Paper 2 Q&A: Mortgage design in an equilibrium model of the housing market
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Bindseil, Ulrich
Krishnamurthy, Arvind
Ivashina, Victoria
Monday, 25 September 2017 Chair: Ulrich Bindseil, European Central Bank Presenter: Arvind Krishnamurthy, Stanford University, Graduate School of Business Discussant: Victoria Ivashina, Harvard Business School
 Hello. So, Arvin, I like the paper. What I like about it is that it's something that one can think about actually implementing. When I think of optimal mortgage design, I wonder why we have mortgages at all. I mean, you have people, you're putting all of your assets, levering up 300% into a house which is highly correlated to your human capital, seems a little bit insane. It would seem that optimal mortgage design might go more for equity sharing and things like car leasing, we've solved that market. House leasing would be the analog and then you wouldn't have the levered sector, the financial crises, all the things that go along with it. I wonder if you have any thoughts for why we don't see more equity. Very nice. Thanks. It's interesting engineering as well, which I appreciate. I think there's a little bit too little emphasis maybe on the dark side of adjustable rate mortgages. When you look at the run up to the great recession in 2007, the jacking up of interest rates by the Fed in 2005 and 2006 basically showed that in the end, those mortgages that defaulted in 2006 and 2007 were ARMs. So, the instability created by ARMs actually only made it necessary later on to reduce interest rates again. So, your effect basically focuses on the downside, but what about the upside of pressure? Couple of further uses of the model because you start with this totally rational and very simple banking. It's the right place to start, but you don't want to jump to policy conclusions too quickly from that. So, one of the criticisms of the Obama administration was that they didn't do anything about bankruptcy rules. In the 80s, there was a crisis with farmland pricing, and at the time a farmer could go bankrupt, the bankruptcy judge could rewrite the mortgage anyway wanted, and that greatly eased that crisis. By the time we got to the big crisis, that didn't work for homeowners because the law had been changed, and it was suggested something like that, you have bankruptcy as one of the central elements in it, so you could evaluate that kind of policy. Secondly, you cited the Boston Fed work on bankruptcy. Other Boston Fed work has looked at the strength and weakness of local banks and what happens in the local housing market, so if you were to be building in some feedback on bank behavior, it seems that would work. Picking up on some of the comments, if you wanted to have an effect on pricing, you have to build in the kind of thing that was being referred to, farms are not popular, they're not easily understood, so the impact on the housing price process might look very different as you fold down the extent of reliance, but this was a terrific place to start. I have two questions. The first one, you're talking about innovative products that are not widespread in the market, and ideally you would want the lenders to be happy to propose these products. Now, my first question is the lenders in your models, your model appear to be in an exogenous or at least in a reduced form. Are there any reasons to think that if you would make them more explicit with a UTT function and optimizing, your results would change? Second question, it's about underwater mortgages. You said the advantages of such products is the advantage is a bit small because the advantage is spread over time. So my second question is should we think of the household as having a very high discount rate? Is it because it's a crisis period and would those advantages be higher in a steady state model? So some of the policies that you talked about had people switching policies, mortgages over time, but in reality of course we don't know exactly when a recession begins for sure in real time. Is that very important or is it sufficient just to know what the current interest rate is? Yeah, one more maybe, or two more, two more. Sorry, I haven't seen you. Picking an adjustable rate mortgage means that lower payments in the crisis and that's good and that's why households want to pick those and then lever more exante. I wonder whether you could check that implication with data before the crisis because not everyone was on a fixed rate mortgage and then you can compare loan-to-value ratios for adjustable rate versus fixed rate mortgage. So very interesting paper. I just want to go back to some points touched by the discussion and also by people about the potential risks. One of them is that here basically you're taking the risk out of the households and putting them into the banking system and what your thoughts are on that, whether there is some underlying assumption in your mind that it's easier for the bank to hedge these risks than for households. The other comment is it's unclear whether people will demand too much or too little of this product. On the one hand because here you have this pricing, pecuniary externalities and so on, people might demand too little of it. On the other hand, if people are somewhat myopic, they may borrow too much in times of low interest rates and then this might be a constraint on monetary