply (due to insurance, timing). - Equivalent to any shock causing variation in house price/income ratios. PTI binds for e i,t ē t Fraction constrained by LTV: θ ltv p h t h t (θ pti ω)w t n b,t /(q t + α). F ltv t = 1 Γ e (ē t ). PTI by Income Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

53 Income Shocks Want heterogeneity so that endogenous fraction are constrained by PTI. Idiosyncratic labor efficiency shocks e i,t iid Γ e, so individual borrower s income is income i,t = w t n b,t e i,t. Shocks affect only credit limits, not consumption or labor supply (due to insurance, timing). - Equivalent to any shock causing variation in house price/income ratios. PTI binds for e i,t ē t Fraction constrained by LTV: θ ltv p h t h t (θ pti ω)w t n b,t /(q t + α). F ltv t = 1 Γ e (ē t ). PTI by Income Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

54 Monetary Policy Monetary policy follows a Taylor rule with time-varying inflation target. log R t = log π t + φ r (log R t 1 log π t 1 ) [ ] + (1 φ r ) log R real + ψ π (log π t log π t ) for log π t = (1 φ π ) log π ss + φ π log π t 1 + ε π,t. Why consider near-permanent policy shocks? - Level factor shocks needed to move long-term nominal rates. - But movements in term premia would also be amplified. - With ARMs, amplification of transitory monetary policy shocks. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

55 Productive Technology Embed in simple New Keynesian environment (e.g., Gali (28)). Intermediate goods producers operate the linear production function y t (i) = a t n t (i) where a t is productivity, and n t (i) are labor hours. TFP process a t : log a t+1 = φ a log a t + ε a,t+1. Monopolistic intermediate producers with Calvo price rigidity (can t reset price with probability ζ p ). Details Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

56 Calibration: Key Parameters Parameter Name Value Internal Target/Source Demographics and Preferences Fraction of borrowers χ b.35 N SCF Income dispersion σ e.411 N Fannie Mae Borr. discount factor β b.95 N Standard Saver discount factor β s.993 Y Real rate = 3% (ann.) Borr. housing preference ξ.3 Y SCF Housing and Mortgages Mortgage amortization ν 1/12 N 3-year duration Max PTI ratio θ pti.36 N See text Max LTV ratio θ ltv.85 N See text Issuance cost mean µ κ.183 Y ρ ss = 4.5% Issuance cost scale s κ.26 Y See text PTI offset (taxes, etc.) α.5 Y qss + α = 1.6% (ann.) PTI offset (other debt) ω.8 N See text Exogenous Shocks TFP (pers.) φ a.9641 N Garriga et al. (215) Taylor rule (inflation) ψ π 1.5 N Standard Other Params. SCF Income Shocks Issuance Costs Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

57 Frontloading Effect Endogenous prepayment critical to transmission into real activity. New Keynesian models: demand can affect output, but depends on timing. - Spending must occur in short run, before intermediate firms reset prices. Exogenous prepayment: debt limits change with rates, but few borrowers take advantage right away. - Most new spending too far in the future to affect output. Endogenous prepayment: wave of new issuance when rates fall. - Frontloaded spending generates large output effects. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

58 Frontloading Effect Endogenous prepayment critical to transmission into real activity. New Keynesian models: demand can affect output, but depends on timing. - Spending must occur in short run, before intermediate firms reset prices. Exogenous prepayment: debt limits change with rates, but few borrowers take advantage right away. - Most new spending too far in the future to affect output. Endogenous prepayment: wave of new issuance when rates fall. - Frontloaded spending generates large output effects. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

59 Frontloading Effect (TFP Shock) TFP shock lowers nominal rates (deflationary) and raises labor income = loosens PTI limits. 1.5 IRF to TFP.4 IRF to TFP IRF to TFP Avg. Debt Limit More Series π IRFs 43% PTI New Issuance Output.5. LTV (Exog Prepay) Benchmark (Exog Prepay) Benchmark Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

60 Frontloading Effect (TFP Shock) Effects large: output response to 1% TFP shock increased by 52% (.5 to.76) on impact. 1.5 IRF to TFP.4 IRF to TFP IRF to TFP Avg. Debt Limit More Series π IRFs 43% PTI New Issuance Output.5. LTV (Exog Prepay) Benchmark (Exog Prepay) Benchmark Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

