Financial Regulation and the Economic Security of Low-Income Households Karen Dynan Brookings Institution October 14, 2010 Note. This presentation was prepared for the Institute for Research on Poverty (IRP) at the University of Wisconsin Madison seminar series Instability in the Lives of the Poor: How Policy Helps or Hurts. All views expressed are my own and not those of the Brookings Institution or any of its other affiliates.
2 Regulation of Household Credit is Key Financial Reform Issue Motivated by view that misguided use of credit contributed importantly to crisis. Dodd-Frank created new independent consumer financial protection bureau.» Law gives it certain powers, but how these powers will be used has yet to be determined.» What lessons can we draw from academic studies and introspection about the experience of the past few years?
3 Outline for Talk Trends in household credit use:» Explanations» Broadly and for low-income households Credit use and household economic security Financial regulation: goals and challenges
4 Trends in Aggregate Household Debt 1.4 Ratio of Household Debt to Disposable Personal Income 1.2 Q2 1.8.6 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: U.S. Flow of Funds Accounts
5 What Explains the Longer-Term Uptrend in Household Credit?
Rise Reflects Democratization and Greater Credit Use Among Those With Access 6 Share of All Households with Debt 1983 70.2% 1989 72.4% 1992 73.2% 1995 74.8% 1998 74.4% 2001 75.2% 2004 76.5% 2007 77.0% Source: Survey of Consumer Finance Debt-to-Income Ratio: All Households 2.0 1.8 1.6 1.4 75th percentile 1.2 1.0 0.8 0.6 0.4 Median 0.2 0.0 1983 1986 1989 1992 1995 1998 2001 2004 2007
7 Patterns Similar for Low-Income Households Share of Low-Income Households * with Debt 1983 57.8% 1989 58.7% 1992 63.7% 1995 61.8% 1998 63.7% 2001 62.3% 2004 63.6% 2007 60.8% Debt-to-Income Ratio: Low-Income Households * 2.0 1.8 1.6 1.4 1.2 75th percentile 1.0 0.8 0.6 0.4 0.2 Median 0.0 1983 1986 1989 1992 1995 1998 2001 2004 2007 Source: Survey of Consumer Finance *Group defined as lowest income quintile of households with heads younger than 60.
8 Why Did Household Debt Rise? The most important factors behind the rise in debt and the associated decline in saving out of current income have probably been the combination of increasing house prices and financial innovation. Dynan and Kohn, The Rise in U.S. Household Indebtedness: Causes and Consequences (2007)
9 Role of House Prices Home Mortgage Debt and House Prices 20 Home Mortgage Debt 20 4-Qtr Percent Change 10 0-10 House Prices 10 0-10 -20-20 1980 1985 1990 1995 2000 2005 2010 Source: U.S. Flow of Funds Accounts and CoreLogic Debt data through 2010q2. House price data through July, 2010
10 Mortgage Debt Also Seems to Be Key Factor for Low-Income Households Average Debt Holdings of Low-Income Households * 25 1983 1995 2007 In Thousands of 2007 Dollars 20 15 10 5 0 All Debt Home Debt Credit Card Debt Student Loans Source: Survey of Consumer Finance *Group defined as lowest income quintile of households with heads younger than 60. Car Loans
11 Financial Innovation and Rising Debt Technological advances have made it easier to collect, disseminate, and process information, so easier to assess creditworthiness and price credit accordingly. Contributed to democratization and lowered costs for those already able to borrow. Hard to quantify full effect of innovation as it has been incremental and taken so many forms.» But story consistent with widespread and gradual increases in indebtedness: all age, education, income groups (Dynan, JEP 2009).
12 Some Specific Innovations Are Very Relevant for Low-Income Households Subprime and other affordable mortgages: e.g. Mayer, Pence, and Sherlund (JEP, 2009). Subprime auto markets: Adams, Einav, and Levin (AER, 2009) Payday lending: Skiba and Tobacman (2008); Barr, Dokko, and Keys (2009).
13 Credit Use and Household Economic Security
14 Credit Use and Household Economic Security Credit use has both benefits and risks for households. For low-income households, it s a doubleedged sword:» Credit can be more beneficial for this group» Credit can be also be more dangerous for this group things can be more likely to go awry and when they do the consequences can be worse.
Benefits of Credit Use 15
16 Credit Makes It Easier to Smooth Consumption Increases in credit availability have allowed consumption to be less responsive to income than in earlier decades. Dynan, Elmendorf, and Sichel (JME, 2006):» Sensitivity of consumption to unusual declines in income has fallen much more than for unusual increases.
17 Ability to Smooth Consumption Smooth May Be Particularly Important Given Evidence of Rising Income Volatility Figure 1. Volatility of Household Income. Standard Deviation of Percent Changes 60 60 Dynan, Elmendorf, and Sichel, 2009: 50 40 50 40 PSID data through 2005 30 20 10 0 30 20 10 0 Focus on family income Standard deviation of growth across HHs up by 1/3 since late 1960s. 1975 1980 1985 1990 1995 2000 2005 Source. Panel Study on Income Dynamics; 3-year moving averages of 2-year percent changes.
18 More Volatility Results from DES (2009).14.12 Figure 2. Frequency of Large Increases and Decreases in Household Income..1 Increases > 50%.14.12.1 Much of the increase reflected rise in frequency of large income changes..08.06.04 Decreases > 50%.08.06.04 Pattern does not appear to be the result of voluntary choices..02.02 0 1975 1980 1985 1990 1995 2000 2005 Source. Panel Study on Income Dynamics; 3-year moving averages of 2-year percent changes; shaded areas denote recessions. 0
19 Benefits of Credit Related to Homeownership Homeownership not for everyone, but if financed prudently, it can be a way to promote household saving. For those who already had access to homeownership: increase in availability of mortgage credit allowed households to buy homes more in line with permanent incomes (Gerardi, Rosen, and Willen, JF, 2010).
