James McAndrews: Mortgage contract design - implications for
households, monetary policy, and financial stability
Opening remarks by Mr James McAndrews, Executive Vice President and Director of
Research of the Federal Reserve Bank of New York, at the "Mortgage Contract Design:
Implications for Households, Monetary Policy, and Financial Stability" Conference, Federal
Reserve Bank of New York, New York City, 21 May 2015.
* * *
The views expressed in this speech are those of the author and do not necessarily reflect the views of the Federal
Reserve Bank of New York or of the Federal Reserve System.
Accompanying charts can be found at the end of the speech.
Good morning, and welcome to the Federal Reserve Bank of New York.
Today is the second and final day of our conference on mortgage contract design. We are
hosting this conference, in association with the NYU Stern Center for Real Estate Finance
Research, because we view mortgage design as an important policy issue, with implications
for monetary policy, household finance and risk management, as well as for the structure and
stability of the financial system.
Mortgage debt is, by far, the largest household financial liability. According to New York Fed
data1, mortgages and home equity lines of credit make up 73 percent of U.S. household
debt, amounting to $8.7 trillion in liabilities outstanding. Mortgage design also varies in
striking ways through time and across countries and even regions; for example, in terms of
the sensitivity of mortgage rates to market rates, borrowers' ability to pay down or increase
the loan balance, the ease with which loans can be modified, and the rights of junior lien
holders. Reflecting this international diversity, we are very happy to have panelists from the
United Kingdom, Sweden and Denmark speaking today, as well as representatives from
many foreign central banks and other international organizations in the audience.
This is also a particularly opportune time to think about mortgage contract design given the
ongoing debate about housing finance reform in the U.S., and the future of the government
sponsored enterprises Fannie Mae and Freddie Mac.
But debates about mortgage design are definitely not new! In fact, 40 years ago the Federal
Reserve Bank of Boston hosted a well-known conference on "new mortgage designs"2,
which included Franco Modigliani, later awarded the Nobel prize in economics, and current
Federal Reserve vice chair Stanley Fischer. An interesting contrast to today - the main focus
of the Boston conference was the design of mortgages to deal with a high and volatile
inflation environment.
The financial crisis and its aftermath have brought mortgage contract design back into sharp
focus. In my remarks today I will focus on one aspect of mortgage design; namely how the
prevalence of adjustable rate mortgages, or ARMs, may affect a number of aspects of
economic performance, including the pass-through of monetary policy, the sharing of interest
rate risk, and the use of resources spent on refinancing.
The federal funds rate dropped from 5-1/4 percent in August 2007 to the current 0-25 basis
point range starting in December 2008. Longer-term interest rates such as the yield on
10-year Treasury bonds also declined significantly, from about 5 percent in mid-2007 to a
range between 2-3 percent in recent years. As illustrated in the chart, however, the average
interest rate paid on the total stock of outstanding mortgages in the U.S. decreased relatively
slowly and by a smaller amount over this period.
The source of the stickiness in mortgage interest rates is that the vast majority of outstanding
mortgages in the U.S. are long-term fixed-rate mortgages, whose pricing is tied to long-term
interest rates, and which require borrowers to refinance to benefit from a decrease in market
rates. This refinancing process in earlier episodes has worked quite smoothly in transmitting
lower market interest rates to the mortgage market - in particular during the large refinancing
wave in 2002-2003. But during the crisis, many borrowers were unable to refinance either
because their property was worth less than the outstanding mortgage balance, or because
they didn't otherwise fulfill underwriting criteria that had also become much more stringent
than during the boom.
These features surely limited the transmission of accommodative monetary policy through
households' balance sheets. Furthermore, borrowers that were able to refinance and benefit
from lower interest rates were mostly those with high credit scores and relatively lower debt
balances. The Administration responded to this limited pass-through by introducing programs
such as the Home Affordable Refinance Program, or HARP, to enable refinancing for
borrowers with high-LTV loans backed by Fannie Mae or Freddie Mac, or facilitating
streamline refinances of FHA loans. While these programs eventually reached a large
number of borrowers, their implementation was complex.
As a simple mortgage design counterfactual, had more borrowers had adjustable-rate
mortgages, which are generally indexed to short-term interest rates, the pass-through of
lower market interest rates would have been more direct. As the Chart illustrates, the
average interest rate on outstanding ARMs declined more rapidly than the rate on FRMs,
even though in the U.S. most ARMs only adjust after a rather long fixed-rate period (often
5 or more years) and then only do so infrequently (generally once or twice a year).
Crucially, ARM interest rate resets reduced mortgage payments without requiring the
borrower to refinance, thereby benefiting a broad range of borrowers, including those with
little or no home equity and/or low credit scores. Research conducted here at the New York
Fed has shown that these lower interest payments resulted in large declines in these
borrowers' default probabilities3. And two papers presented in our academic sessions
yesterday found evidence that these borrowers responded by increasing their consumption
of durable goods4.
