Larry White on How the Fed Contributed to the Housing Boom

I have made the case here many times that the Fed's monetary policy in the early-to-mid 2000s was inordinately loose, and as a result, helped create the housing boom. Two channels through which this accommodative monetary policy affected the housing sector is that it (1) encouraged households to take on excessive leverage and (2) created a "search for yield" environment where investors looked at investment options they normally would ignore (e.g. subprime MBS). Larry H. White in this new paper adds another channel:

The Fed’s policy of lowering short-term interest rates not only fueled growth in the dollar volume of mortgage lending, but had unintended consequences for the type of mortgages written. By pushing very-short-term interest rates down so dramatically between 2001 and 2004, the Fed lowered short-term rates relative to 30-year rates. Adjustable-rate mortgages (ARMs), typically based on a one year interest rate, became increasingly cheap relative to 30-year fixed-rate mortgages. Back in 2001, non teaser ARM rates on average were 1.13 percent cheaper than 10-year fixed-mortgages (5.84 percent vs. 6.97 percent). By 2004, as a result of the ultra-low federal funds rate, the gap had grown to 1.94 percent (3.90 percent vs. 5.84 percent). Not surprisingly, increasing numbers of new mortgage borrowers were drawn away from mortgages with 30-year rates into ARMs. The share of new mortgages with adjustable rates, only one-fifth in 2001, had more than doubled by 2004. An adjustable-rate mortgage shifts the risk of refinancing at higher rates from the lender to the borrower. Many borrowers who took out ARMs implicitly (and imprudently) counted on the Fed to keep short-term rates low indefinitely. They have faced problems as their monthly payments have adjusted upward. The shift toward ARMs thus compounded the mortgage-quality problems arising from regulatory mandates and subsidies.

Read the whole paper here.