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Interest and non-interest credit rationing in the mortgage market
Journal of Monetary Economics 1 (1975) 187-201, 0 North-Holland
Publishing Company
James R. OSTAS and Frank ZAHN* Bowling Gseen State University, Bowling Green, Ohio, U.S.A.
1.
uction
Credit rationing has been viewed as both an equilibrium and a disequilibrium phenomenon. Generally, equilibrium and disequilibrium are discussed with respect to the interest rate because the interest rate is believed to be the primary equilibrating variable in the credit market. If credit is contracted at the equilibrium interest rate (determined by the supply and demand for credit), then equilibrium credit rationing exists. If credit is contracted at an interest rate where there is excess demand or supply, disequilibrium credit rationing exists. Economists have pointed out that non-interest credit terms are a means of rationing credit in disequilibrium markets. Keynes (1930) introduced the concept of non-interest credit rationing when he spoke of the ‘fringe of unsatisfied borrowers’. In testimony before the Patman Committee in 1952, Samuelson (1952) described a theory of credit rationing that emphasized both interest and non-interest credit rationing adjustments in credit markets. He argued that interest rate adjustment was sluggish. A change in supply (or demand) results in a temporary disequilibrium in the market that arises from the interest rate’s inability to move immediately to a market equilibrating level. This temporary disequilibrium is accompanied by changes in the stringency of non-interest credit requirements imposed by lenders. When the interest rate has fully adjusted, non-interest credit requirements return to their former levels. Tucker (1970) developed a formal analysis of the dynamic implications of credit rationing similar to Samuelson’s description. Guttentag (1960) and Vernon (1965) added to our understanding of loan markets by considering the possible ‘“The authors are, respectively, Assistant and Associate Professors of Economics at Bowling Green State Universit,. The former completed part of the work for this paper while on leave of absence at the Federal Reserve Bank of Boston. The authors are indebted to V. Kerry Smith, W.R. Hosek, W. WI-ite, and the referees of this Journal for their valuable comments during the preparation of this manuscript. 1\‘I.Klein, R. Marcis, E. Wicker, J. Green and R. F%ter also provided helpful pre iminary comments.
188
J.R. Ostas and F. Zahn, Interest and non-interest credit rationing
role that noa-interest credit requirements such as the downpayment ratio, termto-maturity, etc., might play in temporarily adjusting excess mortgage demand to current supply conditions when interest rates fail to perform the task. However, non-interest credit terms were not considered market equilibrating variables. In attempts to adequately account for the disequilibrium character of the mortgage market, another problem has emerged. The problem is the inability to identify mortgage credit demand and supply as both interest and non-interest credit rationing occur. Dhrymes and Taubman (1969) clearly expressed the econometric dilemma implied by disequilibrium rationing. Traditionally, in attempting to identify the structure of demand and supply, the observed quantities are considered equilibrium values that’ lie simultaneously on the demand and supply curves. It would seem that this procedure is denied to those who attempt to estimate the structure of the mortgage market under the assumption that disequilibrium rationing exists. However, we shall show that this need not be the case if non-interest credit terms, for example downpayment requirements, are viewed as market equilibrating variables. Uniike previous efforts, our model not only explains the disequilibrium character of the mortgage market with respect to the sluggish mortgage rate, but goes further to suggest that the mortgage market is not in disequilibrium with respect to non-interest credit terms. In fact, we propose Cat both disequilibrium and equilibrium credit rationing exists i.nthe market simultaneousl;l. In the short run, disequilibrium with respect to the interest rate may exist as the mortgage rate adjusts slowly to its equilibrium Ievel. However, non-interest credit terms temporarily equilibrate the market until the mortgage rate fully adjusts. Once the mortgage rate is fully adjusted, non-interest credit terms retIn-n to their longrun levels. Our model can be estimated by conventional means. We assume that observations fall simultaneously on demand and supply curves; yet, we accept the existence and InJuences of non-interest credit rationing variables. In fact, it is the very nature of their influence which allows us to make the market equilibrium assumption. The outline of the paper is as follows. In section 2 bvepresent our basic model. In section 3 we briefly critique previous empirical studies. In section 4 we present the results of our empirical analysis, while in section 5 \be discuss the implications and conclusions of our study.
2. The model
The model is restricted to the market for savings and loan (S&L) credit. It can e summarized by five equations,
(1)
LS, = LD,,
and five unknowns (LD,, LS,, R,‘, R,, and D,) where LD,
= the gross flow ofS&L mortgage credit demanded,
LSt = the gross flow of S&L mortgage credit supplied, R,
= the effective mortgage rate on newly enacted S&L loans,
K
= the lenders’ estimate of the market equilibrium mortgage rate,
4
= the downpayment ratio on newly enacted S&L loans,
effective S&L
XD, = a vector of predetermined demand variables,
xs,
= a vector of predetermined supply variables.
L D,, LS,, and D, are jointly determined ; Rr and R, are recursive.
2.1. Mortgage credit dentattd
Eq. (1) is the mortgage demand function. The demand for mortgage credit is based on utility maximizing behavior subject primarily to the cost of both internal and external financing as well as disposable income and the availability or housing. Potential borrowers will examine the effective mortgage rates among various lending institutions, primarily Savings and Loan Associations (S&Ls) and Commercial Banks (CBS). The mortgage rate (cost of external financing) charged by S&Ls is inversely related to the quantity demanded of S&L mortgage credit. Moreover, the cost of alternative sources of mortgage credit, such as the CB mortgage rate, is positively related to the demand for S&L mortgage credit. When excess supply or demand exists at the current mortgage rate, changes in non-interest credit terms (affecting the cost of internal financing) inversely influences mortgage demand. For example, given excess demand, the increascJ stringency of non-interest credit terms decrease the demand for mortgage credit. If we assume that all non-interest credit terms change in the same direction
190
J.R. Ostas and F. Zahn, Interest arid non-interest credit ratiotrittg
[Vernon (1X5)], the downpaymellt ratio can be considered a measure of noninterest credit terms.’ The decision to borrow depends not only on interest and non-interest credit terms, but the availability of housing hnd the borrowers’ disposable income. In addition to the CB mortgage rate, these are the primary predetermined variables of mortgage demand. If we assume the volume of houses for sale is proportional to housing starts, housing starts can be used as an index of the availability of housing.2 C’hanges in the availability of housing are positively related to the demand for mortgage credit. Disposable income is also positively related to the demand for housing, and therefore, the demand for mortgage credit. Formally, the mortgage demand function to be estimated is specified by
(6)
where the predetermined mortgage demand variables are the effective mortgage rate on newly enacted CB loans, C,, the number of single family housing units started in the t-ith period, II?,_~,and aggregate disposable income, Yf.3 2.2. Mortgage credit supply Eq. (2) is the mortgage credit supply function. The supply of S&L mortgage ‘The model abstracts from the complication that some borrowers may be willing to pay more than the minimum downpayment. Following Guttentag (9960), u.e assume :hat the ma&et determines oozemarket clearing downpayment ratio. This is similar to the assumption frequently made by economists that oozeinterest rate exists in credit markets. Given rising marginal costs of equity capital we would expect rising downpayment requirements to reduce the quantity of mortgage credit demanded for two reasons. First, higher costs of equity capital induces some borrowers to defer their housing purchase, thus deferring mortgage demand. Second, higher costs of equity capital will induce borrowers to purchase smaller homes which, given the downpayment ratio, results ir smaller mortgage demand. Of course, higher downpayment requirements, given the size and number of housing units king fwanced, implies a smaller loan transaction per unit financed. %ential borrowers would also consider the downpayment requirements of CBS. l-lo~vt”r, since CBS are restricted from effective competition with S&Ls in thi:; regard, the doMnp~!ment ratio sf CBS will not be included in the spe:itication of mortgage credit demand. Wousing starts, upon completion, require mortgage financing, and therefore, directly increase the demand for mortgage credit. Further, individuals who sell their csisting housing in order to buy new housing indirectly induce demand (gross) for mortgage credit when the prospective buyers of existing housing attempt to finance their purchases. 3The mortgage stuck is not included in the specification of the demand function. Previous dies [JafTee (1972)] have indicated a very slow speed of adjustment (c.g., approsimately m-rev) in the portion of the mortgage stock associated with existing loans. slow speed of adjustmel:t is due to the large costs of re-negotiating a it is set. Mortgage acquisitilons to finance the purchase of housing currently not as sluggish as the mortgage changes enacted via the re-negotiating of ~~t~ta~di~g mortgage loans. Thus, current home purchases are thought to affect currCnt INXg%gedemand.
