Essays on household finance

Overview. Households' financial decisions are critical for understanding economic dynamics. Yet given the complexity of the decision problems and dynamic choices required, our empirical understanding is limited in terms of how close households' actual decisions come to optimal theoretical benchmarks. An important driver behind the burgeoning field of household finance is the use of newly available micro-level data to better identify and measure these discrepancies (Campbell, 2006). To link up with this promising research agenda, my proposed research project studies household mortgage choice and housing, using micro-level datasets from the UK and quasi-experimental methods such as regression discontinuity designs. Within household balance sheets across advanced economies, housing accounts for the majority of household wealth, while mortgages make up the largest share of household liabilities, making this an important area of study (see Badarinza, Campbell and Ramadorai, 2016a).

Mortgage choice and salience. Mortgage markets have complex contract characteristics such as current and future interest rates, fees, term of the mortgage and refinancing costs. This means that households' optimal mortgage choice requires trade-offs over multiple dimensions and time (see Stanton and Wallace, 1998 and Badarinza, Campbell and Ramadorai 2016b for a review). Given this complex choice environment, recent advances in behavioural economics and psychology provide alternative predictions that build on findings that human decision making is inherently comparative and context-dependent (e.g. Kahnemann and Tversky, 2000). In my main project, which is joint work with Tarun Ramadorai (Imperial College) and Pedro Bordalo (University of Oxford), we develop a simplified benchmark model of mortgage choice that captures key trade-offs households face and which we use to predict how households react to changes in the mortgage market, brought about either by regulatory intervention or competition. We compare this to a model that captures context-dependent choice given a specific choice environment (in this case, the available menu of mortgages). This is based on influential work by Bordalo, Gennaioli and Shleifer (2013, 2015) who propose a model of choice in which individuals focus attention on the most salient attributes, such as quality, or price. Their model predicts that people focus excessively on some aspects and neglect others, in ways that vary systematically with the choice environment. In the mortgage market, the way costs are structured across available options is likely to draw more attention to some costs (e.g. fees) rather than others, with important implications for consumer choice.

Data and methods. We have detailed micro-level data on the universe of mortgage originations in the UK (FCA Product Sales Data (PSD)), and data by Moneyfacts on mortgage offers available over time (accessed through my affiliation as academic visitor to the Bank of England). This allows us to compare mortgages chosen by individuals in different market conditions, who are otherwise similar, and test predictions from the benchmark model against those of the salience-based model.

To complement the model-based analysis, we will seek to identify changes to mortgage menus (as arising from mergers, changes in interest rates and regulation) that are plausibly exogenous to the households' preferences, and estimate the impact of these changes to the choice context on actual consumer choice. Understanding the key decision variables for household mortgage choice and trade-offs that households face under different macroeconomic scenarios is highly policy-relevant: it can help us better understand the effectiveness of the monetary transmission channel, and aid calibration of novel macro-prudential measures used in the housing and mortgage market, which depend on the ability to predict household reactions and the stability of relationships across choice variables.