Politics, Financial Regulation and Housing Bubbles

Recent housing bubbles in OECD countries have been accompanied by large-scale household debt buildups and rising homeownership rates, and have generally occurred in jurisdictions with soft legal limits to loan-to-value (LTV) ratios. We show that all these empirical features can be rationalized within a simple political economy framework of macroprudential regulation, where household debt is secured by housing collateral and is constrained by LTV caps. Specifically, we study an overlapping generations model in which non-altruistic households exhibit heterogeneous tastes for housing tenure. Optimal tenure arrangements may require collateralized debt, which risk-neutral banks supply given the prevailing regulatory framework. Under majority rule, housing bubbles can generate their own electoral support: when collateral values are rationally expected to climb, relatively lax financial regulation is favored by both middle-class mortgage applicants and high-income homeowners, who fear house price reversion to market fundamentals. Home buyers’ beliefs about house price inflation then fuel increasing household leverage across income classes, resulting in a self-confirming housing bubble with widespread homeownership.