Unit 8 Economic dynamics: Financial and environmental crises

8.7 Housing booms and busts: Household borrowing, bank lending, and aggregate consumption

Before you start

The analysis of household wealth, housing, and leverage in this and the following two sections builds on the discussion of these topics in Unit 6. If you have not previously worked through Sections 6.9 to 6.11, you should read them at this point.

Housing booms can be further amplified because rising prices increase both the incentive and the ability of households to borrow. The additional borrowing enables higher spending, including on housing, which contributes to further house price increases.

Capital gains and the incentive to (and risks of) borrowing more

leverage, gearing, leverage ratio: Leverage (or gearing) refers to the process of increasing investments or asset purchases by borrowing. There are several different, but closely related, measures of leverage of a household, a firm, or a bank. CORE uses the proportion of the investment financed by borrowing; in other words, the leverage ratio is the ratio of debt to assets.

When house prices are expected to rise, it is attractive for households to increase their borrowing. This is because the expected capital gain from the price increase raises the return on their investment in housing. Borrowing to invest is referred to as the ‘magic of leverage’ (introduced in Section 6.10). Homeowners as well as businesses, including banks, can take advantage of this, as we show in the following example.

balance sheet: A record of all the current assets and liabilities, and the net worth, of an economic actor such as a household, bank, firm, or government. See also: net worth, liability.
liability: A debt; an amount that is owed, with a contractual obligation to repay it in future.
equity: Shares (stocks) in a business are known collectively as equity. The total value of the equity held by the shareholders is equal to the net worth of the business, and an individual shareholder’s equity in the business is the total value of the shares they own. The term equity is also used more generally for a share of ownership of any asset, and for the net worth of any household, business, or project. There is a second entirely different use of the term, meaning fairness, as in ‘an equitable division of the pie’. See also: net worth.

If we think of a household having a balance sheet (explained in Section 6.2, the house is on the asset side of the household’s balance sheet and the mortgage owed to the bank is on the liabilities side. Concentrating on the house, the value of the house minus what is owed on it (the mortgage) is the household’s equity in the house. It is the proportion of the house that the household owns—the rest is owned by the bank. The crucial point to remember is that the amount of debt is fixed in nominal terms (for example, dollars or pesos), but the value of the house fluctuates as house prices rise and fall. This means that the household’s equity in the house also goes up and down.

The measure of leverage used here, and in Unit 6, is identical to the ‘loan-to-value ratio’ which is commonly used by banks to assess the riskiness of a loan; since this ratio has fallen, the bank may be prepared to increase its lending.

Suppose a house costs $200,000, and the household makes a down payment (deposit) of 10% ($20,000). This means it borrows $180,000 and owns $20,000 of the house. Its initial leverage ratio, in this case the value of its debt divided by the value of the house, is 90% (= 180/200). Suppose the house price rises by 20% to $240,000. The return on the equity the household has invested in the house is 200% (since the value of the equity stake has risen from $20,000 to $60,000: it has tripled). At the same time, leverage will actually have fallen slightly, to 75% (= 180/240). Households that are convinced that house prices will rise further could decide to increase their leverage: that is how they expect to get a high return. As we explain below, because they have more collateral due to the increase in value of their house, this would enable them to implement the higher leverage plan.

net worth: The net worth (or equivalently, wealth) of an individual, household, or organization is the difference between the total value of its assets and the total value of its liabilities.

Moreover, the same mechanism operates when house prices fall. The more highly leveraged is the household, the smaller is their net worth (or equity). While the opportunity to borrow more and increase leverage offers a greater chance to gain when house prices rise, it makes households more vulnerable when house prices fall.

fire sale: The sale of something at a very low price because of the seller’s urgent need for money.

As we explained earlier, when the market value of the house falls below what is owed on the mortgage, this is called negative equity. Using the example above, if leverage is 90%, then a fall in the house price by more than 10% would place the household in negative equity. When this happens, the mortgage lender can repossess the house and sell it to recover (some of) what it is owed. In a broad-based collapse of house prices as in the US, where they fell by 30% between 2006 and 2009, the forced sale of many houses further depresses the price (called a fire sale), reinforcing the downturn.

