Consumer Leverage

Kevin Drum is concerned about consumer leverage:

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But leverage is everywhere, not just on Wall Street. If you buy a house with 20% down, you’re employing leverage of 4:1. At 10% down it’s 9:1. At 5% down it’s 19:1. At the FHA minimum of 3.5%, it’s 27:1. […]

We should limit leverage everywhere: in the real banking system, in the shadow banking system, in hedge funds, and where it’s baked into derivatives. But we should also do it at the individual level: mortgage loans, car loans, and credit card loans. The point is not to cut off credit, but to do what we can to ensure that it grows steadily and sensibly, not catastrophically. A minimum 10% down payment to buy a house is a place to start.

I think a minimum downpayment on mortgages would be a sensible idea. I’d even be happy to go all the way up to a 20 percent minimum. We started encouraging mortgage lending standards to slip as a way of encouraging homeownership, but there’s no reason encouraging homeownership should be a policy goal. If anything we should be trying to encourage deeper, richer rental markets.

But I don’t think this is actually the right general way to think about consumer-side leverage. The key thing there isn’t the level of the downpayment, it’s different kinds of funny-business with balloon payments and so forth. Some consumers really should be leveraged. Kevin Durant is going to earn $4.8 million in salary this year and $6 million next year, but the odds are overwhelmingly that after that his salary will explode to north of $15 million. And beyond salary, he has a lot of potential income upside in terms of endorsement deals. So for Durant to do something like buy a house where the payments are low for the first three years but then reset upwards makes a ton of sense.

Obviously, though, very few of us are NBA superstars on rookie contracts. Students at elite law schools are in a basically similar situation, but again that’s not that many people. The vast majority of people shouldn’t be making purchases that implicitly involve counting on large increases in salary or asset values to make sense. That, however, is a different issue from the how much money down question. A fixed rate self-amortizing mortgage with only five percent down is a risky loan from the point of view of the bank, but if the payments are reasonable relative to the borrower’s income don’t really involve a ton of leverage. It’s the resets and balloon payments that build leverage in.