Taming the housing crisis: An LTV macroprudential policy

This paper develops a DSGE framework featuring heterogeneous housing markets, endogenous mortgage defaults, and a banking sector. We find that the idiosyncratic mortgage risk shock plays an important role in explaining the fluctuations of house prices during the 1980s and the years leading up to the financial crisis. The same shock is also an important driving force of household loans. By placing an occasionally binding constraint on the loan-to-value ratio via a counterfactual analysis, we find that the overheating of the housing economy in the early 2000s and the subsequent crash could have been alleviated, if authorities had adopted such a macroprudential policy measure. A comparison of utility gains suggests that such a maximum loan-to-value ratio policy is preferable over an augmented Taylor rule that responds to house price growth.