policy going forward where you may be reluctant to raise rates and may raise another. So just wanted to hear your thoughts on these things. That's all? You want it? Okay. Then I mean very last one and then when you have five minutes to answer everything. So you'll focus on the price aspect of providing some form of insurance. On the quantity, your model has this hard wire amortization schedule in part for tractability but you basically assume all mortgages are progressively amortized. Now in reality, people can and do lever up. In fact, there's a case that the crisis might much worse but exactly that. So shouldn't that be part of an optimal contract or perhaps be related to some kind of age-related loan to value? I mean Holland for instance, the fiscal system strongly pushes for direct amortization. Okay. First of all, thank you Victoria for your comments. They're all well taken. Thank you all for all of your questions as well. I have five minutes. I'm not going to answer them all. Let me just pick on a couple of points. So a number of you asked about this question about banks. So the way the model is constructed, the lender is this risk neutral present value lender. He's just present valuing at whatever the going short rate is. So they're really not that interesting. Okay. What are the issues with doing that? So the first thing I would say is actually in the mortgage designs which we have considered here, which are mortgage designs where contingencies are based upon interest rates. I'd say that's actually a pretty decent assumption. Why do I say that? It's because interest rates are in the span of kind of traded assets, hedgeable things that banks can do. So for example, I mean if you take my experiment literally, it means households are getting benefits in the recession and banks are losing. That's what's happening in the model. Now you might ask, well, that sounds bad because that's going to hit bank capital and maybe they would lend less, etc. I would say if the mortgage world was one in which as I said mortgage is worth a standard or any form of insurance contract was the standard in the space of interest rates, then banks could change their liabilities. And apparently they do quite frequently. Just change your funding mix so that for example, you're all funded with short rather than long and that would hedge out the interest rate risk. So I have felt that in this question of we have not modeled banks for looking at indexation that is related to interest rates, it's okay. I feel more uncomfortable. So another exercise which we have done is indexation related to home prices, which is also beneficial as you would guess. But that one I start to get worried about because banks can hedge out home price risk and so one could easily imagine that when you transfer home price risk into the banking sector, it sits there as we kind of know it does and then that has spillover effects. Whereas with interest rates, I'm going to make the case I'm more comfortable with this analysis the way it is. So that's one set of questions. A couple of you have made kind of two related questions. First of all, there's a question as to there's basic question of this is such a great contract, why isn't it there? I don't really have a deep answer for this. I'm going to say things like well, it does seem like in the US at least, there's so much inertia in mortgage contracts, there's some social aspect to what contract you take on. The government clearly subsidizes one mortgage design. So one way of reading this model is if you subsidize different mortgage design maybe everyone would switch to that. There is some interesting avenue one could pursue there. I didn't emphasize this in the presentation but the way the model works, if everybody is in a mortgage design in which has insurance features that affects the equilibrium. It affects both equilibrium home prices, it also affects the equilibrium spread, there's less default. And so X-ante actually contracts are cheaper. So there's an externality in the model that's built in as often happens with home price spillovers. And so there is scope here for thinking subsidize a mortgage design with insurance features and it feeds back to having beneficial macro effects. So I don't think I have a deep answer for why this is not offered other than the government does it and it's the common thing. It is true that if you look around the world there's quite a lot of variation in mortgage design. There's many countries that have fixed rate mortgages, there's many countries that have adjustable rate mortgages. My own understanding of this which is driven by a paper by John Campbell wrote is it looks largely like inflation experiences in the ADs sort out which countries seem to have adjustable rate mortgages and which countries seem to have fixed rate mortgages and there's some inertia built into there. So other than that I don't think I have anything else to say about that. There were a couple of questions about arms pre-crisis, could they have destabilized things? It's a hard question to fully analyze because the world was a fixed rate mortgage and the pool of borrowers who took adjustable rate mortgages were kind of an odd pool. So I'm just not clear if I can do that comparison so clearly. Anyway, I'm going to stop there. I'm happy to discuss more with people at lunch. Okay, thanks. Thank you very much. Thank you very much. Thank you.
