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Board of Governors of the Federal Reserve System (US)
Finance and Economics Discussion Series
Risky Mortgages, Bank Leverage and Credit Policy
Francesco Ferrante
Abstract

Two key channels that allowed the 2007-2009 mortgage crisis to severely impact the real economy were: a housing net worth channel, as defined by Mian and Sufi (2014), which affected the wealth of leveraged households; and a bank net worth channel, which reduced the ability of financial intermediaries to provide credit. To capture these features of the Great Recession, I develop a DSGE model with balance-sheet constrained banks financing both risky mortgages and productive capital. Mortgages are provided to agents facing idiosyncratic housing depreciation risk, implying an endogenous default decision and a link between their borrowing capacity and house prices. The interaction among the housing net worth channel, the bank net worth channel and endogenous foreclosures generates novel amplification mechanisms. I analyze the quantitative implications of these new channels by considering two different shocks linked to the supply of mortgage credit: an increase in the variance of housing risk and a deterioration in the collateral value of mortgages for bank funding. Both shocks are able to produce co-movements in house prices, business investment, consumption and output. Finally, I study two types of policy interventions that are able to reduce the severity of a mortgage crisis: debt relief for borrowing households and central bank credit intermediation.


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Francesco Ferrante, Risky Mortgages, Bank Leverage and Credit Policy, Board of Governors of the Federal Reserve System (US), Finance and Economics Discussion Series 2015-110, 18 Dec 2015.
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Keywords: Bank runs; deposit insurance; large depositors
DOI: 10.17016/FEDS.2015.110
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