Meet the Author

Jian Cai |

Research Economist

Jian Cai

Jian Cai is a research economist in the Research Department of the Federal Reserve Bank of Cleveland. She is primarily interested in theoretical and empirical corporate finance and financial intermediation, and empirical asset pricing. Her current work focuses on interbank competition, executive compensation, and agency problems.

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Meet the Author

Kent Cherny |

Research Assistant

Kent Cherny

Kent Cherny was formerly a research assistant in the Research Department of the Federal Reserve Bank of Cleveland.

12.08.09

Economic Trends

Supply and Demand Shocks in Residential Mortgages

Jian Cai and Kent Cherny

The current financial crisis was triggered by severe deteriorations in the U.S. real estate market and sharp increases in mortgage delinquencies and foreclosures, especially among adjustable-rate mortgages issued to subprime borrowers. Having witnessed the unprecedentedly adverse consequences of the crisis, lenders reversed the practice of making highly risky mortgage loans and now require that credit standards be followed more strictly. This shift has led to a contraction in supply of residential mortgages. In the meantime, the decline in housing prices also discouraged quality buyers from entering the market, causing a shrinkage of demand. Now that the economy may be stepping out of the recession, the residential mortgage market may also begin to recover.

The net percentage of banks reporting tightened credit standards on prime and nontraditional residential mortgages decreased by half during the past six months, according to the Senior Loan Officer Opinion Survey on Bank Lending Practices that is conducted by the Board of Governors of the Federal Reserve System on a quarterly basis. In fact, this net percentage reached its peak of 74 percent on prime mortgages in July 2008 and dropped to 24 percent in October 2009. The net percentage of banks reporting tighter credit standards on nontraditional mortgages stayed above 75 percent throughout 2008 and is now down to 30 percent.

Note that the “tightening” reported in recent quarters was based on previously elevated levels of credit standards. Thus, a smaller yet positive net percentage of banks reporting tightened credit standards means that on a net basis, incremental tightening is still occurring, but the pervasiveness of this incremental tightening has generally shown a decreasing-to-flattening trend. That is, fewer banks continue to tighten. Interestingly but not surprisingly, no more than three banks responding to the survey reported that they had originated any subprime residential mortgages in the two most recent quarters. The implications of these results are twofold. On one hand, fewer banks are reducing the availability of mortgages. But on the other hand, banks are offering financing cautiously and selectively−mortgages are likely to be going to borrowers with solid credit history and strong repayment capabilities.

Demand for residential mortgages has also gotten stronger, according to the survey. At the beginning of 2009, the net percentage of banks seeing stronger demand for prime mortgages was −10 percent, that is, there were 10 percent more banks seeing weaker demand than banks seeing stronger demand. This percentage reached 37 percent in April and stayed positive at 16 percent in July and 28 percent in October. For nontraditional mortgages, the net percentage of banks reporting stronger demand was negative throughout 2009, but it increased dramatically from −64 percent in January to −12 percent in April and further increased to −4 percent in October.

An interesting thing to note here is that when the housing market was at its peak from the middle of 2003 to 2006, commercial banks reported sharply declining demand for residential mortgages. A probable cause for that could be that more mortgages were obtained from nonbank lenders at the time, and thus, demand for borrowing from banks decreased even while the market was booming.

Three developments are stimulating the housing market’s recovery. First, the federal funds rate has been reduced to a historical low (from 5.25 percent in September 2007, to 2 percent in April 2008, then to a 0–0.25 percent range in December 2008). Second, the Fed created a program to purchase agency mortgage-backed securities and started making purchases at the beginning of 2009. It has now purchased nearly all of the $1.25 trillion limit. These two developments have helped reduce and stabilize mortgage interest rates. For the greater part of 2009, the interest rate on a 30-year fixed rate mortgage stayed between 4.75 percent and 5.25 percent.

The third development stimulating recovery is the home buyer tax credit created by the Worker, Homeownership, and Business Assistance Act of 2009. Qualified first-time home buyers are eligible for a tax credit of up to $8,000, and qualified repeat home buyers are eligible for up to $6,500. Applying to sales made between January 2009 and April 2010, the tax credit is in fact an effective reduction in house sales prices and motivates potential home buyers to enter the market.

After persistent decreases since 2006, existing single-family home sales jumped significantly in 2009−from 4 million units in January to 5.3 million units in October. There were two small dips in March and August, but sales picked up again in the next month. This steady growth is more proof of stronger demand for residential mortgage loans.

Existing home sales prices, however, tell quite the opposite story. The highest median sales price for existing single-family homes was around $230,000 during the summers of 2005, 2006, and 2007. Apart from seasonal variations in home sales prices, the median has been declining since 2007 and was $173,100 in October 2009.

New home sales show a trend similar to existing home sales (yet with a slower pace to pick up sales volume). The question is then: If the sales growth is an outcome of the economic stimulus program, does the downward trend observed in home sales prices indicate a price correction in the once overheated housing market or still insufficient demand due to a period of oversupply? If the latter, when will the housing market eventually reach its long-run equilibrium, which associates housing supply with fundamental demand? The answer awaits further evidence.