 Hello. So, Arvin, I like the paper. What I like about it is that it's something that  one can think about actually implementing. When I think of optimal mortgage design, I  wonder why we have mortgages at all. I mean, you have people, you're putting all of your  assets, levering up 300% into a house which is highly correlated to your human capital,  seems a little bit insane. It would seem that optimal mortgage design might go more for  equity sharing and things like car leasing, we've solved that market. House leasing would  be the analog and then you wouldn't have the levered sector, the financial crises, all  the things that go along with it. I wonder if you have any thoughts for why we don't  see more equity. Very nice. Thanks. It's interesting engineering as well, which I appreciate.  I think there's a little bit too little emphasis maybe on the dark side of adjustable rate  mortgages. When you look at the run up to the great recession in 2007, the jacking up of  interest rates by the Fed in 2005 and 2006 basically showed that in the end, those mortgages  that defaulted in 2006 and 2007 were ARMs. So, the instability created by ARMs actually  only made it necessary later on to reduce interest rates again. So, your effect basically  focuses on the downside, but what about the upside of pressure?  Couple of further uses of the model because you start with this totally rational and very  simple banking. It's the right place to start, but you don't want to jump to policy conclusions  too quickly from that. So, one of the criticisms of the Obama administration was that they  didn't do anything about bankruptcy rules. In the 80s, there was a crisis with farmland  pricing, and at the time a farmer could go bankrupt, the bankruptcy judge could rewrite  the mortgage anyway wanted, and that greatly eased that crisis. By the time we got to the  big crisis, that didn't work for homeowners because the law had been changed, and it was  suggested something like that, you have bankruptcy as one of the central elements in it, so you  could evaluate that kind of policy. Secondly, you cited the Boston Fed work on bankruptcy.  Other Boston Fed work has looked at the strength and weakness of local banks and what happens  in the local housing market, so if you were to be building in some feedback on bank behavior,  it seems that would work. Picking up on some of the comments, if you wanted to have an  effect on pricing, you have to build in the kind of thing that was being referred to,  farms are not popular, they're not easily understood, so the impact on the housing price  process might look very different as you fold down the extent of reliance, but this was  a terrific place to start. I have two questions. The first one, you're talking about innovative  products that are not widespread in the market, and ideally you would want the lenders to  be happy to propose these products. Now, my first question is the lenders in your models,  your model appear to be in an exogenous or at least in a reduced form. Are there any reasons  to think that if you would make them more explicit with a UTT function and optimizing,  your results would change? Second question, it's about underwater mortgages. You said  the advantages of such products is the advantage is a bit small because the advantage is spread  over time. So my second question is should we think of the household as having a very  high discount rate? Is it because it's a crisis period and would those advantages be higher  in a steady state model? So some of the policies that you talked about had people switching  policies, mortgages over time, but in reality of course we don't know exactly when a recession  begins for sure in real time. Is that very important or is it sufficient just to know  what the current interest rate is? Yeah, one more maybe, or two more, two more. Sorry,  I haven't seen you.  Picking an adjustable rate mortgage means that lower payments in the crisis and that's  good and that's why households want to pick those and then lever more exante. I wonder  whether you could check that implication with data before the crisis because not everyone  was on a fixed rate mortgage and then you can compare loan-to-value ratios for adjustable  rate versus fixed rate mortgage.  So very interesting paper. I just want to go back to some points touched by the discussion  and also by people about the potential risks. One of them is that here basically you're  taking the risk out of the households and putting them into the banking system and what  your thoughts are on that, whether there is some underlying assumption in your mind that  it's easier for the bank to hedge these risks than for households. The other comment is  it's unclear whether people will demand too much or too little of this product. On the  one hand because here you have this pricing, pecuniary externalities and so on, people  might demand too little of it. On the other hand, if people are somewhat myopic, they  may borrow too much in times of low interest rates and then this might be a constraint  on monetary policy going forward where you may be reluctant to raise rates and may raise  another. So just wanted to hear your thoughts on these things.  That's all? You want it? Okay. Then I mean very last one and then when you have five  minutes to answer everything.  