discussion of campbell and hercowitz’s “home equity and wealth during the transition to a high...

Discussion of Campbell and Hercowitz’s“Home Equity and Wealth During the Transition

to a High Debt Economy”

Erik Hurst

November 2006

OverviewOverview

• Stylized Fact – Use of debt has increased dramatically in the U.S. during the Stylized Fact – Use of debt has increased dramatically in the U.S. during the last two decades.last two decades.

OverviewOverview


• My discussionMy discussion::

- - Why should this be of interest to macroeconomists?Why should this be of interest to macroeconomists?

OverviewOverview




-- What are the potential causes for the increase in debt?What are the potential causes for the increase in debt?

OverviewOverview


• My discussion:My discussion:


-- What are the potential causes for the increase in debt?What are the potential causes for the increase in debt?

-- Can we learn anything about the causes of the increase of debt from Can we learn anything about the causes of the increase of debt from time series trends?time series trends?

OverviewOverview




-- What are the potential causes forWhat are the potential causes for the increase in debt?the increase in debt?

-- Can we learn anything about the causes of the increase of debt from Can we learn anything about the causes of the increase of debt from time series trends?time series trends?

-- Throughout, I will discuss the contributions of the Campbell and Throughout, I will discuss the contributions of the Campbell and Hercowitz paper to this literature?Hercowitz paper to this literature?

Part 1: Why Should (Macro) Economists Care?Part 1: Why Should (Macro) Economists Care?

1.1. An Explanation for “The Great Moderation”An Explanation for “The Great Moderation”

- U.S. volatility was reduced dramatically starting around 1983 (see, for U.S. volatility was reduced dramatically starting around 1983 (see, for example, Stock and Watson 2002).example, Stock and Watson 2002).

- Common explanations focus on either 1) better monetary policy, 2) Common explanations focus on either 1) better monetary policy, 2) more favorable aggregate shocks, or 3) improvements in firm more favorable aggregate shocks, or 3) improvements in firm management of inventories.management of inventories.

- Given that consumption is the largest component of GDP, innovations in Given that consumption is the largest component of GDP, innovations in the ability of consumers to weather aggregate shocks will mitigate the ability of consumers to weather aggregate shocks will mitigate aggregate volatility. aggregate volatility.

Part 1: Why Should (Macro) Economists Care?Part 1: Why Should (Macro) Economists Care?

1.1. An Explanation for “The Great Moderation”An Explanation for “The Great Moderation”

- U.S. volatility was reduced dramatically starting around 1983 (see, for U.S. volatility was reduced dramatically starting around 1983 (see, for example, Stock and Watson 2002).example, Stock and Watson 2002).

- Common explanations focus on either 1) better monetary policy, 2) Common explanations focus on either 1) better monetary policy, 2) more favorable aggregate shocks, or 3) improvements in firm more favorable aggregate shocks, or 3) improvements in firm management of inventories.management of inventories.

- Given that consumption is the largest component of GDP, innovations in Given that consumption is the largest component of GDP, innovations in the ability of consumers to weather aggregate shocks will mitigate the ability of consumers to weather aggregate shocks will mitigate aggregate volatility. aggregate volatility. (Behavior of consumption during last recession)(Behavior of consumption during last recession)

- See recent work by Dynan et al (2006) and Campbell and Hercowitz See recent work by Dynan et al (2006) and Campbell and Hercowitz (2006) for novel discussions.(2006) for novel discussions.

Why Should (Macro) Economists Care?Why Should (Macro) Economists Care?

2.2. Welfare Implications for Consumers (Including Sub Populations)Welfare Implications for Consumers (Including Sub Populations)

- Not only smooth aggregate shocks, but better able to smooth Not only smooth aggregate shocks, but better able to smooth idiosyncratic shocks or predictable lifecycle variation.idiosyncratic shocks or predictable lifecycle variation.

-- The increase in debt likely helped some sub groups much more than The increase in debt likely helped some sub groups much more than others. The median household likely always had some access to debt others. The median household likely always had some access to debt (store cards, etc.). (store cards, etc.).