61 Inflation Stabilization (TFP Shock) Monetary policy experiment: how much does central bank need to move policy rate to fully stabilize inflation, π t = π? Rt 1 2 IRF to TFP Debt 1..5 IRF to TFP Prepay Rate 1..5 IRF to TFP LTV (Exog Prepay) Benchmark More Series Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

62 Inflation Stabilization (TFP Shock) Monetary policy stronger under Benchmark model: smaller movement in policy rate required to stabilize. Rt 1 2 IRF to TFP Debt 1..5 IRF to TFP Prepay Rate 1..5 IRF to TFP LTV (Exog Prepay) Benchmark More Series Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

63 Inflation Stabilization (TFP Shock) But smaller movement in policy rate comes with larger movement in debt. Potential trade-off for policymakers. Rt 1 2 IRF to TFP Debt 1..5 IRF to TFP Prepay Rate 1..5 IRF to TFP LTV (Exog Prepay) Benchmark More Series Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

64 Intensive Margin: Credit Constraints Actual 215 underwriting standards from Fannie Mae ( DTI = PTI). Transaction Type Principal Residence Purchase Limited Cash- Out Refinance Standard Eligibility Requirements - Manual Underwriting Excludes: Refi Plus, HomeStyle Renovation, and HomeReady Number of Units 1 Unit 2 Units Maximum LTV, CLTV, HCLTV FRM: 95% ARM: 9% FRM: 85% ARM: 75% Maximum DTI 36% Maximum DTI 45% Credit Score/LTV FRM: 68 if > 75% FRM: 62 if 75% ARM: 68 if > 75% ARM: 64 if 75% Minimum Reserves 66 if > 75% 6 68 if > 75% 64 if 75% Credit Score/LTV 7 if > 75% 64 if 75% FRM: 68 if > 75% FRM: 62 if 75% ARM: 68 if > 75% 7 if > 75% 66 if 75% 68 if > 75% 64 if 75% Minimum Reserves FRM: 75% Units 66 6 ARM: 65% if > 75% 7 if > 75% FRM: 8% 66 if 75% 68 if 75% 1 Unit ARM: 75% 66 if > 75% 68 if > 75% BackCash-Out to Intro Back to Credit Limits 6 2 Refinance 64 if 75% 66 if 75% FRM: 75% Units 68 6 ARM: 65% Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, /

65 Loan Level Price Adjustments PTI not priced, strictly a limit. Table 1: All Eligible Mortgages (excluding MCM) LLPA by Credit Score/LTV Ratio Representative Credit Score < 6.% % LTV Range Applicable for all mortgages with terms greater than 15 years % % % % % % 74.%.25%.25%.5%.25%.25%.25%.75% N/A %.25%.5%.75%.5%.5%.5% 1.% N/A %.5% 1.% 1.25% 1.% 1.% 1.% 1.5% N/A %.5% 1.25% 1.75% 1.5% 1.25% 1.25% 1.5% N/A % 1.% 2.25% 2.75% 2.75% 2.25% 2.25% 2.25% N/A % 1.25% 2.75% 3.% 3.25% 2.75% 2.75% 2.75% N/A % 1.5% 3.% 3.% 3.25% 3.25% 3.25% 3.5% N/A < 62 (1).5% 1.5% 3.% 3.% 3.25% 3.25% 3.25% 3.75% N/A (1) A minimum required credit score of 62 applies to all mortgage loans delivered to Fannie Mae in accordance with the Selling Guide; exceptions to this requirement are limited to loans in which all borrowers have nontraditional credit. SFC Back to Intro Back to Credit Limits Table 2: All Eligible Mortgages (excluding MCM unless otherwise noted) LLPA by Product Feature PRODUCT FEATURE < 6.% % % % % LTV Range % % % Manufactured home.5%.5%.5%.5%.5%.5%.5% N/A 235 Investment property 2.125% 2.125% 2.125% 3.375% 4.125% N/A N/A N/A N/A Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55 SFC

