Correlated Leverage and Its Ramifications

51 Pages Posted: 5 Aug 2014 Last revised: 30 Oct 2014

See all articles by Anand M. Goel

Anand M. Goel

Stevens Institute of Technology

Fenghua Song

Pennsylvania State University - Smeal College of Business

Anjan V. Thakor

Washington University, Saint Louis - John M. Olin School of Business; European Corporate Governance Institute (ECGI)

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Date Written: August 4, 2014


This paper develops a theory in which housing prices, the capital structures of banks (mortgage lenders) and the capital structures of mortgage borrowers are all endogenously determined in equilibrium. There are four main results. First, leverage is a "positively correlated" phenomenon in that high leverage among borrowers is positively correlated with high leverage among banks, and higher house prices lead to higher leverage for both. The intuition is that first-time home-buyers with fixed wealth endowments must borrow more to buy more expensive homes, whereas higher current house prices rationally imply higher expected future house prices and therefore higher collateral values on bank loans, inducing banks to be more highly levered. Second, higher bank leverage leads to greater house price volatility in response to shocks to fundamental house values. Third, a bank's exposure to credit risk depends not only on its own leverage but also on the leverage decisions of other banks. Fourth, positive fundamental shocks to house prices dilute financial intermediation by reducing banks' pre-lending screening, and this reduction in bank screening further increases house prices. Empirical and policy implications of the analysis are drawn out, and empirical evidence is provided for the first two main results. The key policy implications are that greater geographic diversification by banks, tying mortgage tax exemptions to the duration of home ownership, and increasing bank capital requirements when borrower leverage is high can help reduce house price volatility.

Keywords: leverage, high house prices, financial fragility, bank capital

JEL Classification: D11, D12, E50, G21

Suggested Citation

Goel, Anand Mohan and Song, Fenghua and Thakor, Anjan V., Correlated Leverage and Its Ramifications (August 4, 2014). Journal of Financial Intermediation, Forthcoming. Available at SSRN: or

Anand Mohan Goel

Stevens Institute of Technology ( email )

Hoboken, NJ 07030
United States


Fenghua Song

Pennsylvania State University - Smeal College of Business ( email )

University Park, PA 16802
United States
814.863.4905 (Phone)


Anjan V. Thakor (Contact Author)

Washington University, Saint Louis - John M. Olin School of Business ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

European Corporate Governance Institute (ECGI) ( email )

B-1050 Brussels

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