Housing Boom, Mortgage Default and Agency Friction

Abstract

The housing prices and the mortgage debt witnessed faster growth than GDP in the run-up of the Great Recession. I document a mortgage market puzzle during the boom period: (1) the mortgage risk measured by the ex post delinquency increased, but (2) the mortgage spread decreased. The default premium alone cannot explain the decreasing mortgage spread in the boom episode. I develop a dynamic general equilibrium model of the housing and the mortgage markets with borrowers, depositors, and intermediaries to explain the empirical fact. The model features the tightness of the lending condition and the mortgage risk as the aggregate shocks, which generate the time-varying liquidity and default premiums in the mortgage spread. I quantify the contribution of the aggregate risks to the boom-bust dynamics before and after the Great Recession. A plausible size of the income shock alone is insufficient to generate the observed movement in the mortgage spread. The model shows that the lending relaxation that eases the leverage constraint of an intermediary leads to the increasing mortgage credit and the decreasing mortgage spread in the boom period. The lending condition shock generates pro-cyclical leverage of intermediaries that amplifies the aggregate shocks in the boom-bust dynamics.

Keywords: housing boom, mortgage spread, mortgage risk, lending relaxation

JEL Classification: E21, E32, E44, G01