66 Prepayment Rates Fraction prepaying small, but volatile and highly responsive to interest rate incentives..8 Prepayment Rate Rate Incentive Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

67 Subprime PTIs 13 Plot from Foote, Gerardi, Willen (29) shows subprime PTIs bunch at 5 and 55. Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

68 LTV and PTI in the Data Individual borrower s process: 1. Given income, interest rates, compute max loan size m pti i,t. 2. Given max loan size, compute min house price associated with this loan: p h h t i,t = m pti i,t /θltv t. 3. Search for house such that h i,t h i,t. 4. Obtain largest possible loan given house value: mi,t = mltv i,t = θt ltv p h t h i,t < θt ltv p h t h i,t = m pti Result: LTV exactly at limit, PTI slightly below. Why asymmetry? Can choose house price, not income/rates. i,t. Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

69 PTI by Income PTI appear more binding for low income. High (low) income is top (bottom) quartile..1 Fannie Mae: PTI Ratio, Low Income Buyers.1 Fannie Mae: PTI Ratio, High Income Buyers PTI Ratio (%) (a) PTIs: 214 Q3 (Low Income) PTI Ratio (%) (b) PTIs: 214 Q3 (High Income) Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

70 PTI by Income Very high PTIs for low-income borrowers at height of boom..1 Fannie Mae: PTI Ratio, Low Income Buyers.1 Fannie Mae: PTI Ratio, High Income Buyers PTI Ratio (%) (a) PTIs: 26 Q1 (Low Income) PTI Ratio (%) (b) PTIs: 26 Q1 (High Income) Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

71 CLTV by Income In contrast, CLTVs look very similar across income groups during boom and bust..6 Fannie Mae: CLTV Ratio, Low Income Buyers CLTV Ratio (%) (a) CLTVs: 214 Q3 (Low Income).6 Fannie Mae: CLTV Ratio, High Income Buyers CLTV Ratio (%) (b) CLTVs: 214 Q3 (High Income) Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

72 CLTV by Income In contrast, CLTVs look very similar across income groups during boom and bust..6 Fannie Mae: CLTV Ratio, Low Income Buyers CLTV Ratio (%) (a) CLTVs: 26 Q1 (Low Income).6 Fannie Mae: CLTV Ratio, High Income Buyers CLTV Ratio (%) (b) CLTVs: 26 Q1 (High Income) Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

73 Prepayment Prepayment: - Borrower pays remaining principal to lender, cancels future payments. - Borrower can immediately take out new loan, adjust housing holdings. Transaction cost shocks: - Borrower must pay cost κ i,t m t, to obtain a new loan where κ i,t - If κ i,t κ i,t, then the borrower executes transaction, prepays. Timing within the period: iid Γ κ. 1. Borrowers choose labor supply n b,t, threshold transaction cost κ t, target house size ht (conditional on prepaying). 2. Borrowers draw κ i,t, prepay if κ i,t κ t. 3. Borrowers draw e i,t, obtain new loan of size mi,t = min( mltv i,t, mpti i,t ). 4. Insurance claims are paid out, equalizing consumption across borrowers. Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

74 Credit or Redistribution? Prepayment has two effects: - Allows borrower to obtain new debt (credit channel). - Changes payments on existing debt (redistribution channel). Unlike previous work (Rubio (211), Calza et al. (213), Auclert (215)), this framework can generate large redistributions in fixed-rate mortgage environment from prepayment. However, impact on aggregate demand is very small. Key is persistence of transfers. - Impatient borrower consumes out of current income, while patient saver consumes out of permanent income. - But with FRMs, prepayment leads to constant change in payments each month for decades. - Changes in current and permanent income nearly identical = offsetting consumption responses. Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

75 Aggregation Aggregate laws of motion: m t = ρ t mt + (1 ρ t )(1 ν)πt 1 m t 1 pay t = ρ t qt mt + (1 ρ t )(1 ν)πt 1 pay t 1 h b,t = ρ t hb,t + (1 ρ t)h b,t 1. Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

