Mortgage Choices and Housing Speculation

Abstract

We describe a rational expectations model in which speculative bubbles in house prices can emerge. Within this model both speculators and their lenders use interestonly mortgages (IOs) rather than traditional mortgages when there is a bubble. Absent a bubble, there is no tendency for IOs to be used. These insights are used to assess the extent to which house prices in US cities were driven by speculative bubbles over the period [2000][2001][2002][2003][2004][2005][2006][2007][2008]. We find that IOs were used sparingly in cities where elastic housing supply precludes speculation from arising. In cities with inelastic supply, where speculation is possible, there was heavy use of IOs, but only in cities that had boom-bust cycles. Peak IO usage predicts rapid appreciations that cannot be explained by standard correlates and this variable is more robustly correlated with rapid appreciations than other mortgage characteristics, including sub-prime, securitization and leverage. Where IOs were popular, their use does not appear to have been a response to houses becoming more expensive. Indeed, their use anticipated future appreciation. Finally, consistent with the reason why lenders prefer IOs, these mortgages are more likely to be repaid earlier or foreclose. Combined with our model, this evidence suggests that speculative bubbles were an important factor driving prices in cities with boom-bust cycles.JEL Classification Numbers: E0, O4, R0

Asset pledgeability and endogenously leveraged bubbles

“…These predictions are qualitatively consistent with the narratives of the recent leveraged bubble episode in the U.S., which experienced a boom in securitized mortgage and debt-financed homeownership, following a period of drastic financial innovation and deregulation (Cooper, 2009and Mian and Sufi, 2011. When asset prices began to falter in 2006, the credit boom turned into a bust, with widespread default and foreclosures Sufi, 2009 andFisher, 2011). Other leveraged bubble episodes in recent history that began with periods of easy credit and ended with financial crises include those in Japan in the 1980s and early 1990s, in East Asian economies in the period leading up to the East Asian crisis, and in Ireland in the 2000s.…”

Payment Size, Negative Equity, and Mortgage Default

“…26 Barlevy and Fisher (2010) argue that IOs are the perfect product to speculate during a bubble. An alternative type of "exotic" mortgage that was popular during the boom years was the negative amortization or "option" ARM, which allowed the borrower to make less than his scheduled monthly payment and to add the difference to the mortgage balance.…”

Payment Size, Negative Equity, and Mortgage Default

“…First, when these loans reset, the majority of them see large reductions in interest rates, as the 6-month and 1-year LIBOR as well as the constant-maturity 1-year Treasury bill rate, to which these loans are indexed when they reset 27 Barlevy and Fisher (2010) argue that IOs are the perfect product to speculate during a bubble. An alternative type of "exotic" mortgage that was popular during the boom years was the negative amortization or "option" ARM, which allowed the borrower to make less than his scheduled monthly payment and to add the difference to the mortgage balance.…”