J.R. Ostas and F. Zahn, Interest and non-inserest credit rationing
191
credit is exp?ained within the framework of a partial flow adjustment process,
LWLS,- 1
= (LSlr/LS,- J;
O
(7)
where LSF is the desired flow of S&L mortgage credit supplied and a is the partial flow adjustment coefficient. The desired flow of S&L mortgage credit depends primarily on mortgage yields, the opportunity cost of mortgage loans and the capability of S&Ls to make available new mortgage loans. In addition to the lagged value of the flow of mortgage credit, the latter are the predetermined supply variables. Portfolio adjustment considerations imply that the net yield on mortgage loans positively influences the desired quantity of mortgage credit supplied. The mortgage rate positively affects the gross yields from mortgage loans and thereby the difference between gross yields and the opportunity cost of contracting mortgage loans. Further, the downpayment ratio positively affects net yields, and therefore, the supply of mortgage credit since increases (decreases) in the downpayment ratio reduces (increases) the expected default risk associated with mortgage loans.4 The opportunity cost of mortgage loans to S&Ls is the interest rate paid on government bonds. As the government bond rate increases (decreases) the supply of mortgage credit is expected to decrease (increase).’ The capability of S&Ls to extend mortgage credit is reflected in S&L deposit levels and repayments. 6 As deposit and rep.;yment levels increase (decrease) the capability of S&Ls to supply mortgage credit increases (decreases,). Furthermore, the greater the amount of funds already allocated to past mortgages, i.e., the stock of mortgage loans held, the less the amount of additional mortgage credit S&Ls are in a position to extend. ‘In a study of FHA mortgage loans of von Furstenburg (1970) it was found that the probability of loan default rises sharply as the downpayment ratio falls. Further, he discovered that the downpayment ratio far exceeded other mortgage terms, borrower characteristics, and collateral characteristics in determining loan default rates. This is not surprising in that low downpayments imply that the borrowers may default because of large monthly payments. Also low downpayments imply high outstanding loan balances such that the possibility of the collateral property’s value falling below the value of the loan becomes significant. This situation increases the possibility that the borrower will default in a period of economic crisis and, given that default takes place, the loss to the lender as the value of the outstanding loan exceeds the value of the collateral property. “Alternatively, the cost of borrowing at the Federal Home Loan Bank, the borrowing rate, might be considered the opportunity cost of mortgage loans. However, WCwill :~ssumc that the borrowing rate is proportional to the government bond rate. Hence, it need not be in&did in our specification of mortgage supply. 6Foliowing Sparks (1967), Huang (1966), and others, we will consider S&L deposit liabilities as an exogenous variable. This assumption is based on the existence of deposit rate ceilings and the asymmetrical maturity structure of S&L assets and liabilities, i.e., S&Ls borrou, ‘short’ at-id tend ‘long’ [Kendall (1964) and Klein (1972)]. Further, the sluggish Jeposit adjustment behavior characterizing S&L deposit customers implies that S&L deposit levels are determined more by past influences rather than current influences [Silber (197O)l.
192
J. R. Osras ard F. Zahrt, Interest atld mmirtterest credit ratiorrirlg
Formally, the desired mortgage supply function is specified by Ls;
=
NC, D,, G,, VJ,, W-,1;
(8)
9; > 0, g; > 0, g; < 0, g; > 0, g; > 0, g;, c 0, where the predetermined subply variables are the government bond rate, C;,, S&L deposit liabilities, V,, S&L mortgage credit repayments, Z,, and the lagged stock of outstanding S&L mortgage credit, M,_ 1. Substituting eq. (8) into (7) and solving for LS, gives LS, = (g(R,, D,, G,, K, z,, W- #W%?
(9)
the mortgage supply function from which the estimates of the supply parameters are obtained. 2.2. Equilibrium in the mortgage market Eq. (5) specifies the market clearing condition of the model and it must be interpreted for both short-rtn and long-run behavior. In the short run, the downpayment ratio clears, the mortgage market when excess demand or supply exists at the current mortgage rate. In the long run, the mortgage rate adjusts to a market equilibrating level and the downpayment ratio falls back to i;s long run level. The downpayment ratio is assumed to instantaneously adjust to market clearing levels, while the mortgage rate adjusts with a lag. 2.4. Mwtgage rate adjustmcwt
Eq. (3) summarizes the determinants of the mortgage rate. The mortgage rate adjustment is explained within the framework of a partial adjustment process. assume that the mortgage rate adjtasts slowly to its equilibrium level due to ic and governmental alienation of S&Ls that could result from large, tion drawing changes in the mortgage rate [Vernon (1965)]. In addition, ministrative costs of the changes may lead S&Ls to balance the opportunity ot changing the mortgage rate to its equilibrium level against the cost ge, especially if there is uncertainty about future market equilibrium Leeuw-Gramlich (1969) and Griliches (1967)]. If we assume that S&Ls e current mortgage rate so as to minimize cost, the mortgage rate stment process may be specified by
ML
1
= VW,- alb;
3<
6 < I,
(10)
is the lenders’ estimates of the equilibrium mortgage rate and 6 is the artial adjustment. ly a reduced-form expression for the equilibrium mortgage
J. R. Ostas und F. Zahn, Itlterest atd rron-itltemst credit rationby
193
rate where the equilibrium rate is that which equilibrates the markct when the downpayment ratio is at its long-run level.7 It states that the lenders’ estimate of the equilibrium mor,&age rate depends on the predetermined variables of mortgage demand and supply. We assume that lenders’ estimate ofthe equilibrium mortgage rate closely approximates the actllal equilibrium rate. C’hanges in the predetermined variables of either supply or demand displace equilibrium in the mortgage market and the downpayment ratio adjusts instantaneously to clear the market. The downpayment ratio continues to clear the market of remaining excess demand and supply until the mortgage rate fully adjusts to its market equilibrium level, and then returns to its long-run level. For example, assume that an initial long-run equilibrium position in the mortgage market is displaced when an increase in disposable income increases mortgage demand. This creates excess mortgage credit demand at the initial value of the mortgage rate. If the mortgage rate were completely flexible it would rise to eliminate excess demand and thereby ration mortgage credit in equilibrium. The downpayment ratio would remain at its long-run level. However, since the mortgage rate is sluggish in adjusting to its market equilibrating rate the downpayment ratio will increase to clear the market of excess demand in the short run. Equilibrium rationing occurs with respect to the downpayment ratio, but disequilibrium rationing occurs with respect to the mortgage rate. The downpayment ratio continues to clear the market until the mortgage rate increases to its market equilibrium value, and then falls back to its long-run level. Thus, the outcome of the adjustment process approaches the outcome of the traditional view of the mortgage market. Although in the short run the downpayment ratio alone clears the market, in the long run the mortgage rate equilibrates the market at a level consistent with the long-run downpa}‘ment ratio. 3. Previous empirical studies Previous empirical studies [Brady (1967), de Leeuw-Gramlich (1969), Huang (1966), Silber (1970), Sparks (1967), and Smith (1969)] have introduced non-interest credit terms as a means of accounting for non-interest credit rationing effects.8 However, the variables were simply treated as predetermined ‘Our model explains the short-run value of the do\vnpayment ratio and assumes that the long-run value is constant over the period of analysis. This may not be strictly accurate, but it simy,.ifies our analysis without doing injustice to substnntiv~ short-run issucc. The assumption is consistent ivith our specified system. Accordin, (I to the discussion of eq. (3), \x,hen interest equilibrium is reached it will be at an interest rate which clears the market when the do\vnp?yment ratio is at its long-run level. At this point, the long-run level of the downpayment ratio also satisfies eq. (5) since the market is cleared and mortgasc demand equals mortgage supply. *In one of the tirst econometric studies, Sparks (1367) avoided the fundaniental credit rationing issue by assuming that both interert and non-interest credit terms move together. This assumption allotted him to conceptunlizc a composite credit term variable. But, Sparhs did not cbtnin strustural estimntcs ofmortgage demand.
