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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.

Suggested Citation

  • Dilyana Dimova, 2012. "The Role of Consumer Leverage in Generating Financial Crises," Economics Series Working Papers 631, University of Oxford, Department of Economics.
  • Handle: RePEc:oxf:wpaper:631
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    File URL: http://www.economics.ox.ac.uk/materials/papers/12464/paper631.pdf
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    References listed on IDEAS

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    1. Cúrdia, Vasco & Woodford, Michael, 2016. "Credit Frictions and Optimal Monetary Policy," Journal of Monetary Economics, Elsevier, vol. 84(C), pages 30-65.
    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. 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.
    4. Naohisa Hirakata & Nao Sudo & Kozo Ueda, 2017. "Chained Credit Contracts And Financial Accelerators," Economic Inquiry, Western Economic Association International, vol. 55(1), pages 565-579, January.
    5. Aoki, Kosuke & Proudman, James & Vlieghe, Gertjan, 2004. "House prices, consumption, and monetary policy: a financial accelerator approach," Journal of Financial Intermediation, Elsevier, vol. 13(4), pages 414-435, October.
    6. N/A, 2009. "On the Recession," Local Economy, London South Bank University, vol. 24(3), pages 253-253, May.
    7. Luci Ellis, 2010. "The Housing Meltdown: Why Did It Happen in the United States?," International Real Estate Review, Asian Real Estate Society, vol. 13(3), pages 351-394.
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    Blog mentions

    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 09:24:20

    More about this item

    Keywords

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

    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

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