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201342 Pap

201342 Pap

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Published by: caitlynharvey on Jul 08, 2013
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Finance and Economics Discussion SeriesDivisions of Research & Statistics and Monetary AffairsFederal Reserve Board, Washington, D.C.Economic Volatility and Financial Markets: The Case of Mortgage-Backed SecuritiesGaetano Antinolfi and Celso Brunetti
NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminarymaterials circulated to stimulate discussion and critical comment. The analysis and conclusions set forthare those of the authors and do not indicate concurrence by other members of the research staff or theBoard of Governors. References in publications to the Finance and Economics Discussion Series (other thanacknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.
Economic Volatility and Financial Markets: The Caseof Mortgage-Backed Securities
Gaetano Antinolfi
Celso Brunetti
April 29, 2013
The volatility of aggregate economic activity in the United States decreased markedlyin the mid eighties. The decrease involved several components of GDP and has beenlinked to a more stable economic environment, identified by smaller shocks and moreeffective policy, and a diverse set of innovations related to inventory management aswell as financial markets. We document a negative relation between the volatility of GDP and some of its components and one such financial development: the emergenceof mortgage-backed securities. We also document that this relationship changed sign,from negative to positive, in the early 2000’s.
We wish to thank without implicating Sean Campbell, Steve Fazzari, Michael Gordy, James Kennedy,James Morley, Bruce Petersen, Jeremy Piger, Todd Prono, Frank Schorfheide, Tara Sinclair, and seminarparticipants at the Board of Governors and Midwest Macroeconomics Meetings for constructive comments.We also would like to thank Leah Brooks and Jane Dokko for their help with data. Katherine Hamilton,Matt Hayward, Bobak Moallemi, Waldo Ojeda, and Ran Tao provided excellent research assistance. Allerrors are our own. Any views are of the authors alone and do not represent the views of the Board of Governors of the Federal Reserve System.
Board of Governors of the Federal Reserve System and Washington University in Saint Louis, gae-tano@wustl.edu
Board of Governors of the Federal Reserve System, celso.brunetti@frb.gov
1 Introduction
The volatility of aggregate economic activity in the United States decreased in the mideighties. The consensus date for a significant decrease, termed
The Great Moderation 
byStock and Watson (2003), is the last quarter of 1984. Three broad reasons have beensuggested to explain this phenomenon: a structural change in the economy, an improvementin the implementation of economic policy, especially monetary policy, and a lucky draw inthe sequence of random shocks that affect the economy. These explanations are not mutuallyexclusive, and can well interact with one another. A challenge has been to identify moreprecisely which channels of transmission from shocks to economic activity have been affectedand how. Among the channels that have received much attention are monetary policy,technological change and especially inventory management, financial markets development,and international integration. Again, focusing on one aspect is dictated by convenience atsome level; the idea that the decrease in volatility is diffuse across several components andtherefore is not likely to be completely explained by one event is clearly expressed by Kim,Nelson and Piger (2004) and Stock and Watson (2003), among others.We establish a link between a particular form of financial market development, the pro-cess of securitization of mortgage debt, and real economic activity. There are several reasonsto focus on such an aspect of the evolution of financial markets over the last thirty to fortyyears. First, mortgage backed securities (MBS) markets were small as a fraction of GDP inthe late seventies, but have become enormous in present days, and the timing of the marketdevelopment is consistent with the timing of the Great Moderation. By the early 2000’s,about sixty percent of household mortgages had been securitized. Because household mort-gage debt is almost the size of GDP, the mortgage-backed securities market grew from arelatively small fraction to over half of GDP in about twenty years. It is therefore an inter-esting question to document whether real effects are detectable in aggregate real variables.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 evidencethat we document points (indirectly) to the possibility that the availability of risk diversifi-cation through mortgage pools generated a smoother allocation of credit and thereby actedas a coordination mechanism for the supply side as well. This channel of transmission doesnot rely on or require that financial innovation be related to the quantity of credit availableor to the relaxation of credit constraints. Third, mortgage backed securities allow for thediversification of different kinds of risks, in particular interest rate risk and credit risk. Thecredit risk or counterparty risk inherent in mortgage loans has been historically relatively2

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