Discussion of Campbell and Hercowitz’s “Home Equity and Wealth During the Transition to a High Debt Economy”

1. Discussion of Campbell and Hercowitz’s“Home Equity and Wealth During the Transition to a High Debt Economy” Erik Hurst November 2006

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

3. Overview Stylized Fact – Use of debt has increased dramatically in the U.S. during the last two decades. My discussion: - Why should this be of interest to macroeconomists?

4. Overview Stylized Fact – Use of debt has increased dramatically in the U.S. during the last two decades. My discussion: - Why should this be of interest to macroeconomists? - What are the potential causes for the increase in debt?

5. Overview Stylized Fact – Use of debt has increased dramatically in the U.S. during the last two decades. My discussion: - Why should this be of interest to macroeconomists? - What are the potential causes for the increase in debt? - Can we learn anything about the causes of the increase of debt from time series trends?

6. Overview Stylized Fact – Use of debt has increased dramatically in the U.S. during the last two decades. My discussion: - Why should this be of interest to macroeconomists? - What are the potential causes forthe increase in debt? - Can we learn anything about the causes of the increase of debt from time series trends? - Throughout, I will discuss the contributions of the Campbell and Hercowitz paper to this literature?

7. Part 1: Why Should (Macro) Economists Care? An Explanation for “The Great Moderation” U.S. volatility was reduced dramatically starting around 1983 (see, for example, Stock and Watson 2002). Common explanations focus on either 1) better monetary policy, 2) more favorable aggregate shocks, or 3) improvements in firm management of inventories. Given that consumption is the largest component of GDP, innovations in the ability of consumers to weather aggregate shocks will mitigate aggregate volatility.

8. Part 1: Why Should (Macro) Economists Care? An Explanation for “The Great Moderation” U.S. volatility was reduced dramatically starting around 1983 (see, for example, Stock and Watson 2002). Common explanations focus on either 1) better monetary policy, 2) more favorable aggregate shocks, or 3) improvements in firm management of inventories. Given that consumption is the largest component of GDP, innovations in the ability of consumers to weather aggregate shocks will mitigate aggregate volatility. (Behavior of consumption during last recession) See recent work by Dynan et al (2006) and Campbell and Hercowitz (2006) for novel discussions.

9. Why Should (Macro) Economists Care? 2. Welfare Implications for Consumers (Including Sub Populations) - Not only smooth aggregate shocks, but better able to smooth idiosyncratic shocks or predictable lifecycle variation. - The increase in debt likely helped some sub groups much more than others. The median household likely always had some access to debt (store cards, etc.). - Historically, low income households were essentially excluded from credit market. May predict that the welfare gains would be largest for low income individuals.

10. Why Should (Macro) Economists Care? 3. Lower U.S. Savings Rates - Lower U.S. Investment? - Higher U.S. Interest Rates? - Increased Foreign Capital Inflows? Note: I will return to the declining U.S. savings rate in a few minutes. Increased Bankruptcy (Default) Probabilities Changing Wealth Inequality within U.S.

11. Part 2: Natural Question What caused the sharp increase in debt (both collateralized and non-collateralized) among all groups of U.S. households during last forty years? - Supply side factors - Demand side factors

12. Supply Side Factors: Legislation Monetary Control Act: 1980 Garn-St. Germain Act: 1982 - Both of above increased the competitiveness in consumer lending - Focus of the “shock” to credit market in this paper.

13. Supply Side Factors: Legislation Monetary Control Act: 1980 Garn-St. Germain Act: 1982 - Both of above increased the competitiveness in consumer lending - Focus of the “shock” to credit market in this paper. Federal Housing Enterprises Financial Safety Act(Mandate Fannie and Freddie better serve low income households): 1992 - Change the composition of borrowers in the average mortgage pool Riegle-Neal Act(Interstate Banking): 1994 - Further increase competitiveness among banks

14. Supply Side Factors: Technology Technological advances reduced the cost of providing financial services. Computers: Allowed lenders to store large amounts of data about perspective borrowers and, in doing so, allowed them to price borrower risk more effectively. - Invention and use of FICO scores (1990-ish) - Reduced credit rationing - Bennett, Peach, and Peristiani “Structural Change in the Mortgage Market and the Propensity to Refinance” (JMCB ‘01)

