The Role of Consumer Leverage in Generating Financial Crises
AbstractConsumer 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 InfoPaper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number 631.
Date of creation: 28 Nov 2012
Date of revision:
Financial frictions; consumer leverage; credit-constrained consumers; subprime mortgage crisis; pro-cyclical risk-premium;
Find related papers by JEL classification:
- E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
- E27 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Forecasting and Simulation: Models and Applications
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2013-02-03 (All new papers)
- NEP-DGE-2013-02-03 (Dynamic General Equilibrium)
- NEP-MAC-2013-02-03 (Macroeconomics)
- NEP-URE-2013-02-03 (Urban & Real Estate Economics)
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Blog mentionsAs found by EconAcademics.org, the blog aggregator for Economics research:
- 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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