Finance and macroeconomics: the role of household leverage.

• Author: Mian, Atif R.
• Position: Research Summaries

The increase in household leverage prior to the most recent recession was stunning by any historical comparison. From 2001 to 2007, household debt doubled, from $7 trillion to $14 trillion. The household debt-to-income ratio increased by more during these six years than it had in the prior 45 years. In fact, the household debt-to-income ratio in 2007 was higher than at any point since 1929. Our research agenda explores the causes and consequences of this tremendous rise in household debt. Why did U.S. households borrow so much and in such a short span of time? What factors triggered the slowdown and collapse of the real economy? Did household leverage amplify macroeconomic shocks and make a quick recovery less likely? How do politics constrain policy responses to an economic crisis?

While the focus of our research is on the recent U.S. economic downturn, we believe the implications of our work are wider. For example, both the Great Depression and Japan's Great Recession were preceded by sharp increases in leverage. (1) We believe that understanding the impact of household debt on the economy is crucial to developing a better understanding of the linkages between finance and macroeconomics.

The Rise in Household Debt

Our explanation for the increase in household debt begins with the dramatic expansion in mortgage originations to low credit-quality households from 2002 to 2007. (2) Mortgage-related debt is a natural starting point, given that it makes up 70 to 75 percent of household debt and was primarily responsible for the overall increase in household debt. Further, the expansion of new mortgage originations was much larger in zip codes with a large fraction of low credit-quality households.

We argue that the primary explanation behind the dramatic increase in mortgage debt was a securitization-driven shift in the supply of mortgage credit. The fraction of home purchase mortgages that were securitized by non-GSE (government sponsored enterprise) institutions rose from 3 percent to almost 20 percent from 2002 to 2005, before collapsing completely by 2008. We show that non-GSE securitization primarily targeted zip codes that had a large share of subprime borrowers. In these zip codes, mortgage denial rates dropped dramatically and debt-to-income ratios skyrocketed. Our evidence contradicts the hypothesis that the expansion in mortgage credit reflected productivity or permanent income improvements for marginal borrowers. For example, mortgage credit growth and income growth become negatively correlated at the zip code level from 2002 to 2005, despite being positively correlated in every other time period back to 1990.

Part of our research explores the relationship between house prices and mortgage credit growth, which is difficult to disentangle because mortgage credit is likely to both respond to and to drive house price growth. We address this issue by focusing on areas of the country with extremely elastic...