15. Supply Side Factors: Technology Technological advances reduced the cost of providing financial services. Computers: Allowed lenders to store large amounts of data about perspective borrowers and, in doing so, allowed them to price borrower risk more effectively. - Invention and use of FICO scores (1990-ish) - Reduced credit rationing - Bennett, Peach, and Peristiani “Structural Change in the Mortgage Market and the Propensity to Refinance” (JMCB ‘01) Securitization: Innovations and managing risk through pooling loan portfolios (CMO’s, etc.). Increasingly important for non-collateralized loans as well as high risk collateralized loans (early 1990s). Endogenous to regulations? Maybe/Maybe Not

16. Demand Side Factors Aggregate Volatility Declining (Starting in 1983) Declining volatility should result in declining precautionary savings. Although, evidence suggests that for some groups individual income volatility increased despite declining aggregate volatility. Bankruptcy Option Decline in Bankruptcy Costs (stigma, information, out of pocket expenses) Increases in Bankruptcy Exemptions (1978 Bankruptcy Reform) Equilibrium would have higher debt and higher defaults (coupled with higher interest rates).

17. Summary Lots of reasons why debt could have increased during the last 20 years. - The role of technology (including the ability to credit score) and securitization are likely an important component of the story. - Along with changes in GSE’s policies, changed the mix of borrowers. My read of the literature is that the innovations in lending occurred continuously throughout this time period. Cause of the increase in debt is important for interpreting the trends in the aggregate data (and for interpreting the results from calibrated models) .

18. Part 3: What is Campbell and Hercowitz About? Sets out to ask what is the response to consumption, work hours, debt, the wealth distribution, etc. from an exogenous increase in households’ ability to accumulate collateralized debt. Key: All borrowing in the economy is collateralized. Extent of collateralization has two components: π is the required equity needed to purchase a durable (i.e., the down payment). is the parameter that governs the speed of subsequent equity accumulation (think of this as the ability to refinance). Focuses on a shock in the early 1980s (financial deregulation) that causes both π and to change immediately.

19. Part 3: What is Campbell and Hercowitz About? Two types of households: “borrowers” and “savers”. - Utility = f(durables, non-durables, and “leisure”) The only reason “borrowers” accumulate debt within the model is impatience (savers are relatively more patient) Borrowers are always bound by the liquidity constraint in steady state. Model is general equilibrium (wages and interest rates adjust; only borrowers work) Borrowers do no saving and savers do no borrowing.(All action in the model is between the trade of resources between borrowers and savers).

20. Part 3: What is Campbell and Hercowitz About? Results from an exogenous decline in equity needed to purchase durables: 1) “Savers better off” and “borrowers worse off” at the new steady state. 2) Borrowers are worse off because – interest rates on debt increases, labor supply increases, and wages fall. Why do borrowers increase debt? Welfare gains during transition! Constraint is relaxed along the early part of the transition path – borrowers can use current durables to expand current consumption. 3) Steady state wealth distribution becomes more unequal (borrowers go more in debt and savers increase wealth via “loans”)

21. Part 4: A Look at the Data Trends in collateralized debt - LTV’s for mortgages (initial equity requirement, π) - Refinancing behavior (speed of subsequent equity accumulation, ) Trends in non-collateralized debt - Levels - Access Trends in wealth distribution

22. Loan-To-Value (LTV) Ratios At Time of Purchase Increase • Notice that initial LTV is constant up through 1989 • Model predicts debt (LTV) should start to increase immediately

23. Historical LTV’s for New Mortgages (Including Refi’s) 1983 Increase starts ~ 1992 Source: Federal Housing Finance Board

24. Some Facts: Homeownership Rates ~ 1994 1983 Source: Census Bureau

25. Refinancings Over Time Define η as the elasticity of refinancing propensity with respect to interest rate declines. Research shows that η(2002) > η(1998) > η (1993) > η (1986) In other words, refinancing has continuously become more common over time. Bennett et al (2001) attribute this to the continuous decline in the cost of originating a mortgage.

26. Initial Fees and Charges on Conventional Single-Family Mortgages 1983 Understanding The Role of Debt in the Macroeconomy Notice Stead Decline Note the Steady Decline Source: Federal Housing Finance Board

27. Non-Collateralized Debt Per Capita/Per Income

28. Access to Non Collateralized Credit Credit Card Access by Income Quintile by Year (fraction with card) Quintile 1970 1983 1989 1995 Q1 2% 11% 17% 28% Q2 9% 27% 36% 54% Q3 14% 41% 62% 71% Q4 22% 57% 76% 83% Q5 33% 79% 89% 95% Source: Durkin (2000) Note: Trend continues since 1970.

