Mortgage Innovation, Mortgage Choice, and Housing Decisions

By Chambers, Matthew S.; Garriga, Carlos et al. | Federal Reserve Bank of St. Louis Review, November-December 2008 | Go to article overview

Mortgage Innovation, Mortgage Choice, and Housing Decisions


Chambers, Matthew S., Garriga, Carlos, Schlagenhauf, Don, Federal Reserve Bank of St. Louis Review


This paper examines some of the more recent mortgage products now available to borrowers. The authors describe how these products differ across important characteristics, such as the down payment requirement, repayment structure, and amortization schedule. The paper also presents a model with the potential to analyze the implications for various mortgage contracts for individual households, as well as to address many current housing market issues. In this paper, the authors use the model to examine the implications of alternative mortgages for homeownership. The authors use the model to show that interest rate-adjustable mortgages and combo loans can help explain the rise--and fall--in homeownership since 1994.

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Housing is a big-ticket item in the U.S. economy. At the macro level, residential housing investment accounts for 20 to 25 percent of gross private investment. In the aggregate, this financing is about 8 trillion dollars and uses a sizable fraction of the financial resources of the economy. The importance of housing at the individual household level is more evident because the purchase of a house is the largest single consumer transaction and nearly always requires mortgage financing. This decision affects the overall expenditure patterns and asset allocation decisions of the household.

In recent years, interest in the role of housing in the U.S. economy has increased, influenced mainly by two events. During the economic downturn in 2000, the housing sector seemed to mitigate the slowdown in many other sectors of the economy as residential investment remained at high levels. More recently, the large number of foreclosures has again focused attention on the importance of housing. Fears have increased that mortgage market problems will have long-lasting effects on the credit market and thus continue to create a drag on the economy.

Events illustrating the important role of housing in the economy are not limited to those of the past decade. Housing foreclosures soared during the Great Depression as a result of two factors. The mortgage system was very restrictive: Homeowners were required to make down payments that averaged around 35 percent for loans lasting only five to ten years. At the end of the loan period, mortgage holders had to either pay off the loan or find new financing. The 1929 stock market collapse resulted in numerous bank failures. Mortgage issuance fell drastically, and homeowners were dragged into foreclosure. Faced with these problems, the government developed new housing policies as part of the New Deal legislation. The Home Owners' Loan Corporation (HOLC) and the Federal Housing Administration (FHA) were created along with a publicly supported noncommercial housing sector. The HOLC was designed to help distressed homeowners avert foreclosure by buying mortgages near or in foreclosure and replacing them with new mortgages with much longer durations. The HOLC financed these purchases by borrowing from the capital market and the U.S. Treasury. The FHA introduced new types of subsidized mortgage contracts by altering forms and terms, as well as mortgage insurance. In addition, Congress created Federal Home Loan Banks in 1932 and the Federal Home Loan Mortgage Corporation, commonly known as Fannie Mae, in 1938. The latter organization was allowed to purchase long-term mortgage loans from private banks and then bundle and securitize these loans as mortgage-backed securities. (1) These changes had an important impact on the economy: The stock of housing units increased 20 percent during the 1940s, and the homeownership rate increased approximately 20 percentage points from 1945 to 1965.

The need for increased understanding of housing markets, housing finance, and their linkage to the economy--the objective of this paper--should be obvious. We begin by examining the structure of a variety of mortgage contracts. Given the array of available mortgage products, mortgage choice can be a complex problem for potential home buyers. …

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