76 Borrower Optimality Labor supply (n b,t ) condition: w t = un b,t u c. b,t New loan size (m t ) condition: 1 = Ω m b,t + q t Ω pay b,t + µ t where µ t is multiplier, Ω m b,t and Ωpay b,t are marginal continuation costs of extra unit of face value debt and promised payments: { [ ]} Ω m b,t = E t Λ $ b,t+1 (1 ν)ρ t+1 + (1 ν)(1 ρ t+1 )Ω m b,t+1 [ ]} Ω pay b,t = E t {Λ $ b,t (1 ν)(1 ρ t+1 )Ω pay b,t+1 and Λ $ b,t+1 is the nominal SDF. Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

77 Borrower Optimality Prepayment optimality condition: { ρ t = Γ ((m t ) 1 (1 Ω m b,t )( mt (1 ν)πt 1 ) m t 1 }{{} Ω m b,t and Ωpay b,t new debt Ω pay ( b,t q t mt (1 ν)πt 1 ) pay t 1 }{{} new payments }) C t p h ( ) t h b,t (1 δ)h b,t 1. }{{} cost of collateral are the marginal costs of extra unit of principal balance and promised payment: { [ ]} Ω m b,t = E t Λ $ b,t+1 (1 ν)ρ t+1 + (1 ν)(1 ρ t+1 )Ω m b,t+1 Back Ω pay b,t = E t {Λ $ b,t+1 [ 1 + (1 ν)(1 ρ t+1 )Ω pay b,t+1 ]}. Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

78 Saver s Problem Budget constraint: c s,t Π t + w t n s,t ρ t (mt (1 ν)πt 1 m t 1 ) + πt 1 pay }{{} t 1 New Issuance p h t (h s,t (1 δ)h s,t 1 ) Rt 1 b t + b t 1. Optimality conditions: Ω m s,t and Ωpay s,t (b) : 1 = R t E t [Λ $ s,t+1 (m ) : 1 = Ω m s,t + Ω pay s,t q t are the marginal benefits of extra unit of principal balance and promised payment: [ ]} Ω m s,t = E t {Λ $ s,t+1 (1 ν)ρ t+1 + (1 ν)(1 ρ t+1 )Ω m s,t+1 [ ]} Ω pay s,t = E t {Λ $ s,t (1 ν)(1 ρ t+1 )Ω pay s,t+1. ] Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

79 Equilibrium Definition A competitive equilibrium in this model is defined as a sequence of endogenous states (m t 1, q t 1, h b,t 1, h s,t 1 ), allocations (c j,t, n j,t, h j,t ), mortgage market quantities (mt, ρ t), and prices (π t, w t, p h t, R t, qt ) such that: 1. Given prices, (c b,t, n b,t, h b,t, m t, ρ t) solve the borrower s problem. 2. Given prices and borrower refinancing behavior, (c s,t, n s,t, h s,t, m t ) solve the saver s problem. 3. Given wages and consumer demand, π t is the outcome of the intermediate firm s optimization problem. 4. Given inflation and output, R t satisfies the monetary policy rule. 5. The resource, bond, and housing markets clear: y t = c b,t + c s,t + x h t, b s,t = h t = H, h s,t = H s. Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

80 Calvo Pricing Solution to intermediate firm s problem: y t = [ y t (i) λ 1 λ ] λ λ 1 di = a t n t t N t = y t ( mct mc ss ) + ζ p E t [ Λ s,t+1 ( πt+1 ) λ Nt+1 π ss ] D t = y t + ζ p E t [ Λ s,t+1 ( πt+1 π ss ) λ 1 Dt+1 p t = N t D t π t = π ss [ 1 (1 ζp ) p 1 λ ζ p ] 1 λ 1 t = (1 ζ p ) p λ + ζ p (π t /π ss ) λ t 1 where N t and D t are auxiliary variables, p t is the ratio of the optimal price for resetting firms relative to the average price, and t is price dispersion. Back ] Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

