TY - JOUR
T1 - Correlated leverage and its ramifications
AU - Goel, Anand M.
AU - Song, Fenghua
AU - Thakor, Anjan V.
N1 - Funding Information:
For their helpful comments, we thank anonymous referees, Viral Acharya (the editor), Sudipto Bhattacharya, Ulf von Lilienfield-Toal, Robert Marquez (discussant), Robert McDonald (discussant), Darius Palia, Matt Pritsker (discussant), Peter Raupach (discussant), S. Viswanathan (discussant), and participants at the Banco de Portugal Conference on FinancialIntermediation (June 2009), the NBER Summer Institute (July 2009), the Deutsche Bundesbank/Imperial College Conference on the Future of Banking Regulation (September 2009), the Financial Intermediation Research Society (FIRS) conference (June 2010), the CAREFIN/Bocconi Banking Conference on Matching Stability and Performance (September 2010), the NY Fed/NYU Stern Conference on Financial Intermediation (November 2010), the American Economic Association (AEA) conference (January 2011), the Western Finance Association (WFA) conference (June 2011), and seminars at Washington University in St. Louis, Federal Reserve Bank of New York, Federal Reserve Bank of San Francisco, Federal Reserve Bank of Chicago, Imperial College London, and Georgia Institute of Technology. Song acknowledges financial support from Smeal College of Business at Pennsylvania State University , and the hospitality of Singapore Management University where part of this work was done.
Publisher Copyright:
© 2014 Elsevier Inc.
PY - 2014/10/1
Y1 - 2014/10/1
N2 - This paper develops a theory in which housing prices, the capital structures of banks (mortgage lenders) and the capital structures of mortgage borrowers are all endogenously determined in equilibrium. There are four main results. First, leverage is a "positively correlated" phenomenon in that high leverage among borrowers is positively correlated with high leverage among banks, and higher house prices lead to higher leverage for both. The intuition is that first-time homebuyers with fixed wealth endowments must borrow more to buy more expensive homes, whereas higher current house prices rationally imply higher expected future house prices and therefore higher collateral values on bank loans, inducing banks to be more highly levered. Second, higher bank leverage leads to greater house price volatility in response to shocks to fundamental house values. Third, a bank's exposure to credit risk depends not only on its own leverage but also on the leverage decisions of other banks. Fourth, positive fundamental shocks to house prices dilute financial intermediation by reducing banks' pre-lending screening, and this reduction in bank screening further increases house prices. Empirical and policy implications of the analysis are drawn out, and empirical evidence is provided for the first two main results. The key policy implications are that greater geographic diversification by banks, tying mortgage tax exemptions to the duration of home ownership, and increasing bank capital requirements when borrower leverage is high can help reduce house price volatility.
AB - This paper develops a theory in which housing prices, the capital structures of banks (mortgage lenders) and the capital structures of mortgage borrowers are all endogenously determined in equilibrium. There are four main results. First, leverage is a "positively correlated" phenomenon in that high leverage among borrowers is positively correlated with high leverage among banks, and higher house prices lead to higher leverage for both. The intuition is that first-time homebuyers with fixed wealth endowments must borrow more to buy more expensive homes, whereas higher current house prices rationally imply higher expected future house prices and therefore higher collateral values on bank loans, inducing banks to be more highly levered. Second, higher bank leverage leads to greater house price volatility in response to shocks to fundamental house values. Third, a bank's exposure to credit risk depends not only on its own leverage but also on the leverage decisions of other banks. Fourth, positive fundamental shocks to house prices dilute financial intermediation by reducing banks' pre-lending screening, and this reduction in bank screening further increases house prices. Empirical and policy implications of the analysis are drawn out, and empirical evidence is provided for the first two main results. The key policy implications are that greater geographic diversification by banks, tying mortgage tax exemptions to the duration of home ownership, and increasing bank capital requirements when borrower leverage is high can help reduce house price volatility.
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U2 - 10.1016/j.jfi.2014.08.002
DO - 10.1016/j.jfi.2014.08.002
M3 - Article
AN - SCOPUS:84911491443
VL - 23
SP - 471
EP - 503
JO - Journal of Financial Intermediation
JF - Journal of Financial Intermediation
SN - 1042-9573
IS - 4
ER -