Debt finances additional consumption.
That could be the summary of a speech given
on Tuesday to the National Retail Federation’s annual convention by William C.
Dudley, President and CEO of the Federal Reserve Bank of New York. Dudley’s remarks focused on the connections
between housing and retail sales and why changes in the housing and mortgage
markets “Have had important consequences for the dynamics of consumption over
the last decade.” These connections, he said, are among the reasons the
recovery and economic expansion have been weaker than desired. The good news however, is that, while the
current expansion is quite old in chronological terms, it is still quite young
in terms of households’ financial health.
Household incomes tend to increase
as individuals age, but ideally households would like to even out consumption
based on their lifetime incomes, raising consumption in their earlier
years. This would mean that young people
would consume a relatively high share of their incomes while older people would
save more. Young people might even wish
to borrow against their future income to enjoy the benefits of consumption at a
But there are constraints on such a
shift in consumption through borrowing.
Lenders don’t have a reliable way to compel repayment without a pledge
of assets that can be claimed by the lender in the event of default. For most households the main form of wealth
is human capital, but that is difficult to collateralize. The second most important household asset for
many is their housing equity and it, for those that possess it, becomes the
most important form of collateral.
This makes the performance of the
housing and mortgage markets important to retail business, Dudley said. During the housing boom that started in around
1995 and ended in 2006, the aggregate value of real estate owned by households
and nonprofits rose from $8.6 trillion to nearly $25 trillion.
What isn’t as well known is that
borrowing was growing almost exactly as fast.
Households were not saving that extra housing-driven wealth, they were
diverting a large share of it to other purposes. “The fraction of every
additional dollar of households’ housing wealth that was consumed seems to have
been higher than that for financial wealth-such as investments in equities and
bonds-suggesting that [homeowners] viewed the increase in home prices as
Dudley said a database the Federal
Reserve developed with Equifax found that, between 2004 and 2006 households
were increasing their cash flow by over $200 billion a year by borrowing
against their housing equity. They
supplemented this with another $185 billion in non-mortgage borrowing.
They were of course mistaken in
viewing home price increases as permanent. Home values began to fall in
mid-2006 and by 2008 there was a massive reversal in behavior toward equity and
consumption. “People went from borrowing hundreds of billions of dollars
per year and increasing their mortgage debt, to paying back hundreds of billions
of dollars and reducing their mortgage debt.” The $400 billion in net cash
flow from increased borrowing sharply reversed to negative $150 billion by
2010. An increased pay-down in residential mortgage debt was the main source.
This rapid reduction of more than $500 billion annually in resources for
household consumption resulted in a sharp and prolonged slump in such expenditures
during the Great Recession. “Typically, consumption growth slows but
remains positive during a recession. In contrast, consumption actually
contracted by over $300 billion during the Great Recession,” he said.
Households continued to pay down all
kinds of debt (other than student loans).
Housing prices finally stabilized and began to increase again in 2012,
but while values have risen over 40 percent since and are nearly back to
pre-crisis levels, and while other kinds of debt, auto and credit cards have
risen, housing debt has stayed relatively flat. “The previous behavior of using
housing debt to finance other kinds of consumption seems to have completely disappeared.
Instead, people are apparently leaving the wealth generated by rising
home prices “locked up” in their homes.”
This has been quite significant for
the retail sector, Dudley said. If housing debt had risen apace with home
prices since 2012-rather than staying flat as it has-then we would once again
be seeing housing debt making about $200 billion in cash flow available for
consumption. Instead, households are
diverting about that same amount to paying down their housing debt – a difference
of roughly $400 billion per year, or about 3 percent of total consumption.
Household behavior has apparently
changed because of an interaction between the supply and demand sides of the credit
markets. On the demand side, Dudley
Consumers may have become more
cautious about housing’s value as a financial instrument, accepting that
housing wealth, like other investments, can be transitory rather than permanent. Therefore, it is not prudent to spend too
much from this source of wealth.
The deep job losses of the Great
Recession may have brought home the need for precautionary savings.
Some potential homeowners may have,
after experiencing the housing crisis, soured on homeownership altogether, and
homeownership rates have declined, especially among younger workers. But there are also indications that consumers
still view housing as a sound investment and reduced homeownership doesn’t
explain why people who still own homes have become less likely to tap their
available equity to finance consumption.
The housing crisis left a lot of
scars – some lost their homes and saw their credit badly damaged while others
watched it happen to their neighbors. Experiencing
or witnessing these consequences may have led to a precautionary demand for
preserving higher housing equity to guard against the risk of negative equity. Positive equity can provide a cushion in the
event of job loss or another housing downturn.
The demand to tap equity for
consumption might also be constrained by a wish to retain mobility in case of a
change in labor markets or merely a desire to upgrade a home or neighborhood.
The Federal Reserve’s accommodative
monetary policy which has allowed millions to refinance into very low
fixed-rate mortgages may also have lessened demand. As rates rise there is a higher cost to
extracting equity through a cash out refinancing which has indeed been very
low. Even other ways of taping equity
such as second mortgage or home equity lines (HELOCs) are not being utilized
and in fact these loans have been paid down more aggressively than first mortgages.
There has been a change in the
distribution of increasing housing equity which, while in the aggregate is back
to pre-crisis levels, has gone disproportionately to older, wealthier
households. Presumably, these households have less demand for credit to
fund consumption while those who would like to convert housing wealth into
retail purchases have less of it, reflecting, in part, slower rates of mortgage
balance paydown. In addition, younger and less credit-worthy households
also experienced higher relative declines in homeownership rates.
Dudley said that demand-side factors
are reducing equity extraction but there is a strong supply-side effect
operating as well.
Consumer credit data indicate that
minimum credit scores for mortgage lending and more rigorous underwriting
standards for HELOCs have playing an important role in limiting consumers’
ability to convert equity into new consumption.
He calls the drivers of this change in lender behavior complex but
probably include a combination of more regulation and stress testing of bank
portfolios and more conservative practices by Fannie Mae and Freddie Mac.
Bank experiences from the crisis
period have caused lender to reassess the degree to which they lean on
collateral and to shift underwriting more toward the creditworthiness of the
borrower. This is consistent with the fact that mortgage credit is now much
harder to get for lower credit-rated borrowers than during the housing boom.
When and to what extent will
households again start tapping into home equity, making it again a fundamental
driver of consumption? Dudley said we do
not want to repeat the experiences of the housing boom, “but there are prudent
ways for households to access their housing equity.” Still, several milestones have already passed
that could have reignited lenders’ and borrowers’ appetite for home lending yet
have not done so. Home prices stopped falling in 2010 which could have
signaled that the worse was behind us, yet homeowners continued to divert cash
into debt reduction. Home prices and equity resumed growing in 2012 and
homeowners continued to deleverage, reinforcing the role of rising prices in
rebuilding equity. Now both prices and aggregate equity are nearly back to
Perhaps, we will soon see a recovery
in equity extraction expanding consumption, he said, in which case the household
saving rate will begin to decline.
Alternatively, we may have a longer wait until both homeowners and
lenders decide it is safe to go back in the water. “Whatever the timing,”
Dudley says, “a return to a reasonable pattern of home equity extraction would
be a positive development for retailers, and would provide a boost to aggregate
growth.” In the meantime, consumption growth will largely be determined
by income growth, the trajectory of wages and the strength of the labor market.