81 Calibration: Other Parameters Parameter Name Value Internal Target/Source Demographics and Preferences Disutility of labor scale η Y n ss = 1/3 Inv. Frisch elasticity ϕ 1. N Standard Tax rate τ.24 N Elenev et al. (216) Productive Technology TFP (mean) µ a 1.99 Y y ss = 1 TFP (pers.) φ a.9641 N Garriga et al. (215) Variety elasticity λ 6. N Standard Price stickiness ζ.75 N Standard Monetary Policy Steady state inflation π ss 1.75 N 3% (ann.) Taylor rule (inflation) ψ π 1.5 N Standard Taylor rule (smoothing) φ r.89 N Campbell et al. (214) Trend infl (pers.) φ π.994 N Garriga et al. (215) Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

82 Calibration: Fraction of Borrowers Calibrate borrower/saver division to match 21 Survey of Consumer Finances (SCF). Borrowers in the model: have house and mortgage but no liquid assets, save in home equity. - Match to households in 21 SCF with less than one month s income in liquid assets (Kaplan and Violante (214)) with a mortgage (24.3%). - Use housing preference ξ to match housing wealth / income for borrowers. Savers in the model: unconstrained agents with liquid assets. - Match to households in 21 SCF with more than one month s income in liquid assets (45.4%). Remove households with no liquid assets and no mortgage (mostly renters) who are not represented in the model and normalize: χ b =.35. Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

83 Calibration: Income Shock Distribution Parameterize e i shocks to be lognormal, only need to calibrate σ e log value - log income Back Figure: House Price / Income Ratio: 2 Q1 Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

84 Calibration: Income Shock Distribution Choose σ e to match cross-sectional dispersion of log value i,t log income i,t in Fannie Mae loan-level origination data (average over 2-214). - This ratio determines which constraint is binding, given aggregates log value - log income Back Figure: House Price / Income Ratio: 2 Q1 Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

85 Calibration: Issuance Costs Choose Γ κ so that approx. annualized prepayment rate cpr t = 4ρ t has a logistic functional form: cpr t = 1 ( ) 1 + exp κ µ. κ s κ To calibrate s k, estimate prepayment regression logit(cpr i,t ) = γ,t + γ 1 (q t q i,t 1 ) + e i,t using pool-level MBS data (Fannie Mae 3-Year FRMs, ). Choose s κ so that model equation ( logit( cpr t ) = γ,t Ωpay b,t q (1 ν)πt 1 t q s t 1 κ Back satisfies Ω pay b /s κ = ˆγ 1 in steady state. m t m t 1 Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55 )

86 Calibration: Issuance Costs Given s κ can choose µ κ to match average prepayment rates on the same MBS series Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

87 Calibration: Issuance Costs Resulting costs are high (threshold prepayer pays 13.8%, average prepayer pays 11%). Needed to match inertial behavior Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

88 Monetary Policy Shock (Trend Infl.) Focus on mechanism: exogenous prepayment (ρ t = ρ). 4 IRF to Infl. Target IRF to Infl. Target 3 IRF to Infl. Target Price-Rent Ratio Debt F ltv 2 1 LTV (Exog Prepay) PTI (Exog Prepay) Benchmark (Exog Prepay) Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

89 Constraint Switching Effect (TFP Shock) TFP shock lowers nominal rates (deflationary) and raises labor income = loosens PTI limits. 2 IRF to TFP IRF to TFP.6 IRF to TFP Debt 1 Price-Rent Ratio.4.2. F ltv.4.2 LTV PTI Benchmark.2. Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

90 Credit Liberalization: LTV For IRFs, assume log θ t is AR(1) with persistence.9. IRF to LTV Limit IRF to LTV Limit IRF to LTV Limit Price-Rent Ratio 5 Back Debt F ltv 5 1 LTV PTI Benchmark Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

91 Credit Liberalization: LTV Loosening LTV (1%) causes decrease in collateral value, house prices and price-rent ratios fall in Benchmark model. IRF to LTV Limit IRF to LTV Limit IRF to LTV Limit Price-Rent Ratio 5 Back Debt F ltv 5 1 LTV PTI Benchmark Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

92 Credit Liberalization: PTI Loosening PTI (1%) causes increase in collateral value, house prices and price-rent ratios rise in Benchmark model. Price-Rent Ratio 2 1 IRF to PTI Limit Debt IRF to PTI Limit F ltv IRF to PTI Limit LTV PTI Benchmark Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

