Collateral, Credit-History and the Financial Decelerator

Abstract

We construct a simple general equilibrium model in which agents borrow to purchase housing and secure their loans with this long-lived asset. As the housing price falls defaulting becomes a weaker signal of (poor) credit quality, since wealthier agents are forced to default. If housing prices fall sufficiently, some agents may find it in their interest to strategically default - that is, even if they actually have the funds to repay their loan.

We use the model to demonstrate that financial imperfections may sometimes stabilize real fluctuations, rather than aggravating them as suggested by much of the recent literature; we term this a financial decelerator. This occurs because strategic default leaves an agent with more income, which can be applied to purchasing housing, thereby mitigating the decline in its price.

JEL Classification: D52, E44, G12, G21, G33