Credit Supply and the Housing Boom

Credit Supply and the Housing Boom
Alejandro Justiniano, Giorgio Primiceri, and Andrea Tambalotti
Liberty Street Economics, APRIL 20, 2015




LSE_2015_housing-boom-450There 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.

Real House Prices

Household Mortgages-to-GDP Ratio

A common narrative attributes the surge in debt and 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.

Household Mortgages-to-Real Estate Ratio

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.

Real Mortgage Interest Rates

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.

Response to a Change in the Lending-Limit

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.

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_TambalottiAndrea Tambalotti is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Posted by Blog Author at 07:00:00 AM in Macroecon
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  1. VennData commented on May 6

    It was clearly 1) Obama. 2) Clinton(s) 3) the newly created Fannie and Freddie in 2003. 4) Dodd Frank’s strangling of the alabaster white pillars of the community bankers leaving them nowhere else to turn to protect the communities where they live, work hard, and play by the rules while maintaining their pay levels throughout the post crisis era. And Ted Kennedy!

  2. marketmap commented on May 6

    The problem lies in the original premise that credit was made “widely” available ( in the late seventeenth and early eighteenth centuries in Britain, which establish a new usurious monetary system) but only on condition of an exponentially increasing debt burden. To pay back debts, production had to increase correspondingly, leading to the industrial revolution, economic ‘growth,’ and modernity itself. Though private creditors grained a monopoly over the creation of credit, and were disproportionately enriched ( the top 1%, salary inequality within companies between the top and the bottom, etc. ), the resulting economic growth for a time was great enough to benefit most debtors as well as creditors, ensuring widespread prosperity. Yet, we have reached the limits of growth ie. the size of the planet and it’s resources is finite. We no longer have the natural resources to grow fast enough to pay our debts. This is the real root of our current financial crisis. If we are to live sustainably, our system of money and credit must be transformed. We need a non-usurious monetary system appropriate to a steady-state economy, with capital broadly distributed at non-usurious rates of interest.

    • VennData commented on May 7

      Dude, short term money is zero. A thirty year fixed (not included tax deductions) is under 4%.

  3. JimInMissoula commented on May 7

    Seems like chart 3 is really just saying that prices ratchet up just as quickly as there is credit available to support those prices. I wouldn’t expect a spike as authors state.

  4. Blissex commented on May 7

    «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»

    While I agree with that as the immediate causes, my “Big Picture” view is that the “economic policy” of most first-world governments in the past 20 years has been mostly to push up as much as possible financial system capital-leverage ratios, which have rosen to levels of around 60-80 at some point, and currently are often infinite as many parts of the financial system have zero or negative capital.

    Higher capital-leverage ratios have been enabled by legalized accounting fraud, where collateral took the place of capital as the backing for lending, especially theoretically AAA collateral that suitably deformed accounting rules allowed assuming to be entirely risk free; plus ever rising collateral valuations, pushed up by the debt boom enabled by the rise in capital-leverage ratios, resulting in what I call the “debt-collateral spiral”.

    The overall aim was to enable what the UK academic Colin Crouch calls “privatized Keynesianism”, that is the replacement of government borrow-and-spend policies benefiting most workers with (government enabled) private borrow-and-spend benefiting property owners, under the assumption that private borrowing was “safe” as backed by high collateral valuations, regardless of ever higher capital leverage ratios.

    Any halt in the expansion of collateral valuations, never mind a contraction in those valuations, is fatal to the policy, as it results in the technical bankruptcy of many counterparties, given the high capital-leverage ratios, and in extensive freezing of markets as legalized accounting fraud allows bankrupt counterparties to obfuscate their status.

    Thus “negative interest” rates: the very few transparent and well capitalized and thus trustworthy counterparties can charge what are in effect deposit fees to “lenders” for holding their funds.

    The fact that so many fund holders are willing to pay deposit fees to trustworthy counterparties shows that the vast majority of fund holders reckon that the vast majority of counterparties are either technically bankrupt or so opaque it cannot be assumed they are not.

    In the current situation financial market participants that have to pay positive interest rates to lenders ought to be presumed to be an untrustworthy counterparty.

    • Blissex commented on May 12

      «push up as much as possible financial system capital-leverage ratios»

      And Sheila Blair, a Republican (perhaps an old fashioned one) has recently been reported as saying:
      «We had a crisis that was based on solvency problems: banks and households were borrowing too much. They needed to go through a process of deleveraging. Monetary policy cannot address that.»
      «And, so, I think we need to reduce our reliance on monetary policy, which creates instability by encouraging leverage and encouraging lenders and investors to go further and further out on the risk curve.»
      «But this idea that we need to feed the beast by letting them take on higher and higher levels of leverage so that they can make levered returns and generate more shareholder profits for themselves is not sustainable in the long term.»

      As to the «sustainable in the long term» another Republican (perhaps an old fashioned one) wrote:
      «Rather than workable solutions, my party is offering low taxes for the currently rich and high spending for the currently old, to be followed by who-knows-what and who-the-hell-cares. This isn’t conservatism; it’s a going-out-of-business sale for the baby-boom generation.»

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