-- Historically, low income households were essentially excluded from Historically, low income households were essentially excluded from credit market. May predict that the welfare gains would be largest for credit market. May predict that the welfare gains would be largest for low income individuals.low income individuals.

Why Should (Macro) Economists Care?Why Should (Macro) Economists Care?

3.3. Lower U.S. Savings RatesLower U.S. Savings Rates

-- Lower U.S. Investment? Lower U.S. Investment?

-- Higher U.S. Interest Rates? Higher U.S. Interest Rates?

-- Increased Foreign Capital Inflows?Increased Foreign Capital Inflows?

Note:Note: I will return to the declining U.S. savings rate in a few minutes.I will return to the declining U.S. savings rate in a few minutes.

4.4. Increased Bankruptcy (Default) ProbabilitiesIncreased Bankruptcy (Default) Probabilities

5.5. Changing Wealth Inequality within U.S.Changing Wealth Inequality within U.S.

Part 2: Natural QuestionPart 2: Natural Question

• What caused the sharp increase in debt (both collateralized and non-What caused the sharp increase in debt (both collateralized and non-collateralized) among all groups of U.S. households during last collateralized) among all groups of U.S. households during last

forty years?forty years?

-- Supply side factorsSupply side factors

-- Demand side factorsDemand side factors

Supply Side Factors: LegislationSupply Side Factors: Legislation

• Monetary Control ActMonetary Control Act: 1980: 1980

• Garn-St. Germain ActGarn-St. Germain Act: 1982: 1982

- Both of above increased the competitiveness in consumer lending- Both of above increased the competitiveness in consumer lending

- Focus of the “shock” to credit market in this paper.- Focus of the “shock” to credit market in this paper.

Supply Side Factors: LegislationSupply Side Factors: Legislation

• Monetary Control ActMonetary Control Act: 1980: 1980

• Garn-St. Germain ActGarn-St. Germain Act: 1982: 1982

- Both of above increased the competitiveness in consumer lending- Both of above increased the competitiveness in consumer lending

- Focus of the “shock” to credit market in this paper.- Focus of the “shock” to credit market in this paper.

• Federal Housing Enterprises Financial Safety ActFederal Housing Enterprises Financial Safety Act ((Mandate Fannie and Mandate Fannie and Freddie better serve low income households): 1992Freddie better serve low income households): 1992

- Change the composition of borrowers in the average mortgage pool- Change the composition of borrowers in the average mortgage pool

• Riegle-Neal ActRiegle-Neal Act (Interstate Banking): 1994(Interstate Banking): 1994

- Further increase competitiveness among banks- Further increase competitiveness among banks

Supply Side Factors: TechnologySupply Side Factors: Technology

Technological advances reduced the cost of providing financial services.Technological advances reduced the cost of providing financial services.

• ComputersComputers: Allowed lenders to store large amounts of data about : Allowed lenders to store large amounts of data about perspective borrowers and, in doing so, allowed them to price borrower risk perspective borrowers and, in doing so, allowed them to price borrower risk more effectively.more effectively.

-- Invention and use of FICO scores (1990-ish)Invention and use of FICO scores (1990-ish)

-- Reduced credit rationingReduced credit rationing

-- Bennett, Peach, and Peristiani “Structural Change in Bennett, Peach, and Peristiani “Structural Change in the the Mortgage Market and the Propensity to Refinance” Mortgage Market and the Propensity to Refinance” (JMCB ‘01)(JMCB ‘01)

Supply Side Factors: TechnologySupply Side Factors: Technology

Technological advances reduced the cost of providing financial services.Technological advances reduced the cost of providing financial services.

• ComputersComputers: Allowed lenders to store large amounts of data about : Allowed lenders to store large amounts of data about perspective borrowers and, in doing so, allowed them to price borrower risk perspective borrowers and, in doing so, allowed them to price borrower risk more effectively.more effectively.

