The Role of Consumer Leverage in Financial Crises

Consumer leverage can contribute to nancial crises such as the subprime mortgage crisis characterized by increased bankruptcy prospects and tightened credit access. This paper embeds nancial frictions in the mortgage contracts of home-buyers within a two-sector economy to show that although households are not production agents and may not start as highly leveraged as nancial institutions, their worsening debt levels can generate a lasting nancial downturn. Using two seemingly positive disturbances that contributed to the subprime mortgage crisis increased housing supply and relaxed borrowing conditions the model demonstrates that the subprime downturn was not a precedent but the natural consequence of nancial frictions. The surplus of available housing leads to lower asset prices that in turn reduce the value of the mortgaged houses relative to the loan held. This worsens the leverage of indebted consumers and raises their bankruptcy prospects. A relaxation of borrowing conditions turns credit-constrained households into a potential source of disturbance themselves when market optimism allows them to increase their indebtedness with relatively little downpayment. In both cases, the increased debt, along with higher repayment rates due to the larger default likelihood, impairs household access to credit and plunges mortgage-holders into a lasting recession. Adding credit constraints to the nancial sector that provides housing mortgages creates opportunities for risk sharing where banks shift some of the downturn onto indebted consumers in order to hasten their own recovery. This consequence is especially evident in the case of relaxed credit access for banks. Financial institutions repair their debt position relatively fast at the expense of consumers whose borrowing ability is squeezed for a long period despite the fact that they are not the source of this disturbance. The outcome mirrors the recent subprime mortgage crisis characterized by a sharp but brief decline for banks and a protracted recovery for mortgaged households. JEL Classi cation: E21, E27, E44, G21, G33