93 Constraint Switching Effect (Monetary Policy Shock) θ pti = 43% (Dodd-Frank): only 11% constrained by PTI. 1 IRF to Infl. Target 4 IRF to Infl. Target IRF to Infl. Target Debt 5 Price-Rent Ratio 2 F ltv 2 1 LTV PTI Benchmark Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

94 Frontloading Effect (Monetary Policy Shock) Large response of output to -1% near-permanent monetary policy shock. Avg. Debt Limit 5 IRF to Infl. Target New Issuance 2 1 IRF to Infl. Target Output 2 1 IRF to Infl. Target LTV (Exog Prepay) Benchmark (Exog Prepay) Benchmark Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

95 Frontloading Effect (TFP Shock) θ pti = 43% (Dodd-Frank): only 13% constrained by PTI. IRF to TFP IRF to TFP.4 IRF to TFP Debt Price-Rent Ratio. F ltv LTV PTI Benchmark Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

96 Credit Standards and the Boom-Bust Large rise in PTI ratios relative to CLTV ratios. 96 CLTV Ratio, 75th percentile (a) CLTV: 75th Percentile 49 PTI Ratio, 75th percentile (b) PTI: 75th Percentile Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

97 Credit Standards and the Boom-Bust 95 CLTV Ratio, 9th percentile (a) CLTV: 9th Percentile 56 PTI Ratio, 9th percentile (b) PTI: 9th Percentile Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

98 Credit Standards and the Boom-Bust Fannie Mae 27 Selling Guide Although we have established a benchmark qualifying debt-to-income ratio, we recognize that often there are legitimate reasons for exceeding this guideline. Therefore, a lender may use a ratio that is higher than our benchmark guideline, as long as its assessment of the comprehensive risk of the mortgage identifies and documents factors that justify the higher ratio...our benchmark debt-to-income ratio is 36 percent of the borrower s monthly income. Fannie Mae 29 Selling Guide For manually underwritten loans, Fannie Mae s benchmark total debt-to-income ratio is 36% of the borrower s stable monthly income. The benchmark can be exceeded up to a maximum of 45% with strong compensating factors... For loan casefiles underwritten through DU [Desktop Underwriter], DU determines the maximum allowable debt-to income ratio based on the overall risk assessment of the loan casefile. DU will apply a maximum allowable total expense ratio of 45%, with flexibilities offered up to 5% for certain loan casefiles with strong compensating factors. Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

99 Credit Standards and the Boom-Bust A New Method for Evaluating Your Debt (Los Angeles Times: January 27, 22) In the 197s and 198s, a common rule of thumb was that your mortgage-related payments shouldn t eat up more than 25% of your monthly household income. During the late 198s and into the 199s, that rule began to stretch into the 31% to 33% range and sometimes higher. In the 199s, acceptable ratios began creeping above 4%. Late in the decade, even Freddie Mac confirmed that it no longer had hard and fast rules on total monthly debt to monthly income ratios, and lenders reported selling loans to Freddie with debt-to-income ratios of 55% and higher. Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

100 Constraint Switching Effect (Monetary Policy Shock) IRF to near-permanent -1% (annualized) shock to inflation target. q t..5 IRF to Infl. Target Avg. Debt Limit 5 IRF to Infl. Target Prepay Rate 1 5 IRF to Infl. Target LTV PTI Benchmark Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

101 Frontloading Effect (TFP Shock) TFP shock lowers nominal rates (deflationary) and raises labor income = loosens PTI limits.. IRF to TFP 1.5 IRF to TFP 1.5 IRF to TFP LTV (Exog Prepay) Benchmark (Exog Prepay) Benchmark q t Debt Prepay Rate Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

102 Inflation Stabilization (TFP Shock) Monetary policy experiment: how much does central bank need to move policy rate to fully stabilize inflation, π t = π? q t..5 IRF to TFP Avg. Debt Limit 1..5 IRF to TFP F ltv.2. IRF to TFP LTV (Exog Prepay) Benchmark Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

103 Credit Liberalization Experiment Avg. Debt Limit Prepay Rate q t LTV Liberalized PTI Liberalized Back Daniel L. Greenwald (MIT Sloan) The Mortgage Credit Channel March 1, / 55

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