So you'll focus on the price aspect of providing some form of insurance. On the quantity, your  model has this hard wire amortization schedule in part for tractability but you basically  assume all mortgages are progressively amortized. Now in reality, people can and do lever up.  In fact, there's a case that the crisis might much worse but exactly that. So shouldn't  that be part of an optimal contract or perhaps be related to some kind of age-related loan  to value? I mean Holland for instance, the fiscal system strongly pushes for direct amortization.  Okay. First of all, thank you Victoria for your comments. They're all well taken. Thank  you all for all of your questions as well. I have five minutes. I'm not going to answer  them all. Let me just pick on a couple of points. So a number of you asked about this  question about banks. So the way the model is constructed, the lender is this risk neutral  present value lender. He's just present valuing at whatever the going short rate is. So they're  really not that interesting. Okay. What are the issues with doing that? So the first thing  I would say is actually in the mortgage designs which we have considered here, which are mortgage  designs where contingencies are based upon interest rates. I'd say that's actually a  pretty decent assumption. Why do I say that? It's because interest rates are in the span  of kind of traded assets, hedgeable things that banks can do. So for example, I mean  if you take my experiment literally, it means households are getting benefits in the recession  and banks are losing. That's what's happening in the model. Now you might ask, well, that  sounds bad because that's going to hit bank capital and maybe they would lend less, etc.  I would say if the mortgage world was one in which as I said mortgage is worth a standard  or any form of insurance contract was the standard in the space of interest rates, then banks  could change their liabilities. And apparently they do quite frequently. Just change your  funding mix so that for example, you're all funded with short rather than long and that  would hedge out the interest rate risk. So I have felt that in this question of we have  not modeled banks for looking at indexation that is related to interest rates, it's okay.  I feel more uncomfortable. So another exercise which we have done is indexation related to  home prices, which is also beneficial as you would guess. But that one I start to get worried  about because banks can hedge out home price risk and so one could easily imagine that  when you transfer home price risk into the banking sector, it sits there as we kind of  know it does and then that has spillover effects. Whereas with interest rates, I'm going to  make the case I'm more comfortable with this analysis the way it is. So that's one set  of questions. A couple of you have made kind of two related questions. First of all, there's  a question as to there's basic question of this is such a great contract, why isn't  it there? I don't really have a deep answer for this. I'm going to say things like well,  it does seem like in the US at least, there's so much inertia in mortgage contracts, there's  some social aspect to what contract you take on. The government clearly subsidizes one  mortgage design. So one way of reading this model is if you subsidize different mortgage  design maybe everyone would switch to that. There is some interesting avenue one could  pursue there. I didn't emphasize this in the presentation but the way the model works,  if everybody is in a mortgage design in which has insurance features that affects the equilibrium.  It affects both equilibrium home prices, it also affects the equilibrium spread, there's  less default. And so X-ante actually contracts are cheaper. So there's an externality in  the model that's built in as often happens with home price spillovers. And so there is  scope here for thinking subsidize a mortgage design with insurance features and it feeds  back to having beneficial macro effects. So I don't think I have a deep answer for why  this is not offered other than the government does it and it's the common thing. It is true  that if you look around the world there's quite a lot of variation in mortgage design.  There's many countries that have fixed rate mortgages, there's many countries that have  adjustable rate mortgages. My own understanding of this which is driven by a paper by John  Campbell wrote is it looks largely like inflation experiences in the ADs sort out which countries  seem to have adjustable rate mortgages and which countries seem to have fixed rate mortgages  and there's some inertia built into there. So other than that I don't think I have anything  else to say about that. There were a couple of questions about arms pre-crisis, could  they have destabilized things? It's a hard question to fully analyze because the world  was a fixed rate mortgage and the pool of borrowers who took adjustable rate mortgages  were kind of an odd pool. So I'm just not clear if I can do that comparison so clearly.  Anyway, I'm going to stop there. I'm happy to discuss more with people at lunch.  Okay, thanks.  Thank you very much.  Thank you very much.  Thank you.
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