194
J. R.. Osfas and F. Zah, Interest and non-infJ*restcredit rationing
explanatory variables and therefore ;;re subject to simultaneous equation biasa oreover, since the estimate of their supply and demand functions are based on the assumption of market equilibrium with respect to the interest rate, previous estimated models are logically inconsistent when they use non-interest credit terms as measures of disequilibrium rationing. ’ ’ ng (1966) was the first to analyze explicitly the disequilibrium character mortgage market. He assumed that changes in the mortgage rate are ortional to excess mortgage supply and was able to examine the diseq~~~~br~urn growth path of the mortgage rate. However, in estimating his adjustent equation pe assumed that observed quantities fall on the mortgage demand e and not din the supply curve. Thus, his estimates are inconsistent with that of mortgage supply where he assumed the observed quantities fall on the supply e primary problems with previous empirical studies is an inability to supply and demand and at the same time account for disequilibrium g. Jaffee (1972) was the first to adequately address himself to the s of doing both. * 1 He assumed that the observed quantities lie on the ortgage supply curve, and then estimated the mortgage demand curve intrectly from the estimation of a mortgage rate adjustment equation where the ortgage rate is a function of the observed quantity of mortgage credit, the tgage rate lagged one quarter, and the variables in the demand equation r than the mortgage rate itself). 1 2 But, if the ‘sluggish’ mortgage rate Ted the yield differential on mortgages and bonds to represel:t non-interest s. Silber (1970) used the length of amortization in his residential conmand equation and loan-to-property ratio in his mortgage supply equation to non-interest credit rationing effects. nd that the length-of-amortization variable was signi&zant in his housing demand urprisingly, not significant in his mortgage demaad equation. This unexpected butable to the endogenous character of credit rationing, thus biasing his d expect that the non-interest measures of credit availability used by Smith endogenously determined by contemporaneous mortgage demand and ese non-interest measures would, in turn, be correlated with the error terms present in the demand and supply equations resulting in asymtotically biased coeficient 61969) assumes mortgage demand equals mortgage supply when estimating his rate equation. Silber (1970) makes a similar assumption in the estimation of his multi. These assumptions are inconsistent with Smith’s u:se of non-interest credit “:esin his housing starts equation and Silber’s use of such terms in his residential T1heFRB-MIT [de Leeuw-Gramiich (1969)J estimates assumed that all observed quantities ng demand curve. However, if borne buyers cannot obtain their desired credit e rates (i.e., non-interest credit rationing prevails) then the buyers will not and curve and the FRB-?rAIT estimates will be incorrect. here QI is observed quantity of mortgage credit, predetermined demand variables. In equilibrium ated equation can be solved for LD, in terms of he mortgage demiand curve.
J. R. Ostas and F. Zahn, Merest
and non-iuwest
credit ratiorGg
19.5
happens to be above the equilibrium rate one would expect that the observations would fall on the demand curve rather than the supply curve, Jaffee dismisses this possibility with the argument that throughout most of his sample period the change in the interest rate was non-negative. Thus, the actual mortgage rate was either below the equilibrium rate or at the equilibrium rate. Jaffee’s study is consistent in that once he posits disequilibrium, he does not attempt to estimate demand and supply from the same set of quantity observations. In general Jaffee’s assumption will not be able to be used. His model requires ac objective means of analyzing the market to determine whether one is actually in a supply ‘regime’ (as Jaffee assumed to be true for his period of study) or a demand ‘regime’. ’ 3 Fair and Jaffee (1972) suggested procedures for determining whether the market is in a ‘demand regime’ or ‘supply regime’. These procedures utilize the directiorz of interest rate change to determine the condition of the market. If observed changes in the mortgage rate are negative, the market is in a ‘demand regime’ and excess supply exists. If observed changes in the interest rate are positive, the market is in a ‘supply regime’ and excess demand exists in the market. Once the observations have all been classified with respect to being demand or supply determined, ordinary least squares are used to estimate demand and supply schedules. Only demand based mortgages rates and quantities are used to estimate the demand schedule. A similar procedure yields estimates of the supply schedule. Fair and Jaffee also attempt to estimate disequilibrium markets by utilizing the quantitative assumption that positive (negative) interest rate changes are proportional to unobserved excess demand (supply). Consequently, they estimate the unobserved portion of the demand schedule by regressing observed quantities on the determinants of demand and on current mortgage rate changes. Such changes act as proxies for unobserved excess demand. There are problems with the Fair-Jaffee approach. First, their ‘directional’ approach to estimating disequilibrium results in inconsistent coefficient estimates, ’ 4 and in their ‘quantitative’ approach the coefficient constraints on the mortgage rate change variable (equality) across demand and supply equations preclude their use of conventional simultaneous equation estimation. Second, in terms of efficiency, structural specification of disequilibrium processes (like the one used in our study) are preferable to general techniques. The Fair-Jaffee technique ignores the specific means by which lenders ration mortgage credit 13A demand ‘regime’ would be time periods when interest rates were above the market cleating level and, thus, where observations fall on the demand curve rather than the supply curve. “AS Fair and Jnffee explain, if demand is estimated only in a ‘demand regime (i.e., when excess supply exists and demand is relatively small), then \ve might expect large kxlues of exogenous demand determinants to be associated vAth small values of the demand relationship’s error term.
196
J. R. Ostas and F. Zaht, Irrtcrcst and non-in ferestcredit ratiotnhg
when markets are in disequilibrium with respect to the mortgage rate. By the omission of nun-interest credit variables they overlook the incidence of rationing as well as the potential effect of non-interest rationing variables on the supply and demand for mortgage credit. Also, mortgage rate changes may not measure theextentofdisequilibrium but simply the impact such changes have on borrowers’ expectations. Structural measures of market disequilibrium may serve as good a proxy for excess demand and yet not incorporate expectational influences. 4. Our empirid results We estimated mortgage demand and supply, eqs. (6) a:ld (9). Monthly data were used (see the Data Appendix) for the sample period beginning January 1965 through June 1971. Since both equations were over-identified, a simultaneous equation estimator is appropriate. The two-stage least-squares estimator was selected because it corrects for simultaneous equation bias and gives consistent estimates of the parameters. The instruments, i.e., th-: first-stag: regressors, were obtained for both the downpayment ratio and the mortgage rate. The first-stage variables in each case were the predetermined variables in the supply and demand equations. However, the mortgage rate instrument was obtained with one additional first-stage variable, the lagged mortgage rate, according to the specifications of eqs. (4) ani (lo), R; =
Wda-,,
JWb-
1 =
(RF/R,_
Y,, G,, KZ, $;
Mt-I,LS,_l),
0 < b < 1..
