RDP 2003-09: Housing Leverage in Australia 1. Introduction

Australia's housing sector has long been characterised by relatively high homeownership rates and a predominance of variable-rate mortgages. Thus, it might be expected that fluctuations in housing prices would have a relatively strong effect on consumption, and that households would be quite sensitive to interest rates (McLennan, Muellbauer and Stephens 1999). When mortgage rates rise, it impinges on the cash flows of indebted households. This will tend to reduce their consumption, unless they are able to offset this cash-flow effect with further borrowing, or reductions in savings or excess repayments of principal.

In this paper, we focus on a particular dimension of households' balance sheets, the leverage on owner-occupied housing. Although households' debt-income ratios determine the relative effect of a given-sized change in interest rates on their cash flows, we focus on leverage – the debt-assets ratio – because this might help determine the level of debt that households are willing to bear, in addition to the burden of repayments.

Leverage might be expected to influence households' and intermediaries' behaviour through a number of channels. Data from the UK suggests that some households will try to reduce their leverage in response to a negative wealth shock such as a fall in housing prices (Smith, Sterne and Devereux 1994). Households' desired leverage might itself be endogenously affected by the business cycle or uncertainty if choices about balance sheets reflect precautionary savings motives (Carroll and Dunn 1997).

Leverage is also important because of its likely implications for credit supply. Increases in interest rates might not induce households to reduce consumption if they can borrow additional funds, but intermediaries' willingness to lend more to households might be reduced if leverage is particularly high. Households with higher leverage might therefore be less likely to offset fluctuations in their cash flow with further borrowing. Their ability to smooth their consumption during downturns might thus be constrained by asset-price developments associated with that downturn (Bernanke and Gertler 1995; Carroll and Dunn 1997). In addition, since real estate is widely used as collateral for loans, the level of leverage is a determinant of the balance-sheet risk of financial institutions (Kent and Lowe 1997; Schwartz 2002).

Finally, the interaction of leverage with movements in house prices will determine the prevalence of negative equity, which in turn has implications for labour market flexibility (Henley 1999) and the behaviour of the real estate market (Genesove and Mayer 1997). Although we do not cover these issues in this cross-sectional study, an understanding of housing leverage may help explain housing market features such as pricing inertia and the correlation between falling prices and a larger stock of unsold homes.

Despite the range of reasons why households' leverage might be important, most previous literature either focuses on the narrower decision on housing tenure (Bourassa 1994, 1995), or uses broader wealth data as yet unavailable for Australia to examine household portfolio behaviour more generally (e.g., the papers in Guiso, Haliassos and Jappelli (2002)). In this paper, we focus on cross-sectional, microeconomic aspects of households' housing leverage, with a view to understanding which households are most likely to be affected by changes in interest rates or falls in housing prices. In Section 2, we discuss the HILDA dataset and our approach to imputing missing income data; the econometric results underlying our imputation methods are presented in Appendix A. After undertaking some preliminary graphical analysis in Section 3, we set up our core econometric model in Section 4 and discuss its implications. A brief conclusion follows in Section 5.