Correlated Leverage and Its Ramifications

51 Pages Posted: 5 Aug 2014 Last revised: 30 Oct 2014

See all articles by Anand M. Goel

Anand M. Goel

Stevens Institute of Technology

Fenghua Song

Pennsylvania State University - Smeal College of Business

Anjan V. Thakor

Washington University in St. Louis - John M. Olin Business School; Financial Theory Group; European Corporate Governance Institute (ECGI); Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering

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Date Written: August 4, 2014

Abstract

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 home-buyers 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.

Keywords: leverage, high house prices, financial fragility, bank capital

JEL Classification: D11, D12, E50, G21

Suggested Citation

Goel, Anand Mohan and Song, Fenghua and Thakor, Anjan V., Correlated Leverage and Its Ramifications (August 4, 2014). Journal of Financial Intermediation, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2357486 or http://dx.doi.org/10.2139/ssrn.2357486

Anand Mohan Goel

Stevens Institute of Technology ( email )

Hoboken, NJ 07030
United States

HOME PAGE: http://www.anandgoel.org

Fenghua Song

Pennsylvania State University - Smeal College of Business ( email )

University Park, PA 16802
United States
814.863.4905 (Phone)

HOME PAGE: http://sites.google.com/site/fenghua8song/

Anjan V. Thakor (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

Financial Theory Group ( email )

United States

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering ( email )

100 Main Street, E62-618
Cambridge, MA 02142
United States

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