Financial Economics

The U.S. housing finance system has been characterized by fixed-rate, long-term, and high maximum loan-to-value ratio mortgage loans, with unique support from secondary market entities Ginnie Mae and the government-sponsored enterprises, Fannie Mae and Freddie Mac. The authors provide a comprehensive review of the U.S. housing finance system, from its structure and evolution to the current continuing policy debate. The “American Mortgage” provides many more options to borrowers than are commonly provided elsewhere: U.S. homebuyers can choose whether to pay a fixed or floating rate of interest; they can lock in their interest rate in between the time they apply for the mortgage and the time they purchase their house; they can choose the time at which the mortgage rate resets; they can choose the term and the amortization period; they can generally prepay without penalty; and they can generally borrow against home equity. They can also obtain insured home mortgages at attractive terms with very low down payments. Perhaps most importantly, in the typical mortgage, payments remain constant throughout the potentially 30-year term of the loan. The unique characteristics of the U.S. mortgage provide substantial benefits for American homeowners and the overall stability of the economy. This article describes the evolution of the housing finance system which has led to the predominant role of this mortgage instrument in the United States.

Central banks around the world use monetary policy tools to promote economic growth and stability; for example, in the United States, the Federal Reserve (Fed) uses federal funds rate adjustments, quantitative easing (QE) or tightening, forward guidance, and other tools “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Changes in monetary policy affect both businesses and consumers. For consumers, changes in monetary policy affect bank credit supply, refinancing activity, and home purchases, which in turn affect household consumption and thus economic growth and price stability. The U.S. Fed rate cuts and QE programs during COVID-19 led to historically low interest rates, which spurred a huge wave of refinancings. However, the pass-through of rate savings in the mortgage market declined during the pandemic. The weaker pass-through can be linked to the extraordinary growth of shadow bank mortgage lenders during the COVID-19 pandemic: Shadow bank mortgage lenders charged mortgage borrowers higher rates and fees; therefore, a higher market share of them means a smaller overall pass-through of rate savings to mortgage borrowers. It is important to note that these shadow banks did provide convenience to consumers, and they originated loans faster than banks. The convenience and speed could be valuable to borrowers and important in transmitting monetary policy in a timelier way, especially during a crisis.

The global financial crisis of 2007–2009 helped usher in a stronger consensus about the central role that housing plays in shaping economic activity, particularly during large boom and bust episodes. The latest research regards the causes, consequences, and policy implications of housing crises with a broad focus that includes empirical and structural analysis, insights from the 2000s experience in the United States, and perspectives from around the globe. Even with the significant degree of heterogeneity in legal environments, institutions, and economic fundamentals over time and across countries, several common themes emerge. Research indicates that fundamentals such as productivity, income, and demographics play an important role in generating sustained movements in house prices. While these forces can also contribute to boom-bust episodes, periods of large house price swings often reflect an evolving housing premium caused by financial innovation and shifts in expectations, which are in turn amplified by changes to the liquidity of homes. Regarding credit, the latest evidence indicates that expansions in lending to marginal borrowers via the subprime market may not be entirely to blame for the run-up in mortgage debt and prices that preceded the 2007–2009 financial crisis. Instead, the expansion in credit manifested by lower mortgage rates was broad-based and caused borrowers across a wide range of incomes and credit scores to dramatically increase their mortgage debt. To whatever extent changing beliefs about future housing appreciation may have contributed to higher realized house price growth in the 2000s, it appears that neither borrowers nor lenders anticipated the subsequent collapse in house prices. However, expectations about future credit conditions—including the prospect of rising interest rates—may have contributed to the downturn. For macroeconomists and those otherwise interested in the broader economic implications of the housing market, a growing body of evidence combining micro data and structural modeling finds that large swings in house prices can produce large disruptions to consumption, the labor market, and output. Central to this transmission is the composition of household balance sheets—not just the amount of net worth, but also how that net worth is allocated between short term liquid assets, illiquid housing wealth, and long-term defaultable mortgage debt. By shaping the incentive to default, foreclosure laws have a profound ex-ante effect on the supply of credit as well as on the ex-post economic response to large shocks that affect households’ degree of financial distress. On the policy front, research finds mixed results for some of the crisis-related interventions implemented in the U.S. while providing guidance for future measures should another housing bust of similar or greater magnitude reoccur. Lessons are also provided for the development of macroprudential policy aimed at preventing such a future crisis without unduly constraining economic performance in good times.

Lack of affordable housing is a growing and often primary policy concern in cities throughout the world. The main underlying cause for the “affordability crisis,” which has been mounting for decades, is a combination of strong and growing demand for housing in desirable areas in conjunction with tight long-term supply constraints—both physical and man-made regulatory ones. The affordability crisis tends to predominately affect low- and moderate-income households. Increasingly, however, middle-income households—which do not usually qualify for government support—are similarly affected. Policies that aim to tackle the housing affordability issue are numerous and differ enormously across countries. Key policies include mortgage subsidies, government equity loans, rent control, social or public housing, housing vouchers, low-income tax credits, and inclusionary zoning, among others. The overarching aim of these policies is to (a) reduce the periodic housing costs of or (b) improve access to a certain tenure mode for qualifying households. Existing evidence reveals that the effectiveness and the distributional and social welfare effects of housing policies depend not only on policy design but also on local market conditions, institutional settings, indirect (dis)incentives, and general equilibrium adjustments. Although many mainstream housing policies are ineffective, cost-inefficient, and/or have undesirable distributional effects from an equity standpoint, they tend to be politically popular. This is partly because targeted households poorly understand adverse indirect effects, which is exploited by vote-seeking politicians. Partly, it is because often the true beneficiaries of the policies are the politically powerful existing property owners (homeowners and landlords), who are not targeted but nevertheless benefit from positive policy-induced house price and rent capitalization effects. The facts that existing homeowners often have a voter majority and landlords additionally may be able to influence the political process via lobbying lead to the conundrum of ineffective yet politically popular housing policies. In addition to targeted policies for individuals most in need (e.g., via housing vouchers or by providing subsidized housing), the most effective policies to improve housing affordability in superstar cities for all income groups might be those that focus on the root causes of the problem. These are (a) the strongly and unequally growing demand for housing in desirable markets and (b) tight land use restrictions imposed by a majority of existing property owners that limit total supply of housing in these markets. Designing policies that tackle the root causes of the affordability crisis and help those in need, yet are palatable to a voter majority, is a major challenge for benevolent policymakers.