The volatility of residential investment has declined considerably since the mid- 1980s (Chart 1). The timing of this reduction in volatility corresponds to the timing of a fundamental restructuring of the housing finance system, from a heavily regulated system dominated by thrift institutions (savings and loans and mutual savings banks) to a relatively unregulated system dominated by mortgage bankers and brokers and the process of mortgage securitization. With this restructuring, the housing finance system is now integrated with the broader capital markets in the sense that "mortgage rates move in response to changes in other capital market rates, and mortgage funds are readily available at going market rates" (Hendershott and Van Order 1989).
In light of this restructuring, it is certainly possible that the transmission of monetary policy to residential investment has changed. The supply of mortgage credit is now less likely to experience the sharp swings that occurred in the 1960s and 1970s. This, along with much greater competitiveness in the primary mortgage market prompted by deregulation, suggests that a tightening of monetary policy is less likely to result in nonprice rationing of mortgage credit, as was frequently the case under the old system. Our goal in this paper is to document any differences between the effects of changes in monetary policy on residential investment under the current and previous housing finance regimes.
In the first half of the paper, we review the significant changes in the housing finance system over the past thirty years and discuss the implications of these changes for the cost and availability of mortgage credit. In the second half, we present a two-part econometric analysis of the transmission of changes in monetary policy to residential investment. The first part uses a small, reduced-form macroeconomic model to examine the response of the housing market to a monetary policy "shock." We then use a structural model of investment in single-family housing to examine the effect that the changes in the housing finance system have had on the housing market and on the response of that market to changes in monetary policy. Our main conclusion is that the eventual magnitude of the response of residential investment to a given change in monetary policy is similar to what it has been in the past. However, that response does not occur as quickly as it did under the old housing finance system and its timing is now similar to that of the overall economy.
EVOLUTION OF THE HOUSING FINANCE SYSTEM
The housing finance system can be thought of as three interrelated but distinct markets: the primary mortgage market, the secondary mortgage market, and the market for mortgage-backed securities (MBSs). Over the past thirty years, the underlying institutional setting of those markets has changed dramatically in response to macroeconomic conditions, deregulation, and financial and technological innovation. This section reviews those changes and discusses their implications for the cost and availability of mortgage credit.
Trends in the Primary Mortgage Market
The primary mortgage market is where homeowners (mortgagors) borrow from mortgage lenders (originators), pledging their home as collateral for the debt. The debt instrument created in this transaction is typically referred to as a whole loan. Thirty years ago, the primary market was dominated by the heavily regulated thrift industry. Today, it is dominated by the relatively unregulated mortgage banking industry.
As recently as the 1970s, the primary mortgage market had essentially the same structure as the one created during the 1930s, often referred to as the New Deal system.' Under that system, thrifts gathered primarily local time deposits and made long-term fixed-rate mortgage loans on residential properties located near their home offices,2 which were then held in the thrift's portfolio. …