-- Invention and use of FICO scores (1990-ish)Invention and use of FICO scores (1990-ish)

-- Reduced credit rationingReduced credit rationing

-- Bennett, Peach, and Peristiani “Structural Change in Bennett, Peach, and Peristiani “Structural Change in the the Mortgage Market and the Propensity to Refinance” Mortgage Market and the Propensity to Refinance” (JMCB ‘01)(JMCB ‘01)

• SecuritizationSecuritization: Innovations and managing risk through pooling loan : Innovations and managing risk through pooling loan portfolios (CMO’s, etc.). Increasingly important for non-collateralized portfolios (CMO’s, etc.). Increasingly important for non-collateralized loans as well as high risk collateralized loans (early 1990s).loans as well as high risk collateralized loans (early 1990s).

• Endogenous to regulations?Endogenous to regulations? Maybe/Maybe NotMaybe/Maybe Not

Demand Side FactorsDemand Side Factors

• Aggregate Volatility Declining (Starting in 1983)Aggregate Volatility Declining (Starting in 1983)

• Declining volatility should result in declining precautionary savings.Declining volatility should result in declining precautionary savings.• Although, evidence suggests that for some groups individual income Although, evidence suggests that for some groups individual income

volatility increased despite declining aggregate volatility.volatility increased despite declining aggregate volatility.

• Bankruptcy OptionBankruptcy Option

• Decline in Bankruptcy Costs (stigma, information, out of pocket Decline in Bankruptcy Costs (stigma, information, out of pocket expenses)expenses)

• Increases in Bankruptcy Exemptions (1978 Bankruptcy Reform)Increases in Bankruptcy Exemptions (1978 Bankruptcy Reform)• Equilibrium would have higher debt and higher defaults (coupled with Equilibrium would have higher debt and higher defaults (coupled with

higher interest rates).higher interest rates).

SummarySummary

• Lots of reasons why debt could have increased during the last 20 years.Lots of reasons why debt could have increased during the last 20 years.

-- The role of technology (including the ability to credit score) and The role of technology (including the ability to credit score) and securitization are likely an important component of the story.securitization are likely an important component of the story.

-- Along with changes in GSE’s policies, changed the mix of Along with changes in GSE’s policies, changed the mix of borrowers.borrowers.

• My read of the literature is that the innovations in lending occurred My read of the literature is that the innovations in lending occurred continuously throughout this time period.continuously throughout this time period.

• Cause of the increase in debt is important for interpreting the trends in Cause of the increase in debt is important for interpreting the trends in the aggregate data (and for interpreting the results from calibrated the aggregate data (and for interpreting the results from calibrated models) .models) .

Part 3: What is Campbell and Hercowitz About?Part 3: What is Campbell and Hercowitz About?

• Sets out to ask what is the response to consumption, work hours, debt, the Sets out to ask what is the response to consumption, work hours, debt, the wealth distribution, etc. from an exogenous increase in households’ ability wealth distribution, etc. from an exogenous increase in households’ ability to accumulate to accumulate collateralizedcollateralized debt. debt.

• Key: All borrowing in the economy is collateralized.Key: All borrowing in the economy is collateralized.

• Extent of collateralization has two components:Extent of collateralization has two components:

- ππ is the required equity needed to purchase a durable (i.e., the down is the required equity needed to purchase a durable (i.e., the down payment).payment).

- is the parameter that governs the speed of subsequent equity is the parameter that governs the speed of subsequent equity accumulation (think of this as the ability to refinance).accumulation (think of this as the ability to refinance).

• Focuses on a shock in the early 1980s (financial deregulation) that Focuses on a shock in the early 1980s (financial deregulation) that causes both causes both ππ and to change immediately. and to change immediately.


• Two types of households: “borrowers” and “savers”.Two types of households: “borrowers” and “savers”.

-- Utility = f(durables, non-durables, and “leisure”)Utility = f(durables, non-durables, and “leisure”)

• The only reason “borrowers” accumulate debt within the model is The only reason “borrowers” accumulate debt within the model is impatience (savers are relatively more patient)impatience (savers are relatively more patient)

• Borrowers are always bound by the liquidity constraint in steady state.Borrowers are always bound by the liquidity constraint in steady state.

