The Transmission from Households to the Real Economy: Evidence from Mortgage and Consumer Credit Markets

Project Outcomes Statement

This award funded research examining the transmission of economic shocks through mortgage and consumer credit markets. We wrote seven papers, of which six have been already published or accepted for publication: one in the Journal of Political Economy, one in the Review of Economic Studies, one in the Journal of Financial Economics, two in the Brookings Papers on Economic Activity and one in the AEA Papers and Proceedings.

(i) Using panel data of millions of US consumers acquired with the NSF grant, we show that despite various stimulus and debt relief policies, economic recovery from the Great Recession was slow and varied dramatically across US regions. Individual and regional variation in the extent and speed of recovery from the economic crisis is strongly related to several frictions affecting the pass-through of lower interest rates and debt relief to households, including mortgage contract rigidity, refinancing constraints, and the organizational capacity of intermediaries to conduct loan renegotiations.

(ii) This evidence shows that the rigidity of mortgage contracts and a variety of frictions hindered efforts to restructure or refinance household debt in the aftermath of the financial crisis. We then focus on understanding the design and implementation challenges of ex ante and ex post debt relief solutions that are aimed at a more efficient sharing of aggregate risk between borrowers and lenders. Ex ante?designed, automatically indexed mortgages and policies can facilitate the quick implementation of debt relief during a crisis. However, the welfare benefits of such solutions are substantially reduced if there are errors in understanding the underlying structure of income and housing risk and their relation to the indexes on which these solutions are based. Empirical evidence reveals significant spatial heterogeneity and the time-varying nature of the distribution of economic conditions. The design of ex post debt relief policies can be more easily fine-tuned to the specific realizations of economic risk, however the presence of various frictions we document can significantly hamper their effectiveness.

(iii) We expand this work by studying the pandemic-era debt forbearance polices in consumer credit markets during the COVID-19 crisis. Debt forbearance allowed more than 70 million consumers with loans worth more than $2 trillion to miss their loan payments. Borrowers? self-selection is a powerful force in determining forbearance rates: relief flows to households suffering pandemic-induced shocks, many of whom would otherwise have faced debt distress. The level of forbearance we document is large enough to explain the absence of consumer defaults relative to the evolution of economic fundamentals during the pandemic. Taken together, our evidence suggests that appropriately designed consumer debt relief programs can be an important and cost-effective stabilization tool during economic downturns.

(iv) We also study the role of lenders in the transmission of monetary and regulatory shocks to households. We empirically document two adjustment margins, which are usually absent from the predominant ?bank-balance-sheet lending? view of financial intermediation: the shadow bank substitution margin, where shadow banks substitute for traditional banks among loans that are easily sold, and the balance sheet retention margin, where banks switch between balance sheet lending and selling loans based on their balance sheet strength. Estimates from a structural model show that these margins significantly shape policy responses, dampening the effect of capital requirements on lending whose costs are born by wealthier borrowers. Secondary market disruptions such as quantitative easing have significantly larger impacts on lending than capital requirements. This work indicates that a regulatory policy analysis of the intermediation sector must incorporate these two adjustment margins and the intricate industrial organization of the credit market including the equilibrium interaction of banks and shadow banks.

(v) The above implication has also relevance for debt relief polices: we show that despite uniform policy and similar borrowers, shadow banks offered debt forbearance at a significantly lower rate compared to traditional banks during the COVID-19 crisis. This highlights the fragility of shadow bank servicing during downturns that can impede the pass-through of debt relief to households.

(vi) We also study the role of financial technology in alleviating the central frictions in the housing market. We focus on ?iBuyers? who supply liquidity to households by avoiding a lengthy home sale process. Their intermediation is limited to liquid, easy-to-value homes, suggesting that iBuyers? speed induces information losses around difficult-to-observe attributes. We build and calibrate a dynamic search model with intermediaries subject to adverse selection to quantify the economic frictions of dealer intermediation in this market. The central trade-off is that providing valuable liquidity requires that transactions close quickly, but doing so results in less accurate valuation that exposes the intermediary to adverse selection. iBuyer technology provides a limited middle ground by allowing fast transactions with limited information loss, but works well only in liquid, easy-to-value houses. Although iBuyer technology facilitates liquidity provision, it only does so in segments where it is least valuable.