Housing collateral, house price bubbles, and the financial accelerator

The role of collateral in lending is explained in Section 9.9 of the microeconomics volume.

collateral: An asset that a borrower pledges to a lender as a security for a loan. If the borrower is not able to make the loan payments as promised, the lender becomes the owner of the asset.

Whereas rising house prices create the incentive for borrowing more, the opportunity to do so arises from the role of collateral in bank lending. When households borrow to buy a house, this is called a secured or collateralized loan. As part of the mortgage agreement, the bank can take possession of the house if the borrower does not keep up repayments. In economies with relatively developed financial systems, even households with low income and wealth are able to borrow to purchase a house because the lender can repossess the house in the event of non-payment. Such households are likely to be excluded from accessing unsecured loans.

And in some countries such as the US, housing collateral plays a role in the dynamic process sustaining a house price boom. This is because when the market value of a house goes up, this higher value increases the household’s equity in the house (since the amount they owe remains unchanged). In turn, the household can now borrow more from the bank (or mortgage provider) by supplying this more valuable collateral to the bank. This is shown in the left-hand diagram in Figure 8.17. Since the household is able to secure a larger loan, they use it to move up the housing ladder to a better (for example, larger) property. By increasing the demand for houses, this, in turn, pushes up house prices further and sustains the bubble.

The right panel shows the process driving house prices down: a fall in house prices reduces the value of a homeowner’s collateral. This reduces the amount they can borrow and purchases of housing decline.

financial accelerator: When an asset (such as housing) is used as collateral for loans, an increase in price raises the value of the collateral enabling more borrowing, raising demand, and causing further price rises. This amplification process is called a financial accelerator.

The combined role of leverage and collateral in amplifying a house price boom or bust is referred to as the financial accelerator.

There are 2 flowcharts. The first flowchart is labelled as ‘on the way up’. It starts with the increases of household borrowing, resulting in increases of housing purchases. It results in a house price boom, which further leads to a higher value of collateral. Such increased collateral price in turn leads to household borrowing increases, causing this cycle to continue. The second flowchart is labelled as ‘on the way down’. It starts with the household borrowing falls, causing purchases of housing to fall. It results in a house price decline, which further leads to a lower value of collateral. Such decreased collateral price in turn leads to household borrowing to fall, causing this cycle to continue.

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https://www.core-econ.org/macroeconomics/08-financial-environmental-crises-07-borrowing-lending-aggregate-consumption.html#figure-8-17

Figure 8.17 The financial accelerator: housing collateral amplifies house price increases and decreases, contributing to positive feedback process when prices either rise or fall.

Adapted from a figure in Hyun Song Shin. 2009. ‘Discussion of “The Leverage Cycle” by John Geanakoplos’.

How the financial accelerator affects aggregate consumption and output

In Figure 8.1, we identified the housing credit boom in the GDP data for the 2000s in the US and commented on the persistent weakness of output growth in the years following the financial crisis. One important link from housing to GDP is via the effect of changes in house prices on saving behaviour and therefore on the ‘consumption’ component of aggregate demand.

multiplier process: A mechanism through which the direct effect of an increase (or decrease) in aggregate spending is amplified through indirect effects that further increase (or decrease) aggregate output. See also: fiscal multiplier, multiplier model.

Consumption is the largest component of GDP in most economies. Section 3.6 explains how consumption depends on income, and changes in consumption affect aggregate output and employment via the multiplier process. We can now extend our understanding of aggregate consumption by bringing in the effect of housing wealth.

Housing, target wealth, and precautionary saving

credit constraints: Credit constraints are restrictions on the amounts or terms on which individuals can borrow.
life cycle model of consumption: A model of consumption spending in which individuals’ current consumption depends not only on their current income, but also on their expected future income, and their assets, allowing for savings and debts.