• Model is general equilibrium (wages and interest rates adjust; only Model is general equilibrium (wages and interest rates adjust; only borrowers work)borrowers work)

• Borrowers do no savingBorrowers do no saving and and savers do no borrowing.savers do no borrowing. (All action in the (All action in the model is between the trade of resources between borrowers and model is between the trade of resources between borrowers and savers).savers).


Results from an exogenous decline in equity needed to purchase durables:Results from an exogenous decline in equity needed to purchase durables:

1)1) “Savers better off” and “borrowers worse off” at the new steady state.“Savers better off” and “borrowers worse off” at the new steady state.

2)2) Borrowers are worse off because – interest rates on debt increases, labor Borrowers are worse off because – interest rates on debt increases, labor supply increases, and wages fall.supply increases, and wages fall.

- Why do borrowers increase debt? Why do borrowers increase debt? Welfare gains during transition!Welfare gains during transition!- Constraint is relaxed along the early part of the transition path – Constraint is relaxed along the early part of the transition path –

borrowers can use current durables to expand current consumption.borrowers can use current durables to expand current consumption.

3)3) Steady state wealth distribution becomes more unequal (borrowers go more Steady state wealth distribution becomes more unequal (borrowers go more in debt and savers increase wealth via “loans”)in debt and savers increase wealth via “loans”)

Part 4: A Look at the DataPart 4: A Look at the Data

• Trends in collateralized debtTrends in collateralized debt

-- LTV’s for mortgages (initial equity requirement, LTV’s for mortgages (initial equity requirement, ππ))

-- Refinancing behavior (speed of subsequent equity accumulation, Refinancing behavior (speed of subsequent equity accumulation, ))

• Trends in non-collateralized debtTrends in non-collateralized debt

-- LevelsLevels

-- AccessAccess

• Trends in wealth distributionTrends in wealth distribution

Loan-To-Value (LTV) Ratios At Time of PurchaseLoan-To-Value (LTV) Ratios At Time of Purchase

D ata from SCF : Cam pbell and Hercow itz (Table 1 )

72

74

76

78

80

82

84

86

1983 1989 1992 1995 1998 2001

• Notice that initial LTV is constant up through 1989• Model predicts debt (LTV) should start to increase immediately

Increase

Historical LTV’s for New Mortgages Historical LTV’s for New Mortgages (Including Refi’s)(Including Refi’s)

Source: Federal Housing Finance Board

Increase starts ~ 19921983

Some Facts: Homeownership RatesSome Facts: Homeownership Rates

Source: Census Bureau

~ 19941983

Refinancings Over TimeRefinancings Over Time

• Define Define ηη as the e as the elasticity of refinancing propensity with respect to lasticity of refinancing propensity with respect to interest rate declines.interest rate declines.

• Research shows that Research shows that ηη(2002) > (2002) > ηη(1998) > (1998) > ηη (1993) > (1993) > ηη (1986) (1986)

• In other words, refinancing has continuously become more common over In other words, refinancing has continuously become more common over time.time.

• Bennett et al (2001) attribute this to the continuous decline in the cost of Bennett et al (2001) attribute this to the continuous decline in the cost of originating a mortgage.originating a mortgage.

Understanding The Role of Debt in the MacroeconomyUnderstanding The Role of Debt in the Macroeconomy

Source: Federal Housing Finance Board

Notice Stead Decline

Initial Fees and Charges on Conventional Single-Family Mortgages

Note the Steady Decline

1983

Non-Collateralized Debt Per Capita/Per IncomeNon-Collateralized Debt Per Capita/Per Income

Figure 1: Consumer debt in the US, 1960 = 100

50

100

150

200

250

300

350

400

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004

debt per capita

debt/income ratio

Access to Non Collateralized CreditAccess to Non Collateralized Credit

Credit Card Access by Income Quintile by Year (fraction with card)Credit Card Access by Income Quintile by Year (fraction with card)

QuintileQuintile 19701970 19831983 19891989 19951995

Q1Q1 2%2% 11%11% 17%17%28%28%

Q2Q2 9%9% 27%27% 36%36%54%54%

Q3Q3 14%14% 41%41% 62%62%71%71%

Q4Q4 22%22% 57%57% 76%76%83%83%

Q5Q5 33%33% 79%79% 89%89%95%95%

Source: Source: Durkin (2000)Durkin (2000)

Note:Note: Trend continues since 1970.Trend continues since 1970.

