What Happened to Mortgage Interest Rates During the Boom?

Giorgio Primiceri, Andrea Tambalotti and Alejandro Justiniano

No 707, 2015 Meeting Papers from Society for Economic Dynamics

Abstract: Average mortgage rates fell substantially in the first half of the 2000s, suggesting the availability of generally cheaper mortgage financing. These declines might reflect several factors, including changes in (i) the conduct of monetary policy and other developments in the market for Treasuries; (ii) the pool of borrowers' characteristics; (iii) the mix of mortgage products offered by originators; and (iv) the supply of funds channeled into mortgage markets that affected rates across the board. We decompose the variation in mortgage rates between 2000 and 2007 into these four components. To this end, we analyze a large micro dataset of 3.7 million observations on mortgage loans that became part of private label securitized pools. Using a rich set of controls for loan and borrower characteristics, the term structure of yields, zip-code level variables and a flexible specification with multiple interactions, we construct the counterfactual interest rates predicted by each of the aforementioned components in isolation. Our results suggest that changes in the pool of borrowers alone should have resulted in a slight upward trend in mortgage rates, reflecting an increase in the riskiness of the average borrower. In contrast, variations in the mix of mortgage products pushed average interest rates down considerably, particularly through the growing popularity of adjustable rate mortgages, which often commanded relatively low 'teaser' rates. However, even after controlling for these developments, as well as the term structure of Treasury yields, average mortgage rates experienced a significant and rather abrupt fall in mid-2003. This decline is larger for Subprime mortgages (130 basis points) but still substantial for Alt-A and Prime products (80-90 basis points). Conversely, this component of average mortgage rates adjusts upwards suddenly in late 2006, beginning with Subprime products. Interestingly, this component co-varies closely with Gilchrist and Zakrajnek's (AER 2011) excess bond premium. This suggests that the same factors highlighted by their work in the corporate bond market, particularly the risk-bearing capacity of the financial sector, also played an important role in shifting the supply of mortgage financing. Preliminary results using over 4 million loans from an alternative database indicates a similar, albeit more modest, development amongst mortgages that were either agency securitized or retained in banks' portfolios.

Date: 2015
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