Quantitative Easing Didn’t Ease the Housing Crisis for the Neediest

 
 
A new study by Marco Di Maggio and colleagues takes a deep dive into the efficacy of the Fed’s quantitative easing strategy to understand how the various rounds of QE affected “the real economy.”
 
 
by Carmen Nobel

Another tool to stimulate a distressed economy has made its way into the playbooks of central banks across the world.

With quantitative easing, known as QE for short, a central bank makes it easier to borrow money by buying long-term assets and driving down interest rates. In the wake of the 2008 financial crisis, for example, the Federal Reserve orchestrated multiple rounds of QE. In the initial round, QE1, the Fed bought $1.25 trillion in mortgage-backed securities and $300 billion in Treasury bonds. During QE2, the Fed purchased almost $900 billion in Treasury bonds but no mortgage-related debt. QE3 saw the Fed add a little more than $800 billion each of mortgage-backed securities and long-term Treasury debt.

“We find that such a strategy would have allowed more households in distressed areas to lower their monthly payments and extract equity from their homes at a time when a little more liquidity would have gone a long way”

A new study takes a deep dive into the efficacy of the Fed’s quantitative easing strategy, looking at how the various rounds of QE affected “the real economy”—that is, the part of the economy that includes actual goods and services, as opposed to the virtual roller coaster of the financial markets.

The findings are detailed in the paper How Quantitative Easing Works: Evidence on the Refinancing Channel, co-authored by Marco Di Maggio, an assistant professor in the Finance Unit at Harvard Business School; Amir Kermani, an assistant professor at the Haas School of Business; and Christopher Palmer, also an assistant professor at Haas.

“While most researchers have learned about QE by studying the reaction of the asset prices,” says Di Maggio, “we were more interested in whether and how the Fed’s actions actually affected household borrowing, saving, and spending decisions.”

Origination volume of refinance mortgages below and above the conforming loan limit following the first two rounds of quantitative easing, as recorded by LPS Field Services. FHA loans are excluded from the data. (Chart courtesy Marco Di Maggio)

The study focuses on how quantitative easing affected the mortgage market in the years following the financial crisis. Purchases of mortgage-backed securities had a big effect on the supply of mortgages to households across America—but with an important catch that sheds light on where and for whom QE works best.

The researchers report that the Fed’s purchases of mortgage-backed securities (instead of purely Treasuries) during QE1 resulted in an additional $600 billion of refinancing, significantly reducing interest payments for homeowners looking to refinance their home mortgages. They estimate that this led to a $76-billion increase in consumption among American homeowners. That’s laudable.

When the authors dug deeper, however, they found that while QE freed up funds for those households that were able to take advantage of dramatically lower interest rates by refinancing, it did little for the households and geographic areas that may have needed the biggest boost.

Conforming versus nonconforming

The rub lies in the difference between conforming loans and nonconforming loans.

A conforming loan is a loan that conforms to the strict guidelines of government-sponsored enterprises (GSE) Fannie Mae and Freddie Mac, which guarantee and securitize mortgage loans on the secondary market. Those guidelines include the size of the loan (currently a maximum of $417,000 for a single family home in most US cities); the amount of home equity relative to the value of the home (at least 20 percent without additional mortgage insurance); the homebuyer’s credit score, and several other standards.

The researchers found that the benefits of QE mainly accrued to conforming-mortgage borrowers, whose interest rates fell much further and had a much easier time finding a lender to refinance their mortgages than nonconforming mortgage borrowers.

Why the stark difference across market segments? “Quantitative Easing only allowed the Fed to buy conforming loans,” explains Di Maggio. “By law, with limited exception, the Federal Reserve can only purchase government-guaranteed debt. In the context of mortgages, that restricts Fed QE purchases to conforming mortgages because of their GSE guarantee.”

So, while those who refinanced during QE locked in significantly lower interest rates than their original loans, they needed to have excellent credit scores, plenty of home equity, or a whole lot of cash on hand. That was all well and good for people who were already in great financial shape. Interest rates and monthly payments went down for millions of prime borrowers, which was a tremendous boon to the overall economy, not to mention the simulative effect of many households being able to extract equity from their homes. Households refinancing in 2009 saved an average of $250 per month—or $3,000 per year—due to the lower interest rates afforded by quantitative easing, on average cashing out about $20,000 of home equity, says Di Maggio.

“But the unfortunate flip side is that QE was of much less help to the millions of homeowners who lived in areas where the steep crash in house prices left them underwater, unemployed, or with damaged credit,” he explains. “Borrowers in distressed areas tended not to qualify for the strict guidelines of conforming loans.”

Recommendations for the future

Based on their findings, the researchers suggest that adjusting GSE guidelines in concert with Fed mortgage-backed security purchases could have increased the effectiveness of QE for disenfranchised households in the wake of the financial crisis. For instance, the authors use their statistical model to simulate loosening loan-to-value ratio caps, an example of countercyclical macroprudential policy.

“We find that such a strategy would have allowed more households in distressed areas to lower their monthly payments and extract equity from their homes at a time when a little more liquidity would have gone a long way,” Di Maggio says.

About the Author

Carmen Nobel is the senior editor of Harvard Business School Working Knowledge.

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