w
The mortgage rate is predetermined to the suppIy and demand equations in the sense that it recursively influences the supply and demand for mortgage credit. However, the mortgage rate is assumed to adjust slowly to a market clearing level, and the lenders’ estimate of the market clearing level would be a function of not only predetermineld supply and demand elem,nts, but also stochastic supply and demand elements. It follows that the mortgage rate is correlated with e stochastic elements of the supply and demand for mortgage credit. 1 ’ In order to avoid severe problems of multicollinearity, the interest rates in the artgage supply and demamd equations were estimated as ratiosI We thereby slug@shmortgage rate adjustment process implies that the error term of the mortgage ion is correlated with the error terms of the supply and demand equations. Therefore, ce-covatiance matrix of error terms is not diagonal. And the use of a first stage instrumena for the mortgage rate is an appropriate means of obaainin,g consistent estimates of the demandand supply equations [Basmann (1963), Mosback-Wold (19701, Strotz-Wold ve government bond rates were used in the regression analysis, But the one-year e yrelded the best results. Since 3&I-s concentrate their bond portfolio on short-term their appropriate epportunity ctist is related to a short-term rate
J. R. Ostm attd F. Zah, Interest and non-interest credit rationing
197
constrained the elasticities of the demand rates to be equal in absolute value, but opposite in sign. Similarly the elasticities of the supply rates were constrained, The preferred form of the estimated demand and supply equations is log linear. 1 7 The results are as follows: In LD, = - 0.9701 In D, - 3.9746 In (R/C), -t-0.7497 In fit_ (-
3.2989)
(- 2.9692)
f0.7235 In Yt; (5.2937)
1
(1 I-2903)
A2 = 0.7555,
SE. = 0.1520,
(6)
In LS, = - 12.2408 + 2.3564 In D, + 0.4635 In (X/G), (- 4.0308) (2.5924) (4.0347) f6.7105 In V,+1.1997 In&-5.2999 In i&Z,,1 (3.8120) (3.0484) (8.1033) +0.4751 In LS,_ 1; (6.8306)
R2 = 0.8625,
S.E. = 0.1138, (9)
The signs of the estimated coefficients were as expected and significant at the 0.05 level. ’ ’ The R”s are adjusted for degrees-of-freedom and indicate a reasonably good fit to the data. The results obtained from the estimated equations are particularly interesting because a point often overlooked is statistically supported by the estimate of the supply equation. That is, non-interest credit terms influence mortgage supply as well as mortgage dernand. Furthermore, the estimates show that the supply and demand curves for mortgage credit can be identified by conventional means even when there are sluggish adjustments in interest credit terms. Based on the first-stage regressor, the partial adjustment coefficient, b, in the mortgage rate adjustment eq. (10) is 0.4292. Hence, about 43 percent of the mortgage rate adjustment takes place within a period of one month. Further, the
“For _Gnplitkation purposes the adjustment equations specified in the previous section of this paper were assumed at the outset to be exponential in form. This is consistent with the preferred forms of the estimated equations. ‘*The constant term in the demand equation was suppressed since it was not significantly different from zero at the 0.05 level. R2 is the coefficient of determination adjusted for degreesof-freedom and SE. is the standard error of the regression estimate. The values in parenthesis are the r-ratios. The Durbin-Watson statistics of the demand and supply curves are 1.3428 and I .7603, respectively. However, the Durbin-Watson statistic, as well as other means of measuring possible auto-correlation, arc at best difficult to interpret when using a simultaneous equation estimator. F
J.R. Ostas and F. Zah, Interest and non-interest credit rationing
second-stage regressor shtows that the partial flew adjustment coefficient, a, in the supply eq. (9) is 0.5249. Hence, about 52 percent of the adjustment by S&Ls to their desired flow of mortgage credit takes place within a period of one month. 5. Codding
remarks
Thz major conclusion implied by this study is that it is possible to satisfactorily estimate mortgage demand and supply relationships in spite of the disequilibrium character of the mortgage rate and the attendent non-interest credit rationing influences. Accordingly, this study has suggested a theory of interaction in the mortgage market which explains both equilibrium non-interest credit rationing and disequilibrium mortgage rate movements. The theory is supported by appropriate statistical tests. The results of this study imply that structural estimates of mortgage demand and supply which fail to include non-interest credit terms may be subject to serious specification error. The results also imply that the orthodox Keynesian transmission channels by which monetary policy affect the economy through the interest rate’s impact on investment decisions must be supplemented by consideration of the transmission effects working through non-interest, i.e., availability influences. Studies which indicate interest inelastic investment behavior now provide leti compelling arguments for monetary policy’s weakness, particularly in mortgage and housing markets. Paradoxically. this study in]>liesthat the more flexible the mortgage rate, the less it is necessary for non-inte:*est credit stringency to clear the mortgage market. Consequently, as observed by the recent (1971-72) experience of high-interest rates and ‘easy’ non-interest credit terms, the ‘cost’ and ‘availability’ of credit may move in the same direction. Further, this study lends support to those who argue that stringent monetary policy is ‘discrimi.natory’ in its impact. In particular, the evidence cited implies that a restrictive monetary policy which diminishes the credit supply of intermediaries tends to affect those borrowers seeking low downpayment loans, And since theoretical analysis and Iempirical evidence suggest that borrowers desiring few downpayment loans are borrowers with relatively low asset positions [Muth (1962)], it can be concluded that a ‘tight’ monetary policy i\ill have a differential impact within the mortgage market. The incident of such impact will fall most frequently on borrowers with low non-human wealth positions, Finally, the fact of non-intiierest rationing implied by this study indicates that monetary policy may be a useful policy tool without necessitating the disruptive effects of large interest rate movements. Recently, Duesenberry (1969) speculated t the greater the amount of non-interest rationing taking place in the nation’s ancial markets, the greater the ‘elbow room’ there is for monetary policy to rate without requiring large destabilizing interest rate movements.If monetary policy were to operate solely through the: interest rate transmission channel the
J.R. Ostas and F. Zuhtr, Interest and non-interest credit rationhg
199
necessary range in the vaTi”+’ uclon of interest rates needed to effect a given investment spending target might be so great that such policy could be precluded from the policy maker’s itinerary of feasible economic tools. This would be particularly the case with the attendent effects on the bond and stock markets. Data appendix Unless we specify differently, all data series used are seasonally unadjusted, monthly observations. All data series begin January 1965 and end June 1971. The sources of the data are issues of: (1) The Federal Reserve Bzrllctin, published by the Federal Reserve Board, Washington, D.C. (2) Housing and Ut-ban Development Trends, published by the U.S. Department of I-lousing and Urban Development, Washington, D.C. (3) The Federal Howe Loan:Bank Board News, published by the Federal Home Loan Bank Board, Washington, D.C. (4) U.S. S’nrirz~.sand Loart Fact Book, published by the U.S. Savings and Loan League, Chicago, III. Any adjustments or additions will be explained in the text which follows* The S&L mortgage credit series and the housing start series were taken from issues of Housing and Urban Developmerlt Trends, January 1968, June 1970 and September 197 1. The mortgage credit data is in millions of dollars and refers to those loans associated with the purchase of owner-occupied, existing housing. S&Ls specialize in this type of loan. Thus, this series is considered an appropriate representation of their lending activity. The housing start data is in thousands gf single-family, private units. Interest and non-interest credit terms data was obtained partly from the issues of the Fcdcrnl Home Loan Bank Board News, 1968 through 1971. The corresponding 1965 through 1967 data was obtained directly from the Federal Home Loan Bank Board. Downpayment ratios were derived from the loan to price ratio data. The mortgage interest rate series refers to effective interest rates rather than contract interest rates. All credit term data are expressed in percentages and refer to non-insured loans associated with the purchases of existing housing. The terms associated with new home loans were not used because they are often agreed upon through the mortgage commitment process some months prior to the actual disbursement of the loan funds, and therefore, may not adequately represent the contemporaneous conditions of the mortgage market. The S&L deposit series, S&L mortgage stock series, and the government bond rate series were all collected from issues of the Federal Rescrw Bulletin, November 1965, July 1966, April 1967, and February 1968 through February 1972. The bond rate is expressed as a percent and refers to the market yield (daily average over a month) on 9-12 month issues. The S&L deposit and mortgage stock data are expressed in billions of dollars and refer to end-of-period levels. The deposit data were lagged one month throughout the study. The disposable income series is expressed in billions of dollars and was
200
J.R. Ostas and F. Zahn, Interest and norl-interest credit rationing
obtained from the Federal &serne Bulletin, h’ovember 1945, April 1967, and February 1968 through FTebruary 1972 issues. The monthly data were derived from quarterly data by means of IikYearinterpolation. Finally, the S&L mortgage loan repayment series was obtained from the U.S. Savings and Loan Fact Book, 1967 through 1971 issues. The series is expressed in millions of dollars. The six months of the 1971 portion of the series was not available from the initiall source and the information for those months was obtained by splicing the original rlepayment series with similar repayment information obtained from Table 2 of the Federal Home Loan Bunk Board News, !kptember 1971. The splicing of the: series was performed by calculating the monthly percentage change in the new series and assuming the same monthly percentage ch.ange carried over to the original repayment data series.
