Housing ; Housing - Prices ; Business cycles ; Monetary policy ; Consumer behavior

Brent Bundick

Gordon H. Sellon, Jr.

English

Research Papers in Economics

xxi
Housing plays an important role in modern economies. Govern-
ments around the world consider the provision of adequate and af-
fordable housing a key policy objective. In addition, housing is the 
principal asset and mortgage debt is the largest liability of most 
households across many countries. Given the prominence of the 
housing sector in most economies, changes in housing markets and 
the systems of housing finance can have significant implications for 
financial markets, macroeconomic stability, and monetary policy.  
Over the last few decades, considerable changes have occurred in 
the housing markets of many countries around the world. There has 
been a general trend toward market-based systems of housing finance, 
replacing more traditional methods that relied on specialized de-
pository intermediaries or government programs. In addition, many 
countries have experienced rapid home price appreciation and rising 
levels of household debt. These developments have raised concerns 
about the affordability of housing and concerns about the broader 
issues of financial and macroeconomic stability. More recently, rising 
defaults on subprime mortgages in the United States have affected 
investors and financial markets around the world.
Housing, Housing Finance, 
and Monetary Policy— 
An Introduction to the Bank’s 
2007 Economic Symposium
Brent Bundick and Gordon H. Sellon, Jr.xxii  Brent Bundick and Gordon H. Sellon, Jr.
To better understand the causes and effects of the recent changes in 
housing and housing finance and their implications for the economy 
and monetary policy, the Federal Reserve Bank of Kansas City spon-
sored the symposium “Housing, Housing Finance, and Monetary 
Policy” in Jackson Hole, Wyo., from Aug. 30 to Sept. 1, 2007. The 
symposium brought together a distinguished group of central bank-
ers, academic economists, and financial market participants to dis-
cuss the historical evolution and recent developments in the markets 
for housing and housing finance and their broader macroeconomic 
consequences. This introduction provides some brief background in-
formation on the three main themes highlighted at the symposium: 
changes in the structure of housing finance around the world, the 
macroeconomic dimensions of housing and housing finance, and the 
relationship of housing to monetary policy.
Changes in the Structure of Housing Finance
Presentations by Federal Reserve Chairman Ben Bernanke, Richard 
Green and Susan Wachter, and William White discussed the evolu-
tion of housing finance systems around the world. One key develop-
ment highlighted was a shift from government-based mortgage pro-
grams to market-based housing finance over the past few decades in 
many countries. While housing markets generally remain very local 
in nature, changes in the structure of housing finance have increased 
the linkages between the housing sector, financial markets, and the 
macroeconomy. Despite the increase in external influence, however, 
differences across countries still suggest that national institutional fac-
tors are important in understanding the market for housing finance. 
One of the most important structural changes in housing finance 
is securitization, a process by which individual mortgage loans are 
packaged together and used as collateral or backing for a type of bond 
called a mortgage-backed security. Prior to securitization, most mort-
gage loans were made by local depository institutions and financed 
by  deposits  at  these  institutions.  With  securitization,  mortgage   
financing can come from institutional investors, such as pension 
and mutual funds, who purchase the mortgage-backed securities. 
One  consequence  of  securitization  is  that  markets  for  housing   Introduction  xxiii
finance have become integrated with capital markets. As a result of 
the globalization of capital markets over the last few decades, financ-
ing for housing can now come from investors around the world. 
Thus,  macroeconomic  stability  and  well-developed,  long-term   
capital markets are now necessary conditions for well-functioning 
mortgage markets.  
Another implication of securitization is that the process of mort-
gage lending has been unbundled into its component functions. His-
torically, specialized mortgage lenders would originate a loan, service 
the loan (collect payments), and hold the loan in its portfolio. Now, 
all three parts of the process may be done by different institutions, 
each of whom receives payment for performing their more specialized 
function. In countries where securitization has become widespread, 
such as the United States, mortgage borrowers have experienced low-
er costs of mortgage financing. While the process of securitization al-
lows investors to spread risks across many localities and borrowers, it 
also may decrease the incentive for proper risk assessment by lenders 
and can contribute to poor underwriting and documentation stan-
dards. Much of the recent volatility in the U.S. subprime mortgage 
market stems from the uncertainty about the risks associated with 
securities backed by subprime mortgages. 
A second key feature of mortgage markets is the nature of the mort-
gage loan. Important differences across countries exist in the struc-
ture of mortgage loans. Some countries, such as the United States, 
rely heavily on long-term fixed-rate mortgages, while adjustable-rate 
loans are more prominent in other countries. A key difference in 
these mortgage types is whether the borrower or lender absorbs the 
risk of changes in market interest rates. With an adjustable-rate loan, 
the borrower’s payments adjust to changes in interest rates, whereas 
the lender absorbs the cost of adjustment for fixed-rate loans.
In recent years, there has been a proliferation in types of mortgage   
