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The Role of Consumer Leverage in Generating Financial Crises

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  • Dilyana Dimova

Abstract

Consumer leverage can generate financial crises characterized by increased bankruptcy, tightened credit access and reduced demand for goods.� This paper embeds financial frictions in the mortgage contracts of homeowners within a two-sector economy to show that even at moderate initial levels, household indebtedness can create a lasting financial downturn such as the subprime mortgage crisis.� Using two seemingly positive disturbances that triggered the subprime mortgage crisis - an increased housing supply and a relaxation of borrowing conditions - the model demonstrated that the subprime downturn was not a precedent but the natural consequence of financial frictions.� The oversupply of houses lowers asset prices and reduces the value of the real estate collateral used in the mortgage.� This worsens the leverage of indebted consumers and raised their bankruptcy prospects generating a pro-cyclical risk premium.� A relaxation of borrowing conditions turns credit-constrained households into a potential source of disturbances themselves when market optimism allows them to overleverage with little downpayment.� In both cases, the resulting excessive consumer leverage impairs household credit access for a lengthy after-shock period and diverts resources from their consumption.� Their reduced demand for goods may propagate the downturn to the rest of the economy depressing output in other sectors.� Adding credit constraints in the financial sector that provides housing mortgages deepens the negative impact of the shocks and makes recovery even more protracted.

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Bibliographic Info

Paper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number 631.

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Date of creation: 28 Nov 2012
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Handle: RePEc:oxf:wpaper:631

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Keywords: Financial frictions; consumer leverage; credit-constrained consumers; subprime mortgage crisis; pro-cyclical risk-premium;

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  1. Vasco Cúrdia & Michael Woodford, 2009. "Credit frictions and optimal monetary policy," BIS Working Papers 278, Bank for International Settlements.
  2. Duca, John V. & Muellbauer, John & Murphy, Anthony, 2010. "Housing markets and the financial crisis of 2007-2009: Lessons for the future," Journal of Financial Stability, Elsevier, vol. 6(4), pages 203-217, December.
  3. Naohisa Hirakata & Nao Sudo & Kozo Ueda, 2009. "Chained Credit Contracts and Financial Accelerators," IMES Discussion Paper Series 09-E-30, Institute for Monetary and Economic Studies, Bank of Japan.
  4. Luci Ellis, 2008. "The housing meltdown: Why did it happen in the United States?," BIS Working Papers 259, Bank for International Settlements.
  5. Kosuke Aoki & James Proudman & Gertjan Vlieghe, 2002. "House prices, consumption, and monetary policy: a financial accelerator approach," Bank of England working papers 169, Bank of England.
  6. Ronald Jean Degen, 2009. "Moral hazard and the financial crisis of 2007-9: An Explanation for why the subprime mortgage defaults and the housing market collapse produced a financial crisis that was more severe than any previou," Working Papers 46, globADVANTAGE, Polytechnic Institute of Leiria.
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As found by EconAcademics.org, the blog aggregator for Economics research:
  1. The Role of Consumer Leverage in Generating Financial Crises
    by Christian Zimmermann in NEP-DGE blog on 2013-02-11 03:24:20

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