Research by Dr Joao Ejarque from the University of Essex has looked at risks for first-time home buyers and the impact on their spending patterns.

Working with the University of Copenhagen’s Dr Søren Leth-Petersen, Dr Ejarque from Essex’s Department of Economics looked at a Danish household panel dataset of information on income, unemployment, assets, mortgage values and particulars on the house.

Dr Ejarque said: ‘We found that when people buy their first home they borrow as much as they can - in some cases 95% of the house value - and run down their assets to a low level which persists for several years after the purchase. We then looked at what happened if income fell or unemployment hit immediately after the house purchase.

‘We found people cut down their consumption so that whatever little is left of their assets fell even further. However, importantly, they do not increase their debt levels. This suggests that they have borrowed as much as they can.’

Dr Ejarque and his co-author then set out to understand and explain their observations by specifying and estimating a model of rational consumer behaviour. This built on a standard life-cycle model which has people beginning to save for precautionary reasons early in their life but then, after the age of 40, accumulating wealth for retirement. However, introducing a house purchase to this setting changed behaviour dramatically!

The research compared the outcomes of this standard estimated model with an identical set-up that excluded a house purchase. In this scenario, households were exposed to the same income levels but were renting. Dr Ejarque and Dr Leth-Petersen assessed behaviour at the point that would have been just after a house purchase, looking at consumption expenditure reactions to income changes. Their research showed that, without the house purchase, consumption levels fell significantly less in response to income shocks.

Dr Ejarque explains: ‘One change was that, because the house is an illiquid asset, which is an asset that can only be traded with significant transaction costs, people who, for example, experienced temporary unemployment would make more significant adjustments to their consumption patterns to avoid having to sell the house.

‘In our current climate of financial distress, setting up this model was important as the press and some academic schools of thought claim people behave irrationally and that widespread dishonest practices occur in the housing market. While this is certainly possible, our model shows that all features of our data are consistent with rational and optimal behaviour on the part of consumers.’

These results have policy implications, such as the desirability of additional unemployment insurance for the period immediately after a house purchase, while the model also allows further investigation into the effect of down payment and other mortgage laws on behaviour, plus resulting bankruptcy incidence. This will form further research for Dr Ejarque.

Dr Ejarque recently presented this research at the Federal Reserve System Conference on Housing and Mortgage Markets, at the Board of Governors in Washington DC.

Ends

Notes to editors:
A paper on this research can be found at: www.econ.ku.dk/CAM/Files/workingpapers/2008/2008-08.pdf