Market adjustment and dynamic rationing

Dynamic rationing occurs when the mortgage interest rate is slow in adjusting to its long-run market equilibrium. There are several reasons why mortgage interest rates might be sticky. Lagged adjustments can arise from menu costs, convex cost functions and via imperfect competition (Heffernan 1997). Tacit collusion and second-guessing who will make the first interest rate move can all slow down the adjustment of mortgage interest rates to their long-run equilibrium. Brueckner & Arvan (1986) have noted the possibility of risk sharing between borrower and lender that results in less than full adjustment to interest rate changes, though this could result in an equilibrium state.

The usual approach to mortgage pricing/valuation is to posit that the mortgage is a combination of a non-callable bond plus the value of the options to prepay and default (Kau & Keenan 1995; Vandell 1995). These values are all determined in a perfectly competitive no arbitrage economy. Thus, there should be no credit rationing due to inappropriate pricing. Another argument against dynamic rationing is that mortgages exhibit a menu of features that can be traded-off against price, allowing the borrower to achieve equilibrium. The ARM bundles caps, frequency of the adjustment, the choice of index to which the rate is tied, fees, etc. How these features are combined effects the price of the ARM (see SA-Aadu & Sirmans 1989). Consumers may choose combinations of features of the mortgage contract that do not leave them with excess demand for mortgage debt.

Securitisation may also impact upon the prevalence of dynamic credit rationing. The tendency to standardise mortgages, for the purposes of bundling into mortgage-backed securities, may lead to an increasing uniformity of contracts. Some households might then continue to be credit rationed if their individual credit risk is not correctly priced, though this is a form of equilibrium credit rationing. However, the speed of adjustment of mortgage interest rates to exogenous shocks might be increased by securitisation. Lenders who rely on secondary market funding are obliged to pass interest rate changes to security holders quickly and not to smooth changes. Heuson et al. (2001) demonstrated how securitisation can exacerbate fluctuations in the mortgage rate. There may be less risk sharing with borrowers, but also less dynamic credit rationing.

Stiglitz & Weiss (1981) argued that lenders would be reluctant to raise interest rates if it resulted in adverse selection, that is, attracted borrowers with a high risk of default. The first lender to raise interest rates on loans might also find that the 'safer' borrowers leave first. Stiglitz & Weiss show that banks are reluctant to increase rates but readily lower them, therefore excess demand and credit rationing can arise. Thus dynamic credit rationing can emerge out of information asymmetry, and adverse selection. This emphasises that the distinction between disequilibrium and dynamic credit rationing can be arbitrary. Empirically, much depends upon the nature and speed of price adjustment Chapter 6 discusses the integration of mortgage markets with other capital markets, and the effects of this on the speed of mortgage market adjustment.

The theoretical work on the impact of down payment constraints (Stein 1995; Lamont & Stein 1999; Ortalo-Magne & Rady 1998, 1999, 2002) is difficult to place in our categorisation of credit market rationing. This is because the theories are concerned with the consequences of binding liquidity constraints rather than their cause. The theories do have implications for housing and therefore mortgage market adjustment. They predict housing booms and slumps, and over- and under-reaction to exogenous shocks such as changes in income levels. It can be shown that credit constraints amplify the effects of income shocks on the housing market, and significantly effect the timing of housing moves. Thus initial liquidity constraints may generate cycles in which the market is significantly, if temporarily, out of equilibrium, exhibiting an excess demand for mortgage credit. Insofar as house price increases facilitate meeting down payment requirements then credit rationing is endogenous to such models. Of course, any existing and binding loan-to-value ratios might reflect equilibrium rationing.

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