According to the life cycle model of consumption (Section 3.9) households prefer to smooth their consumption over periods when their income varies by borrowing and saving, although many households are unable to smooth their consumption to the extent desired because they face credit constraints. Consumption smoothing is reflected in the size of the multiplier and therefore the slope of the aggregate demand curve in the multiplier model. When we introduce the role of wealth in consumption and saving behaviour, wealth changes can shift the aggregate demand curve.

precautionary saving: An increase in saving to restore wealth to its target level. See also: target wealth.
target wealth: The level of wealth that a household aims to hold, based on its economic goals (or preferences) and expectations. We assume that households try to maintain this level of wealth in the face of changes in their economic situation, as long as it is possible to do so.

The connection to housing is that in addition to saving to help smooth consumption, households also save for precautionary reasons when they have a target level of wealth. Target wealth is the level a household aims to hold based on their economic objectives. They will try to maintain this level when economic circumstances change and this will affect their saving (and therefore consumption behaviour). Changes in house prices will alter a household’s wealth.

A shift in autonomous consumption causes a shift in aggregate demand. Autonomous consumption is represented by the term c₀ in the aggregate consumption function, C = c₀ + c₁Y. A change in c₀ will in turn produce a multiplier response of output and employment through the circular flow of expenditure, output, and income.

autonomous consumption: In a model of consumption demand, autonomous consumption is planned consumption expenditure that does not depend on other variables in the model (such as income, or the interest rate).

Returning to the family with a mortgage on its house, if house prices are falling, the family will be concerned that its wealth, too, may fall. If wealth is at or below its target, then a likely reaction to this is for the household to save more. In the multiplier model, this is modelled as a fall in autonomous consumption.

According to US economist Martin Feldstein (who had been President Ronald Reagan’s chief economist), this effect contributed to an estimated fall in the household savings ratio from ‘2.5 percent of disposable personal income in the third quarter of 2003 to a negative −1.1 percent in the second half of 2005. This sharp decline in the personal saving rate was equivalent to about 2.5 percent of GDP.’

A rise in the value of their house increases a household’s wealth relative to their target and relaxes their credit constraint. They will want to save less (spend more on goods and services and housing) and will be able to borrow more.

Rapidly rising house prices in the years running up to 2008 sent the ‘wrong’ message when interpreted as a signal that they would rise further. We know that resources were misallocated, because the US and European countries with housing booms (most notably Spain and Ireland) were left with thousands of unfinished and abandoned houses when the boom collapsed.

To summarize, the financial accelerator helps explain positive (destabilizing) feedback processes in the housing market and adds to our understanding of aggregate consumption behaviour and how credit-fuelled housing booms are sustained.

For those who are not credit-constrained: If the value of your house increases, this improves your net worth and raises your wealth relative to your target wealth. We would predict that this would reduce your precautionary savings, and increase consumption.
For those who are credit-constrained: A rise in the market value of your house can lead you to increase your consumption spending (and your spending on housing) because the higher collateral enables you to borrow more.
A house price collapse will have an amplified effect, depressing aggregate demand as households increase their savings in order to rebuild their wealth.

Question 8.6 Choose the correct answer(s)

Suppose a household takes out a loan of $220,000 for a house that costs $275,000. Based on this information, read the following statements and choose the correct option(s).

The household’s leverage ratio (defined above in this section) is 80%.
A fall in house prices of 15% is enough to wipe out the household’s equity.
If the house price rises to $300,000, the return on the equity the household has invested in the house is 50%.
This household is less vulnerable to a fall in house prices than a household that takes out a loan of $300,000 for a house that costs $360,000.

The leverage ratio is the value of its loan divided by the value of the house, which is 220/275 = 80%.
A fall in house prices of 20% (the percentage that the household put as a downpayment) is needed to wipe out the household’s equity.
The value of the equity stake has risen from $55,000 to $80,000, which is a return on equity of 45%.
The leverage ratio of the other household is 300/360 = 83.3% (which is greater than 80%), and higher leverage ratios indicate greater vulnerability to falls in house prices.

Exercise 8.6 The financial accelerator

Draw a multiplier diagram to compare the effects of a rise in house prices on aggregate demand in 1) an economy where households can use their houses as collateral, and 2) an economy where households cannot use their houses as collateral. Assume the economies are identical in every other aspect.