Abstract
We investigate the recent financial crisis with an emphasis on the interlock among housing, mortgage, and credit markets. Following Geanakoplos (Econometric Society Monographs 2:170–205, 2003, 2010), we develop a model in which both prices of the mortgage and its collateral are simultaneously and endogenously determined. Our empirical tests confirm the model’s prediction that an adverse change in the risk free rate or the loan recovery rate can trigger the financial crisis as we observed. Finally, we discuss how the pro-cyclical leveraging practice by financial intermediaries can magnify their losses in mortgage-related assets and consequently cause significant contraction in the balance sheets of these firms.
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