Financial Intermediation, Credit Risk, and Credit Supply During the Housing Boom

Abstract

This paper uses a dynamic model of borrowers, savers, and banks to understand the behavior of house prices, mortgage credit and interest rates during the housing boom. Banks lend long-term defaultable mortgages to borrowers and raise funds by issuing equity and deposits to savers. Securitization allows banks to sell loans directly to savers after origination. The model is calibrated to different stages of mortgage finance. The conclusion is that, in addition to laxer borrowing constraints, an increased willingness to supply credit by lenders is needed to jointly explain the dynamics of interest rates, mortgage spreads, and mortgage debt during the boom-bust cycle. The two quantitatively most powerful causes of the boom in the model are (i) reduced intermediation frictions due to securitization and (ii) underestimation of the true credit riskiness by lenders.

Keywords: housing boom, mortgages, credit risk, financial intermediation

JEL Classification: E44, G21