Ijasmann, R.L., 1963, The causal interpfietation or non-triangular systems of economic relations, Econometrica 31,, Yuly, 419448. Body, E.A., 3967, A sectoral econometric study of the postwar residential-housing market, The Journal of Political Economy 75, April, 147-158. Leeuw, F. and E.M. Gramlich, 1969, Tube channels of monetary policy, Federal Reserve Bulletin, June, 472391. Dhrymes, P.J. and P.J. Taubman, 1’69, An empirical analysis of the savings and loan industry, in: I. Friend, Study of the savings and loan industry, vol. 1 (Federal Ho:,,e Loan Bank Board, Washington) 69-l 83. Duesenbgrry, J.S., 1969, Policy effects on thrift institutions, in: Savings and Residential Financing 1969 Conference Proceedings (United States Savings and Loan League, Chicago) 134144. Fair, RX., 19711,Disequilibrium in housing models, Research Memorandum no. 132 (Princeton University Princeton). Fair, R.C. and D.M. Jaffee, 1972, Methods of estimation for markets in disequilibrium, Econometrica 40, May, 497-514. Griliches, Z., 1967, DistributedI lags: .4 survey, Econometrica 35, Jan., 16-48. Gtitentag, J.M., 1960, Credit availability, interest rates, and monetary policy, The Southern Economic Jounral26, Jan., 219-229. g, D.S., 1966, The short run flows of n(,)n-farm residential mortgage credit, Econometrica April, 433-459. D.M., 1972, An econometric model of the mortgage market: Estimation and simulation, m: E. Gramlich and D.M. Jaffee, eds., Savings deposits, mortgages, and housing (D.C. e savings 2nc1 ..” ludn ‘-- business (Prentice-Hall, Englewood Cliffs, N.J.). A treatise Ionmcrrey (Macmillan, London). ., 1972, On the causes and consequencec of saving and loan deposit rate inflexibility, urnal of Finance 27, March, 79-87. , E.J. and H-0. Weld, 1970, Interdependent systems (North-Holland, Amsterdam). ,1962, Interest rates, contract terms and the allocation of mortgage funds, The Journal Finance 17, March, 63-80. P.A., 1952, Heariags before the Sclbcommittee on General Credit Control and Debt ment of the Joint Committee on the Economic Report, 82nd Congress, 2nd Session Printing Ofice, Washington,, D.C.) 691-698. rtfofio behavior of financial institutions (Holt, Rinehart and Winston, ,1930,
J.R.Ostas and F.Zahn, Interest and non-interest credit rationing
201
Smith, L.B., 1969, A model of the Canadian housing r,nd mortgage markets, The Journal of Political Economy 77, Sept., 795-816. Sparks, G.R., 1967, An econometric analysis of the role of financial intermediaries in postwar residential building cycles, in: R. Ferber, ed., Determinants of investment behavior (National Bureau of Economic Research, New York) 302-324. Strotz, R.H. and H.O. Wold, 1960, Recursive versus nonrecursive systems: An attempt at synthesis, Econometrica 28, April, 417-427. Tucker, D.P., 1970, Credit rationing, interest rate lags and monetary policy speed, The Quarterly Journal of Economics 84, Feb., 54-83. U.S. S&L League, 1972, Savings and Loan Fact Book (United States Savings and Loan League, Chicago) 96. Vernon, J.R., 1965, Savings and loan association response to monetary policies, 1953-61: A case study in availability, The Southern Economic Journal 31, Jan., 229-237. von Furstenburg, G.M., 1970, Risk structure and the distribution of benefits within the FHA home mortgage insurance program, The Journal of Money, Banking and Credit 2, Aug., 303-322. Wold, H.O., 1960, A generalization of causal chain models, Econometrica 28,443-463.
Publishing Company
James R. OSTAS and Frank ZAHN* Bowling Gseen State University, Bowling Green, Ohio, U.S.A.
1.
uction
Credit rationing has been viewed as both an equilibrium and a disequilibrium phenomenon. Generally, equilibrium and disequilibrium are discussed with respect to the interest rate because the interest rate is believed to be the primary equilibrating variable in the credit market. If credit is contracted at the equilibrium interest rate (determined by the supply and demand for credit), then equilibrium credit rationing exists. If credit is contracted at an interest rate where there is excess demand or supply, disequilibrium credit rationing exists. Economists have pointed out that non-interest credit terms are a means of rationing credit in disequilibrium markets. Keynes (1930) introduced the concept of non-interest credit rationing when he spoke of the ‘fringe of unsatisfied borrowers’. In testimony before the Patman Committee in 1952, Samuelson (1952) described a theory of credit rationing that emphasized both interest and non-interest credit rationing adjustments in credit markets. He argued that interest rate adjustment was sluggish. A change in supply (or demand) results in a temporary disequilibrium in the market that arises from the interest rate’s inability to move immediately to a market equilibrating level. This temporary disequilibrium is accompanied by changes in the stringency of non-interest credit requirements imposed by lenders. When the interest rate has fully adjusted, non-interest credit requirements return to their former levels. Tucker (1970) developed a formal analysis of the dynamic implications of credit rationing similar to Samuelson’s description. Guttentag (1960) and Vernon (1965) added to our understanding of loan markets by considering the possible ‘“The authors are, respectively, Assistant and Associate Professors of Economics at Bowling Green State Universit,. The former completed part of the work for this paper while on leave of absence at the Federal Reserve Bank of Boston. The authors are indebted to V. Kerry Smith, W.R. Hosek, W. WI-ite, and the referees of this Journal for their valuable comments during the preparation of this manuscript. 1\‘I.Klein, R. Marcis, E. Wicker, J. Green and R. F%ter also provided helpful pre iminary comments.
188
J.R. Ostas and F. Zahn, Interest and non-interest credit rationing
role that noa-interest credit requirements such as the downpayment ratio, termto-maturity, etc., might play in temporarily adjusting excess mortgage demand to current supply conditions when interest rates fail to perform the task. However, non-interest credit terms were not considered market equilibrating variables. In attempts to adequately account for the disequilibrium character of the mortgage market, another problem has emerged. The problem is the inability to identify mortgage credit demand and supply as both interest and non-interest credit rationing occur. Dhrymes and Taubman (1969) clearly expressed the econometric dilemma implied by disequilibrium rationing. Traditionally, in attempting to identify the structure of demand and supply, the observed quantities are considered equilibrium values that’ lie simultaneously on the demand and supply curves. It would seem that this procedure is denied to those who attempt to estimate the structure of the mortgage market under the assumption that disequilibrium rationing exists. However, we shall show that this need not be the case if non-interest credit terms, for example downpayment requirements, are viewed as market equilibrating variables. Uniike previous efforts, our model not only explains the disequilibrium character of the mortgage market with respect to the sluggish mortgage rate, but goes further to suggest that the mortgage market is not in disequilibrium with respect to non-interest credit terms. In fact, we propose Cat both disequilibrium and equilibrium credit rationing exists i.nthe market simultaneousl;l. In the short run, disequilibrium with respect to the interest rate may exist as the mortgage rate adjusts slowly to its equilibrium Ievel. However, non-interest credit terms temporarily equilibrate the market until the mortgage rate fully adjusts. Once the mortgage rate is fully adjusted, non-interest credit terms retIn-n to their longrun levels. Our model can be estimated by conventional means. We assume that observations fall simultaneously on demand and supply curves; yet, we accept the existence and InJuences of non-interest credit rationing variables. In fact, it is the very nature of their influence which allows us to make the market equilibrium assumption. The outline of the paper is as follows. In section 2 bvepresent our basic model. In section 3 we briefly critique previous empirical studies. In section 4 we present the results of our empirical analysis, while in section 5 \be discuss the implications and conclusions of our study.
2. The model
The model is restricted to the market for savings and loan (S&L) credit. It can e summarized by five equations,
(1)
LS, = LD,,
and five unknowns (LD,, LS,, R,‘, R,, and D,) where LD,
= the gross flow ofS&L mortgage credit demanded,
LSt = the gross flow of S&L mortgage credit supplied, R,
= the effective mortgage rate on newly enacted S&L loans,
K
= the lenders’ estimate of the market equilibrium mortgage rate,
4
= the downpayment ratio on newly enacted S&L loans,
effective S&L
XD, = a vector of predetermined demand variables,
xs,
= a vector of predetermined supply variables.
L D,, LS,, and D, are jointly determined ; Rr and R, are recursive.
2.1. Mortgage credit dentattd
Eq. (1) is the mortgage demand function. The demand for mortgage credit is based on utility maximizing behavior subject primarily to the cost of both internal and external financing as well as disposable income and the availability or housing. Potential borrowers will examine the effective mortgage rates among various lending institutions, primarily Savings and Loan Associations (S&Ls) and Commercial Banks (CBS). The mortgage rate (cost of external financing) charged by S&Ls is inversely related to the quantity demanded of S&L mortgage credit. Moreover, the cost of alternative sources of mortgage credit, such as the CB mortgage rate, is positively related to the demand for S&L mortgage credit. When excess supply or demand exists at the current mortgage rate, changes in non-interest credit terms (affecting the cost of internal financing) inversely influences mortgage demand. For example, given excess demand, the increascJ stringency of non-interest credit terms decrease the demand for mortgage credit. If we assume that all non-interest credit terms change in the same direction
190
J.R. Ostas and F. Zahn, Interest arid non-interest credit ratiotrittg
[Vernon (1X5)], the downpaymellt ratio can be considered a measure of noninterest credit terms.’ The decision to borrow depends not only on interest and non-interest credit terms, but the availability of housing hnd the borrowers’ disposable income. In addition to the CB mortgage rate, these are the primary predetermined variables of mortgage demand. If we assume the volume of houses for sale is proportional to housing starts, housing starts can be used as an index of the availability of housing.2 C’hanges in the availability of housing are positively related to the demand for mortgage credit. Disposable income is also positively related to the demand for housing, and therefore, the demand for mortgage credit. Formally, the mortgage demand function to be estimated is specified by
(6)
where the predetermined mortgage demand variables are the effective mortgage rate on newly enacted CB loans, C,, the number of single family housing units started in the t-ith period, II?,_~,and aggregate disposable income, Yf.3 2.2. Mortgage credit supply Eq. (2) is the mortgage credit supply function. The supply of S&L mortgage ‘The model abstracts from the complication that some borrowers may be willing to pay more than the minimum downpayment. Following Guttentag (9960), u.e assume :hat the ma&et determines oozemarket clearing downpayment ratio. This is similar to the assumption frequently made by economists that oozeinterest rate exists in credit markets. Given rising marginal costs of equity capital we would expect rising downpayment requirements to reduce the quantity of mortgage credit demanded for two reasons. First, higher costs of equity capital induces some borrowers to defer their housing purchase, thus deferring mortgage demand. Second, higher costs of equity capital will induce borrowers to purchase smaller homes which, given the downpayment ratio, results ir smaller mortgage demand. Of course, higher downpayment requirements, given the size and number of housing units king fwanced, implies a smaller loan transaction per unit financed. %ential borrowers would also consider the downpayment requirements of CBS. l-lo~vt”r, since CBS are restricted from effective competition with S&Ls in thi:; regard, the doMnp~!ment ratio sf CBS will not be included in the spe:itication of mortgage credit demand. Wousing starts, upon completion, require mortgage financing, and therefore, directly increase the demand for mortgage credit. Further, individuals who sell their csisting housing in order to buy new housing indirectly induce demand (gross) for mortgage credit when the prospective buyers of existing housing attempt to finance their purchases. 3The mortgage stuck is not included in the specification of the demand function. Previous dies [JafTee (1972)] have indicated a very slow speed of adjustment (c.g., approsimately m-rev) in the portion of the mortgage stock associated with existing loans. slow speed of adjustmel:t is due to the large costs of re-negotiating a it is set. Mortgage acquisitilons to finance the purchase of housing currently not as sluggish as the mortgage changes enacted via the re-negotiating of ~~t~ta~di~g mortgage loans. Thus, current home purchases are thought to affect currCnt INXg%gedemand.
