Real Rate Inflation-Indexed Mortgages: A Housing Market Stabilization Proposal

Abstract

The most frequent mortgage loans in the US behave according to nominal interest rates with level loan payments (NRMs), like Fixed Rate Mortgages (FRMs) or Adjustable Rate Mortgages (ARMs). We use a model to show that the tilt effect, an increase of real payments in the early years of the mortgage due to higher inflation (Lessard and Modigliani, 1975), causes frictions and mismatches on the economy. An increase of inflation causes, ceteris paribus, housing market price drops, an increase in the ARM borrowers’ monthly housing expenses/income ratio and lenders’ losses, although neither the NPV of houses nor the expected NPV of borrowers’ income change. NRMs also badly allocate risks, as lenders of FRMs bear the risk of inflation while they do not profit from it, increasing the costs for borrowers. ARMs only solve that problem as long as borrowers do not default. We analyzed the US housing market between 1967 and 2009 and find strong evidence of the negative relationship between “inflation (and nominal interest rates) jumps” and real house prices, housing starts and new house sales. Real Rate Inflation-Indexed Mortgages (RIMs) avoid these problems, as they protect markets from inflation and allow borrowers to get loans with constant loan payments in real terms. RIMs allocate risks more appropriately and help to stabilize the economy, as market participants may have expectations about real and natural interest rates. Although many economists like W.Jevons, I.Fischer, A.Marshall, J.M Keynes, M.Friedman, F.Modigliani, J.Stiglitz or R.Shiller have advocated for inflation-indexed financial products, markets show resistance to RIMs. The slightly better outcomes of NRMs over RIMs when we analyze situations like borrower’s returns, a house price decline due to non-financial causes, a borrower’s loss of real income and a real interest rates jump, do not justify market resistance to RIMs. We finally show the benefits of combining RIMs financial products with fiscal and regulatory measures to stabilize markets.