loans in U.S. markets, especially in adjustable-rate loans. Mortgages 
with interest-only introductory periods, low initial “teaser” rates, and 
negative amortization have become more popular in the low-inter-
est-rate environment of the past few years. These developments are 
closely related to the development of subprime mortgages. The luncheon   xxiv  Brent Bundick and Gordon H. Sellon, Jr.
address,  prepared  by  Edward  Gramlich,  examined  the  growth  in   
subprime lending and the policy implications of the recent problems 
that have emerged in this sector.
In the United States, mortgage loans have not traditionally been 
available to borrowers with questionable credit histories. However, 
the rising use of credit scoring in consumer lending, combined with 
other changes in lending practices in recent years, has allowed many 
borrowers to get mortgage loans who previously could not quali-
fy. Unfortunately, complicated mortgage products were offered to 
the least-educated and lowest-income borrowers in many instances. 
When interest rates on these adjustable-rate loans reset at higher lev-
els, borrowers consequently experienced sizable increases in monthly 
payments, leading to rising defaults and foreclosures. The overall in-
novation of subprime borrowing has been promising because it allows 
low-income and minority borrowers to gain access to credit markets 
for housing finance. Many symposium participants agreed, however, 
that the regulation of the subprime mortgage market needs to be ex-
panded to curtail the predatory lending, inadequate documentation, 
and uncertainty that currently plague the subprime market. 
A third important development in mortgage markets is the in-
creased ability of homeowners to access their home equity via cash-
out refinancing or home equity lines of credit. Homeowners are now 
able to better smooth their consumption by extracting equity from 
their homes. This development is likely to be especially important for 
borrowers who previously had limited access to credit and could have 
implications for overall consumer spending and saving behavior, as 
discussed in more detail in the next section.
Macroeconomic Dimensions of Housing and Housing Finance
These institutional developments in housing finance provided the 
backdrop for a broader discussion of the role of housing and housing 
finance in the macroeconomy. Presentations and discussion focused on 
three key issues: the determinants of house prices and the implication 
of house price changes for the economy, the role of the housing sector 
in business cycle developments, and the implications of house price 
changes and changes in housing finance for consumer behavior.Introduction  xxv
Over the past few decades, many countries around the world have 
experienced episodes of house price appreciation. This has occurred 
in both supply-constrained countries, such as the United Kingdom, 
and in countries with an increase in demand, such as the United 
States. Given the institutional and demographic differences across 
countries, this appreciation could be the result of significant global 
changes within housing markets, such as the liberalization in housing 
finance, but could also reflect country-specific factors. 
Robert Shiller and Christopher Mayer presented two very differ-
ent viewpoints on the cause of the recent rapid housing price ap-
preciation. Professor Shiller argued that psychology, rather than fun-
damentals such as rent or construction costs, has driven the rapid 
housing price appreciation over the past few years. According to 
Shiller, speculative bubbles, such as the most recent housing boom, 
stem from a feedback mechanism where past price appreciation in-
creases the expectation of future price increases. The feedback cycle 
of past increases on future expectations can repeat successively in the 
short run, but the bubble eventually bursts when prices finally stop 
increasing. Professor Shiller believes that large declines in real hous-
ing prices, as large as 50 percent in some areas, are entirely possible 
in the near future. 
In contrast, Christopher Mayer suggested that economic funda-
mentals such as long-term interest rates played a more important 
role in explaining the recent housing boom. Professor Mayer was not 
surprised about the emergence of the housing boom, given the global 
decline in long-term rates and price of risk. He believes psychology 
may play an important role in certain cities, where house prices are 
far out of line with their fundamental value, but argued that eco-
nomic fundamentals such as credit conditions and housing supply 
constraints matter more. 
Turning from housing prices to housing quantities, Edward Leam-
er examined the role of housing in business cycles. Leamer argued 
that residential investment plays a relatively minor role in long-run 
gross domestic product (GDP) growth but contributes heavily to re-
cessions and business cycles. In eight of the last ten recessions in the 
United States, substantial problems in the housing sector preceded xxvi  Brent Bundick and Gordon H. Sellon, Jr.
the downturn in overall GDP. Leamer noted that home prices are 
sticky downward, so the quantity of sales, not prices, must adjust 
downward during a decline in housing demand. In addition, low-
income, first-time homebuyers may experience a disproportionate 
share of the falling housing cycle, because many of these properties 
appreciated fastest. Leamer argued that the quantity of housing stock 
demanded is fairly fixed over a long period of time. Therefore, pe-
riods of overconsumption, such as the fast growth of housing con-
sumption in 2003-04, will be repaid as slower growth in 2007-08.
In his commentary on Leamer’s paper, Frank Smets took issue with 
several of Leamer’s conclusions. In particular, he emphasized that the 
ability of housing to predict recessions historically may be due to inap-
propriate monetary policies that precipitated problems in housing. He 
