Mortgage design in an equilibrium model of the housing market
Guren, Adam M.
McQuade, Timothy J.
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Citation (published version)GUREN, A.M., KRISHNAMURTHY, A. and MCQUADE, T.J. (2020), Mortgage Design in an Equilibrium Model of the Housing Market. The Journal of Finance. https://doi.org/10.1111/jofi.12963
How can mortgages be redesigned to reduce macrovolatility and default? We address this question using a quantitative equilibrium life‐cycle model. Designs with countercyclical payments outperform fixed payments. Among those, designs that front‐load payment reductions in recessions outperform those that spread relief over the full term. Front‐loading alleviates liquidity constraints when they bind most, reducing default and stimulating housing demand. To illustrate, a fixed‐rate mortgage (FRM) with an option to convert to adjustable‐rate mortgage, which front‐loads payment reductions relative to an FRM with an option to refinance underwater, reduces price and consumption declines six times as much and default three times as much.