How High Debt Leads to Income Inequality

But we shouldn’t think of the mortgage lender in this example as an independent entity. The mortgage lender uses money from savers in the economy. Savers give money to the bank either as deposits, debt, or equity, and are therefore the ultimate owners of the mortgage bank. When we say that the mortgage lender has the senior claim on the home, what we really mean is that savers in the economy have the senior claim on the home. Savers, who have high net worth, are protected against house-price declines much more than borrowers.

Now let’s take a step back and consider the entire economy of borrowers and savers. When house prices in the aggregate collapse by 20%, the losses are concentrated on the borrowers in the economy. Given that borrowers already had low net worth before the crash (which is why they needed to borrow), the concentration of losses on them devastates their financial condition. They already had very little net worth—now they have even less. In contrast, the savers, who typically have a lot of financial assets and little mortgage debt, experience a much less severe decline in their net worth when house prices fall. This is because they ultimately own—through their deposits, bonds, and equity holdings—the senior claims on houses in the economy. House prices may fall so far that even the senior claims take losses, but they are much less severe than the devastation wrought on the borrowers.

Hence, the concentration of losses on debtors is inextricably linked to wealth inequality. When house prices collapse in an economy with high debt levels, the collapse amplifies wealth inequality because low-net-worth households bear the lion’s share of the losses. While savers are also negatively impacted, their relative position actually improves. In the example above, before the crash, savers owned 80% of the home whereas the homeowner owned 20%. After the crash, the homeowner is completely wiped out, and the saver owned 100% of the home.

Debt and wealth inequality

During the Great Recession, house values fell $5.5 trillion—this was enormous, especially considering the annual economic output of the US economy is roughly $14 trillion. Given such a massive hit, the net worth of homeowners obviously suffered. But what was the distribution of those losses: How worse off were the borrowers, actually?

Let’s start with an examination of the net-worth distribution in the United States in 2007. A household’s net worth is composed of two main types of assets: financial assets and housing assets. Financial assets include stocks, bonds, checking and savings deposits, and other business interests a household owns. Net worth is defined to be financial assets plus housing assets, minus any debt. Mortgages and home-equity debt are by far the most important components of household debt, making up 80% of all household debt as of 2006.

In 2007, there were dramatic differences across US households in both the composition of net worth and leverage (amount of debt). Homeowners in the bottom 20% of the net-worth distribution—the poorest homeowners—were highly levered. Their leverage ratio, or the ratio of total debt to total assets, was near 80% (as in the example above with a house worth $100,000). Moreover, the poorest homeowners relied almost exclusively on home equity in their net worth. About $4 out of every $5 of net worth was in home equity, so poor homeowners had almost no financial assets going into the recession. They had only home equity, and it was highly levered.

The rich were different in two important ways. First, they had a lot less debt going into the recession. The richest 20% of homeowners had a leverage ratio of only 7%, compared to the 80% leverage ratio of the poorest homeowners. Second, their net worth was overwhelmingly concentrated in nonhousing assets. While the poor had $4 of home equity for every $1 of other assets, the rich were exactly the opposite, with $1 of home equity for every $4 of other assets, like money-market funds, stocks, and bonds. The figure on the previous page shows these facts graphically. It splits homeowners in the US in 2007 into five quintiles based on net worth, with the poorest households on the left side of the graph and the richest on the right. The figure illustrates the fraction of total assets each of the five quintiles had in debt, home equity, and financial wealth. As we move to the right of the graph, we can see how leverage declines and financial wealth increases.

This isn’t surprising. A poor man’s debt is a rich man’s asset. Since it is ultimately the rich who are lending to the poor through the financial system, as we move from poor homeowners to rich homeowners, debt declines and financial assets rise. As we mentioned above, the use of debt and wealth inequality are closely linked. There is nothing sinister about the rich financing the poor. But it is crucial to remember that this lending takes the form of debt financing. When the rich own the stocks and bonds of a bank, they in turn own the mortgages the bank has made, and interest payments from homeowners flow through the financial system to the rich.

The figure summarizes key facts that are important to keep in mind as we enter the discussion of the recession. The poorest homeowners were the most levered and the most exposed to the housing sector, and they owned almost no financial assets. The combination of high leverage, high exposure to housing, and little financial wealth would prove disastrous for exactly the households who were the weakest.