All this implies that a higher share of ARMs at the start of the financial crisis would likely have
enhanced the effectiveness of monetary easing in reducing foreclosures and stimulating the
macroeconomy. More generally, the pass-through of monetary policy is likely to be stronger if
a high share of mortgage debt has an adjustable interest rate, both in easing and tightening
phases of the economic cycle.5 As a result, the amplitude of interest rate adjustments by the
central bank may not need to be quite as large to have the same economic effect. This may
be a particularly important consideration when the economy is at or close to the zero-lower
bound on interest rates, as the U.S. and many other economies are today.
A related consideration is that refinancing to a lower interest rate requires significant
resource costs, which would not be incurred if the borrower's interest rate adjusts
automatically when market interest rates decline. One estimate of the cost of refinancing a
mortgage, which includes costs such as those on a property appraisal or title insurance, is
$2,000 plus one percent of the loan amount.6 Under this estimate, total refinancing
transaction costs over 2008-2013 exceeded $100 billion.7 Furthermore, the re-underwriting
of existing loans leads to resource constraints in the mortgage origination industry during
refinancing waves, frequently followed by lay-offs when the refinancing boom is complete.8
Timing a mortgage refinancing optimally also requires time and attention from the borrower,
and can lead to refinancing mistakes, particularly by less financially sophisticated
households.9
But do these considerations make ARMs preferable to FRMs, either from the point of view of
monetary policymakers, or public policy more generally? Not necessarily. FRMs have many
advantages; for example they are simple for borrowers to understand, and clearly limit
household exposure to interest rate volatility. Consider too the incidence of interest rate
adjustments: widespread reliance on ARMs may have unattractive distributional
consequences for monetary policy, since it implies that a larger component of monetary
transmission falls on a subset of highly indebted mortgage borrowers. A risk-sharing
argument may call for the effects of monetary policy to be more evenly spread across
households. On the other hand, monetary policy might have to adjust interest rates more
dramatically in a world of widespread FRMs, which would affect some potential borrowers a
great deal. Furthermore, FRMs require an extensive financial-sector risk transfer system10,
which may be costly, and may concentrate risks in systemically risky ways. Thus, there are
clearly many tradeoffs that need to be carefully considered. Moreover, as academic research
has emphasized, optimal mortgage choice depends on a borrower's characteristics and
financial circumstances. It therefore seems desirable that the mortgage finance system
makes a range of different contracts available to borrowers, and be open to sensible
innovations in contract design.11
Although I have focused on ARMs, interest rate adjustability is only one of many important
aspects of mortgage design that will be considered in the discussions today. Another
important issue, for example, is how home price movements are shared between the
borrower and lender. Home price risk is already partially borne by lenders and other
mortgage investors, since a fall in home prices increases mortgage defaults and
6
See Agarwal, Driscoll and Laibson, 2013, "Optimal Mortgage Refinancing: A Closed-Form Solution", Journal
of Money, Credit and Banking, Vol. 45, No. 4, pp. 591-622.
7
According to data from the Home Mortgage Disclosure Act, there were 31.8 million refinancings of first-lien
single-family mortgages over 2008-2013, with an average (median) loan amount of $212,000 ($174,000).
8
For evidence on the importance of capacity constraints for time-varying margins in mortgage pricing, see
Fuster, Goodman, Lucca, Madar, Molloy and Willen, 2012, The Rising Gap between Primary and Secondary
Mortgage Rates, Federal Reserve Bank of New York Economic Policy Review, 19(2), pp. 17-39.
9
This is documented for instance in another paper presented yesterday, by Andersen, Campbell, Meisner,
Nielsen and Ramadorai (2015), "Inattention and Inertia in Household Finance: Evidence from the Danish
Mortgage Market".
10
For evidence that lenders are less willing to originate FRMs if mortgage securitization markets are illiquid or
frozen, see Fuster and Vickery (2015), "Securitization and the Fixed-Rate Mortgage", Review of Financial
Studies, 28(1), pp. 176-211. Research presented in yesterday's academic sessions finds that a bank's access
to external bond finance influences the composition of mortgages it originates: see Foá, Gambacorta, Guiso
and Mistrulli (2015), The Supply Side of Mortgage Finance.
11
One proposal for such innovation that would have increased pass-through during the crisis is the "automatic
stabilizer mortgage" of Eberly and Krishnamurthy, 2014; see
http://www.newyorkfed.org/research/conference/2015/mortgage_design/Eberly_Janice_052015.pdf.
foreclosures, and associated credit losses. But a number of proposals have argued that
mortgage balances should be explicitly indexed to movements in home prices in some way.12
I hope I have whetted your appetite for today's events.