Housing Finance in a Stochastic Economy: Theory, Estimation, and Policy Implications

Abstract

Deep, complex interdependencies exist between the capital, mortgage, housing, and labor markets. A life cycle consumption model of durable housing and mortgage demand and an option pricing model of mortgage supply capture the macroeconomic relationships among the markets. A vector autoregressive error correction model is used to examine the long-run equilibrium and short-run dynamics of the mortgage market as it relates to the other sectoral markets. A simultaneous equations model is used to examine the partial equilibrium in the differentiated products market for fixed-and adjustable-rate mortgage contracts. The complete, multistage modeling and estimation strategy yields numerous results that confirm, consolidate, and extend previous theoretical and empirical results in the mortgage choice and mortgage option pricing literature. In addition, policy insights emerge regarding low-income housing segregation and the design of contracts to share the risks of stochastic interest rates, house prices, and income.

JEL Classification: G21, R31, J40