Government Subsidy in the U.S. Mortgage Market: A Structural Analysis with Bunching

It is crucial to better understand the U.S. residential mortgage market, where the global financial crisis originated. In this paper, we develop an infinite-horizon continuous-time structural model to study the effects of the longstanding and widespread Government-Sponsored Enterprises (GSEs) mortgage default insurance subsidy on U.S. mortgage underwriters’ equilibrium lending behaviour. Despite the richness of the model, we obtain analytical solutions for the equilibrium loan size and interest rate. We then employ truncated loan-level data to estimate the subsidy’s magnitude using maximum likelihood by exploiting a distinctive data feature that many borrowers bunch at the subsidy eligibility cutoff. We find that the subsidy is about 25 basis points per dollar, reduces the equilibrium mortgage interest rate by the same amount (3.6% of the average rate), and increases the loan size by $15,026 (10.4% of the average size). Our modelling framework and the structural estimation of this critical parameter, the size of the GSE subsidy, enable further studies to enhance understanding of the complex U.S. housing finance system and its significant implications for financial stability both domestically and globally.