20 For Low-Income HHs, Lower Levels of Liquid Assets Mean Credit Can Offer More Benefits 0.3 Liquid Assets-to-Income Ratio: All Households 0.3 Liquid Assets-to-Income Ratio: Low-Income Households * 75th percentile 0.2 0.2 0.1 Median 0.1 75th percentile 0.0 1983 1986 1989 1992 1995 1998 2001 2004 2007 Source: Survey of Consumer Finance 0.0 Median 1983 1986 1989 1992 1995 1998 2001 2004 2007 Source: Survey of Consumer Finance *Group defined as lowest income quintile of households with heads younger than 60.
Risks Associated with Credit Use 21
22 Debt Service Obligations Grew with Debt 14 Aggregate Ratio of Debt Service to Disposable Personal Income 13 12 Q2 11 10 1980 1985 1990 1995 2000 2005 2010 Source: Federal Reserve
23 Higher Debt Service Associated with More Financial Distress 14 Share of Households with Late Payments 12 10 8 6 4 2 0 Any Debt Service Source: Survey of Consumer Finance Note: Average across all surveys since 1989 Debt Service >20% Debt Service >40%
24 Consequences of Debt Payment Problems Impaired future access to credit as well as Possible bankruptcy: costs of filing, stigma. Possible foreclosure: stigma, may lose home, relocation may lead to loss of job and other family disruptions, communities suffer when foreclosures are concentrated.
25 Debt Service Obligations Tend to Be Higher For Low-Income Households 25 20 Share of Households with Debt Payments Greater than 40% of Pre-Tax Income All Households Low-Income Households * 15 10 5 0 1983 1989 1992 1995 1998 2001 2004 2007 Source: Survey of Consumer Finance *Group defined as lowest income quintile of households with heads younger than 60.
26 Low-Income Households Also More Likely to Be at Risk of Debt Service Surprises 60 50 Share that "Don't Know" Adjustable-Rate Mortgage Features By Income Group Less than $50k $50 - $150k More than $150k *** 40 *** *** *** 30 20 ** 10 0 Per-period Cap on Interest Rate Adjustments Lifetime Cap on Interest Rate Adjustments Source: Bucks and Pence (2006) based on Survey of Consumer Finances Note: Statistically Different from Zero at 1% level (***) and at 5% level (**) Index Rate
Another Downside of More Credit: Enables An Increase in Exposure to Risky Assets 27 Change in Wealth Implied by a 20% Decline in Median House Value (as a Fraction of Median Homeowner Income) 1995 2001 2007 All Households -.47 -.47 -.65 Low-income Households* -.80 -.87 -.95 Source: Survey of Consumer Finances. *Group defined as lowest quintile of households with heads less than 60.
Thoughts about Financial Regulation 28
Point #1: Recent Crisis Example of How Judging How Much Credit is Too Much Credit is Difficult Ex Ante 29 Not so hard ex post (see next graph!) Why didn t regulators do a better job?» Reluctance to call bubble not just in regulatory community» Measures showing the risky tails of the household credit distribution were not readily available should do better on this next time» Didn t recognize exposure of broader financial system issue for future systemic regulators
30 Too Much Credit 600 550 500 450 400 350 300 250 200 150 Household Financial Distress Number of new foreclosures (in thousands, left scale) % of mortgage balances 90+ days delinquent (right scale) 9 8 7 6 5 4 3 2 1 100 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 0 Source: Federal Reserve of New York. Last chart point is 2010:Q2
Point #2: Goal in Credit Regulation Should Be to Achieve Balance Need to strike the right balance between protecting consumers from predatory lenders and financial products that are prone to misuse, while at the same time ensuring that creditworthy households have access to an evolving range of sensible financial products. Achieving the right balance is particularly important for low-income households because of the doubleedged sword aspect of credit access for them. 31
32 Point #3: Getting to this Goal Will Be Challenging Financial education and disclosures appealing because of the potential to solve problems without restricting choice but have inherent limitations:» Some (many?) products are just too complicated for many people to understand.» Self-control and other behavioral issues may lead to problems even if people understand what is best for them.
33 Point #3: Getting to this Goal (cont d) Trying to manage risk by controlling the range of products offered is complicated:» Doing so by ruling out specific products puts regulators in a potentially unwinnable race with financial innovators.» Doing so by limiting offerings to a small number of plain vanilla products seems overly restrictive. One variant is making people opt out of standard products but unclear how effective that would be.
34 Point #3: Getting to this Goal (cont d) New ideas coming out of behavioral literature but these are largely untested:» Create CFPB seal of approval for safer products» Force lenders to reveal full range of products for which borrower qualified» Make lenders liable for mortgage broker misconduct» Change fiduciary duties of mortgage brokers
35 Concluding Thoughts Credit pendulum swung too far in the easy direction in the early to mid-2000s, imposing high costs on many borrowers and by triggering a credit crunch on the broader economy. Consumer regulators need to reduce odds of this happening again but also need to be careful not to overreact:» Wouldn t want to undo all of the benefits of greater access to credit, particularly for low-income households. New agency granted important powers and large budget but will it be able to attract staff and resist competing pressures.