Credit Chains and Mortgage Crises

• Published date: 01 May 2015
• Author: Paula Lourdes Hernandez‐Verme
• Date: 01 May 2015
• DOI: http://doi.org/10.1111/rode.12141

Credit Chains and Mortgage Crises

Paula Lourdes Hernandez-Verme*

Abstract

Here I examine a production economy with a financial sector that contains multiple layers of credit. The

latter constitute credit chains that include a simple mortgage market. The focus is on the nature and conta-

gion properties of credit chains in an economy where the financial sector plays a real allocating role, and

agents have a serious choice of whether to default on mortgages or not. Multiple equilibria with different

rates of default are observed, due to the presence of strategic complementarities. A liquidity crunch is asso-

ciated with higher rates of default that can trigger a financial crisis as well as constrain the purchase of pro-

duction factors, leading to reductions in welfare, together with potentially serious effects on real economic

activity with the potential of causing deep and widespread recessions.

1. Introduction

In this paper, I build a dynamic stochastic general equilibrium model of credit chains

in a closed-economy payments system that shares the spirit of Freeman (1996, 2002),

Hernandez-Verme (2005), and Freeman and Hernandez-Verme (2013). My purpose

is to illustrate the presence and functioning of credit chains in the overall structure of

a financial system where spatial separation is nontrivial. The following innovations in

my model are of the utmost importance: the presence of a simple mortgage market;

the presence of a strategic group of banks who are local monopolies in offering depos-

its and mortgage loans; the double role of the lending sector, which is also the produc-

tive sector in this economy; the presence of a shock that sizes down (or up) the value

of the real state at the time when the mortgages are being repaid, leading to a non-

trivial choice of whether to default on mortgages or not.

My main underlying hypothesis is that, even in the absence of a housing bubble, the

structure of the financial system itself makes it vulnerable to default, systemic risk and

downturns in economic activity. Moreover, the analysis of welfare in equilibrium will

be shown to defy conventional wisdom in terms of who wins and who loses as a result

of a crisis caused by a liquidity crunch in this economy.

I now list what I believe are the contributions of this paper with respect to the pre-

vious literature. In the first place, there is a shock that alters the resources available to

borrowers.1Second, borrowers then choose whether to default or not.2I also intro-

duce a role for market power among the banks, which are members of the payment

system. I also include private banks, which are local monopolies and offer both

deposit and mortgage contracts. The latter leads to the introduction of a very simple

mortgage market in a model of the payment system,3which allows me to explore the

linkages between production possibilities and default on debt from a somewhat differ-

ent perspective. I must mention as well the presence of strategic complementarities

that may lead to the presence of multiple equilibria.

* Hernandez-Verme: Departamento de Economía y Finanzas, Universidad de Guanajuato, Guanajuato,

Mexico. E-mail: paulaherver@gmail.com.

Review of Development Economics, 19(2), 265–281, 2015

DOI:10.1111/rode.12141

© 2015 John Wiley & Sons Ltd

In this model economy, default reduces the resources available to purchase labor,

subsequently reducing output, leading to contagion and potentially severe and deep

recessions. There is always a positive rate of default in equilibrium, whether it is

unique or not. Moreover, universal default and universal repayment cannot obtain in

equilibrium owing to the nature of the shock that continuously hits this economy and

the signaling to lenders by borrowers, respectively. The equilibrium interest rates on

deposits, IOUs and loans display the potential for the existence of two equilibria: one

with a low rate of default and the other with a high rate of default. The presence of

strategic complementarities seems to suggest that one useful criterion for equilibrium

selection is to induce the appropriate belief in the participating agents.4I must also

point out that, against standard intuition, the bank obtains positive profits only when

the equilibrium rates of default are sufficiently high; my interpretation of this result is

that banks are great risk-takers in equilibrium.

2. The Environment

Consider a model closed economy consisting of one central settlement location

(island) and an even number I>2 triplets of outer islands, indexed by i=1,2,...,I.

Time is discrete and indexed by t= 1, 2, . . ., and so on. Each date is divided in two

parts (morning and afternoon) and transactions take place subsequently within each

of them. I assume that all residents of the outer islands must travel to the central

island in the morning of their old age.

All strategic agents are two-period lived overlapping generations with a constant

population. A group of strategic agents lives on each of the islands of the outer triplet

i: a continuum of lenders with unit mass lives on the first island, a continuum of bor-

rowers with a unit mass lives on the second island, and a single monopolistic bank

lives on the third island. The monetary authority resides on the central island, the

only place where contracts can be enforced. It issues a single outside fiat currency

(dollars) and plays the role of the central clearing and settlement institution of private

debt. The initial stocks of outside assets (real estate, fiat money and capital) are dis-

tributed proportionally among the generation of initial old at t=0.

Before proceeding any further I must clarify that “. . . to get money into a model

something must inhibit the operation of markets. Moreover, if terminal conditions are

to be avoided, time must be infinite” (Townsend 1980, p. 265). In addition to the trade

restrictions inherent to models with overlapping generations, I introduce spatial sepa-

ration, meaning that agents are allocated in distinct markets or islands and that

markets must clear on each island in every time period. As a result, there is no central

market or exchange system (other than the clearing and settlement of private debt on

the central island), and I can motivate agents accepting voluntarily both fiat (outside)

money and private credit (inside money). The main underlying friction in this

economy is a variation of the standard absence of double coincidence of wants, which

motivates agents to finance consumption with credit and want to use fiat money both

as a medium of exchange and a standard of deferred payments.

The Lenders

Young lenders born on triplet iat tare ex ante identical and endowed with x>0 units

of an island-specific good that can be sold for pt

idollars per unit and with a nontrans-

ferable technology by which they can transform each unit of the good invested at t

266 Paula Lourdes Hernandez-Verme

© 2015 John Wiley & Sons Ltd