Access to Non Collateralized CreditAccess to Non Collateralized Credit

Credit Card Access by Income Quintile by Year (fraction with card)Credit Card Access by Income Quintile by Year (fraction with card)

QuintileQuintile 19701970 19831983 19891989 19951995

Q1Q1 2%2% 11%11% 17%17%28%28%

Q2Q2 9%9% 27%27% 36%36%54%54%

Q3Q3 14%14% 41%41% 62%62%71%71%

Q4Q4 22%22% 57%57% 76%76%83%83%

Q5Q5 33%33% 79%79% 89%89%95%95%

Source: Source: Durkin (2000)Durkin (2000)

Note:Note: Look at the Trend starting in 1970.Look at the Trend starting in 1970.

Share of Wealth Held By Top 10%Share of Wealth Held By Top 10%

Figure 2 from Campbell and Hercowitz

1990

Share of Housing Held By Top 10%Share of Housing Held By Top 10%

Figure 2 from Campbell and Hercowitz

1990

1990

Mortgage Debt/Owner Occupied Real EstateMortgage Debt/Owner Occupied Real Estate

25 .0

30 .0

35 .0

40 .0

45 .0

50 .01983 1990

Steady increase starting around 1985

Comment 1: Measuring the ShockComment 1: Measuring the Shock

Are the legislative changes in the early 1980s the appropriate shock to Are the legislative changes in the early 1980s the appropriate shock to calibrate the model?calibrate the model?

-- For some analyzes, the distinction is not important.For some analyzes, the distinction is not important.

• However, this paper’s focus (and interpretation of results) hinge on the However, this paper’s focus (and interpretation of results) hinge on the transition dynamics.transition dynamics.





-- How can transition dynamics be isolated from subsequent shocks to How can transition dynamics be isolated from subsequent shocks to lending technology or lending competition?lending technology or lending competition?





-- How can transition dynamics be isolated from subsequent shocks to How can transition dynamics be isolated from subsequent shocks to lending technology or lending competition?lending technology or lending competition?

- Data shows that most of the lending measures (LTV, Debt to Income, Data shows that most of the lending measures (LTV, Debt to Income, credit card debt) did not substantially change until the early 1990s or credit card debt) did not substantially change until the early 1990s or continuously evolved over the period?continuously evolved over the period?

• Timing of shock is important for interpreting magnitudes.Timing of shock is important for interpreting magnitudes.• Timing of shock is important for testing model predictions.Timing of shock is important for testing model predictions.


• Even if we believe qualitative results and the timing of only one shock, Even if we believe qualitative results and the timing of only one shock, do quantitative magnitudes make sense given the data?do quantitative magnitudes make sense given the data?

- Model estimates that the liquidity constraint re-binds for borrowers after Model estimates that the liquidity constraint re-binds for borrowers after 30 quarters (7 years). Yet most of the action does not take place on the 30 quarters (7 years). Yet most of the action does not take place on the borrowing side until after 1990?borrowing side until after 1990?

- If successive shocks were hitting the economy, how do we interpret the If successive shocks were hitting the economy, how do we interpret the model parameters? The imputed welfare gains?model parameters? The imputed welfare gains?

• Understanding the origins of the shock is important for shaping future Understanding the origins of the shock is important for shaping future policy recommendations. Is it deregulation or computers?policy recommendations. Is it deregulation or computers?

• Question: Can you estimate the model where the lending technology is Question: Can you estimate the model where the lending technology is evolving (perhaps at some constant rate) over the last twenty years?evolving (perhaps at some constant rate) over the last twenty years?

Comment 2: Other Motives for Accumulating DebtComment 2: Other Motives for Accumulating Debt

• Other potential reasons households accumulate debt:Other potential reasons households accumulate debt:

1) To smooth idiosyncratic labor risk1) To smooth idiosyncratic labor risk

2) To smooth predictable income changes over the lifecycle.2) To smooth predictable income changes over the lifecycle.

