Saleem Bahaj, Angus Foulis and Gabor Pinter
Apocalypse Now is widely regarded as a masterpiece of the new Hollywood era. Director Francis Ford Coppola displayed audacious vision and a willingness to take risks. But we don’t just mean artistic risk. Mr Coppola gambled financially too: he staked his Napa Valley house and vineyard on the film, pledging it order to get the $32 million in loans necessary to keep the production on the road. While his movie was exceptional, there is nothing unusual about Mr Coppola’s financial strategy. Small business owners worldwide use their personal assets, and often their house, to back loans to their firms: in a new paper, we use microdata for several thousand firms to show how important this can be for UK investment.
In the UK, just under half of new loans to firms with less than 250 employees are financed this way. Of course, this makes a minor mockery of the limited liability that firms are supposed to enjoy. Yet, small firms are often opaque, reliant on a few key people, and lack their own tangible assets or steady cash flows to pledge to lenders. So personal housing wealth, which is a simple asset to borrow against, ends up greasing the financial wheels of smaller enterprises.
The macroeconomic significance of using housing in this way has not really been explored. Economists normally think of rising house prices affecting the economy through consumers. A fall in house prices may make households save more to pay down debt and rebuild equity in their homes. Higher house prices may enable equity extraction or mean people save less for their pension by relying on the increased rewards of downsizing. In these circumstances house prices predominately influence the macro-economy through demand.
However, if the value of houses also determines how much borrowing firms can access, house prices would also have implications for the supply side of the economy as well. This is important and it suggests that policy tools that affect the housing market, such as macroprudential policy, will directly affect firms as well as households. We use detailed data on firms and the individuals in charge of them to estimate the macroeconomic implications of this channel for the first time.
To obtain these estimates we make use of two special features of UK law. First, the persons responsible for running a firm – known as directors – must declare their residential address to the public registrar, Companies House. Directors are not just the board members of large firms. Every firm, no matter how small, must have at least one director. As a result, there are almost 3 million active firm directors in the UK, and around three quarters of them are shareholders of their firm. Second, housing transactions must be publically recorded by the Land Registry. By merging these two sources of data, we are able to estimate the value of each director’s home over time.
Combining this with firm accounting data, we estimate that a £1 rise in the value of the homes of a firm’s directors leads the average firm in our sample to invest 3p more and increase their total wage bill by 3p. These numbers may seem small at the level of the firm, but they have large implications for the wider economy. This is because the homes of firm directors are worth £1.5 trillion. To place this number in context, it is 80% of GDP, almost 10 times larger than annual UK business investment, and around two and a half times larger than firms’ annual wage bills. As a consequence, a 10% rise in real estate prices increases the value of directors’ homes by £150 billion. Combined with the microeconometric evidence that firms invest 3p more for every £1 increase in the value of their director’s homes, this implies that nominal business investment would rise by around £4.5 billion (0.03*150); an increase of about 2.8%. By a similar calculation, a 10% increase in real estate prices would increase the total nominal wages paid by firms by 0.8% due to the homes of firm directors.
In addition to borrowing against their directors’ houses, many firms also borrow against the buildings they operate in. Which type of real estate is the more important source of collateral? To answer this question, we use data on firms’ own commercial real estate holdings and find that a £1 rise in the value of commercial property results in the average firm investing 5p more and increasing the wage bill by 3p. At the level of an individual firm a £1 increase in such commercial property values then has a 70% larger effect on investment than directors’ houses. Strikingly, however, the value of houses owned by firm directors is around four times greater than the total value of owner-occupied commercial property. As a result, directors’ houses have a larger aggregate impact on firm behaviour.
The importance of both types of real estate to firms varies by their size. Figure 1 displays the median ratio of both types of property to total assets, for different firm-size buckets. Intuitively, for smaller firms residential real estate is more important, with the reverse true for larger firms. For firms with less than 250 employees (the UK definition of an SME) directors’ houses are the more valuable source of collateral. And it is directors of these firms that own 99% of the total value of properties held by directors. As a result, the impact of directors’ houses on firm behaviour is driven by SMEs.
Just as house prices can affect firm behaviour, the behaviour of firms can, in aggregate, affect house prices. Increased firm investment and hiring can increase local spending power, driving up the price of housing. The final impact of increased real estate prices on the economy could therefore be much larger once these feedback effects are taken into account. To capture this, we build a general equilibrium model and estimate it on UK data. We find substantial amplification with a 10% rise in house prices now causing around a 7.5% increase in firm investment through the combined effect of both real estate channels. This magnitude would be around a third smaller in the model if company directors could not borrow against their homes.
Our results show that house prices can have a significant impact on aggregate supply, in addition to aggregate demand. But could our results really just be picking up firms responding to increased consumer demand following a rise in house prices? We are able to rule out this alternative as we obtain similar results when focusing (i) on manufacturing firms, who are typically less dependent on the local economy; and (ii) firms whose directors live in a different region to the firm (or sufficiently far away), where director house prices will be less related to economic conditions where the firm is based. In the paper we also rule out a number of alternative possible explanations for our findings.
By staking their house, company directors are able to finance projects that otherwise wouldn’t come to fruition. This can enable many smaller, productive, companies to obtain crucial access to finance. This is great for smaller firms when house prices are rising, but carries risks for the economy when prices fall, with many firms simultaneously finding it harder to borrow.
With limited liability removed, this form of financing can also result in large personal costs. The next film Francis Ford Coppola made was One From The Heart. Following rising costs, and the withdrawal of $8 million in foreign investment, Mr Coppola had to turn to property again, pledging $8 million worth of his own real estate as collateral to secure a replacement bank loan. Unfortunately, this film did not enjoy the success of its predecessor, and Mr Coppola ultimately had to file for personal bankruptcy.
Saleem Bahaj works in the Bank’s Research Hub, Angus Foulis and Gabor Pinter works in the Banks Centre For Central Banking Studies Division
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Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.