AFTER the mortgage-refinancing binge comes the hangover. On October 11th Wells Fargo and JPMorgan Chase announced third-quarter earnings that were dented by a decline in their mortgage business. Similar news followed on October 15th from Citigroup and the following day from Bank of America. The rise in interest rates from historic lows in April, despite a recent hiatus, has ended a period when taking out a new home loan to pay off an old one was a riskless, lucrative step for borrowers and lenders alike.

The increase in rates is a direct response to the Federal Reserve’s signals that it may soon curtail its bond-buying scheme, which is intended to suppress long-term borrowing costs. A higher price for money is not just toxic to the mortgage-refinancing business, and thus bad for banks, it also hurts house prices. That would suggest that it hurts the economy as a whole as well. But a new paperby two professors at the Cox School of Business at Southern Methodist University and a third at the University of Pennsylvania’s Wharton Business School argues otherwise: that efforts to boost housing loans have impeded the flow of credit to more productive uses.


America has long taken steps to prop up housing construction and prices, including a tax deduction for mortgages, tax breaks for certain companies that hold property (real-estate investment trusts) and an implicit state subsidy for the entire industry via state-backed entities with access to cheap credit that buy mortgages (Fannie Mae and Freddie Mac). Since the financial crisis, this has been augmented by the Fed’s efforts to keep interest rates low in an attempt, among other things, to revive the housing market. As the paper notes, Ben Bernanke, the chairman of the Fed, said last year, “to the extent that home prices begin to rise, consumers will feel wealthier; they’ll feel more disposed to spend…that’s going to provide the demand that firms need in order to be willing to hire and to invest.”

In addition to this “wealth effect”, higher home prices can stoke the economy by providing owners with more valuable collateral to borrow against for other purchases; many entrepreneurs fund their businesses this way. Rising home values also make existing mortgages less risky. If higher prices lead to increased construction, they boost GDP directly.

The recent recovery in housing prices has carried with it all these virtues, and perhaps others as well. Banks talk up the idea that as the value of their clients’ assets rises, they have added incentive to deepen their relationship with them. As ties grow, banks have both more reason and more capacity to monitor credit quality. Wells Fargo came out of the crisis with the biggest mortgage operation among America’s banks, and has since become the country’s most valuable financial institution, in part because it has managed to persuade clients with mortgages to take up other offerings, such as personal and business accounts.
Writ large, this would suggest that greater mortgage lending leads to more abundant and efficient channelling of resources from banks to their clients, both corporate and personal, and thus to the economy as a whole. But the paper disputes this. It argues that a rise in property prices simply prompts banks to devote more resources to mortgages and less to other loans (see chart). It shows that as property lending rises, banks in strong housing markets lend less to businesses than banks elsewhere. Businesses, in turn, invest less, as they are unable to replace all their lost bank lending with other sources of financing. The impact is particularly strong for small and medium-sized businesses that rely on banks rather than capital markets for funding, and when the main sources of capital are small and medium-sized banks.