Taming the Housing Crisis: An LTV Macroprudential Policy

This paper develops a DSGE framework featuring a heterogeneous housing market, endogenous default, 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 mid-1980s and the years leading up to the financial crisis. The same shock is also one of the main driving forces of household loans. By placing an occasionally binding constraint on the loan-to-value ratio, 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 welfare comparison indicates that the maximum loan-to-value policy is preferable over an augmented Taylor rule that responds to house price growth.