Economic volatility and financial markets: The case of mortgage‐backed securities

• Published date: 01 May 2019
• Date: 01 May 2019
• Author: Gaetano Antinolfi,Celso Brunetti
• DOI: http://doi.org/10.1111/fmii.12107

DOI: 10.1111/fmii.12107

ORIGINAL ARTICLE

Economic volatility and financial markets: The case

of mortgage-backed securities

Gaetano Antinolfi1Celso Brunetti2

1WashingtonUniversity in Saint Louis

2Board of Governorsof the Federal Reserve

System

Correspondence

CelsoBrunetti, 20th and C Streets, NW, Washing-

ton,DC 20551, US.

Email:celso.brunetti@frb.gov

Abstract

The volatility of aggregate economic activity in the United States

decreased markedly in the mid-eighties. The decrease involved

several components of GDP and has been linked to a more stable

economic environment, identified by smaller shocks, more effective

policy,and a diverse set of innovations in technology as well as finan-

cial markets. We study one such financial innovation, and document

a negative relation between the rapid growth of mortgage-backed

securities and the volatility of GDP and some of its components

from the mid-1970s to the late 1990s. We also document that this

relation changed sign, from negative to positive, in the early 2000s.

KEYWORDS

Great Moderation, Mortgage-backedsecurities, Volatility

JEL CLASSIFICATION

E44, E32, G21, C22

1INTRODUCTION

The volatility of aggregate economic activity in the United States decreased in the mid-eighties. The consensus date

for a significant decrease, termed The Great Moderation byStock and Watson (2002), is the last quarter of 1984. Three

broad reasons have been suggested to explainthis phenomenon: a structural change in the economy, an improvement

in the implementation of economic policy, especially monetary policy, and a lucky drawin the sequence of random

shocks that affect the economy. These explanationsare not mutually exclusive, and can interact with one another. A

challenge has been to identify which channels of transmission from shocks to economic activity have been affected

and how.Among the channels that have received much attention are monetary policy, technological change, especially

inventory management, financial marketsdevelopment, and international integration. Again, focusing on one aspect is

dictated by convenience at some level; the idea that the decrease in volatility is diffused across severalcomponents,

and therefore is not likely to be explainedby one factor is clearly conveyed by Kim, Nelson, and Piger (2004) and Stock

and Watson(2002), among others.

c

2019 New YorkUniversity Salomon Center and Wiley Periodicals, Inc.

Financial Markets,Inst. & Inst. 2019;28:85–113. wileyonlinelibrary.com/journal/fmii 85

86 ANTINOLFI ANDBRUNETTI

Westudy the link between a particular form of financial-marketdevelopment, the process of securitization of mort-

gage debt, and real economic activity.There are several reasons to focus on such an aspect of the evolution of financial

marketsover the last thirty to forty years. First, mortgage backed securities (MBSs) were a small fraction of GDP in the

late seventies, but have become enormous in present days, and the timing of the development of this marketis con-

sistent with the timing of the Great Moderation. By the early 2000s, about sixty percent of household mortgages had

been securitized. Because household mortgage debt is almost the size of GDP,the mortgage-backed securities market

grew from a relatively small fraction to overhalf of GDP in about twenty years. Therefore, it is important to document

whether or not a statistical relation with aggregate real variables is detectable. Second, mortgage backed securities

have a direct link to an important household decision, the purchase of a house, and lenders’ decisions to finance the

purchase. Thus, the evidence that we document points (indirectly) to the possibility that the availability of risk diversi-

fication through mortgage pools generated a smoother allocation of credit. This channel of transmission does not rely

on or require that financial innovation be related to the quantity of credit available or to the relaxation of credit con-

straints. Third, mortgage backedsecurities allow for the diversification of different kinds of risks, in particular interest

rate and prepayment risks, and credit risk. The credit risk or counterparty risk inherent in mortgage loans has been

historically low, in part because of collateraland the fractional support of the house purchase, and in part because the

amount of counterparty risk is, to a large extent, under the control of the lender.On the other hand, interest rate risk

is largely aggregate in nature, and not easily diversifiable by the lender. Diversification of interest and prepayment

risks is, initially, the main purpose ofthe c reationof pools. The observation that both credit risk and interest rate risk

are pooled in mortgage backed securities is important because, potentially,the introduction of these derivatives could

lead to a decrease or an increase in the risks managed by intermediaries. For example, the diversification of prepay-

ment risk could increase the amount of counterparty risk that they are willing to undertake. One of the hypothesisfor

which we find support is that in the aggregate, mortgage backed securities were associated with a decrease in aggre-

gate volatility until about 2000, but that in the last part of the sample the relation changed sign, and higher volatility

is correlated with the expansion of mortgage securities markets. A corollary of this hypothesisis that even if financial

marketdevelopments contributed to the Great Moderation, their contribution could have been temporary,to the point

of not only fading away overtime but also changing direction.

We study the empirical relation between the volatility of economic activity and MBS markets between 1974 and

2011 using quarterly observations on GDP and some of its components, quarterly observations on MBSs issued by

government sponsored enterprises (GSE's), and private intermediaries. More specifically,we construct various mea-

sures of volatility for the growth rates of real GDP,consumption, housing consumption, residential investment, and

investment in single housing, and then examine the empirical relation between real and financial variables with two

statistical models: a linear autoregressivemodel and non-linear Markov switching model. The evidence supports a neg-

ativerelation between the growth of mortgage-backed securities and the volatility of real activity in the first part of the

sample, between the mid-1970sand 2000. Inthe second part of the sample, the relation is to some extent reversed, and

volatility in real economic growth is positively related to changes in volume in MBS markets. Therefore, the empirical

evidence highlights an important change in the relation between MBS markets and the volatility of aggregate vari-

ables, in the late 1990s MBS markets become progressively associated with higher volatility.These results are robust

to changes in the cost of credit, measured by the economy's rate of interest, and to other types of household credit

securitization (auto, student, credit card, and other forms of revolving consumer credit).

The structure of the mortgage pools market was completely dominated by GSE's until the mid-nineties. During

that period, private institutions entered the market with similarly structured pools of mortgages. The data set that we

employ from the Flow of Fundsdistinguishes between GSE's pools and private conduits pools (henceforth, ABS pools).

The potential difference between the two aggregates is the size of individual mortgages in the pool and the credit rat-

ing of borrowers to whom loans were issued. The timing of the beginning of the positive correlation between the MBS

markets and aggregate volatilitycoincides with the emergence of ABS pools, raising the question, whether the change

in the sign of the correlation is due to the introduction of ABS pools. Our results for GSE and ABS pools are very simi-

lar; as a consequence, our findings point to a general transformation of the industry rather than a difference between

GSE pools and ABS pools. An attempt to understand the relation between the historic evolution of MBSs and the