Mortgages and financial expectations: a household-level analysis.

1. Introduction and Background

Arguably, the purchase of property is one of the most important investment and consumption decisions an individual or household will make over a lifetime. Furthermore, such purchases are frequently financed by mortgages. There has been a phenomenal rise in mortgage debt over recent years. For example, the growth rate in mortgage debt as a proportion of GDP in the UK between 1992 and 2002 is estimated at 21% (Catte et al. 2004). Similarly, the secured debt to income ratio has increased by 42% between 1995 and 2005 (Council of Mortgage Lenders 2006). Household mortgage debt far outweighs household unsecured debt: In the UK, average household mortgage debt in 2000 was estimated at 48,300 [pounds sterling and at 73,788 [pounds sterling] for new mortgages, as compared to 3281 [pounds sterling] for unsecured debt. Not surprisingly, the extent of household mortgage debt has been of much concern to policy makers. (1) This is especially problematic as financial assets are typically low: average annual savings in the UK in 2000 were estimated at 934 [pounds sterling]. (2) It is apparent, therefore, that savings typically provide insufficient cover for mortgage debt. Hence, the analysis of mortgage debt is important in determining the potential financial stress at the household level. As argued by Hamilton (2003), increases in household borrowing may make households vulnerable to reductions in their income or to changes in the interest rate. Consequently, understanding what factors drive the decision to acquire increasing amounts of mortgage debt and whether or not such indebtedness is sustainable are important issues for policy makers.

We contribute to the literature on household mortgage borrowing by exploring one particular influence on mortgage debt, namely the financial expectations of the individuals within the household. At the macroeconomic level, a number of studies have found that consumer expectations influence household consumption patterns (e.g., Acemoglu and Scott 1994, for the UK; and Carroll, Fuhrer, and Wilcox 1994, for the United States). Surprisingly, empirical analysis into how expectations influence consumption decisions using individual or household-level data has, however, been somewhat scarce. One reason for this may be that skepticism about the use of information derived from subjective survey data may still prevail in the economics literature (Dominitz and Manski 1997). There are, however, a number of recent studies that do exploit subjective information on income expectations, such as the work of Guiso, Jappelli, and Terlizzese (1992, 1996) and Brown et al. (2005).

We explore the relationship between mortgage debt and financial expectations from a theoretical and an empirical perspective. Our theoretical framework predicts a positive association between the expectations of individuals who are optimistic about their future financial situation and the level of mortgage debt. Our empirical analysis based on the British Household Panel Surveys, 1993-2001, supports our theoretical priors.

The British Household Panel Surveys enable us to explore the level of mortgage debt at the household level by tracking a sample of households over the nine-year period ranging from 1993 to 2001. Such an approach allows us to control for changes experienced by households as a result of events such as marriage and childbirth, which may influence the level of mortgage debt. In addition, the time period of our empirical study is particularly interesting from a macroeconomic perspective, since by 1993 the growth in annual UK GDP at constant prices had recovered to around 2.5% (Office for National Statistics) after the depths of recession in 1991, fueled by inflation and high interest rates, at which time growth was negative at -1.4%. Over the period from 1993 to 2001, GDP growth averaged approximately 2.9% per annum, peaking at 4.7% in 1994 and falling to 2% by 2001.

Our use of household-level data is particularly appropriate since, as argued by Leece (1995), the use of aggregate time-series data may mask household responses to changes in the economic environment. Leece (1995) explores mortgage demand at the household level using cross-section data from the British Family Expenditure Survey (FES) and finds that the financial deregulation that occurred during the 1980s affected mortgage demand during this period. Leece (2000) expands his earlier work and finds that mortgage demand is influenced by the type of mortgage undertaken. Cocco and Campbell (2007), who also use the FES, show that rising house prices may stimulate consumption by increasing the household's perceived wealth or by relaxing borrowing constraints. In a U.S. study on household-level data, Crook (2001) identifies the factors that explain U.S. household debt, incorporating unsecured and mortgage debt, over the period from 1990 to 1995 using data from the Survey of Consumer Finances. Income, home ownership, and family size all have a positive impact on the level of household debt. Interestingly, expectations of future changes in interest rates do not influence the level of household debt.

From the theoretical point of view, there exists a large body of literature that analyzes consumption and housing finance choice based mostly on life-cycle models with income risk and borrowing constraints. For example, in Flavin and Yamashita (2002), households maximize a function of the mean and variance of returns to their asset portfolio (inclusive of housing) conditional on the current value of a state variable represented by the ratio of the house value to net worth. In Cocco (2004), agents living for T periods maximize lifetime expected utility over housing size and non-durable consumption, with a mortgage among available financial instruments and labor income risk. Numerical solutions are provided as, generally, closed-form solutions cannot be obtained. Both papers point to an effect of the portfolio constraint imposed by housing demand and indicate that younger and less well-off investors have limited financial wealth to invest in stocks: Their net worth will be used to pay off the mortgage or to buy bonds instead. Expectations are not explicitly modeled, although their action is implicitly embodied in labor income risk.

2. Theoretical Underpinnings

Assumptions

Our stylized life-cycle model is the simplest possible and serves to illustrate our subsequent empirical analysis. We assume two discrete time periods, t = 1 and t = 2, and demonstrate a positive relationship between the level of mortgage debt undertaken by consumers and optimistic financial expectations, represented by a two-point joint distribution of incomes and house prices. At the start of period 1, risk-averse consumers earn certain income, y1, and choose, optimally, a mortgage deposit, D, toward the purchase of one durable and indivisible unit of housing, h, priced [p.sub.1]. To minimize the algebra, and without loss of generality, consumption prices (of the non-durable numeraire) in each period are normalized to 1, the safe interest rate is set to zero, and there is no housing depreciation. The utility function, U([c.sub.t], h), defined over consumption at time t and housing, is twice differentiable and strictly concave. Consumption in period 1 is given by [c.sub.1] = [y.sub.1] - D, yielding utility U([y.sub.1] - D, 1).

There is second-period uncertainty of both consumer incomes and house prices, which are jointly distributed with two possible realizations of each variable, [y.sub.2i] and [p.sub.2j], where i, j = H, L denote the high and low income and house price realizations, respectively; and where [y.sub.2H] > [y.sub.2L] and [p.sub.2H] > [p.sub.2L]. So, in period 2, there are four possible states of nature (HH, HL, LH, LL) that occur with exogenous probabilities [q.sub.HH], [q.sub.HL], [q.sub.LH], and [q.sub.LL], respectively, that sum to 1. In period 1, a competitive risk-neutral lender provides a mortgage of size ([p.sub.1] - D). The mortgage repayment in period 2 is therefore R([p.sub.1] - D), where, as mentioned, D is saved by the borrower, at an interest factor R [greater than or equal to] 1, which includes a risk premium (see Eqn. 2--implying that consumers will always save in D rather than in the safe interest-yielding asset). The distributions of second-period incomes and house prices are common knowledge to both the consumer and the lender. (3)