The Effects of Housing Price Volatility on Mortgage Rates

In this paper, we develop a residential mortgage valuation tree model that incorporates housing price volatility, along with interest rates and interest rate volatility as determinants of mortgage yield spreads (above Treasury yields). When initial loan-to-value (LTV) ratios are low (e.g., 80%), the sensitivity of theoretical mortgage yield spreads to housing price volatility occurs for housing price volatility at annualized rates of 9%–11%. Annual price volatilities of 9%–11% are primarily observed in ‘hot’ residential markets. When initial LTV ratios are high (e.g., 95%), we find the sensitivity of theoretical mortgage yield spreads to housing price volatility begins at annualized rates of 3%–8%, levels consistent with normal real estate markets. These sensitivities are generally irrespective of interest rate levels and interest rate volatilities. Ignoring the sensitivity of mortgage values to housing price volatility can cause lenders to misprice mortgages, and can cause insurance companies to misprice mortgage insurance. This can cause perverse incentives and unintended consequences, with substantial public policy implications including unsafe lending practices, excessive real estate speculation, and systemic risk.