December 10, 2014
Mortgage Leverage and Bubbles
Albert Alex Zevelev has posted Regulating Mortgage Leverage: Fire Sales, Foreclosure Spirals and Pecuniary Externalities to SSRN. The abstract reads,
The US housing boom was accompanied by a rise in mortgage leverage. The subsequent bust was accompanied by a rise in foreclosure. This paper introduces a dynamic general equilibrium model to study how leverage and foreclosure affect house prices. The model shows how foreclosure sales, through their effect on housing supply, amplify and propagate house price drops. A calibration to match the bust shows consumption and housing need to be sufficiently complementary to fit the data. Since leverage plays a key role in foreclosure, a regulator can reduce systemic risk by placing a cap on leverage. Counterfactual experiments show that in a world with less leverage, the same economic shock leads to less foreclosure and less severe, shorter busts in house prices. A 90% cap on loan-to-value ratios in 2006 predicts house prices would have fallen 12% rather than 18% as in the data. The regulator faces a trade-off in that less leverage means less housing for constrained households, but also fewer foreclosures and less severe busts in house prices. A regulator with reasonable preference parameters would choose a cap of 95%.
This is pretty important stuff as it attempts to model the impact of different LTV ratios on prices and foreclosure rates. Now Zevelev is not the first to see these interactions, but it is important to model how consumer finance regulation (for instance, loan to value ratios) can impact systemic risk. This is particularly important because many commentators downplay that relationship.
I am not in a position to evaluate the model in this paper, but its conclusion is certainly right: “Leverage makes our economy fragile by increasing the risk of default. It is clear that
foreclosure has many externalities and they are quantitatively significant. Since borrowers
and lenders do not fully internalize these externalities, there is a case for regulating mortgage leverage.” (31)