3) To smooth aggregate shocks.3) To smooth aggregate shocks.


• Other potential reasons households accumulate debt:Other potential reasons households accumulate debt:




• Welfare gains from smoothing income could be huge.Welfare gains from smoothing income could be huge.

-- Borrowers could be better off even in the new steady stateBorrowers could be better off even in the new steady state

-- Only reason borrowers accumulate debt in this model is ‘impatience’.Only reason borrowers accumulate debt in this model is ‘impatience’.


• Other reasons households accumulate debt:Other reasons households accumulate debt:




• Welfare gains from smoothing income could be huge.Welfare gains from smoothing income could be huge.

-- Borrowers could be better off even in the new steady stateBorrowers could be better off even in the new steady state

-- Only reason borrowers accumulate debt in this model is ‘impatience’.Only reason borrowers accumulate debt in this model is ‘impatience’.

• To provide quantitative results for policy purposes, it would be important to model other reasons to accumulate debt besides impatience.

• Question: Why not set up an OLG lifecycle analysis? What about the Question: Why not set up an OLG lifecycle analysis? What about the role for non-collateralized debt?role for non-collateralized debt?

Comment 3: Testing the MechanismComment 3: Testing the Mechanism

Sharp decline in U.S. savings rateSharp decline in U.S. savings rate

(From Figure 1 of Maki and Palumbo, 2001)(From Figure 1 of Maki and Palumbo, 2001)

1983 1992

Comment 3: Testing the MechanismComment 3: Testing the Mechanism• Savings rates by income quintiles (Table 2 from Maki and Palumbo, 2001)Savings rates by income quintiles (Table 2 from Maki and Palumbo, 2001)

Comment 3: Testing the MechanismComment 3: Testing the Mechanism• Contribution to aggregate savings rates for each income quintiles (Table 4 Contribution to aggregate savings rates for each income quintiles (Table 4

from Maki and Palumbo, 2001)from Maki and Palumbo, 2001)

Comment 3: Testing the MechanismComment 3: Testing the Mechanism

• What would your model predict about the savings rates for borrowers What would your model predict about the savings rates for borrowers and savers during this time period? and savers during this time period?

• Would they match the aggregate data?Would they match the aggregate data?

• My guess is no – what does that imply? Should we think about the My guess is no – what does that imply? Should we think about the foreign sector being the “savers”? Does your model match foreign foreign sector being the “savers”? Does your model match foreign inflows into the U.S.?inflows into the U.S.?

• Why are rich U.S. households decreasing their savings rate so much?Why are rich U.S. households decreasing their savings rate so much?

• Question: Could your model predict an increase in returns that would Question: Could your model predict an increase in returns that would generate the rich generate the rich decreasingdecreasing their savings and their savings and increasingincreasing their wealth their wealth (at the same time that the poor (at the same time that the poor increasedincreased their savings and their savings and increasedincreased their wealth?)their wealth?)

ConclusionsConclusions

• The expansion of debt (both collateralized and non-collateralized) The expansion of debt (both collateralized and non-collateralized) should be an important area of research for macroeconomists.should be an important area of research for macroeconomists.

• I applaud the authors for working on this topic!I applaud the authors for working on this topic!

• For their research agenda (in both this paper and the previous paper) For their research agenda (in both this paper and the previous paper) which employs calibrated GE models – it is important to model the which employs calibrated GE models – it is important to model the “shock” to lending correctly.“shock” to lending correctly.

• To gauge welfare gains from expansion to credit, it would be good to To gauge welfare gains from expansion to credit, it would be good to include more realistic demands for borrowing (e.g., life cycle model include more realistic demands for borrowing (e.g., life cycle model with idiosyncratic labor income risk). with idiosyncratic labor income risk).

• I would put their mechanism to the test and see how it does at matching I would put their mechanism to the test and see how it does at matching the trends in saving rates for “borrowers” and “savers” (as well as the the trends in saving rates for “borrowers” and “savers” (as well as the aggregate).aggregate).

discussion of campbell and hercowitz’s “home equity and wealth during the transition to a high...

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