March 8, 2007 (Housing Byte)

By Dean Baker

The ratio of mortgage debt to home values hit another record high.

The quarterly Flow of Funds data from the Federal Reserve Board show that homeowners are taking on mortgage debt far more rapidly than their homes are appreciating in value. Homeowners increased their mortgage debt at a 6.4 percent annual rate in the 4th quarter, adding debt at an annual rate of $594.4 billion, down from the $775.2 billion annual rate in the 3rd quarter. This debt includes both money to purchase houses and money borrowed against existing homes. However, home values appreciated at just a 4.4 percent annual rate in the quarter.

As a result, the ratio of equity to home value is falling sharply. At the end of the fourth quarter of 2006, the ratio of equity to home value stood at 53.1 percent, down from 54.3 percent at the end of 2005. By contrast, it stood at 57.9 percent as recently as 2000, and was close to 70 percent until the nineties.

This drop in homeowners’ equity raises concerns about the retirement security of the baby boom generation. Most of the baby boom generation is near retirement and has few assets outside of their homes. The Fed’s most recent Survey of Consumer Finance showed that 53 percent of the age cohort from 45 to 54 had less than $54,000 in financial assets (including defined contribution pensions) in 2004. If workers in this age group are to have any substantial source of income in their retirement years, other than Social Security, they will have to rely on equity in their home. If weak house prices reduce equity even further for this group, it will be difficult for them to save enough in their remaining working years to offset the loss.

The loss of equity also raises short-term issues for the economy. The distribution of equity among homeowners is hugely skewed, with close to one-third of all homeowners having paid off their mortgages. This implies that the vast majority of homeowners have relatively little equity in their homes and some already have negative equity. Many of these homeowners will be losing their ability to borrow further against their homes, especially if continued weakness in the housing market causes house prices to actually fall.

The recent flood of borrowing against home equity has driven consumption since the 2001 recession. This borrowing drove the savings rate into negative territory for the first time since the depression. Through the sixties, seventies, and eighties, the savings rate had averaged close to 10 percent. If the savings rate were to move back just half way to its historic level, this would imply a loss of $600 billion in annual consumption. In fact, since virtually all of the baby boom generation is in its peak saving years, the savings rate should be higher than normal.  

The Flow of Funds data may actually understate the increase in debt burdens, since it likely misses some of the price declines that have taken place in the housing market. The data on house prices are taken from Office of Federal Housing Enterprise Oversight’s House Price Index (HPI). This index excludes the majority of homes in the most inflated markets because the mortgages issues are not conformable for agency mortgage pools. The index would also miss seller concessions that don’t appear in the contracted price, such as paying points towards closing or including repairs and renovations as part of a sale. For this reason, it is likely that home prices have not risen as much as the HPI data show, and may even be falling.

Even with the published data, it is clear that many homeowners are hitting their borrowing limits. This will likely constrain consumption in the months ahead, especially if house prices start to fall in the next few quarters. This process can be self-reinforcing: as more homeowners find themselves with negative equity, it is likely to push the foreclosure rate higher. This will lead to more distress sales, which will put further downward pressure on prices.