J.R. Ostas and F. Zahn, Interest and non-inserest credit rationing
191
credit is exp?ained within the framework of a partial flow adjustment process,
LWLS,- 1
= (LSlr/LS,- J;
O
(7)
where LSF is the desired flow of S&L mortgage credit supplied and a is the partial flow adjustment coefficient. The desired flow of S&L mortgage credit depends primarily on mortgage yields, the opportunity cost of mortgage loans and the capability of S&Ls to make available new mortgage loans. In addition to the lagged value of the flow of mortgage credit, the latter are the predetermined supply variables. Portfolio adjustment considerations imply that the net yield on mortgage loans positively influences the desired quantity of mortgage credit supplied. The mortgage rate positively affects the gross yields from mortgage loans and thereby the difference between gross yields and the opportunity cost of contracting mortgage loans. Further, the downpayment ratio positively affects net yields, and therefore, the supply of mortgage credit since increases (decreases) in the downpayment ratio reduces (increases) the expected default risk associated with mortgage loans.4 The opportunity cost of mortgage loans to S&Ls is the interest rate paid on government bonds. As the government bond rate increases (decreases) the supply of mortgage credit is expected to decrease (increase).’ The capability of S&Ls to extend mortgage credit is reflected in S&L deposit levels and repayments. 6 As deposit and rep.;yment levels increase (decrease) the capability of S&Ls to supply mortgage credit increases (decreases,). Furthermore, the greater the amount of funds already allocated to past mortgages, i.e., the stock of mortgage loans held, the less the amount of additional mortgage credit S&Ls are in a position to extend. ‘In a study of FHA mortgage loans of von Furstenburg (1970) it was found that the probability of loan default rises sharply as the downpayment ratio falls. Further, he discovered that the downpayment ratio far exceeded other mortgage terms, borrower characteristics, and collateral characteristics in determining loan default rates. This is not surprising in that low downpayments imply that the borrowers may default because of large monthly payments. Also low downpayments imply high outstanding loan balances such that the possibility of the collateral property’s value falling below the value of the loan becomes significant. This situation increases the possibility that the borrower will default in a period of economic crisis and, given that default takes place, the loss to the lender as the value of the outstanding loan exceeds the value of the collateral property. “Alternatively, the cost of borrowing at the Federal Home Loan Bank, the borrowing rate, might be considered the opportunity cost of mortgage loans. However, WCwill :~ssumc that the borrowing rate is proportional to the government bond rate. Hence, it need not be in&did in our specification of mortgage supply. 6Foliowing Sparks (1967), Huang (1966), and others, we will consider S&L deposit liabilities as an exogenous variable. This assumption is based on the existence of deposit rate ceilings and the asymmetrical maturity structure of S&L assets and liabilities, i.e., S&Ls borrou, ‘short’ at-id tend ‘long’ [Kendall (1964) and Klein (1972)]. Further, the sluggish Jeposit adjustment behavior characterizing S&L deposit customers implies that S&L deposit levels are determined more by past influences rather than current influences [Silber (197O)l.
192
J. R. Osras ard F. Zahrt, Interest atld mmirtterest credit ratiorrirlg
Formally, the desired mortgage supply function is specified by Ls;
=
NC, D,, G,, VJ,, W-,1;
(8)
9; > 0, g; > 0, g; < 0, g; > 0, g; > 0, g;, c 0, where the predetermined subply variables are the government bond rate, C;,, S&L deposit liabilities, V,, S&L mortgage credit repayments, Z,, and the lagged stock of outstanding S&L mortgage credit, M,_ 1. Substituting eq. (8) into (7) and solving for LS, gives LS, = (g(R,, D,, G,, K, z,, W- #W%?
(9)
the mortgage supply function from which the estimates of the supply parameters are obtained. 2.2. Equilibrium in the mortgage market Eq. (5) specifies the market clearing condition of the model and it must be interpreted for both short-rtn and long-run behavior. In the short run, the downpayment ratio clears, the mortgage market when excess demand or supply exists at the current mortgage rate. In the long run, the mortgage rate adjusts to a market equilibrating level and the downpayment ratio falls back to i;s long run level. The downpayment ratio is assumed to instantaneously adjust to market clearing levels, while the mortgage rate adjusts with a lag. 2.4. Mwtgage rate adjustmcwt
Eq. (3) summarizes the determinants of the mortgage rate. The mortgage rate adjustment is explained within the framework of a partial adjustment process. assume that the mortgage rate adjtasts slowly to its equilibrium level due to ic and governmental alienation of S&Ls that could result from large, tion drawing changes in the mortgage rate [Vernon (1965)]. In addition, ministrative costs of the changes may lead S&Ls to balance the opportunity ot changing the mortgage rate to its equilibrium level against the cost ge, especially if there is uncertainty about future market equilibrium Leeuw-Gramlich (1969) and Griliches (1967)]. If we assume that S&Ls e current mortgage rate so as to minimize cost, the mortgage rate stment process may be specified by
ML
1
= VW,- alb;
3<
6 < I,
(10)
is the lenders’ estimates of the equilibrium mortgage rate and 6 is the artial adjustment. ly a reduced-form expression for the equilibrium mortgage
J. R. Ostas und F. Zahn, Itlterest atd rron-itltemst credit rationby
193
rate where the equilibrium rate is that which equilibrates the markct when the downpayment ratio is at its long-run level.7 It states that the lenders’ estimate of the equilibrium mor,&age rate depends on the predetermined variables of mortgage demand and supply. We assume that lenders’ estimate ofthe equilibrium mortgage rate closely approximates the actllal equilibrium rate. C’hanges in the predetermined variables of either supply or demand displace equilibrium in the mortgage market and the downpayment ratio adjusts instantaneously to clear the market. The downpayment ratio continues to clear the market of remaining excess demand and supply until the mortgage rate fully adjusts to its market equilibrium level, and then returns to its long-run level. For example, assume that an initial long-run equilibrium position in the mortgage market is displaced when an increase in disposable income increases mortgage demand. This creates excess mortgage credit demand at the initial value of the mortgage rate. If the mortgage rate were completely flexible it would rise to eliminate excess demand and thereby ration mortgage credit in equilibrium. The downpayment ratio would remain at its long-run level. However, since the mortgage rate is sluggish in adjusting to its market equilibrating rate the downpayment ratio will increase to clear the market of excess demand in the short run. Equilibrium rationing occurs with respect to the downpayment ratio, but disequilibrium rationing occurs with respect to the mortgage rate. The downpayment ratio continues to clear the market until the mortgage rate increases to its market equilibrium value, and then falls back to its long-run level. Thus, the outcome of the adjustment process approaches the outcome of the traditional view of the mortgage market. Although in the short run the downpayment ratio alone clears the market, in the long run the mortgage rate equilibrates the market at a level consistent with the long-run downpa}‘ment ratio. 3. Previous empirical studies Previous empirical studies [Brady (1967), de Leeuw-Gramlich (1969), Huang (1966), Silber (1970), Sparks (1967), and Smith (1969)] have introduced non-interest credit terms as a means of accounting for non-interest credit rationing effects.8 However, the variables were simply treated as predetermined ‘Our model explains the short-run value of the do\vnpayment ratio and assumes that the long-run value is constant over the period of analysis. This may not be strictly accurate, but it simy,.ifies our analysis without doing injustice to substnntiv~ short-run issucc. The assumption is consistent ivith our specified system. Accordin, (I to the discussion of eq. (3), \x,hen interest equilibrium is reached it will be at an interest rate which clears the market when the do\vnp?yment ratio is at its long-run level. At this point, the long-run level of the downpayment ratio also satisfies eq. (5) since the market is cleared and mortgasc demand equals mortgage supply. *In one of the tirst econometric studies, Sparks (1367) avoided the fundaniental credit rationing issue by assuming that both interert and non-interest credit terms move together. This assumption allotted him to conceptunlizc a composite credit term variable. But, Sparhs did not cbtnin strustural estimntcs ofmortgage demand.
