slide 0 Welfare Implications of the Transition to High Household Debt Jeffrey R. Campbell and Zvi Hercowitz Presentation at the Conference Household Finances and Housing Wealth Banco de España April 2007

slide 1 Introduction  Who benefits in the economy from relaxing a borrowing constraint? Borrowers or Savers?  Microeconomic level  Macroeconomic level  Relaxation of borrowing constraints in the US: Aggressive deregulation of the mortgage market in early 1980s  Background:  Homes and vehicles collateralize most household debt: 90% in 2001 (1962: 85%). Typical debt contract: equity requirements  Deregulation in 1982: Greater access to sub-prime mortgages and refinancing. Lowering “equity requirements”

slide 2  Housing equity 1982: 71% of GDP  Household Debt/GDP: 43% in 1983  56% in 1990  Model: borrower-saver model in Campbell and Hercowitz (2006)  10th wealth decile. 72.8% of financial assets in 2001  "saver"  1st-9th wealth deciles. 73.4% of household debt in 2001  "borrower" M

slide 3 Rest of the Talk  The model  Quantitative results: Computed transition dynamics  Interpretation of the data through the eyes of the model  Welfare effects  Conclusions

slide 4 The Borrower-Saver Model Main Features  Borrowing is collateralized – equity requirement  The two household differ in time preference and in labor supply. Only the borrower supplies labor  In equilibrium: saver holds all the assets, borrower owes all the debt. Borrower’s only asset: equity on durable goods  The capital stock is constant

slide 5 Preferences

slide 6 Technology

slide 7 Trade Markets are competitive: Households sell capital services and labor to the firms – make loans to each other Factor prices: H t, W t Only security traded: Collateralized debt with a period-by- period adjustable rate Notation:

slide 8 Equity Requirement  Equity requirement parameters:  0 <  < 1: initial equity share  δ ≤  < 1: equity accumulation  Required equity share for a good j periods old:

slide 9 The equity constraint on a household is: This constraint can be rewritten as:

slide 10 Optimization and Equilibrium  Equity constraint: binds for at most one type of household at a time  Conjecture: It binds for the borrower from t * ≥ 0. This is verified in the solution

slide 11 Utility Maximization by Savers Budget constraint and first-order conditions:

slide 12 Utility Maximization by Borrowers Constraints:

slide 13 First-order conditions:

slide 14 Production and Equilibrium

slide 15 The Deterministic Steady State

slide 16 Quantitative Results The experiment Initial pre-reform steady state calibrated to the equity requirements observed through 1982:IV Lower equity requirements:  and π values calibrated to the period from 1995:I onwards Computation of the transition path to the new steady state

slide 17 Calibration – Main Features Data: Cars: Average loan-to-value ratios and terms from the data Homes: SCF, and actual change in debt/asset ratio High requirement regime:  = 0.16,  = Low requirement regime:  = 0.11,  = loan to value ratio repayment rate

slide 18 Computation procedure  Equilibrium path beginning at the old steady state  Modified version of Fair and Taylor's (1983) procedure  Borrower's equity constraint does not bind until t * ≥ 0  t * = 30

slide 19 Simulation Results – The Interest rate and the Debt

slide 20 Simulation Results – Individual Decisions

slide 21 Simulation Results – Wealth Distribution

slide 22 Interpretation of the Evidence  Evolution of wealth distribution from the SCF. Every 3 years:  Comovement of household debt and interest rates

slide 23 Shares of the Wealthiest 10% Households (1) Wealth

slide 24 Shares of the Wealthiest 10% Households (2) Housing and Vehicles

slide 25 Household Debt and the Real Interest Rate Debt/Assets Ratios and Real 3-year T Bill Rate fed

slide 26 Welfare Analysis  Equivalent permanent change in both consumption goods  Across steady states: –Saver: 12 % –Borrower: -4.4 %  Including the transition: –Saver: 2.02 % –Borrower: 0.26 %  Wage rate, capital income and interest rate constant: –Saver: 0 % –Borrower: 1.35 %  Wage rate and capital income constant: –Saver: 1.36 % –Borrower: 0.45 %

slide 27 Concluding Comments  The transition is characterized by a prolonged increase in household debt accompanied by high interest rates.  Since 1983: Positive comovement of household debt and interest rates.  The main result: Savers gain from the financial reform more than borrowers---in spite of the fact that the relaxation of equity requirements applies directly to the latter.

slide 28 Extension of the Model: Irreversible Investment The constraint binds only for the saver, and only initially. t ** = 17, t * = 33

slide 29 Irreversible Investment – The Debt and the Interest Rate

slide 30 Irreversible Investment – Individual Decisions

slide 31 Irreversible Investment – Wealth Distribution

slide 32 Mortgage Terms from the Survey of Consumer Finances back

slide 33 Federal Funds and 3-Year Treasury Bill Rate back