Regulating Mortgage Leverage: Fire Sales, Foreclosure Spirals, and Pecuniary Externalities

Abstract

This paper introduces a dynamic general equilibrium model to study how the distribution of leverage and foreclosure affect house prices. In the model, exogenous income shocks drive endogenous foreclosure and equilibrium house prices. The model shows how foreclosure sales, through their effect on housing supply, amplify and propagate house price drops. A calibration 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.