194
J. R.. Osfas and F. Zah, Interest and non-infJ*restcredit rationing
explanatory variables and therefore ;;re subject to simultaneous equation biasa oreover, since the estimate of their supply and demand functions are based on the assumption of market equilibrium with respect to the interest rate, previous estimated models are logically inconsistent when they use non-interest credit terms as measures of disequilibrium rationing. ’ ’ ng (1966) was the first to analyze explicitly the disequilibrium character mortgage market. He assumed that changes in the mortgage rate are ortional to excess mortgage supply and was able to examine the diseq~~~~br~urn growth path of the mortgage rate. However, in estimating his adjustent equation pe assumed that observed quantities fall on the mortgage demand e and not din the supply curve. Thus, his estimates are inconsistent with that of mortgage supply where he assumed the observed quantities fall on the supply e primary problems with previous empirical studies is an inability to supply and demand and at the same time account for disequilibrium g. Jaffee (1972) was the first to adequately address himself to the s of doing both. * 1 He assumed that the observed quantities lie on the ortgage supply curve, and then estimated the mortgage demand curve intrectly from the estimation of a mortgage rate adjustment equation where the ortgage rate is a function of the observed quantity of mortgage credit, the tgage rate lagged one quarter, and the variables in the demand equation r than the mortgage rate itself). 1 2 But, if the ‘sluggish’ mortgage rate Ted the yield differential on mortgages and bonds to represel:t non-interest s. Silber (1970) used the length of amortization in his residential conmand equation and loan-to-property ratio in his mortgage supply equation to non-interest credit rationing effects. nd that the length-of-amortization variable was signi&zant in his housing demand urprisingly, not significant in his mortgage demaad equation. This unexpected butable to the endogenous character of credit rationing, thus biasing his d expect that the non-interest measures of credit availability used by Smith endogenously determined by contemporaneous mortgage demand and ese non-interest measures would, in turn, be correlated with the error terms present in the demand and supply equations resulting in asymtotically biased coeficient 61969) assumes mortgage demand equals mortgage supply when estimating his rate equation. Silber (1970) makes a similar assumption in the estimation of his multi. These assumptions are inconsistent with Smith’s u:se of non-interest credit “:esin his housing starts equation and Silber’s use of such terms in his residential T1heFRB-MIT [de Leeuw-Gramiich (1969)J estimates assumed that all observed quantities ng demand curve. However, if borne buyers cannot obtain their desired credit e rates (i.e., non-interest credit rationing prevails) then the buyers will not and curve and the FRB-?rAIT estimates will be incorrect. here QI is observed quantity of mortgage credit, predetermined demand variables. In equilibrium ated equation can be solved for LD, in terms of he mortgage demiand curve.
J. R. Ostas and F. Zahn, Merest
and non-iuwest
credit ratiorGg
19.5
happens to be above the equilibrium rate one would expect that the observations would fall on the demand curve rather than the supply curve, Jaffee dismisses this possibility with the argument that throughout most of his sample period the change in the interest rate was non-negative. Thus, the actual mortgage rate was either below the equilibrium rate or at the equilibrium rate. Jaffee’s study is consistent in that once he posits disequilibrium, he does not attempt to estimate demand and supply from the same set of quantity observations. In general Jaffee’s assumption will not be able to be used. His model requires ac objective means of analyzing the market to determine whether one is actually in a supply ‘regime’ (as Jaffee assumed to be true for his period of study) or a demand ‘regime’. ’ 3 Fair and Jaffee (1972) suggested procedures for determining whether the market is in a ‘demand regime’ or ‘supply regime’. These procedures utilize the directiorz of interest rate change to determine the condition of the market. If observed changes in the mortgage rate are negative, the market is in a ‘demand regime’ and excess supply exists. If observed changes in the interest rate are positive, the market is in a ‘supply regime’ and excess demand exists in the market. Once the observations have all been classified with respect to being demand or supply determined, ordinary least squares are used to estimate demand and supply schedules. Only demand based mortgages rates and quantities are used to estimate the demand schedule. A similar procedure yields estimates of the supply schedule. Fair and Jaffee also attempt to estimate disequilibrium markets by utilizing the quantitative assumption that positive (negative) interest rate changes are proportional to unobserved excess demand (supply). Consequently, they estimate the unobserved portion of the demand schedule by regressing observed quantities on the determinants of demand and on current mortgage rate changes. Such changes act as proxies for unobserved excess demand. There are problems with the Fair-Jaffee approach. First, their ‘directional’ approach to estimating disequilibrium results in inconsistent coefficient estimates, ’ 4 and in their ‘quantitative’ approach the coefficient constraints on the mortgage rate change variable (equality) across demand and supply equations preclude their use of conventional simultaneous equation estimation. Second, in terms of efficiency, structural specification of disequilibrium processes (like the one used in our study) are preferable to general techniques. The Fair-Jaffee technique ignores the specific means by which lenders ration mortgage credit 13A demand ‘regime’ would be time periods when interest rates were above the market cleating level and, thus, where observations fall on the demand curve rather than the supply curve. “AS Fair and Jnffee explain, if demand is estimated only in a ‘demand regime (i.e., when excess supply exists and demand is relatively small), then \ve might expect large kxlues of exogenous demand determinants to be associated vAth small values of the demand relationship’s error term.
196
J. R. Ostas and F. Zaht, Irrtcrcst and non-in ferestcredit ratiotnhg
when markets are in disequilibrium with respect to the mortgage rate. By the omission of nun-interest credit variables they overlook the incidence of rationing as well as the potential effect of non-interest rationing variables on the supply and demand for mortgage credit. Also, mortgage rate changes may not measure theextentofdisequilibrium but simply the impact such changes have on borrowers’ expectations. Structural measures of market disequilibrium may serve as good a proxy for excess demand and yet not incorporate expectational influences. 4. Our empirid results We estimated mortgage demand and supply, eqs. (6) a:ld (9). Monthly data were used (see the Data Appendix) for the sample period beginning January 1965 through June 1971. Since both equations were over-identified, a simultaneous equation estimator is appropriate. The two-stage least-squares estimator was selected because it corrects for simultaneous equation bias and gives consistent estimates of the parameters. The instruments, i.e., th-: first-stag: regressors, were obtained for both the downpayment ratio and the mortgage rate. The first-stage variables in each case were the predetermined variables in the supply and demand equations. However, the mortgage rate instrument was obtained with one additional first-stage variable, the lagged mortgage rate, according to the specifications of eqs. (4) ani (lo), R; =
Wda-,,
JWb-
1 =
(RF/R,_
Y,, G,, KZ, $;
Mt-I,LS,_l),
0 < b < 1..
