Monetary Policy, Housing, and Collateral Constraints

Abstract

In the U.S., prevailing loan-to-value (LTV) ratios in mortgage markets are not only important for house-purchasing decisions of credit-constrained homebuyers. The relative ease with which existing homeowners can extract equity from real estate additionally renders them a major determinant of mortgage equity withdrawal (MEW) decisions, a non-negligible source of U.S. household finance. As monetary policy influences house prices via its pass-through to mortgage rates it, in turn, also shifts the collateral valuation of homeowners and the required downpayments of potential homebuyers. In this paper, I raise the question as to the extent to which prevailing LTV ratios on U.S. mortgage markets affect the strength of the so-called collateral constraint channel and, thereby, the transmission of monetary policy towards the real economy. Contribution Previous research largely ignored real estate and, especially, its role as collateral in the transmission of monetary policy. By estimating a non-linear model, I allow the transmission of monetary policy in the U.S. to depend on the prevailing LTV ratio in mortgage markets. The approach takes advantage of the relatively homogeneous mortgage market throughout the U.S. and exploits time-variation in average LTV ratios. Findings from the estimation provide novel insight into a mostly unexplored monetary transmission channel. Results In times of high LTV ratios, effects of monetary policy on real mortgage credit, real house prices, real consumption of durables and non-durables, and, ultimately, on real GDP are more pronounced. Apparently, these findings can be at least partially accounted for by a stronger reaction of MEWs when LTV ratios are high. Additionally, LTV ratios in the U.S. are shown to be highly procyclical such that they can deliver a theoretical underpinning of previous findings on a less powerful transmission of monetary policy during recessions. Furthermore, non-linearities in the transmission are mostly due to contractionary shocks in line with predictions of the literature on occasionally binding constraints.

How Does Financial Vulnerability Amplify Housing and Credit Shocks?

“…First, we set c at the historical median of the original state variable, so that the resulting state spends half of the time in both regimes. Second, we calibrate θ equal to 3, in line with Tenreyro and Thwaites (2016) and Franz (2017). Our results are robust to a large range of other calibrations.…”

“…Other works study non-linear effects focusing on the propagation of monetary shocks(Aikman et al (2016(Aikman et al ( , 2017;Alpanda and Zubairy (2017);;Bauer and Granziera (2016);Franz (2017);Harding and Klein (2018); Hofmann and Peersman (2017))…”