29. Access to Non Collateralized Credit Credit Card Access by Income Quintile by Year (fraction with card) Quintile 1970 1983 1989 1995 Q1 2% 11% 17% 28% Q2 9% 27% 36% 54% Q3 14% 41% 62% 71% Q4 22% 57% 76% 83% Q5 33% 79% 89% 95% Source: Durkin (2000) Note: Look at the Trend starting in 1970.

30. Share of Wealth Held By Top 10% 1990 Figure 2 from Campbell and Hercowitz

31. 1990 Share of Housing Held By Top 10% 1990 Figure 2 from Campbell and Hercowitz

32. 1983 1990 Mortgage Debt/Owner Occupied Real Estate Steady increase starting around 1985

33. Comment 1: Measuring the Shock Are the legislative changes in the early 1980s the appropriate shock to calibrate the model? - For some analyzes, the distinction is not important. However, this paper’s focus (and interpretation of results) hinge on the transition dynamics.

34. Comment 1: Measuring the Shock Are the legislative changes in the early 1980s the appropriate shock to calibrate the model? - For some analyzes, the distinction is not important. However, this paper’s focus (and interpretation of results) hinge on the transition dynamics. - How can transition dynamics be isolated from subsequent shocks to lending technology or lending competition?

35. Comment 1: Measuring the Shock Are the legislative changes in the early 1980s the appropriate shock to calibrate the model? - For some analyzes, the distinction is not important. However, this paper’s focus (and interpretation of results) hinge on the transition dynamics. - How can transition dynamics be isolated from subsequent shocks to lending technology or lending competition? Data shows that most of the lending measures (LTV, Debt to Income, credit card debt) did not substantially change until the early 1990s or continuously evolved over the period? Timing of shock is important for interpreting magnitudes. Timing of shock is important for testing model predictions.

36. Comment 1: Measuring the Shock Even if we believe qualitative results and the timing of only one shock, do quantitative magnitudes make sense given the data? 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 borrowing side until after 1990? If successive shocks were hitting the economy, how do we interpret the model parameters? The imputed welfare gains? Understanding the origins of the shock is important for shaping future policy recommendations. Is it deregulation or computers? Question: Can you estimate the model where the lending technology is evolving (perhaps at some constant rate) over the last twenty years?

37. Comment 2: Other Motives for Accumulating Debt Other potential reasons households accumulate debt: 1) To smooth idiosyncratic labor risk 2) To smooth predictable income changes over the lifecycle. 3) To smooth aggregate shocks.

38. Comment 2: Other Motives for Accumulating Debt Other potential reasons households accumulate debt: 1) To smooth idiosyncratic labor risk 2) To smooth predictable income changes over the lifecycle. 3) To smooth aggregate shocks. Welfare gains from smoothing income could be huge. - Borrowers could be better off even in the new steady state - Only reason borrowers accumulate debt in this model is ‘impatience’.

39. Comment 2: Other Motives for Accumulating Debt Other reasons households accumulate debt: 1) To smooth idiosyncratic labor risk 2) To smooth predictable income changes over the lifecycle. 3) To smooth aggregate shocks. Welfare gains from smoothing income could be huge. - Borrowers could be better off even in the new steady state - 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 role for non-collateralized debt?

40. Comment 3: Testing the Mechanism 1983 1992 Sharp decline in U.S. savings rate (From Figure 1 of Maki and Palumbo, 2001)

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

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

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

44. Comment 3: Testing the Mechanism Contribution to aggregate savings rates for each income quintiles (Table 4 from Maki and Palumbo, 2001)

45. Comment 3: Testing the Mechanism What would your model predict about the savings rates for borrowers and savers during this time period? Would they match the aggregate data? My guess is no – what does that imply? Should we think about the foreign sector being the “savers”? Does your model match foreign inflows into the U.S.? Why are rich U.S. households decreasing their savings rate so much? Question: Could your model predict an increase in returns that would generate the rich decreasing their savings and increasing their wealth (at the same time that the poor increased their savings and increased their wealth?)

46. Conclusions The expansion of debt (both collateralized and non-collateralized) should be an important area of research for macroeconomists. I applaud the authors for working on this topic! For their research agenda (in both this paper and the previous paper) which employs calibrated GE models – it is important to model the “shock” to lending correctly. To gauge welfare gains from expansion to credit, it would be good to include more realistic demands for borrowing (e.g., life cycle model with idiosyncratic labor income risk). 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 aggregate).