Macroeconomic Consequences of Bank’s Assets Reallocation After Mortgage Defaults

This paper proposes a DSGE model which uses Bayesian estimations to assess an economy under the strain of borrower’s default on its obligation to intermediary agents, similar to the climate of the Great Recession. The paper finds that the treasury bond market plays an important role in such economy: the default increases the spread between the return of mortgages and deposits, as a result banks prefer to compensate their losses by making profit in the mortgage market and in turn, decreasing their treasury bond holdings. These changes transfer the shock to the real side of the economy through housing, credit, deposit and government loan channels and thereby instigate a business cycle. The model proposed in this paper accurately portrays the behaviour of key economic variables before the Great Recession; in particular housing prices, mortgages, deposits and treasury bond holdings by banks. Significantly, this model illustrates the home price downward spiral which succeeded the recession. The paper demonstrates that the specification of the credit constraint relying on house price expectations as well as frictions in housing and capital investments, which can give rise to the Paradox of Thrift, are the major delay factors in recovery. In addition, the findings argue that macroprudential policies help mitigate financial risks and reduce common exposures across markets. Such policies, however, may be inadequate for the post-crisis restoration of the economy.