Monetary Policy Transmission in the The Korean Jeonse System

Or, how wealthy landlords in Korea may soon default on hundreds of millions of dollars borrowed from their poorer tenants

A tragic recent event in Korean housing markets is that a huge landlord, owning hundreds of properties, suddenly passed away. This landlord somehow managed to borrow hundreds of millions of dollars from his tenants — many tenants were lending around 10 times their annual salary to their landlord!

So what is going on here? How could landlords, who generally are pretty wealthy, have borrowed so much from their poorer tenants? The key here is a unique institution in Korean housing markets, called the Jeonse system. I'll discuss some thoughts on the situation, based on a paper I wrote with Baiyun Jing and Seongjin Park. Here’s a link to the paper.

In Korea, there are two ways you can rent an apartment. You could do the standard thing where you pay, say, 1.2mil KRW ($1,000 USD) per month in rent. Or, you can make a huge security deposit, of like $300,000 USD, to the landlord. The deposit is returned at the end of the lease term, usually 2 years In exchange for the deposit, you pay no rent! This is called the Jeonse, or "key money", system.

So what is really going on here? If you're the tenant, you're basically choosing between paying rent, or giving a big zero-interest loan to landlords. Your opportunity cost of that loan is you could be investing those funds in something that pays you interest instead.

If you're the landlord, especially the professional landlord speculating on housing, you're basically borrowing a mortgage from your tenant! If the house costs $400k, but you borrow $300k from your security deposit, you only need $100k to buy the house. Sure, you need to give the $300k back when the tenant leaves — but you can just get a new tenant...

What determines how big Jeonse deposits are? We write down a simple theory of this: tenants trade off the foregone interest on Jeonse deposits and rent, so in market equilibrium, the two have to be equal. Suppose the interest rate is 5%, and annual rent is $10,000. Then the Chonsei size must be $200,000, since this means tenants give up (200k * 0.05 = $10k) in interest per year on Jeonse deposits, which is just equal to rent.

But what this means is that Jeonse deposit size is very sensitive to interest rates. When rates go down, the opportunity cost of Jeonse deposits is low, so Jeonse size grows massively. We see this happening in Korea for the past 20 years: interest rates, the dashed line, fell, and Jeonse deposit size, the red line, grew significantly.

Landlords are pretty happy in this situation! They buy a $400k house, taking $300k as a Jeonse deposit. As rates go down, Jeonse size goes up, say to $500k. When one deposit expires, they can "roll" it into bigger and bigger deposits!

But what goes up... must come down. Post-COVID, the Bank of Korea increased rates. Capital is now more expensive for tenants, and our theory predicts that Jeonse deposit size should then come down: here's what our fitted model predicts.

When deposit size comes down, landlords now face the unenviable situation of trying to pay back a $500k security deposit... when the next tenant will only give you $300k. Not a fun situation to be in. And if the landlord goes bust, the $500k security deposit made by the tenant — often worth years, even decades, of the tenant’s savings — is gone.

So, how does our paper help understand what's going on in Korea right now? Through the lens of our paper, it's all about monetary policy interest rates. The size of Jeonse loans is very sensitive to rates, leading landlords to lever up when rates go down and Jeonse size is big, and potentially face defaults when rates rise and Jeonse size decreases.

How might we fix this? A simple solution, of course, is just to ban Jeonse deposits. But these were for long periods of time more popular than rental agreements, so this may be operationally difficult.

We propose another solution in the paper: governments could tax Jeonse deposits, making all contracts "partial Jeonse". Instead of paying either $1000 a month in rent and no deposit, or $300k in deposit and no rent, tenants could for example pay $500/mon in rent with a $150k deposit. It's a half-rent, half-Jeonse system.

This maintains the ability of landlords to borrow through deposits, but decreases the size of the deposits, also making them less sensitive to interest rates, which might be beneficial for financial stability.

Again, here’s the paper. Let me know if you have any questions or comments!