Collateralized Borrowing: Illiquid Assets and Households’ Precautionary Savings Motive

Between 2000 and 2006 house prices rose more than fifty percent in real terms. Over that same period households’ mortgage and home equity debt relative to income shot up. Anecdotal and empirical evidence suggest that households accessed the equity in their homes to fund current consumption. Little if any theoretical work, however, has examined the relationship between household consumption behavior and collateralized borrowing. We develop a simple model where households can borrow against the stochastic value of an illiquid asset to increase consumption. Our model is consistent with a world where households can borrow against the value of their home. We find that collateralized borrowing capacity acts like a secondary market for precautionary savings. Households’ spending behavior, however, can leave them vulnerable to future declines in the value of their collateral. We also consider the potential asymmetric spending response of households to rising versus falling illiquid asset prices. In addition, we address how collateralized borrowing affects the excess sensitivity and relative smoothness of consumption growth to labor income growth. The authors would like to thank Eric Sims and participants at the 2007 University of Michigan Summer Seminar and the 2007 Society for Computational Economics Conference in Montreal for helpful suggestions on an earlier version of this work. All errors are our own. Comments welcome. Please do not cite without permission. University of Michigan: [email protected] (Corresponding Author) University of Michigan and Columbia University: [email protected]