April 20th, 2015
by Liberty Street Economics
There is no consensus among economists as to what drove the rise of U.S. house prices and household debt in the period leading up to the recent financial crisis. In this post, we argue that the fundamental factor behind that boom was an increase in the supply of mortgage credit, which was brought about by securitization and shadow banking, along with a surge in capital inflows from abroad. This argument is based on the interpretation of four macroeconomic developments between 2000 and 2006 provided by a general equilibrium model of housing and credit.
The financial crisis precipitated the worst recession since the Great Depression. The spectacular rise in house prices and household debt during the first half of the 2000s, which is illustrated in the first two charts, was a crucial factor behind these events. Yet, economists disagree on the fundamental causes of this credit and housing boom.
A common narrative attributes the surge in debtand house prices to a loosening of collateral requirements for mortgages, associated with higher initial loan-to-value (LTV) ratios, multiple mortgages on the same property, and expansive home equity lines of credit.
The fact that collateral requirements became looser, at least for certain borrowers, is fairly uncontroversial. But can higher LTVs account for the unprecedented increase in house prices and debt, while remaining consistent with other macroeconomic developments during the same period?
Two facts suggest that the answer to this question is no. First, if the relaxation of collateral constraints had been widespread, it should have resulted in a surge of mortgage debt relative to the value of real estate. In the data, however, household debt and real estate values rose in tandem, leaving their ratio roughly unchanged over the first half of the 2000s, as shown in the chart below. In fact, this ratio only spiked when home prices tumbled, starting in 2006.
Second, more relaxed collateral requirements make it possible for the borrowers to demand more credit. Therefore, interest rates should rise to convince the lenders to satisfy this additional demand. In the data, however, real mortgage interest rates fell during the 2000s, as shown below in the fourth chart.
The fall in mortgage interest rates depicted in the fourth chart points to a shift in credit supply as an alternative explanation of the credit and housing boom of the early 2000s. We develop this hypothesis within a simple general equilibrium model in Justiniano, Primiceri, and Tambalotti (2015).
In the model, borrowing is limited by a collateral constraint linked to real estate values. Changes to this constraint, such as when the maximum LTV increases, shift the demand for credit. On the lending side, there is a limit to the amount of funds that savers can direct toward mortgage finance, which is equivalent to a leverage restriction on financial intermediaries. Changes to this constraint shift the supply of credit.
Lending constraints capture a host of technological and institutional factors that restrain the flow of savings into the mortgage market. Starting in the late 1990s, the explosion of securitization together with changes in the regulatory environment lowered many of these barriers, increasing the supply of mortgage credit.
The pooling and tranching of mortgages into mortgage-backed securities (MBS) played a central role in loosening lending constraints through several channels. First, tranching creates highly rated assets out of pools of risky mortgages. These assets can then be purchased by those institutional investors that are restricted by regulation to hold only fixed-income securities with high ratings. As a result, the boom in securitization channeled into mortgages a large pool of savings that had previously been directed toward other safe assets, such as government bonds. Second, investing in these senior MBS tranches freed up intermediary capital, owing to their lower regulatory charges. This form of "regulatory arbitrage" allowed banks to increase leverage without raising new capital, expanding their ability to supply credit to mortgage markets. Third, securitization allowed banks to convert illiquid loans into liquid funds, reducing their funding costs and hence increasing their capacity to lend.
International factors also played an important role in increasing the supply of funds available to American home buyers, as global saving flowed into U.S. safe assets, including agency MBS, before the financial crisis (Bernanke, Bertaut, Pounder, DeMarco, and Kamin 2011).
The fifth chart plots the effects of a relaxation of lending constraints in our model. When savers and financial institutions are less restricted in their lending, the supply of credit increases and interest rates fall. Since access to credit requires collateral, the increased availability of funds at lower interest rates makes the existing collateral - houses - scarcer and hence more valuable. As a result of higher real estate values, borrowers can increase their debt, even though their debt-to-collateral ratio remains unchanged. These responses of debt, house prices, aggregate leverage, and mortgage rates match well the empirical facts illustrated in the previous four charts. We conclude from this experiment that a shift in credit supply, associated with looser lending constraints, was the fundamental driver of the credit and housing boom that preceded the Great Recession.
This interpretation of the sources of the credit and housing boom is consistent with the microeconometric evidence presented in the influential work of Mian and Sufi (2009, 2010). They show that an expansion in credit supply was the fundamental driver of the surge in household debt and that borrowing against the increased value of real estate accounts for a significant fraction of this build-up in debt.
Our model, by providing a theoretical perspective on the important factors behind the financial crisis, should prove useful as a framework to study policies that might prevent a repeat of this experience.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of Chicago, the Federal Reserve Bank of New York, or the Federal Reserve System. Any errors or omissions are the responsibility of the author.
About the Authors
Alejandro Justiniano is a senior economist and research advisor in the Federal Reserve Bank of Chicago's Economic Research Department.
Giorgio Primiceri is an associate professor at Northwestern University.
Andrea Tambalotti is an assistant vice president in the Federal Reserve Bank of New York's Research and Statistics Group.