Quantitative Asset Pricing Implications of Housing Collateral Constraints

To explain the variation in US asset returns in the 20th century, we solve an equilibrium model in which households face housing collateral constraints. An increase in the ratio of housing to human wealth loosens these constraints. It allows for more risk sharing and decreases the rate of return that households require for holding equity. This collateral mechanism can explain the time-variation in equity and risk-free debt returns and the cross-sectional variation in equity returns in the US. Feeding into the model the observed quantity of US housing collateral produces a huge increase in the equity premium to 15 percent during the 1930s, and, subsequently, it generates a decline of the equity premium from 11 percent in the 1960s to 4 percent in 2003. This produces large unexpected capital gains for equity holders, especially in the 1990s. The collateral mechanism can quantitatively replicate the cross-sectional variation in risk premia on stock portfolios sorted by book-to-market value inside the model. When value stocks have shorter duration than growth stocks, the model endogenously generates a value premium because the term structure of equity risk premia it predicts is downward sloping.