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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

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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”

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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

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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

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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

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slide 5 Preferences

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slide 6 Technology

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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:

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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:

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

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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

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

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slide 12 Utility Maximization by Borrowers Constraints:

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slide 13 First-order conditions:

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slide 14 Production and Equilibrium

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slide 15 The Deterministic Steady State

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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

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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, = 0.0315 Low requirement regime: = 0.11, = 0.0186 loan to value ratio repayment rate

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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

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slide 19 Simulation Results – The Interest rate and the Debt

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slide 20 Simulation Results – Individual Decisions

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slide 21 Simulation Results – Wealth Distribution

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slide 22 Interpretation of the Evidence Evolution of wealth distribution from the SCF. Every 3 years: 1983-2001 Comovement of household debt and interest rates

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

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

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

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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 %

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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.

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

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slide 29 Irreversible Investment – The Debt and the Interest Rate

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slide 30 Irreversible Investment – Individual Decisions

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slide 31 Irreversible Investment – Wealth Distribution

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slide 32 Mortgage Terms from the Survey of Consumer Finances back

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

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