noted that both the economy and the housing sector had become less 
volatile in the recent environment of better monetary policy. He also 
emphasized Leamer’s point that housing is too small a share of GDP 
to cause a recession by itself; therefore, it is important to understand 
any significant spillovers from housing to the broader economy.
The third macroeconomic dimension of housing is the linkage be-
tween changes in the structure of housing finance and house price 
changes to consumer behavior. John Muellbauer provided consider-
able insight on these issues in his presentation at the symposium, 
and Sydney Ludvigson provided additional perspective in her dis-
cussion of Muellbauer’s paper. In his paper, Muellbauer provided a 
detailed discussion of the channels by which housing might affect 
consumer behavior and new empirical evidence on the magnitude of 
these channels. Muellbauer argued that the increased access to credit 
from the liberalization of housing finance and other financial mar-
kets has had important implications for consumer behavior in many 
countries. In particular, he suggested that credit market liberalization 
has raised consumption/income ratios and reduced consumer savings 
by increasing the collateral value of housing wealth. Furthermore, 
these developments have resulted in an increase in the size of housing 
wealth effects. House price changes now have larger effects on con-
sumer expenditures than changes in stock prices in some countries. Introduction  xxvii
In her commentary, Ludvigson suggested that changes in risk pre-
mia can explain much of the recent increase in house prices and are 
likely to have quantitatively larger effects on consumer spending than 
credit liberalization. She also noted that empirical work suggests that 
a future decline in house prices is likely to have only modest effects 
on aggregate consumption.
Monetary Policy Issues Associated with Housing
The remaining sessions of the symposium focused on the impli-
cations of housing for monetary policy. Frederic Mishkin provided 
a framework for this discussion by examining the transmission of 
monetary policy through the housing sector and whether changes 
in the structure of housing finance and housing markets may have 
altered the transmission mechanism for monetary policy. The wide 
range of empirical estimates of the various transmission channels 
makes accurately judging the role of housing in the transmission 
mechanism difficult. Taking this variation of estimates into account, 
Mishkin noted that housing could account for up to a quarter of the 
economy’s response to monetary policy changes.
James Hamilton’s discussion of Mishkin’s paper emphasized some 
of the regulatory and supervisory issues behind recent housing market 
developments and suggested that regulatory responses might be more 
appropriate than monetary policy in responding to the recent housing 
market crisis in the United States. The Mishkin/Hamilton session was 
followed by a panel discussion by Stefan Ingves, Kazumasa Iwata, and 
John Taylor about whether and how central banks should take housing 
developments into account in designing and implementing monetary 
policy. Martin Feldstein closed the symposium with an overview of 
the issues discussed and offered his perspective on the recent housing 
problems in the United States and their implications for policy.
Much of the monetary policy discussion in these sessions revolved 
around  the  following  three  related  issues:  whether  central  banks 
should act to restrain asset price increases, how central banks should 
respond to asset price decreases, and whether central bank policy may 
be a contributing factor to the development of asset price bubbles. xxviii  Brent Bundick and Gordon H. Sellon, Jr.
Given the linkages of housing and housing prices to other sectors of 
the economy, some participants suggested that central banks should 
react to asset price bubbles in the housing sector. A preemptive mon-
etary policy response to an inflating asset bubble might help limit 
the effects of falling asset prices when the bubble eventually bursts. 
Other participants took a contrary view, suggesting that preemptive 
action requires three necessary conditions: 1) The central bank must 
be able to identify bubbles; 2) the central bank must know how to 
deflate the bubble; and 3) monetary policy must have limited ability 
to offset the drop in asset prices after the bubble bursts. The issue of 
real-time asset bubble identification was a particular point of discus-
sion among symposium participants. Some suggested that identify-
ing asset bubbles in real time as opposed to identifying historical asset 
bubbles may be very difficult unless central banks have informational 
advantages over the financial or housing markets.
More generally, most central bank participants supported the ap-
proach outlined in a paper by Ben Bernanke and Mark Gertler pre-
sented at the 1997 symposium. In this framework, monetary policy 
only responds to asset price developments when these changes have 
implications for output and inflation. This conclusion suggests that 
asset  prices  may  provide  useful  information  to  policymakers  but 
should not be a formal target of policy.
Finally, a number of participants suggested further research into 
the cause of large asset price movements or the development of asset 
price bubbles. In particular, there was considerable discussion and 
debate about the role that low interest rates and easy credit availabil-
ity in the early part of the decade may have played in the rise in U.S. 
housing prices and the excesses that subsequently developed in U.S. 
mortgage markets.

Housing, housing finance, and monetary policy: an introduction to the Bank's 2007 Economic Symposium

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Housing, housing finance, and monetary policy: an introduction to the Bank's 2007 Economic Symposium

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