Mortgage Design in an Equilibrium Model of the Housing Market

Abstract

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.