September 19, 2006 (Housing Byte)
Housing Byte 

Dwindling Home Equity Threatens Growth

September 19, 2006 
By Dean Baker 
The ratio of homeowner’s debt to equity is at a record high.

Homeowners took on mortgage debt at an $820.4 billion annual rate in the second quarter, down from the $864.4 billion annual rate in the first quarter, according to data in the Federal Reserve Board’s Flow of Funds release. This debt includes both money to purchase houses and money borrowed against existing homes.

However, the rate of house price appreciation slowed sharply in the second quarter. The value of real estate owned by households (mostly residential housing) rose at a 9.8 percent annual rate in the first quarter. By contrast, it rose at just a 7.3 percent rate in the second quarter. As a result of the slow growth in the value of housing (and a slower pace of construction), mortgage debt rose far more rapidly than equity, causing the ratio of homeowner’s equity value to drop to a record low of 54.1 percent.

This drop in equity to value raises both long-term and short-term issues. As a long-term issue, it is striking that the equity to value ratios would be so low at a time when the country’s demographics should be leading to high equity to value ratios. With many baby boomers now close to retirement, many homeowners should be close to having paid off their mortgages, which would lead to a high equity to value ratios. Instead, the ratio stands more than 10 percentage points below the averages for the sixties, seventies, and eighties. With most baby boomers having few assets other than their homes, this decline in home equity should raise concerns about the adequacy of baby boomers’ retirement.

As a short-term issue, the decline in home equity raises concerns about the sustainability of the recovery. Borrowing against home equity was a major support for consumption growth in the recovery. The current pace of borrowing cannot continue for long if home prices don’t appreciate. If housing prices and the pace of borrowing continue to grow at the second quarter pace, the ratio of equity to value would be under 50 percent in just over 3 years. If borrowing stays on its current path and house prices level off, as many economists now predict, then the equity to value ratio would drop below 50 percent in 6 quarters.

Many of those borrowing against their home will soon reach the limit of their ability to borrow as they exhaust their equity. There is evidence that this is already happening. Credit card debt grew at a 10.6 percent annual rate in the second quarter after rising at just a 3.2 percent annual rate in 2002-05. However, credit card debt cannot act as a replacement for mortgage debt for long. Total credit card debt outstanding is just $840 billion. Even a 50 percent increase in credit card debt would replace less than 6 months of mortgage borrowing.

If homeowners draw down the equity on their home, it is likely to lead to a situation in which many are forced to give up their homes. This would place further downward pressure on the house prices, which will compound the problems in the housing market as more homeowners would then exhaust the equity in their house. This situation will accelerate the rapid growth in delinquencies and defaults seen over the last six months.

The other result of millions of homeowners reaching debt limits is that consumption will be curtailed. The growth in annual consumption has outpaced the growth of income growth since the end of the recession by more than $270 billion. While this surge in borrowing helped to fuel the economy’s growth, if consumers must curtail their borrowing, then consumption growth will lag income growth in the future. With weak job growth, real income grew at just a 1.2 percent annual rate in the second quarter. If consumption growth trails even this weak pace of income growth, then the economy’s near-term prospects are bleak. With housing falling sharply and consumption rising at a very slow pace, the economy faces a serious risk of recession.

Dean Baker is a co-director of the Center for Economic and Policy Research in Washington, DC

CEPR’s Housing Byte is published upon release of reports by the Federal Reserve Board Flow of Funds. For more information or to subscribe by fax or email contact CEPR at 202-293-5380 ext. 103 or ray at cepr dot net.