Correlated Leverage and its Ramifications

Abstract

This paper develops a theory in which housing prices, the capital structures of banks that make mortgage loans and the capital structures of borrowers who take these loans are all endogenously determined in equilibrium. There are four main results. First, leverage is a phenomenon in that high leverage among borrowers is positively correlated with high leverage among banks. Both borrower and bank leverage are higher when house prices are higher. 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, inducing banks to be more highly levered. Second, higher bank leverage leads to greater volatility of house prices 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 predictions. 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.