Natural expectations and home equity extraction

Abstract

In this paper we propose a novel explanation for the increase in households’ leverage during the U.S. housing boom in the early 2000s. Specifically, we apply the theory of natural expectations, proposed by Fuster et al. (2010), to show that biased expectations on the two sides of the credit market have been a key determinant of the surge in households’ leverage but also that inaccurate long-run expectations on behalf of financial intermediaries are a necessary - yet so far overlooked - ingredient for matching the observed debt dynamics.