The Role of Consumer Leverage in Generating Financial Crises
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.
|Date of creation:||28 Nov 2012|
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