w
The mortgage rate is predetermined to the suppIy and demand equations in the sense that it recursively influences the supply and demand for mortgage credit. However, the mortgage rate is assumed to adjust slowly to a market clearing level, and the lenders’ estimate of the market clearing level would be a function of not only predetermineld supply and demand elem,nts, but also stochastic supply and demand elements. It follows that the mortgage rate is correlated with e stochastic elements of the supply and demand for mortgage credit. 1 ’ In order to avoid severe problems of multicollinearity, the interest rates in the artgage supply and demamd equations were estimated as ratiosI We thereby slug@shmortgage rate adjustment process implies that the error term of the mortgage ion is correlated with the error terms of the supply and demand equations. Therefore, ce-covatiance matrix of error terms is not diagonal. And the use of a first stage instrumena for the mortgage rate is an appropriate means of obaainin,g consistent estimates of the demandand supply equations [Basmann (1963), Mosback-Wold (19701, Strotz-Wold ve government bond rates were used in the regression analysis, But the one-year e yrelded the best results. Since 3&I-s concentrate their bond portfolio on short-term their appropriate epportunity ctist is related to a short-term rate
J. R. Ostm attd F. Zah, Interest and non-interest credit rationing
197
constrained the elasticities of the demand rates to be equal in absolute value, but opposite in sign. Similarly the elasticities of the supply rates were constrained, The preferred form of the estimated demand and supply equations is log linear. 1 7 The results are as follows: In LD, = - 0.9701 In D, - 3.9746 In (R/C), -t-0.7497 In fit_ (-
3.2989)
(- 2.9692)
f0.7235 In Yt; (5.2937)
1
(1 I-2903)
A2 = 0.7555,
SE. = 0.1520,
(6)
In LS, = - 12.2408 + 2.3564 In D, + 0.4635 In (X/G), (- 4.0308) (2.5924) (4.0347) f6.7105 In V,+1.1997 In&-5.2999 In i&Z,,1 (3.8120) (3.0484) (8.1033) +0.4751 In LS,_ 1; (6.8306)
R2 = 0.8625,
S.E. = 0.1138, (9)
The signs of the estimated coefficients were as expected and significant at the 0.05 level. ’ ’ The R”s are adjusted for degrees-of-freedom and indicate a reasonably good fit to the data. The results obtained from the estimated equations are particularly interesting because a point often overlooked is statistically supported by the estimate of the supply equation. That is, non-interest credit terms influence mortgage supply as well as mortgage dernand. Furthermore, the estimates show that the supply and demand curves for mortgage credit can be identified by conventional means even when there are sluggish adjustments in interest credit terms. Based on the first-stage regressor, the partial adjustment coefficient, b, in the mortgage rate adjustment eq. (10) is 0.4292. Hence, about 43 percent of the mortgage rate adjustment takes place within a period of one month. Further, the
“For _Gnplitkation purposes the adjustment equations specified in the previous section of this paper were assumed at the outset to be exponential in form. This is consistent with the preferred forms of the estimated equations. ‘*The constant term in the demand equation was suppressed since it was not significantly different from zero at the 0.05 level. R2 is the coefficient of determination adjusted for degreesof-freedom and SE. is the standard error of the regression estimate. The values in parenthesis are the r-ratios. The Durbin-Watson statistics of the demand and supply curves are 1.3428 and I .7603, respectively. However, the Durbin-Watson statistic, as well as other means of measuring possible auto-correlation, arc at best difficult to interpret when using a simultaneous equation estimator. F
J.R. Ostas and F. Zah, Interest and non-interest credit rationing
second-stage regressor shtows that the partial flew adjustment coefficient, a, in the supply eq. (9) is 0.5249. Hence, about 52 percent of the adjustment by S&Ls to their desired flow of mortgage credit takes place within a period of one month. 5. Codding
remarks
Thz major conclusion implied by this study is that it is possible to satisfactorily estimate mortgage demand and supply relationships in spite of the disequilibrium character of the mortgage rate and the attendent non-interest credit rationing influences. Accordingly, this study has suggested a theory of interaction in the mortgage market which explains both equilibrium non-interest credit rationing and disequilibrium mortgage rate movements. The theory is supported by appropriate statistical tests. The results of this study imply that structural estimates of mortgage demand and supply which fail to include non-interest credit terms may be subject to serious specification error. The results also imply that the orthodox Keynesian transmission channels by which monetary policy affect the economy through the interest rate’s impact on investment decisions must be supplemented by consideration of the transmission effects working through non-interest, i.e., availability influences. Studies which indicate interest inelastic investment behavior now provide leti compelling arguments for monetary policy’s weakness, particularly in mortgage and housing markets. Paradoxically. this study in]>liesthat the more flexible the mortgage rate, the less it is necessary for non-inte:*est credit stringency to clear the mortgage market. Consequently, as observed by the recent (1971-72) experience of high-interest rates and ‘easy’ non-interest credit terms, the ‘cost’ and ‘availability’ of credit may move in the same direction. Further, this study lends support to those who argue that stringent monetary policy is ‘discrimi.natory’ in its impact. In particular, the evidence cited implies that a restrictive monetary policy which diminishes the credit supply of intermediaries tends to affect those borrowers seeking low downpayment loans, And since theoretical analysis and Iempirical evidence suggest that borrowers desiring few downpayment loans are borrowers with relatively low asset positions [Muth (1962)], it can be concluded that a ‘tight’ monetary policy i\ill have a differential impact within the mortgage market. The incident of such impact will fall most frequently on borrowers with low non-human wealth positions, Finally, the fact of non-intiierest rationing implied by this study indicates that monetary policy may be a useful policy tool without necessitating the disruptive effects of large interest rate movements. Recently, Duesenberry (1969) speculated t the greater the amount of non-interest rationing taking place in the nation’s ancial markets, the greater the ‘elbow room’ there is for monetary policy to rate without requiring large destabilizing interest rate movements.If monetary policy were to operate solely through the: interest rate transmission channel the
J.R. Ostas and F. Zuhtr, Interest and non-interest credit rationhg
199
necessary range in the vaTi”+’ uclon of interest rates needed to effect a given investment spending target might be so great that such policy could be precluded from the policy maker’s itinerary of feasible economic tools. This would be particularly the case with the attendent effects on the bond and stock markets. Data appendix Unless we specify differently, all data series used are seasonally unadjusted, monthly observations. All data series begin January 1965 and end June 1971. The sources of the data are issues of: (1) The Federal Reserve Bzrllctin, published by the Federal Reserve Board, Washington, D.C. (2) Housing and Ut-ban Development Trends, published by the U.S. Department of I-lousing and Urban Development, Washington, D.C. (3) The Federal Howe Loan:Bank Board News, published by the Federal Home Loan Bank Board, Washington, D.C. (4) U.S. S’nrirz~.sand Loart Fact Book, published by the U.S. Savings and Loan League, Chicago, III. Any adjustments or additions will be explained in the text which follows* The S&L mortgage credit series and the housing start series were taken from issues of Housing and Urban Developmerlt Trends, January 1968, June 1970 and September 197 1. The mortgage credit data is in millions of dollars and refers to those loans associated with the purchase of owner-occupied, existing housing. S&Ls specialize in this type of loan. Thus, this series is considered an appropriate representation of their lending activity. The housing start data is in thousands gf single-family, private units. Interest and non-interest credit terms data was obtained partly from the issues of the Fcdcrnl Home Loan Bank Board News, 1968 through 1971. The corresponding 1965 through 1967 data was obtained directly from the Federal Home Loan Bank Board. Downpayment ratios were derived from the loan to price ratio data. The mortgage interest rate series refers to effective interest rates rather than contract interest rates. All credit term data are expressed in percentages and refer to non-insured loans associated with the purchases of existing housing. The terms associated with new home loans were not used because they are often agreed upon through the mortgage commitment process some months prior to the actual disbursement of the loan funds, and therefore, may not adequately represent the contemporaneous conditions of the mortgage market. The S&L deposit series, S&L mortgage stock series, and the government bond rate series were all collected from issues of the Federal Rescrw Bulletin, November 1965, July 1966, April 1967, and February 1968 through February 1972. The bond rate is expressed as a percent and refers to the market yield (daily average over a month) on 9-12 month issues. The S&L deposit and mortgage stock data are expressed in billions of dollars and refer to end-of-period levels. The deposit data were lagged one month throughout the study. The disposable income series is expressed in billions of dollars and was
200
J.R. Ostas and F. Zahn, Interest and norl-interest credit rationing
obtained from the Federal &serne Bulletin, h’ovember 1945, April 1967, and February 1968 through FTebruary 1972 issues. The monthly data were derived from quarterly data by means of IikYearinterpolation. Finally, the S&L mortgage loan repayment series was obtained from the U.S. Savings and Loan Fact Book, 1967 through 1971 issues. The series is expressed in millions of dollars. The six months of the 1971 portion of the series was not available from the initiall source and the information for those months was obtained by splicing the original rlepayment series with similar repayment information obtained from Table 2 of the Federal Home Loan Bunk Board News, !kptember 1971. The splicing of the: series was performed by calculating the monthly percentage change in the new series and assuming the same monthly percentage ch.ange carried over to the original repayment data series.
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