This article discusses the relationship between federal lending restrictions, personal income, and home ownership: three factors that exert tremendous influence on homeownership, and on the economy as a whole.

In the last ten years, more than ever before, the process of homeownership has come to be intertwined with the workings of the economy as a whole. As single family residences (SFRs) became more available, largely thanks to reduced restrictions on lenders, property ownership came to be the most significant investment of a huge proportion of the population. The value of homes thus became a crucial factor enhancing the purchasing power of individuals, perhaps the most important single element in the chain of supply and demand. By the late 1990s, the prosperity of the nation could literally be measured by the wealth built up in its homes. When the real estate (and mortgage) bubble had swollen to its bursting point, the rest of the economy was artificially inflated with it. And when the destabilized economy collapsed and jobs were lost, real estate collapsed simultaneously, and homes were lost by the hundreds of thousands.

To understand the relationship between the housing market and the consumer market, it is helpful to take a look at specific factors, such as personal income, home values and the loan to value (LTV) ratio. A March report from the Federal Reserve Bank of Philadelphia (the Fed) does precisely that, examining whether home ownership tends to rise or fall when income rises, when home value drops, and when the average LTV ratio is moved up or down. The results will be informative to policy makers who in the past have sought to increase homeownership, and to all others whose business it is to predict the future of housing, including first tuesday readers.

First, the effects within the housing market. The Fed researchers found that when personal incomes remain static, or drop, the decline in home values tends to lead to a decline in homeownership. While lower home prices open the door to speculators and make it possible for more renters to become owners, the number of former owners who are forced to leave their suddenly less-valuable assets tends to outweigh other factors. Meanwhile, a decline in home values is an equivalent to a decline in the general wealth of all owners. Such declines thus tend to decrease non-housing consumption as well, depressing the entire economy.

In fact, the Fed’s study indicated that even if personal incomes rise, lowered home values still have a negative effect on the percentage of ownership. Worst of all is when home values drop in tandem with income, as is happening in the current recession. Low home values destroy people’s wealth, while reduced income prevents homeowners from holding onto their homes until circumstances improve.

The Fed also analyzed the probable effects of a return to fundamental lending restrictions, which lower the average LTV ratio by increasing the minimum down payment. The Fed found that a lowered LTV ratio has several predictable effects. It leads to an immediate drop in ownership rates, as a higher percentage of the population becomes unable to afford a down payment on the homes they desire. However, a large down payment also ameliorates future drops in housing prices, and prevents much of the economic turmoil that accompanies such drops. That is to say, high lending standards (with low LTVs) actually have the effect of insulating the housing market from the rest of the economy. The lower the LTV, the less impact a drop in home prices will have on the purchasing power of most people. This is because heightened lending restrictions ensure that those who do own homes are the ones best able to cope when financial conditions turn sour.

The implications for policy makers are clear. Heightened restrictions on the types of loans and LTVs lenders may make, making loans harder to get for those buyers who lack sufficient savings, are necessary if the housing market, and economy at large, are to be stable in the future. Without lending restrictions, the housing market remains a volatile and risky playground for speculators and low-income homebuyers hoping to turn a profit, both gaming the American dream for their own economic benefit. Hats off to the legislators who can resist lenders’ siren call.