Marginal vs. Average Debt to Equity in Housing

Alejandro Justiniano and others write,

if the relaxation of collateral constraints had been widespread, it should have resulted in a surge of mortgage debt relative to the value of real estate.

In the data, however, household debt and real estate values rose in tandem, leaving their ratio roughly unchanged over the first half of the 2000s, as shown in Figure 3. In fact, this ratio only spiked when home prices tumbled starting in 2006.

Pointer from Mark Thoma.

Suppose that back when lenders asked for 20 percent down, three families bought houses for $100,000 each and put $20,000 down each. Total mortgage debt is $240,000 and total home values are $300,000. The ratio of household to real estate debt is 80 percent.

Next, lenders allow someone to buy a house with no money down. As a result, home prices rise to $130,000. Adding $130,000 debt to the debt of the other three households (ignoring any equity they may have built up through paying down mortgage principal), we have total mortgage debt of $370,000. But total home values are $520,000, so that the average ratio of debt to equity has actually fallen, to just over 70 percent.

As long as home prices are rising, the last thing you should expect is for the average debt to equity ratio to rise. The fact that it did not fall is an indication of how powerful the boom in credit was. Only if you use a silly representative-agent model, in which there is no difference between average and marginal borrowers, would you predict something different. I have not read the paper, but I suspect that is what the authors did.

2 thoughts on “Marginal vs. Average Debt to Equity in Housing

  1. Yes, nice explanation.

    A related point is that the expected loss to the lender for a particular mortgage will be highly nonlinear in the debt/value ratio, both because those with significant equity will be much less likely to default, and because recovery will be higher if they do default. To a first approximation all the losses come from the set of mortgages with very high debt/equity. The overall average matters little, a better measure would be the share of mortgages that are above some threshold.

    I suspect as well that homeowners do not ignore sunk costs, and someone who has made a large down payment and/or years of mortgage payments is much less likely to default, even if they have the same debt/value as someone who has not put much skin in the game.

  2. You say to ignore equity built via paying down mortgage loan principal.
    However, when the fourth house sells for $130k, and the earlier purchasers (who are following the market closely) see the rise in sales price & recalculate their equity, aren’t at least one or two of them tempted to run to his mortgage broker/lender/holder (whose appraiser uses the last and most recent sales for his market-based appraisal) and take out a second to pay for his next family ski vacation in Colorado or beach vacay in St. Bart, a HELOC to finance his kitchen remodel, or something similar?
    Is that subsequent housing-secured debt counted in your scenario? Because that would put them close to being a similar situation to #4 who bought with no down whatsoever.

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